UNIT 18 INVENTORY VALUATION AND DEPRECIATION

Structure 18.1 Introduction Objectives 18.2 Inventory Valuation 18.2.1 Definition : Items Included - 18.2.2 Why Inventory Valuation ? 18.2.3 Inventory and Materials 18.2.4 Accounting Relationship Involving Inventory 18.2.5 Importance and Impact of Inventory Evaluation 18.2.6 Methods of Inventory Valuation 18.2.7 Principle of Lower of Cost and Market Price 18.2.8 Classification and Grouping of Inventory for Valuation 18.2.9 Illustration of Inventory Valuation 18.3 Depreciation 18.3.1 Certain Concepts 18.3.2 Elements in Depreciation Computations 18.3.3 Capital Recovery with Return is Equivalent for all Methods of Depreciation 18.3.4 Switch-pointin DRDB Method 18.3.5 Cash Flow Consideration in Choice Between Alternative 18.3.6 Choice of Depreciation Policy 18.3.7 Gain or Loss on Disposal. Relevance of Book Value 18.3.8 Capitalising or Expensing ? 18.4 Summary 18.5 Answers to SAQs

18.1 INTRODUCTION

Inventory is the idle but valuable group of raw materials and raw material based derivatives held in the ordinary course of business. It is important to note that it is not yet actively available for sale (or external consumption), i.e. it is idle, but it is not without value, i.e. realisable worth can be attributed to it; it is not waste or scrap. Essentially, it is a buffer, or better still, a decoupling component of materials as a resource in the business. that decouples "demand" and "supply". Business houses produce their product range to satisfy customers' demands; and procure the materials needed as inputs for the production activity from suppliers. In case both supply and demand are uniform, instantaneous and well-matched, the demand can be directly matChed by supply in both time and quantity. Since this is an absolutely rare possibility. inventories have to be held. Accordingly, inventory is the aggregate of those items which are held for sale in the ordinary course of business (finished goods), or are in the process of production for such sales (work-in- process or work-in-progress) or are to be currently (or soon) consumed in the production of goods and services (raw materials) to be (eventually) available for sale. It is the least liquid current asset, but yet is inevitable as a decoupler as said above. Too much of it locks up funds; too little of it tends to disrupt production and sales activity, besides other ill-effects on the business in several other counts both when overstocked or understocked. Inventory is reported in the BS at cost or market value whichever is lower. Inventory affects the total profits. Hence, its valuation is an important necessity for business. Depreciation as has been brought out in the previous units, has a role in ascertaining the true profit, in correctly stating the financial position and in accumulating funds to replace the asset at the end of its useful life. One may also incidentally note that whereas inventory is essentially a current asset. depreciation refers almost exclusively to the context of fixed assets. Whereas market value is relevant in inventory valuation, market value is rarely quoted in case of fixed assets. Scrap value is relevant for fixed asset but assigning scrap value to inventory as a policy is reflective of ineptitude of the management. But both affect the profits and in major ways too. Construction Accounting : Objectives Principles and Practices After studying this unit, you should be able to distinguish inventory valuation from inventory management, understand the purpose of inventory valuation and its role in defining the profits correctly, reason out the assumptions involved in the different approaches to inventory valuation and value inventory accordingly, apprise the importance of depreciation provisions and on how they affect profits, replacement, cost of production, etc., learn the different methods of computing depreciation and the effect on taxes thereby, choose an appropriate depreciation policy for an organisation, appreciate the occurrence and role of switch point in depreciation, and evaluate the relative effects of expensing or capitalising for repairing costs.

INVENTORY VALUATION

A study course in inventory management would deal with the aspect of right quantity at right price at right time from right source for purchases and also with the several scientific models in the context depending on what are the ccfnponerlts of costs in inventory management that have a major bearing in the development of the respective model. Also relevant would be the nature of the two different pulls that have in effect generated the need for inventory, viz. supply and demand - with supply being classifiable as static or dynamic and demand being classifiable as certain, risk-distributed or uncertain. However, the intent in the present study course is on valuation rather than management of inventory. 18.2.1 Definition : Items Included Lexicographic meaning of "Inventory" is a detailed list of goods. But in inventory management and its management accounting, the term includes, besides stock of raw materials and of finished goods, partly finished goods also. It refers to the aggregate of all such items of tangible personal (or ownable) property which are (a) held in the ordinary course of business (not for speculative or irrelevant purposes); (b) relevant to, and usable in, or in the process of, production for such sale; (c) to be currently (or in the immediate future) consumed (or converted by being worked upon) in the production of goods or services (like petrol being used in transport in a "Travels" company), to be available for sale (or in the line of business by service - like providing transport). By this definition and concept, besides convertible stores, spare parts, loose tools (which are not long-term assets) can also be included in the orbit of inventory. 18.2.2 Why Inventory Valuation ? In a business organisation, be it manufacturing or civil engineering contracting, cost of materials purchased ultimately remains as part of closing inventory if such materials remain unused. And the purchase cost of materials used will constitute, or be distributed within, the cost of finished goods or work-in-progress, as the case may be. If cost accounting is done methodically, it would be possible to determine the value of the inventory of materials, work-in-progress and finished goods with reasonable accuracy. If, however, no proper costing system is in place in an organisation, evaluation of inventory on hand at the close of an accounting period will necessarily be difficult. Even with a costing system in vogue in the organisation, the method adopted for pricing the issues of materials and finished goods will bear on the value of the closing inventory of the items for the simple reason of having to "balance" the monetary values concerned. Said otherwise, cost of materials purchased has to be assigned either as consumed (or converted) or as inventory on hand; likewise, cost of production should be shown either as inventory or work-in-progress and finished goods or as cost of goods sold. 18.2.3 Inventory and Materials Inventory Valuation At this point, the implicit distinction between the terms, materials and inventory, should and Depreciation have been clear. Whereas materials is an omnibus (or all-inclusive) term - as purchased even if only ornamental and not for sale or even saleable and even fixed assets, inventory includes those items which can be valued in the context of the business operations. All inventory is also material; but not vice-versa. 18.2.4 Accounting Relationship Involving Inventory The principle involved is simply that the cost of inputs is to be "balanced against the cost of output. In what follows, the monetary value attached is what is meant even if not explicity so stated. In the case of raw materials : Opening inventory of raw materials + cost of purchases = cost of materials consumed + closing inventory of materials. In this, cost of materials consumed can be calculated by means of appropriateJchosen method for pricing issues (vide FIFO, LIFO, etc. in further pages). Then, the value of the closing inventory of raw materials is simply the balancing figure. In the case of works-in-progress Opening works-in-progress + cost incurred during the year = cost of goods produced + closing works-in-progress. Here, if the cost of goods produced can be calculated by means of cost accounts, the balancing figure is the value of incomplete items in closing works-in-progress. In the case of finished goods : Opening inventory of finished goods + cost of goods produced = production cost of goods sold + closing inventory of finished goods. Here, the method of pricing the completed goods (in closing inventory) (or finished goods stock) will determine the cost of goods sold, whereby profits earned can further be calculated. In all the three cases, closing inventory is always best checked by physical stock-taking. The above-noted relationships could be rather rigorously evaluated if a full-fledged costing system, or priced-stock ledgers are duly maintained in the organisation. Otherwise, it becomes more obligatory to exhaustively evaluated the closing inventory (raw materials, works-in-progress, and finished goods) through detailed physical counting and market corroboration for assistance. 18.2.5 Importance and Impact of Inventory Evaluation Profit (or Loss) of a business is determined by matching revenue with cost. Cost, within itself as a major component, includes cost of materials consumed. Cost of goods sold determines the quantum of profit, given any sales revenue. It is hardly ever possible to manage either of two situations : (a) to match supply totally synchronously with the demand for materials for the production of goods to be sold; (b) continuing on (a), to ensure that nil material balance occurs at the end of any accounting period, leave alone for any particular production set up for any of the goods to be produced to be sold in the line of the business.

From Section 18.2.4, we h \ c, Cost of goods sold = opening inventory + cost incurred during the period -closing inventory. If the value (or figu1.c r assigned to the closing inventorv is varied. it will influence the sold, the pmfit, or the ~QQ~Ssold. Since profit is sales revenue less cdst of w(yhgresult, and hence the financial position of the business are all influenced by the assigned to dosinginventory. If the purchases of the materials are on "due period, it is almost axiomauc that not all the occas'ons of occasions du*ng the -.-,A involved a same and invariant.. . unit. --.. Cod+kot for,,,hat the item nercentage of of the Const~ctionAmounUng : closing inventory belongs to which lot (or occasion) of purchase; and even if the last Principles and Practices enquiry herein could be answered in the affirmative, the effort and processes involved therefor will be totally worthless and detracting from the business if not also downright idiotic. Only certain rational assumptions can be made regarding the composition of the closing inventory as belonging to parts of the several lots (or occasions) of purchase. Dependihg upon the different rational assumptions possible, the profit figure will vary. The different rational assumptions possible to be made institute the several "methods" discussed in the next Section 18.2.6. Company Law in India obliges management to disclose broadly the method of valuation of inventory in their balance sheets. Since 1976, auditors have even to certify on physical verification having been conducted, periodically by the management, and on any significant discrepancies noticed at such verifications relative to the book records and, if any so, whether the same have been duly and properIy dealt with in the books of account and whether the auditor is satisfied on the whole affairs and on the consistency of the accounting and valuation principles adopted or to certify any deviations and changes adopted together with the effect thereof on valuation. Closing inventory comprising raw materials, works-in-progress and finished goods make up to a substantial proportion of the assets of a business for the simple reason that production of goods and services these materials and inventory is the very purpose or raison d'etre of the business. Their values as included in the balance sheet influence the judging of the financial position of the business on the date of the balance sheet. The uncertainty in such judgement or the influencing of the judgement is aggravated if no proper priced stock ledgers are maintained which, if maintained, enables proper pricing of the consumption/issue of materials and finished goods based on the chosen assumptions as given in Section 18.2.6. 18.2.6 Methods of Inventory Valuation As mentioned in the second para of Section 18.2.5, though it would be best to identify the cost of each specific unit of the material used/processedlsold by labelling it according to the particular lot in which was bought and so too for each unit of closing stock in order to make the most correct assessment of the value of the closing stock, such a solution is hardly implementable. In situations, as they happen, where there is a continuous flow of inventory, such a procedure is unthinkable to follow. Consequently, other methods of inventory valuation are in vogue and are discussed by several classifications based on whether actual cost information is available or not. By this criterion, following two groups of methods are available : (i) Methods based on actual costs; and (ii) Methods not based on actual costs. Methods Based on Actual Costs Choice of assumptions regarding the lot from which units of material are fust chosen, or units first moved out gives rise to a few methods. (a) FIFO Method with FIFO standing for FIRST IN FIRST OUT, postulates the assumption that the inventories which are received first move out first. Hence, the inventories which remain unsold are those acquired later. Though the assumption is sound in respect of lesser deterioration in inventory before it is moved out, or at least comparable deterioration (when stored) in all items of inventory before they are moved out, the method does not seem to be logical when prices are continuously rising; that there are no seasonal ups and downs in prices though there may yet be rise in prices over, say, yearly cycIes as the years progress. In a simple way of explaining this situation, one may see that the cost of goods readied for sale would also have to be assigned increasingly costlier with time, and, if sale price is to be held fixed, the profit margin per unit will continuously decrease with time. In a more professional way, one says that this method leads to "inventory profits", which is explained as under. If an item has been bought for, say, Rs. 50, and has been sold for, say, Rs. 70, a profit of Rs. 20 has been made per unit bought and sold. By then, the next lot of purchases would have become costlier, and, as an extreme case, let the unit cost at the subsequent purchases be Rs. 70. Then the profit made earlier is annulled; and one has to wait for making some profi t by sale of this next lot Nnt nnl., ..,:lt +r, ---- -..- r e. ~III. might be less - due to reluctance or resistance from customers) but the Inventory Valuation trader continues to be under the obligation to pay taxes on the profit made and Depreciation earlier, though subsequently nullified - not because the profit made was i fictitious but because the piices have been rising. Besides taxes due, the buslness may also have to face obligations to pay dividends since profit has been made on the individual item between its purchase in and sale out. In the generalised case, both the size of the inventory and also the amount and direction of price changes - affect the quantum and direction of inventory profit. (b) Weighted Average Cost Method is said to moderate this lacuna in the FIFO method. The weighted average cost is taken for each relevant occasion of valuation, say, monthly, if inventory value updations are intended to be done monthly. Summing up the product of quantity and rate for the relevant quantity in each lot (of purchase) as may be appropriate for the intended computation and dividing this total sum of cost by the sum of the respective quantities, the weighted average cost appropriate to the occasion of inventory valuation is obtained. This computational procedure can successiv~lygo with each occasion of inventory valuation updation including till the closing inventory. The iGpact of rising prices could be abated to some extent by this method, where, except for weighted averaging of unit costs as appropriate, the assumption regarding picking up of inventory to be moved out as per order of receipt (as in FIFO) is continued with. (c) LIFO Method with LIFO standing for LAST IN FIRST OUT, considers the latest among the lots of purchases of material as qualified to be moved out first for processing or sale. In times of rising prices, high unit cost items would, by this method, get included in the cost of goods sold, before lower unit cost items would also get to be moved out. This assumption of LIFO is supposed to eliminate the incidence of inventory profits, in most part, if not altogether. Accordingly, though it is a tax-saving device to some extent, it does not record cost expiration. Also this assumption patently is unacceptable in times of falling prices. On close scrutiny, it is obvious that in times of larger volumes of sales, cost of purchases done earlier would also enter the cost of goods sold, and, this would affect profit realisable. A most important disadvantage with this method is, since most of the organisations do not adopt this method, whenever any individual organisation in a similar line of business adopts this method, then inter-organisation comparison of profits and financial positions becomes less meaningful if not also suspect. In any case, deterioration of material purchased earlier is unintentionally promoted by this method. (d) Base Stock Method : In this method, it is assumed that a minimum inventory is always camed (in any decoupling situation, this will always the case and, so, rather than call this as an assumption, it should be called a recognition of a necessary fact) and the value of such inventory is the cost incurred when it was acquired. In a regime of fluctuating prices, there will be a well-informed tendency to buy less at times of high unit cost and to buy more at times of low unit cost. Therefore, the minimum inventory is likely to just closely succeed the time when purchase costs per unit were the highest. This fact can be seen in the worked-out example given further on. Accordingly, in a regime of fluctuating purchase prices, the base stock may be taken to be the residual inventory closely next to the lot purchased at the highest unit cost; however, step-by-step adjustments by adding purchases and deducting sales is the only correct method to determine the base stock. The inventory level upto the base stock in the closing inventory would be valued at a uniform figure. It is most logical to adopt the weighted average cost per unit of the material till the occurrence of the base stock from the beginning of the accounting period, including the opening stock also, as the value of this uniform figure of unit cost for the base stock. This procedure will generally result in a not too low value of base stock cost; and this would be acceptable. Co~~struclionAccounting : Any surpll~sin the closing inventory over the base stock may be valued Principles and Practices based on FIFO or LIFO as the case may be. Though the weighted average unit cost covering the total purchases plus the opening stock can be used for this excess within the closing stock above the base stock, the computational process is generally considered rather cumbersome and so is not much preferred. Methods not Based on Actual Costs Two methods under this criterion are generally in vogue : (e) Market Value Method : The term "Market value" can mean one of two things : One is the value at which the item of inventory could be sold in the market by the organisation. Since the organisation is not a primary dealer in the (raw) goods making up this inventory, its realisation of sales revenue cannot be as much as it would pay if it were to purchase this inventory quantity (if as raw goods). The second is the value at the latter description in the preceding sentence, viz. the value at which the quantity of this inventory (as raw goods) could be obtained or purchased from the market at the time of valuation. Notwithstanding the above distinction, the first implication (or meaning, or connotation) is adopted when valuing finished goods (as these are the market-wise specialised line-of-business outputs of the organisation). But, for raw materials and works-in-progress, management must decide on which of the two implications of market value to adopt. However, as far as taxation is concerned. a coiisistent method of valuation shouid be adopted. (t) Standard Cost Method : Inventories may be valued on rates of estimated costs or of struidard costs. The important commitment required of the management is that these standards must be set up well before hand. It should not be an exercise of "playing football with moving goal posts". Both the consumption aiid inventory must, in this method, be valued at standard costs, whether or not the actual costs tally with the standard costs respectively for each item or type of material. The difference (often called by the term "variance" - which is, however, used in a different purpose in contexts of statistical analysis) between standard and actual costs will have to be adjusted against the profits, i.e. in the current period's accounts itself. On the other hand, the difference in respect of inventories cannot be adjusted in the current period but only in the period to ensue when the inventory will be consumed. This dual aspect necessitates that the variznce in respect of goods sold and inventory remaining unsold be bihlrcated. This dual adjustment necessity is a salient disadvantage of this method. 18.2.7 Principle of Lower of Cost and Market Price While adopting any of the six methods [(a) to (f)] described under Section 18.2.6, two aspects must be highlighted for the information of those responsible for inventory valuation. Firstly, a method once chosen should be consistently followed. Secondly, the basic convention of "conservatism" and "prudence" must also be observed and practised. This convention enjoins that anticipated losses should be included when determining the profit or loss of a period though such losses have not actually been suffered. For this reason, inventories may (have to) be valued at market prices (how they can be sold out) if these prices are lower than cost prices (as recorded in the books). Then, by implication in the balancing relationship discussed in Section 18.2.4, with the cost of inventory being less than their cost price, the figure of the cost of goods sold is automatically inflated by the implied loss in the inventory value due to adopting the (lower) market price. To overcome the several difficulties arising from this conceptually inflated sales (revenue) figure (by balancing the equation), this inflated figure of cost of goods sold should have to be glven under its two obvious components, viz. (a) the actual cost of the items sold; and (b) the part arising from balancing the loss due to undervaluation of the inventory at market value instead of at cost. But in periods when the market value (equal\ or) is higher than cost, the inventory would be valued only at cost; and the second component referred to above will not exist. Hence, if "lower of cost or market price" principle is adopted for inventory valuation, and if the market prices fluctuate above and beIow the cost price, the cost of goods sold will not be unifor~riover the different periods. This will make any comparison of I working results (of the business through several periods) meaningless. To make Inventory Valuation them comparable, the loss if any due to undervaluation of inventory will have to and Depreciation be adjusted separately. 18.2.8 Classification and Grouping of Inventory for Valuation Inventory value when as works-in-progress comprises of material cost, labour cost, and overhead costs. This is so with finished goods also. If the costs other than material cost are duly separated (by adopting a proper costing system,) it will be possible to view all materials together wherever, or in whichever form, they lie - as raw materials, works-in-progress or finished goods. After such separation and then aggregation of quantities of inventory for each of the different items (say, steel, cement, wood, etc.), the value of the inventory of the several items can be individually listed for management's information. To evaluate the inventories on behalf of the organisation taking all the several items together, after they have been individually listed, two approaches are in practice - viz. "global approach" and ''individual approach". Consider, for example, five major items in an organisation whose closing inventories are valued as given in Table 18.1. Table 18.1

Lower of Cost and

In the "global approach", only the final totals are taken for comparison; i.e. the comparison is between Rs. 23,24,000 by cost of the five items of material and Rs. 22,48,000 by market value of the same items, By comparing these "global" sums for all items of inventory the "lower of cost and market value" for all the 5 items taken together will be Rs. 22,48,000. The last column is irrelevant. In the "individual approach", the "lower of cost and market value" for each of the items as has been already indicated in the last column is summed up and the summated value of the inventories of the 5 items taken together will be Rs. 21,90,000. The last column alone will be relevant. C SAQ 1 (a) Define "Inventory Valuation". How is it different from inventory management or inventory control ? (b) "All inventory is also material; but not vice-versa." Comment.

SAQ 2 (a) Describe the accounting relationship involving inventory during the three stages, namely raw material, work-in-progress and finished goods. (b) Discuss in brief the different methods of inventory valuation. Construction Accounting : 18.2.9 Illustration of Inventory Valuation Principles and Practices An example problem is considered for the application of methods of inventory valuation mentioned under Section 18.2.6 along with the principle dealt with in Section 18.2.7. Application of these methods is illustrated also to situations where priced-stock registers may not have been maintained. The working procedure is mostly self-explanatory as per titles of columns and rows; additional explanations are also given wherever further likely to be needed or helpful in understanding the working procedure. It would be worthwhile if the illustrative example problem be worked out by you after abbreviating the data for quarterly periods and the results compared with the case of the detailed data for the twelve months. Example 18.1 Consider the following case of a certain material item whose purchase and sale (without any further processing) is detailed out as given in Table 18.2 from the accounting records of an organisation. Sales have been at a uniform rate of Rs. 475 per unit of the item. Table 18.2

All purchases are made at the beginning of the month, the quantity purchased being stipulated by available closing stock, projected sale in the month's time of follow and the prevailing market rate per unit for purchases and also so as to maintain enough stock in view of the projected demand in the next month to follow after the current starting month. It is desired determine the purchase price of the stock of goods sold, closing 4 inventory and profit by (a) FIFO Method, 1 (b) LIFO Method, and (c) Weighted Average Costs Method, assuming that the company maintains a regular priced-stock register, and f no priced-stock register is maintained. Also to state the profit in case the market for the item is slack and the company cannot sell the product at more than Rs. 345 per unit. Solution It is best to tabulate the computations as far as possible. The tabulated titles are self-explanatory in the tables that follow. Tables 18.3, 18.4 and 18.5 show the computation of above mentioned three methods respectively. It is noted that, together with opening stock, total quantity inward over the whole year is 8650; and total quantity sold is 7800; accordingly, the carryover stock into next year will be 850 at the end of the twelfth month, viz. March. Table 18.3 :FIFO Method with Priced-Stock Ledger Inventory Valuation (Computation Page) and Depreciation

- Particulars Receipt Sold Balance - Quantity Quantity Rate, Value, Rate, Value, Qumtity Rate, Value, RsNnit Rs. & Stock bNnit Rs. (.Month) 1 Source &Source Stock RsNnit Rs.

Opening 850 330 2,80,500 850 330 2,80,500 Stock (0pg.l

Apr. 500 380 1,90,000 700 330 2,3 1,000 150 (opg.) 330 49,500 ------500 (A~r.) 1,90,000 700 2,31,000 ------380 ------650 2,39,500 May 700 360 2952'W0 150 (oP~.) 330 49,500 50 (Apr.) 380 19,000 450 (Apr) 1,7 1,000 700 (May) 2,52,000 ------380 ------360 ------600 2,20,500 750 2,7 1,000 Jun. 600 360 2,16.000 50 (A~r.) 380 19,000 100(May) 360 36,000 600(Ma~) 2,16,000 600 (Jun.) ------360 ------360 ------2.16.000 650 2,35,000 700 2,52,000 loo (May) 36,000 500 (Jul.) 1,90,000 Jul. 500 380 11909000 360 ------380 ------600 (Jun.) 360 2,16,00() ------500 1.90,m 700 2,52,000 500 (Jul.1 1,90,000 300 (Aug.) 1,14,000 Aug. 500 380 1,~,000 380 ------380 ------200 (Aug.) 380 76 O()O ------2,66:000 300 1,14.000 700 300 (Aug-) 1,14,000 350 (Sep.) 1,26.000 Sep. 700 360 2,52,000 380 ------360 ------350 (Sep.) 360 1,26,000 ------350 1,26,000 650 2.40,OOO

Oct. 750 350 2,62.~0 350 (Sep.) 360 1,26,000 400 (Oct.) 350 1,40,000 350 (Oct.) 1,22,500 ------350 ------400 1,40,000 700 2,48,500

Nov. 750 350 2.62.500 350 1,40,000 550 (Nov.) 350 1,92,500 {) 70,000 550 ------350 ------1,92,500 600 2,10,000

Dec. 700 340 2,38,000 (Nov-) 350 1,92,500 600 (Dm.) 340 2,04,000 340 34,000 ------600 2,04,000 650 2.26.500

800 320 2,56,000 600 (Dm.) 340 2,04,000 800 (Jan.) 320 2,56,000 Jan. ------*--- 600 2,04,000 800 2,56,000

340 2,38.000 (Jan.) 320 1,92,000 200 (Jan.) 64,000 Feb. 700 ------700 (Feb.) 238,000 600 1,92,000 ------900 3,02,000

600 360 2,16,000 200 (Jan.) 320 64,000 250 (Feb.) 340 85,000 Mar. 450 (Feb.) 1,53,000 600 (Mar.) 2,16,000 ------340 ------360 ------650 2,17,000 850 3,O 1,000 Finally TOTAL 30,43,500 TOTAL 27,42300 BALANCE 3,01,000 Check : 30,43,500 = 27,42,500 + 3,01,000 +Checked. Opening Stock = 9.2 16% Sales = 90.1 10% Balance = 9.89% Purchases = 90.784% Sales = Purchases Construction Accounting : LIFO Method with Priced-Stock Ledger Principles and Practices (Computation Page)

-- - - Receipt Sold Balance Particulars .- Value, Quantity Rate, Value, Quantity & Rate, Value, - Quantity Rate, Stock Source RsJUnit Rs. & Stock Rs~~nit Rs. Rsmnit Rs. (Month) I Source - 2,80,500 Opening 850 330 2,80,500 850 (0pg.I 330

Stock - Apr. 500 380 1,90,000 (Apt) 380 1,90,000 650 (opg.) 330 2,14,500 2Oo(opg.) 66,000 ------330 ------650 2.14,500 700 2,56,000 2,16,000 650 (opg.) 2,14,500 May 700 360 2,52,000 ------(May) 360 ------330 100 (May) 360 36,000 600 2,16,000 ------750 2,50,500 \ - Jun. 600 360 2,16,000 600 360 2,1z00 650 (opg.) 330 2,14,500 50 (May) 18,000 50 (May) 18,003 ------360 ------360 ------650 2,34,000 700 2,32,500 - (Jul.) 1,90,000 1,65,000 Jul. 500 380 1,90,000 3 80 500------(opg.) 330 ------50 (May) 360 1g,ooo 49,500 500 1,65,000 ------150 (opg.1 330 ------700 2,57,500 --- 500 1,90,000 99.000 Aug. 500 380 1,90,000 380 300------(opg.) 33 0 ------200 (0~g.1 330 66,000 I ------300 99,000 700 2,56,000 Sep. 700 360 2,34,000 300 (opg.) 330 99,000 50 (Sep.) 18,000 ------360 ------350 1,17,000 Oct. 750 350 2,62,500 700 (Oct-) 350 2,%,000 / 300 (opg.) 330 99,000 50 (Sep.) 360 18,000 50 (Oct.) 17,500 ------350 ------400 1.34,SOO Nov. 750 350 2.62500 600 (NOv.) 350 2,10,000 300 (opg.) 330 99,000 50 (Sep.) 360 18,000 50 (Oct.) 17,500 150 (Nov.) 350 52.500 ------350 ------' i 550 1,87,000 Dec. 700 340 22.8.000 1 650 340 2,2 1,000 1 300 (opg.) 330 99,000 50 (Sep.) 360 18,000 50 (Oct.) 17,500 150 (Nov.) 350 52,500 50 (Dec.) 350 17,000 ------340 ------600 2,04,000 Jan. 800 320 2,56,000 *O (Jan.) 320 1,92,000 600 (AS ~n aec ) 320 2,04,000 200 (Jan.) ------64,000 800 2,68,000 Feb. 1 700 340 2,38,000 *O (Feb.) 340 2,@4,000 800 (AS in ran.) 340 268,000 10(Feb.) 34,000 ------990 3,02,000 Mar. 600 360 2.16.000 360 2,16,000 800 (AS in ran.) 340 2,68,000 ()340 17,000 50 (Feb.) 17,000 ------* ------650 2,33,000 850 2,85,00C, Finally TOTAL 30,43,500 TOTAL 27,58,500 BALANCE 2,85,000 Check : 30.43.500 = 27,58,500 + 2,85,500 + Checked - I 138 Table 18.4 :Weighted Average (For Unit Rate, Successively) Method - with Priced-Stock Ledger (Computation Page)

Computations are best presented in stages. The applicable weighted average cost per unit, available for the successive month's sales is computed. The tabular headings are again self-explanatory. Here, ctmeans "carried over".

Total do Total do Purchase in Month Post-Purchase Sales Value to be Month stock value in to Avg. rate Rate in C/O next &. Qty. Ratio Value in Initial Total Value Value in moE!, in Rs. Q~Y. in Rs in Rs. Rs. 1 purchase purchase

I April 850 2,80.500 500 380 1.90,000 1350 4,70,500 348.52 700 348.52 2,43,963 2,26,537 May 650 2,26,537 700 360 2,52,000 1350 4,78337 354.47 600 354.47 2,12,683 2,65,854 June 750 2,65.854 600 360 1 2,16,000 1350 4,81,854 356.93 650 356.93 2,32,004 2,49,850 July 700 2,49.850 500 380 1,90,000 1200 4,39,850 366.54 700 366.54 2,56,579 1,83,271 August 500 1,83,271 500 380 1,90,000 lo00 3,73,271 373.27 700 373.27 2,61,290 1,11,981 Se~tember 300 111,981 700 360 2,52,000 lo00 3,63,981 363.98 650 363.98 2.36.588 1.27.393 October 350 127.393 750 350 2,62,500 1100 3,89,893 354.45 700 354.45 2,48,114 1,41,779 November 400 1.41.779 750 350 2,62,500 1150 4,04,279 351.55 600 351.55 2,10,928 1,93,351 Deember 550 1.93,351 700 340 2,38,000 1250 4,31.351 345.08 650 345.08 2,24,303 2,07,048 January 600 2,07,048 800 320 2,56,000 1400 4,63,048 330.75 600 330.75 1,98,449 2,64,599 February 800 2'64,599 700 340 2,38,000 1500 5,02399 335.07 600 335.07 2,01,040 3,01,559 I March ( 900 ( 3.01,559 ( 600 4 360 1 2,16,000 1 1500 1 517,559 1 345.04 ( 650 ( 345.04 ( 2,24276 1 2,93,283 ( I I I I I I I I I I I Closing 850' 2,93,283 TOTAL 27,63,000 TOTAL 27,50,2 17 Construction Accounting : The computational procedure followed in Table 18.4 is explained stepwise for Principles and Practices purposes of additional clarity. The opening stock of 850 of value Rs. 2,80,500 is carried over into April. With the purchase of 500 at Rs. 380 per unit, the initial stock value in April is Rs. 4,70,500 for 1350 units, i.e. at weighted average cost for initial stock @ Rs. 348.52. Sales of 700 units in April is then a total sale of Rs. 2,43,963 in April. The c/o stock value into May will, by difference, be Rs. 226,537 for the c/o stock of 650 units. This completes the entries made in the first line, second line and into the first three columns of the third line. The table is completed proceeding likewise with the appropriate data for each successive month. In mathematical presentation, Rs. 348.52 in the April-line can be seen as follows : (850 x 330) + (500 x 380) Rs . = Rs. 348.52 850 + 500 which is straight forward. The entry of Rs. 354.47 in the May-line can be seen as follows : (650 x 348.52) + (700 x 360) Rs. = Rs. 354.47 650 + 700 In this case, out of quantities (850 + 500). 700 has been sold in April; then, the balance of 650 (at weighted cost @ Rs. 348.52) plus 700 @ Rs. 360 make up to a total of Rs. 4,78,537 for 1350 units - i.e. Rs. 354.47 per unit. And so on. As in the cases of both FIFO and LIFO, in this case also it rnay be seen that : Rs. 27,63,000 of purchases + Rs. 2,80,500 of opening stock = Rs. 30,43,500

It is reflected also as : Rs. 27,50,217 that have gone into sales + Rs. 2,93,283 as closing stock, again totalling to Rs. 30,43300, checking the balancing between the components of quantities. When No Priced-stock Ledger is Maintained FIFO Method Closing inventory is 850 units. Under FIFO, this 850 will be by : 250 from February purchase and 600 by March purchase, whose value will be : 250 @ 340 + 600 @ 360 = 85000 + 216000 = Rs. 3,01,000 - which agrees (matches) with the priced-stock ledger case valuelfigure of Rs. 3,01,000. [Under FIFO method, generally, the two cases - viz. with, and without, priced-stock ledger - will yield the same value for closing inventory.] Cost of goods sold will be = Rs. 30,43,500 - Rs. 3,01,000 = Rs. 27,42,500. LIFO Method Closing inventory of 850 units, under LIFO, will, in this problem, comprise entirely, and only, of the opening stock, this latter being exactly of the same quantity. Its value will be 850 @ 330 = Rs. 2,80,500; and this does not agree with the priced-stock ledger case valuelfigure of Rs. 2,85,000. Cost of goods sold will be = Rs. 30,43,500 - Rs. 2,80,500 = Rs. 27,63,000, Weighted Average Unit Rate Method The total of opening stock and the purchases over the year (through the twelve months) is 8650; and the total cost on all these stock is Rs. 30,43,500 as seen in the tables of FIFO and LIFO and also in the discussions following Weighted Average Unit Rate Method, all under the priced-stock ledger case. Accordingly, the weighted average purchase cost per number of the stock will be : Rs. 30,43,500 + 8650 = Rs. 351 35; and, thereby, the value of the closing stock by the weighted average unit rate method in the case of no priced-stock ledger will be = 850 @ Rs. 351.85 = Rs. 2,99,072; which does not agree with the priced-stock ledger case valuefigure of Rs. 2,93,283. Cost of goods sold will be = Rs. 30,43,500 - Rs. 2,99,072 = Rs. 27,44,428. SALES RECEIPTS : In all cases, this is 7800 @ 475 = Rs. 37,05,000. The above results can all be tabulated as given in Tab16 18.5. Inventory Valuation and Depreciation Table 18.5 : Compilation of Results

Cost of Goods Cost of Sales Profit Value of Purchased1 Goods Receipts Closing Received, Sold Methods including Opening Stock, (b.) (k.) (h.) (b.) (Rs.) With Priced-stock Ledger 1. FIFO Method 30,43,500 27,42,500 37,05,000 9,62,500 3,01,000 2. LIFO Method 30,43,500 27,58,500 37,05,000 9.46.500 2,85,000 3. Weighted Average Method 30,43,500 27,50,217 37,05,000 9,54,783 2,93,283 Wothout Priced-stock Ledger + 4. FIFO method 30,43,500 27,42300 37,05,000 9,62,500 3,01,000 5. LIFO method 30,43,500 27,63,000 37,05,000 9,42,000 2.80.500 6. We~ghted 30,43,500 27,43,428 37,05,000 9,60,572 2,99,072 Average Method In the situation when the closing stock can be sold at (not more than) Rs. 345 per unit, the market value of the closing stock will be (not more than) Rs. 850 x 345 = Rs. 2,93,250. When the principle of "the lower of cost or market value" is applied, each of the cases (I), (3), (4) and (6) in Table 18.5 will be credited only with Rs. 2,93,250 as the value of closing inventory; in each of these cases (i) Cost of sales will be : [opening inventory + purchases] - [closing inventory] = 30.43.500 - 2,93,250 = Rs. 27,50,250; and, therefore, (ii) profit will be = 37,05,000 - 27,50,250 = Rs. 9,54,750 - which, as it ought to be for reasons implied above, is less than the respective figure in the table. In respect of cases (2) and (5) in Table 18.5, there will be no change. Base Stock Method Consider the above problem. At the FIFO table (Table 18.2) as well as at the LIFO table (Table 18.3), the least quantity of balance stock is 300 units at the end of August. The same is seen in Table 18.4 for the Weighted Average Cost Method also as the pre-purchase stock in September (beginning of September). Thus, it can be said that this minimum inventory is always carried; and this is called the BASE STOCK - defined as the minimum inventory that is always held. The value of such inventory is the cost incurred when it was acquired.

I According to FIFO method (as seen in "Balance" in August end), this is part of the L stock purchased in August and would be of value 300 @ 380 = Rs. 1,14,000.

L According to LIFO method, (as seen in "Balance" in August end), this is part of the opening stock and would be valued at 300 @ 330 = Rs. 99,00i). According to Weighted Average Cost Method, the details of the Table in the previous illustration are not to be taken, the reason being not the simplicity of the procedure to be now mentioned but the very definition of the BASE STOCK, viz. it has always been carried so far (and will be camed hereafter also). For this reason, the weighted average cost till and inclusive of the purchase for August is taken relevantly. t This weighted average cost for the base stock will be : - (850 x 330) + (500 x 380) + (700 x 360) + (600 x 360) + (500 x 380) + (500 x 380) 800+500+700+600+500+500 13,18,500 - = Rs. 366.25 3600 The value of the base stock will be taken as : 300 @ 366.25 = Rs. 1,09,875. Now, we turn our attention to the surplus over the base stock in the final or closing I inventory. This is 850 - 300 = 550 units. Construction Accounting : According to FIFO method, this will be within the 600 of the last month's (March) Principles and Practices purchase as seen under the "Balance" columns. This will be valued at 600 @ 360 (the purchase cost rate for the month of March) = Rs. 2,16,000. Then, under Base Stock method with FIFO, the value of closing inventory (850 units) will be (1,14,000 + 2,16,000) = Rs. 3,30,000. However, if "the lower of cost or market value "(under the same terms as in the above problem) be considered, the value of closing stock will be the lesser of Rs. 3,30,000 or Rs. 2,?3,250, i.e. will be (only) Rs. 2,93,250. According to LIFO method, the total of 850 units of the closing inventory has comprised of: 300 (opg.), 50 (Sept.), 50 (Oct.), 150 (Nov.), 50 (Dec.) 200 (Jan.) and 50 (Feb.). At closing, the base stock part of 300 units, under LIFO, will be taken to comprise of: Last in is first to be out; i.e. earlier the stock purchased, surer it is retained - i.e. 300 (opg.) is what constitutes the base stock within the closing inventory. The surplus of 550 over the base stock of 300 (within the closing stock of 850 units) then comprises of : the rest of the quantities - viz. 50 (Sept.), 50 (Oct.), 150 (Nov.), 50 (Dec.), 200 (Jan.), and 50 (Feb.). Valuing all these and summing up, the value of the closing stock, under the Base Stock method with LIFO, is Rs. 2,85,000 - which, (incidentally in this problem data context,) happens to be the same as in the earlier LIFO method. Incidentally again, it is seen that this is the lower of the "cost or marktt value" and hence will remain the same under the "cost or market value" criterion fos the given data. In the case of Base Stock method taken with weighted average cost, the excess of 550 units in the closing stock (above the base stock of 300 units within 850 units of total closing stock), will be valued at the overall weighted average cost rate of Rs. 351.85 (per unit) (vide - when no priced-stock ledger is maintained - Weighted Average Unit Rate Method). The value of this excess part of the closing inventory 3043500 550. over the base stock will be : 550 @ 351.85, i.e. 1,93517 [= 8650 )

Together with the value of the base stock (Rs. 1,09,875 as derived earlier), the total value of the closing stock will be, by sum, Rs. 3,03,392. If, however, "the lower of cost or market value "criterion is adopted, the value of the closing stock, under this Base Stock method with weighted average cost, will be (only) Rs. 2,93,250 (as in like contexts discussed earlier). It must have been realised from the above details that Base Stock method is rather cumbersome for computations. With the added disadvantage that, going by its definition, base stock itself will, over a period of time, become obsolete and unrealistic, it is but true that this method is not much adopted. SAQ 3 In the third para of Section 18.2.9, a suggestion has been made to rework the example problem. Attempt the same. Explain any differences in the results as best as you can.

18.3 DEPRECIATION

The word depreciation literally, by the structwe of the word, means "decline in price". It refers, in usage, to decrease in the value of assets - fixed assets and capital assets. This decrease occurs (gradually and permanentally) due to wear and tear when used in productive activities, passage of time (even with un-use), obsolescence, depletion (or exhaustion), or any other cause. It is meant to quantify (through policy basis) the permanent and continuous diminution in the quality, and quantity or the value of an asset. It is a measure of the exhaustion of the effective or usefd-Ai&.uf an asset from any cause during a given period and continues upto the end of the life of the asset. ! Machinery, furniture, transport vehicles, etc. depreciate by constant use (and even Inventory Valuation non-use, with passage of time). Buildings and open air structures depreciate with passage and Depreciation of time. Mines decline in asset value by depletion. Accidents also cause decrease in asset value in their wake. Sluggish 01. bearish markets are associated with a permanent fall in prices of an asset, i.e. its value goes down or depreciates, as in cases of investments, residential property (under an adverse environment, say, an epidemic, large scale migration, etc.). 18.3.1 Certain Concepts Depreciation - Repairs - Fluctuations Depreciation is not meant to replace, avoid, or postpone repairs (i.e. spending on repairing the fixed asset) but is in addition to repairs. Also, fluctuations in the price of the asset are not to be taken to affect the amount of depreciation during successive periods. Depreciation is a reduction in the book value of tangible fixed assets, the reduction being gradual, of a continuing nature and permanent. On the other hand, fluctuation happens, in a majority of cases, all of a sudden, and hence, is neither gradual nor continuing, and also not permanent, since the change in the market value of an asset may fluctuate involving either reduction in or appreciation of value. Largely again, fluctuations are more often relevant to floating or current assets whereas depreciation is associated with tangible fixed assets. Exclusions Depreciation accounting is not applicable to I (a) forests and other regenerative resources; (b) expenditures on the exploration for, and extraction of, minerals, natural gas, oil and similar non-regenerative resources; (c) expenditures on research and development; and (d) goodwill - (which is intangible). Need for, and Functions served by, Providing Depreciation (a) To help ascertain the true netprofit : Any business incurs certain expenses (costs) in order to earn revenue. Reduction in the value of assets used in the business processes is necessarily a part of the cost (Depreciation is an expense) and is accordingly shown in the P & L A/c of the period. The implementation of the concept of Matching Costs with revenue emphasises the role of depreciation in this implementation. Otherwise, the correct (or true) net profit will not be shown. (b) To properly account for the cost of production : This goes with (a). Depreciation, being a cost of production, if not properly recorded in the P & L A/c, the cost of production will not be truly reflected, thereby impairing (a). Depreciation is an expense. (c) To ensure that capital is not written oflas profit : If depreciation is not properly accounted for. profits (shown) will be higher (than actuals) and when (the profits are) distributed, capital will be adversely affected. In course of time, the capital will be substantially and significantly reduced as it would have been distributed in the form of profits. Depreciation is a charge on profits. (d) To help depict the correctfinancial position : If (a) and (b) are not duly attended to, and with (c) eventually resulting in such a case, the assets shown in the BS will not show the correct value; and the BS will not set out the financial position truly. Providing for depreciation is not optional but compulsory, and must be charged to the respective accounting period. Depreciation is a period cost, i.e. expense. (e) To apprise creditors with correct information : Whatever ill-effects may be read from (c) and (d), when not warded off, would misinform and misguide potential creditors who would reasonably expect the assets of the business to stand as surety for any loans to be advanced to the business. (f) To spread over a few years thefinancial burden of writing oflan asset : Generally, an asset continues to be useful in the business for much longer than just one, or just a few, years after its (first) purchase and installation; since the advantage thereof is available for many years, the financial burden thereof on Construction Accounting : the business should also be spread over a number of years; and to put all the Principles and Practices burden on the P & L A/c of one year will be unreasonable. (g) To provide for replacement of assets : Continuing on (f), time comes when the assets become useless (at lemt-hr the present post of service) and need to be replaced. The maintenance of a depreciation fund provides (at least a part of) the funds needed to replace such assets. . Depreciation Distinguished from Obsolescence, Depletion and Amortisation The distinction between depreciation and fluctuation (in price) has been discussed hereinbefore, alongwith its relevance notwithstanding repairs. The other terms are also now distinguished from depreciation. When an existing asset, machine or building with its facilities, needs to be scrapped even though it can be physically usable, because of a new machine or designs having come into the market, there is a tendency to move away from using the existing old asset. The fall in value of the existing asset arises more out of better performance and convenience of the newcomer rather than for any deficiency in the exisiting asset. Such a situation is called obsolescence of the (existing) asset. Depletion arises out of extraction, removal or exhaustion of the asset, and though the unit rate value of the asset may not have diminished, and may even have appreciated, yet the total residual quantum reduces with time. Natural resources or wasting assets like mines, oil wells, timbel; etc., are common examples. The asset value is reduced or exhausted with removal or extraction. This reduction in value or expiration of cost of asset is called depletion. Whereas reduction in value of a fixed asset over time by wear and tear (or mere passage of time due to weathering by elements) constitutes depreciation, expiration of cost, or asset value reduction, by process of removal or extraction, is construed as depletion. Amortisation refers to the writing off of the proportionate value of intangible assets, such as goodwill, copyright, patents, etc., while depreciation refers to the \ writing off of the expired cost of tangible assets like machinery, furniture, buildings, etc. (Beyond this distinction from the term depreciation, other contexts of usage of the term amortisation are not included hereinabove.) Concept of Capitalisation : Some Restatements Under (a) in "Need for, . . . . Depreciation" (vide above), the concept of matching costs with revenue was recalled. Another concept which is to be recalled in profit determination is the capital and revenue concept. Any expenditure incurred by a business will ultimately be either part of the costs of the period or as an asset to be, and will so be, camed forward to the subsequent periods. If considered as part of ' costs of the period, it will be taken to the P & L A/c. If considered as part of assets, it will be carried forward, and will be shown in the BS. To recall previous information, the former is "Revenue" and the latter is "Capital". So, those items of expenditure which are treated as assets will not naturally constitute "cost of the period". Then, the quantum of profit is influenced by a judgement on whether to "capitalise" (treat as an asset) an expenditure or to charge it as "cost of the period". As a corollary, and expenditure which is capitalised (i.e. an asset) also becomes part of the "cost of the period" in instalments over a period of years. This concept of allowing to "become" (as in the last sentence) is the concept of depreciation. When an expenditure, which is treated as an asset, is charged off over a period of years, it is called "depreciation". Any expenditure which seeks to create an enduring benefit, or lasting facility, should be capitalised. The amount to be capitalised should include all costs, including the cost of putting the facility to use, i.e. to bring it to a usable condition. As examples : (a) "Cost" of a building purchased is not merely the consideration paid to the seller but includes also all legal fees, commissions, cost of alterations to make it suitable to the buyer's purposes, etc., including any value for own labour involved (say, even the buyer has himself drawn up the sale deed); (b) For a machine, besides purchase price, all incidental costs in acquiring, getting to site, installing it and energising it and providing guard rails and metrology would form part of the amount to be capitalised. The amount of expenditure capitalised will not remain undisturbed in the books of Inventory Valuation accounts, except perhaps cost of land. The cost of other assets will be charged and Depreciation against the revenues of various years in the form of depreciation. Depreciation effects the spreading (or di~tnb~tion)of the capitalised cost or other basic value of tangible capital assets less salvage, if any, over the expected useful life of the facility in a systematic and rational manner. It is a process of allocation, not of valuation. 18.3.2 Elements in Depreciation Computations 3esides the capitalised cost of the asset, three other elements have to be decided upon for omputing the quantum of depreciation to be charged each year; firstly, the useful life of the asset - commercial or physical - whichever is shorter; secondly, the salvage, resale or scrap value of the asset at the end of its useful life (as estimated on current cost index basis); and, thirdly, the method of charging the depreciable amount (i.e. capitalised, or first, cost less salvage value) over the life of the asset. Method of Prorating the Depreciable Cost Depending on whether the method is totally internally controlled (or managed) or involves external parties; whether the internally managed methods consider interest accumulation on the depreciation amounts set apart or not; without interest being considered, whether depreciation is uniform or accelerated - the methods of providing depreciation are classified as given in Figure 18.1. cMethods of Depreciation Allocation

Controlled

I Interest 1 Service Output V@Considered Policy Method Sinking Fund Method (Rapid Depreciation

Uniform Accelerated Allocation Allocation ri (Rapid Depreciation In Early Years)

Declining Balance, or Sum of the Years Written Down Value

Figure 18.1 :Methods of Providing Depreciation , Straight-Line Method of Depreciation Provision (SLM) The amount of depreciation (D) is uniform year after year, bringing down the cost price (P) at time ZERO to the predicted salvage value (L) at time n, (years) where n is the predicted economic (or useful) life. Accordingly,

If an asset has a first cost of Rs. 1&000, and a predicted salvage of R's. 1,000 at the end of a predicted useful life of 10 years, then the depreciation in each of the 10 years will be Rs. 900. Construction Accounting : From time 0, through end-of-years (EOY), 1,2, . . . to 10, the (residual) book value Principles and Practices will, successively, be as follows : Rs. 10,000 (time 0). Rs. 9,100 (EOY-l), Rs. 8,200 (EOY-2), Rs. 7,300 (EOY-3), Rs. 6,400 (EOY-4), Rs. 5,500 (EOY-5), Rs. 4,600 (EOY-6), Rs. 3,700 (EOY-7), Rs. 2,800 (EOY-8), Rs. 1,900 (EOY-9), Rs. 1,000 (EOY-10). In short, the book value (B, or BV, or BKV,) at any time t years, i.e. (EOY-t) will be given as under : 'd

(with n = 10 in this case).

Declining Balance Method (DBM) Within the Indian context, the term "Diminishing" is more used than "Declining". The method is also called the "written down value method". The residual value of the asset after providing for (i.e. deducting) depreciation in the current year is the "Written down value " (WDV) for the next year (at the beginning). Depreciation through the current year is at a fixed percentage of the WDV at the beginning of the year. If R, as a fraction, represents this percentage, then the Table 18.6 is self-explanatory. Table 18.6

Salvage It is seen that salvage value has not been considered in the above computations by DBM. In fact, salvage value, as predicted, can almost never be achieved when the other elements in the computation, viz. Po, n and R, are prescribed. This is a drawback of this (DBM) method. The unabsorbed difference to the salvage value has to be "dumped" to the last year as (total) depreciation. This involves an operational absurdity - i.e. towards the end, when the machine could hardly perform, too much is to be charged off. Consider, for example, a 10-year life of an asset whose first cost is Rs. 10,000, and salvage value is predicted as Rs. 1,000. Table 18.7 refers to the computations. The 1 fixed percentage to be used for depreciation computation is - (for 10 years life). 10 Table 18.7 Inventory Valuation and Depreciation Year EOY BKV.

(RS.1

I 9 - lo [ x 387= 378 ] But has to be : 2874

If it is, however, desired to use a depreciation rate that will result in a particular book value at some point in time, it is possible to solve for the rate that should be used. Recalling that after t-years, the Book value, or the written down value (BV or WDV) will be Pt = Po [l - R] ', R can be calculated, with P, set = L, we get,

1000 O.' In the previous case, R should be = 1 - - = 0.20567, say 0.2057. rL 1000Oi2 The above Table is recomplited with this value of R and presented in Table 18.8. Table 18.8 Construction AccountbZ : Higher Rates of ~ecliningBalance . Principles and Practices The first set of computations, where depreciation was provided by the fraction given by the reciprocal of the number of years to be depreciated through (i.e. the useful life), is called the "straight rate declining balance method". This rate of depreciation will rarely give the predicted salvage value at the end of the useful life. Hence, to overcome this difficulty, higher rates are prescribed (admitted by law in several countries) - the most common being the "Double rate declining balance mehtod", abbreviated as DRDB method. In this, if the useful life is n 2 years, the depreciation in any year is at the rate of -n of the starting book value (WDV), in the year. Here too, the salvage value is not taken into consideration when computing the depreciation except that appropriate adjustments should be made in the appropriate year. These details are explained by Table 18.9 and the discussions thereunder, taking P = Rs. 10,000, n = 10, and DRDB for depreciation. Table 18.9

If, in this case, the salvage value at EOY = 10 is to be at, say Rs. 2,000, then at EOY 8, only Rs. 98 is depreciated (at Col. 2), and the BKV at EOY-8 is set at 2,000, and thereafter the depreciation is ZERO in both EOY-9 and EOY-10, thereby maintaining the same BKV, i.e. at Rs. 2,000. If, however, the salvage value at EOY-10 is to be at, less than Rs. 1074, all the difference from Rs. 1342 (this being the BKV at EOY-9) is dumped at EOY-10, e.g. if salvage value at EOY-10 is to be Rs. 500, the depreciation against EOY-10 would be (1342 - 500) = Rs. 842, instead of Rs. 268; and that would yield EOY-10 as Rs. 500. 11 Other rates on declining balance are also talked of, e.g., 1- 1- rates - i.e, 4. 2 1 1 1 1 depreciation is at (1- times -) or (1- times -), respectively. In all such cases, the 4 n 2 n values of depreciation amounts have to be adjusted for any predicted salvage value. Sum-of-the-Years Digit.Method (SYD Method) The sequence of the years, serially ordered is reversed. Successive depreciation amounts are according to these weightages. As explanation, if 5 years is the useful life, the reversed sequence of digits to be used as weightage for successive years will be 5,4, 3, 2, 1, respectively. Now consider the sum of these digits - which is 15. Then the successive weightages can be re-stated as :

These proportions, when applied to the total amount to be depreciated over the 5 years (i.e. P - L), give the depreciation to be charged in the successive years, respectively. The computations can be illustrated for the same data used earlier : P = Rs. 10,000, L = Rs. 1,000, n = 10 years, depreciation by SYD. It is given in Table 18.10. To compute, first may note that 1 to 10 = 55. In general, for successive integers 1 to N,we get, Inventory Valuation and Depreciation

Hence, depreciation injsuccessive years will be 10,9,8,7,6,5,4,3,2,1 Rs. - x [10000- 10001. 55 Table 18.10

Accelerated Depreciation :A Misnomer In studies in mechanics, increasing speeds with time is what is defined as accelerating. On the other hand, in both the methods by Declining Balance and Sum-of-the-Years digits, it is seen that the quantum of depreciation decreases as the years go by. Thus, in a purely mechanical sense, to call these as accelerated methods of depreciation is rather a misnomer. However, these are called Methods of Accelerated Depreciation. The term "accelerated" as used here is merely to convey the sense that recovery of capital of the asset has been larger in earlier years (which, by general usage in accounting, has been called as "rapid", and the same has been reflected by usage of the word "accelerated"). Sinking Fund Method of Depreciation (SFM) In this method, it is assumed that the value of the asset decreases at an increasing rate. This is really the fact in actual cases. In this method, one of a series of equal amounts is assumed to be deposited into a sinking (not used for any other purpose) fund at the end of each year of the asset's life. The sinking fund is ordinarily compounded annually, and, at the end of the estimated life of the asset, the amount accumulated equals the total depreciation of the asset. (The objection to this' method is that whereas the amounts set apart are credited with compounding interest, the first cost and salvage are at historical costs as at the time of having incurred the first cost.) For the data taken above as P = Rs. 10,000, L = Rs. 1,000, n = 10 years, taking

SFDF = 0.06582; (9%, 10 years) ' Each of the year-end equal amounts = 0.06582 x (10000 - 1000) = Rs. 592.38 The depreciation charge during any year is the sum of the amount deposited into the sinking fund at the end of the year and the amount of interest kedon the accumulating sinking fund during the year. The computations are shown in Table 18.11. Sequence of entries in any row will be, given EOY : (5), (2), (3), (4). It is to be noted that, in Table 18.11 under Col. 2, only Rs. 592.38 is the respective EOY allocation; the rest is made out by the amount of interest earned on the accumulated sinking fund during the year. Construction Accounting : Table 18.11 : Computation in Sinking Fund Method of Depreciation Principles and Practices EOY Depreciation Accumulated Book Interest on Previous at EOY Sinking Fund Value at Accumulation EOY During Period Ending

(h.) (1) (4) 1 I592.38 + (5)] 1 [previous (3) + (2)l ~ [9 % of previous (3)] I

SAQ 4 (a) What is depreciation ? Explain the role of depreciation as it could affect the public image of the company. (b) Distinguish between depreciation on the one hand and repairs/fluctuations/ depletion/amortisationon the other. (c) Inventory management as also depreciation provisioning affect the profitability of an organisation. But there are essential differences between the two. Explain the same. (d) Explain the different methods of prorating the depreciable cost.

18.3.3 Capital Recovery with Return is Equivalent for all Methods of Depreciation The different methods givLn under SLM, DBM, DKDB, SYD, and SFM lead to different value-vs-time functions for book value. But it will be interesting to note that : if the retirement of any asset takes place at the age predicted and, if, at that time, the book value equals the estimated salvage value, then, the depreciation amount and interest on the undepreciated balance will be equivalent to the capital recovery with a return - for any method of depreciation. In this connection, it is recalled that capital recovery with a return is defined as : [(P - L) x CRF] + F x i.

In this, the first term is the capital recovery - i.e. the first cost less salvage; and the second term is the return on the salvage which has been deferred for recovery (out of the firts cost of P). If (P - F) = A + B + C + . . . + N, where A, B, C, . . . N are capital (cost) (i.e. first Inventory Valuation cost) amounts recovered in (the end of) successive years, the following information is and Depreciation easily developed for any schemelmethod of depreciating. (a) Consider, for illustration, P = Rs. 5,000, L = Rs. 1,000, n = 5 years and i = 10% p.a., and SLD Depreciation in each of 5 years = Rs. 800. Computations are shown in Table 18.12. Table 18.12

Rather than consider other methods of depreciation allocation, consider, for illustration, an entirely erratic scheme of depreciation amounts and prevalent interest rates through the useful life of an asset. (b) P = Rs. 5,000, L = Rs. 1,000, n = 8 years, i variable as shown in Col. 4 in Table 18.13 (a) and (b); yearly depreciation amounts as shown in Col. 3 - (variably). In this instance, since i values are varying, SPPWF for one year at a step is considered and the sequential product of SPPWF values from initial time to the year-end as relevant is computed for each EOY,i.e. the n; product as shown in Table 18.13 (b). Table 18.13 (a)

Year Undepreciated Depreciation i for year Interest on balance at during Year % Undepreciated beginning P-a Balance for the Year (h.) (h.) (h.)

(1) (2) (3) (4) (5) = (2) x (4)

0- 1 5,000 800 5 250 1-2 4,200 100 7 294 2-3 4;100 900 10 410 3 - 4 3,200 200 9 288 4-5 1 135 3,000 1,000 4- 2 5 - 6 2,000 400 12 240 6-7 1,600 200 10 160 7-8 1,400 400 6 84 8 - 9 1,000 Construction Accounting : Table 18.13 (b) Principles and Practices i for Sum SPPWF x of PW at time 0 Year for 1 SPPWF % Year at from O given i Time to Year End ~ Rs.

--- 6-7 200 10 360 0.90909 0.57661 207.58 7 - 8 400 6 484 0.94340 0.54397 263.28 8 - 9 0.54397 543.97 TOTAL 5000.00

(c) Since the Sinking Fund Method differs from other methods, let it be considered in the context of the proposition of this Section. Since the procedure of developing the accumulated depreciation arnou~tis different in this method compared to the other methods, the demonstration of the validity of the proposition is also by a different procedure. Consider, as before, P = Rs. 5,000, L = Rs. 1,000, with n = 10 years and i = 7% p.a. The CRF for i = 7% p.a., 10 years = 0.14238 (Table 18.14). Hence, the sinking fund to be set apart at the end of each interval is = Capital Recovery on the total depreciated amount of Rs. 4,000 + Interest (per year) for the salvage = Rs. (4000 x 0.14238) + Rs. 1000 @ 7% = Rs. 569.52 + Rs. 70 = Rs. 639.52 Table 18.14

All this firmly proves and justifies that, depreciation amounts and salvage, together, ensure that the first cost of the asset has been realised in full. 18.3.4 Switch-point in DRDB Method Inventory Valualion and Depreciation The Declining Balance Method, as discussed in Section 18.3.3, leaves a book value of Po [I - R] " and if, as has been explained subsequently therein, R is a fraction taken as [ix multiplier] the multiplier ordinarily being between 1 to 2 (or slightly more than 2). the residual, or written down, or book, value, at the end of the nth year is Po [1 - -:I" where k is the multiplier used. For k = 1, and 2, the depreciation computations have been shown. Depreciation computations have also been shown if L = 1,000 has to be obtained. As the value of n increases to (plus) infinity, the ultimate WDV, or the salvage, or the scrap, value, indicated by this depreciation process, will be, L = Po [1 - -:In as n + -; L L L i.e.= Po x ek.lfk=l,---+0.3679;ifk=2, --+0.1353,(andfor---0.1, Po Po Po k = 2.3026 when n 4 (+ -). Since, with the DBM, whatever the k used, the computed book value at the end of the tax life is independent of the salvage value, L, at that date, the user of the DBM method must contemplete for the contingency that, when L is stipulated previously, as well as k, then there will be either a "dumping" adjustment in the last year, or there may be no depreciation to be provided in a few of the last years. The need for "dumping" adjustment has been earlier discussed. The incidence of no depreciation to be provided in a few of the last years is inferable from the limiting values discussed in the previous paragraph. For example, consider P = Rs. 10,000, L = Rs. 2,500, k = 2, n = 5. The final WDV at the end of the 5thyear indicated by this process will be [P= 100001x [1 - -:I5 = Rs. 777.60 against the (stipulated) expected value of Rs. 2,500, the latter being the larger. Obviously, the depreciation to be provided will not continue till the last year. In fact, for EOY-1, depreciation would be Rs. 4,000 and WDV will be Rs. 6,000; for EOY-2, depreciation would be Rs. 2,400 and WDV will be Rs. 3,600; for EOY-3, depreciation would be only Rs. 1,100 (and not Rs. 1,440), and WDV will be at Rs. 2,500 (and not Rs. 2,160); and for the 4th and 5th years, no depreciation will be provided for. One of the significant advantages of providing for rapid depreciation is the tax-advantage (which is being discussed further on). Considering the above aspects, concepts have been developed on what is called "switching to straight line method of depreciation" from the declining balance method. It is advantageous to make the switch whenever the terminal book value using the DBM (with given k) alone (usually the DRDB method) exceeds the predicted terminal salvage. The working detail for the switch from DRDB to SL method implies that in the year that the annual depreciation charge using SL depreciation method thereafter becomes greater than with continuing with the DRDB method, the switch is made from DRDB (tiU the s that the switch is recommended in

Undepreciated balance - Predicted salvage 1 DRDB depreciation. Remaining life

Computation of Switch Point year for DRDB Method For first cost P, predicted salvage L at the end of useful life of n years and DRDB method used intially since the first year, at the end of (r - 1)th year, t In, the . The DRDB depreciation through the t-th year will be

P [I - +Ii- [!I. If PL method of depreciation is effected from ihe iih year

(inclusive), the amount to be depreciated in all of the remaining years after the Constmctwn Accounting : Principles and RPctien

done will be n - (t - 1) years. Thus, if switch is effected from the ith year (inclusive) onwards, the SL depreciation after the (t - 1)th year will be

Then, switch can be recommended in the tth year (inclusive) if I

n-(t- 1) " nlJ nJ L Solving for p with DRDB Method Consider the condition needed for switch at the end of the (t - 1)th year, i.e. from rth year (inclusive) onwards, developed as :

..U 11II.U n-(t- 1) n nI

Condition for no Switch with DRDB Methods

It can imrnediatelv be noted that when t = n. this last statement. on the right" hand side, reads

This means that, if by chance, the predicted L is equal to the DRDB book value, 1 the switch con occur only in the last year -which is the same as continuing with the DRDB method throughout for all the n years - noting that depreciating the last instalment of depreciation in the last one year is after aH a straight- line depreciation as well, though derived by DRDB method.

Accordingly, the statement at 2, vir. 4 = 11 - is a signal for no switch. Oecurrence of Switch Point with DRDB Method Inventory Valuation and Depreciation L It is obvious that for a switch point to occur, - must have to be less than P L L J I and for n + .o, this will be - < 0.1353. For example, for n = 8, - must have to be P P L less than 0.10; for n = 5, - < 0.07776; etc. I P In condition given in Eq. (18.1), consider the situation of r = /: + 1) . Then I" I [? -!- l]equals zero. For t < , this expression will be negative, which

is inadmissible (as salvage is not to be taken as negative in these computations). Therefore, if there is a switch point, it will occur after the first half-life of the asset, n i.e. only for t > -, and the earliest it will occur is 2

switch point to be looked for. Accordingly, further, it can be seen that the lower limit for n, for a switch- p_oint to be meaningful in its occurrence will be n > 3, since, for n = 3, t 2 L2- :J , i.e. t = 3 for switch point to occur; this statement is meaningless, (i.e. the useful life is already completed as n = 3; and switch point, occurs then). Thus, the conditions for switch point to occur can be summed up as :

(a) 3 < n < m,

, which, when n + a,tends to 0.1353, and

(c) t > n, the earliest being 2

Illustration of DRDB Depreciation With and Without Switch Consider P = Rs. 10,000, L = Rs. 400, n = 10. We may note that conditions (a) and (b) as above are satisfied. The switch point will occur at the 6th year or later. The details are now tabulated in Table 18.15. Table 18.15

SLD thereafter

period, charging off - 0 10000.00

1 ' 8000.00 - 2000.00 lo 1 9600110 = 960.00 20G00 - DRDB 2 6400.00 1600.00 9 760019 = 844.44 1600.00 - DRDB -3 5120.00 1280.00 8 600018 =750.00 1280.00 -DRDB

10 400.00 , % 555.50 555.50 - SLD CHECK : Sum 9600.00 Construc:tion Accounting : 10 Principli!s and Practices L Note :[1 - . = 0.10737 Vs given 0.04 for -. $1 P

It is seen that t = 7, which satisfies the condition (c). All three conditions are satisfied. As a second illustration, consider L = 0 and n = 4 with DRDB method for depreciation. It is seen that condition (a) and (b) are satisfied with - 4 - A < [[I - = By condition (c), the switch can occur at the 3rd year: P $1 21

Whether DRDB is continued with dumping in the 4th year, or if switch is effected for the 3rd year, both (DRDB with dumping and DRDB with switch) methods give 111 1 the same sequence of depreciations through the years, viz. - - - and -; and the 2' 4' 8 8 111 WDV's will, in successive year ends, be : - - - ,O. 2' 4' 8 Accordingly, DRDB with switch is distinctly meaningful only for n 2 5 in condition (a), subject, of course, to conditions (b) and (c). 18.3.5 Cash Flow Consideration in Choice between Alternative The discussions under Sections 18.3.5, 18.3.7 and 18.3.8 are not to be primarily correlated with transfering information therein to or from the P & L Ncor BS. The discussions are primarily regarding choice between alternatives capable of equal performance before choosing the most desirable investment option and also to choose between capitalising and expensing in case of major repair expenditures. Discussions on cash flow in Section 18.3.6 are in the context of their incorporation into or from the P & L A/c or BS. The former said Sections (18.3.5, 18.3.7, 18.3.8) deal with a fixed asset over its life whereas the latter said Section (1 8.3.6) deals with periods of business activity. Cash Flow Cash flow back, or simply cash flow, in the context of operations related to the business in a firm is the sum of the profit and depreciation generated by operations. In general, apart from P & L A/c and BS presentations, a business organisation must also have to concern itself on the economy in the matter of acquisition of capital assets like machinery, particularly when alternative choices may be available. Besides merely checking the profitability against MARR, it is better to compare the breakeven rate of return between alternatives available. It . may also be that the cash flow with and without even a simple addition on a machinery may be for consideration. Suppose that the sales revenue are expected to be Rs. 4,00,000, whether machine set I is chosen or machine set I1 for the production operations. Cost of goods sold in the two cases along with depreciation in both the cases are given in Table 18.16. Tax rate is at 30%. The post-tax cash flow in either case can be computed and the choice can be made appropriately. Table 18.16

Sl. No. Details Machine Set I Machine Set II (1) Sales Rs. 4,00,000 Rs. 4.00.000 (2) Cost of goods sold Rs. 2,80,000 Rs. 2,40,000 (3) Profit before depreciation = (1) - (2) Rs. 1.20,000 1 Rs. 1.60,000 (4) Depreciation Rs. 35,000 Rs. 45,000 (5) Profit before tax= (3) - (4) Rs. 85,000 Rs. 1.15.000 (6) Tax payable @ 30% [of (31 Rs. 25,500 Rs. 34,500 (7) Profit after tax Rs. 59,500 Rs. 80,500 (8) Cash flow after tax = (7) Rs. 94,000 Rs. 1,25,500 (4) I (9) Increase in cash flow after tax : I1 over I Rs. 31,000 Such computations, adopted suitably, are relevant in the choice among alternatives Inventory Valuation before long-term investment in fixed assets are decided upon. and Depreciation Analysis when Tax Life Equals Economic Life To compute tax disbursements, the analyst follows the same accounting procedures as accountants use, as illustrated above. Taxable income is computed as gross income less the sum of operating disbursements and depreciation expense. If, as an alternative method of computations, tax savings are to be computed, the same tax effects must be recognised. In taking the basic data inputs, all items that are not by law permitted to be expensed in one year must be depreciated. All tax regulations must be recognised and all taxes and tax savings must be allowed for, including those on gains or losses on disposal. It is emphasised that the rates and percentages used in the numerical examples may not conform to existing rules, regulations, legal provisions, etc., but are intended only as illustrating their use and handling in the definition and solution of relevant problems. Example 18.2 Field equipment for transporting raw quamed material, say by conveyor belts, as per design provided by consultant X, would involve a first cost of Rs. 35 lakhs and will need Rs. 9 lakhs per year to operate, including maintenance and minor repairs. The alternative design by consultant Y, to deliver the same performance, will cost Rs. 28 lakhs initially but will need Rs. 11 lakhs per year to operate inclusive of maintenance and minor repairs. Both systems will serve satisfactorily for a period of 7 years by when tax regulations may permit their full write off. The company wishes to adopt straight-line depreciation in both cases. The income-tax payable is at 35%. The salvage value at the end of 7 years in either case is "nil". What will be the indifference rate-of-return at post-tax computations ? Solution The post-tax net operating disbursements are computed (Table 18.17) for each case and then post-tax costs are considered relatively for comparison. Table 18.17

SI. No. Details X Y (1) Annual operating disbursements Rs. 9,00,000 Rs. 11,00,000 1 Rs. 5,00,000 Rs. 4,00,000 Yearly depreciation expense @ - of (2) 7 first cost (less zero salvage) (3) Total annual expenses = (1) + (2) Rs. 14,00,000 Rs. 15,00,000 (4) Tax savings due to above expenses Rs. 4,90,000 Rs. 5,25,000 @ 35% [of (3)] (5) Net, post-tax, operating Rs. 4,10,000 Rs. 5,75,000 disbursements = (1) - (4)

Comparative Costs after Tar

X 35 lakhs 4.1 lakhs per Year 0 7

28 lakhr 5.75 lakhs per Year Y 1 0 Figure 18.2 It is taken that annual disbursements are to be committed at the beginning of each year respectively. The indifference rate of return can be computed by, say, equating the respective annual (equivalent) cost for X and Y. 39.1 crf (i, 6 years) + 4.1 = 33.75 crf (i, 6 years) + 5.75 i.e., 5.35 crf (i, 6) = 1.65 crf (i, 6) = 0.30841 157 Construction Accounting : At i = 20% crf = 0.3007 1; and i = 25%, crf = 0.33882 from Interest Tables. Principles and Practices Finally, i = 21.03% (with crf for 6 years = 0.30843). If i < 21.03, X is better and if i > 51.03, Y is better. 18.3.6 Choice of Depreciation Policy Recalling what has so far been said and demonstrated, the choice of depreciation policy depends on the following considerations; however, once a decision on a method is taken, it has to be consistently followed and frequent changes are not in favour, except for switch point, if permitted by law. Tax Implications Providing larger amounts of depreciation in earlier years saves more on taxes in those earlier years; and as any income sooner is better than an equal income later (due to discounting), accelerated depreciation has advantage over straight-line depreciation. Effect on Dividend Distribution Dividends can be paid only out of profits. With straight line depreciation, the distributable surplus in the earlier years would be larger. Thus, with straight line method of depreciation, management is enabled to declare dividend more easily. The image of the company in the minds of the investing public is based on the return the company offers to them; and early impressions often carry the day. Cash Flow Implications As obvious from the above two paragraphs, if the depreciation figure is less, the quantum of profit will be more and vice-versa. With a given cash flow, if a greater amount is paid out as dividend, the part of the cash flow left for replacing the asset will be less. Since replacement costs also increase with time, it is essential to maximise the funds available therefor, i.e. to earn the maximum return on the depreciation funds. Thus, higher quantum of funds in earlier years earns more interest as well over the longer years before replacement - and this policy has this advantage. Implication of Changing Price Levels Depreciation is based on historical costs. Since replacements are likely to be i costlier, extra appropriation out of the distributable profits should have to be made to meet the rising cost of replacement, though there is no tax advantage by this extra provision. 1 18.3.7 Gain or Loss on Disposal, Relevance of Book Value 1 When comparing the relative economy between alternative choices for investment on fixed assets, when tax life exceeds (or equals) economic life and so long as the asset is not disposed of at the end of the economic life, it is the book value at the end of the economic life that has been considered in the comparison. If, however, statements are seen in texts dealing with the subject that book value is irrelevant, this statement is to refer to the fact and needed recognition that the "Investment value of an incumbent asset is its net realisable value and not its book value". To emphasise the point made or implied otherwise in the introductory sentence, it is, on the other hand, important to realise that the book value is relevant (subject to the asset not being disposed of at the end of the economic life) in the choice between alternative options (of assets to be procured) to choose from through computing inclusive of income tax savings (on account of capitalisation) and disbursements (revenue expenses). The book'value in these cases"s synonymous with predicted salvage value. If the net realisable value (on disposal) di bers from the book value, the difference establishes the taxes to be paid on a gain on disposal or saved on a loss on disposal. Thus, the book value, though irrelevant to place an investment value on an incumbent machine (i.e. its net realisable value), is relevant as the basis of computing depreciation (capitalisation) and by its effect on annual tax disbursements and also on tax, on gain or loss on disposal. 18.3.8 Capitalising or Expensing ? It is not necessary that all capital expenditures must be capitalised, i.e. depreciated as part of cost of (i.e. value addition to) fixed assets for tax proposes. Certain of the proposed expenditures may be "expensed", i.e. treated as revenue expenditure relevant for the respective accounting year; and the tax effects will be as immediate tax savings: It is generally felt by many personlel that these jhnediate tax savings, in view of the time Inventory valuation value of money, are more valpable than corresponding tax savings distributed over the .Ra Depreciation tax-life of the asset resulting from the expenditures (and depreciating in hrther years). Expenditure in normal overhaul, normal maintenance and repairs and relocation of equipment, to the extent that they do not increase the productivity or efficiency or life of the equipment can be expensed rather than be viewed as capital expenditure which must be depreciated. However, the underlying opinion entertained in these matters - whether to capitalise or to expense - cannot be rigidly formulated or guided. SAQ 5 (a) Consider P = Rs. 2,00,000, L = Rs. 4,000, n = 8 years, i = 6% p.a., compute the table of yearly depreciation for e ch of SLM, SYM,DBM by simple rate, DRDBM (with and without swit4 point), and DBM complying with L value. (b) Discuss the essential features when the joint effect of depreciation and taxes are I to be considered when the tax life equals the economic life. (c) Illustrate the proposition in the title of Section 18.3.3 for each of the i depreciation schemes worked our under Sections 18.3.2 and 18.3.4 for 8% p.a. intenst. I

I I In this unit, the importance of invenbry valuation has been brought out; the several I ' methods therefor have been fully ilhstrated; the relative merits and diff~cultieshave hem discussed. The incidence, computation, purposes, etc. in respect of depreciation have been described and illustrated. The joint effect of depreciation and taxes as they affect cash flow has been illustrated, and how to choose between alternative options has also been illustrated. The relative wwme of considering a major expenditure either as expensing or capitdising has been dealt with towards the end of the unit. ias ANSWERS TO SAQS 1 Refer the #levant preceding text in the unit or other useful books on the topics listed in the section "Further Reading" given at the end of the block to get the answers of the self-assessment qcstions. Construction Accounting : Principles and Practices FURTHER READING

Desai, Vasant, Project Management, Himalaya Publishing House. Anthony, Robert N., Accounting Principles, Irwin. Backer, M., Modern Accounting Theory, Prentice Hall. Benjamin, James J., Financial Accounting, Dame Publishing. Anderson, L. P., Millar, V. V., Thornson, D. L., The Finance Function, Scranton, Pa., Intext. Shao, Stephen P., Mathematics for Management and Finance, South-Westem Publishing Company. I