Bank Reconciliation, Inventories & Depreciation
Weightage: Chapters 3, 5 and 6 of ICAI's Paper 1 syllabus, together worth roughly 18 marks. These are the most dependable marks in the paper because each question is self-contained: it can be made longer by adding items, but it cannot be made harder by dragging in other chapters.
The three topics here look unrelated and are usually taught as such. They share a structure worth naming at the outset, because it makes all three easier: each is about a difference between two figures that both claim to describe the same thing, and in each case the work is to explain the difference rather than to eliminate it.
The cash book and the bank statement both claim to state the balance at the bank. Cost and net realisable value both claim to state what stock is worth. The purchase price and the current book value both claim to state what an asset represents. In every case the accountant's job is to identify why the two figures differ and to decide which one the accounts should carry.
Bank Reconciliation Statement
Why two records of the same money disagree
A firm records its bank transactions in the bank column of its cash book. The bank independently records the same transactions in the firm's account and reports them in a bank statement, historically a pass book. Both are records of one thing — money at the bank — so they ought to agree. They routinely do not, and the reasons fall into three families.
Timing differences. The commonest family, and the most important to understand, because nothing is wrong in either record. Each party has recorded the transaction, but not on the same date.
- Cheques issued but not yet presented for payment. The firm credits its cash book the moment it writes and hands over the cheque, because from its point of view the money is committed. The bank knows nothing until the payee presents the cheque, which may be days later. Until then the cash book balance is lower than the bank's.
- Cheques deposited but not yet credited by the bank. The firm debits the cash book on depositing the cheque. The bank credits the account only when the cheque clears. Until then the cash book balance is higher than the bank's.
Transactions entered by the bank but not yet by the firm. Here the bank has acted and the firm does not yet know.
- Bank charges, commission, and interest debited by the bank.
- Interest credited by the bank on the balance.
- Direct collections — dividends, interest on investments, or amounts paid in directly by a customer — credited by the bank.
- Standing instructions executed by the bank, such as insurance premiums or loan instalments paid on the firm's behalf.
- A cheque previously deposited being dishonoured, which the bank reverses.
Errors. Either party may err — the firm may record a wrong amount or omit an entry, and the bank may debit a cheque to the wrong account. Errors differ from the other two families in that something is genuinely wrong and must be corrected, not merely reconciled.
Preparing the statement
The reconciliation is not a ledger account. It is a statement that starts from one balance and adjusts it, item by item, to arrive at the other. The disciplined method is a single question asked of every item:
Starting from the balance I have, does this item make the other balance higher or lower?
Work it through with the standard case. Start from the cash book balance as per the firm's books, a debit balance, and reconcile to the bank statement.
- Cheques issued but not presented. The firm has already deducted them; the bank has not. So the bank's balance is higher. Add.
- Cheques deposited but not credited. The firm has already added them; the bank has not. So the bank's balance is lower. Deduct.
- Bank charges debited by the bank. The bank has deducted them; the firm has not. Bank's balance is lower. Deduct.
- Interest credited by the bank. The bank has added it; the firm has not. Bank's balance is higher. Add.
- Direct collection by the bank. Same reasoning as interest. Add.
- Standing instruction paid by the bank. Same reasoning as charges. Deduct.
Running the statement in the opposite direction — from the bank statement to the cash book — reverses every sign. This is why memorising a list of "add these, subtract those" fails: the list is only valid for one starting point. Reasoning from the question each time is both safer and faster than remembering two lists.
Overdrafts
An overdraft is a credit balance in the cash book and a debit balance in the bank statement — the firm owes the bank. The arithmetic of reconciliation is unchanged, but the signs feel inverted because the balance itself is negative in the ordinary sense.
The reliable technique is to treat an overdraft as a negative balance and apply exactly the same reasoning as before. If the cash book shows an overdraft of ₹40,000 and cheques of ₹15,000 issued have not been presented, then the bank has not yet deducted them, so the bank's position is better by ₹15,000 — an overdraft of ₹25,000. Writing the overdraft as ₹(40,000) and adding ₹15,000 produces ₹(25,000) directly, with no special rule to remember.
What reconciliation is for
Beyond the exam, it serves two purposes worth stating in a theory answer. It detects errors and fraud, since an unexplained difference is a signal that something is wrong — unauthorised payments and misappropriation of receipts are classically discovered this way. And it establishes the true bank position, because the cash book balance alone can be misleading when large cheques have been issued but not yet presented, which is precisely when a firm is at risk of issuing further cheques it cannot honour.
Note also which items require entries in the books afterwards. Timing differences require none; they resolve themselves. But bank charges, interest, direct collections and standing instructions must be recorded in the cash book, because these are genuine transactions the firm had not yet entered.
Inventories
What inventory is and why its valuation matters
Inventory is the stock held for sale in the ordinary course of business, in the process of production for such sale, or in the form of materials and supplies to be consumed in production.
Its valuation matters more than its size suggests, because the closing stock figure enters both financial statements at once and with opposite effects. It is deducted from the cost of goods available for sale in the Trading Account, so a higher closing stock raises gross profit; and it appears as a current asset in the Balance Sheet, so the same figure raises total assets. Overstating closing stock therefore overstates profit and assets simultaneously — and because this year's closing stock is next year's opening stock, the overstatement reverses in the following year. A single valuation error thus misstates two years' profits in opposite directions.
The valuation rule
Inventory is valued at the lower of cost and net realisable value.
Cost comprises the purchase price plus duties and taxes not subsequently recoverable, freight inwards and other costs of bringing the inventory to its present location and condition, and for manufactured goods a share of production overheads. Trade discounts and rebates are deducted. Selling and distribution costs are excluded, because they relate to the sale rather than to bringing the goods into their present condition.
Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.
The rule is an application of prudence, and comparison is made item by item rather than in aggregate. Comparing totals would allow an unrealised gain on one item to mask a realised loss on another, which is exactly what prudence forbids.
Cost formulas
Where identical items are bought at different prices, some assumption is needed about which units remain.
FIFO — first in, first out. The earliest purchases are assumed sold first, so closing stock consists of the most recent purchases. In a period of rising prices this values closing stock near current cost, which makes the balance sheet realistic, while charging older and lower costs against revenue, which raises reported profit.
Weighted average cost. A fresh average cost per unit is computed as total cost of goods available divided by total units available, and applied to both goods sold and goods remaining. It smooths price fluctuations and avoids the assumption that any particular units moved.
LIFO — last in, first out — is not permitted for financial statements under Indian accounting standards. Say so if asked. Its exclusion is deliberate: it leaves closing stock valued at the oldest and least relevant costs, which can render the balance sheet figure meaningless after a period of sustained price change.
Worked briefly. Opening stock 100 units at ₹50. Purchases: 200 units at ₹60, then 100 units at ₹70. Sales during the period: 250 units. Total available 400 units costing ₹5,000 + ₹12,000 + ₹7,000 = ₹24,000; closing stock 150 units.
Under FIFO, the 150 units remaining are the most recent: 100 at ₹70 and 50 at ₹60, giving ₹7,000 + ₹3,000 = ₹10,000.
Under weighted average, the average cost is ₹24,000 ÷ 400 = ₹60 per unit, so closing stock is 150 × ₹60 = ₹9,000.
Cost of goods sold is ₹14,000 under FIFO and ₹15,000 under weighted average. The same physical facts produce different profits, which is why the choice of formula must be disclosed and applied consistently.
Inventory systems
Under the periodic system, no continuous record of stock is kept. Purchases are recorded as made, and the closing stock is established by physical counting at the period end. Cost of goods sold is then derived as opening stock plus purchases less closing stock. It is simple and cheap, and its weakness is that losses from theft, wastage or breakage are invisible — they are silently absorbed into the derived cost of goods sold.
Under the perpetual system, stock records are updated continuously with every receipt and issue, so the book quantity is known at any moment. Cost of goods sold is recorded as sales occur, and the closing stock is a book figure. Its strength is exactly the periodic system's weakness: because a book figure exists independently, a physical count can be compared against it and the difference identified as shortage. Its cost is the record-keeping itself.
The two are not alternatives in practice. Even under a perpetual system, physical verification remains necessary, because only a count establishes what is actually there.
Verification on a date other than the balance sheet date
Firms frequently count stock a few days before or after the year end. The count must then be adjusted back or forward to the balance sheet date:
Add back the cost of goods sold between the balance sheet date and the count date, deduct purchases received in that interval, and adjust for returns in both directions — reversing each movement to reconstruct what was present on the balance sheet date.
What to include
The test of inclusion is ownership, not physical possession, and this is the standard trap.
- Goods sent on consignment remain the consignor's property until sold by the consignee, and are included in the consignor's stock even though they are not on the premises.
- Goods sent on sale or return remain the seller's until the buyer signifies approval or the agreed time expires, and are included in the seller's stock at cost.
- Goods in transit purchased are included if ownership has passed under the contract terms, even though they have not arrived.
- Goods held for others — received on consignment or for repair — are excluded, despite being physically present.
Depreciation and Amortisation
What depreciation actually is
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. Note carefully what this definition does not say. It is not a valuation exercise, and it is not a fund set aside to replace the asset.
Both misconceptions are examined. Depreciation does not attempt to state what the asset is worth; a machine's book value after three years is unrecovered cost, not market value, and the two may differ greatly. Nor does charging depreciation set money aside — it is a book entry that reduces profit and reduces the asset's carrying amount, and no cash moves. What it does is give effect to the matching concept: an asset earns revenue across several periods, so its cost must be spread across those periods rather than charged wholly to the period of purchase.
The causes are worth listing because ICAI asks for them: physical wear and tear through use, the passage of time regardless of use, obsolescence through technological change or changing demand, and depletion in the case of wasting assets such as mines.
The depreciable amount is cost less estimated residual value, and it is spread over the useful life — the period over which the asset is expected to be available for use by this enterprise, which may be shorter than its physical life.
The two methods
Straight line method. An equal amount is charged each year:
Annual depreciation = (Cost − Residual value) ÷ Useful life
The charge is constant, and if depreciation ran to the end of the useful life the book value would reach exactly the residual value. It suits assets that give roughly uniform service across their lives, and its merit is simplicity and comparability across years.
Written down value method. A fixed percentage is applied each year to the opening book value rather than to cost, so the charge falls year on year. The book value approaches zero but never quite reaches it, which is why an asset under this method can carry a small balance indefinitely.
The choice between them is not arbitrary. WDV charges more in the early years, which suits assets whose repair costs rise with age: the combined charge of depreciation plus repairs is then more even across the life than under the straight line method, which is a better application of matching for such assets. WDV is also the method the Income-tax Act prescribes for most blocks of assets, so it is common in practice for that reason alone.
Worked comparison. An asset costs ₹1,00,000 with a residual value of ₹10,000 and a useful life of five years. Under SLM the annual charge is (₹1,00,000 − ₹10,000) ÷ 5 = ₹18,000 every year. Under WDV at 20%, the first year's charge is ₹20,000 leaving ₹80,000; the second is ₹16,000 leaving ₹64,000; the third is ₹12,800. The total charged over the life is the same order of magnitude, but its distribution across years differs sharply, and so therefore does the reported profit of each year.
Recording depreciation
Two treatments exist and both are examined.
Charging directly to the asset account credits the asset itself, so the account shows the written down value and the original cost is no longer visible.
Using a Provision for Depreciation Account — also called Accumulated Depreciation — leaves the asset account at cost and accumulates the charges separately. The balance sheet then discloses cost, accumulated depreciation and the net figure. This is the preferable treatment and the one companies use, because it preserves information: a reader can see both what the asset cost and how much of that cost has been consumed, which the first method destroys.
Depreciation on additions and disposals
Depreciation is charged for the period the asset was actually held, so an asset purchased on 1 October in a year ending 31 March attracts six months' depreciation. Where the question says depreciation is charged on the closing balance of assets, or gives no dates, follow the instruction given rather than assuming — a substantial share of the marks in these questions turns on reading the instruction correctly.
On disposal, the treatment follows a fixed sequence:
- Charge depreciation on the asset up to the date of sale.
- Transfer the asset's cost and its accumulated depreciation to an Asset Disposal Account.
- Enter the sale proceeds.
- The balancing figure is the profit or loss on sale, which goes to the Profit and Loss Account.
A profit on sale means depreciation charged over the life exceeded the actual fall in value; a loss means it fell short. Neither is an error, because depreciation rests on estimates of life and residual value made in advance.
Change of method
A change from one method to another is a change in accounting policy and is permitted only where required by statute or a standard, or where the change results in a more appropriate presentation. It is applied retrospectively: depreciation is recomputed for all prior years under the new method, and the difference between the recomputed and the previously charged amounts is adjusted in the year of change and disclosed. Contrast this with a revision of the estimated useful life or residual value, which is a change in estimate and is applied prospectively — the remaining depreciable amount is spread over the remaining revised life, with no restatement of the past.
Amortisation is the same concept applied to intangible assets such as patents, copyrights and goodwill, and depletion the same concept applied to wasting assets such as mines and quarries, where the charge is usually based on units extracted rather than on time.
How these three chapters are examined
Bank reconciliation appears as a statement to be prepared from a list of items, sometimes starting from the cash book and sometimes from the bank statement, and often with an overdraft to test whether the candidate is reasoning or reciting. Present it as a statement with a clear starting balance and one line per item, and state at the end which balance you have arrived at.
Inventory appears as a valuation from purchase and sale data under FIFO or weighted average, frequently with items to be included or excluded on ownership grounds, and often with a count taken on a date other than the year end. Show the cost of goods available and the units reconciliation as working notes.
Depreciation appears as an asset account or a provision for depreciation account maintained over several years with an addition and a disposal, requiring depreciation for part periods. Show the computation for each asset separately as a numbered working note; this is where nearly all the marks are, and where nearly all the errors occur.
