Unit 3: Business Income, Accounting for Depreciation, and Inventory Valuation

1. Measurement of Business Income

  1. Definition: Business income is the net profit earned by a business during an accounting period after deducting all expenses from revenue.

  2. Matching Principle: Revenues must be matched with related expenses incurred during the same period.

  3. Components: Includes sales revenue, other incomes, deducting expenses like COGS, operating expenses, and tax.

  4. Accrual Basis: Business income is recognized when earned, not necessarily when cash is received.

  5. Challenges: Requires adjustments for provisions, depreciation, inventory valuation, and contingent liabilities to achieve accurate profit.

2. Revenue Recognition

  1. Definition: Revenue is recognized when it is earned and realizable, regardless of cash receipt.

  2. Principle (AS-9): Revenue recognition depends on transfer of ownership, not receipt of cash.

  3. Sales of Goods: Recorded when risks and rewards are transferred to the buyer.

  4. Rendering of Services: Recognized when services are performed or proportionately in case of long-term contracts.

  5. Exceptions: Special transactions like consignment sales or installment sales need special treatment.

3. Accounting for Depreciation: Methods and Policy

  1. Definition: Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.

  2. Purpose: Shows accurate valuation of assets, matches expenses with revenue, and provides funds for asset replacement.

  3. Methods: Includes Straight Line Method (SLM), Written Down Value (WDV), units of production, etc.

  4. Depreciation Policy: Choice depends on nature of asset, usage, and statutory requirements.

  5. Disclosure: Policy and method adopted must be disclosed in the financial statements as per accounting standards.

4. Changes in Depreciation Measures and Impact on Business Income

  1. Change in Method: Switching from one method to another (e.g., SLM to WDV) affects profit or loss.

  2. Retrospective Adjustment: Adjustments must be made according to AS-10 or Ind AS-16, often affecting prior periods.

  3. Income Impact: Higher depreciation reduces current period profit and vice versa.

  4. Asset Lifespan and Residual Value: Changes in these estimates can significantly change depreciation expense.

  5. Disclosure Requirement: All changes must be transparently disclosed along with impact in the financial statements.

5. Inventory Valuation through Accounting Standards

  1. Objective: Inventory is valued to determine cost of goods sold and closing stock under AS-2 or Ind AS-2.

  2. Methods: FIFO (First In First Out), Weighted Average Cost, and sometimes Specific Identification.

  3. Cost: Includes purchase price, direct expenses, and conversion costs, excluding abnormal losses.

  4. Lower of Cost or NRV: Inventory is reported at the lower of cost or net realizable value to ensure prudence.

  5. Consistency: Inventory valuation methods must be consistently applied across periods for comparability.

6. Impact of Inventory Valuation on Business Income

  1. Closing Stock Impact: Higher closing stock increases profits; lower stock decreases them.

  2. Cost vs NRV: Writing down inventory reduces business income in the current period.

  3. Method Selection: Choice of FIFO or weighted average affects cost of goods sold and profit.

  4. Inflation Effect: FIFO in inflationary times shows higher profit compared to weighted average.

  5. Auditor Focus: Inventory valuation is a high-risk area for errors and manipulation impacting reported earnings.

7. Capital and Revenue Expenditures and Receipts

  1. Capital Expenditure: Incurred for acquiring or improving fixed assets, produces benefits over multiple periods.

  2. Revenue Expenditure: Incurred for day-to-day operations, benefits only the current accounting period.

  3. Capital Receipts: Funds obtained through sources like issue of shares, loans, or sale of fixed assets.

  4. Revenue Receipts: Income from regular business operations like sales, commission, or service income.

  5. Impact on Accounts: Capital items appear in Balance Sheet, revenue items affect profit or loss statement.

8. Introduction to Deferred Revenue Expenditure

  1. Definition: Expenses that are revenue in nature but whose benefits extend over multiple periods.

  2. Examples: Advertising on a large scale, heavy R&D costs, or preliminary expenses.

  3. Treatment: Shown as an asset initially and written off over several accounting periods.

  4. Prudence: Deferred expenses are gradually charged to profit & loss to avoid sudden burden in a single year.

  5. Compliance: Allowed under accounting standards provided the benefit is reasonably assured over future periods.

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