Depreciation & Inventory

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Concept of ConservatismDepreciation and other Provisions

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Conservatism states that the accountant should not anticipate income and should provide for all possible losses.

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As per conservatism concept, it is not prudent to count unrealised gain but it is desirable to guard against all possible losses.

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When there are many alternatives values of an asset an accountant should choose the method which leads to lesser value.

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For conservatism, there should be three qualitative characteristics, namely

Prudence, i.e., judgment about possible losses which are to be guarded, as well as gains which are uncertain.

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Neutrality i.e., unbiased outlook is required to identify and record such possible losses and to exclude uncertain gains.

Faithful representation of alternative values.

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Example1. Closing stock is valued at

Cost or market price whichever is lower

2. Depreciation is charged every year even though cost of the asset has not decreased.

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Fixed assets like plant and machinery etc. are used in the business for the purpose of production or providing services. With the passage of time and utilisation, value of such fixed assets decreases.

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Value of portion of fixed assets utilized for generating revenue must be charged during a particular accounting year to ascertain the true cost. This portion of cost of fixed asset allocated is called depreciation.

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Depreciation means reduction in value of asset or in the utility due to passage of time, natural wear and tear, exhaustion of the subject matter.

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Lapse of time natural wear and tearexhaustion of the subject matter

Obsolescence of technology

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To ascertain the true results of operations

To present true and fair value of the fixed asset

To accumulate funds for the replacement of the asset

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Estimation of exact amount of depreciation is not easy.

Generally following factors are considered in calculation of depreciation.

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1. Cost of asset including expenses for installation etc.

2. Estimated useful life of the asset.

3. Estimated scrap value (if any) at the time of useful life of the asset.

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1) Straight Line method (SLM)2) Reducing Balance Method RBM3) Machine Hour Method4) Production Units Method

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In this method, an equal amount is written off every year during the working life of the asset to nil or its residual value at the end of its useful life.

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SLM: The underlying assumption of this method is that the particular asset generates equal utility during its lifetime.

Depreciation=

Cost of Asset-Scrap ValueUseful Life

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ExampleCost of machinery: 18000Installation Charges:2000Useful Life of Asset: 5 YearsCalculate Depreciation as per

SLMManagement Accounting - Dr.

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Depreciation = 4000 p.a.

Depreciation=20000-05 years

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Under this method, a fixed percentage of diminishing value of the asset is written off each year. The annual charges of the depreciation decrease from year to year.

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Written Down Value (WDV)= (Acquisition Cost – Depreciation)Depreciation= WDV*Depr Rate

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RBM: The main advantage of this method is that total charge to total revenue is uniform when the depreciation is high, repairs are negligible and as the repairs increases the burden of depreciation gets lesser and lesser.

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RBM:For First Year Depreciation=Acquisition

value* RateFor Second Year on words Depreciation=Written down

value* Rate

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ExampleCost of machinery: 50000Scrap Value of machine:5000Useful Life of Asset: 10 YearsDepreciation %: 15% p.a.

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Calculate Depreciation as per reducing balance method for first 2 years

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RBM:For First Year

Depreciation=50000* 15% =7500

For Second Year Depreciation=42500 * 15%

=6375

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Where it is possible to keep a record of the actual running hours of each machine, depreciation may be calculated on the basis of hours worked.

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The machine hour rate of depreciation is calculated after estimating the total numbers of hours that machine would work during its whole life.

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Under machine hour method Depreciation is calculated for each hour the machine works.

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ExampleCost of machine: 500000Estimated working hours: 40000Scrap Value: 10000The pattern of distribution of effective working hours:

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Year hours1-2:5000 per year3-5:7000 per year6-8:3000 per yearCompute depreciation p.a.

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Solution:1-2 5000 X (500000-10000)40000=61250 p.a.

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Solution:3-5 7000 X (500000-10000)40000=85750 p.a.

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Solution:6-8

3000 X (500000-10000)40000=36750 p.a.

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Under this method depreciation is determined by comparing annual production with the estimated total production.

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The amount of depreciation is computed by the using following formula:Depreciation for the period= depreciable Production during the periodamount X Estimated total production

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ExampleCost of machine: 30000Estimated total production: 4000Scrap Value: 2000Pattern of distribution of production:

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Year Units1 : 20002 : 15003 : 500

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Solution:Year 1 2000 X (30000-2000)4000=14000

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Solution:Year 2 1500 X (30000-2000)4000=10500

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Solution:Year 3 500 X (30000-2000)4000=3500

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A provision is a liability which can not be measured with a substantial degree of accuracy. A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow of resources.

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Where the liabilities are known but amount s cannot be precisely determined, we estimate for liability and provide for it.The principle of conservatism supports making of provisions for probable liabilities.

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ProvisionsExamplesProduct service warranty cost,bad debts, changes in foreign exchange rates in case of international transaction etc.

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