While ascertaining profit, revenue losses are differentiated from capital losses, just as revenue
profits are distinguished from capital profits. Revenue losses arise from the normal course of
business by selling the merchantable at a price less than its purchase price or cost of goods sold
or where there is a declining in the current value of inventories. Capital losses may result from
the sale of assets, other than inventory for less than written down value or the diminution or
elimination of assets other than as the result of use or sale (flood, fire, etc.) or in connection
with raising capital of the business (issue of shares at a discount) or on the settlement of iabilities
for a consideration more than its book value (debenture issued at par but redeemed at a premium).
Treatment of capital losses are same as that of capital profits. Capital losses arising out
of sale of fixed assets generally appear in the Profit and Loss Account (being deducted from
the net profit). But other capital losses are adjusted against the credit balance of capital profits.
Where the capital losses are substantial, the treatment is different. These losses are generally
shown on the balance sheet as fictitious assets and the common practice is to spread that over
a number of accounting years as a charge against revenue profits till the amount is fully exhausted.
Monday 30 May 2011
Capital and Revenue Profits
While ascertaining the trading profit of a business for a particular period, a proper distinction
is to be made between capital and revenue profits. If profit arises out of an ordinary nature,
being the outcome of the ordinary function and object of the business, it is termed as ‘revenue
profit’. But, when a profit arises out of a casual and non-recurring transaction, it is termed as
capital profit. Revenue profit arises out of the sale of the merchandise that the business deals
in.
Generally, capital profits arise out of the sale of assets other than inventory at a price more than
its book value or in connection with the raising of capital or at the time of purchasing an
existing business. For example, if an asset, whose book value is Rs 5,000 on the date of sale, is
sold for Rs 6,000—Rs 1,000 will be considered as capital profit. Likewise, issue of shares at a
premium is also a capital profit. Revenue profits are distributed to the owners of the business
or transferred to General Reserve Account, being shown in the balance sheet as a retained
earning. Capital profits are generally capitalised-transferred to a capital reserve account which
can only be utilised for setting off capital losses in future. Capital profits of a small amount
(arising out of selling of one asset) is taken to the Profit and Loss Account and added with the
revenue profit-applying the concept of materiality.
is to be made between capital and revenue profits. If profit arises out of an ordinary nature,
being the outcome of the ordinary function and object of the business, it is termed as ‘revenue
profit’. But, when a profit arises out of a casual and non-recurring transaction, it is termed as
capital profit. Revenue profit arises out of the sale of the merchandise that the business deals
in.
Generally, capital profits arise out of the sale of assets other than inventory at a price more than
its book value or in connection with the raising of capital or at the time of purchasing an
existing business. For example, if an asset, whose book value is Rs 5,000 on the date of sale, is
sold for Rs 6,000—Rs 1,000 will be considered as capital profit. Likewise, issue of shares at a
premium is also a capital profit. Revenue profits are distributed to the owners of the business
or transferred to General Reserve Account, being shown in the balance sheet as a retained
earning. Capital profits are generally capitalised-transferred to a capital reserve account which
can only be utilised for setting off capital losses in future. Capital profits of a small amount
(arising out of selling of one asset) is taken to the Profit and Loss Account and added with the
revenue profit-applying the concept of materiality.
Capital and Revenue Receipts
A receipt of money may be of a capital or revenue nature. A clear distinction, therefore,
should be made between Capital receipts and revenue receipts.
A receipt of money is considered as capital receipt when a contribution is made by the proprietor
towards the capital of the business or a contribution of capital to the business by someone
outside the business. Capital receipts do not have any effect on the profits earned or losses
incurred during the course of a year. Capital receipts can take one or more of the following
forms:
Additional capital introduced by the proprietor; by partners, in case of partnership firm, by
issuing fresh shares, in case of a company; and, by selling assets, previously not intended for
resale.
A receipt of money is considered as revenue receipt when it is received from customers for
goods supplied or fees received for services rendered in the ordinary course of business, which
is a result of the firm’s activity in the current period. Receipts of money in the revenue nature
increase the profits or decrease the losses of a business and must be set against the revenue
expenses in order to ascertain the profit for the period.
The following are the points of distinction between capital receipts and revenue receipts
should be made between Capital receipts and revenue receipts.
A receipt of money is considered as capital receipt when a contribution is made by the proprietor
towards the capital of the business or a contribution of capital to the business by someone
outside the business. Capital receipts do not have any effect on the profits earned or losses
incurred during the course of a year. Capital receipts can take one or more of the following
forms:
Additional capital introduced by the proprietor; by partners, in case of partnership firm, by
issuing fresh shares, in case of a company; and, by selling assets, previously not intended for
resale.
A receipt of money is considered as revenue receipt when it is received from customers for
goods supplied or fees received for services rendered in the ordinary course of business, which
is a result of the firm’s activity in the current period. Receipts of money in the revenue nature
increase the profits or decrease the losses of a business and must be set against the revenue
expenses in order to ascertain the profit for the period.
The following are the points of distinction between capital receipts and revenue receipts
| Capital Receipts | Revenue Receipts |
| 1. Capital receipts are not available for distri bution as profits | 1. Revenue receipts are available for distri distribution as profits only after deducting revenue expenses. |
| 2. Capital receipts cannot be utilised for creating a reserve fund. | 2. Revenue receipts can be utilised for creating a reserve fund after deducting revenue expenses. |
| 3. A business can survive without any accounting period. | 3. The survival of a business mainly de capital receipts during an pends on the revenue receipts during an accounting period. |
| 4. Capital receipts are the sources for creating capital reserves. | 4. Revenue receipts are the sources for creating revenue reserves. |
Deferred Revenue Expenditures
Deferred revenue expenditures represent certain types of assets whose usefulness does not
expire in the year of their occurrence but generally expires in the near future. These types of
expenditures are carried forward and are written off in future accounting periods. Sometimes,
we make some revenue expenditure but it eventually becomes a capital asset (generally of an
intangible nature). If one undertake substantial repairs to the existing building, the deterioration
of the premises may be avoided. We may employ our own employees to do that work and
pay them at prevailing wage-rate, which is of a revenue nature. If this expenditure is treated as
a revenue expenditure and the current year’s-profit is charged with these expenses, we should
be making the current year absorb the entire expenses, the benefit of which will be enjoyed for
a number of accounting years. To overcome this difficulty, the entire expenditure is capitalised
and is added to the asset account. Another example is an insurance policy. A business can pay
insurance premium in advance, say, for a 3 year period. The right does not expire in the accounting
period in which it is paid but will expire within a fairly short period of time (3 years).
Only a portion of the total premium paid should be treated as a revenue expenditure (portion
pertaining to the current period) and the balance should be carried forward as an asset to be
written off in subsequent years.
expire in the year of their occurrence but generally expires in the near future. These types of
expenditures are carried forward and are written off in future accounting periods. Sometimes,
we make some revenue expenditure but it eventually becomes a capital asset (generally of an
intangible nature). If one undertake substantial repairs to the existing building, the deterioration
of the premises may be avoided. We may employ our own employees to do that work and
pay them at prevailing wage-rate, which is of a revenue nature. If this expenditure is treated as
a revenue expenditure and the current year’s-profit is charged with these expenses, we should
be making the current year absorb the entire expenses, the benefit of which will be enjoyed for
a number of accounting years. To overcome this difficulty, the entire expenditure is capitalised
and is added to the asset account. Another example is an insurance policy. A business can pay
insurance premium in advance, say, for a 3 year period. The right does not expire in the accounting
period in which it is paid but will expire within a fairly short period of time (3 years).
Only a portion of the total premium paid should be treated as a revenue expenditure (portion
pertaining to the current period) and the balance should be carried forward as an asset to be
written off in subsequent years.
Replacement of Fixed Assets
The above rules of capital and revenue expenditure do not hold good when an existing asset is
replaced for another. If an asset is replaced with a similar kind of asset, the expenditure incurred
is treated as Revenue Expenditure. For example, if a set of weighing machines in a shop
becomes defective and is replaced with a similar set, the cost of replacement should be treated
as revenue expenditure and it should be charged to the Profit and Loss Account. However, if
an asset is replaced with an asset which is superior than the previous one, the expense is partly
capital and partly revenue. For example, if a manual typewriter costing Rs 5,000 is replaced
with an electronic typewriter costing Rs 15,000, then Rs 5,000 will be revenue expenditure and
the excess value of the new typewriter over the old one, Rs 10,000 will be capital expenditure.
replaced for another. If an asset is replaced with a similar kind of asset, the expenditure incurred
is treated as Revenue Expenditure. For example, if a set of weighing machines in a shop
becomes defective and is replaced with a similar set, the cost of replacement should be treated
as revenue expenditure and it should be charged to the Profit and Loss Account. However, if
an asset is replaced with an asset which is superior than the previous one, the expense is partly
capital and partly revenue. For example, if a manual typewriter costing Rs 5,000 is replaced
with an electronic typewriter costing Rs 15,000, then Rs 5,000 will be revenue expenditure and
the excess value of the new typewriter over the old one, Rs 10,000 will be capital expenditure.
Some examples of revenue expenditure
(1) Salaries and wages paid to the employees; (2) Rent and rates for the factory or office
premises; (3) Depreciation on plant and machinery; (4) Consumable stores; (5) Inventory of
raw materials, work-in-progress and finished goods; (6) Insurance premium; (7) Taxes and
legal expenses; and (8) Miscellaneous expenses.
premises; (3) Depreciation on plant and machinery; (4) Consumable stores; (5) Inventory of
raw materials, work-in-progress and finished goods; (6) Insurance premium; (7) Taxes and
legal expenses; and (8) Miscellaneous expenses.
Rules for Determining Revenue Expenditure
Any expenditure which cannot be recognised as capital expenditure can be termed as revenue
expenditure. A revenue expenditure temporarily influences only the profit earning capacity of
the business. An expenditure is recognised as revenue when it is incurred for the following
purposes:
Expenditure for day-to-day conduct of the business, the benefits of which last less than one
year. Examples are wages of workmen, interest on borrowed capital, rent, selling expenses,
and so on.
Expenditure on consumable items, on goods and services for resale either in their original or
improved form. Examples are purchases of raw materials, office stationery, and the like. At the
end of the year, there may be some revenue items (stock, stationery, etc.) still in hand. These
are generally passed over to the next year though they were acquired in the previous year.
Expenditures incurred for maintaining fixed assets in working order. For example, repairs,
renewals and depreciation.
expenditure. A revenue expenditure temporarily influences only the profit earning capacity of
the business. An expenditure is recognised as revenue when it is incurred for the following
purposes:
Expenditure for day-to-day conduct of the business, the benefits of which last less than one
year. Examples are wages of workmen, interest on borrowed capital, rent, selling expenses,
and so on.
Expenditure on consumable items, on goods and services for resale either in their original or
improved form. Examples are purchases of raw materials, office stationery, and the like. At the
end of the year, there may be some revenue items (stock, stationery, etc.) still in hand. These
are generally passed over to the next year though they were acquired in the previous year.
Expenditures incurred for maintaining fixed assets in working order. For example, repairs,
renewals and depreciation.
Some examples of capital expenditure:
(1) Purchase of land, building, machinery or furniture; (2) Cost of leasehold land and building;
(3) Cost of purchased goodwill; (4) Preliminary expenditures; (5) Cost of additions or extensions
to existing assets; (6) Cost of overhauling second-hand machines; (7) Expenditure on
putting an asset into working condition; and (8) Cost incurred for increasing the earning capacity
of a business.
(3) Cost of purchased goodwill; (4) Preliminary expenditures; (5) Cost of additions or extensions
to existing assets; (6) Cost of overhauling second-hand machines; (7) Expenditure on
putting an asset into working condition; and (8) Cost incurred for increasing the earning capacity
of a business.
Rules for Determining Capital Expenditure
An expenditure can be recognised as capital if it is incurred for the following purposes:
An expenditure incurred for the purpose of acquiring long term assets (useful life is at least
more than one accounting period) for use in business to earn profits and not meant for resale,
will be treated as a capital expenditure. For example, if a second hand motor car dealer buys a
piece of furniture with a view to use it in business; it will be a capital expenditure. But if he
buys second hand motor cars, it will be a revenue expenditure because he deals in second hand
motor cars.
When an expenditure is incurred to improve the present condition of a machine or putting an
old asset into working condition, it is recognised as a capital expenditure. The expenditure is
capitalised and added to the cost of the asset. Likewise, any expenditure incurred to put an
asset into working condition is also a capital expenditure.
For example, if one buys a machine for Rs 5,00,000 and pays Rs 20,000 as transportation charges
and Rs 40,000 as installation charges, the total cost of the machine comes upto Rs 5,60,000.
Similarly, if a building is purchased for Rs 1,00,000 and Rs 5,000 is spent on registration and
stamp duty, the capital expenditure on the building stands at Rs 1,05,000.
If an expenditure is incurred, to increase earning capacity of a business will be considered as of
capital nature. For example, expenditure incurred for shifting ‘the ‘factory for easy supply of
raw materials. Here, the cost of such shifting will be a capital expenditure.
Preliminary expenses incurred before the commencement of business is considered capital
expenditure. For example, legal charges paid for drafting the memorandum and articles of
association of a company or brokerage paid to brokers, or commission paid to underwriters for
raising capital.
Thus, one useful way of recognising an expenditure as capital is to see that the business will
own something which qualifies as an asset at the end of the accounting period.
An expenditure incurred for the purpose of acquiring long term assets (useful life is at least
more than one accounting period) for use in business to earn profits and not meant for resale,
will be treated as a capital expenditure. For example, if a second hand motor car dealer buys a
piece of furniture with a view to use it in business; it will be a capital expenditure. But if he
buys second hand motor cars, it will be a revenue expenditure because he deals in second hand
motor cars.
When an expenditure is incurred to improve the present condition of a machine or putting an
old asset into working condition, it is recognised as a capital expenditure. The expenditure is
capitalised and added to the cost of the asset. Likewise, any expenditure incurred to put an
asset into working condition is also a capital expenditure.
For example, if one buys a machine for Rs 5,00,000 and pays Rs 20,000 as transportation charges
and Rs 40,000 as installation charges, the total cost of the machine comes upto Rs 5,60,000.
Similarly, if a building is purchased for Rs 1,00,000 and Rs 5,000 is spent on registration and
stamp duty, the capital expenditure on the building stands at Rs 1,05,000.
If an expenditure is incurred, to increase earning capacity of a business will be considered as of
capital nature. For example, expenditure incurred for shifting ‘the ‘factory for easy supply of
raw materials. Here, the cost of such shifting will be a capital expenditure.
Preliminary expenses incurred before the commencement of business is considered capital
expenditure. For example, legal charges paid for drafting the memorandum and articles of
association of a company or brokerage paid to brokers, or commission paid to underwriters for
raising capital.
Thus, one useful way of recognising an expenditure as capital is to see that the business will
own something which qualifies as an asset at the end of the accounting period.
The accounting treatment of capital and revenue expenditure are as under:
Revenue expenditures are charged as an expense against profit in the year they are incurred or
recognised. Capital expenditures are capitalised-added to an asset account.
The following are the points of distinction between capital expenditure and revenue expenditure:
recognised. Capital expenditures are capitalised-added to an asset account.
The following are the points of distinction between capital expenditure and revenue expenditure:
| Capital Expenditure | Revenue Expenditure |
|---|---|
| 1. Capital expenditures are incurred. | 1. Revenue expenditures are incurred for more than one accounting for a particular accounting period. period. |
| 2. Capital expenditure are of | 2. Revenue expenditures are of non-recurring nature. recurring nature. |
| 3. All capital expenditures eventually | 3. Revenue expenditures are not generally become revenue expenditures. capital expenditures. |
| 4. Capital expenditures are not | 4. All revenue expenditures are matched matched with capital receipts. with revenue receipts. |
| 5. Capital expenditures are incurred | 5. Revenue expenditures are incurred before or after the commencement always after the commencement of of the business. the business. |
Capital and Revenue Expenditures
Capital expenditure is the outflow of funds to acquire an asset that will benefit the business
more than one accounting period. A capital expenditure takes place when an asset or service is
acquired or improvement of a fixed asset is effected. These assets are expected to provide
benefits to the business in more than one accounting period and are not intended for resale in
the ordinary course of business. In short, it is an expenditure on assets which is not written off
completely against income in the accounting period in which it is incurred.
Revenue expenditure is the outflow of funds to meet the running expenses of a business and it
will be of benefit for the current period only. A revenue expenditure is incurred to carry on the
normal course of business or maintain the capital assets in a good condition.
It may be pointed out here that an expenditure need not necessarily be a payment made to
somebody in cash - it may be made by cash, by the exchange of another asset, or by incurring
a liability. Expenditure incurrence and expenditure recognition are distinct phenomena. Expenditure
incurrence refers to the receipt of goods and services, whereas expenditure recognition is a
matter to be decided whether the expenditure is of capital or revenue nature, for example, the
buying of an asset is a capital expenditure but charging depreciation against profit is a revenue
expenditure, over the entire life of that asset. Most of the capital expenditures made by a business
become revenue expenditures. On the application of periodicity, accrual and matching
concepts, accountants identify all revenue expenditures for a given period for ascertaining
profit. An expenditure which cannot be identified to a particular accounting period is considered
of capital nature.
more than one accounting period. A capital expenditure takes place when an asset or service is
acquired or improvement of a fixed asset is effected. These assets are expected to provide
benefits to the business in more than one accounting period and are not intended for resale in
the ordinary course of business. In short, it is an expenditure on assets which is not written off
completely against income in the accounting period in which it is incurred.
Revenue expenditure is the outflow of funds to meet the running expenses of a business and it
will be of benefit for the current period only. A revenue expenditure is incurred to carry on the
normal course of business or maintain the capital assets in a good condition.
It may be pointed out here that an expenditure need not necessarily be a payment made to
somebody in cash - it may be made by cash, by the exchange of another asset, or by incurring
a liability. Expenditure incurrence and expenditure recognition are distinct phenomena. Expenditure
incurrence refers to the receipt of goods and services, whereas expenditure recognition is a
matter to be decided whether the expenditure is of capital or revenue nature, for example, the
buying of an asset is a capital expenditure but charging depreciation against profit is a revenue
expenditure, over the entire life of that asset. Most of the capital expenditures made by a business
become revenue expenditures. On the application of periodicity, accrual and matching
concepts, accountants identify all revenue expenditures for a given period for ascertaining
profit. An expenditure which cannot be identified to a particular accounting period is considered
of capital nature.
1.4. DISTINCTION BETWEEN CAPITAL AND REVENUE
Introduction
The concepts of capital and revenue are of fundamental importance to the correct determination
of accounting profit for a period and recognition of business assets at the end of that
period. The distinction affects the measurement of profit in a number of accounting periods.
Capital has been defined by economists as those assets which are used in the production of
goods and services for further production of assets. In accounting, on the other hand, the
capital of a business is increased by that portion of the periodic income which has not been
consumed by the owner.
The relationship between capital and revenue is that between a tree and its fruits. It is the tree
which produces the fruits, and it is the fruit that can be consumed. If the tree is tendered with
care, it will produce more fruits, conversely, if the tree is destroyed, there will be no more
fruits. Likewise, revenue comes out of capital and capital is the source of revenue. Capital is
invested by a person in the business so that it may produce revenue. Moreover, as a fruit may
give birth to another new tree, different revenues may also produce further new capital.
Capital can be brought in by a person into the business in different forms-cash or kind. When
capital is brought in the form of cash, it is spent away on various items of assets that make the
business a running concern. Capital of the firm is thus, represented by its inventory of assets.
Capital of a business can be increased in a two fold way:
1. When the owner brings in more capital to the business; and/or
2. When the owner does not consume the entire periodic income.
When the owner brings in further capital to his business, the amount is credited to the Capital
Account.
Likewise, the net income for a period is credited to the Capital Account, and if his drawings
are less than that income, the capital is increased by the difference.
The difference between the two terms ‘revenue’ and ‘receipt’ should be carefully distinguished.
A receipt is the inflow of money into business, whereas revenue is the aggregate exchange
value received for goods and services provided to the customers.
The concepts of capital and revenue are of fundamental importance to the correct determination
of accounting profit for a period and recognition of business assets at the end of that
period. The distinction affects the measurement of profit in a number of accounting periods.
Capital has been defined by economists as those assets which are used in the production of
goods and services for further production of assets. In accounting, on the other hand, the
capital of a business is increased by that portion of the periodic income which has not been
consumed by the owner.
The relationship between capital and revenue is that between a tree and its fruits. It is the tree
which produces the fruits, and it is the fruit that can be consumed. If the tree is tendered with
care, it will produce more fruits, conversely, if the tree is destroyed, there will be no more
fruits. Likewise, revenue comes out of capital and capital is the source of revenue. Capital is
invested by a person in the business so that it may produce revenue. Moreover, as a fruit may
give birth to another new tree, different revenues may also produce further new capital.
Capital can be brought in by a person into the business in different forms-cash or kind. When
capital is brought in the form of cash, it is spent away on various items of assets that make the
business a running concern. Capital of the firm is thus, represented by its inventory of assets.
Capital of a business can be increased in a two fold way:
1. When the owner brings in more capital to the business; and/or
2. When the owner does not consume the entire periodic income.
When the owner brings in further capital to his business, the amount is credited to the Capital
Account.
Likewise, the net income for a period is credited to the Capital Account, and if his drawings
are less than that income, the capital is increased by the difference.
The difference between the two terms ‘revenue’ and ‘receipt’ should be carefully distinguished.
A receipt is the inflow of money into business, whereas revenue is the aggregate exchange
value received for goods and services provided to the customers.
Valuation of Stock as on the Balance Sheet Date
1. Stocktaking should be made on the date of the close of a financial period. It should
include every item of goods of which the business is the owner. If there are any goodsin-
transit or goods with the selling agent or goods sent on approval for which the sale
is yet to be confirmed such goods should be included in stock. On the other hand, goods
sold but not yet delivered should be excluded.
Goods purchased within the accounting period and recorded in the accounts should be
included in stock. Thus physical stock in the godown of the business may not be the
actual value of stock to be included in the final accounts.
2. If stock taking is made on a date a few days before or after the date of the close of the
financial period, Purchases, Purchase Returns, Sales and Sales Return between these
two dates should be adjusted (to arrive at the value of the stock on the closing date of
the accounting period).
The sales and Sales Return should be taken at cost price or market price whichever is lower.
Notes
1. Where any sale has been made at a loss or at a profit not conforming to the normal rate
of profit, the cost price of the goods thus sold should be separately ascertained.
2. For valuation of inventory the principle of Cost Price or Net Realisable Price whichever
is lower should be applied.
3. Adjustments for undercasting /overcasting of stock, goods held for consignment basis,
etc., should also be made.
include every item of goods of which the business is the owner. If there are any goodsin-
transit or goods with the selling agent or goods sent on approval for which the sale
is yet to be confirmed such goods should be included in stock. On the other hand, goods
sold but not yet delivered should be excluded.
Goods purchased within the accounting period and recorded in the accounts should be
included in stock. Thus physical stock in the godown of the business may not be the
actual value of stock to be included in the final accounts.
2. If stock taking is made on a date a few days before or after the date of the close of the
financial period, Purchases, Purchase Returns, Sales and Sales Return between these
two dates should be adjusted (to arrive at the value of the stock on the closing date of
the accounting period).
The sales and Sales Return should be taken at cost price or market price whichever is lower.
Notes
1. Where any sale has been made at a loss or at a profit not conforming to the normal rate
of profit, the cost price of the goods thus sold should be separately ascertained.
2. For valuation of inventory the principle of Cost Price or Net Realisable Price whichever
is lower should be applied.
3. Adjustments for undercasting /overcasting of stock, goods held for consignment basis,
etc., should also be made.
Methods of Ascertaining Net Realisable Value (NRV)
For ascertaining the net realisable value of different items of stock any one of the following
methods may usually be followed :
1. Total Inventory Method : The aggregate of the total cost of all items is found out. It is
compared with the total net realisable value of such items. The lower of the two is
applied for inventory valuation.
2. Group Method : Items of same nature are grouped. The cost and NRV of each group are
separately compared and the lower amount for each group is applied for stock valuation.
3. Individual Identification Method : For each item of stock, corresponding cost and net
realisable value are compared and the lower of the two is considered for valuation of
the individual stock.
methods may usually be followed :
1. Total Inventory Method : The aggregate of the total cost of all items is found out. It is
compared with the total net realisable value of such items. The lower of the two is
applied for inventory valuation.
2. Group Method : Items of same nature are grouped. The cost and NRV of each group are
separately compared and the lower amount for each group is applied for stock valuation.
3. Individual Identification Method : For each item of stock, corresponding cost and net
realisable value are compared and the lower of the two is considered for valuation of
the individual stock.
If Inventory is Valued at a Notional Price
Notional Price is not the cost or market price. It is a price ascertained on some notional basis. It
may be—
(a) Standard Price Method: The standard price is fixed on the basis of the specific nature of
the product or service and the factors related to that. All issues during an accounting
period are charged at the Standard Price. The stock is valued as the balancing amount of
(1) costs of materials purchased or received at different rates and
(2) the value of quantities issued at standard price.
(b) Inflated Price Method : Issues are priced at an inflated rate. Such rate is calculated after
considering—
(1) addition of proportionate stock holding or carrying costs like costs of inspecting,
issuing. etc.
(2) deduction of natural or normal losses of materials, like leakage, evaporation, etc.
The cost of material issues is computed first by applying any method discussed earlier.
The adjustments [(1) and (2) as stated above] are made to find out the inflated price. The
inventory is valued by deducting the issues priced at inflated rate from the total cost of
materials purchased during a period.
It is to be noted that :
1. Inventories mean any tangible property held for sale, in the process of production for
such safe or for consumption in the production of goods or services for sale.
Maintenance supplies and consumables shall be included. But machinery spares should
be excluded.
2. Valuation of Inventories is required at the end of each accounting period for
(1) determining profit / loss during that period; and (2) for representing these as assets
in the Balance Sheet.
3. The contents of AS 2 mandatory w.e.f. 1.4.1999, should be complied with by all
enterprises for Valuation of Inventories.
4. The method of valuation should be consistent but should not be rigid.
5. In India, inventories should normally be valued at historical cost or net realisable value
whichever is lower.
6. Historical cost is the combination of : (a) Cost of Purchase; (b) Cost of Conversion and
(c) any other cost incurred in the normal course of business for bringing the inventories
up to their present location and condition.
7. Net Realisable value is the Actual or Estimated Selling Price less cost of completion
of works and cost to be incurred to complete the sale.
8. Inventories are to be classified normally in the financial statements as :
(1) Raw materials and components;
(2) Work-in-Process;
(3) Finished goods; and
(4) Stores and spares
9. Where an Inventory is carried at net realisable value, it should be disclosed in the
financial statements separately.
10. By-products should be valued at cost or Net Realisable Value, whichever is lower. But
if the cost of byproducts cannot be ascertained separately, their stock should be valued
at Net Realisable Value.
11. If there is any scope of reprocessing, the inventory of re-usable scrap should be valued
at cost (of material) less reprocessing cost. But if there is no such scope, the inventory
of re-usable scrap should be valued at Net Realisable Value.
12. Inventory of non-reusable scrap should be valued at Net Realisable Value
13. Perishable goods may be valued even below cost if conditions demand
may be—
(a) Standard Price Method: The standard price is fixed on the basis of the specific nature of
the product or service and the factors related to that. All issues during an accounting
period are charged at the Standard Price. The stock is valued as the balancing amount of
(1) costs of materials purchased or received at different rates and
(2) the value of quantities issued at standard price.
(b) Inflated Price Method : Issues are priced at an inflated rate. Such rate is calculated after
considering—
(1) addition of proportionate stock holding or carrying costs like costs of inspecting,
issuing. etc.
(2) deduction of natural or normal losses of materials, like leakage, evaporation, etc.
The cost of material issues is computed first by applying any method discussed earlier.
The adjustments [(1) and (2) as stated above] are made to find out the inflated price. The
inventory is valued by deducting the issues priced at inflated rate from the total cost of
materials purchased during a period.
It is to be noted that :
1. Inventories mean any tangible property held for sale, in the process of production for
such safe or for consumption in the production of goods or services for sale.
Maintenance supplies and consumables shall be included. But machinery spares should
be excluded.
2. Valuation of Inventories is required at the end of each accounting period for
(1) determining profit / loss during that period; and (2) for representing these as assets
in the Balance Sheet.
3. The contents of AS 2 mandatory w.e.f. 1.4.1999, should be complied with by all
enterprises for Valuation of Inventories.
4. The method of valuation should be consistent but should not be rigid.
5. In India, inventories should normally be valued at historical cost or net realisable value
whichever is lower.
6. Historical cost is the combination of : (a) Cost of Purchase; (b) Cost of Conversion and
(c) any other cost incurred in the normal course of business for bringing the inventories
up to their present location and condition.
7. Net Realisable value is the Actual or Estimated Selling Price less cost of completion
of works and cost to be incurred to complete the sale.
8. Inventories are to be classified normally in the financial statements as :
(1) Raw materials and components;
(2) Work-in-Process;
(3) Finished goods; and
(4) Stores and spares
9. Where an Inventory is carried at net realisable value, it should be disclosed in the
financial statements separately.
10. By-products should be valued at cost or Net Realisable Value, whichever is lower. But
if the cost of byproducts cannot be ascertained separately, their stock should be valued
at Net Realisable Value.
11. If there is any scope of reprocessing, the inventory of re-usable scrap should be valued
at cost (of material) less reprocessing cost. But if there is no such scope, the inventory
of re-usable scrap should be valued at Net Realisable Value.
12. Inventory of non-reusable scrap should be valued at Net Realisable Value
13. Perishable goods may be valued even below cost if conditions demand
If Inventory is Valued at Market Price (not recommended by AS 2)
Issues of materials may be priced at the current market price. This may again be :
(a) Replacement Price or Purchase Price: It is the price existing at the time of issue. If materials
are consumed in the process of production or sale, replacement has to be made by new
purchase from the market. So the replacement cost is given importance for inventory
valuation.
(b) Realisable Price or Sale Price Method : It is the price which can be realised if the materials
issued to different jobs or work orders are sold out.
(a) Replacement Price or Purchase Price: It is the price existing at the time of issue. If materials
are consumed in the process of production or sale, replacement has to be made by new
purchase from the market. So the replacement cost is given importance for inventory
valuation.
(b) Realisable Price or Sale Price Method : It is the price which can be realised if the materials
issued to different jobs or work orders are sold out.
8. Latest Purchase Price Method & Next In First Out (or NIFO) Method :
Under this
method stock is not valued at any historical cost already incurred. Rather valuation of
inventory is made at a price which is the probable price of the goods to be received next
to the issue of the inventory.
This method is found to exist very rarely. Its only advantage is that stock valuation is made
at the up-to date replacement cost.
There are some more methods where stock valuation is made at cost. These are
(a) Highest in First Out or HIFO Method : Under this method it is assumed that the lot of
materials whose price is the maximum is to be issued first. The date of actual price of such
materials need not be considered. Thus cost of production is charged at the highest rate
but inventory is valued at the lowest price.
During a period when the price level changes rapidly, this method becomes useful.
(b) Moving Average Method : This may also be Simple Moving Average or Weighted Moving
Average. A moving period is ascertained from a study of past move ments of materials.
Then the average is calculated on the basis of such period.
method stock is not valued at any historical cost already incurred. Rather valuation of
inventory is made at a price which is the probable price of the goods to be received next
to the issue of the inventory.
This method is found to exist very rarely. Its only advantage is that stock valuation is made
at the up-to date replacement cost.
There are some more methods where stock valuation is made at cost. These are
(a) Highest in First Out or HIFO Method : Under this method it is assumed that the lot of
materials whose price is the maximum is to be issued first. The date of actual price of such
materials need not be considered. Thus cost of production is charged at the highest rate
but inventory is valued at the lowest price.
During a period when the price level changes rapidly, this method becomes useful.
(b) Moving Average Method : This may also be Simple Moving Average or Weighted Moving
Average. A moving period is ascertained from a study of past move ments of materials.
Then the average is calculated on the basis of such period.
7. Adjusted Selling Price (also Called Retail Inventory) Method:
It is used in retail business
or in business where the stock consists of items whose individual costs cannot be
readily asertained. At first, the retail price of the goods is ascertained and from that the
anticipated gross margin of profit on such goods is deducted. The calculation of the said
gross margin may be made for individual items or groups of items or by the individual
departments where departmental accounting is possible.
This method may also be used in manufacturing organisations which like to value inventory
of finished products held against forward sale contracts.
or in business where the stock consists of items whose individual costs cannot be
readily asertained. At first, the retail price of the goods is ascertained and from that the
anticipated gross margin of profit on such goods is deducted. The calculation of the said
gross margin may be made for individual items or groups of items or by the individual
departments where departmental accounting is possible.
This method may also be used in manufacturing organisations which like to value inventory
of finished products held against forward sale contracts.
6. Standard Cost Method :
Under this method a rate is predetermined and considered as
the standard rate for valuing cost of sales and inventories. It uses some anticipated
rates. According to AS—2, such rates should be realistic and should be reviewed regularly.
There should be sufficient scope of analysing and reconciling the variances between
actual costs and standard costs. It is usually found in job and process type of
industries.
the standard rate for valuing cost of sales and inventories. It uses some anticipated
rates. According to AS—2, such rates should be realistic and should be reviewed regularly.
There should be sufficient scope of analysing and reconciling the variances between
actual costs and standard costs. It is usually found in job and process type of
industries.
5. Specific Identification Method :
As per Para 11 of AS 2 “The specific identification
formula attributes specific costs to identified goods that have been bought or manufactured
and are segregated for a specific purpose.” Thus, under this method valuation is
made at the original or actual cost price for the specific quantity of identified goods.This
method has limited applications. The scale of operation should not be large and identification
of goods must be possible. There should not be frequent receipts and issues
of materials. The inventories should not be interchangeable and these have to be earmarked
for specific purposes.
Its greatest advantage is that it renders a correct valuation of stock and at the same time
ensures correct matching of costs with revenues.
It involves difficulties and clerical errors if The movement of goods is frequent and if
there are considerable price fluctuations.
formula attributes specific costs to identified goods that have been bought or manufactured
and are segregated for a specific purpose.” Thus, under this method valuation is
made at the original or actual cost price for the specific quantity of identified goods.This
method has limited applications. The scale of operation should not be large and identification
of goods must be possible. There should not be frequent receipts and issues
of materials. The inventories should not be interchangeable and these have to be earmarked
for specific purposes.
Its greatest advantage is that it renders a correct valuation of stock and at the same time
ensures correct matching of costs with revenues.
It involves difficulties and clerical errors if The movement of goods is frequent and if
there are considerable price fluctuations.
4. Base Stock Method :
Under this method,, according to Para 10 of AS 2, it is assumed that
a minimum quantity of inventory (or base stock) must be held at all times to carry on
business. Up to this quantity the inventory is valued at the cost at which it was acquired.
Any excess over this base stock may be valued under FIFO or LIFO method.
As this method assumes that a minimum level of stock must be maintained at all times, it
has a limited application. Where some basic raw materials are required and these are of
the same type. This method is suitable. It is applied in processing industries where processing
takes a considerable time.
Advantages:
(1) As already said this method is ideal for processing industries like refineries, taneries, etc.
(2) Base stock is always valued at its cost of acquisition.
(3) The additional stock over the basic requirement can be valued under any suitable method.
Disadvantages:
(1) Base stock is valued at historical cost. It is treated as a fixed asset, but there is no scope of
depreciating it.
(2) The disadvantages of FIFO or LIFO exist regarding the valuation of additional stock.
(3) This method is somewhat rigid. It requires necessary changes to cope with changes of
production capacity and policy matters regarding stock.
a minimum quantity of inventory (or base stock) must be held at all times to carry on
business. Up to this quantity the inventory is valued at the cost at which it was acquired.
Any excess over this base stock may be valued under FIFO or LIFO method.
As this method assumes that a minimum level of stock must be maintained at all times, it
has a limited application. Where some basic raw materials are required and these are of
the same type. This method is suitable. It is applied in processing industries where processing
takes a considerable time.
Advantages:
(1) As already said this method is ideal for processing industries like refineries, taneries, etc.
(2) Base stock is always valued at its cost of acquisition.
(3) The additional stock over the basic requirement can be valued under any suitable method.
Disadvantages:
(1) Base stock is valued at historical cost. It is treated as a fixed asset, but there is no scope of
depreciating it.
(2) The disadvantages of FIFO or LIFO exist regarding the valuation of additional stock.
(3) This method is somewhat rigid. It requires necessary changes to cope with changes of
production capacity and policy matters regarding stock.
3. Weighted Average Method
For finding out the weighted average rate for stock valuation
both quantity and price of different lots of materials existing in the stock are considered.
The weighted average rate is found by adding the costs of all lots held at the time of issue
and then dividing that total cost by the total quantity of the materials held. Once a rate is
calculated it is applied until a new purchase is made. It does not consider whether the
quantities purchased earlier have already been consumed.
Advantages:
(1) If prices fluctuate considerably and issue of materials has to be made in several lots, this
method becomes very much useful.
(2) Weighted average rate is mathematically sound as it considers both quantity and price.
(3) During inflation, the value of stock becomes much more realistic.
(4) One rate can be consistently applied till a new purchase is made.
Disadvantages :
(1) The prices at which goods are issued do not reflect their actual costs.
(2) Closing stock cannot show the current market price.
(3) Where purchases and receipts of materials are frequent, this method results into mathematical
complications.
(4) If arithmetical accuracy is ignored at the time of calculating the weighted average rate,
unrealised profit or loss may creep into the value of materials.
both quantity and price of different lots of materials existing in the stock are considered.
The weighted average rate is found by adding the costs of all lots held at the time of issue
and then dividing that total cost by the total quantity of the materials held. Once a rate is
calculated it is applied until a new purchase is made. It does not consider whether the
quantities purchased earlier have already been consumed.
Advantages:
(1) If prices fluctuate considerably and issue of materials has to be made in several lots, this
method becomes very much useful.
(2) Weighted average rate is mathematically sound as it considers both quantity and price.
(3) During inflation, the value of stock becomes much more realistic.
(4) One rate can be consistently applied till a new purchase is made.
Disadvantages :
(1) The prices at which goods are issued do not reflect their actual costs.
(2) Closing stock cannot show the current market price.
(3) Where purchases and receipts of materials are frequent, this method results into mathematical
complications.
(4) If arithmetical accuracy is ignored at the time of calculating the weighted average rate,
unrealised profit or loss may creep into the value of materials.
2. Last in First out (abbreviated as LIFO) method :
Here the materials received last are assumed
to be issued first from the stores. So, the issue price becomes the price of that lot of
materials which has entered last into the stores. The current cost of materials is charged
against revenue. The unsold stock is valued at an old price which, generally becomes
lower than the current cost price.
It is a method used for ‘pricing of issues’. The physical issue of materials may not follow the
principle that goods received last are to be issued first. Its emphasis is on the use of latest or
current cost for computing cost of production. If it is followed, the replacement of used stock
does not involve additional cost. So, it is also known as Replacement Cost Method.
Advantages:
(1) Cost of production is charged at current price. If the price level shows an increasing trend,
higher amount is charged against revenue for cost of materials used.
(2) Closing Stock is valued at an earlier or old price. So, the valuation will conform to minimum
realisable price and shall not include any profit element.
(3) During inflation, application of this method gives more pragmatic result.
(4) Current cost is matched against revenue. So, the matching cost principle can be used more
effectively.
Disadvantages:
(1) If the price level is decreasing or fluctuating, this method gives inaccurate result.
(2) The closing stock can never reflect current market price.
(3) In India AS 2 does not approve it. The Income Tax Authorities do not allow it. In USA the
Generally Accepted Accounting Principles allow it for use in Tax Returns only.
to be issued first from the stores. So, the issue price becomes the price of that lot of
materials which has entered last into the stores. The current cost of materials is charged
against revenue. The unsold stock is valued at an old price which, generally becomes
lower than the current cost price.
It is a method used for ‘pricing of issues’. The physical issue of materials may not follow the
principle that goods received last are to be issued first. Its emphasis is on the use of latest or
current cost for computing cost of production. If it is followed, the replacement of used stock
does not involve additional cost. So, it is also known as Replacement Cost Method.
Advantages:
(1) Cost of production is charged at current price. If the price level shows an increasing trend,
higher amount is charged against revenue for cost of materials used.
(2) Closing Stock is valued at an earlier or old price. So, the valuation will conform to minimum
realisable price and shall not include any profit element.
(3) During inflation, application of this method gives more pragmatic result.
(4) Current cost is matched against revenue. So, the matching cost principle can be used more
effectively.
Disadvantages:
(1) If the price level is decreasing or fluctuating, this method gives inaccurate result.
(2) The closing stock can never reflect current market price.
(3) In India AS 2 does not approve it. The Income Tax Authorities do not allow it. In USA the
Generally Accepted Accounting Principles allow it for use in Tax Returns only.
1. First in First out (abbreviated as FIFO) method :
Under this method, the goods which are
produced first or acquired first are sold first or used first for production. The sequence of
issue of goods for sale or production follows the sequence or order in which they have
been received. The goods which remain as unsold stock are valued at current cost price.
According to Littleton and Paton “the cost factors move through the business in procession
fashion” under FIFO method.
Advantages
(1) Stock represents goods purchased recently. So the valuation is made at current purchase
price,
(2) Accounting involves recording of transactions in a chronological manner. FIFO conforms
to that order.
(3) It is a simple method approved by Tax and other authorities.
(4) As issues are priced in the same order in which materials have been acquired, the issues
are made at actual cost.
(5) Where the nature of materials is slow moving or bulk items are not issued, this method is
very useful.
Disadvantages
(1) Where the price level goes up steadily or it fluctuates, this method is not useful.
(2) The prices of issues do not reflect the current market prices.
(3) Matching of current costs with current revenues does not become possible.
produced first or acquired first are sold first or used first for production. The sequence of
issue of goods for sale or production follows the sequence or order in which they have
been received. The goods which remain as unsold stock are valued at current cost price.
According to Littleton and Paton “the cost factors move through the business in procession
fashion” under FIFO method.
Advantages
(1) Stock represents goods purchased recently. So the valuation is made at current purchase
price,
(2) Accounting involves recording of transactions in a chronological manner. FIFO conforms
to that order.
(3) It is a simple method approved by Tax and other authorities.
(4) As issues are priced in the same order in which materials have been acquired, the issues
are made at actual cost.
(5) Where the nature of materials is slow moving or bulk items are not issued, this method is
very useful.
Disadvantages
(1) Where the price level goes up steadily or it fluctuates, this method is not useful.
(2) The prices of issues do not reflect the current market prices.
(3) Matching of current costs with current revenues does not become possible.
Methods of Inventory Valuation
As per AS-2, the following two methods of inventory valuation are recommended :
1. FIFO.
2. Weighted average cost.
Cost Formulae
Inventory should be valued at cost price or net realisable price whichever is lower.
If inventory valuation is made at cost any one of the following methods may be adopted
1. FIFO.
2. Weighted average cost.
Cost Formulae
Inventory should be valued at cost price or net realisable price whichever is lower.
If inventory valuation is made at cost any one of the following methods may be adopted
Valuation of Inventory
AS 2 and its implications
Before going into any discussion regarding any method of inventory valuation the epitome
of Indian Accounting Standard 2 (AS 2) should be understood. It says that—
(1) Inventory should normally be valued at historical cost or net realisable value whichever
is lower.
(2) Historical Cost is the combination of (a) cost of purchase; (b) cost of conversion; and (c)
any other cost incurred in the normal course of a business to bring the inventories up
to their present location and condition.
(3) Net realisable value represents the actual or the estimated selling price less cost of
completion and sale.
(4) By Products should be valued as the lower of cost and net realisable value. Consumable
stores and maintenance supplies should generally be valued at cost.
Re-usable wastes should be valued at net realisable value, if reprocessing is possible.
Goods which are not interchangeable and which are manufactured for a specific purpose
should be valued at specific costs.
Where there is a scope of analysing the difference between the Standard Cost and Actual
Cost (that is, Variance Analysis) direct costing or absorption Costing may be applied.
(5) Cost of Purchase = Purchase Price + Duties and Taxes (unless recoverable from taxing
authorities like CENVAT credit) + Other expenses directly related to the acquisition of
goods (-) Trade Discounts, Rebates, etc.
(6) Cost of Conversion includes any cost related to, production including any overhead
cost.
(7) For retail businesses, adjusted selling price (that is, selling price less gross margin of
profit) may be applied.
(8) Production Overheads should be included only to the extent which has brought the inventory
to the present condition or location. It may be illustrated as—
(a) Production Overheads may be Fixed or Variable by nature.
(b) Fixed Overheads should normally be spread over units produced on the basis of
normal capacity.
For example, if the normal capacity is 10,000 units, actual production is 6,000 units, units sold
is 5,000 units and Fixed Overhead is Rs. 30,000—
Normal Recovery Rate should be Rs.30,000 /10,000 or Rs. 3 per unit. In the case of actual production
overhead recovered becomes 6,000 × Rs. 3 or Rs. 18,000 (at normal rate). The under
recovery of Rs. 30,000 — Rs. 18,000 or Rs. 12,000 is treated as an expense of the year. For valuation
of Stock (in this case 6,000 — 5,000 = 1,000 units), Fixed Production Cost is
1,000 × Rs. 3 = Rs. 3,000.
BUT if actual production is abnormally high say 20,000 units, the overhead rate applicable for
stock valuation should be based on the actual production. It should be Rs. 30,000 / 20,000 or
Rs. 1.50 per unit.
(c) Variable Overheads should be based on the actual units produced.
(3) Inventory carried at net realisable value should be separately disclosed.
Before going into any discussion regarding any method of inventory valuation the epitome
of Indian Accounting Standard 2 (AS 2) should be understood. It says that—
(1) Inventory should normally be valued at historical cost or net realisable value whichever
is lower.
(2) Historical Cost is the combination of (a) cost of purchase; (b) cost of conversion; and (c)
any other cost incurred in the normal course of a business to bring the inventories up
to their present location and condition.
(3) Net realisable value represents the actual or the estimated selling price less cost of
completion and sale.
(4) By Products should be valued as the lower of cost and net realisable value. Consumable
stores and maintenance supplies should generally be valued at cost.
Re-usable wastes should be valued at net realisable value, if reprocessing is possible.
Goods which are not interchangeable and which are manufactured for a specific purpose
should be valued at specific costs.
Where there is a scope of analysing the difference between the Standard Cost and Actual
Cost (that is, Variance Analysis) direct costing or absorption Costing may be applied.
(5) Cost of Purchase = Purchase Price + Duties and Taxes (unless recoverable from taxing
authorities like CENVAT credit) + Other expenses directly related to the acquisition of
goods (-) Trade Discounts, Rebates, etc.
(6) Cost of Conversion includes any cost related to, production including any overhead
cost.
(7) For retail businesses, adjusted selling price (that is, selling price less gross margin of
profit) may be applied.
(8) Production Overheads should be included only to the extent which has brought the inventory
to the present condition or location. It may be illustrated as—
(a) Production Overheads may be Fixed or Variable by nature.
(b) Fixed Overheads should normally be spread over units produced on the basis of
normal capacity.
For example, if the normal capacity is 10,000 units, actual production is 6,000 units, units sold
is 5,000 units and Fixed Overhead is Rs. 30,000—
Normal Recovery Rate should be Rs.30,000 /10,000 or Rs. 3 per unit. In the case of actual production
overhead recovered becomes 6,000 × Rs. 3 or Rs. 18,000 (at normal rate). The under
recovery of Rs. 30,000 — Rs. 18,000 or Rs. 12,000 is treated as an expense of the year. For valuation
of Stock (in this case 6,000 — 5,000 = 1,000 units), Fixed Production Cost is
1,000 × Rs. 3 = Rs. 3,000.
BUT if actual production is abnormally high say 20,000 units, the overhead rate applicable for
stock valuation should be based on the actual production. It should be Rs. 30,000 / 20,000 or
Rs. 1.50 per unit.
(c) Variable Overheads should be based on the actual units produced.
(3) Inventory carried at net realisable value should be separately disclosed.
1.3 ACCOUNTING FOR INVENTORY
Introduction
Inventory means any stock held by a manufacturing business to meet its production requirements.
A trading concern holds stock of goods for sale.
As per Indian Accounting Standard 2 [AS.-2] Inventories mean tangible property held
(i) for sale in the ordinary course of business, or
(ii) in the process of production for such sale, or
(iii) for consumption in the production of goods or services for sale, including maintenance
supplies and consumables other than machinery spares.
Inventory means any stock held by a manufacturing business to meet its production requirements.
A trading concern holds stock of goods for sale.
As per Indian Accounting Standard 2 [AS.-2] Inventories mean tangible property held
(i) for sale in the ordinary course of business, or
(ii) in the process of production for such sale, or
(iii) for consumption in the production of goods or services for sale, including maintenance
supplies and consumables other than machinery spares.
DISPOSAL OF AN ASSET
Sometimes, a firm may sell an asset because of obsolescence or inadequacy or any other reason.
In such cases, the cost of the asset is transferred to a separate account called ‘Asset Disposal
Account’. The entry is passed as under :
Asset Disposal A/c ... Dr.
To Asset A/c
The amount of depreciation provided on this asset from the date of purchase to the date of sale
is also transferred from the ‘Provision for Depreciatio Account’ to the ‘Asset Disposal Account’
the entry being :
Provision for Depreciation A/c ... Dr.
To Asset Disposal A/c
When cash is realised on sale of asset, it is credited to Asset Disposal A/c entry being :
Bank A/c ... Dr.
To Asset Disposal A/c
Loss on disposal is transferred to Profit and Loss Account by passing the following entry :
Profit & Loss A/c ... Dr.
To Asset Disposal A/c
Profit on disposal is transferred by reversing the above entry, i.e.,
Asset Disposal A/c ... Dr.
To Profit & Loss A/c
Profit on disposal represents excess depreciation provided in the past years now credited back
to profit and loss account, whereas loss on disposal represents depreciation not provided for in
the ealier years.
In such cases, the cost of the asset is transferred to a separate account called ‘Asset Disposal
Account’. The entry is passed as under :
Asset Disposal A/c ... Dr.
To Asset A/c
The amount of depreciation provided on this asset from the date of purchase to the date of sale
is also transferred from the ‘Provision for Depreciatio Account’ to the ‘Asset Disposal Account’
the entry being :
Provision for Depreciation A/c ... Dr.
To Asset Disposal A/c
When cash is realised on sale of asset, it is credited to Asset Disposal A/c entry being :
Bank A/c ... Dr.
To Asset Disposal A/c
Loss on disposal is transferred to Profit and Loss Account by passing the following entry :
Profit & Loss A/c ... Dr.
To Asset Disposal A/c
Profit on disposal is transferred by reversing the above entry, i.e.,
Asset Disposal A/c ... Dr.
To Profit & Loss A/c
Profit on disposal represents excess depreciation provided in the past years now credited back
to profit and loss account, whereas loss on disposal represents depreciation not provided for in
the ealier years.
11. Insurance Policy Method
(1) It has a close similarity with the Sinking Fund Method. But, here money is not used for
investment in securities It is used to pay premium on an Insurance Policy which assures
funds necessary for replacement. It may also be called Depreciation Fund Policy Method.
(2) An insurance policy for an assets is taken on the basis of (a) the specific number of years
over which the asset will he used, and (b) the amount that will he required as the
replacement cost of the asset.
(3) At the end of the specific working life of the asset, the policy matures and the Insurance
Company pays the amount including bonus, if any.
(4) Depreciation is substituted by the annual premium on the policy.
Journal Entries : 1st year and subsequent years
1. Profit & Loss A/c Dr.
To Depreciation Fund A/c
[amt. of depreciation]
2. Insurance Policy A/c Dr.
To Bank A/c
[Premium paid at the beginning of the yr.]
At the end of working life of the asset (1) and (2) same as above
3. Bank A/c Dr.
To Insurance Policy A/c
[amt. received on maturity of policy]
4. Insurance Policy A/c Dr.
To Depreciation Fund A/c
[Profit or Bonus received]
5. Depreciation Fund A/c Dr.
To Asset A/c [for closing these accounts]
6. If the asset is sold out—
Bank A/c Dr.
To Asset A/c
If Depreciation is based on the Market Price of asset
1. Revaluation Method
Annual Depreciation is considered to be the reduction in the value of an asset during
a year, or Annual Depreciation is the shortfall in the closing value of an asset from its
opening value.
2. Repairs Provision Method
(1) This method computes depreciation on an asset on the basis of (a) the cost of the asset
and (b) the estimated total cost of repairs to be needed throughout the working life of
the asset.
(2) The expenses for repairs and renewals do not become the same every year. Rather the
amounts spent in different years should be different.
The total cost of repairs for an asset throughout its working life is estimated first.
(3) With total estimated depreciation this total estimated cost of repairs is added.
(4) The result is divided by the working life of the asset to find out annual depreciation.
Thus, Annual Depreciation = (Depreciation + Repairs Cost) / Working Life of the Asset
[*Estimated Total Depreciation = Cost of Acquisition — Scrap Value]
(5) Whatever may be the actual cost of repairs paid in a year, the Annual Depreciation
amount as calculated above is debited to Profit & Loss Account and credited to Provision
for Depreciation and Repairs Account.
The actual amount paid for repairs is debited to Provision for Depreciation and Repairs
account.
(6) After the expiry of the working life of the asset, the balance of the above mentioned
Provision Account is transferred to the Asset Account.
(7) Some concerns create Provision for Repairs & Renewals Account separately with out
including depreciation.
investment in securities It is used to pay premium on an Insurance Policy which assures
funds necessary for replacement. It may also be called Depreciation Fund Policy Method.
(2) An insurance policy for an assets is taken on the basis of (a) the specific number of years
over which the asset will he used, and (b) the amount that will he required as the
replacement cost of the asset.
(3) At the end of the specific working life of the asset, the policy matures and the Insurance
Company pays the amount including bonus, if any.
(4) Depreciation is substituted by the annual premium on the policy.
Journal Entries : 1st year and subsequent years
1. Profit & Loss A/c Dr.
To Depreciation Fund A/c
[amt. of depreciation]
2. Insurance Policy A/c Dr.
To Bank A/c
[Premium paid at the beginning of the yr.]
At the end of working life of the asset (1) and (2) same as above
3. Bank A/c Dr.
To Insurance Policy A/c
[amt. received on maturity of policy]
4. Insurance Policy A/c Dr.
To Depreciation Fund A/c
[Profit or Bonus received]
5. Depreciation Fund A/c Dr.
To Asset A/c [for closing these accounts]
6. If the asset is sold out—
Bank A/c Dr.
To Asset A/c
If Depreciation is based on the Market Price of asset
1. Revaluation Method
Annual Depreciation is considered to be the reduction in the value of an asset during
a year, or Annual Depreciation is the shortfall in the closing value of an asset from its
opening value.
2. Repairs Provision Method
(1) This method computes depreciation on an asset on the basis of (a) the cost of the asset
and (b) the estimated total cost of repairs to be needed throughout the working life of
the asset.
(2) The expenses for repairs and renewals do not become the same every year. Rather the
amounts spent in different years should be different.
The total cost of repairs for an asset throughout its working life is estimated first.
(3) With total estimated depreciation this total estimated cost of repairs is added.
(4) The result is divided by the working life of the asset to find out annual depreciation.
Thus, Annual Depreciation = (Depreciation + Repairs Cost) / Working Life of the Asset
[*Estimated Total Depreciation = Cost of Acquisition — Scrap Value]
(5) Whatever may be the actual cost of repairs paid in a year, the Annual Depreciation
amount as calculated above is debited to Profit & Loss Account and credited to Provision
for Depreciation and Repairs Account.
The actual amount paid for repairs is debited to Provision for Depreciation and Repairs
account.
(6) After the expiry of the working life of the asset, the balance of the above mentioned
Provision Account is transferred to the Asset Account.
(7) Some concerns create Provision for Repairs & Renewals Account separately with out
including depreciation.
10. Annuity Method
Cost of an asset is considered to be an investment. such investment would earn interest if invested
outside the business.
D = Ci(1+i)n / (1+i)n -1
D= Depreciation
C= Cost of the asset
i= Rate of Deprecition
n= Life of the asset
Journal entries
1. Depreciation A/c Dr.
To Asset A/c
(Calculated from annuity table)
2. Asset A/c Dr.
To Interest A/c
(Calculated on diminishing values)
3. Profit & Loss A/c Dr. .
To Depreciation A/c
4. Interest A/c Dr.
To Profit & Loss A/c
Under Annuity Method:
Annual Depreciation = Ci (1 + i)n = 40,000 x 10% x 1.4641 = 12,619
----------- ----------------
(1+i) n -1 1.4641 - 1
In case of Annuity Method, the amount of Rs.12,619 shall not be invested outside the
business.
It shall have to be taken as an yearly appropriation. The total amount to be appropriated
over a period of 4 years = Rs.12,619 x 4 = Rs.50,476.
Cost of Capital = Total Appropriation - Actual Cost of the Asset = Rs.50,476 -40,000 =
Rs.10,476.
outside the business.
D = Ci(1+i)n / (1+i)n -1
D= Depreciation
C= Cost of the asset
i= Rate of Deprecition
n= Life of the asset
Journal entries
1. Depreciation A/c Dr.
To Asset A/c
(Calculated from annuity table)
2. Asset A/c Dr.
To Interest A/c
(Calculated on diminishing values)
3. Profit & Loss A/c Dr. .
To Depreciation A/c
4. Interest A/c Dr.
To Profit & Loss A/c
Under Annuity Method:
Annual Depreciation = Ci (1 + i)n = 40,000 x 10% x 1.4641 = 12,619
----------- ----------------
(1+i) n -1 1.4641 - 1
In case of Annuity Method, the amount of Rs.12,619 shall not be invested outside the
business.
It shall have to be taken as an yearly appropriation. The total amount to be appropriated
over a period of 4 years = Rs.12,619 x 4 = Rs.50,476.
Cost of Capital = Total Appropriation - Actual Cost of the Asset = Rs.50,476 -40,000 =
Rs.10,476.
Sunday 29 May 2011
9. Sinking Fund Method
Annual depreciation is considered as a source of providing the replacement cost of an asset. It becomes a means of maintaining capital.
D = Ci.
_______
(1+i)n -1.
D= Depreciation.
C= Cost of the asset.
i= Rate of Deprecition.
n= Life of the asset.
Notes:
(1) No investment is made in the last year as the investments are to be sold out.
(2) Sinking Fund Account may be called Depreciation Fund Account also. It is to be shown
on the liability side of Balance Sheet.
(3) Sinking Fund Investments Account may be called Depreciation Fund Investments Account
also. It is to be shown on the Asset side of the Balance Sheet.
(4) Annual Contribution (charged in lieu of annual depreciation) = Original Cost x Present
Value of Re. 1 at given interest rate.
Illustration: Cost of an Asset Rs.40,000 Life:4 years. Depreciation 10% p.a.
Under Sinking Fund Method:
Annual Depreciation = Ci
------
(1+i) n -1
This amount shall be invested at the end of years 1,2 and 3. The amount of investment shall fetch 10% interest p.a. which will lead to accumulation of Rs.40,000 at the end of the 4th year.
The amount of Rs.8,619 shall not be invested at the end of the 4th year.
D = Ci.
_______
(1+i)n -1.
D= Depreciation.
C= Cost of the asset.
i= Rate of Deprecition.
n= Life of the asset.
Notes:
(1) No investment is made in the last year as the investments are to be sold out.
(2) Sinking Fund Account may be called Depreciation Fund Account also. It is to be shown
on the liability side of Balance Sheet.
(3) Sinking Fund Investments Account may be called Depreciation Fund Investments Account
also. It is to be shown on the Asset side of the Balance Sheet.
(4) Annual Contribution (charged in lieu of annual depreciation) = Original Cost x Present
Value of Re. 1 at given interest rate.
Illustration: Cost of an Asset Rs.40,000 Life:4 years. Depreciation 10% p.a.
Under Sinking Fund Method:
Annual Depreciation = Ci
------
(1+i) n -1
This amount shall be invested at the end of years 1,2 and 3. The amount of investment shall fetch 10% interest p.a. which will lead to accumulation of Rs.40,000 at the end of the 4th year.
The amount of Rs.8,619 shall not be invested at the end of the 4th year.
8. Service Hours Method
Under this method the expected “service hours or running
time is considered as the basis of charging depreciation. For example, a locomotive
engine renders effective service for some definite running hours. In case of aircrafts
“flying hours” are pre-calculated.
Depreciation per Service Hour = Total Cost —Residual Value / Total Running time or Service hours
And Annual Depreciation = Rate of depreciation per hour x service hours rendered during the period.
time is considered as the basis of charging depreciation. For example, a locomotive
engine renders effective service for some definite running hours. In case of aircrafts
“flying hours” are pre-calculated.
Depreciation per Service Hour = Total Cost —Residual Value / Total Running time or Service hours
And Annual Depreciation = Rate of depreciation per hour x service hours rendered during the period.
6. Mileage Method
(1) It considers the total distance in miles or kilometeres to be run by a vehicle, like bus, car, lorry etc.
(2) Depreciation per mile/km = Cost Price —Scrap Value / Total miles or kms. expected to be run by the vehicle
(3) Annual Depreciation = Depn. per mile or km x distance covered during the year
(2) Depreciation per mile/km = Cost Price —Scrap Value / Total miles or kms. expected to be run by the vehicle
(3) Annual Depreciation = Depn. per mile or km x distance covered during the year
7. Depletion Unit Method
Depreciation or Depletion per unit = Cost of acquisition and development cost —Residual value / Estimated units to be raised or extracted
Annual Depreciation = Depreciation per unit × units produced or raised or extracted
during the week.
Annual Depreciation = Depreciation per unit × units produced or raised or extracted
during the week.
5. Working Hours Method
Features :
The Hourly Rate of Depreciation of an asset is calculated as—
Acquisition Cost — Scrap Value
________________________________
Estimated Total Working Hours
Annual Depreciation is found out as— Hourly Rate of Depreciation x actual working
hours rendered by the asset during the year.
It may also be called a Machine Hour Rate where total machine hours of a machine are
estimated.
The Hourly Rate of Depreciation of an asset is calculated as—
Acquisition Cost — Scrap Value
________________________________
Estimated Total Working Hours
Annual Depreciation is found out as— Hourly Rate of Depreciation x actual working
hours rendered by the asset during the year.
It may also be called a Machine Hour Rate where total machine hours of a machine are
estimated.
4. Double Declining Balance Method :
Features :
(1) Depreciation is charged at a fixed rate and it is calculated on the written down value
of an asset brought forward on the opening date of an accounting year.
(2) The Rate of Depreciation becomes the double of the rate under fixed instalment method.
It may be illustrated as follows:.
(1) Depreciation is charged at a fixed rate and it is calculated on the written down value
of an asset brought forward on the opening date of an accounting year.
(2) The Rate of Depreciation becomes the double of the rate under fixed instalment method.
It may be illustrated as follows:.
3. Sum of Years Digit Method
Features :
(1) It is a revised form of Reducing Balance Method.
(2) Here also the working life of an asset has to be pre-estimated and Total Depreciation is
considered as Cost of the Asset (—) Residual or Scrap Value.
(3) The amount of annual depreciation goes on decreasing with the use. For calculating
depreciation, the denominator becomes the sum of the digits repre senting the life of the
asset. Thus if an asset has a life of 5 years, the denomina tor should be I + 2 + 3 + 4 + 5 or
15.
Depreciation = (Remaining Life of the Asset x Depreciable Amount)/Sum of the Year’s Digit
Where,
Depreciable Amount = Cost of the Asset – Estimated Scrap Value
Sum of the Years’ Digit = n(n+1)/2
n = estimated life of the asset
Example:
If an asset costs Rs. 50,000, it has a residual value of Rs. 5,000 and working life of 5 years
the depreciation will be—
1st year 5/15 of (50,000 —5,000) or Rs. 15,000;
2nd year 4/15 of (50,000 —5,000) or Rs. 12,000;
3rd year 3/15 of (50,000 —5,000) or Rs. 9,000;
4th year 2/15 of (50,000 —5,000) or Rs. 6,000;
5th year 1/15 of (50,000 —5,000) or Rs. 3,000.
(1) It is a revised form of Reducing Balance Method.
(2) Here also the working life of an asset has to be pre-estimated and Total Depreciation is
considered as Cost of the Asset (—) Residual or Scrap Value.
(3) The amount of annual depreciation goes on decreasing with the use. For calculating
depreciation, the denominator becomes the sum of the digits repre senting the life of the
asset. Thus if an asset has a life of 5 years, the denomina tor should be I + 2 + 3 + 4 + 5 or
15.
Depreciation = (Remaining Life of the Asset x Depreciable Amount)/Sum of the Year’s Digit
Where,
Depreciable Amount = Cost of the Asset – Estimated Scrap Value
Sum of the Years’ Digit = n(n+1)/2
n = estimated life of the asset
Example:
If an asset costs Rs. 50,000, it has a residual value of Rs. 5,000 and working life of 5 years
the depreciation will be—
1st year 5/15 of (50,000 —5,000) or Rs. 15,000;
2nd year 4/15 of (50,000 —5,000) or Rs. 12,000;
3rd year 3/15 of (50,000 —5,000) or Rs. 9,000;
4th year 2/15 of (50,000 —5,000) or Rs. 6,000;
5th year 1/15 of (50,000 —5,000) or Rs. 3,000.
2. Reducing / Diminishing Balance Method OR Written Down Value Method
Features :
(1) Depreciation is calculated at a fixed percentage on the original cost in the first year. But
in subsequent years it is calculated at the same percentage on the written down values
gradually reducing during the expected working life of the asset.
(2) The rate of allocation is constant (usually a fixed percentage) but the amount allocated
for every year gradually decreases.
(1) Depreciation is calculated at a fixed percentage on the original cost in the first year. But
in subsequent years it is calculated at the same percentage on the written down values
gradually reducing during the expected working life of the asset.
(2) The rate of allocation is constant (usually a fixed percentage) but the amount allocated
for every year gradually decreases.
I. Fixed / Equal Instalment OR Straight Line Method
Features :
(1) A fixed portion of the cost of a fixed asset is allocated and charged as periodic depreciation.
(2) Such depreciation becomes an equal amount in each period.
Depreciation = (V-S)/n
Where,
V= Cost of the Asset
S= Residual value or the expected scrap value
n= estimated life of the asset.
(1) A fixed portion of the cost of a fixed asset is allocated and charged as periodic depreciation.
(2) Such depreciation becomes an equal amount in each period.
Depreciation = (V-S)/n
Where,
V= Cost of the Asset
S= Residual value or the expected scrap value
n= estimated life of the asset.
Methods of Charging Depreciation
There are different concepts about the nature of depreciation. Moreover, the nature of all
fixed assets cannot be the same. As a result, different methods are found to exist for charging
depreciation. A broad classification of the methods may be summarised as follows
Capital /Source of Fund :
1. Sinking Fund Method
2. Annuity Method
3. Insurance Policy Method
Time Base
1. Fixed Instalment method
2. Reducing Balance Method
3. Sum of Years’ Digit Method
4. Double Declining Method
Use Base
1. Working Hours method
2. Mileage Method
3. Depletion Unit method
4. Service Hours Method
Price Base
1. Revaluation Method
2. Repairs Provision Method
fixed assets cannot be the same. As a result, different methods are found to exist for charging
depreciation. A broad classification of the methods may be summarised as follows
Capital /Source of Fund :
1. Sinking Fund Method
2. Annuity Method
3. Insurance Policy Method
Time Base
1. Fixed Instalment method
2. Reducing Balance Method
3. Sum of Years’ Digit Method
4. Double Declining Method
Use Base
1. Working Hours method
2. Mileage Method
3. Depletion Unit method
4. Service Hours Method
Price Base
1. Revaluation Method
2. Repairs Provision Method
“Depreciation Accounting” (AS 6) (Revised)
The Accounting Standard regarding depreciation was issued at first in 1982. But it was
revised in 1994.
The revised standard (AS 6) is now mandatorily applicable to all concerns in India for
accounting periods commencing on or after 1.4.1995. The important matters to be noted from
(AS 6) are
1. “Depreciable Assets” are the assets which : -
(a) are expected to be used for more than one accounting period; and
(b) have limited useful life; and
(c) are held by an enterprise for use in production or supply of goods and services, for
rental to others or for administrative purposes but not for sale in the ordinary
course of business.
2. “Useful Life” of a depreciable asset may be either :
(a) the period of its expected working life, or
(b) the number of production or similar units expected to be obtained from the use of
the asset by the enterprise.
3. (a) The total amount to be depreciated from the value of a depreciable asset should be
spread over its useful life on a systematic basis.
(b) The method selected for charging depreciation should be consistently followed.
However, if situations demand (like change of statute, compliance with Accounting
Standard, etc.) a change of method may be made. In that case, the depreciation
should be recalculated under the new method with effect from the date of the asset
coming into use, that is, with retrospective effect.
If Depreciation is overcharged earlier, then the following adjustment entry should be made:
Asset A/c…….Dr.
To Profit & Loss Adjustment A/c
If Depreciation is undercharged earlier, then the following adjustment entry should
be made:
Profit & Loss Adjustment A/c…..Dr
To Asset A/c
(c) For ascertaining the useful life of a depreciable asset, these factors should be considered
:
(1) expected physical wear and tear;
(2) obsolescence; and
(3) legal or other limits on the use of the asset.
Useful lives of major depreciable assets may be reviewed periodically.
(d) Any addition or extension essential for an existing asset, should be depreciated
over the remaining life of the asset.
(e) If the historical cost of an asset changes due to exchange fluctuations, price adjustments,
etc. the depreciation on the revised unamortised depreciable amount should
be provided prospectively for the rest of the life of the asset.
(f) For any asset revalued, the provision for depreciation should be made on the
revalued amount for the remaining useful life of the asset.
(g) In the financial statements, the matters to be disclosed are
(1) The historical cost or any amount substituting it;
(2) Total depreciation for the period for each class of depreciable assets; and
(3) The related accumulated depreciation.
The method of charging depreciation should also be disclosed.
revised in 1994.
The revised standard (AS 6) is now mandatorily applicable to all concerns in India for
accounting periods commencing on or after 1.4.1995. The important matters to be noted from
(AS 6) are
1. “Depreciable Assets” are the assets which : -
(a) are expected to be used for more than one accounting period; and
(b) have limited useful life; and
(c) are held by an enterprise for use in production or supply of goods and services, for
rental to others or for administrative purposes but not for sale in the ordinary
course of business.
2. “Useful Life” of a depreciable asset may be either :
(a) the period of its expected working life, or
(b) the number of production or similar units expected to be obtained from the use of
the asset by the enterprise.
3. (a) The total amount to be depreciated from the value of a depreciable asset should be
spread over its useful life on a systematic basis.
(b) The method selected for charging depreciation should be consistently followed.
However, if situations demand (like change of statute, compliance with Accounting
Standard, etc.) a change of method may be made. In that case, the depreciation
should be recalculated under the new method with effect from the date of the asset
coming into use, that is, with retrospective effect.
If Depreciation is overcharged earlier, then the following adjustment entry should be made:
Asset A/c…….Dr.
To Profit & Loss Adjustment A/c
If Depreciation is undercharged earlier, then the following adjustment entry should
be made:
Profit & Loss Adjustment A/c…..Dr
To Asset A/c
(c) For ascertaining the useful life of a depreciable asset, these factors should be considered
:
(1) expected physical wear and tear;
(2) obsolescence; and
(3) legal or other limits on the use of the asset.
Useful lives of major depreciable assets may be reviewed periodically.
(d) Any addition or extension essential for an existing asset, should be depreciated
over the remaining life of the asset.
(e) If the historical cost of an asset changes due to exchange fluctuations, price adjustments,
etc. the depreciation on the revised unamortised depreciable amount should
be provided prospectively for the rest of the life of the asset.
(f) For any asset revalued, the provision for depreciation should be made on the
revalued amount for the remaining useful life of the asset.
(g) In the financial statements, the matters to be disclosed are
(1) The historical cost or any amount substituting it;
(2) Total depreciation for the period for each class of depreciable assets; and
(3) The related accumulated depreciation.
The method of charging depreciation should also be disclosed.
Accounting Standard for Fixed Assets (AS 10)
(a) The gross book value of a fixed asset should be either historical cost or a revaluation
computed in accordance with the Accounting Standard. [Set out in paragraphs 20 to 26
and 27 to 32 of the Standards]
(b) The cost of a fixed asset should comprise its purchase price and any attributable cost
of bringing the asset to its working condition. Financing costs relating to deferred
credits or to borrowed funds attributable to construction or acquisition of fixed assets
should also be included in the gross book value of the asset to which they relate.
However, the financing costs (including interest) on fixed assets purchased on a
deferred credit basis or moneys borrowed for construction or acquisition of fixed
assets should not be capitalised. Thus, the installation cost for a machine should be
added to its value. But any interest paid on a loan taken to buy the machine should
not enhance the value of machine.
(c) In case of any self-constructed assets, costs attributable to its construction and allocable
to it, should be included in its value.
(d) Materials items retired from active use and held for disposal should be shown separately
in the financial statements and stated at net book value or realizable value,
whichever is lower.
(e) If any subsequent expenditure causes an addition to the already expected future benefits
of an asset, such expenditure should be added with the value of the asset.
(f) In case a new asset is acquired in part exchange of an old asset the exchange price
should be recorded at fair market value or net book value of the old asset.
(g) Fixed asset acquired in exchange of shares, etc. should be recorded at its fair market
value or the fair market value of the shares, etc. whichever is lower.
(h) Any loss or gain on the retirement or disposal of any fixed asset carried at cost should
be recognised in the profit and loss account.
(i) If the value of any asset increases on revaluation, its accumulated depreciation should
not be debited to Profit & Loss Account. The depreciation on such revalued amount
should be adjusted against revaluation reserves.
(j) Any fixed asset purchased under hire purchase should be recorded at its Cash Price
showing appropriate narration that its full ownership has not been received.
(k) All direct costs incurred in developing the patents should be capitalised and written off
over their legal term of validity or over their working life, whichever is shorter.
(l) Amount paid for know-how of the plants, layout or designs of buildings, machinery,
etc. should be added with the respective value of the asset. Depreciation should be
provided on the total value. However, if such amounts have been paid compositely
both for manufacturing process and for assets, the management should reasonably
allocate the composite cost.
(o) The following information should be disclosed in the financial statements :
(1) Gross and net book values of fixed assets at the beginning and end of an accounting
period disclosing additions, disposals, acquisitions and other movements;
(2) Expenditure incurred on account of used assets in the course of acquisition or
construction; and
(3) Revalued amounts substituted for historical costs of fixed assets and necessary
particulars regarding the process adopted for revaluation.
computed in accordance with the Accounting Standard. [Set out in paragraphs 20 to 26
and 27 to 32 of the Standards]
(b) The cost of a fixed asset should comprise its purchase price and any attributable cost
of bringing the asset to its working condition. Financing costs relating to deferred
credits or to borrowed funds attributable to construction or acquisition of fixed assets
should also be included in the gross book value of the asset to which they relate.
However, the financing costs (including interest) on fixed assets purchased on a
deferred credit basis or moneys borrowed for construction or acquisition of fixed
assets should not be capitalised. Thus, the installation cost for a machine should be
added to its value. But any interest paid on a loan taken to buy the machine should
not enhance the value of machine.
(c) In case of any self-constructed assets, costs attributable to its construction and allocable
to it, should be included in its value.
(d) Materials items retired from active use and held for disposal should be shown separately
in the financial statements and stated at net book value or realizable value,
whichever is lower.
(e) If any subsequent expenditure causes an addition to the already expected future benefits
of an asset, such expenditure should be added with the value of the asset.
(f) In case a new asset is acquired in part exchange of an old asset the exchange price
should be recorded at fair market value or net book value of the old asset.
(g) Fixed asset acquired in exchange of shares, etc. should be recorded at its fair market
value or the fair market value of the shares, etc. whichever is lower.
(h) Any loss or gain on the retirement or disposal of any fixed asset carried at cost should
be recognised in the profit and loss account.
(i) If the value of any asset increases on revaluation, its accumulated depreciation should
not be debited to Profit & Loss Account. The depreciation on such revalued amount
should be adjusted against revaluation reserves.
(j) Any fixed asset purchased under hire purchase should be recorded at its Cash Price
showing appropriate narration that its full ownership has not been received.
(k) All direct costs incurred in developing the patents should be capitalised and written off
over their legal term of validity or over their working life, whichever is shorter.
(l) Amount paid for know-how of the plants, layout or designs of buildings, machinery,
etc. should be added with the respective value of the asset. Depreciation should be
provided on the total value. However, if such amounts have been paid compositely
both for manufacturing process and for assets, the management should reasonably
allocate the composite cost.
(o) The following information should be disclosed in the financial statements :
(1) Gross and net book values of fixed assets at the beginning and end of an accounting
period disclosing additions, disposals, acquisitions and other movements;
(2) Expenditure incurred on account of used assets in the course of acquisition or
construction; and
(3) Revalued amounts substituted for historical costs of fixed assets and necessary
particulars regarding the process adopted for revaluation.
Application of Accounting Standards Regarding Depreciation
Regarding Depreciation, the applicable accounting standard is ‘Depreciation Accounting’
(AS 6). While solving problems on depreciation accounting, we should try to follow and
apply the texts of these standards. We should also consider ‘Accounting for Fixed Assets’
(AS 10). Some important aspects of these standards are being mentioned here.
(AS 6). While solving problems on depreciation accounting, we should try to follow and
apply the texts of these standards. We should also consider ‘Accounting for Fixed Assets’
(AS 10). Some important aspects of these standards are being mentioned here.
Depreciation — Parameters of Different Views
The exact nature of depreciation is viewed by different accountants from different standpoints.
These are
1. A Process of Allocation : The cost of an asset is allocated over the years of its useful
life. E. S. Hendriksen observed depreciation as “a systematic and rational method of
allocating costs to periods in which benefits are received.” Allocated portion of a capital
expenditure attributed to any accounting period falling within the working life of a
fixed asset is considered as the periodic charge for depreciation. The periodic flow of
the service potential of such asset is represented by the periodic charge. According to
this concept, the useful working life and the residual value of fixed assets arc considered
as constant for determining periodic depreciation.
2. A Decline in Service Potential : With gradual use and effluxion of time, the capability
of a fixed asset to render service is reduced. So, depreciation is the measure of the total
reduction of service potential over the years of use of a fixed asset. As this concept
believes that the consumption of service potentials of a fixed asset follow a decreasing
trend, depreciations for different years do not become equal.
3. A Source of Fund : Depreciation is a non-cash expense but it is charged against profits,
like rent, salaries etc. As it does not cause any outflow of cash in the period in which
it is charged, some accountants prefer to believe that its equivalent amount is retained
in cash. This helps to build up a fund which, in turn, helps to replace the old and
useless asset by a new and useful asset.
But this view is full of defects. Depreciation is a portion of the total out flow of cash already
made for acquiring an asset. It is an internal arrangement that affects the periodic revenue
and the value of a fixed asset of a business. It does not involve any other party. A fund
presumes appropriation of an amount and its external application. Depreciation neither
helps to create, nor to maintain any fund. It definitely affects periodic revenue and quantum
of tax but it does not involve the creation or extinction of any fund.
4. A Provision for Maintenance of Capital : Some accountants think that depreciation
helps to maintain Capital. They feel that depreciation is charged as a part of expired
cost. So, by the time the fixed asset ceases to render any service, the initial capital that
was invested to acquire it, is recovered fully. The American Accounting Association
(AAA) felt that “depreciation must be based on current cost of restoring the service
potential consumed during the period.”
For restoring ‘service potential consumed’ depreciation is needed. But cost of restoration is
more related to the replacement cost, that is, the cost that will be required at the time of
replacement than the historical cost that was originally incurred at the time of acquiring the
asset. If depreciation is based on historical cost, the initial capital invested can be restored.
But due to change of price level, replacement cost is bound to be more. So, real capital
cannot be maintained. For this reason, Sprouse and Moontiz opined in the Accounting
Research Study publised by AICPA that the current cost of restoring service potential
should be based on current replacement cost.
These are
1. A Process of Allocation : The cost of an asset is allocated over the years of its useful
life. E. S. Hendriksen observed depreciation as “a systematic and rational method of
allocating costs to periods in which benefits are received.” Allocated portion of a capital
expenditure attributed to any accounting period falling within the working life of a
fixed asset is considered as the periodic charge for depreciation. The periodic flow of
the service potential of such asset is represented by the periodic charge. According to
this concept, the useful working life and the residual value of fixed assets arc considered
as constant for determining periodic depreciation.
2. A Decline in Service Potential : With gradual use and effluxion of time, the capability
of a fixed asset to render service is reduced. So, depreciation is the measure of the total
reduction of service potential over the years of use of a fixed asset. As this concept
believes that the consumption of service potentials of a fixed asset follow a decreasing
trend, depreciations for different years do not become equal.
3. A Source of Fund : Depreciation is a non-cash expense but it is charged against profits,
like rent, salaries etc. As it does not cause any outflow of cash in the period in which
it is charged, some accountants prefer to believe that its equivalent amount is retained
in cash. This helps to build up a fund which, in turn, helps to replace the old and
useless asset by a new and useful asset.
But this view is full of defects. Depreciation is a portion of the total out flow of cash already
made for acquiring an asset. It is an internal arrangement that affects the periodic revenue
and the value of a fixed asset of a business. It does not involve any other party. A fund
presumes appropriation of an amount and its external application. Depreciation neither
helps to create, nor to maintain any fund. It definitely affects periodic revenue and quantum
of tax but it does not involve the creation or extinction of any fund.
4. A Provision for Maintenance of Capital : Some accountants think that depreciation
helps to maintain Capital. They feel that depreciation is charged as a part of expired
cost. So, by the time the fixed asset ceases to render any service, the initial capital that
was invested to acquire it, is recovered fully. The American Accounting Association
(AAA) felt that “depreciation must be based on current cost of restoring the service
potential consumed during the period.”
For restoring ‘service potential consumed’ depreciation is needed. But cost of restoration is
more related to the replacement cost, that is, the cost that will be required at the time of
replacement than the historical cost that was originally incurred at the time of acquiring the
asset. If depreciation is based on historical cost, the initial capital invested can be restored.
But due to change of price level, replacement cost is bound to be more. So, real capital
cannot be maintained. For this reason, Sprouse and Moontiz opined in the Accounting
Research Study publised by AICPA that the current cost of restoring service potential
should be based on current replacement cost.
Characteristics of Depreciation
The Characteristics of Depreciation are :
1. It is a charge against profit.
2. It indicates diminution in service potential.
3. It is an estimated loss of the value of an asset. It is not an actual loss.
4. It depends upon different assumptions, like effective life and residual value of an asset.
5. It is a process of allocation and not of valuation.
6. It arises mainly from an internal cause like wear and tear or depletion of an asset. But
it is treated as any expense charged against profit like rent, salary, etc., which arise due
to an external transaction.
7. Depreciation on any particular asset is restricted to the working life of the asset.
8. It is charged on tangible fixed assets. It is not charged on any current asset. For allocating
the costs of intangible fixed assets like goodwill. etc, a certain amount of their
total costs may be charged against periodic revenues. This is known as amortization.
Depreciation includes amortization of intangible assets whose effective lives are preestimated.
Intangible assets render benefits but they do not have any physical existence,
their ‘economic- values’ are perceived to exist. ‘Amortization’ or ‘Writing Off such
assets is made to account for the deterioration of their economic values.
Under depreciation, ‘Depletion’ and ‘obsolescence’ are also covered. ‘Depletion’ means gradual
exhaustion of physical resources due to extraction etc, as found in mines, quarries etc.
‘Obsolescence’ means a major deterioration in the utility of an asset due to (i) innovation of
improved substitutes or techniques;’ (ii) drastic fall in the demand of a product arising
through change in market conditions, tastes or fashions; and (iii) usefulness lost and inability
arising to cope with increased scale of operation.
1. It is a charge against profit.
2. It indicates diminution in service potential.
3. It is an estimated loss of the value of an asset. It is not an actual loss.
4. It depends upon different assumptions, like effective life and residual value of an asset.
5. It is a process of allocation and not of valuation.
6. It arises mainly from an internal cause like wear and tear or depletion of an asset. But
it is treated as any expense charged against profit like rent, salary, etc., which arise due
to an external transaction.
7. Depreciation on any particular asset is restricted to the working life of the asset.
8. It is charged on tangible fixed assets. It is not charged on any current asset. For allocating
the costs of intangible fixed assets like goodwill. etc, a certain amount of their
total costs may be charged against periodic revenues. This is known as amortization.
Depreciation includes amortization of intangible assets whose effective lives are preestimated.
Intangible assets render benefits but they do not have any physical existence,
their ‘economic- values’ are perceived to exist. ‘Amortization’ or ‘Writing Off such
assets is made to account for the deterioration of their economic values.
Under depreciation, ‘Depletion’ and ‘obsolescence’ are also covered. ‘Depletion’ means gradual
exhaustion of physical resources due to extraction etc, as found in mines, quarries etc.
‘Obsolescence’ means a major deterioration in the utility of an asset due to (i) innovation of
improved substitutes or techniques;’ (ii) drastic fall in the demand of a product arising
through change in market conditions, tastes or fashions; and (iii) usefulness lost and inability
arising to cope with increased scale of operation.
Accounting Implications of Depreciation
I. Depreciation is a charge against profits. It is not a cash cost. It is a notional loss. The
estimated depreciation of an accounting period is matched against revenues of that
period. The profit or loss of that period is calculated after charging depreciation.
2 It is a compulsory charge. It is not an appropriation of profits. Unless it is considered,
the process of matching costs with revenues become defective.
3. Depreciation. as already pointed out, helps to arrive at correct profit or loss. Final
accounts can be correctly prepared only when depreciation has been correctly charged.
4. Depreciation is necessary to value fixed assets at the end of each accounting period.
Unless it is charged. the assets become overstated.
5. Due to inflation, effective capital of a business is eroded continuously. It means, more
amount of capital becomes needed to replenish the same amount of assets consumed or
utilized every year in the process of production. By charging adequate depreciation, a
proper balance of real capital is maintained.
6. ‘Old order change yielding place to new’. This age-old belief obviates the charging of
depreciation. Old may be gold but that cannot be expected to last for ever. Decay and
senility have to be accepted for which the concept of depreciation has to be applied as
a yardstick of measurement, of such decay.
7. Depreciation Accounting paves the way for replacement of assets. When the effective
and working life of an asset comes to an end, it is replaced by a new asset. Depreciation,
being a notional cost, helps to set aside a fund every year. Such fund is utilized to
acquire the net asset. Thus the requirement of additional capital or loan can be avoided.
8. As per section 205 of the Companies Act of India, a company has to provide for adequate
depreciation before declaring dividends. There arc provisions of the Income Tax
Act of India regarding the adequacy of depreciation. So charging of depreciation is a
legal compliance which a business has to observe.
estimated depreciation of an accounting period is matched against revenues of that
period. The profit or loss of that period is calculated after charging depreciation.
2 It is a compulsory charge. It is not an appropriation of profits. Unless it is considered,
the process of matching costs with revenues become defective.
3. Depreciation. as already pointed out, helps to arrive at correct profit or loss. Final
accounts can be correctly prepared only when depreciation has been correctly charged.
4. Depreciation is necessary to value fixed assets at the end of each accounting period.
Unless it is charged. the assets become overstated.
5. Due to inflation, effective capital of a business is eroded continuously. It means, more
amount of capital becomes needed to replenish the same amount of assets consumed or
utilized every year in the process of production. By charging adequate depreciation, a
proper balance of real capital is maintained.
6. ‘Old order change yielding place to new’. This age-old belief obviates the charging of
depreciation. Old may be gold but that cannot be expected to last for ever. Decay and
senility have to be accepted for which the concept of depreciation has to be applied as
a yardstick of measurement, of such decay.
7. Depreciation Accounting paves the way for replacement of assets. When the effective
and working life of an asset comes to an end, it is replaced by a new asset. Depreciation,
being a notional cost, helps to set aside a fund every year. Such fund is utilized to
acquire the net asset. Thus the requirement of additional capital or loan can be avoided.
8. As per section 205 of the Companies Act of India, a company has to provide for adequate
depreciation before declaring dividends. There arc provisions of the Income Tax
Act of India regarding the adequacy of depreciation. So charging of depreciation is a
legal compliance which a business has to observe.
Problems of Measurement of Depreciation
I. Difficulty of ascertaining working life : It is really difficult to summarise the exact
working life of an asset. Where the duration of the benefits of the asset is time-bound,
like those of a leasehold asset, no problem arises. But in other cases it becomes a guess
work which takes into consideration— (a) the nature of the asset; (b) the quality of the
asset; (c) expert’s opinions and (d) previous experience. These are all conjectures found
to vary. Thus an asset may become incapable of rendering service before its anticipated
expiry date. On the other hand, its effectiveness may remain alive much after such date.
2. Estimation of residual value : Under conservative approach, the residual value is taken
below the expected value at the end of the useful life of an asset. This, at best, helps to
avoid unforeseen losses. But residual value also depends upon market conditions, technological
advancements, etc. So, its correct estimation often proves itself misleading.
3. Unwarranted happenings : Change of law, technological development, innovations. etc.,
may cause a drastic reduction or writing off of an asset. These external factors suddenly
affect the pre-determined quantum of depreciation. On the other hand, over-use or
underuse of an asset may also tell upon the amount of depreciation.
working life of an asset. Where the duration of the benefits of the asset is time-bound,
like those of a leasehold asset, no problem arises. But in other cases it becomes a guess
work which takes into consideration— (a) the nature of the asset; (b) the quality of the
asset; (c) expert’s opinions and (d) previous experience. These are all conjectures found
to vary. Thus an asset may become incapable of rendering service before its anticipated
expiry date. On the other hand, its effectiveness may remain alive much after such date.
2. Estimation of residual value : Under conservative approach, the residual value is taken
below the expected value at the end of the useful life of an asset. This, at best, helps to
avoid unforeseen losses. But residual value also depends upon market conditions, technological
advancements, etc. So, its correct estimation often proves itself misleading.
3. Unwarranted happenings : Change of law, technological development, innovations. etc.,
may cause a drastic reduction or writing off of an asset. These external factors suddenly
affect the pre-determined quantum of depreciation. On the other hand, over-use or
underuse of an asset may also tell upon the amount of depreciation.
Objects of Charging Depreciation
Eric Kohler defined depreciation as “the lost usefulness, expired utility, the diminution in
service yield.” Its measurement and charging are necessary for cost recovery. It is treated as
a part of the expired cost for an asset. For determination of revenue, that part or cost should
be matched against revenue. The objects or necessities of charging depreciation are :
I. Correct calculation of cost of production: Depreciation is an allocated cost of a fixed
asset. It is to be calculated and charged correctly against the revenue of an accounting
period. It must he correctly included within the cost of production.
2. Correct calculation of profits : Costs incurred for earning revenues must be charged
properly for correct calculation of profits. The consumed cost of assets (depreciation)
has to be provided for correct matching of revenues with expenses.
3. Correct disclosure of fixed assets at reasonable value : Unless depreciation is charged.the
depreciable asset cannot be correctly valued and presented in the Balance Sheet. Depreciation
is charged so that the Balance Sheet exhibits a true and fair view of the affairs
of the business.
4. Provision of replacement cost : Depreciation is a non-cash expense. But net profit is
calculated after charging it. Through annual depreciation cash resources are saved and
accumulated to provide replacement cost at the end of the useful life of an asset.
5. Maintenance of capital : A significant portion of capital has to be invested for purchasing
fixed assets. The values of such assets are gradually reduced due to their regular use
and passage of time. Depreciation on the assets is treated as an expired cost and it is
matched against revenue. It is charged against profits. If it is not charged the profits will
remain inflated. This will cause capital erosion.
6. Compliance with technical and legal requirements : Depreciation has to be charged to
comply with the relevant provisions of the Companies Act and Income Tax Act.
service yield.” Its measurement and charging are necessary for cost recovery. It is treated as
a part of the expired cost for an asset. For determination of revenue, that part or cost should
be matched against revenue. The objects or necessities of charging depreciation are :
I. Correct calculation of cost of production: Depreciation is an allocated cost of a fixed
asset. It is to be calculated and charged correctly against the revenue of an accounting
period. It must he correctly included within the cost of production.
2. Correct calculation of profits : Costs incurred for earning revenues must be charged
properly for correct calculation of profits. The consumed cost of assets (depreciation)
has to be provided for correct matching of revenues with expenses.
3. Correct disclosure of fixed assets at reasonable value : Unless depreciation is charged.the
depreciable asset cannot be correctly valued and presented in the Balance Sheet. Depreciation
is charged so that the Balance Sheet exhibits a true and fair view of the affairs
of the business.
4. Provision of replacement cost : Depreciation is a non-cash expense. But net profit is
calculated after charging it. Through annual depreciation cash resources are saved and
accumulated to provide replacement cost at the end of the useful life of an asset.
5. Maintenance of capital : A significant portion of capital has to be invested for purchasing
fixed assets. The values of such assets are gradually reduced due to their regular use
and passage of time. Depreciation on the assets is treated as an expired cost and it is
matched against revenue. It is charged against profits. If it is not charged the profits will
remain inflated. This will cause capital erosion.
6. Compliance with technical and legal requirements : Depreciation has to be charged to
comply with the relevant provisions of the Companies Act and Income Tax Act.
Factors on which Depreciation Depends
1. Historical (original) cost : Which includes money spent for acquisition, installation.
addition and improvement of a fixed asset. Cost of the asset, wages paid for installation.
transportation costs, legal expenses for registration of lease agreements. etc. are included.
There fore, historical cost refers to all expenses incurred before an asset is
brought into use.
2 Useful life of the asset : It is the estimated period over which the utility of an asset will
be enjoyed. It depends upon (a) legal or contractual provisions regarding lease, etc., b)
level of use of the asset, (c) degree of maintenance and (d) technological developments.
Useful life is shorter than the physical life of an asset.
3. Estimated residual value : It is the value expected to be realised after complete commercial
utilization of a fixed asset.
4. Other Relevant Factors : Some other relevant factors may be considered for deciding
the amount to be charged as depreciation. These are—
(a) Replacement cost that is the Cost that would be incurred if the old asset has to be
replaced by a new asset.
(b) Provisions of the Companies Act, Income Tax Act regarding depreciation.
(c) Costs of probable additions, alterations or improvements of the existing asset.
addition and improvement of a fixed asset. Cost of the asset, wages paid for installation.
transportation costs, legal expenses for registration of lease agreements. etc. are included.
There fore, historical cost refers to all expenses incurred before an asset is
brought into use.
2 Useful life of the asset : It is the estimated period over which the utility of an asset will
be enjoyed. It depends upon (a) legal or contractual provisions regarding lease, etc., b)
level of use of the asset, (c) degree of maintenance and (d) technological developments.
Useful life is shorter than the physical life of an asset.
3. Estimated residual value : It is the value expected to be realised after complete commercial
utilization of a fixed asset.
4. Other Relevant Factors : Some other relevant factors may be considered for deciding
the amount to be charged as depreciation. These are—
(a) Replacement cost that is the Cost that would be incurred if the old asset has to be
replaced by a new asset.
(b) Provisions of the Companies Act, Income Tax Act regarding depreciation.
(c) Costs of probable additions, alterations or improvements of the existing asset.
Causes of Depreciation
Its causes are :
A. Internal
(i) Wear and tear : Plant & Machinery. Furniture, Motor Vehicles etc. suffer from loss
of utility due to vibration, chemical reaction, negligent handling, rusting etc.
(ii) Depletion (or exhaustion) : The utility or resources of wasting assets (like mines
etc.) decreases with regular extractions.
B. External or Economic causes
(i) Obsolescence : Innovation of better substitutes, change in market demand, imposition
of legal restrictions may result into discarding an asset.
(ii) Inadequacy : Changes in the scale of production or volume of activities may lead
to discarding an asset.
C. Time element : With the passage of time some intangible fixed assets like lease, patents.
copy-rights etc., lose their value or effectiveness, whether used or not. The word “amortization”
is a better term to speak for the gradual fall in their values.
D. Abnormal occurrences : An Accident, fire or natural calamity can damage the service
potential of an asset partly or fully. As a result the effectiveness of the asset is affected
and reduced.
A. Internal
(i) Wear and tear : Plant & Machinery. Furniture, Motor Vehicles etc. suffer from loss
of utility due to vibration, chemical reaction, negligent handling, rusting etc.
(ii) Depletion (or exhaustion) : The utility or resources of wasting assets (like mines
etc.) decreases with regular extractions.
B. External or Economic causes
(i) Obsolescence : Innovation of better substitutes, change in market demand, imposition
of legal restrictions may result into discarding an asset.
(ii) Inadequacy : Changes in the scale of production or volume of activities may lead
to discarding an asset.
C. Time element : With the passage of time some intangible fixed assets like lease, patents.
copy-rights etc., lose their value or effectiveness, whether used or not. The word “amortization”
is a better term to speak for the gradual fall in their values.
D. Abnormal occurrences : An Accident, fire or natural calamity can damage the service
potential of an asset partly or fully. As a result the effectiveness of the asset is affected
and reduced.
DEPRECIATION - Introduction
A business or concern holds fixed assets for regular use and not for re-sale. The capability
of a fixed asset to render service cannot be unlimited. Except land, all other fixed assets have
a limited useful life. The benefit of a fixed asset is received throughout its useful life. So its
cost is the price paid for the ‘Series of Services’ to be received or enjoyed from it over a
number of years and it should be spread over such years,
Depreciation is the allocation of the cost of a fixed asset over the years of its working life.
Indian Accounting Standard (AS 6) states that “Depreciation is allocated so as to charge a
fair proportion of the depreciable amount in each accounting period during the expected
useful life of the asset.”
Long-term fixed assets are used in the process of earning revenue. Due to regular use such
assets gradually lose their service potentials. Such losses are considered as expired costs
which have to be matched against the periodic revenues. The latin word ‘depretium’ literally
means ‘reduction of value’. So depreciation means the reduction in value of assets which has
to be considered for determining revenue. R. S. Anthony and J. S. Reece observed that “the
cost of an asset that has a long but nevertheless limited life is systematically reduced over
that life by the process called depreciation.”
The cost of a fixed asset is a capital expenditure. Depreciation is allocated for every accounting
period as a cost or an expense which is matched against the revenue of such period.
Although it is a measure of the decrease in the value of assets put to use, it is actually a
process of allocation. For this reason, International Accounting Standard (IAS)-4 provides
that “Depreciation is the allocation of the depreciable amount of an asset over its estimated
useful life.” In Accounting Research Bulletin No. 22, AICPA observed that “Depreciation for
the year is the portion of the total charge under such a system that is allocated to the year.
Although the allocation may properly take into account occurences during the year, it is not
intended to be the measurement of the effect of all such occurrences.”
of a fixed asset to render service cannot be unlimited. Except land, all other fixed assets have
a limited useful life. The benefit of a fixed asset is received throughout its useful life. So its
cost is the price paid for the ‘Series of Services’ to be received or enjoyed from it over a
number of years and it should be spread over such years,
Depreciation is the allocation of the cost of a fixed asset over the years of its working life.
Indian Accounting Standard (AS 6) states that “Depreciation is allocated so as to charge a
fair proportion of the depreciable amount in each accounting period during the expected
useful life of the asset.”
Long-term fixed assets are used in the process of earning revenue. Due to regular use such
assets gradually lose their service potentials. Such losses are considered as expired costs
which have to be matched against the periodic revenues. The latin word ‘depretium’ literally
means ‘reduction of value’. So depreciation means the reduction in value of assets which has
to be considered for determining revenue. R. S. Anthony and J. S. Reece observed that “the
cost of an asset that has a long but nevertheless limited life is systematically reduced over
that life by the process called depreciation.”
The cost of a fixed asset is a capital expenditure. Depreciation is allocated for every accounting
period as a cost or an expense which is matched against the revenue of such period.
Although it is a measure of the decrease in the value of assets put to use, it is actually a
process of allocation. For this reason, International Accounting Standard (IAS)-4 provides
that “Depreciation is the allocation of the depreciable amount of an asset over its estimated
useful life.” In Accounting Research Bulletin No. 22, AICPA observed that “Depreciation for
the year is the portion of the total charge under such a system that is allocated to the year.
Although the allocation may properly take into account occurences during the year, it is not
intended to be the measurement of the effect of all such occurrences.”
Suspense Account / Difference in Books of Account
If there arises a difference in the trial balance, it is transferred to ‘Suspense Account’ or
‘Difference in Books Account’ to make the Trial Balance agree. After detection of error or errors,
they are rectified and the suspense account is closed.
At a glance
‘Difference in Books Account’ to make the Trial Balance agree. After detection of error or errors,
they are rectified and the suspense account is closed.
At a glance
Procedure to locate Errors, Or, Steps to be taken if the Trial Balance does not agree :
If the Trial balance does not agree, the following procedure should carefully by followed :
(i) At first, check the extraction and listing of the ledger account balance one by one.
(ii) Check the addition of both the columns (Debit and Credit) of the Trial Balance and
ascertain the amount of difference.
(iii) Divide the difference by 2 and see whether the said figure appear on the correct side or
not.
(iv) Check the additions of the subsidiary books.
(v) Check the additions of the ledger accounts and also the balances of each account.
(vi) Check the posting from subsidiary books to the ledger.
(vii) Check that balance of the account which is exactly equal the differences of Trial balance,
if any.
(viii) Check the opening balance of all account whether brought forward correctly or not.
(ix) Upto this level, if the errors are not even debited, checking and re-checking must be done
both by other stuffs following the same principles
(x) If the trial balance is still not agreed, checking should be started again from the journal
and book of original entry using tick mark (<) against each and every transaction,
In order to locate the cause of disagreement of a Trial balance, a thorough checking is
necessary in the books of account. After several checking and re-checking if the Trial balance
does not agree, put the difference to Suspense Account. This account will be automatically
closed, when the error or errors in Trial Balance are subsequently discovered or rectified.
(i) At first, check the extraction and listing of the ledger account balance one by one.
(ii) Check the addition of both the columns (Debit and Credit) of the Trial Balance and
ascertain the amount of difference.
(iii) Divide the difference by 2 and see whether the said figure appear on the correct side or
not.
(iv) Check the additions of the subsidiary books.
(v) Check the additions of the ledger accounts and also the balances of each account.
(vi) Check the posting from subsidiary books to the ledger.
(vii) Check that balance of the account which is exactly equal the differences of Trial balance,
if any.
(viii) Check the opening balance of all account whether brought forward correctly or not.
(ix) Upto this level, if the errors are not even debited, checking and re-checking must be done
both by other stuffs following the same principles
(x) If the trial balance is still not agreed, checking should be started again from the journal
and book of original entry using tick mark (<) against each and every transaction,
In order to locate the cause of disagreement of a Trial balance, a thorough checking is
necessary in the books of account. After several checking and re-checking if the Trial balance
does not agree, put the difference to Suspense Account. This account will be automatically
closed, when the error or errors in Trial Balance are subsequently discovered or rectified.
Errors which are not disclosed by a Trial Balance/Limitations of a Trial Balance
The following errors cannot be detected by a Trial Balance :
(a) Errors of Ommission : When the transaction is not at all recorded in the books of accounts,
i.e. neither in the debit sider nor in the credit side of the account – trial balance will agree.
(b) Errors of Commission : Where there is any varition in figure/amount, e.g. instead of Rs.
800 either Rs. 80 or Rs. 8,000 is recorded, in both sides of ledger accounts – trial balance
will agree.
(c) Errors of Principal : Where wrong posting is made in the books of accounts, i.e. accounts
are prepared not according to double entry principle e.g. Purchased a Plant wrongly
debited to Purchase Account – Trial balance will agree.
(d) Errors of Misposting : When wrong posting is made to a wrong account instead of a
correct one although amount is correctly recorded, e.g., sold goods to B but wrongly
debited to D’s Account – trial balance will agree.
(e) Compensating Errors : When one error is compensated by another error e.g. Discount
allowed Rs. 100 not debited to discount allowed account, whereas interest received Rs.
100, but not credit to Interest Account – trial balance will agree.
(a) Errors of Ommission : When the transaction is not at all recorded in the books of accounts,
i.e. neither in the debit sider nor in the credit side of the account – trial balance will agree.
(b) Errors of Commission : Where there is any varition in figure/amount, e.g. instead of Rs.
800 either Rs. 80 or Rs. 8,000 is recorded, in both sides of ledger accounts – trial balance
will agree.
(c) Errors of Principal : Where wrong posting is made in the books of accounts, i.e. accounts
are prepared not according to double entry principle e.g. Purchased a Plant wrongly
debited to Purchase Account – Trial balance will agree.
(d) Errors of Misposting : When wrong posting is made to a wrong account instead of a
correct one although amount is correctly recorded, e.g., sold goods to B but wrongly
debited to D’s Account – trial balance will agree.
(e) Compensating Errors : When one error is compensated by another error e.g. Discount
allowed Rs. 100 not debited to discount allowed account, whereas interest received Rs.
100, but not credit to Interest Account – trial balance will agree.
Errors which are disclosed by a Trial Balance/Advantages of a Trial Balance
It has already been stated earlier that Trial Balance is a way to test the arithmetical accuracy
of the records in the books of accounts. If any error, whether clerical or otherwise, exists in the
books of accounts the same will cause for disagreement of a Trial Balance. The following errors may
be noted :
(i) Wrong Posting : Posting on the wrong side of an account and posting of a wrong amount
in a ledger account, will cause disagreement of Trial Balance.
(ii) Omission of Posting : Omission of posting of an entry from the subsidiary Book will
cause disagreement.
(iii) Errors in casting or Totalling : Errors in casting or totalling or totalling of subsidiary
books of accounts will cause disagreement.
(iv) Errors in Balancing : If any errors arises as a result of balancing of an amount, the same
will cause disagreements.
(v) Double Posting : If any item is posted twice in a ledger account from a subsidiary book,
the same will create disagreement.
of the records in the books of accounts. If any error, whether clerical or otherwise, exists in the
books of accounts the same will cause for disagreement of a Trial Balance. The following errors may
be noted :
(i) Wrong Posting : Posting on the wrong side of an account and posting of a wrong amount
in a ledger account, will cause disagreement of Trial Balance.
(ii) Omission of Posting : Omission of posting of an entry from the subsidiary Book will
cause disagreement.
(iii) Errors in casting or Totalling : Errors in casting or totalling or totalling of subsidiary
books of accounts will cause disagreement.
(iv) Errors in Balancing : If any errors arises as a result of balancing of an amount, the same
will cause disagreements.
(v) Double Posting : If any item is posted twice in a ledger account from a subsidiary book,
the same will create disagreement.
Summary of Rules
Debit Balance — All Assets, Drawings, Debtors, Expenses and losses.
Credit Balance — All liabilities, Capital, Creditors, Gains and Incomes.
Credit Balance — All liabilities, Capital, Creditors, Gains and Incomes.
Method of Preparation
1. Total Method or Gross Trial Balance.
2. Balance Method or Net Trial Balance.
3. Compound Method.
1. Total Method or Gross Trial Balance : Under this method, two sides of the accounts are
totalled. The total of the debit side is called the “debit total” and the total of the credit side is
called the “credit total”. Debit totals are entered on the debit side of the Trial Balance while the
credit total is entered on the credit side of the Trial Balance.
If a particular account has total in one side, it will be entered either in the debit column or
the credit column as the case may be.
Advantages : 1. It facilitates arithmetical accuracy of the accounts.
2. Extraction of ledger balances is not required at the time of preparation
of Trial Balance.
Disadvantages : Preparation of final accounts is not possible.
2. Balance Method or Net Trial Balance : Under this method, all the ledger accounts are
balanced. The balances may be either “debit-balance” or “credit balance”.
Advantages : 1. It helps in the easy preparation of final accounts.
2. It saves time and labour in constructing a Trial Balance.
Disadvantages : Errors may remain undisclosed irrespective of the agreement of Trial
Balance.
3. Compound Method : Under this method, totals of both the sides of the accounts are
written in the separate columns. Alongwith this, the balances are also written in the separate
columns. Debit balances are written in the debit column and credit balances are written in the
credit coloumn of the Trial Balance.
Advantages: It offers the advantage of both the methods.
Disadvantages: Lengthy process and more time consumed in the preparation of a Trial
Balance.
2. Balance Method or Net Trial Balance.
3. Compound Method.
1. Total Method or Gross Trial Balance : Under this method, two sides of the accounts are
totalled. The total of the debit side is called the “debit total” and the total of the credit side is
called the “credit total”. Debit totals are entered on the debit side of the Trial Balance while the
credit total is entered on the credit side of the Trial Balance.
If a particular account has total in one side, it will be entered either in the debit column or
the credit column as the case may be.
Advantages : 1. It facilitates arithmetical accuracy of the accounts.
2. Extraction of ledger balances is not required at the time of preparation
of Trial Balance.
Disadvantages : Preparation of final accounts is not possible.
2. Balance Method or Net Trial Balance : Under this method, all the ledger accounts are
balanced. The balances may be either “debit-balance” or “credit balance”.
Advantages : 1. It helps in the easy preparation of final accounts.
2. It saves time and labour in constructing a Trial Balance.
Disadvantages : Errors may remain undisclosed irrespective of the agreement of Trial
Balance.
3. Compound Method : Under this method, totals of both the sides of the accounts are
written in the separate columns. Alongwith this, the balances are also written in the separate
columns. Debit balances are written in the debit column and credit balances are written in the
credit coloumn of the Trial Balance.
Advantages: It offers the advantage of both the methods.
Disadvantages: Lengthy process and more time consumed in the preparation of a Trial
Balance.
Forms of a Trial Balance
A trial balance may be prepared in two forms, they are –
1. Journal Form
2. Ledger Form
The trial balance must tally irrespective of the form of a trial balance.
1. Journal Form : This form of a Trial balance will have a format of Journal Folio. It will
have a column for serial number, name of the account, ledger folio, debit amount and credit
amount columns in this journal form.
The ledger folio will show the page number on which such account appear in the ledger.
Specimen of Journal Form of Trial Balance :
2. Ledger Form : This form of a trial balance have two sides i.e. debit side and credit side. In
fact, the ledger form of a trial balance is prepared in the form of an account. Each side of the
trial balance will have particulars (name of the account) column, folio column and the amount
column.
Specimen of ledger form of Trial Balance
1. Journal Form
2. Ledger Form
The trial balance must tally irrespective of the form of a trial balance.
1. Journal Form : This form of a Trial balance will have a format of Journal Folio. It will
have a column for serial number, name of the account, ledger folio, debit amount and credit
amount columns in this journal form.
The ledger folio will show the page number on which such account appear in the ledger.
Specimen of Journal Form of Trial Balance :
2. Ledger Form : This form of a trial balance have two sides i.e. debit side and credit side. In
fact, the ledger form of a trial balance is prepared in the form of an account. Each side of the
trial balance will have particulars (name of the account) column, folio column and the amount
column.
Specimen of ledger form of Trial Balance
Is Trial Balance indispensable ?
It is a mere statement prepared by the accountants for his own convenience and if it agrees,
it is assumed that at least arithmetical accuracy has been done although there may be a lot of
errors.
Trial Balance is not a process of accounts. But its preparation helps us to finalise the accounts.
Since it is prepared on a particular date, as at ........ / as on ........ is stated.
it is assumed that at least arithmetical accuracy has been done although there may be a lot of
errors.
Trial Balance is not a process of accounts. But its preparation helps us to finalise the accounts.
Since it is prepared on a particular date, as at ........ / as on ........ is stated.
Preparation of a Trial Balance
1. It may be prepared on a loose sheet of paper.
2. The ledger accounts are balanced at first. They will have either “debit-balance” or “credit
balance” or “nil-balance”.
3. The accounts having debit-balance is written on the debit column and those having creditbalance
are written on the credit coloumn.
The sum total of both the balances must be equal, for “Every debit has its corresponding
and equal credit”.
2. The ledger accounts are balanced at first. They will have either “debit-balance” or “credit
balance” or “nil-balance”.
3. The accounts having debit-balance is written on the debit column and those having creditbalance
are written on the credit coloumn.
The sum total of both the balances must be equal, for “Every debit has its corresponding
and equal credit”.
Purpose of a Trial Balance
It serves the following purposes :
1. To check the arithmetical accuracy of the recorded transactions.
2. To ascertain the balance of any ledger Account.
3. To serve as an evidence of fact that the double entry has been completed in respect of
every transaction.
4. To facilitate the preparation of final accounts promptly.
1. To check the arithmetical accuracy of the recorded transactions.
2. To ascertain the balance of any ledger Account.
3. To serve as an evidence of fact that the double entry has been completed in respect of
every transaction.
4. To facilitate the preparation of final accounts promptly.
Feature’s of a Trial Balance
1. It is a list of debit and credit balances which are extracted from various ledger accounts.
2. It is a statement of debit and credit balances.
3. The purpose is to establish arithmetical accuracy of the transactions recorded in the
Books of Accounts.
4. It does not prove arithmetical accuracy which can be determined by audit.
5. It is not an account. It is only a statement of account.
6. It is not a part of the process of accounts.
7. It is usually prepared at the end of the accounting year but it can also be prepared
anytime as and when required like weekly, monthly, quarterly or half-yearly.
8. It is a link between books of accounts and the Profit and Loss account and Balance
sheet.
2. It is a statement of debit and credit balances.
3. The purpose is to establish arithmetical accuracy of the transactions recorded in the
Books of Accounts.
4. It does not prove arithmetical accuracy which can be determined by audit.
5. It is not an account. It is only a statement of account.
6. It is not a part of the process of accounts.
7. It is usually prepared at the end of the accounting year but it can also be prepared
anytime as and when required like weekly, monthly, quarterly or half-yearly.
8. It is a link between books of accounts and the Profit and Loss account and Balance
sheet.
TRIAL BALANCE - Definition
According to the Dictionary for Accountants by Eric. L. Kohler, Trial Balance is defined
as “a list or abstract of the balances or of total debits and total credits of the accounts in a
ledger, the purpose being to determine the equality of posted debits and credits and to
establish a basic summary for financial statements”
According to Rolland, Trial Balance is defined as “The final list of balances, totalled and
combined, is called Trial Balance”.
According to Carter, Trial Balance is “a schedule or list of those debit and credit balances
which are extracted from various accounts in the ledger and balances of Cash in hand and at
Bank as shown by the Cash Book and are also included in it”
as “a list or abstract of the balances or of total debits and total credits of the accounts in a
ledger, the purpose being to determine the equality of posted debits and credits and to
establish a basic summary for financial statements”
According to Rolland, Trial Balance is defined as “The final list of balances, totalled and
combined, is called Trial Balance”.
According to Carter, Trial Balance is “a schedule or list of those debit and credit balances
which are extracted from various accounts in the ledger and balances of Cash in hand and at
Bank as shown by the Cash Book and are also included in it”
TRIAL BALANCE
Trial Balance is a statement where all the balances of accounts including the Cash Book
balances (both Cash and Bank) are written in the debit and credit coloumns together with
reference to their folios. The debit and the credit coloumns are totalled and tallied to prove
the arithmetical accuracy of the books of accounts. In case of disagreement, existence of
errors is indicated, which are to be located.
balances (both Cash and Bank) are written in the debit and credit coloumns together with
reference to their folios. The debit and the credit coloumns are totalled and tallied to prove
the arithmetical accuracy of the books of accounts. In case of disagreement, existence of
errors is indicated, which are to be located.
Process of Ledger Posting
The two aspects i.e. the debit aspect and the credit aspect if each transaction should be
carefully recorded in the Ledger Account.
Each ledger account has two identical parts
— debit side – on the left hand side and
— credit side – on the right hand side.
The basic rules about recording transactions are :
1. Debit the receiver and credit the giver.
2. Debit what comes in and credit what goes out.
3. Debit all expenses and losses and credit all incomes and gains.
The rules for writing up accounts of various types are as follows :
Assets : Increases on the left handside or the debit side and decreases on the credit side
or the right hand side.
Liabilities : Increases on the credit side and decreases on the debit side.
Capitals : The same as liabilities.
Expenses : Increases on the debit side and decreases on the credit side.
Incomes or gain : Increases on the credit side and decrease on the debit side.
The student should a clearly understand the nature of debit and credit.
A debit denotes :
(a) In the case of a person that he has received some benefit against which he has already
rendered some service or will render service in future. When a person becomes liable to
do something in favour of the firm, the fact is recorded by debiting that person’s account
: (relating to Personal Account)
(b) In case of goods or properties, that the value and the stock of such goods or properties
has increased, (relating to Real Acounts)
(c) In case of other accounts like losses or expenses, that the firm has incurred certain expenses
or has lost money. (relating to Nominal Account)
A credit denotes :
(a) In case of a person, that some benefit has been received from him, entitling him to claim
from the firm a return benefit in the form of cash or goods or service. When a person
becomes entitled to money or money’s worth for any reason. The fact is recorded by
crediting him (relating to Personal Account)
(b) In the case of goods or properties, that the stock and value of such goods or properties
has decreased. (relating to Real Acounts)
(c) In case of other accounts like interest or dividend or commission received, or discount
received, that the firm has made a gain (relating to Nominal Account)
Ledger Posting
As and when the transaction takes place, it is recorded in the journal in the form of journal
entry. This entry is posted again in the respective ledger accounts under double entry principle
from the journal. This is called ledger posting.
Balancing of an account
The difference between the debit side total and the credit side total is called balance.
If debit side total is greater than the credit side total of the same ledger account, the “balance”
is known as the debit balance.
If credit side total is greater than the debit side total of the same ledger account, the “balance”
is known as the credit balance.
A debit balance shows that :
(a) Money is owing to the firm (Personal Account)
(b) The firm owns property or goods. (Real Account)
(c) The firm has lost money or increased certain expense. (Nominal Account)
A debit balance is shown on the credit side as “By Balance carried down” or “By Balance c/
d”.
A credit balance shows that :
(a) Money is owing to some person (Personal Account)
(b) The firm has given up so much property. (Real Account)
(c) The firm has earned an income or gains. (Nominal Account)
A credit balance is shown on the debit side as “To Balance carried down” or “To Balance c/d”.
With reference to the previous illustration, let us show the ledger balancing at the end of the
month :
With reference to the previous illustration, let us show the ledger balancing at the end of the
month :
In the above cash account, the debit side total is Rs. 40,000 while the credit side total is NIL.
So, the debit side total is Rs. 40,000 more than the credit side total. This balance is placed on the
credit side as “By Balance c/d”. again the balance is brought down at the beginning of the next
accounting period as “To Balance b/d”.
In the above Capital Account, the credit side total is Rs. 40,000 and the debit side total is
NIL. So the credit side total is Rs. 40,000 more than the debit side total. This balance is placed
on the debit-side as “To Balance c/d”. again the balance is brought down at the beginning is
brought down at the beginning of the next accounting period as “By Balance b/d”.
Closing balance and Opening balance
The debit or credit balance of an account what we get at the end of the accounting period is
known as closing balance of that account.
The “balance of the nominal accounts” is closed by transferring to trading account and the
profit and loss account which shows the net operating results – net profit or net loss.
The “balance of the personal accounts and real accounts” representing assets, liabilities,
owners equity are reflected in the Balance sheet, which shows the financial position of a business
on a particular date. These balances are transported as opening balance in the succeeding
accounting period.
Some terms used :
Casting — totalling
Balancing — to find the difference between debit side total and credit side total of an account.
C/d - Carried down B/d - Brought down
C/o - Carried over B/o - Brought over
C/f - Carried forward B/f - Brought forward
carefully recorded in the Ledger Account.
Each ledger account has two identical parts
— debit side – on the left hand side and
— credit side – on the right hand side.
The basic rules about recording transactions are :
1. Debit the receiver and credit the giver.
2. Debit what comes in and credit what goes out.
3. Debit all expenses and losses and credit all incomes and gains.
The rules for writing up accounts of various types are as follows :
Assets : Increases on the left handside or the debit side and decreases on the credit side
or the right hand side.
Liabilities : Increases on the credit side and decreases on the debit side.
Capitals : The same as liabilities.
Expenses : Increases on the debit side and decreases on the credit side.
Incomes or gain : Increases on the credit side and decrease on the debit side.
The student should a clearly understand the nature of debit and credit.
A debit denotes :
(a) In the case of a person that he has received some benefit against which he has already
rendered some service or will render service in future. When a person becomes liable to
do something in favour of the firm, the fact is recorded by debiting that person’s account
: (relating to Personal Account)
(b) In case of goods or properties, that the value and the stock of such goods or properties
has increased, (relating to Real Acounts)
(c) In case of other accounts like losses or expenses, that the firm has incurred certain expenses
or has lost money. (relating to Nominal Account)
A credit denotes :
(a) In case of a person, that some benefit has been received from him, entitling him to claim
from the firm a return benefit in the form of cash or goods or service. When a person
becomes entitled to money or money’s worth for any reason. The fact is recorded by
crediting him (relating to Personal Account)
(b) In the case of goods or properties, that the stock and value of such goods or properties
has decreased. (relating to Real Acounts)
(c) In case of other accounts like interest or dividend or commission received, or discount
received, that the firm has made a gain (relating to Nominal Account)
Ledger Posting
As and when the transaction takes place, it is recorded in the journal in the form of journal
entry. This entry is posted again in the respective ledger accounts under double entry principle
from the journal. This is called ledger posting.
Balancing of an account
The difference between the debit side total and the credit side total is called balance.
If debit side total is greater than the credit side total of the same ledger account, the “balance”
is known as the debit balance.
If credit side total is greater than the debit side total of the same ledger account, the “balance”
is known as the credit balance.
A debit balance shows that :
(a) Money is owing to the firm (Personal Account)
(b) The firm owns property or goods. (Real Account)
(c) The firm has lost money or increased certain expense. (Nominal Account)
A debit balance is shown on the credit side as “By Balance carried down” or “By Balance c/
d”.
A credit balance shows that :
(a) Money is owing to some person (Personal Account)
(b) The firm has given up so much property. (Real Account)
(c) The firm has earned an income or gains. (Nominal Account)
A credit balance is shown on the debit side as “To Balance carried down” or “To Balance c/d”.
With reference to the previous illustration, let us show the ledger balancing at the end of the
month :
With reference to the previous illustration, let us show the ledger balancing at the end of the
month :
In the above cash account, the debit side total is Rs. 40,000 while the credit side total is NIL.
So, the debit side total is Rs. 40,000 more than the credit side total. This balance is placed on the
credit side as “By Balance c/d”. again the balance is brought down at the beginning of the next
accounting period as “To Balance b/d”.
In the above Capital Account, the credit side total is Rs. 40,000 and the debit side total is
NIL. So the credit side total is Rs. 40,000 more than the debit side total. This balance is placed
on the debit-side as “To Balance c/d”. again the balance is brought down at the beginning is
brought down at the beginning of the next accounting period as “By Balance b/d”.
Closing balance and Opening balance
The debit or credit balance of an account what we get at the end of the accounting period is
known as closing balance of that account.
The “balance of the nominal accounts” is closed by transferring to trading account and the
profit and loss account which shows the net operating results – net profit or net loss.
The “balance of the personal accounts and real accounts” representing assets, liabilities,
owners equity are reflected in the Balance sheet, which shows the financial position of a business
on a particular date. These balances are transported as opening balance in the succeeding
accounting period.
Some terms used :
Casting — totalling
Balancing — to find the difference between debit side total and credit side total of an account.
C/d - Carried down B/d - Brought down
C/o - Carried over B/o - Brought over
C/f - Carried forward B/f - Brought forward
LEDGER
The book which contains accounts is known as the ledger. Since finding information
pertaining to the financial position of a business emerges only from the accounts, the ledger is
also called the Principal Book. As a result, all the necessary information relating to any account
is available from the ledger. This is the most important book of the business and hence is
rightly called the “King of All Books”.
The specimen form of a leger account is presented below :
pertaining to the financial position of a business emerges only from the accounts, the ledger is
also called the Principal Book. As a result, all the necessary information relating to any account
is available from the ledger. This is the most important book of the business and hence is
rightly called the “King of All Books”.
The specimen form of a leger account is presented below :
Accounts
Account
An account denotes a summarized records of transactions pertaining to one person, one
kind of asset, or one class of income, expense or loss.
It can also be explained as :
“TO COUNT”
→ the financial value of each events,
which are termed as Transactions.
Classification of Accounts
Accounts are usually subdivided into the following classes :
1. Personal Accounts : These accounts deal with transactions relating to persons or an
organization. It can be classified as :
(a) Natural Persons : Mr. S. Sharma, Triveni & Sons, etc.
(b) Artificial Persons : State Bank of India, ITC Ltd, CC & FC, Royal Calcutta Golf
Club, etc.
(c) Representative Persons : Outstanding Expenses (represent ting liability for
expenses to supplies) ; Prepaid Salary (representating employess) etc.
2. Impersonal Accounts : There accounts do not relate to any persons are known as
impersonal accounts.
(a) Real Accounts : It is an accounts relating to assets and properties.
Eg: Land, Building, Plant, Machinery, Cash, Bank, Stock, etc.
(b) Nominal Accounts : It is an account relating to expenses, losses, incomes and gains.
They do not have any physical existence except names.
Eg: Sales, Purchases, Salary, Wages, Rent, Interest, Repairs, Travelling, etc.
Debit and Credit
Debit is derived from the latin word “debitum”, which means `what we will receive’. It is
the destination, who enjoys the benefit.
Credit is derived from the latin word “credre” which means `what we will have to pay’. It is
the source, who sacrifices for the benefit.
Diagrammatic Representation of Accounting Rules or the Golden Rules of Accounting
Modern Version : Any change in any variable of the equation must have another change in
another variable either in the opposite direction in the same side, or in the same direction in
the opposite side.
Events : Any or all activities which we are doing in our day-to-day life.
Example : Reading, Sleeping, Eating, Thinking, Singing, Gossiping, Buying, Selling, Playing
and etc.
Transactions : An event which has the following characteristics :
(i) Which changes the financial position of a person.
(ii) Which can be measured in terms of money.
(iii) Which can be recorded in the Books of Accounts.
Example : Purchase, Sales, Travelling Expenses, Rent, Wages, Salaries, and etc. It is therefore
concluded that “All transactions are events but all events are not transactions”.
Classification of Transaction
Cash Transactions : Those transactions which involves inflow / outflow of cash.
Example : (i) Purchased goods for cash Rs. 100.
(ii) Paid Expenses Rs. 20.
(iii) Sold goods for cash Rs. 300 and etc.
Non-cash Transaction : Those transaction which is not involved with immediate inflow /
outflow of cash. They are again sub-divided cost.
Credit Transactions : Those transactions which involve increase in assets /liabilities.
Example : (i) Goods sold to Mr. Sen on credit
— increase in asset.
(ii) Purchased goods from Sunny on credit
— increase in liability.
Other Non - Cash Transactions : Those which involves loses and does not result in immediate
outflow of cash.
Example : (i) Depreciation of Fixed assets
(ii) Bad Debts and etc.
An account denotes a summarized records of transactions pertaining to one person, one
kind of asset, or one class of income, expense or loss.
It can also be explained as :
“TO COUNT”
→ the financial value of each events,
which are termed as Transactions.
Classification of Accounts
Accounts are usually subdivided into the following classes :
1. Personal Accounts : These accounts deal with transactions relating to persons or an
organization. It can be classified as :
(a) Natural Persons : Mr. S. Sharma, Triveni & Sons, etc.
(b) Artificial Persons : State Bank of India, ITC Ltd, CC & FC, Royal Calcutta Golf
Club, etc.
(c) Representative Persons : Outstanding Expenses (represent ting liability for
expenses to supplies) ; Prepaid Salary (representating employess) etc.
2. Impersonal Accounts : There accounts do not relate to any persons are known as
impersonal accounts.
(a) Real Accounts : It is an accounts relating to assets and properties.
Eg: Land, Building, Plant, Machinery, Cash, Bank, Stock, etc.
(b) Nominal Accounts : It is an account relating to expenses, losses, incomes and gains.
They do not have any physical existence except names.
Eg: Sales, Purchases, Salary, Wages, Rent, Interest, Repairs, Travelling, etc.
Debit and Credit
Debit is derived from the latin word “debitum”, which means `what we will receive’. It is
the destination, who enjoys the benefit.
Credit is derived from the latin word “credre” which means `what we will have to pay’. It is
the source, who sacrifices for the benefit.
Diagrammatic Representation of Accounting Rules or the Golden Rules of Accounting
Modern Version : Any change in any variable of the equation must have another change in
another variable either in the opposite direction in the same side, or in the same direction in
the opposite side.
Events : Any or all activities which we are doing in our day-to-day life.
Example : Reading, Sleeping, Eating, Thinking, Singing, Gossiping, Buying, Selling, Playing
and etc.
Transactions : An event which has the following characteristics :
(i) Which changes the financial position of a person.
(ii) Which can be measured in terms of money.
(iii) Which can be recorded in the Books of Accounts.
Example : Purchase, Sales, Travelling Expenses, Rent, Wages, Salaries, and etc. It is therefore
concluded that “All transactions are events but all events are not transactions”.
Classification of Transaction
Cash Transactions : Those transactions which involves inflow / outflow of cash.
Example : (i) Purchased goods for cash Rs. 100.
(ii) Paid Expenses Rs. 20.
(iii) Sold goods for cash Rs. 300 and etc.
Non-cash Transaction : Those transaction which is not involved with immediate inflow /
outflow of cash. They are again sub-divided cost.
Credit Transactions : Those transactions which involve increase in assets /liabilities.
Example : (i) Goods sold to Mr. Sen on credit
— increase in asset.
(ii) Purchased goods from Sunny on credit
— increase in liability.
Other Non - Cash Transactions : Those which involves loses and does not result in immediate
outflow of cash.
Example : (i) Depreciation of Fixed assets
(ii) Bad Debts and etc.
Limitations of Double Entry System
(1) The system does not disclose all the errors committed in the books accounts.
(2) The trial balance prepared under this system does not disclose certain types of errors.
(3) It is costly as it involves maintenance of numbers of books of accounts.
(2) The trial balance prepared under this system does not disclose certain types of errors.
(3) It is costly as it involves maintenance of numbers of books of accounts.
Advantages of Double Entry System
(i) Since personal and impersonal accounts are maintained under the double entry system,
both the effects of the transactions are recorded.
(ii) It ensures arithmetical accuracy of the books of accounts, for every debit, there is a
corresponding and equal credit. This is ascertained by preparing a trial balance
periodically or at the end of the financial year.
(iii) It prevents and minimizes frauds. Moreover frauds can be detected early.
(iv) Errors can be checked and rectified easily.
(v) The balances of receivables and payables are determined easily, since the personal
accounts are maintained.
(vi) The businessman can compare the financial position of the current year with that of the
past year/s.
(vii) The businessman can justify the standing of his business in comparison with the previous
years purchase, sales, stocks, in comes and expenses with that of the current year figures.
(viii) Helps in decision making.
(ix) The net operating results can be calculated by preparing the Trading and Profit and
Loss A/C for the year ended and the financial position can be ascertained by the
preparation of the Balance Sheet.
(x) It becomes easy for the Government to decide the tax.
(xi) It helps the Government to decide sickness of business units and extend help accordingly.
(xii) The other stakeholders like suppliers, banks, etc take a proper decision regarding grant
of credit or loans.
both the effects of the transactions are recorded.
(ii) It ensures arithmetical accuracy of the books of accounts, for every debit, there is a
corresponding and equal credit. This is ascertained by preparing a trial balance
periodically or at the end of the financial year.
(iii) It prevents and minimizes frauds. Moreover frauds can be detected early.
(iv) Errors can be checked and rectified easily.
(v) The balances of receivables and payables are determined easily, since the personal
accounts are maintained.
(vi) The businessman can compare the financial position of the current year with that of the
past year/s.
(vii) The businessman can justify the standing of his business in comparison with the previous
years purchase, sales, stocks, in comes and expenses with that of the current year figures.
(viii) Helps in decision making.
(ix) The net operating results can be calculated by preparing the Trading and Profit and
Loss A/C for the year ended and the financial position can be ascertained by the
preparation of the Balance Sheet.
(x) It becomes easy for the Government to decide the tax.
(xi) It helps the Government to decide sickness of business units and extend help accordingly.
(xii) The other stakeholders like suppliers, banks, etc take a proper decision regarding grant
of credit or loans.
Features of Double Entry System
(i) Every transaction has two fold aspects, i.e., one party giving the benefit and the other
receiving the benefit.
(ii) Every transaction is divided into two aspects, Debit and Credit.
One account is to be debited and the other account is to be credited.
(iii) Every debit must have its corresponding and equal credit.
receiving the benefit.
(ii) Every transaction is divided into two aspects, Debit and Credit.
One account is to be debited and the other account is to be credited.
(iii) Every debit must have its corresponding and equal credit.
BASICS OF ACCOUNTING - DOUBLE ENTRY SYSTEM
It was in 1494 that Luca Pacioli the Italian mathematician, first published his comprehensive
treatise on the principles of Double Entry System. The use of principles of double entry system
made it possible to record not only cash but also all sorts of Mercantile transactions. It had
created a profound impact on auditing too, because it enhanced the duties of an auditor to a
considerable extent.
treatise on the principles of Double Entry System. The use of principles of double entry system
made it possible to record not only cash but also all sorts of Mercantile transactions. It had
created a profound impact on auditing too, because it enhanced the duties of an auditor to a
considerable extent.
ACCOUNTING CONVENTIONS - Convention of Conservatism
This is the policy of ‘playing safe’. It takes into consideration all prospective losses but
leaves all prospective profits. This accounting principle is given recognition in A.S. – 1 which
recommends the observance of prudence in the framing of accounting policies. “Uncertainties
inevitably surround many transactions. This should be recognised by exercising prudence in
financial statements. Prudence does not, however, justify the creation of secret or hidden
reserves”. Following are the examples of the application of the convention of conservatism :
(a) Making the provision for doubtful debts and discount on debtors in anticipation of
actual bad debts and discount,
(b) Valuing the stock in trade at market price or cost price whichever is less,
(c) Creating provision against fluctuation in the price of investments,
(d) Charging of small capital items, like crockery, to revenue,
(e) Adopting written-down-value method of depreciation as against straight-line
method. The written-down-value method of depreciaiton is more conservative in a
approach.
(f) Amortization of intangible assets like goodwill which has indefinite life,
(g) Showing joint life policy at surrender value as against the amount paid,
(h) Not providing for discount on creditors,
(i) Taking into consideration claims intimated but not accepted as a loss for calculating
profit for a general insurance company,
(j) Considering the loss relating to premium on the redemption of debentures when
they are issued at par or at discount but redeemable at premium, at the time of their
issue.
The principle of conservatism is applied :
(a) When there is an uncertainty inherent in the activity, e.g., uncertainty as to the useful
life of an asset, occurrence of loss, realization of income, remaining utility of an
asset, estimated liability.
(b) When there are two equally acceptable methods then the one which is more
conservative will be accepted.
(c) When there is judgement based on estimates and doubt exists as to which of the
several estimates is correct, the most conservative would be selected.
(d) When there is possibility of the occurrence of a loss or profit, losses will be considered
and profits will be overlooked.
This principle has effect on :
(a) Income statement. Here the principle results in lower net income than would
otherwise be the case.
(b) Balance sheet. When applied to the balance sheet, the conservative approach results
in understatement of assets and capital and overstatement of liabilities and provisions.
The principle of conservatism, however should be applied cautiously. If the principle is
stretched without reservations it results in the creation of secret reserves which is in direct
conflict with the doctrine of full disclosure. Since the main aim of published accounts is to
convey and not to conceal the information, the policy of secrecy is being abandoned in favour
of the modern and more logical policy of disclosure.
leaves all prospective profits. This accounting principle is given recognition in A.S. – 1 which
recommends the observance of prudence in the framing of accounting policies. “Uncertainties
inevitably surround many transactions. This should be recognised by exercising prudence in
financial statements. Prudence does not, however, justify the creation of secret or hidden
reserves”. Following are the examples of the application of the convention of conservatism :
(a) Making the provision for doubtful debts and discount on debtors in anticipation of
actual bad debts and discount,
(b) Valuing the stock in trade at market price or cost price whichever is less,
(c) Creating provision against fluctuation in the price of investments,
(d) Charging of small capital items, like crockery, to revenue,
(e) Adopting written-down-value method of depreciation as against straight-line
method. The written-down-value method of depreciaiton is more conservative in a
approach.
(f) Amortization of intangible assets like goodwill which has indefinite life,
(g) Showing joint life policy at surrender value as against the amount paid,
(h) Not providing for discount on creditors,
(i) Taking into consideration claims intimated but not accepted as a loss for calculating
profit for a general insurance company,
(j) Considering the loss relating to premium on the redemption of debentures when
they are issued at par or at discount but redeemable at premium, at the time of their
issue.
The principle of conservatism is applied :
(a) When there is an uncertainty inherent in the activity, e.g., uncertainty as to the useful
life of an asset, occurrence of loss, realization of income, remaining utility of an
asset, estimated liability.
(b) When there are two equally acceptable methods then the one which is more
conservative will be accepted.
(c) When there is judgement based on estimates and doubt exists as to which of the
several estimates is correct, the most conservative would be selected.
(d) When there is possibility of the occurrence of a loss or profit, losses will be considered
and profits will be overlooked.
This principle has effect on :
(a) Income statement. Here the principle results in lower net income than would
otherwise be the case.
(b) Balance sheet. When applied to the balance sheet, the conservative approach results
in understatement of assets and capital and overstatement of liabilities and provisions.
The principle of conservatism, however should be applied cautiously. If the principle is
stretched without reservations it results in the creation of secret reserves which is in direct
conflict with the doctrine of full disclosure. Since the main aim of published accounts is to
convey and not to conceal the information, the policy of secrecy is being abandoned in favour
of the modern and more logical policy of disclosure.
ACCOUNTING CONVENTIONS - Convention of Consistency
In order to enable the management to draw important conclusions regarding the working
of a company over a number of years, it is but essential that accounting practices and methods
remain unchanged from one accounting period to another. The comparison for one accounting
period with that in the past is possible only when the convention of consistency is adhered to.
But the idea of consistency does not imply non-flexibility as not to permit the introduction of
improved techniques of accounting. According to A.S. – 1 consistency is a fundamental
assumption and it is assumed that accounting policies are consistent from one period to another.
Where this assumption is not followed, the fact should be disclosed together with reasons.
The principle of consistency plays its role particularly when alternative accounting method
is equally acceptable. For example, in applying the principle that fixed asset is depreicaied
over its useful life a company may adopt any of the several methods of depreciaiton, viz.,
written-down-value method, straight-line method, sinking fund method, annuity method, sumof-
years-digit method, unit-of-production method or any other method. But in keeping with
the convention of consistency it is expected that the company would consistently follow the
same method of depreciation which is chosen. Any change from one method to another would
result in inconsistency.
In the following cases, however, there is no inconsistency although apparently they make
look inconsistent :
(a) The application of principle for stock valuation ‘at cost or market price whichever is
lower’ will result in the valuation of stock sometimes at cost price and sometimes at
market price. But there is no inconsistency here because the shift from the cost to
market is only the application of the principle.
(b) Similarly, if investments are valued at cost or market price whichever is lower, it is
only an application of the principle
Kohler has talked about three types of consistencies :
(a) Vertical consistency. This consistency is maintained within the interrelated financial
statement of the same date. Vertical inconsistency will occur when an asset has been
depreciated on one basis for income statement and on another basis for balance
sheet.
(b) Horizontal consistency. This enables the comparison of performance of an organisation
in one year with its performance in the next year.
(c) Third dimensional consistency. This enables the comparison of the performance of one
organisation with the performance of other organisation in the same industry.
of a company over a number of years, it is but essential that accounting practices and methods
remain unchanged from one accounting period to another. The comparison for one accounting
period with that in the past is possible only when the convention of consistency is adhered to.
But the idea of consistency does not imply non-flexibility as not to permit the introduction of
improved techniques of accounting. According to A.S. – 1 consistency is a fundamental
assumption and it is assumed that accounting policies are consistent from one period to another.
Where this assumption is not followed, the fact should be disclosed together with reasons.
The principle of consistency plays its role particularly when alternative accounting method
is equally acceptable. For example, in applying the principle that fixed asset is depreicaied
over its useful life a company may adopt any of the several methods of depreciaiton, viz.,
written-down-value method, straight-line method, sinking fund method, annuity method, sumof-
years-digit method, unit-of-production method or any other method. But in keeping with
the convention of consistency it is expected that the company would consistently follow the
same method of depreciation which is chosen. Any change from one method to another would
result in inconsistency.
In the following cases, however, there is no inconsistency although apparently they make
look inconsistent :
(a) The application of principle for stock valuation ‘at cost or market price whichever is
lower’ will result in the valuation of stock sometimes at cost price and sometimes at
market price. But there is no inconsistency here because the shift from the cost to
market is only the application of the principle.
(b) Similarly, if investments are valued at cost or market price whichever is lower, it is
only an application of the principle
Kohler has talked about three types of consistencies :
(a) Vertical consistency. This consistency is maintained within the interrelated financial
statement of the same date. Vertical inconsistency will occur when an asset has been
depreciated on one basis for income statement and on another basis for balance
sheet.
(b) Horizontal consistency. This enables the comparison of performance of an organisation
in one year with its performance in the next year.
(c) Third dimensional consistency. This enables the comparison of the performance of one
organisation with the performance of other organisation in the same industry.
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