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Valuation of Assets » Direct Expenses
• Asset Valuation Principle
The value of an asset includes all the expenses incurred before bringing the asset into usable condition.
• Direct Expenditure
In financial accounting, we use the term Direct Expense in relation to assets.
Any expenditure that goes into the value of an asset is identified as Direct Expenditure for that asset.
• Assets » Treatment of Direct Expenses
All the expenses incurred in relation to an asset before bringing the asset into usable condition would form direct expenses for the asset
All the direct expenses in relation to an asset are to be made part of the value of the asset i.e. are to be capitalised.
If a machine is purchased at Delhi and brought to Tenali for use, then all the expenses incurred before bringing the machine into working mode (usable condition) like transportation charges from Delhi to Tenali, Unloading Charges at Tenali, Installation Charges etc., should be considered to be part of the value of the machine.
These expenses should not be debited to the respective expenditure accounts, but should be debited to the Machinery a/c. The Machinery a/c balance which indicates the value of the asset would be the sum of the cost of the machine, the transportation charges, unloading charges, installations charges, etc..
Is Stock an Asset?
• Dual nature of Stock
» Purchases : During the Accounting Period
Whenever we purchase stock/goods we debit the Purchases a/c (Nominal account). This implies that we treat the amount spent on purchasing stock as an expenditure.
Such a treatment is adopted all throughout the year.
» Asset : At the end of the Accounting Period
At the end of the accounting period, while preparing the final accounts we treat stock an asset and show it in the Balance Sheet on the assets side.
Thus we can say that stock has dual nature. All throughout the year the amount spent on it is expenditure and only for the moment the balance sheet is prepared it is an asset.
• Valuation of Stock » Based on the Principle for Valuation of Assets
Since Stock is an asset, its valuation should also be made based on the principle for valuation of assets.
The value of stock should include all the expenses incurred before bringing stock into usable condition.
• Usable Condition for Stock » Being ready for Sale
Considering the Stock used in sale, the usable condition for stock would mean getting it ready for sale i.e. it being finally set up in the show case or sale area.
• Value of Stock
All the expenses incurred on the stock till it is placed in the sales area would form direct expenses for the stock and should be treated as a part of the value of stock.
In situations where it would be difficult/impossible to collect all the expenses in detail, this idea is modified to mean the expenses incurred before that stage till which point it would be convenient to collect information.
Direct Expenses for Stock used in Trading Business
In relation to a trading business, the stock used for sale would be an asset.
The usable condition for that stock would be, it being placed ready for sale in the showroom.
Therefore, the direct expenses in relation to this stock would be all the expenses incurred before placing it in the show room or any other relevant place ready for sale.
Conventionally, expenses like Wages, Carriage Inwards (carriage on purchases), Octroi, Excise, Duties etc., Stock purchased, etc. are treated as direct expenses apart from the actual cost of the goods purchased which is revealed by the "Purchases a/c".
It is not a rule that only these form direct expenses. Any expenditure that would have been incurred in relation to stock before it is made ready for sale would form direct expenditure for the stock.
Cost of Goods Sold
• Cost of Goods Sold = Value of the Goods Sold
The cost of goods sold is a term used to indicate the value of the goods sold.
This value is needed to identify the amount of basic/core (gross) profit made by the organisation
» Gross Profit = Sales − Cost of Goods Sold
» Illustrative Explanation
Consider the following data relating to an organisation.
The formula for calculating the value of Cost of Goods Sold based on the above calculations can be written as
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses
Do we need Cost of Goods Sold to find Gross Profit
• Gross Profit = Sales − Cost of Goods Sold
By definition Gross Profit = Sales − Cost of Goods Sold ← (1)
⇒ To obtain the value of gross profit we need the figures of cost of goods sold and sales.
• Bypassing finding Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses − Closing Stock − Stock Unused for trading
Substituting this in (1) we get,
Thus we do not specifically need to calculate the value of cost of goods sold for finding gross profit, only its affect is to be brought into account.
Such an ascertainment of Gross Profit is done in the Trading and Profit and Loss account.
» Finding Cost of Goods Sold in such cases
Cost of goods sold is a figure that is not straight away available in the books of accounts used in financial accounting. That figure can be obtained either from the "Trading a/c" or by preparing a separate ledger account to specific account which gives the information relating to the cost of goods sold.
Ascertaining Cost of Goods Sold from Trading a/c
Each ledger account serves one or more informational needs of the organisation. The Trading a/c gives the information relating to the Gross Profit made by the organisation. It can also be used to derive the information relating to the "Cost of Goods Sold".
» Ascertaining Cost of Goods Sold
Cost of Goods Sold = (Opening Stock + Purchases + Direct Expenses) − (Closing Stock + Stock Unused for trading)
The "Trading a/c" with this information posted to it would be
The trading account before crediting sales would have a greater total on the debit side and thus has a debit balance. That debit balance represents the cost of goods sold.
Thus, to ascertain the cost of goods sold, we need to balance the "Trading a/c" without crediting sales.
The Sales a/c can be subsequently transferred to the Trading a/c to ascertain the Gross Profit.
If such a two stage Trading a/c is prepared, we would be able to ascertain the Cost of Goods Sold as well as Gross Profit from the Trading a/c itself.
» Ascertaining Cost of Goods Sold by Mathematical Calculations
The Trading a/c is generally prepared only as a single stage account as follows
To obtain the value of cost of goods sold from this we use the definition for gross profit.
Finding Cost of Goods Sold using Goods Consumed a/c
The value of Cost of Goods Sold can also be obtained specifically, by maintaining a separate account for the purpose. This may be named "Goods Consumed a/c" (any other indicative name may be used).
The Goods Consumed a/c is nothing but the first part of the trading account where it was balanced twice.
The balance in the Goods Consumed a/c represents Cost of Goods sold. This account is closed by transferring the balance to the Trading a/c.
• Cost of Goods Consumed
If the balances in the ledger accounts representing direct expenses are not transferred to the "Goods Consumed a/c" but are transferred to the "Trading a/c", then the balance from the "Goods Consumed a/c" cannot be called cost of goods sold (value of goods sold).
It just represents the cost of goods consumed. To obtain the cost of goods sold from this, the direct expenses have to be added to this.
Goods used within the Organisation have to be valued at Cost
The stock that is used within the organisation (stock drawn by the proprietor for own purposes, stock used for building an asset, stock used for advertisement purposes, etc.,) have to be valued at cost.
This is for the reason that if such usages are recorded at a value which includes an element of profit, the transaction when recorded would generate a profit, which would amount to making a profit out of a transaction with oneself.
» Illustrative Explanation
Consider the following data relating to an organisation which started its operations on 28th December 2006:
The accounting period ends on 31st December 2006.
• Stock used up internally recorded at Sales Value
There is no commercial activity (no sales), there is no scope for earning profits. But the Trading a/c reveals a Gross Profit of Rs. 5,000 which is on account of the stock used up internally being recorded at sales value.
Such profit generation is inappropriate for the reason that in using up stock within the organisation, the organisation is not conducting a transaction with an outside party.
Thus to avoid profit generation in such cases, the stocks so used are to be valued at cost.
• Stock used up internally recorded at Cost
The Trading a/c would reveal no profit when the stock used up internally is valued at cost.
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