Depreciation Accounting and Inventory Valuation (B.Com Hons) Notes || Unit 2 || Sem

Unit-2 : Depreciation Accounting and Inventory Valuation (Sem-1) Delhi University

Accounting for Property, Plant, and Equipment (PP&E)

PP&E are tangible long-term assets that are vital for a company's operations and are expected to provide economic benefits over multiple periods.

1.1 Initial Recognition and Measurement

Cost at Recognition: PP&E should be initially recorded at cost, which includes:
- Purchase price (including import duties and non-refundable taxes)
- Directly attributable costs to bring the asset to its working condition and location (e.g., site preparation, installation)
- Initial estimates of dismantling and removing the asset, and restoring the site

1.2 Subsequent Measurement

Cost Model: After initial recognition, an entity may choose the cost model, where PP&E is carried at cost less accumulated depreciation and any accumulated impairment losses.
Revaluation Model: Alternatively, under the revaluation model, PP&E is carried at a revalued amount, being its fair value at the date of revaluation less subsequent accumulated depreciation and impairment losses. Revaluations should be made with sufficient regularity to ensure that the carrying amount does not differ materially from its fair value.

Journal Entry :

PPE A/c Dr.

To Cash/Bank/Payable A/c

1.3 Depreciation

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.

Depreciable Amount: The cost of an asset, or other amount substituted for cost, less its residual value.
Useful Life: The period over which an asset is expected to be available for use by an entity.
Methods of Depreciation:
- Straight-Line Method: Allocates an equal amount of depreciation each year.
- Diminishing Balance Method: Allocates higher depreciation in the earlier years of the asset's life.
Change in Depreciation Method: If there is a significant change in the expected pattern of economic benefits from an asset, the depreciation method should be reviewed and, if necessary, changed to reflect the new pattern. Such a change is accounted for prospectively.

Journal Entry :

Depreciation Expense A/c Dr.

To Accumulated Depreciation A/c

1.4 Derecognition

An asset should be derecognized upon disposal or when no future economic benefits are expected from its use or disposal. The gain or loss arising from derecognition is the difference between the net disposal proceeds and the carrying amount of the asset and should be recognized in profit or loss.

2. Relevant Accounting Standards

In India, the accounting for PP&E and depreciation is governed by Accounting Standard (AS) 10, "Property, Plant and Equipment," issued by the Institute of Chartered Accountants of India (ICAI).

2.1 AS 10: Property, Plant and Equipment

Scope: AS 10 prescribes the accounting treatment for PP&E, including recognition, measurement, depreciation, and derecognition.
Key Points:

Component Accounting: Significant parts of an asset with different useful lives should be depreciated separately.
Depreciation: The standard provides guidance on various depreciation methods and emphasizes that the method should reflect the pattern in which the asset's future economic benefits are expected to be consumed.
Revaluation: Entities are permitted to revalue their assets, provided the revaluations are carried out regularly.

Depreciation: Meaning and Concept

1. Introduction to Depletion and Amortization

Accounting recognizes the reduction in the value of both tangible and intangible assets over time. Two specific concepts that deal with this are depletion and amortization, both of which ensure that expenses related to long-term assets are systematically recorded.
Depletion applies to natural resources that are physically consumed over time, such as coal, oil, gas, timber, and minerals.
Amortization applies to intangible assets that have a definite useful life, such as patents, copyrights, trademarks, and franchises.

2. Depletion

2.1 Meaning of Depletion

Depletion refers to the allocation of the cost of natural resources as they are extracted or used. Unlike depreciation, which applies to fixed assets like machinery and buildings, depletion is specific to assets that physically reduce in quantity over time.

2.2 Examples of Assets Subject to Depletion

Mineral resources (coal, iron ore, gold, silver)
Oil and gas reserves
Forests and timber
Quarries and mines

2.3 Depletion Methods

There are two main methods used to calculate depletion:

2.3.1 Cost Depletion Method

This method is based on the total cost of the resource and the estimated amount that can be extracted.
Formula:
$Depletion Expense = (\frac{Total Cost - Residual Value}{Total Estimated Units}) \times Units Extracted in the Period$ Units Extracted in the Period
This method ensures that depletion expense is based on actual usage.

2.3.2 Percentage Depletion Method

This method applies a fixed percentage to the gross income from the resource to determine depletion expense. It is commonly used for tax purposes, especially in industries like oil and gas.
Formula:
$Depletion Expense = Gross Revenue \times Depletion Rate$

$Depletion Expense = Gross Revenue \times Depletion Rate$

2.4 Significance of Depletion

Ensures that the financial statements reflect the declining value of natural resources.
Helps businesses track the cost of resource extraction.
Provides accurate tax deductions for resource-based industries.

3. Amortization

3.1 Meaning of Amortization

Amortization is the process of systematically allocating the cost of intangible assets over their useful life. Unlike tangible assets that physically deteriorate, intangible assets do not have physical form but still lose value over time due to obsolescence or expiration.

3.2 Examples of Intangible Assets Subject to Amortization

Patents (legal rights to inventions)
Copyrights (ownership of creative works like books and music)
Trademarks (brand names and logos)
Franchise agreements (licenses to operate under a brand)
Goodwill (reputation and customer relationships acquired during a business merger)

3.3 Methods of Amortization

The most common method for amortizing intangible assets is the Straight-Line Method.

3.3.1 Straight-Line Method

This method spreads the cost of the intangible asset evenly over its useful life.
Formula:
$Amortization Expense = \frac{Cost of the Asset - Residual Value}{Useful Life (in years)}$

4. Accounting Treatment of Depletion and Amortization

4.1 Depletion Accounting

Depletion expense is recorded in the Profit & Loss Account.
The asset's book value is reduced in the Balance Sheet.
If the resource has a salvage value, it is subtracted before depletion is calculated.

4.2 Amortization Accounting

Amortization expense is recorded under Operating Expenses in the Profit & Loss Account.
The book value of the intangible asset is reduced each year in the Balance Sheet.
Some intangible assets (e.g., goodwill) are subject to impairment rather than amortization.

5. Relevant Accounting Standards

AS 6 – Depreciation Accounting (replaced by Ind AS 16): Deals with the allocation of costs of tangible assets, related to amortization in some cases.
AS 26 – Accounting for Intangible Assets: Provides guidelines on how intangible assets should be recognized, measured, and amortized.
Ind AS 38 – Intangible Assets: Governs the accounting treatment of intangible assets under Indian Accounting Standards.

Key Takeaways:

Depletion applies to natural resources and ensures their cost is allocated as they are consumed.
Amortization applies to intangible assets and spreads their cost over their useful life.
Proper accounting for these concepts ensures accurate financial reporting and tax compliance.
Objective and Methods of depreciation (Straight line, Diminishing Balance)

2. Objectives of Depreciation

2.1 Accurate Profit Determination

Depreciation is an expense that must be deducted to accurately calculate net profit or loss. Overstating profits by ignoring depreciation can mislead stakeholders.

2.2 Asset Valuation in the Balance Sheet

Depreciation ensures that assets are reported at their correct book value, preventing overstatement in financial statements.

2.3 Compliance with Accounting Standards and Tax Regulations

Companies must follow Accounting Standard (AS) 10 and Ind AS 16 (Property, Plant & Equipment) when accounting for depreciation.
Depreciation is essential for tax purposes, as it helps businesses claim deductions on fixed assets.

2.4 Capital Replacement Fund

Depreciation allows businesses to build funds over time, ensuring that old assets can be replaced without financial difficulty.

2.5 Prevents Overstatement of Dividends

By deducting depreciation before calculating profits, companies avoid distributing excessive dividends to shareholders.

3. Methods of Depreciation

3.1 Overview of Depreciation Methods

Depreciation methods vary based on how businesses want to allocate asset costs. The choice of method affects profit and tax calculations.

3.2 Straight-Line Method (SLM)

Meaning

Depreciation is charged equally over the asset's useful life.
The value of the asset reduces evenly each year.

Formula

$Annual Depreciation Expense = \frac{Cost of Asset - Residual Value}{Useful Life}$

Example

A company purchases machinery for ₹60,000, with a salvage value of ₹10,000 and a useful life of 5 years.
$Depreciation per year = \frac{60, 000 - 10, 000}{5} = ₹ 10, 000 per year$

Suitability

Used for assets that provide consistent utility, such as buildings, office furniture, and fixtures.
Preferred when depreciation expense needs to be stable and predictable.

Advantages

✔ Simple to calculate and apply.
✔ Suitable for businesses with stable profits.
✔ Ensures a uniform expense each year.

Disadvantages

✖ Does not consider the decreasing efficiency of assets over time.
✖ Does not account for higher maintenance costs in later years.

3.3 Diminishing Balance Method (Reducing Balance Method or Written Down Value Method - WDV)

Meaning

A fixed depreciation rate is applied to the asset's book value at the beginning of each year.
The amount of depreciation decreases over time.

Formula

$Depreciation Expense = Book Value at Beginning of Year \times Depreciation Rate$

× Depreciation Rate

Example

A company purchases equipment for ₹1,00,000 with a depreciation rate of 20%.
Year 1: ₹1,00,000 × 20% = ₹20,000
Year 2: ₹(1,00,000 - 20,000) × 20% = ₹16,000
Year 3: ₹(80,000 - 16,000) × 20% = ₹12,800

Suitability

Used for assets that lose value quickly, such as technology, vehicles, and machinery.
Best for businesses with higher initial profits that decline over time.

Advantages

✔ Recognizes that assets are more productive in earlier years.
✔ Higher depreciation expense in initial years reduces taxable income.

Disadvantages

✖ Book value never reaches zero.
✖ Complex calculations compared to the straight-line method.

5. Change of Depreciation Method

Sometimes, a business may need to change its depreciation method for better financial reporting.

Accounting Treatment for Change in Method

Changes must be made prospectively, not retrospectively.
The revised depreciation method should be applied to the remaining useful life.
The reason for the change must be disclosed in the financial statements.
Example:
If a company originally used the Straight-Line Method (SLM) but decides to switch to the Diminishing Balance Method (DBM), it must calculate depreciation using the new method from the point of change onward, without adjusting past entries.

6. Relevant Accounting Standards for Depreciation

6.1 AS 10 – Accounting for Fixed Assets

Depreciation must be charged as per the company’s depreciation policy.
The method of depreciation must be disclosed in financial statements.
Depreciation should be calculated on the historical cost of the asset.

6.2 Ind AS 16 – Property, Plant & Equipment

Allows different depreciation methods based on asset usage patterns.
Requires regular review of depreciation rates and residual values.
Change of Method

Meaning of Change in Depreciation Method

A change in depreciation method means switching from one depreciation calculation method to another. According to Accounting Standard (AS) 6, a change is allowed if required by:
Legal regulations
Accounting standards
Better financial presentation

Reasons for Change

New Accounting Standards
Legal Compliance
Change in Business Strategy
Better Financial Reporting
Mergers or Acquisitions
Technological Advances

Common Depreciation Methods

1. Straight-Line Method (SLM)

Equal depreciation every year.
Formula:

2. Diminishing Balance Method (DBM)

Depreciation applied to reducing book value.
Formula:

Accounting Treatment of Change

1. Prospective Change (applies from current year onward)

No adjustment to past records.

2. Retrospective Change (applies from asset acquisition)

Adjusts prior financial statements and reserves.

Disclosure Requirements

Reason for the change
Impact on financial statements
Method used
Effect on profits
Comparative figures (if retrospective)

Impact of Change

Net Profit - Higher depreciation lowers profit and vice versa.
Asset Valuation - Book value may change.
Tax Liability - Higher depreciation reduces taxable income.
Investor Confidence - Requires transparency.

Example

Company XYZ Ltd. switched from SLM to DBM for an asset worth ₹10,00,000. Under SLM, annual depreciation was ₹90,000, but after switching to DBM (20%), first-year depreciation became ₹2,00,000, reducing profits initially but increasing them in later years.
Inventory valuation
Inventory valuation refers to the process of determining the value of a company's inventory at the end of an accounting period. Inventory represents the goods and materials a business holds for the purpose of resale, production, or utilization in its operations. The valuation of inventory is critical as it affects both the Balance Sheet and the Income Statement. Accurate inventory valuation ensures that financial statements reflect the true financial position of the business and aligns with accounting standards.

1. Importance of Inventory Valuation

Impact on Profitability: The valuation of inventory directly affects the Cost of Goods Sold (COGS), which in turn influences the net profit of the business. A higher ending inventory value reduces the COGS and increases profits, while a lower ending inventory value results in higher COGS and lower profits.
Financial Reporting: Inventory is listed as a current asset on the Balance Sheet. An incorrect valuation can mislead stakeholders, including investors, creditors, and management, about the financial health of the business.
Tax Implications: Inventory valuation methods influence the business's taxable income. Different methods lead to different reported profits, which may impact the tax liability.
Liquidity and Working Capital: The valuation also affects the business's working capital calculation. Overvalued inventory can make a business appear more liquid than it actually is, whereas undervaluation can lead to inaccurate assessments of its financial stability.

2. Methods of Inventory Valuation

There are several methods available for valuing inventory, and the choice of method depends on factors such as the nature of the business, inventory turnover, and accounting policies. Each method has its advantages and implications on the financial statements.

2.1 First-In, First-Out (FIFO)

Concept: Under the FIFO method, it is assumed that the first units of inventory purchased are the first to be sold. Therefore, the oldest inventory is used up first, and the most recent purchases are left in inventory.
Effect on Financial Statements:
In a period of rising prices, FIFO results in lower cost of goods sold (COGS), as older, cheaper items are sold first. This leads to higher profits and a higher inventory valuation.
It is commonly used in businesses dealing with perishable goods or items that are physically used in the order of acquisition.
Advantages:
Reflects the actual flow of goods in many businesses.
Provides a more accurate and realistic picture of the value of remaining inventory.
Disadvantages:
Results in higher taxable income in periods of inflation.

2.2 Last-In, First-Out (LIFO)

Concept: LIFO assumes that the last items purchased are the first to be sold. In other words, the most recent inventory is sold first, and older items remain in stock.
Effect on Financial Statements:
During periods of rising prices, LIFO results in higher COGS because the latest, more expensive items are expensed first. This leads to lower profits and lower inventory valuation.
This method is not allowed under International Financial Reporting Standards (IFRS) but is permitted under Generally Accepted Accounting Principles (GAAP) in certain countries, such as the U.S.
Advantages:
LIFO can reduce the tax burden in times of rising prices by reducing reported profits.
Disadvantages:
May not reflect the actual flow of goods in many businesses and may create an inaccurate portrayal of inventory.

2.3 Weighted Average Cost (WAC)

Concept: The weighted average method calculates the average cost of all units of inventory during the accounting period, regardless of when they were purchased. Each item is valued at this average cost.
Effect on Financial Statements:
The COGS and inventory valuation are calculated based on the average cost per unit of goods available for sale. This method smooths out the fluctuations in purchase prices over time.
Advantages:
Easier to implement in businesses where goods are indistinguishable or difficult to track individually (e.g., bulk commodities).
Disadvantages:
May not reflect the actual physical flow of goods.

2.4 Specific Identification Method

Concept: Under this method, each unit of inventory is individually identified and tracked. The cost of each specific item is assigned to inventory, making this method applicable in businesses dealing with unique or high-value items (e.g., cars, real estate, jewelry).
Effect on Financial Statements:
The inventory and COGS are directly impacted by the individual cost of each item.
Advantages:
Provides the most accurate cost and valuation, particularly in businesses with unique or costly items.
Disadvantages:
Not practical for businesses with large volumes of similar items.

3. Inventory Record Systems

3.1 Periodic Inventory System

Concept: In a periodic inventory system, the inventory is physically counted at specific intervals, such as monthly, quarterly, or annually. The cost of goods sold is calculated at the end of the period by subtracting the ending inventory from the sum of the beginning inventory and purchases during the period.
Advantages:
Simple to use and cost-effective for businesses with small inventory or irregular stock turnovers.
Disadvantages:
Inventory levels are not updated in real time, making it harder for businesses to track stock and manage replenishment.

3.2 Perpetual Inventory System

Concept: The perpetual inventory system continuously updates the inventory records after each transaction, whether it’s a sale, purchase, or return. It uses technology, such as barcode scanners or RFID, to track inventory movements in real time.
Advantages:
Provides real-time updates, allowing for better inventory management and control.
Ideal for businesses with large inventories or high-volume sales.
Disadvantages:
Requires more sophisticated systems and higher implementation costs.

4. Impact of Inventory Valuation on Financial Statements

The chosen method of inventory valuation has direct implications on key financial metrics:
Cost of Goods Sold (COGS): The valuation method affects how much expense is recognized in the period, which in turn affects net profit.
Net Profit: Higher COGS (from methods like LIFO) will reduce profit, while lower COGS (from FIFO) will increase profit.
Taxes: The method chosen impacts the taxable income and, consequently, the taxes payable.
Inventory on Balance Sheet: The valuation method affects the reported value of inventory on the Balance Sheet. FIFO typically results in higher inventory values, while LIFO may result in lower values.

5. Accounting Standards for Inventory Valuation

In India, Accounting Standard 2 (AS 2) governs the valuation of inventories. Key provisions include:
Cost of Inventory: Inventory should be valued at the lower of cost and net realizable value (NRV).
Cost Determination: Costs should include all costs incurred in bringing the inventory to its present condition and location, including purchase cost, conversion cost, and other direct costs.
Valuation Methods: AS 2 permits the use of FIFO, WAC, or the specific identification method but prohibits LIFO under Indian accounting standards.
Under International Financial Reporting Standards (IFRS), IAS 2 – Inventories provides similar guidance, allowing FIFO, WAC, or specific identification, but excluding LIFO.