UNIT - 4 Treatment of certain Items

                         Treatment of  certain Items  

1 Interest on capital
2. Amortization

3. Cost of finance

1. Interest on capital:    

(i)Different people have differences of opinion on the question of whether interest on capital should be included in the cost or not.

(ii) This is so because, whether a concern pays interest on capital or not, depends upon its method of capitalization. 

(iii)This means a company raising finance by equity capital only has not to pay interest whereas a company raising finance partly through debenture has to pay interest.

(iv)If interest actually paid is included in the cost, companies not paying any interest will have lower costs, and companies paying interest will show a higher cost of production.

(v) This makes difficult the comparison of costs in different companies. 

(vi)Therefore, for the sake of uniformity, either interest paid should be included in the cost, or alternatively, interest on the total capital employed (both equity and debenture capital) should be included in the cost so that costs become comparable.

The following arguments are put forward for the inclusion of interest in cost accounts:

Arguments for Inclusion:

(i) Interest is a reward of capital as wages are the reward of labor.

(ii) Interest on borrowed capital is included in costs.

(iii)  Cost Comparision and profit evaluation are possible when interest is included in cost accounts.

(iv) The inclusion of interest in cost accounts also facilitates making or buying decisions and owning or hiring a machine.

(v) It enables determining the cost of holding the inventory.

(vi) If interest is not included in the cost of production, the cost of goods sold is understated and profit is overstated.

Arguments against Inclusion:

(i) The remuneration payable on capital is profit as such interest should not be included in cost accounts.

(ii) Actual interest paid can be included in cost accounts but not the notional interest.

(iii) Interest is a matter of pure finance and hence it should be taken into the costing Profit and Loss Account but not into the Cost of Production Account.

(iv) Interest need not be included in determining the comparative cost of installation of a new asset as it is governed by depreciation, repairs and maintenance cost, etc.

(v) It involves additional clerical work and creates unnecessary complications in cost accounts.

(vi) It is quite difficult to determine the exact amount of capital upon which interest should be calculated. This is because working capital in the form of stock, debtors, cash, etc., changes every year now and then.

(vii) It is also difficult to determine a fair rate of interest as the market rate of interest varies considerably.

(ix) Managerial decisions and comparisons involving interest can be best made on separate statements without introducing interest in cost accounts. The inclusion of interest in cost accounts creates unnecessary complications.

     After considering the above arguments it can be concluded that :

1. Interest should be excluded from cost accounts

2. Interest should be considered while making cost comparisons for managerial decision-making.

Decision areas for which interest should always be considered:   Interest on capital should be taken into a/c for the following decisions:

1. For submitting cost estimates for long-term contracts

2. For ascertaining the cost of jobs requiring long-term periods for completion& large investments.

3. For taking make/buy decisions.

4. For all long-term policy decisions involving capital resources.

2)   Amortization:  Amortization is the written off of an asset over its expected period of use, which shifts the asset from the balance sheet to the income statement. It essentially reflects the consumption of an intangible asset over its useful life.

  Amortization is most commonly used for the gradual written down of the cost of those intangible assets that have a specific useful life. Ex: Patents, copyrights, trademarks.

Amortization example

Amortization is important for managing intangible items and loan principles. The following are the amortization examples.

Amortizing an intangible asset

You own a patent on a machine, and that patent lasts 20 years. You spent rupees 20,000 to design and create the machine (initial cost of the patent). You should record rs.1,000 each year as an amortization expense for the patent (rs.20,000 / 20 years).

Amortizing a loan

You have an Rs.5,000 loan outstanding. If you pay Rs.1,000 of the principal every year, Rs.1,000 of the loan has amortized each year. You should record Rs.1,000 each year in your books as an amortization expense.

  The difference between depreciation & amortization is that amortization is associated with charging intangible assets and depreciation is associated with charging tangible assets to expense over time.

3Q) Cost of finance: