Nagaon manufacturer: mid-year purchases, a bad disposal and three 'prudent' proposals
Sunrise Industries, a small manufacturing unit in Nagaon, closes its books on 31 March. Its policy is depreciation at 10% p.a. on the straight-line method on original cost, prorated monthly from the month of purchase. The fixed asset register shows:
- Machine P: purchased 1 April 2021 for ₹6,00,000; in use throughout.
- Machine Q: purchased 1 October 2023 for ₹4,00,000; the accountant has charged ₹40,000 for the year.
- Machine R: purchased 1 April 2019 for ₹3,00,000; sold on 31 December 2023 for ₹1,20,000. No depreciation has been charged for 2023-24 and the sale proceeds were credited to Sales.
The proprietor also asks the accountant to: (i) create a 'Provision for Repairs' of ₹50,000 because repairs next year will be heavy; (ii) reduce closing stock by ₹80,000 to create a hidden reserve for a future expansion; and (iii) change from 1 April 2023 to the written-down-value method at 15% because 'everyone else does it'.
1. Compute the correct depreciation charge for 2023-24 and the profit or loss on the sale of Machine R, and give the journal entries needed to correct the treatment of Machine R.
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Depreciation for 2023-24
| Machine | Working | ₹ |
|---|---|---|
| P | 6,00,000 × 10% | 60,000 |
| Q | 4,00,000 × 10% × 6/12 | 20,000 |
| R | 3,00,000 × 10% × 9/12 | 22,500 |
| Total | 1,02,500 |
The accountant charged ₹40,000 on Q instead of ₹20,000 - an excess of ₹20,000.
Sale of Machine R
- Cost 3,00,000, less depreciation for 4 years to 31 March 2023 (4 × 30,000) = WDV ₹1,80,000.
- Less depreciation to the date of sale (9 months) ₹22,500 → WDV at sale ₹1,57,500.
- Sale proceeds ₹1,20,000 → loss on sale ₹37,500.
Correction (combined entry)
Dr Sales 1,20,000; Dr Provision for Depreciation 1,42,500 (1,20,000 + 22,500); Dr Loss on Sale of Machinery 37,500; Cr Machinery 3,00,000.
This removes the asset, removes the accumulated depreciation, cancels the false sales credit and records the loss. For Q: Dr Machinery 20,000 / Cr Depreciation 20,000.
2. Evaluate the three proposals of the proprietor: the provision for repairs, the hidden reserve through stock, and the change of depreciation method.
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(i) Provision for repairs ₹50,000 - reject as a charge. A provision is recognised only for a present obligation arising from a past event, where an outflow is probable and can be reliably estimated. Heavy repairs expected next year are a future cost, not a present obligation, so charging them now understates this year's profit and overstates liabilities. If the firm wants to earmark money, it is an appropriation to a reserve out of profits, shown under reserves and surplus, and it does not reduce the reported profit.
(ii) Reducing stock to create a hidden reserve - reject. Stock must be valued at the lower of cost and net realisable value. Deliberate understatement is not prudence; it is a misstatement that makes the accounts false and not true and fair. Secret reserves are prohibited (they also destroy comparability and can conceal fraud). The auditor should insist on restoration and, if refused, consider a qualification.
(iii) Change to WDV at 15% - permitted with discipline. A change in the method of depreciation is a change in accounting estimate, applied prospectively from 1 April 2023 with no retrospective restatement; the change and its quantified effect must be disclosed in the notes. But 'everyone else does it' is not a valid basis: the method must reflect the pattern in which the asset's benefits are consumed, and the rate must be justified by useful life.
3. Quantify the net overstatement or understatement of profit for 2023-24 caused by the accountant's errors, and state which items affect the balance sheet as well.
Read the worked answer
Build the reconciliation item by item, comparing the recorded effect with the correct effect:
| Item | Recorded | Correct | Effect on profit |
|---|---|---|---|
| Depreciation on Q | 40,000 expense | 20,000 expense | understated by 20,000 |
| Depreciation on R (9 months) | nil | 22,500 expense | overstated by 22,500 |
| Sale of R | ₹1,20,000 credited to Sales | loss of ₹37,500 | overstated by 1,57,500 |
Net effect = 22,500 + 1,57,500 − 20,000 = profit overstated by ₹1,60,000.
Balance sheet effects as well:
- Machinery account still carries R at ₹3,00,000 and its accumulated depreciation, so the asset side is overstated.
- The ₹1,20,000 shown as Sales inflates revenue and debtors/bank analysis; it must be replaced by a ₹37,500 loss.
- Depreciation on Q is understated as an accumulated provision by ₹20,000.
Note the trap: the sale proceeds credited to Sales look like a ₹1,20,000 error, but the real overstatement is ₹1,57,500, because the correct answer is a loss of ₹37,500, not nil. The difference between a reversal and a reclassification matters.