Cash Vs Accrual system of accounting Cash system of accounting: Most small businesses use the cash basis method of

accounting, which is based on real-time cash flow. In cash method, you report an expense when it is paid

and record income when it is received. In most cases, small businesses that primarily sell

services will choose the cash basis method of accounting because it is easier to track and account for.

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Accrual system of accounting: With accrual accounting, you record income when it

is earned, not when it is paid. Similarly, you record your expenses when the

obligation arises, not when you pay it. It is not necessary for cash to change hands.

India follows HYBRID accounting

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When is delivery complete? When does the title to goods and the risk of

loss transfer from the seller to the buyer? Does the buyer have the right to return the

product? Has payment been received for a service to

be provided in the future? Is any or all of a sales agreement contingent

on a future event?

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Why to control inventory? Starting point of production. Need based purchase is possible. More flexible. Controllable input. Indian Materials Management Association says that in

every one rupee spent: 64 paise – Material cost 16 paise – Labour cost 20 paise – Overheads.

Improves profitability – A study says that “5% saving in the material cost, would be as good as increasing production or sales by 36%”

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Managing materials and inventories is important because, on average, the cost of materials account for more than 50% of total cost in manufacturing companies and over 70% of total costs in trading companies.

In the normal course of business, managers respond to the high cost of materials and inventory in several ways.

The top management always focuses on reducing the purchasing cost of materials without dilution of quality.

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In India valuation of inventories has been dealt with Indian

Accounting Standards (AS 2) given by ICAI.

As per AS 2 inventories are assets

▪ held for sale in the ordinary course of business;

▪ in the process of production for such sale; or

▪ in the form of materials or supplies to be consumed in

the production process or in the rendering of services.

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The financial statements should disclose:

▪ the accounting policies adopted in measuring

inventories, including the cost formula used; and

▪ the total carrying amount of inventories and its

classification appropriate to the enterprise.

▪ All time inventories should valued at the lower of the

cost and net realisable value.

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The cost of inventories should comprise all

costs of purchase,

▪ (Basic purchase price + Duties)

costs of conversion

▪ (Labour, Fixed and Variable cost in Prod.)

other costs incurred in bringing the inventories to their

present location and condition.

▪ (e.g. cost involved in designing the customer’s requirement)

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Exclusions from the cost of inventory:

▪ abnormal amounts of wasted materials, labour, or

other production costs;

▪ storage costs, unless those costs are necessary in the

production process prior to a further production stage;

▪ administrative overheads that do not contribute to

bringing the inventories to their present location and

condition; and

▪ selling and distribution costs.

In general, the term “Depreciation” means decline in the value of a fixed assets due to use, passage of time or obsolescence.

In other words, if a business enterprise procures a machine and uses it in production process then the value of machine declines with its usage.

Even if the machine is not used in production process, we can not expect it to realise the same sales price due to the passage of time or arrival of a new model (obsolescence).

It implies that fixed assets are subject to decline in value and this decline is technically referred to as depreciation.

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There are some terms — like depletion and amortization, which are also used in connection with depreciation.

The term depletion is used in the context of extraction of natural resources like mines, quarries, etc. that reduces the availability of the quantity of the material or asset.

Amortization refers to writing-off the cost of intangible assets like patents, copyright, trade marks, franchises, leasehold mines which have entitlements to use for a specified period of time. The procedure for amortization or periodic write-off of a portion of the cost of intangible assets is the same as that for the depreciation of fixed assets.

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Causes

Wear and Tear due to usage and passage of time.

Expiration of legal rights.

Obsolescence.

Abnormal factors like natural calamities.

Need

Matching of cost and revenue

Consideration of tax

True and fair financial position

Compliance with law

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Basic cost of the asset

Estimated residual value of the asset

Estimated life of the asset

Depreciable cost

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Straight Line Method It is also called fixed installment method because the amount of

depreciation remains constant from year to year over the useful life of the asset.

According to this method, a fixed and an equal amount is charged as depreciation in every accounting period during the lifetime of an asset.

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1. A company purchased Furniture for Rs.28,000. Depreciation is to be

provided annually according to the Straight Line Method. The useful life

of the furniture is 5 years and the residual value is Rs.2,000. You are

required to find out the amount of depreciation. (Ans: 5200)

2. From the following particulars, find out the rate of depreciation, under

Straight Line Method.

• Cost of Fixed Asset Rs. 50,000

• Residual Value Rs. 5,000

• Estimated Life 10 years (Ans: Rate of Dep. 9%)

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M/s. Shankar & Co. purchased a Machinery on 1.1.2002 for

Rs.10,00,000. The firm writes off depreciation at 10% on the

original cost every year. The books are closed on 31st March every

year. Pass the necessary journal entries, prepare Machinery

account and Depreciation account for the first three years. (Answer: Balance at the end of the third year : Rs. 7,75,000)

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Written Down Value Method Under this method, depreciation is charged on the book value of the

asset.

Since book value keeps on reducing by the annual charge of

depreciation, it is also known as reducing balance method.

This method involves the application of a pre-determined proportion /

percentage of the book value of the asset at the beginning of every

accounting period, so as to calculate the amount of depreciation. The

amount of depreciation reduces year after year.

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Written Down Value Method – Calculation

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A firm bought a machinery on 1.1.2002 for Rs.5,00,000. On

31.12.2003 the machinery was sold for Rs.3,90,000. The firm

charges depreciation at the rate of 10% per annum on Diminishing

Balance Method. The books are closed on 31st March every year.

Prepare Machinery account and Depreciation account.

(Answer: Loss on sale of machinery Rs.15,844)

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Depreciation – is a non-cash expense.

Depreciation – is tax deductible expense.

Depreciation – is subject to window dressing.

Can we use depreciation as internal source of finance?

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Sometimes depreciation is also loosely spoken of as a 'source of internal funds'. You now know that depreciation expense is a 'book entry' that reduces the amount of non-current assets (in the position statement) and reduces profit (in the performance statement). There is no cash transaction or any other external transaction so depreciation is not a form or source of finance.

However, recording depreciation expense does have two important financial effects:

It reduces the profit available for dividends and may reduce the cash outflow for dividend payments

It reduces taxable income and the amount payable for income tax, which may also reduce cash outflows.

In this sense it is possible to argue that recording depreciation has a savings effect by reducing possible cash outflows, and that managers can use the cash 'saved' for other purposes.

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Buildings

i. Buildings which are used mainly for residential purposes 5%

ii. Buildings which are not used mainly for residential purposes - 10%

Furniture & Fittings 10%

Computers 60%

Machinery & Plant 15%

Motor Car 15%

Plant & Machinery 15%

A.C, Electrical office equipment, fax machine & water cooler at 10% because all

are electrical fittings

If the value of asset is less than Rs.5000 we can claim 100% depreciation as per

sec.32 of income tax act,1961