14 July 2024
Internal profit in the context of a self-constructed asset refers to the profit that arises within the entity due to the transfer of the asset from one stage of production or department to another at a price higher than its cost. This concept ensures that each stage or department within the entity is properly valued for their contribution to the asset's overall cost.
### Example of Internal Profit in Self-Constructed Asset:
Let's consider a manufacturing company that constructs a building for its own use. The company undertakes the construction in phases, involving various departments and stages:
1. **Land Acquisition and Preparation (Department A):** - The company acquires land and prepares it for construction, incurring costs such as land purchase costs, site preparation, and initial project planning. - Total costs incurred in Department A: ₹1,000,000.
2. **Construction (Department B):** - Department B begins the actual construction of the building on the prepared land. It incurs costs such as materials, labor, and overheads directly attributable to construction. - Costs incurred in Department B: ₹2,500,000.
3. **Completion and Handover (Department C):** - Department C oversees the final stages of construction, including finishing touches, inspections, and any additional costs. - Costs incurred in Department C: ₹500,000.
Now, let's calculate the total cost of the self-constructed building:
- Total Cost of Self-Constructed Building = Cost in Department A + Cost in Department B + Cost in Department C - Total Cost = ₹4,000,000
However, during the internal transfer of the building from one department to another, there might be a transfer price applied. This transfer price could be higher than the actual cost incurred by the transferring department, thereby creating internal profit. For example:
- The building is transferred from Department B to Department C at a transfer price of ₹3,000,000, although Department B's actual cost was ₹2,500,000.
### Calculation of Internal Profit:
- Internal Profit = Transfer Price - Actual Cost of Department B - Internal Profit = ₹500,000
### Accounting Treatment:
The internal profit of ₹500,000 is not recognized as income in the financial statements because it represents a transfer of value within the entity and not an external transaction. Instead, the cost of the building is accounted for as the sum of all costs incurred across departments (₹4,000,000 in this example).
### Conclusion:
Internal profit in self-constructed assets ensures that each stage of production or department within the entity is properly valued for their contribution to the asset's overall cost. It's important for accurate cost allocation and internal financial reporting within the entity, reflecting the true cost of assets under construction.
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