There are two approaches to valuing an asset.

• Cost approach

  If you ask someone, who has got a house newly constructed, on a recently purchased plot of land, about the value of their property, what would they say?

  on completion

  They would recollect the amount they have spent on buying land, registration charges paid, materials for construction, labour payments, etc., add up the same and express that figure as the value of their property.

  during construction

  If we put the same question before the completion of construction of the house, they would generally say under construction and if we still insist on their expressing the value, they would arrive at the value using a similar approach.

  usable condition

  The house attains usable condition once the construction is complete.

• Realisable Rate approach

  If you ask someone, who has a house that was constructed long time back, about the value of their property, what would they say?

  They would assess the market value i.e. the price at which they would be able to sell it at that point of time and express that figure as the value of their property.

  The value of a newly constructed house may also be expressed employing this approach.

Principle for valuation of an Asset

The value of an asset includes all the expenses incurred before bringing the asset into usable condition.

This principle, used predominantly in accounting in valuing assets, is based on the cost approach.

Usable condition is dependent on the asset in consideration and the purpose for which it is possessed.

Capital Expenses

Expenses which go into the value of an asset are capital expenses.

By the principle of valuation of assets, direct expenses are capital expenses.

Revenue Expenses

Expenses which do not go into the value of an asset and whose utility is within the accounting period during which they are incurred are revenue expenses.

The term direct expense being discussed is in the context of valuation of assets.

Direct Expense

• An expense which goes into the value of an asset
• Capital expense

Direct expenses are expenses which

• are incurred before bringing the asset into usable condition
• go into the value of the asset

Illustration

Consider the following costs and expenses incurred on a machine purchased at a distant place and brought to the factory for being setup and used in a manufacturing operation.

• Purchase price - 50,000,
• Transportation charges from the place of purchase to the factory - 15,000
• Unloading charges at the factory - 2,500
• Installation charges - 10,000

Treating the expenses other than purchase price as normal expenses, a journal (simple compound) entry for recording these transactions of purchase and subsequent expenses would be.

Since the expenses were incurred in relation to the machine, before bringing it into usable condition, they should be capitalised.

Thus, the appropriate entry would be

All the direct expenses are capitalised by debiting them to the asset (Machinery) a/c, thereby increasing the value of the asset to the extent of these expenses.

Indirect Expenses

Expenses which are not direct are indirect expenses.

Revenue expenses are indirect expenses.

Is the expenditure incurred on purchasing stock, a revenue expenditure or a capital expenditure?

Should it be treated as expenditure incurred towards purchasing an asset? Can we treat stock as an asset?

The following discussion is based on what we do in accounting and final accounting.

As an expenditure

Taking the case of a trading business, whenever stock/goods are purchased, a nominal account (Purchases a/c) is debited.

This implies that we are treating the amount spent on purchasing stock as an expenditure. Such a treatment is adopted all throughout the year.

As an asset

At the end of the accounting period, at the time of preparation of final accounts, we record the following journal entry to bring the value of closing stock into the books of accounts.

by debiting a Real account (Closing Stock a/c) which is shown on the assets side of the balance sheet.

Closing Stock a/c is a real account, has a debit balance, and is shown on the assets side of the balance sheet. This amounts to treating stock an asset at the time of preparation of balance sheet.

Dual nature

We can say that stock has dual nature. All throughout the year, the amount spent on it, is expenditure, and at the moment the balance sheet is prepared, it is an asset.

Closing stock is stock at the end

Closing Stock a/c, representing Stock as an asset, is created at the last moment of the accounting period. It is a real account whose balance is carried forward to the next accounting period by recording the closing entry.

In short the closing entry would be.

Every ledger posting should have a journal support. The closing entry supports the postings, To/By Balance c/d in ledger accounts.

Opening stock is prior periods Closing Stock

Closing stock of an accounting period forms the opening stock of the subsequent period.

Opening Stock a/c (nominal account), is brought into the books, at the first moment of the accounting period by recording the opening entry.

Closing Stock a/c in the closing entry is renamed as Opening Stock a/c in the opening entry, thereby treating the value of closing stock of the prior period, as an expenditure at the beginning of the subsequent accounting period.

The nature of the Opening Stock a/c can be understood from the fact that it is closed at the end of the accounting period, by transferring its balance to the Trading a/c.

Valuation of closing stock is the most common instance of stock valuation. At the end of the accounting period, the value closing stock, which is not readily available in the books of accounts, is ascertained , so as to bring it into the books.

Closing stock being an asset, the principle for valuation of an asset is used in valuing closing stock also.

Value of opening stock is the value of prior periods closing stock. As such there is no valuation involved with respect to opening stock.

Principle for valuation of Stock

The value of stock includes all expenses incurred before bringing stock into usable condition.

Usable Condition for Stock

Goods purchased are used either in the activity of trading or as inputs in the manufacturing processes.

Where stock is being used as input in the manufacturing process, it being ready for use as input, i.e. ready to be input into, or used in, the manufacturing operations, would represent usable condition.

Where the stock is being used in trading, ready for sale, i.e., where it can be just picked up for purchase without needing anything else to be done to it, would represent usable condition.

Expenses included in the value of Stock

Value of stock includes the cost of purchase and the expenses incurred on it before it attains usable condition. Thus, its value is dependent on its usage and the point where it attains the usable condition.

stock used in manufacturing

All expenses incurred on the stock till it is placed ready for being used in or input into the manufacturing process would form direct expenses for the stock.

stock used in trading

All expenses incurred on the stock till it is placed ready for sale would form direct expenses for the stock.

In valuing stock, it would be difficult to collect all the expenses in detail so as to capitalise the expenses incurred in relation to the stock till it reaches usable condition. Therefore, direct expenses up to a point, prior to the point where the stock attains usable condition, are only capitalised.

Theoretically direct expenses till the stock reaches usable condition can be collected and capitalised. Practically, the cost and effort incurred for such an exercise would outweigh the advantage of being able to ascertain the direct expenses relating to stock precisely.

stock used in manufacturing

Expenses till the stock reaches the store, where stock is placed before it is sent to the shop floor for being used in the manufacturing operations, are treated as direct expenses.

stock used in trading

Expenses till the stock reaches the warehouse or godown relating to the sales area, where stock is placed before it is made ready for sale, are treated as direct expenses.

Note

This is only a convention and not a rule.

There may be instances when stock does not reach the usable condition that we contemplate.

Eg: Abnormal loss of stock before the point where the stock reaches usable condition. Loss in transit, Loss before goods reach the godown etc.

In such cases we value the stock as if it is an asset and the principle of valuation of stock would be the same as is with any other asset.

Usable condition not having been attained, all the expenses incurred on the stock till that point would amount to direct expenses.

Direct expenses in relation to stock, would be dependent on the circumstance under which the stock is being valued and the expenses incurred in relation to that stock, till that point.

In a consignment business, stock is required to be valued in multiple circumstances.

1. Valuation of Closing Stock at the end of the accounting period.
2. Valuation of Stock lost on account of abnormal reasons.
3. Valuation of Stock in transit.
4. Valuation of Stock transferred to other businesses.
5. Valuation of Stock returned to the consignor.

• Stock sold/unsold

  The stock consigned to the consignee is to be sold at the consignee's place. As such, usable condition for stock consigned would be, it being ready for sale at the consignee's place. Thus, all expenses incurred in relation to the consigned stock, before they are ready for sale at the consignee's place of business would be direct expenses for it, and would go into its value.

  Usable state assumed to be attained on stock reaching the godown

  The goods consigned would be unloaded at the consignee's godown, unpacked, sorted and placed in the showroom as and when needed. Till the time the goods are placed in the show room they lie in the godown.

  Expenses may be incurred at the consignee's place, in common, for a lot of stock together.

  • unloading charges

    Charges may be paid for many items together.

  • cost of unpacking

    The same workers may be unpacking many items.

  • cost of sorting

    The same workers may be sorting many items.

  • cost of storing (rent, insurance)

    The godown may be stocking different types of goods, till the goods are taken to the showroom.

  • cost of handling

    The same workers might be moving many items to the showroom.

  In valuing the consigned stock, it would be required to ascertain, in relation to one or more items of stock, proportionate expense that can be attributed to the specific stock being valued.

  Such an ascertainment may not be difficult till the goods are unloaded and placed in the consignee's godown. Beyond that point, for being able to ascertain the proportionate expenses, additional records for collecting information have to be maintained. The cost to be incurred for this would outweigh the benefit of being able to ascertain the direct expenses to a greater precision.

  For this reason, only the expenses incurred till the stock reaches the consignee's godown are considered to be direct expenses in relation to stock cosigned.

  Direct/Indirect based on who incurs the expenditure

  Expenses on consignment may be incurred both by the consignor and the consignee and could be either direct or indirect.

  • Expenses incurred by the Consignor

    All the expenses incurred by the consignor, in relation to the consigned stock, are incurred before the stock reach the consignee's place and are therefore direct expenses.

  • Expenses incurred by the Consignee

    Expenses incurred by the consignee, in relation to consigned stock, may be direct or indirect based on at what point they are incurred.

    Expenses incurred in relation to consigned stock, before it reaches (kept in) the consignee's godown, like cost of transportation, octroi duties, insurance in transit, unloading charges etc., are direct expenses. Any other expenditure would be indirect expenditure.

• Other Stock

  In valuing all other stocks, the same principle for valuation of stocks is followed.

  The point where the stock is being valued decides the value of the stock. Only the direct expenses incurred to that point where the stock is being valued would go into its value.