UNIT - 4 Treatment Of Certain Items

          Treatment of certain items :

1. Depreciation
2. Research & development
3. Material losses

1. Depreciation(Accounting standard 6 ) :

         Depreciation is the diminution in the value of a fixed asset. Say a machine due to usage & lapse of time. A fixed asset has a  span of life during which it renders services for production purposes till the expiry of the asset. The life of an asset is enhanced by efficient maintenance & reduced by its extensive use. Throughout its life, the machine has been gradually diminishing its value to reach the scrap value at the expiry of its life. The gradual reduction in the value of an asset is called ''depreciation''. 
           Depreciation thus is the result of two factors - usage & lapse of time. The more the use of an asset the larger the amount of depreciation. Similarly, the use of assets is lower, the smaller the amount of depreciation.

Reasons for charging depreciation :

• To ascertain the true & comparable cost of production.
• To show a true & fair view in the balance sheet
• To keep the capital intact & to make a provision for the replacement of the asset in future.
• To keep the asset intact & distributing the loss over a no.of years.

 Methods:    The following are the methods of charging depreciation based on,
1. Time factor
2. Usage
3. Maintenance
4. Elements of interest

(1) Methods based on time factor: Under methods based on the time factor, depreciation is a fixed overhead expenditure as the time factor is taken into consideration.
(i) Straight line method
(ii) Diminishing balance method / Reducing.

(i)Straight line method:  Under this method, a fixed percentage of the original value of the asset is written off every year so as to reduce the asset account to nil / to its scrap value at the end of the estimated life.

Depreciation = Original cost - scrap value / Estimated life of the asset

Merits :
1. Simple & easy to calculate.
2. Original cost of asset reduced up to scrap value at the end of estimated life.
3. Estimated useful life of the asset can be estimated under this method.

Demerits:
1.  It doesn't consider the intensity of the use of assets.
2. It ignores any additions/opportunity costs while calculating depreciation.
3. It ignores the effective utilization of fixed assets, and it becomes difficult to calculate the correct depreciation rate.

(ii) Diminishing / reducing balance method :
  It is mostly used for taxation purposes, it is also called as written-down value method. Under this method, depreciation will be calculated at a certain % each year on the balance of the asset which is brought forward from the previous year. Every year the instalment of depreciation will be reduced as the beginning balance of the asset in each year will reduce.

Merits :
1. This method is accepted by I.T. authorities.
2. Impact of obsolescence will be reduced to a minimum level.
3. For Any addition to fixed assets, there is no need to have a fresh calculation unless the purchase is made in the middle of the year.

Demerits :
1. Interest lost due to the capital investment in the asset is not taken into a/c.
2. Book value of the asset cannot be brought down to zero.

(2) Methods based on usage : 
Under methods based on usage, depreciation is a variable overhead expenditure. They are as follows : 
(i) Production unit method 
(ii) Production hour method

(i)Production unit method:    Under this method, depreciation is calculated by means of a fixed rate per unit of production by dividing the value of the asset by the estimated no.of units to be produced during its life. 
                      Depreciation = V-S/P
Whereas, V = Value of asset
                    S = Scrap value
                    P = Units of production

(ii)Production hour method:  This is the method of providing for depreciation by means of a fixed rate per hour of production calculated by diving the value of the asset by the estimated no.of working hours of its life. 
              Depreciation = Value of asset-Scrap value /Estimated no.of hours.

3. Method based on maintenance: The maintenance-based method is generally suitable for small businesses. Under this method, the total amount of depreciation may be calculated as per the requirements of the business. The aggregate amount is to be charged as depreciation. 

   Depreciation= (V-S)+M/N×V
Whereas,     M =maintenance
                    N= no.of years
                    V= value of an asset
                    S= scrap value

4. Method based on elements of interest :  
 Elements of interest mean the best alternative cost/opportunity cost is to be charged out to the machine if the amount is not invested on machinery that creates revenue. 

2Q)Research & development cost: " Research cost " is the cost of searching for new & improved products, new applications of materials /new/ improved methods.
           " Development" starts where research ends as development expenditure, is incurred for putting the results of research on a practical commercial basis.  The benefits of research are passed on to the development & the results obtained from development work are passed on to benefit production. 

Objectives:  The following are the objectives of research & development.

• To acquire better knowledge & know-how
• To find out new /improved products or methods of production & new applications of material so as to maximise profit.
• To find new uses for products.
• To find methods by which better service may be rendered to the customers.
• To improve the organisation & layout of the business.
• To explore possibilities of a large market.
• To find out the possibilities of expansion of present business/enter into other fields with the intention to increase profits.   

Classification:   This may be done according to the needs of an enterprise.

• Based upon nature:  Specific materials used, wages & salaries of technical personnel, equipment expenses.
• Based upon function:  It refers to the organisation of expenses in such a way as to measure the costs of operating an experimental laboratory or testing centre/amounts spent by other depts in this connection. Examples: Designing, distribution, marketing & quality control, warehousing etc.
• Based on responsibility:  Attention is given to individuals/depts responsible for the incurrence of these costs. Ex: By sales mgt, by production management etc.
• Project: Expenses may be grouped project-wise. In that case, a project card will provide details like estimated costs, sanctioning authority, individuals/depts responsible for the project etc.

Treatment :
1. Controversial:  All expenditure on research & development is capital expenditure. Hence no treatment in cost a/cs.
2. Non-Contraversial:  All direct costs such as direct material, direct labour, and direct expenses are charged to projects /costs/job/work orders. All standing & fixed costs are charged to fixed overheads.

3Q) Material losses:  Material losses may take the form of waste, scrap, defectives & spoilage. Usually, the quantity of the output is less than that of the input because of waste, scrap/ spoilage.

i) Waste:   The portion of raw material which is lost during storage or production and discarded. The waste may or may not have any value. 

Normal- The cost of normal waste is absorbed by good production units. 

Abnormal- The cost of abnormal loss is transferred to the Costing Profit and loss account.  

(ii) Scrap: The materials which are discarded and disposed of without further treatment. Generally, scrap has either no value or insignificant value. Sometimes, it may be reintroduced into the process as raw material

Treatment of Scrap 

Normal- The cost of scrap is borne by good units and income arises on account of realisable value deducted from the cost. 

Abnormal- The scrap account should be charged with the full cost. The credit is given to the job or process concerned. The profit or loss in the scrap account, on realisation, will be transferred to the Costing Profit and Loss Account.

(iii) Spoilage: It is the term used for materials which are badly damaged in manufacturing operations, and they cannot be rectified economically and hence taken out of the process to be disposed off in some manner without further processing.

Treatment of Spoilage 

Normal- Normal spoilage (i.e., which is inherent in the operation) costs are included in costs, either by charging the loss due to spoilage to the production order or by charging it to the production overhead so that it is spread over all the products. Any value realised from spoilage is credited to the production order or production overhead account, as the case may be. 

Abnormal- The cost of abnormal spoilage (i.e., arising out of causes not inherent in the manufacturing process) is charged to the Costing Profit and Loss Account. When spoiled work is the result of rigid specification, the cost of spoiled work is absorbed by good production while the cost of disposal is charged to production overhead.

(iv) Defectives: It signifies those units or portions of production which do not meet the quality standards. Defectives arise due to sub-standard materials, bad supervision, bad planning, poor workmanship, inadequate equipment and careless inspection. 

 

      The defectives which can be re-made as per the quality standard by using additional materials are known as reworks. Reworks include repairs, reconditioning and refurbishing. 

    Defectives which cannot be brought up to the quality standards are known as rejects. The rejects may either be disposed- off or re-cycled for the production process. 

Treatment of Defectives: 

Normal- An amount equal to the cost less realisable value on the sale of defectives is charged to the material cost of good production. 

Abnormal- Material Costs of abnormal defectives are not included in the material cost but treated as loss after giving credit to the realisable value of such defectives. The material cost of abnormal loss is transferred to the costing profit and loss account.

(v) Obsolescence: Obsolescence is defined as “the loss in the intrinsic value of an asset due to its supersession”. In simple words, obsolescence refers to the loss in the value of an asset due to technological advancements.

 Treatment: Materials may become obsolete under any of the following circumstances: 

(i) where it is a spare part or a component of the machinery that is used in manufacturing and is now obsolete; 

(ii) where it is used in the manufacturing of a product which has now become obsolete; 

(iii) where the material itself is replaced by another material due to either improved quality or a fall in price. 

      In all three cases, the value of the obsolete material held in stock is a total loss and immediate steps should be taken to dispose of it at the best available price. The loss arising out of obsolete materials is an abnormal loss and it does not form part of the cost of manufacture.