Module 5 Depreciation Inventory 1 Index Goodwill and

Module 5 Depreciation & Inventory 1

Index • Goodwill and its Amortization • Valuation and Accounting for Inventory • Window Dressing Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 2

Goodwill is the benefit and advantage of good name, reputation and connections of an entity. It is a thing which distinguishes an established business from new business. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 3

Goodwill It is the attractive force which brings in customers/ suppliers/ employees. An established business earns more than normal profits because of its reputation, while newly established business has to strive hard just to earn normal profit. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 4

Goodwill of a business is a composite thing influenced by: i) Location (s) of business ii) The way in which business is conducted Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 5

Goodwill iii) The personality of the people conducting the business. iv) customer relationship and service quality v) good relation with employees Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 6

Goodwill vi) No. of years the business or entity exists vii) track-record of benevolent management Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 7

Goodwill • Goodwill is an intangible asset. • Self-generated goodwill is not recognised in financial statements. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 8

Goodwill • Goodwill is recognised in the business as an asset only if it is purchased from third party. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 9

Goodwill If some business is purchased and the purchase consideration exceeds the value of net assets taken over, then loss suffered is treated as goodwill. (AS-14, Ind AS 38, IAS 38) Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 10

Goodwill Example A Ltd. took over B Ltd. Purchase consideration paid by A Ltd. is 150 crores and assets of B Ltd. are as follows: Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 11

Goodwill Net Assets of B Ltd Taken Over by A Ltd. Machinery Book Value (crores) 60 Market Value (crores) 50 Land 10 70 Net Current Assets 50 40 Liabilities 30 20 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 12

Goodwill Solution Purchase Consideration 150 Crs Net Assets (MV) 140 Crs Goodwill 10 Crs Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 13

Amortisation of Goodwill Æ The depreciable amount of an intangible asset should be allocated on a systematic basis over its estimated useful life. (known as amortisation) Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 14

Amortisation of Goodwill Amortisation should commence when the asset is available for use. Æ Estimation of the useful life of an intangible asset generally Æ Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 15

Amortisation becomes less reliable as the length of the useful life increases. Therefore as per AS-26 adopts the presumption that the useful life of an intangible asset is unlikely to exceed ten years. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 16

Amortisation Therefore goodwill is amortised over maximum of 10 year. Æ A variety of amortisation methods can be used to allocate the depreciable amount of an asset on a Æ Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 17

Amortisation systematic basis over its useful life. Æ These method includes the straight line method, reducing balance method, unit of production method. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 18

Amortisation Goodwill arising on business purchases represents the payment made in anticipation of future income. Æ It is appropriate to treat it as an asset to be amortised to income on a systematic basis over its useful life. Æ Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 19

Amortisation Æ Due to nature of goodwill, it is considered appropriate to amortise goodwill over period not exceeding 5 years unless somewhat longer period can be justified. (AS-14) Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 20

Amortisation Example Goodwill 10 Crs Say, company expects that during next 4 years such goodwill should be written off as per straight line method. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 21

Amortisation Therefore, amortisation of goodwill be 2. 5 lakhs per year. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 22

Inventory Ø Inventory is tangible current asset Ø it includes finished goods, work in progress, and raw materials. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 23

Inventory Ø Inventories include assets held for sale in the ordinary course of business (finished goods), assets in the production process for sale in the ordinary course of business (work in process), and materials and supplies that are consumed in production (raw materials). [IAS 2. 6] Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 24

Inventory Valuation of inventory is crucial because of its direct impact in measuring profit/loss and also on financial position. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 25

Inventory Cost of inventories should include only those cost which are expected to generate future expected benefits. Such cost include the cost of acquisition and cost that change either (i) location of the inventory e. g. freight, carriage, import duty or Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 26

Inventory Cost (ii) condition of the inventory, e. g. costs incurred to convert the raw materials into finished goods. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 27

Inventory Cost • Cost should include all: [IAS 2. 10] • costs of purchase (including taxes, transport, and handling) net of trade discounts received • costs of conversion (including fixed and variable manufacturing overheads) and • other costs incurred in bringing the inventories to their present location and condition Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 28

Inventory Valuation Inventories should be valued at cost or net realisable value whichever is lower. (AS-2/ IAS 2. 9) This is based on view that no asset should be carried at a value which is in excess of the value realisable by its sale or use. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 29

Inventory Valuation Net realisable value is the estimated selling price in the ordinary course of business less the estimated cost of completion and estimated cost necessary to make sale. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 30

Inventory Valuation Example Cost of semi-finished products at the end of the 2011 -12 is Rs. 70000. This products can be finished in the next year by further expenditure of Rs. 10000. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 31

Inventory Valuation This products can be sold at Rs. 60000 subject to selling commission of 5% on selling price. Determine the value of inventory for the year ended 2011 -12. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 32

Inventory Valuation Solution: Selling Price Less: Estimated cost of completion Less: Commission Net realisable value Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 60000 10000 3000 47000 33

Inventory Valuation NRV : Rs. 47000 Cost : Rs. 70000 Therefore, value of inventory (lower of cost and NRV): 47000 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 34

Techniques of Inventory Valuation ØSpecific identification method ØFirst in First Out (FIFO) ØLast in First Out (LIFO) ØWeighted Average Price ØAdjusted selling price Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 35

Specific Identification Method q. Pricing under this method is based on actual physical flow of goods. q. It attributes specific cost to identified goods. q. This method is generally used to ascertain the cost of inventories of Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 36

Specific Identification Method items that are not ordinarily interchangeable or having high value. q. Cost of inventory will be determined on the basis of their specific purchase price or production cost. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 37

FIFO The goods are assumed to be issued from the earliest lot on hand. The stock of goods on hand therefore, consist of the latest purchases. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 38

FIFO Example: Following are the purchases for the month of Jun 2012. Date 12 17 20 Units 5000 3000 6900 Price p. u. 7 9 9 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 39

FIFO Date 22 27 Units 8000 2000 Price p. u. 11 13 20000 units were issued during the month. Determine the value of closing stock at the end of month Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 40

FIFO The closing stock is 4900 units and would consist of: 2000 units purchased on 27 th and 2900 units purchased on 22 nd as per FIFO method Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 41

FIFO 2000 X 13= 2900 X 11= Value of Closing Stock 26000 31900 57900 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 42

LIFO Under this method good issued are valued at price paid for the latest lot of the goods. In other words stock of goods on hand will be valued at a price paid for earliest lots. LIFO method is based on an irrational assumption that entering last in stores are consumed first. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 43

LIFO method is not permitted for valuing inventories. AS- 2, IAS – 2, Income Tax Act Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 44

LIFO Example: Following are the purchases for the month of Jul 2011. Date Units Price p. u. 11 3000 16 14 6000 20 18 2500 15 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 45

LIFO Date 25 30 Units 7000 9000 Price p. u. 14 19 22000 units were issued during the month. Determine the value of closing stock at the end of month as per LIFO. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 46

LIFO The closing stock is 5500 units and would consist of: 3000 units purchased on 11 th and 2500 units purchased on 14 th as per LIFO method Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 47

LIFO 3000 X 16= 2500 X 20= Value of Closing Stock 48000 50000 98000 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 48

Weighted Average Price Under this method value of inventory is determined by weighted average price per unit. Weighted average price is calculated by using quantity purchased in a lot as weights. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 49

Weighted Average price per unit = Total cost of goods available for sale during the period Total number of units available for sale during period Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 50

Example: Compute value of closing stock as per weighted average method Quantity Price p. u. Amount 900 10 9000 400 14 5600 18 10800 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 51

Quantity 500 800 3200 Price p. u. 16 12 Total Amount 8000 9600 43000 units were issued during the period Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 52

Weighted Average price per unit = 43000 3200 = 13. 44 Hence value of closing stock is 200 X 13. 44= Rs. 2688 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 53

Adjusted selling price § This is also known as retail inventory method § This method is used where inventory comprises of items, the individual costs of which are not readily ascertainable. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 54

Adjusted selling price The cost of stock is determined by reducing appropriate percentage of gross margin from sales value of the inventory. Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 55

Adjusted selling price Example: Compute value of closing stock for month ended 30 th Jun 2011. Particulars Goods purchased Amount 25000 Transportation cost 5000 Storage cost 2000 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 56

Adjusted selling price Particulars Sales during period Selling price of closing stock Amount 50000 10000 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 57

Adjusted selling price Solution Particulars Sales during period Selling price of closing stock Total Amount 50000 10000 60000 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 58

Adjusted selling price Solution Particulars Less: Goods purchased Less : Transportation cost Less: Storage cost Gross Profit Amount 25000 2000 28000 Management Accounting - Dr. Varadraj Bapat, IIT Mumbai 59

Gross Profit Margin: 28000/60000 = 46. 67% Particulars Selling price of closing stock Less: Gross profit margin Value of inventory Management Accounting - Dr. Varadraj Bapat, IIT Mumbai Amount 10000 4667 5333 60

Window Dressing • Window Dressing means something done to make a better impression, and implies dishonest or deceptive. • Window Dressing refers to attempts to mis-represent and present financials in the better light. Management Accounting Dr. -Varadraj Dr. Varadraj Bapat, IIT Mumbai 61

Window Dressing • Window dressing is an unethical practice • Deliberate deception in the financial statements is fraud. • Enron - Arthur Anderson • Satyam - PWC Management Accounting Dr. -Varadraj Dr. Varadraj Bapat, IIT Mumbai 62

Window Dressing • Examples • Delay major payment (and not making provision) • Include large injection of cash/assets • Hiding sales return • Overstatement of stock /debtors Management Accounting Dr. -Varadraj Dr. Varadraj Bapat, IIT Mumbai 63