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 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. they are to be capitalised.

Example

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.

Journal

Particulars		Amount (Dr)	Amount (Cr)
Machinery a/c To HM Tools a/c	Dr	1,20,000	1,20,000
Transportation Charges a/c Unloading Charges a/c Installation Charges a/c To Cash/Bank a/c	Dr Dr Dr	10,000 2,000 12,000	24,000

They should be debited to the Machinery a/c.

Journal

Particulars		Amount (Dr)	Amount (Cr)
Machinery a/c To HM Tools a/c	Dr	1,20,000	1,20,000
Machinery a/c To Cash/Bank a/c	Dr	24,000	24,000

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..

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 on 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 the stock into usable condition.

Usable Condition for Stock - Being ready for Sale

Considering the Stock is used in sale in a retail shop, 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 relating to the stock in detail, this idea is modified to mean the expenses incurred before that stage till which it would be feasible to collect information.

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 such 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 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. An expenditure being or not being a direct expenditure is dependent on the facts of the case in consideration.

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. Thus the term cost of goods sold would include the purchase price of the goods as well as all the direct expenses incurred in relation to it before bringing it to usable condition.

This value is needed to ascertain 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.

1. Opening Stock at the beginning of the accounting period, 20,000.
2. Purchases of goods/stock during the accounting period : 2,48,000.
3. Direct expenses incurred : 54,000.
4. Unsold stock at the end of the accounting period valued at 36,000.
5. Value of Stock used for other purposes 14,000.

Value of stock includes the direct expenses incurred in relation to it.

Value of Goods Purchased

=

Net Purchases + Direct Expenses

The total stock available for sale during the current period includes the opening stock along with the stock purchased during the current period.

Total value of goods	=	Opening Stock + Value of Goods Purchased
	=	Opening Stock + Purchases + Direct Expenses

This data presented in the form of a statement.

Particulars	Amount	Amount
Opening Stock + a) Purchases (Cost Value) b) Direct Expenses	2,48,000 54,000	20,000 3,02,000
Total Value of Goods		3,22,000

Goods not sold

=

Closing Stock + Stock Used for Non Trading purposes

Cost of Goods Sold

=

Total value of goods − Goods not sold

Cost of Goods Sold

=

Opening Stock + Purchases + Direct Expenses − Closing Stock − Stock Used for Non Trading purposes

Particulars	Amount	Amount
Opening Stock (+) Net Purchases (Cost Value) Direct Expenses	2,48,000 54,000	20,000 3,02,000
Total Value of Goods (−) Closing Stock (Value) Stock Used for Non Trading purposes	36,000 14,000	3,22,000 50,000
Cost of Goods Sold		2,72,000

Stock Used for Non Trading purposes

Stock with the organisation may have been used for purposes other than trading. The value of such stock unused for trading purposes together with the value of closing stock has to be deducted from the total value of stock so as to arrive at the value of cost of goods sold.

Some such instances

• Goods being taken away by the proprietor for personal purposes;
• Stock used in building up an asset;
• Stock used for advertisement purposes;
• Normal loss of stock;
• Abnormal loss of stock;
• Stock used up for other types of businesses (like consignments, branches, joint ventures etc.)

The margin that sales would provide over the cost of goods sold id gross profit.

Mathematically

Gross Profit = Sales − Cost of Goods Sold

To find gross profit we need cost of goods sold and sales.

This can also be interpreted as

Gross Profit + Cost of goods sold

=

Sales

Bypassing finding Cost of Goods Sold

Cost of Goods Sold

=

Opening Stock + Purchases + Direct Expenses − Closing Stock − Stock Used for Non Trading purposes

Gross Profit + Cost of Goods Sold

=

Sales

⇒ Gross Profit + Opening Stock + Purchases + Direct Expenses − Closing Stock − Stock Used for Non Trading purposes

=

Sales

⇒ Opening Stock + Purchases + Direct Expenses + Gross Profit

=

Sales + Closing Stock + Stock Used for Non Trading purposes

This relation bypasses ascertaining the value of cost of goods sold for ascertaining gross profit.

Such an ascertainment of Gross Profit is done in the Trading a/c.

Trading a/c

DrCr
Particulars	Amount	Particulars	Amount
To Opening Stock To Purchases To Direct Expenses To Gross Profit	– – – –	By Sales By Stock Used for       Non Trading Purposes By Closing Stock	– – –

Why Purchases on Debit side and Sales on Credit side?

• All nominal accounts representing direct expenses are closed at the end of the accounting period by transfer to the Trading a/c.

  Purchases a/c is a nominal account with a debit balance and represents a direct expenditure (for stock). Thus Purchases a/c is closed by transfer to the Trading a/c.

  Transferring a debit balance from one account to a second results in the second account being debited and the first account being credited. Thus, the balance of purchases a/c appears on the debit side of the Trading a/c.

  We can also say that all the items that appear as an addition to purchases in the equation that is the basis for trading account would also appear on the debit side of the Trading a/c.

• All nominal accounts representing direct incomes are closed at the end of the accounting period by transfer to the Trading a/c.

  Sales a/c is a nominal account with a credit balance and represents a direct income. Thus Sales a/c is closed by transfer to the Trading a/c.

  Transferring a credit balance from one account to a second results in the second account being credited and the first account being debited. Thus, the balance of Sales a/c appears on the credit side of the Trading a/c.

  We can also say that all the items that appear as an addition to sales in the equation that is the basis for trading account would also appear on the credit side of the Trading a/c.

Finding Cost of Goods Sold

Cost of goods sold is a figure that is not straight away available in the books of accounts. Trading a/c straight away reveals the gross profit without specifically ascertaining the value of cost of goods sold.

Deliberate effort has to be made to ascertain the cost of goods sold. Trading a/c can be made to reveal the cost of goods sold or a separate ledger account can be prepared to obtain the value.

Each ledger account is used to collect all the information relating to an element at a single place. It 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 Used for Non Trading purposes)

The Trading a/c with this information posted would be

Trading a/c

DrCr
Particulars	Amount	Particulars	Amount
To Opening Stock To Purchases To Direct Expenses	20,000 2,48,000 54,000	By Closing Stock By Stock Used for       Non Trading Purposes	36,000 14,000
sub-total	3,22,000	sub-total	50,000

The trading account before crediting net 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.

To ascertain the cost of goods sold, we just need to balance the Trading a/c without crediting sales.

Trading a/c

DrCr
Particulars	Amount	Particulars	Amount
To Opening Stock To Purchases To Direct Expenses	20,000 2,48,000 54,000	By Closing Stock By Stock Used for       Non Trading Purposes By Balance c/d	36,000 14,000 2,72,000
	3,22,000		3,22,000
To Balance b/d	2,72,000

For providing clear information, we will use an intermediary account by name Cost of Goods Sold a/c to which the balance is transferred from the Trading a/c and from which the balance is transferred back to the Trading a/c.

Trading a/c

DrCr
Particulars	Amount	Particulars	Amount
To Opening Stock To Purchases To Direct Expenses	20,000 2,48,000 54,000	By Closing Stock By Stock Used for       Non Trading Purposes By Cost of Goods Sold	36,000 14,000 2,72,000
	3,22,000		3,22,000
To Cost of Goods Sold To Gross Profit	2,72,000 1,08,000	By Sales	3,80,000
	3,80,000		3,80,000

The Sales a/c can be subsequently transferred to the Trading a/c to ascertain the Gross Profit.

Ascertaining Cost of Goods Sold by Mathematical Calculations

If the Trading a/c is a single stage account as follows

Trading a/c

DrCr
Particulars	Amount	Particulars	Amount
To Opening Stock To Purchases To Direct Expenses To Gross Profit	20,000 2,48,000 54,000 1,08,000	By Sales By Stock Used for       Non Trading Purposes By Closing Stock	3,80,000 14,000 36,000
	4,30,000		4,30,000

We can obtain the value of cost of goods sold from this by using the definition for gross profit.

Gross Profit = Sales − Cost of Goods Sold

⇒ Cost of Goods Sold	=	Sales − Gross Profit
	=	3,80,000 − 1,08,000
	=	2,72,000

The value of Cost of Goods Sold can also be obtained specifically, by maintaining a separate account for the purpose. This may be named Cost of Goods Sold a/c (or any other convenient name).

The Cost of Goods Sold a/c would be made to function as a regular ledger account instead of being an intermediary account.

Instead of balancing the Trading a/c twice, once to obtain the cost of goods sold and then to obtain Gross profit, we can segregate the Trading a/c into two accounts.

Trading a/c

DrCr
Particulars	Amount	Particulars	Amount
To Opening Stock To Purchases To Direct Expenses	20,000 2,48,000 54,000	By Closing Stock By Stock Used for       Non Trading Purposes By Cost of Goods Sold	36,000 14,000 2,72,000
	3,22,000		3,22,000
To Cost of Goods Sold To Gross Profit	2,72,000 1,08,000	By Sales	3,80,000
	3,80,000		3,80,000

The first part of the account would be Cost of Goods Sold a/c and the subsequent part the Trading a/c.

Cost of Goods Sold a/c

DrCr
Particulars	Amount	Particulars	Amount
To Opening Stock To Purchases To Direct Expenses	20,000 2,48,000 54,000	By Stock Used for       Non Trading Purposes By Closing Stock By Trading a/c	14,000 36,000 2,72,000
	3,22,000		3,22,000

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.

Trading a/c

DrCr
Particulars	Amount	Particulars	Amount
To Cost of Goods Sold To Gross Profit	2,72,000 1,08,000	By Sales	3,80,000
	3,80,000		3,80,000

Direct Expenses

If Cost of Goods Sold a/c is maintained the direct expenses relating to stocks should be transferred to it and not to Trading a/c. If not the balance transferred from the Cost of Goods Sold a/c to the Trading a/c may not represent cost of goods sold.

The balancing figure in the Cost of Goods Sold a/c transferred to the Trading a/c does not represent cost of goods sold, in the following cases

• Direct Expenses Transferred to Trading a/c

  Where the Cost of Goods Sold a/c is being used to ascertain the cost of goods sold and direct expenses have been transferred to the Trading a/c instead of the Cost of Goods Sold a/c, the balancing figure in Cost of Goods Sold a/c does not represent cost of goods sold.

  Cost of Goods Sold a/c

  DrCr
  Particulars	Amount	Particulars	Amount
  To Opening Stock To Purchases	20,000 2,48,000	By Trading a/c (?) By Stock Used for       Non Trading Purposes By Closing Stock	2,18,000 14,000 36,000
  	2,68,000		2,68,000

  Cost of Goods Sold implies the total value of goods sold which includes both cost of the goods (derived from the purchases a/c) and direct expenses thereon.

  Since Direct Expenses have not been debited to Cost of Goods Sold a/c, the balancing figure represents the value of goods sold excluding direct expenses.

  Trading a/c

  DrCr
  Particulars	Amount	Particulars	Amount
  To Direct Expenses To Cost of Goods Sold To Gross Profit	54,000 2,18,000 1,08,000	By Sales	3,80,000
  	3,80,000		3,80,000

• Opening Stock transferred to Trading a/c

  Where the balance in Opening Stock a/c has been transferred to the Trading a/c instead of the Cost of Goods Sold a/c, the balancing figure in Cost of Goods Sold a/c may not represent Cost of Goods Sold.

  Cost of Goods Sold a/c

  DrCr
  Particulars	Amount	Particulars	Amount
  To Purchases To Direct Expenses	2,48,000 54,000	By Trading a/c (?) By Stock Used for       Non Trading Purposes By Closing Stock	2,52,000 14,000 36,000
  	3,02,000		3,02,000

  The balance in the Cost of Goods Sold a/c transferred to the Trading a/c represents the value of goods that have been purchased and sold away during the current period.

  This does not include the value of opening stock that might also have been sold away. Thus this balance, cannot be called cost of goods sold though it represents value.

  Trading a/c

  DrCr
  Particulars	Amount	Particulars	Amount
  To Opening Stock To Goods Consumed To Gross Profit	20,000 2,52,000 1,08,000	By Sales	3,80,000
  	3,80,000		3,80,000

Recording Closing Stock

Valuation of closing stock is independent of the accounting treatment adopted for bringing the value of closing stock into books.

Crediting or not crediting the closing stock to the cost of goods sold account would make no difference in both the above cases, as the balance of the cost of goods sold a/c being transferred to the Trading a/c does not represent the cost of goods sold.

Thus in these cases, the value of Closing Stock may be credited to either the Trading a/c or the Cost of Goods Sold a/c.

Where appropriate

In both the above cases, crediting the value of closing stock to the Trading a/c where the total value is debited ultimately would be appropriate. This is based on the rationale that some of the value that cost in to the value of closing stock is missing from the Cost of Goods sold a/c and the total value relating to the closing stock is in the Trading a/c, whereby it would be appropriate to adjust closing stock to the Trading a/c.

However, recording Closing Stock through Cost of Goods Sold a/c would be appropriate

• where direct expenses are transferred to the Trading a/c and the value of closing stock does not include any part of those direct expenses or
• where opening stock has been transferred to the Trading a/c and the value of closing stock includes only that stock which has been purchased during the current accounting period.

This discussion is more of academic relevance to understand paying attention to where costs are included while adjusting or eliminating them. Practically in both the above cases, it would not matter whether we are crediting the value of closing stock to the Trading a/c or the Cost of Goods sold a/c as there is already an error and that cannot be set right by making a choice regarding closing stock.

The stock that is used for non trading purposes within the organisation (stock drawn by the proprietor for own purposes, stock used for building an asset, stock used for advertisement purposes, etc.,) has 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 28^th December 20_6:

• Opening Stock - Nil;
• Purchases - 1,20,000;
• Direct Expenses - 30,000
• Sales - Nil
• Stock used by the organisation internally 20,000 (Valued at Cost).

  Generally Sales are made by adding 25% profit to cost.

• Closing Stock - ?

The accounting period ends on 31^st December 20_6.

Value of Closing Stock with the Organisation	=	Total Value of Stock − Value of Stock used up internally
	=	Purchases + Direct Expenses − 20,000
	=	(1,20,000 + 30,000) − 20,000
	=	1,50,000 − 20,000
	=	1,30,000

Sales value of the stock used within the organisation	=	Cost + 25% of Cost
	=	20,000 + 25% of 20,000
	=	20,000 + 5,000
	=	25,000

Stock used up internally recorded at Sales Value

Trading a/c

DrCr
Particulars	Amount	Particulars	Amount
To Purchases To Direct Exp. To Gross Profit	1,20,000 30,000 5,000	By Sales By Stock Used for       Non Trading Purposes By Closing Stock	– 25,000 1,30,000
	1,55,000		1,55,000

There is no commercial activity (no sales), there is no scope for earning profits. But the Trading a/c reveals a Gross Profit of 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

Trading a/c

DrCr
Particulars	Amount	Particulars	Amount
To Purchases To Direct Exp. To Gross Profit	1,20,000 30,000 Nil	By Sales By Stock Used for       Non Trading Purposes By Closing Stock	– 20,000 1,30,000
	1,50,000		1,50,000

The Trading a/c would reveal no profit when the stock used up internally is valued at cost.