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Module 5

Module 5. Depreciation & Inventory. Index. Concept of Conservatism Depreciation and other Provisions. Concept of Conservatism. Conservatism states that the accountant should not anticipate income and should provide for all possible losses.

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Module 5

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  1. Module 5 Depreciation & Inventory Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  2. Index Management Accounting - Dr. Varadraj Bapat, IIT Mumbai Concept of Conservatism Depreciation and other Provisions

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

  4. 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 Mumbai

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

  6. 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 Mumbai

  7. 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 Mumbai

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

  9. Depreciation Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 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.

  10. 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 Mumbai

  11. 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 Mumbai

  12. Causesof Depreciation Management Accounting - Dr. Varadraj Bapat, IIT Mumbai Lapse of time natural wear and tear exhaustion of the subject matter Obsolescence of technology

  13. Objectives of Providing for Depreciation Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 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

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

  15. 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 Mumbai

  16. Methods of providing depreciation Management Accounting - Dr. Varadraj Bapat, IIT Mumbai Straight Line method (SLM) Reducing Balance Method RBM Machine Hour Method Production Units Method

  17. Straight Line method Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 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.

  18. SLM: The underlying assumption of this method is that the particular asset generates equal utility during its lifetime. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  19. Example Cost of machinery: 18000 Installation Charges:2000 Useful Life of Asset: 5 Years Calculate Depreciation as per SLM Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  20. Depreciation = 4000 p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  21. Reducing Balance Method 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 Mumbai

  22. Reducing Balance Method Written Down Value (WDV)= (Acquisition Cost – Depreciation) Depreciation= WDV*Depr Rate Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  23. 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 Mumbai

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

  25. Example Cost of machinery: 50000 Scrap Value of machine:5000 Useful Life of Asset: 10 Years Depreciation %: 15% p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

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

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

  28. Machine Hour Method Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 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.

  29. 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 Mumbai

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

  31. Example Cost of machine: 500000 Estimated working hours: 40000 Scrap Value: 10000 The pattern of distribution of effective working hours: Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  32. Year hours 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 Mumbai

  33. Solution: 1-2 5000 X (500000-10000) 40000 =61250 p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  34. Solution: 3-5 7000 X (500000-10000) 40000 =85750 p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  35. Solution: 6-8 3000 X (500000-10000) 40000 =36750 p.a. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  36. Production Unit Method Management Accounting - Dr. Varadraj Bapat, IIT Mumbai Under this method depreciation is determined by comparing annual production with the estimated total production.

  37. 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 Mumbai

  38. Example Cost of machine: 30000 Estimated total production: 4000 Scrap Value: 2000 Pattern of distribution of production: Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  39. Year Units 1 : 2000 2 : 1500 3 : 500 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  40. Solution: Year 1 2000 X (30000-2000) 4000 =14000 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  41. Solution: Year 2 1500 X (30000-2000) 4000 =10500 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  42. Solution: Year 3 500 X (30000-2000) 4000 =3500 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai

  43. Provision Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 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.

  44. Provision Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 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.

  45. 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 Mumbai

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