Depreciation & Inventory Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 1

 Concept of Conservatism  Depreciation and other Provisions Management Accounting - Dr. Varadraj Bapat, IIT Mumbai2

 Conservatism states that the accountant should not anticipate income and should provide for all possible losses. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai3

 As per conservatism concept, it is not prudent to count unrealised gain but it is desirable to guard against all possible losses. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai4

 When there are many alternatives values of an asset an accountant should choose the method which leads to lesser value. 5 Concept of Conservatism 5Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

For conservatism, there should be three qualitative characteristics, namely  Prudence, i.e., judgment about possible losses which are to be guarded, as well as gains which are uncertain. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai6

 Neutrality i.e., unbiased outlook is required to identify and record such possible losses and to exclude uncertain gains.  Faithful representation of alternative values. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai7

Example 1. Closing stock is valued at Cost or market price whichever is lower 2. Depreciation is charged every year even though cost of the asset has not decreased. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai8

Fixed assets like plant and machinery etc. are used in the business for the purpose of production or providing services. With the passage of time and utilisation, value of such fixed assets decreases. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai9

Value of portion of fixed assets utilized for generating revenue must be charged during a particular accounting year to ascertain the true cost. This portion of cost of fixed asset allocated is called depreciation. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai10

Depreciation means reduction in value of asset or in the utility due to passage of time, natural wear and tear, exhaustion of the subject matter. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai11

 Lapse of time  natural wear and tear  exhaustion of the subject matter  Obsolescence of technology Management Accounting - Dr. Varadraj Bapat, IIT Mumbai12

 To ascertain the true results of operations  To present true and fair value of the fixed asset  To accumulate funds for the replacement of the asset Management Accounting - Dr. Varadraj Bapat, IIT Mumbai13

 Estimation of exact amount of depreciation is not easy.  Generally following factors are considered in calculation of depreciation. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai14

1. Cost of asset including expenses for installation etc. 2. Estimated useful life of the asset. 3. Estimated scrap value (if any) at the time of useful life of the asset. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai15

1)Straight Line method (SLM) 2)Reducing Balance Method RBM 3)Machine Hour Method 4)Production Units Method Management Accounting - Dr. Varadraj Bapat, IIT Mumbai16

In this method, an equal amount is written off every year during the working life of the asset to nil or its residual value at the end of its useful life. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai17

SLM: The underlying assumption of this method is that the particular asset generates equal utility during its lifetime. Depreciation= Cost of Asset- Scrap Value Useful Life Management Accounting - Dr. Varadraj Bapat, IIT Mumbai18

Example Cost of machinery: Installation Charges:2000 Useful Life of Asset: 5 Years Calculate Depreciation as per SLM Management Accounting - Dr. Varadraj Bapat, IIT Mumbai19

Depreciation = 4000 p.a. Depreciation= years Management Accounting - Dr. Varadraj Bapat, IIT Mumbai20

Under this method, a fixed percentage of diminishing value of the asset is written off each year. The annual charges of the depreciation decrease from year to year. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai21

Written Down Value (WDV)= (Acquisition Cost – Depreciation) Depreciation=WDV*Depr Rate Management Accounting - Dr. Varadraj Bapat, IIT Mumbai22

RBM: The main advantage of this method is that total charge to total revenue is uniform when the depreciation is high, repairs are negligible and as the repairs increases the burden of depreciation gets lesser and lesser. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai23

RBM: For First Year Depreciation=Acquisition value* Rate For Second Year on words Depreciation=Written down value* Rate Management Accounting - Dr. Varadraj Bapat, IIT Mumbai24

Example Cost of machinery: Scrap Value of machine:5000 Useful Life of Asset: 10 Years Depreciation %: 15% p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai25

Calculate Depreciation as per reducing balance method for first 2 years Management Accounting - Dr. Varadraj Bapat, IIT Mumbai26

RBM: For First Year Depreciation=50000* 15% =7500 For Second Year Depreciation=42500 * 15% =6375 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai27

Where it is possible to keep a record of the actual running hours of each machine, depreciation may be calculated on the basis of hours worked. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai28

The machine hour rate of depreciation is calculated after estimating the total numbers of hours that machine would work during its whole life. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai29

Under machine hour method Depreciation is calculated for each hour the machine works. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai30

Example Cost of machine: Estimated working hours: Scrap Value: The pattern of distribution of effective working hours: Management Accounting - Dr. Varadraj Bapat, IIT Mumbai31

Yearhours 1-2:5000 per year 3-5:7000 per year 6-8:3000 per year Compute depreciation p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai32

Solution: X ( ) =61250 p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai33

Solution: X ( ) =85750 p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai34

Solution: X ( ) =36750 p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai35

Under this method depreciation is determined by comparing annual production with the estimated total production. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai36

The amount of depreciation is computed by the using following formula: Depreciation for the period= depreciable Production during the period amount X Estimated total production Management Accounting - Dr. Varadraj Bapat, IIT Mumbai37

Example Cost of machine: Estimated total production: 4000 Scrap Value: 2000 Pattern of distribution of production: Management Accounting - Dr. Varadraj Bapat, IIT Mumbai38

YearUnits 1 : : :500 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai39

Solution: Year X ( ) 4000 =14000 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai40

Solution: Year X ( ) 4000 =10500 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai41

Solution: Year X ( ) 4000 =3500 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai42

A provision is a liability which can not be measured with a substantial degree of accuracy. A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow of resources. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai43

Where the liabilities are known but amount s cannot be precisely determined, we estimate for liability and provide for it. The principle of conservatism supports making of provisions for probable liabilities. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai44

Provisions Examples Product service warranty cost, bad debts, changes in foreign exchange rates in case of international transaction etc. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai45