Understanding Business Accounting For Dummies, 2nd Edition (101 page)

Determining current replacement cost values for every product in your stock isn't easy! Applying the NRV test leaves much room for interpretation.

Keeping accurate track of your stock costs is important to your bottom line, both now and in the future, so don't fall into the trap of doing a quick NRV scan and making a snap judgment that you don't need a stock write-down.

Some shady characters abuse NRV to cheat on their company tax returns. They
write down
their ending stock cost value - decrease ending stock cost more than can be justified by the NRV test - to increase the deductible expenses on their tax returns and thus decrease taxable income. A product may have a proper cost value of £100, for example, but a shady character may invent some reason to lower it to £75 and thus record a £25stock write-down expense in this period for each unit - which is not justified by the facts. But, even though the person can deduct more this year, he or she will have a lower stock cost to deduct in the future. Also, if the person is selected for an HM Revenue and Customs audit and the tax inspectors discover an unjustified stock write-down, the person may end up being charged with tax evasion.

Most accounting software packages either support or have plug-in modules that allow you to run all these costing methods and compare their effect on your apparent financial performance. For example, the Sage Pro Inventory Control module (check out their Web site at
www.sageproerp.com/products/accounting/ic
) supports LIFO, FIFO, average weighted, and standard cost inventory valuation methods.

Appreciating Depreciation Methods

In theory, depreciation expense accounting is straightforward enough: You divide the cost of a fixed asset among the number of years that the business expects to use the asset. In other words, instead of having a huge lump-sum expense in the year that you make the purchase, you charge a fraction of the cost to expense for each year of the asset's lifetime. Using this method is much easier on your bottom line in the year of purchase, of course.

But theories are rarely as simple in real life as they are on paper, and this one is no exception. Do you divide the cost
evenly
across the asset's lifetime, or do you charge more to certain years than others? Furthermore, when it eventually comes time to dispose of fixed assets, the assets may have some disposable, or
salvage
,
value. Only cost minus the salvage value should be depreciated, right? Or, should salvage value estimates be ignored and the total cost of a fixed asset be depreciated? And how do you estimate how long an asset will last in the first place? Do you consult an accountant psychic hot line?

As it turns out, HM Revenue and Customs runs its own little psychic business on the side, with a crystal ball known as the HM Revenue and Customs Code. The HM Revenue and Customs Code doesn't give you predictions of how long your fixed assets will
last
;
it only tells you what kind of timeline to use for income tax purposes, as well as how to divide the cost along that timeline. HM Revenue and Customs have a little help in their psychic predictions. They have a direct line to their boss, the Chancellor of the Exchequer, who varies these rules every year or so to stimulate capital spending by businesses. This is done by varying the
writing down allowance
, which is tax speak for the amount of depreciation expense you can get tax relief for. So if the Chancellor wants to encourage businesses to buy computers, he can set a 100 per cent writing down allowance for the first year, whereas the asset may well have an economic life of three years or more. Confused? Well at least you know what you are getting for your money when you hire a tax accountant.

Hundreds of books have been written on depreciation, but the only book that counts is the HM Revenue and Customs Code. Most businesses adopt the useful lives allowed by the income tax law for their financial statement accounting; they don't go to the trouble of keeping a second depreciation schedule for financial reporting. Why complicate things if you don't have to? Why keep one depreciation schedule for income tax and a second for preparing your financial statements? However, they do tell you what their policy is.

Tesco's annual report contains this explanation of their depreciation policy:

Depreciation is provided on a straight-line basis over the anticipated useful economic lives of the assets. The following rates applied for the Group and are consistent with the prior year:

Land premiums paid in excess of the alternative use value - at 2.5 per cent of cost.

Freehold and leasehold buildings with greater than 40 years unexpired - at 2.5 per cent of cost.

Leasehold properties with less than 40 years unexpired are amortised by equal annual instalments over the unexpired period of the lease.