1.64 - Query


(a) Method of valuation of work-in-progress.

The following principles have been laid down by a holding company in the textile industry for valuation of stock-in-trade:

(a) Stock-in-process in spinning and weaving at cost.
(b) Packed bales at cost or market price whichever is lower.
(c) Loose cloth awaiting packing at cost or market price less expenses, whichever is lower. Loose cloth would include cloth at grey, process, stamping, folding and packing stage.
(d) Raw materials at cost or market price whichever is lower.
(e) Stores valued at cost.
(f) Controlled cloth at cost or realisable value whichever is lower.

The subsidiaries have been following the above principles consistently. While auditing the accounts a Member Audit Board, Bhopal under Section 619 (4) of the Companies Act, has desired that since most of the subsidiaries have been incurring heavy losses, the valuation of closing stock-in-process (i.e. spinning and weaving) should be done uniformly at the lower of the cost or market price (realisable value) in accordance with the generally accepted accounting principles.

The closing stock of loose cloth is being valued in accordance with the generally accepted accounting principles i.e. at cost or the market value (realisable value) whichever is lower. There have been no difficulties experienced by the subsidiaries in following this mode of valuation. The sortwise market value is readily ascertained and in case of loose stock, the stagewise cost yet to be incurred is being deducted from the market price and the valuation of stock is done. However, in cast of stock-in-process at spinning and weaving stage, it is practically difficult to ascertain the end product and know its realisable or market value. Most of the stocks at this stage are not saleable unless entire processing is done. The stocks-in-process at spinning and weaving stage remain constant and do not fluctuate. In view of such stocks being valued consistently at cost, the profit and loss account should reflect a true and fair position.

In our opinion finished stock and loose cloth awaiting packing is very important, where there is a periodical accumulation as well as heavy market fluctuations which make a material difference in valuation as well as in reflecting the profit and loss position. Due care has already been taken to value them as per the generally accepted accounting principle mentioned above.

The Member, Audit Board, has taken a stand only on the basis of loss making subsidiaries wherein the cost is likely to be more than realisable value, but this cannot be said to be true in all the cases since out of nine subsidiaries, three subsidiaries have already started earning profits. Even in the case of loss making units, the market price for the stock-in-process at spinning and weaving stage being unascertained, the cost cannot be said to be more than the realisable value.

In view of keeping a consistent and uniform policy for valuation of closing stocks in all the subsidiaries, it is considered by the holding company to continue with the policies already laid down. Expert opinion is, therefore, solicited on the mode of valuation adopted for valuing stock-in-process at spinning and weaving stage for the purpose of reflecting true and fair position of the profit or loss incurred during the year.



Opinion

September 5, 1980

The arguments advanced by the company in the query may be replied as under:

(i) The company has pointed out that in case of stock-in-process at spinning and weaving stage, it is practically difficult to ascertain the end product and know its realisable or market value. It may by mentioned that if the company has various end-products, the most profitable and feasible mix of end-products within the limits of plant capacity and other facilities may be assumed and then reasonable estimate of difference between cost and realisable value may be worked out.

(ii) The fact that the stocks at spinning and weaving stage are not at all saleable unless processing is done should not be the factor for not working out realisable value of such stocks. In order to get reasonable estimate of realisable value of stocks-in-process, the estimated process charges and other expenses yet to be incurred may be deducted from the realisable value of the end-product.

(iii) If the levels of opening and closing balances of stocks-in-process do not fluctuate much, true and fair view of Profit and Loss Account may not be affected. However, if the shortfall of realisable value compared to cost is material in amount, true and fair view of Balance Sheet may be affected.

(iv) The argument that even in case of loss making units, the market price for the stocks-in-process at spinning and weaving stage being unascertained, the cost cannot be said to be more than the realisable value, does not hold good, since it should be possible, as discussed earlier, to get reasonable estimate of realisable value of stocks-in-process by deducting estimated process charges and other expenses yet to be incurred from the realisable value of end product.

The Companies Act, 1956, does not lay down any specific method of valuation of stock-in-trade. The requirement laid down under Schedule VI is that the mode of valuation of stock-in-trade should be disclosed in balance sheet.

One more requirement under Schedule VI in respect of valuation of current assets is that if the realisable value of current assets is lower than the book value in the opinion of the Board of Directors of the company, the fact is to be stated on the face of the Balance Sheet.

If reasonable estimate of the realisable value of stocks-in-process indicates that the shortfall of realisable value compared to cost is significant, it may be desirable from the point of view of concept of conservatism to adopt the “lower of cost and market price” method. However, if the company desires to value the stock-in-process at cost and not at lower of cost or market price, the fact that the realisable value of current assets is lower than the book value in the opinion of the Board of Directors of the company must be disclosed on the face of the Balance Sheet.

If the shortfall of realisable value compared to book value is material in amount and the same has not been provided for in the accounts, qualification in auditor’s report also may become necessary.



Query

(b) Changing of depreciation on value of assets taken
over as on 1/4/1974

On take over of some undertakings, all the assets belonging to the undertaking were vested with the holding company. The value of assets was determined after taking into account the assumed liabilities and the amount of purchase consideration fixed for each undertaking. The total value was allocated between Fixed Assets, Loans and Advances. The values of investments, current assets, loans and advances were taken as appearing in the books of accounts as on 31/3/74 and no allowance was made even for obsolete current assets and bad and doubtful debts. The following guidelines were issued to the subsidiary corporations to arrive at the value of assets taken over:

(i) The written down value as per the books of accounts as on 1/4/74 should be treated as the value of fixed assets taken over.

(ii) In case the up-to-date books of accounts are not available, the value of assets should be determined on the basis of income-tax returns after making suitable adjustments of additions/disposal of assets up to 1/4/74.

(iii) In case where the total value of assets taken over exceeds the assumed liabilities and the compensation fixed for the undertakings, the amount should be credited to a capital reserve account.

(iv) Where the total liabilities assumed and the amount of compensation fixed exceeds the amount of total assets taken over, the difference should be added to the value of the land.

Thus according to the above principles, all the assets except land were basically accounted for on written down value basis as acquisition cost of the assets taken over. This cost price has been taken as the basis for calculation of depreciation for the subsequent years. As per the guidelines of the Bureau of Public Enterprises, the depreciation has to be charged on straight line method. According to the method prescribed, 90% or 95% value of assets (original cost) has to be written off during its useful life. The company has followed this method by taking the cost price as the acquisition cost of the assets and useful life prescribed by the BPE, for various categories of assets taken over and depreciation has been charged on straight line method in the annual accounts for the year 1974-75 onwards.

While auditing the accounts, the Comptroller and Auditor General of India observed that basis of full life assumed for the assets taken over as per the BPE’s guidelines is not correct since the estimated life given by the BPE relates to the new assets and not to the old assets taken over by the company. The correct method would be to calculate depreciation after determining the residual life of each asset as on 1/4/74 and then calculate depreciation for the purpose of profit and loss account. In their opinion, the method followed by the company results in under-statement of losses and over-statement of profits on account of provision for depreciation on the basis of full life of assets.

The company has taken a stand that the written down value as on 1/4/74 has become the cost price of the assets acquired by the company. The depreciation is charged under straight line method on the value of assets acquired as on 1/4/74. 90%-95% cost is being written off on the basis of number of years of useful life determined with reference to the depreciation rates prescribed under the Income-tax Act on written down value method. This practice is normally followed where second hand assets are purchased by any company. No separate rates for charging depreciation on second hand assets have been prescribed either by the Income-tax Act or by the BPE and in absence of this, the practice followed by the company is fair.

Before take over, different companies were following different methods of depreciation. Plant registers were not maintained to ascertain the dates of purchases of assets as well as the expected lives of the machines. In the absence of all these details, the written down value has been taken as cost. It is technically difficult to determine the residual life of the assets as suggested by the C & AG. It is considered that the cost of acquisition of assets is the purchase price and the depreciation be charged at the rates prescribed. This is consistent with the Income-tax Rules.

Expert opinion is, therefore, solicited whether the practice followed by us is correct in the given circumstances for the purpose of reflecting true and fair position of the profit and loss account.




Opinion

September 5, 1980

The company has taken over assets and liabilities of several undertakings. Fixed Assets taken over were accounted for in the books of the company at the respective written down values in the books of transferor undertakings.

The company has taken a stand that the written down value as appearing in the books of the undertaking, on the date of its transfer, has become the cost price of fixed assets acquired by the company and charged depreciation on straight line method on the same at the rates computed with reference to “specified period” as prescribed in Section 205 of the Companies Act, 1956. The company has further contended that no separate rates for charging depreciation on second hand assets have been prescribed either by the Income-tax Rules or by the Bureau of Public Enterprises and in absence of this, the practice followed by the company is fair.

The Deputy Director of Commercial Audit has contended that depreciation should have been provided by the company on the basis of residual lives of the assets and not on the basis of their full life as if they were new.

Section 205(2)(b) lays down that depreciation shall be provided in respect of each item of depreciable asset, for such an amount as is arrived at by dividing 95% of the original cost thereof to the company by the “specified period” in respect of such asset.

“Specified period” has been defined in Section 205(5)(a) as under :

“Specified period” in respect of any depreciable asset shall mean the number of years at the end of which at least 95% of the original cost of that asset to the company will have been provided for by way of depreciation if depreciation were to the calculated in accordance with the provisions of Section 350.

No specific treatment or rates have been provided in the Companies Act in respect of second hand assets. However, the Committee is of the opinion that the expired life of the depreciable asset must be taken into consideration and depreciation for second hand asset should be provided with reference to unexpired period of the life of the asset from the point of view of sound accounting principles. Particularly in the case narrated by the querist where most of the fixed assets acquired are second hand assets on account of take over of various undertakings, it will not be proper from accounting point of view to ignore the expired period of the lives of the assets and to charge depreciation on the basis that the fixed assets acquired are brand new assets.

If it is not at all possible to get reasonable details about the period for which these fixed assets have been used by the erstwhile companies, then a technical estimate of the remaining useful life (being not more than the life as per Income-tax Rules) should be made and depreciation should be provided accordingly.