Inventory Valuation & Depreciation (Cambridge (CIE) A Level Business)

Introduction to Depreciation

• Depreciation is an accounting technique which recognises that the value of fixed (non-current) assets falls over time
  

  • It reflects wear and tear, the reduction in an asset's value as it ages or obsolescence
    
    

• Depreciation aims to allocate the historic cost of the asset in a way that reflects its reduction in value over time

  • The current value of assets are recorded accurately in the statement of financial position

  • The loss in the value of an asset over an accounting period is recorded accurately in the statement of profit or loss
     

Reasons for Calculating Depreciation

Net Realisable Value

• Inventory should always be valued at its purchase price (also known as its historic cost) or, if it is lower, at its net realisable value

  • Accountants are encouraged to follow the principle of conservatism when compiling accounts

    • Over-valuing assets would lead to the net worth of a business being reported higher than it should be

    • It would also mean that insufficient expenses are recorded, leading to a higher than appropriate level of profit being recorded
      

• The net realisable value is calculated using the formula

The Difficulties of Valuing Inventory

• The accurate valuation of inventory can be difficult for several reasons
  
  

  • The actual number of inventory items may be different to the number recorded in stock management systems

    • These differences can arise as a result of errors in recording deliveries, theft, loss or damage

    • Regularly carrying out stocktakes can identify and correct these discrepancies, but they are time-consuming, costly and distract workers from productive tasks
      

  • The fluctuation of market prices means that the value of inventory can change frequently

    • Market prices can change as a result of supply and demand, economic conditions, and changes in the cost of extracting or processing raw materials

  • Some items of inventory may spoil or become obsolete before the business has the opportunity to use or sell them

    • These losses are difficult to accurately predict but need to be fully accounted for when valuing inventory
      

  • Valuing work in progress is especially complex because it involves estimating the value of partially-completed goods

    • This valuation can be somewhat subjective, relying on experience and careful judgment, and is influenced by factors such as how close to completion the inventory is
       
       

Straight-line Depreciation

• The straight line method reduces the value of an asset by the same value each year of its useful life
  
  

• Three key variables are required to calculate the annual rate of depreciation of an asset

  • Life expectancy

    • The number of years it is expected to be used before it will need to be replaced

  • Residual value

    • The scrap value of the asset at the end of its useful life

  • Historic cost

    • The initial cost of purchasing the asset
      

• The annual rate of depreciation is calculated using the following formula

• Once the annual rate of depreciation has been calculated, until the end of its life expectancy

  • It is recorded each year as an expense in the statement of profit or loss

  • The value of the asset is reduced each year by this amount, with this value being placed in the statement of financial position and recorded as its net book value 

Strengths and Weaknesses of the Straight Line Method

• The main benefit of the straight line depreciation over other methods is that it is simple to calculate 

• In many countries it is preferred for tax purposes as it allows for a consistent deduction of depreciation expenses over the asset's useful life
   

The Main Strengths and Weaknesses of Using Straight Line Depreciation