Intermediate Course

Study Material
(Modules 1 to 3)

Paper 1

Accounting
Module – 1

BOARD OF STUDIES
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

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This study material has been prepared by the faculty of the Board of Studies. The
objective of the study material is to provide teaching material to the students to
enable them to obtain knowledge in the subject. In case students need any
clarifications or have any suggestions to make for further improvement of the
material contained herein, they may write to the Director of Studies.
All care has been taken to provide interpretations and discussions in a manner
useful for the students. However, the study material has not been specifically
discussed by the Council of the Institute or any of its Committees and the views
expressed herein may not be taken to necessarily represent the views of the
Council or any of its Committees.
Permission of the Institute is essential for reproduction of any portion of this
material.

© The Institute of Chartered Accountants of India

All rights reserved. No part of this book may be reproduced, stored in a retrieval
system, or transmitted, in any form, or by any means, electronic, mechanical,
photocopying, recording, or otherwise, without prior permission, in writing, from
the publisher.

Edition : September, 2021

Website : www.icai.org

E-mail : [email protected]

Committee/ : Board of Studies

Department

ISBN No. :

Price (All Modules) : `

Published by : The Publication Department on behalf of The

Institute of Chartered Accountants of India, ICAI
Bhawan, Post Box No. 7100, Indraprastha Marg, New
Delhi 110 002, India.

Printed by :

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BEFORE WE BEGIN …

Evolving role of a CA - Shift towards strategic decision making

The traditional role of a chartered accountant restricted to accounting and

auditing, has now changed substantially and there has been a marked shift
towards strategic decision making and entrepreneurial roles that add value
beyond traditional financial reporting. The primary factors responsible for the
change are the increasing business complexities on account of plethora of laws,
borderless economies consequent to giant leap in e-commerce, emergence of
new financial instruments, emphasis on corporate social responsibility, significant
developments in information technology, to name a few. These factors
necessitate an increase in the competence level of chartered accountants to take
up the role of not merely an accountant or auditor, but a global solution provider.
Towards this end, the scheme of education and training is being continuously
reviewed so that it is in sync with the requisites of the dynamic global business
environment; the competence requirements are being continuously reviewed to
enable aspiring chartered accountants to acquire the requisite professional
competence to take on new roles.

Skill requirements at Intermediate Level

Under the Revised Scheme of Education and Training, at the Intermediate Level,
you are expected to not only acquire professional knowledge but also the ability
to apply such knowledge in problem solving. The process of learning should also
help you inculcate the requisite professional skills, i.e., the intellectual skills and
communication skills, necessary for achieving the desired level of professional
competence.
Accounting is one of the core competence areas of chartered accountants. The
paper of 'Accounting' at Intermediate level concentrates on conceptual
understanding of the crucial aspects of accounting. The objective of the paper at
this level is to acquire the ability to apply specific accounting standards and
legislations to different transactions and events for preparation and presentation
of financial statements of various business entities. The students are required to
develop understanding of the Accounting Standards and gain ability to apply the
provisions contained therein to practical situations.

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Know your syllabus and Study Material

The syllabus of Accounting has an appropriate mix of various topics of sole

proprietorship, partnership and companies as the objective of the paper is to gain
ability to solve simple problems related to different businesses entities. The
Study Material of Accounting has been designed having regard to the needs of
home study and distance learning students. The Study Material has been divided
into fourteen chapters in line with the syllabus. It is important to read the Study
Material thoroughly for understanding the coverage of syllabus in the paper of
Accounting.
The study material has been bifurcated into three modules for the easy handling
and convenience of students. For bare text of Framework for Preparation and
Presentation of Financial Statements and Accounting Standards, the students are
advised to refer the “Accounting Pronouncements” which has been separately
published by the Board of Studies.

Framework of Chapters – Uniform Structure comprising of specific

components
Efforts have been made to present each topic of the syllabus in a lucid manner.
Care has been taken to present the chapters in a logical sequence to facilitate
easy understanding by the students. Sincere efforts have been taken to
incorporate the relevant amendments in the Accounting Standards, Companies
Act, 2013 and SEBI regulations in this study material.
The content for each chapter/unit of the study Material has been structured in the
following manner –

Components of About the component

each Chapter
1. Learning Learning outcomes which you need to demonstrate
Outcomes after learning each topic have been detailed in the first
page of each chapter/unit. Demonstration of these
learning outcomes would help you to achieve the
desired level of technical competence
2. Chapter/Unit As the name suggests, the flow chart/table/diagram
Overview given at the beginning of each chapter would give a
broad outline of the contents covered in the chapter
3. Content of each The concepts and provisions of each accounting

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unit/ chapter standards/topics are explained in student-friendly

manner with the aid of
Examples/illustrations/diagrams/flow charts. These
value additions would help you develop conceptual
clarity and get a good grasp of the topic. Diagrams and
Flow charts would help you understand the
concept/application of accounting standard/topic in a
better manner.
4. Illustrations Illustrations would help the students to understand the
involving application of concepts/provisions of accounting
conceptual standards. In effect, it would test understanding of
understanding concepts/ provisions as well as ability to apply the
concepts/provisions learnt in solving problems and
addressing issues.
5. Summary A summary of the chapter is given at the end to help
you revise what you have learnt. It would especially
facilitate quick revision of the chapter the day before
the examination.
6. Test Your This section comprises of number of multiple choice
Knowledge questions, theoretical questions and practical questions
which would help students to evaluate what they have
understood after studying the chapter. The questions
given in this section have also been supplemented with
the answers to help the students in evaluating their
solutions so that they can know about their grey areas.

We hope that these student-friendly features in the Study Material makes your
learning process more enjoyable, enriches your knowledge and sharpens your
application skills.

Happy Reading and Best Wishes!

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SYLLABUS

PAPER 1: ACCOUNTING
(One paper – Three hours – 100 Marks)

Objective:
To acquire the ability to apply specific accounting standards and legislations to
different transactions and events and in preparation and presentation of financial
statements of various business entities.
Contents:
1. Process of formulation of Accounting Standards including Ind AS (IFRS
converged standards) and IFRSs; convergence vs adoption; objective and
concepts of carve outs.
2. Framework for Preparation and Presentation of Financial Statements (as
per Accounting Standards).
3. Applications of Accounting Standards:
AS 1 : Disclosure of Accounting Policies
AS 2 : Valuation of Inventories
AS 3 : Cash Flow Statements
AS 10 : Property, Plant and Equipment
AS 11 : The Effects of Changes in Foreign Exchange Rates
AS 12 : Accounting for Government Grants
AS 13 : Accounting for Investments
AS 16 : Borrowing Costs
4. Company Accounts
(i) Preparation of financial statements – Statement of Profit and Loss,
Balance Sheet and Cash Flow Statement;
(ii) Managerial Remuneration;
(iii) Profit (Loss) prior to incorporation;
(iv) Accounting for bonus issue and right issue;

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(v) Redemption of preference shares;

(vi) Redemption of debentures.
5. Accounting for Special Transactions:
(i) Investment;
(ii) Insurance claims for loss of stock and loss of profit;
(iii) Hire- purchase and Instalment sale transactions.
6. Special Type of Accounting
(i) Departmental Accounting;
(ii) Accounting for Branches including foreign branches;
(iii) Accounts from Incomplete Records.
Note : If either new Accounting Standards (AS), Announcements and Limited
Revisions to AS are issued or the earlier ones are withdrawn or new AS,
Announcements and Limited Revisions to AS are issued in place of existing AS,
Announcements and Limited Revisions to AS, the syllabus will accordingly
include/exclude such new developments in the place of the existing ones with
effect from the date to be notified by the Institute.

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SIGNIFICANT CHANGES IN 2021 EDITION

OVER 2020 EDITION

Chapter Sections/Sub Sections wherein major

updations have been done

Chapter 3 - Unit 1 Unit updated in line with the scheme for

applicability of Accounting Standards to Non-
Applicability of Accounting company entities revised by the ICAI in March
Standards 2021.

Chapter 4 The chapter has been updated in line with the

provisions of the Companies Act. It also
Preparation of Financial incorporates the amendments in Schedule III
Statements of Companies to the Companies Act, 2013 Vide MCA
notification dated 24th March, 2021.
Schedule III (given as Annexure
at the end of chapter 4)

The chapters have been updated in line with

Chapters 5, 6, 7 and 8
the provisions of the Companies Act.

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CONTENTS

MODULE I

CHAPTER 1: Introduction to Accounting Standards

CHAPTER 2: Framework for Preparation and Presentation of Financial
Statements

CHAPTER 3: Overview of Accounting Standards

MODULE II

CHAPTER 4: Financial Statements of Companies

CHAPTER 5: Profit or Loss Pre and Post Incorporation

CHAPTER 6: Accounting for Bonus Issue and Right Issue

CHAPTER 7: Redemption of Preference Shares

CHAPTER 8: Redemption of Debentures

MODULE III

CHAPTER 9: Investment Accounts

CHAPTER 10: Insurance Claims for Loss of Stock and Loss of Profit

CHAPTER 11: Hire Purchase and Instalment Sale Transactions

CHAPTER 12: Departmental Accounts

CHAPTER 13: Accounting for Branches Including Foreign Branches

CHAPTER 14: Accounts from Incomplete Records

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DETAILED CONTENTS: MODULE – 1

CHAPTER 1: INTRODUCTION TO ACCOUNTING STANDARDS .......... 1.1 – 1.29

Learning Outcomes ................................................................................................................. 1.1
Chapter overview ..................................................................................................................... 1.2
1. Introduction ................................................................................................................. 1.2
2. Standards Setting Process ....................................................................................... 1.6
3. How Many Accounting Standards? ....................................................................... 1.8
4. Status of Accounting Standards........................................................................... 1.10
5. Need for Convergence towards Global Standards ......................................... 1.10
6. International Accounting Standard Board......................................................... 1.12
7. International Financial Reporting Standards as Global Standards ............. 1.13
8. Becoming IFRS Compliant .................................................................................... 1.14
9. What are Carve Outs/Ins in Ind AS? .................................................................... 1.15
10. Convergence to IFRS in India ................................................................................ 1.16
11. What are Indian Accounting Standards (Ind AS)? ........................................... 1.17
12. History of IFRS Converged Indian Accounting Standards (Ind AS) ............ 1.18
13. List of Ind AS ............................................................................................................. 1.19
14. Roadmap for Implementation of Indian Accounting Standards (Ind AS): A
Snapshot ...................................................................................................................... 1.22
Summary .................................................................................................................................. 1.25
Test Your Knowledge ............................................................................................................ 1.26

CHAPTER 2: FRAMEWORK FOR PREPARATION AND PRESENTATION OF

FINANCIAL STATEMENTS .............................................. 2.1 – 2.34
Learning Outcomes ................................................................................................................. 2.1
Chapter overview ..................................................................................................................... 2.2
1. Introduction ................................................................................................................. 2.2
2. Purpose of the Framework ...................................................................................... 2.3
3. Status and Scope of the Framework ..................................................................... 2.3

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4. Components of Financial Statements ................................................................... 2.3

5. Objectives and Users of Financial Statements ................................................... 2.4
6. Fundamental Accounting Assumptions ............................................................... 2.6
7. Qualitative Characteristics ..................................................................................... 2.10
8. True and Fair View ................................................................................................... 2.12
9. Elements of Financial Statements ........................................................................ 2.12
10. Measurement of Elements of Financial Statements ....................................... 2.19
11. Capital Maintenance................................................................................................ 2.23
Summary .................................................................................................................................. 2.27
Test Your Knowledge ............................................................................................................ 2.30

CHAPTER 3: OVERVIEW OF ACCOUNTING STANDARDS .................. 3.1 – 3.162

UNIT-1: APPLICABILITY OF ACCOUNTING STANDARDS ................... 3.1 – 3.26
Learning Outcomes ................................................................................................................. 3.1
Unit overview ............................................................................................................................ 3.2
1.1 Status of Accounting Standards............................................................................. 3.2
1.2 Applicability of Accounting Standards ................................................................. 3.6
Summary .................................................................................................................................. 3.23
Test Your Knowledge ......................................................................................................... 3.23
UNIT-2: OVERVIEW OF ACCOUNTING STANDARDS ...................... 3.27– 3.62
Learning Outcomes ............................................................................................................... 3.28
Unit Overview.......................................................................................................................... 3.28
2.1 AS1: Disclosure of Accounting Policies .............................................................. 3.28
2.2 AS 2: Valuation of Inventory ................................................................................. 3.38
2.3 AS 3: Cash Flow Statement .................................................................................... 3.49
2.4 AS 10: Property, Plant and Equipment ............................................................... 3.65
2.5 AS 11: The Effects of Changes in Foreign Exchange Rates ........................... 3.97
2.6 AS 12: Accounting for Government Grants .................................................... 3.113
2.7 AS 13: Accounting for Investments .................................................................. 3.126
2.8 AS 16: Borrowing Costs ...................................................................................... 3.134
Test Your Knowledge ......................................................................................................... 3.143

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CHAPTER 1

INTRODUCTION TO
ACCOUNTING
STANDARDS

LEARNING OUTCOMES
 After studying this chapter, you will be able to–
 Understand the concept of Accounting Standards;
 Grasp the objectives and benefits and limitations of Accounting
Standards;
 Learn the standards setting process;
 Familiarize with the status of Accounting Standards in India;
 Recognize the International Accounting Standard Authorities;
 Appreciate the emergence of International Financial Reporting
Standards as global standards;
 Differentiate between convergence vs. adoption;
 Know the process of convergence of IFRS in India;
 Understand the concept of Ind AS;
 Understand the objectives and concepts of carve outs/ins.

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Introduction,
objectives and Accounting
List of Accounting
benefits of Standards setting
Standards
Accounting process
Standards

International Need for

Convergence to IFRS
Financial Reporting convergence to
in India
Standards (IFRS) Global Standards

Carve Outs and Carve Roadmap for Ind AS

Concept of Ind AS
Ins implementation

1. INTRODUCTION
Generally Accepted Accounting Principles
Generally accepted accounting principles (GAAP) refer to a common set of
accepted accounting principles, standards, and procedures that business reporting
entity must follow when it prepares and presents its financial statements.
GAAP is a combination of authoritative standards (set by policy boards) and the
commonly accepted ways of recording and reporting accounting information. At
international level, such authoritative standards are known as International
Financial Reporting Standards (IFRS) at many places and in India we have
authoritative standards named as Accounting Standards (ASs) and Indian
Accounting Standard (Ind AS).

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Accounting Standards (ASs) are written policy documents issued by the

Government with the support of other regulatory bodies e.g., Ministry of Corporate
Affairs (MCA) issuing Accounting Standards for corporates in consultation with
National Financial Reporting Authority (NFRA) covering the following aspects of
accounting transaction or events in the financial statements:
• recognition;
• measurement;
• presentation; and
• disclosure.
The ostensible purpose of the standard setting bodies is to promote the
dissemination of timely and useful financial information to investors and certain
other stakeholders, having an interest in the company's economic performance.
Accounting Standards reduce the accounting alternatives in the preparation of
financial statements within the bounds of rationality, thereby, ensuring
comparability of financial statements of different enterprises.
Accounting Standards deal with the following aspects:
(i) recognition of events and transactions in the financial statements;
(ii) measurement of these transactions and events;
(iii) presentation of these transactions and events in the financial statements in a
manner that is meaningful and understandable to the reader; and
(iv) the disclosures relating to these transactions and events to enable the public
at large and the stakeholders and the potential investors in particular, to get
an insight into what these financial statements are trying to reflect and
thereby facilitating them to take prudent and informed business decisions.

Accounting Standards deal with aspects of

accounting events
Recognition of Measurement of Presentation of
Disclosure
events and transactions and transactions and
requirements
transactions events events

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The following are the benefits of Accounting Standards:

(i) Standardisation of alternative accounting treatments: Accounting
Standards reduce or eliminate, to a reasonable extent, any confusing variations in
the accounting treatment and presentation of economic events while preparing
financial statements.
The standard policies are intended to reflect a consensus on accounting policies to
be used in different identified areas, e.g. inventory valuation, capitalisation of costs,
depreciation and amortisation, etc.
Since it is not possible to prescribe a single set of policies for any specific
accounting area that would be appropriate for all enterprises, it is not enough to
comply with the standards and state that they have been followed.
In other words, one must also disclose the accounting policies used in preparation
of financial statements. (Refer AS 1, Disclosure of Accounting Policies given in
Accounting Pronouncements).
For example, an enterprise should disclose which of the permitted cost formula (FIFO,
Weighted Average, etc.) has actually been used for ascertaining inventory costs.
(ii) Requirements for additional disclosures: There are certain areas where
information is not statutorily required to be disclosed. However, accounting
standards may call for appropriate disclosures of accounting policies followed and
other required information in the financial statements which would be helpful for
readers to understand the accounting treatment done for various items in those
financial statements.
(iii) Comparability of financial statements: In addition to improving
credibility of accounting data, standardisation of accounting procedures
improves comparability of financial statements, both intra-enterprise and
inter-enterprise. Such comparisons are very effective and most widely used tools
for assessment of enterprise’s financial health and performance by users of financial
statements for taking economic decisions, e.g., whether or not to invest, whether
or not to lend and so on.
The intra-enterprise comparison involves comparison of financial statements
of same enterprise over a number of years. The intra-enterprise comparison is
possible if the enterprise uses same accounting policies every year in drawing up
its financial statements.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.5

The inter-enterprise comparison involves comparison of financial statements

of different enterprises for same accounting period. This is possible only when
comparable enterprises use similar accounting policies in preparation of respective
financial statements (or in case the policies are slightly different, the same are
disclosed in the financial statements). The disclosure of accounting policies allows
a user to make appropriate adjustments while comparing the financial statements
of comparable enterprises.

Standardisation
of alternative
accounting
treatments

Benefits of
Accounting
Standards

Comparability Requirements
of financial for additional
statements disclosures

Since Accounting Standards are principle based, application of Accounting

Standards becomes judgemental in case of complex business transactions.
Accounting Standards have to be read in line with the legal requirements, i.e., in
case of any conflict, Statute would prevail over Accounting Standards.
Another advantage of standardisation is reduction of scope for creative accounting.
The creative accounting refers to twisting of accounting policies to produce financial
statements favourable to a particular interest group. For example, it is possible to
overstate profits and assets by capitalising revenue expenditure or to understate them
by writing off a capital expenditure against revenue of current accounting period. Such
practices can be curbed only by framing policies for capitalisation, particularly for the
borderline cases where it is possible to have divergent views. The accounting standards
provide adequate guidance in this regard.

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 1.6 ACCOUNTING

2. STANDARDS SETTING PROCESS

The Institute of Chartered Accountants of India (ICAI), being a premier accounting
body in the country, took upon itself the leadership role by constituting the
Accounting Standards Board (ASB) in 1977. The ICAI has taken significant initiatives
for the issuance of Accounting Standards to ensure that the standard-setting
process is fully consultative and transparent. The ASB considered the International
Accounting Standards (IASs)/International Financial Reporting Standards (IFRSs)
while framing Accounting Standards (ASs) in India and tried to integrate them, in
the light of the applicable laws, customs, usages and business environment in the
country. The composition of ASB includes representatives of industries,
associations of industries (namely, ASSOCHAM, CII, FICCI), regulators,
academicians, government departments, etc. Although ASB is a body constituted
by the Council of the ICAI, it (ASB) is independent in the formulation of accounting
standards. NFRA recommend these standards to the MCA. MCA has to spell out the
accounting standards applicable for companies in India.
The standard-setting procedure of ASB can be briefly outlined as follows:
♦ Identification of broad areas by ASB for formulation of AS.
♦ Constitution of study groups by ASB to consider specific projects and to
prepare preliminary drafts of the proposed accounting standards. The draft
normally includes objective and scope of the standard, definitions of the
terms used in the standard, recognition and measurement principles
wherever applicable and presentation and disclosure requirements.
♦ Consideration of the preliminary draft prepared by the study group of ASB
and revision, if any, of the draft on the basis of deliberations.
♦ Circulation of draft of accounting standard (after revision by ASB) to the Council
members of the ICAI and specified outside bodies such as MCA, Securities and
Exchange Board of India (SEBI), Comptroller and Auditor General of India
(C&AG), Central Board of Direct Taxes (CBDT), Standing Conference of Public
Enterprises (SCOPE), etc. for comments.
♦ Meeting with the representatives of the specified outside bodies to ascertain
their views on the draft of the proposed accounting standard.
♦ Finalisation of the exposure draft of the proposed accounting standard and
its issuance inviting public comments.
♦ Consideration of comments received on the exposure draft and finalisation

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.7

of the draft accounting standard by the ASB for submission to the Council of
the ICAI for its consideration and approval for issuance.
♦ Consideration of the final draft of the proposed standard by the Council of
the ICAI and if found necessary, modification of the draft in consultation with
the ASB is done.
♦ The accounting standard on the relevant subject (for non-corporate entities)
is then issued by the ICAI. For corporate entities the accounting standards are
issued by the Ministry of Corporate Affairs in consultation with the NFRA.
Standard – Setting Process

Identification of area

Constitution of study group

Preparation of draft and its circulation

Ascertainment of views of different bodies on

draft

Finalisation of exposure draft (E.D.)

Comments received on exposure draft (E.D.)

Modification of the draft

Issue of AS

Earlier, ASB used to issue Accounting Standard Interpretations (ASIs) which address
questions that arise in course of application of standard. These were, therefore,
issued after issuance of the relevant standard. Authority of the ASIs was same as
that of the AS to which it relates.
However, after notification of Accounting Standards by the Central Government for
the companies, where the consensus portion of ASI was merged as ‘Explanation’ to

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the relevant paragraph of the Accounting Standard, the Council of ICAI also
decided to merge the consensus portion of ASI as ‘Explanation’ to the relevant
paragraph of the AS issued by them. This initiative was taken by the Council of the
ICAI to harmonise both the set of standards, i.e., ASs issued by the ICAI for non-
corporates and ASs notified by the MCA for corporates.
It may be noted that as per Section 133 of the Companies Act, 2013, the Central
Government may prescribe the standards of accounting or any addendum thereto,
as recommended by the ICAI, constituted under section 3 of the Chartered
Accountants Act, 1949, in consultation with and after examination of the
recommendations made by NFRA.

3. HOW MANY ACCOUNTING STANDARDS?

The Institute of Chartered Accountants of India has, so far, issued 29 Accounting
Standards. However, AS 6 on ‘Depreciation Accounting’ has been withdrawn on
revision of AS 10 ‘Property, Plant and Equipment ∗’ and AS 8 on ‘Accounting for
Research and Development’ has been withdrawn consequent to the issuance of AS
26 on ‘Intangible Assets’.
Thus effectively, there are 27 Accounting Standards at present. The ‘Accounting
Standards’ issued by the Accounting Standards Board establish standards which
have to be complied by the business entities so that the financial statements are
prepared in accordance with GAAP.
In recent times there are various improvements/developments in the global
accounting standards which have taken place. In India, Ind AS have become
mandatory for certain class of companies as per the MCA roadmap. AS being the
guidelines to prepare financial statements, have to keep pace with these changes
in global accounting scenarios. Number of fundamental changes have been made
in these AS so as to be globally aligned as far as possible.
MCA vide notification date 30th March 2016 announced Companies (Accounting
Standards) Amendment Rules, 2016. Various ASs i.e. AS 2, AS 4, AS 10, AS 13, AS
14, AS 21, AS 29 were revised vide this notification to make them in line with
corresponding Ind AS to the extent possible.

∗
Earlier AS 10 was on ‘Accounting for Fixed Assets’.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.9

The following is the list of Accounting Standards with their respective date of
applicability:

AS AS Title Date of
No. applicability
1 Disclosure of Accounting Policies 01/04/1993
2 Valuation of Inventories (Revised) 01/04/1999
3 Cash Flow Statement 01/04/2001
4 Contingencies and Events Occurring after the Balance 01/04/1998
Sheet Date (Revised)
5 Net Profit or Loss for the Period, Prior Period Items and 01/04/1996
Changes in Accounting Policies
7 Construction Contracts 01/04/2002
9 Revenue Recognition 01/04/1993
10 Property, Plant and Equipment (Revised) 01/04/2016
11 The Effects of Changes in Foreign Exchange Rates 01/04/2004
(Revised)
12 Accounting for Government Grants 01/04/1994
13 Accounting for Investments (Revised) 01/04/1995
14 Accounting for Amalgamations (Revised) 01/04/1995
15 Employee Benefits 01/04/2006
16 Borrowing Costs 01/04/2000
17 Segment Reporting 01/04/2001
18 Related Party Disclosures 01/04/2001
19 Leases 01/04/2001
20 Earnings Per Share 01/04/2001
21 Consolidated Financial Statements (Revised) 01/04/2001
22 Accounting for Taxes on Income 01/04/2006
23 Accounting for Investments in Associates in 01/04/2002
Consolidated Financial Statements

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 1.10 ACCOUNTING

24 Discontinuing Operations 01/04/2004

25 Interim Financial Reporting 01/04/2002
26 Intangible Assets 01/04/2003
27 Financial Reporting of Interests in Joint Ventures 01/04/2002
28 Impairment of Assets 01/04/2008
29 Provisions, Contingent Liabilities and Contingent Assets 01/04/2004
(Revised)

NOTE: AS 1; AS 2 (Revised); AS 3; AS 10 (Revised); AS 11(Revised); AS 12;

AS 13 (Revised); AS 16 are covered in the syllabus of this paper at
Intermediate Level.

4. STATUS OF ACCOUNTING STANDARDS

It has already been mentioned that the ASs are developed by the ASB of the ICAI.
The Institute not being a legislative body can enforce compliance with its standards
only by its members. Also, the standards cannot override laws and local regulations.
The ASs are nevertheless made mandatory from the dates specified in respective
standards and are generally applicable to all enterprises, subject to certain
exceptions. The implication of mandatory status of an AS depends on whether the
statute governing the enterprise concerned requires compliance with the ASs. The
Companies Act had earlier notified 28 ASs and mandated the corporate entities to
comply with the provisions stated therein. However, in 2016 the MCA withdrew AS
6. Hence there are now only 27 notified ASs as per the Companies (Accounting
Standards) Rules, 2006 (as amended in 2016).

5. NEED FOR CONVERGENCE TOWARDS

GLOBAL STANDARDS
The last decade has witnessed a sea change in the global economic scenario. The
emergence of trans-national corporations in search of money, not only for
fuelling growth, but to sustain on-going activities has necessitated raising of
capital from all parts of the world, cutting across frontiers.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.11

Each country has its own set of rules and regulations for accounting and financial
reporting. Therefore, when an enterprise decides to raise capital from the markets
other than the country in which it is located, the rules and regulations of that
other country will apply and this in turn will require that the enterprise is in a
position to understand the differences between the rules governing financial
reporting in the foreign country as compared to its own country of origin.
Therefore, translation and reinstatements are of utmost importance in a world
that is rapidly globalising in all ways. Further, the ASs and principles need to be
robust so that the larger society develops degree of confidence in the financial
statements, which are put forward by organisations.

International analysts and investors would like to compare financial statements

based on similar ASs, and this has led to the growing need for an internationally
accepted set of ASs for cross-border filings. The harmonization of financial
reporting around the world will help to raise confidence of investors, generally,
in the information they are using to make their decisions and assess their risks.

Also, a strong need was felt by legislation to bring about uniformity,

rationalisation, comparability, transparency and adaptability in financial
statements. Having a multiplicity of types of ASs around the world is against the
public interest. If accounting for the same events and information produces
different reported numbers, depending on the system of standards that are being
used, then it is self-evident that accounting will be increasingly discredited in the
eyes of those using the numbers. It creates confusion, encourages error and may
facilitate fraud. The cure for these ills is to have a single set of global standards,
of the highest quality, set in the interest of public. Global Standards facilitate cross
border flow of money, global listing in different stock markets and comparability
of financial statements.

The convergence of financial reporting and ASs is a valuable process that

contributes to the free flow of global investment and achieves substantial benefits
for all capital market stakeholders. It improves the ability of investors to compare
investments on a global basis and, thus, lower their risk of errors of judgment. It
facilitates accounting and reporting for companies with global operations and
eliminates some costly requirements like reinstatement of financial statements. It

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 1.12 ACCOUNTING

has the potential to create a new standard of accountability and greater

transparency provides value to all market participants including regulators. It
reduces operational challenges for accounting firms and focuses their values and
expertise around an increasingly unified set of standards. It creates an
unprecedented opportunity for standard setters and other stakeholders to
improve the reporting model. For the companies with joint listings in both
domestic and foreign country, the convergence is very much significant.

6. INTERNATIONAL ACCOUNTING STANDARD

BOARD (IASB)
With a view of achieving the objective of setting global standards, the London
based group namely the International Accounting Standards Committee (IASC),
responsible for developing International Accounting Standards (IAS), was
established in June, 1973. It is presently known as International Accounting
Standards Board (IASB), The IASC comprises the professional accountancy bodies
of over 75 countries (including the ICAI). Primarily, the IASC was established, in the
public interest, to formulate and publish, IASs to be followed in the preparation
and presentation of financial statements. IASs were issued to promote acceptance
and observance of IASs worldwide. The members of IASC undertook a responsibility
to support the standards developed by IASC and to propagate those standards in
their respective countries.
Between 1973 and 2001, the IASC released IASs. Between 1997 and 1999, the IASC
restructured their organisation, which resulted in formation of IASB. These changes
came into effect on 1st April, 2001. Subsequently, IASB issued statements about
current and future standards. IASB publishes its Standards in a series of
pronouncements called International Financial Reporting Standards (IFRS).
However, IASB has not rejected the standards issued by the IASC. Those
pronouncements continue to be designated as “International Accounting
Standards” (IAS).
The standards issued by IASC till 31.03.2001 are known as IASs and the standards
issued by IASB since 01.04.2001 are known as IFRSs.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.13

7. INTERNATIONAL FINANCIAL REPORTING

STANDARDS (IFRS) AS GLOBAL STANDARDS

IFRS issued
by IASB

Interpretations
IAS issued by
on IAS/IFRS
IASC and
adopted by IFRS issued by IFRS
Interpretation
IASB
Commitee

Interpretation
on IAS issued
by SIC

The term International Financial Reporting Standards (IFRS) comprises IFRS issued
by IASB; IAS issued by IASC; Interpretations issued by the Standard Interpretations
Committee (SIC) and the IFRS Interpretations Committee of the IASB.
IFRSs are considered as a "principles-based" set of standards. In fact, they establish
broad rules rather than dictating specific treatments. Every major nation is moving
toward adopting them to some extent. Large number of authorities permits public
companies to use IFRS for stock-exchange listing purposes, and in addition, banks,
insurance companies and stock exchanges may use them for their statutorily
required reports. So, over the next few years, number of companies will adopt the
international standards. This requirement will affect thousands of enterprises,
including their subsidiaries, equity investors and joint venture partners. The
increased use of IFRS is not limited to public-companies listing requirements or
statutory reporting. Many lenders and regulatory and government bodies are
looking to IFRS to fulfil local financial reporting obligations related to financing or
licensing.

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 1.14 ACCOUNTING

8. BECOMING IFRS COMPLIANT

Any country can become IFRS compliant either by adoption process or by
convergence process. Adoption would mean that the country sets a specific
timetable when specific entities would be required to use IFRS as issued by the
IASB. Convergence means that the country will develop high quality, compatible
accounting standards and there would be alignment of the standards of different
standard setters with a certain rate of compromise, by adopting the requirements of
the standards either fully or partially. Ind AS are almost similar to IFRS but with few
carve outs so as to make them suitable for Indian Environment.
Convergence with IFRS will result in following benefits:
 Improves investor confidence across the world with transparency and
comparability
 Improves inter-unit/ inter-firm/inter-industry comparison
 Group consolidation will be easy with same standard by all companies in group
irrespective of their global location.
 Acceptability of financial statements by stock exchanges across the globe, which
will facilitate listing of Indian companies to international stock exchanges.

Cross border
flow of money

Listing of
Helps investors
companies at
in decision
global stock
making
exchange

Becoming IFRS
compliant
Comparability
Low risk of
of financial
error
statements

Greater
transparency

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.15

9. WHAT ARE CARVE OUTS/INS IN IND AS?

The Government of India in consultation with the ICAI decided to converge and not
to adopt IFRS issued by the IASB. The decision of convergence rather than adoption
was taken after the detailed analysis of IFRS requirements and extensive discussion
with various stakeholders.

Accordingly, while formulating Ind AS, efforts have been made to keep these
Standards, as far as possible, in line with the corresponding IAS/IFRS and
departures have been made where considered absolutely essential. These changes
have been made considering various factors, such as

 Various terminology related changes have been made to make it consistent

with the terminology used in law, e.g., ‘statement of profit and loss’ in place
of ‘statement of comprehensive income’ and ‘balance sheet’ in place of
‘statement of financial position’.

 Removal of options in accounting principles and practices in Ind AS vis-a-vis

IFRS, have been made to maintain consistency and comparability of the
financial statements to be prepared by following Ind AS. However, these
changes will not result into carve outs.

 Certain changes have been made considering the economic environment of

the country, which is different as compared to the economic environment
presumed to be in existence by IFRS. These differences are due to differences
in economic conditions prevailing in India. These differences which are in
deviation to the accounting principles and practices stated in IFRS, are
commonly known as ‘Carve-outs’.

Additional guidance given in Ind AS over and above what is given in IFRS, is termed
as ‘Carve in’.

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 1.16 ACCOUNTING

Formulation of Ind AS

Departures

Resulting into Carve-outs not resulting into carve-outs

Deviation from the Removal of options in accounting

accounting principles stated principles and practices in Ind AS vis-
in IFRS a-vis IFRS

10. CONVERGENCE TO IFRS IN INDIA

In the scenario of globalisation, India cannot isolate itself from the accounting
developments taking place worldwide. In India, so far as the ICAI, NFRA and various
regulators such as SEBI and Reserve Bank of India (RBI) are concerned, the aim is
to comply with the IFRS to the extent possible with the objective to formulate sound
financial reporting standards for the purpose of preparing globally accepted
financial statements. The ICAI, being a member of the International Federation of
Accountants (IFAC), considered the IFRS and tried to integrate them, to the extent
possible, in the light of the laws, customs, practices and business environment
prevailing in India.
Due to the recent stream of overseas acquisitions by Indian companies, there is
need for adoption of high quality standards to convince foreign enterprises about
the financial standing as also the disclosure and governance standards of Indian
acquirers.
In India, the ICAI has worked towards convergence of global accounting standards
by considering the application of IFRS in Indian corporate environment.
Recognising the growing need of full convergence of Ind AS with IFRS, ICAI
constituted a Task Force to examine various issues involved.
Full convergence involves adoption of IFRS in the same form as that issued by the
IASB.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.17

For convergence of Ind AS with IFRS, the ASB in consultation with the MCA, decided
that there will be two separate sets of accounting standards viz. (i) Ind AS
converged with the IFRS – standards which are being converged by eliminating the
differences of the Ind AS vis-à-vis IFRS and (ii) Existing notified AS.

Deviation from
Application corresponding
of IFRS in IFRS, if required
India
convergence considering
ICAI to IFRS; legal and
other Decision to
not adoption conditions Indian Accounting Standards (Ind AS)
have two
prevailing set of
in India Accounting
standards
Existing Accounting Standards (ASs)

11. WHAT ARE INDIAN ACCOUNTING

STANDARDS (IND AS)?
Ind AS are IFRS converged standards issued by the Central Government of India
under the supervision and control of ASB of ICAI and in consultation with NFRA.
NFRA recommends these standards to the MCA. MCA has to spell out the
accounting standards applicable for companies in India.
Ind AS are named and numbered in the same way as the corresponding IAS.
However, for Ind AS corresponding to IFRS, one need to add 100 to the IFRS
number e g. for IFRS 1 corresponding Ind AS number is 101.

Indian Accounting Standards

Transparency of Comparability of Enhanced
Globalization and
financial financial Disclosure
Libreralization
statements statements requirements

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 1.18 ACCOUNTING

12. HISTORY OF IFRS-CONVERGED INDIAN

ACCOUNTING STANDARDS (IND AS)
First Step towards IFRS
The ICAI being the accounting standards-setting body in India, way back in 2006,
initiated the process of moving towards the IFRS issued by the IASB with a view to
enhance acceptability and transparency of the financial information communicated
by the Indian corporates through their financial statements. This move towards IFRS
was subsequently accepted by the Government of India.
Government of India - Commitment to IFRS Converged Ind AS
As per the original roadmap for implementation of IFRS-converged Ind AS issued
by the Government of India, initially Ind AS were expected to be implemented from
the year 2011. However, keeping in view the fact that certain issues including tax
issues were still to be addressed, the Ministry of Corporate Affairs decided to
postpone the date of implementation of Ind AS. In 2014, the then Hon'ble Union
Finance Minister of India, Late Shri Arun Jaitely, in his Budget Speech in July 2014
stated that – “There is an urgent need to converge the current Indian accounting
standards with the International Financial Reporting Standards (IFRS). I propose for
adoption of the new Indian Accounting Standards (Ind AS) by the Indian companies
from the financial year 2015-16 voluntarily and from the financial year 2016-17 on
a mandatory basis. Based on the international consensus, the regulators will
separately notify the date of implementation of Ind AS for the Banks, Insurance
companies etc. Standards for the computation of tax would be notified separately”.
Pursuant to the above announcement, various steps were taken to facilitate the
implementation of IFRS-converged Indian Accounting Standards (Ind AS). Moving
in this direction, the Ministry of Corporate Affairs (MCA) has issued the Companies
(Indian Accounting Standards) Rules, 2015 vide Notification dated February 16,
2015 including the revised roadmap of implementation of Ind AS for companies
other than Banking companies, Insurance Companies and NBFCs. As per the
Notification, Ind AS converged with IFRS shall be implemented on voluntary basis
from 1st April, 2015 and mandatorily from 1st April, 2016. Further, the MCA on
March 30, 2016, had also notified the Roadmap for implementation of Ind AS for
Scheduled Commercial Banks, Insurance companies and NBFCs from 1st April, 2018
onwards and also amendments to Ind AS in line with the amendments made in
IFRS/IAS vide Companies (Indian Accounting Standards) Amendment Rules, 2016.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.19

However, IRDAI vide press release dated June 28, 2017 had deferred the
implementation of Ind AS for the Insurance Sector in India for a period of two years,
whereby the effective date was deferred to FY 2020-21. Thereafter, vide circular
dated January 21, 2020, IRDAI has deferred Implementation of Ind AS in the
Insurance Sector till further notice. Additionally, the insurance companies are no
longer required to submit proforma Ind AS financial statements to IRDAI on
quarterly basis as was required earlier. The Reserve Bank of India vide its circular
dated April 05, 2018 had deferred the implementation of Ind AS for Schedule
Commercial Banks (SCBs), excluding Regional Rural Banks (RRBs) by one year i.e.,
to be made effective from 1st April, 2019 onwards. However, vide circular dated
22nd March, 2019, the implementation of Ind AS for Scheduled Commercial Banks
(SCBs) has been further deferred until further notice by the Reserve Bank of India.
One of the most significant steps in moving towards to Ind AS taken by the ICAI
was to provide a stable platform to the Indian entities for smoother and for effective
implementation of Ind AS it has been decided to converge early by notifying Ind
AS corresponding to IFRS 9, Financial Instruments (effective from January 01, 2018)
issued by the IASB. The ICAI continues with its march towards continuous
convergence with IFRS Standards at all times and closely monitors the amendments
in IFRS Standards with timely incorporation of those changes in Ind ASs The IASB
issued IFRS 15 Revenue from Contracts with Customers with effect from January 01,
2018 and IFRS 16 Leases with effect from January 01, 2019. Consequently to keep
in pace with the global standards, ICAI formulated Ind AS 115 Revenue from
Contracts with Customers which was notified by MCA in March, 2018 effective for
F.Y. 2018-19 onwards and Ind AS 116 Leases, which was notified by MCA in March,
2019 for F.Y. 2019-20 onwards.

13. LIST OF IND AS

The following is the list of Ind AS vis-a-vis IFRS and AS:

Ind AS IAS/ IFRS Title of Ind AS/IFRS AS/GN AS/GN Title

101 IFRS 1 First Time Adoption of - -
Indian Accounting
Standards
102 IFRS 2 Share Based Payment GN Guidance Note on
Accounting for

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 1.20 ACCOUNTING

Ind AS IAS/ IFRS Title of Ind AS/IFRS AS/GN AS/GN Title

Employee Share-based
Payments
103 IFRS 3 Business Combinations AS 14 Accounting for
Amalgamations
104 IFRS 4 Insurance Contracts - -
105 IFRS 5 Non-current Assets AS 24 Discontinuing
Held for Sale and Operations
Discontinued
Operations
106 IFRS 6 Exploration for and GN 15 Guidance Note on
Evaluation of Mineral Accounting for Oil and
Resources Gas Producing
Activities
107 IFRS 7 Financial Instruments: - -
Disclosures
108 IFRS 8 Operating Segments AS 17 Segment Reporting
109 IFRS 9 Financial Instruments - -
110 IFRS 10 Consolidated Financial AS 21 Consolidated Financial
Statements Statements
111 IFRS 11 Joint Arrangements AS 27 Financial Reporting of
Interests in Joint
Ventures
112 IFRS 12 Disclosure of Interests - -
in Other Entities
113 IFRS 13 Fair Value - -
Measurement
114 IFRS 14 Regulatory Deferral GN Accounting for Rate
Accounts Regulated Activities
115 IFRS 15 Revenue from AS 7 Construction Contract
contracts with AS 9 Revenue Recognition
customers
116 IFRS 16 Leases AS 19 Leases

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.21

Ind AS IAS/ IFRS Title of Ind AS/IFRS AS/GN AS/GN Title

117 IFRS 17 Insurance Contracts
is under (It will
formulat replace
ion IFRS 4)
1 IAS 1 Presentation of AS 1 Disclosure of
Financial Statements Accounting Policies
2 IAS 2 Inventories AS 2 Valuation of
Inventories
7 IAS 7 Statement of Cash AS 3 Cash Flow Statements
Flows
8 IAS 8 Accounting Policies, AS 5 Net Profit or Loss for
Changes in Accounting the Period, Prior period
Estimates and Errors Items and Changes in
Accounting Policies
10 IAS 10 Events after the AS 4 Contingencies and
Reporting Period Events Occurring After
the Balance Sheet date
12 IAS 12 Income Taxes AS 22 Accounting for Taxes
on Income
16 IAS 16 Property, Plant and AS 10 Property, Plant and
Equipment Equipment
19 IAS 19 Employee Benefits AS 15 Employee Benefits
20 IAS 20 Accounting for AS 12 Accounting for
Government Grants Government Grants
and Disclosure of
Government Assistance
21 IAS 21 The Effects of Changes AS 11 The Effects of Changes
in Foreign Exchange in Foreign Exchange
Rates Rates
23 IAS 23 Borrowing Costs AS 16 Borrowing Costs
24 IAS 24 Related Party AS 18 Related Party
Disclosures Disclosures

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 1.22 ACCOUNTING

Ind AS IAS/ IFRS Title of Ind AS/IFRS AS/GN AS/GN Title

27 IAS 27 Separate Financial - -
Statements
28 IAS 28 Investment in AS 23 Accounting for
Associates and Joint Investment in
Ventures Associates in
Consolidated Financial
Statements
29 IAS 29 Financial Reporting in - -
Hyperinflationary
Economies
32 IAS 32 Financial Instruments: - -
Presentation
33 IAS 33 Earnings per Share AS 20 Earnings per Share
34 IAS 34 Interim Financial AS 25 Interim Financial
Reporting Reporting
36 IAS 36 Impairment of Assets AS 28 Impairment of Assets
37 IAS 37 Provisions, Contingent AS 29 Provisions, Contingent
Liabilities and Liabilities and
Contingent Assets Contingent Assets
38 IAS 38 Intangible Assets AS 26 Intangible Assets
40 IAS 40 Investment Property AS 13 Accounting for
Investments
41 IAS 41 Agriculture - -

14. ROADMAP FOR IMPLEMENTATION OF INDIAN

ACCOUNTING STANDARDS (IND AS): A
SNAPSHOT
For Companies other than Banks, NBFCs and Insurance Companies
Phase I: 1st April 2015 or thereafter (with Comparatives): Voluntary Basis for any
company (other than Banks, NBFCs and Insurance companies) and its holding,
subsidiary, Joint venture (JV) or Associate Company.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.23

1st April 2016: Mandatory Basis

(a) Companies listed/in process of listing on Stock Exchanges in India or Outside
India having net worth of INR 500 crore or more;
(b) Unlisted Companies having net worth of INR 500 crore or more;
(c) Parent, Subsidiary, Associate and JV of above.
Phase II: 1st April 2017: Mandatory Basis
(a) All companies which are listed/or in process of listing on Stock Exchanges in
India or outside India not covered in Phase I (other than companies listed on SME
Exchanges);
(b) Unlisted companies having net worth of INR 250 crore or more but less than
INR 500 crore;
(c) Parent, Subsidiary, Associate and JV of above.
Special Points to Consider:-
• Companies listed on SME exchange are not required to apply Ind AS. Such
companies shall continue to apply existing ASs unless they choose otherwise.
• Once Ind AS are applicable, an entity shall be required to follow the Ind AS
for all the subsequent financial statements i.e. there is no looking back once
the Ind AS are adopted by companies.
• Companies not covered by the above roadmap shall continue to apply
Accounting Standards notified in Companies (Accounting Standards) Rules,
2006.
For Scheduled Commercial Banks (Excluding RRBs), Insurers/Insurance
Companies and Non-Banking Financial Companies (NBFCs)

Non-Banking Financial Companies (NBFCs)

Phase I: From 1st April, 2018 (with comparatives)
• NBFCs (whether listed or unlisted) having net worth INR 500
crores or more
• Holding, Subsidiary, JV and Associate companies of above
NBFC other than those already covered under corporate
roadmap shall also apply from said date

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 1.24 ACCOUNTING

Phase II: From 1st April, 2019 (with comparatives)

• NBFCs whose equity and/or debt securities are listed or are in
the process of listing on any stock exchange in India or outside
India and having net worth less than INR 500 crores
• NBFCs that are unlisted having net worth INR 250 crores or
more but less than INR 500 crores
• Holding, Subsidiary, JV and Associate companies of above
companies other than those already covered under corporate
roadmap shall also apply Ind AS from the said date.
 Applicable to both Consolidated and Individual Financial Statements
 NBFC having net worth below INR 250 crores and not covered under the
above provisions shall continue to apply ASs specified in Annexure to
Companies (Accounting Standards) Rules, 2006.
 Adoption of Ind AS is allowed only when required as per the roadmap.
 Voluntary adoption of Ind AS is not allowed.
Scheduled Commercial banks (excluding RRBs)
 Scheduled Commercial Banks (SCBs) excluding Regional Rural Banks
(RRBs) were initially required to implement Ind AS from 1 April 2018.
However, RBI (Reserve Bank of India) vide a press release dated 5 April
2018, deferred the implementation of Ind AS by one year i.e. to be
effective from 1 April 2019 instead of 1 April 2018.
 Further, the RBI through a notification dated 22 March 2019, deferred
the Ind AS implementation till further notice. This was because the
amendments recommended by the RBI are still under consideration of
the Government of India, therefore, RBI took a decision to defer the
applicability of Ind AS till further notice.
 Urban Cooperative banks (UCBs) and Regional Rural banks (RRBs) are not
required to apply Ind AS.

Insurers/Insurance companies
 MCA had outlined the road map for implementation of Ind AS by
insurers/insurance companies from 1 April 2018.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.25

 IRDAI (Insurance Regulatory and Development Authority of India)

deferred the implementation of Ind AS in the insurance sector in India
for a period of two years whereby the effective date was deferred to 1
April 2020. However, insurance companies were required to submit
proforma Ind AS financial statements to IRDAI on a quarterly basis
effective 31 December 2016 (vide circular dated 28 June 2017).
 Further, IRDAI in its meeting held on 20 December 2019 decided to
implement Ind AS 109, Financial Instruments and Ind AS 117
simultaneously, along with other applicable Ind AS. In India, Ind AS 117
(converged with IFRS 17) is still at an exposure draft stage and will be
updated based on the amendments made to IFRS 17. Once Ind AS 117 is
notified in India by MCA, IRDAI would be in a position to notify the
regulation on preparation of Ind AS compliant financial statements and
modify other regulations that may be impacted due to the
implementation of Ind AS 117.
 Therefore, the effective date of implementation of Ind AS for insurance
companies is not yet finalized and it would be finalized after the
finalisation of IFRS 17 by IASB.
 IRDAI, vide circular dated 21 January 2020, has deferred implementation
of Ind AS in the insurance sector till further notice. The circular dated 28
June 2017 was also withdrawn by IRDAI along with the requirement of
proforma Ind AS financial statements being submitted on a quarterly
basis as directed in that circular.

SUMMARY
The accounting standards aim at improving the quality of financial reporting by
promoting comparability, consistency and transparency, in the interests of users
of financial statements. The ICAI has, so far, issued 29 ASs. However, AS 6 on
‘Depreciation Accounting’ was withdrawn on revision of AS 10 ‘Property, Plant
and Equipment and AS 8 on ‘Accounting for Research and Development’ has been
withdrawn consequent to the issuance of AS 26 on ‘Intangible Assets’. Thus, there
are 27 ASs at present.

In the scenario of globalisation, India cannot isolate itself from the developments
taking place worldwide. In India, so far as the ICAI and the Government authorities
and various regulators such as SEBI and RBI are concerned, the aim has always

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 1.26 ACCOUNTING

been to comply with the IFRS to the extent possible with the objective of
formulating sound financial reporting standards.

Ind AS are IFRS converged standards issued by the Central Government of India
under the supervision and control of ASB of ICAI and in consultation with NFRA.

As per the MCA Notification dated 16 th February 2015, Ind AS converged with
IFRS shall be implemented on voluntary basis from 1st April, 2015 and
mandatorily from 1st April, 2016.

Separate roadmaps have been prescribed for implementation of Ind AS in Banking

companies, Insurance companies and NBFCs.

TEST YOUR KNOWELDGE

MCQs
1. Accounting Standards for non-corporate entities in India are issued by
(a) Central Govt.
(b) State Govt.
(c) Institute of Chartered Accountants of India.
2. Accounting Standards
(a) Harmonise accounting policies and eliminate the non-comparability of
financial statements.
(b) Improve the reliability of financial statements.
(c) Both (a) and (b).
3. It is essential to standardize the accounting principles and policies in order
to ensure
(a) Transparency.
(b) Consistency.
(c) Both (a) and (b).
4. Which committee is responsible for approval of accounting standards and
their modification for the purpose of applicability to companies?
(a) NFRA.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.27

(b) MCA.
(c) Central Government Advisory Committee.
5. Global Standards facilitate
(a) Cross border flow of money.
(b) Comparability of financial statements.
(c) Both (a) and (b).
6. Additional guidance given in Ind AS over and above what is given in IFRS are
called
(a) Carve-outs.
(b) Carve-ins.
(c) Carve clarifications.
7. IASB stands for
(a) International Accounting Standards Bureau
(b) International Advisory Standards Board
(c) International Accounting Standard Board.
8. IFRS stands for
(a) International Financial Reporting System
(b) International Finance Reporting Standard
(c) International Financial Reporting Standard.
9. Phase I of Ind AS was applicable to:
(a) All listed companies in India or outside India
(b) Companies with turnover INR 500 crores or more
(c) Companies with net worth INR 500 crores or more.
Theoretical Questions
1. Explain the objective of “Accounting Standards” in brief. State the
advantages of setting Accounting Standards.
2. Briefly explain the process of issuance of Indian Accounting Standards.

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 1.28 ACCOUNTING

3. Explain the significance of emergence of IFRS as Global Standards.

4. What do you mean by Carve outs/ins in Ind AS? Explain.

ANSWER/HINTS
MCQs
1. (c) 2. (c) 3. (c) 4. (b) 5. (c) 6. (b)
7. (c) 8. (c) 9. (c)
Theoretical Questions
1. Accounting Standards are the written policy documents issued by
Government relating to various aspects of measurement, treatment,
presentation and disclosure of accounting transactions and events.
Following are the objectives of Accounting Standards:
a. Accounting Standards harmonize the diverse accounting policies and
practices followed by different companies in India.
b. Accounting Standards facilitates the preparation of financial statements
and make them comparable.
c. Accounting Standards give a sense of faith and reliability to the users.
The main advantage of setting accounting standards are as follows:
a. Accounting Standards makes the financial statements of different
companies comparable which helps investors in decision making.
b. Accounting Standards prevent any misleading accounting treatment.
c. Accounting Standards prevent manipulation of data by the
management.
2. Due to the recent stream of overseas acquisitions by Indian companies, there
is need for adoption of high quality standards to convince foreign enterprises
about the financial standing as also the disclosure and governance standards
of Indian acquirers.
The Government of India in consultation with the ICAI decided to converge
and not to adopt IFRSs issued by the IASB. The decision of convergence rather
than adoption was taken after the detailed analysis of IFRSs requirements and
extensive discussion with various stakeholders.

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 INTRODUCTION TO ACCOUNTING STANDARDS 1.29

The ICAI has worked towards convergence of global accounting standards by

considering the application of IFRS in Indian corporate environment.
Recognising the growing need of full convergence of Ind AS with IFRS, ICAI
constituted a Task Force to examine various issues involved.
Ind AS are issued by the Central Government of India under the supervision
and control of ASB of ICAI and in consultation with NFRA. NFRA recommends
these standards to the MCA and MCA has to spell out the accounting
standards applicable for companies in India.
3. Global Standards facilitate cross border flow of money, global listing in
different bourses and comparability of financial statements. Global Standards
improve the ability of investors to compare investments on a global basis and
thus lowers their risk of errors of judgment. It facilitates accounting and
reporting for companies with global operations and eliminates some costly
requirements say reinstatement of financial statements.
4. Certain changes have been made in Ind AS considering the economic
environment of the country, which is different as compared to the economic
environment presumed to be in existence by IFRS. These differences are due
to differences in economic conditions prevailing in India. These differences
which are in deviation to the accounting principles and practices stated in
IFRS, are commonly known as ‘Carve-outs’. Additional guidance given in Ind
AS over and above what is given in IFRS, is termed as ‘Carve in’.

© The Institute of Chartered Accountants of India

 1.1

CHAPTER 2

FRAMEWORK FOR
PREPARATION AND
PRESENTATION OF
FINANCIAL STATEMENTS

LEARNING OUTCOMES
After studying this chapter, you will be able to–
 Understand the meaning and significance of Framework for
the Preparation and Presentation of Financial Statements;
 Learn objectives of Financial Statements
 Understand qualitative characteristics of Financial
Statements;
 Comprehend recognition and measurement of elements of
Financial Statements;
 Know concepts of capital, capital maintenance and
determination of profit.

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 2.2 ACCOUNTING

The framework sets out the concepts underlying the preparation and
presentation of general purpose financial statements prepared by enterprises
for wide range of users. The Accounting Standards Board (ASB) of the Institute
of Chartered Accountants of India (ICAI) issued a framework for the Preparation
and Presentation of Financial Statements in July 2000. This Framework is relevant
in context of Companies (Accounting Standards) Rules, 2006, Companies
(Accounting Standards) Amendments Rules, 2016, notified by the Central
Government and Accounting Standards issued by the ICAI.
This framework provides the fundamental basis for development of new
standards as also for review of existing standards. This framework also explains
components of financial statements, users of financial statements, qualitative
characteristics of financial statements and elements of financial statements. The
framework also explains concepts of capital, capital maintenance and
determination of profit.

1. INTRODUCTION
The development of accounting standards or any other accounting guidelines need
a foundation of underlying principles. (ASB) of ICAI issued a framework in July, 2000
which provides the fundamental basis for development of new standards as also
for review of existing standards. The principal areas covered by the framework are
as follows:
(a) Components of financial statements;
(b) Objectives of financial statements;
(c) Assumptions underlying financial statements;
(d) Qualitative characteristics of financial statements;
(e) Elements of financial statements;
(f) Criteria for recognition of elements in financial statements;
(g) Principles for measurement of financial elements;
(h) Concepts of Capital and Capital Maintenance.

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2. PURPOSE OF THE FRAMEWORK

The framework sets out the concepts underlying the preparation and presentation
of general-purpose financial statements prepared by enterprises for external users.
The main purpose of the framework is to assist:
(a) Enterprises in preparation of their financial statements in compliance with
Accounting Standards and in dealing with the topics not yet covered by any
Accounting Standard,
(b) ASB in its task of development and review of Accounting Standards,
(c) ASB in promoting harmonisation of regulations, Accounting Standards and
procedures relating to the preparation and presentation of financial
statements by providing a basis for reducing the number of alternative
accounting treatments permitted by Accounting Standards,
(d) Auditors in forming an opinion as to whether financial statements conform
to the Accounting Standards,
(e) Users in interpretation of financial statements,
(f) those who are interested in the work of ASB with information about its
approach to the formulation of Accounting Standards.

3. STATUS AND SCOPE OF THE FRAMEWORK

The framework applies to general-purpose financial statements (hereafter referred
to as ‘financial statements’ usually prepared annually for external users, by all
commercial, industrial and business enterprises, whether in public or private sector.
The special purpose financial reports, for example computations prepared for tax
purposes are outside the scope of the framework. Nevertheless, the framework may
be applied in preparation of such reports, to the extent not inconsistent with their
requirements.
Nothing in the framework overrides any specific Accounting Standard. In case of
conflict between an Accounting Standard and the framework, the requirements of
the Accounting Standard will prevail over those of the framework.

4. COMPONENTS OF FINANCIAL STATEMENTS

A complete set of financial statements normally consists of a Balance Sheet, a
Statement of Profit and Loss and a Cash Flow Statement together with notes, other

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statements and explanatory materials that form an integral part of the financial
statements.
All components of the financial statements are interrelated because they reflect
different aspects of same transactions or other events. Although each statement
provides information that is different from each other, none in isolation is likely to
serve any single purpose nor can anyone provide all information needed by a user.
The major information contents of different components of financial statements
are explained as below:
Balance Sheet portrays value of economic resources controlled by an enterprise.
It also provides information about liquidity and solvency of an enterprise which is
useful in predicting the ability of the enterprise to meet its financial commitments
as they fall due.
Statement of Profit and Loss presents the result of operations of an enterprise
for an accounting period, i.e., it depicts the performance of an enterprise, in
particular its profitability.
Cash Flow Statement shows the way an enterprise has generated cash and the
way they have been used in an accounting period and helps in evaluating the
investing, financing and operating activities during the reporting period.
Notes and other statements present supplementary information explaining
different items of financial statements. For example, they may contain additional
information that is relevant to the needs of users about the items in the balance
sheet and statement of profit and loss. They include various other disclosures such
as disclosure of accounting policies, segment reporting, related party disclosures,
earnings per share, etc.

5. OBJECTIVES AND USERS OF FINANCIAL

STATEMENTS
The objective of financial statements is to provide information about the financial
position, performance and cash flows of an enterprise that is useful to a wide range
of users in making economic decisions.
The framework identifies seven broad groups of users of financial statements.

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 FRAMEWORK 2.5

Users of Financial Statements

Suppliers
Investors Employees Lenders and Customers Govt. Public
Creditors

All users of financial statements expect the statements to provide useful

information needed to make economic decisions. The financial statements provide
information to suit the common needs of most users. However, they cannot and do
not intend to provide all information that may be needed, e.g. they do not provide
non-financial data even if they may be relevant for making decisions.
The aforesaid users use financial statements in order to satisfy some of their
information needs. These needs may include the following:
a) Investors - The providers of risk capital are concerned with the risk inherent
in, and return provided by, their investments. They are also interested in
information which enables them to assess the ability of the enterprise to pay
dividends.
b) Employees - Employees and their representative groups are interested in
information about the stability and profitability of their employers. They are
also interested in information which enables them to assess the ability of the
enterprise to provide remuneration, retirement benefits and employment
opportunities.
c) Lenders - Lenders are interested in information which enables them to
determine whether their loans, and the interest attaching to them, will be paid
when due.
d) Suppliers and other trade creditors - Suppliers and other creditors are
interested in information which enables them to determine whether amounts
owing to them will be paid when due. Trade creditors are likely to be
interested in an enterprise over a shorter period than lenders unless they are
dependent upon the continuance of the enterprise as a major customer.
e) Customers - Customers have an interest in information about the
continuance of an enterprise, especially when they have a long term
involvement with, or are dependent on, the enterprise for their goods and
services.

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 2.6 ACCOUNTING

f) Governments and their agencies - Governments and their agencies are

interested in the allocation of resources and, therefore, the activities of
enterprises. They also require information in order to regulate the activities
of enterprises and determine taxation policies, and to serve as the basis for
determination of national income and similar statistics.
g) Public - Enterprises affect members of the public in a variety of ways. For
example, enterprises may make a substantial contribution to the local
economy in many ways including the number of people they employ and their
patronage of local suppliers. Financial statements may assist the public by
providing information about the trends and recent developments in the
prosperity of the enterprise and the range of its activities.

6. FUNDAMENTAL ACCOUNTING ASSUMPTIONS

As per the framework, there are three fundamental accounting assumptions:

Fundamental Accounting
Assumptions

Going concern Accrual Consistency

These are assumptions, i.e., the users of financial statements believe that the same
has been considered while preparing the financial statements. That is why, as long
as financial statements are prepared in accordance with these assumptions, no
separate disclosure in financial statements would be necessary.
If nothing has been written about the fundamental accounting assumption in the
financial statements, then it is assumed that they have already been followed in
their preparation of financial statements.
However, if any of the above-mentioned fundamental accounting assumption is
not followed then this fact should be specifically disclosed.
Let us discuss these assumptions in detail.
(a) Going Concern: Financial statements are normally prepared on the
assumption that an enterprise will continue in operation in the foreseeable future
and neither there is an intention, nor there is a need to materially curtail the scale
of operations.

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Financial statements prepared on going concern basis recognise among other

things the need for sufficient retention of profit to replace assets consumed in
operation and for making adequate provision for settlement of its liabilities. If any
financial statement is prepared on a different basis, e.g. when assets of an
enterprise are stated at net realisable values in its financial statements, the basis
used should be disclosed.
Illustration 1
Balance sheet of a trader on 31st March, 20X1 is given below:
Liabilities ` Assets `
Capital 60,000 Property, Plant and 65,000
Equipment
Profit and Loss Account 25,000 Stock 30,000
10% Loan 35,000 Trade receivables 20,000
Trade payables 10,000 Deferred costs 10,000
Bank 5,000
1,30,000 1,30,000
Additional information:
(a) The remaining life of Property, Plant and Equipment is 5 years. The pattern of
use of the asset is even. The net realisable value of Property, Plant and
Equipment on 31.03.X2 was ` 60,000.
(b) The trader’s purchases and sales in 20X1-X2 amounted to ` 4 lakh and ` 4.5
lakh respectively.
(c) The cost and net realisable value of stock on 31.03.X2 were ` 32,000 and
` 40,000 respectively.
(d) Expenses (including interest on 10% Loan of ` 3,500 for the year) amounted to
` 14,900.
(e) Deferred cost is amortised equally over 4 years.
(f) Trade receivables on 31.03.X2 is ` 25,000, of which ` 2,000 is doubtful.
Collection of another ` 4,000 depends on successful re-installation of certain
product supplied to the customer.
(g) Closing trade payable is ` 12,000, which is likely to be settled at 5% discount.
(h) Cash balance on 31.03.X2 is ` 37,100.
(i) There is an early repayment penalty for the loan ` 2,500.

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You are required to prepare Profit and Loss Accounts and Balance Sheets of the trader
in both cases (i) assuming going concern (ii) not assuming going concern.
Solution
Profit and Loss Account for the year ended 31st March, 20X2

Case (i) Case (ii) Case (i) Case (ii)

` ` ` `
To Opening Stock 30,000 30,000 By Sales 4,50,000 4,50,000
To Purchases 4,00,000 4,00,000 By Closing 32,000 40,000
Stock
To Expenses 14,900 14,900 By Trade − 600
payables
To Depreciation 13,000 5,000
To Provision for
doubtful 2,000 6,000
debts
To Deferred cost 2,500 10,000
To Loan penalty − 2,500
To Net Profit 19,600 22,200
(b.f.)
4,82,000 4,90,600 4,82,000 4,90,600
Balance Sheet as at 31st March, 20X2

Liabilities Case (i) Case Assets Case (i) Case (ii)

` (ii) ` ` `
Capital 60,000 60,000 Property, Plant 52,000 60,000
and Equipment
Profit & Loss A/c 44,600 47,200 Stock 32,000 40,000
10% Loan 35,000 37,500 Trade
receivables 23,000 19,000
(less provision)
Trade payables 12,000 11,400 Deferred costs 7,500 Nil
Bank 37,100 37,100
1,51,600 1,56,100 1,51,600 1,56,100

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 FRAMEWORK 2.9

(b) Accrual Basis: According to AS 1, revenues and costs are accrued, that is,
recognised as they are earned or incurred (and not as money is received or paid)
and recorded in the financial statements of the periods to which they relate.
Further Section 128(1) of the Companies Act, 2013 makes it mandatory for
companies to maintain accounts on accrual basis only. It is not necessary to
expressly state that accrual basis of accounting has been followed in preparation
of a financial statement. In case, any income/ expense is recognised on cash basis,
the fact should be stated.
Let’s understand the impact of both approaches of accounting by way of an
example.
Example 1
(a) A trader purchased article A on credit in period 1 for ` 50,000.
(b) He also purchased article B in period 1 for ` 2,000 cash.
(c) The trader sold article A in period 1 for ` 60,000 in cash.
(d) He also sold article B in period 1 for ` 2,500 on credit.
Profit and Loss Account of the trader by two basis of accounting are shown below. A
look at the cash basis Profit and Loss Account will convince any reader of the
irrationality of cash basis of accounting.
Cash basis of accounting
Cash purchase of article B and cash sale of article A is recognised in period 1 while
purchase of article A on payment and sale of article B on receipt is recognised in
period 2.
Profit and Loss Account

` `
Period 1 To Purchase 2,000 Period 1 By Sale 60,000
To Net Profit 58,000 _______
60,000 60,000
Period 2 To Purchase 50,000 Period 2 By Sale 2,500
_______ By Net Loss 47,500
50,000 50,000

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Accrual basis of accounting

Credit purchase of article A and cash purchase of article B and cash sale of article A
and credit sale of article B is recognised in period 1 only.
Profit and Loss Account

` `
Period 1 To Purchase 52,000 Period 1 By Sale 62,500
To Net Profit 10,500
62,500 62,500

(c) Consistency: It is assumed that accounting policies are consistent from one
period to another. The consistency improves comparability of financial statements
through time. According to Accounting Standards, an accounting policy can be
changed if the change is required
(i) by a statute or
(ii) by an Accounting Standard or
(iii) for more appropriate presentation of financial statements.

7. QUALITATIVE CHARACTERISTICS OF
FINANCIAL STATEMENTS
The qualitative characteristics are attributes that improve the usefulness of
information provided in financial statements. The framework suggests that the
financial statements should observe and maintain the following four qualitative
characteristics as far as possible within limits of reasonable cost/ benefit.

Qualitative Characteristics of Financial

Statements

Understandability Relevance Comparability Reliability

These attributes can be explained as:

1. Understandability: The financial statements should present information in a
manner as to be readily understandable by the users with reasonable
knowledge of business and economic activities and accounting.

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 FRAMEWORK 2.11

2. Relevance: It is not right to think that more information is always better.. A

mass of irrelevant information creates confusion and can be even more
harmful than non-disclosure.
The financial statements should contain relevant information only.
Information, which is likely to influence the economic decisions by the users,
is said to be relevant. Such information may help the users to evaluate past,
present or future events or may help in confirming or correcting past
evaluations. The relevance of a piece of information should be judged by its
materiality. A piece of information is said to be material if its misstatement
(i.e., omission or erroneous statement) can influence economic decisions of a
user taken on the basis of the financial information. Materiality depends on
the size and nature of the item or error, judged in the specific circumstances
of its misstatement. Materiality provides a threshold or cut-off point rather
than being a primary qualitative characteristic which the information must
have if it is to be useful.
Further it is important to know the constraints also on Relevant and Reliable
Information to better understand the qualitative characteristics of financial
statements. Following are some of the constraints:
a) Timeliness
If there is undue delay in the reporting of information it may lose its
relevance. Management may need to balance the relative merits of
timely reporting and the provision of reliable information. To provide
information on a timely basis it may often be necessary to report before
all aspects of a transaction or other event are known, thus impairing
reliability. Conversely, if reporting is delayed until all aspects are known,
the information may be highly reliable but of little use to users who
have had to make decisions in the interim. In achieving a balance
between relevance and reliability, the overriding consideration is how
best to satisfy the information needs of users.
b) Balance between Benefit and Cost
The balance between benefit and cost is a pervasive constraint rather
than a qualitative characteristic. The benefits derived from information
should exceed the cost of providing it. The evaluation of benefits and
costs is, however, substantially a judgmental process. The preparers and
users of financial statements should be aware of this constraint.

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3. Reliability: To be useful, the information must be reliable; that is to say, they

must be free from material error and bias. The information provided are not
likely to be reliable unless:
(a) Transactions and events reported are faithfully represented.
(b) Transactions and events are reported on the principle of 'substance
over form (discussed later in AS-1)'.
(c) The reporting of transactions and events are neutral, i.e. free from bias.
(d) Prudence is exercised in reporting uncertain outcome of transactions or
events.
(e) The information in financial statements must be complete.
4. Comparability: Comparison of financial statements is one of the most
frequently used and most effective tools of financial analysis. The financial
statements should permit both inter-firm and intra-firm comparison. One
essential requirement of comparability is disclosure of financial effect of
change in accounting policies. However, the need for comparability should
not be confused with mere uniformity and should not be allowed to become
an impediment to the introduction of improved accounting standards. It is
not appropriate for an enterprise to continue accounting in the same manner
for a transaction or other event if the policy adopted is not in keeping with
the qualitative characteristics of relevance and reliability. It is also
inappropriate for an enterprise to leave its accounting policies unchanged
when more relevant and reliable alternatives exist.

8. TRUE AND FAIR VIEW

Financial statements are required to show a true and fair view of the performance,
financial position and cash flows of an enterprise. The framework does not deal
directly with this concept of true and fair view, yet application of the principal
qualitative characteristics and appropriate accounting standards normally results in
financial statements portraying true and fair view of information about an enterprise.

9. ELEMENTS OF FINANCIAL STATEMENTS

The framework classifies items of financial statements in five broad groups
depending on their economic characteristics.

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Elements of Financial Statements

Asset Liability Equity Income Expenses

Gains and losses differ from income and expenses in the sense that they may or
may not arise in the ordinary course of business. Except for the way they arise,
economic characteristics of gains are same as income and those of losses are same
as expenses. For these reasons, gains and losses are not recognised as separate
elements of financial statements.
Let us discuss each element of financial statement in detail.
1. Asset: An asset is a resource controlled by the enterprise as a result of past
events from which future economic benefits are expected to flow to the enterprise.
The following points must be considered while recognising an asset:
(a) The resource regarded as an asset, need not have a physical substance. The
resource may represent a right generating future economic benefit, e.g.
patents, copyrights, trade receivables. An asset without physical substance
can be either intangible asset, e.g. patents and copyrights or monetary assets,
e.g. trade receivables. The monetary assets are money held and assets to be
received in fixed or determinable amounts of money.
(b) An asset is a resource controlled by the enterprise. This means it is possible
to recognise a resource not owned but controlled by the enterprise as an
asset, i.e., legal ownership may or may not vest with the enterprise. Such is
the case of financial lease, where lessee recognises the asset taken on lease,
even if ownership lies with the lessor. Likewise, the lessor does not recognise
the asset given on finance lease as asset in his books, because despite of
ownership, he does not control the asset.
(c) A resource cannot be recognised as an asset if the control is not sufficient.
For this reason specific management or technical talent of an employee
cannot be recognised because of insufficient control. When the control over
a resource is protected by a legal right, e.g. copyright, the resource can be
recognised as an asset.
(d) To be considered as an asset, it must be probable that the resource generates
future economic benefits. If the economic benefits from a resource is
expected to expire within the current accounting period, it is not an asset. For

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example, economic benefits, i.e. profit on sale, from machinery purchased by

an enterprise who deals in such kind of machinery is expected to expire within
the current accounting period. Such purchase of machinery is therefore
booked as an expense rather than capitalised in the machinery account.
However, if the articles purchased by a dealer remain unsold at the end of
accounting period, the unsold items are recognised as assets, i.e. closing
stock, because the sale of the article and resultant economic benefit, i.e. profit
is expected to be earned in the next accounting period.
(e) To be considered as an asset, the resource must have a cost or value that can
be measured reliably.
(f) When flow of economic benefit to the enterprise beyond the current
accounting period is considered improbable, the expenditure incurred is
recognised as an expense rather than as an asset.
2. Liability: A liability is a present obligation of the enterprise arising from past
events, the settlement of which is expected to result in an outflow of a resource
embodying economic benefits. The following points may be noted:
(a) A liability is a present obligation 1, i.e. an obligation the existence of which,
based on the evidence available on the balance sheet date is considered
probable. For example, an enterprise may have to pay compensation if it loses
a damage suit filed against it. The damage suit is pending on the balance
sheet date. The enterprise should recognise a liability for damages payable
by a charge against profit if it is probable that the enterprise will lose the suit
and if the amount of damages payable can be ascertained with reasonable
accuracy. The enterprise should create a provision for damages payable by
charge against profit, if probability of losing the suit is more than not losing
it and if the amount of damages payable can be ascertained with reasonable
accuracy. In other cases, the company reports the damages payable as
‘contingent liability’, which does not meet the definition of liability.
Accounting standards define provision as a liability, which can be measured
only by using a substantial degree of estimation.

1
Present obligation may be legally enforceable as a consequence of a binding contract or
statutory requirement or they may arise from normal business practice, custom and a desire
to maintain good business relations or act in an equitable manner.

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(b) It may be noted that certain provisions, e.g. provisions for doubtful debts,
depreciation and impairment losses, represent diminution in value of assets
rather than obligations. These provisions should not be considered as liability.
(c) A liability is recognised only when outflow of economic resources in
settlement of a present obligation can be anticipated and the value of outflow
can be reliably measured. Otherwise, the liability is not recognised. For
example, liability cannot arise on account of future commitment. A decision
by the management of an enterprise to acquire assets in the future does not,
of itself, give rise to a present obligation. An obligation normally arises only
when the asset is delivered or the enterprise enters into an irrevocable
agreement to acquire the asset.
Example 2
A Ltd. has entered into a binding agreement with P Ltd. to buy a custom-made
machine for ` 40,000. At the end of 20X1-X2, before delivery of the machine, A Ltd.
had to change its method of production. The new method will not require the machine
ordered and it will be scrapped after delivery. The expected scrap value is nil.
A liability is recognised when outflow of economic resources in settlement of a present
obligation can be anticipated and the value of outflow can be reliably measured. In
the given case, A Ltd. should recognise a liability of ` 40,000 to P Ltd.
When flow of economic benefit to the enterprise beyond the current accounting period
is considered improbable, the expenditure incurred is recognised as an expense rather
than as an asset. In the present case, flow of future economic benefit from the machine
to the enterprise is improbable. The entire amount of purchase price of the machine
should be recognised as an expense. The accounting entry is suggested below:
` `
Loss on change in production Method Dr. 40,000
To P Ltd. 40,000
(Loss due to change in production method)
Profit and loss A/c Dr. 40,000
To Loss on change in production method 40,000
(loss transferred to profit and loss account)

3. Equity: Equity is defined as residual interest in the assets of an enterprise

after deducting all its liabilities. It is important to avoid mixing up liabilities with

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equity. Equity is the excess of aggregate assets of an enterprise over its aggregate
liabilities. In other words, equity represents owners’ claim consisting of items like
capital and reserves, which are clearly distinct from liabilities, i.e. claims of parties
other than owners. The value of equity may change either through contribution
from / distribution to equity participants or due to income earned /expenses
incurred.
4. Income: Income is increase in economic benefits during the accounting
period in the form of inflows or enhancement of assets or decreases in liabilities
that result in increase in equity other than those relating to contributions from
equity participants. The definition of income encompasses revenue and gains.
Revenue is an income that arises in the ordinary course of activities of the
enterprise, e.g. sales by a trader. Gains are income, which may or may not arise in
the ordinary course of activity of the enterprise, e.g. profit on disposal of Property,
Plant and Equipment. Gains are showed separately in the statement of profit and
loss because this knowledge is useful in assessing performance of the enterprise.
Income earned is always associated with either increase of asset or reduction of
liability. This means, no income can be recognised unless the corresponding
increase of asset or decrease of liability can be recognised. For example, a bank
does not recognise interest earned on non-performing assets because the
corresponding asset (increase in advances) cannot be recognised, as flow of
economic benefit to the bank beyond current accounting period is not probable.
Thus
Balance sheet of an enterprise can be written in form of:
A – L = E.
Where:
A = Aggregate value of asset
L = Aggregate value of liabilities
E = Aggregate value of equity
Example 3
Suppose at the beginning of an accounting period, aggregate values of assets,
liabilities and equity of a trader are ` 5 lakh, ` 2 lakh and ` 3 lakh respectively.
Also suppose that the trader had the following transactions during the accounting
period.

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(a) Introduced capital ` 20,000.

(b) Earned income from investment ` 8,000.
(c) A liability of ` 31,000 was finally settled on payment of ` 30,000.
Balance sheets of the trader after each transaction are shown below:

Assets Liabilities Equity

Transactions – =
` lakh ` lakh ` lakh
Opening 5.00 – 2.00 = 3.00
(a) Capital introduced 5.20 – 2.00 = 3.20
(b) Income from investments 5.28 – 2.00 = 3.28
(c) Settlement of liability 4.98 – 1.69 = 3.29
The example given above explains the definition of income. The equity increased by
` 29,000 during the accounting period, due to (i) Capital introduction ` 20,000 and
(ii) Income earned ` 9,000 (Income from investment + Discount earned). Incomes
therefore result in increase in equity without introduction of capital.
Also note that income earned is accompanied by either increase of asset (Cash
received as investment income) or by decrease of liability (Discount earned).
5. Expense: An expense is decrease in economic benefits during the accounting
period in the form of outflows or depletions of assets or incurrence of liabilities
that result in decrease in equity other than those relating to distributions to equity
participants. The definition of expenses encompasses expenses that arise in the
ordinary course of activities of the enterprise, e.g. wages paid. Losses may or may
not arise in the ordinary course of activity of the enterprise, e.g. loss on disposal of
Property, Plant and Equipment. Losses are separately shown in the statement of
profit and loss because this knowledge is useful in assessing performance of the
enterprise.
Expenses are always incurred simultaneously with either reduction of asset or
increase of liability. Thus, expenses are recognised when the corresponding
decrease of asset or increase of liability are recognised by application of the
recognition criteria stated above. Expenses are recognised in Profit & Loss A/c by
matching them with the revenue generated. However, application of matching
concept should not result in recognition of an item as asset (or liability), which does
not meet the definition of asset or liability as the case may be.

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Where economic benefits are expected to arise over several accounting periods,
expenses are recognised in the profit and loss statement on the basis of systematic
and rational allocation procedures. The obvious example is that of depreciation.
An expense is recognised immediately in the profit and loss statement when it does
not meet or ceases to meet the definition of asset or when no future economic
benefit is expected. An expense is also recognised in the profit and loss statement
when a liability is incurred without recognition of an asset, as is the case when a
liability under a product warranty arises.
Example 4
Continuing with the example 3 given earlier, suppose the trader had the following
further transactions during the period:
(a) Wages paid ` 2,000.
(b) Rent outstanding ` 1,000.
(c) Drawings ` 4,000.
Balance sheets of the trader after each transaction are shown below:

Assets Liabilities Equity

Transactions – =
` lakh ` lakh ` lakh
Opening 5.00 – 2.00 = 3.00
(a) Capital introduced 5.20 – 2.00 = 3.20
(b) Income from investments 5.28 – 2.00 = 3.28
(c) Settlement of liability 4.98 – 1.69 = 3.29
(d) Wages paid 4.96 – 1.69 = 3.27
(e) Rent Outstanding 4.96 – 1.70 = 3.26
(f) Drawings 4.92 – 1.70 = 3.22

The example given above explains the definition of expense. The equity decreased by
` 7,000 from ` 3.29 lakh to ` 3.22 lakh due to (i) Drawings ` 4,000 and (ii) Expenses
incurred ` 3,000 (Wages paid + Rent).
Expenses therefore result in decrease of equity without drawings. Also note that
expenses incurred is accompanied by either decrease of asset (Cash paid for wages)
or by increase in liability (Rent outstanding).
Note: The points discussed above leads us to the following relationships:
Closing equity (CE) = Closing Assets (CA) – Closing Liabilities (CL)

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 FRAMEWORK 2.19

Opening Equity (OE) = Opening Assets (OA) – Opening Liabilities (OL)

Capital Introduced = C
Drawings = D
Income = I
Expenses = E
CE= OE + C + (I – E) – D
Or CE = OE + C + Profit – D
Or Profit = CE – OE – C + D
Or Profit = (CA – CL) – (OA – OL) – C + D
From above, one can clearly see that profit depends on values of assets and
liabilities. Since historical costs are mostly used for valuation, the reported profits
are mostly based on historical cost conventions. The framework recognises other
methods of valuation of assets and liabilities. The point to note is that reported
figures of profit change with the changes in the valuation basis. Conceptually, this
is the foundation of idea of Capital Maintenance.

10. MEASUREMENT OF ELEMENTS OF FINANCIAL

STATEMENTS
Measurement is the process of determining money value at which an element can
be recognised in the balance sheet or statement of profit and loss. The framework
recognises four alternative measurement bases. These bases relate explicitly to the
valuation of assets and liabilities. The valuation of income or expenses, i.e. profit is
implied, by the value of change in assets and liabilities.

Historical
Cost

Present Measurement Current

Value
bases Cost

Realisable
Value

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 2.20 ACCOUNTING

In preparation of financial statements, all or any of the measurement basis can be

used in varying combinations to assign money values to items, subject to the
requirements under the Accounting Standards. However, it may be noted, that
Accounting Standards largely uses the ‘historical cost’ for the purpose of
preparation of financial statements though for some items, use of other value is
permitted, e.g., inventory is recorded at historical costs on its acquisition, however,
at year end, it is valued at lower of costs and net realisable value.
A brief explanation of each measurement basis is as follows:
1. Historical Cost: Historical cost means acquisition price. For example, the
businessman paid ` 7,00,000 to purchase the machine, its acquisition price
including installation charges is ` 8,00,000. The historical cost of machine would be
` 8,00,000.
According to this, assets are recorded at an amount of cash or cash equivalent paid
or the fair value of the asset at the time of acquisition. Liabilities are recorded at
the amount of proceeds received in exchange for the obligation. In certain
circumstances a liability is recorded at the amount of cash or cash equivalent
expected to be paid to satisfy the obligation in the normal course of business.
When Mr. X, a businessman, takes ` 5,00,000 loan from a bank @ 10% interest p.a.,
it is to be recorded at the amount of proceeds received in exchange for the
obligation. Here the obligation is the repayment of loan as well as payment of
interest at an agreed rate i.e. 10%. Proceeds received are ` 5,00,000 - it is the
historical cost of the transaction. Take another case regarding payment of income
tax liability. You know that every individual has to pay income tax on his income if
it exceeds certain minimum limit. But the income tax liability is not settled
immediately when one earns his income. The income tax authority settles it
sometime later, which is technically called assessment year. Then how does he
record this liability? As per historical cost basis, it is to be recorded at an amount
expected to be paid to discharge the liability.
Example 5
Mr. X purchased a machine on 1st January, 20X1 at ` 7,00,000. As per historical cost
basis, he has to record it at ` 7,00,000 i.e. the acquisition price. As on 1.1.20X6, Mr. X
found that it would cost ` 25,00,000 to purchase that machine. Mr. X also took loan
from a bank as on 20X1 for ` 5,00,000 @ 18% p.a. repayable at the end of 15 th year
together with interest.

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 FRAMEWORK 2.21

As per historical cost, the liability is recorded at` 5,00,000 at the amount of proceeds
received in exchange for obligation and asset is recorded at ` 7,00,000.
2. Current Cost: Current cost gives an alternative measurement basis. Assets
are carried at the amount of cash or cash equivalent that would have to be paid if
the same or an equivalent asset was acquired currently. Liabilities are carried at the
undiscounted amount of cash or cash equivalents that would be required to settle
the obligation currently.
Example 6
A machine was acquired for $ 10,000 on deferred payment basis. The rate of
exchange on the date of acquisition was ` 49 per $. The payments are to be made in
5 equal annual instalments together with 10% interest per year. The current market
value of similar machine in India is ` 5 lakhs.
Current cost of the machine = Current market price = ` 5,00,000.
By historical cost convention, the machine would have been recorded at ` 4,90,000.
To settle the deferred payment on current date one must buy dollars at ` 49/$. The
liability is therefore recognised at ` 4,90,000 ($ 10,000 × ` 49). Note that the amount
of liability recognised is not the present value of future payments. This is because, in
current cost convention, liabilities are recognised at undiscounted amount.
3. Realisable (Settlement) Value: For assets, this is the amount of cash or cash
equivalents currently realisable on sale of the asset in an orderly disposal. For
liabilities, this is the undiscounted amount of cash or cash equivalents expected to
be paid on settlement of liability in the normal course of business.
4. Present Value: Assets are carried at the present value of the future net cash
inflows that the item is expected to generate in the normal course of business.
Liabilities are carried at the present value of the future net cash outflows that are
expected to be required to settle the liabilities in the normal course of business.
Present value (P) is an amount, one has to invest on current date to have an amount
(A) after n years. If the rate of interest is R then,
A = P(1 + R)n
A 1
Or P (Present value of A after n years) = n
= A× n
(1+R ) (1+R )
The process of obtaining present value of future cash flow is called discounting.

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 2.22 ACCOUNTING

The rate of interest used for discounting is called the discounting rate. The
expression [1/(1+R)n], called discounting factor which depends on values of R and
n.
Let us take a numerical example assuming interest 10%, A = ` 11,000 and n = 1 year
11,000 = 10,000(1 + 0.1)1
11,000 1
Or Present value of ` 11,000 after 1 year = 1
=11,000×
(1.10 ) (1.10 )1
Or Present value of ` 11,000 after 1 year = 11,000 × 0.909 = ` 10,000
Note that a receipt of ` 10,000 (present value) now is equivalent of a receipt of
` 11,000 (future cash inflow) after 1 year, because if one gets ` 10,000 now he can
invest to collect ` 11,000 after 1 year. Likewise, a payment of ` 10,000 (present value)
now is equivalent of paying of ` 11,000 (future cash outflow) after 1 year.
Thus if an asset generates ` 11,000 after 1 year, it is actually contributing ` 10,000
at the current date if the rate of earning required is 10%. In other words, the value of
the asset is ` 10, 000. which is the present value of net future cash inflow it generates.
If an asset generates ` 11,000 after 1 year, and ` 12,100 after two years, it is actually
contributing ` 20,000 (approx.) at the current date if the rate of earning required is
10% (` 11,000 × 0.909 + ` 12,100 × 0.826). In other words the value of the asset is
` 20,000(approx.), i.e. the present value of net future cash inflow it generates.
Under present value convention, assets are carried at present value of future net cash
flows generated by the concerned assets in the normal course of business. Liabilities
under this convention are carried at present value of future net cash flows that are
expected to be required to settle the liability in the normal course of business.
Illustration 2
Carrying amount of a machine is ` 40,000 (Historical cost less depreciation). The
machine is expected to generate ` 10,000 net cash inflow. The net realisable value
(or net selling price) of the machine on current date is ` 35,000. The enterprise’s
required earning rate is 10% per year.
The enterprise can either use the machine to earn ` 10,000 for 5 years. This is
equivalent of receiving present value of ` 10,000 for 5 years at discounting rate 10%
on current date. The value realised by use of the asset is called value in use. The value
in use is the value of asset by present value convention.
Value in use = ` 10,000 (0.909 + 0.826 + 0.751 + 0.683 + 0.621) = ` 37,900

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 FRAMEWORK 2.23

Net selling price = ` 35,000

The present value of the asset is ` 37,900, which is called its recoverable value. It is
obviously not appropriate to carry any asset at a value higher than its recoverable
value. Thus the asset is currently overstated by ` 2,100 (` 40,000 – ` 37,900).

11. CAPITAL MAINTENANCE

Capital refers to net assets of a business. Since a business uses its assets for its
operations, a fall in net assets will usually mean a fall in its activity level. It is
therefore important for any business to maintain its net assets in such a way, as to
ensure continued operations at least at the same level year after year. In other
words, dividends should not exceed profit after appropriate provisions for
replacement of assets consumed in operations. For this reason, the Companies Act
does not permit distribution of dividend without providing for depreciation on
Property, Plant and Equipment. Unfortunately, this may not be enough in case of
rising prices. The point is explained below:
We have already observed: P = (CA – CL) – (OA – OL) – C + D
Where: Profit = P
Opening Assets = OA and Opening Liabilities = OL
Closing Assets = CA and Closing Liabilities = CL
Introduction of capital = C and Drawings / Dividends = D
Retained Profit = P – D = (CA – CL) – (OA – OL) – C
A business should ensure that Retained Profit (RP) is not negative, i.e. closing equity
should not be less than capital to be maintained, which is sum of opening equity
and capital introduced.
It should be clear from above that the value of retained profit depends on the
valuation of assets and liabilities. In order to check maintenance of capital, i.e.
whether or not retained profit is negative, we can use any of following three bases:
Financial capital maintenance at historical cost: Under this convention, opening
and closing assets are stated at respective historical costs to ascertain opening and
closing equity. If retained profit is greater than or equals to zero, the capital is said
to be maintained at historical costs. This means the business will have enough funds
to replace its assets at historical costs. This is quite right as long as prices do not
rise.

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 2.24 ACCOUNTING

Illustration 3
A trader commenced business on 01/01/20X1 with ` 12,000 represented by 6,000
units of a certain product at ` 2 per unit. During the year 20X1 he sold these units at
` 3 per unit and had withdrawn ` 6,000. Thus:
Opening Equity = ` 12,000 represented by 6,000 units at ` 2 per unit.
Closing Equity = ` 12,000 (` 18,000 – ` 6,000) represented entirely by cash.
Retained Profit = ` 12,000 – ` 12,000 = Nil

The trader can start year 20X2 by purchasing 6,000 units at ` 2 per unit once again
for selling them at ` 3 per unit. The whole process can repeat endlessly if there is no
change in purchase price of the product.
Financial capital maintenance at current purchasing power: Under this
convention, opening and closing equity at historical costs are restated at closing
prices using average price indices. (For example, suppose opening equity at historical
cost is ` 3,00,000 and opening price index is 100. The opening equity at closing prices
is ` 3,60,000 if closing price index is 120). A positive retained profit by this method
means the business has enough funds to replace its assets at average closing price.
This may not serve the purpose because prices of all assets do not change at
average rate in real situations. For example, price of a machine can increase by 30%
while the average increase is 20%.
Illustration 4
In the previous illustration (Illustration 3), suppose that the average price indices at
the beginning and at the end of year are 100 and 120 respectively.
Opening Equity = ` 12,000 represented by 6,000 units at ` 2 per unit.
Opening equity at closing price = (` 12,000 / 100) x 120 = ` 14,400 (6,000 x ` 2.40)
Closing Equity at closing price
= ` 12,000 (` 18,000 – ` 6,000) represented entirely by cash.
Retained Profit = ` 12,000 – ` 14,400 = (–) ` 2,400
The negative retained profit indicates that the trader has failed to maintain his
capital. The available fund of ` 12,000 is not sufficient to buy 6,000 units again at

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 FRAMEWORK 2.25

increased price ` 2.40 per unit. In fact, he should have restricted his drawings to
` 3,600 (` 6,000 – ` 2,400).
Had the trader withdrawn ` 3,600 instead of ` 6,000, he would have left with ` 14,400,
the fund required to buy 6,000 units at ` 2.40 per unit.
Physical capital maintenance at current costs: Under this convention, the
historical costs of opening and closing assets are restated at closing prices using
specific price indices applicable to each asset. The liabilities are also restated at a
value of economic resources to be sacrificed to settle the obligation at current date,
i.e. closing date. The opening and closing equity at closing current costs are
obtained as an excess of aggregate of current cost values of assets over aggregate
of current cost values of liabilities. A positive retained profit by this method ensures
retention of funds for replacement of each asset at respective closing prices.
Illustration 5
A trader commenced business on 01/01/20X1 with ` 12,000 represented by 6,000
units of a certain product at` 2 per unit. During the year 20X1 he sold these units at
` 3 per unit and had withdrawn ` 6,000. Let us assume that the price of the product
at the end of year is ` 2.50 per unit. In other words, the specific price index applicable
to the product is 125.
Current cost of opening stock = (` 12,000 / 100) x 125 = 6,000 x ` 2.50 = ` 15,000
Current cost of closing cash = ` 12,000 (` 18,000 – ` 6,000)

Opening equity at closing current costs = ` 15,000

Closing equity at closing current costs = ` 12,000
Retained Profit = ` 12,000 – ` 15,000 = (-) ` 3,000

The negative retained profit indicates that the trader has failed to maintain his
capital. The available fund of` 12,000 is not sufficient to buy 6,000 units again at
increased price of ` 2.50 per unit. The drawings should have been restricted to ` 3,000
(` 6,000 – ` 3,000). Had the trader withdrawn ` 3,000 instead of ` 6,000, he would
have left with `15,000, the fund required to buy 6,000 units at ` 2.50 per unit.
You are required to compute the Capital maintenance under all three bases ie. (i)
Historical costs, (ii) Current purchasing power and (iii) Physical capital maintenance.

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 2.26 ACCOUNTING

Solution
Financial Capital Maintenance at historical costs

` `

Closing capital (At historical cost) 12,000

Less: Capital to be maintained

Opening capital (At historical cost) 12,000

Introduction (At historical cost) Nil (12,000)

Retained profit Nil

Financial Capital Maintenance at current purchasing power

` `
Closing capital (At closing price) 12,000

Less: Capital to be maintained

Opening capital (At closing price) 14,400

Introduction (At closing price) Nil (14,400)

Retained profit/(loss) (2,400)

Physical Capital Maintenance

` `
Closing capital (At current cost) ( 4,800 units) 12,000

Less: Capital to be maintained

Opening capital (At current cost) (6,000 units) 15,000

Introduction (At current cost) Nil (15,000)

Loss resulting in non-maintenance of capital (3,000)

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 FRAMEWORK 2.27

SUMMARY
• Components of Financial Statements
Balance sheet Portrays value of economics resources
controlled by an enterprise
Statement of Profit and Presents the results of operations of an
loss enterprise
Cash flow statement Shows the way an enterprise generates cash and
uses it
Notes, other statements Presents supplementary information explaining
and other explanatory different items
materials

• Users of Financial Statements

Investors Analysis of performance, profitability, financial
position of company
Employees Knowledge of stability, continuity, growth
Suppliers, creditors Determination of credit worthiness
Customers Analysis of stability, profitability
Government Evaluation of entity’s performance and contribution
to social objectives
Lenders Determine whether their loans, and the interest
attaching to them, will be paid when due
Public Determine contribution to the local economy and
public at large

• Fundamental Accounting Assumptions

Accrual Transactions are recognised as and when they occur,
without considering receipt /payment of cash.
Going concern Enterprise will continue in operation in foreseeable
future and will not liquidate.
Consistency Using same accounting policies for similar
transactions in all accounting periods

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 2.28 ACCOUNTING

• Qualitative Characteristics of Financial Statements

Understandability Information presented in financial statements should
be readily understandable by the users with
reasonable knowledge of business and economic
activities.
Relevance Financial statements should contain relevant
information only. Information, which is likely to
influence the economic decisions of the users is called
relevant.
Reliability Information must be reliable; that is to say, they must
be free from material error and bias.
Comparability Financial statements should provide both inter-firm
and intra-firm comparison.

• Elements of Financial Statements

Asset Resource controlled by the enterprise as a result of
past events from which future economic benefits are
expected to flow to the enterprise
Liability Present obligation of the enterprise arising from past
events, the settlement of which is expected to result
in an outflow of a resource embodying economic
benefits.
Equity Residual interest in the assets of an enterprise after
deducting all its liabilities
Income/gain Increase in economic benefits during the accounting
period in the form of inflows or enhancement of assets
or decreases in liabilities that result in increase in
equity other than those relating to contributions from
equity participants
Expense/loss Decrease in economic benefits during the accounting
period in the form of outflows or depletions of assets
or incurrence of liabilities that result in decrease in
equity other than those relating to distributions to
equity participants

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 FRAMEWORK 2.29

• Measurement of Elements in Financial Statements

Historical cost Acquisition price

Current Cost Assets are carried at the amount of cash or cash
equivalent that would have to be paid if the same or
an equivalent asset is acquired currently. Liabilities are
carried at the undiscounted amount of cash or cash
equivalents that would be required to settle the
obligation currently.
Realisable For assets, amount currently realisable on sale of the
(Settlement) Value asset in an orderly disposal. For liabilities, this is the
undiscounted amount expected to be paid on
settlement of liability in the normal course of
business.
Present Value Assets are carried at present value of future net cash
flows generated by the concerned assets in the
normal course of business. Liabilities are carried at
present value of future net cash flows that are
expected to be required to settle the liability in the
normal course of business.

• Financial Capital Maintenance

At historical cost Opening and closing assets are stated at historical

costs
At current purchasing Restatement at closing prices using average price
power indices
Physical capital Restatement at closing prices using specific price
maintenance indices

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 2.30 ACCOUNTING

TEST YOUR KNOWLEDGE

MCQs
1. The 'going concern' concept assumes that
(a) The business can continue in operational existence for the foreseeable
future.
(b) The business cannot continue in operational existence for the
foreseeable future.
(c) The business is continuing to be profitable.
2. Two principal qualitative characteristics of financial statements are
(a) Understandability and materiality
(b) Relevance and reliability
(c) Relevance and materiality
3. All of the following are components of financial statements except
(a) Balance sheet
(b) Statement of Profit and loss
(c) Human responsibility report
4. An accounting policy can be changed if the change is required
(a) By statute or accounting standard
(b) For more appropriate presentation of financial statements
(c) Both (a) and (b)
5. Value of equity may change due to
(a) Contribution from or Distribution to equity participants
(b) Income earned/expenses incurred
(c) Both (a) and (b)
6. An item that meets the definition of an element of financial statements should
be recognised in the financial statements if:
(a) It is probable that any future economic benefit associated with the item
will flow to the enterprise

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 FRAMEWORK 2.31

(b) Item has a cost or value that can be measured with reliability
(c) Both (a) and (b)
7. A machine was acquired in exchange of an old machine and ` 20,000 paid in
cash. The carrying amount of old machine was ` 2,00,000 whereas its fair value
was ` 1,50,000 on the date of exchange. The historical cost of the new
machine will be taken as
(a) ` 2,00,000
(b) ` 1,70,000
(c) ` 2,20,000
8. Which of the assumption is not considered as fundamental accounting
assumption?
(a) Going Concern
(b) Accrual
(c) Reliability.
9. Liabilities are recorded at the undiscounted amount of cash expected to be
paid on settlement of liability in the normal course of business under:
(a) Present value.
(b) Realizable value.
(c) Current cost.
Theoretical Questions
Question 1
What are the qualitative characteristics of the financial statements which improve
the usefulness of the information furnished therein?
Question 2
“One of the characteristics of financial statements is neutrality”- Do you agree with
this statement?
Practical Questions
Question 1
Mohan started a business on 1st April 20X1 with ` 12,00,000 represented by 60,000

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 2.32 ACCOUNTING

units of ` 20 each. During the financial year ending on 31st March, 20X2, he sold
the entire stock for ` 30 each. In order to maintain the capital intact, calculate the
maximum amount, which can be withdrawn by Mohan in the year 20X1-X2 if
Financial Capital is maintained at historical cost.
Question 2
Opening Balance Sheet of Mr. A is showing the aggregate value of assets, liabilities
and equity ` 8 lakh, ` 3 lakh and ` 5 lakh respectively. During accounting period,
Mr. A has the following transactions:
(1) Earned 10% dividend on 2,000 equity shares held of ` 100 each
(2) Paid ` 50,000 to creditors for settlement of ` 70,000
(3) Rent of the premises is outstanding ` 10,000
(4) Mr. A withdrew ` 9,000 for his personal use.
You are required to show the effect of above transactions on Balance Sheet in the
form of Assets - Liabilities = Equity after each transaction.
Question 3
Balance Sheet of Anurag Trading Co. on 31st March, 20X1 is given below:

Liabilities Amount (`) Assets Amount (`)

Capital 50,000 Property, Plant and Equipment 69,000
Profit and Loss A/c 22,000 Stock in Trade 36,000
10% Loan 43,000 Trade Receivables 10,000
Trade Payables 18,000 Deferred Expenditure 15,000
Bank 3,000
1,33,000 1,33,000

Additional Information:
(i) Remaining life of Property, Plant and Equipment is 5 years with even use. The
net realisable value of Property, Plant and Equipment as on 31st March, 20X2
was ` 64,000.
(ii) Firm’s sales and purchases for the year 20X1-X2 amounted to ` 5 lacs and
` 4.50 lacs respectively.

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 FRAMEWORK 2.33

(iii) The cost and net realisable value of the stock were ` 34,000 and ` 38,000
respectively.

(iv) General Expenses for the year 20X1-X2 were `16,500.

(v) Deferred Expenditure is normally amortised equally over 4 years starting from
F.Y. 20X0-X1 i.e. `5,000 per year.

(vi) Out of trade receivables worth `10,000, collection of `4,000 depends on

successful re-design of certain product already supplied to the customer.

(vii) Closing trade payable is `10,000, which is likely to be settled at 95%.

(viii) There is pre-payment penalty of `2,000 for Bank loan outstanding.

Prepare Profit & loss Account for the year ended 31st March, 20X2 by assuming it
is not a Going Concern.

ANSWERS/HINTS
MCQs
1. (a), 2. (b), 3. (c), 4. (c), 5. (c), 6. (c),
7. (b), 8. (c), 9. (b)

Theoretical Questions
Answer 1

The qualitative characteristics are attributes that improve the usefulness of

information provided in financial statements. Understandability; Relevance;
Reliability; Comparability are the qualitative characteristics of financial statements.
For details, refer para 7 of the chapter.

Answer 2

Yes, one of the characteristics of financial statements is neutrality. To be reliable,

the information contained in financial statement must be neutral, that is free from
bias. Financial Statements are not neutral if by the selection or presentation of
information, the focus of analysis could shift from one area of business to another
thereby arriving at a totally different conclusion on the business results.

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Practical Questions
Answer 1

Particulars Financial Capital Maintenance

at Historical Cost (`)
Closing equity
18,00,000 represented by cash
(` 30 x 60,000 units)
Opening equity 60,000 units x ` 20 = 12,00,000
Permissible drawings to keep Capital intact 6,00,000 (18,00,000 – 12,00,000)
Answer 2
Effects of each transaction on Balance sheet of the trader is shown below:
Assets Liabilities Equity
Transactions – =
` lakh ` lakh ` lakh
Opening 8.00 – 3.00 = 5.00
(1) Dividend earned 8.20 – 3.00 = 5.20
(2) Settlement of Creditors 7.70 - 2.30 = 5.40
(3) Rent Outstanding 7.70 – 2.40 = 5.30
(4) Drawings 7.61 – 2.40 = 5.21
Answer 3
Profit and Loss Account of Anurag Trading Co. for the year ended
31st March, 20X2
(Assuming business is not a going concern)
` `
To Opening Stock 36,000 By Sales 5,00,000
To Purchases 4,50,000 By Trade payables 500
To General expenses 16,500 By Closing Stock 38,000
To Depreciation (69,000-64,000) 5,000
To Provision for doubtful debts 4,000
To Deferred expenditure 15,000
To Loan penalty 2,000
To Net Profit (b.f.) 10,000
5,38,500 5,38,500

© The Institute of Chartered Accountants of India

 1.1

CHAPTER 3

OVERVIEW OF ACCOUNTING
STANDARDS

UNIT 1: APPLICABILITY OF ACCOUNTING

STANDARDS

LEARNING OUTCOMES
 After studying this unit, you will be able to–
 Comprehend the status of Accounting Standards;
 Understand the applicability of Accounting Standards.

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 3.2 ACCOUNTING

Applicability
Applicability of AS
of AS for Non-
Status of AS for Corporate
Corporate
Entities
Entities

1.1 STATUS OF ACCOUNTING STANDARDS

It has already been mentioned in chapter 1 that the standards are developed by
the Accounting Standards Board (ASB) of the Institute of Chartered Accountants of
India and are issued under the authority of its Council which are approved by the
MCA (Ministry of Corporate Affairs) for Corporate entities. The standards cannot
override laws and local regulations. The Accounting Standards are nevertheless
made mandatory from the dates notified by the MCA and are generally applicable
to all enterprises, subject to certain exceptions as stated below. The implication of
mandatory status of an Accounting Standard depends on whether the statute
governing the enterprise concerned requires compliance with the Standard, e.g.,
the Ministry of Corporate Affairs have notified Accounting Standards for companies
incorporated under the Companies Act, 1956 (or the Companies Act, 2013).
In assessing whether an accounting standard is applicable, one must find correct
answer to the following three questions.
(a) Does it apply to the enterprise concerned? If yes, the next question is:
(b) Does it apply to the financial statement concerned? If yes, the next question
is:
(c) Does it apply to the financial item concerned?
The preface to the statements of accounting standards answers the above
questions.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.3

Enterprises to which the accounting standards apply?

Accounting Standards apply in respect of any enterprise (whether organised in
corporate, co-operative or other forms) engaged in commercial, industrial or
business activities, whether or not profit oriented and even if established for
charitable or religious purposes. Accounting Standards, however, do not apply to
enterprises solely carrying on the activities, which are not of commercial, industrial
or business nature, (e.g., an activity of collecting donations and giving them to
flood affected people). Exclusion of an enterprise from the applicability of the
Accounting Standards would be permissible only if no part of the activity of such
enterprise is commercial, industrial or business in nature. Even if a very small
proportion of the activities of an enterprise were considered to be commercial,
industrial or business in nature, the Accounting Standards would apply to all its
activities including those, which are not commercial, industrial or business in
nature.
Implication of mandatory status
Where the statute governing the enterprise does not require compliance with the
accounting standards, e.g. a partnership firm, the mandatory status of an
accounting standard implies that, in discharging their attest functions, the
members of the Institute are required to examine whether the financial statements
are prepared in compliance with the applicable accounting standards. In the event
of any deviation from the accounting standards, they have the duty to make
adequate disclosures in their reports so that the users of financial statements may
be aware of such deviations. It should nevertheless be noted that responsibility for
the preparation of financial statements and for making adequate disclosure is that
of the management of the enterprise. The auditor’s responsibility is to form his
opinion and report on such financial statements.
Section 129 (1) of the Companies Act, 2013 requires companies to present their
financial statements in accordance with the accounting standards notified under
Section 133 of the Companies Act, 2013 (refer Note below). Also, the auditor is
required by Section 143(3)(e) to report whether, in his opinion, the financial
statements of the company audited, comply with the accounting standards referred
to in Section 133 of the Companies Act, 2013. Where the financial statements of a
company do not comply with the accounting standards, the company should
disclose in its financial statements, the deviation from the accounting standards,
the reasons for such deviation and the financial effects, if any, arising out of such
deviations as per Section 129(5) of the Companies Act, 2013. Provided also that the

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financial statements should not be treated as not disclosing a true and fair view of
the state of affairs of the company, merely by reason of the fact that they do not
disclose—

(a) in the case of an insurance company, any matters which are not required to
be disclosed by the Insurance Act, 1938, or the Insurance Regulatory and
Development Authority Act, 1999;
(b) in the case of a banking company, any matters which are not required to be
disclosed by the Banking Regulation Act, 1949;
(c) in the case of a company engaged in the generation or supply of electricity, any
matters which are not required to be disclosed by the Electricity Act, 2003;
(d) in the case of a company governed by any other law for the time being in
force, any matters which are not required to be disclosed by that law.
Note: As per the Companies Act, 2013, the Central Government may prescribe
standards of accounting or addendum thereto, as recommended by the Institute of
Chartered Accountants of India, in consultation with the National Financial
Reporting Authority (NFRA).
Financial items to which the accounting standards apply
The Accounting Standards are intended to apply only to items, which are material.
An item is considered material, if its omission or misstatement is likely to affect
economic decision of the user. Materiality is not necessarily a function of size; it is
the information content i.e. the financial item which is important. A penalty of
` 50,000 paid for breach of law by a company can seem to be a relatively small
amount for a company incurring crores of rupees in a year, yet is a material item
because of the information it conveys. The materiality should, therefore, be judged
on a case-to-case basis. If an item is material, it should be shown separately instead
of clubbing it with other items. For example, it is not appropriate to club the
penalties paid with legal charges.
Accounting Standards and Income Tax Act, 1961
Accounting standards intend to reduce diversity in application of accounting
principles. They improve comparability of financial statements and promote
transparency and fairness in their presentation. Deductions and exemptions
allowed in computation of taxable income on the other hand, is a matter of fiscal
policy of the government.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.5

Thus, an expense required to be taken to the Statement of profit and loss by an

accounting standard does not imply that the same is always deductible for income
tax purposes. For example, depreciation on assets taken on finance lease is charged
in the books of lessee as per AS 19 but depreciation for tax purposes is allowed to
lessor, being legal owner of the asset, rather than to lessee. Likewise, recognition
of revenue in the financial statements cannot be avoided simply because it is
exempted under Section 10 of the Income Tax Act, 1961.
Income Computation and Disclosure Standards
Section 145(2) of the Income Tax Act, 1961, empowers the Central Government to
notify in the Official Gazette from time to time, Income Computation and Disclosure
Standards to be followed by any class of assesses or in respect of any class of
income. Accordingly, the Central Government has, in exercise of the powers
conferred under Section 145(2) of the Income Tax Act, 1961, notified ten Income
Computation and Disclosure Standards (ICDSs) to be followed by all assesses (other
than an individual or a Hindu undivided family who is not required to get his
accounts of the previous year audited in accordance with the provisions of Section
44AB of the Income Tax Act, 1961) following the mercantile system of accounting,
for the purposes of computation of income chargeable to income-tax under the
head “Profit and gains of business or profession” or “ Income from other sources”,
from the Assessment Year (A.Y.) 2017-18. The ten notified ICDSs are:
ICDS I : Accounting Policies
ICDS II : Valuation of Inventories
ICDS III : Construction Contracts
ICDS IV : Revenue Recognition
ICDS V : Tangible Fixed Assets
ICDS VI : The Effects of Changes in Foreign Exchange Rates
ICDS VII : Government Grants
ICDS VIII : Securities
ICDS IX : Borrowing Costs
ICDS X : Provisions, Contingent Liabilities and Contingent Assets

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1.2 APPLICABILITY OF ACCOUNTING STANDARDS

For the purpose of compliance of the accounting Standards, the ICAI has issued an
announcement on ‘Criteria for Classification of Entities and Applicability of
Accounting Standards’. As per the announcement, entities are classified into four
levels. Level IV, Level III and Level II entities as per the said Announcement were
referred to as Micro, Small and Medium Entities (MSMEs).
However, when the accounting standards were notified by the Central Government
in consultation with the National Advisory Committee on Accounting Standards∗,
the Central Government also issued the ‘Criteria for Classification of Entities and
Applicability of Accounting Standards’for the companies.
According to the‘Criteria for Classification of Entities and Applicability of
Accounting Standards’as issued by the Government, there are two levels, namely,
Small and Medium-sized Companies (SMCs) as defined in the Companies
(Accounting Standards) Rules, 2021 and companies other than SMCs (Non-SMCs).
Non-SMCs are required to comply with all the Accounting Standards in their
entirety, while certain exemptions/ relaxations have been given to SMCs.
“Criteria for Classification of Entities and Applicability of Accounting Standards” for
corporate entities and non-corporate entities have been explained in the coming
paragraphs.

∗
The Companies Act, 1956 is being replaced by the Companies Act 2013 in a phased manner.
Now, as per Section 133 of the Companies Act, 2013, the Central Government may prescribe
the standards of accounting or any addendum thereto, as recommended by the Institute of
Chartered Accountants of India, constituted under section 3 of the Chartered Accountants
Act, 1949, in consultation with and after examination of the recommendations made by the
National Financial Reporting Authority (NFRA). Section 132 of the Companies Act, 2013 deals
with constitution of NFRA.
However, the Ministry of Corporate Affairs has, vide clarification dated 13th September, 2013,
announced that the existing Accounting Standards notified under the Companies Act, 1956
shall continue to apply till the Standards of Accounting or any addendum thereto are
prescribed by Central Government in consultation and recommendation of the National
Financial Reporting Authority.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.7

1.2.1. Criteria for classification of Non-company entities for

applicability of Accounting Standards
The Council of the ICAI, at its 400th meeting, held on March 18-19, 2021,
considered the matter relating to applicability of Accounting Standards issued by
the ICAI, to Non-company entities (Enterprises). The scheme for applicability of
Accounting Standards to Non-company entities shall come into effect in respect of
accounting periods commencing on or after 1 April 2020.
1. For the purpose of applicability of Accounting Standards, Non-company
entities are classified into four categories, viz., Level I, Level II, Level III and
Level IV.
Level I entities are large size entities, Level II entities are medium size entities,
Level III entities are small size entities and Level IV entities are micro entities.
Level IV, Level III and Level II entities are referred to as Micro, Small and
Medium size entities (MSMEs). The criteria for classification of Non-company
entities into different levels are given in Annexure 1.
The terms ‘Small and Medium Enterprise’ and ‘SME’ used in Accounting
Standards shall be read as ‘Micro, Small and Medium size entity’ and ‘MSME’
respectively.
2. Level I entities are required to comply in full with all the Accounting
Standards.
3. Certain exemptions/relaxations have been provided to Level II, Level III and
Level IV Non-company entities. Applicability of Accounting Standards and
exemptions/relaxations to such entities are given in Annexure 2.
4. This Announcement supersedes the earlier Announcement of the ICAI on
‘Harmonisation of various differences between the Accounting Standards
issued by the ICAI and the Accounting Standards notified by the Central
Government’ issued in February 2008, to the extent it prescribes the criteria
for classification of Non-company entities (Non-corporate entities) and
applicability of Accounting Standards to non-company entities, and the
Announcement ‘Revision in the criteria for classifying Level II non-
corporate entities’ issued in January 2013.
5. This Announcement is not relevant for Non-company entities who may be
required to follow Ind AS as per relevant regulatory requirements applicable
to such entities.

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Annexure 1
Criteria for classification of Non-company Entities as decided by the Institute
of Chartered Accountants of India
Level I Entities
Non-company entities which fall in any one or more of the following categories, at
the end of the relevant accounting period, are classified as Level I entities:
(i) Entities whose securities are listed or are in the process of listing on any stock
exchange, whether in India or outside India.
(ii) Banks (including co-operative banks), financial institutions or entities carrying
on insurance business.
(iii) All entities engaged in commercial, industrial or business activities, whose
turnover (excluding other income) exceeds rupees two-fifty crore in the
immediately preceding accounting year.
(iv) All entities engaged in commercial, industrial or business activities having
borrowings (including public deposits) in excess of rupees fifty crore at any
time during the immediately preceding accounting year.
(v) Holding and subsidiary entities of any one of the above.
Level II Entities
Non-company entities which are not Level I entities but fall in any one or more of
the following categories are classified as Level II entities:
(i) All entities engaged in commercial, industrial or business activities, whose
turnover (excluding other income) exceeds rupees fifty crore but does not
exceed rupees two-fifty crore in the immediately preceding accounting year.
(ii) All entities engaged in commercial, industrial or business activities having
borrowings (including public deposits) in excess of rupees ten crore but not
in excess of rupees fifty crore at any time during the immediately preceding
accounting year.
(iii) Holding and subsidiary entities of any one of the above.
Level III Entities
Non-company entities which are not covered under Level I and Level II but fall in
any one or more of the following categories are classified as Level III entities:

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 OVERVIEW OF ACCOUNTING STANDARDS 3.9

(i) All entities engaged in commercial, industrial or business activities, whose

turnover (excluding other income) exceeds rupees ten crore but does not
exceed rupees fifty crore in the immediately preceding accounting year.
(ii) All entities engaged in commercial, industrial or business activities having
borrowings (including public deposits) in excess of rupees two crore but does
not exceed rupees ten crore at any time during the immediately preceding
accounting year.
(iii) Holding and subsidiary entities of any one of the above.
Level IV Entities
Non-company entities which are not covered under Level I, Level II and Level III are
considered as Level IV entities.
Additional requirements
(1) An MSME which avails the exemptions or relaxations given to it shall disclose
(by way of a note to its financial statements) the fact that it is an MSME, the
Level of MSME and that it has complied with the Accounting Standards
insofar as they are applicable to entities falling in Level II or Level III or Level
IV, as the case may be.
(2) Where an entity, being covered in Level II or Level III or Level IV, had qualified
for any exemption or relaxation previously but no longer qualifies for the
relevant exemption or relaxation in the current accounting period, the
relevant standards or requirements become applicable from the current
period and the figures for the corresponding period of the previous
accounting period need not be revised merely by reason of its having ceased
to be covered in Level II or Level III or Level IV, as the case may be. The fact
that the entity was covered in Level II or Level III or Level IV, as the case may
be, in the previous period and it had availed of the exemptions or relaxations
available to that Level of entities shall be disclosed in the notes to the
financial statements. The fact that previous period figures have not been
revised shall also be disclosed in the notes to the financial statements.
(3) Where an entity has been covered in Level I and subsequently, ceases to be
so covered and gets covered in Level II or Level III or Level IV, the entity will
not qualify for exemption/relaxation available to that Level, until the entity
ceases to be covered in Level I for two consecutive years. Similar is the case
in respect of an entity, which has been covered in Level II or Level III and
subsequently, gets covered under Level III or Level IV.

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 3.10 ACCOUNTING

(4) If an entity covered in Level II or Level III or Level IV opts not to avail of the
exemptions or relaxations available to that Level of entities in respect of any
but not all of the Accounting Standards, it shall disclose the Standard(s) in
respect of which it has availed the exemption or relaxation.
(5) If an entity covered in Level II or Level III or Level IV opts not to avail any one
or more of the exemptions or relaxations available to that Level of entities, it
shall comply with the relevant requirements of the Accounting Standard.
(6) An entity covered in Level II or Level III or Level IV may opt for availing certain
exemptions or relaxations from compliance with the requirements prescribed
in an Accounting Standard:
Provided that such a partial exemption or relaxation and disclosure shall not
be permitted to mislead any person or public.
(7) In respect of Accounting Standard (AS) 15, Employee Benefits, exemptions/
relaxations are available to Level II and Level III entities, under two sub-
classifications, viz., (i) entities whose average number of persons employed
during the year is 50 or more, and (ii) entities whose average number of
persons employed during the year is less than 50. The requirements stated in
paragraphs (1) to (6) above, mutatis mutandis, apply to these sub-
classifications.
Annexure 2
Applicability of Accounting Standards to Non-company Entities
The Accounting Standards issued by the ICAI, as on April 1, 2020, and such
standards as issued from time-to-time are applicable to Non-company entities
subject to the relaxations and exemptions in the announcement. The Accounting
Standards issued by ICAI as on April 1, 2020, are:

AS 1 Disclosure of Accounting Policies

AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events Occurring After the Balance Sheet Date
AS 5 Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies
AS 7 Construction Contracts
AS 9 Revenue Recognition

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 OVERVIEW OF ACCOUNTING STANDARDS 3.11

AS 10 Property, Plant and Equipment

AS 11 The Effects of Changes in Foreign Exchange Rates
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments
AS 14 Accounting for Amalgamations
AS 15 Employee Benefits
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 18 Related Party Disclosures
AS 19 Leases
AS 20 Earnings Per Share
AS 21 Consolidated Financial Statements
AS 22 Accounting for Taxes on Income
AS 23 Accounting for Investments in Associates in Consolidated Financial
Statements
AS 24 Discontinuing Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interests in Joint Ventures
AS 28 Impairment of Assets
AS 29 Provisions, Contingent Liabilities and Contingent Assets
(1) Applicability of the Accounting Standards to Level 1 Non- company
entities.
Level I entities are required to comply in full with all the Accounting
Standards.
(2) Applicability of the Accounting Standards and exemptions/relaxations
for Level II, Level III and Level IV Non-company entities
(A) Accounting Standards applicable to Non-company entities

AS Level II Entities Level III Entities Level IV Entities

AS 1 Applicable Applicable Applicable
AS 2 Applicable Applicable Applicable

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 3.12 ACCOUNTING

AS 3 Not Applicable Not Applicable Not Applicable

AS 4 Applicable Applicable Applicable
AS 5 Applicable Applicable Applicable
AS 7 Applicable Applicable Applicable
AS 9 Applicable Applicable Applicable
AS 10 Applicable Applicable with Applicable with
disclosures disclosures
exemption exemption
AS 11 Applicable Applicable with Applicable with
disclosures disclosures
exemption exemption
AS 12 Applicable Applicable Applicable
AS 13 Applicable Applicable Applicable with
disclosures
exemption
AS 14 Applicable Applicable Not Applicable
(Refer note 2(C))
AS 15 Applicable with Applicable with Applicable with
exemptions exemptions exemptions
AS 16 Applicable Applicable Applicable
AS 17 Not Applicable Not Applicable Not Applicable
AS 18 Applicable Not Applicable Not Applicable
AS 19 Applicable with Applicable with Applicable with
disclosures disclosures disclosures
exemption exemption exemption
AS 20 Not Applicable Not Applicable Not Applicable
AS 21 Not Applicable Not Applicable Not Applicable
(Refer note 2(D)) (Refer note 2(D)) (Refer note 2(D))
AS 22 Applicable Applicable Applicable only
for current tax
related provisions
(Refer note
2(B)(vi))

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 OVERVIEW OF ACCOUNTING STANDARDS 3.13

AS 23 Not Applicable Not Applicable Not Applicable

(Refer note 2(D)) (Refer note 2(D)) (Refer note 2(D))
AS 24 Applicable Not Applicable Not Applicable
AS 25 Not Applicable Not Applicable Not Applicable
(Refer note 2(D)) (Refer note 2(D)) (Refer note 2(D))
AS 26 Applicable Applicable Applicable with
disclosures
exemption
AS 27 Not Applicable Not Applicable Not Applicable
(Refer notes 2(C) (Refer notes 2(C) and (Refer notes 2(C)
and 2(D)) 2(D)) and 2(D))
AS 28 Applicable with Applicable with Not Applicable
disclosures disclosures
exemption exemption
AS 29 Applicable with Applicable with Applicable with
disclosures disclosures disclosures
exemption exemption exemption

(B) Accounting Standards in respect of which relaxations/exemptions

from certain requirements have been given to Level II, Level III and
Level IV Non-company entities:
(i) Accounting Standard (AS) 10, Property, Plant and Equipments
Paragraph 87 relating to encouraged disclosures is not applicable
to Level III and Level IV Non-company entities.
(ii) AS 11, The Effects of Changes in Foreign Exchange Rates (revised
2018)
Paragraph 44 relating to encouraged disclosures is not applicable
to Level III and Level IV Non-company entities.
(iii) AS 13, Accounting for Investments
Paragraph 35(f) relating to disclosures is not applicable to Level IV
Non-company entities.
(iv) Accounting Standard (AS) 15, Employee Benefits (revised 2005)
(1) Level II and Level III Non-company entities whose average

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number of persons employed during the year is 50 or more are

exempted from the applicability of the following paragraphs:
(a) paragraphs 11 to 16 of the standard to the extent they
deal with recognition and measurement of short-term
accumulating compensated absences which are non-
vesting (i.e., short-term accumulating compensated
absences in respect of which employees are not
entitled to cash payment for unused entitlement on
leaving);
(b) paragraphs 46 and 139 of the Standard which deal
with discounting of amounts that fall due more than
12 months after the balance sheet date;
(c) recognition and measurement principles laid down in
paragraphs 50 to 116 and presentation and disclosure
requirements laid down in paragraphs 117 to 123 of
the Standard in respect of accounting for defined
benefit plans. However, such entities should
actuarially determine and provide for the accrued
liability in respect of defined benefit plans by using
the Projected Unit Credit Method and the discount
rate used should be determined by reference to
market yields at the balance sheet date on
government bonds as per paragraph 78 of the
Standard. Such entities should disclose actuarial
assumptions as per paragraph 120(l) of the Standard;
and
(d) recognition and measurement principles laid down in
paragraphs 129 to 131 of the Standard in respect of
accounting for other long-term employee benefits.
However, such entities should actuarially determine
and provide for the accrued liability in respect of other
long-term employee benefits by using the Projected
Unit Credit Method and the discount rate used should
be determined by reference to market yields at the
balance sheet date on government bonds as per
paragraph 78 of the Standard.

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(2) Level II and Level III Non-company entities whose average

number of persons employed during the year is less than 50
and Level IV Non-company entities irrespective of number of
employees are exempted from the applicability of the following
paragraphs:
(a) paragraphs 11 to 16 of the standard to the extent they
deal with recognition and measurement of short-term
accumulating compensated absences which are non-
vesting (i.e., short-term accumulating compensated
absences in respect of which employees are not
entitled to cash payment for unused entitlement on
leaving);
(b) paragraphs 46 and 139 of the Standard which deal
with discounting of amounts that fall due more than
12 months after the balance sheet date;
(c) recognition and measurement principles laid down in
paragraphs 50 to 116 and presentation and disclosure
requirements laid down in paragraphs 117 to 123 of
the Standard in respect of accounting for defined
benefit plans. However, such entities may calculate
and account for the accrued liability under the defined
benefit plans by reference to some other rational
method, e.g., a method based on the assumption that
such benefits are payable to all employees at the end
of the accounting year; and
(d) recognition and measurement principles laid down in
paragraphs 129 to 131 of the Standard in respect of
accounting for other long-term employee benefits.
Such entities may calculate and account for the
accrued liability under the other long-term employee
benefits by reference to some other rational method,
e.g., a method based on the assumption that such
benefits are payable to all employees at the end of the
accounting year.
(v) AS 19, Leases
(a) Paragraphs 22 (c),(e) and (f); 25 (a), (b) and (e); 37 (a) and (f);

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and 46 (b) and (d) relating to disclosures are not applicable to

Level II Non-company entities.
(b) Paragraphs 22 (c),(e) and (f); 25 (a), (b) and (e); 37 (a), (f) and (g);
and 46 (b), (d) and (e) relating to disclosures are not applicable
to Level III Non-company entities.
(c) Paragraphs 22 (c),(e) and (f); 25 (a), (b) and (e); 37 (a), (f) and (g);
38; and 46 (b), (d) and (e) relating to disclosures are not
applicable to Level IV Non-company entities.
(vi) AS 22, Accounting for Taxes on Income
(a) Level IV Non-company entities shall apply the requirements of
AS 22, Accounting for Taxes on Income, for Current tax defined
in paragraph 4.4 of AS 22, with recognition as per paragraph 9,
measurement as per paragraph 20 of AS 22, and presentation
and disclosure as per paragraphs 27-28 of AS 22.
(b) Transitional requirements
On the first occasion when a Non-company entity gets
classified as Level IV entity, the accumulated deferred tax
asset/liability appearing in the financial statements of
immediate previous accounting period, shall be adjusted
against the opening revenue reserves.
(vii) AS 26, Intangible Assets
Paragraphs 90(d)(iii); 90(d)(iv) and 98 relating to disclosures are not
applicable to Level IV Non-company entities.
(viii) AS 28, Impairment of Assets
(a) Level II and Level III Non-company entities are allowed to
measure the ‘value in use’ on the basis of reasonable estimate
thereof instead of computing the value in use by present value
technique. Consequently, if Level II or Level III Non-company
entity chooses to measure the ‘value in use’ by not using the
present value technique, the relevant provisions of AS 28, such
as discount rate etc., would not be applicable to such an entity.
Further, such an entity need not disclose the information
required by paragraph 121(g) of the Standard.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.17

(b) Also, paragraphs 121(c)(ii); 121(d)(i); 121(d)(ii) and 123 relating

to disclosures are not applicable to Level III Non-company
entities.
(ix) AS 29, Provisions, Contingent Liabilities and Contingent Assets
(revised 2016)
Paragraphs 66 and 67 relating to disclosures are not applicable to
Level II, Level III and Level IV Non-company entities.
(C) In case of Level IV Non-company entities, generally there are no such
transactions that are covered under AS 14, Accounting for
Amalgamations, or jointly controlled operations or jointly controlled
assets covered under AS 27, Financial Reporting of Interests in Joint
Ventures. Therefore, these standards are not applicable to Level IV Non-
company entities. However, if there are any such transactions, these
entities shall apply the requirements of the relevant standard.
(D) AS 21, Consolidated Financial Statements, AS 23, Accounting for
Investments in Associates in Consolidated Financial Statements, AS 27,
Financial Reporting of Interests in Joint Ventures (to the extent of
requirements relating to Consolidated Financial Statements), and AS 25,
Interim Financial Reporting, do not require a Non-company entity to
present consolidated financial statements and interim financial report,
respectively. Relevant AS is applicable only if a Non-company entity is
required or elects to prepare and present consolidated financial
statements or interim financial report.
Example 1
M/s Omega & Co. (a partnership firm), had a turnover of ` 1.25 crores (excluding
other income) and borrowings of ` 0.95 crores in the previous year. It wants to avail
the exemptions available in application of Accounting Standards to non-corporate
entities for the year ended 31.3.20X1. Advise the management of M/s Omega & Co
in respect of the exemptions of provisions of ASs, as per the directive issued by the
ICAI.
Solution
The question deals with the issue of Applicability of Accounting Standards to a non-
corporate entity. For availment of the exemptions, first of all, it has to be seen that
M/s Omega & Co. falls in which level of the non-corporate entities. Its classification
will be done on the basis of the classification of non-corporate entities as

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prescribed by the ICAI. According to the ICAI, non-corporate entities can be

classified under 4 levels viz Level I, Level II, Level III and Level IV entities.
Non-corporate entities which meet following criteria are classified as Level IV
entities:
(i) All entities engaged in commercial, industrial or business activities, whose
turnover (excluding other income) does not exceed rupees ten crores in the
immediately preceding accounting year.
(ii) All entities engaged in commercial, industrial or business activities having
borrowings (including public deposits) does not exceed rupees two crores at any
time during the immediately preceding accounting year.
(iii) Holding and subsidiary entities of any one of the above.
As the turnover of M/s Omega & Co. is less than ` 10 crores and borrowings less
than ` 2 crores, it falls under Level IV non-corporate entities. In this case, AS 3, AS
14, AS 17, AS 18, AS 20, AS 21, AS 23, AS 24, AS 25, AS 27 and AS 28 will not be
applicable to M/s Omega & Co. Relaxations from certain requirements in respect
of AS 10, AS 11, AS 13, AS 15, AS 19, AS 22, AS 26 and AS 29 are also available to
M/s Omega & Co.

1.2.2 Criteria for classification of Companies under the Companies

(Accounting Standards) Rules, 2021
Small and Medium-Sized Company (SMC) as defined in Clause 2(e) of the
Companies (Accounting Standards) Rules, 2021:
“Small and Medium Sized Company” (SMC) means, a company-
(i) whose equity or debt securities are not listed or are not in the process of
listing on any stock exchange, whether in India or outside India;
(ii) which is not a bank, financial institution or an insurance company;
(iii) whose turnover (excluding other income) does not exceed rupees two-fifty
crores in the immediately preceding accounting year;
(iv) which does not have borrowings (including public deposits) in excess of
rupees fifty crores at any time during the immediately preceding accounting
year; and
(v) which is not a holding or subsidiary company of a company which is not a
small and medium-sized company.

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Explanation: For the purposes of clause 2(e), a company should qualify as a Small
and Medium Sized Company, if the conditions mentioned therein are satisfied as
at the end of the relevant accounting period.
Non-SMCs
Companies not falling within the definition of SMC are considered as Non-SMCs.
Instructions
• General Instructions
1. SMCs should follow the following instructions while complying with Accounting
Standards under these Rules:
1.1 The SMC which does not disclose certain information pursuant to the exemptions
or relaxations given to it should disclose (by way of a note to its financial
statements) the fact that it is an SMC and has complied with the Accounting
Standards insofar as they are applicable to an SMC on the following lines:
“The Company is a Small and Medium Sized Company (SMC) as defined in the
General Instructions in respect of Accounting Standards notified under the
Companies Act Accordingly, the Company has complied with the Accounting
Standards as applicable to a Small and Medium Sized Company.”
1.2 Where a company, being an SMC, has qualified for any exemption or relaxation
previously but no longer qualifies for the relevant exemption or relaxation in the
current accounting period, the relevant standards or requirements become
applicable from the current period and the figures for the corresponding period
of the previous accounting period need not be revised merely by reason of its
having ceased to be an SMC. The fact that the company was an SMC in the
previous period and it had availed of the exemptions or relaxations available to
SMCs should be disclosed in the notes to the financial statements.
1.3 If an SMC opts not to avail of the exemptions or relaxations available to an SMC
in respect of any but not all of the Accounting Standards, it should disclose the
standard(s) in respect of which it has availed the exemption or relaxation.
1.4 If an SMC desires to disclose the information not required to be disclosed pursuant
to the exemptions or relaxations available to the SMCs, it should disclose that
information in compliance with the relevant accounting standard.
1.5 The SMC may opt for availing certain exemptions or relaxations from compliance
with the requirements prescribed in an Accounting Standard:

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Provided that such a partial exemption or relaxation and disclosure should not be
permitted to mislead any person or public.
Note:
An existing company which was previously not a SMC and subsequently becomes
a SMC, shall not be qualified for exemption or relaxation in respect of Accounting
Standards available to a SMC until the company remains a SMC for two consecutive
accounting periods.
1.2.3 Applicability of Accounting Standards to Companies
1.2.3.1 Accounting Standards applicable to all companies in their entirety for
accounting periods commencing on or after 7th December, 2006

AS 1 Disclosures of Accounting Policies

AS 2 (Revised) Valuation of Inventories
AS 4 (Revised) Contingencies and Events Occurring After the Balance Sheet
Date
AS 5 Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies
AS 7 Construction Contracts
AS 9 Revenue Recognition
AS 10 (Revised) Property, Plant and Equipment
AS 11 (Revised) The Effects of Changes in Foreign Exchange Rates
AS 12 Accounting for Government Grants
AS 13 (Revised) Accounting for Investments
AS 14 (Revised) Accounting for Amalgamations
AS 16 Borrowing Costs
AS 18 Related Party Disclosures
AS 22 Accounting for Taxes on Income
AS 24 Discontinuing Operations
AS 26 Intangible Assets
1.2.3.2 Exemptions or Relaxations for SMCs as defined in the Notification
(A) Accounting Standards not applicable to SMCs in their entirety:
AS 3 Cash Flow Statements
AS 17 Segment Reporting

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Note:
Under Section 129 of the Companies Act, 2013, the financial statement, with respect
to One Person Company, small company and dormant company, may not include
the cash flow statement. As per the Amendment, under Chapter I, clause (40) of
section 2, an exemption has been provided vide Notification dated 13th June, 2017
under Section 462 of the Companies Act 2013 to a startup private company besides
one person company, small company and dormant company. As per the
amendment, a startup private company is not required to include the cash flow
statement in the financial statements.
Thus, the financial statements, with respect to one person company, small
company, dormant company and private company (if such a private company is a
start-up), may not include the cash flow statement.
(B) Accounting Standards not applicable to SMCs since the relevant Regulations
require compliance with them only by certain Non-SMCs ∗:
(i) AS 21 (Revised), Consolidated Financial Statements
(ii) AS 23, Accounting for Investments in Associates in Consolidated
Financial Statements
(iii) AS 27, Financial Reporting of Interests in Joint Ventures (to the extent
of requirements relating to Consolidated Financial Statements)
(C) Accounting Standards in respect of which relaxations from certain
requirements have been given to SMCs:
(i) Accounting Standard (AS) 15, Employee Benefits
(a) paragraphs 11 to 16 of the standard to the extent they deal with
recognition and measurement of short-term accumulating
compensated absences which are non-vesting (i.e., short-term
accumulating compensated absences in respect of which employees
are not entitled to cash payment for unused entitlement on leaving);
(b) paragraphs 46 and 139 of the Standard which deal with
discounting of amounts that fall due more than 12 months after
the balance sheet date;

∗
AS 21, AS 23 and AS 27 (relating to consolidated financial statements) are required to be
complied with by a company if the company, pursuant to the requirements of a
statute/regulator or voluntarily, prepares and presents consolidated financial statements.

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(c) recognition and measurement principles laid down in paragraphs

50 to 116 and presentation and disclosure requirements laid down
in paragraphs 117 to 123 of the Standard in respect of accounting
for defined benefit plans. However, such companies should
actuarially determine and provide for the accrued liability in
respect of defined benefit plans by using the Projected Unit Credit
Method and the discount rate used should be determined by
reference to market yields at the balance sheet date on
government bonds as per paragraph 78 of the Standard. Such
companies should disclose actuarial assumptions as per
paragraph 120(l) of the Standard; and
(d) recognition and measurement principles laid down in paragraphs
129 to 131 of the Standard in respect of accounting for other long
term employee benefits. However, such companies should
actuarially determine and provide for the accrued liability in
respect of other long-term employee benefits by using the
Projected Unit Credit Method and the discount rate used should
be determined by reference to market yields at the balance sheet
date on government bonds as per paragraph 78 of the Standard.
(ii) AS 19, Leases
Paragraphs 22 (c), (e) and (f); 25 (a), (b) and (e); 37 (a) and (f); and 46 (b)
and (d) relating to disclosures are not applicable to SMCs.
(iii) AS 20, Earnings Per Share
Disclosure of diluted earnings per share (both including and excluding
extraordinary items) is exempted for SMCs.
(iv) AS 28, Impairment of Assets
SMCs are allowed to measure the ‘value in use’ on the basis of
reasonable estimate thereof instead of computing the value in use by
present value technique. Consequently, if an SMC chooses to measure
the ‘value in use’ by not using the present value technique, the relevant
provisions of AS 28, such as discount rate etc., would not be applicable
to such an SMC. Further, such an SMC need not disclose the information
required by paragraph 121(g) of the Standard.
(v) AS 29 (Revised), Provisions, Contingent Liabilities and Contingent Assets
Paragraphs 66 and 67 relating to disclosures are not applicable to SMCs.

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(D) AS 25, Interim Financial Reporting, does not require a company to present
interim financial report. It is applicable only if a company is required or elects
to prepare and present an interim financial report. Only certain Non-SMCs
are required by the concerned regulators to present interim financial results,
e.g, quarterly financial results required by the SEBI. Therefore, the recognition
and measurement requirements contained in this Standard are applicable to
those Non-SMCs for preparation of interim financial results.

SUMMARY
According to the Criteria for Classification of Entities and Applicability of Accounting
Standards’as issued by the Government, there are two levels, namely, Small and
Medium-sized Companies (SMCs) as defined in the Companies (Accounting Standards)
Rules and companies other than SMCs. Non-SMCs are required to comply with all the
Accounting Standards in their entirety, while certain exemptions/ relaxations have
been given to SMCs. Criteria for classification of entities for applicability of
accounting standards for corporate and non-corporate entities have been
prescribed as per the Govt. notification.

TEST YOUR KNOWLEDGE

MCQ
1. Non-corporate entities which are not Level I entities whose turnover
(excluding other income) exceeds rupees ___________ but does not exceed
rupees two-fifty crores in the immediately preceding accounting year are
classified as Level II entities.
(a) five crores.
(b) two crores.
(c) fifty crores.
2. The following Accounting Standard is not applicable to Non-corporate
Entities falling in Level II in its entirety

(a) AS 10.
(b) AS 17.
(c) AS 2.

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3. All non-corporate entities engaged in commercial, industrial and business

reporting entities, whose turnover (excluding other income) exceeds rupees
250 crores in the immediately preceding accounting year, are classified as
(a) Level II entities.
(b) Level I entities.
(c) Level III entities.
4. All non-corporate entities engaged in commercial, industrial or business
activities having borrowings (including public deposits) in excess of rupees
two crores but does not exceed rupees ten crores at any time during the
immediately preceding accounting year.
(a) Level II entities.
(b) Level IV entities.
(c) Level III entities.
5. “Small and Medium Sized Company” (SMC) means, a company-
(a) which may be a bank, financial institution or an insurance company.
(b) whose turnover (excluding other income) does not exceed rupees two-
fifty crores in the immediately preceding accounting year;
(c) whose turnover (excluding other income) does not exceed rupees fifty
crores in the immediately preceding accounting year;
Theory Questions
1. What are the issues, with which Accounting Standards deal?
2. List the criteria to be applied for rating a non-corporate entity as Level-I entity
and Level II entity for the purpose of compliance of Accounting Standards in
India.
3. List the criteria to be applied for rating a non-corporate entity as Level IV
entity for the purpose of compliance of Accounting Standards in India.
Practical Questions
Question 1
XYZ Ltd., with a turnover of ` 50 crores during previous year and borrowings of ` 1

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 OVERVIEW OF ACCOUNTING STANDARDS 3.25

crore during any time in the previous year, wants to avail the exemptions available
in adoption of Accounting Standards applicable to companies for the year ended
31.3.20X1. Advise the management on the exemptions that are available as per the
Companies (Accounting Standards) Rules, 2021.
Question 2

A company was classified as Non-SMC in 20X1-X2. In 20X2-X3, it has been classified

as SMC. The management desires to avail the exemptions or relaxations available
for SMCs in 20X2-X3. However, the accountant of the company does not agree with
the same. Comment.

ANSWERS
MCQ
1. (c), 2. (b), 3. (b) 4. (c) 5. (b)
Answers to Theory Questions
1. Accounting Standards deal with the issues of (i) Recognition of events and
transactions in the financial statements, (ii) Measurement of these
transactions and events, (iii) Presentation of these transactions and events in
the financial statements in a manner that is meaningful and understandable
to the reader, and (iv) Disclosure requirements.
2. Refer para 1.2.1 for Criteria to be applied for rating a non-corporate entity as
Level-I entity and Level II entity for the purpose of compliance of Accounting
Standards in India.
3. Refer para 1.2.1 for Criteria to be applied for rating a non-corporate entity as
Level IV entity for the purpose of compliance of Accounting Standards in
India.
Answers to Practical Questions
Answer 1

The question deals with the issue of Applicability of Accounting Standards for
corporate entities.
The companies can be classified under two categories viz SMCs and Non SMCs
under the Companies (Accounting Standards) Rules, 2021.

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As per the Companies (Accounting Standards) Rules, 2021, criteria for above
classification as SMCs, are:
“Small and Medium Sized Company” (SMC) means, a company-
• whose equity or debt securities are not listed or are not in the process of listing
on any stock exchange, whether in India or outside India;
• which is not a bank, financial institution or an insurance company;
• whose turnover (excluding other income) does not exceed rupees two-fifty
crores in the immediately preceding accounting year;
• which does not have borrowings (including public deposits) in excess of rupees
fifty crores at any time during the immediately preceding accounting year; and
• which is not a holding or subsidiary company of a company which is not a small
and medium-sized company.
Since, XYZ Ltd.’s turnover was ` 50 crores which does not exceed ` 250 crores and
borrowings of ` 1 crore are less than ` 50 crores, it is a small and medium sized
company (SMC).

Answer 2
As per Companies (Accounting Standards) Rules, 2021, an existing company, which
was previously not a SMC and subsequently becomes a SMC, should not be
qualified for exemption or relaxation in respect of accounting standards available
to a SMC until the company remains a SMC for two consecutive accounting periods.
Therefore, the management of the company cannot avail the exemptions/
relaxations available to the SMCs for the FY 20X2-X3.

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UNIT 2: OVERVIEW OF ACCOUNTING STANDARDS

LEARNING OUTCOMES
After studying this unit, you will be able to–

 Understand the provisions of the specified Accounting
Standards.
 Relate relevant Accounting Standards to various situations
and apply them accordingly.
 Solve the practical problems based on application of
Accounting Standards.

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Practical Application of :
AS 1 : Disclosure of Accounting Policies
AS 2 : Valuation of Inventories
AS 3 : Cash Flow Statements
AS 10 : Property, Plant and Equipment
AS 11 : The Effects of Changes in Foreign Exchange Rates
AS 12 : Accounting for Government Grants
AS 13 : Accounting for Investments
AS 16 : Borrowing Costs

Note: The students are advised to refer the bare text of the above-mentioned
Accounting Standards while studying this chapter.

2.1 DISCLOSURE OF ACCOUNTING POLICIES (AS 1)

Introduction
Irrespective of extent of standardization, diversity in accounting policies is
unavoidable for two reasons. First, accounting standards cannot and do not cover
all possible areas of accounting and enterprises have the freedom of adopting any
reasonable accounting policy in areas not covered by a standard.
Second, since enterprises operate in diverse situations, it is impossible to develop
a single set of policies applicable to all enterprises for all time.
The accounting standards therefore permit more than one policy even in areas
covered by it. Differences in accounting policies lead to differences in reported
information even if underlying transactions are same. The qualitative characteristic
of comparability of financial statements therefore suffers due to diversity of
accounting policies. Since uniformity is impossible, and accounting standards
permit more than one alternative in many cases, it is not enough to say that all

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standards have been complied with. For these reasons, accounting standard 1
requires enterprises to disclose significant accounting policies actually adopted by
them in preparation of their financial statements. Such disclosures allow the users
of financial statements to take the differences in accounting policies into
consideration and to make necessary adjustments in their analysis of such
statements.
The purpose of Accounting Standard 1, Disclosure of Accounting Policies, is to
promote better understanding of financial statements by requiring disclosure of
significant accounting policies in orderly manner. As explained in the preceding
paragraph, such disclosures facilitate more meaningful comparison between
financial statements of different enterprises for same accounting periods. The
standard also requires disclosure of changes in accounting policies such that the
users can compare financial statements of same enterprise for different accounting
periods.
The standard applies to all enterprises.
Fundamental Accounting Assumptions

Fundamental Accounting
Assumptions

Going concern Consistency Accrual

Fundamental Accounting
Assumptions

If not
If followed
followed

Disclosure required in financial

Not required to be disclosed
statements

Going Concern: The financial statements are normally prepared on the assumption
that an enterprise will continue its operations in the foreseeable future and neither

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there is intention, nor there is need to materially curtail the scale of operations.
Financial statements prepared on going concern basis recognise among other
things the need for sufficient retention of profit to replace assets consumed in
operation and for making adequate provision for settlement of its liabilities.
Consistency: The principle of consistency refers to the practice of using same
accounting policies for similar transactions in all accounting periods. The
consistency improves comparability of financial statements through time. An
accounting policy can be changed if the change is required (i) by a statute (ii) by
an accounting standard (iii) for more appropriate presentation of financial
statements.
Accrual basis of accounting: Under this basis of accounting, transactions are
recognised as soon as they occur, whether or not cash or cash equivalent is actually
received or paid. Accrual basis ensures better matching between revenue and cost
and profit/loss obtained on this basis reflects activities of the enterprise during an
accounting period, rather than cash flows generated by it.
While accrual basis is a more logical approach to profit determination than the cash
basis of accounting, it exposes an enterprise to the risk of recognising an income
before actual receipt. The accrual basis can therefore overstate the divisible profits
and dividend decisions based on such overstated profit lead to erosion of capital.
For this reason, accounting standards require that no revenue should be recognised
unless the amount of consideration and actual realisation of the consideration is
reasonably certain.
Despite the possibility of distribution of profit not actually earned, accrual basis of
accounting is generally followed because of its logical superiority over cash basis
of accounting as illustrated below. Section 128(1)(iii) of the Companies Act makes
it mandatory for companies to maintain accounts on accrual basis only. It is not
necessary to expressly state that accrual basis of accounting has been followed in
preparation of a financial statement. In case, any income/expense is recognised on
cash basis, the fact should be stated.
Accounting Policies
The accounting policies refer to the specific accounting principles and the methods
of applying those principles adopted by the enterprise in the preparation and
presentation of financial statements.
Accountant has to make decisions from various options for recording or disclosing
items in the books of accounts e.g.

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Items to be disclosed Method of disclosure or valuation

Inventories FIFO, Weighted Average etc.
Cash Flow Statement Direct Method, Indirect Method

This list is not exhaustive i.e. endless. For every item right from valuation of assets
and liabilities to recognition of revenue, providing for expected losses, for each
event, accountant need to form principles and evolve a method to adopt those
principles. This method of forming and applying accounting principles is known as
accounting policies.
As we say that accounts is both science and art. It is a science because we have
some tested accounting principles, which are applicable universally, but
simultaneously the application of these principles depends on the personal ability
of each accountant. Since different accountants may have different approach, we
generally find that in different enterprise under same industry, different accounting
policy is followed. Though ICAI along with Government is trying to reduce the
number of accounting policies followed in India but still it cannot be reduced to
one. Accounting policy adopted will have considerable effect on the financial
results disclosed by the financial statements; it makes it almost difficult to compare
two financial statements.
Selection of Accounting Policy
Financial Statements are prepared to portray a true and fair view of the
performance and state of affairs of an enterprise. In selecting a policy, alternative
accounting policies should be evaluated in that light. In particular, major
considerations that govern selection of a particular policy are:
Prudence: In view of uncertainty associated with future events, profits are not
anticipated, but losses are provided for as a matter of conservatism. Provision
should be created for all known liabilities and losses even though the amount
cannot be determined with certainty and represents only a best estimate in the
light of available information. The exercise of prudence in selection of accounting
policies ensure that (i) profits are not overstated (ii) losses are not understated (iii)
assets are not overstated and (iv) liabilities are not understated.
Example 1
The most common example of exercise of prudence in selection of accounting policy
is the policy of valuing inventory at lower of cost and net realisable value.

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Suppose a trader has purchased 500 units of certain article @ ` 10 per unit. He sold
400 articles @ ` 15 per unit. If the net realisable value per unit of the unsold article
is ` 15, the trader should value his stock at ` 10 per unit and thus ignoring the profit
` 500 that he may earn in next accounting period by selling 100 units of unsold
articles. If the net realisable value per unit of the unsold article is ` 8, the trader
should value his stock at ` 8 per unit and thus recognising possible loss ` 200 that he
may incur in next accounting period by selling 100 units of unsold articles.
Profit of the trader if net realisable value of unsold article is ` 15
= Sale – Cost of goods sold = (400 x ` 15) – (500 x ` 10 – 100 x ` 10) = ` 2,000
Profit of the trader if net realisable value of unsold article is ` 8
= Sale – Cost of goods sold = (400 x ` 15) – (500 x ` 10 – 100 x ` 8) = ` 1,800
Example 2
Exercise of prudence does not permit creation of hidden reserve by understating
profits and assets or by overstating liabilities and losses. Suppose a company is facing
a damage suit. No provision for damages should be recognised by a charge against
profit, unless the probability of losing the suit is more than the probability of not
losing it.
Substance over form: Transactions and other events should be accounted for and
presented in accordance with their substance and financial reality and not merely
by their legal form.
Materiality: Financial statements should disclose all ‘material items, i.e. the items
the knowledge of which might influence the decisions of the user of the financial
statement. Materiality is not always a matter of relative size. For example a small
amount lost by fraudulent practices of certain employees can indicate a serious
flaw in the enterprise’s internal control system requiring immediate attention to
avoid greater losses in future. In certain cases quantitative limits of materiality is
specified. A few of such cases are given below:
(a) A company should disclose by way of notes additional information regarding
any item of income or expenditure which exceeds 1% of the revenue from
operations or `1,00,000 whichever is higher (Refer general Instructions for
preparation of Statement of Profit and Loss in Schedule III to the Companies
Act, 2013).
(b) A company should disclose in Notes to Accounts, shares in the company held
by each shareholder holding more than 5 per cent shares specifying the

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number of shares held. (Refer general Instructions for Balance Sheet in

Schedule III to the Companies Act, 2013).
Manner of disclosure: All significant accounting policies adopted in the
preparation and presentation of financial statements should be disclosed
The disclosure of the significant accounting policies as such should form part of
the financial statements and the significant accounting policies should normally be
disclosed in one place.
Note: Being a part of the financial statement, the opinion of auditors should cover
the disclosures of accounting policies.
Disclosure of Changes in Accounting Policies
Any change in the accounting policies which has a material effect in the current
period or which is reasonably expected to have a material effect in a later period
should be disclosed. In the case of a change in accounting policies, which has a
material effect in the current period, the amount by which any item in the financial
statements is affected by such change should also be disclosed to the extent
ascertainable. Where such amount is not ascertainable, wholly or in part, the fact
should be indicated.

Change in Accounting
Policy

Non material in current period

Material in current period
but ascertainable in later periods

Fact of such change in later

Amount
Not ascertained period to be disclosed in
ascertained
current period.

Amount to be Fact to be
disclosed disclosed

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Example 3
A simple disclosure that an accounting policy has been changed is not of much use
for a reader of a financial statement. The effect of change should therefore be
disclosed wherever ascertainable. Suppose a company has switched over to weighted
average formula for ascertaining cost of inventory, from the earlier practice of using
FIFO. If the closing inventory by FIFO is ` 2 lakh and that by weighted average
formula is ` 1.8 lakh, the change in accounting policy pulls down profit and value of
inventory by ` 20,000. The company may disclose the change in accounting policy in
the following manner:
‘The company values its inventory at lower of cost or net realisable value. Since net
realisable value of all items of inventory in the current year was greater than
respective costs, the company valued its inventory at cost. In the present year the
company has changed to weighted average formula, which better reflects the
consumption pattern of inventory, for ascertaining inventory costs from the earlier
practice of using FIFO for the purpose. The change in policy has reduced profit and
value of inventory by ` 20,000’.
A change in accounting policy is to be disclosed if the change is reasonably expected
to have material effect in future accounting periods, even if the change has no
material effect in the current accounting period.
The above requirement ensures that all important changes in accounting policies are
actually disclosed. Suppose a company makes provision for warranty claims based on
estimated costs of materials and labour. The company changed the policy in 20X1-X2 to
include overheads in estimating costs for servicing warranty claims. If value of warranty
sales in 20X1-X2 is not significant, the change in policy will not have any material effect
on financial statements of 20X1-X2. Yet, the company must disclose the change in
accounting policy in 20X1-X2 because the change can affect future accounting periods
when value of warranty sales may rise to a significant level. If the disclosure is not made
in 20X1-X2, then no disclosure in future years will be required. This is because an enterprise
has to disclose changes in accounting policies in the year of change only.
Disclosure of deviations from fundamental accounting assumptions
If the fundamental accounting assumptions, viz. Going concern, Consistency and
Accrual are followed in financial statements, specific disclosure is not required. If a
fundamental accounting assumption is not followed, the fact should be disclosed.
The principle of consistency refers to the practice of using same accounting policies
for similar transactions in all accounting periods.

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Illustration 1
In the books of M/s Prashant Ltd., closing inventory as on 31.03.20X2 amounts to
` 1,63,000 (on the basis of FIFO method).
The company decides to change from FIFO method to weighted average method for
ascertaining the cost of inventory from the year 20X1-X2. On the basis of weighted
average method, closing inventory as on 31.03.20X2 amounts to ` 1,47,000.
Realisable value of the inventory as on 31.03.20X2 amounts to ` 1,95,000.
Discuss disclosure requirement of change in accounting policy as per AS-1.
Solution
As per AS 1 “Disclosure of Accounting Policies”, any change in an accounting policy
which has a material effect should be disclosed in the financial statements. The
amount by which any item in the financial statements is affected by such change
should also be disclosed to the extent ascertainable. Where such amount is not
ascertainable, wholly or in part, the fact should be indicated. Thus Prashant Ltd.
should disclose the change in valuation method of inventory and its effect on
financial statements. The company may disclose the change in accounting policy in
the following manner:
‘The company values its inventory at lower of cost and net realizable value. Since
net realizable value of all items of inventory in the current year was greater than
respective costs, the company valued its inventory at cost. In the present year i.e.
201X1-X2, the company has changed to weighted average method, which better
reflects the consumption pattern of inventory, for ascertaining inventory costs from
the earlier practice of using FIFO for the purpose. The change in policy has reduced
current profit and value of inventory by ` 16,000.
Illustration 2
Jagannath Ltd. had made a rights issue of shares in 20X2. In the offer document to
its members, it had projected a surplus of ` 40 crores during the accounting year to
end on 31st March, 20X2. The draft results for the year, prepared on the hitherto
followed accounting policies and presented for perusal of the board of directors
showed a deficit of ` 10 crores. The board in consultation with the managing director,
decided on the following:
(i) Value year-end inventory at works cost (` 50 crores) instead of the hitherto
method of valuation of inventory at prime cost (` 30 crores).
(ii) Not to provide for “after sales expenses” during the warranty period. Till the

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last year, provision at 2% of sales used to be made under the concept of

“matching of costs against revenue” and actual expenses used to be charged
against the provision. The board now decided to account for expenses as and
when actually incurred. Sales during the year total to ` 600 crores.
(iii) Provide for permanent fall in the value of investments - which fall had taken
place over the past five years - the provision being ` 10 crores.
As chief accountant of the company, you are asked by the managing director to draft
the notes on accounts for inclusion in the annual report for 20X1-20X2.
Solution
As per AS 1, any change in the accounting policies which has a material effect in
the current period or which is reasonably expected to have a material effect in later
periods should be disclosed. In the case of a change in accounting policies which
has a material effect in the current period, the amount by which any item in the
financial statements is affected by such change should also be disclosed to the
extent ascertainable. Where such amount is not ascertainable, wholly or in part, the
fact should be indicated. Accordingly, the notes on accounts should properly
disclose the change and its effect.
Notes on Accounts:
(i) During the year inventory has been valued at factory cost, against the practice
of valuing it at prime cost as was the practice till last year. This has been done
to take cognizance of the more capital intensive method of production on
account of heavy capital expenditure during the year. As a result of this
change, the year-end inventory has been valued at ` 50 crores and the profit
for the year is increased by ` 20 crores.
(ii) So far, the company has been providing 2% of sales for meeting “after sales
expenses during the warranty period. With the improved method of
production, the probability of defects occurring in the products has reduced
considerably. Hence, the company has decided not to make provision for such
expenses but to account for the same as and when expenses are incurred. Due
to this change, the profit for the year is increased by ` 12 crores than would
have been the case if the old policy were to continue.
(iii) The company has decided to provide ` 10 crores for the permanent fall in the
value of investments which has taken place over the period of past five years.
The provision so made has reduced the profit disclosed in the accounts by
` 10 crores.

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Illustration 3
XYZ Company is engaged in the business of financial services and is undergoing tight
liquidity position, since most of the assets of the company are blocked in various
claims/petitions in a Special Court. XYZ has accepted Inter-Corporate Deposits (ICDs)
and, it is making its best efforts to settle the dues. There were claims at varied rates
of interest, from lenders, from the due date of ICDs to the date of repayment. The
company has provided interest, as per the terms of the contract till the due date and
a note for non-provision of interest on the due date to date of repayment was affected
in the financial statements. On account of uncertainties existing regarding the
determination of the amount and in the absence of any specific legal obligation at
present as per the terms of contracts, the company considers that these claims are in
the nature of "claims against the company not acknowledged as debt”, and the same
has been disclosed by way of a note in the accounts instead of making a provision in
the profit and loss accounts. State whether the treatment done by the Company is
correct or not.
Solution
AS 1 ‘Disclosure of Accounting Policies’ recognises 'prudence' as one of the major
considerations governing the selection and application of accounting policies. In
view of the uncertainty attached to future events, profits are not anticipated but
recognised only when realised though not necessarily in cash. Provision is made for
all known liabilities and losses even though the amount cannot be determined with
certainty and represents only a best estimate in the light of available information.
Also as per AS 1, ‘accrual’ is one of the fundamental accounting assumptions.
Irrespective of the terms of the contract, so long as the principal amount of a loan
is not repaid, the lender cannot be replaced in a disadvantageous position for non-
payment of interest in respect of overdue amount. From the aforesaid, it is apparent
that the company has an obligation on account of the overdue interest. In this
situation, the company should provide for the liability (since it is not waived by the
lenders) at an amount estimated or on reasonable basis based on facts and
circumstances of each case. However, in respect of the overdue interest amounts,
which are settled, the liability should be accrued to the extent of amounts settled.
Non-provision of the overdue interest liability amounts to violation of accrual basis
of accounting. Therefore, the treatment, done by the company, of not providing
the interest amount from due date to the date of repayment is not correct.

Reference: The students are advised to refer the full text of AS 1 “Disclosure of
Accounting Policies”.

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2.2 VALUATION OF INVENTORY [AS 2 (REVISED)]

Introduction
The accounting treatment for inventories is prescribed in AS 2 (Revised) ‘Valuation
of Inventories’, which provides guidance for determining the value at which
inventories, are carried in the financial statements until related revenues are
recognised. It also provides guidance on the cost formulas that are used to assign
costs to inventories and any write-down thereof to net realisable value.
Inventories
AS 2 (Revised) defines inventories as assets held
• for sale in the ordinary course of business, or
• in the process of production for such sale, or
• for consumption in the production of goods or services for sale, including
maintenance supplies and consumables other than machinery spares,
servicing equipment and standby equipment meeting the definition of
Property, plant and equipment.
Inventories encompass goods purchased and held for resale, for example merchandise
(goods) purchased by a retailer and held for resale, or land and other property held for
resale. Inventories also include finished goods produced, or work in progress being
produced, by the enterprise and include materials, maintenance supplies, consumables
and loose tools awaiting use in the production process. Inventories do not include
spare parts, servicing equipment and standby equipment which meet the definition of
property, plant and equipment as per AS 10 (Revised), Property, Plant and Equipment.
Such items are accounted for in accordance with Accounting Standard (AS) (Revised)
10, Property, Plant and Equipment.
Following are excluded from the scope of AS 2 (Revised).
(a) Work in progress arising under construction contracts, i.e. cost of part
construction, including directly related service contracts, being covered under
AS 7, Accounting for Construction Contracts; Inventory held for use in
construction, e.g. cement lying at the site should however be covered by AS
2 (Revised).
(b) Work in progress arising in the ordinary course of business of service
providers i.e. cost of providing a part of service. For example, for a shipping
company, fuel and stores not consumed at the end of accounting period is

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inventory but not costs for voyage-in-progress. Work-in-progress may arise

for different other services e.g. software development, consultancy, medical
services, merchant banking and so on.
(c) Shares, debentures and other financial instruments held as stock-in-trade. It
should be noted that these are excluded from the scope of AS 13 (Revised)
as well. The current Indian practice is however to value them at lower of cost
and fair value.
(d) Producers’ inventories of livestock, agricultural and forest products, and
mineral oils, ores and gases to the extent that they are measured at net
realisable value in accordance with well established practices in those
industries, e.g. where sale is assured under a forward contract or a
government guarantee or where a homogenous market exists and there is
negligible risk of failure to sell.
The types of inventories are related to the nature of business. The inventories of a
trading concern consist primarily of products purchased for resale in their existing
form. It may also have an inventory of supplies such as wrapping paper, cartons,
and stationery. The inventories of manufacturing concern consist of several types
of inventories: raw material (which will become part of the goods to be produced),
parts and factory supplies, work-in-process (partially completed products in the
factory) and, of course, finished products.
At the year end every business entity needs to ascertain the closing balance of
Inventory which comprise of Inventory of raw material, work-in-progress, finished
goods and miscellaneous items. The cost of closing inventory, e.g. cost of closing
stock of raw materials, closing work-in-progress and closing finished stock, is a part
of costs incurred in the current accounting period that is carried over to next
accounting period. Likewise, the cost of opening inventory is a part of costs
incurred in the previous accounting period that is brought forward to current
accounting period.
Since inventories are assets, and assets are resources expected to generate future
economic benefits to the enterprise, the costs to be included in inventory costs, are
costs that are expected to generate future economic benefits to the enterprise.
Such costs must be costs of acquisition and costs incurred in bringing the assets to
their present (i) location of the inventory, e.g. freight incurred to carry the materials
to factory and (ii) conditions of the inventory, e.g. costs incurred to convert the
materials into finished stock. The costs incurred to maintain the inventory, e.g.
storage costs, do not generate any extra economic benefits for the enterprise and

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therefore should not be included in inventory costs unless those costs are necessary
in production process prior to a further production stage.
The valuation of inventory is crucial because of its direct impact in measuring
profit/loss for an accounting period. Higher the value of closing inventory lower is
the cost of goods sold and hence higher is the profit. The principle of prudence
demands that no profit should be anticipated while all foreseeable losses should
be recognised. Thus, if net realisable value of inventory is less than inventory cost,
inventory is valued at net realisable value to reduce the reported profit in
anticipation of loss. On the other hand, if net realisable value of inventory is more
than inventory cost, the anticipated profit is ignored and the inventory is valued at
cost. In short, inventory is valued at lower of cost and net realisable value. The
standard specifies (i) what the cost of inventory should consist of and (ii) how the
net realisable value is determined.
Abnormal gains or losses are not expected to recur regularly. For a meaningful
analysis of an enterprise’s performance, the users of financial statements need to
know the amount of such gains/losses included in current profit/loss. For this
reason, instead of taking abnormal gains and losses in inventory costs, these are
shown in the Profit and Loss statement in such way that their impact on current
profit/loss can be perceived.
Part I of Schedule III to the Companies Act, 2013 prescribes that valuation method
should be disclosed for inventory held by companies.
Measurement of Inventories
Inventories should be valued at lower of cost and net realisable value. 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 valuation of inventory at lower of cost and net realisable value is based on the
view that no asset should be carried at a value which is in excess of the value
realisable by its sale or use.

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Inventories

Raw Materials Finished Goods and

Work in progress
At cost (if
finished goods Lower of the following
are sold at or
above cost),
otherwise at Net Realisable
Cost
replacement Value
cost
Realisable Value
Cost of Cost of Other
Less Selling
Purchase Conversion Costs
Expenses less
estimated cost of
completion

Example 1
Cost of a partly finished unit at the end of 20X1-X2 is ` 150. The unit can be finished
next year by a further expenditure of ` 100. The finished unit can be sold at ` 250,
subject to payment of 4% brokerage on selling price. Assume that the partly finished
unit cannot be sold in semi-finished form and its NRV is zero without processing it
further. The value of inventory will be determined as below:
`
Net selling price 250
Less: Estimated cost of completion (100)
150
Less: Brokerage (4% of 250) (10)
Net Realisable Value 140
Cost of inventory 150
Value of inventory (Lower of cost and net realisable value) 140

Costs of inventory
Costs of inventories comprise all costs of purchase, costs of conversion and other
costs incurred in bringing the inventories to their present location and condition.

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Costs of purchase
The costs of purchase consist of the purchase price including duties and taxes
(other than those subsequently recoverable by the enterprise from the taxing
authorities, and other expenditure directly attributable to the acquisition. Trade
discounts, rebates, duty drawbacks and other similar items are deducted in
determining the costs of purchase.
Costs of Conversion
The costs of conversion include costs directly related to production, e.g. direct
labour. They also include overheads, both fixed and variable that are incurred in
converting raw material to finished goods.
The fixed production overheads should be absorbed systematically to units of
production over normal capacity. Normal capacity is the production the enterprise
expects to achieve on an average over a number of periods or seasons under
normal circumstances, taking into account the loss of capacity resulting from
planned maintenance. The actual level of production may be used if it approximates
the normal capacity. The amount of fixed production overheads allocated to each
unit of production should not be increased as a consequence of low production or
idle plant. Unallocated overheads (i.e. under recovery) are recognised as an expense
in the period in which they are incurred. In periods of abnormally high production,
the amount of fixed production overheads allocated to each unit of production is
decreased so that inventories are not measured above cost. Variable production
overheads are assigned to each unit of production on the basis of the actual use of
the production facilities.
Example 2
ABC Ltd. has a plant with the capacity to produce 1 lac unit of a product per annum
and the expected fixed overhead is ` 18 lacs. Fixed overhead on the basis of normal
capacity is ` 18 (18 lacs/1 lac).
Case 1: Actual production is 1 lac units. Fixed overhead on the basis of normal
capacity and actual overhead will lead to same figure of ` 18 lacs. Therefore, it is
advisable to include this on normal capacity.
Case 2: Actual production is 90,000 units. Fixed overhead is not going to change with
the change in output and will remain constant at ` 18 lacs, therefore, overheads on
actual basis is ` 20 per unit (18 lacs/ 90 thousands). Hence by valuing inventory at
` 20 each for fixed overhead purpose, it will be overvalued and the losses of ` 1.8 lacs
will also be included in closing inventory leading to a higher gross profit then actually

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earned. Therefore, it is advisable to include fixed overhead per unit on normal

capacity to actual production (90,000 x 18)` 16.2 lacs and rest ` 1.8 lacs should be
transferred to Profit & Loss Account.
Case 3: Actual production is 1.2 lacs units. Fixed overhead is not going to change
with the change in output and will remain constant at ` 18 lacs, therefore, overheads
on actual basis is ` 15 (18 lacs/ 1.2 lacs). Hence by valuing inventory at ` 18 each for
fixed overhead purpose, we will be adding the element of cost to inventory which
actually has not been incurred. At ` 18 per unit, total fixed overhead comes to ` 21.6
lacs whereas, actual fixed overhead expense is only ` 18 lacs. Therefore, it is advisable
to include fixed overhead on actual basis (1.2 lacs x 15) ` 18 lacs.
Joint or By-Products
In case of joint or by products, the costs incurred up to the stage of split off should
be allocated on a rational and consistent basis. The basis of allocation may be sale
value at split off point, for example, value of by products, scraps and wastes are
usually not material. These are therefore valued at net realisable value. The cost of
main product is then valued as joint cost minus net realisable value of by-products,
scraps or wastes.
Other Costs
(a) These may be included in cost of inventory provided they are incurred to
bring the inventory to their present location and condition. Cost of design,
for example, for a custom made unit may be taken as part of inventory cost.
(b) Interest and other borrowing costs are usually considered as not relating to
bringing the inventories to their present location and condition. These costs
are therefore not usually included in cost of inventory. Interests and other
borrowing costs however are taken as part of inventory costs, where the
inventory necessarily takes substantial period of time for getting ready for
intended sale. Example of such inventory is wine.
(c) The standard is silent on treatment of amortisation of intangibles for
ascertaining inventory costs. It nevertheless appears that amortisation of
intangibles related to production, e.g. patents right of production or
copyright for a publisher should be taken as part of inventory costs.
(d) Exchange differences are not taken in inventory costs.

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Conversion Cost

Factory Overheads Direct labour Joint Cost

Fixed Variable Main/Joint*** By Products

Sale Value Measured at

At actual at Sale Value NRV. This NRV is
At Normal At actual
Production* Separation at deducted from
Capacity* Production
* completion cost of main /
joint products

*When actual production is almost equal or lower than normal capacity.

** When actual production is higher than normal capacity.
*** Allocation at reasonable and consistent basis.
Exclusions from the cost of inventories
In determining the cost of inventories, it is appropriate to exclude certain costs and
recognise them as expenses in the period in which they are incurred. Examples of
such costs are:
(a) Abnormal amounts of wasted materials, labour, or other production costs;
(b) Storage costs, unless the production process requires such storage;
(c) Administrative overheads that do not contribute to bringing the inventories
to their present location and condition;
(d) Selling and distribution costs.
Cost Formula
Mostly inventories are purchased / made in different lots and unit cost of each lot
frequently differs. In all such circumstances, determination of closing inventory cost
requires identification of units in stock to have come from a particular lot. This
specific identification is best wherever possible. In all other cases, the cost of
inventory should be determined by the First-In First-Out (FIFO), or Weighted
Average cost formula. The formula used should reflect the fairest possible
approximation to the cost incurred in bringing the items of inventory to their
present location and condition.

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Other techniques of cost measurement

(a) Instead of actual, the standard costs may be taken as cost of inventory
provided standards fairly approximate the actual. Such standards (for finished
or partly finished units) should be set in the light of normal levels of material
consumption, labour efficiency and capacity utilisation. The standards so set
should be regularly reviewed and if necessary, be revised to reflect current
conditions.
(b) In retail business, where a large number of rapidly changing items are traded,
the actual costs of items may be difficult to determine. The units dealt by a
retailer however, are usually sold for similar gross margins and a retail
method to determine cost in such retail trades makes use of the fact. By this
method, cost of inventory is determined by reducing sale value of unsold
stock by appropriate average percentage of gross margin.
Example 3
A trader purchased certain articles for ` 85,000. He sold some of articles for
` 1,05,000. The average percentage of gross margin is 25% on cost. Opening stock of
inventory at cost was ` 15,000.
Cost of closing inventory is shown below:

`
Sale value of opening stock and purchase 1,25,000
(` 85,000 + ` 15,000) x 1.25
Sales (1,05,000)
Sale value of unsold stock 20,000
Less: Gross Margin (` 20,000 / 1.25) x 0.25 (4,000)
Cost of inventory 16,000

Estimates of Net Realisable Value

Estimates of net realisable value are based on the most reliable evidence available
at the time the estimates are made as to the amount the inventories are expected
to realise. These estimates take into consideration fluctuations of price or cost
directly relating to events occurring after the balance sheet date to the extent that
such events confirm the conditions existing at the balance sheet date.

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Comparison of Cost and Net Realisable Value

The comparison between cost and net realisable value should be made on item-
by-item basis. In some cases nevertheless, it may be appropriate to group similar
or related items.
Example 4
The cost, net realisable value and inventory value of two items that a company has
in its inventory are given below:

Cost Net Realisable Value Inventory Value

` ` `
Item 1 50,000 45,000 45,000
Item 2 20,000 24,000 20,000
Total 70,000 69,000 65,000
Estimates of NRV should be based on evidence available at the time of estimation.
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. AS 2 (Revised) also provides that estimates of net realisable value are to
be based on the most reliable evidence available at the time the estimates are made
as to the amount the inventories are expected to realise. These estimates take into
consideration fluctuations of price or cost directly relating to events occurring after
the balance sheet date to the extent that such events confirm the conditions
existing at the balance sheet date.
NRV of materials held for use or disposal
Materials and other supplies held for use in the production of inventories are not
written down below cost if the selling price of finished product containing the
material exceeds the cost of the finished product. The reason is, as long as these
conditions hold the material realises more than its cost as shown below.
Review of net realisable value at each balance sheet date
An assessment is made of net realisable value as at each balance sheet date.
Disclosures
The financial statements should disclose:
(a) The accounting policies adopted in measuring inventories, including the cost
formula used; and

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(b) The total carrying amount of inventories together with a classification

appropriate to the enterprise.
Information about the carrying amounts held in different classifications of
inventories and the extent of the changes in these assets is useful to financial
statement users. Common classifications of inventories are
(1) raw materials and components,
(2) work in progress,
(3) finished goods,
(4) Stock-in-trade (in respect of goods acquired for trading),
(5) stores and spares,
(6) loose tools, and
(7) Others (specify nature).
Illustration 1
The company deals in three products, A, B and C, which are neither similar nor
interchangeable. At the time of closing of its account for the year 20X1-X2, the
Historical Cost and Net Realisable Value of the items of closing stock are determined
as follows:

Items Historical Cost (` in lakhs) Net Realisable Value (` in lakhs)

A 40 28
B 32 32
C 16 24
What will be the value of closing stock?
Solution
As per AS 2 (Revised) on ‘Valuation of Inventories’, inventories should be valued at
the lower of cost and net realisable value. Inventories should be written down to
net realisable value on an item-by-item basis in the given case.

Items Historical Cost Net Realisable Valuation of closing

(` in lakhs) Value (` in lakhs) stock (` in lakhs)
A 40 28 28
B 32 32 32

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C 16 24 16
88 84 76

Hence, closing stock will be valued at ` 76 lakhs.

Illustration 2
X Co. Limited purchased goods at the cost of ` 40 lakhs in October, 20X1. Till March,
20X2, 75% of the stocks were sold. The company wants to disclose closing stock at
` 10 lakhs. The expected sale value is ` 11 lakhs and a commission at 10% on sale is
payable to the agent. Advise, what is the correct closing stock to be disclosed as at
31.3.20X2.
Solution
As per AS 2 (Revised) “Valuation of Inventories”, the inventories are to be valued at
lower of cost or net realisable value.
In this case, the cost of inventory is ` 10 lakhs. The net realisable value is 11,00,000
× 90% = ` 9,90,000. So, the stock should be valued at ` 9,90,000.
Illustration 3
In a production process, normal waste is 5% of input. 5,000 MT of input were put in
process resulting in wastage of 300 MT. Cost per MT of input is ` 1,000. The entire
quantity of waste is on stock at the year end. State with reference to Accounting
Standard, how will you value the inventories in this case?
Solution
As per AS 2 (Revised), abnormal amounts of wasted materials, labour and other
production costs are excluded from cost of inventories and such costs are
recognised as expenses in the period in which they are incurred.
In this case, normal waste is 250 MT and abnormal waste is 50 MT. The cost of 250
MT will be included in determining the cost of inventories (finished goods) at the
year end. The cost of abnormal waste (50 MT x 1,052.6315 = ` 52,632) will be
charged to the profit and loss statement.
Cost per MT (Normal Quantity of 4,750 MT) = 50,00,000 / 4,750 = ` 1,052.6315
Total value of inventory = 4,700 MT x ` 1,052.6315 = ` 49,47,368.

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Illustration 4
You are required to value the inventory per kg of finished goods consisting of:

` per kg.
Material cost 200
Direct labour 40
Direct variable overhead 20

Fixed production charges for the year on normal working capacity of 2 lakh kgs is
` 20 lakhs. 4,000 kgs of finished goods are in stock at the year end.
Solution
In accordance with AS 2 (Revised), the cost of conversion include a systematic
allocation of fixed and variable overheads that are incurred in converting materials
into finished goods. The allocation of fixed overheads for the purpose of their
inclusion in the cost of conversion is based on normal capacity of the production
facilities.
Cost per kg. of finished goods:
`
Material Cost 200
Direct Labour 40
Direct Variable Production Overhead 20
 20,00,000 
Fixed Production Overhead   10 70
 2,00,000 
270
Hence the value of 4,000 kgs. of finished goods = 4,000 kgs x ` 270 = ` 10,80,000

2.3 CASH FLOW STATEMENT (AS 3)

Introduction
This Standard is mandatory for the enterprises, which fall in the category of
level I, at the end of the relevant accounting period. For all other enterprises though
it is not compulsory but it is encouraged to prepare such statements. Where an
enterprise was not covered by this statement during the previous year but qualifies
in the current accounting year, they are not supposed to disclose the figures for

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the corresponding previous years. Whereas, if an enterprises qualifies under this

statement to prepare the cash flow statements during the previous year but now
disqualified, will continue to prepare cash flow statements for another two
consecutive years.
Note:
Under Section 129 of the Companies Act, 2013, the financial statement, with respect
to One Person Company, small company and dormant company, may not include
the cash flow statement. As per the Amendment, under Chapter I, clause (40) of
section 2, an exemption has been provided vide Notification dated 13th June, 2017
under Section 462 of the Companies Act 2013 to a startup private company besides
one person company, small company and dormant company. As per the
amendment, a startup private company is not required to include the cash flow
statement in the financial statements.
Thus the financial statements, with respect to one person company, small company,
dormant company and private company (if such a private company is a start-up),
may not include the cash flow statement.
Objective
Cash flow Statement (CFS) is an additional information provided to the users of
accounts in the form of an statement, which reflects the various sources from where
cash was generated (inflow of cash) by an enterprise during the relevant accounting
year and how these inflows were utilised (outflow of cash) by the enterprise. This
helps the users of accounts:
♦ To identify the historical changes in the flow of cash & cash equivalents.
♦ To determine the future requirement of cash & cash equivalents.
♦ To assess the ability to generate cash & cash equivalents.
♦ To estimate the further requirement of generating cash & cash equivalents.
♦ To compare the operational efficiency of different enterprises.
♦ To study the insolvency and liquidity position of an enterprise.
♦ As an indicator of amount, timing and certainty of future cash flows.
♦ To check the accuracy of past assessments of future cash flows
♦ In examining the relationship between profitability and net cash flow and the
impact of changing prices.

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Meaning of the term cash and cash equivalents for cash flow statements
Cash and cash equivalents for the purpose of cash flow statement consists of the
following:
(a) Cash in hand and deposits repayable on demand with any bank or other
financial institutions and

(b) Cash equivalents, which are short term, highly liquid investments that are
readily convertible into known amounts of cash and are subject to
insignificant risk of change in value. A short-term investment is one, which is
due for maturity within three months from the date of acquisition.
Investments in shares are not normally taken as cash equivalent, because of
uncertainties associated with them as to realisable value.

Note: For the purpose of cash flow statement, ‘cash and cash equivalent’ consists
of at least three balance sheet items, viz. cash in hand; demand deposits with banks
etc. and investments regarded as cash equivalents. For this reason, the AS 3
requires enterprises to give a break-up of opening and closing cash shown in their
cash flow statements. This is presented as a note to cash flow statement.

Meaning of the term cash flow

Cash flows are inflows (i.e. receipts) and outflows (i.e. payments) of cash and cash
equivalents. Any transaction, which does not result in cash flow, should not be
reported in the cash flow statement. Movements within cash or cash equivalents
are not cash flows because they do not change cash as defined by AS 3, which is
sum of cash, bank and cash equivalents. For example, acquisitions of cash
equivalent investments or cash deposited into bank are not cash flows.

It is important to note that a change in cash does not necessarily imply cash flow.
For example suppose an enterprise has a bank balance of USD 10,000, stated in books
at ` 4,90,000 using the rate of exchange ` 49/USD prevailing on date of receipt of
dollars. If the closing rate of exchange is ` 50/USD, the bank balance will be restated
at ` 5,00,000 on the balance sheet date. The increase is however not a cash flow
because neither there is any cash inflow nor there is any cash outflow.

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Types of cash flow

Cash flows for an enterprise occur in various ways, e.g. through operating income
or expenses, by borrowing or repayment of borrowing or by acquisition or disposal
of fixed assets. The implication of each type of cash flow is clearly different. Cash
received on disposal of a useful fixed asset is likely to have adverse effect on future
performance of the enterprise and it is completely different from cash received
through operating income or cash received through borrowing. It may also be
noted that implications of each cash flow types are interrelated. For example,
borrowed cash used for meeting operating expenses is not same as borrowed cash
used for acquisition of useful fixed assets.
For the aforesaid reasons, the standard identifies three types of cash flows, i.e.
operating cash flows, investing cash flows and financing cash flows. Separate
presentation of each type of cash flow in the cash flow statement improves
usefulness of cash flow information.
The operating cash flows are cash flows generated by operating activities or by
other activities that are not investing or financing activities. Operating activities are
the principal revenue-producing activities of the enterprise. Examples include, cash
purchase and sale of goods, collections from customers for goods, payment to
suppliers of goods, payment of salaries, wages etc.
The investing cash flows are cash flows generated by investing activities. The investing
activities are the acquisition and disposal of long-term assets and other investments
not included in cash equivalents. The examples of investing cash flows include cash
flow arising from investing activities include: (a) receipts from disposals of fixed assets;
(b) loan given to / recovered from other entities (other than loans by financial
enterprises) (c) payments to acquire fixed assets (d) Interests and dividends earned
(other than interests and dividends earned by financial institutions).
The financing cash flows are cash flows generated by financing activities. Financing
activities are activities that result in changes in the size and composition of the
owners’ capital (including preferences share capital in the case of company) and
borrowings of the enterprise. Examples include issue of shares / debentures,
redemption of debentures / preference shares, payment of dividends and payment
of interests (other than interests paid by financial institutions).

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Identifying type of cash flows

Classification of Cash Flows

Net Cash Flow

Operating Activities Investing Activities Financing Activities

Direct Indirect Direct Direct

Method Method Method Method

Cash flow type depends on the business of the enterprise and other factors. For
example, since principal business of financial enterprises consists of borrowing,
lending and investing, loans given and interests earned are operating cash flows
for financial enterprises and investing cash flows for other enterprises. A few typical
cases are discussed below.
Loans/Advances given and Interests earned
(a) Loans and advances given and interests earned on them in the ordinary
course of business are operating cash flows for financial enterprises.
(b) Loans and advances given and interests earned on them are investing cash
flows for non-financial enterprises.
(c) Loans and advances given to subsidiaries and interests earned on them are
investing cash flows for all enterprises.
(d) Loans and advances given to employees and interests earned on them are
operating cash flows for all enterprises.
(e) Advance payments to suppliers and interests earned on them are operating
cash flows for all enterprises.
(f) Interests earned from customers for late payments are operating cash flows
for non-financial enterprises.
Loans/Advances taken and interests paid
(a) Loans and advances taken and interests paid on them in the ordinary course
of business are operating cash flows for financial enterprises.
(b) Loans and advances taken and interests paid on them are financing cash flows

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for non-financial enterprises.

(c) Loans and advances taken from subsidiaries and interests paid on them are
financing cash flows for all enterprises.
(d) Advance taken from customers and interests paid on them are operating cash
flows for non-financial enterprises.
(e) Interests paid to suppliers for late payments are operating cash flows for all
enterprises.
(f) Interests taken as part of inventory costs in accordance with AS 16 are
operating cash flows.
Investments made and dividends earned
(a) Investments made and dividends earned on them in the ordinary course of
business are operating cash flows for financial enterprises.
(b) Investments made and dividends earned on them are investing cash flows for
non-financial enterprises.
(c) Investments in subsidiaries and dividends earned on them are investing cash
flows for all enterprises.
Dividends Paid
Dividends paid are financing cash outflows for all enterprises.
Income Tax
(a) Tax paid on operating income is operating cash outflows for all enterprises
(b) Tax deducted at source against income are operating cash outflows if
concerned incomes are operating incomes and investing cash outflows if the
concerned incomes are investment incomes, e.g. interest earned.
(c) Tax deducted at source against expenses are operating cash inflows if
concerned expenses are operating expenses and financing cash inflows if the
concerned expenses are financing expenses, e.g. interests paid.
Insurance claims received
(a) Insurance claims received against loss of stock or loss of profits are
extraordinary operating cash inflows for all enterprises.
(b) Insurance claims received against loss of fixed assets are extraordinary
investing cash inflows for all enterprises.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.55

AS 3 requires separate disclosure of extraordinary cash flows, classifying them as

cash flows from operating, investing or financing activities, as may be appropriate.
Reporting Cash Flows from Operating Activities
Net cash flow from operating activities can be reported either as direct method or
as indirect method.
In ‘Direct method’ we take the gross receipts from sales, trade receivables and other
operating inflows subtracted by gross payments for purchases, creditors and other
expenses ignoring all non-cash items like depreciation, provisions. In ‘Indirect
method’ we start from the net profit or loss figure, eliminate the effect of any non-
cash items, investing items and financing items from such profit figure i.e. all such
expenses like depreciation, provisions, interest paid, loss on sale of assets etc. are
added and interest received etc. are deducted. Adjustment for changes in working
capital items are also made ignoring cash and cash equivalent to reach to the figure
of net cash flow.
Direct method is preferred over indirect because, direct method gives us the clear
picture of various sources of cash inflows and outflows which helps in estimating
the future cash inflows and outflows.
Below is the format for Cash Flow Statement (Illustrative):
Cash Flow Statement of X Ltd. for the year ended March 31, 20X1
(Direct Method)

Particulars ` `
Operating Activities:
Cash received from sale of goods xxx
Cash received from Trade receivables xxx
Cash received from sale of services xxx xxx
Less: Payment for Cash Purchases xxx
Payment to Trade payables xxx
Payment for Operating Expenses xxx
e.g. power, rent, electricity
Payment for wages & salaries xxx
Payment for Income Tax xxx xxx
xxx

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 3.56 ACCOUNTING

Adjustment for Extraordinary Items xxx

Net Cash Flow from Operating Activities xxx

Cash Flow Statement of X Ltd. for the year ended March 31, 20X1
(Indirect Method)

Particulars ` `
Operating Activities:
Closing balance of Profit & Loss Account xxx
Less: Opening balance of Profit & Loss Account xxx
xxx
Reversal of the effects of Profit & Loss Appropriation xxx
Account
Add: Provision for Income Tax xxx
Effects of Extraordinary Items xxx
Net Profit Before Tax and Extraordinary Items xxx
Reversal of the effects of non-cash and non-operating items xxx
Effects for changes in Working Capital except cash & cash xxx
equivalent
xxx
Less : Payment of Income Tax xxx xxx
Adjustment for Extraordinary Items xxx
Net Cash Flow from Operating Activities xxx

Profit or loss on disposal of fixed assets

Profit or loss on sale of fixed asset is not operating cash flow. The entire proceeds
of such transactions should be taken as cash inflow from investing activity.
Fundamental techniques of cash flow preparation
A cash flow statement is a summary of cash receipts and payments of an enterprise
during an accounting period. Any attempt to compile such a summary from
cashbooks is impractical due to the large volume of transactions. Fortunately, it is
possible to compile such a summary by comparing financial statements at the
beginning and at the end of accounting period.

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Reporting Cash Flows on Net Basis

AS 3 forbids netting of receipts and payments from investing and financing activities.
Thus, cash paid on purchase of fixed assets should not be shown net of cash realised
from sale of fixed assets. For example, if an enterprise pays ` 50,000 in acquisition of
machinery and realises ` 10,000 on disposal of furniture, it is not right to show net cash
outflow of ` 40,000. The exceptions to this rule are stated below.
Cash flows from the following operating, investing or financing activities may be
reported on a net basis.
(a) Cash receipts and payments on behalf of customers, e.g. cash received and
paid by a bank against acceptances and repayment of demand deposits.
(b) Cash receipts and payments for items in which the turnover is quick, the
amounts are large and the maturities are short, e.g. purchase and sale of
investments by an investment company.
AS 3 permits financial enterprises to report cash flows on a net basis in the
following three circumstances.
(a) Cash flows on acceptance and repayment of fixed deposits with a fixed
maturity date
(b) Cash flows on placement and withdrawal deposits from other financial
enterprises
(c) Cash flows on advances/loans given to customers and repayments received
therefrom.
Interest and Dividends
Cash flows from interest and dividends received and paid should each be disclosed
separately. Cash flows arising from interest paid and interest and dividends
received in the case of a financial enterprise should be classified as cash flows
arising from operating activities. In the case of other enterprises, cash flows arising
from interest paid should be classified as cash flows from financing activities while
interest and dividends received should be classified as cash flows from investing
activities. Dividends paid should be classified as cash flows from financing activities.
Non-Cash transactions
Investing and financing transactions that do not require the use of cash or cash
equivalents, e.g. issue of bonus shares, should be excluded from a cash flow
statement. Such transactions should be disclosed elsewhere in the financial

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statements in a way that provides all the relevant information about these investing
and financing activities.
Business Purchase
The aggregate cash flows arising from acquisitions and disposals of subsidiaries or
other business units should be presented separately and classified as cash flow
from investing activities.
(a) The cash flows from disposal and acquisition should not be netted off.
(b) An enterprise should disclose, in aggregate, in respect of both acquisition and
disposal of subsidiaries or other business units during the period each of the
following:
(i) The total purchase or disposal consideration; and
(ii) The portion of the purchase or disposal consideration discharged by
means of cash and cash equivalents.
Treatment of current assets and liabilities taken over on business purchase
Business purchase is not operating activity. Thus, while taking the differences
between closing and opening current assets and liabilities for computation of
operating cash flows, the closing balances should be reduced by the values of
current assets and liabilities taken over. This ensures that the differences reflect the
increases/decreases in current assets and liabilities due to operating activities only.
Exchange gains and losses
The foreign currency monetary assets (e.g. balance with bank, debtors etc.) and
liabilities (e.g. creditors) are initially recognised by translating them into reporting
currency by the rate of exchange transaction date. On the balance sheet date, these
are restated using the rate of exchange on the balance sheet date. The difference
in values is exchange gain/loss. The exchange gains and losses are recognised in
the statement of profit and loss.
The exchange gains/losses in respect of cash and cash equivalents in foreign
currency (e.g. balance in foreign currency bank account) are recognised by the
principle aforesaid, and these balances are restated in the balance sheet in
reporting currency at rate of exchange on balance sheet date. The change in cash
or cash equivalents due to exchange gains and losses are however not cash flows.
This being so, the net increases/decreases in cash or cash equivalents in the cash
flow statements are stated exclusive of exchange gains and losses. The resultant

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 OVERVIEW OF ACCOUNTING STANDARDS 3.59

difference between cash and cash equivalents as per the cash flow statement and
that recognised in the balance sheet is reconciled in the note on cash flow
statement.
Disclosures
AS 3 requires an enterprise to disclose the amount of significant cash and cash
equivalent balances held by it but not available for its use, together with a
commentary by management. This may happen for example, in case of bank
balances held in other countries subject to such exchange control or other
regulations that the fund is practically of no use.
AS 3 encourages disclosure of additional information, relevant for understanding
the financial position and liquidity of the enterprise together with a commentary
by management. Such information may include:
(a) The amount of undrawn borrowing facilities that may be available for future
operating activities and to settle capital commitments, indicating any
restrictions on the use of these facilities; and
(b) The aggregate amount of cash flows required for maintaining operating
capacity, e.g. purchase of machinery to replace the old, separately from cash
flows that represent increase in operating capacity, e.g. additional machinery
purchased to increase production.
Illustration 1
Classify the following activities as (a) Operating Activities, (b) Investing Activities, (c)
Financing Activities (d) Cash Equivalents.
(a) Purchase of Machinery.
(b) Proceeds from issuance of equity share capital
(c) Cash Sales.
(d) Proceeds from long-term borrowings.
(e) Cheques collected from Trade receivables.
(f) Cash receipts from Trade receivables.
(g) Trading Commission received.
(h) Purchase of investment.
(i) Redemption of Preference Shares.
(j) Cash Purchases.

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 3.60 ACCOUNTING

(k) Proceeds from sale of investment

(l) Purchase of goodwill.
(m) Cash paid to suppliers.
(n) Interim Dividend paid on equity shares.
(o) Wages and salaries paid.
(p) Proceed from sale of patents.
(q) Interest received on debentures held as investment.
(r) Interest paid on Long-term borrowings.
(s) Office and Administration Expenses paid
(t) Manufacturing Overheads paid.
(u) Dividend received on shares held as investments.
(v) Rent Received on property held as investment.
(w) Selling and distribution expense paid.
(x) Income tax paid
(y) Dividend paid on Preference shares.
(z) Underwritings Commission paid.
(aa) Rent paid.
(bb) Brokerage paid on purchase of investments.
(cc) Bank Overdraft
(dd) Cash Credit
(ee) Short-term Deposits
(ff) Highly liquid Marketable Securities (without risk of change in value)
(gg) Refund of Income Tax received.
Solution
(a) Operating Activities: c, e, f, g, j, m, o, s, t, w, x, aa & gg.
(b) Investing Activities: a, h, k, l, p, q, u, v, bb & ee.
(c) Financing Activities: b, d, i, n, r, y, z, cc & dd.
(d) Cash Equivalent: ff.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.61

Illustration 2
X Ltd. purchased debentures of ` 10 lacs of Y Ltd., which are redeemable within three
months. How will you show this item as per AS 3 while preparing cash flow statement
for the year ended on 31st March, 20X1?
Solution
As per AS 3 on ‘Cash flow Statement’, cash and cash equivalents consists of cash in
hand, balance with banks and short-term, highly liquid investments ∗. If investment,
of ` 10 lacs, made in debentures is for short-term period then it is an item of ‘cash
equivalents’.
However, if investment of ` 10 lacs made in debentures is for long-term period
then as per AS 3, it should be shown as cash flow from investing activities.
Illustration 3
Classify the following activities as per AS 3 Cash Flow Statement:
(i) Interest paid by financial enterprise
(ii) Tax deducted at source on interest received from subsidiary company
(iii) Deposit with Bank for a term of two years
(iv) Insurance claim received towards loss of machinery by fire
(v) Bad debts written off
Solution
(i) Interest paid by financial enterprise
Cash flows from operating activities
(ii) TDS on interest received from subsidiary company
Cash flows from investing activities
(iii) Deposit with bank for a term of two years
Cash flows from investing activities

∗
As per AS 3, an investment normally qualifies as a cash equivalent only when it has a short
maturity of, say three months or less from the date of acquisition and is subject to
insignificant risk of change in value.

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 3.62 ACCOUNTING

(iv) Insurance claim received against loss of fixed asset by fire

Extraordinary item to be shown as a separate heading under ‘Cash flow from
investing activities’
(v) Bad debts written off
It is a non-cash item which is adjusted from net profit/loss under indirect
method, to arrive at net cash flow from operating activity.
Illustration 4
Following is the cash flow abstract of Alpha Ltd. for the year ended 31st March, 20X1:
Cash Flow (Abstract)

Inflows ` Outflows `
Opening balance: Payment for Account
Cash 10,000 Payables 90,000
Bank 70,000 Salaries and wages 25,000
Share capital – shares issued 5,00,000 Payment of overheads 15,000
Collection on account of Property, plant and
Trade Receivables 3,50,000 equipment acquired 4,00,000
Debentures redeemed 50,000
Sale of Property, plant and 70,000 Bank loan repaid 2,50,000
equipment
Taxation 55,000
Dividends 1,00,000
Closing balance:
Cash 5,000
bank 10,000
10,00,000 10,00,00
0

Prepare Cash Flow Statement for the year ended 31st March, 20X1 in accordance with
Accounting standard 3.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.63

Solution
Cash Flow Statement for the year ended 31.3.20X1

` `
Cash flow from operating activities
Cash received on account of trade receivables 3,50,000
Cash paid on account of trade payables (90,000)
Cash paid to employees (salaries and wages) (25,000)
Other cash payments (overheads) (15,000)
Cash generated from operations 2,20,000
Income tax paid (55,000)
Net cash generated from operating activities 1,65,000
Cash flow from investing activities
Payment for purchase of Property, plant and equipment (4,00,000)
Proceeds from sale of Property, plant and equipment 70,000
Net cash used in investment activities (3,30,000)
Cash flow from financing activities
Proceeds from issue of share capital 5,00,000
Bank loan repaid (2,50,000)
Debentures redeemed (50,000)
Dividends paid (1,00,000)
Net cash used in financing activities 1,00,000
Net decrease in cash and cash equivalents (65,000)
Cash and cash equivalents at the beginning of the year 80,000
Cash and cash equivalents at the end of the year 15,000

Illustration 5
Prepare Cash Flow from Investing Activities of M/s. Creative Furnishings Limited for
the year ended 31-3-20X1.

Particulars `
Plant acquired by the issue of 8% Debentures 1,56,000
Claim received for loss of plant in fire 49,600
Unsecured loans given to subsidiaries 4,85,000

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 3.64 ACCOUNTING

Interest on loan received from subsidiary companies 82,500

Pre-acquisition dividend received on investment made 62,400
Debenture interest paid 1,16,000
Term loan repaid 4,25,000
Interest received on investment 68,000
(TDS of ` 8,200 was deducted on the above interest)
Book value of plant sold (loss incurred ` 9,600) 84,000
Solution
Cash Flow Statement from Investing Activities of
M/s Creative Furnishings Limited for the year ended 31-03-20X1

Cash generated from investing activities ` `

Interest on loan received 82,500
Pre-acquisition dividend received on investment made 62,400
Unsecured loans given to subsidiaries (4,85,000)
Interest received on investments (gross value) 76,200
TDS deducted on interest (8,200)
Sale of plant 74,400
Cash used in investing activities (before extra ordinary item) (1,97,700)
Extraordinary claim received for loss of plant 49,600
Net cash used in investing activities (after extra ordinary item) (1,48,100)

Note:
1. Debenture interest paid and Term Loan repaid are financing activities and
therefore not considered for preparing cash flow from investing activities.
2. Plant acquired by issue of 8% debentures does not amount to cash outflow,
hence also not considered in the above cash flow statement.
Note: For details regarding preparation of Cash Flow Statement and Problems
based on practical application of AS 3, students are advised to refer unit 2 of
Chapter 4.
Reference: The students are advised to refer the full text of AS 3 “Cash Flow
Statement.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.65

2.4 AS 10 (REVISED): PROPERTY, PLANT AND

EQUIPMENT
Introduction
The objective of this Standard is to prescribe accounting treatment for Property,
Plant and Equipment (PPE).

Information
Help the about Investment
Prescribe Users of in PPE
Objectives of "Accounting Financial
AS 10 (Revised) Treatment Statements
for PPE" to
Changes in such
understand
Investment

The principal issues in Accounting for PPE are:

Determination
of their Depreciation
carrying charge
amounts

Impairment
Recognition of losses to be
PPE Principle recognised in
Issues in relation to
Accounting them
of PPE

Scope of the Standard

As a general principle, AS 10 (Revised) should be applied in accounting for PPE.
Exception:
When another Accounting Standard requires or permits a different accounting
treatment.

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 3.66 ACCOUNTING

Example: AS 19 1 on Leases, requires an enterprise to evaluate its recognition of an

item of leased PPE on the basis of the transfer of risks and rewards. However, it
may be noted that in such cases other aspects of the accounting treatment for
these assets, including depreciation, are prescribed by this Standard.
This Standard does not apply to:

AS 10 (Revised)
Not Applicable to

Biological Assets (other than Wasting Assets including Mineral

Bearer Plants) related to rights, Expenditure on the exploration
agricultural activity for and extraction of minerals, oil,
natural gas and similar non-
regenerative resources

Note: AS 10 (Revised) applies to Bearer Plants but it does not apply to the
produce on Bearer Plants.
Clarifications:
1. AS 10 (Revised) applies to PPE used to develop or maintain the assets
described above.
2. Investment property (defined in AS 13 (Revised)), should be accounted for
only in accordance with the Cost model prescribed in this standard.
DEFINITION OF PROPERTY, PLANT AND EQUIPMENT(PPE)
There are 2 conditions to be satisfied for a TANGIBLE item to be called PPE. PPE are
tangible items that:

1
The students may note that AS 19 on Leases is not covered in syllabus of Intermediate Paper
1: Accounting syllabus.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.67

Use in Production or Supply

of Goods or Services
Condition 1:
For Rental to others
Held for
PPE
For Administrative purposes
(Tangible Items)
Condition 2: Used for more than 12
Expected to be months

Note: Intangible items are covered under AS 26.

“Administrative purposes”: The term ‘Administrative purposes’ has been used in
wider sense to include all business purposes. Thus, PPE would include assets used
for:
• Selling and distribution
• Finance and accounting
• Personnel and other functions of an Enterprise.
Items of PPE may also be acquired for safety or environmental reasons.
The acquisition of such PPE, although not directly increasing the future economic
benefits of any particular existing item of PPE, may be necessary for an enterprise
to obtain the future economic benefits from its other assets.
Such items of PPE qualify for recognition as assets because they enable an
enterprise to derive future economic benefits from related assets in excess of what
could be derived had those items not been acquired.
Example: A chemical manufacturer may install new chemical handling processes to
comply with environmental requirements for the production and storage of
dangerous chemicals; related plant enhancements are recognised as an asset because
without them the enterprise is unable to manufacture and sell chemicals.
The resulting carrying amount of such an asset and related assets is reviewed for
impairment in accordance with AS 28 (Impairment of Assets) 2.

2
The students may note that AS 28 on Impairment of Assets is not covered in syllabus of
Intermediate Paper 1: Accounting syllabus.

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OTHER DEFINITIONS
1. Biological Asset: An Accounting Standard on “Agriculture” is under
formulation, which will, inter alia, cover accounting for livestock. Till the time,
the Accounting Standard on “Agriculture” is issued, accounting for livestock
meeting the definition of PPE, will be covered as per AS 10 (Revised).

AS 10 (Revised)
Living Animal does not apply if definition of
PPE not met
Biological Asset
AS 10 (Revised) applies to
Plant
Bearer Plants

2. Bearer Plant: Is a plant that (satisfies all 3 conditions):

Is used in the production or supply •Of Agricultural produce

•For more than a period of

Is expected to bear produce
12 months

Has a remote likelihood of being •Except for incidental scrap

sold as Agricultural produce sales

Note: When bearer plants are no longer used to bear produce they might be cut
down and sold as scrap. For example - use as firewood. Such incidental scrap sales
would not prevent the plant from satisfying the definition of a Bearer Plant.
The following are not Bearer Plants:
(a) Plants cultivated to be harvested as Agricultural produce
Example: Trees grown for use as lumber
(b) Plants cultivated to produce Agricultural produce when there is more than a
remote likelihood that the entity will also harvest and sell the plant as
agricultural produce, other than as incidental scrap sales
Example: Trees which are cultivated both for their fruit and their lumber

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 OVERVIEW OF ACCOUNTING STANDARDS 3.69

(c) Annual crops

Example: Maize and wheat
What are not
"Bearer Plants"

Plants cultivated to be Plants cultivated to Annual Crops

harvested as Agricultural
Produce Agricultural produce
produce
And
Harvest and sell the plant as Maize and wheat
Trees grown for use as Agricultural produce
lumber

Trees which are cultivated both for

their fruit and their lumber

Agricultural Produce is the harvested product of Biological Assets of the enterprise.

3. Agricultural Activity: Is the management by an Enterprise of:
o Biological transformation; and
o Harvest of Biological Assets
• For sale, Or
• For conversion into Agricultural Produce, Or
• Into additional Biological Assets

For Sale

Biological
Agricultural transformation For Conversion into
Management
Activity and harvest of Agriculture Produce
Biological Assets
Into Additional
Biological Assets

Recognition Criteria for PPE

The cost of an item of PPE should be recognised as an asset if, and only if:
(a) It is probable that future economic benefits associated with the item will flow
to the enterprise, and

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(b) The cost of the item can be measured reliably.

Notes:
1. It may be appropriate to aggregate individually insignificant items, such as
moulds, tools and dies and to apply the criteria to the aggregate value.
2. An enterprise may decide to expense an item which could otherwise have
been included as PPE, because the amount of the expenditure is not material.
When do we apply the above criteria for Recognition?
An enterprise evaluates under this recognition principle all its costs on PPE at the
time they are incurred.
These costs include costs incurred:

Situation I To acquire or construct an

Initially item of PPE
Cost Incurred
Situation II To add to, replace part of,
Subsequently or service it

Treatment of Spare Parts, Stand by Equipment and Servicing

Equipment
Case I If they meet the definition of PPE as per AS 10 (Revised):
• Recognised as PPE as per AS 10 (Revised)
Case II If they do not meet the definition of PPE as per AS 10 (Revised):
• Such items are classified as Inventory as per AS 2 (Revised)
Illustration 1 (Capitalising the cost of “Remodelling” a Supermarket)
Entity A, a supermarket chain, is renovating one of its major stores. The store will
have more available space for in store promotion outlets after the renovation and
will include a restaurant. Management is preparing the budgets for the year after the
store reopens, which include the cost of remodelling and the expectation of a 15%
increase in sales resulting from the store renovations, which will attract new
customers. State whether the remodelling cost will be capitalised or not.

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Solution
The expenditure in remodelling the store will create future economic benefits (in
the form of 15% of increase in sales) and the cost of remodelling can be measured
reliably, therefore, it should be capitalised.
TREATMENT OF SUBSEQUENT COSTS
Cost of day-to-day servicing
Meaning
Costs of day-to-day servicing are primarily the costs of labour and consumables,
and may include the cost of small parts. The purpose of such expenditures is often
described as for the ‘Repairs and Maintenance’ of the item of PPE.
Accounting Treatment:
An enterprise does not recognise in the carrying amount of an item of PPE the costs
of the day-to-day servicing of the item. Rather, these costs are recognised in the
Statement of Profit and Loss as incurred.
Replacement of Parts of PPE
Parts of some items of PPE may require replacement at regular intervals.
Examples
1. A furnace may require relining after a specified number of hours of use.
2. Aircraft interiors such as seats and galleys may require replacement several
times during the life of the airframe.
3. Major parts of conveyor system, such as, conveyor belts, wire ropes, etc., may
require replacement several times during the life of the conveyor system.
4. Replacing the interior walls of a building, or to make a non-recurring
replacement.
Accounting Treatment
An enterprise recognises in the carrying amount of an item of PPE the cost of replacing
part of such an item when that cost is incurred if the recognition criteria are met.
Note: The carrying amount of those parts that are replaced is derecognised in
accordance with the de-recognition provisions of this Standard.

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Regular Major Inspections - Accounting Treatment

When each major inspection is performed, its cost is recognised in the carrying amount
of the item of PPE as a replacement, if the recognition criteria are satisfied.
Any remaining carrying amount of the cost of the previous inspection (as distinct
from physical parts) is derecognised.
Illustration 2
What happens if the cost of the previous part/inspection was/ was not identified in
the transaction in which the item was acquired or constructed?
Solution

De-recognition of the carrying amount occurs regardless of whether the cost of the
previous part/inspection was identified in the transaction in which the item was
acquired or constructed.
Illustration 3
What will be your answer in the above question, if it is not practicable for an
enterprise to determine the carrying amount of the replaced part/inspection?
Solution
It may use the cost of the replacement or the estimated cost of a future similar
inspection as an indication of what the cost of the replaced part/existing inspection
component was when the item was acquired or constructed.
Measurement of PPE

Cost Model
At Recognition
Measurement Cost Model
After Recognition
Revaluation Model

Measurement at Recognition
An item of PPE that qualifies for recognition as an asset should be measured at its
cost.
What are the elements of Cost?

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 OVERVIEW OF ACCOUNTING STANDARDS 3.73

Cost of an item of PPE comprises:

Cost of an Item of
PPE

Includes Excludes

Any Directly Decommissioning, Costs of opening a new

Purchase
Attributable Restoration and facility or business (Such as,
Price
Costs similar Liabilities Inauguration costs)
Costs of introducing a new
product or service (including
costs of advertising and
promotional activities)
Costs of conducting business
in a new location or with a
new class of customer
(including costs of staff
training)
Administration and other
general overhead costs

Let us understand the above in detail.

A. Purchase Price:
• It includes import duties and non –refundable purchase taxes.
• It requires deduction of Trade discounts and rebates
B. Directly Attributable Costs:
Any costs directly attributable to bringing the asset to the ‘location and condition’
necessary for it to be capable of operating in the manner intended by management
Recognition of costs in the carrying amount of an item of PPE ceases when the item
is in the location and condition necessary for it to be capable of operating in the
manner intended by management.
The following costs are not included in the carrying amount of an item of PPE:
1. Costs incurred while an item capable of operating in the manner intended by
management has yet to be brought into use or is operated at less than full
capacity.

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2. Initial operating losses, such as those incurred while demand for the output
of an item builds up. And
3. Costs of relocating or reorganising part or all of the operations of an
enterprise.
Examples of directly attributable costs are:
1. Costs of employee benefits (as defined in AS 15) arising directly from the
construction or acquisition of the item of PPE
2. Costs of site preparation
3. Initial delivery and handling costs
4. Installation and assembly costs
5. Costs of testing whether the asset is functioning properly, after deducting the
net proceeds from selling any items produced while bringing the asset to that
location and condition (such as samples produced when testing equipment)
6. Professional fees
Examples of costs that are not costs of an item of property, plant and
equipment are:
(a) costs of opening a new facility or business, such as, inauguration costs
(b) costs of introducing a new product or service (including costs of advertising
and promotional activities)
(c) costs of conducting business in a new location or with a new class of customer
(including costs of staff training)
(d) administration and other general overhead costs
Note: Some operations occur in connection with the construction or development
of an item of PPE, but are not necessary to bring the item to the location and
condition necessary for it to be capable of operating in the manner intended by
management. These incidental operations may occur before or during the
construction or development activities.
Example: Income may be earned through using a building site as a car park until
construction starts because incidental operations are not necessary to bring an item
to the location and condition necessary for it to be capable of operating in the manner
intended by management, the income and related expenses of incidental operations
are recognised in the Statement of Profit and Loss and included in their respective
classifications of income and expense.

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Illustration 4
Entity A has an existing freehold factory property, which it intends to knock down and
redevelop. During the redevelopment period the company will move its production
facilities to another (temporary) site. The following incremental costs will be incurred:
1. Setup costs of ` 5,00,000 to install machinery in the new location.
2. Rent of ` 15,00,000
3. Removal costs of ` 3,00,000 to transport the machinery from the old location to
the temporary location.
Can these costs be capitalised into the cost of the new building?
Solution
Constructing or acquiring a new asset may result in incremental costs that would have
been avoided if the asset had not been constructed or acquired. These costs are not
to be included in the cost of the asset if they are not directly attributable to bringing
the asset to the location and condition necessary for it to be capable of operating in
the manner intended by management. The costs to be incurred by the company are in
the nature of costs of relocating or reorganising operations of the company and do
not meet the requirement of AS 10 (Revised) and therefore, cannot be capitalised.
Illustration 5
Omega Ltd. contracted with a supplier to purchase machinery which is to be installed
in its one department in three months' time. Special foundations were required for
the machinery which were to be prepared within this supply lead time. The cost of
the site preparation and laying foundations were ` 1,40,000. These activities were
supervised by a technician during the entire period, who is employed for this purpose
of ` 45,000 per month. The machine was purchased at ` 1,58,00,000 and ` 50,000
transportation charges were incurred to bring the machine to the factory site. An
Architect was appointed at a fee of ` 30,000 to supervise machinery installation at
the factory site. You are required to ascertain the amount at which the Machinery
should be capitalized.
Solution

Particulars `
Purchase Price Given 1,58,00,000
Add: Site Preparation Cost Given 1,40,000
Technician’s Salary Specific/Attributable overheads 1,35,000

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for 3 months (45,000 x3)

Initial Delivery Cost Transportation 50,000
Professional Fees for Architect’s Fees 30,000
Installation
Total Cost of Machinery 1,61,55,000
Illustration 6 (Capitalisation of directly attributable costs)
Entity A, which operates a major chain of supermarkets, has acquired a new store
location. The new location requires significant renovation expenditure. Management
expects that the renovations will last for 3 months during which the supermarket will
be closed.
Management has prepared the budget for this period including expenditure related
to construction and remodelling costs, salaries of staff who will be preparing the store
before its opening and related utilities costs. What will be the treatment of such
expenditures?
Solution
Management should capitalise the costs of construction and remodelling the
supermarket, because they are necessary to bring the store to the condition
necessary for it to be capable of operating in the manner intended by management.
The supermarket cannot be opened without incurring the remodelling expenditure,
and thus the expenditure should be considered part of the asset.
However, if the cost of salaries, utilities and storage of goods are in the nature of
operating expenditure that would be incurred if the supermarket was open, then
these costs are not necessary to bring the store to the condition necessary for it to
be capable of operating in the manner intended by management and should be
expensed.
Illustration 7 (Operating costs incurred in the start-up period)
An amusement park has a 'soft' opening to the public, to trial run its attractions.
Tickets are sold at a 50% discount during this period and the operating capacity is
80%. The official opening day of the amusement park is three months later.
Management claim that the soft opening is a trial run necessary for the amusement
park to be in the condition capable of operating in the intended manner. Accordingly,
the net operating costs incurred should be capitalised. Comment.

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Solution
The net operating costs should not be capitalised, but should be recognised in the
Statement of Profit and Loss.
Even though it is running at less than full operating capacity (in this case 80% of
operating capacity), there is sufficient evidence that the amusement park is capable
of operating in the manner intended by management. Therefore, these costs are
specific to the start-up and, therefore, should be expensed as incurred.
C. Decommissioning, Restoration and similar Liabilities:
Initial estimate of the costs of dismantling, removing the item and restoring the
site on which it is located, referred to as ‘Decommissioning, Restoration and similar
Liabilities’, the obligation for which an enterprise incurs either when the item is
acquired or as a consequence of having used the item during a particular period
for purposes other than to produce inventories during that period.
Exception: An enterprise applies AS 2 (Revised) “Valuation of Inventories”, to the
costs of obligations for dismantling, removing and restoring the site on which an
item is located that are incurred during a particular period as a consequence of
having used the item to produce inventories during that period.
Note: The obligations for costs accounted for in accordance with AS 2 (Revised) or
AS 10 (Revised) are recognised and measured in accordance with AS 29 (Revised)
“Provisions, Contingent Liabilities and Contingent Assets”.
COST OF A SELF-CONSTRUCTED ASSET
Cost of a self-constructed asset is determined using the same principles as for an
acquired asset.
1. If an enterprise makes similar assets for sale in the normal course of business,
the cost of the asset is usually the same as the cost of constructing an asset
for sale. Therefore, any internal profits are eliminated in arriving at such costs.
2. Cost of abnormal amounts of wasted material, labour, or other resources
incurred in self constructing an asset is not included in the cost of the asset.
3. AS 16 on Borrowing Costs, establishes criteria for the recognition of interest
as a component of the carrying amount of a self-constructed item of PPE.
4. Bearer plants are accounted for in the same way as self-constructed items of
PPE before they are in the location and condition necessary to be capable of
operating in the manner intended by management.

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MEASUREMENT OF COST
Cost of an item of PPE is the cash price equivalent at the recognition date.
A. If payment is deferred beyond normal credit terms:
Total payment minus Cash price equivalent
• is recognised as an interest expense over the period of credit
• unless such interest is capitalised in accordance with AS 16
B. PPE acquired in Exchange for a Non-monetary Asset or Assets or A
combination of Monetary and Non-monetary Assets:
Cost of such an item of PPE is measured at fair value unless:
(a) Exchange transaction lacks commercial substance; Or
(b) Fair value of neither the asset(s) received nor the asset(s) given up is reliably
measurable.
Note:
1. The acquired item(s) is/are measured in this manner even if an enterprise
cannot immediately derecognise the asset given up.
2. If the acquired item(s) is/are not measured at fair value, its/their cost is
measured at the carrying amount of the asset(s) given up.
3. An enterprise determines whether an exchange transaction has commercial
substance by considering the extent to which its future cash flows are
expected to change as a result of the transaction. An exchange transaction
has commercial substance if:
(a) the configuration (risk, timing and amount) of the cash flows of the
asset received differs from the configuration of the cash flows of the
asset transferred; or
(b) the enterprise-specific value of the portion of the operations of the
enterprise affected by the transaction changes as a result of the
exchange;
(c) and the difference in (a) or (b) is significant relative to the fair value of
the assets exchanged.

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For the purpose of determining whether an exchange transaction has commercial

substance, the enterprise-specific value of the portion of operations of the
enterprise affected by the transaction should reflect post-tax cash flows. In certain
cases, the result of these analyses may be clear without an enterprise having to
perform detailed calculations.
Illustration 8 (Consideration received comprising a combination of non-
monetary and monetary assets)
Entity A exchanges land with a book value of ` 10,00,000 for cash of ` 20,00,000 and
plant and machinery valued at ` 25,00,000. What will be the measurement cost of
the assets received. (Consider that the transaction has commercial substance)?
Solution
Since the transaction has commercial substance the plant and machinery would be
recorded at ` 25,00,000, which is equivalent to the fair value of the land of
` 45,00,000 less the cash received of ` 20,00,000.
Illustration 9 (Exchange of assets that lack commercial substance)
Entity A exchanges car X with a book value of ` 13,00,000 and a fair value of
` 13,25,000 for cash of ` 15,000 and car Y which has a fair value of ` 13,10,000. The
transaction lacks commercial substance as the company’s cash flows are not expected
to change as a result of the exchange. It is in the same position as it was before the
transaction. What will be the measurement cost of the assets received?
Solution
The entity recognises the assets received at the book value of car X. Therefore, it
recognises cash of ` 15,000 and car Y as PPE with a carrying value of ` 12,85,000.
C. PPE purchased for a Consolidated Price:
Where several items of PPE are purchased for a consolidated price, the
consideration is apportioned to the various items on the basis of their
respective fair values at the date of acquisition.
Note: In case the fair values of the items acquired cannot be measured reliably,
these values are estimated on a fair basis as determined by competent valuers.
D. PPE held by a lessee under a Finance Lease:
The cost of an item of PPE held by a lessee under a finance lease is determined
in accordance with AS 19 (Leases).

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E. Government Grant related to PPE:

The carrying amount of an item of PPE may be reduced by government grants
in accordance with AS 12 (Accounting for Government Grants).
Measurement after Recognition
An enterprise should choose
• Either Cost model,
• Or Revaluation model
as its accounting policy and should apply that policy to an entire class of PPE.
Class of PPE: A class of PPE is a grouping of assets of a similar nature and use in
operations of an enterprise.
Examples of separate classes:
(a) Land (b) Land and Buildings
(c) Machinery (d) Ships
(e) Aircraft (f) Motor Vehicles
(g) Furniture and Fixtures (h) Office Equipment
(j) Bearer plants
Cost Model
After recognition as an asset, an item of PPE should be carried at:
Cost- Any Accumulated Depreciation- Any Accumulated Impairment losses
Revaluation Model
After recognition as an asset, an item of PPE whose fair value can be measured
reliably should be carried at a revalued amount.
Fair value at the date of the revaluation —
Less: Any subsequent accumulated depreciation (—)
Less: Any subsequent accumulated impairment losses (—)
Carrying value —
Revaluation for entire class of PPE
If an item of PPE is revalued, the entire class of PPE to which that asset belongs
should be revalued.

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Reason
The items within a class of PPE are revalued simultaneously to avoid selective
revaluation of assets and the reporting of amounts in the Financial Statements that
are a mixture of costs and values as at different dates.
Illustration 10 (Revaluation on a class by class basis)
Entity A is a large manufacturing group. It owns a number of industrial buildings, such
as factories and warehouses and office buildings in several capital cities. The industrial
buildings are located in industrial zones, whereas the office buildings are in central
business districts of the cities. Entity A's management want to apply the revaluation
model as per AS 10 (Revised) to the subsequent measurement of the office buildings but
continue to apply the historical cost model to the industrial buildings.
State whether this is acceptable under AS 10 (Revised) or not with reasons?
Solution
Entity A's management can apply the revaluation model only to the office buildings.
The office buildings can be clearly distinguished from the industrial buildings in
terms of their function, their nature and their general location.AS 10 (Revised)
permits assets to be revalued on a class by class basis.
The different characteristics of the buildings enable them to be classified as
different PPE classes. The different measurement models can, therefore, be applied
to these classes for subsequent measurement.
However, all properties within the class of office buildings must be carried at
revalued amount.
Frequency of Revaluations
Revaluations should be made with sufficient regularity to ensure that the carrying
amount does not differ materially from that which would be determined using Fair
value at the Balance Sheet date.
The frequency of revaluations depends upon the changes in fair values of the items
of PPE being revalued.
When the fair value of a revalued asset differs materially from its carrying amount,
a further revaluation is required.
A. Items of PPE experience significant and volatile changes in Fair value
Annual revaluation should be done.

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B. Items of PPE with only insignificant changes in Fair value

Revaluation should be done at an interval of 3 or 5 years.
Frequency of Revaluations
(Sufficient Regularity)

Items of PPE experience significant Items of PPE with only insignificant

and volatile changes in Fair value changes in Fair value

Revalue the item only every 3 or 5

Annual revaluation
years

Determination of Fair Value

Fair value of items of PPE is usually determined from market-based evidence by
appraisal that is normally undertaken by professionally qualified valuers.
If there is no market-based evidence of fair value because of the specialised nature
of the item of PPE and the item is rarely sold, except as part of a continuing
business, an enterprise may need to estimate fair value using an income approach.
Example
Based on
• Discounted cash flow projections, Or
• A depreciated replacement cost approach
Which aims at making a realistic estimate of the current cost of acquiring or
constructing an item that has the same service potential as the existing item.
Accounting Treatment of Revaluations
When an item of PPE is revalued, the carrying amount of that asset is adjusted to
the revalued amount.
At the date of the revaluation, the asset is treated in one of the following ways:

A. Technique 1: Gross carrying amount is adjusted in a manner that is consistent

with the revaluation of the carrying amount of the asset.

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Gross carrying amount

• May be restated by reference to observable market data, or
• May be restated proportionately to the change in the carrying amount.
Accumulated depreciation at the date of the revaluation is
• Adjusted to equal the difference between the gross carrying amount and
the carrying amount of the asset after taking into account accumulated
impairment losses
Case Study on Technique I

PPE is revalued to ` 1,500 consisting of ` 2,500 Gross cost and ` 1,000

Depreciation based on observable market data.
Details of the PPE before and after revaluation are as follows:

Particulars Cost/ Accumulated Net

Revalued depreciation book
Cost value
PPE before revaluation (assumed) 1,000 400 600
Fair Value 1,500
Revaluation Gain 900
Gain allocated proportionately to 1,500 600 900
cost and depreciation
PPE after revaluation 2,500 1,000 1,500
The increase on revaluation is ` 900 (i.e., ` 1,500 – ` 600).
B. Technique 2: Accumulated depreciation Is eliminated against the Gross
Carrying amount of the asset
Case Study on Technique II
(Taking the information given in the above Example)
Details of the PPE before and after revaluation are as follows:

Particulars Cost/Revalued Accumulated Net book

Cost depreciation value
PPE before revaluation 1,000 400 600
(assumed)

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PPE after revaluation 1,500 1,500

Revaluation gain 500 400
The increase on revaluation is ` 900 (i.e., ` 500 + ` 400).
Revaluation – Increase or Decrease

Revaluation

Increase Decrease

Credited directly Exception:

Exception: Charged to
to owners’
When it is the Statement When it is subsequently
interests under
subsequently of profit and Decreased (Initially
the heading of
Increased loss Increased)
Revaluation
surplus (Initially
Decreased)
Decrease should be
debited directly to
owners’ interests under
Recognised in the Statement the heading of
of profit and loss to the Revaluation surplus to the
extent that it reverses a extent of any credit
revaluation decrease of the balance existing in the
same asset previously Revaluation surplus in
recognised in the Statement respect of that asset
of profit and loss

Treatment of Revaluation Surplus

The revaluation surplus included in owners’ interests in respect of an item of PPE
may be transferred to the Revenue Reserves when the asset is derecognised.
Case I: When whole surplus is transferred:
When the asset is:
• Retired; Or
• Disposed of
Case II: Some of the surplus may be transferred as the asset is used by an
enterprise:

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In such a case, the amount of the surplus transferred would be:

Depreciation (based on Revalued Carrying amount) – Depreciation
(based on Original Cost)
Transfers from Revaluation Surplus to the Revenue Reserves are not made
through the Statement of Profit and Loss.
Depreciation
Component Method of Depreciation:
Each part of an item of PPE with a cost that is significant in relation to the total cost
of the item should be depreciated separately.
Example: It may be appropriate to depreciate separately the airframe and engines
of an aircraft, whether owned or subject to a finance lease.
Is Grouping of Components possible?
Yes.
A significant part of an item of PPE may have a useful life and a depreciation
method that are the same as the useful life and the depreciation method of another
significant part of that same item. Such parts may be grouped in determining the
depreciation charge.
Accounting Treatment
Depreciation charge for each period should be recognised in the Statement of
Profit and Loss unless it is included in the carrying amount of another asset.
Examples on Exception
AS 2 (Revised): Depreciation of manufacturing plant and equipment is included in
the costs of conversion of inventories as per AS 2 (Revised).
AS 26: Depreciation of PPE used for development activities may be included in the cost
of an intangible asset recognised in accordance with AS 26 on Intangible Assets.
Depreciable Amount and Depreciation Period
What is “Depreciable Amount”?
Depreciable amount is:
Cost of an asset (or other amount substituted for cost i.e. revalued amount) -
Residual value

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The depreciable amount of an asset should be allocated on a systematic basis over

its useful life.
Illustration 11
Entity A has a policy of not providing for depreciation on PPE capitalised in the year
until the following year, but provides for a full year's depreciation in the year of
disposal of an asset. Is this acceptable?
Solution
The depreciable amount of a tangible fixed asset should be allocated on a
systematic basis over its useful life. The depreciation method should reflect the
pattern in which the asset's future economic benefits are expected to be consumed
by the entity.
Useful life means the period over which the asset is expected to be available for
use by the entity. Depreciation should commence as soon as the asset is acquired
and is available for use. Thus, the policy of Entity A is not acceptable.
Review of Residual Value and Useful Life of an Asset
Residual value and the useful life of an asset should be reviewed at least at each
financial year-end and, if expectations differ from previous estimates, the change(s)
should be accounted for as a change in an accounting estimate in accordance with
AS 5 ‘Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies’.
Illustration 12 (Change in estimate of useful life)
Entity A purchased an asset on 1st January 20X1 for ` 1,00,000 and the asset had an
estimated useful life of 10 years and a residual value of nil.
On 1st January 20X5, the directors review the estimated life and decide that the asset
will probably be useful for a further 4 years.
Calculate the amount of depreciation for each year, if company charges depreciaion
on Straight Line basis.
Solution
The entity has charged depreciation using the straight-line method at ` 10,000 per
annum i.e (1,00,000/10 years).
On 1st January 20X5, the asset's net book value is [1,00,000 – (10,000 x 4)] ` 60,000.
The remaining useful life is 4 years.

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The company should amend the annual provision for depreciation to charge the
unamortised cost over the revised remaining life of four years.
Consequently, it should charge depreciation for the next 4 years at ` 15,000 per
annum i.e. (60,000 / 4 years).
Note: Depreciation is recognised even if the Fair value of the Asset exceeds its
Carrying Amount. Repair and maintenance of an asset do not negate the need to
depreciate it.
Commencement of period for charging Depreciation
Depreciation of an asset begins when it is available for use, i.e., when it is in the
location and condition necessary for it to be capable of operating in the manner
intended by the management.
Illustration 13
Entity B constructs a machine for its own use. Construction is completed on 1st
November 20X1 but the company does not begin using the machine until 1st March
20X2. Comment.
Solution
The entity should begin charging depreciation from the date the machine is ready
for use – that is, 1st November 20X1. The fact that the machine was not used for a
period after it was ready to be used is not relevant in considering when to begin
charging depreciation.
Cessesation of Depreciation
I. Depreciation ceases to be charged when asset’s residual value exceeds
its carrying amount
The residual value of an asset may increase to an amount equal to or greater than
its carrying amount. If it does, depreciation charge of the asset is zero unless and
until its residual value subsequently decreases to an amount below its carrying
amount.
Illustration 14 (Depreciation where residual value is the same as or close to
Original cost)
A property costing ` 10,00,000 is bought in 20X1. Its estimated total physical life is
50 years. However, the company considers it likely that it will sell the property after
20 years.

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The estimated residual value in 20 years' time, based on 20X1 prices, is:
Case (a) ` 10,00,000
Case (b) ` 9,00,000.
Calculate the amount of depreciation.
Solution
Case (a)
The company considers that the residual value, based on prices prevailing at the
balance sheet date, will equal the cost.
There is, therefore, no depreciable amount and depreciation is correctly zero.
Case (b)
The company considers that the residual value, based on prices prevailing at the
balance sheet date, will be ` 9,00,000 and the depreciable amount is, therefore,
` 1,00,000.
Annual depreciation (on a straight-line basis) will be ` 5,000 [{10,00,000 – 9,00,000}
÷ 20].
II. Depreciation of an asset ceases at the earlier of:
• The date that the asset is retired from active use and is held for disposal, and
• The date that the asset is derecognised
Therefore, depreciation does not cease when the asset becomes idle or is retired
from active use (but not held for disposal) unless the asset is fully depreciated.
However, under usage methods of depreciation, the depreciation charge can be
zero while there is no production.
Land and Buildings
Land and buildings are separable assets and are accounted for separately, even
when they are acquired together.
A. Land: Land has an unlimited useful life and therefore is not depreciated.
Exceptions: Quarries and sites used for landfill.
Depreciation on Land:
I. If land itself has a limited useful life:

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It is depreciated in a manner that reflects the benefits to be derived from it.

II. If the cost of land includes the costs of site dismantlement, removal and
restoration:
That portion of the land asset is depreciated over the period of benefits
obtained by incurring those costs.
B. Buildings:
Buildings have a limited useful life and therefore are depreciable assets.
An increase in the value of the land on which a building stands does not affect
the determination of the depreciable amount of the building.
Depreciation Method
The depreciation method used should reflect the pattern in which the future
economic benefits of the asset are expected to be consumed by the enterprise.
The method selected is applied consistently from period to period unless:
• There is a change in the expected pattern of consumption of those future
economic benefits; Or
• That the method is changed in accordance with the statute to best reflect the
way the asset is consumed.

Methods of Depreciation

Straight-line Diminishing Units of Production

Method Balance Method Method

Results in a constant Results in a Results in a

charge over the useful decreasing charge charge based on
life if the residual value over the useful the expected use
of the asset does not life or output
change

Review of Depreciation Method:

The depreciation method applied to an asset should be reviewed at least at each
financial year-end and, if there has been a significant change in the expected

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pattern of consumption of the future economic benefits embodied in the asset, the
method should be changed to reflect the changed pattern.
Such a change should be accounted for as a change in an accounting estimate
in accordance with AS 5.
Depreciation Method based on Revenue

A depreciation method that is based on revenue that is generated by an activity

that includes the use of an asset is not appropriate.
Illustration 15(Determination of appropriate Depreciation Method)

Entity B manufactures industrial chemicals and uses blending machines in the

production process. The output of the blending machines is consistent from year to
year and they can be used for different products.
However, maintenance costs increase from year to year and a new generation of
machines with significant improvements over existing machines is available every 5
years. Suggest the depreciation method to the management.
Solution
The straight-line depreciation method should be adopted, because the production
output is consistent from year to year.
Factors such as maintenance costs or technical obsolescence should be considered
in determining the blending machines’ useful life.
Changes in Existing Decommissioning, Restoration and other Liabilities
The cost of PPE may undergo changes subsequent to its acquisition or construction
on account of:
• Changes in Liabilities

• Price Adjustments
• Changes in Duties
• Changes in initial estimates of amounts provided for Dismantling, Removing,
Restoration, and
• Similar factors

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The above are included in the cost of the asset.

Accounting for the above changes:

Related Asset is measured using Cost

Accounitng Model

(Depends upon) Related Asset is measured using

Revaluation Model

A. If the related asset is measured using the Cost model

Changes in the Liability should be added to, or deducted from, the cost of the
related asset in the current period
Note: Amount deducted from the cost of the asset should not exceed its
carrying amount. If a decrease in the liability exceeds the carrying amount of
the asset, the excess should be recognised immediately in the Statement of
Profit and Loss.

If the adjustment results in an addition to the cost of an asset

• Enterprise should consider whether this is an indication that the new
carrying amount of the asset may not be fully recoverable.
Note: If it is such an indication, the enterprise should test the asset for
impairment by estimating its recoverable amount, and should account for any
impairment loss, in accordance with applicable Accounting standards.

B. If the related asset is measured using the Revaluation model:

Changes in the liability alter the revaluation surplus or deficit previously
recognised on that asset, so that:
(i) Decrease in the liability credited directly to revaluation surplus in the
owners’ interest
Exception
*It should be recognised in the Statement of Profit and Loss to the
extent that it reverses a revaluation deficit on the asset that was
previously recognised in the Statement of Profit and Loss
Note: In the event that a decrease in the liability exceeds the carrying
amount that would have been recognised had the asset been carried

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under the cost model, the excess should be recognised immediately in

the Statement of Profit and Loss.
(ii) Increase in the liability should be recognised in the Statement of Profit
and Loss
Exception
*It should be debited directly to Revaluation surplus in the owners’
interest to the extent of any credit balance existing in the Revaluation
surplus in respect of that asset
Caution
A change in the liability is an indication that the asset may have to be
revalued in order to ensure that the carrying amount does not differ
materially from that which would be determined using fair value at the
balance sheet date.
What happens if the related asset has reached the end of its useful life?
All subsequent changes in the liability should be recognised in the
Statement of Profit and Loss as they occur.
Note: This applies under both the cost model and the revaluation
model.

Situations and Its

Accounting

De-recognition Compensation from Cost of items of PPE

Impairments of of items of PPE third parties for items restored, purchased
items of PPE retired or of PPE that were or constructed as
disposed of impaired, lost or given replacements
up

Recognised in Determined in Is included in

accordance with accordance with determining profit or Is determined in
AS 28* AS 10 (Revised) loss when it becomes accordance with AS
receivable 10 (Revised)

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Illustration 16 (Gain on replacement of Insured Assets)

Entity A carried plant and machinery in its books at ` 2,00,000. These were destroyed
in a fire. The assets were insured 'New for old' and were replaced by the insurance
company with new machines that cost ` 20,00,000. The machines were acquired by the
insurance company and the company did not receive ` 20,00,000 as cash
compensation. State, how Entity A should account for the same?
Solution
Entity A should account for a loss in the Statement of Profit and Loss on de-
recognition of the carrying value of plant and machinery in accordance with AS 10
(Revised).
Entity A should separately recognise a receivable and a gain in the income
statement resulting from the insurance proceeds under AS 29 (Revised)* once
receipt is virtually certain. The receivable should be measured at the fair value of
assets that will be provided by the insurer.
Retirements
Items of PPE retired from active use and held for disposal should be stated at the
lower of:
• Carrying Amount, and
• Net Realisable Value
Note: Any write-down in this regard should be recognised immediately in the
Statement of Profit and Loss.
*Students may note that AS 5, AS19, AS 26, AS 28 and AS 29 are not covered in
syllabus of Intermediate paper 1 Accounting.

De-recognition
The carrying amount of an item of PPE should be derecognised:

• On disposal
o By sale
o By entering into a finance lease, or

o By donation, Or
• When no future economic benefits are expected from its use or disposal

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Accounting Treatment
Gain or loss arising from de-recognition of an item of PPE should be included in
the Statement of Profit and Loss when the item is derecognised unless AS 19 on
Leases, requires otherwise on a sale and leaseback (AS 19 on Leases, applies to
disposal by a sale and leaseback.)
Where,
Gain or loss arising from de-recognition of an item of PPE
= Net disposal proceeds (if any) - Carrying Amount of the item
Note: Gains should not be classified as revenue, as defined in AS 9 ‘Revenue
Recognition’.
Exception
An enterprise that in the course of its ordinary activities, routinely sells items of PPE
that it had held for rental to others should transfer such assets to inventories at
their carrying amount when they cease to be rented and become held for sale.
The proceeds from the sale of such assets should be recognised in revenue in
accordance with AS 9 on Revenue Recognition.
Determining the date of disposal of an item:
An enterprise applies the criteria in AS 9 for recognising revenue from the sale of
goods.
Disclosure

Disclosures

General Additional Disclosures related to Revalued Assets

General Disclosures
The financial statements should disclose, for each class of PPE:
(a) The measurement bases (i.e., cost model or revaluation model) used for
determining the gross carrying amount;
(b) The depreciation methods used;

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(c) The useful lives or the depreciation rates used.

In case the useful lives or the depreciation rates used are different from those
specified in the statute governing the enterprise, it should make a specific
mention of that fact;
(d) The gross carrying amount and the accumulated depreciation (aggregated
with accumulated impairment losses) at the beginning and end of the period;
and
(e) A reconciliation of the carrying amount at the beginning and end of the
period showing:
(i) additions
(ii) assets retired from active use and held for disposal
(iii) acquisitions through business combinations
(iv) increases or decreases resulting from revaluations and from impairment
losses recognised or reversed directly in revaluation surplus in
accordance with AS 28
(v) impairment losses recognised in the statement of profit and loss in
accordance with AS 28
(vi) impairment losses reversed in the statement of profit and loss in
accordance with AS 28
(vii) depreciation
(viii) net exchange differences arising on the translation of the financial
statements of a non-integral foreign operation in accordance with
AS 11
(ix) other changes
Additional Disclosures
The financial statements should also disclose:
(a) The existence and amounts of restrictions on title, and property, plant and
equipment pledged as security for liabilities;
(b) The amount of expenditure recognised in the carrying amount of an item of
property, plant and equipment in the course of its construction;
(c) The amount of contractual commitments for the acquisition of property, plant
and equipment;

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(d) If it is not disclosed separately on the face of the statement of profit and loss,
the amount of compensation from third parties for items of property, plant
and equipment that were impaired, lost or given up that is included in the
statement of profit and loss; and
(e) The amount of assets retired from active use and held for disposal.
Disclosures related to Revalued Assets
If items of property, plant and equipment are stated at revalued amounts, the
following should be disclosed:
(a) The effective date of the revaluation;
(b) Whether an independent valuer was involved;
(c) The methods and significant assumptions applied in estimating fair values of
the items;
(d) The extent to which fair values of the items were determined directly by
reference to observable prices in an active market or recent market
transactions on arm’s length terms or were estimated using other valuation
techniques; and
(e) The revaluation surplus, indicating the change for the period and any
restrictions on the distribution of the balance to shareholders.
Transitional Provisions
Previously Recognised Revenue Expenditure
Where an entity has in past recognised an expenditure in the Statement of Profit
and Loss which is eligible to be included as a part of the cost of a project for
construction of PPE in accordance with the requirements of this standard
It may do so retrospectively for such a project.
Note: The effect of such retrospective application, should be recognised net-of-tax
in Revenue reserves.
PPE acquired in Exchange of Assets
The requirements of AS 10 (Revised) regarding the initial measurement of an item of
PPE acquired in an exchange of assets transaction should be applied prospectively only
to transactions entered into after this Standard becomes mandatory.

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Spare parts
On the date of this Standard becoming mandatory, the spare parts, which hitherto
were being treated as inventory under AS 2 (Revised), and are now required to be
capitalised in accordance with the requirements of this Standard, should be
capitalised at their respective carrying amounts.
Note: The spare parts so capitalised should be depreciated over their remaining
useful lives prospectively as per the requirements of this Standard.
Revaluations
The requirements of AS 10 (Revised) regarding the revaluation model should be
applied prospectively.
In case, on the date of this Standard becoming mandatory, an enterprise does not
adopt the revaluation model as its accounting policy but the carrying amount of
items of PPE reflects any previous revaluation it should adjust the amount
outstanding in the Revaluation reserve against the carrying amount of that item.
Note: The carrying amount of that item should never be less than residual value.
Any excess of the amount outstanding as Revaluation reserve over the carrying
amount of that item should be adjusted in Revenue reserves.

Reference: The students are advised to refer the full text of AS 10 (Revised)
“Property, Plant and Equipment” (2016).

2.5 AS 11: THE EFFECTS OF CHANGES IN FOREIGN

EXCHANGE RATES
Introduction
The standard deals with the issues involved in accounting for foreign currency
transactions and foreign operations i.e., to decide which exchange rate to use and
how to recognise the financial effects of changes in exchange rates in the financial
statements.
Scope
This Standard should be applied:
(a) In accounting for transactions in foreign currencies.
(b) In translating the financial statements of foreign operations.

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(c) This Statement also deals with accounting for foreign currency transactions
in the nature of forward exchange contracts.
This Standard does not:
(a) Specify the currency in which an enterprise presents its financial statements.
However, an enterprise normally uses the currency of the country in which it
is domiciled. If it uses a different currency, the Standard requires disclosure
of the reasons for using that currency. The Standard also requires disclosure
of the reason for any change in the reporting currency.
(b) Deal with the presentation in a cash flow statement of cash flows arising from
transactions in a foreign currency and the translation of cash flows of a
foreign operation, which are addressed in AS 3 ‘Cash flow statement’.
(c) Deal with exchange differences arising from foreign currency borrowings to
the extent that they are regarded as an adjustment to interest costs.
(d) Deal with the restatement of an enterprise’s financial statements from its
reporting currency into another currency for the convenience of users
accustomed to that currency or for similar purposes.
Definitions of the terms used in the Standard
A foreign currency transaction is a transaction which is denominated in or
requires settlement in a foreign currency, including transactions arising when an
enterprise either:
(a) Buys or sells goods or services whose price is denominated in a foreign
currency.
(b) Borrows or lends funds when the amounts payable or receivable are
denominated in a foreign currency.
(c) Becomes a party to an unperformed forward exchange contract or
(d) Otherwise acquires or disposes of assets, or incurs or settles liabilities,
denominated in a foreign currency.
Monetary items are money held and assets and liabilities to be received or paid in
fixed or determinable amounts of money. For example, cash, receivables and payables.
Non-monetary items are assets and liabilities other than monetary items. For
example, fixed assets, inventories and investments in equity shares.

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Foreign operation is a subsidiary, associate, joint venture or branch of the

reporting enterprise, the activities of which are based or conducted in a country
other than the country of the reporting enterprise.
Integral foreign operation is a foreign operation, the activities of which are an
integral part of those of the reporting enterprise. A foreign operation that is
integral to the operations of the reporting enterprise carries on its business as if it
were an extension of the reporting enterprise's operations.
Non-integral foreign operation is a foreign operation that is not an integral
foreign operation. When there is a change in the exchange rate between the
reporting currency and the local currency, there is little or no direct effect on the
present and future cash flows from operations of either the non-integral foreign
operation or the reporting enterprise. The change in the exchange rate affects the
reporting enterprise's net investment in the non-integral foreign operation rather
than the individual monetary and non-monetary items held by the non-integral
foreign operation.
‘Net investment in a non-integral foreign operation’ is the reporting enterprise’s
share in the net assets of that operation.
Forward exchange contract means an agreement to exchange different currencies
at a forward rate.
Forward rate is the specified exchange rate for exchange of two currencies at a
specified future date.
‘Foreign currency’ is a currency other than the reporting currency of an enterprise.
Initial Recognition
A foreign currency transaction should be recorded, on initial recognition in the
reporting currency, by applying to the foreign currency amount the exchange rate
between the reporting currency and the foreign currency at the date of the
transaction.
A rate that approximates the actual rate at the date of the transaction is often used,
for example, an average rate for a week or a month might be used for all
transactions in each foreign currency occurring during that period. However, if
exchange rates fluctuate significantly, the use of the average rate for a period is
unreliable.

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Reporting at each balance sheet date

The treatment of foreign currency items at the balance sheet date depends on
whether the item is:
• monetary or non-monetary; and
• carried at historical cost or fair value (for non-monetary items).
(a) Foreign currency monetary items should be reported using the closing rate.
However, in certain circumstances, the closing rate may not reflect with
reasonable accuracy the amount in reporting currency that is likely to be
realised from, or required to disburse, a foreign currency monetary item at
the balance sheet date, e.g., where there are restrictions on remittances or
where the closing rate is unrealistic and it is not possible to effect an
exchange of currencies at that rate at the balance sheet date. In such
circumstances, the relevant monetary item should be reported in the
reporting currency at the amount which is likely to be realised from or
required to disburse, such item at the balance sheet date.
(b) Non-monetary items which are carried in terms of historical cost
denominated in a foreign currency should be reported using the exchange
rate at the date of the transaction.
(c) Non-monetary items which are carried at fair value or other similar valuation
denominated in a foreign currency should be reported using the exchange
rates that existed when the values were determined.
(d) The contingent liability denominated in foreign currency at the balance sheet
date is disclosed by using the closing rate.
Recognition of Exchange Differences
Exchange differences arising on the settlement of monetary items or on reporting
an enterprise’s monetary items at rates different from those at which they were
initially recorded during the period, or reported in previous financial statements,
should be recognised as income or as expenses in the period in which they arise.
An exchange difference results when there is a change in the exchange rate
between the transaction date and the date of settlement of any monetary items
arising from a foreign currency transaction. When the transaction is settled within
the same accounting period as that in which it occurred, all the exchange difference
is recognised in that period. However, when the transaction is settled in a
subsequent accounting period, the exchange difference recognised in each

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intervening period up to the period of settlement is determined by the change in

exchange rates during that period.
Note: Central Government in consultation with National Advisory Committee on
Accounting Standards made an amendment to AS 11 “The Effects of Changes in
Foreign Exchange Rates” in the form of Companies (Accounting Standards)
Amendment Rules, 2009 and 2011.
According to the Notification, exchange differences arising on reporting of long-
term foreign currency monetary items at rates different from those at which they
were initially recorded during the period, or reported in previous financial
statements, insofar as they relate to the acquisition of a depreciable capital asset,
can be added to or deducted from the cost of the asset and should be depreciated
over the balance life of the asset, and in other cases, can be accumulated in the
Foreign Currency Monetary Item Translation Difference (FCMITD) Account and
should be written off over the useful life of the assets (amortised over the balance
period of such long term assets or liability, by recognition as income or expense in
each of such periods) but not beyond 31st March, 2020.
Any difference pertaining to accounting periods which commenced on or after 7th
December, 2006, previously, recognised in the profit and loss account before the
exercise of the option should be reversed insofar as it relates to the acquisition of a
depreciable capital asset by addition or deduction from the cost of the asset and in
other cases by transfer to Foreign Currency Monetary Item Translation Difference
(FCMITD) Account, and by debit or credit, as the case may be, to the general reserve.
If the above option is exercised, disclosure should be made of the fact of such
exercise of such option and of the amount remaining to be amortised in the
financial statements of the period in which such option is exercised and in every
subsequent period so long as any exchange difference remains unamortised.
For the purposes of exercise of this option, an asset or liability should be designated
as a long-term foreign currency monetary item, if the asset or liability is expressed
in a foreign currency and has a term of 12 months or more at the date of origination
of the asset or liability.
Further in December, 2011, the Ministry of Corporate Affairs inserted paragraph
46A in AS 11 of the Companies (Accounting Standards) Rules, 2006. According to
it, in respect of accounting periods commencing on or after the 1st April, 2011, an
enterprise which had earlier exercised the option under paragraph 46 and at the
option of any other enterprise, the exchange differences arising on reporting of
long-term foreign currency monetary items at rates different from those at which

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they were initially recorded during the period, or reported in previous financial
statements, in so far as they relate to the acquisition of a depreciable capital assets,
can be added to or deducted from the cost of the assets and should be depreciated
over the balance life of the assets, and in other cases, can be accumulated in a
“Foreign Currency Monetary Item Translation Difference Account” in the
enterprise’s financial statements and amortised over the balance period of such
long term assets or liability, by recognition as income or expense in each of
such periods.
Such option is irrevocable and should be applied to all such foreign currency
monetary items. The enterprise exercising such option should disclose the fact of
such option and of the amount remaining to be amortised in the financial
statements of the period in which such option is exercised and in every subsequent
period so long as any exchange difference remains unamortised.
Classification of Foreign Operations as Integral or Non-integral
The method used to translate the financial statements of a foreign operation
depends on the way in which it is financed and operates in relation to the reporting
enterprise. For this purpose, foreign operations are classified as either ‘integral
foreign operations’ or ‘non-integral foreign operations’.
An integral foreign operation carries on its business as if it were an extension of
the reporting enterprise’s operations. For example, such an operation might only
sell goods imported from the reporting enterprise and remits the proceeds to the
reporting enterprise. In such cases, a change in the exchange rate between the
reporting currency and the currency in the country of foreign operation has an
almost immediate effect on the reporting enterprise’s cash flow from operations.
Therefore, the change in the exchange rate affects the individual monetary items
held by the foreign operation rather than the reporting enterprise’s net investment
in that operation.
In contrast, a non-integral foreign operation accumulates cash and other monetary
items, incurs expenses, generates income and perhaps arranges borrowings, all
substantially in its local currency. It may also enter into transactions in foreign
currencies, including transactions in the reporting currency. When there is a change
in the exchange rate between the reporting currency and the local currency, there
is little or no direct effect on the present and future cash flows from operations of
either the non-integral foreign operation or the reporting enterprise. The change
in the exchange rate affects the reporting enterprise’s net investment in the non-
integral foreign operation rather than the individual monetary and non- monetary

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items held by the non-integral foreign operation.

Translation of Foreign Integral Operations
The individual items in the financial statements of the foreign operation are
translated as if all its transactions had been entered into by the reporting enterprise
itself. The cost and depreciation of tangible fixed assets is translated using the
exchange rate at the date of purchase of the asset or, if the asset is carried at fair
value or other similar valuation, using the rate that existed on the date of the
valuation. The cost of inventories is translated at the exchange rates that existed
when those costs were incurred. The recoverable amount or realisable value of an
asset is translated using the exchange rate that existed when the recoverable
amount or net realisable value was determined. For example, when the net
realisable value of an item of inventory is determined in a foreign currency, that
value is translated using the exchange rate at the date as at which the net realisable
value is determined. The rate used is therefore usually the closing rate.
Translation of Non-Integral Foreign Operations
The translation of the financial statements of a non-integral foreign operation is
done using the following procedures:
(a) The assets and liabilities, both monetary and non-monetary, of the non-
integral foreign operation should be translated at the closing rate;
(b) Income and expense items of the non-integral foreign operation should be
translated at exchange rates at the dates of the transactions; and
(c) All resulting exchange differences should be accumulated in a foreign
currency translation reserve until the disposal of the net investment.
(d) For practical reasons, a rate that approximates the actual exchange rates, for
example an average rate for the period is often used to translate income and
expense items of a foreign operation.
(e) Any goodwill or capital reserve arising on the acquisition of a non-integral
foreign operation is translated at the closing rate.
(f) A contingent liability disclosed in the financial statements of a non-integral
foreign operation is translated at the closing rate for its disclosure in the
financial statements of the reporting enterprise.
(g) The incorporation of the financial statements of a non-integral foreign
operation in those of the reporting enterprise follows normal consolidation

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procedures, such as the elimination of intra-group balances and intra-group

transactions of a subsidiary. However, an exchange difference arising on an
intra-group monetary item, whether short-term or long-term, cannot be
eliminated against a corresponding amount arising on other intra-group
balances because the monetary item represents a commitment to convert
one currency into another and exposes the reporting enterprise to a gain or
loss through currency fluctuations.
(h) When the financial statements of a non-integral foreign operation are drawn
up to a different reporting date from that of the reporting enterprise, the
non-integral foreign operation often prepares, for purposes of incorporation
in the financial statements of the reporting enterprise, statements as at the
same date as the reporting enterprise (AS 21 (Revised) ∗.
(i) The exchange differences are not recognised as income or expenses for the
period because the changes in the exchange rates have little or no direct
effect on the present and future cash flows from operations of either the non-
integral foreign operation or the reporting enterprise. When a non-integral
foreign operation is consolidated but is not wholly owned, accumulated
exchange differences arising from translation and attributable to minority
interests are allocated to, and reported as part of, the minority interest in the
consolidated balance sheet.
(j) An enterprise may dispose of its interest in a non-integral foreign operation
through sale, liquidation, repayment of share capital, or abandonment of all,
or part of, that operation. The payment of a dividend forms part of a disposal
only when it constitutes a return of the investment. Remittance from a non-
integral foreign operation by way of repatriation of accumulated profits does
not form part of a disposal unless it constitutes return of the investment €. In
the case of a partial disposal, only the proportionate share of the related
accumulated exchange differences is included in the gain or loss. A write-
down of the carrying amount of a non-integral foreign operation does not
constitute a partial disposal. Accordingly, no part of the deferred foreign
exchange gain or loss is recognized at the time of a write-down".

∗
AS 21 is not covered in syllabus of Intermediate Paper 1 Accounting.
€
MCA amended this paragraph, by notification dated 18 th June, 2018, which is relevant for
companies.

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The following are indications that a foreign operation is a non-integral foreign

operation rather than an integral foreign operation:

(a) While the reporting enterprise may control the foreign operation, the
activities of the foreign operation are carried out with a significant degree of
autonomy from those of the reporting enterprise.

(b) Transactions with the reporting enterprise are not a high proportion of the
foreign operation's activities.
(c) The activities of the foreign operation are financed mainly from its own
operations or local borrowings rather than from the reporting enterprise.
(d) Costs of labour, material and other components of the foreign operation's
products or services are primarily paid or settled in the local currency rather
than in the reporting currency.
(e) The foreign operation's sales are mainly in currencies other than the reporting
currency.

(f) Cash flows of the reporting enterprise are insulated from the day-to-day
activities of the foreign operation rather than being directly affected by the
activities of the foreign operation.

(g) Sales prices for the foreign operation’s products are not primarily responsive
on a short-term basis to changes in exchange rates but are determined more
by local competition or local government regulation.
(h) There is an active local sales market for the foreign operation’s products,
although there also might be significant amounts of exports.
Illustration 1

Classify the following items as monetary or non-monetary item:

Inventories
Trade Receivables
Investment in Equity shares
Property, Plant and Equipment.

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Solution

Inventories Non-monetary
Trade receivables Monetary
Investment in equity shares Non-monetary
Property, Plant and Equipment Non-monetary

Illustration 2

Exchange Rate per $

Goods purchased on 1.1.20X1 for US $ 15,000 ` 75
Exchange rate on 31.3.20X1 ` 74
Date of actual payment 7.7.20X1 ` 73
You are required to ascertain the loss/gain to be recognized for financial years ended
31st March, 20X1 and 31st March, 20X2 as per AS 11.
Solution
As per AS 11 on ‘The Effects of Changes in Foreign Exchange Rates’, all foreign
currency transactions should be recorded by applying the exchange rate on the
date of transactions. Thus, goods purchased on 1.1.20X1 and corresponding
creditors would be recorded at ` 11,25,000 (i.e. $15,000 × ` 75)
According to the standard, at the balance sheet date all monetary transactions
should be reported using the closing rate. Thus, creditors of US $15,000 on
31.3.20X1 will be reported at ` 11,10,000 (i.e. $15,000 × ` 74) and exchange profit
of ` 15,000 (i.e. 11,25,000 – 11,10,000) should be credited to Profit and Loss account
in the year ended 31st March, 20X1.
On 7.7.20X1, creditors of $15,000 is paid at the rate of ` 73. As per AS 11, exchange
difference on settlement of the account should also be transferred to Profit and
Loss account. Therefore, ` 15,000 (i.e. 11,10,000 – 10,95,000) will be credited to
Profit and Loss account in the year ended 31st March, 20X2.
Illustration 3

Kalim Ltd. borrowed US$ 4,50,000 on 01/01/20X1, which will be repaid as on

31/07/20X1. Kalim Ltd. prepares financial statement ending on 31/03/20X1. Rate of
exchange between reporting currency (INR) and foreign currency (USD) on different

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dates are as under:

01/01/20X1 1 US$ = ` 48.00

31/03/20X1 1 US$ = ` 49.00

31/07/20X1 1 US$ = ` 49.50
Solution
Journal Entries in the Books of Kalim Ltd.

Date Particulars ` (Dr.) ` (Cr.)

20X1 216,00,000
Jan. 01 Bank Account (4,50,000 x 48) Dr.
To Foreign Loan Account 216,00,000
March Foreign Exchange Difference Account Dr. 4,50,000
31
To Foreign Loan Account 4,50,000
[4,50,000 x (49-48)]
July 01 Foreign Exchange Difference Account Dr. 2,25,000
[4,50,000 x (49.5-49)]
Foreign Loan Account Dr. 220,50,000
To Bank Account 2,22,75,000

Change in the Classification of a Foreign Operation

When a foreign operation that is integral to the operations of the reporting
enterprise is reclassified as a non-integral foreign operation, exchange differences
arising on the translation of non-monetary assets at the date of the reclassification
are accumulated in a foreign currency translation reserve.
When a non-integral foreign operation is reclassified as an integral foreign
operation, the translated amounts for non-monetary items at the date of the
change are treated as the historical cost for those items in the period of change
and subsequent periods. Exchange differences which have been deferred are not
recognised as income or expenses until the disposal of the operation.
Tax Effects of Exchange Differences
Gains and losses on foreign currency transactions and exchange differences arising
on the translation of the financial statements of foreign operations may have
associated tax effects which are accounted for in accordance with AS 22.

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Forward Exchange Contract

An enterprise may enter into a forward exchange contract or another financial
instrument that is in substance a forward exchange contract, which is not intended
for trading or speculation purposes, to establish the amount of the reporting
currency required or available at the settlement date of a transaction. The premium
or discount arising at the inception of such a forward exchange contract should be
amortised as expense or income over the life of the contract.
Exchange differences on such a contract should be recognised in the statement of
profit and loss in the reporting period in which the exchange rates change. Any
profit or loss arising on cancellation or renewal of such a forward exchange contract
should be recognised as income or as expense for the period.
Illustration 4
Rau Ltd. purchased a plant for US$ 1,00,000 on 01st February 20X1, payable after
three months. Company entered into a forward contract for three months @
` 49.15 per dollar. Exchange rate per dollar on 01 st Feb. was ` 48.85. How will you
recognise the profit or loss on forward contract in the books of Rau Ltd.?
Solution
Forward Rate ` 49.15
Less: Spot Rate (` 48.85)
Premium on Contract ` 0.30
Contract Amount US$ 1,00,000
Total Loss (1,00,000 x 0.30) ` 30,000
Contract period 3 months (2 months falling in the year ended 31st March, 20X1)
Loss to be recognised (30,000/3) x 2 = ` 20,000 in the year ended 31st March, 20X1.
Rest ` 10,000 will be recognised in the following year.
In recording a forward exchange contract intended for trading or speculation
purposes, the premium or discount on the contract is ignored and at each balance
sheet date, the value of the contract is marked to its current market value and the
gain or loss on the contract is recognised.

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Illustration 5
Mr. A bought a forward contract for three months of US$ 1,00,000 on 1st December
at 1 US$ = ` 47.10 when exchange rate was US$ 1 = ` 47.02. On 31st December
when he closed his books exchange rate was US$ 1 = ` 47.15. On 31st January, he
decided to sell the contract at ` 47.18 per dollar. Show how the profits from contract
will be recognised in the books.
Solution
Since the forward contract was for speculation purpose the premium on contract
i.e. the difference between the spot rate and contract rate will not be recorded in
the books. Only when the contract is sold the difference between the contract rate
and sale rate will be recorded in the Profit & Loss Account.
Sale Rate ` 47.18
Less: Contract Rate (` 47.10)
Premium on Contract ` 0.08
Contract Amount US$ 1,00,000
Total Profit (1,00,000 x 0.08) ` 8,000
Illustration 6
Assets and liabilities and income and expenditure items in respect of foreign branches
(integral foreign operations) are translated into Indian rupees at the prevailing rate
of exchange at the end of the year. The resultant exchange differences in the case of
profit, is carried to other Liabilities Account and the Loss, if any, is charged to the
statement of profit and loss. Comment.
Solution
The financial statements of an integral foreign operation (for example, dependent
foreign branches) should be translated using the principles and procedures
described in AS 11. The individual items in the financial statements of a foreign
operation are translated as if all its transactions had been entered into by the
reporting enterprise itself.
Individual items in the financial statements of the foreign operation are translated
at the actual rate on the date of transaction. For practical reasons, a rate that
approximates the actual rate at the date of transaction is often used, for example,
an average rate for a week or a month may be used for all transactions in each
foreign currency during the period. The foreign currency monetary items (for

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example cash, receivables, payables) should be reported using the closing rate at
each balance sheet date. Non-monetary items (for example, fixed assets,
inventories, investments in equity shares) which are carried in terms of historical
cost denominated in a foreign currency should be reported using the exchange
date at the date of transaction. Thus the cost and depreciation of the tangible fixed
assets is translated using the exchange rate at the date of purchase of the asset if
asset is carried at cost. If the fixed asset is carried at fair value, translation should
be done using the rate existed on the date of the valuation. The cost of inventories
is translated at the exchange rates that existed when the cost of inventory was
incurred and realisable value is translated applying exchange rate when realisable
value is determined which is generally closing rate.
Exchange difference arising on the translation of the financial statements of integral
foreign operation should be charged to profit and loss account. Exchange difference
arising on the translation of the financial statement of foreign operation may have tax
effect which should be dealt as per AS 22 ‘Accounting for Taxes on Income’.
Thus, the treatment by the management of translating all assets and liabilities;
income and expenditure items in respect of foreign branches at the prevailing rate
at the year end and also the treatment of resultant exchange difference is not in
consonance with AS 11.
Illustration 7
A business having the Head Office in Kolkata has a branch in UK. The following is
the trial balance of Branch as at 31.03.20X4:

Account Name Amount in £

Dr. Cr.
Machinery (purchased on 01.04.20X1) 5,000
Debtors 1,600
Opening Stock 400
Goods received from Head Office Account 6,100
(Recorded in HO books as ` 4,02,000)
Sales 20,000
Purchases 10,000
Wages 1,000
Salaries 1,200

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Cash 3,200
Remittances to Head Office (Recorded in HO books as 2,900
` 1,91,000)
Head Office Account (Recorded in HO books as 7,400
` 4,90,000)
Creditors 4,000

• Closing stock at branch is £ 700 on 31.03.20X4.

• Depreciation @ 10% p.a. is to be charged on Machinery.
• Prepare the trial balance after been converted in Indian Rupees.
• Exchange rates of Pounds on different dates are as follow:
01.04.20X1– ` 61; 01.04.20X3– ` 63 & 31.03.20X4 – ` 67
Solution
Trial Balance of the Foreign Branch converted into Indian Rupees as on March
31, 20X4
Particulars £ (Dr.) £ (Cr.) Conversion Basis ` (Dr.) ` (Cr.)
Machinery 5,000 Transaction date rate 3,05,000
Debtors 1,600 Closing Rate 1,07,200
Opening Stock 400 Opening Rate 25,200
Goods Received from HO 6,100 Actuals 4,02,000
Sales 20,000 Average Rate 13,00,000
Purchases 10,000 Average Rate 6,50,000
Wages 1,000 Average Rate 65,000
Salaries 1,200 Average Rate 78,000
Cash 3,200 Closing Rate 2,14,400
Remittance to HO 2,900 Actuals 1,91,000
HO Account 7,400 Actuals 4,90,000
Creditors 4,000 Closing Rate 2,68,000
Exchange Rate Difference Balancing Figure 20,200
31,400 31,400 20,58,000 20,58,000
Closing Stock 700 Closing Rate 46,900
Depreciation 500 Fixed Asset Rate 30,500

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Disclosure
An enterprise should disclose:
(a) The amount of exchange differences included in the net profit or loss for the
period.
(b) Net exchange differences accumulated in foreign currency translation reserve
as a separate component of shareholders’ funds, and a reconciliation of the
amount of such exchange differences at the beginning and end of the period.
When the reporting currency is different from the currency of the country in which
the enterprise is domiciled, the reason for using a different currency should be
disclosed. The reason for any change in the reporting currency should also be
disclosed.
When there is a change in the classification of a significant foreign operation, an
enterprise should disclose:
(a) The nature of the change in classification;
(b) The reason for the change;
(c) The impact of the change in classification on shareholders' funds; and
(d) The impact on net profit or loss for each prior period presented had the
change in classification occurred at the beginning of the earliest period
presented.
Presentation of Foreign Currency Monetary Item Translation Difference
Account (FCMITDA)
In the format of Schedule III to the Companies Act, 2013, no line item has been
specified for the presentation of “Foreign Currency Monetary Item Translation
Difference Account (FCMITDA)”. Since the balance in FCMITDA represents foreign
currency translation loss, it does not meet the above definition of ‘asset’ as it is
neither a resource nor any future economic benefit would flow to the entity
therefrom. Therefore, such balance cannot be reflected as an asset. Therefore, debit
or credit balance in FCMITDA should be shown on the “Equity and Liabilities” side
of the balance sheet under the head ‘Reserves and Surplus’ as a separate line item.
Illustration 8
A Ltd. purchased fixed assets costing ` 3,000 lakhs on 1.1.20X1 and the same was
fully financed by foreign currency loan (U.S. Dollars) payable in three annual equal
instalments. Exchange rates were 1 Dollar = ` 40.00 and ` 42.50 as on 1.1.20X1 and

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31.12.20X1 respectively. First instalment was paid on 31.12.20X1. The entire

difference in foreign exchange has been capitalised.
You are required to state, how these transactions would be accounted for.
Solution
As per AS 11 ‘The Effects of Changes in Foreign Exchange Rates’, exchange
differences arising on the settlement of monetary items or on reporting an
enterprise’s monetary items at rates different from those at which they were initially
recorded during the period, or reported in previous financial statements, should be
recognised as income or expenses in the period in which they arise. Thus exchange
differences arising on repayment of liabilities incurred for the purpose of acquiring
fixed assets are recognised as income or expense.
Calculation of Exchange Difference:
` 3,000 lakhs
Foreign currency loan = = 75 lakhs US Dollars
` 40
Exchange difference = 75 lakhs US Dollars × (42.50 – 40.00) = `187.50 lakhs
(including exchange loss on payment of first instalment)
Therefore, entire loss due to exchange differences amounting ` 187.50 lakhs should
be charged to profit and loss account for the year.
Note: The above answer has been given on the basis that the company has not
exercised the option of capitalisation available under paragraph 46 of AS 11.
However, if the company opts to avail the benefit given in paragraph 46A, then
nothing is required to be done since the company has done the correct treatment.
Reference: The students are advised to refer the full text of AS 11 “The Effects of
Changes in Foreign Exchange Rates”.

2.6 AS 12: ACCOUNTING FOR GOVERNMENT

GRANTS
Introduction
AS 12 deals with accounting for government grants such as subsidies, cash
incentives, duty drawbacks, etc. and specifies that the government grants should
not be recognised until there is reasonable assurance that the enterprise will
comply with the conditions attached to them, and the grant will be received. The

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standard also describes the treatment of non-monetary government grants;

presentation of grants related to specific fixed assets and revenue and those in the
nature of promoters’ contribution; treatment for refund of government grants etc.
This Standard does not deal with:
(i) The special problems arising in accounting for government grants in financial
statements reflecting the effects of changing prices or in supplementary
information of a similar nature.
(ii) Government assistance other than in the form of government grants.
(iii) Government participation in the ownership of the enterprise.
The receipt of government grants by an enterprise is significant for preparation of the
financial statements for two reasons. Firstly, if a government grant has been received,
an appropriate method of accounting therefore is necessary. Secondly, it is desirable
to give an indication of the extent to which the enterprise has benefited from such
grant during the reporting period. This facilitates comparison of an enterprise’s
financial statements with those of prior periods and with those of other enterprises.
Government Grants
Government grants are assistance by government in cash or kind to an enterprise
for past or future compliance with certain conditions. They exclude those forms of
government assistance which cannot reasonably have a value placed upon them
and transactions with government which cannot be distinguished from the normal
trading transactions of the enterprise.
Accounting Treatment of Government Grants
Two broad approaches may be followed for the accounting treatment of
government grants:
• the ‘capital approach’, under which a grant is treated as part of shareholders’
funds, and
• the ‘income approach’, under which a grant is taken to income over one or
more periods.
It is generally considered appropriate that accounting for government grant should
be based on the nature of the relevant grant. Grants which have the characteristics
similar to those of promoters’ contribution should be treated as part of
shareholders’ funds. Income approach may be more appropriate in the case of
other grants.

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Recognition of Government Grants

A government grant is not recognised until there is reasonable assurance that:
• the enterprise will comply with the conditions attaching to it; and
• the grant will be received.
Receipt of a grant is not of itself conclusive evidence that the conditions attaching
to the grant have been or will be fulfilled.
Non-monetary Government Grants
Government grants may take the form of non-monetary assets, such as land or
other resources, given at concessional rates. In these circumstances, it is usual to
account for such assets at their acquisition cost. Non-monetary assets given free of
cost are recorded at a nominal value.
Presentation of Grants Related to Specific Fixed Assets
Grants related to specific fixed assets are government grants whose primary
condition is that an enterprise qualifying for them should purchase, construct or
otherwise acquire such assets. Other conditions may also be attached restricting
the type or location of the assets or the periods during which they are to be
acquired or held.
Two methods of presentation in financial statements of grants related to specific
fixed assets are regarded as acceptable alternatives.
Method I :
• The grant is shown as a deduction from the gross value of the asset concerned
in arriving at its book value.
• The grant is thus recognised in the profit and loss statement over the useful
life of a depreciable asset by way of a reduced depreciation charge.
• Where the grant equals the whole, or virtually the whole, of the cost of the
asset, the asset is shown in the balance sheet at a nominal value.
Illustration 1
Z Ltd. purchased a fixed asset for ` 50 lakhs, which has the estimated useful life of 5
years with the salvage value of ` 5,00,000. On purchase of the assets government
granted it a grant for ` 10 lakhs. Pass the necessary journal entries in the books of
the company for first two years if the grant amount is deducted from the value of
fixed asset.

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Solution
Journal in the books of Z Ltd.

Year Particulars ` (Dr.) ` (Cr.)

1st Fixed Assets Account Dr. 50,00,000
To Bank Account 50,00,000
(Being Fixed Assets purchased)
Bank Account Dr. 10,00,000
To Fixed Assets Account 10,00,000
(Being grant received from the government)
Depreciation Account Dr. 7,00,000
To Fixed Assets Account 7,00,000
(Being Depreciation charged on SLM)
Profit & Loss Account Dr. 7,00,000
To Depreciation Account 7,00,000
(Being Depreciation transferred to P/L Account)
2nd Depreciation Account Dr. 7,00,000
To Fixed Assets Account 7,00,000
(Being Depreciation charged on SLM)
Profit & Loss Account Dr. 7,00,000
To Depreciation Account 7,00,000
(Being Depreciation transferred to P/L Account)

Method II:
• Grants related to depreciable assets are treated as deferred income which is
recognised in the profit and loss statement on a systematic and rational basis
over the useful life of the asset.
• Grants related to non-depreciable assets are credited to capital reserve under
this method, as there is usually no charge to income in respect of such assets.
• If a grant related to a non-depreciable asset requires the fulfilment of certain
obligations, the grant is credited to income over the same period over which
the cost of meeting such obligations is charged to income.

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Illustration 2
Z Ltd. purchased a fixed asset for ` 50 lakhs, which has the estimated useful life of 5
years with the salvage value of ` 5,00,000. On purchase of the assets government
granted it a grant for ` 10 lakhs. Pass the necessary journal entries in the books of
the company for first two years if the grant is treated as deferred income.
Solution
Journal in the books of Z Ltd.

Year Particulars ` (Dr.) ` (Cr.)

1st Fixed Assets Account Dr. 50,00,000
To Bank Account 50,00,000
(Being fixed assets purchased)
Bank Account Dr. 10,00,000
To Deferred Government Grant Account 10,00,000
(Being grant received from the government)
Depreciation Account Dr. 9,00,000
To Fixed Assets Account 9,00,000
(Being depreciation charged on SLM)
Profit & Loss Account Dr. 9,00,000
To Depreciation Account 9,00,000
(Being depreciation transferred to P/L Account)
Deferred Government Grants Account Dr. 2,00,000
To Profit & Loss Account 2,00,000
(Being proportionate government grant taken to P/L
Account)
2nd Depreciation Account Dr. 9,00,000
To Fixed Assets Account 9,00,000
(Being depreciation charged on SLM)
Profit & Loss Account Dr. 9,00,000
To Depreciation Account 9,00,000
(Being depreciation transferred to P/L Account)

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Deferred Government Grant Account Dr. 2,00,000

To Profit & Loss Account 2,00,000
(Being proportionate government grant taken to P/L
Account)

Illustration 3
Santosh Ltd. has received a grant of `8 crores from the Government for setting up a
factory in a backward area. Out of this grant, the company distributed `2 crores as
dividend. Also, Santosh Ltd. received land free of cost from the State Government but
it has not recorded it at all in the books as no money has been spent. In the light of
AS 12 examine, whether the treatment of both the grants is correct.
Solution
As per AS 12 ‘Accounting for Government Grants’, when government grant is
received for a specific purpose, it should be utilised for the same. So the grant
received for setting up a factory is not available for distribution of dividend.
In the second case, even if the company has not spent money for the acquisition of
land, land should be recorded in the books of accounts at a nominal value. The
treatment of both the elements of the grant is incorrect as per AS 12.
Presentation of Grants Related to Revenue
Grants related to revenue are sometimes presented as a credit in the profit and loss
statement, either separately or under a general heading such as ‘Other Income’.
Alternatively, they are deducted in reporting the related expense.
Presentation of Grants of the Nature of Promoters’ Contribution
Where the government grants are of the nature of promoters’ contribution, i.e.,
they are given with reference to the total investment in an undertaking or by way
of contribution towards its total capital outlay (for example, central investment
subsidy scheme) and no repayment is ordinarily expected in respect thereof, the
grants are treated as capital reserve which can be neither distributed as dividend
nor considered as deferred income.
Illustration 4
Top & Top Limited has set up its business in a designated backward area which
entitles the company to receive from the Government of India a subsidy of 20% of
the cost of investment, for which no repayment was ordinarily expected. Moreover,

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there was no condition that the company should purchase any specified assets for
this subsidy. Having fulfilled all the conditions under the scheme, the company on
its investment of ` 50 crore in capital assets received ` 10 crore from the Government
in January, 20X2 (accounting period being 20X1-20X2). The company wants to treat
this receipt as an item of revenue and thereby reduce the losses on profit and loss
account for the year ended 31st March, 20X2.
Keeping in view the relevant Accounting Standard, discuss whether this action is
justified or not.
Solution
As per para 10 of AS 12 ‘Accounting for Government Grants’, where the government
grants are of the nature of promoters’ contribution, i.e. they are given with
reference to the total investment in an undertaking or by way of contribution
towards its total capital outlay (for example, central investment subsidy scheme)
and no repayment is ordinarily expected in respect thereof, the grants are treated
as capital reserve which can be neither distributed as dividend nor considered as
deferred income.
In the given case, the subsidy received is neither in relation to specific fixed asset
nor in relation to revenue. Thus, it is inappropriate to recognise government grants
in the profit and loss statement, since they are not earned but represent an
incentive provided by government without related costs. The correct treatment is
to credit the subsidy to capital reserve. Therefore, the accounting treatment desired
by the company is not proper.
Illustration 5
How would you treat the following in the accounts in accordance with AS 12
'Government Grants'?
(i) ` 35 Lakhs received from the Local Authority for providing Medical facilities to
the employees.
(ii) ` 100 Lakhs received as Subsidy from the Central Government for setting up a
unit in notified backward area. This subsidy is in nature of nature of promoters’
contribution.
Solution
(i) ` 35 lakhs received from the local authority for providing medical facilities to
the employees is a grant received in nature of revenue grant. Such grants are
generally presented as a credit in the profit and loss statement, either

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separately or under a general heading such as ‘Other Income’. Alternatively,

` 35 lakhs may be deducted in reporting the related expense i.e. employee
benefit expenses.
(ii) As per AS 12 ‘Accounting for Government Grants’, where the government grants
are in the nature of promoters’ contribution, i.e. they are given with reference to
the total investment in an undertaking or by way of contribution towards its total
capital outlay and no repayment is ordinarily expected in respect thereof, the
grants are treated as capital reserve which can be neither distributed as dividend
nor considered as deferred income. In the given case, the subsidy received
from the Central Government for setting up a unit in notified backward area is
neither in relation to specific fixed asset nor in relation to revenue. Thus, amount
of ` 100 lakhs should be credited to capital reserve.
Refund of Government Grants
• Government grants sometimes become refundable because certain
conditions are not fulfilled and are treated as an extraordinary item (AS 5).
• The amount refundable in respect of a government grant related to revenue
is applied first against any unamortised deferred credit remaining in respect
of the grant. To the extent that the amount refundable exceeds any such
deferred credit, or where no deferred credit exists, the amount is charged
immediately to profit and loss statement.
• The amount refundable in respect of a government grant related to a specific
fixed asset is recorded by increasing the book value of the asset or by
reducing the deferred income balance, as appropriate, by the amount
refundable. In the first alternative, i.e., where the book value of the asset is
increased, depreciation on the revised book value is provided prospectively
over the residual useful life of the asset.
• Where a grant which is in the nature of promoters’ contribution becomes
refundable, in part or in full, to the government on non-fulfillment of some
specified conditions, the relevant amount recoverable by the government is
reduced from the capital reserve.
Disclosure
i. The accounting policy adopted for government grants, including the methods
of presentation in the financial statements;
ii. The nature and extent of government grants recognised in the financial

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statements, including grants of non-monetary assets given at a concessional

rate or free of cost.
Illustration 6
Z Ltd. purchased a fixed asset for ` 50 lakhs, which has the estimated useful life of 5
years with the salvage value of ` 5,00,000. On purchase of the assets government
granted it a grant for ` 10 lakhs (This amount was reduced from the cost of fixed
asset). Grant was considered as refundable in the end of 2nd year to the extent of
` 7,00,000. Pass the journal entry for refund of the grant as per the first method.
Solution
Fixed Assets Account Dr. ` 7,00,000
To Bank Account ` 7,00,000
(Being government grant on asset refunded)
Illustration 7
A fixed asset is purchased for ` 20 lakhs. Government grant received towards it is
` 8 lakhs. Residual Value is ` 4 lakhs and useful life is 4 years. Assume depreciation
on the basis of Straight Line method. Asset is shown in the balance sheet net of grant.
After 1 year, grant becomes refundable to the extent of ` 5 lakhs due to non-
compliance with certain conditions. Pass journal entries for first two years.
Solution
Journal Entries

Year Particulars ` in lakhs ` in lakhs

(Dr.) (Cr.)
1 Fixed Asset Account Dr. 20
To Bank Account 20
(Being fixed asset purchased)
Bank Account Dr. 8
To Fixed Asset Account 8
(Being grant received from the government
reduced the cost of fixed asset)
Depreciation Account (W.N.1) Dr. 2
To Fixed Asset Account 2
(Being depreciation charged on Straight
Line method (SLM))

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Profit & Loss Account Dr. 2

To Depreciation Account 2
(Being depreciation transferred to Profit
and Loss Account at the end of year 1)
2 Fixed Asset Account Dr. 5
To Bank Account 5
(Being government grant on asset partly
refunded which increased the cost of fixed
asset)
Depreciation Account (W.N.2) Dr. 3.67
To Fixed Asset Account 3.67
(Being depreciation charged on SLM on
revised value of fixed asset prospectively)
Profit & Loss Account Dr. 3.67
To Depreciation Account 3.67
(Being depreciation transferred to Profit
and Loss Account at the end of year 2)
Working Notes:
1. Depreciation for Year 1

` in lakhs
Cost of the Asset 20
Less: Government grant received (8)
12
12-4 
Depreciation 
 4 
 2

2. Depreciation for Year 2

` in lakhs
Cost of the Asset 20
Less: Government grant received (8)
12

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 OVERVIEW OF ACCOUNTING STANDARDS 3.123

 12 − 4 
Less: Depreciation for the first year 
 4 
 2
10
Add: Government grant refundable 5
15
 15 − 4 
Depreciation for the second year 
 3 
 3.67

Illustration 8
On 1.4.20X1, ABC Ltd. received Government grant of ` 300 lakhs for acquisition of
machinery costing ` 1,500 lakhs. The grant was credited to the cost of the asset. The
life of the machinery is 5 years. The machinery is depreciated at 20% on WDV basis.
The Company had to refund the grant in May 20X4 due to non-fulfillment of certain
conditions.
How you would deal with the refund of grant in the books of ABC Ltd. assuming that
the company did not charge any depreciation for year 20X4?
Solution
According to para 21 of AS 12 on Accounting for Government Grants, the amount
refundable in respect of a grant related to a specific fixed asset should be recorded
by increasing the book value of the asset or by reducing deferred income balance,
as appropriate, by the amount refundable. Where the book value is increased,
depreciation on the revised book value should be provided prospectively over the
residual useful life of the asset.

(` in lakhs)
1st April, 20X1 Acquisition cost of machinery (` 1,500 – 1,200.00
` 300)
31st March, 20X2 Less: Depreciation @ 20% (240.00)
Book value 960.00
31st March, 20X3 Less: Depreciation @ 20% (192.00)
Book value 768.00
31st March, 20X4 Less: Depreciation @ 20% (153.60)

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1st April, 20X4 Book value 614.40

May, 20X4 Add: Refund of grant 300.00
Revised book value 914.40

Depreciation @ 20% on the revised book value amounting ` 914.40 lakhs is to be

provided prospectively over the residual useful life of the asset.
Illustration 9
A Ltd. purchased a machinery for ` 40 lakhs. (Useful life 4 years and residual value
` 8 lakhs) Government grant received is ` 16 lakhs.
Show the Journal Entry to be passed at the time of refund of grant in the third year
and the value of the fixed assets, if:
(1) the grant is credited to Fixed Assets A/c.
(2) the grant is credited to Deferred Grant A/c.
Solution
In the books of A Ltd.
Journal Entries (at the time of refund of grant)
(1) If the grant is credited to Fixed Assets Account:
` `
I Fixed Assets A/c Dr. 16 lakhs
To Bank A/c 16 lakhs
(Being grant refunded)

II The balance of fixed assets after two years depreciation will be `16 lakhs
(W.N.1) and after refund of grant it will become (`16 lakhs + `16 lakhs)
= `32 lakhs on which depreciation will be charged for remaining two
years. Depreciation = (32-8)/2 = `12 lakhs p.a. will be charged for next
two years.
(2) If the grant is credited to Deferred Grant Account:
As per para 14 of AS 12 ‘Accounting for Government Grants,’ income from
Deferred Grant Account is allocated to Profit and Loss account usually over
the periods and in the proportions in which depreciation on related assets is
charged. Accordingly, in the first two years (`16 lakhs /4 years) = `4 lakhs p.a.

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x 2 years = `8 lakhs were credited to Profit and Loss Account and `8 lakhs
was the balance of Deferred Grant Account after two years.
Therefore, on refund in the 3rd year, following entry will be passed:
` `
I Deferred Grant A/c Dr. 8 lakhs
Profit & Loss A/c Dr. 8 lakhs
To Bank A/c 16 lakhs
(Being Government grant refunded)
II Deferred grant account will become Nil. The fixed assets will continue
to be shown in the books at `24 lakhs (W.N.2) and depreciation will
continue to be charged at`8 lakhs per annum for the remaining two
years.
Working Notes:
1. Balance of Fixed Assets after two years but before refund (under
first alternative)
Fixed assets initially recorded in the books = `40 lakhs – `16 lakhs =
`24 lakhs
Depreciation p.a. = (`24 lakhs – `8 lakhs)/4 years = `4 lakhs per year
Value of fixed assets after two years but before refund of grant
= `24 lakhs – (`4 lakhs x 2 years) = `16 lakhs
2. Balance of Fixed Assets after two years but before refund (under
second alternative)
Fixed assets initially recorded in the books = `40 lakhs
Depreciation p.a. = (`40 lakhs – `8 lakhs)/4 years = `8 lakhs per year
Book value of fixed assets after two years = `40 lakhs – (`8 lakhs x 2 years)
= `24 lakhs
Note: Value of fixed assets given above is after refund of government
grant.
Reference: The students are advised to refer the full text of AS 12
“Accounting for Government Grants”.

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2.7 ACCOUNTING FOR INVESTMENTS [AS 13

(REVISED)]
Introduction
The standard deals with accounting for investments in the financial statements of
enterprises and related disclosure requirements. The enterprises are required to
disclose the current investments (realisable in nature and intended to be held for
not more than one year from the date of its acquisition) and long terms investments
(other than current investments) distinctly in their financial statements. The cost of
investments should include all acquisition costs (including brokerage, fees and
duties) and on disposal of an investment, the difference between the carrying
amount and net disposal proceeds should be charged or credited to profit and loss
statement.
This Standard does not deal with:
a. The basis for recognition of interest, dividends and rentals earned on
investments which are covered by AS 9
b. Operating or finance leases
c. Investments on retirement benefit plans and life insurance enterprises
d. Mutual funds, venture capital funds and/ or the related asset management
companies, banks and public financial institutions formed under a Central or
State Government Act or so declared under the Companies Act, 2013.
Definition of the terms used in the Standard
Investments are assets held by an enterprise for earning income by way of
dividends, interest, and rentals, for capital appreciation, or for other benefits to the
investing enterprise. Assets held as stock-in-trade (inventory) are not ‘investments’
Fair value is the amount for which an asset could be exchanged between a
knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length
transaction. Under appropriate circumstances, market value or net realisable value
provides an evidence of fair value.
Market value is the amount obtainable from the sale of an investment in an open
market, net of expenses necessarily to be incurred on or before disposal.

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Forms of Investments
Enterprises hold investments for diverse reasons. For some enterprises, investment
activity is a significant element of operations, and assessment of the performance
of the enterprise may largely, or solely, depend on the reported results of this
activity. Some investments have no physical existence and are represented merely
by certificates or similar documents (e.g., shares) while others exist in a physical
form (e.g., buildings). For some investments, an active market exists from which a
market value (fair value) can be established. For other investments, an active market
does not exist and other means are used to determine fair value.
Classification of Investments

Classification of Investments

Current Investments Long Term Investments

A current investment is an investment that is by its nature readily realisable and

is intended to be held for not more than one year from the date on which such
investment is made. The intention to hold for not more than one year is to be
judged at the time of purchase of investment.
A long term investment is an investment other than a current investment.
Cost of Investments
The cost of an investment includes acquisition charges such as brokerage, fees and
duties etc.
If an investment is acquired, or partly acquired, by the issue of shares or other
securities, the acquisition cost is the fair value of the securities issued or asset given
up. The fair value may not necessarily be equal to the nominal or par value of the
securities issued.
If an investment is acquired in exchange, or part exchange, for another asset, the
acquisition cost of the investment is determined by reference to the fair value of
the asset given up or the fair value of the investment acquired, whichever is more
clearly evident.
Interest, dividends and rentals receivables in connection with an investment are
generally regarded as income, being the return on the investment. However, in
some circumstances, such inflows represent a recovery of cost and do not form part

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of income. For example, when unpaid interest has accrued before the acquisition
of an interest-bearing investment and is therefore included in the price paid for the
investment, the subsequent receipt of interest is allocated between pre-acquisition
and post-acquisition periods; the pre-acquisition portion is deducted from cost.
When dividends on equity are declared from pre-acquisition profits, a similar
treatment may apply. If it is difficult to make such an allocation except on an
arbitrary basis, the cost of investment is normally reduced by dividends receivable
only if they clearly represent a recovery of a part of the cost.
When right shares offered are subscribed for, the cost of the right shares is added
to the carrying amount of the original holding. If rights are not subscribed for but
are sold in the market, the sale proceeds are taken to the profit and loss statement.
However, where the investments are acquired on cum-right basis and the market
value of investments immediately after their becoming ex-right is lower than the
cost for which they were acquired, it may be appropriate to apply the sale proceeds
of rights to reduce the carrying amount of such investments to the market value.
Carrying Amount of Investments
The carrying amount for current investments is the lower of cost and fair value.
Valuation of current investments on overall (or global) basis is not considered
appropriate. Sometimes, the concern of an enterprise may be with the value of a
category of related current investments and not with each individual investment,
and accordingly the investments may be carried at the lower of cost and fair value
computed category-wise (i.e. equity shares, preference shares, convertible
debentures, etc.). However, the more prudent and appropriate method is to carry
investments individually at the lower of cost and fair value.
Any reduction to fair value is debited to profit and loss account, however, if fair
value of investment is increased subsequently, the increase in value of current
investment up to the cost of investment is credited to the profit and loss account
(and excess portion, if any, is ignored).
Long term investments are usually carried at cost. The carrying amount of long-
term investments is therefore determined on an individual investment basis.
Where there is a decline, other than temporary, in the carrying amounts of long
term valued investments, the resultant reduction in the carrying amount is charged
to the profit and loss statement. The reduction in carrying amount is reversed when
there is a rise in the value of the investment, or if the reasons for the reduction no
longer exist.

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Investment Properties
An investment property is an investment in land or buildings that are not intended
to be occupied substantially for use by, or in the operations of, the investing
enterprise.
An investment property is accounted for in accordance with cost model as
prescribed in AS 10 (Revised), ‘Property, Plant and Equipment’. The cost of any
shares in a co-operative society or a company, the holding of which is directly
related to the right to hold the investment property, is added to the carrying
amount of the investment property.

Disposal of Investments
On disposal of an investment, the difference between the carrying amount and the
disposal proceeds, net of expenses, is recognised in the profit and loss statement.
When disposing of a part of the holding of an individual investment, the carrying
amount to be allocated to that part is to be determined on the basis of the average
carrying amount of the total holding of the investment 3.
Reclassification of Investments
Where long-term investments are reclassified as current investments, transfers are
made at the lower of cost and carrying amount at the date of transfer.
Where investments are reclassified from current to long-term, transfers are made
at the lower of cost and fair value at the date of transfer.
Disclosure
The following disclosures in financial statements in relation to investments are
appropriate: -
a. The accounting policies followed for valuation of investments.
b. The amounts included in profit and loss statement for:
i. Interest, dividends (showing separately dividends from subsidiary
companies), and rentals on investments showing separately such
income from long term and current investments. Gross income should

3
In respect of shares, debentures and other securities held as stock-in-trade, the cost of
stocks disposed of is determined by applying an appropriate cost formula (e.g. first-in, first-
out, average cost, etc.). These cost formulae are the same as those specified in AS 2
(Revised), in respect of Valuation of Inventories.

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be stated, the amount of income tax deducted at source being included

under Advance Taxes Paid.
ii. Profits and losses on disposal of current investments and changes in
carrying amount of such investments.
iii. Profits and losses on disposal of long term investments and changes in
the carrying amount of such investments.
c. Significant restrictions on the right of ownership, realisability of investments
or the remittance of income and proceeds of disposal.
d. The aggregate amount of quoted and unquoted investments, giving the
aggregate market value of quoted investments.
e. Other disclosures as specifically required by the relevant statute governing
the enterprise.
Illustration 1
An unquoted long term investment is carried in the books at a cost of ` 2 lakhs. The
published accounts of the unlisted company received in May, 20X1 showed that the
company was incurring cash losses with declining market share and the long term
investment may not fetch more than ` 20,000. How will you deal with this in
preparing the financial statements of R Ltd. for the year ended 31st March, 20X1?
Solution
As it is stated in the question that financial statements for the year ended
31st March, 20X1 are under preparation, the views have been given on the basis
that the financial statements are yet to be completed and approved by the Board
of Directors. Also, the fall in value of investments has been considered on account
of conditions existing on the balance sheet date.
Investments classified as long term investments should be carried in the financial
statements at cost. However, provision for diminution should be made to recognise
a decline, other than temporary, in the value of the investments, such reduction
being determined and made for each investment individually. AS 13 (Revised)
‘Accounting for Investments’ states that indicators of the value of an investment
are obtained by reference to its market value, the investee's assets and results and
the expected cash flows from the investment. On these bases, the facts of the given
case clearly suggest that the provision for diminution should be made to reduce
the carrying amount of long term investment to ` 20,000 in the financial statements
for the year ended 31st March, 20X1.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.131

Illustration 2
X Ltd. on 1-1-20X1 had made an investment of ` 600 lakhs in the equity shares of Y
Ltd. of which 50% is made in the long term category and the rest as temporary
investment. The realisable value of all such investment on 31-3-20X1 became ` 200
lakhs as Y Ltd. lost a case of copyright. From the given market conditions, it is
apparent that the reduction in the value is not temporary in nature. How will you
recognise the reduction in financial statements for the year ended on 31-3-20X1?
Solution
X Ltd. invested ` 600 lakhs in the equity shares of Y Ltd. Out of the same, the
company intends to hold 50% shares for long term period i.e. ` 300 lakhs and
remaining as temporary (current) investment i.e. ` 300 lakhs. Irrespective of the fact
that investment has been held by X Ltd. only for 3 months (from 1.1.20X1 to
31.3.20X1), AS 13 (Revised) lays emphasis on intention of the investor to classify
the investment as current or long term even though the long term investment may
be readily marketable.
In the given situation, the realisable value of all such investments on 31.3.20X1
became ` 200 lakhs i.e. ` 100 lakhs in respect of current investment and ` 100 lakhs
in respect of long term investment.
As per AS 13 (Revised), ‘Accounting for Investment’, the carrying amount for current
investments is the lower of cost and fair value. In respect of current investments for
which an active market exists, market value generally provides the best evidence of
fair value.
Accordingly, the carrying value of investment held as temporary investment should
be shown at realisable value i.e. at ` 100 lakhs. The reduction of ` 200 lakhs in the
carrying value of current investment will be charged to the profit and loss account.
Standard further states that long-term investments are usually carried at cost.
However, when there is a decline, other than temporary, in the value of long term
investment, the carrying amount is reduced to recognise the decline.
Here, Y Ltd. lost a case of copyright which drastically reduced the realisable value of its
shares to one third which is quiet a substantial figure. Losing the case of copyright may
affect the business and the performance of the company in long run. Accordingly, it
will be appropriate to reduce the carrying amount of long term investment by ` 200
lakhs and show the investments at ` 100 lakhs, since the downfall in the value of shares
is other than temporary. The reduction of ` 200 lakhs in the carrying value of long term
investment will also be charged to the Statement of profit and loss.

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Illustration 3
M/s Innovative Garments Manufacturing Company Limited invested in the shares of
another company on 1st October, 20X3 at a cost of ` 2,50,000. It also earlier
purchased Gold of ` 4,00,000 and Silver of ` 2,00,000 on 1st March, 20X1. Market
value as on 31st March, 20X4 of above investments are as follows:
`
Shares 2,25,000
Gold 6,00,000
Silver 3,50,000
How above investments will be shown in the books of accounts of M/s Innovative
Garments Manufacturing Company Limited for the year ending 31st March, 20X4 as
per the provisions of Accounting Standard 13 "Accounting for Investments"?
Solution
As per AS 13 (Revised) ‘Accounting for Investments’, for investment in shares - if
the investment is purchased with an intention to hold for short-term period (less
than one year), then it will be classified as current investment and to be carried at
lower of cost and fair value, i.e., in case of shares, at lower of cost (` 2,50,000) and
market value (` 2,25,000) as on 31 March 20X4, i.e., ` 2,25,000.
If equity shares are acquired with an intention to hold for long term period (more than
one year), then should be considered as long-term investment to be shown at cost in
the Balance Sheet of the company. However, provision for diminution should be made
to recognise a decline, if other than temporary, in the value of the investments.
Gold and silver are generally purchased with an intention to hold it for long term
period (more than one year) until and unless given otherwise. Hence, the
investment in Gold and Silver (purchased on 1st March, 20X1) should continue to
be shown at cost (since there is no ‘other than temporary’ diminution) as on 31st
March, 20X4, i.e., ` 4,00,000 and ` 2,00,000 respectively, though their market values
have been increased.
Illustration 4
ABC Ltd. wants to re-classify its investments in accordance with AS 13 (Revised).
Decide and state on the amount of transfer, based on the following information:
(1) A portion of current investments purchased for ` 20 lakhs, to be reclassified as
long term investment, as the company has decided to retain them. The market
value as on the date of Balance Sheet was ` 25 lakhs.

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(2) Another portion of current investments purchased for ` 15 lakhs, to be

reclassified as long term investments. The market value of these investments as
on the date of balance sheet was ` 6.5 lakhs.

(3) Certain long term investments no longer considered for holding purposes, to be
reclassified as current investments. The original cost of these was ` 18 lakhs
but had been written down to ` 12 lakhs to recognise other than temporary
decline as per AS 13 (Revised).

Solution

As per AS 13 (Revised), where investments are reclassified from current to long-

term, transfers are made at the lower of cost and fair value at the date of transfer.

(1) In the first case, the market value of the investment is ` 25 lakhs, which is
higher than its cost i.e. ` 20 lakhs. Therefore, the transfer to long term
investments should be carried at cost i.e. ` 20 lakhs.

(2) In the second case, the market value of the investment is ` 6.5 lakhs, which is
lower than its cost i.e. ` 15 lakhs. Therefore, the transfer to long term
investments should be carried in the books at the market value i.e. ` 6.5 lakhs.
The loss of ` 8.5 lakhs should be charged to profit and loss account.

As per AS 13 (Revised), where long-term investments are re-classified as

current investments, transfers are made at the lower of cost and carrying
amount at the date of transfer.

(3) In the third case, the book value of the investment is ` 12 lakhs, which is lower
than its cost i.e. ` 18 lakhs. Here, the transfer should be at carrying amount and
hence this re-classified current investment should be carried at ` 12 lakhs.

Reference:

1. Students are advised to refer ‘chapter 9’ for more problems on practical

application of AS 13 (Revised).

2. The students are also advised to refer the full bare text of AS 13
(Revised) “Accounting for Investments”.

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2.8 AS 16: BORROWING COSTS

Introduction
The objective of AS 16 is accounting for borrowing costs. It does not deal with the
actual or imputed cost of owners’ equity, including preference share capital not
classified as a liability.
Definitions
Borrowing costs are interest and other costs incurred by an enterprise in
connection with the borrowing of funds.

Borrowing Cost

Finance
Amortisation
Interest & Amortisation charges for
of ancillary
Commitment of Discount/ assets Exchange
costs
charges on Premium on acquired on Differences*
relating to
Borrowings Borrowings Finance
Borrowings
Lease

*To the extent they are regarded as an adjustment to interest cost

A qualifying asset is an asset that necessarily takes a substantial period of time to

get ready for its intended use or sale.
Examples of qualifying assets are manufacturing plants, power generation facilities,
inventories that require a substantial period of time to bring them to a saleable
condition, and investment properties. Other investments and those inventories that
are routinely manufactured or otherwise produced in large quantities on a
repetitive basis over a short period of time, are not qualifying assets. Assets that
are ready for their intended use or sale when acquired also are not qualifying assets.
Accounting standard further clarifies the meaning of the expression ‘substantial
period of time’. According to it, substantial period of time primarily depends on the
facts and circumstances of each case. It further states that, ordinarily, a period of
twelve months is considered as substantial period of time unless a shorter or longer
period can be justified on the basis of the facts and circumstances of the case. In

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estimating the period, time which an asset takes technologically and commercially
to get it ready for its intended use or sale should be considered.
Exchange Differences on Foreign Currency Borrowings
Exchange differences arising from foreign currency borrowing and considered as
borrowing costs are those exchange differences which arise on the amount of
principal of the foreign currency borrowings to the extent of the difference between
interest on local currency borrowings and interest on foreign currency borrowings.
Thus, the amount of exchange difference not exceeding the difference between
interest on local currency borrowings and interest on foreign currency borrowings
is considered as borrowings cost to be accounted for under this Standard and the
remaining exchange difference, if any, is accounted for under AS 11, ‘The Effect
of Changes in Foreign Exchange Rates’. For this purpose, the interest rate for the
local currency borrowings is considered as that rate at which the enterprise would
have raised the borrowings locally had the enterprise not decided to raise the
foreign currency borrowings.
Example
XYZ Ltd. has taken a loan of USD 10,000 on April 1, 20X1, for a specific project at an
interest rate of 5% p.a., payable annually. On April 1, 20X1, the exchange rate
between the currencies was ` 45 per USD. The exchange rate, as at March 31, 20X2,
is ` 48 per USD. The corresponding amount could have been borrowed by XYZ Ltd. in
local currency at an interest rate of 11 per cent per annum as on April 1, 20X1.
The following computation would be made to determine the amount of borrowing
costs for the purposes of paragraph 4(e) of AS 16:
(i) Interest for the period = USD 10,000 x 5% x ` 48/USD = ` 24,000
(ii) Increase in the liability towards the principal amount = USD 10,000 x (48-45)
= ` 30,000
(iii) Interest that would have resulted if the loan was taken in Indian currency
= USD 10,000 x 45 x 11% = ` 49,500
(iv) Difference between interest on local currency borrowing and foreign currency
borrowing = ` 49,500 – ` 24,000 = ` 25,500
Therefore, out of ` 30,000 increase in the liability towards principal amount, only
` 25,500 will be considered as the borrowing cost. Thus, total borrowing cost would
be ` 49,500 being the aggregate of interest of ` 24,000 on foreign currency
borrowings (covered by paragraph 4(a) of AS 16) plus the exchange difference to the

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extent of difference between interest on local currency borrowing and interest on

foreign currency borrowing of ` 25,500.
Thus, ` 49,500 would be considered as the borrowing cost to be accounted for as per
AS 16 and the remaining ` 4,500 would be considered as the exchange difference to
be accounted for as per Accounting Standard (AS) 11, The Effects of Changes in
Foreign Exchange Rates.
In the above example, if the interest rate on local currency borrowings is assumed to
be 13% instead of 11%, the entire exchange difference of ` 30,000 would be
considered as borrowing costs, since in that case the difference between the interest
on local currency borrowings and foreign currency borrowings [i.e., ` 34,500 (` 58,500
– ` 24,000)] is more than the exchange difference of ` 30,000. Therefore, in such a
case, the total borrowing cost would be ` 54,000 (` 24,000 + ` 30,000) which would
be accounted for under AS 16 and there would be no exchange difference to be
accounted for under AS 11 ‘The Effects of Changes in Foreign Exchange Rates’.
Borrowing Costs Eligible for Capitalisation
Treatment of Borrowing Costs

Borrowing Costs

Directly related* for

* acquisition
* construction
* production of

Qualifying Assets Assets other than Qualifying assets

Capitalized Revenue Expenditure

*or that could have been avoided if the expenditure on qualifying assets had not been made

The borrowing costs that are directly attributable to the acquisition, construction
or production of a qualifying asset are those borrowing costs that would have been
avoided if the expenditure on the qualifying asset had not been made. Borrowing
costs are capitalised as part of the cost of a qualifying asset when it is probable

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that they will result in future economic benefits to the enterprise and the costs can
be measured reliably. Other borrowing costs are recognised as an expense in the
period in which they are incurred.

Borrowing costs

Specific borrowings General borrowings

Illustration 1
PRM Ltd. obtained a loan from a bank for ` 50 lakhs on 30-04-20X1. It was utilised
as follows:

Particulars Amount (` in lakhs)

Construction of a shed 50
Purchase of a machinery 40
Working Capital 20
Advance for purchase of truck 10

Construction of shed was completed in March 20X2. The machinery was installed on
the date of acquisition. Delivery of truck was not received. Total interest charged by
the bank for the year ending 31-03-20X2 was ` 18 lakhs. Show the treatment of
interest.
Solution
Qualifying Asset as per AS 16 = ` 50 lakhs (construction of a shed)
Borrowing cost to be capitalised = 18 x 50/120 = ` 7.5 lakhs
Interest to be debited to Profit or Loss account = ` (18 – 7.5) lakhs = ` 10.5 lakhs
Specific borrowings
When an enterprise borrows funds specifically for the purpose of obtaining a
particular qualifying asset, the borrowing costs that directly relate to that qualifying
asset can be readily identified.
To the extent that funds are borrowed specifically for the purpose of obtaining a
qualifying asset, the amount of borrowing costs eligible for capitalisation on that
asset should be determined as the actual borrowing costs incurred on that

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borrowing during the period less any income on the temporary investment of those
borrowings.
The financing arrangements for a qualifying asset may result in an enterprise
obtaining borrowed funds and incurring associated borrowing costs before some
or all of the funds are used for expenditure on the qualifying asset. In such
circumstances, the funds are often temporarily invested pending their expenditure
on the qualifying asset. In determining the amount of borrowing costs eligible for
capitalisation during a period, any income earned on the temporary investment of
those borrowings is deducted from the borrowing costs incurred.
General borrowings
It may be difficult to identify a direct relationship between particular borrowings and
a qualifying asset and to determine the borrowings that could otherwise have been
avoided. To the extent that funds are borrowed generally and used for the purpose of
obtaining a qualifying asset, the amount of borrowing costs eligible for capitalisation
should be determined by applying a capitalisation rate to the expenditure on that
asset. The capitalisation rate should be the weighted average of the borrowing costs
applicable to the borrowings of the enterprise that are outstanding during the period,
other than borrowings made specifically for the purpose of obtaining a qualifying
asset. The amount of borrowing costs capitalised during a period should not exceed
the amount of borrowing costs incurred during that period.
Excess of the Carrying Amount of the Qualifying Asset over Recoverable
Amount
When the carrying amount or the expected ultimate cost of the qualifying asset
exceeds its recoverable amount or net realisable value, the carrying amount is
written down or written off in accordance with the requirements of other
Accounting Standards. In certain circumstances, the amount of the write-down or
write-off is written back in accordance with those other Accounting Standards.
Illustration 2
X Ltd. began construction of a new building on 1st January, 20X1. It obtained ` 1 lakh
special loan to finance the construction of the building on 1st January, 20X1 at an
interest rate of 10%. The company’s other outstanding two non-specific loans were:

Amount Rate of Interest

` 5,00,000 11%
` 9,00,000 13%

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The expenditures that were made on the building project were as follows:

`
January 20X1 2,00,000
April 20X1 2,50,000
July 20X1 4,50,000
December 20X1 1,20,000
Building was completed by 31st December 20X1. Following the principles prescribed
in AS 16 ‘Borrowing Cost,’ calculate the amount of interest to be capitalised and pass
one Journal Entry for capitalising the cost and borrowing cost in respect of the
building.
Solution
(i) Computation of weighted average accumulated expenses
`
` 2,00,000 x 12 / 12 = 2,00,000
` 2,50,000 x 9 / 12 = 1,87,500
` 4,50,000 x 6 / 12 = 2,25,000
` 1,20,000 x 1 / 12 = 10,000
6,22,500

(ii) Calculation of weighted average interest rate other than for specific
borrowings

Amount of loan (`) Rate of Amount of

interest interest (`)
5,00,000 11% = 55,000
9,00,000 13% = 1,17,000
14,00,000 1,72,000
Weighted average rate of interest = 12.285% (approx)
 1,72,000 
 14,00,000 × 100 
 

(iii) Interest on weighted average accumulated expenses

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`
Specific borrowings (` 1,00,000 x 10%) = 10,000
Non-specific borrowings (` 5,22,500 ∗ x 12.285%) = 64,189
Amount of interest to be capitalised = 74,189

(iv) Total expenses to be capitalised for building

`
Cost of building ` (2,00,000 + 2,50,000 + 4,50,000 + 1,20,000) 10,20,000
Add: Amount of interest to be capitalised 74,189
10,94,189

(v) Journal Entry

Date Particulars Dr. (`) Cr. (`)

31.12. 20X1 Building account Dr. 10,94,189
To Bank account 10,94,189
(Being amount of cost of building
and borrowing cost thereon
capitalised)

Commencement of Capitalisation
The capitalisation of borrowing costs as part of the cost of a qualifying asset should
commence when all the following conditions are satisfied:
a. Expenditure for the acquisition, construction or production of a
qualifying asset is being incurred: Expenditure on a qualifying asset
includes only such expenditure that has resulted in payments of cash,
transfers of other assets or the assumption of interest-bearing liabilities.
Expenditure is reduced by any progress payments received and grants
received in connection with the asset. The average carrying amount of the
asset during a period, including borrowing costs previously capitalised, is
normally a reasonable approximation of the expenditure to which the
capitalisation rate is applied in that period.
b. Borrowing costs are being incurred.

∗
(` 6,22,500 – ` 1,00,000)

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c. Activities that are necessary to prepare the asset for its intended use or
sale are in progress: The activities necessary to prepare the asset for its
intended use or sale encompass more than the physical construction of the
asset. They include technical and administrative work prior to the
commencement of physical construction. However, such activities exclude the
holding of an asset when no production or development that changes the
asset’s condition is taking place. For example, borrowing costs incurred while
land is under development are capitalised during the period in which
activities related to the development are being undertaken. However,
borrowing costs incurred while land acquired for building purposes is held
without any associated development activity do not qualify for capitalisation.
Suspension of Capitalisation
Capitalisation of borrowing costs should be suspended during extended periods in
which active development is interrupted.
Borrowing costs may be incurred during an extended period in which the activities
necessary to prepare an asset for its intended use or sale are interrupted. Such
costs are costs of holding partially completed assets and do not qualify for
capitalisation. However, capitalisation of borrowing costs is not normally
suspended during a period when substantial technical and administrative work is
being carried out. Capitalisation of borrowing costs is also not suspended when a
temporary delay is a necessary part of the process of getting an asset ready for its
intended use or sale. For example: capitalisation continues during the extended
period needed for inventories to mature or the extended period during which high
water levels delay construction of a bridge, if such high water levels are common
during the construction period in the geographic region involved.
Cessation of Capitalisation
Capitalisation of borrowing costs should cease when substantially all the activities
necessary to prepare the qualifying asset for its intended use or sale are complete.
An asset is normally ready for its intended use or sale when its physical construction
or production is complete even though routine administrative work might still
continue. If minor modifications, such as the decoration of a property to the user’s
specification, are all that are outstanding, this indicates that substantially all the
activities are complete.
When the construction of a qualifying asset is completed in parts and a completed

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part is capable of being used while construction continues for the other parts,
capitalisation of borrowing costs in relation to a part should cease when
substantially all the activities necessary to prepare that part for its intended use or
sale are complete. A business park comprising several buildings, each of which can
be used individually, is an example of a qualifying asset for which each part is
capable of being used while construction continues for the other parts. An example
of a qualifying asset that needs to be complete before any part can be used is an
industrial plant involving several processes which are carried out in sequence at
different parts of the plant within the same site, such as a steel mill.
Disclosure
The financial statements should disclose:
a. The accounting policy adopted for borrowing costs; and

b. The amount of borrowing costs capitalised during the period.

Illustration 3
The company has obtained Institutional Term Loan of ` 580 lakhs for modernisation
and renovation of its Plant & Machinery. Plant & Machinery acquired under the
modernisation scheme and installation completed on 31st March, 20X2 amounted to
` 406 lakhs, ` 58 lakhs has been advanced to suppliers for additional assets and the
balance loan of ` 116 lakhs has been utilised for working capital purpose. The
Accountant is on a dilemma as to how to account for the total interest of ` 52.20
lakhs incurred during 20X1-20X2 on the entire Institutional Term Loan of ` 580 lakhs.
Solution
As per para 6 of AS 16 ‘Borrowing Costs’, borrowing costs that are directly
attributable to the acquisition, construction or production of a qualifying asset
should be capitalised as part of the cost of that asset. Other borrowing costs should
be recognised as an expense in the period in which they are incurred.
A qualifying asset is an asset that necessary takes a substantial period of time* to
get ready for its intended use or sale.
The treatment for total interest amount of ` 52.20 lakhs can be given as:

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Purpose Nature Interest to be Interest to be

capitalised charged to profit
and loss account
` in lakhs ` in lakhs
Modernisation Qualifying asset
and renovation of 406
* *52.20 × = 36.54
plant and 580
machinery
58
* *52.20 × = 5.22
580
Advance to Qualifying asset
supplies for 116
additional assets 52.20 × = 10.44
580
Working Capital Not a qualifying
asset
41.76 10.44
* A substantial period of time primarily depends on the facts and circumstances of
each case. However, ordinarily, a period of twelve months is considered as substantial
period of time unless a shorter or longer period can be justified on the basis of the
facts and circumstances of the case.
** It is assumed in the above solution that the modernisation and renovation of plant
and machinery will take substantial period of time (i.e. more than twelve months).
Regarding purchase of additional assets, the nature of additional assets has also been
considered as qualifying assets. Alternatively, the plant and machinery and additional
assets may be assumed to be non-qualifying assets on the basis that the renovation
and installation of additional assets will not take substantial period of time. In that
case, the entire amount of interest, ` 52.20 lakhs will be recognised as expense in the
profit and loss account for year ended 31st March, 20X2.
Illustration 4
Take Ltd. has borrowed ` 30 lakhs from State Bank of India during the financial year
20X1-20X2. The borrowings are used to invest in shares of Give Ltd., a subsidiary
company of Take Ltd., which is implementing a new project, estimated to cost ` 50
lakhs. As on 31st March, 20X2, since the said project was not complete, the directors

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of Take Ltd. resolved to capitalise the interest accruing on borrowings amounting to

` 4 lakhs and add it to the cost of investments. Comment.
Solution
As per AS 13 (Revised) "Accounting for Investments", the cost of investment
includes acquisition charges such as brokerage, fees and duties. In the present case,
Take Ltd. has used borrowed funds for purchasing shares of its subsidiary company
Give Ltd. ` 4 lakhs interest payable by Take Ltd. to State Bank of India cannot be
called as acquisition charges, therefore, cannot be constituted as cost of
investment.
Further, as per para 3 of AS 16 "Borrowing Costs", a qualifying asset is an asset that
necessarily takes a substantial period of time to get ready for its intended use or
sale. Since, shares are ready for its intended use at the time of sale, it cannot be
considered as qualifying asset that can enable a company to add the borrowing
cost to investments. Therefore, the directors of Take Ltd. cannot capitalise the
borrowing cost as part of cost of investment. Rather, it has to be charged to the
Statement of Profit and Loss for the year ended 31st March, 20X2.
Reference: The students are advised to refer the full text of AS 16 “Borrowing
Costs” (issued 2000).

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TEST YOUR KNOWLEDGE

MCQ
1. Which item of inventory is under the scope of AS 2 (Revised)?
(a) WIP arising under construction contracts
(b) Raw materials
(c) Shares, Debentures held as stock in trade.
2. Crown Ltd. wants to prepare its cash flow statement. It sold equipment of
book value of ` 60,000 at a gain of ` 8,000. The amount to be reported in its
cash flow statement under operating activities is
(a) Nil
(b) ` 8,000
(c) ` 68,000
3. While preparing cash flows statement, an entity (other than a financial
institution) should disclose the dividends received from its investment in
shares as
(a) operating cash inflow
(b) investing cash inflow
(c) financing cash inflow
4. As per AS 10 (Revised) ‘Property, plant and equipment’, which of the following
costs is not included in the carrying amount of an item of PPE
(a) Costs of site preparation
(b) Costs of relocating
(c) Installation and assembly costs.
5. As per AS 10 (Revised) ‘Property, Plant and Equipment’, an enterprise holding
investment properties should value Investment property
(a) as per fair value
(b) under discounted cash flow model.
(c) under cost model

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6. As per AS 11 assets and liabilities of non-integral foreign operations should

be converted at __________ rate.
(a) Opening
(b) Average
(c) Closing
7. The debit or credit balance of “Foreign Currency Monetary Item Translation
Difference Account”
(a) Is shown as “Miscellaneous Expenditure” in the Balance Sheet
(b) Is shown under “Reserves and Surplus” as a separate line item
(c) Is shown as “Other Non-current/Current Assets” in the Balance Sheet
8. If asset of an integral foreign operation is carried at cost, cost and
depreciation of tangible fixed asset is translated at
(a) Average exchange rate
(b) Closing exchange rate
(c) Exchange rate at the date of purchase of asset
9. To encourage industrial promotion, IDCI offers subsidy worth Rs. 50 lakhs to
all new industries set up in the specified industrial areas. This grant is in the
nature of promoter’s contribution. How such subsidy should be accounted in
the books?
(a) Credit it to capital reserve
(b) Credit it as ‘other income’ in the profit and loss account in the year of
commencement of commercial operations
(c) Both (a) and (b) are permitted
10. As per AS 16, all of the following are qualifying assets except
(a) Manufacturing plants and Power generation facilities
(b) Inventories that require substantial period of time
(c) Assets those are ready for sale.
11. Materials and other supplies held for use in the production of inventories are
not written down below cost if the finished products in which they will be
incorporated are expected to be

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(a) sold above cost.

(b) sold less than cost.
(c) sold at or above cost.
12. All of the following costs are excluded while computing value of inventories
except?
(a) Selling and Distribution costs
(b) Allocated fixed production overheads based on normal capacity.
(c) Abnormal wastage
13. If an investment is acquired in exchange for another asset, it will be valued at
(a) Fair value of the asset given up.
(b) Fair value of the investment acquired.
(c) Either (a) or (b), whichever is more clearly evident.
14. XYZ Co. is a financial enterprise. In its cash flow statement, interest paid and
dividends received should be
(a) classified as operating cash flows.
(b) classified as financing cash flows.
(c) Not shown in cash flow statement.
15. Government grants that are receivable as compensation for expenses or
losses incurred in a previous accounting period or for the purpose of giving
immediate financial support to the enterprise with no further related costs,
should be
(a) recognised and disclosed in the Statement of Profit and Loss of the
period in which they are receivable as an ordinary item.
(b) recognised and disclosed in the Statement of Profit and Loss of the
period in which the losses or expenses were incurred.
(c) recognised and disclosed in the Statement of Profit and Loss of the
period in which they are receivable, as an extraordinary item if
appropriate as per AS 5.

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Theory Questions
1. What are the three fundamental accounting assumptions recognised by
Accounting Standard (AS) 1? Briefly describe each one of them.
2. “In determining the cost of inventories, it is appropriate to exclude certain
costs and recognise them as expenses in the period in which they are
incurred”. Provide examples of such costs as per AS 2 (Revised) ‘Valuation of
Inventories’.
3. What are the main features of the Cash Flow Statement?
4. When can a company change its accounting policy? Explain.
5. Explain “monetary item” as per Accounting Standard 11. How are foreign
currency monetary items to be recognised at each Balance Sheet date?
6. Briefly explain disclosure requirements for Investments as per AS-13.
7. When capitalisation of borrowing cost should cease as per Accounting
Standard 16?
8. Explain 'Bearer Plant’ and 'Biological Asset' as per Accounting Standard 10.
9. Distinguish Non-Integral Foreign Operation (NFO) with Integral Foreign
Operation (IFO) as per AS 11.
Practical Questions
Question 1
State whether the following statements are 'True' or 'False'. Also give reason for
your answer.
(i) Certain fundamental accounting assumptions underline the preparation and
presentation of financial statements. They are usually specifically stated
because their acceptance and use are not assumed.
(ii) If fundamental accounting assumptions are not followed in presentation and
preparation of financial statements, a specific disclosure is not required.
(iii) All significant accounting policies adopted in the preparation and
presentation of financial statements should form part of the financial
statements.
(iv) Any change in an accounting policy, which has a material effect should be
disclosed. Where the amount by which any item in the financial statements is

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affected by such change is not ascertainable, wholly or in part, the fact need
not to be indicated.
Question 2
With reference to AS-10 Revised, classify the items under the following heads:
HEADS
(i) Purchase Price of Property, plant and Equipment (PPE)
(ii) Directly attributable cost of PPE or
(iii) Cost not included in determining the carrying amount of an item of PPE.
ITEMS
(1) Import duties and non-refundable purchase taxes.
(2) Initial delivery and handling costs.
(3) Initial operating losses, such as those incurred while demand for the output
of an item builds up.
(4) Costs incurred while an item capable of operating in the manner intended by
management has yet to be brought into use or is operated at less than full
capacity.
(5) Trade discounts and rebates.
(6) Costs of relocating or reorganizing part or all of the operations of an
enterprise.
(7) Installation and assembly costs.
(8) Administration and other general overhead costs.
Question 3
Capital Cables Ltd., has a normal wastage of 4% in the production process. During
the year 20X1-20X2 the Company used 12,000 MT of raw material costing ` 150
per MT. At the end of the year 630 MT of wastage was in stock. The accountant
wants to know how this wastage is to be treated in the books. Explain in the context
of AS 2 (Revised) the treatment of normal loss and abnormal loss and also find out
the amount of abnormal loss, if any.
Question 4
Mr. Mehul gives the following information relating to items forming part of
inventory as on 31-3-20X1. His factory produces Product X using Raw material A.

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(i) 600 units of Raw material A (purchased @ ` 120). Replacement cost of raw
material A as on 31-3-20X1 is ` 90 per unit.
(ii) 500 units of partly finished goods in the process of producing X and cost
incurred till date ` 260 per unit. These units can be finished next year by
incurring additional cost of ` 60 per unit.
(iii) 1500 units of finished Product X and total cost incurred ` 320 per unit.
Expected selling price of Product X is ` 300 per unit.
Determine how each item of inventory will be valued as on 31-3-20X1. Also
calculate the value of total inventory as on 31-3-20X1.
Question 5
Money Ltd., a non-financial company has the following entries in its Bank Account.
It has sought your advice on the treatment of the same for preparing Cash Flow
Statement.
(i) Loans and Advances given to the following and interest earned on them:
(1) to suppliers
(2) to employees
(3) to its subsidiaries companies
(ii) Investment made in subsidiary Smart Ltd. and dividend received
(iii) Dividend paid for the year
(iv) TDS on interest income earned on investments made
(v) TDS on interest earned on advance given to suppliers
Discuss in the context of AS 3 Cash Flow Statement.
Question 6
ABC Ltd. is installing a new plant at its production facility. It has incurred these costs:

1. Cost of the plant (cost per supplier’s invoice plus taxes) ` 25,00,000
2. Initial delivery and handling costs ` 2,00,000
3. Cost of site preparation ` 6,00,000
4. Consultants used for advice on the acquisition of the plant ` 7,00,000
5. Interest charges paid to supplier of plant for deferred credit ` 2,00,000

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6. Estimated dismantling costs to be incurred after 7 years ` 3,00,000

7. Operating losses before commercial production ` 4,00,000

Please advise ABC Ltd. on the costs that can be capitalised in accordance with
AS 10 (Revised).
Question 7
Explain briefly the accounting treatment needed in the following cases as per AS
11 as on 31.3. 20X1.
Trade receivables include amount receivable from Umesh ` 5,00,000 recorded at
the prevailing exchange rate on the date of sales, transaction recorded at US $ 1=
`58.50.
Long term loan taken from a U.S. Company, amounting to ` 60,00,000. It was
recorded at US $ 1 = ` 55.60, taking exchange rate prevailing at the date of
transaction. US $ 1 = `61.20 was on 31.3. 20X1.
Question 8
Supriya Ltd. received a grant of ` 2,500 lakhs during the accounting year 20X1-20X2
from government for welfare activities to be carried on by the company for its
employees. The grant prescribed conditions for its utilisation. However, during the
year 20X2-20X3, it was found that the conditions of grants were not complied with
and the grant had to be refunded to the government in full. Elucidate the current
accounting treatment, with reference to the provisions of AS-12
Question 9
Blue-chip Equity Investments Ltd., wants to re-classify its investments in accordance
with AS 13 (Revised). State the values, at which the investments have to be
reclassified in the following cases:
(i) Long term investments in Company A, costing ` 8.5 lakhs are to be re-
classified as current. The company had reduced the value of these
investments to ` 6.5 lakhs to recognise ‘other than temporary’ decline in
value. The fair value on date of transfer is ` 6.8 lakhs.
(ii) Long term investments in Company B, costing ` 7 lakhs are to be re-classified
as current. The fair value on date of transfer is ` 8 lakhs and book value is
` 7 lakhs.

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(iii) Current investment in Company C, costing ` 10 lakhs are to be re-classified

as long term as the company wants to retain them. The market value on date
of transfer is ` 12 lakhs.
Question 10
From the following information of XYZ Limited, calculate cash and cash equivalent
as on 31-03-20X2 as per AS 3.

Particulars Amount
(`)
Balance as per the Bank Statement 25,000
Cheque issued but not presented in the Bank 15,000
Short Term Investment in liquid equity shares of ABC Limited 50,000
Fixed Deposit created on 01-11-20X1 and maturing on 15-04-20X2 75,000
Short Term Investment in highly liquid Sovereign Debt Mutual fund 1,00,000
on 01-03-20X2 (having maturity period of less than 3 months)
Bank Balance in a Foreign Currency Account in India $ 1,000
(Conversion Rate: On the day of deposit ` 69/USD as on
31-03-20X2 ` 70/USD)
Question 11
On 31st March 20X1, a business firm finds that cost of a partly finished unit on that
date is ` 530. The unit can be finished in 20X1-X2 by an additional expenditure of
` 310. The finished unit can be sold for ` 750 subject to payment of 4% brokerage
on selling price. The firm seeks your advice regarding the amount at which the
unfinished unit should be valued as at 31st March, 20X1 for preparation of final
accounts. Assume that the partly finished unit cannot be sold in semi-finished form
and its NRV is zero without processing it further.
Question 12
On 1st April, 20X1, Amazing Construction Ltd. obtained a loan of ` 32 crores to be
utilised as under:

(i) Construction of sealink across two cities:

(work was held up totally for a month during the : ` 25 crores
year due to high water levels)
(ii) Purchase of equipments and machineries : ` 3 crores

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(iii) Working capital : ` 2 crores

(iv) Purchase of vehicles : ` 50,00,000
(v) Advance for tools/cranes etc. : ` 50,00,000
(vi) Purchase of technical know-how : ` 1 crores
(vii)Total interest charged by the bank for the year : ` 80,00,000
ending 31st March, 20X2

Show the treatment of interest by Amazing Construction Ltd.

ANSWERS
MCQ
1. (b); 2. (a); 3. (b); 4. (b); 5. (c); 6. (c);
7. (b); 8. (c); 9. (a); 10. (c); 11. (c); 12. (b);
13. (c); 14. (a); 15. (c) ]
Answers to Theory Questions
1. Accounting Standard (AS) 1 recognises three fundamental accounting
assumptions. These are: (i) Going Concern; (ii) Consistency; (iii) Accrual
basis of accounting.
2. As per AS 2 (Revised) ‘Valuation of Inventories’, certain costs are excluded
from the cost of the inventories and are recognised as expenses in the period
in which incurred. Examples of such costs are:
(a) abnormal amount of wasted materials, labour, or other production costs;
(b) storage costs, unless those costs are necessary in the production
process prior to a further production stage;
(c) administrative overheads that do not contribute to bringing the
inventories to their present location and condition; and
(d) selling and distribution costs.
3. According to AS 3 on “Cash Flow Statement”, cash flow statement deals with
the provision of information about the historical changes in cash and cash
equivalents of an enterprise during the given period from operating, investing
and financing activities. Cash flows from operating activities can be reported
using either (a) the direct method, or (b) the indirect method. A cash flow
statement when used in conjunction with the other financial statements,

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provides information that enables users to evaluate the changes in net assets
of an enterprise, its financial structure (including its liquidity and solvency),
and its ability to affect the amount and timing of cash flows in order to adapt
to changing circumstances and opportunities.
4. A change in accounting policy should be made in the following conditions:
(i) If the change is required by some statute or
(ii) for compliance with an Accounting Standard or
(iii) change would result in more appropriate presentation of the financial
statement.
5. As per AS 11 ‘The Effects of Changes in Foreign Exchange Rates’, Monetary
items are money held and assets and liabilities to be received or paid in fixed
or determinable amounts of money.
Foreign currency monetary items should be reported using the closing rate
at each balance sheet date. However, in certain circumstances, the closing
rate may not reflect with reasonable accuracy the amount in reporting
currency that is likely to be realised from, or required to disburse, a foreign
currency monetary item at the balance sheet date. In such circumstances, the
relevant monetary item should be reported in the reporting currency at the
amount which is likely to be realised from or required to disburse, such item
at the balance sheet date.
6. The disclosure requirements as per AS 13 (Revised) are as follows:
(i) Accounting policies followed for valuation of investments.
(ii) Classification of investment into current and long term.
(iii) The amount included in profit and loss statements for
(a) Interest, dividends and rentals for long term and current investments,
disclosing therein gross income and tax deducted at source thereon;
(b) Profits and losses on disposal of current investment and changes in
carrying amount of such investments;
(c) Profits and losses and disposal of long term investments and changes
in carrying amount of investments.
(iv) Aggregate amount of quoted and unquoted investments, giving the
aggregate market value of quoted investments;

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(v) Any significant restrictions on investments like minimum holding period

for sale/disposal, utilisation of sale proceeds or non-remittance of sale
proceeds of investment held outside India.
(vi) Other disclosures required by the relevant statute governing the
enterprises
7. Capitalisation of borrowing costs should cease when substantially all the
activities necessary to prepare the qualifying asset for its intended use or sale
are complete. An asset is normally ready for its intended use or sale when its
physical construction or production is complete even though routine
administrative work might still continue. If minor modifications such as the
decoration of a property to the user’s specification, are all that are
outstanding, this indicates that substantially all the activities are complete.
When the construction of a qualifying asset is completed in parts and a
completed part is capable of being used while construction continues for the
other parts, capitalisation of borrowing costs in relation to a part should cease
when substantially all the activities necessary to prepare that part for its
intended use or sale are complete.
8. As per AS 10 Property, Plant and Equipment, biological asset is a living animal
or plant. Bearer plant is a plant that (a) is used in the production or supply
of agricultural produce; (b)is expected to bear produce for more than a period
of twelve months; and (c) has a remote likelihood of being sold as agricultural
produce, except for incidental scrap sales. Plants cultivated to be harvested
as agricultural produce (for example, trees grown for use as lumber); plants
cultivated to produce agricultural produce when there is more than a remote
likelihood that the entity will also harvest and sell the plant as agricultural
produce, other than as incidental scrap sales (for example, trees that are
cultivated both for their fruit and their lumber); and annual crops (for
example, maize and wheat) are not bearer plants.
9. As per AS 11, Integral foreign operation (IFO) is a foreign operation, the
activities of which are an integral part of those of the reporting enterprise. A
foreign operation that is integral to the operations of the reporting enterprise
carries on its business as if it were an extension of the reporting enterprise's
operations. In contrast, a non-integral foreign operation (NFO) is a foreign
operation that is not an integral operation. For details, refer para 2.5 of chapter.

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Answers to Practical Questions

Answer 1
(i) False; As per AS 1 “Disclosure of Accounting Policies”, certain fundamental
accounting assumptions underlie the preparation and presentation of
financial statements. They are usually not specifically stated because their
acceptance and use are assumed. Disclosure is necessary if they are not
followed.
(ii) False; As per AS 1, if the fundamental accounting assumptions, viz. Going
Concern, Consistency and Accrual are followed in financial statements,
specific disclosure is not required. If a fundamental accounting assumption is
not followed, the fact should be disclosed.
(iii) True; To ensure proper understanding of financial statements, it is necessary
that all significant accounting policies adopted in the preparation and
presentation of financial statements should be disclosed. The disclosure of
the significant accounting policies as such should form part of the financial
statements and they should be disclosed in one place.
(iv) False; Any change in the accounting policies which has a material effect in the
current period or which is reasonably expected to have a material effect in
later periods should be disclosed. Where such amount is not ascertainable,
wholly or in part, the fact should be indicated.
Answer 2
Heads
(i) Purchase price of PPE
(ii) Directly attributable cost of PPE
(iii) Cost not included in determining the carrying amount of an item of PPE

Items Classified
under Head
1 Import duties and non-refundable purchase taxes (i)
2 Initial delivery and handling costs (ii)
3 Initial operating losses, such as those incurred (iii)
while demand for the output of an item builds up

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4 Costs incurred while an item capable of operating (iii)

in the manner intended by management has yet to
be brought into use or is operated at less than full
capacity.
5 Trade discounts and rebates (deducted for (i)
computing purchase price)
6 Costs of relocating or reorganizing part or all of the (iii)
operations of an enterprise.
7 Installation and assembly costs (ii)
8 Administration and other general overhead costs (iii)

Answer 3
As per AS 2 (Revised) ‘Valuation of Inventories’, abnormal amounts of wasted
materials, labour and other production costs are excluded from cost of inventories
and such costs are recognised as expenses in the period in which they are incurred.
The normal loss will be included in determining the cost of inventories (finished
goods) at the year end.
Amount of Abnormal Loss:
Material used 12,000 MT @ `150 = `18,00,000
Normal Loss (4% of 12,000 MT) 480 MT
Net quantity of material 11,520 MT
Abnormal Loss in quantity 150 MT
Abnormal Loss ` 23,437.50
[150 units @ ` 156.25 (` 18,00,000/11,520)]
Amount ` 23,437.50 will be charged to the Statement of Profit and Loss.
Answer 4
As per AS 2 (Revised) “Valuation of Inventories”, materials and other supplies held
for use in the production of inventories are not written down below cost if the
finished products in which they will be incorporated are expected to be sold at cost
or above cost. However, when there has been a decline in the price of materials
and it is estimated that the cost of the finished products will exceed net realisable
value, the materials are written down to net realisable value. In such circumstances,
the replacement cost of the materials may be the best available measure of their

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net realisable value. In the given case, selling price of product X is ` 300 and total
cost per unit for production is ` 320.
Hence the valuation will be done as under:
(i) 600 units of raw material will be written down to replacement cost as market
value of finished product is less than its cost, hence valued at ` 90 per unit.
(ii) 500 units of partly finished goods will be valued at 240 per unit i.e. lower of
cost (` 260) or Net realisable value ` 240 (Estimated selling price ` 300 per
unit less additional cost of ` 60).
(iii) 1,500 units of finished product X will be valued at NRV of ` 300 per unit since
it is lower than cost ` 320 of product X.
Valuation of Total Inventory as on 31.03.20X1:

Units Cost NRV / Value = units x

(` ) Replacement cost or NRV
cost whichever is less
(` )
Raw material A 600 120 90 54,000
Partly finished goods 500 260 240 1,20,000
Finished goods X 1,500 320 300 4,50,000
Value of Inventory 6,24,000
Answer 5
Treatment as per AS 3 ‘Cash Flow Statement’
(i) Loans and advances given and interest earned
(1) to suppliers Cash flows from operating activities
(2) to employees Cash flows from operating activities
(3) to its subsidiary companiesCash flows from investing activities
(ii) Investment made in subsidiary company and dividend received
Cash flows from investing activities
(iii) Dividend paid for the year
Cash flows from financing activities
(iv) TDS on interest income earned on investments made

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No cash inflow/ cash outflow

(v) TDS on interest earned on advance given to suppliers
No cash inflow/ cash outflow
Answer 6
According to AS 10 (Revised), these costs can be capitalised:

1. Cost of the plant ` 25,00,000

2. Initial delivery and handling costs ` 2,00,000
3. Cost of site preparation ` 6,00,000
4. Consultants’ fees ` 7,00,000
5. Estimated dismantling costs to be incurred after 7 years ` 3,00,000
` 43,00,000

Note: Interest charges paid on “Deferred credit terms” to the supplier of the plant
(not a qualifying asset) of ` 2,00,000 and operating losses before commercial
production amounting to ` 4,00,000 are not regarded as directly attributable costs
and thus cannot be capitalised. They should be written off to the Statement of Profit
and Loss in the period they are incurred.
Answer 7
As per AS 11 “The Effects of Changes in Foreign Exchange Rates”, exchange
differences arising on the settlement of monetary items or on reporting an
enterprise’s monetary items at rates different from those at which they were initially
recorded during the period, or reported in previous financial statements, should be
recognised as income or as expenses in the period in which they arise.
However, at the option of an entity, exchange differences arising on reporting of
long-term foreign currency monetary items at rates different from those at which
they were initially recorded during the period, or reported in previous financial
statements, in so far as they relate to the acquisition of a non-depreciable capital
asset can be accumulated in a “Foreign Currency Monetary Item Translation
Difference Account” in the enterprise’s financial statements and amortised over the
balance period of such long-term asset/ liability, by recognition as income or
expense in each of such periods.

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Trade receivables Foreign `

Currency Rate
Initial recognition US $8,547 (5,00,000/58.50) 1 US $ = ` 58.50 5,00,000
Rate on Balance sheet date 1 US $ = ` 61.20
Exchange Difference Gain US $ 8,547 X 23,077
(61.20-58.50)
Treatment: Credit Profit and Loss A/c by
` 23,077
Long term Loan
Initial recognition US $ 1,07,913.67 1 US $ = ` 55.60 60,00,000
(60,00,000/55.60)
Rate on Balance sheet date 1 US $ = ` 61.20
Exchange Difference Loss US $ 1,07,913.67 X 6,04,317
(61.20 – 55.60)
Treatment: Credit Loan A/c
And Debit FCMITD A/C or Profit and Loss A/c
by ` 6,04,317

Thus Exchange Difference on Long term loan amounting ` 6,04,317 may either be
charged to Profit and Loss A/c or to Foreign Currency Monetary Item Translation
Difference Account but exchange difference on debtors amounting ` 23,077 is
required to be transferred to Profit and Loss A/c.
Answer 8
As per AS 12 ‘Accounting for Government Grants’, Government grants sometimes
become refundable because certain conditions are not fulfilled. A government
grant that becomes refundable is treated as an extraordinary item as per AS 5.
The amount refundable in respect of a government grant related to revenue is
applied first against any unamortised deferred credit remaining in respect of the
grant. To the extent that the amount refundable exceeds any such deferred credit,
or where no deferred credit exists, the amount is charged immediately to profit and
loss statement.
In the present case, the amount of refund of government grant should be shown in
the profit & loss account of the company as an extraordinary item during the year.

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 OVERVIEW OF ACCOUNTING STANDARDS 3.161

Answer 9
As per AS 13 (Revised) ‘Accounting for Investments’, where long-term investments
are reclassified as current investments, transfers are made at the lower of cost and
carrying amount at the date of transfer. And where investments are reclassified
from current to long term, transfers are made at lower of cost and fair value on the
date of transfer.
Accordingly, the re-classification will be done on the following basis:
(i) In this case, carrying amount of investment on the date of transfer is less than
the cost; hence this re-classified current investment should be carried at ` 6.5
lakhs in the books.
(ii) The carrying / book value of the long term investment is same as cost i.e.
` 7 lakhs. Hence this long term investment will be reclassified as current
investment at book value of ` 7 lakhs only.
(iii) In this case, reclassification of current investment into long-term investments
will be made at ` 10 lakhs as cost is less than its market value of ` 12 lakhs.
Answer 10
Computation of Cash and Cash Equivalents as on 31st March, 20X2
`
Cash balance with bank (` 25,000 less ` 15,000) 10,000
Short term investment in highly liquid sovereign debt mutual 1,00,000
fund on 1.3.20X2
Bank balance in foreign currency account ($1,000 x ` 70) 70,000
1,80,000

Note: Short term investment in liquid equity shares and fixed deposit will not be
considered as cash and cash equivalents.
Answer 11
Valuation of unfinished unit
`
Net selling price 750
Less: Estimated cost of completion (310)
440
Less: Brokerage (4% of 750) (30)

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 3.162 ACCOUNTING

Net Realisable Value 410

Cost of inventory 530
Value of inventory (Lower of cost and net realisable value) 410

Answer 12
According to AS 16 ‘Borrowing costs’, qualifying asset is an asset that necessarily
takes substantial period of time to get ready for its intended use.
Borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset should be capitalised as part of the cost of that
asset. Other borrowing costs should be recognised as an expense in the period in
which they are incurred.
The treatment of interest by Amazing Construction Ltd. can be shown as:

Qualifying Interest to Interest to

Asset be be charged
capitalised to Profit &
` Loss A/c `
Construction of Yes 62,50,000 [80,00,000x(25/32)]
sea-link
Purchase of No 7,50,000 [80,00,000x(3/32)]
equipment and
machineries
Working capital No 5,00,000 [80,00,000x(2/32)]
Purchase of No 1,25,000 [80,00,000x(0.5/32)]
vehicles
Advance for tools, No 1,25,000 [80,00,000x(0.5/32)]
cranes etc.
Purchase of No 2,50,000 [80,00,000x(1/32)]
technical know-
how
Total 62,50,000 17,50,000

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