Financial Accounting
Sandeep Kumar Mishra
Asst Prof. Finance
Astha School of management
Module II

Recognition of Transactions

Verifiable objective evidence concept

Under this concept each entry must have documentary proof so that it can beverified as and when required.
An auditor has to give certificate of the accuracy of the accounts. He does so after verifying the entries on
the basis of documentary proof. These documentary proofs are papers, letters, agreements, cash, memo,
invoice, bills, money receipts, agreement papers, etc.

Revenue and Expense recognition

Capital and Revenue Expenditure
All expenditure, which results in the acquisition of permanent assets, which are intended to be continually used in
the business for the purpose of earning revenue, is called capital expenditure. In other words, the expenditure,
which yields benefits for a long period, is termed as capital expenditure. The term capital expenditure is generally
used to signify that expenditure which
Increases quantity of fixed assets,
Increases quantity of the fixed assets,
Results in the replacement of fixed asset.
The quality of fixed asset said to be increased, when expenditure results in any or some of the following events:
When probable useful life of the fixed asset increases
When capacity of the fixed asset increases
When efficiency of the fixed asset increases
When quality of its output increases beyond that originally anticipated.
Example:

Acquisition and purchase of fixed assets. land, building, plant and machinery, furniture and
fixtures etc.
Expenditure related to erection or installation of fixed assets.
Expenditure on legal charges in relation to fixed assets. Etc.
Cost of replacing petrol driven engine to a diesel driven engine.
Expenditure incurred for increasing the sitting accommodation in a cinema hall or restaurant.
Expenditure incurred for acquiring some right to carry on business. E.g., copy right,
goodwill, trademark, patent rights etc.
Expenditure incurred on major repairs and replacement of plant and machinery or any other
fixed asset, which results in, increased efficiency.
Revenue Expenditure:
When the benefits of the expenditure expires within one accounting period is referred to as revenue expenditure.
These are recurring in nature. Normally, the day to day expenses incurred during regular course of business are
revenue expenditure. All expenses incurred by way of repairs, replacement of existing assets, which do not in any
way add to their earning capacity but simply serve to maintain the original equipment in an effective working order
are charged to revenue expenditure. Or simply the benefit of the expenditure expires within one accounting year; it
is referred to as revenue expenditure.
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Example:
Expenses incurred in the normal course of business, administrative expenses, selling expenses,
manufacturing expenses, insurance, rent, postage, stationery, repairs to assets etc.
Expenses incurred to maintain the business. Cost of stores consumed in the course of manufacturing, i.e.
oils, cotton-waste, machinery spares consumed.
Cost of goods purchased for resale.
Depreciation on fixed asset, interest on loans for business, loss from sale of fixed asset.
Obsolesce cost.

Accounting Treatment of Capital and Revenue Expenditure

All revenue expenses are taken to the debit side of the profit and loss account. All capital expenditure is shown in
the assets side of the balance sheet. The expired portion of the capital expenditure is taken to the debit side of the
profit and loss account. Ex: depreciation is charged to profit and loss account.
Difference between Capital and Revenue Expenditure
Capital Expenditure
Revenue Expenditure
1. Benefit of such expenditure is available Benefits of such expenditure are available
for a long period of time may be for several for one financial year.
financial years.
2. These expenses are non-recurring in These expenses are recurring in nature.
nature.
3. These expenses are incurred for the These expenses are incurred to earn profits.
Normally, the day-to-day expenses
acquisition and improvement of assets.
incurred during regular course of business
are revenue expenditure.
4. The expired portion of such expenditure These expenses are charged to Profit and
is shown in the Profit & Loss Account and loss account.
the Unexpired portion is shown in the
Balance sheet.
5. Examples are Acquisition and purchase Examples are administrative expenses,
of fixed assets., land, building, plant and selling expenses, manufacturing expenses,
machinery, furniture and fixtures etc.
insurance, rent, postage, stationery, repairs
etc.
Deferred Revenue Expenditure:
A heavy expenditure of revenue nature incurred for getting benefit over a number of years is classified as deferred
revenue expenditure. Generally these expenses are revenue in nature but have some features of capital expenditure.
The expenses give benefits for a long period.
Example:
Preliminary expenses, brokerage on issue of shares & debentures, exceptional repairs, heavy advertisements,
expenses incurred in removing the business to more convenient premises.
Accounting Treatment of Deferred Revenue Expenditure.
Deferred Revenue Expenditure will be taken into Profit & Loss account in part every year and thus unwritten off
portion may be allowed to stand in the Balance Sheet on the assets side. This treatment is also justifiable on the
ground that the benefit of such expenses likely to extend beyond the year in which it takes place and each of these
years are concerned be burdened with a proportionate share of such expenses, and not the whole amount be charged
off to the profit and loss account of the very year in which it had been so expended.
Capital and Revenue Receipts:
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Capital receipts refer to the amounts received not in the normal course of business. Money obtained from the sale
of fixed assets or investments, issue of shares, debentures, money obtained by way of loans is examples of capital
receipts. These are non-recurring in nature. These receipts do not affect the profitability of the concern. They can
only cause increase in liabilities or decrease in assets.
Revenue receipts refer to the amount received in the normal course of business. Money obtained in the course of
business is revenue receipts. These receipts are recurring in nature. The profitability of the concern influenced
directly by the revenue receipts. . For example, money obtained from sale of goods, interest on deposits, dividends
on investments, commission received, and rent received etc.
Accounting Treatment of Capital and Revenue Receipts
Capital receipts are shown in the assets or liabilities side of Balance Sheet and Revenue Receipts in the credit side
of the Trading & Profit and Loss account.
Difference between Capital and Revenue Receipts
Capital Receipts
Revenue Receipts
1. These receipts are not frequent in the These receipts arise in the day to day
regular course of business activities. .
operation of the business.
2. These receipts are non-recurring in These receipts are recurring in nature.
nature.
3. These receipts are shown in the balance These receipts are shown in the credit side
sheet under assets or liabilities side.
of the profit and loss account.
4. These receipts do not affect the The profitability of the concern influenced
profitability of the firm directly.
directly by the revenue receipts.
Capital Profit: Capital profit is that profit, which is not earned in the day-to-day operation of business. These
profits are non-recurring in nature. Sale of fixed assets for profit, issue of shares at a premium, purchase of an
existing business cause such profits, These profits are not utilized for the payment of dividend.
Revenue Profit: A Revenue profit is that profit, which is earned in the day-to-day operation of business. These
profits are recurring in nature and arise by matching of revenue receipts and revenue expenses. Dividend is paid out
of revenue profit and not out of capital profit.
Capital Loss: capital losses are those lose, which do not arise in day-to-day operation of business. These losses are
non-recurring in nature. Examples of such losses are selling the fixed assets less than its book values, issue of
shares at discount, redemption of debentures at premium etc.
Revenue Loss: Revenue losses arise in the normal course of business. Such losses are incurred during the process
of selling the goods or rendering services. It is the loss of some revenue receipts or loss incurred in the normal
course of business.

Accounting for Business Transactions:

Preparation of Books of Original records (journal, subsidiary books, ledger, and trial balance)
CLASSIFICATION OF ACCOUNTS:
The transactions of a business entity can be classified into the following 3 categories
Transactions relating to persons or individuals Personal Accounts
Transactions relating to property, assets to possessions Real Accounts
Transactions relating to income and expenditures Nominal Accounts

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Personal Accounts: personal accounts record the dealings of a trader with persons or firms, transactions.
Personal accounts can take the following forms:
1. Natural Persons: ex. Natural persons,
ACCOUNTS
Personal Accounts
Natural
Artificial
Persons
Person
Ram,
Sita, Bank,
Club,
Harish, etc.
Any
Firm,
Limited
Company etc.

Representative
Personal Accounts
Rent prepaid, interest
received in advance,
prepaid
insurance,
outstanding
salary
etc.

Impersonal Accounts
Real
Tangible
Furniture,
Plant,
Machinery,
Stock Cash
Etc.

Nominal

Rent, Interest,
Intangible Discount,
Goodwill,
Cartage etc.
Trade
Marks,
Patents
Etc.

Rules of Debit and Credit:

Type of the Account
Personal Accounts
Real Account
Nominal Account

Debit
The Receiver
What Comes in
All loses and Expenses

Credit
The Giver
What goes out
All gains and incomes

Recording transactions and events in the journal (Journalisation)

Journal: A Journal is a book of original entry wherein transactions are first recorded. It is a book of original entry
wherein transactions are recorded chronologically (i.e. in order of date). Showing date for each amounts and
accounts to be debited and credited and an explanation (narration).
Features of Journal:
1. It is a book of primary entry in which transactions are recorded in a chronological order.
2. It serves as a source for future reference to the accounting transactions.
3. It gives adequate explanation in the form of narration to each transaction, which describes briefly the true
nature and context of the transactions.
4. Amount of the transaction is recorded in both debit and credit column side by side. It helps in maintaining
arithmetical accuracy of the books of accounts.
5. It establishes the linkage with the ledger.
Example:
Transactions of M/S Ramesh & Co.for April, 2001 are given below journalize them.
Date
Transaction
Amount (RS.)
April1 Rajesh started business with cash
10,000
2
Paid into bank
7,000
3
Bought goods for cash
500
5
Drew cash from bank
100
13
Sold to Krishna goods on credit
150
20
Bought from shyam goods on credit
225
24
Received from Krishna
145
Allowed him discount
5
28
Paid shyam cash
215
Discount allowed
10
30
Cash sales for the month
800
30
Paid rent
50
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30

Paid salary

100

Solution:
GENERAL JOURNAL
Date
Particulars
2001
1st April
2nd April
3rd April
4th April
13th April
20th April
24th April

28th April

30th April
th

30 April


 

L.F.

Cash A/c. Dr. To Rajeshs Capital A/c. (being

money invested in the business)
Bank Account Dr. To Cash Account
(being the account paid into bank)
Purchases A/c. Dr. To Cash Account
(being goods purchased for cash)
Cash A/c. Dr. To Bank A/c.
(Being the cash withdraw from the bank)
Krishna A/c. Dr. To Sales A/c.
(being goods sold to Krishna on credit)

Debit
(Rs.)
10,000

Credit (Rs.)

10,000
7000
7000
500
500
100
150

100
150

Purchases A/C. Dr. To Shyam A/c.

(being the goods bought from shyam on credit)
Cash A/c. Dr. Discount A/c. Dr.
To Krishna A/c.
(being cash received from Krishna and discount
allowed to him)

225

225

Shyam A/c. Dr. To Cash A/c.

To Discount A/c.
(being cash paid to shyam and discount allowed by
him)
Cash Account Dr. To Sales A/c.
(being goods sold for cash)
Rent A/c.
Dr.
Salary A/c.
Dr.
To Cash A/c. (being the amount)

225

145
5
150

215
10

800
800
50
100
150

Posting Journal entries in appropriate accounts in the general Ledger

Ledger: The ledger is the principal book of accounts where similar transactions relating to a particular account
(personal, real and nominal in nature) are recorded. Ledger contains a classified summary of all transaction
recorded in the Journal. Financial statements are prepared on the basis of balance in Ledger account at the end of
the accounting period.
Features of Ledger:
1. It is the book, which contains all the accounts.
2. The pages of the ledger are consecutively numbered and index of the page numbers of various accounts is
provided at the beginning of ledger book.
3. All the information relating to any account is available from the ledger.

Journal

Difference between Journal and Ledger

Ledger

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1. It is the book of original entry or primary It is the book of secondary entry.

entry.
2. Transactions are recorded sequentially or Transactions are classified according to the
chronologically, i.e., strictly in order of nature and are grouped in the concerned
dates.
accounts.
3. Transactions are recorded in the journal 3. Transactions are posted in the ledger
applying the rules of debit and credit.
systematically from the journal.
4. Ledger folio is written in L.F. column
Journal Folio is written in the J.F. column.
5. Brief description of the transaction is Narration is not required.
recorded for each entry, which is called
narration.
6. The process of recording financial The process of recording transactions in the
transactions in the journal is called ledger is known as Posting.
Journalizing.
7. In Journal there are two columns one for In ledger there are two sides left side is
debit amount and another for credit debit and right side is credit side.
amount.
8. Balancing is not required in case of Balancing is required for every account in
journal
the ledger
Ex: 2 for the above problem, the ledger accounts can be prepared as below:
Dr.
Cash Account
Cr.
Date
Particulars
J.F. Amount
Particulars
J.F. Amount
Date
(Rs.)
(Rs.)
st
nd
1 April,2001 To Capital
10,000
2 April
By Bank
7000
4th April
To Bank
100
3rd April
By Purchases
500
th
30th
24 April
To Krishna
145
April
By Shyam
215
30th
30th
April
To Sales
800
April
By Rent
50
30th
April
Salary
100
30th
April
By Balance c/d
3,180
11,045
11,045
1st May
To Balance b/d
3,180
Dr.
Capital Account
Cr
Particulars
J.F. Amount
Particulars
J.F. Amount
Date
Date
(Rs.)
(Rs.)
st
1 April By Cash
10,000
30th April To Balance c/d
10,000
10,000
10,000
1st May By Balance b/d
10,000
Dr.
Date

Particulars

2ndApril

To Cash

1st May

To Bal b/d

Dr.

J.F.

Bank Account
Amount
Date
(Rs.)
7000
4th April
30th
April

Cr.
Particulars

J.F.

By Cash
By Balance
c/d

Amount
(Rs.)
100
6900

6900
Purchases Account

S.A. SALAKA ROLL NO 72 SECTION B REGISTRATION NUMBER 70

Cr.

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Date

Particulars

3rd

To Cash
To Shyam

April
20th
April
1 May

Date

Particulars

30th

By
c/d

Particulars

13th April

To Sales

J.F.

Balance

J.F.

Particulars

J.F.

To Bal c/d

725

Krishna Account
Date
Amount
(Rs.)
150
24th April
24th April
150

Amount
(Rs.)

1300

April

Cr.
.
Particulars

By Krishna

30th

By Cash

800

April
1st May

Dr.
Date

Particulars

28th April
28th April

To Cash
To Discount

24th
April
st

1 May

Dr.
Date
30th

April

Dr.

Amount
(Rs.)
145
5
150

Cr.
J.F. Amount
(Rs.)
500

Sales Account
Date
Particulars
13th
April

J.F.

By Cash
By Discount

1300

Dr.
Date

Amount
(Rs.)
725

725
725

To Bal b/d

Dr.
Date

30th

Amount
(Rs.)
500
225

April

st

Dr.
Date

J.F.


 

Particulars

Shyam Account
J.F. Amount
(Rs.)
215
10
225

J.F.

To krishna

To Bal b/d

Particulars
By Balance
c/d

J.F.

1300
1300

By Balance
b/d

Cr.
Date

Particulars

13th April

By Purchases

S.A. SALAKA ROLL NO 72 SECTION B REGISTRATION NUMBER 70

Amount
(Rs.)
225
225

Discount Allowed Account

Amount
Date
Particulars
J.F.
(Rs.)
30th
5
By Balance
April
c/d
5
5

Discount Received Account

Amount
Date
Particulars
(Rs.)
10
28th
By Shyam
April
10
1st May To Bal b/d
Rent Account

J.F.

Cr.
Amount
(Rs.)
5
5

Cr.
J.F. Amount
(Rs.)
10
10
10
Cr.
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Date

Particulars

J.F.

30th

To Cash

Amount
(Rs.)
50

To Bal b/d

50
50

April
1st May
Dr.
Date
30th

Date

Particulars

J.F.

30th

By Balance c/d


 

Amount
(Rs.)
50

April

Particulars
To Cash

J.F.

Amount
(Rs.)
100

50

Salary Account
Date
Particulars

J.F.

Cr.
Amount
(Rs.)

April
30th

1st
May

To Bal b/d

April

By
Balance
c/d

100
100

100

100

Sub Division of Journal (Different Types of Journal)

Journalizing of every transaction is a lengthy task especially when the size of a business is large. When the
size of the business grows, then the main journal is split into a number of separate journal or Day Books. A separate
Day Book is used for each type of transaction. They are called as special purpose subsidiary books.
Reasons for Maintaining the Subsidiary books:
1. Economy in Labour: If the transactions are recorded in the subsidiary books of accounts directly, it will
consume less time than if the transaction is recorded in the journal and then posted to the ledger.
2. More Accuracy: there will be more accuracy in the books of accounts, as entries are made in total directly
in the subsidiary books.
3. Additional information than in a simple ledger account: in subsidiary books we can also include
additional columns for recording date of payment, cheque no. Debit note number, Credit note number,
payable banks name etc.
Types of Journal/Subsidiary books/Sub-divisions of Journal
1. Sales Journal: It is used to record credit sales of goods. If some asset instead of goods sold on credit cannot be
recorded in the sales book. The term goods is used to describe those things which are purchases by the business
for the purpose of resale. The transactions relating to credit sale of goods after having been recorded in the sales
journal are debited to individual (debtors) accounts and total sales for a period normally one month is credited to
sales account.
Date

Outward invoice No.

Name of the customer

L.F Amount(Rs.)

2. Purchase Journal: It is used to record the purchase of goods on credit basis. Purchase of goods for the purpose
of resale only can be entered in the purchase book. The transactions relating to credit purchases of goods after
having been recorded in the purchases journal are credited to individual (creditors) accounts and total purchases
for a period normally one month is debit of purchases account.
Date
Inward invoice No.
Name of the supplier
L.F Amount(Rs.)

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3. Purchase Returns Journal: It is used to record the transactions relating to return of such goods as were
purchased on credit basis. It is also called returns outwards book.
Date
Debit Note No.
Name of the supplier
L.F Amount(Rs.)
Debit Note: it is a note made out with a carbon duplicate. The duplicate copy is for office record and the original
is sent to the party to whom the goods are returned. We call it as a debit note because the partys account is
debited with the amount written in this note.
4. Sales Returns Journal: It is used to record the transactions relating to return of such goods as were sold by the
firm to its customers on credit basis. It is also called as returns inward book or sales return book.
Date
Credit note No.
Name of the customer
L.F Amount(Rs.)
Credit note: a credit note is also like a debit note. It is made with a carbon duplicate-the duplicate copy being for
office use. The original copy is sent to the party from which goods are received. This is called as credit note
because the partys account is credited with the amount written in this note.
5. Bills Payable Journal: the bills payables consists of all promissory notes given or bills of exchanges accepted by
the business in respect of amounts owning to suppliers.
Date
Name of Date
of Term
Date
of Payable
Amount
Remarks
the
bill
maturity
Banks
(Rs.)
Draw
name
er
2002
Best & 15-9-2002 90 days 17-12-2002
HDFC Bank
2,00,000
Sept,15
Co.
6. Bills Receivable Journal: it consists of all promissory notes given or bills of exchange accepted by customers in
respect of amounts due from them.
Date
2002
Sept,15

Acceptor Date of Term

bill
Quality
15-990 days
Deal
2002
ers

Date of maturity
17-12-2002

Payable
Banks name
HDFC Bank

Amount
(Rs.)
2,00,000

Remarks

7. Journal Proper: It is used for recording such transactions as occur so infrequently that they do not warrant the
setting up of special journals. For example
Opening entries, adjustment entries, closing entries, correction entries, transfer entries etc. The transactions of
infrequent nature which cannot be recorded in any of the special journal they will be recorded in General Journal
or Journal Proper. For example loss of goods by theft or fire etc., writing off bad debts, credit purchase of sale of
fixed assets, investments etc., proprietor withdraws goods from the business for his personal consumption etc.
and opening entries, adjustment entries, closing entries, correction entries, transfer entries etc.
8. Cash Book: Cash Book may be defined as the record of transactions concerning cash receipts and cash payment.
Cash Book fulfils the function of book of original entry as also a ledger account. All cash received is recorded on
the left hand side or the debit side of the cashbook while all cash payments are recorded on the right hand side or
the credit side of the cashbook, the difference between the two totals indicating the balance of cash in hand.

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Types of Cash Book:

1. Single Column Cash Book with Cash Column only: It is just like a Cash Account.
Dr.
Date
Receipts
L.F.
Amount (Rs.)
Date
Payments
L.F.

Amount(Rs.)

2. Two-Column Cash Book (Double Column Cash Book):

In this cash book, two columns are kept on both sides. One is for cash and other is for discount. There are two
columns for discount account one on the debit side of cash book (discount allowed) and other is on the credit
side of cash book (discount received). These two columns are not balanced.
Dr.
D Receipts
L. Discount
Amount
Date Payments L. Discount
Amount
at
F. Allowed
(Rs.)
F. Received
(Rs.)
e
(Rs.)
(Rs.)

3. Triple Column Cash Book (Cash, Bank & Discount Columns): In three-column cash book. Bank column is
provided on both sides. All deposits into bank are written on the debit side while all withdrawals from bank are
written on the credit side. The difference between the two sides reflects the balance at bank. Thus, this bank
column serves the functions of a bank account in the ledger.
One important feature of this cash book is that if a transaction involves both sides of the cash, one in the cash
column and second in the bank column though on opposite sides. This is called a Contra entry and the word C
is indicated against that item.
Dr.
Amount Bank
Amount Bank
D Receipts
L.F Discount
D Receipts L.F. Discount
Allowed
(Rs.)
(Rs.)
at
.
Received
(Rs.)
(Rs.)
at
(Rs.)
e
(Rs.)
e

Triple Column Cash Book

From the following transactions of M/s. J.Choudhary, write up his cash book (three column form) bringing down
the balance as on May 31, 2002.
Date
Particulars
Amount(Rs.)
1st May
Balance at bank
1,50,000
nd
2 May
Drew from bank for office use
50,000
3rd May
Bought office furniture for cash
32,000
8th May
Paid wages in cash
15,000
14th May
Drew from bank for office use
25,000
th
16 May
Sold goods for cash
22,000
19th May
Received a cheque from B Batiwala & Co in
settlement of their account of Rs...75,000 less 5
percent
23rd May
Bought goods for cash
45,000
th
25 May
Drew cheque for self
40,000
31st May
Paid Agarwals account Rs.40,000 by cheque
less 2.5 %

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Sol.
Dat
e
Ma
y
1st

Receipts

L.
F

Discoun
t
Allowed
Rs.

To Balance
b/d
To
Bank C
a/c.

2nd
14th
16th
19th

To
Bank C
a/c.
To sales a/c.
To Batiwala
& Co.

Cash
Rs.

Bank
Rs.

Dat
e

1,50,00
0

2nd

50,00
0

3rd

25,00
0
22,00
0

8th

3,750

14th
71,250

23rd
25th
31st
31st

Total
1st
June

To Balance
b/d

3750

97,00
0
5000

2,21,25
0
67,250


 

Payment L Discou
s
. nt
F receive
. d
Rs.
By Cash C

Cash
Rs.

By
Furnitur
e a/c.
By
wages
By Cash

32,00
0

By
Purchas
es
By
drawing
s
By
Agarwal
a
By
balance
c/d
Total

45,00
0

Bank
Rs.

50,000

15,00
0
25,000

40,000

1000

1000

39,000

5000

67,250

97,00
0

22125
0

Whenever a transaction relates to cash and bank both it is recorded on both sides of the cash book. For the
purpose of reference a capital letter
C is put in parenthesis on both sides of the cash book. This letter
stands for Contra, a Latin phrase, which stands for opposite side.
If a cheque is received and deposited on the same date, then it is directly debited to bank account. The entry is
Bank a/c. Dr.
To Party a/c.
If a cherub is received and deposited on different dates, then the entry on receipt of cheque is debited cash and
credit party.
Cash a/c. Dr.
To Party a/c.
4. Petty Cash Book: Imprest system of maintaining petty cash is the most scientific method. The essential
feature of this system is that the total petty cash expenditure for a period (say, a month) is estimated at the
beginning of the month and then a round sum is given to the petty cashier for making petty payments during
the month. At the end of the month, the petty cashier submits the statements of expenditure made along with
supporting voucher in the form of petty cash book to the main cashier. The main advantage of this imprest
system of petty cash book is the small payments are not stuffed in the main cash book. They are shown
separately in petty cash book.
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Accounting and Depreciation

Fixed assets are used by a business enterprise for the purpose of producing or providing goods or services. They are
not held for sale in the normal course of business. They are long lived in the sense that they provide service for
several future years. Therefore the amount invested in fixed assets must be equitably allocated to different period of
their economic life in a systematic and rational manner. The amount to b e charged to each period is called
depreciation. Hence it is a process of allocation of the cost of fixed assets to the product or process in a number of
years. The process of spreading the cost of fixed asset over a number of years during which benefit is derived from
the asset is known as depreciation. To conclude Depreciation is a process of allocating the depreciable amount over
the useful life of the asset.
Definition:
1. Depreciation is a permanent continuing and gradual shrinkage in the book value of a fixed asset. The above
definition clearly indicates Depreciation relates to book value of the asset, it has nothing to do with the market
value.
2. According to International Accounting Standard Committee Depreciation is the allocation of the depreciable
amount of an asset over its estimated useful life.
Factors in measurement of depreciation:
a. Depreciable Assets: these are the assets, which have a limited useful life, and are expected to be used during
more than one accounting period. These assets are held by an enterprise for use in the production and supply of
goods and services and not for the purpose of sale in ordinary course of business.
b. Useful life: this is the period over which the asset gives a series of future services.
c. Residual Value: it is the salvage value or the scrap value or the price at which the asset can be disposed of at the
end of its useful life.
Causes of Depreciation:
a. Physical depreciation it is caused mainly due to wear & tears which the asset is in use and also from erosion or
decay from being exposed to wind, rain, sun and other elements of nature.
b. Economic factors: certain factors are also responsible to put the asset out of use even though these are in good
physical condition. These arise due to Obsolescence. As a result of technological revolutions, the asset in use
may become outdated and lose a large part of its value. This fall may also be due to the changes in tastes and
habits of customer, changes in the supply and location of material resources etc.
c. Time factors: certain assets have a fixed period of legal life like lease period, patent and copy right etc. In this
case depreciation is a time function. By the expiration of time for which legal right to use such assets is created,
the assets lose their value. This loss of value is called depreciation. Provision for consumption of these assets is
called amortization rather than depreciation.
d. Depletion: Some assets are of wasting character such as mines, forests, quarries and oil wells, due to the
extraction of some materials, the assets will be depleted. This case the value of mines or quarries decrease and
this decrease is termed as depletion.
Need for providing depreciation:
1. To know the true profit. One of the objectives of accounting is to ascertain the true income. If depreciation is
ignored the loss that is occurring in respect of fixed assets is also ignored. The loss will suddenly look large
when the asset becomes useless after its useful life. From another angle when goods are prodded it involves use
of fixed assets. The reduction in their value should be treated as an element of cost of production of goods.
There fore deprecation should be debited to Profit and Loss account in order to ascertain the true profit.
2. To show true financial position: Financial position can be studied from the balance sheet and for the
preparation of the balance sheet fixed assets are required to be shown at their true value. If assets are shown in
the balance sheet without any charge made for their use, then their value must have been overstated in the
balance sheet and will not reflect the true financial position of the business. Therefore, for the purpose of
reflecting the true financial position, it is necessary that deprecation must be deducted from the assets and then
at such reduced value of these may be shown in the balance sheet.
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3. To provide for the replacement of assets: Another objective of depreciation is to create a depreciation fund
out of profits for replacement of assets. The amount debited to Profit and Loss Account towards depreciation is
invested in a fund. The fund is available for replacement of the asset when its useful life is over.
Characteristics/Features of Depreciation:
Depreciation is the decrease in the value of fixed assets.
It is a permanent loss and the lost value due to depreciation cannot be recovered after wards.
It does not result in cash outflow, so it is considered as non-cash expenses.
Depreciation is always related to fixed assets and not to current assets.
Depreciation is the reduction in the book value of the asset not the market value.
Depreciation is the result of the use of assets, passage of time and obsolescence.
Depreciation, Depletion and Amortization:
Depreciation: the term depreciation is used when expired utility of a physical asset (building, machinery, or
equipment) is to be recorded. In other words, the accounting process of converting the cost of such fixed assets to
expenses is called depreciation. Depreciation has a significant effect in determining and presenting the financial
poison and results of operations of a firm.
Depletion: Some assets are of wasting character such as mines, forests, quarries and oil wells, due to the extraction
of some materials, the assets will be depleted. This case the value of mines or quarries decrease and this decrease is
termed as depletion. The accounting process of converting the cost of these natural resources (which are usually
reported as a separate category of assets) to expenses is called depletion. Depletion differs from depreciation in
physical shrinkage or lessening of an estimated available quantity the latter implying a reduction in the service
capacity of an asset.
Amortization: the term Amortization is usually used for describing the process of writing down the long-term
investments in intangibles such as leaseholds, patents, copyrights, trademarks, goodwill and heavy organization
cost. In other words, the accounting process of converting such intangibles assets to expenses is called amortization.
Accounting and Depreciation:
1. When provision for depreciation account is not maintained.
2. When provision for depreciation account is maintained.
1. When provision for depreciation account is not maintained: The following entries are passed to record
depreciation.
a. At the time of purchase of asset:
Asset a/c.
Dr.
To
Bank
b. Entry for providing annual depreciation
Depreciation a/c.
Dr.
To Asset a/c.
c. Entry for closing the depreciation account by transferring to P&L a/c.
P&La/c.
Dr.
To Depreciation a/c.
d. If the asset is sold in the middle of the accounting year the amount of depreciation is calculated from the
beginning of the current accounting year up to the middle of the accounting year i.e. the time when the asset is
sold and the amount is credited to asset a/c. any difference between cash and bank realized and the written down
value of the asset is to be transferred to P&L a/c. (Profit / Loss on sale )
Bank a/c.
Dr.
(with the amount released)
Depreciation a/c Dr (with the amount of depreciation calculated on the asset sold)
P&L a/c.
Dr
(loss on sale of the asset)
To Asset a/c.
(With the original cost of the asset).
To P&L a/c.
(Profit on sale of the asset)

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2. When provision for depreciation account is maintained.

a. at the time of purchase of asset:
Asset a/c.
Dr.
To Bank
b. Entry for providing annual depreciation
Depreciation a/c.
Dr.
To Provision for Depreciation a/c. (will appear on the liability side of the Balance sheet
c. Entry for closing the depreciation account by transferring to P&L a/c.
P&L a/c.
Dr.
To Depreciation a/c.
e. If the asset is sold in the middle of the accounting year the amount of depreciation is calculated from the
beginning of the current accounting year up to the middle of the accounting year i.e. the time when the asset is
sold and the amount is credited to asset a/c. any difference between cash and bank realized and the written down
value of the asset is to be transferred to P&L a/c. (Profit / Loss on sale )
Bank a/c.
Dr. (disposal value of the asset)
Provision for Depreciation a/c Dr. (with the amount of depreciation already accumulated on the asset sold)
P&L a/c
.
Dr
(loss on sale of the asset)
To Asset a/c.
(With the original cost of the asset).
To P&L a/c.
(Profit on sale of the asset)
Methods of providing Depreciation
1. Fixed Percentage on Original cost or Straight line or Fixed Installment Method:
Under this method the amount to be written of as depreciation every year during the useful life of the asset remains
same for every year. To ascertain the annual charges towards depreciation the following formula is applied.
*Depreciation = Total cost of acquisition including the installation charges scrap value
Estimated life of the asset
Depreciation may be expressed as a rate; the rate on cost will be calculated as under
r = R X100 where r stands for depreciation rate,
C
R= the amount of depreciation
C= acquisition cost includes the cost of installation.
Advantages:
1. This method is simple, as arithmetical calculations are not at all complicated.
2. The rate or the amount of depreciation over the useful life of the assets remains uniform and same.
3. After charging depreciation for the entire life period of the asset the value of the asset reduces to zero.
Limitations:
1. The amount of depreciation is same in all the years, although the usefulness of the machine to the business
is more in the beginning year than that it is in later years.
2. The unevenness of the loss in the market value of an asset over several years is also not reflected in this method.
3. The assumption that the asset will be equally useful throughout its life seems to be illogical.
4. The charge for depreciation remains constant year after year. The expenses of repairs and maintenance are
increasing, as the asset grows older. The profit and loss account thus in the later years bears more than it share
of valuation.
2. Diminishing Balance method (Written down Value Method): under this method, depreciation is calculated on the
written down value of the asset at a certain percentage. The amount of depreciation charged each year goes on
decreasing as it is calculated on the balance of the asset carried forward from previous year. The written down value
of the asset does not become zero at the end of its estimated useful life. This method can be applied only when there
is some residual value of the asset. It is impossible to calculate the rate of depreciation if the residual value is
assumed to be zero. The rate of depreciation under this method may be determined by the following formula:
r = 1 - ns/c
Where r = rate of depreciation
n = useful life
s = scrap value
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c= cost of acquisition including cost of installation.

Advantages:
1. This method is commonly used for plant, fixtures etc. under this method, the annual charge for depreciation
decreases from year to year.
2. This method is an approved method under Income Tax Act, 1961.
3. It is logical that the higher depreciation is charged in the earlier years when the machine is more efficient as
compared to later years.
4. It tends to give a fairly even charge of depreciation against revenue each year, Depreciation is generally
heavy during the first few years and is counter-balanced by repairs being light in the later years when reprise
are heavy this is counter-balanced by the decreasing charge for depreciation.
Disadvantages:
1. Under this method the written down value of an asset can never be zero.
2. Calculation of proper rate of depreciation is difficult.
3. This method does not take into consideration the asset as an investment and interest is not taken into
consideration.
Difference between Straight line method and Diminishing balance method.
Straight line method
Diminishing balance method
1. Calculation of depreciation is on original 1. Calculation of depreciation is on written
cost
down value.
2. Instalment of depreciation is same every 2. Installment of depreciation goes on
year.
diminishing every year.
3. At the expiry of working life of the asset, 3. The balance in the asset account will
the balance in the asset account will reduce never reduce to Zero.
to zero.
4. Suited for assets, which get depreciated
4. Suitable for assets, which require heavy
more on account of expiry of time e.g.
repairs in the later years of their working
patent, lease.
life. Plant, machinery etc.
5. Calculation of depreciation is simple.
5. Calculation of depreciation is difficult.
6. The overall charges, i.e., depreciation
6. The overall charges more or less same
and repairs taken together go on increasing for every year through out the life of the
from year to year. In other words the
asset. Since depreciation goes on
amount of depreciation and repairs is
decreasing and the amount of repairs goes
relatively less during the earlier years of
on increasing.
the life of the asset than
3. Depreciation fund method: Depreciation fund method is otherwise known as sinking fund method. This method
provides funds for replacement of assets at the end of its useful life. Under this method the amount written of as
depreciation is set aside and invested in readily saleable securities the security earns interest and accumulates, every
year the amount of depreciation along with the interest is again invested. It is sold when the life of the asset expires;
and a new asset is purchased with the amount realized to replace the old one. How much amount to be provided and
invested each year can be known by referring to the sinking fund table. While providing annual depreciation here
depreciation fund accounted is credited instead of asset account. Asset account appears at its original cost in the
balance sheet till it is so sold/replaced. In the last year, the asset is written off by transferring it to depreciation fund
account. This method is suitable when the intention is not only to provide depreciation but also to provide for its
replacement as required in case of plant and machinery.

Accounting Entries:
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Year
At the end of
1st year

2ndand
subsequent
years

For providing annual depreciation

For investing the amount outside the
business.
For transfer of depreciation a/c to
P&L account.
For receiving interest on investment

For providing annual depreciation

Last year

For investing the amount of

Depreciation + interest outside the
business.
For transfer of depreciation a/c to
P&L account.
Amount realized from Sale of
investments
If sale of investment is at profit
If sale is at loss
Sale of old asset
Depreciation fund is transferred to
asset a/c. and any balance left in the
asset account is transferred to profit
and loss a/c.(for transfer of loss)
For transfer of profit


 

Entry
Depreciation a/c.
Dr.
To Dep. Fund a/c.
Dep. Fund investment a/c. Dr.
To Bank a/c.
P&L a/c.
Dr.
To Depreciation a/c.
Bank a/c.
Dr.
To Depreciation fund a/c.
Depreciation a/c.
Dr.
To Dep. Fund a/c.
Dep. Fund investment a/c.
To Bank a/c.

Dr.

P&L a/c.
Dr.
To Depreciation a/c.
Bank a/c.
Dr.
To Dep. Fund investment/c.
Dep. Fund investment a/c. Dr.
To Depreciation fund a/c.
Depreciation fund a/c. Dr.
To Dep. Fund investment a/c.
Bank a/c.
Dr.
To Asset a/c.
P&L a/c.
Dr.
To Asset a/c.

Asset a/c.
Dr.
To P&L a/c.
For purchasing of the new asset.
New asset a/c.
Dr.
To Bank.
4. Insurance Policy method: This method is quite similar to depreciation fund method /sinking fund method. But the
difference is that instead of investment is made annually a fixed amount of premium is paid to the insurance
company at the beginning of each year in return the insurance company pays the required amount at the expiry of
the specified period to replaced the old asset. In this method an insurance policy is purchased for the value of the
asset. This policy is taken up for the life of the asset and it matures at a time when the asset is to be replaced. The
amount provided for depreciation is paid towards insurance premium. On the maturity of the policy, insurance
company will pay the amount and the amount will be utilized for replacing the asset.
Year
Entry
st
1 and
Entry for depreciation
P&L a/c.
Dr.
subsequent
To Depreciation fund a/c
years
For the payment of premium
Dep. Insurance policy a/c. Dr.
To Bank a/c.
Last year
For the amount received from
Bank a/c.
Dr.
the insurance company
To Dep. insurance policy a/c.
Profit/loss on realization or
For profit
any more/ less amount
Dep. insurance policy a/c. Dr.
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received from the insurance

company is to be adjusted
through Dep. Reserve a/c.
Closing down the Dep.fund
account and asset account,
Purchase of a new asset


 

To Depreciation fund a/c.

Depreciation fund a/c.

Dr.
To old Asset a/c.
New Asset a/c.
Dr.
To Bank.
5. Revaluation method: Asset is revalued at the end of the accounting year and it is compared with the value of the
asset at the beginning any addition during the year is added to the asset at the beginning. Any difference
between the value at the beginning and the value at the end is treated as depreciation. This method is usually
used in case of assets like drums, containers, loose tools, patens, bottles etc.
6. Depletion Method: this method is used mainly in mines and quarries etc. from which a fixed quantity of output
is expected to be obtained. The value of mines depend up on the quantity of output is expected to that can be
extracted. When all the available deposit in the mine is extracted, its value reduces to zero. The amount of
depreciation to be charged in a particular year is ascertained by multiplying the rate of depreciation with the
quantity of output extracted during that particular year.
Depreciation rate = cost of mine (Asset)
Quantity
Quantity = no. of units of output expected to be extracted during the life of the asset.
7. Machine Hour Rate method: This is another method of charging depreciation where the life of the asset is
estimated in hours. The value of the asset minus scrap value is divided by the estimated number of hour to
ascertain the machine hour rate. Under this method the life of the machine is fixed in terms of no. of hours it is
expected to run. Annual depreciation to be charged is calculated as follows;
Depreciation = Cost of machine X No. of hours the machine runs in a year.
Life of the machine in hours
Example: A machine was purchased for Rs.3, 00,000 having an estimated total working 24,000 hours. The scrap
value is expected to be Rs.20, 000 and anticipated pattern of distribution of effective hours is as follows.
Year
1-3
3,000 hours per year.
4-6
2,600 hours per year.
7-10
1,800 hours per year.
Determine Annual Depreciation under Machine Hours Rate Method.
Solution:
Statement of Annual depreciation under machine hours rate method
Year
Machine hours
Annual Depreciation
1-3
3,000 hours per year. 3,000/24,000X(3,00,000 20,000) = 35,000
4-6
2,600 hours per year. ,2600/24,000X(3,00,000 20,000) = 30,333
7-10
1,800 hours per year
1800/24,000X(3,00,000 20,000) = 21,000
8. Sum of the Digits method: under this method depreciation to be provided is calculated as follows:
Amount to be written off X No. Of years the remaining life of the asset
including current year._______________________
Total of all digits represented by life time of assets in years.
Ex: Machinery was purchased for Rs. 30,000 on 1st January, 03. Provide depreciation for 3 years assuming
that its useful life is 3 years.
Solution:
Year
No. of years the remaining
Depreciation to be
life of asset
provided.
1st year
3 years
30,000X 3/6 = 15,000/nd
2 year
2years
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3rd year
1 year
30,000X 1/6 = 5,000/-.
Total digits
6
9. Annuity method: under this method the cost of the asset is treated as an investment and it is assumed to earn
interest at certain rate. Every year the asset account is debited with the amount of interest calculated at certain
rate on the opening balance of the asset in that year, and credited with the amount of depreciation. The amount
of depreciation to be provided each year is calculated by referring to the annuity table, which depends up on the
rate of interest and the period over which the asset is to be written off.
This method is to a great extent scientific as it treats the purchase of an asset as an investment in the business
itself and charge interest on the same. But the chief defect is that the total charges of depreciation and repairs
put together do not remain fairly uniform from year to year as in the diminishing balance method. This method
is mainly used in the case of costly leases of long period and other assets to which additions are not usually
made and as such in case of machinery this method is not found suitable.
Example: A firm purchases a 5 year lease for Rs.40, 000 on 1st January, 2000. It decides to write off
depreciation on the annuity method. Presuming the rate of interest to be 5% p.a. the annuity table shows that a
sum of Rs. 9230/- should be written off every year. Show the lease (Asset) account for 5 years. Calculations are
to be made to the nearest rupee.
Solution:
Dr.
Lease (Asset) A/.c.
Cr.
Date
Particulars
Amount(Rs.)
Date
Particulars
Amount(Rs.)
1-1-2000 To Bank
40,000
31-12By Dep.
9239
2000
31-12To Interest
2,000
31-12By Bal c/d.
32,761
2000
(5% on 40,000/)
2000
42,000
42,000
1-1-2001 To bal b/d
32,761
31-12By Dep.
9239
2001
31-12To Interest
1638
31-12By Bal c/d.
25,160
2001
(5% on 32,761/)
2001
34,399
34,399
1-1-02
To bal b/d
25,160
31-12By Dep.
9239
2002
31-12-02 To Interest
1258
31-12By Bal c/d.
17,179
(5% on 25,160)
2002
26,418
26,418
1-1-03
To bal b/d
17,179
31-12By Dep.
9239
2003
31-12-03 To Interest
859
31-12By Bal c/d.
8799
(5% on 17,179)
2003
18038
18038
1-1-04
To bal b/d
8799
31-12By Dep.
9239
2004
31-12-04 To Interest
440
(5% on 8799)
9239
9239
Change in the method of Depreciation: sometimes the method of providing depreciation is changed either from
written down value method to straight lien method or from straight lien method to written down value method. If
the change in method becomes effective from current year we need not make any adjustment but simply to change
the method of depreciation. But if the change in method is to be effective with retrospective effect (change in
method to be effective from some past period) the following steps are to be followed.
1. First of all value of asset on the beginning date from which the method is charged is to be calculated.
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2. Depreciation is calculated under both the methods old method and changed method till the period when
adjustment is to be made.
3. The differential amount of depreciation between the existing method and the new changed method is to be
adjusted through asset account by giving debit or credit to P&L account.
If depreciation under changed method is less than the existing method.
Asset a/c.
Dr.
To P&L a/c.
If depreciation to be provided under new method is more than existing method.
P&L a/c.
Dr.
To Asset a/c.
In surplus, it should be credited to profit and loss account.
Factors influencing selection of Depreciation method:
Depreciation has a significant effect in determining the financial position and result of operations of an enterprise
via calculating net income as well as deduction from taxable income. The quantum of depreciation to be provided
in an accounting period involves the exercise of judgment by management in the light of technical, commercial,
accounting and legal requirements and accordingly may need periodical review.
The following factors influence the selection of a depreciation method.
1. Legal provisions
2. Financial reporting
3. Effect on managerial decisions.
4. Inflation
5. Technology. Etc.

Inventory Valuation
Meaning of inventories: According to Accounting Standards (AS-2) Revised, issued by the institute of Chartered
Accountants of India, Inventories are assets,
i.
Held for sale in the ordinary course of business;
ii.
In the process of production for such sale, or
iii.
In the form of materials or supplies to be consumed in the production process or in the rendering of
services.
Both manufacturing concern and trading concern maintain inventories.
Manufacturing Concerns: Inventories of a manufacturing concern consists of raw materials, work-in progress,
finished goods, spares and stores.
Trading concerns: Inventories of a trading concern primarily consists of finished goods purchased for resale.
Significance of Valuation of Inventory: it arises mainly because it serves two purposes.
To determine the true income
To determine the true financial position.
Two Inventory Systems:
There are two inventory systems. Viz. Periodic Inventory System and Perpetual Inventory System.
Meaning of Periodic Inventory System: Periodic inventory system is a method of ascertain inventory by
taking an actual physical count (or measure or weight) of all the inventory items on hand at a particular date on
which information about inventory is required. The cost of goods sold is calculated as residual figure (which
includes lost goods also) as under. .
Cost of goods Sold (materials consumed) = Opening Inventory+ Purchases- Closing Inventory.
Meaning of Perpetual Inventory System: Perpetual inventory system is a method of recording inventory
balances after each receipt and issue in order to ensure accuracy of perpetual inventory records, physical stocks
should be checked and compared with recorded balances. The discrepancies, if any should be investigated and
adjusted in the accounts properly.
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Methods of Valuation of Inventories

1. FIFO method: FIFO method is known as First in first out method. Under this method the materials in the store
are issued according to their order of receipts in the store. In other words the material received first is issued
first. Material from the next lot is issued only after the previous lot is fully exhausted. The material in the
opening stock is used first. The material in the closing stock is valued at the latest purchase price. This method
is most suitable in times of falling prices, because the issue price of materials to job will be high, while the cost
of replacement of material will be low.
Merits:
1. The FIFO method is rational, systematic and consistent with the actual physical flow of materials.
2. Materials are issued at their purchase cost. Hence cost of the work order or job is correctly determined.
3. This method is useful when prices of material are falling.
4. The method is simple and easy to understand and operate.
5. Closing stock of material under FIFO will be valued at the most recent cost price.
Demerits:
1. This method increases the possibility of clerical errors if there is very frequent fluctuation in the price.
2. Sometimes more than one prices for valuing material issues are to be adopted when materials to be issued
from different lot, even in a single requisition.
3. When prices of material rise, the issue price does not reflect the market price. And therefore the charges to
production are low, because the cost of replacing the material consumed will be higher than the price of
issue.
2. LIFO Method: under this method pricing of issue of material is done in the reverse order of purchase.
The materials received last in the store is issued first and also priced at that rate. Hence this method is
known as Last in First Out method. This method is suitable at the time of rising prices because
materials issued are priced at the price of latest available consignment, which is very closely related to
the market price. Pricing the issue of materials under this method will help in fixing the competitive
selling price of the product.
Merits:
1. Materials are priced at cost price, and therefore no profit or loss will result by following this method like
FIFO method recovers the actual cost from production.
2. Production is changed at recent prices as far as possible because materials are issued from latest consignment.
3. At the time of rising prices, this method is most suitable, because materials are issued at the current market
prices, which are high, hence lowering the profit and paying less tax.
Demerits:
1. Like FIFO this method may also leads to clerical error as materials are to be issued from different lots.
2. Like FIFO method comparison between one job and another will become difficult.
3. The stock of material in hand is valued at a price, which doesnt reflect the current market price.
Consequently closing stock will be overstated or understated in the Balance Sheet.
4. Sometimes more than one price is to be adopted for pricing the material issue when it is issued form more
than one lot.
3. Average Cost method:
a. Simple Average: A price which is calculated by dividing the total of the prices of materials in stock from
which the materials to be priced could be drawn by the no. of prices used in that total.
For example: 1000 units purchased @ 10
2000 units purchased @ 11
3000 units purchased @ 12
Average price = 10+11+12 = 11.3
b. Weighted Average Price: A price which is calculated by dividing the total cost of materials in stock by the
total quantity of materials in stock. This method considers both the price and quantity in stock in the above

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4.

5.

6.

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example the weighted average price = 1000X10 + 2000X11 + 3000X 12 = Rs. 11.33
1000+2000+3000
This method is most suitable when there is a price fluctuation, as the actual cost can be recovered from the
cost of the product.
Merits:
1. This method is a rational, systematic one. It represents the prices prevailed during the entire period,
beginning to ending or that point of time when material is issued.
2. When the prices fluctuate considerably this method is most suitable.
3. Issue prices are not to be calculated each time issues are made, issue prices are charged only when new lot of
material is purchased.
4. This method covers the cost of material from production.
5. This method maintains the issue prices as near to the market price as possible.
6. This method does not require any adjustment in stock valuation.
Demerits:
1. The major drawback of the system is that a fresh rate is to be calculated as soon as a new lot of material is
purchased which may involve tedious calculations. Hence there are chances of clerical errors.
2. Issue price of materials does not represent actual cost price of materials issued, but it represents average cost of
materials in the store.
3. This method cannot be used in job order industry where each individual order must be priced at each stage up to
completion.
Inflated Price Method:
There are some materials, which are subjected to natural wastage. Example: coal lost due to loading and unloading,
timber lost due to seasoning. In such cases the, materials are issued at inflated price so as to recover the cost of natural
wastage of materials from the production.
EX: if 100 tones coals are purchased at Rs.75 per tone and if it is expected that 5 tones coals will be lost due to
loading or unloading the inflated price in this case will be = 100X75
` :- Inventory Valuation= Rs.78.95
(100-5) tones
Base stock method: the base stock method is based on the assumption that every organization always maintains a
minimum quantity of materials in stock. This minimum quantity is known as safety and base stock. This should be
used only when an emergency arises. The base stock is created out of the first lot; hence it is always valued at the cost
price of the first lot.
HIFO method: This method is based on the assumption that the closing stock of materials should always be valued at
minimum price. Hence the materials issued are to be priced at the highest value of available consignments in the
stores. This method is not suitable as this method always undervalues the closing stock, which causes creation of a
secret reserve. This method is mainly used in case of cost plus contract.
Standard Cost method: under this method, a standard cost is set for each material and this cost is used as a basis for
pricing the material issues. The use of standard cost for determining the cost of inventories requires that standards are
realistic, are reviewed regularly and where necessary, revised in the light of current conditions and that there exists a
proper system of pro rating significant variances between the cost of sales and inventories.
Specific Identification method: the specific identification method attributes specific costs to identified goods that
have been bought or manufactured and are segregated for a specific purpose. According to Accounting Standard2,
this method should be used for inventories of items that are not ordinarily interchangeable or for goods produced and
segregated for specific projects.
Lower of cost or market (LCM): different methods of inventory costing such as FIFO and LIFO determine the
value of inventory in terms of historical cost. However, according to the conservatism concept, inventory should be
reported on the balance sheet at the lower of its cost or its market value.
Material price method: market price can either be replaced price or realizable price. Replacement price is applicable
in case of stock is held for use in production, while realizable price is used in case of finished product or the stock
ready for sale. Under this method material issued is priced at that price at which it can be replaced. Hence cost of the
material is issued at the price prevailing in the market on the date of issue. This method is ideal when quotations have
to be sent, because this would reflect the latest competitive conditions. This method is also good for pricing of issue
of obsolete materials, lying in the store for a long period. This method doesnt recover the cost price of the material

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from production, because market price may be more or less than the actual cost. It makes stores ledger unnecessarily
complicated.
Accounting Standard 2 (revised) has curtailed the methods available for valuation. The earlier AS-2 permitted a
variety of cost formula to be adopted for inventory valuation. The revised standard permits the use of only FIFO or
weighted average cost formula for determining the cost of inventories where the specific identification of cost of
inventories is not possible.

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