MANAGERIAL ACCOUNTING

MODULE 3: Measuring and Reporting Assets and Liabilities

AS-10 Fixed Asset

Introduction:

Financial statements disclose certain information relating to fixed assets. In many enterprises
these assets are grouped into various categories, such as land, buildings, plant and machinery,
vehicles, furniture and fittings.

This statement does not deal with the specialized aspects of accounting for fixed assets that
arise under a comprehensive system reflecting the effects of changing prices but applies to
financial statements prepared on historical cost basis.

This statement does not deal with accounting for the following items to which special
considerations apply:

(i) forests, plantations and similar regenerative natural resources;

(ii) wasting assets including mineral rights, expenditure on the exploration for and
extraction of minerals, oil, natural gas and similar non-regenerative resources;
(iii) expenditure on real estate development;
(iv) Livestock.

This statement does not cover the allocation of the depreciable amount of fixed assets to future
periods since this subject is dealt with in Accounting Standard 6 on ‘Depreciation
Accounting’.

This statement does not deal with the treatment of government grants and subsidies, and
assets under leasing rights. It makes only a brief reference to the capitalization of borrowing
costs and to assets acquired in an amalgamation or merger. These subjects require more
extensive consideration than can be given within this Statement.

Definitions:

Fixed asset is an asset held with the intention of being used for the purpose of producing or
providing goods or services and is not held for sale in the normal course of business.

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Fair market value is the price that would be agreed to in an open and unrestricted market
between knowledgeable and willing parties dealing at arm’s length who are fully informed and
are not under any compulsion to transact.

Gross book value of a fixed asset is its historical cost or other amount substituted for historical
cost in the books of account or financial statements. When this amount is shown net of
accumulated depreciation, it is termed as net book value.

Fixed assets often comprise a significant portion of the total assets of an enterprise, and
therefore are important in the presentation of financial position. Furthermore, the determination
of whether an expenditure represents an asset or an expense can have a material effect on an
enterprise’s reported results of operations.

Components of Cost:

 The cost of an item of fixed asset comprises its purchase price, including import duties
and other non-refundable taxes or levies and any directly attributable cost of bringing
the asset to its working condition for its intended use; any trade discounts and rebates
are deducted in arriving at the purchase price. Examples of directly attributable costs
are:

(i) Site preparation;

(ii) Initial delivery and handling costs;

(iii) Installation cost, such as special foundations for plant;

(iv) Professional fees, for example fees of architects and engineers.

The cost of a fixed asset may undergo changes subsequent to its acquisition or
construction on account of exchange fluctuations, price adjustments, and changes in
duties or similar factors.

 Financing costs relating to deferred credits or to borrowed funds attributable to

construction or acquisition of fixed assets for the period up to the completion of
construction or acquisition of fixed assets are also sometimes included in the gross book
value of the asset to which they relate. However, financing costs (including interest) on
fixed assets purchased on a deferred credit basis or on monies borrowed for construction
or acquisition of fixed assets are not capitalized to the extent that such costs relate to
periods after such assets are ready to be put to use.

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 Administration and other general overhead expenses are usually excluded from the cost
of fixed assets because they do not relate to a specific fixed asset. However, in some
circumstances, such expenses as are specifically attributable to construction of a project
or to the acquisition of a fixed asset or bringing it to its working condition, may be
included as part of the cost of the construction project or as a part of the cost of the
fixed asset.
 The expenditure incurred on start-up and commissioning of the project, including the
expenditure incurred on test runs and experimental production, is usually capitalized as
an indirect element of the construction cost. However, the expenditure incurred after
the plant has begun commercial production, i.e., production intended for sale or captive
consumption, is not capitalized and is treated as revenue expenditure even though the
contract may stipulate that the plant will not be finally taken over until after the
satisfactory completion of the guarantee period.
 If the interval between the date a project is ready to commence commercial production
and the date at which commercial production actually begins is prolonged, all expenses
incurred during this period are charged to the profit and loss statement. However, the
expenditure incurred during this period is also sometimes treated as deferred revenue
expenditure to be amortized over a period not exceeding 3 to 5 years after the
commencement of commercial production.

Non-monetary Consideration:

 When a fixed asset is acquired in exchange for another asset, its cost is usually
determined by reference to the fair market value of the consideration given. It may be
appropriate to consider also the fair market value of the asset acquired if this is more
clearly evident. An alternative accounting treatment that is sometimes used for an
exchange of assets, particularly when the assets exchanged are similar, is to record the
asset acquired at the net book value of the asset given up; in each case an adjustment is
made for any balancing receipt or payment of cash or other consideration.
 When a fixed asset is acquired in exchange for shares or other securities in the
enterprise, it is usually recorded at its fair market value, or the fair market value of the
securities issued, whichever is more clearly evident.

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Improvements and Repairs:

 Frequently, itis difficult to determine whether subsequent expenditure related to fixed

asset represents improvements that ought to be added to the gross book value or repairs
that ought to be charged to the profit and loss statement. Only expenditure that increases
the future benefits from the existing asset beyond its previously assessed standard of
performance is included in the gross book value, e.g., an increase in capacity.
 The cost of an addition or extension to an existing asset which is of a capital nature and
which becomes an integral part of the existing asset is usually added to its gross book
value. Any addition or extension, which has a separate identity and is capable of being
used after the existing asset is disposed of, is accounted for separately.

Retirements and Disposals:

 An item of fixed asset is eliminated from the financial statements on disposal.

 Items of fixed assets that have been retired from active use and are held for disposal are
stated at the lower of their net book value and net realizable value and are shown
separately in the financial statements. Any expected loss is recognized immediately in
the profit and loss statement.
 In historical cost financial statements, gains or losses arising on disposal are generally
recognized in the profit and loss statement.
 On disposal of a previously revalued item of fixed asset, the difference between net
disposal proceeds and the net book value is normally charged or credited to the profit
and loss statement except that, to the extent such a loss is related to an increase which
was previously recorded as a credit to revaluation reserve and which has not been
subsequently reversed or utilized, it is charged directly to that account. The amount
standing in revaluation reserve following the retirement or disposal of an asset which
relates to that asset may be transferred to general reserve.

Valuation of Fixed Assets in Special Cases:

 In the case of fixed assets acquired on hire purchase terms, although legal ownership
does not vest in the enterprise, such assets are recorded at their cash value, which, if not
readily available, is calculated by assuming an appropriate rate of interest. They are
shown in the balance sheet with an appropriate narration to indicate that the enterprise
does not have full ownership thereof.

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 Where an enterprise owns fixed assets jointly with others (otherwise than as a partner
in a firm), the extent of its share in such assets, and the proportion in the original cost,
accumulated depreciation and written down value are stated in the balance sheet.
Alternatively, the pro rata cost of such jointly owned assets is grouped together with
similar fully owned assets. Details of such jointly owned assets are indicated separately
in the fixed assets register.
 Where several assets are purchased for a consolidated price, the consideration is
apportioned to the various assets on a fair basis as determined by competent valuers.

Disclosure:

 Certain specific disclosures on accounting for fixed assets are already required by
Accounting Standard 1 on ‘Disclosure of Accounting Policies’ and Accounting
Standard 6 on ‘Depreciation Accounting’
 Further disclosures that are sometimes made in financial statements include:
(i) Gross and net book values of fixed assets at the beginning and end of an
accounting period showing additions, disposals, acquisitions and other
movements;
(ii) Expenditure incurred on account of fixed assets in the course of
construction or acquisition;
(iii) Revalued amounts substituted for historical costs of fixed assets, the
method adopted to compute the revalued amounts, the nature of any
indices used, the year of any appraisal made, and whether an external
valuer was involved, in case where fixed assets are stated at revalued
amounts.

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AS – 6 Depreciation

Introduction:

This Statement deals with depreciation accounting and applies to all depreciable assets, except
the following items to which special considerations apply:-

(i) forests, plantations and similar regenerative natural resources;

(ii) wasting assets including expenditure on the exploration for and extraction of
minerals, oils, natural gas and similar non-regenerative resources;
(iii) expenditure on research and development;
(iv) goodwill;
(v) live stock

This statement also does not apply to land unless it has a limited useful life for the enterprise.

Definitions:

The following terms are used in this Statement with the meanings specified:

 Depreciation is a measure of the wearing out, consumption or other loss of value of a

depreciable asset arising from use, effluxion of time or obsolescence through
technology and market changes. Depreciation is allocated so as to charge a fair
proportion of the depreciable amount in each accounting period during the expected
useful life of the asset. Depreciation includes amortization of assets whose useful life
is predetermined.
 Depreciable assets are assets which
(i) are expected to be used during more than one accounting period;
(ii) have a limited useful life;
(iii) Are held by an enterprise for use in the production or supply of goods
and services, for rental to others, or for administrative purposes and not
for the purpose of sale in the ordinary course of business.
 Useful life is either (i) the period over which a depreciable asset is expected to be used
by the enterprise; or (ii) the number of production or
similarunitsexpectedtobeobtainedfromtheuseoftheassetbytheenterprise.

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 Depreciable amount of a depreciable asset is its historical cost, or other amount

substituted for historical cost in the financial statements, less the estimated residual
value.
 Depreciation has a significant effect in determining and presenting the financial
position and results of operations of an enterprise. Depreciation is
chargedineachaccountingperiodbyreferencetotheextentofthedepreciable amount,
irrespective of an increase in the market value of the assets.

Disclosure:

 The depreciation methods used, the total depreciation for the period for each class of
assets, the gross amount of each class of depreciable assets and the related accumulated
depreciation are disclosed in the financial statements along with the disclosure of other
accounting policies. The depreciation rates or the useful lives of the assets are disclosed
only if they are different from the principal rates specified in the statute governing the
enterprise.
 In case the depreciable assets are revalued, the provision for depreciation is based on
the revalued amount on the estimate of the remaining useful life of such assets. In case
the revaluation has a material effect on the amount of depreciation, the same is disclosed
separately in the year in which revaluation is carried out.
 A change in the method of depreciation is treated as a change in an accounting policy
and is disclosed accordingly.

Meaning and Definition of Depreciation:

Depreciation is a permanent decline in the value of an asset. The gradual decrease, both in the
value and usefulness, of an asset due to its nature and usage is termed as depreciation.
Depreciation is the measure of wearing out of a fixed asset. All fixed assets are expected to be
less efficient as time goes on. Depreciation is calculated as the estimate of this measure of
wearing out and is charged to the Profit & Loss account either on a monthly or annual basis.
The cost of the asset less the total depreciation will give you the Net Book Value of the asset.

It is common experience that whenever an asset is used it reduces in value. The net result of
depreciation is that sooner or letter, the asset becomes useless. So, it can be stated that
depreciation is that portion of the cost of an asset which is reduced from revenues for the
services of the asset in the operation of a business.

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According to Spicer and Pegler “Depreciation is thee measure of the exhaustion of the effective
life of an asset from any cause during a given period.”

According to the Institute Of Chartered Accountants Of India, “Depreciation is a measure of

the wearing out, consumption or other loss of value of a depreciable asset arising from use
effluxion of time or obsolescence through technology and market changes.”

According to International Accounting Standards Committee, “Depreciation is the allocation

of the depreciable amount of an asset over its estimated useful life. Depreciation for the
accounting period is charged to income either directly or indirectly.”

Methods of calculating Depreciation

1. Straight Line Method or Fixed Installment Method.

2. Written Down Value Method or Diminishing Balance Method.

3. Annuity Method.

4. Depreciation Fund Method.

5. Insurance Policy Method

6. Revaluation Method.

Straight-line Method or Fixed Instalment Method or Original Cost Method

Under this method, the same amount of depreciation is charged every year throughout the life
of thee asset. The amount and rate of depreciation is calculated as under.

1. Amount of depreciation = Total cost - Scrap value / Estimated life

2. Rate of depreciation = Amount of depreciation / Original cost x 100

MERITS:

1. Simplicity: It is every simple and easy to understand.

2. Easy to calculate; It is easy to calculate the amount and rate of depreciation.

3. Assets can be completely written off: Under this method, the book value of the asset become
zero or equal to its scarp value at the expiry of its useful life.

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DEMERITS: The amount of depreciation is same in all the years, although the usefulness of
the machine to the business is more in the initial years, although the usefulness of the machine
to the business is more in the initial years than in the later years.

Written Down Value Method or Diminishing Balance Method or Reducing Balance

Method

Under this method, depreciation is charged at a fixed percentage each year on the reducing
balance (i.e., cost less depreciation) of asset. The amount of depreciation goes on decreasing
every year.

MERITS:

1. Uniform effect on the profit and loss account of different years. The total charge (i.e.
depreciation plus repairs and renewals) remains almost uniform year after year, since in earlier
year the amount of depreciation is more and the amount of repairs and renewals is less, whereas
in later years the amount of depreciation is less and the amount of repairs and renewals is more.

2. Recognized by the income tax authorities; this method is recognized by the income tax
authorities.

3. Logical Method: It is a logical method as the depreciation is calculated on the diminished

balance every year.

DEMERITS:

It is very difficult to determine the rate by which the value of asset could be written down to
zero.

Annuity Method: The annuity method considers that the business besides losing the original
cost of the asset in terms of depreciation and also loses interest. On the amount used for buying
the asset. This is based on the assumption that the amount invested in the asset would have
earned in case the same amount would have been invested in some other form of investment.
The annual amount of depreciation is determined with the help of annuity table.

Depreciation Fund Method or Sinking Fund Method: Under this method, funds are mad
available for the replacement of asset at the end of its useful life.th depreciation remains the

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same year after year and is changed to profit and loss account every year through the creation
of depreciation fund. The aggregate amount of interest and annual provision is invested every
year. When the asset is completely written off or is to be replaced, the securities are sold and
the amount so realized by selling securities is used to replace the old asset.

Insurance Policy Method: According to this method, an insurance policy is taken for the
amount of the asset to be replaced. The amount of the policy is such that it is sufficient to
replace the asset when it is worn out. A sum equal to the amount of depreciation is paid as
premium every year. The amount goes on accumulating at a certain rate of interest and is
received on maturity. The amount so received is used for the purchase of new asset, replacing
the old one.

Revaluation Method: Under this method, the asset like loose tools are revalued at the end of
the accounting period and the same is compared with the value of the asset at the beginning of
the year. The difference is considered as depreciation.

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AS – 2 Valuation of Inventories

Objective:

A primary issue in accounting for inventories is the determination of the value at which
inventories are carried in the financial statements until the related revenues are recognized.
This Statement deals with the determination of such value, including the ascertainment of cost
of inventories and any write-down thereof to net realizable value.

Scope:

This Statement should be applied in accounting for inventories other than:

(a) work in progress arising under construction contracts, including directly related
service contracts (see Accounting Standard (AS) 7, Accounting for Construction
Contracts)
(b) work in progress arising in the ordinary course of business of service providers;
(c) shares, debentures and other financial instruments held as stock-in-trade; and
(d) producers’ inventories of livestock, agricultural and forest products, and mineral
oils, ores and gases to the extent that they are measured at net realizable value in
accordance with well-established practices in those industries.

Definitions:

The following terms are used in this Statement with the meanings specified:

Inventories are assets:

(a) Held for sale in the ordinary course of business;

(b) In the process of production for such sale; or

(c) In the form of materials or supplies to be consumed in the production process or in the
rendering of services.

Net realizable value is the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.

Inventories encompass goods purchased and held for resale, for example, merchandise
purchased by a retailer and held for resale, computer software held for resale, or land and other

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property held for resale. Inventories also encompass finished goods produced, or work in
progress being produced, by the enterprise and include materials, maintenance supplies,
consumables and loose tools awaiting use in the production process. Inventories do not include
machinery spares which can be used only in connection with an item of fixed asset and whose
use is expected to be irregular; such machinery spares are accounted for in accordance with
Accounting Standard (AS) 10, Accounting for Fixed Assets.

Measurement of Inventories:

 Inventories should be valued at the lower of cost and net realizable value.
 Cost of Inventories: The cost of inventories should comprise all costs of purchase,
costs of conversion and other costs incurred in bringing the inventories to their present
location and condition.
 Costs of Purchase: The costs of purchase consist of the purchase price including duties
and taxes (other than those subsequently recoverable by the enterprise from the taxing
authorities), freight inwards and other expenditure directly attributable to the
acquisition. Trade discounts, rebates, duty drawbacks and other similar items are
deducted in determining the costs of purchase.
 Costs of Conversion: The costs of conversion of inventories include costs directly
related to the units of production, such as direct labor. They also include a systematic
allocation of fixed and variable production overheads that are incurred in converting
materials into finished goods. Fixed production overheads are those indirect costs of
production that remain relatively constant regardless of the volume of production, such
as depreciation and maintenance of factory buildings and the cost of factory
management and administration. Variable production overheads are those indirect costs
of production that vary directly, or nearly directly, with the volume of production, such
as indirect materials and indirect labor.

Techniques for the Measurement of Cost:

 Techniques for the measurement of the cost of inventories, such as the standard cost
method or the retail method, may be used for convenience if the results approximate
the actual cost. Standard costs take into account normal levels of consumption of
materials and supplies, labor, efficiency and capacity utilization. They are regularly
reviewed and, if necessary, revised in the light of current conditions.

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 The retail method is often used in the retail trade for measuring inventories of large
numbers of rapidly changing items that have similar margins and for which it is
impracticable to use other costing methods. The cost of the inventory is determined
by reducing from the sales value of the inventory the appropriate percentage gross
margin. The percentage used takes into consideration inventory which has been
marked down to below its original selling price. An average percentage for each
retail department is often used.

Net Realizable Value:

The cost of inventories may not be recoverable if those inventories are damaged, if they have
become wholly or partially obsolete, or if their selling prices have declined. The cost of
inventories may also not be recoverable if the estimated costs of completion or the estimated
costs necessary to make the sale have increased. The practice of writing down inventories
below cost to net realizable value is consistent with the view that assets should not be carried
in excess of amounts expected to be realized from their sale or use.

Disclosure:

The financial statements should disclose:

(a) the accounting policies adopted in measuring inventories, including the cost
formula used;
(b) The total carrying amount of inventories and its classification appropriate to the
enterprise.

Information about the carrying amounts held in different classifications of inventories and the
extent of the changes in these assets is useful to financial statement users. Common
classifications of inventories are raw materials and components, work in progress, finished
goods, stores and spares, and loose tools.

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Valuation of Goodwill

Goodwill is an intangible asset which is not visible or cannot be touched but can be purchased
and traded and is real. The value of an enterprise’s brand name, solid consumer base, functional
consumer associations, good employee associations and any patents or proprietary technology
represent some instances of goodwill.

Meaning of Goodwill:

The valuation of goodwill is based on the assumption obtained by the valuer. A successful
business earns a reputation in the industry, develops trust with its clients, and has more
extensive business links, unlike new companies. All these points contribute while evaluating
the business, and its financial worth that a customer is eager to give is known as goodwill.

Customers who buy a company looking at its goodwill hopes to gain super-profits. Hence,
goodwill applies to only firms that make super-profits and not to those who earn regular losses
or profits.

Features of Goodwill:

1. It is an intangible asset: Goodwill cannot be seen or touched, it does not have any physical
existence, thus it belongs to the category of intangible assets such as patents, trademarks,
copyrights, etc.

2. It is a valuable asset

3. It is helpful in earning excess profits.

4. Its value is liable to constant fluctuations: While goodwill does not depreciate, its value
is liable to constant fluctuation, its value is liable to constant fluctuations. It is always present
as a silent asset in a business where there are super profits (i.e. more than the normal) but
declines in value with the decline in earnings.

5. It is valuable only when entire business is sold: Goodwill cannot be sold in part. It can be
sold with the entire business only. The only exception is at the time of admission or retirement
of the partner.

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6. It is difficult to place an exact value on goodwill: This is because its value may fluctuate
from time to time due to changing circumstances which are internal and external to business.

Goodwill is divided into two categories:

I. Purchased Goodwill: Purchased goodwill means goodwill for which a consideration has been
paid e.g. when business is purchased the excess of purchase consideration of its net assets i.e.
(Assets – Liabilities) is the Purchased Goodwill. It is separately recorded in the books because
as it is purchased by paying in form of cash or kind.

Characteristics:

(i) It arises on purchase of a business or brand.

(ii) Consideration is paid for it so it is recorded in books.

(iii) Shown in balance sheet as on asset.

(iv) It is amortized (depreciated).

(v) Value is a subjective judgment & ascertained by agreement of seller & purchaser. It is
approximate value and cannot be sold separately in the market or in parts.

II. Self-generated Goodwill also called as inherent goodwill. It is an internally generated

goodwill which arises from a number of factors that a running business possesses due to which
it is able to earn more profits in the future.

Features:

(i) It is generated internally over the years.

(ii) A true cost cannot be placed on this type of goodwill.

(iii) Value depends on subjective judgment of the value.

(iv) As per Accounting Standard 26(Intangible Asset), it is not recorded in the books of accounts
because consideration in money or money’s worth has not be paid for it.

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Factors Affecting the Value of Goodwill:

1. Efficient management: If the business is run by experienced and efficient management, its
profits will go on increasing, which results in increase in the value of goodwill.

2. Quality of products: If the firm is supplying good quality of products, then the customer will
come again and again for the same and thus will create the goodwill and brand name for the
same.

3. Location of business: If the business is located at a convenient or prominent place, it will

attract more customers and therefore will have more goodwill.

4. The Longevity of the business: An older business is better known to its customers, therefore
it is likely to have more goodwill. When a business enterprise has built up good reputation over
a period of time, the number of customers will be more in comparison to the customers of new
entrants. Number of customers is an indicator of profit earning capacity of a business.

5. Monopolistic and other Rights: If a business enjoys monopoly market, it will have assured
profits. Similarly, if it holds some special rights such as patents, trademarks, copyrights or
concessions, etc., it will have more goodwill.

6. Other factor:
(i) Good industrial relations.
(ii) Favorable Government regulations
(iii) Stable political conditions
(iv) Research and development efforts
(v) Effective advertising to establish brand popularity
(vi) Popularity of product in terms of quality.

Need for Valuing Goodwill: Whenever the mutual rights of the partner’s changes the party
which makes a sacrifice must be compensated. This basis of compensation is goodwill so we
need to calculate goodwill.

Mutual rights change under following circumstances

1. When profit sharing ratio changes

2. On admission of a partner

3. On Retirement or death of a partner

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4. When amalgamation of two firms taken place

5. When partnership firm is sold.

Methods of Valuation of Goodwill:

Various ways are used in the valuation of goodwill. However, the valuation methods are based
on the situation of an individual company and different practices of the trade. The top three
processes of valuation of goodwill are mentioned below.

(i) Average Profits Method – This method is divided into two sub-division.
 Simple Average – In this process, goodwill evaluation is done by calculating the average
profit by the number of years it is called years purchase. It can be calculated by using
the formula. Goodwill = Average Profit x No. of years’ of purchase.
 Weighted Average – Here, last year’s profit is calculated by a specific number of
weights. It is used to obtain the value of goods, which is divided by the total number of
weights for determining the average weight profit. This technique is used when there is
a change in profits and giving high importance to the present year’s profit. It is
evaluated by using the formula. Goodwill = Weighted Average Profit x No. of years’
of purchase, where Weighted Average Profit = Sum of Profits multiplied by weights/
Sum of weights
(ii) Super Profits Method – It is a surplus of expected future maintainable profits over
normal profits. The two methods of these methods are.
 The Purchase Method by Number of Years – The goodwill is established by evaluating
super-profits by a specific number of the purchase year. It can be estimated by applying
the below formula. Super Profit = Actual or Average profit – Normal Profit
 Annuity Method –Here, the average super profit is taken as an annuity value over a
definite number of years. A discounted amount of super profit calculates the current
value of an annuity at the given rate of interest. The formula to be used here is.

Goodwill = Super Profit x Discounting Factor

(iii) Capitalization Method – Under this method, goodwill can be evaluated by two
methods.

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 Average Profits Method – In this process, goodwill is measured by subtracting the

original capital applied from the capitalized amount of the average profits based on the
average return rate. The formula used is mentioned below.

Capitalized Average profits = Average Profits x (100/average return rate)

 Super Profits Method- Here, the super profit is capitalized, and the goodwill is
calculated. The formula applied is. Goodwill = Super Profits x (100/ Normal Rate of
Return)

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