Paper-1 Advanced Accounting
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Saurabh JainCHAPTER a
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 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.
© The Institute of Chartered Accountants of India
1.2 ADVANCED ACCOUNTING
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CHAPTER
v OVERVIEW
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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INTRODUCTION TO ACCOUNTING STANDARDS 1.3
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Accounting Standards (ASs) are written policy documents issued by the
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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.
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Accounting Standards deal with aspects of
accounting events
Recognition of Measurement of Presentation of Disclosure
events and transactions and transactions requirements
transactions events and events
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-
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INTRODUCTION TO ACCOUNTING STANDARDS 1.5
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enterprise. Such comparisons are very effective and most widely used toolsv
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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.
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.
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Another advantage of standardisation is reduction of scope for creative accounting.
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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.
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:
Step I – Identification of area:
Identification of broad areas by ASB for formulation of AS.
Step II – Constitution of study groups:
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
© The Institute of Chartered Accountants of India
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standard, recognition and measurement principles wherever applicable and
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Consideration of the preliminary draft prepared by the study group of ASB and
revision, if any, of the draft on the basis of deliberations.
Step III - Preparation of draft and its circulation:
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.
Step IV - Ascertainment of views of different bodies on draft:
Meeting with the representatives of the specified outside bodies to ascertain
their views on the draft of the proposed accounting standard.
Step V - Finalisation of exposure draft (E.D.):
Finalisation of the exposure draft of the proposed accounting standard and its
issuance inviting public comments.
Step VI – Comments received on exposure draft (E.D.):
Consideration of comments received on the exposure draft and finalisation of
the draft accounting standard by the ASB for submission to the Council of the
ICAI for its consideration and approval for issuance.
Step VII – Modification of the draft:
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.
Step VIII – Issue of AS:
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.
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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
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.
© The Institute of Chartered Accountants of India
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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,v
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 cha nges
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 30 th March 2016 announced Companies (Accounting
Standards) Amendment Rules, 2016. These rules were superseded by the
Companies (Accounting Standards) Rules, 2021 which were notified by the MCA on
23rd June, 2021. Various ASs i.e. AS 2, AS 4, AS 10, AS 13, AS 14, AS 21, AS 29 have
been revised 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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The following is the list of Accounting Standards with their respective date of
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applicability:
AS No. AS Title Date of 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 01/04/1998
the Balance Sheet Date (Revised)
5 Net Profit or Loss for the Period, Prior 01/04/1996
Period Items and 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 01/04/2004
Exchange Rates (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 01/04/2001
(Revised)
22 Accounting for Taxes on Income 01/04/2006
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23 Accounting for Investments in Associates 01/04/2002 v
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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 01/04/2002
Ventures
28 Impairment of Assets 01/04/2008
29 Provisions, Contingent Liabilities and 01/04/2004
Contingent Assets (Revised)
NOTE:
In the study material, Accounting Standards have not been discussed sequentially;
instead the related Accounting Standards have been grouped and discussed in the
ensuing chapters for ease of understanding. For example, the ‘Presentation and
Disclosure based Accounting Standards like AS 1, AS 3, AS 17, AS 18, AS 20, AS 24
and AS 25 have been grouped in one chapter. The chapter-wise grouping of
Accounting Standards, has been discussed in the Study Material, as follows:
Chapter 4: Presentation & Disclosures based Accounting Standards
AS 1 : Disclosure of Accounting Policies
AS 3 : Cash Flow Statements
AS 17 : Segment Reporting
AS 18 : Related Party Disclosures
AS 20 : Earnings Per Share
AS 24 : Discontinuing Operations
AS 25 : Interim Financial Reporting
Chapter 5: Assets based Accounting Standards
AS 2 : Valuation of Inventories
AS 10 : Property, Plant and Equipment
AS 13 : Accounting for Investments
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AS 16 : Borrowing Costs
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AS 19 : Leases
AS 26 : Intangible Assets
AS 28 : Impairment of Assets
Chapter 6: Liabilities based Accounting Standards
AS 15 : Employee Benefits
AS 29 : Provisions, Contingent Liabilities and Contingent Assets
Chapter 7: Accounting Standards based on items impacting Financial
Statements
AS 4 : Contingencies and Events Occurring After the Balance Sheet Date
Net Profit or Loss for the Period, Prior Period Items and Changes in
AS 5 :
Accounting Policies
AS 11 : The Effects of Changes in Foreign Exchange Rates
AS 22 : Accounting for Taxes on Income
Chapter 8: Revenue based Accounting Standards
AS 7 : Construction Contracts
AS 9 : Revenue Recognition
Chapter 9: Other Accounting Standards
AS 12 : Accounting for Government Grants
AS 14 : Accounting for Amalgamations (excluding inter- company holdings)
Chapter 10: Accounting Standards for Consolidated Financial Statements
Consolidated Financial Statements of single subsidiaries (excluding
problems involving acquisition of Interest in Subsidiary at Different
AS 21 :
Dates, Cross holding, Disposal of a Subsidiary and Foreign
Subsidiaries).
Accounting for Investment in Associates in Consolidated Financial
AS 23 :
Statements
AS 27 : Financial Reporting of Interests in Joint Ventures
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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, 20211.
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.
Few key aspects which required the need for convergence are as under:
1. Raising funds from international markets:
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
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Companies (Accounting Standards) Rules, 2021, has replaced Companies (Accounting
Standards) Rules, 2006, (as amended from time to time) notified by the Central Government
and Accounting Standards issued by the ICAI. The Companies (Accounting Standards) Rul es,
2021 will apply to accounting periods beginning on or after April 1, 2021.
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and reinstatements are of utmost importance in a world that is rapidly globalising
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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.
2. Comparability of Financial Statements:
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.
3. Uniformity, Comparability Transparency etc.:
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.
4. Global Investment:
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
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
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the reporting model. For the companies with joint listings in both domestic and
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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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7. v INTERNATIONAL FINANCIAL REPORTING
STANDARDS (IFRS) AS GLOBAL STANDARDS
The term International Financial Reporting Standards (IFRS) comprises:
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
1. IFRS issued by IASB;
2. IAS issued by IASC;
3. Interpretations issued by the Standard Interpretations Committee (SIC); and
4. Interpretations issued by the IFRS Interpretations Committee of the IASB
(called IFRIC – International Financial Reporting Standards Interpretation
Committee).
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
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companies to use IFRS for stock-exchange listing purposes, and in addition, banks, v
insurance companies and stock exchanges may use them for their statutorily v
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.
8. BECOMING IFRS COMPLIANT
Any country can become IFRS compliant either by adoption process or by
convergence process.
Technique I - Adoption
IFRS
compliant
Tecnique II - Convergence
Technique I – Adoption 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.
Technique II – Convergence Process:
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.
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Convergence with IFRS will result in following benefits:
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▪ 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
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.
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Accordingly, while formulating Ind AS, efforts have been made to keep these
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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:
➢ Terminology differences:
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’ (SOCI) and ‘balance sheet’ in place of
‘statement of financial position’(SOFP).
➢ Removal of options in accounting principles and practices:
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.
➢ Difference in economic environment:
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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v Formulation of Ind AS
Departures
Resulting into Carve-outs not resulting into carve-outs
Removal of options in accounting
Deviation from the accounting
principles and practices in Ind AS vis-a-
principles stated in IFRS
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.
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Recognising the growing need of full convergence of Ind AS with IFRS, ICAI
constituted a Task Force to examine various issues involved. v
Full convergence involves adoption of IFRS in the same form as that issued by the
IASB.
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
corresponding
IFRS, if required
Application
of IFRS in
India
convergence considering
ICAI to IFRS; legal and Indian Accounting Standards (Ind AS)
other Decision to
not adoption conditions 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.
© The Institute of Chartered Accountants of India
1.22 ADVANCED ACCOUNTING
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Indian Accounting Standards
Globalization and Transparency of Comparability Enhanced
Liberalization financial of financial Disclosure
statements statements requirements
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 July 2014, the Finance Minister of India at that time, Late Shri Arun Jaitley Ji, in
his Budget Speech, announced an urgency to converge the existing accounting
standards with the IFRS through adoption of the Ind AS by the Indian companies.
Pursuant to the above announcement, various steps have been taken to facilitate
the implementation of IFRS-converged Ind AS. Moving in this direction, the MCA
issued the Companies (Indian Accounting Standards) Rules, 2015 vide Notification
dated February 16, 2015 covering the revised roadmap of implementation of Ind
AS for companies other than Banking companies, Insurance Companies and NBFCs
and Ind AS.
© The Institute of Chartered Accountants of India
INTRODUCTION TO ACCOUNTING STANDARDS 1.23
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As per the Notification, Ind AS converged with IFRS were required to be
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implemented on voluntary basis from 1st April, 2015 and mandatorily from 1st
April, 2016.
Separate roadmaps were prescribed for implementation of Ind AS to Banking,
Insurance companies and NBFCs.
13. LIST OF IND AS
The following is the list of notified 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 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
© The Institute of Chartered Accountants of India
1.24 ADVANCED ACCOUNTING
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Ind AS IAS/ IFRS Title of Ind AS/IFRS AS/GN AS/GN Title
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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
IFRS 17 Insurance Contracts
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 the
Changes in Accounting 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
© The Institute of Chartered Accountants of India
INTRODUCTION TO ACCOUNTING STANDARDS 1.25
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Ind AS IAS/ IFRS Title of Ind AS/IFRS AS/GN AS/GN Title v
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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
27 IAS 27 Separate Financial - -
Statements
28 IAS 28 Investment in AS 23 Accounting for
Associates and Joint Investment in Associates
Ventures 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
© The Institute of Chartered Accountants of India
1.26 ADVANCED ACCOUNTING
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Ind AS IAS/ IFRS Title of Ind AS/IFRS AS/GN AS/GN Title
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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.
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.
© The Institute of Chartered Accountants of India
INTRODUCTION TO ACCOUNTING STANDARDS 1.27
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• 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 Non-Banking Financial Companies (NBFCs), Scheduled Commercial Banks
(Excluding RRBs) and Insurers/Insurance Companies and
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.
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.
© The Institute of Chartered Accountants of India
1.28 ADVANCED ACCOUNTING
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Scheduled Commercial banks (excluding RRBs)
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➢ 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. 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.
➢ 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 1st April 2020.
IRDAI, vide circular dated 21 January 2020, has deferred implementation of Ind
AS in the insurance sector till further notice.
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
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.
© The Institute of Chartered Accountants of India
INTRODUCTION TO ACCOUNTING STANDARDS 1.29
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th v
As per the MCA Notification dated 16 February 2015, Ind AS converged with
IFRS shall be implemented on voluntary basis from 1st April, 2015 and v
mandatorily from 1st April, 2016.
Separate roadmaps have been prescribed for implementation of Ind AS in Banking
companies, Insurance companies and NBFCs.
TEST YOUR KNOWLEDGE
Multiple Choice Questions
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.
(d) MCA
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).
(d) manipulate the data for the management.
3. It is essential to standardize the accounting principles and policies in order to
ensure
(a) Transparency.
(b) Consistency.
(c) Comparability .
(d) All the above.
© The Institute of Chartered Accountants of India
1.30 ADVANCED ACCOUNTING
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Which committee is responsible for approval of accounting standards and
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their modification for the purpose of applicability to companies?
(a) NFRA.
(b) MCA.
(c) Central Government Advisory Committee.
(d) IASB
5. Global Standards facilitate
(a) Cross border flow of money.
(b) Comparability of financial statements.
(c) Uniformity and Transparency of financial statements.
(d) All the three..
Theoretical Questions
6. Explain the objective of “Accounting Standards” in brief. State the advantages
of setting Accounting Standards.
7. Briefly explain the process of issuance of Indian Accounting Standards.
8. Explain the significance of emergence of IFRS as Global Standards.
9. What do you mean by Carve outs/ins in Ind AS? Explain.
ANSWERS/HINTS
Answers to the Multiple Choice Questions
1 (c) 2 (c) 3 (d) 4 (b) 5 (d)
Answers to the Theoretical Questions
6 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.
© The Institute of Chartered Accountants of India
INTRODUCTION TO ACCOUNTING STANDARDS 1.31
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Following are the objectives of Accounting Standards:
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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.
7. 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.
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.
© The Institute of Chartered Accountants of India
1.32 ADVANCED ACCOUNTING
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Global Standards facilitate cross border flow of money, global listing in different
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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.
9. 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
CHAPTER a
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.
© The Institute of Chartered Accountants of India
2.2 ADVANCED ACCOUNTING
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v OVERVIEW
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, 2021, (which has replaced Companies (Accounting Standards) Rules,
2006, as amended from time to time) 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;
© The Institute of Chartered Accountants of India
FRAMEWORK 2.3
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(f) Criteria for recognition of elements in financial statements; v
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(g) Principles for measurement of financial elements;
(h) Concepts of Capital and Capital Maintenance.
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.
© The Institute of Chartered Accountants of India
2.4 ADVANCED ACCOUNTING
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Nothing in the framework overrides any specific Accounting Standard. In case of
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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
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
© The Institute of Chartered Accountants of India
FRAMEWORK 2.5
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as disclosure of accounting policies, segment reporting, related party disclosures,
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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.
Users of Financial
Statements
Investors Employees Lenders Suppliers Customers Public
Govt.
and
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.
© The Institute of Chartered Accountants of India
2.6 ADVANCED ACCOUNTING
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Lenders - Lenders are interested in information which enables them to
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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.
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
© The Institute of Chartered Accountants of India
FRAMEWORK 2.7
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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 v
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.
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 31 st 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 expenditure 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
© The Institute of Chartered Accountants of India
2.8 ADVANCED ACCOUNTING
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use of the asset is even. The net realisable value of Property, Plant and
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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 expenditure 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.
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 debts 2,000 6,000
To Deferred 2,500 10,000
© The Institute of Chartered Accountants of India
FRAMEWORK 2.9
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expenditure v
To Loan penalty − 2,500 v
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 (ii) Assets Case (i) Case (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 (less 23,000 19,000
provision)
Trade payables 12,000 11,400 Deferred 7,500 Nil
expenditure
Bank 37,100 37,100
1,51,600 1,56,100 1,51,600 1,56,100
(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.
© The Institute of Chartered Accountants of India
2.10 ADVANCED ACCOUNTING
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He also purchased article B in period 1 for ` 2,000 cash.
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(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
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
© The Institute of Chartered Accountants of India
FRAMEWORK 2.11
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(c) v
Consistency: It is assumed that accounting policies are consistent from one
period to another. The consistency improves comparability of financial statementsv
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.
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
© The Institute of Chartered Accountants of India
2.12 ADVANCED ACCOUNTING
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materiality. A piece of information is said to be material if its misstatement
v
(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.
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.
© The Institute of Chartered Accountants of India
FRAMEWORK 2.13
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(d) v
Prudence is exercised in reporting uncertain outcome of transactions or
events. v
(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.
Elements of Financial Statements
Asset Liability Equity Income Expenses
© The Institute of Chartered Accountants of India
2.14 ADVANCED ACCOUNTING
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Gains and losses differ from income and expenses in the sense that they may or
v
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
© The Institute of Chartered Accountants of India
FRAMEWORK 2.15
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is not an asset. For example, economic benefits, i.e. profit on sale, from
v
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
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.
© The Institute of Chartered Accountants of India
2.16 ADVANCED ACCOUNTING
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v accuracy. In other cases, the company reports the damages payable as
v
‘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.
(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
© The Institute of Chartered Accountants of India
FRAMEWORK 2.17
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(Loss due to change in production method) v
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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 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.
© The Institute of Chartered Accountants of India
2.18 ADVANCED ACCOUNTING
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Thusv
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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.
(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.
© The Institute of Chartered Accountants of India
FRAMEWORK 2.19
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Also note that income earned is accompanied by either increase of asset (Cash
v
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.
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.
© The Institute of Chartered Accountants of India
2.20 ADVANCED ACCOUNTING
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Example 4
v
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)
Opening Equity (OE) = Opening Assets (OA) – Opening Liabilities (OL)
Capital Introduced = C
Drawings = D
© The Institute of Chartered Accountants of India
FRAMEWORK 2.21
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Income = I v
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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
© The Institute of Chartered Accountants of India
2.22 ADVANCED ACCOUNTING
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In preparation of financial statements, all or any of the measurement basis can be
v
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.
© The Institute of Chartered Accountants of India
FRAMEWORK 2.23
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Example 5 v
v
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 15th
year together with interest.
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.
© The Institute of Chartered Accountants of India
2.24 ADVANCED ACCOUNTING
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4. Present Value: Assets are carried at the present value of the future net cash
v
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) = = A×
(1+R ) (1+R )
n n
The process of obtaining present value of future cash flow is called
discounting. 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
© The Institute of Chartered Accountants of India
FRAMEWORK 2.25
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required is 10% (` 11,000 × 0.909 + ` 12,100 × 0.826). In other words the value v
v
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.
Example 7
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
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
© The Institute of Chartered Accountants of India
2.26 ADVANCED ACCOUNTING
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Property, Plant and Equipment. Unfortunately, this may not be enough in case of
v
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.
Example 8
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.
© The Institute of Chartered Accountants of India
FRAMEWORK 2.27
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Financial capital maintenance at current purchasing power: Under this v
convention, opening and closing equity at historical costs are restated at closing v
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%.
Example 9
In the previous example 8, 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
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.
© The Institute of Chartered Accountants of India
2.28 ADVANCED ACCOUNTING
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Illustration
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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.
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
© The Institute of Chartered Accountants of India
FRAMEWORK 2.29
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Financial Capital Maintenance at current purchasing power v
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Closing capital (At closing price) 12,000
Less: Capital to be maintained
Opening capital (At closing price) 15,000
Introduction (At closing price) Nil (15,000)
Retained profit/(loss) (3,000)
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)
SUMMARY
• Components of Financial Statements
Balance sheet Portrays value of economics resources
controlled by an enterprise
Statement of Profit and loss Presents the results of operations of an
enterprise
Cash flow statement Shows the way an enterprise generates
cash and uses it
Notes, other statements and Presents supplementary information
other explanatory materials explaining different items
© The Institute of Chartered Accountants of India
2.30 ADVANCED ACCOUNTING
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Users of Financial Statements
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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
• 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.
© The Institute of Chartered Accountants of India
FRAMEWORK 2.31
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Comparability Financial statements should provide both inter-v
v
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
• 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
(Settlement) the asset in an orderly disposal. For liabilities, this
© The Institute of Chartered Accountants of India
2.32 ADVANCED ACCOUNTING
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vValue is the undiscounted amount expected to be paid
v 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
TEST YOUR KNOWLEDGE
Multiple Choice Questions
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.
(d) The business cannot continue if it is not able to earn profits.
2. Two principal qualitative characteristics of financial statements are
(a) Understandability and materiality
© The Institute of Chartered Accountants of India
FRAMEWORK 2.33
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(b) Relevance and reliability
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(c) Relevance and materiality
(d) Comparability 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
(d) Social 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)
(d) By statute as well as accounting standards.
5. Value of equity may change due to
(a) Contribution from or Distribution to equity participants
(b) Income earned
(c) expenses incurred
(d) All the three.
Theoretical Questions
6. What are the qualitative characteristics of the financial statements which
improve the usefulness of the information furnished therein?
7. “One of the characteristics of financial statements is neutrality”- Do you agree
with this statement?
© The Institute of Chartered Accountants of India
2.34 ADVANCED ACCOUNTING
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Scenario based Questions
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8. Mohan started a business on 1 st April 20X1 with ` 12,00,000 represented by
60,000 units of ` 20 each. During the financial year ending on 31 st 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.
9. 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.
10. Balance Sheet of Anurag Trading Co. on 31 st March, 20X1 is given below:
Liabilities Amount (`) Assets Amount (`)
Capital 50,000 Property, Plant and 69,000
Equipment
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
© The Institute of Chartered Accountants of India
FRAMEWORK 2.35
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Additional Information: v
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(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 31 st
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.
(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 31 st March, 20X2 by assuming
it is not a Going Concern.
11. A Ltd. has entered into a binding agreement with Gamma Ltd. to buy a custom-
made machine ` 1,00,000. 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.
You are required to advise the accounting treatment and give necessary journal
entry in the year 20X1-X2.
© The Institute of Chartered Accountants of India
2.36 ADVANCED ACCOUNTING
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v ANSWERS/HINTS
Answers to the Multiple Choice Questions
1 (a) 2 (b) 3 (c) 4 (c) 5 (d)
Answers to the Theoretical Questions
6. 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.
7. 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.
Answers to the Scenario based Questions
8.
Particulars Financial Capital Maintenance
at Historical Cost (`)
Closing equity (` 30 x 60,000 units) 18,00,000 represented by cash
Opening equity 60,000 units x ` 20 = 12,00,000
Permissible drawings to keep 6,00,000 (18,00,000 – 12,00,000)
Capital intact
© The Institute of Chartered Accountants of India
FRAMEWORK 2.37
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9. v
Effects of each transaction on Balance sheet of the trader is shown
below: v
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
10. 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
11. 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
` 1,00,000 to Gamma Ltd.
© The Institute of Chartered Accountants of India
2.38 ADVANCED ACCOUNTING
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Whenv flow of economic benefit to the enterprise beyond the current
v
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.
Journal entry
Loss on change in production method Dr. 1,00,000
To Gamma Ltd. 1,00,000
(Loss due to change in production
method)
Profit and loss A/c Dr. 1,00,000
To Loss on change in production method 1,00,000
(Loss transferred to profit and loss account)
© The Institute of Chartered Accountants of India
CHAPTER a
3
APPLICABILITY OF
ACCOUNTING
STANDARDS
LEARNING OUTCOMES
After studying this chapter, you will be able to:
Comprehend the status of Accounting Standards;
Understand the applicability of Accounting Standards.
CHAPTER OVERVIEW
Applicability of AS Applicability
Status of
for Corporate of AS for
AS
Entities Non-Corporate Entities
© The Institute of Chartered Accountants of India
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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.
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
© The Institute of Chartered Accountants of India
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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,v
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
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;
© The Institute of Chartered Accountants of India
3.4 ADVANCED ACCOUNTING
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(b) v
in the case of a banking company, any matters which are not required to be
v
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.
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
© The Institute of Chartered Accountants of India
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APPLICABILITY OF ACCOUNTING STANDARDS
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of revenue in the financial statements cannot be avoided simply because it vis
exempted under Section 10 of the Income Tax Act, 1961. v
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
© The Institute of Chartered Accountants of India
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2. v 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.
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
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..
© The Institute of Chartered Accountants of India
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APPLICABILITY OF ACCOUNTING STANDARDS
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Accounting Standards to Non-company entities shall come into effect in respect of
accounting periods commencing on or after 1 April 2020. v
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. recurrence
© The Institute of Chartered Accountants of India
3.8 ADVANCED ACCOUNTING
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v Annexure 1
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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.
© The Institute of Chartered Accountants of India
3.9
APPLICABILITY OF ACCOUNTING STANDARDS
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Level III Entities v
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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:
(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.
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(3) v
Where an entity has been covered in Level I and subsequently, ceases to be
v
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.
(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.
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Annexure v2
v
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
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
© The Institute of Chartered Accountants of India
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v
v Accounting for Investments in Associates in Consolidated Financial
AS 23
v
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
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 exemption disclosures
exemption
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AS 11 Applicable Applicable with Applicable with
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disclosures exemption disclosures
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 exemption disclosures
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))
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))
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AS 26 Applicable Applicable Applicable with
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disclosures
exemption
AS 27 Not Applicable Not Applicable Not Applicable
(Refer notes 2(C) (Refer notes 2(C) and (Refer notes 2(C) and
and 2(D)) 2(D)) 2(D))
AS 28 Applicable with Applicable with Not Applicable
disclosures disclosures exemption
exemption
AS 29 Applicable with Applicable with Applicable with
disclosures disclosures exemption disclosures
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 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
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(i.e., short-term accumulating compensated absences in v
respect of which employees are not entitled to cash v
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.
(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
© The Institute of Chartered Accountants of India
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v respect of which employees are not entitled to cash
v
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); 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.
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(vi) AS 22, Accounting for Taxes on Income v
v
(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.
(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)
© The Institute of Chartered Accountants of India
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v Paragraphs 66 and 67 relating to disclosures are not applicable to Level
v
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
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:
© The Institute of Chartered Accountants of India
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(i) v
All entities engaged in commercial, industrial or business activities, whose
turnover (excluding other income) does not exceed rupees ten crores in the v
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.
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.
© The Institute of Chartered Accountants of India
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Explanation: For the purposes of clause 2(e), a company should qualify as a Small
v
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 Companies (Accounting Standards) Rules, 2021 notified under the
Companies Act, 2013. 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
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disclose the standard(s) in respect of which it has availed the exemption or
v
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:
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.
2.3 Applicability of Accounting Standards to Companies
other than those following Indian Accounting Standards
(Ind AS)1
2.3.1 Accounting Standards applicable in their entirety to companies
AS 1 Disclosures of Accounting Policies
AS 2 Valuation of Inventories (revised 2016)
AS 3 Cash Flow Statements
AS 4 Contingencies and Events Occurring After the Balance Sheet Date (revised
2016)
1
For applicability of Ind AS to companies, refer Notification dated 16th February, 2015, issued
by the Ministry of Corporate Affairs, Government of India.
© The Institute of Chartered Accountants of India
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AS 5 v
Net Profit or Loss for the Period, Prior Period Items and Changes in
v
Accounting Policies
AS 7 Construction Contracts (revised 2002)
AS 9 Revenue Recognition
AS 10 Property, Plant and Equipment
AS 11 The Effects of Changes in Foreign Exchange Rates (revised 2003)
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments (revised 2016)
AS 14 Accounting for Amalgamations (revised 2016)
AS 16 Borrowing Costs
AS 18 Related Party Disclosures
AS 21 Consolidated Financial Statements (revised 2016)
AS 22 Accounting for Taxes on Income
AS 23 Accounting for Investments in Associates in Consolidated Financial
Statements
AS 24 Discontinuing Operations
AS 26 Intangible Assets
AS 27 Financial Reporting of Interest in Joint Ventures
2.3.2Exemptions or Relaxations for Small and Medium Sized
Companies (SMCs) as defined in the Notification dated June 23,
2021, issued by the Ministry of Corporate Affairs, Government of
India
(1) Accounting Standards not applicable to SMCs in their entirety:
AS 17 Segment Reporting
(2) Accounting Standards in respect of which relaxations from certain requirements
have been given to SMCs:
(i) Accounting Standard (AS) 15, Employee Benefits (revised 2005)
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(a) v
paragraphs 11 to 16 of the standard to the extent they deal with
recognition and measurement of short-term accumulating v
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 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.
© The Institute of Chartered Accountants of India
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(iii) AS 20, Earnings Per Share
v
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, Provisions, Contingent Liabilities and Contingent Assets (revised)
Paragraphs 66 and 67 relating to disclosures are not applicable to SMCs.
(3) 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.
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TEST YOUR KNOWLEDGE v
Multiple Choice Questions
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.
(d) ten 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.
(d) AS 13.
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.
(d) Level IV 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.
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(b) Level IV entities.
v
(c) Level III entities.
(d) Level I 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;
(d) whose turnover (excluding other income) does not exceed rupees five
hundred crores in the immediately preceding accounting year.
Theoretical Questions
6. What are the issues, with which Accounting Standards deal?
7. 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.
8. 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.
Scenario based Question
9. XYZ Ltd., with a turnover of ` 50 crores during previous year and borrowings of
` 1 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.
10. 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.
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ANSWERS/HINTS v
Answers to the Multiple Choice Questions
1 (c) 2 (b) 3 (b) 4 (c) 5 (b)
Answers to the Theoretical Questions
6. 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.
7. 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.
8. 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 the Scenario based Question
9. 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.
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-
© The Institute of Chartered Accountants of India
3.28 ADVANCED ACCOUNTING
v
v
v fifty crores in the immediately preceding accounting year;
v
• 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).
10. 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.
© The Institute of Chartered Accountants of India
4
1.1
CHAPTER a
PRESENTATION &
DISCLOSURES BASED
ACCOUNTING
STANDARDS
UNIT 1: ACCOUNTING STANDARD 1
DISCLOSURE OF ACCOUNTING POLICIES
LEARNING OUTCOMES
After studying this chapter, you would be able to Comprehend the-
Fundamental Accounting Assumptions
Nature of Accounting Policies
Areas in Which Different Accounting Policies are Encountered.
Considerations in the Selection of Accounting Policies.
© The Institute of Chartered Accountants of India
4.2 ADVANCED ACCOUNTING
1.1 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
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 financial
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 an orderly manner. As explained in the preceding
paragraph, such disclosures facilitate more meaningful comparison between
financial statements of different enterprises for same accounting period. 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.
This Accounting Standard applies to all enterprises.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.3
ACCOUNTING STANDARDS v
v v
v
1.2 FUNDAMENTAL ACCOUNTING ASSUMPTIONS
v
Fundamental Accounting
Assumptions
Going concern Consistency Accrual
Fundamental Accounting
Assumptions
If followed If not 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
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
© The Institute of Chartered Accountants of India
4.4 ADVANCED ACCOUNTING
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. 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.
1.3 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.
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.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.5
ACCOUNTING STANDARDS v
v v
v some
As we say that accounts is both science and art, it’s a science because we have
v
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 enterprises under same industry, different accounting policies
are 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.
1.4 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.
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
© The Institute of Chartered Accountants of India
4.6 ADVANCED ACCOUNTING
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
number of shares held. (Refer general Instructions for Balance Sheet in
Schedule III to the Companies Act, 2013).
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.7
ACCOUNTING STANDARDS v
v v
Manner of disclosure: All significant accounting policies adopted vin the
preparation and presentation of financial statements should be disclosed v
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.
1.5 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
Not material in current period but
Material in current period
ascertainable in later periods
Fact of such change in later
Amount Amount not
period to be disclosed in
ascertained ascertained
current period.
Amount to be
Fact to be disclosed
disclosed
© The Institute of Chartered Accountants of India
4.8 ADVANCED ACCOUNTING
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 using FIFO method is `2 lakhs and that by weighted
average method is `1.8 lakhs, 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 method, which better reflects the
consumption pattern of inventory, for ascertaining inventory costs from the earlier
practice of using FIFO method for the purpose. The change in policy has reduced
profit for the year and value of inventory as at the year end 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.
1.6 DISCLOSURE OF DEVIATIONS FROM FUNDA-
MENTAL 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.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.9
ACCOUNTING STANDARDS v
v v
Illustration 1 v
v
In the books of M/s Prashant Ltd., closing inventory as at 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.
20X1-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:
© The Institute of Chartered Accountants of India
4.10 ADVANCED ACCOUNTING
(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) Provide for permanent diminution in the value of investments, which had taken
place over the past five years, the amount of 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 has increased by ` 20 crores.(ii) The company has decided to
provide `10 crores for the permanent diminution 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.
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
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.11
ACCOUNTING STANDARDS v
v v
a note for non-provision of interest on the due date to date of repayment was vaffected
in the financial statements. On account of uncertainties existing regarding v 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 statement of profit and loss. 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”.
© The Institute of Chartered Accountants of India
4.12 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Which of the following is NOT a major consideration in selection and
application of accounting policies?
(a) Prudence
(b) Comparability
(c) Materiality
(d) Substance over form
2. Adoption of different accounting policies by different companies operating in
the same industry affects which of the qualitative characteristics the most?
(a) Comparability
(b) Relevance
(c) Faithful representation
(d) Reliability
3. Which of the following statement would not be correct in relation to disclosures
to be made in the financial statements after making any change in an
accounting policy?
(a) Any change in an accounting policy which has a material effect should
be disclosed.
(b) The amount by which any item in the financial statements is affected by
such change should be disclosed to the extent ascertainable. Where such
amount is not ascertainable, wholly or in part, the fact should be
indicated.
(c) If a change is made in the accounting policies which has no material effect
on the financial statements for the current period but which is reasonably
expected to have a material effect in later periods, the fact of such change
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.13
ACCOUNTING STANDARDS v
v v
v
should be appropriately disclosed in the period in which the change is
adopted. v
(d) If a change is made in an accounting policy which has material effect on
the financial statements for the current period and is reasonably expected
to have a material effect in later periods, the fact of such change should
be appropriately disclosed only in the later periods i.e. year(s) next to the
year in which the change is adopted.
Theoretical Questions
4. What are the three fundamental accounting assumptions recognised by
Accounting Standard (AS) 1? Briefly describe each one of them.
5. Has Accounting Standard 1 prescribed the manner in which the accounting
policies followed by the entity should be disclosed?
Scenario based Questions
6. 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 affected by such change is not ascertainable, wholly or in
part, the fact need not to be indicated.
© The Institute of Chartered Accountants of India
4.14 ADVANCED ACCOUNTING
7. Give examples of areas where accounting policies adopted could be different
for different enterprises. Would there be any adverse impact due to the
adoption of different policies, and if yes, how does Accounting Standard 1 seek
to address such issue?
8. ABC Ltd. was making provision for non-moving inventories based on issues for
the last 12 months up to 31.3.20X1.
The company wants to provide during the year ending 31.3.20X2 based on
technical evaluation:
Total value of Inventory ` 100 lakhs
Provision required based on 12 months issue `3.5 lakhs
Provision required based on technical ` 2.5 lakhs
evaluation
Does this amount to change in Accounting Policy?
Can the company change the method of provision?
ANSWERS/HINTS
Answers to the Multiple Choice Questions
1 (b) 2 (a) 3 (d)
Answers to the Theoretical Questions
4. Accounting Standard (AS) 1 recognises three fundamental accounting
assumptions. These are: (i) Going Concern; (ii) Consistency; and (iii) Accrual
basis of accounting.
5. Paras 18-20 of Accounting Standard 1, Disclosure of Accounting Policies, lay
down the manner in which accounting policies have to be disclosed, which is
stated as under:
▪ 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 Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.15
ACCOUNTING STANDARDS v
v v
▪ v
Such disclosure should form part of the financial statements.
v
▪ All the disclosures should be made at one place instead of being
scattered over several statements, schedules and notes.
Answers to the Scenario based Question
6. (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.
7. There are various areas where different accounting policies could be adopted
by different entities within the same industry. An entity may choose to value
its inventories using FIFO method, whereas another entity may choose to
value the same using Weighted Average method.
While an entity is free to choose its accounting policy as long as in the
financial statements reflect a true and fair view of the state of affairs of the
enterprise as at the balance sheet date and of the profit or loss for the period
ended, the application of different accounting policies by different entities
affects the comparability of the financial statements of such different entities
© The Institute of Chartered Accountants of India
4.16 ADVANCED ACCOUNTING
by stakeholders, analysts, investors etc. To mitigate the loss of comparability,
Accounting Standard 1, Disclosure of Accounting Policies requires disclosure
of significant accounting policies as a part of the financial statements. This
would help users of the financial statements to understand the policies
followed by different entities, particularly if they belong to the same industry,
and make a correct analysis of each entity resulting in more informed
decision-making.
8. Accounting policy of a company may require that provision for non-moving
inventories should be made. The method of estimating the amount of
provision may be changed in case a more prudent estimate can be made.
The decision of making provision for non-moving inventories on the basis of
technical evaluation does not amount to change in accounting policy.
In the above case, considering the total value of inventory, the change in the
amount of required provision of non-moving inventory from ` 3.5 lakhs to
` 2.5 lakhs is also not material.
The disclosure can be made for such change in the following lines by way of
notes to the accounts in the annual accounts of ABC Ltd. for the
year 20X1-X2:
"The company has provided for non-moving inventories on the basis of
technical evaluation unlike preceding years. Had the same method been
followed as in the previous year, the profit for the year and the corresponding
effect on the year-end net assets would have been lower by ` 1 lakh."
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.17
ACCOUNTING STANDARDS v
v v
UNIT 2: ACCOUNTING STANDARD 3CASH FLOW
v
v
STATEMENT
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend –
What are Cash and Cash Equivalents
Presentation of a Cash Flow Statement
Reporting Cash Flows from Operating Activities
Reporting Cash Flows from Investing and Financing Activities
Reporting Cash Flows on a Net Basis
Foreign Currency Cash Flows
Extraordinary Items
Interest and Dividends
Taxes on Income
Non-Cash Transactions.
2.1 INTRODUCTION
This Standard is mandatory for Non-SMCs (Non Small & Medium Companies) and
the enterprises which fall in the category of Level I (for non-corporate entities), 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.
However, the Companies Act, 2013, mandates preparation of Cash flow statement
by all companies except one person company, small company and dormant
company (refer note below).
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 the corresponding previous years. Whereas, if an enterprises qualifies
© The Institute of Chartered Accountants of India
4.18 ADVANCED ACCOUNTING
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.
2.2 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.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.19
ACCOUNTING STANDARDS v
v v
v
2.3 MEANING OF THE TERM CASH AND CASH
v
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
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.
2.4 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.
© The Institute of Chartered Accountants of India
4.20 ADVANCED ACCOUNTING
2.5 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.
i. operating cash flows;
ii. investing cash flows; and
iii. 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)
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.21
ACCOUNTING STANDARDS v
v v
v
and borrowings of the enterprise. Examples include issue of shares / debentures,
v
redemption of debentures / preference shares, payment of dividends and payment
of interests (other than interests paid by financial institutions).
2.6 IDENTIFYING TYPE OF CASH FLOWS
Classification of Cash Flows
Net Cash Flows
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.
2.6.1 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.
© The Institute of Chartered Accountants of India
4.22 ADVANCED ACCOUNTING
(f) Interests earned from customers for late payments are operating cash flows
for non-financial enterprises.
2.6.2 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
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.
2.6.3 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.
2.6.4 Dividends Paid
Dividends paid are financing cash outflows for all enterprises.
2.6.5 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
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.23
ACCOUNTING STANDARDS v
v v
v if the
concerned incomes are operating incomes and investing cash outflows
concerned incomes are investment incomes, e.g. interest earned. v
(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.
2.6.6 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.
AS 3 requires separate disclosure of extraordinary cash flows, classifying them as
cash flows from operating, investing or financing activities, as may be appropriate.
2.7 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.
© The Institute of Chartered Accountants of India
4.24 ADVANCED ACCOUNTING
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
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
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.25
ACCOUNTING STANDARDS v
v v
Reversal of the effects of Profit & Loss Appropriation xxx v
Account v
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 end of accounting period.
2.8 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.
© The Institute of Chartered Accountants of India
4.26 ADVANCED ACCOUNTING
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
statements in a way that provides all the relevant information about these investing
and financing activities.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.27
ACCOUNTING STANDARDS v
v v
v
v
2.9 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.
2.10 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
© The Institute of Chartered Accountants of India
4.28 ADVANCED ACCOUNTING
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
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.
2.11 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.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.29
ACCOUNTING STANDARDS v
v v
(f) Cash receipts from Trade receivables. v
v
(g) Trading Commission received.
(h) Purchase of investment.
(i) Redemption of Preference Shares.
(j) Cash Purchases.
(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
© The Institute of Chartered Accountants of India
4.30 ADVANCED ACCOUNTING
(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.
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 31 st 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
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.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.31
ACCOUNTING STANDARDS v
v v
Solution v
v
(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
(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 31 st 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:
© The Institute of Chartered Accountants of India
4.32 ADVANCED ACCOUNTING
Cash 5,000
bank 10,000
10,00,000 10,00,000
Prepare Cash Flow Statement for the year ended 31 st March, 20X1in accordance with
Accounting Standard 3.
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
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.33
ACCOUNTING STANDARDS v
v v
Illustration 5 v
v
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
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)
© The Institute of Chartered Accountants of India
4.34 ADVANCED ACCOUNTING
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 11.
Reference: The students are advised to refer the full text of AS 3 “Cash Flow
Statement.
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. 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
(d) ` 60,000
2. 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
(d) cash & cash equivalent
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.35
ACCOUNTING STANDARDS v
v v
3. v and
XYZ Co. is a financial enterprise. In its cash flow statement, interest paid
dividends received should be v
(a) classified as operating cash flows.
(b) classified as financing cash flows.
(c) Not shown in cash flow statement.
(d) classified as investing cash flows.
4. In the cash flow statement, ‘cash and cash equivalents’ donot include
(a) Bank balances .
(b) Short-term investments readily convertible into Cash are subject to an
insignificant risk of changes in value.
(c) Cash balances.
(d) Loan from bank.
5. While preparing a Cash Flow Statement using the Indirect method as required
under AS 3, which of the following will not be deducted from/added to the Net
Profit to arrive at the “Cash flow from Operating activities”?
(a) Interest income
(b) Gain on sale of a fixed asset.
(c) Depreciation.
(d) Gain on sale of inventory
Theoretical Questions
6. What are the main features of the Cash Flow Statement?
7. Mayuri Ltd. acquired Plant and Machinery for ` 25 lakhs. During the same year,
it also sold Furniture and Fixtures for ` 4 lakhs. Can the company disclose, Net
Cash Outflow towards purchase of Fixed Assets ` 21 lakhs (i.e., 25 lakhs – 4
lakhs) in the Cash Flow Statement?
© The Institute of Chartered Accountants of India
4.36 ADVANCED ACCOUNTING
Scenario based Question
8. How would the following cash flows be classified in accordance with AS 3?
Corporate Income Tax paid amounting to ` 70 lakhs during the reporting
period.
Payment of advance tax ` 8,75,000 out of which ` 75,000 was towards
capital gains arising on account of sale of assets during the reporting
period.
Fixed Deposits withdrawn by customers of State Bank of India ` 3 crores.
9. 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
Discuss in the context of AS 3 Cash Flow Statement.
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 50,000
Limited
Fixed Deposit created on 01-11-20X1 and maturing on 15- 75,000
04-20X2
Short Term Investment in highly liquid Sovereign Debt 1,00,000
Mutual fund on 01-03-20X2 (having maturity period of less
than 3 months)
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.37
ACCOUNTING STANDARDS v
v v
Bank Balance in a Foreign Currency Account in India $v1,000
(Conversion Rate: On the day of deposit ` 69/USD as on v
31-03-20X2 ` 70/USD)
11. Z Ltd. has no Foreign Currency Cash Flow during the reporting period. It held a
deposit in a bank in France. The balances as at the beginning of the year and
at the end of the year were € 100,000 and € 105,000 respectively. The exchange
rate at the beginning of the year was € 1 = ` 82, and at the end of the year was
€ 1 = ` 85. The increase in the deposit balance of € 5,000 was on account of
interest credited on the last day of the reporting period. The deposit was
reported at ` 82,00,000 in the opening balance sheet and at ` 89,25,000 in the
closing balance sheet. You are required to show how these transactions would
be presented in the Cash Flow Statement as per AS 3.
12. Following is the Balance Sheet of Fox Ltd. You are required to prepare cash flow
statement using Indirect Method.
Particulars Note 31st 31st
No. March,20X2 March,20X1
(` ) (` )
(I) Equity and Liabilities
1. Shareholders’ Funds
(a) Share capital 1 5,60,000 3,00,000
(b) Reserve and 2 35,000 25,000
Surplus
2. Current Liabilities
(a) Trade payables 1,50,000 60,000
(b) Short-term 8,000 5,000
provisions
(Provision for
taxation)
Total 7,53,000 3,90,000
(II) Assets
1. Non-current assets
© The Institute of Chartered Accountants of India
4.38 ADVANCED ACCOUNTING
(a) Property, Plant 3,50,000 1,80,000
and Equipment
2. Current assets
(a) Inventories 1,20,000 50,000
(b) Trade receivables 1,00,000 25,000
(c) Cash and cash 1,05,000 90,000
equivalents
(d) Other current 78,000 45,000
assets
Total 7,53,000 3,90,000
Notes to Accounts
Particulars 31st 31st
March,20X2 (` ) March,20X1 (` )
1. Share capital
(a) Equity share capital 4,10,000 2,00,000
(b) Preference share capital 1,50,000 1,00,000
5,60,000 3,00,000
2. Reserve and surplus
Surplus in statement of profit 25,000
and loss at the beginning of the
year
Add: Profit of the year 20,000
Less: Dividend (10,000)
Surplus in statement of profit 35,000 25,000
and loss at the end of the year
Additional Information:
1. Dividend paid during the year ` 10,000
2. Depreciation charges during the year ` 40,000.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.39
ACCOUNTING STANDARDS v
v v
v
ANSWERS/HINTS v
Answers to the Multiple Choice Questions
1. (a) 2. (b) 3. (a) 4. (d) 5. (d)
Answers to the Theoretical Questions
6. 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,
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.
7. As per AS 3, Cash Flow Statements, an enterprise should report separately
major classes of gross cash receipts and gross cash payments arising from
investing and financing activities, except in the case of:
• cash receipts and payments on behalf of customers when the cash flows
reflect the activities of the customer rather than those of the enterprise;
and
• cash receipts and payments for items in which the turnover is quick, the
amounts are large, and the maturities are short.
In the given case, since the purchase of Plant and Machinery and disposal of
Furniture and Fixtures do not fall in the criteria of exception mentioned above,
the same should be presented on a gross basis as an outflow of ` 25 lakhs
and an inflow of ` 4 lakhs. Presentation of net cash outflow of ` 21 lakhs is
not permitted as per AS 3.
© The Institute of Chartered Accountants of India
4.40 ADVANCED ACCOUNTING
Answers to Scenario based Question
8. As per AS 3, the given cash flows shall be recorded as under:
Corporate Income Tax paid ` 70 lakhs: Operating Cash Flows
amounting to ` 70 lakhs during the
reporting period.
Payment of advance tax ` 8,75,000 ` 8,00,000: Operating Cash Flows
out of which ` 75,000 was towards ` 75,000: Investing Cash Flows
capital gains arising on account of
sale of assets during the reporting
period.
Fixed Deposits withdrawn by ` 3 crores: Operating Cash Flows for
customers of State Bank of India ` 3 State Bank of India.
crores.
9. 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 companies - Cash 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
10. Computation of Cash and Cash Equivalents as on 31 st 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
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.41
ACCOUNTING STANDARDS v
v v
v
Note: Short term investment in liquid equity shares and fixed deposit will
not be considered as cash and cash equivalents. v
11. The Statement of Profit and Loss was credited on account of:
Interest Income: € 5,000 x ` 85 = ` 4,25,000
Exchange difference = € 100,000 x (` 85 – ` 82) = ` 3,00,000
In preparing the Cash Flow Statement, the exchange difference of ` 3,00,000
should be deducted from the Net Profit before taxes, since it is a non-cash
item. However, in order to reconcile the opening balance of the Cash and
Cash Equivalents with its closing balance, the Exchange Difference of
` 3,00,000 should be added to the opening balance in a Note to the Cash
Flow Statement.,
Cash Flows arising from transactions in a Foreign Currency shall be recorded
in Z Ltd.’s 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 cash flow.
12. Fox Ltd.
Cash Flow Statement for the year ended 31 st March, 20X2
` `
Cash flows from operating activities
Net Profit (35,000 less 25,000) 10,000
Add: Dividend 10,000
Provision for tax 8,000
Net profit before taxation and extraordinary items 28,000
Adjustments for:
Depreciation 40,000
Operating profit before working capital changes 68,000
Increase in trade receivables (75,000)
Increase in inventories (70,000)
Increase in other current assets (33,000)
Increase in trade payables 90,000 (88,000)
© The Institute of Chartered Accountants of India
4.42 ADVANCED ACCOUNTING
Cash used in operating activities (20,000)
Less: Tax paid* (5,000)
Net cash used in operating activities (25,000)
Cash flows from investing activities
Purchase of PPE (2,10,000)
Net cash used in investing activities (2,10,000)
Cash flows from financing activities
Issue of equity shares for cash 2,10,000
Issue of preference shares 50,000
Dividends paid (10,000)
Net cash generated from financing activities 2,50,000
Net increase in cash and cash equivalents 15,000
Cash and cash equivalents at beginning of period 90,000
Cash and cash equivalents at end of period 1,05,000
*Provision for tax of last year considered to be paid in the current year.
Working Note:
Property, plant and equipment acquisitions
W.D.V. at 31.3.20X2 3,50,000
Add back:
Depreciation for the year 40,000
3,90,000
Less: W.D.V. at 31.12.20X1 1,80,000
Acquisitions during 20X1-20X2 2,10,000
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.43
ACCOUNTING STANDARDS v
v v
v
v
UNIT 3: ACCOUNTING STANDARD
17 SEGMENT REPORTING
LEARNING OUTCOMES
❑ After studying this unit, you will be able to comprehend the-
Definition and Identification of Reportable Segments
Primary and Secondary Segment Reporting Formats
Business and Geographical Segments
How to identify the Reportable Segments
Disclosures.
3.1 INTRODUCTION
AS 17 is mandatory in respect of non-SMCs (and level I entities in case of non-
corporates). Other entities are encouraged to comply with AS 17.
This standard establishes principles for reporting financial information about
different types of products and services an enterprise produces and different
geographical areas in which it operates. The standard is more relevant for assessing
risks and returns of a diversified or multi-locational enterprise which may not be
determinable from the aggregated data.
Before we start the standard, let us lay down the areas to be covered from the
examination point of view.
© The Institute of Chartered Accountants of India
4.44 ADVANCED ACCOUNTING
Identify the Segments - Business or Geographical
Identify the Reportable Segments
Prepare a Segmental Report + Make appropriate Disclosures
3.2 OBJECTIVE
Many enterprises provide groups of products and services or operate in
geographical areas that are subject to differing rates of profitability, opportunities
for growth, future prospects, and risks. The objective of this Standard is to establish
principles for reporting financial information, about the different types of products
and services an enterprise produces and the different geographical areas in which
it operates. Such information helps users of financial statements:
(a) Better understand the performance of the enterprise;
(b) Better assess the risks and returns of the enterprise; and
(c) Make more informed judgements about the enterprise as a whole.
3.3 SCOPE
AS 17 should be applied in presenting general purpose financial statements.
An enterprise should comply with the requirements of this Standard fully and not
selectively. If a single financial report contains both consolidated financial
statements and separate financial statements of the parent, segment information
need be presented only on the basis of the consolidated financial statements.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.45
ACCOUNTING STANDARDS v
v v
v
3.4 DEFINITION OF THE TERMS USED IN v THE
ACCOUNTING STANDARD
A business segment is a distinguishable component of an enterprise that is
engaged in providing an individual product or service or a group of related
products or services and that is subject to risks and returns that are different from
those of other business segments. Factors that should be considered in
determining whether products or services are related include:
(a) The nature of the products or services
(b) The nature of the production processes
(c) The type or class of customers for the products or services
(d) The methods used to distribute the products or provide the services
(e) If applicable, the nature of the regulatory environment, for example, banking,
insurance, or public utilities
A single business segment does not include products and services with significantly
differing risks and returns. While there may be dissimilarities with respect to one or
several of the factors listed in the definition of business segment, the products and
services included in a single business segment are expected to be similar with
respect to a majority of the factors.
A geographical segment is a distinguishable component of an enterprise that is
engaged in providing products or services within a particular economic
environment and that is subject to risks and returns that are different from those
of components operating in other economic environments. Factors that should be
considered in identifying geographical segments include:
(a) Similarity of economic and political conditions.
(b) Relationships between operations in different geographical areas.
(c) Proximity of operations.
(d) Special risks associated with operations in a particular area.
(e) Exchange control regulations and
(f) The underlying currency risks.
© The Institute of Chartered Accountants of India
4.46 ADVANCED ACCOUNTING
A single geographical segment does not include operations in economic
environments with significantly differing risks and returns. A geographical segment
may be a single country, a group of two or more countries, or a region within a
country.
The risks and returns of an enterprise are influenced both by the geographical
location of its operations (where its products are produced or where its service
rendering activities are based) and also by the location of its customers (where its
products are sold or services are rendered). The definition allows geographical
segments to be based on either:
(a) The location of production or service facilities and other assets of an
enterprise; or
(b) The location of its customers.
The predominant sources of risks affect how most enterprises are organised and
managed. Therefore, the organisational structure of an enterprise and its internal
financial reporting system are normally the basis for identifying its segments.
A reportable segment is a business segment or a geographical segment identified
on the basis of foregoing definitions for which segment information is required to
be disclosed by AS 17.
Segment revenue is the aggregate of
(i) The portion of enterprise revenue that is directly attributable to a segment;
(ii) The relevant portion of enterprise revenue that can be allocated on a
reasonable basis to a segment; and
(iii) Revenue from transactions with other segments of the enterprise.
Segment revenue does not include:
(a) Extraordinary items as defined in AS 5;
(b) Interest or dividend income, including interest earned on advances or loans to
other segments unless the operations of the segment are primarily of a financial
nature; and
(c) Gains on sales of investments or on extinguishment of debt unless the
operations of the segment are primarily of a financial nature.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.47
ACCOUNTING STANDARDS v
v v
Segment expense is the aggregate of v
v
(i) The expense resulting from the operating activities of a segment that is
directly attributable to the segment;
(ii) The relevant portion of enterprise expense that can be allocated on a
reasonable basis to the segment; and
(iii) Including expense relating to transactions with other segments of the enterprise.
Segment expense does not include:
(a) Extraordinary items as defined in AS 5;
(b) Interest expense, including interest incurred on advances or loans from other
segments, unless the operations of the segment are primarily of a financial nature;
(c) Losses on sales of investments or losses on extinguishment of debt unless the
operations of the segment are primarily of a financial nature;
(d) Income tax expense; and
(e) General administrative expenses, head-office expenses, and other expenses that
arise at the enterprise level and relate to the enterprise as a whole. However,
costs are sometimes incurred at the enterprise level on behalf of a segment. Such
costs are part of segment expense if they relate to the operating activities of the
segment and if they can be directly attributed or allocated to the segment on a
reasonable basis.
Segment result is segment revenue less segment expense.
Segment assets are those operating assets that are employed by a segment in its
operating activities and that either are directly attributable to the segment or can
be allocated to the segment on a reasonable basis.
If the segment result of a segment includes interest or dividend income, its segment
assets include the related receivables, loans, investments, or other interest or
dividend generating assets.
Segment assets do not include:
income tax assets; and
assets used for general enterprise or head-office purposes.
© The Institute of Chartered Accountants of India
4.48 ADVANCED ACCOUNTING
Segment assets are determined after deducting related allowances/provisions that
are reported as direct offsets in the balance sheet of the enterprise.
Segment liabilities are those operating liabilities that result from the operating
activities of a segment and that either are directly attributable to the segment or
can be allocated to the segment on a reasonable basis.
If the segment result of a segment includes interest expense, its segment liabilities
include the related interest-bearing liabilities.
Examples of segment liabilities include trade and other payables, accrued liabilities,
customer advances, product warranty provisions, and other claims relating to the
provision of goods and services.
Segment liabilities do not include:
income tax liabilities; and
borrowings and other liabilities that are incurred for financing rather than
operating purposes.
Assets and liabilities that relate jointly to two or more segment should be allocated
to segments if, and only if, their related revenues and expenses also are allocated
to those segments.
3.5 TREATMENT OF INTEREST FOR
DETERMINING SEGMENT EXPENSE
The interest expense relating to overdrafts and other operating liabilities identified
to a particular segment should not be included as a part of the segment expense
unless the operations of the segment are primarily of a financial nature or unless
the interest is included as a part of the cost of inventories.
In case interest is included as a part of the cost of inventories where it is so required
as per AS 16, read with AS 2 (Revised), and those inventories are part of segment
assets of a particular segment, such interest should be considered as a segment
expense. In this case, the amount of such interest and the fact that the segment
result has been arrived at after considering such interest should be disclosed by
way of a note to the segment result.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.49
ACCOUNTING STANDARDS v
v v
v
3.6 ALLOCATION v
An enterprise looks to its internal financial reporting system as the starting point for
identifying those items that can be directly attributed, or reasonably allocated, to
segments. There is thus a presumption that amounts that have been identified with
segments for internal financial reporting purposes are directly attributable or
reasonably allocable to segments for the purpose of measuring the segment revenue,
segment expense, segment assets, and segment liabilities of reportable segments.
In some cases, however, a revenue, expense, asset or liability may have been
allocated to segments for internal financial reporting purposes on a basis that is
understood by enterprise management but that could be deemed arbitrary in the
perception of external users of financial statements. Conversely, an enterprise may
choose not to allocate some item of revenue, expense, asset or liability for internal
financial reporting purposes, even though a reasonable basis for doing so exists.
Such an item is allocated pursuant to the definitions of segment revenue, segment
expense, segment assets, and segment liabilities in AS 17.
Segment revenue, segment expense, segment assets and segment liabilities are
determined before intra-enterprise balances and intra-enterprise transactions are
eliminated as part of the process of preparation of enterprise financial statements,
except to the extent that such intra-enterprise balances and transactions are within
a single segment.
While the accounting policies used in preparing and presenting the financial
statements of the enterprise as a whole are also the fundamental segment accounting
policies, segment accounting policies include, in addition, policies that relate
specifically to segment reporting, such as identification of segments, method of pricing
inter-segment transfers, and basis for allocating revenues and expenses to segments.
3.7 PRIMARY AND SECONDARY SEGMENT
REPORTING FORMATS
The dominant source and nature of risks and returns of an enterprise should govern
whether its primary segment reporting format will be business segments or
geographical segments.
© The Institute of Chartered Accountants of India
4.50 ADVANCED ACCOUNTING
If the risks and returns of an enterprise are affected predominantly by differences
in the products and services it produces, its primary format for reporting segment
information should be business segments, with secondary information reported
geographically. Similarly, if the risks and returns of the enterprise are affected by
the fact that it operates in different countries or other geographical areas, its
primary format for reporting segment information should be geographical
segments, with secondary information reported for groups of related products and
services.
3.8 BUSINESS AND GEOGRAPHICAL SEGMENTS
Generally, business and geographical segments are determined on the basis of
internal financial reporting to the board of directors and the Chief Executive Officer.
But if such segment does not satisfy the definitions given in AS, then following
points should be considered:
(a) If one or more of the segments reported internally to the directors and
management is a business segment or a geographical segment based on the
factors in the definitions but others are not, paragraph below should be
applied only to those internal segments that do not meet the definitions (that
is, an internally reported segment that meets the definition should not be
further segmented).
(b) For those segments reported internally to the directors and management that
do not satisfy the definitions, management of the enterprise should look to
the next lower level of internal segmentation that reports information along
product and service lines or geographical lines, as appropriate under the
definitions and
(c) If such an internally reported lower-level segment meets the definition of
business segment or geographical segment, the criteria for identifying
reportable segments should be applied to that segment.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.51
ACCOUNTING STANDARDS v
v v
v
3.9 IDENTIFYING REPORTABLE SEGMENTS
v
(QUANTITATIVE THRESHOLDS)
A business segment or geographical segment should be identified as a reportable
segment if:
(a) Its revenue from sales to external customers and from transactions with other
segments is 10% or more of the total revenue, external and internal, of all
segments; or
(b) Its segment result, whether profit or loss, is 10% or more of –
(i) The combined result of all segments in profit, or
(ii) The combined result of all segments in loss,
Whichever is greater in absolute amount; or
(c) Its segment assets are 10% or more of the total assets of all segments.
A business segment or a geographical segment which is not a reportable segment
as per above paragraph, may be designated as a reportable segment despite its
size at the discretion of the management of the enterprise. If that segment is not
designated as a reportable segment, it should be included as an unallocated
reconciling item.
If total external revenue attributable to reportable segments constitutes less than
75% of the total enterprise revenue, additional segments should be identified as
reportable segments, even if they do not meet the 10% thresholds, until at least
75% of total enterprise revenue is included in reportable segments.
We can summarize the steps as under:
Step I – Apply 10% Test (Materiality Test):
Any 1 Test needs to be met – For Reportable Segment:
Revenue Test Revenue (External + Internal) of the segment is 10% or more of
the Total Revenue of all segments
Profit/Loss Test Case I – All segments have profits:
Profit of the segment is 10% or more of the total profit of all
segments
© The Institute of Chartered Accountants of India
4.52 ADVANCED ACCOUNTING
Case II – Few segments have profit + Few segments have losses:
1. Add the profits of profitable segments only.
2. Add the losses of loss-making segments only.
3. Take the figure (from 1 and 2) whichever is greater (in
absolute values).
4. The segment which has profit/loss equal to 10% or more
of the absolute figure computed in Point 3 becomes
reportable.
Asset Test The segment assets are 10% or more of the total assets of all
segments.
Note:
A business segment or a geographical segment which is not a reportable segment as per
above steps, may be designated as a reportable segment despite its size at the
discretion of the management of the enterprise.
Step II – Apply 75% Test (Overall Test):
Ensure that the total external revenue attributable to reportable segments
constitutes at least 75% of the total enterprise revenue.
If not, additional segments should be identified as reportable segments, even if
they do not meet the 10% thresholds, until at least 75% of total enterprise revenue
is included in reportable segments.
Notes:
1. A segment identified as a reportable segment in the immediately preceding
period because it satisfied the relevant 10% thresholds should continue to be
a reportable segment for the current period notwithstanding that its revenue,
result, and assets all no longer meet the 10% thresholds.
2. If a segment is identified as a reportable segment in the current period
because it satisfies the relevant 10% thresholds, preceding-period segment
data that is presented for comparative purposes should, unless it is
impracticable to do so, be restated to reflect the newly reportable segment
as a separate segment, even if that segment did not satisfy the 10%
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.53
ACCOUNTING STANDARDS v
v v
thresholds in the preceding period. v
v
3.10 SEGMENT ACCOUNTING POLICIES
Segment information should be prepared in conformity with the accounting
policies adopted for preparing and presenting the financial statements of the
enterprise as a whole. AS 17 does not prohibit the disclosure of additional segment
information that is prepared on a basis other than the accounting policies adopted
for the enterprise financial statements provided that-
(a) the information is reported internally to the board of directors and the chief
executive officer for purposes of making decisions about allocating resources
to the segment and assessing its performance; and
(b) the basis of measurement for this additional information is clearly described.
3.11 PRIMARY REPORTING FORMAT
An enterprise should disclose the following for each reportable segment:
(a) Segment revenue, classified into segment revenue from sales to external
customers and segment revenue from transactions with other segments;
(b) Segment result;
(c) Total carrying amount of segment assets;
(d) Total amount of segment liabilities;
(e) Total cost incurred during the period to acquire segment assets that are
expected to be used during more than one period (tangible and intangible fixed
assets);
(f) Total amount of expense included in the segment result for depreciation and
amortisation in respect of segment assets for the period; and
(g) Total amount of significant non-cash expenses, other than depreciation and
amortisation in respect of segment assets that were included in segment
expense and, therefore, deducted in measuring segment result.
© The Institute of Chartered Accountants of India
4.54 ADVANCED ACCOUNTING
An enterprise that reports the amount of cash flows arising from operating,
investing and financing activities of a segment need not disclose depreciation and
amortisation expense and non-cash expenses.
An enterprise should present a reconciliation between the information disclosed
for reportable segments and the aggregated information in the enterprise financial
statements.
In presenting the reconciliation:,
- segment revenue should be reconciled to enterprise revenue;
- segment result should be reconciled to enterprise net profit or loss;
- segment assets should be reconciled to enterprise assets; and
- segment liabilities should be reconciled to enterprise liabilities.
3.12 SECONDARY SEGMENT INFORMATION
If primary format of an enterprise for reporting segment information is business
segments, it should also report the following information:
(a) Segment revenue from external customers by geographical area based on the
geographical location of its customers, for each geographical segment whose
revenue from sales to external customers is 10% or more of enterprise
revenue;
(b) The total carrying amount of segment assets by geographical location of
assets, for each geographical segment whose segment assets are 10% or more
of the total assets of all geographical segments; and
(c) The total cost incurred during the period to acquire segment assets that are
expected to be used during more than one period (tangible and intangible
fixed assets) by geographical location of assets, for each geographical
segment whose segment assets are 10% or more of the total assets of all
geographical segments.
If primary format of an enterprise for reporting segment information is
geographical segments (whether based on location of assets or location of
customers), it should also report the following segment information for each
business segment whose revenue from sales to external customers is 10% or more
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.55
ACCOUNTING STANDARDS v
v v
v assets
of enterprise revenue or whose segment assets are 10% or more of the total
of all business segments: v
a. Segment revenue from external customers;
b. The total carrying amount of segment assets; and
c. The total cost incurred during the period to acquire segment assets that are
expected to be used during more than one period (tangible and intangible
fixed assets).
3.13 OTHER DISCLOSURES
In measuring and reporting segment revenue from transactions with other
segments, inter-segment transfers should be measured on the basis that the
enterprise actually used to price those transfers. The basis of pricing inter-segment
transfers and any change therein should be disclosed in the financial statements.
Changes in accounting policies adopted for segment reporting that have a material
effect on segment information should be disclosed. Such disclosure should include
a description of the nature of the change, and the financial effect of the change if
it is reasonably determinable.
Some changes in accounting policies may relate specifically to segment reporting.
Example could be:
changes in identification of segments; and
changes in the basis for allocating revenues and expenses to segments.
Such changes can have a significant impact on the segment information reported
but will not change aggregate financial information reported for the enterprise. To
enable users to understand the impact of such changes, this Standard requires the
disclosure of the nature of the change and the financial effects of the change, if
reasonably determinable.
An enterprise should indicate the types of products and services included in each
reported business segment and indicate the composition of each reported
geographical segment, both primary and secondary, if not otherwise disclosed in
the financial statements.
© The Institute of Chartered Accountants of India
4.56 ADVANCED ACCOUNTING
Illustration 1
The Chief Accountant of Sports Ltd. gives the following data regarding its six
segments: ` in lakhs
Particulars M N O P Q R Total
Segment Assets 40 80 30 20 20 10 200
Segment Results 50 (190) 10 10 (10) 30 (100)
Segment Revenue 300 620 80 60 80 60 1,200
The Chief accountant is of the opinion that segments “M” and “N” alone should be
reported. Is he justified in his view? Discuss.
Solution
As per AS 17 ‘Segment Reporting’, a business segment or geographical segment
should be identified as a reportable segment if:
Its revenue from sales to external customers and from other transactions with other
segments is 10% or more of the total revenue- external and internal of all segments;
or
Its segment result whether profit or loss is 10% or more of:
The combined result of all segments in profit; or
The combined result of all segments in loss,
whichever is greater in absolute amount; or
Its segment assets are 10% or more of the total assets of all segments.
If the total external revenue attributable to reportable segments constitutes less
than 75% of total enterprise revenue, additional segments should be identified as
reportable segments even if they do not meet the 10% thresholds until atleast 75%
of total enterprise revenue is included in reportable segments.
On the basis of turnover criteria segments M and N are reportable segments.
On the basis of the result criteria, segments M, N and R are reportable segments
(since their results in absolute amount is 10% or more of` 200 lakhs).
On the basis of asset criteria, all segments except R are reportable segments.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.57
ACCOUNTING STANDARDS v
v v
v
Since all the segments are covered in at least one of the above criteria, all segments
have to be reported in accordance with Accounting Standard (AS) 17. Hence v the
opinion of chief accountant is wrong.
Illustration 2
A Company has an inter-segment transfer pricing policy of charging at cost less 10%.
The market prices are generally 25% above cost. Is the policy adopted by the company
correct?
Solution
AS 17 ‘Segment Reporting’ requires that inter-segment transfers should be
measured on the basis that the enterprise actually used to price these transfers.
The basis of pricing inter-segment transfers and any change therein should be
disclosed in the financial statements. Hence the enterprise can have its own policy
for pricing inter-segment transfers and hence inter-segment transfers may be
based on cost, below cost or market price. However, whichever policy is followed,
the same should be disclosed and applied consistently. Therefore, in the given case
inter-segment transfer pricing policy adopted by the company is correct if, followed
consistently.
Illustration 3
M/s XYZ Ltd. has three segments namely X, Y, Z. The total Assets of the Company are
` 10.00 crores. Segment X has ` 2.00 crores, segment Y has ` 3.00 crores and segment
Z has` 5.00 crores. Deferred tax assets included in the assets of each segments are X-
` 0.50 crores, Y—` 0.40 crores and Z—` 0.30 crores. The accountant contends that
all the three segments are reportable segments. Comment.
Solution
According to AS 17 “Segment Reporting”, segment assets do not include income
tax assets. Therefore, the revised total assets are ` 8.8 crores [` 10 crores – (` 0.5 +
` 0.4 +` 0.3)]. Segment X holds total assets of ` 1.5 crores (` 2 crores –` 0.5 crores);
Segment Y holds ` 2.6 crores (` 3 crores –` 0.4 crores); and Segment Z holds ` 4.7
crores (` 5 crores –` 0.3 crores). Thus all the three segments hold more than 10%
of the total assets, all segments are reportable segments.
© The Institute of Chartered Accountants of India
4.58 ADVANCED ACCOUNTING
Illustration4
Prepare a segmental report for publication in Diversifiers Ltd. from the following
details of the company’s three divisions and the head office:
` (‘000)
Forging Shop Division
Sales to Bright Bar Division 4,575
Other Domestic Sales 90
Export Sales 6,135
10,800
Bright Bar Division
Sales to Fitting Division 45
Export Sales to Rwanda 300
345
Fitting Division
Export Sales to Maldives 270
Particulars Head Forging Bright Bar Fitting
Office Shop Division Division
` (‘000) Division ` (‘000) ` (‘000)
` (‘000)
Pre-tax operating result 240 30 (12)
Head office cost reallocated 72 36 36
Interest costs 6 8 2
Fixed assets 75 300 60 180
Net current assets 72 180 60 135
Long-term liabilities 57 30 15 180
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PRESENTATION & DISCLOSURES BASED 4.59
ACCOUNTING STANDARDS v
v v
Solution v
Diversifiers Ltd. v
Segmental Report
(` ’000)
Divisions Inter Consolidated
Particulars Segment Total
Forging Bright Fitting
Eliminations
shop Bar
Segment Revenue
Sales:
Domestic 90 − − − 90
Export 6,135 300 270 − 6,705
External Sales 6,225 300 270 − 6,795
Inter-Segment Sales 4,575 45 − 4,620 −
Total Revenue 10,800 345 270 4,620 6,795
Segment Result (Given) 240 30 (12) 258
Head Office Expenses (144)
Operating Profit 114
Interest Expense (16)
Profit Before Tax 98
Information in Relation
to Assets and Liabilities:
Fixed Assets 300 60 180 − 540
Net Current Assets 180 60 135 − 375
Segment assets 480 120 315 − 915
Unallocated Corporate
Assets (75 + 72) − − − − 147
Total assets 1,062
Segment liabilities 30 15 180 − 225
Unallocated corporate 57
liabilities
Total liabilities 282
© The Institute of Chartered Accountants of India
4.60 ADVANCED ACCOUNTING
Sales Revenue by Geographical Market
(` ’000)
Home Export Sales Export to Export to Consolidated
Sales (by forging Rwanda Maldives Total
shop division)
External 90 6,135 300 270 6,795
sales
Illustration 5
Microtech Ltd. produces batteries for scooters, cars, trucks, and specialised batteries
for invertors and UPS. How many segments should it have and why?
Solution
In case of Microtech Ltd., the basic product is the batteries, but the risks and returns
of the batteries for automobiles (scooters, cars and trucks) and batteries for
invertors and UPS are affected by different set of factors. In case of automobile
batteries, the risks and returns are affected by the Government policy, road
conditions, quality of automobiles, etc. whereas in case of batteries for invertors
and UPS, the risks and returns are affected by power condition, standard of living,
etc. Therefore, it can be said that Microtech Ltd. has two business segments viz-
‘Automobile batteries’ and ‘batteries for Invertors and UPS’.
Reference: The students are advised to refer the full text of AS 17 “Segment
Reporting”.
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. As per AS 17, reportable segments are those whose total revenue from external
sales and inter-segment sales is
(a) 10% or more of the total revenue of all segments
(b) 10% or more of the total revenue of all external segments
(c) 12% or more of the total revenue of all segments
(d) 12% or more of the total revenue of all external segments
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PRESENTATION & DISCLOSURES BASED 4.61
ACCOUNTING STANDARDS v
v v
2. Which of the following statements is correct? v
v
(a) Management has a discretion to include a segment as a reportable
segment even if it passes the 10% materiality test.
(b) Management has a discretion to include any segment as a reportable
segment if it fails the 12% materiality test.
(c) It is mandatory for the management to include the segment as a
reportable segment if it passes the 10% materiality test.
(d) It is not mandatory for the management to include the segment as a
reportable segment if it passes the 10% materiality test.
3. Which of the following statements is correct?
(a) The overall test of 75% considers only external revenue to compute the
threshold limit.
(b) The overall test of 75% considers only internal revenue to compute the
threshold limit.
(c) The overall test of 75% considers both internal and external revenue to
compute the threshold limit.
(d) It is management choice whether they want to include both external
and internal revenue for computing threshold limit.
4. Which of the following statements is correct?
(a) The 10% test computed on the basis of revenue, considers both internal
and external revenue to compute the threshold limit.
(b) The 10% test computed on the basis of revenue, considers only external
revenue to compute the threshold limit.
(c) The 10% test computed on the basis of revenue, considers only internal
revenue to compute the threshold limit.
(d) It is management choice whether they want to include both external
and internal revenue for computing threshold limit.
5. Which of the following statements is correct?
(a) In case of 10% test based on profit/loss, we need to consider that any
segment whose profit or loss is 10% or more than the net profit or net
© The Institute of Chartered Accountants of India
4.62 ADVANCED ACCOUNTING
loss respectively of all segments taken together becomes reportable
segment.
(b) In case of 10% test based on profit/loss, we need to consider that any
segment whose profit or loss is 10% or more than the net profit (after
netting the losses) of all segments taken together becomes reportable
segment.
(c) In case of 10% test based on profit/loss, we need to consider that any
segment whose profit or loss is 10% or more than the net profit or loss
(whichever is higher in absolute figures) of all segments taken together
becomes reportable segment.
(d) In case of 10% test based on profit/loss, we need to consider that any
segment whose profit or loss is 10% or more than the net profit or loss
(whichever is lower in absolute figures) of all segments taken together
becomes reportable segment.
Scenario based Question
6. Nathan Limited has three segments namely P, Q and R. The assets of the
company are ` 15 crores. Segment P has 4 crores, Segment Q has 6 crores and
Segment R has 5 crores. Deferred tax assets included in the assets of each
segment are P - ` 1 crore, Q - ` 0.90 crores and R - ` 0.80 crores. The accountant
contends all these three segments are reportable segments. Comment.
7. Company A is engaged in the manufacture and sale of products, which
constitute two distinct business segments. The products of the Company are
sold in the domestic market only. The management information system of the
Company is organized to reflect operating information by two broad market
segments, rural and urban.
Besides the two business segments, how should Company A identify
geographical segments? Do geographical segments exist within the same
country? Explain in line with the provisions of AS 17.
8. PK Ltd. has identified business segment as its primary reporting format. It has
identified India, USA and UK as three geographical segments. It sells its
products in the Indian market, which constitutes 70 percent of the Company’s
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PRESENTATION & DISCLOSURES BASED 4.63
ACCOUNTING STANDARDS v
v v
sales. 25 per cent is sold in USA and the balance is sold in UK. v
v
Is PK Ltd. as part of its geographical secondary segment information, required
to disclose segment revenue from export sales, where such sales are not
significant?
9. XYZ Ltd. has 5 business segments. Profit / Loss of each of the segments for the
year ended 31st March, 20X2 have been provided below. You are required to
identify from the following whether reportable segments or not reportable
segments, on the basis of "profitability test" as per AS-17.
Segment Profit (Loss) ` in lakhs
A 225
B 25
C (175)
D (20)
E (105)
10. ABC Limited has 5 segments namely A, B, C, D and E. The profit/loss of each
segment for the year ended March 31st, 20X2 is as follows:
Segment Profit/(Loss)
(` in crore)
A 780
B 1,500
C (2,300)
D (4,500)
E 6,000
Total 1,480
Identify the Reportable segments.
© The Institute of Chartered Accountants of India
4.64 ADVANCED ACCOUNTING
11. Heavy Goods Ltd. has 6 segments namely L-Q (below).
The total revenues (internal and external), profits or losses and assets are set
out below:
(In `)
Segment Inter Segment Sales External Profit / loss Total
Sales assets
L 4,200 12,300 3,000 37,500
M 3,500 7,750 1,500 23,250
N 1,000 3,500 (1,500) 15,750
0 0 5,250 (750) 10,500
P 500 5,500 900 10,500
Q 1,200 1,050 600 5,250
10,400 35,350 3,750 1,02,750
Heavy Goods Ltd. needs to determine how many reportable segments it has.
You are required to advice Heavy Goods Ltd. as per the criteria defined in
AS 17.
12. Calculate the segment results of a manufacturing organization from the
following information:
Segments A B C Total
Directly attributed revenue 5,00,000 3,00,000 1,00,000 9,00,000
Enterprise revenue 1,10,000
(allocated in 5 :4 : 2 basis)
Revenue from transactions with
other segments
Transaction from B 1,00,000 50,000 1,50,000
Transaction from C 10,000 50,000 60,000
Transaction from A 25,000 1,00,000 1,25,000
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PRESENTATION & DISCLOSURES BASED 4.65
ACCOUNTING STANDARDS v
v v
Operating expenses 3,00,000 1,50,000 75,000 v
5,25,000
v
Enterprise expenses 77,000
(allocated in 5 :4 :2 basis)
Expenses on transactions with other
segments
Transaction from B 75,000 30,000
Transaction from C 6,000 40,000
Transaction from A 18,000 82,000
13. The Senior Accountant of AMF Ltd. gives the following data regarding its five
segments:
(` in lakhs)
Particulars P Q R S T Total
(`) (`) (`) (`) (`) (`)
Segment Assets 80 30 20 20 10 160
Segment Results (190) 10 10 (10) 30 (150)
Segment Revenue 620 80 60 80 60 900
The Senior Accountant is of the opinion that segment "P" alone should be
reported. Is he justified in his view? Examine his opinion in the light of
provision of AS-17 'Segment Reporting'.
ANSWERS/ HINTS
Answers to the Multiple Choice Questions
1. (a) 2. (c) 3. (a) 4. (a) 5. (c)
Answers to the Scenario based Question
6. According to AS 17 "Segment Reporting", segment assets do not include
income tax assets.
Therefore, the revised total assets are 12.3 crores [` 15 - (` 1 +0.9 + 0.8).
© The Institute of Chartered Accountants of India
4.66 ADVANCED ACCOUNTING
Details of Segment wise assets:
Segment P holds total assets of ` 3 crores (` 4 crores - ` 1 crores);
Segment Q holds ` 5.1 crores (` 6 crores - ` 0.9 crores);
Segment R holds ` 4.2 crores (` 5 crores - ` 0.8 crores).
Thus, all the three segments hold more than 10% of the total assets, all
segments are reportable segments.
Hence, the contention of the Accountant that all three segments are
reportable segments is correct.
7. AS 17 explains that, “a single geographical segment does not include
operations in economic environments with significantly differing risks and
returns. A geographical segment may be a single country, a group of two or
more countries, or a region within a country”.
Accordingly, to identity geographical segments, Company A needs to
evaluate whether the segments reflected in the management information
system function in environments that are subject to significantly differing
risks and returns irrespective of the fact whether they are within the same
country.
The Standard recognizes that, “Determining the composition of a business or
geographical segment involves a certain amount of judgement…”.
Accordingly, while the management information system of the Company
provides segment information for rural and urban geographical segments for
the purpose of internal reporting, judgement is required to determine
whether these segments are subject to significantly differing risks and returns
based on the definition of geographical segment. In making such a
judgement, aspect like different pricing and other policies, e.g., credit policies,
deployment of resources between different regions etc., may be considered
for the purpose identifying ‘urban and ‘rural’ as separate geographical
segment.
Company A, in making judgment for identifying geographical segments,
should also consider the relevance, reliability and comparability over time of
segment information that will be reported. The Standard, explains that, “In
making that judgement, enterprise management takes into account the
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.67
ACCOUNTING STANDARDS v
v v
objective of reporting financial information by segment as set forthv in the
standard and the qualitative characteristics of financial statements. v The
qualitative characteristics include the relevance, reliability and comparability
over time of financial information that is reported about the different groups
of products and services of an enterprise and about its operations in
particular geographical areas, and the usefulness of that information for
assessing the risks and returns of the enterprise.”
8. As per AS 17, if primary format of an enterprise for reporting segment
information is business segments, it should also report segment revenue from
external customers by geographical area based on the geographical location of
its customers, for each geographical segment whose revenue from sales to
external customers is 10 per cent or more of enterprise revenue.
Therefore, for the purposes of disclosing secondary segment information, PK Ltd.
is not required to disclose segment revenue from export sales to UK, since that
segment does not meet the 10 per cent or more of enterprise revenue threshold.
However, other secondary segment information as per AS 17 should be disclosed
in respect of this segment if the thresholds prescribed in the AS 17 are met.
9. As per AS 17 ‘Segment Reporting’, a business segment or geographical
segment should be identified as a reportable segment if:
Its segment results whether profit or loss is 10% or more of:
The combined result of all segments in profit; i.e. ` 250 Lakhs or
The combined result of all segments in loss; i.e. ` 300 Lakhs
Whichever is greater in absolute amount i.e. ` 300 Lakhs.
Operating Absolute amount of Profit Reportable Segment
Segment or Loss (` In lakhs) Yes or No
A 225 Yes
B 25 No
C 175 Yes
D 20 No
E 105 Yes
© The Institute of Chartered Accountants of India
4.68 ADVANCED ACCOUNTING
On the basis of the profitability test (result criteria), segments A, C and E are
reportable segments (since their results in absolute amount is 10% or more
of` 300 lakhs i.e. 30 lakhs).
10. In compliance with AS 17, the segment profit/loss of respective segment will
be compared with the greater of the following:
(i) All segments in profit, i.e., A, B and E - Total profit ` 8,280 crores.
(ii) All segments in loss, i.e., C and D - Total loss ₹ 6,800 crores.
Greater of the above - ` 8,280 crores.
Based on the above, reportable segments will be determined as follows:
Segment Profit/(Loss) Absolute Reportable
Profit/Loss as a % Segment
of 8,280
A 780 9% No
B 1,500 18% Yes
C (2,300) 28% Yes
D (4,500) 54% Yes
E 6,000 72% Yes
Total 1,480
11. Quantitative Threshold Test:
Revenue Test:
Combined total sales of all the segment = ` 10,400 + ` 35,350 = ` 45,750.
10% thresholds = 45,750 x 10% = 4,575.
Profitability Test:
In the given situation, combined reported profit = ` 6,000 and combined
reported loss (` 2,250). Hence, for 10% thresholds ` 6,000 will be
considered.
10% thresholds = ` 6,000 x 10% = ` 600
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.69
ACCOUNTING STANDARDS v
v v
Asset Test: v
v
Combined total assets of all the segment = ` 1,02,750
10% thresholds = ` 1,02,750 x 10% = 10,275
Accordingly, quantitative thresholds are calculated below:
Segments L M N O P Q Reportable
segments
% segment sales 36.66% 24.59% 9.84% 11.48% 13.11% 4.92% L, M,O,P
to total sales
% segment 50% 25% 25% 12.5% 15% 10% L,M,N,O,P,Q
profit to total
profits
% segment 36.50% 22.63% 15.33% 10.22% 10.22% 5.11% L,M,N,O,P
assets to total
assets
Conclusion:
Segments L, M, O and P clearly satisfy the revenue and assets tests and
they are separate reportable segments.
Segment N does not satisfy the revenue test, but it does satisfy the asset
test and it is a reportable segment.
Segment Q does not satisfy the revenue or the assets test but is does
satisfy the profits test. Therefore, Segment Q is also a reportable segment.
Hence all segments i.e. L, M, N, O, P and Q are reportable segments.
12.
Computation of segment result:
Segments A B C Total
` ` ` `
Directly attributed revenue 5,00,000 3,00,000 1,00,000 9,00,000
Enterprise revenue 50,000 40,000 20,000 1,10,000
(allocated in 5 :4 :2 basis)
© The Institute of Chartered Accountants of India
4.70 ADVANCED ACCOUNTING
Revenue from transactions with
other segments
Transaction from B 1,00,000 50,000 1,50,000
Transaction from C 10,000 50,000 60,000
Transaction from A 25,000 1,00,000 1,25,000
Total segment revenue (1) 6,60,000 4,15,000 2.70,000 13,45,000
Operating expenses 3,00,000 1,50,000 75,000 5,25,000
Enterprise expenses 35,000 28,000 14,000 77,000
(allocated in 5 :4 :2 basis)
Expenses on transactions with other
segments
Transaction from B 75,000 30,000 1,05,000
Transaction from C 6,000 40,000 46,000
Transaction from A 18,000 82,000 1,00,000
Total segment expenses (2) 4,16,000 2,36,000 2,01,000 8,53,000
Segment result (1-2) 2,44,000 1,79,000 69,000 4,92,000
13. As per AS 17 ‘Segment Reporting’, a business segment or geographical
segment should be identified as a reportable segment if:
(i) Its revenue from sales to external customers and from other
transactions with other segments is 10% or more of the total revenue-
external and internal of all segments; or
(ii) Its segment result whether profit or loss is 10% or more of:
(1) The combined result of all segments in profit; or
(2) The combined result of all segments in loss,
whichever is greater in absolute amount; or
(iii) Its segment assets are 10% or more of the total assets of all segments.
Accordingly,
(a) On the basis of revenue from sales criteria, segment P is a reportable
segment.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.71
ACCOUNTING STANDARDS v
v v
(b) On the basis of the result criteria, segments P & T are reportable
v
segments (since their results in absolute amount is 10% or more
v of
` 200 Lakhs).
(c) On the basis of asset criteria, all segments except T are reportable
segments.
Since all the segments are covered in at least one of the above criteria, all
segments have to be reported upon in accordance with AS 17. Hence, the
opinion of chief accountant that only segment ‘P’ is reportable is wrong.
© The Institute of Chartered Accountants of India
4.72 ADVANCED ACCOUNTING
UNIT 4: ACCOUNTING STANDARD 18 RELATED
PARTY DISCLOSURES
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the –
❑
Need for disclosure of related party relationship;
How to identify the related party relationships;
Which parties are not treated as related party;
Exemption from Related Party Disclosure in certain situations;
Disclosure requirements under AS-18.
4.1 INTRODUCTION
AS 18 prescribes the requirements for disclosure of related party relationship and
transactions between the reporting enterprise and its related parties. The
requirements of the standard apply to the financial statements of each reporting
enterprise as also to consolidated financial statements presented by a holding
company.
4.2 RELATED PARTY ISSUE – WHY DISCLOSURE
IS NEEDED?
Related party relationships are a normal feature of commerce and business.
There is a general presumption that transactions reflected in financial statements
are consummated on an arm’s-length basis between independent parties. However,
that presumption may not be valid when related party relationships exist because
related parties may enter into transactions which unrelated parties would not enter
into.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.73
ACCOUNTING STANDARDS v
v v
v terms
Also, transactions between related parties may not be effected at the same
v
and conditions as between unrelated parties. Sometimes, no price is charged in
related party transactions, for example, free provision of management services and
the extension of free credit on a debt.
Also, sometimes the operating results and financial position of an enterprise may
be affected by a related party relationship even if related party transactions do not
occur. The mere existence of the relationship may be sufficient to affect the
transactions of the reporting enterprise with other parties. For example, a
subsidiary may terminate relations with a trading partner on acquisition by the
holding company of a fellow subsidiary engaged in the same trade as the former
partner. Alternatively, one party may refrain from acting because of the control or
significant influence of another - for example, a subsidiary may be instructed by its
holding company not to engage in research and development.
Likewise, in certain cases transactions would not have taken place if the related party
relationship had not existed. For example, a company that sold a large proportion
of its production to its holding company at cost might not have found an alternative
customer if the holding company had not purchased the goods.
In view of the aforesaid, the resulting accounting measures may not represent what
they usually would be expected to represent. Thus, a related party relationship
could have an effect on the financial position and operating results of the reporting
enterprise.
4.3 RELATED PARTY RELATIONSHIPS, AS
CONTEMPLATED UNDER AS-18
Related Party - As per AS-18, parties are considered to be related if at any time
during the reporting period one party has the ability to control the other party or
exercise significant influence over the other party in making financial and/or
operating decisions.
It is worthwhile to note that AS-18 provides a definitive list of related party
relationships to which AS-18 applies. Accordingly, AS 18 deals only with the
following five types of related party relationships described in (a) to (e) below:
© The Institute of Chartered Accountants of India
4.74 ADVANCED ACCOUNTING
(a) Enterprises that directly, or indirectly through one or more intermediaries,
control, or are controlled by, or are under common control with, the reporting
enterprise (this includes holding companies, subsidiaries and fellow
subsidiaries).
Note: This is the case when there is a parent-subsidiary relationship
(including relationship among fellow subsidiaries), as illustrated later in
this chapter. For meaning of the term control, refer to subsequent
discussion under this chapter.
(b) Associates and joint ventures of the reporting enterprise and the investing
party or venturer in respect of which the reporting enterprise is an associate
or a joint venture.
(c) Individuals owning, directly or indirectly, an interest in the voting power of
the reporting enterprise that gives them control or significant influence over
the enterprise, and relatives of any such individual.
(d) Key management personnel and relatives of such personnel; and
(e) Enterprises over which any person described in (c) or (d) is able to exercise
significant influence. This includes enterprises owned by directors or major
shareholders of the reporting enterprise and enterprises that have a member
of key management in common with the reporting enterprise.
4.4 WHO ARE NOT DEEMED TO BE RELATED
PARTIES UNDER AS-18?
In the context of AS 18, the following are deemed not to be related parties:
(a) Two companies are not related parties simply because they have a director in
common (unless the director is able to affect the policies of both companies
in their mutual dealings). Accordingly, if the common director is able to
influence the policies of both the companies in their mutual dealings –
then related party relationship exists.
(b) A single customer, supplier, franchiser, distributor, or general agent with
whom an enterprise transacts a significant volume of business merely by
virtue of the resulting economic dependence; and
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.75
ACCOUNTING STANDARDS v
v v
(c) The parties listed below, in the course of their normal dealings vwith an
v
enterprise by virtue only of those dealings (although they may circumscribe
the freedom of action of the enterprise or participate in its decision-making
process):
(i) Providers of finance
(ii) Trade unions
(iii) Public utilities
(iv) Government departments and government agencies including
government sponsored bodies
4.5 EXEMPTION FROM RELATED PARTY
DISCLOSURE IN CERTAIN SITUATIONS
1. Conflict with the reporting enterprise’s duties of confidentiality: Related
party disclosure requirements as laid down in AS 18 do not apply in
circumstances where providing such disclosures would conflict with the
reporting enterprise’s duties of confidentiality as specifically required in
terms of a statute or by any regulator or similar competent authority.
Put differently, in cases where a statute or a regulator or a similar competent
authority governing an enterprise prohibit the enterprise to disclose certain
information which is required to be disclosed as per this Standard, disclosure
of such information is not warranted. For example, banks are obliged by law
to maintain confidentiality in respect of their customers’ transactions and this
Standard would not override the obligation to preserve the confidentiality of
customers’ dealings.
2. Consolidated financial statements: No disclosure is required in
consolidated financial statements in respect of intra-group transactions -
since disclosure of transactions between members of a group is unnecessary
in consolidated financial statements. This is mainly because consolidated
financial statements present information about the holding and its
subsidiaries as a single reporting enterprise.
3. State-controlled enterprises: No disclosure is required in the financial
© The Institute of Chartered Accountants of India
4.76 ADVANCED ACCOUNTING
statements of state-controlled enterprises as regards related party
relationships with other state-controlled enterprises and transactions with
such enterprises.
4.6 DEFINITIONS OF OTHER TERMS USED IN AS 18
Related party transaction:AS-18 defines related party transaction as, “A transfer
of resources or obligations between related parties, regardless of whether or not a
price is charged”.
Control: As per AS-18 Control means:
(a) ownership, directly or indirectly, of more than one half of the voting power
of an enterprise, or
(b) control of the composition of the board of directors in the case of a company
or of the composition of the corresponding governing body in case of any
other enterprise, or
(c) a substantial interest in voting power and the power to direct, by statute or
agreement, the financial and/or operating policies of the enterprise.
It is pertinent to note that the above definition of control under AS-18 is relatively wider than
that under AS-21 Consolidated Financial Statements. This is so because - clause (c) in the
definition of control under AS-18 is an addition, which is not found in AS-21 Consolidated
Financial Statements.
Also, AS-18 clarifies that for the purpose of AS 18, an enterprise is considered to
control the composition of the board of directors of a company or governing
body of an enterprise, if it has the power, without the consent or concurrence of
any other person, to appoint or remove all or a majority of directors/members of
the governing body of that company/enterprise. Put differently, control to the
composition of the Board of directors is determined with reference to the authority
of an enterprise to appoint or remove all or majority of directors of another
enterprise without concurrence of any other person.
Further, an enterprise is deemed to have the power to appoint a director/
member of the governing body, if any of the following conditions is satisfied:
(a) A person cannot be appointed as director/member of the governing body
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.77
ACCOUNTING STANDARDS v
v v
v
without the exercise in his favour by that enterprise of such a power as
aforesaid or v
(b) A person’s appointment as director/member of the governing body follows
necessarily from his appointment to a position held by him in that enterprise
or
(c) The director/member of the governing body is nominated by that enterprise;
in case that enterprise is a company, the director is nominated by that
company/subsidiary thereof.
An enterprise is considered to have a substantial interest in another enterprise if
that enterprise owns, directly or indirectly, 20% or more interest in the voting
power of the other enterprise. Similarly, an individual is considered to have a
substantial interest in an enterprise, if that individual owns, directly or indirectly, 20
per cent or more interest in the voting power of the enterprise.
Associate: AS-18 defines an Associate as an enterprise in which an investing
reporting party has significant influence and which is neither a subsidiary nor a joint
venture of that party. Therefore, an associate should not be a subsidiary neither a
joint venture of that investing reporting enterprise.
And, the term Significant influence is defined by AS-18 as “Participation in the
financial and/or operating policy decisions of an enterprise, but not control of those
policies”.
Further,AS-18 clarifies that significant influence may be exercised in several ways,
for example, (1) by representation on the board of directors;, (2) participation in
the policy making process; (3) material inter-company transactions, (4) interchange
of managerial personnel or (5) dependence on technical information.
Significant influence may be gained by share ownership, statute or agreement. As
regards share ownership, if an investing party holds, directly or indirectly through
intermediaries, 20 per cent or more of the voting power of the enterprise, it is
presumed that the investing party has significant influence, unless it can be clearly
demonstrated that this is not the case. Conversely, if the investing party holds,
directly or indirectly through intermediaries, less than 20% of the voting power
of the enterprise, it is presumed that the investing party does not have significant
influence, unless such influence can be clearly demonstrated. A substantial or
© The Institute of Chartered Accountants of India
4.78 ADVANCED ACCOUNTING
majority ownership by another investing party does not necessarily preclude an
investing party from having significant influence.
Key Management Personnel: As per AS-18, Key Management Personnel are those
persons who have the authority and responsibility for planning, directing and
controlling the activities of the reporting enterprise.
For example, in the case of a company, (1) the managing director(s), (2) whole time
director(s), (3) manager and (4) any person in accordance with whose directions or
instructions the board of directors of the company is accustomed to act, are usually
considered key management personnel.
AS-18 further provides an explanation that a non-executive director of a company
-is not considered as a key management person under this Standard by virtue of
merely his being a director unless he has the authority and responsibility for
planning, directing and controlling the activities of the reporting enterprise.
The requirements of AS 18 should not be applied in respect of a non-executive
director even if he participates in the financial and/or operating policy decision of
the enterprise, unless he falls in any of the categories of ‘related party relationships’
discussed above.
Relative: As per AS-18, a Relative in relation to an individual, means the spouse,
son, daughter, brother, sister, father and mother who may be expected to influence,
or be influenced by, that individual in his/her dealings with the reporting enterprise.
Joint Venture - AS-18 defines a Joint Venture as a contractual arrangement
whereby two or more parties undertake an economic activity which is subject to
joint control.
Joint Control–AS-18 defines a Joint Control as the contractually agreed sharing of
power to govern the financial and operating policies of an economic activity so as
to obtain benefits from it. Accordingly, when two or more parties contractually
agree to share power to govern the financial and operating policies of an economic
activity, this contractual agreement is termed as joint control.
It is pertinent to note that joint venture does not depend upon voting power of the
parties involved. Rather, it is linked to the ability to exercise joint control over an
economic activity.
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PRESENTATION & DISCLOSURES BASED 4.79
ACCOUNTING STANDARDS v
v v
Holding Company–AS-18 defines Holding Company as a company havingv one or
more subsidiaries v
Subsidiary AS 18 defines a Subsidiary – as a company:
(a) in which another company (the holding company) holds, either by itself
and/or through one or more subsidiaries, more than one-half, in nominal
value of its equity share capital; or
(b) of which another company (the holding company) controls, either by itself
and/or through one or more subsidiaries, the composition of its board of
directors.
Fellow Subsidiary–AS-18 clarifies that a company is considered to be a fellow
subsidiary of another company if both are subsidiaries of the same holding
company.
Illustration 1
Identify the related parties in the following case as per AS 18:
A Ltd. holds 51% of B Ltd.
B Ltd holds 51% of O Ltd.
Z Ltd holds 49% of O Ltd.
Solution
In relation to Reporting enterprise - A Ltd.
B Ltd. (subsidiary) is a related party
O Ltd.(subsidiary) is a related party
In relation to Reporting enterprise - B Ltd.
A Ltd. (holding company) is a related party
O Ltd. (subsidiary) is a related party
In relation to Reporting enterprise - O Ltd.
A Ltd. (ultimate holding company) is a related party
B Ltd. (holding company) is a related party
© The Institute of Chartered Accountants of India
4.80 ADVANCED ACCOUNTING
Z Ltd. (investor/ investing party) is a related party (O Ltd being Associate of
Z Ltd)
Reporting enterprise - Z Ltd.
O Ltd. (Associate) is a related party
Illustration 2
Consider a scenario wherein:
A Ltd. has 60% voting right in B Ltd.
A Ltd. also has 22% voting right in C Ltd.; and
B Ltd. has 30% voting right in C Ltd.
Whether C Ltd. is to be treated under AS-18 as a party related to A Ltd.?
Solution
Yes – in relation to A Ltd. (the reporting enterprise), C Ltd. is a related party under
AS-18. This is because A Ltd. indirectly controls C Ltd.
In this case, A Ltd. (together with its subsidiary B Ltd.) controls more than one half
of the voting rights of C Ltd.
Illustration 3
Consider a scenario wherein:
X Ltd. holds 28% voting right in Y Ltd. (and hence Y Ltd. is an associate of X
Ltd.)
Y Ltd. holds 32% voting right in Z Ltd. (and hence Z Ltd. is an associate of Y
Ltd.)
X Ltd.
28 % Voting rights
Y Ltd.
32 % Voting rights
Z Ltd.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.81
ACCOUNTING STANDARDS v
v v
v to X
In the above case, since Y Ltd. is an associate of X Ltd. – Y Ltd. is a related party
Ltd. v
Likewise, since Z Ltd. is an associate of Y Ltd. - Z Ltd. is a related party to Y Ltd.
The question is: Whether Z Ltd. is to be treated under AS-18 as a party related to X
Ltd.?
Solution
No – in relation to X Ltd. (the reporting enterprise), Z Ltd. is a not a related party.
This is because as per the requirements of AS-18, ‘associate of an associate’ is not
a related party.
Illustration 4
Consider the following organization structure related to P Ltd.
P Ltd.
80% Shares
Q Ltd.
60% Shares 80% Shares
R Ltd. S Ltd.
65% Shares 70% Shares
X Ltd. Y Ltd.
Given the above structure: Identify related party relationships, if R Ltd. is the
reporting enterprise
Solution
The following table identifies the related party relationships for R Ltd. (being the
reporting enterprise):
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4.82 ADVANCED ACCOUNTING
Party Name Relationship under AS-18
P Ltd. has indirect control on R Ltd. (through Q Ltd.)
P Ltd.
Hence R Ltd. is related to P Ltd.
Q Ltd. has direct control of R Ltd.
Q Ltd.
Hence R Ltd. is related to Q Ltd.
R Ltd. and S Ltd. are under common control of Q Ltd.
S Ltd.
Hence R Ltd. is related to S Ltd.
X Ltd. is controlled by R Ltd.
X Ltd.
Hence R Ltd. is related to X Ltd.
Y Ltd. is the sub-subsidiary of Q Ltd.
Both R Ltd. and Y Ltd. are under common control of Q
Y Ltd.
Ltd.
Hence R Ltd. is related to Y Ltd.
Illustration 5
Consider the following organization structure related to UH Ltd. (the ultimate parent
company of a Group), wherein UH Ltd. has made the following investments:
Investment in two of the wholly owned subsidiaries, viz. Sub 1 and Sub 2
Investment in JC 1, in which UH Ltd. has a joint control
20% investment in Ass 1 (and hence, Ass 1 is an associate of UH Ltd.)
UH Ltd
100% 100% Joint Control Associate
28%
Sub 1 Sub 2 JC 1 Ass 1
Given the above structure: Identify related party relationships for each of the above
entities under AS-18.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.83
ACCOUNTING STANDARDS v
v v
Solution v
v
The following table identifies the related party relationships for each of the entities
in the Group:
Reporting
Related Party as per AS-18
enterprise
UH Ltd. All the four entities (viz. Sub 1, Sub 2, JC 1 and Ass 1)
Sub 1 Only two of the entities in the Group (viz. UH Ltd. and Sub 2)
Sub 2 Only two of the entities in the Group (viz. UH Ltd. and Sub 1)
JC 1 Only UH Ltd.
Ass 1 Only UH Ltd.
Illustration 6
Consider a scenario wherein:
▪ Mr. Robert holds 70% shares and voting rights in P Ltd
Mr. Robert 70% Shares
P Ltd.
and, has control
Are they related?
Mrs. Andy
(Spouse of Mr. Robert)
Determine: Whether Andy (spouse of Mr. Robert) is a related party to P Ltd. under
AS-18?
© The Institute of Chartered Accountants of India
4.84 ADVANCED ACCOUNTING
Solution
Yes – Andy is a related party to P Ltd., in view of the requirements of AS-18.
It may be recalled that under AS-18 ‘relatives of individuals owning an interest in
the voting power of the reporting enterprise that gives them control or significant
influence over the enterprise’ are considered as related parties.
Illustration 7
Consider a scenario wherein:
Mr. Robert is a Managing Director of P Ltd.
Andy (spouse of Robert) received a remuneration of Rs 5 lacs from P Ltd. – for
the services she rendered to P Ltd. for the period 1 st April 20X1 through 30 th
June 20X1
Andy left the services of P Ltd. on 1 st July 20X1
Consider 31 st March 20X2 as the year-end date for P Ltd.
MD
Mr. Robert P Ltd.
Received remuneration
of ` 5 lacs
Mrs. Andy
(Spouse of Mr. Robert)
Year - end
31st March 20X2
1st April 20X1 30th June 20X1
Mrs. Andy left on 1 st July 20X1
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.85
ACCOUNTING STANDARDS v
v v
Whether Andy is to be identified as related party at the year-end date (31 stv March
20X2) for the purposes of AS-18? v
Solution
Yes – This is because as per AS-18, parties are considered to be related if at any
time during the reporting period one party has the ability to control the other party
or exercise significant influence over the other party in making financial and/or
operating decisions.
Hence Andy (being the spouse and relative of the KMP of P Ltd.) needs to be
reported as related party at the year-end date (i.e. 31st March 20X2). This is because
the remuneration Andy received from P Ltd. (for the period April 20X1 to 30 June
20X1) falls within the reporting year April 20X1 to March 20X2.
Illustration 8
Consider a scenario wherein:
UK Bank holds 23% equity shares with voting rights in P Ltd.
The bank has provided a loan of Rs. 20 million to P Ltd. at market interest rate
As per the terms and conditions of the loan agreement, the bank has appointed
one person as its nominee to the board of directors of P Ltd. and any major
transaction to be entered into by P Ltd. will require the consent of the Bank
UK Bank
BANK Holds 23% Shares with voting rights
P
Provided loan of ` 20 Million @ market rates
Ltd.
Hence has power to nominate 1 member to
BoDs
© The Institute of Chartered Accountants of India
4.86 ADVANCED ACCOUNTING
Determine: Whether under AS-18 - UK Bank is a related party to P Ltd. (the reporting
enterprise)?
Solution
In the instant case, the UK Bank holds 23% shares with voting rights in P Ltd. and
hence is deemed to exercise significant influence over P Ltd.
The bank is also a provider of finance to P Ltd. (the reporting enterprise) and as per
AS-18, parties like providers of finance are deemed not to be considered as a
related party in the course of normal dealings with an enterprise by virtue only of
those dealings. However, this exemption will not be available to UK Bank in this
case – since it exercises significant influence over P Ltd. (by virtue of holding 23%
shares with voting rights in P Ltd.)
Accordingly, for P Ltd. (the reporting enterprise), the UK Bank is a related party and
it will be required to disclose the transactions with UK Bank in its financial
statements.
4.7 DISCLOSURE REQUIREMENTS UNDER AS-18
At the outset, it is to be noted that AS-18 prescribe related party disclosure
requirements.
(a) name of the related party and (b) nature of the related party relationship where
control exists should be disclosed - irrespective of whether or not there have been
transactions between the related parties.
This is to enable users of financial statements to form a view about the effects of
related party relationships on the enterprise.
If there have been transactions between related parties, during the existence of a
related party relationship, the reporting enterprise should disclose the following:
(i) The name of the transacting related party;
(ii) A description of the relationship between the parties;
(iii) A description of the nature of transactions;
(iv) Volume of the transactions either as an amount or as an appropriate
proportion;
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.87
ACCOUNTING STANDARDS v
v v
(v) Any other elements of the related party transactions necessary v for an
understanding of the financial statements; v
(vi) The amounts or appropriate proportions of outstanding items pertaining to
related parties at the balance sheet date and provisions for doubtful debts
due from such parties at that date;
(vii) Amounts written off or written back in the period in respect of debts due from
or to related parties.
Items of a similar nature may be disclosed in aggregate by type of related party
except when separate disclosure is necessary for an understanding of the effects of
related party transactions on the financial statements of the reporting enterprise.
Remuneration paid to key management personnel should be considered as a
related party transaction requiring disclosures. In case non-executive directors on
the Board of Directors are not related parties, remuneration paid to them should
not be considered a related party transaction.
4.8 LIST OF RELATED PARTY TRANSACTIONS,
TO BE DISCLOSED (WHAT NEEDS TO BE
DISCLOSED?)
AS-18 gives following examples of related party transactions, in respect of which
disclosures may be made by a reporting enterprise:
1. purchases or sales of goods (finished or unfinished)
2. purchases or sales of fixed assets
3. rendering or receiving of services
4. agency arrangements
5. leasing or hire purchase arrangements
6. transfer of research and development
7. licence agreements
8. finance (including loans and equity contributions in cash or in kind)
9. guarantees and collaterals
10. management controls including for deputation of employees.
© The Institute of Chartered Accountants of India
4.88 ADVANCED ACCOUNTING
Illustration 9
Consider a scenario wherein:
P Ltd. hold 22% shares and voting rights in Q Ltd. (and hence Q Ltd. is an
associate of P Ltd.)
On 1st April 20X1, P Ltd. sold certain goods to Q Ltd. amounting to Rs. 5 lacs
On 30th June 20X1, P Ltd. sold its entire 22% stake in Q Ltd. (and hence the
related party relationship ceased to exist after 30 th June 20X1)
However, P Ltd. continued supply goods to Q Ltd. subsequent to 30 th June 20X1
(just like any other customer) and sold goods worth Rs. 15 lacs during 9-month
period ended 31st March 20X2
Consider 31 st March 20X2 as the year-end date for P Ltd.
P Ltd.
22% shares and Goods sold on 1 st April
voting rights 20X1 amounting to ` 5
lacs
Q Ltd .
Year end
st
1 April 20X1 30th June 20X1 st
31 March 20X2
Goods sold ` 5 Goods worth ` 15 lacs sold
lacs
Sold entire 22% shareholding
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.89
ACCOUNTING STANDARDS v
v v
Determine whether the transaction for the entire year (ending on 31 st March v20X2) is
required to be disclosed under AS-18 as related party transaction. v
Solution
No – This is because as per AS-18, the disclosure requirements under the Standard
relate only to the period during related party relationship existed.
Accordingly, only transactions between P Ltd and Q Ltd till 30 th June 20X1 (being
sale of goods worth Rs. 5 lacs) are required to be reported / disclosed under AS-
18.
Transactions entered into after 30 th June 20X1 are NOT required to be disclosed
under AS-18.
Illustration 10
Narmada Ltd. sold goods for ` 90 lakhs to Ganga Ltd. during financial year ended
31-3-20X1. The Managing Director of Narmada Ltd. owns 100% shares of Ganga
Ltd. The sales were made to Ganga Ltd. at normal selling prices by Narmada Ltd.
The Chief accountant of Narmada Ltd contends that these sales need not require a
different treatment from the other sales made by the company and hence no
disclosure is necessary as per the accounting standard. Is the Chief Accountant
correct?
Solution
As per AS 18 ‘Related Party Disclosures’, Enterprises over which a key management
personnel is able to exercise significant influence are related parties. This includes
enterprises owned by directors or major shareholders of the reporting enterprise
and enterprise that have a member of key management in common with the
reporting enterprise.
In the given case, Narmada Ltd. and Ganga Ltd are related parties and hence
disclosure of transaction between them is required irrespective of whether the
transaction was done at normal selling price.
Hence the contention of Chief Accountant of Narmada Ltd is wrong.
© The Institute of Chartered Accountants of India
4.90 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. According to AS-18 Related Party Disclosures, which ONE of the following is
not a related party of Skyline Limited?
(a) A shareholder of Skyline Limited owning 30% of the ordinary share
capital
(b) An entity providing banking facilities to Skyline Limited in the normal
course of business
(c) An associate of Skyline Limited
(d) Key management personnel of Skyline Limited
2. Are the following statements in relation to related parties true or false,
according to AS-18 Related Party Disclosures?
(A) A party is related to another entity that it is jointly controlled by.
(B) A party is related to another entity that it controls.
Statement (A) Statement (B)
(a) False False
(b) False True
(c) True False
(d) True True
3. Which of the following is not a related party as envisaged by AS-18 Related
Party Disclosures?
(a) A director of the entity
(b) The parent company of the entity
(c) A shareholder of the entity that holds 1% stake in the entity
(d) The spouse of the managing director of the entity
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.91
ACCOUNTING STANDARDS v
v v
4. According to AS-18 Related Party Disclosures, related party transactionv is a
transfer of resources or obligations between related parties – providedv a price
is charged for such transfer.
(a) True
(b) False
5. According to AS-18 Related Party Disclosures, parties are considered to be
related, if and only if at the end of the reporting period - one party has the
ability to control the other party or exercise significant influence over the other
party in making financial and/or operating decisions.
(a) True
(b) False
Theoretical Questions
6 Who are related parties under AS 18? What are the related party disclosure
requirements?
7 ABC Limited is in the business of manufacturing textiles. It has certain
commercial contracts with its customers and those customer contracts carry
various clauses, imposing restriction on ABC Limited for disclosure of certain
information. Accordingly, the company doesn’t intend to provide related party
disclosure under AS-18 in its ensuing financial statements. Is this correct?
8 Should the related parties be identified as at the reporting date (i.e. balance
sheet date) for the purposes of AS-18? In disclosing transactions with related
parties, are the transactions of the entire reporting period to be disclosed or
only those for the period during which related party relationship exists?
Scenario based Question
9. Mr. Raj, a relative of key management personnel, received remuneration of
` 2,50,000 for his services in the company for the period from 1.4.20X1 to
30.6.20X1. On 1.7.20X1, he left the service of the company.
Should the relative be identified as at the closing date i.e. on 31.3.20X2 for the
purposes of AS 18?
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4.92 ADVANCED ACCOUNTING
10. X Ltd. sold goods to its associate company during the 1st quarter ended
30.6.20X1. After that, the related party relationship ceased to exist. However,
goods were supplied as were supplied to any other ordinary customer. Decide
whether transactions of the entire year have to be disclosed as related party
transaction.
11. You are required to identify the related parties in the following cases as per AS
18:
M Ltd. holds 61 % shares of S Ltd.
S Ltd. holds 51 % shares of F Ltd.
C Ltd. holds 49% shares of F Ltd.
(Give your answer - Reporting Entity wise for M Ltd., S Ltd., C Ltd. and F Ltd.)
ANSWERS/HINTS
Answers to the Multiple Choice Questions
1. (b) 2. (d) 3. (c) 4. (b) 5. (b)
Answers to the Theoretical Questions
6. Parties are considered to be related if at any time during the reporting period
one party has the ability to control the other party or exercise significant
influence over the other party in making financial and/or operating decisions.
If there have been transactions between related parties, during the existence
of a related party relationship, the reporting enterprise should disclose the
following:
(i) The name of the transacting related party;
(ii) A description of the relationship between the parties;
(iii) A description of the nature of transactions;
(iv) Volume of the transactions either as an amount or as an appropriate
proportion;
(v) Any other elements of the related party transactions necessary for an
understanding of the financial statements;
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PRESENTATION & DISCLOSURES BASED 4.93
ACCOUNTING STANDARDS v
v v
(vi) The amounts or appropriate proportions of outstandingv items
v
pertaining to related parties at the balance sheet date and provisions
for doubtful debts due from such parties at that date;
(vii) Amounts written off or written back in the period in respect of debts
due from or to related parties.
7. As per AS-18 stipulate that related party disclosure requirements under AS-
18 do not apply in circumstances, where providing such disclosures would
conflict with the reporting enterprise's duties of confidentiality, as specifically
required in terms of a statute or by any regulator or similar competent
authority.
In case, where (1) a statute or (2) a regulator or (3) a similar competent
authority governing an enterprise prohibit the enterprise to disclose certain
information, which is required to be disclosed as per AS 18, disclosure of such
information is not warranted. For example, banks are obliged by law to
maintain confidentiality in respect of their customers' transactions and AS-18
would not override the obligation to preserve the confidentiality of
customers' dealings.
However, this exemption is not available in respect of confidentiality
provisions in a commercial contract between two enterprises - where
confidentiality is not specifically required in terms of (1) a statute or (2) by
any regulator or (3) similar competent authority.
Therefore, in the given case AS-18 related party disclosures would have to be
made by ABC Limited in its ensuing financial statements.
8. As per the definition of related parties in AS-18, the existence of a related
party relationship should be identified at all points during the year (and not
only at the close of the financial year). However, AS 18 requires disclosure of
transactions with these parties only during the existence of the related party
relationship.
Answers to the Scenario based Question
9. According to AS 18 on ‘Related Party Disclosures’, parties are considered to
be related if at any time during the reporting period one party has the ability
to control the other party or exercise significant influence over the other party
in making financial and/or operating decisions. Hence Mr. Raj, a relative of
© The Institute of Chartered Accountants of India
4.94 ADVANCED ACCOUNTING
key management personnel, should be identified as related party for
disclosure in the financial statements for the year ended 31.3.20X2.
10. As per AS 18, transactions of X Ltd. with its associate company for the first
quarter ending 30.06.20X1 only are required to be disclosed as related party
transactions. The transactions for the period in which related party
relationship did not exist would not be reported.
11. Reporting Entity Related Party
M Ltd. S Ltd. (subsidiary)
F Ltd.(subsidiary)
S Ltd. M Ltd. (holding company)
F Ltd. (subsidiary)
F Ltd. M Ltd. (ultimate holding company)
S Ltd. (holding company)
C Ltd. (investor/ investing party)
C Ltd. F Ltd. (associate)
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.95
ACCOUNTING STANDARDS v
v v
UNIT 5: ACCOUNTING STANDARD 20 EARNINGS
v
v
PER SHARE
LEARNING OUTCOMES
❑
After studying this unit, you will be able to comprehend the following:
Basic Earnings Per Share
• Issues related to Numerator – Earnings
• Issues related to Denominator – Weighted average number of
shares
Diluted Earnings Per Share
• Issues related to Numerator – Earnings
• Issues related to Denominator – Weighted average number of
shares
Dilutive Potential Equity Shares
Restatement of Earnings per share
Disclosures
5.1 INTRODUCTION
The objective of AS 20 is to describe principles for determination (i.e. computation)
and presentation (i.e. presentation in the Statement of Profit and Loss) of earnings
per share which will improve comparison of performance among different
enterprises for the same period and among different accounting periods for the
same enterprise.
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4.96 ADVANCED ACCOUNTING
Computation Presentation Results in
Where - In the Inter firm
i.e. Determination
Income Statement comparision
Of - Basic & On the Face of the Intra Firm
Diluted EPS P&L A/c comparision
Earnings per share (EPS) is a financial ratio indicating the amount of profit or loss
for the period attributable to each equity share and AS 20 gives computational
methodology for determination and presentation of basic and diluted earnings per
share.
This Accounting Standard is mandatory for all companies. However, disclosure of
diluted earnings per share (both including and excluding extraordinary items) is not
mandatory for SMCs. Such companies are however encouraged to make these
disclosures.
In consolidated financial statements, the information required by AS 20 should be
presented on the basis of consolidated information.
5.2 DEFINITION OF THE TERMS USED IN AS 20
An equity share is a share other than a preference share.
A preference share is a share carrying preferential rights to dividends and
repayment of capital.
A financial instrument is any contract that gives rise to both a financial asset of
one enterprise and a financial liability or equity shares of another enterprise.
A financial asset is any asset that is
a. Cash;
b. A contractual right to receive cash or another financial asset from another
enterprise;
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PRESENTATION & DISCLOSURES BASED 4.97
ACCOUNTING STANDARDS v
v v
c. v
A contractual right to exchange financial instruments with another enterprise
under conditions that are potentially favourable; or v
d. An equity share of another enterprise.
A financial liability is any liability that is a contractual obligation to deliver cash
or another financial asset to another enterprise or to exchange financial
instruments with another enterprise under conditions that are potentially
unfavourable.
A potential equity share is a financial instrument or other contract that entitles,
or may entitle, its holder to equity shares.
Examples of potential equity shares are:
a. Debt instruments or preference shares, that are convertible into equity shares;
b. Share warrants;
c. Options including employee stock option plans under which employees of an
enterprise are entitled to receive equity shares as part of their remuneration
and other similar plans; and
d. Shares which would be issued upon the satisfaction of certain conditions
resulting from contractual arrangements (contingently issuable shares), such
as the acquisition of a business or other assets, or shares issuable under a
loan contract upon default of payment of principal or interest, if the contract
so provides.
Note:
A partly paid-up share where the holder is not entitled to dividends is treated as a
potential equity share for the purposes of computing Diluted EPS.
Share warrants or options are financial instruments that give the holder the right
to acquire equity shares.
Fair value is the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arm’s length transaction.
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4.98 ADVANCED ACCOUNTING
Basic Earnings Per Share
Basic earnings per share is calculated as
Net profit (loss) attributable to equity shareholders
Weighted average number of equity shares outstanding during the period
5.3 EARNINGS-BASIC
All items of income and expense which are recognised in a period, including tax
expense and extraordinary items, are included in the determination of the net profit
or loss for the period unless AS 5 requires or permits otherwise.
The amount of preference dividends and any attributable tax thereto for the period
is deducted from the net profit for the period (or added to the net loss for the
period) in order to calculate the net profit or loss for the period attributable to
equity shareholders.
The amount of preference dividends for the period that is deducted from the net
profit for the period is:
a. The amount of any preference dividends on non-cumulative preference
shares provided for in respect of the period; and
b. The full amount of the required preference dividends for cumulative
preference shares for the period, whether or not the dividends have been
provided for. The amount of preference dividends for the period does not
include the amount of any preference dividends for cumulative preference
shares paid or declared during the current period in respect of previous
periods.
Note:
If an enterprise has more than one class of equity shares, net profit or loss for the
period is apportioned over the different classes of shares in accordance with their
dividend rights.
[In other words, there will be more than 1 Basic EPS for such a company; i.e. EPS for
each class of equity shares]
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.99
ACCOUNTING STANDARDS v
v v
v
A quick recap of adjustments to be made to the numerator will be as under:
v
Particulars Adjusted in the numerator of
Basic EPS
Tax expense Yes
(Current and Deferred Tax)
Exceptional items as per AS 5 Yes
Extraordinary items as per AS 5 Yes
Changes in Accounting estimates as per AS 5 Yes
Changes in Accounting Policy as per AS 5 Yes
Amount of preference dividends and any
attributable tax thereto
(a) Non-cumulative preference Yes – only if it has been
(b) Cumulative preference shares provided in the books
Yes – irrespective, whether or
not the dividends have been
provided for in the books
5.4 PER SHARE- BASIC
The number of shares used in the denominator for basic EPS should be the
weighted average number of equity shares outstanding during the period.
The weighted average number of equity shares outstanding during the period is
the number of shares outstanding at the beginning of the period, adjusted by the
number of equity shares bought back or issued during the period multiplied by a
time-weighting factor.
The time-weighting factor is:
Numbers of days the shares are outstanding
Number of days in the period
Although the Standard defines the time-weighting factor as being determined on
a daily basis, it acknowledges that a reasonable approximation of the weighted
average is adequate in many circumstances.
© The Institute of Chartered Accountants of India
4.100 ADVANCED ACCOUNTING
Illustration 1
Date Particulars Balance
1st January Balance at beginning of year 1,800 - 1,800
31st May Issue of shares for cash 600 - 2,400
1st November Buy Back of shares - 300 2,100
Calculate Weighted Number of Shares.
Solution
Computation of Weighted Average:
(1,800 x 5/12) + (2,400 x 5/12) + (2,100 x 2/12) = 2,100 shares.
The weighted average number of shares can alternatively be computed as follows:
(1,800 x12/12) + (600 x 7/12) - (300 x 2/12) = 2,100 shares
In most cases, shares are included in the weighted average number of shares from
the date the consideration is receivable, for example:
a. Equity shares issued in exchange for cash are included when cash is
receivable;
b. Equity shares issued as a result of the conversion of a debt instrument to
equity shares are included as of the date of conversion;
c. Equity shares issued in lieu of interest or principal on other financial
instruments are included as of the date interest ceases to accrue;
d. Equity shares issued in exchange for the settlement of a liability of the
enterprise are included as of the date the settlement becomes effective;
e. Equity shares issued as consideration for the acquisition of an asset other
than cash are included as of the date on which the acquisition is recognised;
and
f. Equity shares issued for the rendering of services to the enterprise are
included as the services are rendered.
In these and other cases, the timing of the inclusion of equity shares is determined
by the specific terms and conditions attaching to their issue. Due consideration
should be given to the substance of any contract associated with the issue.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.101
ACCOUNTING STANDARDS v
v v
v
5.5 SHARES ISSUED IN A SCHEME v OF
AMALGAMATION
1. Equity shares issued as part of the consideration in an amalgamation in the
nature of purchase are included in the weighted average number of shares
as of the date of the acquisition because the transferee incorporates the
results of the operations of the transferor into its statement of profit and loss
as from the date of acquisition.
2. Equity shares issued as part of the consideration in an amalgamation in the
nature of merger are included in the calculation of the weighted average
number of shares from the beginning of the reporting period because the
financial statements of the combined enterprise for the reporting period are
prepared as if the combined entity had existed from the beginning of the
reporting period. Therefore, the number of equity shares used for the
calculation of basic earnings per share in an amalgamation in the nature of
merger is the aggregate of the weighted average number of shares of the
combined enterprises, adjusted to equivalent shares of the enterprise whose
shares are outstanding after the amalgamation.
Partly paid equity shares are treated as a fraction of an equity share to the extent
that they were entitled to participate in dividends relative to a fully paid equity
share during the reporting period.
Illustration 2
Date Particulars No. of Face Paid up
Shares Value Value
1st January Balance at beginning of year 1,800 ` 10 ` 10
31st October Issue of Shares 600 ` 10 ` 5
Calculate Weighted Number of Shares.
Solution
Assuming that partly paid shares are entitled to participate in the dividend to the
extent of amount paid, number of partly paid equity shares would be taken as 300
for the purpose of calculation of earnings per share.
© The Institute of Chartered Accountants of India
4.102 ADVANCED ACCOUNTING
Computation of weighted average would be as follows:
(1,800 x 12/12) + (300 x 2/12) = 1,850 shares.
Where an enterprise has equity shares of different nominal values but with the
same dividend rights, the number of equity shares is calculated by converting all
such equity shares into equivalent number of shares of the same nominal value.
Contingently Issuable Shares
Equity shares which are issuable upon the satisfaction of certain conditions resulting
from contractual arrangements (contingently issuable shares) are considered
outstanding, and included in the computation of basic earnings per share from the
date when all necessary conditions under the contract have been satisfied.
Bonus Issue, Share split and Right issue
Equity shares may be issued, or the number of shares outstanding may be reduced,
without a corresponding change in resources. Examples include:
a. A bonus issue;
b. A bonus element in any other issue, for example a bonus element in a rights
issue to existing shareholders;
c. A share split; and
d. A reverse share split (consolidation of shares).
In case of a bonus issue or a share split, equity shares are issued to existing
shareholders for no additional consideration. Therefore, the number of equity
shares outstanding is increased without an increase in resources. The number of
equity shares outstanding before the event is adjusted for the proportionate
change in the number of equity shares outstanding as if the event had occurred at
the beginning of the earliest period reported means along with the impact to
current year adjustment, it will also impact the calculation of EPS of last year
retrospectively.
For example, upon a two-for-one bonus issue, the number of shares outstanding
prior to the issue is multiplied by a factor of three to obtain the new total number
of shares, or by a factor of two to obtain the number of additional shares.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.103
ACCOUNTING STANDARDS v
v v
Illustration 3 v
v
Net profit for the year 20X1 ` 18,00,000
Net profit for the year 20X2 ` 60,00,000
No. of equity shares outstanding until 30th September 20X2 20,00,000
Bonus issue 1st October 20X2 was 2 equity shares for each equity share outstanding
at 30th September, 20X2
Calculate Basic Earnings Per Share.
Solution
No. of Bonus Issue 20,00,000 x 2 = 40,00,000 shares
` 60,00,000
Earnings per share for the year 20X2 = ` 1.00
( 20,00,000+ 40,00,000 )
` 18,00,000
Adjusted earnings per share for the year 20X1 = ` 0.30
( 20,00,000+ 40,00,000 )
Since the bonus issue is an issue without consideration, the issue is treated as if it
had occurred prior to the beginning of the year 20X1, the earliest period reported.
The issue of equity shares at the time of exercise or conversion of potential equity
shares will not usually give rise to a bonus element, since the potential equity shares
will usually have been issued for full value, resulting in a proportionate change in
the resources available to the enterprise. In a rights issue, on the other hand, the
exercise price is often less than the fair value of the shares. Therefore, a rights
issue usually includes a bonus element.
[Thus, it may be noted that if a company makes a right issue at fair value itself, then
there will be no bonus element in the right issue].
The number of equity shares to be used in calculating basic earnings per share for
all periods prior to the rights issue is the number of equity shares outstanding prior
to the issue, multiplied by the following adjustment factor:
Fair value per share immediately prior to the exercise of rights
Theoretical ex-rights fair value per share
© The Institute of Chartered Accountants of India
4.104 ADVANCED ACCOUNTING
The theoretical ex-rights fair value per share is calculated by adding the aggregate
fair value of the shares immediately prior to the exercise of the rights to the
proceeds from the exercise of the rights, and dividing by the number of shares
outstanding after the exercise of the rights.
Illustration 4
Net profit for the year 20X1 ` 11,00,000
Net profit for the year 20X2 ` 15,00,000
No. of shares outstanding prior to rights issue 5,00,000 shares
Rights issue price ` 15.00
Last date to exercise rights 1st March 20X2
Rights issue is one new share for each five outstanding (i.e. 1,00,000 new shares)
Fair value of one equity share immediately prior to exercise of rights on 1st March
20X2 was ` 21.00. Compute Basic Earnings Per Share.
Solution
Fair value of shares immediately prior to exercise of rights + Total amount received from exercise
Number of shares outstanding prior to exercise + Number of shares issued in the exercise
(` 21.00×5,00,000 shares) + ( ` 15.00 ×1,00,000 Shares)
5,00,000 Shares + 1,00,000 Shares
Theoretical ex-rights fair value per share = ` 20.00
Computation of adjustment factor:
Fair value per share prior to exercise of rights ` (21.00)
= 1.05
Theoretical ex-rights value per share ` (20.00)
Computation of earnings per share:
EPS for the year 20X1 as originally reported: ` 11,00,000/5,00,000 shares = 2.20
EPS for the year 20X1 restated for rights issue: ` 11,00,000/ (5,00,000 shares x 1.05)
= ` 2.10
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.105
ACCOUNTING STANDARDS v
v v
EPS for the year 20X2 including effects of rights issue: v
v
(5,00,000 x 1.05 x 2/12) + (6,00,000 x 10/12) = 5,87,500 shares
EPS = 15,00,000/5,87,500 = ` 2.55
5.6 DILUTED EARNINGS PER SHARE
In calculating diluted earnings per share, effect is given to all dilutive potential
equity shares that were outstanding during the period., that is:
a. The net profit for the period attributable to equity shares is:
i. Increased by the amount of dividends recognised in the period in
respect of the dilutive potential equity shares as adjusted for any
attributable change in tax expense for the period;
ii. Increased by the amount of interest recognised in the period in respect
of the dilutive potential equity shares as adjusted for any attributable
change in tax expense for the period; and
iii. Adjusted for the after-tax amount of any other changes in expenses or
income that would result from the conversion of the dilutive potential
equity shares.
b. The weighted average number of equity shares outstanding during the period
is increased by the weighted average number of additional equity shares
which would have been outstanding assuming the conversion of all dilutive
potential equity shares.
For the purpose of AS 20, share application money pending allotment or any
advance share application money as at the balance sheet date, which is not
statutorily required to be kept separately and is being utilised in the business of
the enterprise, is treated in the same manner as dilutive potential equity shares for
the purpose of calculation of diluted earnings per share.
Note:
As mentioned earlier, a partly paid-up share where the holder is not entitled to
dividends is treated as a potential equity share for the purposes of computing Diluted
EPS.
© The Institute of Chartered Accountants of India
4.106 ADVANCED ACCOUNTING
5.7 EARNINGS-DILUTED
For the purpose of calculating diluted earnings per share, the amount of net profit
or loss for the period attributable to equity shareholders, should be adjusted by
the following, after taking into account any attributable change in tax expense for
the period:
(a) any dividends on dilutive potential equity shares which have been deducted
in arriving at the net profit attributable to equity shareholders;
(b) interest recognised in the period for the dilutive potential equity shares; and
(c) any other changes in expenses or income that would result from the
conversion of the dilutive potential equity shares.
After the potential equity shares are converted into equity shares, the dividends,
interest and other expenses or income associated with those potential equity shares
will no longer be incurred (or earned). Instead, the new equity shares will be entitled
to participate in the net profit attributable to equity shareholders. Therefore, the
net profit for the period attributable to equity shareholders calculated in Basic
Earnings Per Share is increased by the amount of dividends, interest and other
expenses that will be saved, and reduced by the amount of income that will cease
to accrue, on the conversion of the dilutive potential equity shares into equity
shares. The amounts of dividends, interest and other expenses or income are
adjusted for any attributable taxes.
Illustration 5
Net profit for the current year ` 1,00,00,000
No. of equity shares outstanding 50,00,000
Basic earnings per share ` 2.00
No. of 12% convertible debentures of ` 100 each 1,00,000
Each debenture is convertible into 10 equity shares
Interest expense for the current year ` 12,00,000
Tax relating to interest expense (30%) ` 3,60,000
Compute Diluted Earnings Per Share.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.107
ACCOUNTING STANDARDS v
v v
Solution v
v
Adjusted net profit for the current year (1,00,00,000 + 12,00,000 – 3,60,000) =
` 1,08,40,000
No. of equity shares resulting from conversion of debentures: 10,00,000 Shares
No. of equity shares used to compute diluted EPS: (50,00,000 + 10,00,000)
= 60,00,000 Shares
Diluted earnings per share: (1,08,40,000/60,00,000) = ` 1.81
5.8 PER SHARE- DILUTED
For the purpose of calculating diluted earnings per share, the number of equity
shares should be the aggregate of the weighted average number of equity shares,
and the weighted average number of equity shares which would be issued on the
conversion of all the dilutive potential equity shares into equity shares. Dilutive
potential equity shares should be deemed to have been converted into equity
shares at the beginning of the period or, if issued later, the date of the issue of the
potential equity shares.
The number of equity shares which would be issued on the conversion of dilutive
potential equity shares is determined from the terms of the potential equity shares.
The computation assumes the most advantageous conversion rate or exercise price
from the standpoint of the holder of the potential equity shares.
Equity shares which are issuable upon the satisfaction of certain conditions
resulting from contractual arrangements (contingently issuable shares) are
considered outstanding and included in the computation of both the basic earnings
per share and diluted earnings per share from the date when the conditions under
a contract are met. If the conditions have not been met, for computing the diluted
earnings per share, contingently issuable shares are included as of the beginning
of the period (or as of the date of the contingent share agreement, if later). The
number of contingently issuable shares included in this case in computing the
diluted earnings per share is based on the number of shares that would be issuable
if the end of the reporting period was the end of the contingency period.
© The Institute of Chartered Accountants of India
4.108 ADVANCED ACCOUNTING
Restatement is not permitted if the conditions are not met when the contingency
period actually expires subsequent to the end of the reporting period. The provisions
of this paragraph apply equally to potential equity shares that are issuable upon the
satisfaction of certain conditions (contingently issuable potential equity shares).
Potential equity shares are weighted for the period they were outstanding.
Potential equity shares that were cancelled or allowed to lapse during the reporting
period are included in the computation of diluted earnings per share only for the
portion of the period during which they were outstanding. Potential equity shares
that have been converted into equity shares during the reporting period are
included in the calculation of diluted earnings per share from the beginning of the
period to the date of conversion; from the date of conversion, the resulting equity
shares are included in computing both basic and diluted earnings per share.
A quick recap of the timing factor when these potential equity shares will be
considered as a part of the denominator for weighted average computations.
Particulars From which date Till which date
Potential equity shares which were Beginning of the End of the year
issued last year and not yet converted year
into equity shares in current year
Potential equity shares which were Beginning of the End of the year
issued last year and have been year
(Till date of conversion
converted into equity shares in
as a potential equity
current year
share and after
conversion both as a
part of Basic and
Diluted EPS)
Potential equity shares which were Date of issue End of the year
issued in the current year and not yet
converted into equity shares in
current year
Potential equity shares which were Beginning of the Till the date of
issued last year and have been year cancellation or when
cancelled or have lapsed in current they lapse
year
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.109
ACCOUNTING STANDARDS v
v v
Diluted EPS in case of share options v
v
For the purpose of calculating diluted earnings per share, an enterprise should assume
the exercise of dilutive options and other dilutive potential equity shares of the
enterprise. The assumed proceeds from these issues should be considered to have
been received from the issue of shares at fair value. The difference between the
number of shares issuable and the number of shares that would have been issued at
fair value should be treated as an issue of equity shares for no consideration.
Options and other share purchase arrangements are dilutive when they would
result in the issue of equity shares for less than fair value. The amount of the
dilution is fair value less the issue price. Therefore, in order to calculate diluted
earnings per share, each such arrangement is treated as consisting of:
a. A contract to issue a certain number of equity shares at their average fair
value during the period. The shares to be so issued are fairly priced and are
assumed to be neither dilutive nor anti-dilutive. They are ignored in the
computation of diluted earnings per share; and
b. A contract to issue the remaining equity shares for no consideration. Such
equity shares generate no proceeds and have no effect on the net profit
attributable to equity shares outstanding. Therefore, such shares are dilutive
and are added to the number of equity shares outstanding in the
computation of diluted earnings per share.
Illustration 6
Net profit for the year 20X1 ` 12,00,000
Weighted average number of equity shares outstanding 5,00,000 shares
during the year 20X1
Average fair value of one equity share during the year 20X1 ` 20.00
Weighted average number of shares under option during the 1,00,000 shares
year 20X1
Exercise price for shares under option during the year 20X1 ` 15.00
Compute Basic and Diluted Earnings Per Share.
© The Institute of Chartered Accountants of India
4.110 ADVANCED ACCOUNTING
Solution
Computation of earnings per share
Earnings Shares Earnings/Share
` `
Net profit for the year 20X1 12,00,000
Weighted average no. of shares during 5,00,000
year 20X1
Basic earnings per share 2.40
Number of shares under option 1,00,000
Number of shares that would have
been issued at
fair value (100,000 x 15.00)/20.00 (75,000)
Diluted earnings per share 12,00,000 5,25,000 2.29
Note: The earnings have not been increased as the total number of shares has been
increased only by the number of shares (25,000) deemed for the purpose of the
computation to have been issued for no consideration.
5.9 DILUTIVE POTENTIAL EQUITY SHARES
Potential equity shares are anti-dilutive when their conversion to equity shares
would increase earnings per share from continuing ordinary activities or decrease
loss per share from continuing ordinary activities. The effects of anti-dilutive
potential equity shares are ignored in calculating diluted earnings per share.
Thus, it is important to note that the ‘control factor’ is the profit from continuing
ordinary activities.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.111
ACCOUNTING STANDARDS v
v v
In simple words, we can conclude as under: v
v
Particulars Remarks Is it to be taken as a part
of Diluted EPS or not?
Conversion to equity shares Dilutive Yes
would decrease earnings per
share from continuing
ordinary activities.
Conversion to equity shares Anti-dilutive No
would increase earnings per
share from continuing
ordinary activities.
Conversion to equity shares Dilutive Yes
would increase loss per share
from continuing ordinary
activities.
Conversion to equity shares Anti-dilutive No
would decrease loss per share
from continuing ordinary
activities.
Illustration 7
X Limited, during the year ended March 31, 20X1, has income from continuing
ordinary operations of ` 2,40,000, a loss from discontinuing operations of ` 3,60,000
and accordingly a net loss of ` 1,20,000. The Company has 1,000 equity shares and
200 potential equity shares outstanding as at March 31, 20X1.
You are required to compute Basic and Diluted EPS?
Solution
As per AS 20 “Potential equity shares should be treated as dilutive when, and only
when, their conversion to equity shares would decrease net profit per share from
continuing ordinary operations”.
As income from continuing ordinary operations, ` 2,40,000 would be considered
and not ` (1,20,000), for ascertaining whether 200 potential equity shares are
© The Institute of Chartered Accountants of India
4.112 ADVANCED ACCOUNTING
dilutive or anti-dilutive. Accordingly, 200 potential equity shares would be dilutive
potential equity shares since their inclusion would decrease the net profit per share
from continuing ordinary operations from ` 240 to ` 200. Thus, the basic E.P.S
would be ` (120) and diluted E.P.S. would be ` (100).
In case there are more than 1 potential equity shares:
In considering whether potential equity shares are dilutive or antidilutive, each
issue or series of potential equity shares is considered separately rather than in
aggregate. The sequence in which potential equity shares are considered may affect
whether or not they are dilutive. Therefore, in order to maximise the dilution of
basic earnings per share, each issue or series of potential equity shares is
considered in sequence from the most dilutive to the least dilutive. For the purpose
of determining the sequence from most dilutive to least dilutive potential equity
shares, the earnings per incremental potential equity share is calculated. Where the
earnings per incremental share is the least, the potential equity share is considered
most dilutive and vice-versa.
5.10 RESTATEMENT
If the number of equity or potential equity shares outstanding increases as a result
of a bonus issue or share split or decreases as a result of a reverse share split
(consolidation of shares), the calculation of basic and diluted earnings per share
should be adjusted for all the periods presented. If these changes occur after the
balance sheet date but before the date on which the financial statements are
approved by the board of directors, the per share calculations for those financial
statements and any prior period financial statements presented should be based
on the new number of shares. When per share calculations reflect such changes in
the number of shares, that fact should be disclosed.
5.11 PRESENTATION
An enterprise should present basic and diluted earnings per share on the face of
the statement of profit and loss for each class of equity shares that has a different
right to share in the net profit for the period. An enterprise should present basic
and diluted earnings per share with equal prominence for all periods presented.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.113
ACCOUNTING STANDARDS v
v v
v even
AS 20 requires an enterprise to present basic and diluted earnings per share,
if the amounts disclosed are negative (a loss per share). v
5.12 DISCLOSURE
An enterprise should disclose the following:
a. Where the statement of profit and loss includes extraordinary items (as
defined is AS 5), basic and diluted EPS computed on the basis of earnings
excluding extraordinary items (net of tax expense);
b. The amounts used as the numerators in calculating basic and diluted earnings
per share, and a reconciliation of those amounts to the net profit or loss for
the period;
c. The weighted average number of equity shares used as the denominator in
calculating basic and diluted earnings per share, and a reconciliation of these
denominators to each other; and
d. The nominal value of shares along with the earnings per share figures.
If an enterprise discloses, in addition to basic and diluted earnings per share, per
share amounts using a reported component of net profit other than net profit or
loss for the period attributable to equity shareholders, such amounts should be
calculated using the weighted average number of equity shares determined in
accordance with AS 20. If a component of net profit is used which is not reported
as a line item in the statement of profit and loss, a reconciliation should be provided
between the component used and a line item which is reported in the statement of
profit and loss. Basic and diluted per share amounts should be disclosed with equal
prominence.
© The Institute of Chartered Accountants of India
4.114 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. AB Company Ltd. had 1,00,000 shares of common stock outstanding on January
1. Additional 50,000 shares were issued on July 1, and 25,000 shares were re-
acquired on September 1. The weighted average number of shares outstanding
during the year on Dec. 31 is
(a) 1,40,000 shares
(b) 1,25,000 shares
(c) 1,16,667 shares
(d) 1,20,000 shares
2. As per AS 20, potential equity shares should be treated as dilutive when, and
only when, their conversion to equity shares would
(a) Decrease net profit per share from continuing ordinary operations.
(b) Increase net profit per share from continuing ordinary operations.
(c) Make no change in net profit per share from continuing ordinary
operations.
(d) Decrease net loss per share from continuing ordinary operations.
3. As per AS 20, equity shares which are issuable upon the satisfaction of certain
conditions resulting from contractual arrangements are
(a) Dilutive potential equity shares
(b) Contingently issuable shares
(c) Contractual issued shares
(d) Potential equity shares
4. In case potential equity shares have been cancelled during the year, they should
be:
(a) Ignored for computation of Diluted EPS.
(b) Considered from the beginning of the year till the date they are cancelled.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.115
ACCOUNTING STANDARDS v
v v
(c) v
The company needs to make an accounting policy and can follow the
treatment in (a) or (b) as it decides. v
(d) Considered for computation of diluted EPS only if the impact of such
potential equity shares would be material.
5. Partly paid up equity shares are:
(a) Always considered as a part of Basic EPS.
(b) Always considered as a part of Diluted EPS.
(c) Depending upon the entitlement of dividend to the shareholder, it will be
considered as a part of Basic or Diluted EPS as the case may be.
(d) Considered as part of Basic/ Diluted EPS depending on the accounting
policy of the company.
Theoretical Questions
6. In the following list of shares issued, for the purpose of calculation of weighted
average number of shares, from which date weight is to be considered:
(i) Equity Shares issued in exchange of cash,
(ii) Equity Shares issued as a result of conversion of a debt instrument,
(iii) Equity Shares issued in exchange for the settlement of a liability of the
enterprise,
(iv) Equity Shares issued for rendering of services to the enterprise,
(v) Equity Shares issued in lieu of interest and/or principal of an other
financial instrument,
(vi) Equity Shares issued as consideration for the acquisition of an asset other
than in cash.
Also define Potential Equity Share.
7. Stock options have been granted by AB Limited to its employees and they vest
equally over 5 years, i.e., 20 per cent at the end of each year from the date of
grant. The options will vest only if the employee is still employed with the
company at the end of the year. If the employee leaves the company during the
vesting period, the options that have vested can be exercised, while the others
© The Institute of Chartered Accountants of India
4.116 ADVANCED ACCOUNTING
would lapse. Currently, AB Limited includes only the vested options for
calculating Diluted EPS.
Should only completely vested options be included for computation of Diluted
EPS? Is this in accordance with the provisions of AS 20? Explain.
8. Explain why the bonus issue of shares and the shares issue at full market price
are treated differently in the calculation of the basic earnings per share?
Scenario based Question
9 NAT, a listed entity, as on 1st April, 20X1 had the following capital structure:
Particulars `
10,00,000 Equity Shares having face value of ` 1 each 10,00,000
10,00,000 8% Preference Shares having face value of ` 10 each 1,00,00,000
During the year 20X1-20X2, the company had profit after tax of Rs. 90,00,000.
On 1st January, 20X2, NAT made a bonus issue of one equity share for every 2
equity shares outstanding as at 31st December, 20X1.
On 1st January, 20X2, NAT issued 2,00,000 equity shares of Rs. 1 each at their
full market price of Rs. 7.60 per share.
NAT's shares were trading at Rs. 8.05 per share on 31st March, 20X2.
Further it has been provided that the basic earnings per share for the year
ended 31st March, 20X1 was previously reported at Rs. 62.30.
You are required to:
(i) Calculate the basic earnings per share to be reported in the financial
statements of NAT for the year ended 31st March, 20X2 including the
comparative figure, in accordance with AS-20 Earnings Per Share.
(ii) Explain why the bonus issue of shares and the shares issue at full market
price are treated differently in the calculation of the basic earnings per
share?
10. X Ltd. supplied the following information. You are required to compute the
basic earnings per share:
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.117
ACCOUNTING STANDARDS v
v v
(Accounting year 1.1.20X1– 31.12.20X1) v
v
Net Profit : Year 20X1: ` 20,00,000
: Year 20X2: ` 30,00,000
No. of shares outstanding prior to : 10,00,000 shares
Right Issue
Right Issue : One new share for each four
outstanding i.e., 2,50,000
shares.
Right Issue price – ` 20
Last date of exercise rights–
31.3.20X2.
Fair rate of one Equity share : ` 25
immediately prior to exercise of rights
on 31.3.20X2
11. On 1st April, 20X1 a company had 6,00,000 equity shares of ` 10 each ( ` 5 paid
up by all shareholders). On 1 st September, 20X1 the remaining ` 5 was called
up and paid by all shareholders except one shareholder having 60,000 equity
shares. The net profit for the year ended 31 st March, 20X2 was ` 21,96,000 after
considering dividend on preference shares of ` 3,40,000.
You are required to compute Basic EPS for the year ended 31 st March, 20X2 as
per Accounting Standard 20 "Earnings Per Share".
12. No. of equity shares outstanding = 30,00,000
Basic earnings per share ` 5.00
No. of 12% convertible debentures of ` 100 each; 50,000
Each debenture is convertible into 10 equity shares
Tax Rate 30%
Compute Diluted Earnings per Share.
Working notes should form part of the answer.
© The Institute of Chartered Accountants of India
4.118 ADVANCED ACCOUNTING
13. Following information is supplied by K Ltd.:
Number of shares outstanding prior to right issue - 2,50,000 shares.
Right issue - two new share for each 5 outstanding shares (i.e. 1,00,000 new
shares)
Right issue price - ` 98
Last date of exercising rights - 30-06-20X2.
Fair value of one equity share immediately prior to exercise of right on
30-06-20X2 is ` 102.
Net Profit to equity shareholders:
20X1-20X2 - ` 50,00,000
20X2-20X3 -` 75,00,000
You are required to calculate the basic earnings per share as per AS-20
Earnings per Share.
ANSWERS/HINTS
Answers to the Multiple Choice Questions
1. (c) 2. (a) 3. (b) 4. (b) 5. (c)
Answers to the Theoretical Questions
6. The following dates should be considered for consideration of weights for the
purpose of calculation of weighted average number of shares in the given
cases:
(i) Date of Cash receivable
(ii) Date of conversion
(iii) Date on which settlement becomes effective
(iv) When the services are rendered
(v) Date when interest ceases to accrue
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ACCOUNTING STANDARDS v
v v
(vi) Date on which the acquisition is recognised. v
v
A Potential Equity Share is a financial instrument or other contract that
entitles or may entitle its holder to equity shares.
7. As per AS 20 “A potential equity share is a financial instrument or other
contract that entitles, or may entitle, its holder to equity shares”.
Options including employee stock option plans under which employees of an
enterprise are entitled to receive equity shares as part of their remuneration
and other similar plans are examples of potential equity shares. Further, for
the purpose of calculating diluted earnings per share, the net profit or loss
for the period attributable to equity shareholders and the weighted average
number of shares outstanding during the period should be adjusted for the
effects of all dilutive potential equity shares.
The current method of calculating Diluted EPS adopted by AB limited is not
in accordance with AS 20. The calculation of Diluted EPS should include all
potential equity shares, i.e., all the stock options granted at the balance sheet
date, which are dilutive in nature, irrespective of the vesting pattern. The
options that have lapsed during the year should be included for the portion
of the period the same were outstanding, pursuant to the requirement of the
standard.
8. In case of a bonus issue, equity shares are issued to existing shareholders for
no additional consideration. Therefore, the number of equity shares
outstanding is increased without an increase in resources. Since the bonus
issue is an issue without consideration, the issue is treated as if it had occurred
prior to the beginning of the earliest period reported.
However, the share issued at full market price does not carry any bonus
element and usually results in a proportionate change in the resources
available to the enterprise. Therefore, it is taken into consideration from the
time it has been issued i.e. the time- weighting factor is considered based on
the specific shares outstanding as a proportion of the total number of days
in the period.
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Answers to the Scenario based Question
9. (i) Computation of Basic Earnings per share for the year ended 31 st
March, 20X2:
(including the comparative figure)
Working Note – I:
Earnings for the year ended 31st March, 20X1:
= EPS x Number of shares outstanding during 20X0-20X1
= ` 62.30 x 10,00,000 equity shares
= ` 6,23,00,000
Adjusted/Restated Earnings per share for the year ended 31 st March
20X1:
(after taking into consideration bonus issue)
Adjusted/Restated Basic EPS:
= Earnings for the year 20X0-20X1 / (Total outstanding shares +Bonus
issue)
= ` 6,23,00,000 / (10,00,000+ 5,00,000)
= ` 6,23,00,000 / 15,00,000
= ` 41.53 per share
Computation of Basic EPS for the year 20X1-20X2:
Basic EPS = (Total Earnings – Preference Shares Dividend) / (Total shares
outstanding at the beginning + Bonus issue + weighted average of the
shares issued in January, 20X2)
= (` 90,00,000 – ` (1,00,00,000 x 8%)) / (10,00,000 + 5,00,000 +
(2,00,000 x 3/12))
= ` 82,00,000 / 15,50,000 shares
= ` 5.29 per share
(ii) In case of a bonus issue, equity shares are issued to existing
shareholders for no additional consideration. Therefore, the number of
equity shares outstanding is increased without an increase in resources.
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ACCOUNTING STANDARDS v
v v
Since the bonus issue is an issue without consideration, the vissue is
v
treated as if it had occurred prior to the beginning of the year 20X1, the
earliest period reported.
However, the share issued at full market price does not carry any bonus
element and usually results in a proportionate change in the resources
available to the enterprise. Therefore, it is taken into consideration from the
time it has been issued i.e. the time- weighting factor is considered based on
the specific shares outstanding as a proportion of the total number of days
in the period.
10. Computation of Basic Earnings Per Share
(as per paragraphs 10 and 26 of AS 20 on Earnings Per Share)
Year 20X1 Year 20X2
` `
EPS for the year 20X1 as originally reported
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑎𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑎𝑏𝑙𝑒 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
= (` 20,00,000 / 10,00,000 shares) 2.00
EPS for the year 20X1 restated for rights issue
= [` 20,00,000 / (10,00,000 shares 1.04 )] 1.91
(approx.)
EPS for the year 20X2 including effects of rights
issue
` 30,00,000
(10,00,000shares 1.04 3/12) + (12,50,000shares 9/12)
` 30,00,000 2.51
11,97,500 shares (approx.)
Refer working note 2.
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4.122 ADVANCED ACCOUNTING
Working Notes:
1. Computation of theoretical ex-rights fair value per share
Fair value of all outstanding shares immediately prior to
exercise of rights + Total amount received from exercise
Number of shares outstanding prior to exercise+
Number of shares issued in the excercise
=
( ` 25 ×10,00,000 shares) + ( ` 20 × 2,50,000 shares )
10,00,000 shares + 2,50,000 shares
` 3,00,00,000
= = ` 24
12,50,000 shares
2. Computation of adjustment factor
Fair value per share prior to exercise of rights
=
Theoretical ex-rights value per share
` 25
= =1.04 (approx.)
` 24 (Refer Working Note 1)
11. Basic Earnings per share (EPS) =
Net profit attributable to equity shareholders
Weighted average number of equity shares outstanding during the year
21,96,000 = ` 4.80 per share
=
4,57,500 Shares (as per working note)
Working Note:
Calculation of weighted average number of equity shares
As per AS 20 ‘Earnings Per Share’, partly paid equity shares are treated as a
fraction of equity share to the extent that they were entitled to participate in
dividend relative to a fully paid equity share during the reporting period.
Assuming that the partly paid shares are entitled to participate in the dividend
to the extent of amount paid, weighted average number of shares will be
calculated as follows:
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ACCOUNTING STANDARDS v
v v
Date No. of Amount v
Weighted average no. of equity
equity paid per v
shares
shares share
` ` `
1.4.20X1 6,00,000 5 6,00,000 х 5/10 х 5/12 = 1,25,000
1.9.20X1 5,40,000 10 5,40,000 х 7/12 = 3,15,000
1.9.20X1 60,000 5 60,000 х 5/10 х 7/12 = 17,500
Total weighted average equity shares 4,57,500
12. Earnings for the year:
= No. of Shares x Basic EPS
= 30,00,000 shares x ` 5 per share = ` 1,50,00,000
Computation of Adjusted Net Profit:
= Earnings for the year + Interest on debentures net of tax
= 1,50,00,000 + (6,00,000 - 1,80,000) = ` 1,54,20,000
Computation of Adjusted Denominator:
No. of equity shares resulting from conversion of debentures:
= 50,000 x 10 shares = 5,00,000 shares
No. of equity shares for diluted EPS = 30,00,000 + 5,00,000
= 35,00,000 shares
Computation of Diluted EPS:
= ` 1,54,20,000/35,00,000 shares = ` 4.4 per share.
Fair value of shares immediately prior to exercise of rights + Total amount received from exercise
13.
Number of shares outstanding prior to exercise + Number of shares issued in the exercise
102 x 2,50,000 Shares + ` 98 x 1,00,000 shares
3,50,000 shares
Theoretical ex-rights fair value per share = ` 100.86
Computation of adjustment factor:
Fair value per share prior to exercise of rights
= 102/100.86 = 1.01
Theoretical ex - rights value per share
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4.124 ADVANCED ACCOUNTING
Computation of earnings per share:
EPS for the year 20X1-X2 as originally reported: ` 50,00,000/2,50,000 shares = ` 20
EPS for the year 20X1-X2 restated for rights issue: =` 50,00,000/ (2,50,000
shares x 1.01)
= ` 19.80
EPS for the year 20X2-X3 including effects of rights issue:
EPS = 75,00,000/3,25,625* = ` 23.03
* [(2,50,000 x 1.01 x 3/12) + (3,50,000 x 9/12)] =63,125 + 2,62,500 = 3,25,625 shares
Note: Financial year (ended 31st March) is considered as accounting year while
giving the above answer.
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ACCOUNTING STANDARDS v
v v
UNIT 6: ACCOUNTING STANDARD 24 v
v
DISCONTINUING OPERATIONS
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the following:
Meaning of Discontinuing Operation;
Definition of Initial Disclosure Event;
Recognition and Measurement principles;
Presentation and Disclosures as required under the standard.
6.1 INTRODUCTION
Imagine that a large company selling several products in the market decides to
discontinue the sale of one of its key product as it plans to sell that portion of its
business to another entity.
Ideally, this information should be disclosed to primary stakeholders as they would
take economic decisions based on the performance of the remaining portion of the
business that is expected to be continued by the company in future. Therefore, the
presentation requirements of such discontinuing operations becomes relevant and
the aspects of AS 24 need to be understood. AS 24 is applicable to all discontinuing
operations.
The objective of AS 24 is to establish principles for reporting information about
discontinuing operations, thereby enhancing the ability of users of financial
statements to make projections of an enterprise's cash flows, earnings-generating
capacity, and financial position by segregating information about discontinuing
operations from information about continuing operations.
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6.2 DISCONTINUING OPERATION
A discontinuing operation is a component of an enterprise:
(a) That the enterprise, pursuant to a single plan, is:
(i) Disposing of substantially in its entirety, such as by selling the
component in a single transaction or by demerger or spin-off of
ownership of the component to the enterprise's shareholders; or
(ii) Disposing of piecemeal, such as by selling off the component's assets
and settling its liabilities individually; or
(iii) Terminating through abandonment; and
(b) That represents a separate major line of business or geographical area of
operations.
(c) That can be distinguished operationally and for financial reporting purposes.
Example 1
Co XY runs a famous chain of restaurants. It decides to sell its stake in one of the
restaurant. This restaurant contributes around 5% of total revenue to the entire
business. XY does not intend to sell any other restaurant as part of its strategy.
In the above case, the sale of one restaurant out of the chain does not constitute
disposal of business under a single plan, or a portion that represents a major line
of business or geographical area of operations. Thus, it cannot be regarded as a
discontinuing operation.
Example 2
Group MN operates in various industries including Hotels, Airlines and Software
through its subsidiaries. It has decided to sell its Airline business to be able to
concentrate on other verticals. As a result, it has started to sell its aircrafts and
paying off the associated liabilities. During the year, it has sold off 5 aircrafts out
of the fleet of 50 aircrafts so far as part of the sale. The Airline business constitutes
25% of total group revenue.
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ACCOUNTING STANDARDS v
v v
v
In the above case, Airline business may be considered as discontinuing operation.
v that
This is due to the fact that the assets are sold off as part of a single plan, and
the business represents a separate major line of business, and can be distinguished
both operationally and for financial reporting purposes.
Separate major line of business or geographical area of operations:
A reportable business segment or geographical segment as defined in AS 17
‘Segment Reporting’, would normally satisfy criteria and it would represent a
separate major line of business or geographical area of operations.
A part of such a segment may also satisfy criteria and it would represent a
separate major line of business or geographical area of operations
For an enterprise that operates in a single business or geographical segment
which does not report segment information, a major product or service line
may also satisfy the criteria (see example below)
Example 3
Entity RT operates in a single state and is trading in 3 products – X, Y and Z. Details
with respect to the performance of each of the products are as under:
Particulars X Y Z Total
Sales 1,00,000 14,00,000 20,00,000 35,00,000
Cost of Goods Sold (80,000) (10,80,000) (14,40,000) (26,00,000)
Gross Margin 20,000 3,20,000 5,60,000 9,00,000
Operational Expenses (15,000) (1,70,000) (3,60,000) (5,45,000)
Profit before Tax 5,000 1,50,000 2,00,000 3,55,000
RT has decided to sell the business relating to Product Y to another entity. Since
Product Y constitutes a major product, it may be considered as a discontinuing
operations.
Instead of disposing of a component substantially in its entirety, an enterprise may
discontinue and dispose of the component by selling its assets and settling its
liabilities piecemeal (individually or in small groups). For piecemeal disposals, while
the overall result may be a net gain or a net loss, the sale of an individual asset or
settlement of an individual liability may have the opposite effect. Moreover, there
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is no specific date at which an overall binding sale agreement is entered into.
Rather, the sales of assets and settlements of liabilities may occur over a period of
months or perhaps even longer. Thus, disposal of a component may be in progress
at the end of a financial reporting period. To qualify as a discontinuing operation,
the disposal must be pursuant to a single coordinated plan.
An enterprise may terminate an operation by abandonment without substantial
sales of assets. An abandoned operation would be a discontinuing operation if it
satisfies the criteria in the definition. However, changing the scope of an operation
or the manner in which it is conducted is not abandonment because that operation,
although changed, is continuing.
Example 4
GH, a large car manufacturing company, decides to discontinue its manufacturing
operations relating to the diesel cars production. It plans to restructure the business
by revamping its existing operations, and starting new manufacturing process for
manufacture and sale of electric vehicles.
In the above example, it needs to be evaluated whether the restructuring is a result
of continuing operations, or termination of existing operations, and accordingly it
can be concluded whether it is a case of discontinuing operations or not.
Examples of activities that do not necessarily satisfy criterion (a) of the definition,
but that might do so in combination with other circumstances, include:
(a) Gradual or evolutionary phasing out of a product line or class of service;
(b) Discontinuing, even if relatively abruptly, several products within an ongoing
line of business;
(c) Shifting of some production or marketing activities for a particular line of
business from one location to another; and
(d) Closing of a facility to achieve productivity improvements or other cost
savings.
An example in relation to consolidated financial statements is selling a subsidiary
whose activities are similar to those of the parent or other subsidiaries.
A component can be distinguished operationally and for financial reporting
purposes - criterion (c) of the definition of a discontinuing operation - if all the
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ACCOUNTING STANDARDS v
v v
following conditions are met: v
v
(a) The operating assets and liabilities of the component can be directly
attributed to it.
(b) Its revenue can be directly attributed to it.
(c) At least a majority of its operating expenses can be directly attributed to it.
Assets, liabilities, revenue, and expenses are directly attributable to a component if
they would be eliminated when the component is sold, abandoned or otherwise
disposed of. If debt is attributable to a component, the related interest and other
financing costs are similarly attributed to it.
Discontinuing operations are infrequent events, but this does not mean that all
infrequent events are discontinuing operations.
The fact that a disposal of a component of an enterprise is classified as a
discontinuing operation under AS 24 does not, in itself, bring into question the
enterprise's ability to continue as a going concern.
6.3 INITIAL DISCLOSURE EVENT
With respect to a discontinuing operation, the initial disclosure event is the
occurrence of one of the following, whichever occurs earlier:
(a) The enterprise has entered into a binding sale agreement for substantially all
of the assets attributable to the discontinuing operation; or
(b) The enterprise's board of directors or similar governing body has both
(i) approved a detailed, formal plan for the discontinuance and
(ii) made an announcement of the plan.
A detailed, formal plan for the discontinuance normally includes:
identification of the major assets to be disposed of;
the expected method of disposal;
the period expected to be required for completion of the disposal;
the principal locations affected;
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4.130 ADVANCED ACCOUNTING
the location, function, and approximate number or employees who will be
compensated for terminating their services; and
the estimated proceeds or salvage to be realised by disposal.
An enterprise’s board of directors or similar governing body is considered to have
made the announcement of a detailed, formal plan for discontinuance, if it has
announced the main features of the plan to those affected by it, such as, lenders,
stock exchanges, trade payables, trade unions, etc. in a sufficiently specific manner
so as to make the enterprise demonstrably committed to the discontinuance.
6.4 RECOGNITION AND MEASUREMENT
For recognising and measuring the effect of discontinuing operations, this AS does
not provide any guidelines, but for the purpose the relevant Accounting Standards
should be referred.
6.5 PRESENTATION AND DISCLOSURE
6.5.1 Initial Disclosure
An enterprise should include the following information relating to a discontinuing
operation in its financial statements beginning with the financial statements for the
period in which the initial disclosure event occurs:
(a) A description of the discontinuing operation(s);
(b) The business or geographical segment(s) in which it is reported as per AS 17;
(c) The date and nature of the initial disclosure event;
(d) The date or period in which the discontinuance is expected to be completed
if known or determinable;
(e) The carrying amounts, as of the balance sheet date, of the total assets to be
disposed of and the total liabilities to be settled;
(f) The amounts of revenue and expenses in respect of the ordinary activities
attributable to the discontinuing operation during the current financial
reporting period;
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ACCOUNTING STANDARDS v
v v
(g) v
The amount of pre-tax profit or loss from ordinary activities attributable to
v
the discontinuing operation during the current financial reporting period, and
the income tax expense related thereto;
(h) The amounts of net cash flows attributable to the operating, investing, and
financing activities of the discontinuing operation during the current financial
reporting period;
6.5.2 Disclosures Other Than Initial Disclosures Note
All the disclosures above should be presented in the notes to the financial
statements except for amounts pertaining to pre-tax profit/loss of the
discontinuing operation and the income tax expense thereon (second last bullet
above) which should be shown on the face of the statement of profit and loss.
6.5.3 Other disclosures
When an enterprise disposes of assets or settles liabilities attributable to a
discontinuing operation or enters into binding agreements for the sale of such
assets or the settlement of such liabilities, it should include, in its financial
statements, the following information when the events occur:
(a) For any gain or loss that is recognised on the disposal of assets or settlement
of liabilities attributable to the discontinuing operation, (i) the amount of the
pre-tax gain or loss and (ii) income tax expense relating to the gain or loss
and
(b) The net selling price or range of prices (which is after deducting expected
disposal costs) of those net assets for which the enterprise has entered into
one or more binding sale agreements, the expected timing of receipt of those
cash flows and the carrying amount of those net assets on the balance sheet
date.
6.6 UPDATING THE DISCLOSURES
In addition to these disclosures, an enterprise should include, in its financial
statements, for periods subsequent to the one in which the initial disclosure event
occurs, a description of any significant changes in the amount or timing of cash
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flows relating to the assets to be disposed or liabilities to be settled and the events
causing those changes.
The disclosures should continue in financial statements for periods up to and
including the period in which the discontinuance is completed. Discontinuance is
completed when the plan is substantially completed or abandoned, though full
payments from the buyer(s) may not yet have been received.
If an enterprise abandons or withdraws from a plan that was previously reported as
a discontinuing operation, that fact, reasons therefore and its effect should be
disclosed.
6.7 SEPARATE DISCLOSURE FOR EACH
DISCONTINUING OPERATION
Any disclosures required by AS 24 should be presented separately for each
discontinuing operation.
6.8 PRESENTATION OF THE REQUIRED
DISCLOSURES
The above disclosures should be presented in the notes to the financial statements
except the following which should be shown on the face of the statement of profit
and loss:
(a) The amount of pre-tax profit or loss from ordinary activities attributable to
the discontinuing operation during the current financial reporting period, and
the income tax expense related thereto; and
(b) The amount of the pre-tax gain or loss recognised on the disposal of assets
or settlement of liabilities attributable to the discontinuing operation.
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ACCOUNTING STANDARDS v
v v
v
v
6.9 RESTATEMENT OF PRIOR PERIODS
Comparative information for prior periods that is presented in financial statements
prepared after the initial disclosure event should be restated to segregate assets,
liabilities, revenue, expenses, and cash flows of continuing and discontinuing
operations in a manner similar to that mentioned above.
6.10 DISCLOSURE IN INTERIM FINANCIAL
REPORTS
Disclosures in an interim financial report in respect of a discontinuing operation
should be made in accordance with AS 25, ‘Interim Financial Reporting’, including:
(a) Any significant activities or events since the end of the most recent annual
reporting period relating to a discontinuing operation and
(b) Any significant changes in the amount or timing of cash flows relating to the
assets to be disposed or liabilities to be settled.
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. AB decided to dispose of its Clothing division as part of its long-term strategy.
(a) Date of Board approval - 1st March 20X1;
(b) Date of formal announcement made to affected parties - 15th March 20X1.
(c) Date of Binding Sale agreement – 1st July 20X1;
(d) Reporting date – 31st March 20X1
The date of initial disclosure event would be:
(a) 1st March 20X1
(b) 15th March 20X1
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4.134 ADVANCED ACCOUNTING
(c) 31st March 20X1
(d) 31st July 20X1
2. To qualify as a component that can be distinguished operationally and for
financial reporting purposes, the condition(s) to be met is (are):
(a) The operating assets and liabilities of the component can be directly
attributed to it.
(b) Its revenue can be directly attributed to it.
(c) At least a majority of its operating expenses can be directly attributed to it.
(d) All of the above
3. Identify which of the following statements is incorrect?
(a) A discontinuing operation is a component of an enterprise that represents
a separate major line of business or geographical area of operations.
(b) A discontinuing operation is a component of an enterprise that can be
distinguished operationally and for financial reporting purposes.
(c) A discontinuing operation is a component of an enterprise that may or
may not be distinguished operationally and for financial reporting
purposes.
(d) A discontinuing operation may be disposed of in its entirety or piecemeal,
but always pursuant to an overall plan to discontinue the entire
component.
4. Identify the incorrect statement.
(a) Discontinuing operations are infrequent events, but this does not mean
that all infrequent events are discontinuing operations.
(b) The fact that a disposal of a component of an enterprise is classified as a
discontinuing operation under AS 24 would always raise a question
regarding the enterprise's ability to continue as a going concern.
(c) For recognising and measuring the effect of discontinuing operations, AS
24 does not provide any guidelines, but for the purpose the relevant
Accounting Standards should be referred.
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ACCOUNTING STANDARDS v
v v
(d) v
An enterprise shall include a description of the discontinuing operation,
in its financial statements beginning with the financial statementsv for the
period in which the initial disclosure event occurs.
Theoretical Questions
5. (i) What are the disclosure and presentation requirements of AS 24 for
discontinuing operations?
(ii) Give four examples of activities that do not necessarily satisfy criterion
(a) of paragraph 3 of AS 24, but that might do so in combination with
other circumstances.
6. What are the initial disclosure requirements of AS 24 for discontinuing
operations?
Scenario based Question
7. Rohini Limited is in the business of manufacture of passenger cars and
commercial vehicles. The Company is working on a strategic plan to close the
production of passenger cars and to produce only commercial vehicles over the
coming 5 years. However, no specific plans have been drawn up for sale of
neither the division nor its assets. As part of its prospective plan it will reduce
the production of passenger cars by 20% annually. It also plans to establish
another new factory for the manufacture of commercial vehicles and transfer
surplus employees in a phased manner.
You are required to comment:
(i) If mere gradual phasing out in itself can be considered as a 'discontinuing
operation' within the meaning of AS-24.
(ii) If the Company passes a resolution to sell some of the assets in the
passenger car division and also to transfer few other assets of the
passenger car division to the new factory, does this trigger the application
of AS-24?
(iii) Would your answer to (ii) above be different if the Company resolves to
sell the assets of the passenger car division in a phased but time bound
manner?
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8. A consumer goods producer has changed the product line as follows:
Dish washing Clothes washing
Bar Bar
(Per month) (Per month)
January 2021 - September 2021 2,00,000 2,00,000
October 2021 - December 2021 1,00,000 3,00,000
January 2022 - March 2022 Nil 4,00,000
The company has enforced a gradual enforcement of change in product line on
the basis of an overall plan. The Board of Directors has passed a resolution in
March 2021 to this effect. The company follows calendar year as its accounting
year.
You required to advise the company whether it should be treated as
discontinuing operation or not as per AS 24?
ANSWERS/HINTS
Answers to the Multiple Choice Questions
1. (b) 2. (d) 3. (c) 4. (b)
Answers to the Theoretical Questions
5. (i) An enterprise should include prescribed information relating to a
discontinuing operation in its financial statements beginning with the
financial statements for the period in which the initial disclosure event
(as defined in paragraph 15 of AS 24) occurs. For details, please refer
Section 6.5 of this Chapter above.
(ii) Examples of activities that do not necessarily satisfy criterion (a) of the
definition, but that might do so in combination with other circum-
stances, include:
(a) Gradual or evolutionary phasing out of a product line or class of
service;
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ACCOUNTING STANDARDS v
v v
(b) Discontinuing, even if relatively abruptly, several productsv within
an ongoing line of business; v
(c) Shifting of some production or marketing activities for a particular
line of business from one location to another; and
(d) Closing of a facility to achieve productivity improvements or other
cost savings.
6. An enterprise should include the following information relating to a
discontinuing operation in its financial statements beginning with the
financial statements for the period in which the initial disclosure event occurs:
(a) A description of the discontinuing operation(s)
(b) The business or geographical segment(s) in which it is reported as per
AS 17.
(c) The date and nature of the initial disclosure event.
(d) The date or period in which the discontinuance is expected to be
completed if known or determinable
(e) The carrying amounts, as of the balance sheet date, of the total assets
to be disposed of and the total liabilities to be settled.
(f) The amounts of revenue and expenses in respect of the ordinary
activities attributable to the discontinuing operation during the current
financial reporting period.
(g) The amount of pre-tax profit or loss from ordinary activities attributable
to the discontinuing operation during the current financial reporting
period, and the income tax expense related thereto.
(h) The amounts of net cash flows attributable to the operating, investing,
and financing activities of the discontinuing operation during the
current financial reporting period.
© The Institute of Chartered Accountants of India
4.138 ADVANCED ACCOUNTING
Answer to the Scenario based Question
7. (i) A discontinuing operation is a component of an enterprise:
(a) that the enterprise, pursuant to a single plan, is:
(i) disposing of substantially in its entirety, such as by selling
the component in a single transaction or by demerger or
spin-off of ownership of the component to the enterprise's
shareholders; or
(ii) disposing of piecemeal, such as by selling off the
component's assets and settling its liabilities individually; or
(iii) terminating through abandonment; and
(b) that represents a separate major line of business or geographical
area of operations; and
(c) that can be distinguished operationally and for financial reporting
purposes.
Mere gradual phasing out is not considered as discontinuing operation
as defined under AS 24, ‘Discontinuing Operations’.
Examples of activities that do not necessarily satisfy criterion of the
definition, but that might do so in combination with other
circumstances, include:
(i) Gradual or evolutionary phasing out of a product line or class of
service;
(ii) Shifting of some production or marketing activities for a particular
line of business from one location to another; and
(iii) Closing of a facility to achieve productivity improvements or other
cost savings. In this case, it cannot be considered as Discontinuing
Operation as per AS-24 as the companies’ strategic plan has no
final approval from the board through a resolution and there is
no specific time bound activities like shifting of assets and
employees. Moreover, the new segment i.e. commercial vehicle
production line in a new factory has not started.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.139
ACCOUNTING STANDARDS v
v v
(ii) No, the resolution is silent about stoppage of the Car segment
v in
definite time period. Though, sale of some assets and some vtransfer
proposal were passed through a resolution to the new factory, but the
closure road map and new segment starting roadmap are missing.
Hence AS 24 will not be applicable and it cannot be considered as
Discontinuing operations.
(iii) Yes, phased and time bound program resolved in the board clearly
indicates the closure of the passenger car segment in a definite time
frame and will constitute a clear roadmap.
Hence this action will attract compliance of AS 24 and it will be
considered as Discontinuing Operations as per AS-24.
8. As per AS 24 ‘Discontinuing Operations’, a discontinuing operation is a
component of an enterprise:
(i) that the enterprise, pursuant to a single plan, is:
(1) disposing of substantially in its entirety,
(2) disposing of piecemeal, or
(3) terminating through abandonment; and
(ii) that represents a separate major line of business or geographical area
of operations; and
(iii) that can be distinguished operationally and for financial reporting
purposes.
As per provisions of the standard, business enterprises frequently close
facilities, abandon products or even product lines, and change the size of
their work force in response to market forces. While those kinds of
terminations generally are not, in themselves, discontinuing operations, they
can occur in connection with a discontinuing operation. Examples of activities
that do not necessarily satisfy criterion of discontinuing operation are gradual
or evolutionary phasing out of a product line or class of service,
discontinuing, even if relatively abruptly, several products within an ongoing
line of business;
© The Institute of Chartered Accountants of India
4.140 ADVANCED ACCOUNTING
In the given case, the company has enforced a gradual enforcement of
change in product line and does not represent a separate major line of
business and hence is not a discontinued operation. If it were a discontinuing
operation, the initial disclosure event is the occurrence of one of the
following, whichever occurs earlier:
(i) the enterprise has entered into a binding sale agreement for
substantially all of the assets attributable to the discontinuing
operation; or
(ii) the enterprises board of directors or similar governing body has both
approved a detailed, formal plan for discontinuance and made an
announcement of the plan.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.141
ACCOUNTING STANDARDS v
v v
UNIT 7: ACCOUNTING STANDARD 25 INTERIM
v
v
FINANCIAL REPORTING
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the following:
Objective and scope of AS 25
Content of an Interim Financial Report
Minimum Components of an Interim Financial Report
Form and Content of Interim Financial Statements
Selected Explanatory Notes
Periods for which Interim Financial Statements are required to be
presented
Disclosure in Annual Financial Statements
Recognition and Measurement principles as per the Standard.
7.1 INTRODUCTION
AS 25 does not mandate which enterprises should be required to present interim
financial reports, how frequently, or how soon after the end of an interim period.
If an enterprise is required or elects to prepare and present an interim financial
report, it should comply with this Standard. The standard prescribes the minimum
contents of an interim financial report and requires that an enterprise which elects
to prepare and present an interim financial report, should comply with this
standard. It also lays down the principles for recognition and measurement in a
complete or condensed financial statements for an interim period. Timely and
reliable interim financial reporting improves the ability of investors, creditors,
lenders and others to understand an enterprise’s capacity to generate earnings and
cash flows, its financial condition and liquidity.
© The Institute of Chartered Accountants of India
4.142 ADVANCED ACCOUNTING
A statute governing an enterprise or a regulator may also require an enterprise to
prepare and present certain information at an interim date which may be different
in form and/or content as required by this Standard. In such a case, the recognition
and measurement principles as laid down in this Standard are applied in respect of
such information, unless otherwise specified in the statute or by the regulator.
7.2 DEFINITIONS OF THE TERMS USED UNDER
THE ACCOUNTING STANDARD
Interim period is a financial reporting period shorter than a full financial year.
Interim financial report means a financial report containing either a complete set
of financial statements or a set of condensed financial statements for an interim
period.
During the first year of operations of an enterprise, its annual financial reporting
period may be shorter than a financial year. In such a case, that shorter period is
not considered as an interim period.
7.3 CONTENT OF AN INTERIM FINANCIAL
REPORT
A complete set of financial statements normally includes Balance sheet, Statement
of Profit & Loss, Cash flow statement and Notes including those relating to
accounting policies and other statements and explanatory material that are an
integral part of the financial statements.
The benefit of timeliness of presentation may be partially offset by a reduction in
detail in the information provided. Therefore, this Standard requires preparation
and presentation of an interim financial report containing, as a minimum, a set of
condensed financial statements. Accordingly, it focuses on new activities, events,
and circumstances and does not duplicate information previously reported. AS 25
does not prohibit or discourage an enterprise from presenting a complete set of
financial statements in its interim financial report, rather than a set of condensed
financial statements. The recognition and measurement principles set out in this
Standard apply also to complete financial statements for an interim period, and
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.143
ACCOUNTING STANDARDS v
v v
such statements would include all disclosures required by this Standard asvwell as
those required by other Accounting Standards. Minimum components of anvInterim
Financial Report includes condensed Financial Statement.
Note: Interim financial report may contain a complete set of financial statements
or condensed financial statements. If the entity opted for a complete set of financial
statements, it will be like annual set of financial statements. The condensed
financial statements would include the limited information as required by this
standard.
7.4 FORM AND CONTENT OF INTERIM
FINANCIAL STATEMENTS
If an enterprise prepares and presents a complete set of financial statements in its
interim financial report, the form and content of those statements should conform
to the requirements as applicable to annual complete set of financial statements.
If an enterprise prepares and presents a set of condensed financial statements in
its interim financial report, those condensed statements should include, at a
minimum, each of the headings and sub-headings that were included in its most
recent annual financial statements and the selected explanatory notes as required
by this Statement.
Additional line items or notes should be included if their omission would make the
condensed interim financial statements misleading.
If an enterprise presents basic and diluted earnings per share in its annual financial
statements in accordance with AS 20 then it has to present basic and diluted
earnings per share as per AS 20 on the face of Statement of Profit and Loss
complete or condenses for an interim period also.
7.5 SELECTED EXPLANATORY NOTES
An enterprise should include the following information, as a minimum, in the notes
to its interim financial statements, if material and if not disclosed elsewhere in the
interim financial report:
© The Institute of Chartered Accountants of India
4.144 ADVANCED ACCOUNTING
(a) A statement that the same accounting policies are followed in the interim
financial statements as those followed in the most recent annual financial
statements or, if those policies have been changed, a description of the
nature and effect of the change.
(b) Explanatory comments about the seasonality of interim operations.
(c) The nature and amount of items affecting assets, liabilities, equity, net
income, or cash flows that is unusual because of their nature, size, or
incidence as per AS 5.
(d) The nature and amount of changes in estimates of amounts reported in prior
interim periods of the current financial year or changes in estimates of
amounts reported in prior financial years, if those changes have a material
effect in the current interim period.
(e) Issuances, buy-backs, repayments and restructuring of debt, equity and
potential equity shares.
(f) Dividends, aggregate or per share (in absolute or percentage terms),
separately for equity shares and other shares.
(g) Segment revenue, segment capital employed (segment assets minus segment
liabilities) and segment result for business segments or geographical
segments, whichever is the enterprise's primary basis of segment reporting
(disclosure of segment information is required in an enterprise's interim
financial report only if the enterprise is required, in terms of AS 17, Segment
Reporting, to disclose segment information in its annual financial
statements).
(h) The effect of changes in the composition of the enterprise during the interim
period, such as amalgamations, acquisition or disposal of subsidiaries and
long-term investments, restructurings, and discontinuing operations and
(i) Material changes in contingent liabilities since the last annual balance sheet
date.
The above information should normally be reported on a financial year-to-date
basis. However, the enterprise should also disclose any events or transactions that
are material to an understanding of the current interim period.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.145
ACCOUNTING STANDARDS v
v v
v
7.6 PERIODS FOR WHICH INTERIM FINANCIAL
v
STATEMENTS ARE REQUIRED TO BE
PRESENTED
Interim reports should include interim financial statements (whether condensed or
complete) for the periods listed in the following table:
Statement Current period Comparative period
Balance sheet End of current End of immediately preceding
interim period financial year
Statement of profit and Current interim Comparable interim period
loss period and and year-to-date of
cumulatively for the immediately preceding
year-to-date financial year
Cash flow statement Cumulatively for the Comparable year-to-date of
current financial immediately preceding
year-to-date financial year
7.7 MATERIALITY
In deciding how to recognise, measure, classify, or disclose an item for interim
financial reporting purposes, materiality should be assessed in relation to the
interim period financial data.
In making assessments of materiality, it should be recognised that interim
measurements may rely on estimates to a greater extent than measurements of
annual financial data.
For reasons of understandability of the interim figures, materiality for making
recognition and disclosure decision is assessed in relation to the interim period
financial data.
Thus, for example, unusual or extraordinary items, changes in accounting policies
or estimates, and prior period items are recognised and disclosed based on
materiality in relation to interim period data.
© The Institute of Chartered Accountants of India
4.146 ADVANCED ACCOUNTING
The Preface to the Statements of Accounting Standards states that “The Accounting
Standards are intended to apply only to items which are material”. The Framework
for the Preparation and Presentation of Financial Statements, issued by the Institute
of Chartered Accountants of India, states that “information is material if its
misstatement (i.e., omission or erroneous statement) could influence the economic
decisions of users taken on the basis of the financial information”.
Illustration 1
Sincere Corporation is dealing in seasonal product. Sales pattern of the product
quarter-wise is as follows:
1st quarter 30th June 10%
2nd quarter 30 th September 10%
3rd quarter 31 st December 60%
4th quarter 31 st March 20%
Information regarding the 1 st quarter ended on 30 th June, 20X1 is as follows:
Sales 80 crores
Salary and other expenses 60 crores
Advertisement expenses (routine) 4 crores
Administrative and selling expenses 8 crores
While preparing interim financial report for first quarter Sincere Corporation wants
to defer ` 10 crores expenditure to third quarter on the argument that third quarter
is having more sales, therefore, the third quarter should be debited by more
expenditure. Considering the seasonal nature of business and the expenditures are
uniform throughout all quarters, calculate the result of the first quarter as per AS 25.
Also give a comment on the company’s view.
Solution
Particulars (` In crores)
Result of first quarter ended 30th June, 20X1
Turnover 80
Other Income Nil
Total (a) 80
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.147
ACCOUNTING STANDARDS v
v v
Less: Changes in inventories vNil
Salaries and other cost v60
Administrative and selling Expenses (4+8) 12
Total (b) 72
Profit (a)-(b) 8
According to AS 25, the Income and Expense should be recognized when they are
earned and incurred respectively. Therefore, seasonal incomes will be recognized
when they occur. Thus, the company’s view is not as per AS 25.
Illustration 2
The accounting year of X Ltd. ends on 30 th September, 20X1 and it makes its reports
quarterly. However for the purpose of tax, year ends on 31 st March every year. For the
Accounting year from 1-10-20X0 to 30-9-20X1, the quarterly income is as under:
1st quarter ending on 31 st December, 20X0 ` 200 crores
2nd quarter ending on 31 st March, 20X1 ` 200 crores
3rd quarter ending on 30 th June, 20X1 ` 200 crores
4th quarter ending on 30 th September, 20X1 ` 200 crores
Total ` 800 crores
Average actual tax rate for the financial year ending on 31 st March, 20X1 is 20% and
for financial year ending 31 st March, 20X2 is 30%. Calculate tax expense for each
quarter.
Solution
Calculation of tax expense
1st quarter ending on 31 st December, 20X0 200 20% ` 40 lakhs
2nd quarter ending on 31 st March, 20X1 200 20% ` 40 lakhs
3rd quarter ending on 30 th June, 20X1 200 30% ` 60 lakhs
4th quarter ending on 30 th September, 20X1 200 30% ` 60 lakhs
© The Institute of Chartered Accountants of India
4.148 ADVANCED ACCOUNTING
7.8 DISCLOSURE IN ANNUAL FINANCIAL
STATEMENTS
AS 5, requires disclosure, in financial statements, of the nature and (if practicable)
the amount of a change in an accounting estimate which has a material effect in
the current period, or which is expected to have a material effect in subsequent
periods. Similarly, if an estimate of an amount reported in an interim period is
changed significantly during the final interim period of the financial year but a
separate financial report is not prepared and presented for that final interim period,
the nature and amount of that change in estimate should be disclosed in a note to
the annual financial statements for that financial year.
7.9 ACCOUNTING POLICIES
Same Accounting Policies as annual financial statements
An enterprise should apply the same accounting policies in its interim financial
statements as are applied in its annual financial statements, except for accounting
policy changes made after the date of the most recent annual financial statements
that are to be reflected in the next annual financial statements. However, the
frequency of an enterprise's reporting (annual, half-yearly, or quarterly) should not
affect the measurement of its annual results. To achieve that objective,
measurements for interim reporting purposes should be made on a year-to-date
basis.
To illustrate:
(a) The principles for recognising and measuring losses from inventory write-
downs, restructurings, or impairments in an interim period are the same as
those that an enterprise would follow if it prepared only annual financial
statements. However, if such items are recognised and measured in one
interim period and the estimate changes in a subsequent interim period of
that financial year, the original estimate is changed in the subsequent interim
period either by accrual of an additional amount of loss or by reversal of the
previously recognised amount;
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.149
ACCOUNTING STANDARDS v
v v
(b) A cost that does not meet the definition of an asset at the end of anvinterim
period is not deferred on the balance sheet date either to awaitv future
information as to whether it has met the definition of an asset or to smooth
earnings over interim periods within a financial year; and
(c) Income tax expense is recognised in each interim period based on the best
estimate of the weighted average annual effective income tax rate expected
for the full financial year. Amounts accrued for income tax expense in one
interim period may have to be adjusted in a subsequent interim period of
that financial year if the estimate of the annual effective income tax rate
changes.
Income is recognised in the statement of profit and loss when an increase in future
economic benefits related to an increase in an asset or a decrease of a liability has
arisen that can be measured reliably. Expenses are recognised in the statement of
profit and loss when a decrease in future economic benefits related to a decrease
in an asset or an increase of a liability has arisen that can be measured reliably. The
recognition of items in the balance sheet which do not meet the definition of assets
or liabilities is not allowed.
An enterprise that reports more frequently than half-yearly, measures income and
expenses on a year-to-date basis for each interim period using information
available when each set of financial statements is being prepared. Amounts of
income and expenses reported in the current interim period will reflect any changes
in estimates of amounts reported in prior interim periods of the financial year. The
amounts reported in prior interim periods are not retrospectively adjusted.
However, the nature and amount of any significant changes in estimates be
disclosed.
Changes in Accounting Policies
Preparers of interim reports in compliance with AS 25 are required to consider any
changes in accounting policies that will be applied for the next annual financial
statements, and to implement the changes for interim reporting purposes.
If there has been any change in accounting policy since the most recent annual financial
statements, the interim report is required to include a description of the nature and
effect of the change.
© The Institute of Chartered Accountants of India
4.150 ADVANCED ACCOUNTING
7.10 REVENUE RECEIVED SEASONALLY OR
OCCASIONALLY
Revenues that are received seasonally or occasionally within a financial year should
not be anticipated or deferred as of an interim date if anticipation or deferral would
not be appropriate at the end of the enterprise's financial year.
For example: Dividend revenue, royalties, and government grants. Additionally,
some enterprises consistently earn more revenues in certain interim periods of a
financial year than in other interim periods, for example, seasonal revenues of
retailers. Such revenues are recognised when they occur.
7.11 COST INCURRED UNEVENLY DURING THE
FINANCIAL YEAR
Costs that are incurred unevenly during an enterprise's financial year should be
anticipated or deferred for interim reporting purposes if, and only if, it is also
appropriate to anticipate or defer that type of cost at the end of the financial year.
A cost that does not meet the definition of an asset at the end of an interim period
is not deferred in the interim balance sheet either to await future information as to
whether it has met the definition of an asset, or to smooth earnings over interim
periods within a financial year. Thus, when preparing interim financial statements,
the enterprise’s usual recognition and measurement practices are followed. The
only costs that are capitalized are those incurred after the specific point in time at
which the criteria for recognition of the particular class of asset are met.
Deferral of costs as assets in an interim balance sheet in the hope that the criteria
will be met before the year-end is prohibited.
7.12 USE OF ESTIMATES
The measurement procedures to be followed in an interim financial report should
be designed to ensure that the resulting information is reliable and that all material
financial information that is relevant to an understanding of the financial position
or performance of the enterprise is appropriately disclosed.
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.151
ACCOUNTING STANDARDS v
v v
v
7.13 RESTATEMENT OF PREVIOUSLY REPORTED
v
INTERIM PERIODS
One objective of the preceding principle is to ensure that a single accounting policy
is applied to a particular class of transactions throughout an entire financial year.
The effect of the principle requires that within the current financial year any change
in accounting policy be applied retrospectively to the beginning of the financial
year.
7.14 TRANSITIONAL PROVISION
On the first occasion that an interim financial report is presented in accordance
with this Statement, the following need not be presented in respect of all the
interim periods of the current financial year:
(a) Comparative statements of profit and loss for the comparable interim periods
(current and year-to-date) of the immediately preceding financial year; and
(b) Comparative cash flow statement for the comparable year-to-date period of
the immediately preceding financial year.
7.15 APPLICABILITY OF AS 25 TO INTERIM
FINANCIAL RESULTS
The presentation and disclosure requirements contained in AS 25 should be applied
only if an enterprise prepares and presents an 'interim financial report' as defined
in AS 25. Accordingly, presentation and disclosure requirements contained in AS 25
are not required to be applied in respect of interim financial results (which do not
meet the definition of 'interim financial report' as per AS 25) presented by an
enterprise.
For example, quarterly financial results presented under Clause 41 of the Listing
Agreement entered into between Stock Exchanges and the listed enterprises do
not meet the definition of 'interim financial report' as per AS 25. However, the
recognition and measurement principles laid down in AS 25 should be applied for
recognition and measurement of items contained in such interim financial results.
© The Institute of Chartered Accountants of India
4.152 ADVANCED ACCOUNTING
Illustration 3
Accountants of Poornima Ltd. showed a net profit of ` 7,20,000 for the third quarter
of 20X1 after incorporating the following:
(i) Bad debts of ` 40,000 incurred during the quarter. 50% of the bad debts have
been deferred to the next quarter.
(ii) Extra ordinary loss of ` 35,000 incurred during the quarter has been fully
recognized in this quarter.
(iii) Additional depreciation of ` 45,000 resulting from the change in the method of
charge of depreciation assuming that ` 45,000 is the charge for the 3 rd quarter
only.
Ascertain the correct quarterly income.
Solution
In the above case, the quarterly income has not been correctly stated. As per AS
25 “Interim Financial Reporting”, the quarterly income should be adjusted and
restated as follows:
Bad debts of ` 40,000 have been incurred during current quarter. Out of this, the
company has deferred 50% (i.e.) ` 20,000 to the next quarter. Therefore, ` 20,000
should be deducted from ` 7,20,000. The treatment of extra-ordinary loss of `
35,000 being recognized in the same quarter is correct.
Recognising additional depreciation of ` 45,000 in the same quarter is in tune with
AS 25. Hence no adjustments are required for these two items.
Poornima Ltd should report quarterly income as ` 7,00,000 (` 7,20,000 – ` 20,000).
Illustration 4
Intelligent Corporation (I −Corp.) is dealing in seasonal products. The quarterly sales
pattern of the product is given below:
Quarter I II III IV
Ending 30th June 30th September 31st December 31st March
15% 15% 50% 25%
For the First quarter ending 30th June, 20X1, I −Corp. gives you the following
information:
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.153
ACCOUNTING STANDARDS v
v v
v
` crores
v
Sales 50
Salary and other expenses 30
Advertisement expenses (routine) 02
Administrative and selling expenses 08
While preparing interim financial report for the first quarter, ‘I −Corp.’ wants to defer
` 21 crores expenditure to third quarter on the argument that third quarter is having
more sales, therefore, third quarter should be debited by higher expenditure,
considering the seasonal nature of business and that the expenditures are uniform
throughout all quarters.
Calculate the result of first quarter as per AS 25 and comment on the company’s view.
Solution
Result of the first quarter ended 30 th June, 20X1
(` in crores)
Turnover 50
Add: Other Income Nil
Total 50
Less: Change in inventories Nil
Salaries and other cost 30
Administrative and selling expenses (8 + 2) 10 40
Profit 10
As per AS 25 on Interim Financial Reporting, the income and expense should be
recognized when they are earned and incurred respectively. As per AS 25, the costs
should be anticipated or deferred only when
(i) it is appropriate to anticipate that type of cost at the end of the financial year,
and
(ii) costs are incurred unevenly during the financial year of an enterprise.
Therefore, the argument given by I-Corp relating to deferment of ` 21 crores is not
tenable as expenditures are uniform throughout all quarters.
© The Institute of Chartered Accountants of India
4.154 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. AS 25 mandates the following in relation to interim financial reports.
(a) which entities should publish interim financial reports.
(b) how frequently it should publish interim financial reports.
(c) how soon it should publish after the end of interim period.
(d) none of the above.
2. The standard defines Interim financial Report as a financial report for an interim
period that contains a set of ………. financial statements.
(a) Complete
(b) Condensed
(c) Financial statement similar to annual
(d) Either complete or condensed
3. ABC Limited has reported ` 85,000 as per tax profit in first quarter and expects a
loss of ` 25,000 each in subsequent quarters. It has corporate tax rate slab of 20%
on the first ` 20,000 earnings and 40% on all additional earnings. Calculate tax
expenses that should report in first quarter interim financial report.
(a) ` 17,000
(b) ` 30,000
(c) ` 2,000
(d) AS 25 does not mandate to report tax expenses
4. An entity prepares quarterly interim financial reports in accordance with AS 25.
The entity is engaged in sale of mobile phones and normally 5% of customers claim
on their warranty. The provision in the first quarter was calculated as 5% of sales
to date, which was `10 million. However, in the second quarter, a fault was found
and warranty claims were expected to be 10% for the whole of the year. Sales in
© The Institute of Chartered Accountants of India
PRESENTATION & DISCLOSURES BASED 4.155
ACCOUNTING STANDARDS v
v v
v in the
the second quarter were ` 15 million. What would be the provision charged
second quarter’s interim financial statements? v
(a) ` 1 million
(b) ` 2 million
(c) ` 1.25 million
(d) ` 1.5 million
Theoretical Questions
5. What are the periods for which Interim financial Statements are required to be
presented? You are required to answer your question in light of preparation of financial
statements for the period ended and as at 31st December, 20X1. The Financial Year is
FY 20X1-X2.
6. Whether quarterly financial results presented under Clause 41 of the Listing
Agreement entered into between Stock Exchanges and the listed enterprises meet the
definition of 'interim financial report' as per AS 25 and the provisions of AS 25 should
be applied on the same?
7. Whether the impairment loss recognized on property, plant and equipment in
first quarter of the financial year can be reversed in the second quarter in that
financial year?
Scenario based Question
8. In view of the provisions of Accounting Standard 25 on Interim Financial
Reporting, on what basis will you calculate, for an interim period, the provision
in respect of defined benefit schemes like pension, gratuity etc. for the
employees?
9. On 30th June, 20X1, Asmitha Ltd. incurred ` 2,00,000, net loss from disposal of
a business segment. Also, on 31 st July, 20X1, the company paid ` 60,000 for
property taxes assessed for the calendar year 20X1. How the above transactions
should be included in determination of net income of Asmitha Ltd. for the six
months interim period ended on 30 th September, 20X1.
10. An enterprise reports quarterly, estimates an annual income of ` 10 lakhs.
Assume tax rates on 1 st ` 5,00,000 at 30% and on the balance income at 40%.
© The Institute of Chartered Accountants of India
4.156 ADVANCED ACCOUNTING
The estimated quarterly income are ` 75,000, ` 2,50,000, ` 3,75,000 and
` 3,00,000.
Calculate the tax expense to be recognized in each quarter.
11. Antarbarti Limited reported a Profit Before Tax (PBT) of ` 4 lakhs for the third
quarter ending 30-09-20X1. On enquiry you observe the following. Give the
treatment required under AS 25:
(i) Dividend income of ` 4 lakhs received during the quarter has been
recognized to the extent of ` 1 lakh only.
(ii) 80% of sales promotion expenses ` 15 lakhs incurred in the third quarter
has been deferred to the fourth quarter as the sales in the last quarter is
high.
(iii) In the third quarter, the company changed depreciation method from
WDV to SLM, which resulted in excess depreciation of ` 12 lakhs. The
entire amount has been debited in the third quarter, though the share of
the third quarter is only ` 3 lakhs.
(iv) ` 2 lakhs extra-ordinary gain received in third quarter was allocated
equally to the third and fourth quarter.
(v) Cumulative loss resulting from change in method of inventory valuation
was recognized in the third quarter of ` 3 lakhs. Out of this loss ` 1 lakh
relates to previous quarters.
(vi) Sale of investment in the first quarter resulted in a gain of ` 20 lakhs. The
company had apportioned this equally to the four quarters.
Prepare the adjusted profit before tax for the third quarter.
ANSWERS/HINTS
Answers to the Multiple Choice Questions
1. (d) 2. (d) 3. (a) 4. (b)
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Answers to the Theoretical Questions v
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5. As per Accounting Standard 25, Interim reports should include interim
financial statements (condensed or complete) for periods as given below.
Statement Current period Comparative period
Balance sheet End of current interim End of immediately
period preceding financial year
Statement of profit Current interim period Comparable interim
and loss and cumulatively for period and year-to-date of
the year-to-date immediately preceding
financial year
Cash flow statement Cumulatively for the Comparable year-to-date
current financial year- of immediately preceding
to-date financial year
In light of the above, following periods needs to be covered in interim
financial statements for the period ended and as at 31 st December, 20X1:
Balance Sheet as of the end of the current interim period and a comparative
balance sheet as of the end of the immediately preceding
financial year (As at 31 December 20X1 and 31 March 20X1).
Statements of for the current interim period and cumulatively for the
Profit and Loss current financial year to date, with comparative statements of
profit and loss for the comparable interim periods (current
and year-to-date) of the immediately preceding financial
year. (for 3 months and 9 months i.e., year to date ended 31
December 20X1 and same for 31 December 20X0 being
comparative period).
Cash Flow cumulatively for the current financial year to date, with a
Statement comparative statement for the comparable year-to-date
period of the immediately preceding financial year. (year to
date i.e., 1 April 20X1 to 31 December 20X1 and 1 April 20X0
to 31 December 20X0).
© The Institute of Chartered Accountants of India
4.158 ADVANCED ACCOUNTING
6. The presentation and disclosure requirements contained in AS 25 should be
applied only if an enterprise prepares and presents an 'interim financial report'
as defined in AS 25. Accordingly, presentation and disclosure requirements
contained in AS 25 are not required to be applied in respect of interim financial
results (which do not meet the definition of 'interim financial report' as per AS
25) presented by an enterprise.
The quarterly financial results presented under Clause 41 of the Listing
Agreement do not meet the definition of 'interim financial report' as per AS 25.
However, the recognition and measurement principles laid down in AS 25 should
be applied for recognition and measurement of items contained in such interim
financial results.
7. As per AS 25, the principles for recognising and measuring losses from inventory
write-downs, restructurings, or impairments in an interim period are the same as
those that an enterprise would follow if it prepared only annual financial
statements. However, if such items are recognised and measured in one interim
period and the estimate changes in a subsequent interim period of that financial
year, the original estimate is changed in the subsequent interim period either by
accrual of an additional amount of loss or by reversal of the previously
recognised amount. In light of the same, the impairment loss recognized in one
quarter can be reversed in the another quarter of the financial year, if favourable
indicator exists as per AS 28 and the recoverable amount increased in
comparison to earlier period.
Answers to the Scenario based Question
8. Accounting Standard 25 suggests that provision in respect of defined benefit
schemes like pension and gratuity for an interim period should be calculated
based on the year-to-date basis by using the actuarially determined rates at
the end of the prior financial year, adjusted for significant market fluctuations
since that time and for significant curtailments, settlements or other
significant one-time events.
9. According to Para 10 of AS 25 “Interim Financial Reporting”, if an enterprise
prepares and presents a complete set of financial statements in its interim
financial report, the form and content of those statements should conform to
the requirements as applicable to annual complete set of financial
© The Institute of Chartered Accountants of India
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statements. As at 30th September, 20X1, Asmitha Ltd would report thev entire
amount of ` 2,00,000 as loss on the disposal of its business segmentv since
the loss was incurred during interim period. A cost charged as an expense in
an annual period should be allocated to interim periods on accrual basis.
Since ` 60,000 Property tax payment relates to entire calendar year 20X1,
` 30,000 would be reported as an expense for six months ended on 30th
September, 20X1 while out of the remaining ` 30,000, ` 15,000 for January,
20X1 to March, 20X1 should be shown as payment of the outstanding amount
of previous year and another ` 15,000 related to quarter October, 20X1 to
December, 20X1 would be reported as prepaid expenses.
10. As per para 29 of AS 25 ‘Interim Financial Reporting’, income tax expense is
recognised in each interim period based on the best estimate of the weighted
average annual income tax rate expected for the full financial year.
`
Estimated Annual Income (A) 10,00,000
Tax expense:
30% on ` 5,00,000 1,50,000
40% on remaining ` 5,00,000 2,00,000
(B) 3,50,000
B 3,50,000
Weighted average annual income tax rate = = = 35%
A 10,00,000
Tax expense to be recognized in each of the quarterly reports `
Quarter I - ` 75,000 x 35% 26,250
Quarter II - ` 2,50,000 x 35% 87,500
Quarter III - ` 3,75,000 x 35% 1,31,250
Quarter IV - ` 3,00,000 x 35% 1,05,000
` 10,00,000 3,50,000
11. As per para 36 of AS 25 “Interim Financial Reporting”, seasonal or occasional
revenue and cost within a financial year should not be deferred as of interim
date until it is appropriate to defer at the end of the enterprise’s financial
year. Therefore, dividend income, extra-ordinary gain, and gain on sale of
© The Institute of Chartered Accountants of India
4.160 ADVANCED ACCOUNTING
investment received during 3 rd quarter should be recognised in the 3 rd quarter
only. Similarly, sales promotion expenses incurred in the 3 rd quarter should
also be charged in the 3 rd quarter only.
Further, as per AS 10, Property, Plant and Equipment, if there is change in the
depreciation method, such a change should be accounted for as a change in
accounting estimate in accordance with AS 5, Net Profit or Loss for the Period,
Prior Period Items and Changes in Accounting Policies, and applied
prospectively. Therefore, no adjustment would be required due to change in
the method of depreciation.
Accordingly, the adjusted profit before tax for the 3 rd quarter will be as
follows:
Statement showing Adjusted Profit Before Tax for the third quarter
(` in lakhs)
Profit before tax (as reported) 4
Add: Dividend income ` (4-1) lakhs 3
rd
Excess depreciation charged in the 3 quarter,
due to change in the method -
Extra ordinary gain ` (2-1) lakhs 1
Cumulative loss due to change in the
method of inventory valuation should be
applied retrospectively ` (3-2) lakhs 1
9
Less: Sales promotion expenses (80% of ` 15 lakhs) (12)
Gain on sale of investment (occasional gain should (5)
not be deferred)
Adjusted Profit before tax for the third quarter (8)
© The Institute of Chartered Accountants of India
CHAPTER a
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ASSETS BASED ACCOUNTING
STANDARDS
UNIT 1: ACCOUNTING STANDARD 2
VALUATION OF INVENTORY
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the
Definition of Inventory;
Measurement of Inventories;
What is included in Cost of Inventories;
Exclusions from the Cost of Inventories;
Cost Formulas;
Techniques for the Measurement of Cost.
© The Institute of Chartered Accountants of India
5.2 ADVANCED ACCOUNTING
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1.1v 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.
1.2 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).
© The Institute of Chartered Accountants of India
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(b) v
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,v
fuel and stores not consumed at the end of accounting period is 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,
© The Institute of Chartered Accountants of India
5.4 ADVANCED ACCOUNTING
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are costs that are expected to generate future economic benefits to the
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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 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.
1.3 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 Institute of Chartered Accountants of India
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the sale. The valuation of inventory at lower of cost and net realisable value vis
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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.
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
© The Institute of Chartered Accountants of India
5.6 ADVANCED ACCOUNTING
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1.4v 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.
1.5 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.
1.6 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.
© The Institute of Chartered Accountants of India
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Example 2 v
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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 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.
1.7 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.
© The Institute of Chartered Accountants of India
5.8 ADVANCED ACCOUNTING
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1.8 v 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.
Conversion Cost
Factory Overheads Direct labour Joint Cost
Fixed Variable Main/Joint*** By Products
Sale Value Measured at NRV.
at Sale Value This NRV is
At Normal At actual At actual
Separation at deducted from
Capacity* Production** 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.
© The Institute of Chartered Accountants of India
5.9
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1.9 EXCLUSIONS FROM THE COST OF
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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.
1.10 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.
1.11 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.
© The Institute of Chartered Accountants of India
5.10 ADVANCED ACCOUNTING
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(b) v
In retail business, where a large number of rapidly changing items are traded,
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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 markup 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 Markup (` 20,000 / 1.25) x 0.25 (4,000)
Cost of inventory 16,000
Note: Margin is on sales and mark-up is on cost.
1.12 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.
© The Institute of Chartered Accountants of India
5.11
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1.13 COMPARISON OF COST AND NET
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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.
1.14 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.
© The Institute of Chartered Accountants of India
5.12 ADVANCED ACCOUNTING
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Review of net realisable value at each balance sheet date
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An assessment is made of net realisable value as at each balance sheet date.
1.15 DISCLOSURES
The financial statements should disclose:
(a) The accounting policies adopted in measuring inventories, including the cost
formula used; and
(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?
© The Institute of Chartered Accountants of India
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Solution v
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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 Value Valuation of closing
(` in lakhs) stock (` in lakhs)
(` in lakhs)
A 40 28 28
B 32 32 32
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?
© The Institute of Chartered Accountants of India
5.14 ADVANCED ACCOUNTING
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Solutionv
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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.
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.
© The Institute of Chartered Accountants of India
5.15
5.15
ASSETS BASED ACCOUNTING STANDARDS
v
v v
Cost per kg. of finished goods: v
v
`
Material Cost 200
Direct Labour 40
Direct Variable Production Overhead 20
20,00,000
10 70
Fixed Production Overhead 2,00,000
270
Hence the value of 4,000 kgs. of finished goods = 4,000 kgs x ` 270 = ` 10,80,000
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Which item of inventory is under the scope of AS 2 (Revised)?
(a) WIP arising under construction contracts
(b) Raw materials
(c) Shares
(d) Debentures held as stock in trade.
2. 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
(a) sold at or above cost.
(b) sold above cost.
(c) sold less than cost.
(d) sold at market value(where market value is more than cost).
© The Institute of Chartered Accountants of India
5.16 ADVANCED ACCOUNTING
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v
3. v
All of the following costs are excluded while computing value of inventories
v
except?
(a) Selling and Distribution costs
(b) Allocated fixed production overheads based on normal capacity.
(c) Abnormal wastage
(d) Storage costs (which is not necessary part of the production process)
4. Identify the statement(s) which is/are incorrect.
(a) Storage costs which is a necessary part of the production process is
included in inventory valuation.
(b) Administration overheads are never included in inventory valuation.
(c) Full amount of variable production overheads incurred are included in
inventory valuation.
(d) Administration overheads are always included in inventory valuation.
Theoretical Questions
5. “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’.
Scenario base Questions
6. 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.
7. 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.
© The Institute of Chartered Accountants of India
5.17
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ASSETS BASED ACCOUNTING STANDARDS
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v v
(i) v
600 units of Raw material A (purchased @ ` 120). Replacement cost of
raw material A as on 31-3-20X1 is ` 90 per unit. v
(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.
8. 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.
9. Alpha Ltd. sells flavored milk to customers; some of the customers consume
the milk in the shop run by Alpha Limited. While leaving the shop, the
consumers leave the empty bottles in the shop and the company takes
possession of these empty bottles. The company has laid down a detailed
internal record procedure for accounting for these empty bottles which are
sold by the company by calling for tenders.
Keeping this in view:
Decide whether the inventory of empty bottles is an asset of the company;
If so, whether the inventory of empty bottles existing as on the date of
Balance Sheet is to be considered as inventories of the company and valued
as per AS 2 or to be treated as scrap and shown at realizable value with
corresponding credit to ‘Other Income’?
© The Institute of Chartered Accountants of India
5.18 ADVANCED ACCOUNTING
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v
v
v
ANSWERS/SOLUTION
Answer to the Multiple Choice Questions
1. (b) 2. (a) 3. (b) 4. (b)
Answer to the Theoretical Questions
5. 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.
Answer to the Scenario base Questions
6. 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.
© The Institute of Chartered Accountants of India
5.19
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ASSETS BASED ACCOUNTING STANDARDS
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v v
7. As per AS 2 (Revised) “Valuation of Inventories”, materials and other v
supplies held for use in the production of inventories are not written down v
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 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
© The Institute of Chartered Accountants of India
5.20 ADVANCED ACCOUNTING
v
v
v
8. v Valuation of unfinished unit
`
Net selling price 750
Less: Estimated cost of completion (310)
440
Less: Brokerage (4% of 750) (30)
Net Realisable Value 410
Cost of inventory 530
Value of inventory (Lower of cost and net realisable value) 410
9. As per the ‘Framework on Presentation and Preparation of Financial
Statements’:
Tangible objects or intangible rights carrying probable future benefits,
owned by an enterprise are called assets.
Alpha Ltd. sells these empty bottles by calling tenders. It means further
benefits are accrued on its sale.
Therefore, empty bottles are assets for the company.
As per AS 2, inventories are assets held for sale in the ordinary course of
business.
Inventory of empty bottles existing on the Balance Sheet date is the
inventory and Alpha Ltd. has detailed controlled recording and accounting
procedure which duly signify its materiality.
Thus, inventory of empty bottles cannot be considered as scrap and should
be valued as inventory in accordance with AS 2.
© The Institute of Chartered Accountants of India
5.21
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v v
v
v
UNIT 2: ACCOUNTING STANDARD 10
PROPERTY, PLANT AND EQUIPMENT
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the
Definition of PPE
What is the Recognition Criteria for PPE
• Initial Costs
• Subsequent Costs
Measurement at Recognition
• What is included in elements of Cost
• Measurement of Cost
Measurement after Recognition
• Cost Model
• Revaluation Model
Depreciation
• Depreciable Amount and Useful life
• Depreciation Method
Retirement in case of PPE
Derecognition aspects
Disclosure requirements.
© The Institute of Chartered Accountants of India
5.22 ADVANCED ACCOUNTING
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v
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2.1 v INTRODUCTION
The objective of this Standard is to prescribe accounting treatment for Property,
Plant and Equipment (PPE).
Help the Information about
Prescribe Users of Investment 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
Depreciation
of their carrying
charge
amounts
Impairment
Recognition of losses to be
PPE Principle recognised in
Issues in relation to
Accounting them
of PPE
2.2 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.
Example:
AS 19 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.
© The Institute of Chartered Accountants of India
5.23
ASSETS BASED ACCOUNTING STANDARDS
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v v
v
AS 10 (Revised)
v
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.
2.3 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:
Use in Production or Supply
of Goods or Services, or
Condition 1:
Held for For Rental to others, or
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.
© The Institute of Chartered Accountants of India
5.24 ADVANCED ACCOUNTING
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v
v
“Administrative purposes”: The term ‘Administrative purposes’ has been used in
v
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’.
2.4 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).
© The Institute of Chartered Accountants of India
5.25
ASSETS BASED ACCOUNTING STANDARDS
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v v
v
AS 10 (Revised) v
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.
What are not
"Bearer Plants"
Plants cultivated to be Plants cultivated to Produce when Annual Crops
harvested as Agricultural there is more than a remote
produce likelihood that the entity will also
harvest and sell the plant as
agricultural produce, other than as Maize and wheat
Trees grown for use as incidental scrap sales
lumber
Trees which are cultivated both for
their fruit and their lumber
Agricultural Produce is the harvested product of Biological Assets of the
enterprise.
© The Institute of Chartered Accountants of India
5.26 ADVANCED ACCOUNTING
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v
3. v
Agricultural Activity: Is the management by an Enterprise of:
v
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 Agriculture Produce
Activity and harvest of
Biological Assets
Into Additional
Biological Assets
2.5 RECOGNITION CRITERIA FOR PPE
The cost of an item of PPE should be recognised as an asset if, and only if:
o It is probable that future economic benefits associated with the item will flow
to the enterprise, and
o 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.
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.
© The Institute of Chartered Accountants of India
5.27
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v v
Solution v
v
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 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)
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
2.6 MEASUREMENT OF PPE
Cost Model
At Recognition
Measurement Cost Model
After Recognition
Revaluation Model
© The Institute of Chartered Accountants of India
5.28 ADVANCED ACCOUNTING
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v
v
2.7v INITIAL RECOGNITION
An item of PPE that qualifies for recognition as an asset should be measured at its
cost.
What are the elements of Cost?
Cost of an item of PPE comprises:
Cost of an Item of
PPE
Includes Excludes
Any Directly Decommissioning, 1. Costs of opening a new
Purchase
Attributable Restoration and facility or business (Such as,
Price
Costs similar Liabilities Inauguration costs)
2. Costs of introducing a new
product or service (including
costs of advertising and
promotional activities)
3. Costs of conducting
business in a new location or
with a new class of customer
(including costs of staff
training)
4. 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
© The Institute of Chartered Accountants of India
5.29
ASSETS BASED ACCOUNTING STANDARDS
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v v
v
is in the location and condition necessary for it to be capable of operating in the
manner intended by management. v
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.
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
© The Institute of Chartered Accountants of India
5.30 ADVANCED ACCOUNTING
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v
v
Note: Some operations occur in connection with the construction or development
v
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.
Income earned during
development of PPE
Directly Attributable
Incomes (e.g. sale of Not directly attriubtable
debris/ scrap material to the asset (e.g. car
on demolition in case parking rental income)
of redevelopment
Recognize as income in
Adjust from the cost of the Statement of Profit
PPE and Loss
Illustration 2
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
© The Institute of Chartered Accountants of India
5.31
ASSETS BASED ACCOUNTING STANDARDS
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v v
3. v
Removal costs of ` 3,00,000 to transport the machinery from the old location
to the temporary location. v
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 3
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
for 3 months (45,000 x 3)
Initial Delivery Cost Transportation 50,000
Professional Fees for Architect’s Fees 30,000
Installation
Total Cost of Machinery 1,61,55,000
© The Institute of Chartered Accountants of India
5.32 ADVANCED ACCOUNTING
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v
v 4 (Capitalisation of directly attributable costs)
Illustration
v
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 5 (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.
Solution
The net operating costs should not be capitalised but should be recognised in the
Statement of Profit and Loss.
© The Institute of Chartered Accountants of India
5.33
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v
Even though it is running at less than full operating capacity (in this case 80% of
v
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”.
2.8 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 (Refer AS 2). 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.
© The Institute of Chartered Accountants of India
5.34 ADVANCED ACCOUNTING
v
v
v
v Summary: Initial Recognition
(COST)
Purchase Self-constructed
Purchase Price xxx
Material xxx
+ non-creditable taxes xxx
+ Labour xxx
- Trade discount xxx
+ Fixed/Variable Prod. Overheads xxx
+ Directly attributable Expense/Income xxx
+ Directly attributabel Exp/Income xxx
+ Initial Estimate of Restoration etc. xxx
+ Initial Estimate of Restoration etc. xxx
COST OF ASSET xxx
+ Borrowing Cost (if qualifying asset) xxx
COST OF ASSET xxx
2.9 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. The fair value of an asset is reliably measurable if (a) the variability in the range
of reasonable fair value measurements is not significant for that asset or (b) the
© The Institute of Chartered Accountants of India
5.35
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v v
probabilities of the various estimates within the range can be reasonably v
v
assessed and used when measuring fair value. If an enterprise is able to measure
reliably the fair value of either the asset received or the asset given up, then the
fair value of the asset given up is used to measure the cost of the asset received
unless the fair value of the asset received is more clearly evident.
3. 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.
4. 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.
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.
© The Institute of Chartered Accountants of India
5.36 ADVANCED ACCOUNTING
v
v
v
Acquisition of Assets for non-
v cash/partly cash partly non-cash
consideration
Transaction has Transaction has no
Commercial Substance Commercial Substance
Cost of such PPE is measured at Fair A transaction lacks commercial substance if
Value (FV) of the assets given up the position of the company (in terms of
unless the FV of the asset received is cash flows or enterprise-specific values)
more reliable. before and after the exchange transaction
reamin the same.
If information about reliability is not
available, the following order of
preference for recording PPE can be
followed:
In such cases, the assets
1. Measure at FV of asset given up.
acquired will be measured at
2. Measure at FV of assets received (if the WDV of the assets given up.
FV of asset given up is not available).
3. WDV of assets given up (ONLY if
Points 1 and 2 are not available, which
is a very remote possibility).
Illustration 6 (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
In the given case, Plant & Machinery is valued at ` 25,00,000, which is assumed to
be fair value in absence of information. Further, since fair value of land (asset given
up) is not given, the transaction will be recorded at fair value of assets acquired of
` 45,00,000 (` Cash 20,00,000 + ` Plant & Machinery 25,00,000). Since land of book
value ` 10,00,000 is transferred in exchange of assets worth ` 45,00,000, a gain of
` 35,00,000 will be recognised in the books of Entity A.
© The Institute of Chartered Accountants of India
5.37
ASSETS BASED ACCOUNTING STANDARDS
v
v v
The following journal entry will be passed in the books of Entity A: v
v
Cash/ Bank A/c Dr. 20,00,000
Plant & Machinery A/c Dr. 25,00,000
To Land 10,00,000
To Profit on Sale of Land (balancing figure) 35,00,000
Illustration 7 (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
Since the transaction lacks commercial substance, 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.
The following journal entry will be passed in the books of Entity A:
Cash/ Bank A/c Dr. 15,000
Car Y A/c (balancing figure) Dr. 12,85,000
To Car X A/c 13,00,000
Determination of Cost in special cases:
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 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.
© The Institute of Chartered Accountants of India
5.38 ADVANCED ACCOUNTING
v
v
v
Note: In case the fair values of the items acquired cannot be measured
v
reliably, these values are estimated on a fair basis as determined by
competent valuers.
C. 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).
D. 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).
2.10 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.
© The Institute of Chartered Accountants of India
5.39
ASSETS BASED ACCOUNTING STANDARDS
v
v v
4. v
Replacing the interior walls of a building, or to make a non-recurring
replacement. v
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.
Regular Major Inspections - Accounting Treatment
In certain cases, a condition of continuing to operate an item of property, plant and
equipment (for example, an aircraft) may be performing regular major inspections for
faults regardless of whether parts of the item are replaced. When each such 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.
Subsequent
Expenditure
Expenses which
increase life or Major replacements / major
Regular / day-to-day
efficiency of the asset inspection / major overhaul
Repairs & Maintenance
beyond the originally
assessed life or
efficiency
Capitalized as under:
Expensed to P/L WDV of Asset xxx
Capitalized + Cost of New Part xxx
- WDV of Old Part xxx
Revised WDV xxx
The WDV of the old part / inspection (in case of major replacements / inspection)
can be determined through the following sources (in order of preference):
© The Institute of Chartered Accountants of India
5.40 ADVANCED ACCOUNTING
v
v
(i) v
Breakup from suppliers’ invoice
v
(ii) Fair value of the part / inspection at the time of purchase
If it is not practicable for an enterprise to determine the carrying amount of the
replaced part/ inspection, 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.
The WDV of the old part / inspection is computed after deducting the applicable
depreciation.
Illustration 8
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 9
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 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.
© The Institute of Chartered Accountants of India
5.41
ASSETS BASED ACCOUNTING STANDARDS
v
v v
Class of PPE: A class of PPE is a grouping of assets of a similar nature and use vin
operations of an enterprise. v
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.
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. It will ensure true and fair
view of financial statements.
© The Institute of Chartered Accountants of India
5.42 ADVANCED ACCOUNTING
v
v
v 10 (Revaluation on a class by class basis)
Illustration
v
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.
© The Institute of Chartered Accountants of India
5.43
ASSETS BASED ACCOUNTING STANDARDS
v
v v
Frequency of Revaluations v
(Sufficient Regularity) v
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
Based on (Discounted cash flow projections) Ora 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.
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
© The Institute of Chartered Accountants of India
5.44 ADVANCED ACCOUNTING
v
v
v
Case Study on Technique I
v
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 book
Revalued depreciation value
Cost
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 (900 x 1,000/600) (900 x 400/600)
PPE after revaluation 2,500 1,000 1,500
The increase on revaluation is ` 900 (i.e., ` 1,500 – ` 600).
The following journal entry will be passed:
PPE Dr. 1,500
To Accumulated Depreciation 600
To Gain on Revaluation* 900
* Accounting treatment discussed later
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)
© The Institute of Chartered Accountants of India
5.45
ASSETS BASED ACCOUNTING STANDARDS
v
v v
Details of the PPE before and after revaluation are as follows: v
v
Particulars Cost/Revalued Accumulated Net book value
Cost depreciation
PPE before 1,000 400 600
revaluation
(assumed)
PPE after 1,500 1,500
revaluation
Revaluation gain 500 400
The increase on revaluation is ` 900 (i.e., ` 500 + ` 400).
The following journal entries will be passed:
Accumulated Depreciation Dr. 400
To PPE 400
(Accumulated depreciation eliminate against gross carrying amount of asset)
Therefore, carrying amount of asset is reduced to = 1,000 – 400 = 600
PPE Dr. 900
To Gain on Revaluation* 900
* Gain on Revaluation 1,500 – 600 = 900 recognized entirely in PPE, accounting
treatment of this gain to be discussed later.
© The Institute of Chartered Accountants of India
5.46 ADVANCED ACCOUNTING
v
v
v
Revaluation – Increase or Decrease
v
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 of
the heading of
profit and loss to the extent that it
Revaluation surplus to the
reverses a revaluation decrease of
extent of any credit
the same asset previously
balance existing in the
recognised in the Statement of
Revaluation surplus in
profit and loss
respect of that asset
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:
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.
© The Institute of Chartered Accountants of India
5.47
ASSETS BASED ACCOUNTING STANDARDS
v
v v
Depreciation v
v
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. An enterprise allocates the amount
initially recognised in respect of an item of PPE to its significant parts and
depreciates each such part 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
Depreciable amount is:
Cost of an asset (or other amount substituted for cost i.e. revalued amount) less
Residual value.
The depreciable amount of an asset should be allocated on a systematic basis over
its useful life.
© The Institute of Chartered Accountants of India
5.48 ADVANCED ACCOUNTING
v
v
v is:
Useful life
v
(a) the period over which an asset is expected to be available for use by an
enterprise; or
(b) the number of production or similar units expected to be obtained from the
asset by an enterprise.
The residual value of an asset is the estimated amount that an enterprise would
currently obtain from disposal of the asset, after deducting the estimated costs of
disposal, if the asset were already of the age and in the condition expected at the
end of its useful life.
All the following factors are considered in determining the useful life of an asset:
(a) expected usage of the asset. Usage is assessed by reference to the expected
capacity or physical output of the asset.
(b) expected physical wear and tear, which depends on operational factors
such as the number of shifts for which the asset is to be used and the repair
and maintenance programme, and the care and maintenance of the asset
while idle.
(c) technical or commercial obsolescence arising from changes or
improvements in production, or from a change in the market demand for the
product or service output of the asset. Expected future reductions in the
selling price of an item that was produced using an asset could indicate the
expectation of technical or commercial obsolescence of the asset, which, in
turn, might reflect a reduction of the future economic benefits embodied in
the asset.
(d) legal or similar limits on the use of the asset, such as the expiry dates of
related leases.
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?
© The Institute of Chartered Accountants of India
5.49
ASSETS BASED ACCOUNTING STANDARDS
v
v v
Solution v
v
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’.
Example:
As per accounting policy of NS Limited, engaged in shipping business, residual value
of Steel containers is 5%. Based on the external factors, steel prices have increased in
recent past and based on the recent data, company has observed that realized scrap
value is approximately 10% of the cost of the container. The company does not
anticipate any material movement in the steel price in the foreseeable future.
In the above case, based on the yearly review of residual value of Steel containers,
company should revise the residual value to 10%. The above change shall be treated
as change in accounting estimate as per AS 5 and should be applied prospectively.
Illustration 12 (Change in estimate of useful life)
Entity A purchased an asset on 1 st 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 depreciation
on Straight Line basis.
© The Institute of Chartered Accountants of India
5.50 ADVANCED ACCOUNTING
v
v
Solutionv
v
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.
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 1 st
November 20X1 but the company does not begin using the machine until 1 st 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.
© The Institute of Chartered Accountants of India
5.51
ASSETS BASED ACCOUNTING STANDARDS
v
v v
Cessation of Depreciation v
v
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.
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.
© The Institute of Chartered Accountants of India
5.52 ADVANCED ACCOUNTING
v
v
v
Therefore, depreciation does not cease when the asset becomes idle or is retired
v
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:
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 enterprise selects the method that most closely reflects the expected pattern
of consumption of the future economic benefits embodied in the asset. 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
© The Institute of Chartered Accountants of India
5.53
ASSETS BASED ACCOUNTING STANDARDS
v
v v
• v
That the method is changed in accordance with the statute to best reflect the
way the asset is consumed. v
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
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. Because the price component
of revenue may be affected by inflation, which has no bearing upon the way in
which an asset is consumed.
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.
© The Institute of Chartered Accountants of India
5.54 ADVANCED ACCOUNTING
v
v
Solutionv
v
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
The above are included in the cost of the asset.
Accounting for the above changes:
Related Asset is measured using Cost
Accounting 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.
© The Institute of Chartered Accountants of India
5.55
ASSETS BASED ACCOUNTING STANDARDS
v
v v
If the adjustment results in an addition to the cost of an asset v
v
• 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
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.
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v
v The adjusted depreciable amount of the asset is depreciated over its
v
useful life.
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.
Accounting for Compensation for Impairment:
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)
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).
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v v
Entity A should separately recognise a receivable and a gain in the income v
statement resulting from the insurance proceeds under AS 29 (Revised)* once v
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.
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
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
© The Institute of Chartered Accountants of India
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v
v
Note: Gains should not be classified as revenue, as defined in AS 9 ‘Revenue
v
Recognition’. The consideration receivable on disposal of an item of property, plant
and equipment is recognised in accordance with the principles enunciated in AS 9.
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 given in AS 9 for recognising revenue from the
sale of goods.
Disclosure
Disclosures
General Additional Disclosures related to Voluntary
Revalued Assets disclosures
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;
(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
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v v
(e) v
A reconciliation of the carrying amount at the beginning and end of the
period showing: v
(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;
(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.
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v
v related to Revalued Assets
Disclosures
v
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.
(f) Disclosure of the methods adopted and the estimated useful lives or
depreciation rates.
(g) Disclosures as per AS 5, applicable if any.
(h) Information on impaired PPE.
Voluntary disclosures:
An enterprise is encouraged to disclose the following:
(a) the carrying amount of temporarily idle property, plant and equipment;
(b) the gross carrying amount of any fully depreciated property, plant and
equipment that is still in use;
(c) for each revalued class of property, plant and equipment, the carrying amount
that would have been recognised had the assets been carried under the cost
model;
(d) the carrying amount of property, plant and equipment retired from active use
and not held for disposal.
Reference: The students are advised to refer the full text of AS 10 (Revised)
“Property, Plant and Equipment” (2016).
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v v
v
TEST YOUR KNOWLEDGE v
Multiple Choice Questions
1. 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.
(d) initial delivery and handling costs
2. 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
(d) under cash flow model
3. A plot of land with carrying amount of ` 1,00,000 was revalued to ` 1,50,000
at the end of Year 2. Subsequently, due to drop in market values, the land was
determined to have a fair value of ` 1,30,000 at the end of Year 4. Assuming
that the entity adopts Revaluation Model, what would be the accounting
treatment of Revaluation?
(a) Initial upward valuation of ` 50,000 credited to Revaluation Reserve.
Subsequent downward revaluation of ` 20,000 debited to P/L.
(b) Initial upward valuation of ` 50,000 credited to P/L. Subsequent
downward revaluation of ` 20,000 debited to P/L.
(c) Initial upward valuation of ` 50,000 credited to Revaluation Reserve.
Subsequent downward revaluation of ` 20,000 debited to Revaluation
Reserve.
(d) Initial upward valuation of ` 50,000 debited to P/L. Subsequent
downward revaluation of ` 20,000 credited to P/L.
© The Institute of Chartered Accountants of India
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v
4. v
A plot of land with carrying amount of ` 1,00,000 was revalued to ` 90,000 at
v
the end of Year 2. Subsequently, due to increase in market values, the land was
determined to have a fair value of ` 1,05,000 at the end of Year 4. Assuming
that the entity adopts Revaluation Model, what would be the accounting
treatment of Revaluation?
(a) Initial downward valuation of ` 10,000 debited to Revaluation Reserve.
Subsequent upward revaluation of ` 15,000 credited to P/L.
(b) Initial downward valuation of ` 10,000 debited to P/L. Subsequent
upward revaluation of ` 15,000 credited to P/L.
(c) Initial downward valuation of ` 10,000 debited to P/L. Subsequent
upward revaluation of ` 10,000 credited to P/L and ` 5,000 credited to
Revaluation Reserve.
(c) Initial downward valuation of ` 10,000 credited to P/L. Subsequent
upward revaluation of ` 10,000 debited to P/L and ` 5,000 debited to
Revaluation Reserve.
5. On sale of an asset which was revalued upwards, what would be the treatment
of Revaluation Reserve?
(a) The Revaluation Reserve is credited to P/L since the profit on sale of such
asset is now realized.
(b) The Revaluation Reserve is credited to Retained Earnings as a movement
in reserves without impacting the P/L.
(c) No change in Revaluation Reserve since profit on sale of such asset is
already impacting the P/L.
(d) The Revaluation Reserve is reduced from the asset value to compute profit
or loss.
6. A machinery was purchased having an invoice price ` 1,18,000 (including GST
` 18,000) on 1 April 20X1. The GST amount is available as input tax credit. The
rate of depreciation is 10% on SLM basis. The depreciation for 20X2 -X3 would
be
(a) ` 10,000.
(b) ` 11,800.
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(c) ` 9,000. v
v
(d) ` 10,500.
Theoretical Questions
7. A company changed its method of depreciation from SLM to WDV. How should
the change be recognised?
8. A company has debited the Building Account with the Cost of the Land on which
the building stands and has provided depreciation on such total cost. Comment
on the accounting treatment.
9. An entity is setting up a manufacturing plant. Construction of the plant is
completed in August and the plant is ready for commercial production in
November. However, the entity commences production in March. When should
be company start charging depreciation.
10. Which factors should be considered by a company while determining useful
life?
11. An entity gave the following Note in its Financial Statements:
‘The company chooses not to charge depreciation on Property, Plant and
Equipment on account of:
(a) Annual Maintenance Contracts being expensed thereby ensuring timely
repairs of Plant and Machinery.
(b) Depreciation being a non-cash expense has no impact on cash flows.
Accordingly, it is not necessary to depreciate an asset when repairs and
maintenance charges are expensed in the Statement of Profit and Loss.
(c) The values of certain assets like Property increase with passage of time,
and hence charging depreciation does not make sense.
(d) At the end of the useful life, the asset is ultimately sold, and since the
asset is at cost due to no depreciation, exact profit or loss on sale of the
asset is stated.’
You are required to state the appropriateness of the above accounting policy in
line with the relevant Accounting Standards.
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v
v
Scenario based Questions
v
12. 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.
13. 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 ` 7,00,000
plant
5. Interest charges paid to supplier of plant for deferred ` 2,00,000
credit
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v v
v
6. Estimated dismantling costs to be incurred after 7 ` 3,00,000
v
years
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).
14. Arka Ltd. purchased machinery for ` 3,000 lakhs. Depreciation was charged at 10%
on SLM basis for a useful life of 10 years. At the end of Year 4, the machinery was
revalued to ` 2,700 lakhs and the same was adopted. What will be the carrying
amount of the asset at the end of Year 5 and Year 6? Assume no change in the
useful life.
15. Skanda Ltd. acquired a machinery for ` 2,50,00,000 five years ago. Depreciation
was charged at 10% p.a. on SLM basis, useful life being 10 years. At the
beginning of Year 3, the machinery was revalued to ` 3,00,00,000 with the
surplus on revaluation being credited to Revaluation Reserve. Depreciation was
provided on the revalued amount over the balance useful life of 8 years. The
machinery was sold in the current year for ` 1,12,50,000. Give the accounting
treatment for the above in the Company’s accounts. What will be the treatment
if the machinery fetched only ` 42,50,000 now?
16. Akshar Ltd. installed a new Plant (not a qualifying asset), at its production
facility, and incurred the following costs:
▪ Cost of the Plant (as per supplier’s invoice): ` 30,00,000
▪ Initial delivery and handling costs: ` 1,00,000
▪ Cost of site preparation: ` 2,00,000
▪ Consultant fee for advice on acquisition of Plant: ` 50,000
▪ Interest charges paid to supplier against deferred credit: ` 1,00,000
▪ Estimate of Dismantling and Site Restoration costs: ` 50,000 after 10
years (Present Value is ` 30,000)
▪ Operating losses before commercial production: ` 40,000
The company identified motors installed in the Plant as a separate component
and a cost of ` 5,00,000 (Purchase Price) and other costs were allocated to them
proportionately. The company estimates the useful life of the Plant and those
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v
v
of the Motors as 10 years and 6 years respectively and SLM method of
v
Depreciation is used.
At the end of Year 4, the company replaces the Motors installed in the Plant at
a cost of ` 6,00,000 and estimated the useful life of new motors to be 5 years.
Also, the company revalued its entire class of Fixed Assets at the end of Year 4.
The revalued amount of Plant as a whole is ` 25,00,000. At the end of Year 8,
the company decides to retire the Plant from active use and also disposed the
Plant as a whole for ` 6,00,000.
There is no change in the Dismantling and Site Restoration liability during the
period of use. You are required to explain how the above transaction would be
accounted in accordance with AS 10.
17. Bharat Infrastructure Ltd. acquired a heavy machinery at a cost of ` 1,000 lakhs,
the breakdown of its components is not provided. The estimated useful life of
the machinery is 10 years. At the end of Year 6, the turbine, which is a major
component of the machinery, needed replacement, as further usage and
maintenance was uneconomical. The remainder of the machine is in good
condition and is expected to last for the remaining 4 years. The cost of the new
turbine is ` 450 lakhs. Give the accounting treatment for the new turbine,
assuming SLM Depreciation and a discount rate of 8%.
18. Preet Ltd. intends to set up a steel plant, for which it has acquired a dilapidated
factor having an area of 5,000 acres at a cost of ₹ 60,000 per acre. Preet Ltd.
has incurred ` 1.10 crores on demolishing the old Factory Building thereon. A
sum of ` 63,00,000 (including 5% GST thereon) was realized from the sale of
material salvaged from the site. Preet Ltd. incurred Stamp Duty and
Registration Charges of 7% of land value, paid legal and consultancy charges
` 8,00,000 for land acquisition and incurred ` 1,25,000 on title guarantee
insurance. Compute the value of the land acquired.
19 Star Limited purchased machinery for ` 6,80,000 (inclusive of GST of
` 40,000). Input credit is available for entire amount of GST paid. The company
incurred the following other expense for installation.
`
Cost of preparation of site for installation 21,200
Total Labour charges 56,000
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v v
(200 out of the total of 500 men hours worked, v
were spent on installation of the machinery) v
Spare parts and tools consumed in installation 5,000
Total salary of supervisor 26,000
(Time spent for installation was 25% of the total time worked)
Total technical expense 34,000
(1/10 relates to the plant installation)
Test run and experimental production expenses 18,000
Consultancy charges to architect for plant set up 11,000
Depreciation on assets used for installation 12,000
The machine was ready for use on 15.01.20X1 but was used from 01.02.20X1.
Due to this delay further expenses of ` 8,900 were incurred. Calculate the value
at which the plant should be capitalized in the books of Star Limited.
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (b) 2. (c) 3. (c) 4. (c) 5. (b) 6. (a)
Answer to the Theoretical Questions
7. As per AS 10, Property, Plant and Equipment, 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 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.
Accordingly, the change in method of depreciation should be accounting for
as a change in accounting estimate, prospectively.
8. As per AS 10, Property, Plant and Equipment, each part of an item of property,
plant and equipment with a cost that is significant in relation to the total cost
© The Institute of Chartered Accountants of India
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v
v
of the item should be depreciated separately. Further, Land and buildings are
v
separable assets and are accounted for separately, even when they are
acquired together. With some exceptions, such as quarries and sites used for
landfill, land has an unlimited useful life and therefore is not depreciated.
Buildings have a limited useful life and therefore are depreciable assets.
In the given case, land should not be depreciated unless it has a limited useful
life. Accordingly, it is incorrect to debit the cost of land to the Building
Account and provide depreciation on the aggregate cost.
9. As per AS 10, Property, Plant and Equipment, 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
management.
In the given case, since the plant is ready for commercial production in
November, depreciation shall commence from November. The date of
commencement of commercial production is irrelevant for charging
depreciation.
10. All the following factors are considered in determining the useful life of an
asset:
(a) expected usage of the asset. Usage is assessed by reference to the
expected capacity or physical output of the asset.
(b) expected physical wear and tear, which depends on operational factors
such as the number of shifts for which the asset is to be used and the
repair and maintenance programme, and the care and maintenance of
the asset while idle.
(c) technical or commercial obsolescence arising from changes or
improvements in production, or from a change in the market demand
for the product or service output of the asset. Expected future
reductions in the selling price of an item that was produced using an
asset could indicate the expectation of technical or commercial
obsolescence of the asset, which, in turn, might reflect a reduction of
the future economic benefits embodied in the asset.
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(d) v
legal or similar limits on the use of the asset, such as the expiry dates
of related leases. v
11. Depreciation refers to writing off the value of the asset over its useful life.
Such write-off is necessitated on account of normal wear-and-tear, usage, or
obsolescence. Since items of Property, Plant and Equipment are generally
used in generating revenue, the pro-rated write-off in value of such item
should be recorded in the books against the income earned by such an asset.
Providing depreciation is mandatory, in spite of the fact that repairs are
expensed in the Statement of Profit and Loss, or the value of the Property is
appreciating. Depreciation is a systematic allocation of cost of the asset
against the income generated from the continued use of the asset. Further,
the Companies Act, 2013 mandates depreciation to be charged in order to
determine the correct profits. Thus, not charging depreciation would result in
non-compliance with the Companies Act provisions as well.
The argument laid down by the company and the reasons for the same being
invalid are discussed below.
(a) Annual Maintenance Contracts being expensed thereby ensuring timely
repairs of Plant and Machinery:
The fact that the company enters into Annual Maintenance Contracts
for timely repairs can be regarded as a running cost. Such expense is
incurred in order to ensure that the machine continues to run as
intended. Thus, it implies that because the machine is being utilized, it
will need regular repairs. In other words, continuous use is resulting in
normal wear-and-tear which is the reason why depreciation should be
charged by the company. By stating that the company incurs Annual
Maintenance Expenses, the company is recording only the ’maintenance
expenses’, but not the wear-and-tear requiring the maintenance in the
first place. Hence, this argument put forth by the company is not valid.
(b) Depreciation being a non-cash expense has no impact on cash flows.
Accordingly, it is not necessary to depreciate an asset when repairs and
maintenance charges are expensed in the Statement of Profit and Loss.
When viewed from the prism of depreciation alone, it appears that the
fact that depreciation is a non-cash item is correct. However, it must be
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v
v noted that at the time of procurement of the asset, the company would
v
have paid cash. Depreciation is after all writing off this amount over the
life of the asset. Hence the argument that depreciation is a non-cash
item is not valid. Depreciation is writing off the cost of the asset (which
was already paid for) over the useful life of the asset, and hence is
mandatory.
(c) The values of certain assets like Property increase with passage of time,
and hence charging depreciation does not make sense.
Certain assets like immovable property do increase in value with the
passage of time. However, such assets are ‘used for the purposes of
business’ and are not ‘held for sale’ or held as investment property.
Accordingly, since the asset is being used for carrying on business,
providing depreciation will give a true and fair view of the results of the
company, and hence the argument that the value of the property
appreciates is not valid.
If the company wants to show the fair market value of the PPE, then it
has the option to apply Revaluation model. However, depreciation is
mandatory to be charged in Revaluation model also.
(d) At the end of the useful life, the asset is ultimately sold, and since the
asset is at cost due to no depreciation, exact profit or loss on sale of the
asset is stated.’
The value of any asset, after usage, will reduce. Accordingly, the
argument that the ‘exact profit or loss on sale of the asset’ will be
obtained is incorrect. Due to usage of the asset, the value of the asset
would be lower than the cost. Charging depreciation would seek to
bring the book value approximating to such reduced value. Thereafter,
on sale of the asset, the true profit or loss would be available.
Accordingly, this argument is also invalid.
It may be pertinent to note that Accounting Standard 1, Disclosure of
Accounting Policies states that Disclosure of accounting policies or of
changes therein cannot remedy a wrong or inappropriate treatment of the
item in the accounts. In other words, the company cannot be absolved of the
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fact that it has not complied with the relevant accounting standards merely v
by giving a disclosure of incorrect policies or practices being followed. v
Thus, the company’s stand of disclosing the incorrect policy as a remedy is
not correct. The company is suggested to charge depreciation on a systematic
basis over the useful life of the asset thereby complying with the Accounting
Standards.
Answer to the Scenario based Questions
12. Heads
(i) Purchase price of PPE
(iii) 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 while (iii)
demand for the output of an item builds up
4 Costs incurred while an item capable of operating in (iii)
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 computing (i)
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)
13. According to AS 10 (Revised), these costs can be capitalised:
1. Cost of the plant ` 25,00,000
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v
2. Initial delivery and handling costs ` 2,00,000
v
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.
14.
Particulars ` in lakhs
Original Cost of the Asset 3,000.00
Less: Depreciation for 4 years (` 3,000 lakhs x 10% x 4 years) (1,200.00)
Book Value at the end of Year 4 1,800.00
Add: Revaluation Surplus (balancing figure) 900.00
Revalued Amount as given (= revised depreciable value) 2,700.00
Less: Depreciation for Year 5 (` 2,700 lakhs ÷ 6 years) 450.00
Carrying Amount at the end of Year 5 2,250.00
Less: Depreciation for Year 6 (` 2,700 lakhs ÷ 6 years) 450.00
Carrying Amount at the end of Year 6 1,800.00
15.
Particulars `
Original Cost of the Asset 2,50,00,000
Less: Depreciation for 2 years (` 2,50,00,000 x 10% x 2 years) 50,00,000
Book Value at the beginning of Year 3 2,00,00,000
Add: Revaluation Surplus (balancing figure) 1,00,00,000
Revalued Amount as given (= revised depreciable value) 3,00,00,000
© The Institute of Chartered Accountants of India
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v v
Less: Depreciation for Years 3-5 (` 3,00,00,000 ÷ 8 yrs x 3 v
1,12,50,000
yrs) v
Carrying Amount at the end of Year 5 1,87,50,000
The treatment of Gain / Loss on Disposal / Revaluation is as below:
Particulars Disposal Proceeds = Disposal Proceeds =
` 1,12,50,000 ` 42,50,000
Book Value Less
` 1,87,50,000 – ` 1,87,50,000 –
Disposal Proceeds
` 1,12,50,000 = ` 42,50,000 =
= Loss recognized
` 75,00,000 (Loss) ` 1,45,00,000 (Loss)
in Profit or Loss
Revaluation
Surplus directly
` 1,00,00,000 ` 1,00,00,000
transferred to
Retained Earnings
16. 1. Cost at Initial Recognition:
Particulars `
Cost of the Plant (as per Invoice) 30,00,000
Initial Delivery and Handling Costs 1,00,000
Cost of Site Preparation 2,00,000
Consultants’ Fees 50,000
Estimated Dismantling and Site Restoration Costs 30,000
Total Cost of Plant including Motors 33,80,000
Less: Cost of Motors identified as a separate component 5,63,333
(1/6)*
Cost of the Plant (excluding Motors – balance 5/6) 28,16,667
* Purchase price of Motors = ` 5,00,000 out of ` 30,00,000 i.e., 1/6 of
value of Plant
© The Institute of Chartered Accountants of India
5.74 ADVANCED ACCOUNTING
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Note: Since the asset is not a qualifying asset, payment of interest to
v
the supplier is not capitalized. Further, operating losses of ` 40,000
incurred before commercial production is not a directly attributable
cost, and hence excluded from cost of asset. These costs are expensed
to the P/L as and when they are incurred.
2 Recognition of Motors Replacement
Particulars `
Cost of Motors determined above 5,63,333
Less: Depreciation for 4 years (as per SLM) 3,75,555
5,63,333 ÷ 6 years x 4 years
Carrying Amount of Motors at the end of Year 4 1,87,778
Accounting: The company should derecognize the existing Carrying
Amount of Motors replaced of ` 1,87,778. Further, the acquisition cost
of new motors of ` 6,00,000 would be capitalized as a separate
component. This amount will be depreciated over the next 5 years at
` 6,00,000 ÷ 5 years = ` 1,20,000 p.a.
3. Revaluation
Particulars `
Cost of the Plant at initial recognition [from (1) above] 28,16,667
Less: SLM Depreciation for 4 years: ` 28,16,667 ÷ 10 years 11,26,667
x 4 years
Carrying Amount of Plant at the end of Year 4 16,90,000
Revalued Amount of Plant (Excluding Motors, since the 19,00,000
same is treated as a separate component: ` 25,00,000 –
` 6,00,000)
Therefore, Gain on Revaluation credited to 2,10,000
Revaluation Reserve
Revised Depreciation Charge p.a.: 19,00,000 ÷ 6 years 3,16,667
© The Institute of Chartered Accountants of India
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4. Derecognition v
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Particulars Motors Plant
(excluding
Motors)
Cost / Revalued Amount at end of 6,00,000 19,00,000
Year 4
Less: Depreciation for Years 5-8 1,20,000 x 4 3,16,667 x 4
= 4,80,000 =12,66,668
Carrying Amount before Disposal / 1,20,000 6,33,332
De-recognition
Less: Disposal Proceeds ` 6,00,000 95,575 5,04,425
allocated in ratio of carrying amount
Loss to be written off to P/L 24,425 1,28,907
Notes:
(a) The Revaluation Surplus of ` 2,10,000 would be transferred
directly to Retained Earnings.
(b) The allocation of disposal proceeds of ` 6,00,000 for the plant as
whole is apportioned based on carrying amount of motors and
plant (excluding motors)
Alternatively, it may be apportioned as 1/6 towards motors and 5/6
plant (excluding motors) based on the reasoning that the initially,
motors amounted to 1/6 of the entire plant. This approach may not be
preferable because there has been a revaluation of the plant (excluding
motors) and a disposal and subsequent acquisition of the Motor, which
is not in the initial proportion of 5/6 and 1/6 respectively.
17. As per AS 10, Property, Plant and Equipment, the derecognition of the
carrying amount of components of an item of Property, Plant and Equipment
occurs regardless of whether the cost of the previous part / inspection was
identified in the transaction in which the item was acquired or constructed. If
it is not practicable for an enterprise to determine the carrying amount of the
replaced part/ inspection, it may use the cost of the replacement or the
© The Institute of Chartered Accountants of India
5.76 ADVANCED ACCOUNTING
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estimated cost of a future similar inspection as an indication of what the cost
v
of the replaced part/ existing inspection component was when the item was
acquired or constructed.
In the given case, the new turbine will produce economic benefits to Bharat
Infrastructure Ltd. and the cost is measurable. Since the recognition criteria
is fulfilled, the same should be recognised as a separate item of Property,
Plant and Equipment. However, since the initial breakup of the components
is not available, the cost of the replacement of ` 450 lakhs can be used as an
indication based on the guidance given above, discounted at 8% for the 6-
year period lapsed.
Thus, estimate of cost 6 years back = ` 450 lakhs ÷ 1.08 6 = ` 283.58 lakhs
Current carrying amount of turbine (to be de-recognised) = Estimated cost `
283.58 lakhs (–) SLM depreciation at 10% (useful life 10 years) for 6 years
` 170.15 lakhs= ` 113.43 lakhs.
Hence revised carrying amount of the machinery will be as under:
Particulars ` in lakhs
Historical Cost [` 1,000 lakhs (–) SLM Depreciation at 10% 400.00
(10 year life) for 6 years]
Add: Cost of new turbine 450.00
Less: Derecognition of current carrying amount of old turbine (113.43)
New Carrying Amount of Machinery 736.57
18.
Particulars `
Purchase Price: 5,000 acres x ` 60,000 per acre 3,000.00
Stamp Duty and Registration Charges at 7% 210.00
Legal and Consultancy Fees 8.00
Title Guarantee Insurance 1.25
Demolition Expenses (Net of Salvage Income) 50.00
[` 110 lakhs (–)` 60 lakhs (` 63 lakhs x 100/105)]
Cost of Land 3,269.25
© The Institute of Chartered Accountants of India
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19. Calculation of Cost of Plant v
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Particulars `
Purchase Price Given 6,80,000
Add: Site Preparation Cost Given 21,200
Labour charges (56,000×200/500) 22,400
Given
Spare parts 5,000
Supervisor’s Salary 25% of ` 26,000 6,500
Technical costs 1/10 of ` 34,000 3,400
Test run and experimental Given 18,000
production charges
Architect Fees for set up Given 11,000
Depreciation on assets used for Given 12,000
installation
Total Cost of Asset 7,79,500
Less: GST credit receivable (40,000)
Value to be capitalized 7,39,500
Note: Further Expenses of ` 8,900 from 15.1.20X1 to 1.2.20X1 to be charged
to profit and loss A/c as plant was ready for production on 15.1.20X1.
© The Institute of Chartered Accountants of India
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UNIT 3: ACCOUNTING STANDARD 13
ACCOUNTING FOR INVESTMENTS
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend–
What are the various Forms of Investments
Classification of Investments
How to compute the Cost of Investments
• Current Investments
• Long-term Investments
• Investment Properties
Disposal of Investments
Reclassification of Investments
Disclosure Requirements as per the standard.
3.1 INTRODUCTION
The standard deals with accounting for investments in the financial statements of
enterprises and related disclosure requirements.
Shares, debentures and other securities held as stock-in-trade (i.e., for sale in the
ordinary course of business) are not ‘investments’ as defined in this Standard.
However, the manner in which they are accounted for and disclosed in the financial
statements is quite similar to that applicable in respect of current investments.
Accordingly, the provisions of this Standard, to the extent that they relate to current
investments, are also applicable to shares, debentures and other securities held as
stock-in-trade, with suitable modifications as specified in this Standard.
© The Institute of Chartered Accountants of India
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This Standard does not deal with: v
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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.
3.2 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.
3.3 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.
© The Institute of Chartered Accountants of India
5.80 ADVANCED ACCOUNTING
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3.4v 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.
Further classification of current and long-term investments should be as specified
in the statute governing the enterprise. In the absence of a statutory requirement,
such further classification should disclose, where applicable, investments in:
(a) Government or Trust securities
(b) Shares, debentures or bonds
(c) Investment properties
(d) Others—specifying nature
3.5 COST OF INVESTMENTS
The cost of an investment includes acquisition charges such as brokerage, fees and
duties etc.
Example
X Ltd invests in long-term deposit worth ` 200 lakhs on 1st April 2022. It incurs
brokerage cost of ` 1 lakh to be able to make the investment. The value of the
investment on 1st April 2022 is ` 201 lakhs.
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. The fair value
may not necessarily be equal to the nominal or par value of the securities issued.
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If an investment is acquired in exchange, or part exchange, for another asset, the
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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
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.
© The Institute of Chartered Accountants of India
5.82 ADVANCED ACCOUNTING
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v Acquisition Charges
Fair value of the securities
issued
Added fair value of the asset given up
or the fair value of the
investment acquired, whichever
is more clearly evident.
Cost of Right shares
subscribed
Cost of
Investment Interest received for pre-
acquisition period
Dividend received for
pre-acquisition period
only if they clearly
represent a recovery of
cost.
Reduced
If investments 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,
then sale proceeds till carrying
amount becomes equal to market
value.
3.6 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.
© The Institute of Chartered Accountants of India
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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 v
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. Example of Decline other than temporary:
(A) Company in which investment is made is making cash operating losses which
has resulted in reduction of its net worth,
(B) New regulation which has negative impact in the working of the investee,
(C) Significant reduction of quoted price of the investment, etc.
Carrying Amount
Current Long term
investments investments
Lower of cost Carried Valuation
Valuation
and fair value.
Any reduction to fair on overall (or global) at cost. Determined on
value is debited to basis is not an individual
profit and loss considered investment
account, however, if appropriate; prudent basis.
fair value of method is to carry Where there is a decline, other
investment is investment than temporary,in the carrying
increased individually. amounts of long term valued
subsequently, the investments, the resultant
increase in value of reduction in the carrying amount is
current investment charged to the profit and loss
up to the cost of statement. The reduction in
investment is carrying amount is reversed when
credited to the profit there is a rise in the value of the
and loss account investment, or if the reasons for
(and excess portion, the reduction no longer exist.
if any, is ignored).
© The Institute of Chartered Accountants of India
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v 1
Illustration
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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 31 st March, 20X1?
Solution
As stated in the question that financial statements for the year ended 31st March,
20X1 are still under preparation – The answer has been given on the assumption
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 the above basis, 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 31 st March, 20X1.
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?
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.85
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Solution v
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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 1.1.20 X1 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.
The 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 the 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.
© The Institute of Chartered Accountants of India
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3.7v 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.
3.8 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 1.
3.9 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.
Illustration 3
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
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 sp ecified in AS 2
(Revised), in respect of Valuation of Inventories.
© The Institute of Chartered Accountants of India
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(1) v
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 v
value as on the date of Balance Sheet was ` 25 lakhs.
(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).
Reclassfication of investment
Long term to Current Current to Long term
lower of cost and carrying lower of cost and fair value
amount at the date of at the date of transfer
transfer
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.
© The Institute of Chartered Accountants of India
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As per AS 13 (Revised), where long-term investments are re-classified as
v
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.
3.10 DISCLOSURE
The following disclosures in financial statements in relation to investments are
appropriate: -
a. The accounting policies followed for the determination of carrying amount 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
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.
f. Classification of investments.
© The Institute of Chartered Accountants of India
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Illustration 4 v
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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 1 st March, 20X1. Market
value as on 31 st 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, 20 X4 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 1 st March, 20X1) should continue to
be shown at cost (since there is no ‘other than temporary’ diminution) as on 31 st
March, 20X4, i.e., ` 4,00,000 and ` 2,00,000 respectively, though their market values
have been increased.
© The Institute of Chartered Accountants of India
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Illustration
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In 20X1, M/s. Wye Ltd. issued 12% fully paid debentures of ` 100 each, interest being
payable half yearly on 30th September and 31 st March of every accounting year.
On 1st December, 20X2, M/s. Bull & Bear purchased 10,000 of these debentures at
` 101 ex-interest price, also paying brokerage @ 1% of ex-interest amount of the
purchase. On 1st March, 20X3 the firm sold all these debentures at ` 103 ex-interest
price, again paying brokerage @ 1 % of ex-interest amount. Prepare Investment
Account in the books of M/s. Bull & Bear for the period 1 st December, 20X2 to 1 st
March, 20X3.
Solution
In the books of M/s Bull & Bear
Investment Account
for the period from 1 December 20X2 to 1 st March, 20X3
st
(Scrip: 12% Debentures of M/s. Wye Ltd.)
Date Particulars Nominal Interest Cost Date Particulars Nominal Interest Cost
Value (` ) Value (`)
(` ) (` )
1.12.20X2 To Bank A/c 10,00,000 20,000 10,20,100 1.03.20X3 By Bank A/c 10,00,000 50,000 10,19,700
(W.N.1) (W.N.2)
1.3.20X3 To Profit & 1.3.20X3 By Profit &
loss A/c* loss A/c
(b.f.) - 30,000 (b.f.) 400
10,00,000 50,000 10,20,100 10,00,000 50,000 10,20,100
* This represents income for M/s. Bull & Bear for the period 1 st December, 20X2 to
1st March, 20X3, i.e., interest for three months- 1st December, 20X2 to 28 February, 20X3).
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.91
5.91
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Working Notes: v
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1. Cost of 12% debentures purchased on 1.12.20X2 `
Cost Value (10,000 ` 101) = 10,10,000
Add: Brokerage (1% of ` 10,10,000) = 10,100
Total = 10,20,100
2. Sale proceeds of 12% debentures sold `
Sales Price (10,000 ` 103) = 10,30,000
Less: Brokerage (1% of ` 10,30,000) = (10,300)
Total = 10,19,700
Illustration 6
On 1.4.20X1, Mr. Krishna Murty purchased 1,000 equity shares of ` 100 each in TELCO
Ltd. @ ` 120 each from a Broker, who charged 2% brokerage. He incurred 50 paise per
` 100 as cost of shares transfer stamps. On 31.1.20X2, Bonus was declared in the ratio
of 1: 2. Before and after the record date of bonus shares, the shares were quoted at
` 175 per share and ` 90 per share respectively. On 31.3.20X2, Mr. Krishna Murty sold
bonus shares to a Broker, who charged 2% brokerage.
Show the Investment Account in the books of Mr. Krishna Murty, who held the shares as
Current assets and closing value of investments shall be made at Cost or Market value
whichever is lower.
Solution
In the books of Mr. Krishna Murty
Investment Account for the year ended 31st March, 20X2
(Scrip: Equity Shares of TELCO Ltd.)
Date Particulars Nominal Cost Date Particulars Nominal Cost
Value (`) (`) Value (`) (`)
1.4.20X1 To Bank A/c 1,00,000 1,23,000 31.3.20X2 By Bank A/c 50,000 44,100
(W.N.1) (W.N.2)
© The Institute of Chartered Accountants of India
5.92 ADVANCED ACCOUNTING
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31.1.20X2 To Bonus shares 50,000 − 31.3.20X2 By Balance c/d
v
(W.N.5) (W.N.4) 1,00,000 82,000
31.3.20X2 To Profit & loss
A/c (W.N.3) − 3,100
1,50,000 1,26,100 1,50,000 1,26,100
Working Notes:
1. Cost of equity shares purchased on 1.4.20X1 = (1,000 ` 120) + (2% of
` 1,20,000) + (½% of ` 1,20,000) = ` 1,23,000
2. Sale proceeds of equity shares (bonus) sold on 31st March, 20X2= (500 ` 90) –
(2% of ` 45,000) = ` 44,100.
3. Profit on sale of bonus shares on 31st March, 20X2
= Sale proceeds – Average cost
Sale proceeds = ` 44,100
Average cost = ` (1,23,000 /1,50,000) x 50,000 = ` 41,000
Profit = ` 44,100 – ` 41,000 = ` 3,100.
4. Valuation of equity shares on 31st March, 20X2
Cost = (` 1,23,000/1,50,000) x 1,00,000 = ` 82,000
Market Value = 1,000 shares × ` 90 = ` 90,000
Closing balance has been valued at ` 82,000 being lower than the market value.
5. Bonus shares do not have any cost.
Illustration 7
Mr. X purchased 500 equity shares of ` 100 each in Omega Co. Ltd. for ` 62,500 inclusive
of brokerage and stamp duty. Some years later the company resolved to capitalise its
profits and to issue to the holders of equity shares, one equity bonus share for every share
held by them. Prior to capitalisation, the shares of Omega Co. Ltd. were quoted at ` 175
per share. After the capitalisation, the shares were quoted at ` 92.50 per share. Mr. X.
sold the bonus shares and received at ` 90 per share.
Prepare the Investment Account in X’s books on average cost basis.
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.93
5.93
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Solution v
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In the books of X
Investment Account
[Scrip: Equity shares in Omega Co. Ltd.]
Particulars Nominal Cost Particulars Nominal Cost
Value Value
` ` ` `
To Cash 50,000 62,500 By Cash - Sale (500 x 90) 50,000 45,000
To Bonus shares (W.N.1) 50,000 - By Balance c/d (W.N. 3) 50,000 31,250
To P & L A/c (W.N. 2) - 13,750
1,00,000 76,250 1,00,000 76,250
To Balance b/d 50,000 31,250
Working Notes:
1. Bonus shares do not have any cost.
2. Profit on sale of bonus shares = Sales proceeds – Average cost
Sales proceeds = ` 45,000
Average cost = 500 62,500 = ` 31,250
1,000
Profit = ` 45,000 – `31,250 = ` 13,750.
3. Valuation of Closing Balance of Shares at the end of year
The total cost of 1,000 share including bonus is `62,500
Therefore, cost of 500 shares (carried forward) is 500 62,500 = ` 31,250
1,000
Market price of 500 shares = 92.50 x 500 = ` 46,250
Cost being lower than the market price, therefore shares are carried forward at cost.
© The Institute of Chartered Accountants of India
5.94 ADVANCED ACCOUNTING
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v 8
Illustration
v
On 1st April, 20X1, Rajat has 50,000 equity shares of P Ltd. at a book value of ` 15 per
share (nominal value ` 10 each). He provides you the further information:
(1) On 20th June, 20X1 he purchased another 10,000 shares of P Ltd. at ` 16 per share.
(2) On 1st August, 20X1, P Ltd. issued one equity bonus share for every six shares held
by the shareholders.
(3) On 31st October, 20X1, the directors of P Ltd. announced a right issue which entitles
the holders to subscribe three shares for every seven shares at ` 15 per share.
Shareholders can transfer their rights in full or in part.
Rajat sold 1/3rd of entitlement to Umang for a consideration of ` 2 per share and
subscribed the rest on 5th November, 20X1.
You are required to prepare Investment A/c in the books of Rajat for the year ending
31st March, 20X2.
Solution
In the books of Rajat
Investment Account
(Equity shares in P Ltd.)
Date Particulars No. of Amount Date Particulars No. of Amount
shares (`) shares (`)
1.4.X1 To Balance b/d 50,000 7,50,000 31.3.X2 By Balance c/d 90,000 12,10,000
20.6.X1 To Bank A/c 10,000 1,60,000 (Bal. fig.)
1.8.X1 To Bonus issue
(W.N.1) 10,000 -
5.11.X1 To Bank A/c
(right shares)
(W.N.4) 20,000 3,00,000
90,000 12,10,000 90,000 12,10,000
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.95
5.95
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Working Notes: v
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50,000 + 10,000
(1) Bonus shares = = 10,000 shares
6
50,000 + 10,000 + 10,000
(2) Right shares = 3 = 30,000 shares
7
1
(3) Sale of rights = 30,000 shares× × ` 2= ` 20,000 to be credited to
3
statement of profit and loss
2
(4) Rights subscribed = 30,000 shares × × ` 15 = ` 3,00,000
3
Illustration 9
On 1.4.20X1, Sundar had 25,000 equity shares of ‘X’ Ltd. at a book value of ` 15 per
share (Nominal value ` 10). On 20.6.20X1, he purchased another 5,000 shares of the
company at `16 per share. The directors of ‘X’ Ltd. announced a bonus and rights issue.
No dividend was payable on these issues. The terms of the issue are as follows:
Bonus basis 1:6 (Date 16.8.20X1).
Rights basis 3:7 (Date 31.8.20X1) Price ` 15 per share.
Due date for payment 30.9.20X1.
Shareholders were entitled to transfer their rights in full or in part. Accordingly,
Sundar sold 33.33% of his entitlement to Sekhar for a consideration of ` 2 per share.
Dividends: Dividends for the year ended 31.3.20X1 at the rate of 20% were declared
by X Ltd. and received by Sundar on 31.10.20X1. Dividends for shares acquired by
him on 20.6.20X1 are to be adjusted against the cost of purchase.
On 15.11.20X1, Sundar sold 25,000 equity shares at a premium of ` 5 per share.
You are required to prepare in the books of Sundar.
(1) Investment Account
(2) Profit & Loss Account.
For your exercise, assume that the books are closed on 31.12.20X1and shares are valued
at average cost.
© The Institute of Chartered Accountants of India
5.96 ADVANCED ACCOUNTING
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Solutionv
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Books of Sundar
Investment Account
(Scrip: Equity Shares in X Ltd.)
No. Amount No. Amount
` `
1.4.20X1 To Bal b/d 25,000 3,75,000 31.10.20X1 By Bank — 10,000
20.6.20X1 To Bank 5,000 80,000 (dividend
16.8.20X1 To Bonus 5,000 — on shares
(W.N.1) acquired on
30.9.20X1 To Bank 10,000 1,50,000 20/6/20X1)
(Rights (W.N.4)
Shares)
(W.N.3)
15.11.20X1 To Profit 44,444 15.11.20X1 By Bank 25,000 3,75,000
(on sale of (Sale of
shares) shares)
31.12.20X1 By Bal. c/d 20,000 2,64,444
(W.N.6)
45,000 6,49,444 45,000 6,49,444
Profit and Loss Account (An extract)
To Balance c/d 1,04,444 By Profit transferred 44,444
By Sale of rights (W.N.3) 10,000
By Dividend (W.N.4) 50,000
1,04,444 1,04,444
Working Notes:
( 25,000+5,000 )
(1) Bonus Shares = = 5,000 shares
6
(2) Right Shares =
(25,000+5,000+5,000 ) ×3 = 15,000 shares
7
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.97
5.97
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(3) Right shares renounced = 15,000×1/3 = 5,000 shares v
v
Sale of right shares = 5,000 x 2 = ` 10,000
Right shares subscribed = 15,000 – 5,000 = 10,000 shares
Amount paid for subscription of right shares = 10,000 x 15 = ` 1,50,000
(4) Dividend received = 25,000 (shares as on 1st April 20X1) × 10 × 20% = ` 50,000
Dividend on shares purchased on 20.6.20X1 = 5,000×10×20% = ` 10,000 is
adjusted to Investment A/c
(5) Profit on sale of 25,000 shares
= Sales proceeds – Average cost
Sales proceeds = ` 3,75,000
Average cost =
(3,75,000+80,000+1,50,000 -10,000 ) ×25,000 = ` 3,30,556
45,000
Profit = ` 3,75,000– ` 3,30,556= `44,444.
(6) Cost of shares on 31.12.20X1
(3,75,000+80,000+1,50,000 -10,000 ) ×20,000 = ` 2,64,444
45,000
Reference: The students are also advised to refer the full bare text of AS 13
(Revised) “Accounting for Investments”.
© The Institute of Chartered Accountants of India
5.98 ADVANCED ACCOUNTING
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TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. The cost of Right shares is
(a) added to the cost of investments.
(b) subtracted from the cost of investments.
(c) no treatment is required.
(d) added to cost of investments at market value.
2. Long term investments are carried at
(a) fair value.
(b) cost less ‘other than temporary’ decline.
(c) Cost and market value whichever is less.
(d) Cost and market value whichever is higher.
3 Current investments are carried at
(a) Fair value.
(b) cost.
(c) Cost and fair value, whichever is less.
(d) Cost and fair value, whichever is higher.
4. A Ltd. acquired 2,000 equity shares of Omega Ltd. on cum-right basis at ` 75
per share. Subsequently, omega Ltd. made a right issue of 1:1 at ` 60 per share,
which was subscribed for by A. Total cost of investments at the year-end will
be `
(a) 2,70,000.
(b) 1,50,000.
(c) 1,20,000.
(d) 1,70,000.
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.99
5.99
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5. Cost of investment includes v
v
(a) Purchase costs.
(b) Brokerage and Stamp duty paid.
(c) Both (a) and (b).
(d) none of the above.
Theoretical Questions
6. Briefly explain disclosure requirements for Investments as per AS-13.
7. How will you classify the investments as per AS 13? Explain in Brief.
8. Whether the accounting treatment 'at cost' under the head ‘Long Term
Investments’ without providing for any diminution in value is correct and in
accordance with the provisions of AS 13. If not, what should have been the
accounting treatment in such a situation? Explain in brief.
Scenario based Questions
9 Mr. X acquires 200 shares of a company on cum-right basis for ` 70,000. He
subsequently receives an offer of right to acquire fresh shares in the company
in the proportion of 1:1 at ` 107 each. He does not subscribe but sells all the
rights for ` 12,000. The market value of the shares after their becoming ex-
rights has also gone down to ` 60,000. What should be the accounting
treatment in this case?
10. On 1st April, 20X1, XY Ltd. has 15,000 equity shares of ABC Ltd. at a book value
of ` 15 per share (nominal value ` 10 per share). On 1 st June, 20X1, XY Ltd.
acquired 5,000 equity shares of ABC Ltd. for ` 1,00,000. ABC Ltd. announced a
bonus and right issue.
(1) Bonus was declared, at the rate of one equity share for every five shares
held, on 1 st July 20X1.
(2) Right shares are to be issued to the existing shareholders on 1 st September
20X1. The company will issue one right share for every 6 shares at 20%
premium. No dividend was payable on these shares.
© The Institute of Chartered Accountants of India
5.100 ADVANCED ACCOUNTING
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(3) Dividend for the year ended 31.3.20X1 were declared by ABC Ltd. @ 20%,
v
which was received by XY Ltd. on 31 st October 20X1.
XY Ltd.
(i) Took up half the right issue.
(ii) Sold the remaining rights for ` 8 per share.
(iii) Sold half of its shareholdings on 1st January 20X2 at ` 16.50 per share.
Brokerage being 1%.
You are required to prepare Investment account of XY Ltd. for the year ended
31st March 20X2 assuming the shares are being valued at average cost.
11. The following information is presented by Mr. Z (a stock broker), relating to his
holding in 9% Central Government Bonds.
Opening balance (nominal value) ` 1,20,000, Cost ` 1,18,000 (Nominal value of
each unit is ` 100).
1.3.20X1 Purchased 200 units, ex-interest at ` 98.
1.7.20X1 Sold 500 units, ex-interest out of original holding at ` 100.
1.10.20X1 Purchased 150 units at ` 98, cum interest.
1.11.20X1 Sold 300 units, ex-interest at ` 99 out of original holdings.
Interest dates are 30th September and 31st March. Mr. Z closes his books every
31st December. Show the investment account as it would appear in his books. Mr.
Z follows FIFO method.
12. Mr. Purohit furnishes the following details relating to his holding in 8% Debentures
(` 100 each) of P Ltd., held as Current assets:
1.4.20X1 Opening balance – Nominal value ` 1,20,000, Cost ` 1,18,000
1.7.20X1 100 Debentures purchased ex-interest at ` 98
1.10.20X1 Sold 200 Debentures ex-interest at ` 100
1.1.20X2 Purchased 50 Debentures at ` 98 ex-interest
1.2.20X2 Sold 200 Debentures ex-interest at `99
Due dates of interest are 30th September and 31st March.
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.101
5.101
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Mr. Purohit closes his books on 31.3.20X2. Brokerage at 1% is to be paid for each v
v
transaction (at ex-interest price). Show Investment account as it would appear in his
books. Assume FIFO method. Market value of 8% Debentures of P Limited on 31.3.20X2
is ` 99.
13. On 1st April, 20X1, Mr. Vijay had 30,000 Equity shares in X Ltd. at a book value
of ` 4,50,000 (Face Value ` 10 per share). On 22 nd June, 20X1, he purchased
another 5000 shares of the same company for ` 80,000.
The Directors of X Ltd. announced a bonus of equity shares in the ratio of one
share for seven shares held on 10th August, 20X1.
On 31st August, 20X1 the Company made a right issue in the ratio of three
shares for every eight shares held, on payment of ` 15 per share. Due date for
the payment was 30th September, 20X1, Mr. Vijay subscribed to 2/3rd of the
right shares and sold the remaining of his entitlement to Viru for a
consideration of ` 2 per share.
On 31st October, 20X1, Vijay received dividends from X Ltd. @ 20% for the year
ended 31st March, 20X1. Dividend for the shares acquired by him on 22nd June,
20X1 to be adjusted against the cost of purchase.
On 15th November, 20X1 Vijay sold 20,000 Equity shares at a premium of ` 5 per
share.
You are required to prepare Investment Account in the books of Mr. Vijay for
the year ended 31st March, 20X2 assuming the shares are being valued at
average cost.
14. 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.
© The Institute of Chartered Accountants of India
5.102 ADVANCED ACCOUNTING
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(iii) Current investment in Company C, costing ` 10 lakhs are to be re-
v
classified as long term as the company wants to retain them. The market
value on date of transfer is ` 12 lakhs.
15. Gowtham Limited invested in shares of another company (with the intention
to hold the shares for short-term period) on 30th November, 2021 at a cost of
` 4,25,000. It also earlier purchased Gold of ` 8,00,000 and Silver of ` 3,50,000
on 31st March, 20X1.
Market values as on 31st March, 20X4, of the above investments are as
follows:
Shares ` 3,50,000
Gold ` 10,25,000
Silver ` 5,10,000
You are required to explain how will the above investments be shown
(individually and in total) in the books of account of Gowtham Limited for the
year ending 31st March, 20X4 as per the provisions of AS 13.
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (a) 2. (b) 3. (c) 4. (a) 5. (c)
Answer to the Theoretical Questions
6. The disclosure requirements as per AS 13 (Revised) are as follows:
(i) Accounting policies followed for the determination of carrying amount
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;
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.103
5.103
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v
(b) v
Profits and losses on disposal of current investment and changes
in carrying amount of such investments; v
(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;
(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. The investments are classified into two categories as per AS 13, viz., Current
Investments and 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 carrying amount for current investments is the lower of
cost and fair value. Any reduction to fair value and any reversals of such
reductions are included in the statement of profit and loss.
A long-term investment is an investment other than a current investment. Long
term investments are usually carried at cost. However, when there is a decline,
other than temporary, in the value of a long term investment, the carrying
amount is reduced to recognise the decline. The reduction in carrying amount
is charged to the statement of profit and loss.
8. The accounting treatment 'at cost' under the head 'Long Term Investment’ in
the financial statements of the company without providing for any diminution
in value is correct and is in accordance with the provisions of AS 13 provided
that there is no decline, other than temporary, in the value of investment. If
the decline in the value of investment is, other than temporary, compared to
the time when the shares were purchased, provision is required to be made.
© The Institute of Chartered Accountants of India
5.104 ADVANCED ACCOUNTING
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Answerv to the Scenario based Questions
v
9. As per AS 13, 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. In this case, the amount of the ex-right market value of 200
shares bought by X immediately after the declaration of rights falls to ` 60,000.
In this case, out of sale proceeds of ` 12,000, ` 10,000 may be applied to reduce
the carrying amount to bring it to the market value and ` 2,000 would be
credited to the profit and loss account.
10.
In the books of XY Ltd.
Investment in equity shares of ABC Ltd.
for the year ended 31st March, 20X2
Date Particulars No. Dividend Amount Date Particulars No. Dividend Amount
` ` ` `
20X1 April To Balance b/d 15,000 - 2,25,000 20X1 By Bank A/c - 30,000 10,000
1 Oct. 31 (W.N. 5)
June 1 To Bank A/c 5,000 -- 1,00,000 20X2 By Bank A/c 13,000 - 2,12,355
Jan. 1 (W.N.4)
July 1 To Bonus Issue 4,000 - - March By Balance c/d 13,000 - 1,69,500
(W.N. 1) 31 (W.N. 6)
Sept.1 To Bank A/c 2,000 - 24,000
(W.N. 2)
20X2 To P & L A/c - - 42,855
Jan 1 (W.N. 4)
“20X2 To P & L A/c - 30,000 -
March 31
26,000 30,000 3,91,855 26,000 30,000 3,91,855
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.105
5.105
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Working Notes: v
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1. Calculation of no. of bonus shares issued
15,000 shares+5,000 shares
Bonus Shares = x 1= 4,000 shares
5
2. Calculation of right shares subscribed
15,000 shares+5,000 shares+4,000 shares
Right Shares = = 4,000 shares
6
4,000
Shares subscribed by XY Ltd. = = 2,000 shares
2
Value of right shares subscribed = 2,000 shares @ ` 12 per share
= ` 24,000
3. Calculation of sale of right entitlement
2,000 shares x ` 8 per share = ` 16,000
Amount received from sale of rights will be credited to statement of profit
and loss.
4. Calculation of profit on sale of shares
Total holding = 15,000 shares original
5,000 shares purchased
4,000 shares bonus
2,000 shares right shares
26,000 shares
50% of the holdings were sold
i.e. 13,000 shares (26,000 x1/2) were sold.
Cost of total holdings of 26,000 shares (on average basis)
= ` 2,25,000 + ` 1,00,000 + ` 24,000– ` 10,000 = ` 3,39,000
Average cost of 13,000 shares would be
3,39,000
= ×13,000 = ` 1,69,500
26,000
© The Institute of Chartered Accountants of India
5.106 ADVANCED ACCOUNTING
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v
v `
v Sale proceeds of 13,000 shares (13,000 x `16.50) 2,14,500
Less: 1% Brokerage (2,145)
2,12,355
Less: Cost of 13,000 shares (1,69,500)
Profit on sale 42,855
5. Dividend received on investment held as on 1st April, 20X1
= 15,000 shares x ` 10 x 20%
= ` 30,000 will be transferred to Profit and Loss A/c
Dividend received on shares purchased on 1st June, 20X1
= 5,000 shares x ` 10 x 20% = `10,000 will be adjusted to Investment A/c
Note: It is presumed that no dividend is received on bonus shares as
bonus shares are declared on 1st July, 20X1 and dividend pertains
to the year ended 31.3.20X1.
6. Calculation of closing value of shares (on average basis) as on
31st March, 20X2
3,39,000
13,000× = ` 1,69,500
26,000
11.
In the Books of Mr. Z
9% Central Government Bonds (Investment) Account
Particulars Nominal Interest Principal Particulars Nominal Interest Principal
Value Value
20X1 ` ` ` 20X1 ` ` `
Jan.1 To Balance Mar. By Bank A/c
b/d 1,20,000 2,700 1,18,000 31 (W.N.3) - 6,300 -
(W.N.1)
Marc To Bank A/c July 1 By Bank A/c
h1 (W.N.2) 20,000 750 19,600 (W.N.4) 50,000 1,125 50,000
July 1 To P&L A/c - - 833 Sept. By Bank A/c
(W.N.5) 30 (W.N.6) - 4,050 -
Oct. To Bank A/c Nov. By Bank A/c
1 (150 x 98) 15,000 - 14,700 1 (W.N.7) 30,000 225 29,700
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.107
5.107
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v
Nov. To P&L A/c - - 200 Dec. By Balance v
1 (W.N.8) 31 c/d (W.N. 9 75,000 1,688 v
73,633
& W.N.10)
Dec. To P&L A/c
31 (b.f.) 9,938
(Transfer)
1,55,000 13,388 1,53,333 1,55,000 13,388 1,53,333
Working Note:
1. Interest element in opening balance of bonds = 1,20,000 x 9% x 3/12 =
` 2,700
2. Purchase of bonds on 1. 3.20X1
Interest element in purchase of bonds = 200 x 100 x 9% x 5/12 = ` 750
Investment element in purchase of bonds = 200 x 98 = ` 19,600
3. Interest for half-year ended 31 March = 1,400 x 100 x 9% x 6/12 = ` 6,300
4. Sale of bonds on 1.7.20X1
Interest element = 500 x 100 x 9% x 3/12 = ` 1,125
Investment element = 500 x 100 = ` 50,000
5. Profit on sale of bonds on 1.7.20X1
Cost of bonds = (1,18,000/ 1,200) x 500 = ` 49,167
Sale proceeds = ` 50,000
Profit element = ` 833
6. Interest for half-year ended 30 September
= 900 x 100 x 9% x 6/12 = ` 4,050
7. Sale of bonds on 1.11.20X1
Interest element = 300 x 100 x 9% x 1/12 = ` 225
Investment element = 300 x 99 = ` 29,700
8. Profit on sale of bonds on 1.11.20X1
Cost of bonds = (1,18,000/ 1,200) x 300 = ` 29,500
Sale proceeds = ` 29,700
Profit element = ` 200
© The Institute of Chartered Accountants of India
5.108 ADVANCED ACCOUNTING
v
v
9. v Closing value of investment
v
Calculation of closing Nominal `
balance: value
Bonds in hand remained in
hand at 31st December 20X1
From original holding 1,18,000 39,333
40,000
1,20,000
(1,20,000 – 50,000 – 30,000) = 40,000
Purchased on 1st March 20,000 19,600
Purchased on 1st October 15,000 14,700
75,000 73,633
10. Interest element in closing balance of bonds = 750 x 100 x 9% x 3/12
= ` 1,688
12.
Investment A/c of Mr. Purohit
for the year ending on 31-3-20X2
(Scrip: 8% Debentures of P Limited)
(Interest Payable on 30th September and 31st March)
Date Particulars Nominal Interest Cost Date Particulars Nominal Interest Cost
Value Value
` ` ` `
1.4.20X1 To Balance b/d 1,20,000 - 1,18,000 30.9.20X1 By Bank (1,300 x - 5,200 -
100 x 8% x 6/12)
1.7.20X1 To Bank (ex- 10,000 200 9,898 1.10.20X1 By Bank (W.N.4) 20,000 - 19,800
Interest)
(W.N.1)
1.10.20X1 To Profit & Loss 133 1.2.20X2 By Bank (ex- 20,000 533 19,602
A/c (W.N.4) Interest) (W.N.5)
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.109
5.109
v
v
1.1.20X2 To Bank (ex- 5,000 100 4,949 1.2.20X2 By Profit & Loss
v
64
v
Interest) A/c (W.N.5)
(W.N.2)
31.3.20X2 To Profit & Loss - 9,233 31.3.20X2 By Bank (950 x - 3,800 -
A/c (Bal. fig.) 100 x 8% x 6/12)
31.3.20X2 By Balance c/d 95,000 - 93,514
(W.N.3)
1,35,000 9,533 1,32,980 1,35,000 9,533 1,32,980
Working Notes:
1. Purchase of debentures on 1.7.20X1
Interest element = 100 x 100 x 8% x 3/12 = ` 200
Investment element = (100 x 98) + [1% (100 x 98)] = ` 9,898
2. Purchase of debentures on 1.1.20X2
Interest element = 50 x 100 x 8% x 3/12 = ` 100
Investment element = {(50 x 98) + [1%(50 x 98)]} = ` 4,949
3. Valuation of closing balance as on 31.3.20X2:
Market value of 950 Debentures at ` 99 = ` 94,050
Cost of
1,18,000
800 Debentures cost = x80,000 = 78,667
1,20,000
100 Debentures cost = 9,898
50 Debentures cost = 4,949
93,514
Value at the end = ` 93,514, i.e., whichever is less
4. Profit on sale of debentures as on 1.10.20X1
Sales price of debentures (200 x ` 100) 20,000
© The Institute of Chartered Accountants of India
5.110 ADVANCED ACCOUNTING
v
v
v
Less: Brokerage @ 1% (200)
v
19,800
Less: Cost of Debentures 1,18,000 x20,000 = (19,667)
1,20,000
Profit on sale 133
5. Loss on sale of debentures as on 1.2.20X2
Sales price of debentures (200 x ` 99) 19,800
Less: Brokerage @ 1% (198)
19,602
1,18,000 (19,666
Less: Cost of Debentures x20,000 =
1,20,000 )
Loss on sale 64
Interest element in sale of investment = 200 x 100 x 8% x 4/12 ` 533
13.
Investment Account in Books of Vijay
(Scrip: Equity Shares in X Ltd.)
No. Amount No. Amount
` `
1.4.20X1 To Bal b/d 30,000 4,50,000 31.10.20X1 By Bank — 10,000
(dividend
22.6.20X1 To Bank 5,000 80,000 on shares
acquired on
22.6.20X1)
10.8.20X1 To Bonus 5,000 _
30.9.20X1 To Bank 10,000 1,50,000
(Rights
Shares)
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.111
5.111
v
v
v
15.11.20X1 To P&L A/c 32,000 15.11.20X1 By Bank 20,000 3,00,000
v
(Profit
on sale of (Sale of
shares) shares)
31.3.20X2 By Bal. c/d 30,000 4,02,000
50,000 7,12,000 50,000 7,12,000
Working Notes:
(1) Bonus Shares = (30,000 + 5,000) / 7 = 5,000 shares
(2) Right Shares =
( 30, 000 + 5, 000 + 5, 000 ) 3 = 15,000 shares
8
(3) Rights shares sold = 15,000×1/3 = 5,000 shares
(4) Dividend received = 30,000×10×20% = ` 60,000 will be taken to P&L
statement
(5) Dividend on shares purchased on 22.6.20X1
= 5,000×10×20%
= ` 10,000 is adjusted to Investment A/c
(6) Profit on sale of 20,000 shares
= Sales proceeds – Average cost
Sales proceeds = ` 3,00,000
Average cost =
( 4, 50, 000 + 80, 000 + 1, 50, 000 - 10, 000) × 20, 000 = ` 2,68,000
50, 000
Profit = ` 3,00,000– ` 2,68,000= ` 32,000.
(7) Cost of shares on 31.3.20X2
( 4, 50, 000 + 80, 000 + 1, 50, 000 - 10, 000) × 30, 000 = ` 4,02,000
50, 000
(8) Sale of rights amounting ` 10,000 (` 2 x 5,000 shares) will not be shown
in investment A/c but will directly be taken to P & L statement.
14. As per AS 13 (Revised) ‘Accounting for Investments’, where long-term
investments are reclassified as current investments, transfers are made at the
© The Institute of Chartered Accountants of India
5.112 ADVANCED ACCOUNTING
v
v
v
lower of cost and carrying amount at the date of transfer. And where
v
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.
15. 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 (` 4,25,000) and market value (` 3,50,000) as on 31 March 20X4, i.e.,
` 3,50,000.
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 31 stMarch, 20X1) should
continue to be shown at cost (since there is no ‘other than temporary’
diminution) as on 31 st March, 20X4, i.e., ` 8,00,000 and `3,50,000 respectively,
though their market values have been increased.
Thus the shares, gold and silver will be shown at ` 3,50,000, ` 8,00,000 and
` 3,50,000 respectively and hence, total investment will be valued at
` 15,00,000 for the year ending on 31st March, 20X4 as per AS 13.
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.113
UNIT 4: ACCOUNTING STANDARD 16
BORROWING COSTS
LEARNING OUTCOMES
After studying this unit, you will be able to recognize–
♦ Meaning of Borrowing costs;
♦ Definition of Qualifying Asset;
♦ Accounting treatment for borrowings – Specific and general
borrowings;
♦ Time when does Commencement of Capitalisation takes place;
♦ Time when does Suspension and cessation of Capitalisation takes
place;
♦ Disclosure requirements for this standard.
4.1 INTRODUCTION
The objective of AS 16 is to prescribe the accounting treatment 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.
Clarification Chart:
Particulars Remarks – Is the fund
covered by AS 16?
Equity share capital No
Retained earnings No
Preference Share Capital classified as a liability Yes
Preference Share Capital classified as equity No
© The Institute of Chartered Accountants of India
5.114 ADVANCED ACCOUNTING
4.2 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 (Tangible or intangible) 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.
Clarification Chart:
Particulars Is it a qualifying asset?
PPE (Property, plant and equipment) Yes
Intangible assets Yes
Investment Properties Yes
(Building meant for capital appreciation
and earning rental income)
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.115
Inventory Yes – If they require a substantial
period of time to bring them to a
saleable condition.
Investments (Financial assets) No
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. Therefore, a rebuttable presumption of a period of twelve months is
considered “substantial” period of time. In estimating the period, time which an
asset takes technologically and commercially to get it ready for its intended use
or sale should be considered.
4.3 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.
Clarification Chart:
Particulars Accounting Treatment
Exchange Credited to P&L
Gain
© The Institute of Chartered Accountants of India
5.116 ADVANCED ACCOUNTING
Exchange Lower of the following is treated as a part of borrowing costs:
Loss 1. Actual exchange loss;
2. Difference between interest on local currency borrowings
and interest on foreign currency borrowings.
Note: The excess exchange difference if any will be charged to
P&L A/c.
If the difference between the interest on local currency borrowings and the interest
on foreign currency borrowings is equal to or more than the exchange difference on
the amount of principal of the foreign currency borrowings, the entire amount of
exchange difference is covered under paragraph 4 (e) of AS 16.
If there is exchange gain in the next year, then it will reduce the borrowing cost in
that year to the extent exchange loss was earlier treated as borrowing cost for that
borrowing.
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 Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.117
the 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’.
4.4 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 Institute of Chartered Accountants of India
5.118 ADVANCED ACCOUNTING
The borrowing costs (including exchange loss treated as borrowing cost as per
para 4(e)) 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. Other
borrowing costs are recognised as an expense in the period in which they are
incurred.
4.5 RECOGNITION CRITERIA
Borrowing costs are capitalised as part of the cost of a qualifying asset when:
(a) it is probable that they will result in future economic benefits to the
enterprise; and
(b) the costs can be measured reliably.
Borrowing costs
Specific borrowings General borrowings
Illustration 1
PRM Ltd. obtained a loan from a bank for ` 120 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.
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.119
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
4.6 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
borrowing during the period less any income on the temporary investment of
those borrowings.
Amount eligible for capitalisation:
= Actual borrowing costs incurred (-) 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.
4.7 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
© The Institute of Chartered Accountants of India
5.120 ADVANCED ACCOUNTING
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.
Step 1 - Compute the capitalisation rate:
Where,
Borrowing cost on general borrowings
Capitalization Rate = ×100
Weighted average of general borrowings
outstanding during the period
Step 2 - Amount eligible for capitalisation:
= Expenditure incurred on Qualifying asset x Capitalisation rate
Step 3 – Cross check:
The amount of borrowing costs capitalised during a period should not exceed the
amount of borrowing costs incurred during that period.
4.8 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:
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.121
Amount Rate of Interest
` 5,00,000 11%
` 9,00,000 13%
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
© The Institute of Chartered Accountants of India
5.122 ADVANCED ACCOUNTING
(iii) Interest on weighted average accumulated expenses
`
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 capitalized for building
`
Cost of building ` (2,00,000 + 2,50,000 + 4,50,000 + 10,20,000
1,20,000)
Add: Amount of interest to be capitalised 74,189
10,94,189
(v) Journal Entry
Date Particulars Dr. (`) Cr. (`)
31.12. Building account Dr. 10,94,189
20X1
To Bank account 10,94,189
(Being amount of cost of building
and borrowing cost thereon
capitalised)
4.9 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,
∗
(` 6,22,500 – ` 1,00,000)
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.123
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.
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.
4.10 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
© The Institute of Chartered Accountants of India
5.124 ADVANCED ACCOUNTING
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.
4.11 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 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.
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.125
Capitalization of
Borrowing Cost
Commencement Suspension Cessation
Expenditure during when
Borrowing Activities to
for extended substantia
costs are prepare the
qualifying periods in lly all the
being qualifying
asset is which active activities
incurred asset is in
being development are
progress.
incurred. is interrupted. complete.
4.12 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.
© The Institute of Chartered Accountants of India
5.126 ADVANCED ACCOUNTING
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:
Purpose Nature Interest to be Interest to be
capitalised charged to profit
and loss account
` in lakhs ` in lakhs
Modernisation Qualifying asset
406
and renovation * *52.20 × = 36.54
580
of plant and
machinery
58
* *52.20 × = 5.22
580
Advance to Qualifying asset
supplies for 116
52.20 × = 10.44
additional assets 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
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ASSETS BASED ACCOUNTING STANDARDS 5.127
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 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).
© The Institute of Chartered Accountants of India
5.128 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. As per AS 16, all 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.
(d) None of the above
2. Which of the following statement is correct:
(a) Entire exchange gain is reduced from the cost of the Qualifying asset.
(b) Entire exchange loss is added to the cost of a Qualifying asset.
(c) No adjustment is done for the exchange loss while computing cost of
Qualifying asset.
(d) None of the above
3. Capitalisation rate considers:
(a) Borrowing costs on general borrowings only.
(b) Borrowing costs on general and specific borrowings both.
(c) Borrowing costs on specific borrowings only
(d) None of the above
4. If the amount eligible for capitalisation in case of inventory as per AS 16 is `
12,000 and cost of inventory is ` 40,000 and its net realizable value is `
45,000; What amount can be capitalised as a part of inventory cost.
(a) ` 12,000.
(b) ` 5,000.
(c) ` 7,000.
(c) ` 10,000.
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ASSETS BASED ACCOUNTING STANDARDS 5.129
5. X Ltd is commencing a new construction project, which is to be financed by
borrowing. The key dates are as follows:
(i) 15th May, 20X1: Loan interest relating to the project starts to be
incurred
(ii) 2nd June, 20X1: Technical site planning commences
(iii) 19th June, 20X1: Expenditure on the project started to be incurred
(iv) 18th July, 20X1: Construction work commences
Identify the commencement date for capitalisation under AS 16.
(a) 15th May, 20X1.
(b) 19th June, 20X1.
(c) 18th July, 20X1.
(d) 2nd June, 20X1
Theoretical Questions
6. When capitalization of borrowing cost should cease as per Accounting Standard
16? Explain the provision.
7. H Ltd. incurs borrowing costs for the purpose of construction of a qualifying asset
for its own use. The construction gets completed on May 31, 20X1. However,
decoration work is under process which is expected to be completed by
November 20X1 after which H Ltd. will be able to start using the said asset for its
own use. H Ltd. wants to capitalize the eligible borrowing costs incurred up to
November 20X1.
8. ABC Ltd. is in the process of getting an entertainment park constructed. For this
purpose, it has taken loan from a bank. The said park consists of several rides
and facilities, each of which can be used individually. Three fourth part of the
park has been constructed and can be opened up for public, while construction
on the remaining part is continuing. Whether the capitalization of borrowing cost
should continue for the whole park until construction continues?
© The Institute of Chartered Accountants of India
5.130 ADVANCED ACCOUNTING
Scenario based Questions
9. 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
(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.
10. Rainbow Limited borrowed an amount of ` 150 crores on 1.4.20X1 for
construction of boiler plant @ 11% p.a. The plant is expected to be completed
in 4 years. Since the weighted average cost of capital is 13% p.a., the
accountant of Rainbow Ltd. capitalized ` 19.50 crores for the accounting
period ending on 31.3.20X2. Due to surplus fund out of ` 150 crores, income
of ` 3.50 crores were earned and credited to profit and loss account.
Comment on the above treatment of accountant with reference to relevant
accounting standard.
11. Harish Construction Company is constructing a huge building project consisting
of four phases. It is expected that the full building will be constructed over several
years but Phase I and Phase II of the building will be started as soon as they are
completed.
Following is the detail of the work done on different phases of the building
during the current year:
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ASSETS BASED ACCOUNTING STANDARDS 5.131
(` in lakhs)
Phase I Phase II Phase III Phase IV
` ` ` `
Cash expenditure 10 30 25 30
Building purchased 24 34 30 38
Total expenditure 34 64 55 68
Total expenditure of all phases 221
Loan taken @ 15% at the 200
beginning of the year
During mid of the current year, Phase I and Phase II have become operational.
Find out the total amount to be capitalized and to be expensed during the year.
12. Expert Limited issued 12% secured debentures of ` 100 lakhs on 01.06.20X1.
Money raised from debentures to be utilized as under:
Intended Purpose Amount ` in
lakhs
Construction of factory building 40
Working Capital 30
Purchase of Machinery 15
Purchase of Furniture 2
Purchase of truck 13
Additional Information:
(i) Interest on debentures for the Financial Year 20X1-20X2 was paid by
the Company.
(ii) During the year, the company invested idle fund of ` 5 lakhs (out of
the money raised from debentures) in Bank's fixed deposit and earned
interest of ` 50,000.
(iii) In March, 20X2 construction of factory building was not completed (it
is expected that it will take another 6 months).
© The Institute of Chartered Accountants of India
5.132 ADVANCED ACCOUNTING
(iv) In March 20X2, Machinery was installed and ready for its intended use.
(v) Furniture was put to use at the end of March 20X2.
(vi) Truck is going to be received in April, 20X2.
You are required to show the treatment of interest as per AS 16 in respect
of borrowing cost for the year ended 31st March, 20X2 in the Books of
Expert Limited.
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (c) 2. (c) 3. (a) 4. (b) 5. (b)
Answer to the Theoretical Questions
6. Capitalization 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.
7. The capitalization of borrowing costs shall cease when substantially all the
activities necessary to prepare the qualifying assets for its intended use or sale
is completed.
In the given case, H Ltd. should capitalize borrowing costs only up to May 31,
20X1. The borrowing cost incurred thereafter cannot be capitalized as the asset
was ready for its intended use on May 31, 20X1. The fact that decoration work
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ASSETS BASED ACCOUNTING STANDARDS 5.133
was being carried out should not be considered as the asset was ready for its
intended use on May 31, 20X1.
8. ABC Ltd. is in process of constructing an entertainment park which consists of
several rides and facilities that can operate independently for their intended
use. Even though the park as whole is not complete, the individual facilities are
ready for their intended use.
The cessation of capitalization depends upon the nature of the qualifying
assets, particularly where the qualifying assets consists of various parts. There
are qualifying assets where each part is capable of being used while the
construction continues on other parts. There are qualifying assets where all
parts have to be completed before any earlier completed part can be put to
use.
Since in the given scenario, the individual facilities are capable of operating
independently and are ready for their intended use, therefore the borrowing
costs shall cease to be capitalized for the three-fourth part of the project.
Answer to the Scenario based Questions
9. 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 Yes 62,50,000 [80,00,000x(25/32)]
of sea-link
Purchase of No 7,50,000 [80,00,000x(3/32)]
© The Institute of Chartered Accountants of India
5.134 ADVANCED ACCOUNTING
equipment and
machineries
Working No 5,00,000 [80,00,000x(2/32)]
capital
Purchase of No 1,25,000 [80,00,000x(0.5/32)]
vehicles
Advance for No 1,25,000 [80,00,000x(0.5/32)]
tools, cranes
etc.
Purchase of No 2,50,000 [80,00,000x(1/32)]
technical
know-how
Total 62,50,000 17,50,000
*It is assumed that work held up for a month due to high water level is normal
during the construction of sealink and capitalization of borrowing cost should
not be suspended for necessary temporary delay.
10. Para 10 of AS 16 'Borrowing Costs' states "To the extent that funds are
borrowed specifically for the purpose of obtaining a qualifying asset, the
amount of borrowing costs eligible for capitalization on that asset should be
determined as the actual borrowing costs incurred on that borrowing during
the period less any income on the temporary investment of those borrowings."
The capitalization 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.
Thus, the treatment of accountant of Rainbow Ltd. is incorrect.
Amount of borrowing costs capitalized should be calculated as follows:
Particulars ` in crores
Actual interest for 20X1-20X2 (11% of ` 150 crores) 16.50
Less: Income on temporary investment from specific (3.50)
borrowings
Borrowing costs to be capitalized during year 20X1-20X2 13.00
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ASSETS BASED ACCOUNTING STANDARDS 5.135
11. Computation of amount to be capitalized
No. Particulars `
1. Interest expense on loan ` 2,00,00,000 at 15% 30,00,000
2. Total cost of Phases I and II (` 34,00,000 +64,00,000) 98,00,000
3. Total cost of Phases III and IV (` 55,00,000 + 1,23,00,000
` 68,00,000)
4. Total cost of all 4 phases 2,21,00,000
5. Total loan 2,00,00,000
6. Interest on loan used for Phases I & II, based on 13,30,317
proportionate (approx.)
30,00,000
Loan amount = × 98,00,000
2,21,00,000
7. Interest on loan used for Phases III & IV, based on 16,69,683
30,00,000 (approx.)
proportionate Loan amount = ×1,23,00,000
2,21,00,000
Accounting treatment
For Phase I and Phase II
Since Phase I and Phase II have become operational at the mid of the year, half
of the interest amount of ` 6,65,158.50 (i.e. ` 13,30,317/2) relating to Phase I
and Phase II should be capitalized (in the ratio of asset costs 34:64) and added
to respective assets in Phase I and Phase II and remaining half of the interest
amount of ` 6,65,158.50 (i.e. ` 13,30,317/2) relating to Phase I and Phase II
should be expensed during the year.
For Phase III and Phase IV
Interest of ` 16,69,683 relating to Phase III and Phase IV should be held in
Capital Work-in-Progress till assets construction work is completed, and
thereafter capitalized in the ratio of cost of assets. No part of this interest
amount should be charged/expensed off during the year since the work on
these phases has not been completed yet.
12. According to AS 16 “Borrowing Costs”, a qualifying asset is an asset that
necessarily takes a substantial period of time to get ready for its intended
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5.136 ADVANCED ACCOUNTING
use. As per the Standard, borrowing costs that are directly attributable to
the acquisition, construction or production of a qualifying asset should be
capitalized as part of the cost of that asset. The amount of borrowing costs
eligible for capitalization should be determined in accordance with this
Standard. Other borrowing costs should be recognized as an expense in the
period in which they are incurred. It also states that to the extent that funds
are borrowed specifically for the purpose of obtaining a qualifying asset, the
amount of borrowing costs eligible for capitalization on that asset should
be determined as the actual borrowing costs incurred on that borrowing
during the period less any income on the temporary investment of those
borrowings.
Thus, eligible borrowing cost = ` 10,00,000 (100 lakhs x 12% x 10/12) –
` 50,000 = ` 9,50,000
Particulars Nature of assets Interest to be Interest to be
capitalized charged to Profit
(`) & Loss Account
(`)
Construction of Qualifying Asset 9,50,000x40/1 NIL
factory building 00
= ` 3,80,000
Purchase of Not a Qualifying NIL 9,50,000x15/100
Machinery Asset = 1,42,500
Purchase of and Not a Qualifying NIL 9,50,000x2/100
furniture Asset =19,000
Purchase of truck Not a Qualifying NIL 9,50,000x13/100
Asset = 1,23,500
Working Capital Not a Qualifying NIL 9,50,000x30/100
Asset = ` 2,85,000
Total ` 3,80,000 ` 5,70,000
© The Institute of Chartered Accountants of India
ASSETS BASED ACCOUNTING STANDARDS 5.137
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UNIT 5: ACCOUNTING STANDARD 19 LEASES v
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend–
What is a lease
What are the parameters for Classification of Leases
Accounting for leases in the Financial Statements of Lessees
• Finance Leases
• Operating Leases
Accounting for Leases in the Financial Statements of Lessors
• Finance Leases
• Operating Leases
Sale And Leaseback Transactions
Disclosures required as per the standard.
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5.1 v INTRODUCTION
Before, we start with the standard, let us lay down the coverage of AS 19 from the
examination point of view as under:
Areas covered by AS 19:
What is a lease and how do we classify a lease (Finance or Operating)?
Lessee's point of view Lessor's point of view
Accounting of a Lease (Finance and Opearting)
Books of Lessee Books of Lessor
Special Issue - Related to Lease Accounting
Sale and Lease back Transaction
The objective of AS 19 is to prescribe, for lessees and lessors, the appropriate
accounting policies and disclosures in relation to finance leases and operating
leases.
What is a Lease?
A Lease is an agreement whereby the Lessor (legal owner of an asset) conveys to
the Lessee (another party) in return for a payment or series of periodic payments
(Lease rents), the right to use an asset for an agreed period of time.
5.2 APPLICABILITY OF AS 19 [SCOPE]
The standard applies to all leases other than:
(a) lease agreements to explore for or use of natural resources, such as oil, gas,
timber metals and other mineral rights; and
(b) licensing agreements for items such as motion picture films, video
recordings, plays, manuscripts, patents and copyrights; and
(c) lease agreements to use lands
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5.3 DEFINITIONS v
A non-cancellable lease is a lease that is cancellable only:
(a) upon the occurrence of some remote contingency; or
(b) with the permission of the lessor; or
(c) if the lessee enters into a new lease for the same or an equivalent asset with
the same lessor; or
(d) upon payment by the lessee of an additional amount such that, at inception,
continuation of the lease is reasonably certain.
The lease term is the non-cancellable period for which the lessee has agreed to
take on lease the asset together with any further periods for which the lessee has
the option to continue the lease of the asset, with or without further payment,
which option at the inception of the lease it is reasonably certain that the lessee
will exercise.
The inception of the lease is the earlier of the date of the lease agreement and
the date of a commitment by the parties to the principal provisions of the leas e.
Minimum lease payments are the payments over the lease term that the lessee
is, or can be required, to make excluding contingent rent, costs for services and
taxes to be paid by and reimbursed to the lessor, together with:
(a) in the case of the lessee, any residual value guaranteed by or on behalf of
the lessee; or
(b) in the case of the lessor, any residual value guaranteed to the lessor:
(i) by or on behalf of the lessee; or
(ii) by an independent third party financially capable of meeting this
guarantee.
However, if the lessee has an option to purchase the asset at a price which is
expected to be sufficiently lower than the fair value at the date the option
becomes exercisable that, at the inception of the lease, is reasonably certain to be
exercised, the minimum lease payments comprise minimum payments payable
over the lease term and the payment required to exercise this purchase option.
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5.140 ADVANCED ACCOUNTING
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The above definition can be summarized as under:
v
Note: The definition can be seen separately from the point of view of Lessee and
Lessor.
From the point of view of Lessee
Case I – Lessee will return the asset Case II – Lessee will retain the asset
at the end of the lease term at the end of the lease term (as he
has option to buy the asset and it is
reasonably certain that he will exercise
the option)
Payments over the lease term that Payments over the lease term that the
the lessee is, or can be required, to lessee is, or can be required, to make
make excluding: excluding:
(a) contingent rent. (a) contingent rent.
(b) costs for services and (b) costs for services and taxes
taxes to be paid by and to be paid by and
reimbursed to the lessor. reimbursed to the lessor.
+ +
Any residual value guaranteed by or Payment required to exercise the
on behalf of the lessee. purchase option.
From the point of view of Lessor
Case I – Lessee will return the asset Case II – Lessee will retain the asset
at the end of the lease term at the end of the lease term (as he
Payments over the lease term that has option to buy the asset and it is
the lessee is, or can be required, to reasonably certain that he will exercise
make excluding: the option)
(a) contingent rent. Same as Lessee given above
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(b) costs for services and taxes to v
v
be paid by and reimbursed to
the lessor.
+
Any residual value guaranteed:
(a) by or on behalf of the lessee; or
(b) by an independent third party
financially capable of meeting
this guarantee.
Fair value is the amount for which an asset could be exchanged or a liability
settled between knowledgeable, willing parties in an arm’s length transaction.
Economic life is either:
(a) the period over which an asset is expected to be economically usable by
one or more users; or
(b) the number of production or similar units expected to be obtained from the
asset by one or more users.
Useful life of a leased asset is either:
(a) the period over which the leased asset is expected to be used by the lessee;
or
(b) the number of production or similar units expected to be obtained from the
use of the asset by the lessee.
Note: The economic life is always greater than the useful life of the asset. Useful
life represents the depreciable life of an asset whereas, economic life represents
the total life during which an asset is capable of generating economic benefits.
Residual value of a leased asset is the estimated fair value of the asset at the end
of the lease term.
Guaranteed residual value is:
(a) in the case of the lessee, that part of the residual value which is guaranteed
by the lessee or by a party on behalf of the lessee (the amount of the
guarantee being the maximum amount that could, in any event, become
payable); and
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(b) v
in the case of the lessor, that part of the residual value which is guaranteed
v
by or on behalf of the lessee, or by an independent third party who is
financially capable of discharging the obligations under the guarantee.
Unguaranteed residual value of a leased asset is the amount by which the
residual value of the asset exceeds its guaranteed residual value.
Note: Residual value = Guaranteed Residual value (GRV) + Unguaranteed
Residual value (UGRV)
Gross investment in the lease is the aggregate of the minimum lease payments
under a finance lease from the standpoint of the lessor and any unguaranteed
residual value accruing to the lessor.
In simple words,
Gross Undiscounted total cash inflows from the point of view of the
Investment lessor
(GI) Undiscounted total of:
(a) Minimum Lease Payments (MLP); and
(b) Unguaranteed Residual Value (UGRV).
Undiscounted total of:
(a) Lease Payments;
(b) Guaranteed residual value (GRV); and
(c) Unguaranteed Residual value (UGRV).
Undiscounted total of:
(a) Lease Payments; and
(b) Residual value (GRV and UGRV);
Unearned finance income is the difference between:
(a) the gross investment in the lease; and
(b) the present value of
(i) the minimum lease payments under a finance lease from the
standpoint of the lessor; and
(ii) any unguaranteed residual value accruing to the lessor,
at the interest rate implicit in the lease.
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Unearned Gross Investment (GI) – Net Investment (NI)
v
Finance
Gross Investment (GI) – Present value of Gross Investment
Income
Gross Investment – Fair Value
(UFI)
Simply speaking = Total Interest
Net investment in the lease is the gross investment in the lease less unearned
finance income.
In simple words,
Net Discounted total cash inflows from the point of view of the
Investment lessor
(NI) Discounted total of:
(a) Minimum Lease Payments (MLP); and
(b) Unguaranteed Residual Value (UGRV).
Discounted total of:
(a) Lease Payments;
(b) Guaranteed residual value (GRV); and
(c) Unguaranteed Residual value (UGRV).
Discounted total of:
(a) Lease Payments; and
(b) Residual value (GRV and UGRV);
Discounted Gross Investment (GI) i.e. Present value of GI
Simply speaking = Fair value
The interest rate implicit in the lease is the discount rate that, at the inception
of the lease, causes the aggregate present value of
(a) the minimum lease payments under a finance lease from the standpoint of
the lessor; and
(b) any unguaranteed residual value accruing to the lessor, to be equal to the
fair value of the leased asset.
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Interest Discount rate at which:
v
rate Cash Outflows = Present value of Cash Inflows
implicit in Where,
the lease
Cash Outflow = Fair value of the asset;
Cash Inflow = Lease Payments + Residual Value (GRV and
UGRV)
Simply speaking = Lessor’s IRR
The lessee’s incremental borrowing rate of interest is the rate of interest the
lessee would have to pay on a similar lease or, if that is not determinable, the rate
that, at the inception of the lease, the lessee would incur to borrow over a similar
term, and with a similar security, the funds necessary to purchase the asset.
Contingent rent is that portion of the lease payments that is not fixed in amount
but is based on a factor other than just the passage of time (e.g., percentage of
sales, amount of usage, price indices, market rates of interest).
The definition of a lease includes agreements for the hire of an asset which
contain a provision giving the hirer an option to acquire title to the asset upon
the fulfillment of agreed conditions. These agreements are commonly known as
hire purchase agreements. Hire purchase agreements include agreements under
which the property in the asset is to pass to the hirer on the payment of the last
instalment and the hirer has a right to terminate the agreement at any time
before the property so passes.
5.4 TYPES OF LEASES
For accounting purposes, leases are classified as:
(i) Finance leases; and
(ii) Operating leases.
Finance lease - A lease classified as Finance Lease if it transfers substantially all
the risks and rewards incident to ownership of an asset. Title may or may not be
eventually transferred.
Operating Lease -A lease is classified as an Operating Lease if it does not transfer
substantially all the risk and rewards incident to ownership.
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Whether a lease is a finance lease or an operating lease depends on the
substance of the transaction rather than its form. v
Risks include the possibilities of losses from idle capacity or technological
obsolescence and of variations in return due to changing economic conditions.
Rewards may be represented by the expectation of profitable operation over the
economic life of the asset and of gain from appreciation in value or realisation of
residual value.
We can summarize the types of lease conceptually as under:
Transfers the risk and reward
Finance
Typically, a loan arrangement
Type of Lease
Does not transfer the risk and reward
Operating
Typically, a rental arrangement
5.5 INDICATORS OF FINANCE LEASE
AS 19 has given a total of 8 parameters to decide whether it is a finance
lease or not. (These parameters have been discussed in para 5.6 and 5.7.
These 8 conditions can be divided into following categories:
5 Parameters -
Any 1 condition is met – It will
Deterministic in
be classified as finance lease.
nature
8 Parameters
3 Parameters - Even if all the conditions are met
Suggestive in – It does not necessarily imply
nature that it is a finance lease.
Let us take up these conditions one by one;
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5.146 ADVANCED ACCOUNTING
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5.6v DETERMINISTIC CONDITIONS
Situations, which would normally lead to a lease being classified as a finance lease
are:
(a) The lease transfers ownership of the asset to the lessee by the end of the
lease term;
(b) The lessee has the option to purchase the asset at a price which is expected
to be sufficiently lower than the fair value at the date the option becomes
exercisable such that, at the inception of the lease, it is reasonably certain
that the option will be exercised;
Example
Mr. A has taken a car on lease for 5 years from XYZ. After 5 years of lease
term Mr. A has the option to purchase this car for ` 20,000, whereas it is
assumed the car market value at the end of 5 th year would be ` 2,00,000.
Considering the option to buy it at bargain price, it is reasonably certain
that Mr. A would exercise that option.
(c) The lease term is for the major part of the economic life of the asset even if
title is not transferred;
Example
XYZ has taken a property on lease for 32 years from ABC, expected economic
life of the property is 40 years. Since XYZ is going to use the asset over major
part of its economic life (80% in this case), it will meet the condition to be
treated as finance lease.
(d) At the inception of the lease, present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset; and
(e) The leased asset is of a specialized nature such that only the lessee can use
it without major modifications being made.
Example
PQR, a hospital ordered 10 ambulances, specially designed as per the
requirement of PQR. These ambulances are taken on lease and it cannot be
used by anyone else without major modifications. This would meet the
condition of finance lease.
© The Institute of Chartered Accountants of India
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v
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5.7 SUGGESTIVE CONDITIONS v
Additional Indicators of situations which individually or in combination could also
lead to a lease being classified as a finance lease are:
(a) If the lessee can cancel the lease and the lessor’s losses associated with the
cancellation are borne by the lessee;
(b) If gains or losses from the fluctuations in the residual value accrue to the
lessee (for example if the lessor agrees to allow rent rebate equaling most
of the disposal value of leased asset at the end of the lease); and
(c) If the lessee can continue the lease for a secondary period at a rent, which is
substantially lower than market rent.
Lease classification is made at the inception of the lease. If at any time the
lessee and the lessor agree to change the provisions of the lease, other than by
renewing the lease, in a manner that would have resulted in a different
classification of the lease had the changed terms been in effect at the inception of
the lease, the revised agreement is considered as a new agreement over its
revised term.
Changes in estimates (for example, changes in estimates of the economic life or
of the residual value of the leased asset) or changes in circumstances (for
example, default by the lessee), however, do not give rise to a new classification
of a lease for accounting purposes.
5.8 ACCOUNTING FOR FINANCE LEASES
(BOOKS OF LESSEE)
Following is the accounting treatment of Finance Leases in the books of Lessee:
(i) On the date of inception of Lease, Lessee should show it as an asset and
corresponding liability at lower of:
• Fair value of leased asset at the inception of the lease
• Present value of minimum lease payments from the standpoint of the
lessee
© The Institute of Chartered Accountants of India
5.148 ADVANCED ACCOUNTING
v
v
v (Present value to be calculated with discount rate equal to interest
v
rate implicit in the lease, if this is practicable to determine; if not, the
lessee’s incremental borrowing rate should be used).
Thus, the journal entry at inception will be as under:
Particulars Debit Credit
Asset Refer Note
To Lessor (Lease Liability) Refer Note
It is not appropriate to present the liability for a leased asset as a deduction
from the leased asset in the financial statements. The liability for a leased
asset should be presented separately in the balance sheet as a current
liability or a long-term liability as the case may be.
Note:
The amount will be lower of the two:
(a) Fair value.
(b) Present value of MLP (Minimum Lease payments) from the point of
view of lessee.
(ii) Lease payments to be apportioned between the finance charge and the
reduction of the outstanding liability.
(iii) Finance charges to be allocated to periods during the lease term so as to
produce a constant rate of interest on the remaining balance of liability for
each period.
(iv) A finance lease gives rise to a depreciation expense for the asset as well as a
finance expense for each accounting period. The depreciation policy for a
leased asset should be consistent with that for depreciable assets which are
owned, and the depreciation recognised should be calculated on the basis
set out in AS 10 (Revised), Property, Plant and Equipment.
(v) If there is no reasonable certainty that the lessee will obtain ownership by
the end of the lease term, the asset should be fully depreciated over the
lease term or its useful life, whichever is shorter.
© The Institute of Chartered Accountants of India
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Note: v
v
Cases Useful life for Depreciation
Case I – Asset will be retained by the Useful life
lessee
Case II – Asset will be returned to the Useful life or lease term
lessor whichever is shorter
(vi) Initial direct costs are often incurred in connection with specific leasing
activities, as in negotiating and securing leasing arrangements. The costs
identified as directly attributable to activities performed by the lessee for a
finance lease are included as part of the amount recognised as an asset
under the lease.
5.8.1 Computation of interest rate implicit on lease
The interest rate implicit in the lease is the discount rate that, at the inception of
the lease, causes the aggregate present value of:
(a) the minimum lease payments under a finance lease from the standpoint of
the lessor; and
(b) any unguaranteed residual value accruing to the lessor, to be equal to the
fair value of the leased asset.
Discounting rate = R% p.a;
Lease Rents = L 1, L2 ……… Ln (Payable annually, at the end of each year)
Lease period = n years;
Guaranteed residual value = GR;
Unguaranteed residual value = UGR
Fair Value at the inception (beginning) of lease = FV
L1 L2 Ln GR
PV of MLP = + + +
(1+ R ) 1
(1+ R )2
(1+ R )n
(1+ R )n
© The Institute of Chartered Accountants of India
5.150 ADVANCED ACCOUNTING
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v
v UGR
Presentvvalue of unguaranteed residual value =
(1+ R )n
If interest rate implicit on lease is used as discounting rate:
Fair Value = PV of Minimum Lease Payments + PV of unguaranteed residual
value ….. (1)
The interest rate implicit on lease can be computed by trial and error, provided
the information required, e.g. the unguaranteed residual value can be reasonably
ascertained.
Example 1
Annual lease rents = ` 50,000 at the end of each year.
Lease period = 5 years;
Guaranteed residual value = ` 25,000
Unguaranteed residual value (UGR) = ` 15,000
Fair Value at the inception (beginning) of lease = ` 2,00,000
Interest rate implicit on lease is computed below:
Interest rate implicit on lease is a discounting rate at which present value of
minimum lease payments and unguaranteed residual value is ` 2 lakhs.
PV of minimum lease payments and unguaranteed residual value at guessed rate 10%
Year MLP + UGR DF (10%) PV
` `
1 50,000 0.909 45,450
2 50,000 0.826 41,300
3 50,000 0.751 37,550
4 50,000 0.683 34,150
5 50,000 0.621 31,050
5 25,000 0.621 15,525
5 15,000 0.621 9,315
2,14,340
© The Institute of Chartered Accountants of India
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v
v
PV of minimum lease payments and unguaranteed residual value at guessed rate
v
14%
Year MLP + UGR DF (14%) PV
` `
1 50,000 0.877 43,850
2 50,000 0.769 38,450
3 50,000 0.675 33,750
4 50,000 0.592 29,600
5 50,000 0.519 25,950
5 25,000 0.519 12,975
5 15,000 0.519 7,785
1,92,360
Interest rate implicit on lease is computed below by interpolation:
14% − 10%
Interest rate implicit on lease =10% + (2,14,340 − 2,00,000 ) = 12.6%
2,14,340 − 1,92,360
Example 2
Annual lease rents = ` 50,000 at the end of each year.
Lease period = 5 years;
Guaranteed residual value = ` 25,000
Unguaranteed residual value (UGR) = ` 15,000
Fair Value at the inception (beginning) of lease = ` 2,00,000
Interest rate implicit on lease is =12.6%
Present value of minimum lease payment is computed below:
Year MLP PV
DF (12.6%)
` `
1 50,000 0.890 44,500
2 50,000 0.790 39,500
3 50,000 0.700 35,000
© The Institute of Chartered Accountants of India
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v
v
4 50,000 0.622 31,100
v
5 50,000 0.552 27,600
5 25,000 0.552 13,800
1,91,500
Present value of minimum lease payment = ` 1,91,500
Fair value of leased asset = ` 2,00,000
The accounting entry at the inception of lease to record the asset taken on finance
lease in books of lessee is suggested below:
` `
Asset A/c Dr. 1,91,500
To Lessor (Lease Liability) A/c 1,91,500
(Being recognition of finance lease as asset
and liability)
Example 3
Using data for example 2 and assuming zero residual value, allocation of finance
charge over lease period is shown below:
Year Minimum Lease Finance Charge Principal Principal due
Payments (12.6%)
` ` ` `
0 -- -- -- 1,91,500
1 50,000 24,129 25,871 1,65,629
2 50,000 20,869 29,131 1,36,498
3 50,000 17,199 32,801 1,03,697
4 50,000 13,066 36,934 66,763
5 75,000 8,237 66,763
2,75,000 83,500 1,91,500
The difference between this figure and finance charge [66,763×12.6%=8412] is due to
approximation in computation.
© The Institute of Chartered Accountants of India
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v
v
Accounting entries in year 1 to recognise the finance charge in books of lessee are
v
suggested below:
` `
Finance Charge A/c Dr. 24,129
To Lessor 24,129
(Being finance charge due for the year)
Lessor Dr. 50,000
To Bank A/c 50,000
(Being payment of lease rent for the year)
P & L A/c Dr. 24,129
To Finance Charge A/c 24,129
(Being recognition of finance charge as expense for the
year)
Example 4
In example 2, suppose unguaranteed residual value is not determinable and lessee’s
incremental borrowing rate is 10%.
Since interest rate implicit on lease is discounting rate at which present value of
minimum lease payment and present value of unguaranteed residual value equals
the fair value, interest rate implicit on lease cannot be determined unless
unguaranteed residual value is known. If interest rate implicit on lease is not
determinable, the present value of minimum lease payments should be determined
using lessee’s incremental borrowing rate.
Present value of minimum lease payment using lessee’s incremental borrowing rate
10% is computed below:
Year MLP DF (10%) PV
` `
1 50,000 0.909 45,450
© The Institute of Chartered Accountants of India
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v
v
2 50,000 0.826 41,300
v
3 50,000 0.751 37,550
4 50,000 0.683 34,150
5 50,000 0.621 31,050
5 25,000 0.621 15,525
2,05,025
Present value of minimum lease payment = ` 2,05,025
Fair value of leased asset = ` 2,00,000
The accounting entry at the inception of lease to record the asset taken on finance
lease in books of lessee is suggested below:
` `
Asset A/c Dr. 2,00,000
To Lessor (Lease Liability) 2,00,000
(Being recognition of finance lease as asset and liability)
Since the liability is recognised at fair value ` 2 lakh (total principal), we need to
ascertain a discounting rate at which present value minimum lease payments
equals ` 2 lakh. The discounting rate can then be used for allocation of finance
charge over lease period.
PV of minimum lease payments at guessed rate 12%.
Minimum Lease Payments DF (12%) PV
Year
` `
1 50,000 0.893 44,650
2 50,000 0.797 39,850
3 50,000 0.712 35,600
4 50,000 0.636 31,800
5 50,000 0.567 28,350
© The Institute of Chartered Accountants of India
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v
5 25,000 0.567 14,175
v
1,94,425
12% − 10%
Required discounting rate = 10%+ (2,05,025 − 2,00,000 ) = 10.95%
2,05,025 − 1,94,425
Allocation of finance charge over lease period is shown below:
Year Minimum Lease Finance Charge Principal Principal due
Payments (10.95%)
` ` ` `
0 -- -- -- 2,00,000
1 50,000 21,900 28,100 1,71,900
2 50,000 18,823 31,177 1,40,723
3 50,000 15,409 34,591 1,06,132
4 50,000 11,621 38,379 67,753
5 75,000 7,247 67,753
2,75,000 75,000 2,00,000
Accounting entries in year 1 to recognise the finance charge in books of lessee are
suggested below:
` `
Finance Charge A/c Dr. 21,900
To Lessor 21,900
(Being finance charge due for the year)
Lessor Dr. 50,000
To Bank A/c 50,000
(Being payment of lease rent for the year)
The difference between this figure & finance charge [67,753×10.95% = 7418] is due to
approximation in computation
© The Institute of Chartered Accountants of India
5.156 ADVANCED ACCOUNTING
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v
v
P & L A/c Dr. 21,900
v
To Finance Charge 21,900
(Being recognition of finance charge as expense for the year)
Illustration 1
S. Square Private Limited has taken machinery on finance lease from S.K. Ltd. The
information is as under:
Lease term = 4 years
Fair value at inception of lease = ` 20,00,000
Lease rent = ` 6,25,000 p.a. at the end of year
Guaranteed residual value = ` 1,25,000
Expected residual value = ` 3,75,000
Implicit interest rate = 15%
Discounted rates for 1 st year, 2nd year, 3 rd year and 4 th year are 0.8696, 0.7561,
0.6575 and 0.5718 respectively.
Calculate the value of the lease liability as per AS-19 and disclose impact of this on
Balance sheet and Profit & loss account at the end of year 1
Solution
According to para 11 of AS 19 “Leases”, the lessee should recognise the lease as
an asset and a liability at an amount equal to the lower of the fair value of the
leased asset at the inception of the finance lease and the present value of the
minimum lease payments from the standpoint of the lessee.
In calculating the present value of the minimum lease payments the discount rate
is the interest rate implicit in the lease. Present value of minimum lease payments
will be calculated as follows:
© The Institute of Chartered Accountants of India
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v
v
Year Minimum Lease Implicit interest rate Present value `
v
Payment ` (Discount rate @15%)
1 6,25,000 0.8696 5,43,500
2 6,25,000 0.7561 4,72,563
3 6,25,000 0.6575 4,10,937
4 7,50,000 0.5718 4,28,850
Total 26,25,000 18,55,850
Present value of minimum lease payments ` 18,55,850 is less than fair value at
the inception of lease i.e. ` 20,00,000, therefore, the asset and corresponding
lease liability should be recognised at ` 18,55,850 as per AS 19.
5.8.2 Disclosures made by the Lessee
The lessee should, in addition to the requirements of AS 10 (Revised), Property,
Plant and Equipment, and the governing statute, make the following disclosures
for finance leases:
(a) assets acquired under finance lease as segregated from the assets owned;
(b) for each class of assets, the net carrying amount at the balance sheet date;
(c) a reconciliation between the total of minimum lease payments at the balance
sheet date and their present value. In addition, an enterprise should disclose the
total of minimum lease payments at the balance sheet date, and their present
value, for each of the following periods:
(i) not later than one year;
(ii) later than one year and not later than five years;
(iii) later than five years;
(d) contingent rents recognised as expense in the statement of profit and loss
for the period;
Minimum Lease Payment of 4 th year includes guaranteed residual value amounting
` 1,25,000.
© The Institute of Chartered Accountants of India
5.158 ADVANCED ACCOUNTING
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v
(e) v
the total of future minimum sublease payments expected to be received
v
under non-cancelable subleases at the balance sheet date; and
(f) a general description of the lessee's significant leasing arrangements
including, but not limited to, the following:
(i) the basis on which contingent rent payments are determined;
(ii) the existence and terms of renewal or purchase options and escalation
clauses; and
(iii) restrictions imposed by lease arrangements, such as those concerning
dividends, additional debt, and further leasing.
5.8.3 Accounting for finance leases (Books of lessor)
The lessor should recognise assets given under a finance lease in its balance sheet
as a receivable at an amount equal to the net investment in the lease.
In a finance lease, the lessor recognises the net investment in lease (which is
usually equal to fair value, i.e. usual market price of the asset, as shown below) as
receivable by debiting the Lessee A/c.
Journal entries at inception:
Particulars Debit Credit
Asset Fair value
To Bank Fair value
(Being purchase of asset by lessor at FV)
Lease Receivable Fair value = NI
To Asset Fair value = NI
(Being asset by lessor given at lease)
Where,
Gross investment in Lease (GI)
= Minimum Lease Payments (MLP) + Unguaranteed Residual value (UGRV)
© The Institute of Chartered Accountants of India
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v
Net investment in Lease (NI) v
v
= Gross investment in Lease (GI) – Unearned Finance Income (UFI).
Unearned finance income (UFI) = GI – (PV of MLP + PV of UGRV)
The discounting rate for the above purpose is the rate of interest implicit in the
lease.
From the definition of interest rate implicit on lease:
(PV of MLP + PV of UGRV) = Fair Value.
The above definitions imply that:
(a) Unearned Finance Income (UFI) = GI – Fair Value
(b) Net Investment in Lease = GI – UFI = GI – (GI – Fair Value) = Fair Value
Since the sale and receivables are recognised at net investment in lease, which is
equal to fair value: Profit recognised at the inception of lease = Fair Value – Cost
Total earning of lessor = GI – Cost
= (GI – Fair Value) + (Fair Value – Cost)
= Unearned Finance Income + (Fair Value – Cost)
The above analysis does not hold where the discounting rate is not equal to interest
rate implicit on lease. Such is the case, where the interest rate implicit on lease is
artificially low. The discounting rate in such situations should be the commercial rate
of interest (refer discussion on ‘manufacturer or dealer lessor’ below).
5.8.4 Recognition of Finance Income
The unearned finance income is recognised over the lease term on a systematic
and rational basis. This income allocation is based on a pattern reflecting a
constant periodic return on the net investment in lease outstanding.
The constant periodic return is the rate used for discounting, i.e. either the
interest rate implicit on lease or the commercial rate of interest.
© The Institute of Chartered Accountants of India
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v
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5.8.5 Initial Direct Costs
v
Initial direct costs, such as commissions and legal fees, are often incurred by lessors in
negotiating and arranging a lease. For finance leases, these initial direct costs are
incurred to produce finance income and are either recognised immediately in the
statement of profit and loss or allocated against the finance income over the lease
term.
5.8.6 Review of unguaranteed residual value by lessor
AS 19 requires a lessor to review unguaranteed residual value used in computing
the gross investment in lease regularly.
In case any reduction in the estimated unguaranteed residual value is identified,
the income allocation over the remaining lease term is to be revised. Also, any
reduction in respect of income already accrued is to be recognised immediately.
An upward adjustment of the estimated residual value is not made.
Illustration 2
Prakash Limited leased a machine to Badal Limited on the following terms:
(` In lakhs)
(i) Fair value of the machine 28.3
(ii) Lease term 5 years
(iii) Lease rental per annum 8.00
(iv) Guaranteed residual value 1.60
(v) Expected residual value 3.00
(vi) Internal rate of return 15%
Discounted rates for 1 st year to 5th year are 0.8696, 0.7561, 0.6575, 0.5718, and
0.4972 respectively.
Ascertain Unearned Finance Income.
© The Institute of Chartered Accountants of India
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Solution v
v
As per AS 19 on Leases, unearned finance income is the difference between (a)
the gross investment in the lease and (b) the present value of minimum lease
payments under a finance lease from the standpoint of the lessor; and any
unguaranteed residual value accruing to the lessor, at the interest rate implicit in
the lease.
Where:
(a) Gross investment in the lease is the aggregate of (i) minimum lease
payments from the stand point of the lessor and (ii) any unguaranteed
residual value accruing to the lessor.
Gross investment = Minimum lease payments + Unguaranteed residual
value
= [Total lease rent + Guaranteed residual value (GRV)] +
Unguaranteed residual value (URV)
= [(` 8,00,000 5 years) + ` 1,60,000] + ` 1,40,000
= ` 43,00,000 (a)
(b) Table showing present value of (i) Minimum lease payments (MLP) and
(ii) Unguaranteed residual value (URV).
Year MLP inclusive of Internal rate of return Present Value
URV (`) (Discount factor @ 15%) (`)
1 8,00,000 0.8696 6,95,680
2 8,00,000 0.7561 6,04,880
3 8,00,000 0.6575 5,26,000
4 8,00,000 0.5718 4,57,440
5 8,00,000 0.4972 3,97,760
1,60,000 (GRV) 0.4972 79,552
41,60,000 27,61,312 (i)
1,40,000 (URV) 0.4972 69,608 (ii)
43,00,000 (i)+ (ii) 28,30,920 (b)
Unearned Finance Income (a) - (b) = ` 43,00,000 – ` 28,30,920= ` 14,69,080.
© The Institute of Chartered Accountants of India
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v
v
Manufacturer or dealer lessor
v
The manufacturer or dealer lessor should recognise the transaction of sale in the
statement of profit and loss for the period, in accordance with the policy followed
by the enterprise for outright sales. If artificially low rates of interest are quoted,
profit on sale should be restricted to that which would apply if a commercial rate
of interest were charged. Initial direct costs should be recognised as an expense
in the statement of profit and loss at the inception of the lease.
Disclosures
The lessor should make the following disclosures for finance leases:
(a) a reconciliation between the total gross investment in the lease at the
balance sheet date, and the present value of minimum lease payments
receivable at the balance sheet date. In addition, an enterprise should
disclose the total gross investment in the lease and the present value of
minimum lease payments receivable at the balance sheet date, for each of
the following periods:
(i) not later than one year;
(ii) later than one year and not later than five years;
(iii) later than five years;
(b) unearned finance income;
(c) the unguaranteed residual values accruing to the benefit of the lessor;
(d) the accumulated provision for uncollectible minimum lease payments
receivable;
(e) contingent rents recognised in the statement of profit and loss for the
period;
(f) a general description of the significant leasing arrangements of the lessor;
and
(g) accounting policy adopted in respect of initial direct costs.
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v
v
As an indicator of growth, it is often useful to also disclose the gross investment
v
less unearned income in new business added during the accounting period, after
deducting the relevant amounts for cancelled leases.
5.9 ACCOUNTING FOR OPERATING LEASES
5.9.1 Accounting treatment in the Books of lessee
Lease payments under an operating lease should be recognised as an expense in the
statement of profit and loss of a lessee on a straight line basis over the lease term
unless another systematic basis is more representative of the time pattern of the
user’s benefit.
Lease payments may be tailor made to suit the payment capacity of the lessee.
For example, a lease term may provide for low initial rents and high terminal rent.
Such payment patterns do not reflect the pattern of benefit derived by the lessee
from the use of leased asset. To have better matching between revenue and costs,
AS 19 requires lessees to recognise operating lease payments as expense in the
statement of profit and loss on a straight line basis over the lease term unless
another systematic basis is more representative of the time pattern of the user's
benefit.
Example
Suppose outputs from a machine taken on a 3 year operating lease are estimated
as 10,000 units in year 1; 20,000 units in year 2 and 50,000 units in year 3. The
agreed annual lease payments are ` 25,000, ` 45,000 and ` 50,000 respectively.
The total lease payment ` 1,20,000 in this example should be recognised in
proportion of output as ` 15,000 in year 1, ` 30,000 in year 2 and ` 75,000 in year
3. The difference between lease rent due and lease rent recognised can be debited /
credited to Lease Equalisation A/c.
The accounting entries for year 1 in books of lessee are suggested below:
` `
Lease Rent A/c Dr. 15,000
© The Institute of Chartered Accountants of India
5.164 ADVANCED ACCOUNTING
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v
v
Lease Equalization A/c Dr. 10,000
v
To Lessor 25,000
(Being lease rent for the year due)
Lessor Dr. 25,000
To Bank A/c 25,000
(Being payment of lease rent for the year)
P & L A/c Dr. 15,000
To Lease Rent A/c 15,000
(Being recognition of lease rent as expense for the year)
Since total lease rent due and recognised must be same, the Lease Equalisation A/c
will close in the terminal year. Till then, the balance of Lease Equalisation A/c can
be shown in the balance sheet under "Current Assets" or Current Liabilities"
depending on the nature of balance.
5.9.2 Disclosures by lessees
The paragraph 25 requires lessees to make following disclosures for operating
leases:
(a) the total of future minimum lease payments under non-cancelable
operating leases for each of the following periods:
(i) not later than one year;
(ii) later than one year and not later than five years;
(iii) later than five years;
(b) the total of future minimum sublease payments expected to be received
under non-cancelable subleases at the balance sheet date;
(c) lease payments recognised in the statement of profit and loss for the
period, with separate amounts for minimum lease payments and contingent
rents;
(d) sub-lease payments received (or receivable) recognised in the statement of
profit and loss for the period;
© The Institute of Chartered Accountants of India
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v
(e) v
a general description of the lessee's significant leasing arrangements
including, but not limited to, the following: v
(i) the basis on which contingent rent payments are determined;
(ii) the existence and terms of renewal or purchase options and escalation
clauses; and
(iii) restrictions imposed by lease arrangements, such as those concerning
dividends, additional debt, and further leasing.
5.9.3 Accounting treatment in the books of lessor
(i) The lessor should present an asset given under operating lease as PPE in its
balance sheets.
(ii) Lease income from operating leases should be recognised in the statement
of profit and loss on a straight line basis over the lease term, unless another
systematic basis is more representative of the time pattern in which benefit
derived from the use of the leased asset is diminished.
(iii) Depreciation should be recognised in the books of lessor. The depreciation
of leased assets should be on a basis consistent with the normal
depreciation policy of the lessor for similar assets, and the depreciation
charge should be calculated on the basis set out in AS 10.
(iv) The impairment losses on assets given on operating leases are determined
and treated as per AS 28
We can summarize the accounting treatment for the lessor and lessee for an
operating lease as under:
Particulars Books of lessor Books of Lessee
Asset Continues to appear in Asset does not appear in his
his books books
Depreciation Yes - charged Not applicable
Impairment Yes - applicable Not applicable
Lease rent Income recognized on Expense recognized on SLM
SLM
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Initial direct costs incurred specifically to earn revenues from an operating lease
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are either deferred and allocated to income over the lease term in proportion to
the recognition of rent income, or are recognised as an expense in the statement
of profit and loss in the period in which they are incurred.
A manufacturer or dealer lessor should recognise the asset given on operating
lease as PPE in their books by debiting concerned PPE A/c and crediting Cost of
Production / Purchase at cost. No selling profit should be recognised on entering
into operating lease, because such leases are not equivalents of sales.
Suppose outputs from a machine of economic life of 6 years are estimated as
10,000 units in year 1, 20,000 units in year 2 and 30,000 units in year 3, 40,000
units in year 4, 20,000 units in year 5 and 5,000 units in year 6. The machine was
given on 3-year operating lease by a dealer of the machine for equal annual lease
rentals to yield 20% profit margin on cost ` 5,00,000. Straight-line depreciation in
proportion of output is considered appropriate.
Total lease rent = 120% of ` 5 lakhs Output during lease period
Total output
60,000 units
= ` 6 lakhs = ` 2.88 lakhs
1,25,000 units
Annual lease rent = ` 2,88,000 / 3 = ` 96,000
Total lease rent should be recognised as income in proportion of output during
lease period, i.e. in the proportion of 10 : 20 : 30. Hence income recognised in years
1, 2 and 3 are ` 48,000, ` 96,000 and ` 1,44,000 respectively.
Since depreciation in proportion of output is considered appropriate, the
depreciable amount ` 5 lakh should be allocated over useful life 6 years in
proportion of output, i.e. in proportion of 10 : 20 : 30 : 40 : 20 : 5. Depreciation for
year 1 is ` 40,000.
The accounting entries for year 1 in books of lessor are suggested below:
` `
Machine given on Operating Lease Dr. 5,00,000
To Purchase 5,00,000
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(Being machine given on operating lease brought into
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books)
Lessee Dr. 96,000
To Lease Equalization A/c 48,000
To Lease Rent 48,000
(Being lease rent for the year due)
Bank Dr. 96,000
To Lessee 96,000
(Being receipt of lease rent for the year)
Lease Rent Dr. 48,000
To P & L A/c 48,000
(Being recognition of lease rent as income for the year)
Depreciation Dr. 40,000
To Machine given on Operating Lease 40,000
(Being depreciation for the year)
P & L A/c Dr. 40,000
To Depreciation 40,000
(Being depreciation for the year transferred to P & L A/c)
Since total lease rent due and recognised must be same, the Lease Equalisation A/c
will close in the terminal year. Till then, the balance of Lease Equalisation A/c can
be shown in the balance sheet under "Current Assets" or Current Liabilities"
depending on the nature of balance.
5.9.4 Disclosures by lessors
As per AS 19, the lessor should, in addition to the requirements of AS 10 (Revised)
and the governing statute, make the following disclosures for operating leases:
(a) for each class of assets, the gross carrying amount, the accumulated
depreciation and accumulated impairment losses at the balance sheet date;
and
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(i) v the depreciation recognized in the statement of profit and loss for the
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period;
(ii) impairment losses recognized in the statement of profit and loss for
the period;
(iii) impairment losses reversed in the statement of profit and loss for the
period;
(b) the future minimum lease payments under non-cancellable operating leases
in the aggregate and for each of the following periods:
(i) not later than one year;
(ii) later than one year and not later than five years;
(iii) later than five years;
(c) total contingent ren recognized as income in the statement of profit and
loss for the period;
(d) a general description of the lessor ’s significant leasing arrangements; and
(e) accounting policy adopted in respect of initial direct costs.
5.10 SALE AND LEASEBACK
The basis of a sale and leaseback agreement is simply that one sells an asset for
cash and then leases it back from the buyer. The asset subject to such sale and
leaseback agreement is generally property. Under such an agreement the
property owner agrees to sell the property at an agreed valuation and lease it
back from the buyer. The lessee or seller receives cash immediately and makes
periodic payment in form of lease rents for right to use the property. The lease
payments and the sale price are generally interdependent as they are negotiated
as a package. The accounting treatment of a sale and lease back depends upon
the type of lease involved. Accounting treatment of profits / losses on sale of
asset, as required by the standard in respect of sale and lease-back transactions,
are summarised below.
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The accounting treatment depends upon the classification of the lease in the
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books of the seller-lessee.
Situation I
• Where sale and leaseback results in finance lease
The excess or deficiency of sales proceeds over the carrying amount should be
deferred and amortised over the lease term in proportion to the depreciation of
the leased asset.
Situation II
• Where sale and leaseback results in operating lease
Case 1: Sale price = Fair Value
Profit or loss should be recognised immediately.
Case 2: Sale Price < Fair Value
Profit and loss should be recognised immediately. However if the loss is
compensated by future lease payments at below market price, it should be
deferred and amortised in proportion to the lease payments over the period for
which the asset is expected to be used.
Case 3: Sale Price > Fair Value
The excess over fair value should be deferred and amortised over the period for
which the asset is expected to be used.
For operating leases, if the fair value at the time of a sale and leaseback
transaction is less than the carrying amount of the asset, a loss equal to the
amount of the difference between the carrying amount and fair value should be
recognised immediately.
For finance leases, no such adjustment is necessary unless there has been an
impairment in value, in which case the carrying amount is reduced to recoverable
amount in accordance with AS 28.
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Thus it can be summarised as:
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Sale price at Carrying Carrying amount less Carrying amount
fair value amount than fair value above fair value
equal to fair
value
Profit No Profit Recognise profit Not Applicable
immediately
Loss No Loss Not Applicable Recognise loss
immediately
Sale price below fair Carrying Carrying Carrying amount
value amount amount less above fair value
equal to fair than fair value
value
Profit No Profit Recognise profit No Profit.
immediately (Carrying amount
of an asset to be
written down to
fair value)
Loss not compensated Recognise loss Recognise loss Carrying amount
by future lease immediately immediately of an asset to be
payments at below written down to
market price fair value
Loss compensated by Defer and Defer and Carrying amount
future lease payments amortise loss. amortise loss. of an asset to be
at below market price written down to
fair value
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Sale Carrying Carrying amount less Carrying amount
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price amount than fair value above fair value
Above equal to fair
fair value
value
Profit Defer and 1. Difference between Defer and amortise profit.
amortise carrying amount and (The profit would be the
profit. fair value to be difference between fair
immediately value and sale price as the
recognised. carrying amount would
2. Excess over fair have been written down to
value to be Deferred fair value)
and amortised.
Loss No Loss No Loss 1. Carrying amount of an
asset to be written
down to fair value.
2. Defer and amortise the
difference of sale price
and fair value.
Illustration 3
A Ltd. sold machinery having WDV of ` 40 lakhs to B Ltd. for ` 50 lakhs and the same
machinery was leased back by B Ltd. to A Ltd. The lease back is operating lease.
Comment if –
(a) Sale price of ` 50 lakhs is equal to fair value.
(b) Fair value is ` 60 lakhs.
(c) Fair value is ` 45 lakhs and sale price is ` 38 lakhs.
(d) Fair value is ` 40 lakhs and sale price is ` 50 lakhs.
(e) Fair value is ` 46 lakhs and sale price is ` 50 lakhs
(f) Fair value is ` 35 lakhs and sale price is ` 39 lakhs.
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Solutionv
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Following will be the treatment in the given cases:
(a) When sales price of ` 50 lakhs is equal to fair value, A Ltd. should
immediately recognise the profit of ` 10 lakhs (i.e. 50 – 40) in its books.
(b) When fair value is ` 60 lakhs then also profit of ` 10 lakhs should be
immediately recognised by A Ltd.
(c) When fair value of leased machinery is ` 45 lakhs & sales price is ` 38 lakhs,
then loss of ` 2 lakhs (40 – 38) to be immediately recognised by A Ltd. in its
books provided loss is not compensated by future lease payment, otherwise
defer and amortise the loss.
(d) When fair value is ` 40 lakhs & sales price is ` 50 lakhs then, profit of ` 10
lakhs is to be deferred and amortised over the lease period.
(e) When fair value is ` 46 lakhs & sales price is ` 50 lakhs, profit of ` 6 lakhs
(46 - 40) to be immediately recognised in its books and balance profit of ` 4
lakhs (50-46) is to be amortised/deferred over lease period.
(f) When fair value is ` 35 lakhs & sales price is ` 39 lakhs, then the loss of ` 5
lakhs (40-35) to be immediately recognised by A Ltd. in its books and profit
of ` 4 lakhs (39-35) should be amortised/deferred over lease period.
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. A Ltd. sold machinery having WDV of ` 40 lakhs to B Ltd. for ` 50 lakhs (Fair
value ` 50 lakhs) and same machinery was leased back by B Ltd. to A Ltd. The
lease back is in nature of operating lease. The treatment will be
(a) A Ltd. should amortise the profit of ` 10 lakhs over lease term.
(b) A Ltd. should recognise the profit of ` 10 lakhs immediately.
(c) A Ltd. should defer the profit of ` 10 lakhs.
(d) B Ltd. should recognise the profit of ` 10 lakhs immediately.
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2. In case of an operating lease – identify which statement is correct: v
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(a) The lessor continues to show the leased asset in its books of accounts.
(b) The lessor de-recognises the asset from its Balance Sheet.
(c) The lessor discontinues to claim depreciation in its books.
(d) The lessee recognises the asset in its Balance Sheet.
3. In case of finance lease, if the asset is returned back to the lessor at the end of
the lease term - the lessee always claims depreciation based on which of the
following:
(a) Useful life.
(b) Lease term.
(c) Useful life or lease term whichever is less.
(d) Useful life or lease term whichever is higher.
4. AS 19 lays down 5 deterministic conditions to classify the lease as a finance
lease. To classify the lease as an operating lease – which statement is correct?
(a) Any 1 condition fails.
(b) Majority of the 5 conditions fail.
(c) All 5 conditions fail.
(d) Any 2 conditions fails.
5. The basis of classification of a lease is:
(a) Control Test.
(b) Risk and reward Test.
(c) Both control test and risk and reward test.
(d) Only reward Test
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Theoretical Questions
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6. Explain the types of lease as per AS 19.
7. Explain the accounting treatment for a sale and leaseback transaction under
Operating lease.
8. What do you understand by the term “Interest rate implicit on lease”?
9. What are the disclosures requirements for operating leases by the lessee as
per AS-19?
Scenario based Questions
10. Classify the following into either operating or finance lease:
(i) Lessee has option to purchase the asset at lower than fair value, at the
end of lease term;
(ii) Economic life of the asset is 7 years, lease term is 6 years, but asset is
not acquired at the end of the lease term;
(iii) Economic life of the asset is 6 years, lease term is 2 years, but the asset
is of special nature and has been procured only for use of the lessee;
(iv) Present value (PV) of Minimum lease payment (MLP) = “X”. Fair value of
the asset is “Y”.
11. A machine was given on 3 years operating lease by a dealer of the machine
for equal annual lease rentals to yield 30% profit margin on cost ` 1,50,000.
Economic life of the machine is 5 years and output from the machine are
estimated as 40,000 units, 50,000 units, 60,000 units, 80,000 units and 70,000
units consecutively for 5 years. Straight line depreciation in proportion of
output is considered appropriate. Compute the following:
(i) Annual Lease Rent
(ii) Lease Rent income to be recognized in each operating year and
(iii) Depreciation for 3 years of lease.
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12. v
Lessee Ltd. took a machine on lease from Lessor Ltd., the fair value being
` 7,00,000. v
The economic life of machine as well as the lease term is 3 years. At the end
of each year Lessee Ltd. pays ` 3,00,000. The Lessee has guaranteed a residual
value of ` 22,000 on expiry of the lease to the Lessor. However, Lessor Ltd.,
estimates that the residual value of the machinery will be only ` 15,000. The
implicit rate of return is 15% p.a. and present value factors at 15% are 0.869,
0.756 and 0.657 at the end of first, second and third years respectively.
Calculate the value of machinery to be considered by Lessee Ltd. and the
finance charges in each year.
13. B&P Ltd. availed a lease from N&L Ltd. The conditions of the lease terms are
as under:
(i) Lease period is 3 years, in the beginning of the year 2009, for
equipment costing ` 10,00,000 and has an expected useful life of 5
years.
(ii) The Fair market value is also ` 10,00,000
(iii) The property reverts back to the lessor on termination of the lease.
(iv) The unguaranteed residual value is estimated at ` 1,00,000 at the end
of the year 2011.
(v) 3 equal annual payments are made at the end of each year.
(vi) Consider IRR = 10%.
The present value off ` 1 due at the end of 3rd year at 10% rate of interest is
` 0.7513. The present value of annuity of ` 1 due at the end of 3rd year at
10% IRR is ` 2.4868.
State whether the lease constitute finance lease and also calculate unearned
finance income.
14. X Ltd. sold machinery having WDV of ` 300 lakhs to Y Ltd. for ` 400 lakhs and
the same machinery was leased back by Y Ltd. to X Ltd. The lease back
arrangement is operating lease.
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Give your comments in the following situations:
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(i) Sale price of ` 400 lakhs is equal to fair value.
(ii) Fair value is ` 450 lakhs.
(iii) Fair value is ` 350 lakhs and the sale price is ` 250 lakhs.
(iv) Fair value is ` 300 lakhs and sale price is ` 400 lakhs.
(v) Fair value is ` 250 lakhs and sale price is ` 290 lakhs.
ANSWERS/solutions
Answer to the Multiple Choice Questions
1. (b) 2. (a) 3. (c) 4. (c) 5. (b)
Answer to the Theoretical Questions
6. For the purpose of accounting AS 19, classifies leases into two categories as
follows:
1. Finance Lease
2. Operating Lease
Finance Lease:
It is a lease, which transfers substantially all the risks and rewards incidental
to ownership of an asset to the lessee by the lessor but not the legal
ownership.
As per para 8 of the standard, in following situations, the lease transactions
are called Finance lease:
1. The lessee will get the ownership of leased asset at the end of the
lease term.
2. The lessee has an option to buy the leased asset at the end of the
lease term at price, which is lower than its expected fair value at the
date on which option will be exercised.
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3. The lease term covers the major part of the life of asset even if title vis
not transferred. v
4. At the beginning of lease term, present value of minimum lease rental
covers the initial fair value.
5. The asset given on lease to lessee is of specialized nature and can only
be used by the lessee without major modification.
Operating Lease:
It is lease, which does not transfer all the risks and rewards incidental to
ownership.
7. As per AS 19, where sale and leaseback results in operating lease, then the
accounting treatment in different situations is as follows:
Situation 1: Sale price = Fair Value
Profit or loss should be recognized immediately.
Situation 2: Sale Price < Fair Value
Profit should be recognized immediately. The loss should also be
recognized immediately except that, if the loss is compensated by future
lease payments at below market price, it should be deferred and amortized
in proportion to the lease payments over the period for which the asset is
expected to be used.
Situation 3: Sale Price > Fair Value
The excess over fair value should be deferred and amortized over the period
for which the asset is expected to be used.
8. As per para 3 of AS 19 'Leases' the interest rate implicit in the lease is the
discount rate that, at the inception of the lease, causes the aggregate
present value of:
(a) the minimum lease payments under a finance lease from the
standpoint of the lessor; and
(b) any unguaranteed residual value accruing to the lessor,
to be equal to the fair value of the leased asset.
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9. v
As per AS 19, lessees are required to make following disclosures for
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operating leases:
(a) the total of future minimum lease payments under non-cancelable
operating leases for each of the following periods:
(i) not later than one year;
(ii) later than one year and not later than five years;
(iii) later than five years;
(b) the total of future minimum sublease payments expected to be
received under non- cancelable subleases at the balance sheet date;
(c) lease payments recognized in the statement of profit and loss for the
period, with separate amounts for minimum lease payments and
contingent rents;
(d) sub-lease payments received (or receivable) recognized in the
statement of profit and loss for the period;
(e) a general description of the lessee's significant leasing arrangements
including, but not limited to, the following:
(i) the basis on which contingent rent payments are determined;
(ii) the existence and terms of renewal or purchase options and
escalation clauses; and
(iii) restrictions imposed by lease arrangements, such as those
concerning dividends, additional debt, and further leasing.
Answer to the Scenario based Questions
10. (i) If it becomes certain at the inception of lease itself that the option will
be exercised by the lessee, it is a Finance Lease.
(ii) The lease will be classified as a finance lease, since a substantial
portion of the life of the asset is covered by the lease term.
(iii) Since the asset is procured only for the use of lessee, it is a finance
lease.
(iv) The lease is a finance lease if X = Y, or where X substantially equals Y.
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11. (i) Annual lease rent v
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Total lease rent
Output during lease period
= 130% of ` 1,50,000
Total output
= 130% of ` 1,50,000 x (40,000 +50,000+ 60,000)/(40,000 + 50,000 +
60,000 + 80,000 + 70,000)
= 1,95,000 x 1,50,000 units/3,00,000 units = ` 97,500
Annual lease rent = ` 97,500 / 3 = ` 32,500
(ii) Lease rent Income to be recognized in each operating year
Total lease rent should be recognised as income in proportion of
output during lease period, i.e. in the proportion of 40 : 50 : 60.
Hence income recognised in years 1, 2 and 3 will be as:
Year 1 ` 26,000,
Year 2 ` 32,500 and
Year 3 ` 39,000.
(iii) Depreciation for three years of lease
Since depreciation in proportion of output is considered appropriate,
the depreciable amount ` 1,50,000 should be allocated over useful life
5 years in proportion of output, i.e. in proportion of 40 : 50 : 60 : 80 :
70 .
Depreciation for year 1 is ` 20,000, year 2 = 25,000 and year 3 =
30,000.
12. As per para 11 of AS 19 "Leases", the lessee should recognize the lease as
an asset and a liability at the inception of a finance lease. Such recognition
should be at an amount equal to the fair value of the leased asset at the
inception of lease. However, if the fair value of the leased asset exceeds the
present value of minimum lease payment from the standpoint of the lessee,
the amount recorded as an asset and liability should be the present value of
minimum lease payments from the standpoint of the lessee.
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Computation of Value of machinery:
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Present value of minimum lease payment = ` 6,99,054
(See working note below)
Fair value of leased asset = ` 7,00,000
Therefore, the recognition will be at the lower of the two i.e. 6,99,054
Working Note - Present value of minimum lease payments:
Annual lease rental × PVIF+ Present value of guaranteed residual value
= ` 3,00,000 × (0.869 + 0.756 + 0.657) + ` 22,000 × 0.657
= ` 6,84,600 + ` 14,454 = 6,99,054
Computation of finance charges:
Year Finance Payment Reduction in Outstanding
charge outstanding liability
liability
1st Year – – – 6,99,054
beginning
End of 1st year 1,04,858 3,00,000 1,95,142 5,03,912
End of 2nd year 75,587 3,00,000 2,24,413 2,79,499
rd
End of 3 year 41,925 3,00,000 2,58,075 21,424
13. Computation of annual lease payment:
Particulars `
Cost of equipment 10,00,000
Unguaranteed residual value 1,00,000
Present value of unguaranteed residual value
(` 1,00,000 x 0.7513) 75,130
Present value of lease payments
(` 10,00,000 - ` 75,130) 9,24,870
Present value of annuity for three years is 2.4868
Annual lease payment [9,24,870/2.4868] 3,71,911.70
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Classification of lease: v
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Parameter 1:
The present value of lease payment i.e., ` 9,24,870 which equals 92.48% of
the fair market value i.e., ` 10,00,000.
The present value of minimum lease payments substantially covers the fair
value of the leased asset
Parameter 2:
The lease term (i.e. 3 years) covers the major part of the life of asset (i.e. 5
years).
Therefore, it constitutes a finance lease.
Computation of Unearned Finance Income:
Particulars `
Total lease payments (` 3,71,911.70 x 3) 11,15,735
Add: Unguaranteed residual value 1,00,000
Gross investment in the lease 1,215,735
Less: Present value of lease payments and residual value
i.e.
(10,00,000)
Net Investment (` 75,130 + ` 9,24,870)
Unearned finance income 2,15,735
14. Accounting Treatment:
S. No. Particulars Accounting Treatment
(i) When sale price of X Ltd. should immediately recognize
` 400 lakhs is equal to the profit of ` 100 lakhs (i.e. 400 –
fair value 300) in its books.
(ii) When fair value is Profit of ` 100 lakhs should be
` 450 lakhs immediately recognized by X Ltd.
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(iii) When fair value of Then loss of ` 50 lakhs (300 – 250) to
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leased machinery is be immediately recognized by X Ltd.
` 350 lakhs & sales in its books provided loss is not
price is ` 250 lakhs compensated by future lease
payment.
(iv) When fair value is Then, profit of ` 100 lakhs is to be
` 300 lakhs & sales deferred and amortized over the
price is ` 400 lakhs lease period.
(v) When fair value is Then the loss of ` 50 lakhs (300-250)
` 250 lakhs & sales to be immediately recognized by X
price is ` 290 lakhs Ltd. in its books and profit of ` 40
lakhs (290-250) should be amortized/
deferred over lease period.
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UNIT 6: ACCOUNTING STANDARD 26
INTANGIBLE ASSETS
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend–
Definition of Intangible Assets
Parameters for Recognition and Initial Measurement of an Intangible
Asset
• Separate Acquisition
• Acquisition as part of an Amalgamation
• Acquisition by way of a Government Grant
• Exchanges of Assets
• Internally Generated Goodwill and other Intangible Assets
Measurement Subsequent to Initial Recognition
Principles for
• Amortisation Period
• Amortisation Method
• Residual Value
• Review of Amortisation Period and Amortisation Method
Retirements and Disposals
Disclosures as per the standard.
6.1 INTRODUCTION
The objective of AS 26 is to prescribe the accounting treatment for intangible
assets that are not dealt with specifically in another Accounting Standard. AS 26
requires an enterprise to recognise an intangible asset if, and only if, certain
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criteria are met. AS 26 also specifies how to measure the carrying amount of
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intangible assets and requires certain disclosures about intangible assets.
6.2 SCOPE
AS 26 should be applied by all enterprises in accounting for intangible assets,
except:
a. Intangible assets that are covered by another Accounting Standard, such as:
(a) intangible assets held by an enterprise for sale in the ordinary course
of business (AS 2, Valuation of Inventories and AS 7, Construction
Contracts)
(b) deferred tax assets (AS 22, Accounting for Taxes on Income)
(c) leases that fall within the scope of AS 19, Leases; and
(d) goodwill arising on an amalgamation (AS 14 (Revised), Accounting for
Amalgamations) and goodwill arising on consolidation (AS 21
(Revised), Consolidated Financial Statements)
b. Financial assets.
c. Mineral rights and expenditure on the exploration for, or development and
extraction of, minerals, oil, natural gas and similar non-regenerative
resources and
d. Intangible assets arising in insurance enterprises from contracts with
policyholders.
e. expenditure in respect of termination benefits.
However, AS 26 applies to other intangible assets used (such as computer
software), and other expenditure (such as start-up costs), in extractive industries
or by insurance enterprises.
AS 26 also applies to:
(i) expenditure on advertising, training, start - up cost
(ii) Research and development activities
(iii) Right under licensing agreements for items such as motion picture films,
video recordings, plays, manuscripts, patents and copyrights. These items
are excluded from the scope of AS 19.
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(iv) the underlying intangible asset in finance lease after its initial recognition. v
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6.3 DEFINITIONS
An asset is a resource:
a. Controlled by an enterprise as a result of past events and
b. From which future economic benefits are expected to flow to the enterprise.
Monetary assets are money held and assets to be received in fixed or
determinable amounts of money.
Non-monetary assets are assets other than monetary assets.
Amortisation is the systematic allocation of the depreciable amount of an
intangible asset over its useful life.
Depreciable amount is the cost of an asset less its residual value.
Useful life is either:
(a) the period of time over which an asset is expected to be used by the
enterprise; or
(b) the number of production or similar units expected to be obtained from the
asset by the enterprise.
Fair value of an asset is the amount for which that asset could be exchanged
between knowledgeable, willing parties in an arm's length transaction.
An active market is a market where all the following conditions exist:
a. The items traded within the market are homogeneous.
b. Willing buyers and sellers can normally be found at any time and
c. Prices are available to the public.
An impairment loss is the amount by which the carrying amount of an asset
exceeds its recoverable amount.
Carrying amount is the amount at which an asset is recognised in the balance
sheet, net of any accumulated amortisation and accumulated impairment losses
thereon.
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A financial asset is any asset that is:
v
a. Cash;
b. A contractual right to receive cash or another financial asset from another
enterprise;
c. A contractual right to exchange financial instruments with another
enterprise under conditions that are potentially favourable; or
d. An ownership interest in another enterprise.
Termination benefits are employee benefits payable as a result of either:
a. an enterprise’s decision to terminate an employee’s employment before the
normal retirement date; or
b. an employee’s decision to accept voluntary redundancy in exchange for
those benefits (voluntary retirement).
Intangible Asset is
• an identifiable
• non-monetary asset
• without physical substance
• held for use in the production or supply of goods or services, for rental to
others, or for administrative purposes.
Enterprises frequently expend resources, or incur liabilities, on the acquisition,
development, maintenance or enhancement of intangible resources such as
scientific or technical knowledge, design and implementation of new processes or
systems, licences, intellectual property, market knowledge and trademarks
(including brand names and publishing titles). Common examples are computer
software, patents, copyrights, motion picture films, customer lists, mortgage
servicing rights, fishing licences, import quotas, franchises, customer or supplier
relationships, customer loyalty, market share and marketing rights. Goodwill is
another example of an item of intangible nature which either arises on acquisition
or is internally generated.
Not all the items described above will meet the definition of an intangible asset,
that is, identifiability, control over a resource and expectation of future economic
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benefits flowing to the enterprise. If an item covered by AS 26 does not meet the v
v
definition of an intangible asset, expenditure to acquire it or generate it internally
is recognised as an expense when it is incurred.
Some intangible assets may be contained in or on a physical substance such as a
compact disk (in the case of computer software), legal documentation (in the case
of a licence or patent) or film (in the case of motion pictures). The cost of the
physical substance containing the intangible assets is usually not significant.
Accordingly, the physical substance containing an intangible asset, though tangible
in nature, is commonly treated as a part of the intangible asset contained in or on
it.
In some cases, an asset may incorporate both intangible and tangible elements
that are, in practice, inseparable. Judgement is required to assess as to which
element is predominant. For example, computer software for a computer-
controlled machine tool that cannot operate without that specific software is an
integral part of the related hardware and it is treated as a fixed asset. The same
applies to the operating system of a computer. Where the software is not an
integral part of the related hardware, computer software is treated as an
intangible asset.
6.4 IDENTIFIABILITY
• The definition of an intangible asset requires that an intangible asset be
identifiable. To be identifiable, it is necessary that the intangible asset is
clearly distinguished from goodwill.
• An intangible asset can be clearly distinguished from goodwill if the asset is
separable which means that enterprise could rent, sell, exchange or
distribute the specific future economic benefits attributable to the asset
without also disposing of future economic benefits that flow from other
assets used in the same revenue earning activity.
• Separability is not a necessary condition for identifiability since an
enterprise may be able to identify an asset in some other way. For example,
if an intangible asset is acquired with a group of assets, the transaction may
involve the transfer of legal rights that enable an enterprise to identify the
intangible asset. Also, even If an asset generates future economic benefits
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only in combination with other assets, the asset is identifiable if the
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enterprise can identify the future economic benefits that will flow from the
asset.
6.5 CONTROL
An enterprise controls an asset if the enterprise has the power to obtain the
future economic benefits flowing from the underlying resource and also can
restrict the access of others to those benefits. The capacity of an enterprise to
control the future economic benefits from an intangible asset would normally
stem from legal rights that are enforceable in a court of law. However, legal
enforceability of a right is not a necessary condition for control since an
enterprise may be able to control the future economic benefits in some other
way.
Market and technical knowledge may give rise to future economic benefits. An
enterprise controls those benefits if, for example, the knowledge is protected by
legal rights such as copyrights, a restraint of trade agreement or by a legal duty
on employees to maintain confidentiality.
Future economic benefit is also flown from the skill of labour and customer
loyalty but usually this flow of benefits cannot be controlled by the enterprise as
employees may leave the enterprise anytime or even loyal customers may decide
to purchase goods and services from other suppliers. Hence, these items don’t
even qualify as intangible asset as per the definition given in AS 26.
Example 1:
Moon Limited has provided training to its staff on various new topics like GST, AS,
Ind AS etc. to ensure the compliance as per the required law. Can the company
recognise such cost of staff training as intangible asset?
In this case, it is clear that the company will obtain the economic benefits from the
work performed by the staff as it increases their efficiency. But it does not have
control over them because staff could choose to resign the company at any time.
Hence the company lacks the ability to restrict the access of others to those
benefits. Therefore, the staff training cost does not meet the definition of an
intangible asset.
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6.6 FUTURE ECONOMIC BENEFITS v
The future economic benefits flowing from an intangible asset may include
revenue from the sale of products or services, cost savings, or other benefits
resulting from the use of the asset by the enterprise. For example, the use of
intellectual property in a production process may reduce future production costs
rather than increase future revenues.
6.7 RECOGNITION AND INITIAL MEASUREMENT
OF AN INTANGIBLE ASSET
The recognition of an item as an intangible asset requires an enterprise to
demonstrate that the item meets the definition of an intangible asset and
recognition criteria set out as below:
An intangible asset should be recognised if, and only if:
a. It is probable that the future economic benefits that are attributable to the
asset will flow to the enterprise; and
b. The cost of the asset can be measured reliably.
An enterprise should assess the probability of future economic benefits using
reasonable and supportable assumptions that represent best estimate of the set
of economic conditions that will exist over the useful life of the asset.
An intangible asset should be measured initially at cost.
6.8 SEPARATE ACQUISITION
If an intangible asset is acquired separately, the cost of the intangible asset can
usually be measured reliably. This is particularly so when the purchase
consideration is in the form of cash or other monetary assets.
The cost of an intangible asset comprises:
• its purchase price,
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• any v import duties and other taxes (other than those subsequently
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recoverable by the enterprise from the taxing authorities), and
• any directly attributable expenditure on making the asset ready for its
intended use. Directly attributable expenditure includes, for example,
professional fees for legal services.
• Any trade discounts and rebates are deducted in arriving at the cost.
If an intangible asset is acquired in exchange for shares or other securities of the
reporting enterprise, the asset is recorded at its fair value, or the fair value of the
securities issued, whichever is more clearly evident.
6.9 ACQUISITION AS PART OF AN
AMALGAMATION
An intangible asset acquired in an amalgamation in the nature of purchase is
accounted for in accordance with AS 14 (Revised). In accordance with AS 26:
a. A transferee recognises an intangible asset that meets the recognition
criteria, even if that intangible asset had not been recognised in the
financial statements of the transferor and
b. If the cost (i.e. fair value) of an intangible asset acquired as part of an
amalgamation in the nature of purchase cannot be measured reliably, that
asset is not recognised as a separate intangible asset but is included in
goodwill.
Where in preparing the financial statements of the transferee company, the
consideration is allocated to individual identifiable assets and liabilities on the
basis of their fair values at the date of amalgamation.
Hence, judgement is required to determine whether the cost (i.e. fair value) of an
intangible asset acquired in an amalgamation can be measured with sufficient
reliability for the purpose of separate recognition. Quoted market prices in an
active market provide the most reliable measurement of fair value. The
appropriate market price is usually the current bid price. If current bid prices are
unavailable, the price of the most recent similar transaction may provide a basis
from which to estimate fair value, provided that there has not been a significant
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change in economic circumstances between the transaction date and the date at
which the asset's fair value is estimated. v
If no active market exists for an asset, its cost reflects the amount that the
enterprise would have paid, at the date of the acquisition, for the asset in an
arm's length transaction between knowledgeable and willing parties, based on
the best information available. The cost initially recognised for the intangible
asset in this case is restricted to an amount that does not create or increase any
capital reserve arising at the date of the amalgamation.
Quoted market price
Determination of Fair value
Current bid price
If active market exists
Price of the most
recently similar
transaction
Amount that the
If active market does
enterprise would
not exist
have paid
6.10 ACQUISITION BY WAY OF A GOVERNMENT
GRANT
In some cases, an intangible asset may be acquired free of charge, or for nominal
consideration, by way of a government grant. This may occur when a government
transfers or allocates to an enterprise intangible assets such as airport landing
rights, licences to operate radio or television stations, import licences or quotas
or rights to access other restricted resources.
AS 12, requires that government grants in the form of non-monetary assets, given
at a concessional rate should be accounted for on the basis of their acquisition
cost.
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Accordingly, intangible asset acquired free of charge, or for nominal
v
consideration, by way of government grant is recognised at a nominal value or at
the acquisition cost, as appropriate; any expenditure that is directly attributable
to making the asset ready for its intended use is also included in the cost of the
asset.
6.11 EXCHANGE OF ASSETS
An intangible asset may be acquired in exchange or part exchange for another
asset. In such a case, the cost of the asset acquired is determined in accordance
with the principles laid down in this regard in AS 10.
The cost of such an item is measured at fair value unless:
(a) the exchange transaction lacks commercial substance or
(b) the fair value of neither the asset(s) received nor the asset(s) given up is
reliably measurable.
The acquired item is measured in this manner even if an enterprise cannot
immediately derecognize the asset given up. If the acquired item is not measured at
fair value, its/their cost is measured at the carrying amount of the asset(s) given up.
6.12 INTERNALLY GENERATED GOODWILL
Internally generated goodwill is not recognised as an asset because it is not an
identifiable resource controlled by the enterprise that can be measured reliably at
cost.
Differences between the market value of an enterprise and the carrying amount
of its identifiable net assets at any point in time may be due to a range of factors
that affect the value of the enterprise. However, such differences cannot be
considered to represent the cost of intangible assets controlled by the enterprise.
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6.13 INTERNALLY GENERATED INTANGIBLE
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ASSETS
It is sometimes difficult to assess whether an internally generated intangible asset
qualifies for recognition. It is often difficult to:
(a) identify whether, and the point of time when, there is an identifiable asset
that will generate probable future economic benefits; and
(b) determine the cost of the asset reliably. In some cases, the cost of
generating an intangible asset internally cannot be distinguished from the
cost of maintaining or enhancing the enterprise’s internally generated
goodwill or of running day-to- day operations.
To assess whether an internally generated intangible asset meets the criteria for
recognition, an enterprise classifies the generation of the asset into
➢ Research Phase &
➢ Development Phase
If an enterprise cannot distinguish the research phase from the development
phase of an internal project to create an intangible asset, the enterprise treats the
expenditure on that project as if it were incurred in the research phase only.
6.14 RESEARCH PHASE
Research is original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding.
No intangible asset arising from research or from the research phase should be
recognised. Expenditure on research or on the research phase should be
recognised as an expense when it is incurred.
Examples of research activities are:
a. Activities aimed at obtaining new knowledge.
b. The search for, evaluation and final selection of, applications of research
findings or other knowledge.
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c. v
The search for alternatives for materials, devices, products, processes, systems
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or services;
d. The formulation, design, evaluation and final selection of possible alternatives
for new or improved materials, devices, products, processes, systems or
services.
6.15 DEVELOPMENT PHASE
Development is the application of research findings or other knowledge to a plan
or design for the production of new or substantially improved materials, devices,
products, processes, systems or services prior to the commencement of
commercial production or use.
An intangible asset arising from development (or from the development phase of
an internal project) should be recognised if, and only if, an enterprise can
demonstrate all of the following:
a. The technical feasibility of completing the intangible asset so that it will be
available for use or sale.
b. Its intention to complete the intangible asset and use or sell it.
c. Its ability to use or sell the intangible asset.
d. How the intangible asset will generate probable future economic benefits.
Among other things, the enterprise should demonstrate the existence of a
market for the output of the intangible asset or the intangible asset itself or,
if it is to be used internally, the usefulness of the intangible asset.
e. The availability of adequate technical, financial and other resources to
complete the development and to use or sell the intangible asset and
f. Its ability to measure the expenditure attributable to the intangible asset
during its development reliably.
Examples of development activities are:
a. The design, construction and testing of pre-production or pre-use
prototypes and models.
b. The design of tools, jigs, moulds and dies involving new technology.
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The design, construction and operation of a pilot plant that is not of a scale
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d. The design, construction and testing of a chosen alternative for new or
improved materials, devices, products, processes, systems or services.
AS 26 takes the view that expenditure on internally generated brands, mastheads,
publishing titles, customer lists and items similar in substance cannot be
distinguished from the cost of developing the business as a whole. Therefore,
such items are not recognised as intangible assets.
To demonstrate how an intangible asset will generate probable future economic
benefits, an enterprise assesses the future economic benefits to be received from
the asset using the principles in Accounting Standard on Impairment of Assets. If
the asset will generate economic benefits only in combination with other assets,
the enterprise applies the concept of cash generating units as set out in
Accounting Standard on Impairment of Assets.
6.16 COST OF AN INTERNALLY GENERATED
INTANGIBLE ASSET
The cost of an internally generated intangible asset is the sum of expenditure
incurred from the time when the intangible asset first meets the recognition
criteria. Reinstatement of expenditure recognised as an expense in previous
annual financial statements or interim financial reports is prohibited.
The cost of an internally generated intangible asset comprises all expenditure that
can be directly attributed, or allocated on a reasonable and consistent basis, to
creating, producing and making the asset ready for its intended use from the time
when the intangible asset first meets the recognition criteria. The cost includes, if
applicable:
a Expenditure on materials and services used or consumed in generating the
intangible asset.
b. The salaries, wages and other employment related costs of personnel
directly engaged in generating the asset.
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Any expenditure that is directly attributable to generating the asset, such as
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fees to register a legal right and the amortisation of patents and licenses
that are used to generate the asset (E.g., borrowing cost as per para 4(e) of
AS 16, etc.) and
d. Overheads that are necessary to generate the asset and that can be
allocated on a reasonable and consistent basis to the asset. Allocations of
overheads are made on bases similar to those discussed in AS 2 & AS 16.
The following are not components of the cost of an internally generated
intangible asset, these should be expensed off in profit and loss account:
a. Selling, administrative and other general overhead expenditure unless this
expenditure can be directly attributed to making the asset ready for use.
b. Clearly identified inefficiencies and initial operating losses incurred before
an asset achieves planned performance and
c. Expenditure on training the staff to operate the asset.
Example
An enterprise is developing a new production process. During the year 20X1,
expenditure incurred was ` 10 lacs, of which ` 9 lacs was incurred before 1
December 20X1 and 1 lac was incurred between 1 December 20X1 and 31
December 20X1. The enterprise is able to demonstrate that, at 1 December 20X1,
the production process met the criteria for recognition as an intangible asset. The
recoverable amount of the know-how embodied in the process (including future
cash outflows to complete the process before it is available for use) is estimated to
be ` 5 lacs.
At the end of 20X1, the production process is recognised as an intangible asset at a
cost of ` 1 lac (expenditure incurred since the date when the recognition criteria
were met, that is, 1 December 20X1). The ` 9 lacs expenditure incurred before 1
December 20X1 is recognised as an expense because the recognition criteria were
not met until 1 December 20X1. This expenditure will never form part of the cost of
the production process recognised in the balance sheet.
During the year 20X2, expenditure incurred is ` 20 lacs. At the end of 20X2, the
recoverable amount of the know-how embodied in the process (including future
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cash outflows to complete the process before it is available for use) is estimated to
be ` 19 lacs. v
At the end of the year 20X2, the cost of the production process is ` 21 lacs ( ` 1 lac
expenditure recognised at the end of 20X1 plus ` 20 lacs expenditure recognised in
20X2). The enterprise recognises an impairment loss of ` 2 lacs to adjust the
carrying amount of the process before impairment loss ( ` 21 lacs) to its recoverable
amount (` 19 lacs). This impairment loss will be reversed in a subsequent period if
the requirements for the reversal of an impairment loss in AS 28, are met.
6.17 RECOGNITION OF AN EXPENSE
Expenditure on an intangible item should be recognised as an expense when it is
incurred unless:
a. It forms part of the cost of an intangible asset that meets the recognition
criteria or
b. The item is acquired in an amalgamation in the nature of purchase and
cannot be recognised as an intangible asset. It forms part of the amount
attributed to goodwill (capital reserve) at the date of acquisition.
In some cases, expenditure is incurred to provide future economic benefits to an
enterprise, but no intangible asset or other asset is acquired or created that can
be recognised. In these cases, the expenditure is recognised as an expense when
it is incurred. For example, expenditure on research is always recognised as an
expense when it is incurred.
Examples of other expenditure that is recognised as an expense when it is
incurred include:
(a) expenditure on start-up activities (start-up costs), unless this expenditure is
included in the cost of an item of fixed asset under AS 10. Start-up costs
may consist of preliminary expenses incurred in establishing a legal entity
such as legal and secretarial costs, expenditure to open a new facility or
business (pre-opening costs) or expenditures for commencing new
operations or launching new products or processes (pre-operating costs);
(b) expenditure on training activities;
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(c) v
expenditure on advertising and promotional activities; and
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(d) expenditure on relocating or re-organising part or all of an enterprise.
The above guidance does not apply to payments for the delivery of goods or
services made in advance of the delivery of goods or the rendering of services.
Such prepayments are recognised as assets.
Past Expenses not to be recognised as an Asset
Expenditure on an intangible item that was initially recognised as an expense in
previous annual financial statements or interim financial reports should not be
recognised as part of the cost of an intangible asset at a later date.
6.18 SUBSEQUENT EXPENDITURE
Subsequent expenditure on an intangible asset after its purchase or its
completion should be recognised as an expense when it is incurred unless:
a. It is probable that the expenditure will enable the asset to generate future
economic benefits in excess of its originally assessed standard of
performance and
b. The expenditure can be measured and attributed to the asset reliably.
If these conditions are met, the subsequent expenditure should be added to the
cost of the intangible asset.
Subsequent expenditure on brands, mastheads, publishing titles, customer lists
and items similar in substance is always recognised as an expense to avoid the
recognition of internally generated goodwill.
The nature of intangible assets is such that, in many cases, it is not possible to
determine whether subsequent expenditure is likely to enhance or maintain the
economic benefits that will flow to the enterprise from those assets. Therefore,
only rarely will expenditure incurred after the initial recognition of a purchased
intangible asset or after completion of an internally generated intangible asset
result in additions to the cost of the intangible asset.
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6.19 MEASUREMENT SUBSEQUENT TO INITIAL
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RECOGNITION
After initial recognition, an intangible asset should be carried at its cost less any
accumulated amortisation and any accumulated impairment losses.
6.20 AMORTISATION PERIOD
The depreciable amount of an intangible asset should be allocated on a
systematic basis over the best estimate of its useful life. Amortisation should
commence when the asset is available for use.
Estimates of the useful life of an intangible asset generally become less reliable as
the length of the useful life increases. AS 26 adopts a rebuttable presumption that
the useful life of an intangible asset will not exceed ten years from the date when
the asset is available for use. Amortisation is recognised whether or not there has
been an increase in, for example, the asset's fair value or recoverable amount.
Many factors need to be considered in determining the useful life of an intangible
asset including:
(a) the expected usage of the asset by the enterprise and whether the asset
could be efficiently managed by another management team;
(b) typical product life cycles for the asset and public information on estimates
of useful lives of similar types of assets that are used in a similar way;
(c) technical, technological or other types of obsolescence;
(d) the stability of the industry in which the asset operates and changes in the
market demand for the products or services output from the asset;
(e) expected actions by competitors or potential competitors;
(f) the level of maintenance expenditure required to obtain the expected future
economic benefits from the asset and the company's ability and intent to
reach such a level;
(g) the period of control over the asset and legal or similar limits on the use of
the asset, such as the expiry dates of related leases; and
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(h) v
whether the useful life of the asset is dependent on the useful life of other
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assets of the enterprise.
Given the history of rapid changes in technology, computer software and many
other intangible assets are susceptible to technological obsolescence. Therefore,
it is likely that their useful life will be short.
In some cases, there may be persuasive evidence that the useful life of an
intangible asset will be a specific period longer than ten years. In these cases, the
presumption that the useful life generally does not exceed ten years is rebutted
and the enterprise:
a. Amortises the intangible asset over the best estimate of its useful life.
b. Estimates the recoverable amount of the intangible asset at least annually in
order to identify any impairment loss and
c. Discloses the reasons why the presumption is rebutted and the factors that
played a significant role in determining the useful life of the asset.
Example:
A. An enterprise has purchased an exclusive right to generate hydroelectric power
for 60 years. The costs of generating hydro-electric power are much lower than the
costs of obtaining power from alternative sources. It is expected that the
geographical area surrounding the power station will demand a significant amount
of power from the power station for at least 60 years.
The enterprise amortises the right to generate power over 60 years, unless there is
evidence that its useful life is shorter.
B. An enterprise has purchased an exclusive right to operate a toll motorway for 30
years. There is no plan to construct alternative routes in the area served by the
motorway. It is expected that this motorway will be in use for at least 30 years.
The enterprise amortises the right to operate the motorway over 30 years, unless
there is evidence that its useful life is shorter.
If control over the future economic benefits from an intangible asset is achieved
through legal rights that have been granted for a finite period, the useful life of the
intangible asset should not exceed the period of the legal rights unless the legal
rights are renewable and renewal is virtually certain.
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The useful life of an intangible asset may be very long but it is always finite.
v
There may be both economic and legal factors influencing the useful life of an
intangible asset: economic factors determine the period over which future
economic benefits will be generated; legal factors may restrict the period over
which the enterprise controls access to these benefits. The useful life is the
shorter of the periods determined by these factors.
Example:
Company X has purchased a copyright to produce a safety equipment for sale in the
market. The rights have been obtained for 10 years. Hence, company is amortizing
the intangible asset in 10 years. After 7 years, due to change in the environmental
law, safety equipments produced out of new technology are only considered valid.
In above scenario, the company need to write off the balance amount in the year of
implementation of the law.
6.21 AMORTISATION METHOD
The amortisation method used should reflect the pattern in which the asset's
economic benefits are consumed by the enterprise. If that pattern cannot be
determined reliably, the straight-line method should be used. A variety of
amortisation methods can be used to allocate the depreciable amount of an asset
on a systematic basis over its useful life. These methods include
• the straight-line method,
• the diminishing balance method and
• the unit of production method.
The method used for an asset is selected based on the expected pattern of
consumption of economic benefits and is consistently applied from period to
period, unless there is a change in the expected pattern of consumption of
economic benefits to be derived from that asset.
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The amortisation charge for each period should be recognised as an expense
v
unless another Accounting Standard permits or requires it to be included in the
carrying amount of another asset. For example, the amortisation of intangible
assets used in a production process is included in the carrying amount of
inventories.
6.22 RESIDUAL VALUE
Residual value is the amount, which an enterprise expects to obtain for an asset at
the end of its useful life after deducting the expected costs of disposal.
The residual value of an intangible asset should be assumed to be zero unless:
a. There is a commitment by a third party to purchase the asset at the end of
its useful life or
b. There is an active market for the asset and:
i. Residual value can be determined by reference to that market and
ii. It is probable that such a market will exist at the end of the asset's
useful life.
A residual value other than zero implies that an enterprise expects to dispose of
the intangible asset before the end of its economic life.
6.23 REVIEW OF AMORTISATION PERIOD AND
AMORTISATION METHOD
The amortisation period and the amortisation method should be reviewed at least
at each financial year end. If the expected useful life of the asset is significantly
different from previous estimates, the amortisation period should be changed
accordingly. If there has been a significant change in the expected pattern of
economic benefits from the asset, the amortisation method should be changed to
reflect the changed pattern. Such changes should be accounted for in accordance
with AS 5.
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6.24 RECOVERABILITY OF THE CARRYING
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AMOUNT-IMPAIRMENT LOSSES
Impairment losses of intangible assets are calculated on the basis of AS 28 . AS 28
“Impairment of Assets” is covered in next unit of this chapter.
In addition to the requirements of Accounting Standard on Impairment of Assets,
an enterprise should estimate the recoverable amount of the following intangible
assets at least at each financial year end even if there is no indication that the
asset is impaired:
(a) an intangible asset that is not yet available for use; and
(b) an intangible asset that is amortised over a period exceeding ten years from
the date when the asset is available for use.
AS 26 requires an enterprise to test for impairment, at least annually, the carrying
amount of an intangible asset that is not yet available for use.
Example:
X limited is developing a customized software for ` 10 Cr. It will take 3 years to
complete development. Present value of future economic benefit is considered to be
` 15 Cr. After 2 years, 70% work is completed. However, due to change in market
conditions, present value of future economic benefits are estimated to be ` 6 Cr
only.
Company should recognize ` 1 Cr as impairment loss on "Intangible asset under
development” as per AS 28. Only ` 6 Cr can be shown as "Intangible asset under
development”. Company cannot capitalize any further amount till the time
recoverable amount increases even if work of ` 10 Cr is completed.
6.25 RETIREMENTS AND DISPOSALS
An intangible asset should be derecognised (eliminated from the balance sheet) if
➢ disposed or
➢ when no future economic benefits are expected from its use and
subsequent disposal.
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Gains or losses arising from the retirement or disposal of an intangible asset
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should be determined as the difference between the net disposal proceeds and
the carrying amount of the asset and should be recognised as income or expense
in the statement of profit and loss.
An intangible asset that is retired from active use and held for disposal is carried
at its carrying amount at the date when the asset is retired from active use.
6.26 DISCLOSURE
The financial statements should disclose the following for each class of intangible
assets, distinguishing between internally generated intangible assets and other
intangible assets:
1. The useful lives or the amortisation rates used.
2. The amortisation methods used.
3. The gross carrying amount and the accumulated amortisation (aggregated
with accumulated impairment losses) at the beginning and end of the
period.
4. A reconciliation of the carrying amount at the beginning and end of the
period showing:
I. Additions, indicating separately those from internal development and
through amalgamation.
II. Retirements and disposals.
III. Impairment losses recognised in the statement of profit and loss
during the period.
IV Impairment losses reversed in the statement of profit and loss during
the period.
V Amortisation recognised during the period and
VI Other changes in the carrying amount during the period.
A class of intangible assets is a grouping of assets of a similar nature and
use in an enterprise's operations. Examples of separate classes may include:
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(a) brand names; v
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(b) mastheads and publishing titles;
(c) computer software;
(d) licences and franchises;
(e) copyrights, and patents and other industrial property rights, service
and operating rights;
(f) recipes, formulae, models, designs and prototypes; and
(g) intangible assets under development.
6.27 OTHER DISCLOSURES
The financial statements should also disclose:
a. If an intangible asset is amortised over more than ten years, the reasons
why it is presumed that the useful life of an intangible asset will exceed ten
years from the date when the asset is available for use. In giving these
reasons, the enterprise should describe the factor(s) that played a significant
role in determining the useful life of the asset.
b. A description, the carrying amount and remaining amortisation period of
any individual intangible asset that is material to the financial statements of
the enterprise as a whole.
c. The existence and carrying amounts of intangible assets whose title is
restricted and the carrying amounts of intangible assets pledged as security
for liabilities and
d. The amount of commitments for the acquisition of intangible assets.
The financial statements should disclose the aggregate amount of research and
development expenditure recognised as an expense during the period.
An enterprise is encouraged, but not required, to give a description of any fully
amortised intangible asset that is still in use.
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Illustration
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ABC Ltd. developed know-how by incurring expenditure of ` 20 lakhs, The know-how
was used by the company from 1.4.20X1. The useful life of the asset is 10 years from
the year of commencement of its use. The company has not amortised the asset till
31.3.20X8. Pass Journal entry to give effect to the value of know-how as per
Accounting Standard-26 for the year ended 31.3.20X8.
Solution
Journal Entry
` `
Profit and Loss A/c (Prior period item) Dr. 12,00,000
Amortization A/c Dr. 2,00,000
To Know-how A/c
14,00,000
[Being amortization of 7 years (out of which
amortization of 6 years charged as prior period
item)]
Illustration 2
The company had spent ` 45 lakhs for publicity and research expenses on one of its
new consumer product, which was marketed in the accounting year 20X1-20X2, but
proved to be a failure. State, how you will deal with the following matters in the
accounts of U Ltd. for the year ended 31st March, 20X2.
Solution
In the given case, the company spent ` 45 lakhs for publicity and research of a
new product which was marketed but proved to be a failure. It is clear that in
future there will be no related further revenue/benefit because of the failure of
the product. Thus, according to AS 26 ‘Intangible Assets’, the company should
charge the total amount of ` 45 lakhs as an expense in the profit and loss
account.
As per para 63 of AS 26 “Intangible Assets”, there is a rebuttable presumption that the useful life of an
intangible asset will not exceed ten years from the date when the asset is available for use. Amortisation
should commence when the asset is available for use.
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A company with a turnover of ` 250 crores and an annual advertising budget of
` 2 crores had taken up the marketing of a new product. It was estimated that the
company would have a turnover of ` 25 crores from the new product. The company
had debited to its Profit and Loss account the total expenditure of ` 2 crore incurred
on extensive special initial advertisement campaign for the new product.
Is the procedure adopted by the company correct?
Solution
According to AS 26 ‘Intangible Assets’, “expenditure on an intangible item should
be recognised as an expense when it is incurred unless it forms part of the cost of
an intangible asset”.
AS 26 mentions that expenditure on advertising and promotional activities should
be recognised as an expense when incurred.
In the given case, advertisement expenditure of ` 2 crores had been taken up for
the marketing of a new product which may provide future economic benefits to
an enterprise by having a turnover of ` 25 crores. Here, no intangible asset or
other asset is acquired or created that can be recognised. Therefore, the
accounting treatment by the company of debiting the entire advertising
expenditure of ` 2 crores to the Profit and Loss account of the year is correct.
Reference: The students are advised to refer the full text of AS 28
“Intangible Assets” (issued 2002).
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TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Which of the following is not covered within the scope of AS 26?
(a) Intangible assets held-for-sale in the ordinary course of business
(b) Assets arising from employee benefits
(c) (a) & (b) both
(d) Research and development activities
2. Intangible asset is recognised if it:
(a) meets the definition of an intangible asset
(b) is probable that future economic benefits will flow
(c) the cost can be measured reliably
(d) meets all of the above parameters
3. Sun Limited has purchased a computer with various additional software.
These are integral part of the computer. Which of the following are true in the
context of AS 26:
(a) Recognise Computer and software as tangible asset
(b) Recognise tangible and intangible separately
(c) Recognise computer and software as intangible asset
(d) Does not recognize the software as an asset.
4. Hexa Ltd developed a technology to enhance the battery life of mobile
devices. Hexa has capitalised development expenditure of ` 5,00,000. Hexa
estimates the life of the technology developed to be 3 years but the company
has forecasted that 50% of sales will be in year 1, 35% in year 2 and 15% in
year 3. What should be the amortisation charge in the second year of the
product’s life?
(a) ` 2,50,000
(b) ` 1,75,000
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(d) ` 1,85,000
Theoretical Questions
5. What is meant by Intangible Assets and what are the important factors to
consider the recognition of item as an Intangible asset? What is the
recognition criteria in accordance with the provisions of AS 26?
6. What is the measurement criteria at the time of initial recognition of Intangible
assets acquired through separate acquisition?
7. What is the criteria for recognition and measurement of Internally generated
intangible assets. Describe which kind of cost is considered for capitalisation with
respect to provisions of AS 26. Whether the same applies for internally generated
goodwill also?
8. Advise the complete accounting treatment for Research and development phase
as per AS 26.
9. What is meant by Amortisation of an Intangible asset. What are the different
methods for amortisation as per AS 26?
Scenario based Questions
10. Swift Ltd. acquired a patent at a cost of ` 80,00,000 for a period of 5 years
and the product life-cycle is also 5 years. The company capitalized the cost
and started amortizing the asset at ` 10,00,000 per annum. The company
had amortized the patent at 10,00,000 per annum in first two years on the
basis of economic benefits derived from the product manufactured under the
patent. After two years it was found that the product life-cycle may continue
for another 5 years from then. The patent was renewable and Swift Ltd. got it
renewed after expiry of five years. The net cash flows from the product during
these 5 years were expected to be ` 36,00,000, ` 46,00,000, ` 44,00,000,
` 40,00,000 and ` 34,00,000. Find out the amortization cost of the patent for
each of the years.
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11. v
AB Ltd. launched a project for producing product X in October, 20X1. The
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Company incurred ` 20 lakhs towards Research. Due to prevailing market
conditions, the Management came to conclusion that the product cannot be
manufactured and sold in the market for the next 10 years. The Management
hence wants to defer the expenditure write off to future years.
Advise the Company as per the applicable Accounting Standard.
12. During 20X1-X2, an enterprise incurred costs to develop and produce a
routine low risk computer software product, as follows:
Particular `
Completion of detailed program and design (Phase 1) 50,000
Coding and Testing (Phase 2) 40,000
Other coding costs (Phase 3 & 4) 63,000
Testing costs (Phase 3 & 4) 18,000
Product masters for training materials (Phase 5) 19,500
Packing the products (1,500 units) (Phase 6) 16,500
After completion of phase 2, it was established that the product is technically
feasible for the market. You are required to state how the above referred cost
to be recognized in the books of accounts.
13. As per provisions of AS-26, how would you deal to the following situations:
(1) ` 23,00,000 paid by a manufacturing company to the legal advisor for
defending the patent of a product is treated as a capital expenditure.
(2) During the year 20X1-X2, a company spent ` 7,00,000 for publicity and
research expenses on one of its new consumer product which was
marketed in the same accounting year but proved to be a failure.
(3) A company spent ` 25,00,000 in the past three years to develop a
product, these expenses were charged to profit and loss account since
they did not meet AS-26 criteria for capitalization. In the current year
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approval of the concerned authority has been received. The company v
wishes to capitalize ` 25,00,000 by disclosing it as a prior period item.v
(4) A company with a turnover of ` 200 crores and an annual advertising
budget of ` 50,00,000 had taken up for the marketing of a new
product by a company. It was estimated that the company would
have a turnover of ` 20 crore from the new product. The company had
debited to its Profit & Loss Account the total expenditure of `
50,00,000 incurred on extensive special initial advertisement campaign
for the new product.
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (c) 2. (d) 3. (a) 4. (b)
Answer to the Theoretical Questions
5. An intangible asset is an identifiable non-monetary asset, without physical
substance, held for use in the production or supply of goods or services, for
rental to others, or for administrative purposes. Below are the 3 key
ingredients to be satisfied to cover an item as an intangible asset under this
standard:
• identifiability,
• control over a resource and
• expectation (i.e. probable – 50% plus) of future economic benefits
flowing to the enterprise.
The recognition of an item as an intangible asset requires an enterprise to
demonstrate that the item meets the definition of an intangible asset and
recognition criteria set out as below:
a. It is probable that the future economic benefits that are attributable
to the asset will flow to the enterprise; and
b. The cost of the asset can be measured reliably.
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6. If anv intangible asset is acquired separately, the cost of the intangible asset
can vusually be measured reliably. This is particularly so when the purchase
consideration is in the form of cash or other monetary assets.
The cost of an intangible asset comprises:
• its purchase price,
• any import duties and other taxes (other than those subsequently
recoverable by the enterprise from the taxing authorities), and
• any directly attributable expenditure on making the asset ready for its
intended use. Directly attributable expenditure includes, for example,
professional fees for legal services.
• Any trade discounts and rebates are deducted in arriving at the cost.
7. To assess whether an internally generated intangible asset meets the criteria
for recognition, an enterprise classifies the generation of the asset into 2
phases:
➢ Research Phase &
➢ Development Phase
Research Phase - The expenses related to Research phase is expensed off in
statement of Profit and loss.
Development Phase - Development is the application of research findings or
other knowledge to a plan or design for the production of new or
substantially improved materials, devices, products, processes, systems or
services prior to the commencement of commercial production or use.
An intangible asset arising from development (or from the development
phase of an internal project) should be recognised if, and only if, an
enterprise can demonstrate all of the conditions given in para 6.15.
Cost of an Internally Generated Intangible Asset
The cost of an internally generated intangible asset is the sum of
expenditure incurred from the time when the intangible asset first meets the
recognition criteria. Reinstatement of expenditure recognised as an expense
in previous annual financial statements or interim financial reports is
prohibited.
The cost of an internally generated intangible asset comprises all
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expenditure that can be directly attributed, or allocated on a reasonable and
consistent basis, to creating, producing and making the asset ready for its v
intended use from the time when the intangible asset first meets the
recognition criteria. For details, refer para 6.16.
Internally generated goodwill is not recognised as an asset because it is not
an identifiable resource controlled by the enterprise that can be measured
reliably at cost.
8. Research phase means acquisition of knowledge and Development phase
means application of knowledge.
The expenditure related to Research phase is expensed off in statement of
Profit and loss. However, the expenditure incurred in Development phase is
capitalised as a cost of the internally generated intangible asset.
If an enterprise cannot distinguish the research phase from the
development phase of an internal project to create an intangible asset, the
enterprise treats the expenditure on that project as if it were incurred in the
research phase only.
9. Amortisation is the systematic allocation of the depreciable amount of an
intangible asset over its useful life.
The amortisation method used should reflect the pattern in which the
asset's economic benefits are consumed by the enterprise. If that pattern
cannot be determined reliably, the straight-line method should be used. A
variety of amortisation methods can be used to allocate the depreciable
amount of an asset on a systematic basis over its useful life. These methods
include
• the straight-line method,
• the diminishing balance method and
• the unit of production method.
The method used for an asset is selected based on the expected pattern of
consumption of economic benefits and is consistently applied from period
to period, unless there is a change in the expected pattern of consumption
of economic benefits to be derived from that asset.
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Answerv to the Scenario based Questions
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10. Swift Limited amortised ` 10,00,000 per annum for the first two years i.e.
` 20,00,000. The remaining carrying cost can be amortised during next
5 years on the basis of net cash flows arising from the sale of the product.
The amortisation may be found as follows:
S Net cash flows ` Amortisation Ratio Amortisation Amount `
I - 0.125 10,00,000
II - 0.125 10,00,000
III 36,00,000 0.180 10,80,000
IV 46,00,000 0.230 13,80,000
V 44,00,000 0.220 13,20,000
VI 40,00,000 0.200 12,00,000
VII 34,00,000 0.170 10,20,000
Total 2,00,00,000 1.000 80,00,000
It may be seen from above that from third year onwards, the balance of
carrying amount i.e., ` 60,00,000 has been amortised in the ratio of net cash
flows arising from the product of Swift Ltd.
11. As per para 41 of AS 26 “Intangible Assets”, expenditure on research should
be recognised as an expense when it is incurred. Hence, the expenses
amounting ` 20 lakhs incurred on the research has to be charged to the
statement of profit and loss in the current year ending 31 st March, 20X2.
12. As per AS 26, costs incurred in creating a computer software product should
be charged to research and development expense when incurred until
technological feasibility/asset recognition criteria has been established for
the product. Technological feasibility/asset recognition criteria have been
established upon completion of detailed program design, coding and
testing. In this case, ` 90,000 would be recorded as an expense (` 50,000 for
completion of detailed program design and ` 40,000 for coding and testing
to establish technological feasibility/asset recognition criteria). Cost
incurred from the point of technological feasibility/asset recognition criteria
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until the time when products costs are incurred are capitalized as software
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cost (63,000+ 18,000+ 19,500) = ` 1,00,500. Packing cost ` 16,500 should be
recognized as expenses and charged to P & L A/c.
13. As per AS 26 “Intangible Assets”, subsequent expenditure on an intangible
asset after its purchase or its completion should be recognized as an
expense when it is incurred unless (a) it is probable that the expenditure will
enable the asset to generate future economic benefits in excess of its
originally assessed standard of performance; and (b) expenditure can be
measured and attributed to the asset reliably. If these conditions are met,
the subsequent expenditure should be added to the cost of the intangible
asset.
(i) In the given case, the legal expenses to defend the patent of a
product amounting ` 23,00,000 should not be capitalized and be
charged to Profit and Loss Statement.
(ii) The company is required to expense the entire amount of ` 7,00,000
in the Profit and Loss account for the year ended 31 st March, 20X2
because no benefit will arise in the future.
(iii) As per AS 26, expenditure on an intangible item that was initially
recognized as an expense by a reporting enterprise in previous annual
financial statements should not be recognized as part of the cost of an
intangible asset at a later date. Thus the company cannot capitalize
the amount of ` 25,00,000 and it should be recognized as expense
(iv) Expenditure of ` 50,00,000 on advertising and promotional activities
should always be charged to Profit and Loss Statement. Hence, the
company has done the correct treatment by debiting the sum of 50
lakhs to Profit and Loss Account.
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UNIT 7: ACCOUNTING STANDARD 28
IMPAIRMENT OF ASSETS
LEARNING OUTCOMES
After studying this unit, you will be able to:
Define the terms ‘recoverable amount’, ‘value in use’, ‘net selling
price’, ‘cost of disposal’, ‘impairment loss’ and other related terms.
Identify an asset that may be Impaired.
Measure the recoverable amount after computing net selling price
and value in use
Recognise and measure the impairment loss
Identify the cash generating units
Compute the recoverable amount and carrying amount of a cash-
generating unit
Identify goodwill that whether it relates to the cash-generating unit
Impair the cash generating unit
Set out the requirements for reversing an impairment loss
Apply impairment provisions in case of discontinuing operations
7.1 INTRODUCTION
AS 28 came into effect in respect of accounting period commenced on or after
1-4-2004 and is mandatory in nature from that date for the following:
(i) Enterprises whose equity or debt securities are listed on a recognised stock
exchange in India, and enterprises that are in the process of issuing equity
or debt securities that will be listed on a recognised stock exchange in India
as evidenced by the board of directors’ resolution in this regard.
(ii) All other commercial, industrial and business reporting enterprises, whose
turnover for the accounting period exceeds ` 50 crores.
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In respect of all other enterprises, the Accounting Standard came into effect
in respect of accounting periods commenced on or after 1-4-2005 and vis
mandatory in nature from that date.
This standard prescribes the procedures to be applied to ensure that the assets of
an enterprise are carried at an amount not exceeding their recoverable amount
(amount to be recovered through use or sale of the asset). The standard also lays
down principles for reversal of impairment losses and prescribes certain
disclosures in respect of impaired assets. An enterprise is required to assess at
each balance sheet date whether there is an indication that an enterprise’s assets
may be impaired. If such an indication exists, the enterprise is required to
estimate the recoverable amount and the impairment loss, if any, should be
recognised in the profit and loss account.
7.2 SCOPE
The standard should be applied in accounting for impairment of all assets except
1. inventories (AS 2),
2. assets arising under construction contracts (AS 7),
3. financial assets including investments covered under AS 13, and
4. deferred tax assets (AS 22).
There are chances that the provision on account of impairment losses may
increase sickness of companies and potentially sick companies may actually
become sick.
7.3 ASSESSMENT
An enterprise should assess at each balance sheet date whether there is any
indication that an asset may be impaired. If any such indication exists, the
enterprise should estimate the recoverable amount of the asset. An asset is
impaired when the carrying amount of the asset exceeds its recoverable amount.
The requirements use the term ‘an asset’ but apply equally to an individual asset
or a cash-generating unit. In assessing whether there is any indication that an
asset may be impaired, an enterprise should consider, as a minimum, the
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following vindications:
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External sources
Indicators of Impairment
[List is NOT exhaustive]
Internal sources
External sources of information
a. During the period, an asset’s market value has declined significantly more
than would be expected as a result of the passage of time or normal use.
b. Significant changes with an adverse effect on the enterprise have taken
place during the period, or will take place in the near future, in the
technological, market, economic or legal environment in which the
enterprise operates or in the market to which an asset is dedicated.
c. Market interest rates or other market rates of return on investments have
increased during the period, and those increases are likely to affect the
discount rate used in calculating an asset’s value in use and decrease the
asset’s recoverable amount materially.
d. The carrying amount of the net assets of the reporting enterprise is more
than its market capitalization.
Internal sources of information
a. Evidence is available of obsolescence or physical damage of an asset.
b. Significant changes with an adverse effect on the enterprise have taken
place during the period, or are expected to take place in the near future, in
the extent to which, or manner in which, an asset is used or is expected to
be used. These changes include plans to discontinue or restructure the
operation to which an asset belongs or to dispose of an asset before the
previously expected date and
c. Evidence is available from internal reporting that indicates that the
economic performance of an asset is, or will be, worse than expected.
An enterprise may identify other indications that an asset may be impaired and
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these would also require the enterprise to determine the asset’s recoverable
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Example that indicates that an asset may be impaired because of the following:
a) cash flows for acquiring the asset, or subsequent cash needs for operating or
maintaining it, that are significantly higher than those originally budgeted;
b) actual net cash flows or operating profit or loss flowing from the asset that
are significantly worse than those budgeted;
c) a significant decline in budgeted net cash flows or operating profit, or a
significant increase in budgeted loss, flowing from the asset; or
d) operating losses or net cash outflows for the asset, when current period
figures are aggregated with budgeted figures for the future.
The concept of materiality applies in identifying whether the recoverable amount
of an asset needs to be estimated.
Note: If there is an indication that an asset may be impaired, this may indicate
that the remaining useful life, the depreciation method or the residual value
for the asset need to be reviewed and adjusted under the Accounting Standard
10, even if no impairment loss is recognised for the asset.
7.4 MEASUREMENT OF RECOVERABLE AMOUNT
An impairment loss is the amount by which the carrying amount of an asset
exceeds its recoverable amount.
Recoverable amount is the higher of an asset’s net selling price and it’s value in
use.
Net selling price is the amount obtainable from the sale of an asset in an arm’s
length transaction between knowledgeable, willing parties, less the costs of
disposal.
Costs of disposal are incremental costs directly attributable to the disposal of an
asset, excluding finance costs and income tax expense.The best evidence for net
selling price is a price in the bidding sales agreement for the disposal of the
assets or similar assets. In the absence of this, net selling price is estimated from
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the transactions for the assets in active market, if the asset has the active market.
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If there is no binding sale agreement or active market for an asset, net selling
price is based on the best information available to reflect the amount that an
enterprise could obtain, at the balance sheet date, for the disposal of the asset in
an arm’s length transaction between knowledgeable, willing parties, after
deducting the costs of disposal.
Value in Use is the present value of estimated future cash flows expected to arise
from the continuing use of an asset and from its disposal at the end of its useful
life.
Estimating the value in use of an asset involves the following steps:
a. Estimating the future cash inflows and outflows arising from continuing use
of the asset and from its ultimate disposal; and
b. Applying the appropriate discount rate to these future cash flows.
Carrying amount is the amount at which an asset is recognised in the balance
sheet after deducting any accumulated depreciation (amortisation) and
accumulated impairment losses thereon.
Depreciation (Amortisation) is a systematic allocation of the depreciable
amount of an asset over its useful life.
Depreciable amount is the cost of an asset, or other amount substituted for cost
in the financial statements, less its residual value.
Useful life is either:
• The period of time over which an asset is expected to be used by the
enterprise; or
• The number of production or similar units expected to be obtained from the
asset by the enterprise.
Note 1: If there is no reason to believe that an asset’s value in use materially
exceeds its net selling price, the asset’s recoverable amount may be taken to be
its net selling price. This will often be the case for an asset that is held for
disposal. Otherwise, if it is not possible to determine the selling price we take
value in use of assets as it’s recoverable amount.
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It is not always necessary to determine both an asset’s net selling price and itsv
v
value in use. For example, if either of these amounts exceeds the asset’s carrying
amount, the asset is not impaired, and it is not necessary to estimate the other
amount.
It may be possible to determine net selling price, even if an asset is not traded in
an active market. However, sometimes it will not be possible to determine net
selling price because there is no basis for making a reliable estimate of the
amount obtainable from the sale of the asset in an arm’s length transaction
between knowledgeable and willing parties. In this case, the recoverable amount
of the asset may be taken to be its value in use.
Note 2: Recoverable amount is determined for an individual asset, unless the
asset does not generate cash inflows from continuing use that are largely
independent of those from other assets or groups of assets. If this is the case,
recoverable amount is determined for the cash-generating unit to which the
asset belongs, unless either:
a. The asset’s net selling price is higher than its carrying amount; or
b. The asset’s value in use can be estimated to be close to its net selling price
and net selling price can be determined.
7.5 BASIS FOR ESTIMATES OF FUTURE CASH
FLOWS
Cash flow projections should be based on the most recent approved
budgets/forecasts for a maximum of five years. Financial budgets/forecasts over a
period longer than five years may be used if management is confident that these
projections are reliable and it can demonstrate its ability, based on past
experience, to forecast cash flows accurately over that longer period.
Cash flow projections until the end of an asset’s useful life are estimated by
extrapolating the cash flow projections based on the financial budgets/forecasts
using a growth rate for subsequent years. This rate is steady or declining. This
growth rate should not exceed the long-term average growth rate for the
products, industries, or country or countries in which the enterprise operates, or
for the market in which the asset is used, unless a higher rate can be justified.
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Cash flow projections should be based on reasonable and supportable
v
assumptions that represent management’s best estimate of the set of economic
conditions that will exist over the remaining useful life of the asset. Greater
weight should be given to external evidence.
7.6 COMPOSITION OF ESTIMATES OF FUTURE
CASH FLOWS
Estimates of future cash flows should include
(i) Projections of net cash inflows from the continuing use of the asset
(ii) projections of cash outflows that are necessarily incurred to generate
the cash inflows from continuing use of the asset and that can be
directly attributed, or allocated on a reasonable and consistent basis,
to the asset; and
(iii) Net cash flows, if any, to be received (or paid) for the disposal of the
asset at the end of its useful life.
Care should be taken for the following points:
a. When the carrying amount of an asset does not yet include all the cash
outflows to be incurred before it is ready for use or sale, estimate of any
further cash outflow that is expected to be incurred before the asset is
ready for use or sale should be included.
b. Cash inflows from assets that generate cash inflows from continuing use
that are largely independent of the cash inflows from the asset under review
should not be included.
c. Cash outflows that relate to obligations that have already been recognised
as liabilities to be excluded.
d. Future cash outflows or inflows expected to arise because of restructuring
of the organization should be not considered.
e. Any future capital expenditure enhancing the capacity of the assets and its
related savings/outflow should be excluded.
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f. v
Any increase in expected cash inflow from the above expenditure should
also be excluded. v
g. Estimates of future cash flows should not include cash inflows or outflows
from financing activities and also income tax receipts or payments.
h. The estimate of net cashflow upon disposal of the asset should be the
amount that an enterprise expects to obtain from the disposal of the asset
in an arm’s length transaction between knowledgeable, willing parties
prevailing at the date of the estimates, after deducting the estimated costs
of disposal.
When an enterprise becomes committed to a restructuring, some assets are likely
to be affected by this restructuring. Once the enterprise is committee to the
restructuring, in determining value in use, estimates of future cash inflows and
cash outflows reflect the cost savings and other benefits from the restructuring
(based on the most recent financial budgets/forecasts that have been approved
by management).
Foreign Currency Future Cash Flows are estimated in the currency in which it
will be generated and then they are discounted for the time value of money using
a discount rate appropriate for that currency. we convert cashflow in the
reporting currency on the basis of AS 11.
Discount Rate
The discount rate(s) should be a pre-tax rate(s) that reflect(s) current market
assessments of the time value of money and the risks specific to the asset. The
discount rate(s) should not reflect risks for which future cash flow estimates have
been adjusted.
A rate that reflects current market assessments of the time value of money and
the risks specific to the asset is the return that investors would require if they
were to choose an investment that would generate cash flows of amounts, timing
and risk profile equivalent to those that the enterprise expects to derive from the
asset.
When an asset-specific rate is not directly available from the market, an enterprise
uses other bases to estimate the discount rate such as incremental borrowing
rate, rate using capital asset pricing model, etc.
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These rates
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(a) to reflect the way that the market would assess the specific risks associated
with the projected cash flows; (Consideration is given to risks such as country risk,
currency risk, price risk and cash flow risk) and
(b) to exclude risks that are not relevant to the projected cash flows.
An enterprise normally uses a single discount rate for the estimate of an asset’s
value in use. However, an enterprise uses separate discount rates for different
future periods where value in use is sensitive to a difference in risks for different
periods or to the term structure of interest rates.
7.7 RECOGNITION AND MEASUREMENT OF AN
IMPAIRMENT LOSS
Case I:
If recoverable amount of assets more than carrying amount, we ignore the
difference and asset is carried on at the same book value.
Note: As mentioned above, if there is an indication that an asset may be impaired,
this may indicate that the remaining useful life, the depreciation method or the
residual value for the asset need to be reviewed and adjusted under the
Accounting Standard 10, even if no impairment loss is recognised for the asset.
Case II:
When this recoverable amount is less than the carrying amount, this difference
termed as Impairment Loss.
Accounting implications:
Particulars Remarks
Treatment of Impairment It should be written off immediately as expenses to
loss Profit & Loss Account.
If assets are carried out at revalued figures then the
impairment loss equivalent to revalued surplus is
adjusted with it and the balance (if any) is charged
to Profit & Loss Account.
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Depreciation Depreciation for the coming years on the assets are
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recalculated on the basis of the new carrying
amount, residual value and remaining useful life of
the asset, according to AS 10.
Case III:
When the amount estimated for an impairment loss is greater than the carrying
amount of the asset to which it relates, an enterprise should recognise a liability
if, and only if, that is required by another Accounting Standard.
7.8 IDENTIFICATION OF THE CASH-
GENERATING UNIT TO WHICH AN ASSET
BELONGS
A cash generating unit is the smallest identifiable group of assets that generates
cash inflows from continuing use that are largely independent of the cash inflows
from other assets or groups of assets.
If there is any indication that an asset may be impaired, the recoverable amount
should be estimated for the individual asset, if it is not possible to estimate the
recoverable amount of the individual asset because the value in use of the asset
cannot be determined and it is probably different from scrap value. Therefore, the
enterprise estimates the recoverable amount of the cash-generating unit to which
the asset belongs.
If recoverable amount cannot be determined for an individual asset, an enterprise
identifies the lowest aggregation of assets that generate largely independent cash
inflows from continuing use. Even if part or all of the output produced by an asset
or a group of assets is used by other units of the reporting enterprise, this asset
or group of assets forms a separate cash-generating unit if the enterprise could
sell this output in an active market. This is because this asset or group of assets
could generate cash inflows from continuing use that would be largely
independent of the cash inflows from other assets or groups of assets. In using
information based on financial budgets/forecasts that relates to such a cash-
generating unit, an enterprise adjusts this information if internal transfer prices
do not reflect management’s best estimate of future market prices for the cash-
generating unit’s output.
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Cash-generating units should be identified consistently from period to period for
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the same asset or types of assets, unless a change is justified.
Example 1
A mining enterprise owns a private railway to support its mining activities. The
private railway could be sold only for scrap value and the private railway does not
generate cash inflows from continuing use that are largely independent of the cash
inflows from the other assets of the mine.
It is not possible to estimate the recoverable amount of the private railway because
the value in use of the private railway cannot be determined and it is probably
different from scrap value. Therefore, the enterprise estimates the recoverable
amount of the cash-generating unit to which the private railway belongs, that is,
the mine as a whole.
Example 2
A bus company provides services under contract with a municipality that requires
minimum service on each of five separate routes. Assets devoted to each route and
the cash flows from each route can be identified separately. One of the routes
operates at a significant loss.
Since the enterprise does not have the option to curtail any one bus route, the
lowest level of identifiable cash inflows from continuing use that are largely
independent of the cash inflows from other assets or groups of assets is the cash
inflows generated by the five routes together. The cash-generating unit for each
route is the bus company as a whole.
If an active market exists for the output produced by an asset or a group of
assets, this asset or group of assets should be identified as a separate cash-
generating unit, even if some or all of the output is used internally.
7.9 RECOVERABLE AMOUNT AND CARRYING
AMOUNT OF A CASH-GENERATING UNIT
The carrying amount of a cash-generating unit should be determined consistently
with the way the recoverable amount of the cash-generating unit is determined
i.e., carrying amount is the summation of the carrying amount of all the assets
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v v
grouped under one cash-generating unit. This also includes the liability only vif
that liability is necessary to be considered to determine the recovery amount. This v
may occur if the disposal of a cash-generating unit would require the buyer to
take over a liability. In this case, the net selling price of the cash-generating unit is
the estimated selling price for the assets of the cash-generating unit and the
liability together, less the costs of disposal. In order to perform a meaningful
comparison between the carrying amount of the cash-generating unit and its
recoverable amount, the carrying amount of the liability is deducted in
determining both the cash-generating unit’s value in use and its carrying amount.
For practical reasons, the recoverable amount of a cash-generating unit is
sometimes determined after consideration of assets that are not part of the cash-
generating unit or liabilities that have already been recognised in the financial
statements. In such cases, the carrying amount of the cash-generating unit is
increased by the carrying amount of those assets and decreased by the carrying
amount of those liabilities.
Example 3
A company operates a mine in a country where legislation requires that the owner
must restore the site on completion of its mining operations. The cost of restoration
includes the replacement of the overburden, which must be removed before mining
operations commence. A provision for the costs to replace the overburden was
recognised as soon as the overburden was removed. The amount provided was
recognised as part of the cost of the mine and is being depreciated over the mine’s
useful life. The carrying amount of the provision for restoration costs is ` 50,00,000,
which is equal to the present value of the restoration costs.
The enterprise is testing the mine for impairment. The cash-generating unit for the
mine is the mine as a whole. The enterprise has received various offers to buy the
mine at a price of around ` 80,00,000; this price encompasses the fact that the
buyer will take over the obligation to restore the overburden. Disposal costs for the
mine are negligible. The value in use of the mine is approximately
` 1,20,00,000 excluding restoration costs. The carrying amount of the mine is
` 1,00,00,000.
The net selling price for the cash-generating unit is ` 80,00,000. This amount
considers restoration costs that have already been provided for. As a consequence,
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the value in use for the cash-generating unit is determined after consideration of
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the restoration costs and is estimated to be ` 70,00,000 ( ` 1,20,00,000 less `
50,00,000). The carrying amount of the cash-generating unit is ` 50,00,000, which
is the carrying amount of the mine ( ` 1,00,00,000) less the carrying amount of the
provision for restoration costs ( ` 50,00,000).
7.10 GOODWILL
Goodwill does not generate cash flows independently from other assets or groups
of assets and, therefore, the recoverable amount of goodwill as an individual
asset cannot be determined. As a consequence, if there is an indication that
goodwill may be impaired, recoverable amount is determined for the cash-
generating unit to which goodwill belongs. This amount is then compared to the
carrying amount of this cash-generating unit and any impairment loss is
recognized.
If goodwill can be allocated on a reasonable and consistent basis, an enterprise
applies the ‘bottom-up’ test only. If it is not possible to allocate goodwill on a
reasonable and consistent basis, an enterprise applies both the ‘bottom-up’ test
and ‘top-down’ test.
Can be allocated on a
Perform Bottom up
reasonable and
Test ONLY
consistent basis
Goodwill
Cannot be allocated Perform Bottom up
on a reasonable and and Top Down Test
consistent basis BOTH
Example:
At the end of 20X0, enterprise M acquired 100% of enterprise Z for ` 3,000 lakhs. Z
has 3 cash-generating units A, B and C with net fair values of ` 1,200 lakhs, ` 800
lakhs and` 400 lakhs respectively. M recognises goodwill of ` 600 lakhs (` 3,000
lakhs less ` 2,400 lakhs) that relates to Z.
At the end of 20X4, A makes significant losses. Its recoverable amount is estimated
to be ` 1,350 lakhs. Carrying amounts are detailed below ( ` In Lakh).
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End of 20X4 A B C Goodwill Total
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Net carrying 1300 1200 800 120 3420
amount
Scenario A - Goodwill Can be Allocated on a Reasonable and
Consistent Basis
On the date of acquisition of Z, the net fair values of A, B and C are considered a
reasonable basis for a pro-rata allocation of the goodwill to A, B and C.
Allocation of goodwill at the end of 20X4:
A B C Goodwill
End of 20X0
Net fair values 1200 800 400 2400
Pro-Rata 50% 33% 17% 100%
End of 20X4
Net carrying amount 1300 1200 800 3300
Allocation of goodwill 60 40 20 120
(Using pro rate above)
Net carrying amount (After goodwill) 1360 1240 820 3420
In accordance with the ‘bottom-up’ test in paragraph 78(a) of AS 28, M compares
A’s recoverable amount to its carrying amount after the allocation of the carrying
amount of goodwill:
End of 20X4 A (Rs. In Lakh)
Carrying amount after allocation of goodwill 1360
Recoverable amount 1350
Impairment loss 10
M recognises an impairment loss of ` 10 lakhs for A. The impairment loss is fully
allocated to the goodwill in accordance with paragraph 87 of AS 28.
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Scenariov B - Goodwill Cannot be Allocated on a Reasonable and
v Basis
Consistent
There is no reasonable way to allocate the goodwill that arose on the acquisition
of Z to A, B and C. At the end of 20X4, Z’s recoverable amount is estimated to be
` 3,400 lakhs.
At the end of 20X4, M first applies the ‘bottom-up’ test in accordance with
paragraph 78(a) of this Statement. It compares A’s recoverable amount to its
carrying amount excluding the goodwill.
End of 20X4 A (Rs. In Lakh)
Carrying amount 1300
Recoverable amount 1350
Impairment loss 0
Therefore, no impairment loss is recognised for A as a result of the ‘bottom-up’
test.
Since the goodwill could not be allocated on a reasonable and consistent basis to
A, M also performs a ‘top-down’ test in accordance with paragraph 78(b) of AS
28. It compares the carrying amount of Z as a whole to its recoverable amount (Z
as a whole is the smallest cash-generating unit that includes A and to which
goodwill can be allocated on a reasonable and consistent basis).
Application of the ‘top-down’ test (Amount in ` lakhs)
End of 20X4 A B C Goodwill Total
Carrying amount 1300 1200 800 120 3420
Impairment loss arising from the 0 - - - 0
‘bottom-up’ test
Carrying amount after the ‘bottom-up’ 1300 1200 800 120 3420
test
Recoverable amount - - - - 3400
Impairment loss arising from ‘top- - - - - 20
down’ test
Therefore, M recognises an impairment loss of ` 20 lakhs that it allocates fully to
goodwill in accordance with paragraph 87 of AS 28.
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7.11 CORPORATE ASSETS v
Key characteristics of corporate assets are that they do not generate cash inflows
independently from other assets or groups of assets and their carrying amount
cannot be fully attributed to the cash-generating unit under review.
Examples
Building of a headquarter or a division of the enterprise, EDP equipment or a
research Centre.
In testing a cash-generating unit for impairment, an enterprise should identify all
the corporate assets that relate to the cash-generating unit under review. For
each identified corporate asset:
a. If the carrying amount of the corporate asset can be allocated on a
reasonable and consistent basis to the cash-generating unit under review,
an enterprise should apply the ‘bottom-up’ test only; and
b. If the carrying amount of the corporate asset cannot be allocated on a
reasonable and consistent basis to the cash-generating unit under review,
an enterprise should apply both the ‘bottom-up’ and ‘top-down’ tests.
Can be allocated on a
Perform Bottom up
reasonable and
Test ONLY
consistent basis
Corporate Assets
Cannot be allocated Perform Bottom up
on a reasonable and and Top Down Test
consistent basis BOTH
7.12 IMPAIRMENT LOSS FOR A CASH-
GENERATING UNIT
The impairment loss should be allocated to reduce the carrying amount of the
assets of the unit in the following order:
a. First, to goodwill allocated to the cash-generating unit (if any); and
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Then, to the other assets of the unit on a pro-rata basis based on the
v
carrying amount of each asset in the unit.
These reductions in carrying amounts should be treated as impairment losses on
individual assets
The carrying amount of an asset should not be reduced below the highest of:
a. Its net selling price (if determinable);
b. Its value in use (if determinable); and
c. Zero.
The amount of the impairment loss that would otherwise have been allocated to
the asset should be allocated to the other assets of the unit on a pro-rata basis.
After the requirements of impairment loss have been applied, a liability should be
recognised for any remaining amount of an impairment loss for a cash-generating
unit if that is required by another Accounting Standard.
Example 4
A machine has suffered physical damage but is still working, although not as well
as it used to. The net selling price of the machine is less than its carrying amount.
The machine does not generate independent cash inflows from continuing use.
The smallest identifiable group of assets that includes the machine and generates
cash inflows from continuing use that are largely independent of the cash inflows
from other assets is the production line to which the machine belongs. There
coverable amount of the production line shows that the production line taken as
a whole is not impaired.
Assumption 1: Budgets/forecasts approved by management reflect no
commitment of management to replace the machine.
The recoverable amount of the machine alone cannot be estimated since the
machine’s value in use:
(a) may differ from its net selling price; and
(b) can be determined only for the cash-generating unit to which the machine
belongs (the production line).
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The production line is not impaired, therefore, no impairment loss is recognisedv
for the machine. Nevertheless, the enterprise may need to reassess the v
depreciation period or the depreciation method for the machine. Perhaps, a
shorter depreciation period or a faster depreciation method is required to reflect
the expected remaining useful life of the machine or the pattern in which
economic benefits are consumed by the enterprise.
Assumption 2: Budgets/forecasts approved by management reflect a
commitment of management to replace the machine and sell it in the near future.
Cash flows from continuing use of the machine until its disposal are estimated to
be negligible.
The machine’s value in use can be estimated to be close to its net selling price.
Therefore, the recoverable amount of the machine can be determined and no
consideration is given to the cash-generating unit to which the machine belongs
(the production line). Since the machine’s net selling price is less than its carrying
amount, an impairment loss is recognised for the machine.
7.13 REVERSAL OF AN IMPAIRMENT LOSS
An enterprise should assess at each balance sheet date whether there is any
indication that an impairment loss recognised for an asset in prior accounting
periods may no longer exist or may have decreased. If any such indication exists,
the enterprise should estimate the recoverable amount of that asset. An
impairment loss recognised for an asset in prior accounting periods should be
reversed if there has been a change in the estimates of cash inflows, cash
outflows or discount rates used to determine the asset’s recoverable amount
since the last impairment loss was recognised. If this is the case, the carrying
amount of the asset should be increased to its recoverable amount. That increase
is a reversal of an impairment loss. Indications of a potential decrease in an
impairment loss are mainly mirror the indications of a potential impairment loss
discussed above as external and internal indicators. The concept of materiality
applies in identifying whether an impairment loss recognised for an asset in prior
accounting periods may need to be reversed and the recoverable amount of the
asset determined.
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7.14
v REVERSAL OF AN IMPAIRMENT LOSS FOR
AN INDIVIDUAL ASSET
Case I:
If impairment loss was written off to profit and loss account, then the reversal of
impairment loss should be recognized as income in the financial statement
immediately.
Case II:
If impairment loss was adjusted with the Revaluation Reserve; then reversal of
impairment loss will be written back to the reserve account to the extent it was
adjusted, any surplus will be recognised as revenue. But in any case the increased
carrying amount of an asset due to a reversal of an impairment loss should not
exceed the carrying amount that would have been determined (net of
amortisation or depreciation) had no impairment loss been recognised for the
asset in prior accounting periods. This is mainly because any further increase in
value of asset is revaluation, which is governed by AS 10.
Depreciation impact post reversal of impairment loss:
After a reversal of an impairment loss is recognised, the depreciation
(amortisation) charge for the asset should be adjusted in future periods to
allocate the asset’s revised carrying amount, less its residual value (if any), on a
systematic basis over its remaining useful life.
7.15 REVERSAL OF AN IMPAIRMENT LOSS FOR A
CASH-GENERATING UNIT
A reversal of an impairment loss for a cash-generating unit should be allocated to
increase the carrying amount of the assets of the unit in the following order:
a. First, assets other than goodwill on a pro-rata basis based on the carrying
amount of each asset in the unit; and
b. Then, to goodwill allocated to the cash-generating unit (if any),
In allocating a reversal of an impairment loss for a cash generating unit under
paragraph 106, the carrying amount of an asset should not be increased above
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(a) its recoverable amount (if determinable); and
(b) the carrying amount that would have been determined (net of amortisation or
depreciation) had no impairment loss been recognised for the asset in prior
accounting periods.
The amount of the reversal of the impairment loss that would otherwise have
been allocated to the asset should be allocated to the other assets of the unit on
a pro-rata basis.
7.16 REVERSAL OF AN IMPAIRMENT LOSS FOR
GOODWILL
This Statement does not permit an impairment loss to be reversed for goodwill
because of a change in estimates (for example, a change in the discount rate or in
the amount and timing of future cash flows of the cash generating unit to which
goodwill relates), an impairment loss recognised for goodwill should not be
reversed in a subsequent period unless:
a. The impairment loss was caused by a specific external event of an
exceptional nature that is not expected to recur; and
b. Subsequent external events have occurred that reverse the effect of that
event.
7.17 IMPAIRMENT IN CASE OF DISCONTINUING
OPERATIONS
The approval and announcement of a plan for discontinuance is an indication that
the assets attributable to the discontinuing operation may be impaired or that an
impairment loss previously recognised for those assets should be increased or
reversed.
In applying this Statement to a discontinuing operation, an enterprise determines
whether the recoverable amount of an asset of a discontinuing operation is
assessed for the individual asset or for the asset’s cash-generating unit. For
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example: v
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a. If the enterprise sells the discontinuing operation substantially in its
entirety, none of the assets of the discontinuing operation generate cash
inflows independently from other assets within the discontinuing operation.
Therefore, recoverable amount is determined for the discontinuing
operation as a whole and an impairment loss, if any, is allocated among the
assets of the discontinuing operation in accordance with this Statement;
b. If the enterprise disposes of the discontinuing operation in other ways such
as piecemeal sales, the recoverable amount is determined for individual
assets, unless the assets are sold in groups; and
c. If the enterprise abandons the discontinuing operation, the recoverable
amount is determined for individual assets as set out in this Statement.
After announcement of a plan, negotiations with potential purchasers of the
discontinuing operation or actual binding sale agreements may indicate that the
assets of the discontinuing operation may be further impaired or that impairment
losses recognised for these assets in prior periods may have decreased.
7.18 DISCLOSURE
For each class of assets, the financial statements should disclose:
a. The amount of impairment losses recognised in the statement of profit and
loss during the period and the line item(s) of the statement of profit and
loss in which those impairment losses are included;
b. The amount of reversals of impairment losses recognised in the statement
of profit and loss during the period and the line item(s) of the statement of
profit and loss in which those impairment losses are reversed;
c. The amount of impairment losses recognised directly against revaluation
surplus during the period; and
d. The amount of reversals of impairment losses recognised directly in
revaluation surplus during the period.
This information may be included in a reconciliation of the carrying amount of
fixed assets, at the beginning and end of the period, as required under AS 10.
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An enterprise that applies AS 17, Segment Reporting, should disclose the v
v
following for each reportable segment based on an enterprise’s primary format
(as defined in AS 17):
a. The amount of impairment losses recognised in the statement of profit and
loss and directly against revaluation surplus during the period; and
b. The amount of reversals of impairment losses recognised in the statement
of profit and loss and directly in revaluation surplus during the period.
If an impairment loss for an individual asset or a cash-generating unit is
recognised or reversed during the period and is material to the financial
statements of the reporting enterprise as a whole, an enterprise should disclose:
a. The events and circumstances that led to the recognition or reversal of the
impairment loss;
b. The amount of the impairment loss recognised or reversed;
c. For an individual asset:
(i) The nature of the asset; and
(ii) The reportable segment to which the asset belongs, based on the
enterprise’s primary format (as defined in AS 17, Segment Reporting);
d. For a cash-generating unit:
(i) A description of the cash-generating unit (such as whether it is a product
line, a plant, a business operation, a geographical area, a reportable
segment as defined in AS 17 or other);
(ii) The amount of the impairment loss recognised or reversed by class of
assets and by reportable segment based on the enterprise’s primary
format (as defined in AS 17); and
(iii) If the aggregation of assets for identifying the cash-generating unit has
changed since the previous estimate of the cash-generating unit’s
recoverable amount (if any), the enterprise should describe the current
and former way of aggregating assets and the reasons for changing the
way the cash-generating unit is identified;
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Whether the recoverable amount of the asset (cash-generating unit) is its
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net selling price or its value in use;
f. If recoverable amount is net selling price, the basis used to determine net
selling price (such as whether selling price was determined by reference to
an active market or in some other way); and
g. If recoverable amount is value in use, the discount rate(s) used in the
current estimate and previous estimate (if any) of value in use.
If impairment losses recognised (reversed) during the period are material in
aggregate to the financial statements of the reporting enterprise as a whole, an
enterprise should disclose a brief description of the following:
a. The main classes of assets affected by impairment losses (reversals of
impairment losses);
b. The main events and circumstances that led to the recognition (reversal) of
these impairment losses.
An enterprise is encouraged to disclose key assumptions used to determine the
recoverable amount of assets (cash-generating units) during the period.
7.19 ILLUSTRATIONS
Illustration 1
Ergo Industries Ltd. gives the following estimates of cash flows relating to Property,
Plant and Equipment on 31-12-20X1. The discount rate is 15%.
Year Cash Flow (` in lakhs)
20X2 4000
20X3 6000
20X4 6000
20X5 8000
20X6 4000
Residual value at the end of 20X6 = ` 1000 lakhs
Property, Plant and Equipment purchased on 1-1-20XX = ` 40,000 lakhs
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Useful life = 8 years v
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Net selling price on 31-12-20X1 = ` 20,000 lakhs
Calculate on 31-12-20X1:
(a) Carrying amount at the end of 20X1
(b) Value in use on 31-12-20X1
(c) Recoverable amount on 31-12-20X1
(d) Impairment loss to be recognized for the year ended 31-12-20X1
(e) Revised carrying amount
(f) Depreciation charge for 20X2.
Note: The year 20XX is the immediate preceding year before the year 20X0.
Solution
Calculation of value in use
Year Cash Flow Discount as per 15% Discounted cash flow
20X2 4,000 0.870 3,480
20X3 6,000 0.756 4,536
20X4 6,000 0.658 3,948
20X5 8,000 0.572 4,576
20X6 4,000 0.497 1,988
20X6 (residual) 1,000 0.497 497
19,025
(a) Calculation of carrying amount:
Original cost = ` 40,000 lakhs
Depreciation for 3 years = [(40,000-1000)3/8] = ` 14,625 lakhs
Carrying amount on 31-12-20X1 = [40,000-14,625] = ` 25,375 lakhs
(b) Value in use = ` 19,025 lakhs
(c) Recoverable amount = higher of value in use and net selling price i.e.
` 20,000 lakhs.
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Recoverable amount = ` 20,000 lakhs
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(d) Impairment Loss = ` (25,375-20,000) = ` 5,375 lakhs
(e) Revised carrying amount = ` (25,375-5,375) = ` 20,000 lakhs
(f) Depreciation charge for 20X2 = (20,000-1000)/5 = ` 3,800 lakhs
Illustration 2
X Ltd. is having a plant (asset) carrying amount of which is ` 100 lakhs on
31.3.20X1. Its balance useful life is 5 years and residual value at the end of 5 years
is ` 5 lakhs. Estimated future cash flow from using the plant in next 5 years are:
For the year ended on Estimated cash flow (` in lakhs)
31.3.20X2 50
31.3.20X3 30
31.3.20X4 30
31.3.20X5 20
31.3.20X6 20
Calculate “value in use” for plant if the discount rate is 10% and also calculate the
recoverable amount if net selling price of plant on 31.3.20X1 is ` 60 lakhs.
Solution
Present value of future cash flow
Year Future Discount @ 10% Rate Discounted cash
ended Cash Flow flow
31.3.20X2 50 0.909 45.45
31.3.20X3 30 0.826 24.78
31.3.20X4 30 0.751 22.53
31.3.20X5 20 0.683 13.66
31.3.20X6 20 0.620 12.40
118.82
Present value of residual price on 31.3.20X6 = 5 0.620 3.10
Present value of estimated cash flow by use of an asset and
residual value, which is called “value in use”. 121.92
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If net selling price of plant on 31.3.20X1 is ` 60 lakhs, the recoverable amount will
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be higher of ` 121.92 lakhs (value in use) and ` 60 lakhs (net selling price), hence
recoverable amount is ` 121.92 lakhs.
Illustration 3
G Ltd., acquired a machine on 1 st April, 20X0 for ` 7 crore that had an estimated
useful life of 7 years. The machine is depreciated on straight line basis and does
not carry any residual value. On 1 st April, 20X4, the carrying value of the machine
was reassessed at ` 5.10 crore and the surplus arising out of the revaluation being
credited to revaluation reserve. For the year ended March, 20X6, conditions
indicating an impairment of the machine existed and the amount recoverable
ascertained to be only ` 79 lakhs. You are required to calculate the loss on
impairment of the machine and show how this loss is to be treated in the books of
G Ltd. G Ltd., had followed the policy of writing down the revaluation surplus by
the increased charge of depreciation resulting from the revaluation.
Solution
Statement Showing Impairment Loss
(` in crores)
Carrying amount of the machine as on 1 st April, 20X0 7.00
Depreciation for 4 years i.e. 20X0-20X1 to 20X3-20X4
7 crores (4.00)
7 years × 4 years
Carrying amount as on 31.03.20X4 3.00
Add: Upward Revaluation (credited to Revaluation Reserve 2.10
account)
Carrying amount of the machine as on 1 st April, 20X4 (revalued) 5.10
Less: Depreciation for 2 years i.e. 20X4-20X5& 20X5-20X6
5.10 crores (3.40)
3 years ×2 years
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Carrying amount as on 31.03.20X6 1.70
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Less: Recoverable amount (0.79)
Impairment loss 0.91
Less: Balance in revaluation reserve as on 31.03.20X6:
Balance in revaluation reserve as on 31.03.20X4 2.10
Less: Enhanced depreciation met from revaluation reserve
20X4-20X5 & 20X5-20X6=[(1.70 – 1.00) x 2 years] (1.40)
Impairment loss set off against revaluation reserve balance as
per para 58 of AS 28 “Impairment of Assets” (0.70)
Impairment Loss to be debited to profit and loss account 0.21
Illustration 4
X Ltd. purchased a Property, Plant and Equipment four years ago for ` 150 lakhs
and depreciates it at 10% p.a. on straight line method. At the end of the fourth
year, it has revalued the asset at ` 75 lakhs and has written off the loss on
revaluation to the profit and loss account. However, on the date of revaluation, the
market price is ` 67.50 lakhs and expected disposal costs are ` 3 lakhs. What will
be the treatment in respect of impairment loss on the basis that fair value for
revaluation purpose is determined by market value and the value in use is
estimated at ` 60 lakhs?
Solution
Treatment of Impairment Loss
As per para 57 of AS 28 “Impairment of assets”, if the recoverable amount (higher
of net selling price and its value in use) of an asset is less than its carrying
amount, the carrying amount of the asset should be reduced to its recoverable
amount. In the given case, net selling price is ` 64.50 lakhs (` 67.50 lakhs – ` 3
lakhs) and value in use is ` 60 lakhs. Therefore, recoverable amount will be ` 64.50
lakhs. Impairment loss will be calculated as ` 10.50 lakhs [` 75 lakhs (Carrying
Amount after revaluation - Refer Working Note) less ` 64.50 lakhs (Recoverable
Amount)].
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Thus impairment loss of ` 10.50 lakhs should be recognised as an expense in the
Statement of Profit and Loss immediately since there was downward revaluation v
of asset which was already charged to Statement of Profit and Loss.
Working Note:
Calculation of carrying amount of the Property, Plant and Equipment at the
end of the fourth year on revaluation
(` in lakhs)
Purchase price of a Property, Plant and Equipment 150.00
Less: Depreciation for four years [(150 lakhs / 10 years) x 4 (60.00)
years]
Carrying value at the end of fourth year 90.00
Less: Downward revaluation charged to profit and loss account (15.00)
Revalued carrying amount 75.00
Reference: The students are advised to refer the full text of AS 28
“Impairment of Assets” (issued 2002).
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. If there is indication that an asset may be impaired but the recoverable
amount of the asset is more than the carrying amount of the asset, the
following are true:
(a) No further action is required and the company can continue the asset in
the books at the book value itself.
(b) The entity should review the remaining useful life, scrap value and
method of depreciation and amortization for the purposes of AS 10.
(c) The entity can follow either (a) or (b).
(d) The entity should review the scrap value and method of depreciation
and amortization for the purposes of AS 10.
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2. v Goodwill appears in the Balance Sheet of an entity, the following is
In case
true:v
(a) Apply Bottom up test if goodwill cannot be allocated to CGU (cash
generating unit) under review.
(b) Apply Top down test if goodwill cannot be allocated to CGU (cash
generating unit) under review.
(c) Apply both Bottom up test and Top down test if goodwill cannot be
allocated to CGU (cash generating unit) under review.
(d) Apply either Bottom up test or Top down test if goodwill cannot be
allocated to CGU (cash generating unit) under review.
3. In case of Corporate assets in the Balance Sheet of an entity, the following is
true:
(a) Apply Bottom up test if corporate assets cannot be allocated to CGU
(cash generating unit) under review.
(b) Apply Top down test if corporate assets cannot be allocated to CGU
(cash generating unit) under review.
(c) Apply both Bottom up test and Top down test if corporate assets cannot
be allocated to CGU (cash generating unit) under review.
(d) Apply either Bottom up test or Top down test if corporate assets cannot
be allocated to CGU (cash generating unit) under review.
4. In case of reversal of impairment loss, which statement is true:
(a) Goodwill written off can never be reversed.
(b) Goodwill written off can be reversed without any conditions to be met.
(c) Goodwill written off can be reversed only if certain conditions are met.
(d) Goodwill written off can be reversed.
Theoretical Questions
5. Write short note on impairment of asset and its application to inventory.
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Scenario based Questions
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6. A publisher owns 150 magazine titles of which 70 were purchased and 80
were self-created. The price paid for a purchased magazine title is recognized
as an intangible asset. The costs of creating magazine titles and maintaining
the existing titles are recognized as an expense when incurred. Cash inflows
from direct sales and advertising are identifiable for each magazine title.
Titles are managed by customer segments. The level of advertising income for
a magazine title depends on the range of titles in the customer segment to
which the magazine title relates. Management has a policy to abandon old
titles before the end of their economic lives and replace them immediately
with new titles for the same customer segment. What is the cash-generating
unit for an individual magazine title?
7. An asset does not meet the requirements of environment laws which have
been recently enacted. The asset has to be destroyed as per the law. The asset
is carried in the Balance Sheet at the year end at ` 6,00,000. The estimated
cost of destroying the asset is ` 70,000. How is the asset to be accounted for?
8. Venus Ltd. has a fixed asset, which is carried in the Balance Sheet on
31.3.20X1 at ` 500 lakhs. As at that date the value in use is ` 400 lakhs and
the net selling price is ` 375 lakhs.
From the above data:
(i) Calculate impairment loss.
(ii) Prepare journal entries for adjustment of impairment loss.
(iii) Show, how impairment loss will be shown in the Balance Sheet.
9. Good Drugs and Pharmaceuticals Ltd. acquired a sachet filling machine on
1st April, 20X1 for ` 60 lakhs. The machine was expected to have a productive
life of 6 years. At the end of financial year 20X1-20X2 the carrying amount
was ` 41 lakhs. A short circuit occurred in this financial year but luckily the
machine did not get badly damaged and was still in working order at the
close of the financial year. The machine was expected to fetch ` 36 lakhs, if
sold in the market. The machine by itself is not capable of generating cash
flows. However, the smallest group of assets comprising of this machine also,
is capable of generating cash flows of ` 54 crore per annum and has a
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carrying amount of ` 3.46 crore. All such machines put together could fetch a
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sum of ` 4.44 crore if disposed. Discuss the applicability of Impairment loss.
10. From the following details of an asset
(i) Find out impairment loss
(ii) Treatment of impairment loss
(iii) Current year depreciation
Particulars of asset:
Cost of asset ` 56 lakhs
Useful life period 10 years
Salvage value Nil
Current carrying value ` 27.30 lakhs
Useful life remaining 3 years
Recoverable amount ` 12 lakhs
Upward revaluation done in last year ` 14 lakhs
11. A plant was acquired 15 years ago at a cost of ` 5 crores. Its accumulated
depreciation as at 31 st March, 20X1 was ` 4.15 crores. Depreciation estimated
for the financial year 20X1-20X2 is ` 25 lakhs. Estimated Net Selling Price as
on 31st March, 20X1 was ` 30 lakhs, which is expected to decline by 20 per
cent by the end of the next financial year.
Its value in use has been computed at ` 35 lakhs as on 1 st April, 20X1, which
is expected to decrease by 30 per cent by the end of the financial year.
(i) Assuming that other conditions for applicability of the impairment
Accounting Standard are satisfied, what should be the carrying amount
of this plant as at 31 st March, 20X2?
(ii) How much will be the amount of write off for the financial year ended
31st March, 20X2?
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(iii) If the plant had been revalued ten years ago and the current v
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revaluation reserves against this plant were to be ` 12 lakhs, how would
you answer to questions (i) and (ii) above?
(iv) If the value in use was zero and the enterprise were required to incur a
cost of ` 2 lakhs to dispose of the plant, what would be your response to
questions (i) and (ii) above?
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (b) 2. (c) 3. (c) 4. (c)
Answer to the Theoretical Questions
5. The objective of AS 28 ‘Impairment of Assets’ is to prescribe the procedures
that an enterprise applies to ensure that its assets are carried at no more
than their recoverable amount. An asset is carried at more than its
recoverable amount if its carrying amount exceeds the amount to be
recovered through use or sale of the asset. If this is the case, the asset is
described as impaired and this Standard requires the enterprise to
recognize an impairment loss.
If carrying amount < = Recoverable amount : Asset is not impaired
If carrying amount > Recoverable amount : Asset is impaired
Impairment Loss = Carrying Amount – Recoverable Amount
Recoverable amount is the higher of net selling price and its value in use
This standard should be applied in accounting for the impairment of all
assets, other than (i) inventories (AS 2, Valuation of Inventories); (ii) assets
arising from construction contracts (AS 7, Accounting for Construction
Contracts); (iii) financial assets, including investments that are included in
the scope of AS 13, Accounting for Investments; and (iv) deferred tax assets
(AS 22, Accounting for Taxes on Income). AS 28 does not apply to
inventories, assets arising from construction contracts, deferred tax assets or
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investments because other accounting standards applicable to these assets
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already contain specific requirements for recognizing and measuring the
impairment related to these assets.
Answer to the Scenario based Questions
6. It is likely that the recoverable amount of an individual magazine title can
be assessed. Even though the level of advertising income for a title is
influenced, to a certain extent, by the other titles in the customer segment,
cash inflows from direct sales and advertising are identifiable for each title.
In addition, although titles are managed by customer segments, decisions
to abandon titles are made on an individual title basis.
Therefore, it is likely that individual magazine titles generate cash inflows
that are largely independent of each other and that each magazine title is a
separate cash-generating unit.
7. As per AS 28 “Impairment of Assets”, impairment loss is the amount by
which the carrying amount of an asset exceeds its recoverable amount,
where recoverable amount is the higher of an asset’s net selling price and
its value in use •. In the given case, recoverable amount will be nil [higher of
value in use (nil) and net selling price (negative ` 70,000)]. Thus impairment
loss will be calculated as ` 6,00,000 [carrying amount (` 6,00,000) –
recoverable amount (nil)]. Therefore, asset is to be fully impaired and
impairment loss of ` 6,00,000 has to be recognized as an expense
immediately in the statement of Profit and Loss as per para 58 of AS 28.
Further, as per para 60 of AS 28, When the amount estimated for an
impairment loss is greater than the carrying amount of the asset to which it
relates, an enterprise should recognise a liability if, and only if, that is
required by another Accounting Standard. Hence, the entity should
recognize liability for cost of disposal of ` 70,000 as per AS 10 & 29.
Net selling price is the amount obtainable from the sale of an asset in an arm’s length
transaction between knowledgeable, willing parties, less the costs of disposal. In the given
case, Net Selling Price = Selling price – Cost of disposal = Nil – ` 70,000 = (` 70,000)
•
Value in use is the present value of estimated future cash flows expected to arise from the
continuing use of an asset and from its disposal at the end of its useful life. In the given
case, value in use is nil.
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8. (i) v
Recoverable amount is higher of value in use ` 400 lakhs and net
selling price ` 375 lakhs. v
Recoverable amount = ` 400 lakhs
Impairment loss = Carried Amount – Recoverable amount
= ` 500 lakhs – ` 400 lakhs = ` 100 lakhs.
(ii) Journal Entries
Dr. Cr.
Particulars Amount Amount
( ` in lakhs) ( ` in lakhs)
(i) Impairment loss account Dr. 100
To Provision for Accumulated 100
Impairment Loss Account
(Being the entry for accounting
impairment loss)
(ii) Profit and loss account Dr. 100
To Impairment loss 100
(Being the entry to transfer impairment
loss to profit and loss account)
(iii) Balance Sheet of Venus Ltd. as on 31.3.20X1
( ` in lakhs)
Fixed Asset
Asset less depreciation 500
Less: Impairment loss (100)
400
9. As per provisions of AS 28 “Impairment of Assets”, impairment loss is not to
be recognized for a given asset if its cash generating unit (CGU) is not
impaired. In the given question, the related cash generating unit which is
group of asset to which the damaged machine belongs is not impaired; and
the recoverable amount is more than the carrying amount of group of
assets. Hence there is no need to provide for impairment loss on the
damaged sachet filling machine.
© The Institute of Chartered Accountants of India
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10. v
According to AS 28 “Impairment of Assets”, an impairment loss on a
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revalued asset is recognised as an expense in the statement of profit and
loss. However, an impairment loss on a revalued asset is recognised directly
against any revaluation surplus for the asset to the extent that the
impairment loss does not exceed the amount held in the revaluation surplus
for that same asset.
Impairment Loss and its treatment `
Current carrying amount (including revaluation amount of 27,30,000
` 14 lakhs)
Less: Current recoverable amount (12,00,000)
Impairment Loss 15,30,000
Impairment loss charged to revaluation reserve 14,00,000
Impairment loss charged to profit and loss account 1,30,000
After the recognition of an impairment loss, the depreciation (amortization)
charge for the asset should be adjusted in future periods to allocate the
asset’s revised carrying amount, less its residual value (if any), on a
systematic basis over its remaining useful life.
In the given case, the carrying amount of the asset will be reduced to
` 12,00,000 after impairment. This amount is required to be depreciated
over remaining useful life of 3 years (including current year). Therefore, the
depreciation for the current year will be ` 4,00,000.
11. As per AS 28 “Impairment of Assets”, if the recoverable amount of an asset
is less than its carrying amount, the carrying amount of the asset should be
reduced to its recoverable amount and that reduction is an impairment loss.
An impairment loss on a revalued asset is recognized as an expense in the
statement of profit and loss. However, an impairment loss on a revalued
asset is recognised directly against any revaluation surplus for the asset to
the extent that the impairment loss does not exceed the amount held in the
revaluation surplus for that same asset.
Recoverable amount is the higher of an asset’s net selling price and its value in use.
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In the given case, recoverable amount (higher of asset’s net selling price
and value in use) will be ` 24.5 lakhs on 31.3.20X2 according to the v
provisions of AS 28 [Refer working note].
(` in lakhs)
(i) Carrying amount of plant (after impairment) as on 31 st 24.50
March, 20X2
(ii) Amount of write off (impairment loss) for the financial 35.50
year ended 31st March, 20X2 [` 60 lakhs – ` 24.5 lakhs]
(iii) If the plant had been revalued ten years ago
Debit to revaluation reserve 12.00
Amount charged to profit and loss account 23.50
(` 35.50 lakhs – ` 12 lakhs)
(iv) If Value in use is zero
Value in use (a) Nil
Net selling price (b) (-)2.00
Recoverable amount [higher of (a) and (b)] Nil
Carrying amount (closing book value) Nil
Amount of write off (impairment loss) (` 60 lakhs – Nil) 60.00
Entire book value of plant will be written off and
charged to profit and loss account.
Working Note:
Calculation of Closing Book Value, Estimated Net Selling Value and
Estimated Value in Use of Plant at 31st March, 20X2
(` in lakhs)
Opening book value as on 1.4.20X1 (` 500 lakhs – 85
` 415 lakhs)
Less: Depreciation for financial year 20X1–20X2 (25)
Closing book value as on 31.3.20X2 60
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Estimated net selling price as on 1.4.20X1 30
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Less: Estimated decrease during the year (20% of (6)
` 30 lakhs)
Estimated net selling price as on 31.3.20X2 24
Estimated value in use as on 1.4.20X1 35.0
Less: Estimated decrease during the year (30% of (10.5)
` 35 lakhs)
Estimated value in use as on 31.3.20X2 24.5
© The Institute of Chartered Accountants of India
CHAPTER a
6
LIABILITIES BASED
ACCOUNTING
STANDARDS
UNIT 1: ACCOUNTING STANDARD 15
EMPLOYEE BENEFITS
LEARNING OUTCOMES
After studying this unit, you will be able to
Define ‘Employee benefits’, ‘Short-term employee benefits’, ‘Post-
employment benefits’ and other related terms used in the Standard
Enumerate various types of employee benefits
Recognise and measure Short-term Employee Benefits, Short-term
Compensated Absences and Profit-sharing and Bonus Plans along
with the accounting thereof
Classify the post-employment benefits into defined contribution plans
and defined benefit plans
Examine the various aspects inherent in these post-employment benefit
plans and recognize and measure the obligations under these plans
Apply the actuarial valuation methods and assumptions while valuing
the obligations under Defined benefit plans
Calculate the actuarial gains and losses on such plans
Recognise gains or losses on the curtailment or settlement of a
defined benefit plan
Recognise and measure other long-term benefit and termination benefits
Understand the disclosure requirement of these employee benefits
and comply with the same.
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1.1v INTRODUCTION
The Accounting Standard 15 - ‘Employee Benefits’ (AS 15), generally deals with all
forms of employee benefits all forms of consideration given by an enterprise in
exchange for services rendered by employees The objective of this Standard is to
prescribe the accounting treatment and disclosure for employee benefits in the
books of employer except employee share-based payments. It does not deal with
accounting and reporting by employee benefit plans.
Formal
Plan/Agreement
Employee Legislative
Benefits Requirement
Informal Practices
The Standard addresses only the accounting of employee benefits by employers.
The Standard makes four things very clear at the outset:
(i) the Standard is applicable to benefits provided to all types of employees
(whether full-time, part-time, or casual staff);
(ii) employee benefits can be paid in cash or in kind;
(iii) employee benefits include benefits provided to employees and their
dependents (spouses, children and others); and
(iv) payment can be made directly to employees, their dependent or to any
other party (e.g., legal heirs, nominees, insurance companies, trust etc.).
The Standard is based on the premise that the costs associated with employees-
benefits should be matched with the timing of their service. This requires
assessment of the anticipated costs and their timing in future and aligning those
costs over the period of their service. For example, a bonus payable to an
employee for a long-term service, should ideally be spread over the period of his
service and the expectations that the employee is expected to complete that
service. Likewise, pension payable to an employee must be recognized as a cost
during the service period itself, irrespective of the fact that the pension is payable
after the service is completed.
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What are the kinds of employees covered in the revised AS 15 and whether a formal
employer employee relationship is necessary or not, for benefits to be covered under
the Standard?
Solution
The Standard does not define the term “employee”. Paragraph 6 of the Standard
states that ‘an employee may provide services to an enterprise on a full time, part
time, permanent, casual or temporary basis and the term would also include the
whole-time directors and other management personnel. The Standard is
applicable to all forms of employer employee relationships. There is no
requirement for a formal employer employee relationship. Several factors need to
be considered to determine the nature of relationship.
Generally, ‘outsourcing contracts’ may not meet the definition of employer -
employee relationship. However, such contracts need to be carefully examined to
distinguish between a “contract of service” and a “contract for services”. A
‘contract for services’ implies a contract for rendering services, e.g., professional
or technical services which is subject to limited direction and control whereas a
‘contract of service’ implies a relationship of an employer and employee, and the
person is obliged to obey orders in the work to be performed and as to its mode
and manner of performance.
Illustration 2
Whether an enterprise is required to provide for employee benefits arising from
informal practices?
Solution
Paragraph 3(c) of the Standard defines employee benefits to include those
informal practices that give rise to an obligation where the enterprise has no
realistic alternative but to pay employee benefits. The historical pattern of
granting such benefits, the expectation created and the impact on the
relationship with employees in the event such benefit is withdrawn should be
considered in determining whether the informal practice gives rise to a benefit
covered by the Standard. For example, where an employer has a practice of
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making a lumpsum payment on occasion of a festival or regularly grants advances
v
against informal benefits to employees it would be necessary to provide for such
benefits.
Careful judgement should be applied in assessing whether an obligation has
arisen particularly in instances where an enterprise's practice is to provide
improvements only during the collective bargaining process and not during any
informal process. If the employer has not set a pattern of benefits that can be
projected reliably to give rise to an obligation there is no requirement to provide
for the benefits.
However, if the practice established by an employer was that of a consistent
benefit granted either as part of union negotiations or otherwise that clearly
established a pattern (e.g., a cost of living adjustment or fixed rupee increase), it
could be concluded that an obligation exists and that those additional benefits
should be included in the measurement of the benefit obligation.
Employee benefits include:
(a) Short-term employee benefits (e.g., wages, salaries, paid annual leave and
sick leave, profit sharing bonuses etc. (payable within 12 months of the
year-end) and non-monetary benefits for current employees.
(b) Post-employment benefits (e.g., gratuity, pension, provident fund, post-
employment medical care etc.).
(c) long-term employee benefits (e.g., long-service leave, long-term disability
benefits, bonuses not wholly payable within 12 months of the year end etc.) ,
and
(d) termination benefits (e.g. VRS payments)
The Standard lays down recognition and measurement criteria and disclosure
requirements for the above four types of employee benefits separately.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.5
6.5
v
v
v
v
Short Term Post Terminal
Employee Long Term
Benefits Employment Benefits
Benefits Benefits
Salary, Wages Sabbatical Retrenchment
Gratuity
Leave
Social Security Voluntary
Contributions Long Service Pension Retirement
Awards
Annual Paid
leaves Long Term Medical Care
Disability
Medical, Benefit
Housing, Car
1.2 APPLICABILITY
The Standard applies from April 1, 2006 in its entirety for all Level 1 enterprises.
Certain exemptions are given to other than Level 1 enterprises, depending upon
whether they employ 50 or more employees. This Standard is applicable
predominantly for Level 1 enterprises and applied to other entities with certain
relaxations.
1.3 MEANING OF THE TERM “EMPLOYEE
BENEFITS”
The term employee is not defined under the standard AS 15 does not define who
is an ‘employee’, but states in that "an employee may provide services to an entity
on a full-time, part-time, permanent, casual or temporary basis. For the purpose
of this Standard, employees include directors and other management personnel".
This suggests that the intention was for the term ‘employee’ to apply more widely
than simply to persons with a contract of employment as ‘casual’ and ‘temporary’
staff may frequently not have such contracts.
© The Institute of Chartered Accountants of India
6.6 ADVANCED ACCOUNTING
v
v
v
The following indicators may suggest an employee relationship may be more
v
likely to exist, and may help in making individual judgements:
• A contract of employment exists;
• Individuals are considered employees for legal/tax/social security purposes;
• There is a large amount of oversight and direction by the employer and
necessary tools, equipment and materials are provided by the employer;
• Services are performed at a location specified by the employer;
Services provided through an entity are in substance services provided by a
specific individual, indications of which could be that the entity:
• Has no other clients;
• Has served the employer for a long period;
• Faces little or no financial risk;
• Requires the explicit permissions of the employer to concurrently undertake
additional employment elsewhere.
1.4 SHORT-TERM EMPLOYEE BENEFITS
• Short-term employee benefits (other than termination benefits) are payable
within twelve months after the end of the period in which the service is
rendered.
• Accounting for these benefits is generally straightforward because no
actuarial assumptions are required to measure the obligation or cost.
• Short-term employee benefits are broadly classified into four categories:
(i) regular period benefits (e.g., wages, salaries);
(ii) short-term compensated absences (e.g., paid annual leave, maternity
leave, sick leave etc.);
(iii) profit sharing and bonuses payable within twelve months after the
end of the period in which employee render the related services and
(iv) non-monetary benefits (e.g., medical care, housing, cars etc.)
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.7
6.7
v
v
v
All Short term
Employee v
Vesting
Benefits
Accumulating
Short term
Short Term Paid
Employee Non-vesting
Abscences
Benefits Non-
accumulating
Profit-sharing
and Bonus Plans
1.4.1 All Short-term Employee Benefits
• The Standard lays down some general recognition criteria for all short-term
employee benefits. There are further requirements in respect of short-term
compensated absences and profit sharing and bonus plans.
• The general criteria is that an enterprise should recognize as an expense
(unless another accounting standard permits a different treatment) the
undiscounted amount of all short-term employee benefits attributable to
services that been already rendered in the period.
• Any difference between the amount of expenses so recognized and cash
payments made during the period should be treated as a liability or
prepayment (asset) as appropriate.
Illustration 3
Entity XY is required to pay salary of ` 2 crore for the year 20X1-X2. It actually paid
a salary of ` 1.90 crore up to 31 st March 20X2, and balance in April 20X2.
Determine the actual costs to be recognized in the year 20X1-X2 and any amounts
to be shown through balance sheet.
Solution
Total expense for the year (20X1-X2) ` 2 crore
Amount to be shown under liability (unpaid) ` 2 crore – 1.90 `crore
= ` 10 lakhs
© The Institute of Chartered Accountants of India
6.8 ADVANCED ACCOUNTING
v
v
v
1.4.2 Short-term Compensated Absences
v
Entitlement to compensated absences falls into two categories:
(a) Accumulating
Accumulating compensated absences are those that are carried
forward and can be used in future periods if the current period’s
entitlement is not used in full.
Accumulating compensated absences may be
(i) Vesting
It implies that employees are entitled to a cash payment for
unused entitlement on leaving the enterprise
(ii) Non-vesting
It implies that when employees are not entitled to a cash
payment for unused entitlement on leaving. An obligation arises
as employees render service that increases their entitlement to
future compensated absences.
The expected cost of accumulating compensated absences should be
recognized when employees render the service that increase their
entitlement to future compensated absences.
‘An enterprise should measure the expected cost of accumulating
compensated absences as the additional amount that the enterprise
expects to pay as a result of the unused entitlement that has
accumulated at the balance sheet date’.
No distinction should be made between vesting and non-vesting
entitlements. However, in measuring non-vesting entitlements, the
possibility of employees leaving the enterprise before receiving them
should be taken into account.
Example
An enterprise has 100 employees, who are each entitled to five working days
of leave for each year. Unused leave may be carried forward for one calendar
year. The leave is taken first out of the current year’s entitlement and then out
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.9
6.9
v
v
of any balance brought forward from the previous year (a LIFO basis). At 31vst
December, 20X4, the average unused entitlement is two days per employee. v
The enterprise expects, based on past experience which is expected to
continue, that 92 employees will take no more than five days of leave in 20X5
and that the remaining eight employees will take an average of six and a half
days each.
The enterprise expects that it will pay an additional 12 days of pay as a result
of the unused entitlement that has accumulated at 31 st December, 20X4 (one
and a half days each, for eight employees). Therefore, the enterprise
recognises a liability, as at 31 st December, 20X4, equal to 12 days of pay.
(b) Non-accumulating
Non-accumulating compensated absences (e.g., maternity leave) do
not carry forward and are not directly linked to the services rendered
by employees in the past. Therefore, an enterprise recognizes no
liability or expense until the time of the absence.
In other words, the cost of non-accumulating absences should be
recognized as and when they arise.
Exception
Small and Medium-sized Company and Micro, Small and Medium-sized
Enterprises (Levels IV, III and II non-corporate entities) may not comply with short
term absences to the extent they deal with recognition and measurement of
absences which are non-vesting (i.e., short-term accumulating compensated
absences in respect of which employees are not entitled to cash payment of
unused entitlement on leaving).
1.4.3 Profit-sharing and Bonus Plans
Recognition of expenses for profit sharing and bonus plans would depend on
fulfillment of conditions mentioned the Standard. The conditions are:
(a) Enterprise has a present obligation to make such payments as a result of
past events; and
(b) Reliable estimate of the obligation can be made.
© The Institute of Chartered Accountants of India
6.10 ADVANCED ACCOUNTING
v
v
v
The second condition can be satisfied only when the profit sharing and bonus
v
plans contained a formula for determining the amount of benefit. The enterprise
should recognize the expected cost of profit sharing and bonus payments in the
financial statements.
Example
A profit-sharing plan requires an enterprise to pay a specified proportion of its net
profit for the year to employees who serve throughout the year. If no employees
leave during the year, the total profit-sharing payments for the year will be 3% of
net profit. The enterprise estimates that staff turnover will reduce the payments to
2.5% of net profit.
The enterprise recognises a liability and an expense of 2.5% of net profit.
Illustration 4
Whether an entitlement to earned leave which can be carried forward to future
periods is a short -term employee benefit or a long-term employee benefit.
Solution
Paragraph 7.2 of the Standard defines ‘Short-term’ benefits as employee benefits
(other than termination benefits) which fall due wholly within twelve months after
the end of the period in which the employees render the related service.
Paragraph 8(b) of the Standard illustrates the term ‘Short -term benefits’ to
include “short term compensated absences (such as paid annual leave) where the
absences are expected to occur within twelve months after the end of the period
in which the employees render the related employee service”.
Paragraph 7.2 of the Standard uses “falls due” as the basis, paragraph 8(b) of the
Standard uses “expected to occur” as the basis to illustrate classification of short
term compensated absences. A reading of paragraph 8(b) together with
paragraph 7.2 would imply that the classification of short -term compensated
absences should be only when absences have “fallen due” and are also “expected
to occur”. In other words, where employees are entitled to earned leave which can
be carried forward to future periods, the benefit would be a ‘short-term benefit’
provided the employee is entitled to either encash or utilise the benefit during
the twelve months after the end of the period when the employee became
entitled to the leave and is also expected to utilise the leave.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.11
6.11
v
v
Where there are restrictions on encashment and/or availment, clearly the v
compensated absence has not fallen due and the benefit of compensated v
absences is more likely to be a long-term benefit. For example, where an
employee has 100 days of earned leave which he is entitled to an unlimited carry
forward, but the rules of the enterprise allow him to encash/utilise only 30 days
during the next twelve months, the benefit would be considered as a ‘long-term’
benefit. In some situations, where there is no restriction but the absence is not
expected to wholly occur in the next twelve months, the benefit should be
considered as ‘long-term’. For example, where an employee has 400 days carry
forward earned leave and the past pattern indicates that the employees are
unlikely to avail / encash the entire carry forward during the next twelve months,
the benefit would not be ‘short-term’.
Whilst it is necessary to consider the earned leave which “falls due”, the pattern of
actual utilisation/encashment by employees, although reflective of the
behavioural pattern of employees, does determine the status of the benefit, i.e.,
whether ‘short-term’ or ‘long-term’. The value of short-term benefits should be
determined without discounting and if the benefit is determined as long-term, it
would be recognised and measured as “Other long-term benefits” in accordance
with paragraph 129 of the Standard.
The categorisation in ‘short-term’ or ‘long-term’ employee benefits should be
done on the basis of the overall behavioural pattern of all the employees of the
enterprise and not on individual basis.
Illustration 5
In case an enterprise allows unutilised employee benefits, e.g., medical care, leave
travel, etc., to be carried forward, whether it is required to recognise a provision in
respect of carried forward benefits.
Solution
A provision should be recognised for all benefits (conditional or unconditional)
which an employee becomes entitled to as a result of rendering of the service and
should be recorded as part of the cost of service rendered during the period in
which the service was rendered which resulted the entitlement. In estimating the
cost of such benefit the probability of the employee availing such benefit should
be considered.
© The Institute of Chartered Accountants of India
6.12 ADVANCED ACCOUNTING
v
v
v
1.5v POST EMPLOYMENT BENEFITS: DEFINED
CONTRIBUTION VS DEFINED BENEFITS
Multi-
employer
State Plan
Non-
Controlled
Insured
Funded
DCP
(Mostly)
Trust/legal
Controlled Entity
The accounting treatment and disclosures required for a post-employment
benefit plan depend upon whether it is a defined contribution or a defined
benefit plan. In addition to addressing defined contribution and defined benefit
plans generally, the Standard also gives guidance as to how its requirements
should be applied to insured benefits, multi-employment benefit plans.
1. Defined contribution plans (DCP) are post-employment benefit plans
under which an enterprise pays fixed contributions into a separate fund and
will have no obligation to pay further contributions. Under defined
contribution plans, actuarial risk (that benefits will be less than expected)
and investment risk (that assets invested will be insufficient to meet
expected benefits) fall on the employee. A common example of Defined
Contribution plans is Provident Fund.
2. Defined benefit plans are post-employment benefit plans other than
defined contribution plans. In defined benefits plans, the actuarial and
investment risk fall on the employer.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.13
6.13
v
v
In defined contribution plans, the contribution is charged to income statement,v
v
whereas in defined benefit plans, detailed actuarial calculation is performed to
determine the charge.
1.6 IS THE GRATUITY SCHEME A DEFINED
CONTRIBUTION OR DEFINED BENEFIT
SCHEME?
An enterprise may pay insurance premiums to fund a post-employment benefit
plan. The enterprise should treat such a plan as a defined contribution plan unless
the enterprise will have an obligation to either:
(a) pay the employee benefits directly when they fall due; or
(b) pay further amounts if the insurer does not pay all future employee benefits
relating to employee service in the current and prior periods.
On the asset side, a question arises as to whether the funds under the scheme as
certified by LIC would be treated as plan assets or reimbursement rights. The
distinction is important (though both are measured on fair valuation basis)
because plan assets are reduced from the defined benefit obligation and the net
amount is disclosed in the balance sheet, whereas, in the case of reimbursement
rights, the defined benefit obligation and the reimbursement rights are shown
separately as liability and asset on the balance sheet. This would have the impact
of making the balance sheet heavy both on the asset side as well as the liabilities
side.
1.7 ACCOUNTING TREATMENT
In the Balance Sheet of the enterprise, ‘the amount recognized as a defined
benefit liability should be the net total of the following amounts:
(a) the present value of the defined benefit obligation at the balance sheet
date;
(b) minus any past service cost not yet recognized;
(c) minus the fair value at the balance sheet date of plan assets (if any) out of
which the obligations are to be settled directly.’
© The Institute of Chartered Accountants of India
6.14 ADVANCED ACCOUNTING
v
v
v
In case where fair value of plan assets is high, it may so happen that the net
v
amount under defined benefit liability turns negative (giving rise to net assets).
AS 15 states that the enterprise, in such a situation, should measure the resulting
asset at the lower of:
(i) the amount so determined; and
(ii) the present value of any economic benefits available in the form of refunds
from the plan or reductions in future contributions to the plan.
The recognition of expenses relating to defined benefits in the Statement of Profit
and Loss is stated in Para 61 of the Standard. The Standard identifies seven
components of defined employee benefit costs:
(a) current service cost;
(b) interest cost;
(c) the expected return on any plan assets (and on any reimbursement rights);
(d) actuarial gains and losses (to the extent they are recognized);
(e) past service cost (to the extent they are recognized);
(f) the effect of any curtailments or settlements; and
(g) the extent to which the negative net amount of defined benefit liability
exceeds the amount mentioned in Para 59(b) of the Standard.
A settlement occurs when an employer enters into a transaction that eliminates all
further legal or constructive obligations for part or whole of the benefits provided
under a defined benefit plan. For example, the commuted portion of pension. A
curtailment occurs when an employer either commits to reduce the number of
employees covered by a plan or reduces the benefits under a plan. The gains or
losses on the settlement or curtailment of a defined benefit plan should be
recognized when the settlement or curtailment occurs.
1.8 DISCLOSURES
Where there is uncertainty about the number of employees who will accept an
offer of termination benefits, a contingent liability exists.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.15
6.15
v
v
v
As required by AS 29, "Provisions, Contingent Liabilities and Contingent Assets"
v
an enterprise discloses information about the contingent liability unless the
possibility of an outflow in settlement is remote.
As required by AS 5, "Net Profit or Loss for the Period, Prior Period items and
Changes in Accounting Policies" an enterprise discloses the nature and amount of
an expense if it is of such size, nature or incidence that its disclosure is relevant to
explain the performance of the enterprise for the period.
Termination benefits may result in an expense needing disclosure in order to
comply with this requirement.
Where required by AS 18, "Related Party Disclosures", an enterprise discloses
information about termination benefits for key management personnel.
When drafting AS 15 (revised), the Standard setters felt that merely on the basis
of a detailed formal plan, it would not be appropriate to recognise a provision
since a liability cannot be considered to be crystallized at this stage. AS 15
requires more certainty for recognition of termination cost, for example, if the
employee has sign up for the termination scheme.
1.9 ACTUARIAL ASSUMPTIONS
The actuarial assumptions should be unbiased and mutually compatible. They are
an enterprise’s best estimates of the variables that will determine the ultimate
cost of providing post-employment benefits. They should be neither imprudent
nor excessively conservative, and should reflect the economic relationships
between factors such as inflation, rates of salary increase, return on plan assets
and discount rates.
AS 15 explains that actuarial assumptions comprise:
(a) demographic assumptions about the future characteristics of current and
former employees (and their dependents) who are eligible for benefits.
Demographic assumptions deal with matters such as:
(i) mortality, both during and after employment;
(ii) rates of employee turnover, disability and early retirement;
© The Institute of Chartered Accountants of India
6.16 ADVANCED ACCOUNTING
v
v
v
(iii) the proportion of plan members with dependents who will be eligible
v
for benefits;
(iv) claim rates under medical plans; and
(b) financial assumptions, dealing with items such as:
(i) the discount rate
(ii) future salary and benefit levels
(iii) in the case of medical benefits, future medical costs, including, where
material, the cost of administering claims and benefit payments and
(iv) the expected rate of return on plan assets.
Financial assumptions: Financial assumptions should be based on market
expectation at the balance sheet date for the period over which the post-
employment benefit obligations will be settled. Discount rates and other financial
assumptions should not be inflation-adjusted unless such measures are more
reliable (e.g. where benefits are index-linked)
1.10 ACTUARIAL GAINS AND LOSSES
Actuarial gains and losses comprise:
• experience adjustments (the effects of difference between the previous
actuarial assumptions and what has actually occurred); and
• the effects of changes in actuarial assumptions.
Actuarial gains and losses should be recognized immediately in the statement of
profit and loss as income or expense.
Illustration 6
Omega Limited belongs to the engineering industry. The company received an
actuarial valuation for the first time for its pension scheme which revealed a surplus
of ` 6 lakhs. It wants to spread the same over the next 2 years by reducing the
annual contribution to ` 2 lakhs instead of ` 5 lakhs. The average remaining life of
the employees is estimated to be 6 years. You are required to advise the company
on the following items from the viewpoint of finalization of accounts, taking note of
the mandatory accounting standards.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.17
6.17
v
v
Solution v
v
According to AS 15 (Revised 2005) ‘Employee Benefits’, actuarial gains and losses
should be recognized immediately in the statement of profit and loss as income
or expense. Therefore, surplus amount of ` 6 lakhs is required to be credited to
the profit and loss statement of the current year.
Illustration 7
As on 1 st April, 20X1 the fair value of plan assets was ` 1,00,000 in respect of a
pension plan of Zeleous Ltd. On 30 th September, 20X1 the plan paid out benefits of
` 19,000 and received inward contributions of ` 49,000. On 31 st March, 20X2 the
fair value of plan assets was ` 1,50,000 and present value of the defined benefit
obligation was ` 1,47,920. Actuarial losses on the obligations for the year 20X1-
20X2 were ` 600.
On 1st April, 20X1, the company made the following estimates, based on its market
studies, understanding and prevailing prices.
Interest & dividend income, after tax payable by the fund 9.25
Realised and unrealised gains on plan assets (after tax) 2.00
Fund administrative costs (1.00)
Expected Rate of Return 10.25
You are required to find the expected and actual returns on plan assets.
Solution
Computation of Expected and Actual Returns on Plan Assets
`
Return on ` 1,00,000 held for 12 months at 10.25% 10,250
Return on ` 30,000 (49,000-19,000) held for six months at 5%
(equivalent to 10.25% annually, compounded every six
1,500
months)
Expected return on plan assets for 20X1-20X2 11,750
© The Institute of Chartered Accountants of India
6.18 ADVANCED ACCOUNTING
v
v
v
Fair value of plan assets as on 31 March, 20X2 1,50,000
v
Less: Fair value of plan assets as on 1 April,20X1 1,00,000
Contributions received 49,000 (1,49,000)
1,000
Add: Benefits paid 19,000
Actual return on plan assets 20,000
Alternatively, the above question may be solved without giving compound effect
to rate of return.
Illustration 8
Rock Star Ltd. discontinues a business segment. Under the agreement with
employee’s union, the employees of the discontinued segment will earn no further
benefit. This is a curtailment without settlement, because employees will continue
to receive benefits for services rendered before discontinuance of the business
segment. Curtailment reduces the gross obligation for various reasons including
change in actuarial assumptions made before curtailment. If the benefits are
determined based on the last pay drawn by employees, the gross obligation reduces
after the curtailment because the last pay earlier assumed is no longer valid.
Rock Star Ltd. estimates the share of unamortized service cost that relates to the
part of the obligation at ` 18 (10% of ` 180). Calculate the gain from curtailment
and liability after curtailment to be recognised in the balance sheet of Rock Star
Ltd. on the basis of given information:
(a) Immediately before the curtailment, gross obligation is estimated at ` 6,000
based on current actuarial assumption.
(b) The fair value of plan assets on the date is estimated at ` 5,100.
(c) The unamortized past service cost is ` 180.
(d) Curtailment reduces the obligation by ` 600, which is 10% of the gross
obligation.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.19
6.19
v
v
Solution v
v
Gain from curtailment is estimated as under:
`
Reduction in gross obligation 600
Less: Proportion of unamortised past service cost (18)
Gain from curtailment 582
The liability to be recognised after curtailment in the balance sheet is estimated
as under:
`
Reduced gross obligation (90% of ` 6,000) 5,400
Less: Fair value of plan assets (5,100)
300
Less: Unamortised past service cost (90% of ` 180) (162)
Liability to be recognised in the balance sheet 138
Illustration 9
An employee Roshan has joined a company XYZ Ltd. in the year 20X1. The annual
emoluments of Roshan as decided is ` 14,90,210. The company also has a policy of
giving a lump sum payment of 25% of the last drawn annual salary of the
employee for each completed year of service if the employee retires after
completing minimum 5 years of service. The salary of the Roshan is expected to
grow @ 10% per annum.
The company has inducted Roshan in the beginning of the year and it is expected
that he will complete the minimum five year term before retiring. Thus he will get
5 yearly increment.
What is the amount the company should charge in its Profit and Loss account every
year as cost for the Defined Benefit obligation? Also calculate the current service
cost and the interest cost to be charged per year assuming a discount rate of 8%.
(P.V factor for 8% - 0.735, 0.794, 0.857, 0.926, 1)
© The Institute of Chartered Accountants of India
6.20 ADVANCED ACCOUNTING
v
v
Solutionv
v
Calculation of Defined Benefit Obligation (DBO)
Expected last drawn salary = ` 14,90,210 x 110% x 110% x 110% x 110% x 110%
= ` 24,00,000
Defined Benefit Obligation (DBO) = ` 24,00,000 x 25% x 5 = ` 30,00,000
Amount of ` 6,00,000 will be charged to Profit and Loss Account of the company
every year as cost for Defined Benefit Obligation.
Calculation of Current Service Cost
Year Equal apportioned amount of Discounting @ Current service cost
DBO [i.e. ` 30,00,000/5 years] 8% PV factor
(Present Value)
a b c d=bxc
1 6,00,000 0.735 (4 Years) 4,41,000
2 6,00,000 0.794 (3 Years) 4,76,400
3 6,00,000 0.857 (2 Years) 5,14,200
4 6,00,000 0.926 (1 Year) 5,55,600
5 6,00,000 1 (0 Year) 6,00,000
Calculation of Interest Cost to be charged per year
Year Opening Interest Current Closing balance
balance cost service
cost
a b c = b x 8% d e=b+c+d
1 0 0 4,41,000 4,41,000
2 4,41,000 35,280 4,76,400 9,52,680
3 9,52,680 76,214 5,14,200 15,43,094
4 15,43,094 1,23,447 5,55,600 22,22,141
5 22,22,141 1,77,859* 6,00,000 30,00,000
*Due to approximations used in calculation, this figure is adjusted accordingly.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.21
6.21
v
v
v
1.11 OTHER LONG TERM EMPLOYEE BENEFITS v
Other long-term employee benefits include, for example:
(a) long-term compensated absences such as long-service or sabbatical leave;
(b) jubilee or other long-service benefits;
(c) long-term disability benefits;
(d) profit-sharing and bonuses payable twelve months or more after the end of
the period in which the employees render the related services and
(e) deferred compensation paid twelve months or more after the end of the
period in which it is earned.
1.12 TERMINATION BENEFITS
Termination Benefits are employee benefits payable as a result of either an
enterprise’s decision to terminate an employee’s employment before the normal
retirement date or an employee’s decision to accept voluntary redundancy in
exchange for those benefits (e.g., payments under VRS). Termination benefits are
recognized by an enterprise as a liability and an expense only when the enterprise
has
(i) a detailed formal plan for the termination which is duly approved, and
(ii) a reliable estimate can be made of the amount of the obligation.
Where the termination benefits fall due within twelve months after the balance
sheet date, an undiscounted amount of such benefits should be recognized as
liability in the balance sheet with a corresponding charge to Profit & Loss
Account. However, when the termination benefits fall due more than twelve
months after the balance sheet date, such benefits should be discounted using an
appropriate discount rate. Where an offer has been made to encourage voluntary
redundancy, the termination benefits should be measured by reference to the
number of employees expected to accept the offer. Where there is uncertainty
with regard to the number of employees who will accept an offer of voluntary
redundancy, a contingent liability exists and should be so disclosed as per AS 29
‘Provisions, Contingent Liabilities and Contingent Assets’.
Reference: The students are advised to refer the full text of AS 15
“Employee Benefits” (Revised 2005).
© The Institute of Chartered Accountants of India
6.22 ADVANCED ACCOUNTING
v
v
v
v
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Gratuity and Pension would be examples of:
(a) Short-term employee benefits
(b) Long-term employee benefits
(c) Post-employment benefits.
(d) None of the above.
2. Non-accumulating compensating absence is commonly referred to as:
(a) Earned Leave
(b) Sick Leave
(c) Casual leave
(d) All of the above
3. The plans that are established by legislation to cover all enterprises and are
operated by Governments include:
(a) Multi-Employer plans
(b) State plans
(c) Insured Benefits
(d) Employee benefit plan
4. Best estimates of the variable to determine the eventual cost of post-
employment benefits is referred to as:
(a) Employer’s contribution
(b) Actuarial assumptions
(c) Cost to Company
(d) Employee’s contribution
5. Actuarial gains / losses should be:
(a) Recognised through reserves
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.23
6.23
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(b) Charged over the expected life of employees v
v
(c) Charged immediately to Profit and Loss Statement
(d) Do not charged to Profit and Loss Statement
Theoretical Questions
6. What are the types of Employees benefits and what is the objective of
Introduction of this Standard i.e. AS 15?
Scenario based Questions
7. A company has a scheme for payment of settlement allowance to retiring
employees. Under the scheme, retiring employees are entitled to
reimbursement of certain travel expenses for class they are entitled to as per
company rule and to a lump-sum payment to cover expenses on food and
stay during the travel. Alternatively, employees can claim a lump sum
amount equal to one month pay last drawn.
The company’s contentions in this matter are:
(i) Settlement allowance does not depend upon the length of service of
employee. It is restricted to employee’s eligibility under the Travel rule
of the company or where option for lump-sum payment is exercised,
equal to the last pay drawn.
(ii) Since it is not related to the length of service of the employees, it is
accounted for on claim basis.
State whether the contentions of the company are correct as per relevant
Accounting Standard. Give reasons in support of your answer.
8. The following data apply to ‘X’ Ltd. defined benefit pension plan for the year
ended 31.03.20X2 calculate the actual return on plan assets:
- Benefits paid 2,00,000
- Employer contribution 2,80,000
- Fair market value of plan assets on 31.03.20X2 11,40,000
- Fair market value of plan assets as on 31.03.20X1 8,00,000
© The Institute of Chartered Accountants of India
6.24 ADVANCED ACCOUNTING
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9. v
The fair value of plan assets of Anupam Ltd. was ` 2,00,000 in respect of
v
employee benefit pension plan as on 1 st April, 20X1. On 30 th September, 20X1
the plan paid out benefits of ` 25,000 and received inward contributions of
` 55,000. On 31 st March, 20X2 the fair value of plan assets was ` 3,00,000.
On 1st April, 20X1 the company made the following estimates, based on its
market studies and prevailing prices.
Interest and dividend income (after tax) payable by fund 10.25
Realized gains on plan assets (after tax) 3.00
Fund administrative costs (3.00)
Expected rate of return 10.25
Calculate the expected and actual returns on plan assets as on 31 st March,
20X2, as per AS 15.
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (c) 2. (c) 3. (b) 4. (b) 5. (c)
Answer to the Theoretical Questions
6. There are four types of employee benefits according to AS 15 (Revised
2005). They are:
(a) short-term employee benefits, such as wages, salaries and social
security contributions (e.g., contribution to an insurance company by
an employer to pay for medical care of its employees), paid annual
leave, profit-sharing and bonuses (if payable within twelve months of
the end of the period) and non-monetary benefits (such as medical
care, housing, cars and free or subsidised goods or services) for
current employees;
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.25
6.25
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(b) v
post-employment benefits such as gratuity, pension, other retirement
v
benefits, post-employment life insurance and post-employment
medical care;
(c) other long-term employee benefits, including long-service leave or
sabbatical leave, jubilee or other long-service benefits, long-term
disability benefits and, if they are not payable wholly within twelve
months after the end of the period, profit-sharing, bonuses and
deferred compensation; and
(d) termination benefits.
Because each category identified in (a) to (d) above has different
characteristics, this Statement establishes separate requirements for
each category.
The objective of AS 15 is to prescribe the accounting and disclosure for
employee benefits. The statement requires an enterprise to recognise:
(a) a liability when an employee has provided service in exchange for
employee benefits to be paid in the future; and
(b) an expense when the enterprise consumes the economic benefit
arising from service provided by an employee in exchange for
employee benefits.
Answer to the Scenario based Questions
7. The present case falls under the category of defined benefit scheme under
Para 49 of AS 15 (Revised) “Employee Benefits”. The said para encompasses
cases where payment promised to be made to an employee at or near
retirement presents significant difficulties in the determination of periodic
charge to the statement of profit and loss. The contention of the Company
that the settlement allowance will be accounted for on claim basis is not
correct even if company’s obligation under the scheme is uncertain and
requires estimation. In estimating the obligation, assumptions may need to
be made regarding future conditions and events, which are largely outside
the company’s control. Thus,
© The Institute of Chartered Accountants of India
6.26 ADVANCED ACCOUNTING
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(1) Settlement allowance payable by the company is a defined retirement
v
benefit, covered by AS 15 (Revised).
(2) A provision should be made every year in the accounts for the
accruing liability on account of settlement allowance. The amount of
provision should be calculated according to actuarial valuation.
(3) Where, however, the amount of provision so determined is not
material, the company can follow some other method of accounting
for settlement allowances.
8.
Fair value of plan assets on 31.3.20X1 8,00,000
Add: Employer contribution 2,80,000
Less: Benefits paid (2,00,000)
(A) 8,80,000
Fair market value of plan assets at 31.3.20X2 (B) 11,40,000
Actual return on plan assets (B-A) 2,60,000
9. Computation of Expected Returns on Plan Assets as on 31st March, 20X2, as
per AS 15
Return on opening value of plan assets of ` 2,00,000 (held 20,500
for the year) @ 10.25%
Add: Return on net gain of ` 30,000 (i.e. ` 55,000 –
` 25,000) during the year i.e. held for six months @ 5% 1,500
(equivalent to 10.25% annually, compounded every six
months)
Expected return on plan assets as on 31 st March, 20X2 22,000
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.27
6.27
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Computation of Actual Returns on Plan Assets as on 31st March, 20X2, v
as per AS 15 v
` `
Fair value of Plan Assets as on 31 st March, 20X2 3,00,000
Less: Fair value of Plan Assets as on (2,00,000)
1st April, 20X1
Add: Contribution received as on 55,000 (2,55,000)
th
30 September, 20X1
45,000
Add: Benefits paid as on 30 th September, 20X1 25,000
Actual returns on Plan Assets as on 70,000
31st March, 20X2
© The Institute of Chartered Accountants of India
6.28 ADVANCED ACCOUNTING
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UNIT 2: AS 29 (REVISED)
PROVISIONS, CONTINGENT LIABILITIES AND
CONTINGENT ASSETS
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the –
Meaning of ‘Executory contracts’, ‘Provision’, ‘Liability, Obligating
event’ and other related terms used in the standard;
Need for recognition of provision;
Definition of Present Obligation and Past Event;
Probable Outflow of Resources Embodying Economic Benefits;
Application of the Recognition and Measurement Rules;
Disclosure requirements as per the Standard.
2.1 INTRODUCTION
AS 29 (Revised) came into effect in respect of accounting periods commenced on
or after 1-4-2004. The objective of AS 29 (Revised) is to ensure that appropriate
recognition criteria and measurement bases are applied to provisions and
contingent liabilities and sufficient information is disclosed in the notes to the
financial statements to enable users to understand their nature, timing and
amount. The objective of AS 29 (Revised) is also to lay down appropriate
accounting for contingent assets.
Companies would create provisions on arbitrary basis when profits in a particular
year is more and then reverse those provisions when profits are lower in
subsequent years. This would lead to manipulation of profits. This is popularly
known as ‘profit smoothing”.
© The Institute of Chartered Accountants of India
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Thus, there is a need for certain parameters on the basis of which provisions are
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measured and recognised, as they impact both Profit and Loss Statement and v
Balance Sheet (creation of an expense and creation of a liability).
AS-29 prescribes the guidance in respect of recognition, measurement and
disclosures of provisions, contingent liabilities and contingent assets.
The standard clearly defines the role of management while making an estimate
for creating provisions and the auditors to vouch for the correctness or otherwise
of the estimate made by the management. This ensures that manipulations do
not take place at the time of creation of provisions.
Earlier, the companies were not recognising the liability on the ground of
uncertainty regarding its timing or amount. With the issuance of AS 29,
transactions which qualify for creating a provision need to be accounted for in the
Balance sheet as a liability.
Example 1
During 20X1, XY Enterprise has made lower amount of profits. However, to ensure
that the Earnings Per Share do not decline significantly, XY Enterprise does not
provide for a warranty amount which should have been provided for. XY is
confident of higher amount of profits during later years, and would like to take this
provision to the later stage. This ensures consistent performance for the company
throughout the period. With AS 29, this anomaly stands removed.
Example 2
During 20X1, AB Shops has made huge profits during a particular year. This may
have resulted in payment of taxes on these profits. Further, AB Shop’s management
foresees challenges in operations in later years, and therefore, low profits. AB Shop
did not create a provision during 20X2 which should have been otherwise made.
However, to get the desired impact, AB Shop created the provision in 20X1. Since,
the intention of management is not to reflect a true and fair view; AS-29 would
ensure appropriate provisions are made in 20X2 only.
AS 29 helps to ensure transparency of information in Financial Statements.
© The Institute of Chartered Accountants of India
6.30 ADVANCED ACCOUNTING
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Higher Lower
profits profits
Create provision Do not create
while it is not provision while
required it is required
Show high
Show less profits
profits and
and avoid taxes
higher EPS
Thus, an accounting standard on provisions is essential to rule out the potential
scope for companies to manipulate profits and provisions are made on valid
grounds (based on a recognition criterion being met).
2.2 SCOPE
AS 29 should be applied in accounting for provisions and contingent liabilities
and in dealing with contingent assets, other than:
a. Those resulting from financial instruments that are carried at fair value;
b. Those resulting from executory contracts except where the contract is
onerous;
c. Those arising in insurance enterprises from contracts with policy-holders;
and
d. Those covered by another Accounting Standard.
Where another Accounting Standard such as AS 7; AS 9; AS 15; AS 19 and AS 22
deals with a specific type of provision, contingent liability or contingent asset, an
enterprise applies that Standard instead of AS 29.
© The Institute of Chartered Accountants of India
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2.3 DEFINITIONS
Executory contracts are contracts under which neither party has performed any
of its obligations or both parties have partially performed their obligations to an
equal extent.
A Provision is a liability which can be measured only by using a substantial
degree of estimation.
A Liability is a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of
resources embodying economic benefits.
An Obligating event is an event that creates an obligation that results in an
enterprise having no realistic alternative to settling that obligation.
A Contingent liability is:
(a) A possible obligation that arises from past events and the existence of
which will be confirmed only by the occurrence or non-occurrence of one or
more uncertain future events not wholly within the control of the enterprise;
or
(b) A present obligation that arises from past events but is not recognised
because:
(i) It is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation; or
(ii) A reliable estimate of the amount of the obligation cannot be made.
A Contingent asset is a possible asset that arises from past events the existence
of which will be confirmed only by the occurrence or non-occurrence of one or
more uncertain future events not wholly within the control of the enterprise.
Present obligation - an obligation is a present obligation if, based on the
evidence available, its existence at the balance sheet date is considered probable,
i.e., more likely than not.
Possible obligation - an obligation is a possible obligation if, based on the
evidence available, its existence at the balance sheet date is considered not
probable.
© The Institute of Chartered Accountants of India
6.32 ADVANCED ACCOUNTING
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A Restructuring is a programme that is planned and controlled by management,
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and materially changes either:
(a) The scope of a business undertaken by an enterprise; or
(b) The manner in which that business is conducted.
2.4 RECOGNITION OF PROVISION
A provision should be recognised when:
(a) An enterprise has a present obligation as a result of a past event;
(b) It is probable that an outflow of resources embodying economic benefits
will be required to settle the obligation; and
(c) A reliable estimate can be made of the amount of the obligation.
If these conditions are not met, no provision should be recognised.
2.5 PRESENT OBLIGATION
An enterprise determines whether a present obligation exists at the balance sheet
date by taking account of all available evidence, e.g., the opinion of experts.
Based on such evidence:
(a) Where it is more likely than not that a present obligation exists at the
balance sheet date, the enterprise recognises a provision (if the recognition
criteria are met); and
(b) Where it is more likely that no present obligation exists at the balance sheet
date, the enterprise discloses a contingent liability, unless the possibility of
an outflow of resources embodying economic benefits is remote.
Example 3
X Ltd sells refrigerators with a warranty of 6 months. The refrigerators would be
repaired free of cost by X Ltd. if some problem arises during the next 6 months of
sale. There is a present obligation for X Ltd because if some defect arises, X Ltd
would need to incur expenses on repairs of the refrigerator. Thus, a provision is
required to be made in the books of X Ltd.
© The Institute of Chartered Accountants of India
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Example 4 v
Z Ltd takes a building on lease for 10 years. The terms of the contract provide that v
Z Ltd must vacate the building in its original condition. Z Ltd expects that there is a
likely cost of ` 10 lakhs to be spent at the end of 10 years for restoration. Since
there is a present obligation on X Ltd at the time of entering into the lease contract,
a provision to the extent of present value of this amount should be created.
2.6 PAST EVENT
A past event that leads to a present obligation is called an obligating event. For
an event to be an obligating event, it is necessary that the enterprise has no
realistic alternative to settling the obligation created by the event.
Financial statements deal with the financial position of an enterprise at the end of
its reporting period and not its possible position in the future.
Therefore, no provision is recognised for costs that need to be incurred to
operate in the future. The only liabilities recognised in an enterprise's balance
sheet are those that exist at the balance sheet date.
It is only those obligations arising from past events existing independently of an
enterprise's future actions (i.e. the future conduct of its business) that are
recognised as provisions.
Examples of such obligations are penalties or clean-up costs for unlawful
environmental damage, both of which would lead to an outflow of resources
embodying economic benefits in settlement regardless of the future actions of
the enterprise.
Similarly, an enterprise recognises a provision for the decommissioning costs of
an oil installation to the extent that the enterprise is obliged to rectify damage
already caused. In contrast, because of commercial pressures or legal
requirements, an enterprise may intend or need to carry out expenditure to
operate in a particular way in the future (for example, by fitting smoke filters in a
certain type of factory). Because the enterprise can avoid the future expenditure
by its future actions, for example by changing its method of operation, it has no
present obligation for that future expenditure and no provision is recognised.
© The Institute of Chartered Accountants of India
6.34 ADVANCED ACCOUNTING
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An event that does not give rise to an obligation immediately may do so at a later
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date, because of changes in the law. For example, when environmental damage is
caused there may be no obligation to remedy the consequences. However, the
causing of the damage will become an obligating event when a new law requires
the existing damage to be rectified.
Where details of a proposed new law have yet to be finalized, an obligation arises
only when the legislation is virtually certain to be enacted.
2.7 PROBABLE OUTFLOW OF RESOURCES
EMBODYING ECONOMIC BENEFITS
For a liability to qualify for recognition there must be not only a present
obligation but also the probability of an outflow of resources embodying
economic benefits to settle that obligation.
For the purpose of AS 29, an outflow of resources or other event is regarded as
probable if the probability that the event will occur is greater than the probability
that it will not. Where it is not probable that a present obligation exists, an
enterprise discloses a contingent liability, unless the possibility of an outflow of
resources embodying economic benefits is remote.
Where there are a number of similar obligations (e.g., product warranties or
similar contracts) the probability that an outflow will be required in settlement is
determined by considering the class of obligations as a whole. Although the
likelihood of outflow for any one item may be small, it may well be probable that
some outflow of resources will be needed to settle the class of obligations as a
whole. If that is the case, a provision is recognized (if the other recognition
criteria are met).
Example 5
Kell Ltd sells laptops with a replacement warranty of 1 year. If something happens
to the laptop within 1 year of purchase, the company would replace the complete
laptop. A few laptops during past years have been replaced by Kell Ltd.
In the above situation, Kell Ltd would incur some expenses to replace a laptop, if
something goes wrong. There is an outflow of resources expected to settle the
obligation that arises by virtue of sale of laptop (past event).
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.35
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Example 6 v
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AB Ltd has received a notice from one of the customers about health issues from
using the products of AB Ltd. The customer in the notice claims damages of
` 5,00,000.
The conditions of past event (i.e. sale of goods resulting in damage) and reliable
estimate ( ` 5,00,000) have been met. However, whether an outflow of resources will
be probable or not, cannot be confirmed since the customer may or may not win
the case. This would be clear only when the decision will be taken by the court.
Hence, in the above situation, no provision for damages will be made. However, a
disclosure of the case filed is required to be made.
2.8 RELIABLE ESTIMATE OF THE OBLIGATION
The use of estimates is an inherent part of preparing financial statements and
does not undermine their reliability. Provisions require a greater degree of
estimation than most other items, but AS 29 (Revised) emphasizes that it should
not be impossible to determine a range of possible outcomes and, from this
range, to reach an appropriate conclusion that is sufficiently reliable for the
provision to be recognized. AS 29 (Revised) concludes that the circumstances in
which it will not be possible to reach a reliable estimate, will be extremely rare.
In the extremely rare case where no reliable estimate can be made, a liability
exists that cannot be recognized. That liability will, instead, be disclosed as a
contingent liability.
For example: XYZ is in mining business. It is operating in a country where XYZ is
legally bound to clean and restore the environment on expiry of license after 10
years. XYZ can reliably estimate the amount required to restore the environment
caused by the mining business. Since it if a present obligation which cannot be
avoided resulted from past event, it is probable that resources will flow out of
business to settle the same and estimate can be measured reliably. XYZ is
required to recognize a provision for the same.
2.9 CONTINGENT LIABILITIES
An enterprise should not recognize a contingent liability but should be disclosed.
A contingent liability is disclosed, unless the possibility of an outflow of resources
embodying economic benefits is remote.
© The Institute of Chartered Accountants of India
6.36 ADVANCED ACCOUNTING
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Where anventerprise is jointly and severally liable for an obligation, the part of the
obligationv that is expected to be met by other parties is treated as a contingent
liability. The enterprise recognizes a provision for the part of the obligation for
which an outflow of resources embodying economic benefits is probable, except
in the extremely rare circumstances where no reliable estimate can be made.
Contingent liabilities may develop in a way not initially expected. Therefore, they are assessed
continually to determine whether an outflow of resources embodying economic benefits has
become probable. If it becomes probable that an outflow of future economic benefits will be
required for an item previously dealt with as a contingent liability, a provision is recognized in the
financial statements of the period in which the change in probability occurs.
Example: 7
A customer of XYZ has filed a case against them for providing them wrong product
and not returning the same. XYZ has taken legal advice from their lawyer who
believes it is not probable yet that resources may be required to settle the same.
Since it is not meeting all the criteria of provision, it will be treated as contingent
liability and will just be disclosed in the notes.
Decision tree
Start
Present obligation as No No
a result of an Possible
obligating event? Obligation
Yes
Yes
No Yes
Probable outflow Remote
Yes No
No (rare)
Reliable estimate
Yes
Disclose contingent Do nothing
Provide liability
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.37
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2.10 CONTINGENT ASSETS v
Contingent assets usually arise from unplanned or other unexpected events that
give rise to the possibility of an inflow of economic benefits to the enterprise. An
example is a claim that an enterprise is pursuing through legal processes, where
the outcome is uncertain.
An enterprise should not recognize a contingent asset, since this may result in the
recognition of income that may never be realized. However, when the realization
of income is virtually certain, then the related asset is not a contingent asset and
its recognition is appropriate. A contingent asset is not disclosed in the financial
statements. It is usually disclosed in the report of the approving authority (Board
of Directors in the case of a company, and, the corresponding approving
authority in the case of any other enterprise), where an inflow of economic
benefits is probable.
Contingent assets are assessed continually and if it has become virtually certain
that an inflow of economic benefits will arise, the asset and the related income
are recognized in the financial statements of the period in which the change
occurs.
Table- Provisions and contingent liabilities
Where, as a result of past events, there may be an outflow of resources
embodying future economic benefits in settlement of: (a) a present
obligation the one whose existence at the balance sheet date is considered
probable; or (b) a possible obligation the existence of which at the balance
sheet date is considered not probable.
There is a present There is a possible There is a possible
obligation that probably obligation or a present obligation or a present
requires an outflow of obligation that may, but obligation where the
resources and a reliable probably will not, require likelihood of an outflow of
estimate can be made of an outflow of resources. resources is remote.
the amount of
obligation.
© The Institute of Chartered Accountants of India
6.38 ADVANCED ACCOUNTING
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Provisionv is recognised. No provision is No provision is
v
recognised. recognised.
Disclosures are required
for the provision. Disclosures are required No disclosure is required.
for the contingent
liability.
2.11 MEASUREMENT: BEST ESTIMATE
The amount recognised as a provision should be the best estimate of the
expenditure required to settle the present obligation at the balance sheet date.
The estimates of outcome and financial effect are determined by:
• the judgment of the management of the enterprise,
• supplemented by experience of similar transactions and,
• in some cases, reports from independent experts.
The amount of a provision should not be discounted to its present value except in
case of decommissioning, restoration and similar liabilities that are recognised as
cost of Property, Plant and Equipment.
The discount rate (or rates) should be a pre-tax rate (or rates) that reflect(s)
current market assessments of the time value of money and the risks specific to
the liability. The discount rate(s) should not reflect risks for which future cash
flow estimates have been adjusted. Periodic unwinding of discount should be
recognised in the statement of profit and loss.
The provision is measured before tax; the tax consequences of the provision, and
changes in it, are dealt with under AS 22.
2.12 RISKS AND UNCERTAINTIES
The risks and uncertainties that inevitably surround many events and
circumstances should be taken into account in reaching the best estimate of a
provision.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.39
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2.13 FUTURE EVENTS v
It is only those obligations arising from past events that exist independently of
the enterprise’s future actions (i.e. the future conduct of its business) that are
recognized as provisions.
Future events that may affect the amount required to settle an obligation should
be reflected in the amount of a provision where there is sufficient objective
evidence that they will occur.
For example, an enterprise may believe that the cost of cleaning up a site at the
end of its life will be reduced by future changes in technology. The amount
recognized reflects a reasonable expectation of technically qualified, objective
observers, taking account of all available evidence as to the technology that will
be available at the time of the clean-up. Thus, it is appropriate to include, for
example, expected cost reductions associated with increased experience in
applying existing technology or the expected cost of applying existing technology
to a larger or more complex clean-up operation than has previously been carried
out. However, an enterprise does not anticipate the development of a completely
new technology for cleaning up unless it is supported by sufficient objective
evidence.
The effect of possible new legislation is taken into consideration in measuring an
existing obligation when sufficient objective evidence exists that the legislation is
virtually certain to be enacted. The variety of circumstances that arise in practice
usually makes it impossible to specify a single event that will provide sufficient,
objective evidence in every case. Evidence is required both of what legislation will
demand and of whether it is virtually certain to be enacted and implemented in
due course. In many cases sufficient objective evidence will not exist until the new
legislation is enacted.
2.14 EXPECTED DISPOSAL OF ASSETS
Gains on the expected disposal of assets are not taken into account in measuring
a provision, even if the expected disposal is closely linked to the event giving rise
to the provision. Instead, an enterprise recognizes gains on expected disposals of
assets at the time specified by the Accounting Standard dealing with the assets
concerned.
© The Institute of Chartered Accountants of India
6.40 ADVANCED ACCOUNTING
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2.15
v REIMBURSEMENTS
An enterprise with a present obligation may be able to seek reimbursement of
part or all of the expenditure from another party, for example via:
• An insurance contract arranged to cover a risk;
• An indemnity clause in a contract; or
• A warranty provided by a supplier.
The basis underlying the recognition of a reimbursement is that any asset arising
is separate from the related obligation. Consequently, such a reimbursement
should be recognized only when it is virtually certain that it will be received
consequent upon the settlement of the obligation.
In most cases, the enterprise will remain liable for the whole of the amount in
question so that the enterprise would have to settle the full amount if the third
party failed to pay for any reason. In this situation, a provision is recognized for
the full amount of the liability, and a separate asset for the expected
reimbursement is recognized when it is virtually certain that reimbursement will
be received if the enterprise settles the liability.
In some cases, the enterprise will not be liable for the costs in question if the third
party fails to pay. In such a case, the enterprise has no liability for those costs and
they are not included in the provision.
2.16 TABLE- REIMBURSEMENTS
Some or all of the expenditure required to settle a provision is expected to
be reimbursed by another party.
The enterprise has The obligation for the The obligation for the
no obligation for the amount expected to be amount expected to be
part of the reimbursed remains with reimbursed remains with the
expenditure to be the enterprise and it is enterprise and the
reimbursed by the virtually certain that reimbursement is not
other party. reimbursement will be virtually certain if the
received if the enterprise enterprise settles the
settles the provision. provision.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.41
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The enterprise has The reimbursement is The expected reimbursementv
no liability for the recognized as a separate is not recognized as an asset.v
amount to be asset in the balance
reimbursed. sheet and may be offset
against the expense in
the statement of profit
and loss. The amount
recognized for the
expected reimbursement
does not exceed the
liability.
No disclosure is The reimbursement is The expected reimbursement
required. disclosed together with is disclosed.
the amount recognized
for the reimbursement.
2.17 CHANGES IN PROVISIONS
Provisions should be reviewed at each balance sheet date and adjusted to reflect
the current best estimate. If it is no longer probable that an outflow of resources
embodying economic benefits will be required to settle the obligation, the
provision should be reversed.
2.18 USE OF PROVISIONS
A provision should be used only for expenditures for which the provision was
originally recognized. Only expenditures that relate to the original provision are
adjusted against it. Adjusting expenditures against a provision that was originally
recognized for another purpose would conceal the impact of two different events.
© The Institute of Chartered Accountants of India
6.42 ADVANCED ACCOUNTING
v
v
v
2.19
v APPLICATION OF THE RECOGNITION AND
MEASUREMENT RULES
2.19.1 Future Operating Losses
Future operating losses do not meet the definition of a liability and the general
recognition criteria; therefore, provisions should not be recognized for future
operating losses.
2.19.2 Restructuring
The following are examples of events that may fall under the definition of
restructuring:
(a) Sale or termination of a line of business
(b) The closure of business locations in a country or region or the relocation of
business activities from one country or region to another
(c) Changes in management structure, for example, eliminating a layer of
management
(d) Fundamental re-organizations that have a material effect on the nature and
focus of the enterprise's operations
A provision for restructuring costs is recognized only when the recognition
criteria for provisions are met. No obligation arises for the sale of an operation
until the enterprise is committed to the sale, i.e., there is a binding sale
agreement. Until there is a binding sale agreement, the enterprise will be able to
change its mind and indeed will have to take another course of action if a
purchaser cannot be found on acceptable terms.
A restructuring provision should include only the direct expenditures arising from
the restructuring, which are those that are both:
(a) Necessarily entailed by the restructuring; and
(b) Not associated with the ongoing activities of the enterprise.
A restructuring provision does not include such costs as:
(a) Retraining or relocating continuing staff;
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.43
6.43
v
v
(b) Marketing; or v
(c) Investment in new systems and distribution networks. v
These expenditures relate to the future conduct of the business and are not
liabilities for restructuring at the balance sheet date. Such expenditures are
recognized on the same basis as if they arose independently of a restructuring.
Identifiable future operating losses up to the date of a restructuring are not
included in a provision.
Gains on the expected disposal of assets are not taken into account in measuring
a restructuring provision, even if the sale of assets is envisaged as part of the
restructuring.
2.20 DISCLOSURE
For each class of provision, an enterprise should disclose:
(a) The carrying amount at the beginning and end of the period;
(b) Additional provisions made in the period, including increases to existing
provisions;
(c) Amounts used (i.e., incurred and charged against the provision) during the
period; and
(d) Unused amounts reversed during the period.
Note: SMCs are exempt from the above disclosure requirements of AS 29
(Revised)
An enterprise should disclose the following for each class of provision:
(a) A brief description of the nature of the obligation and the expected timing
of any resulting outflows of economic benefits;
(b) An indication of the uncertainties about those outflows. Where necessary to
provide adequate information, an enterprise should disclose the major
assumptions made concerning future events, and
(c) The amount of any expected reimbursement, stating the amount of any
asset that has been recognized for that expected reimbursement.
© The Institute of Chartered Accountants of India
6.44 ADVANCED ACCOUNTING
v
v
v
Note: SMCs are exempt from the above disclosure requirements of AS 29
v
(Revised)
Unless the possibility of any outflow in settlement is remote, an enterprise should
disclose for each class of contingent liability at the balance sheet date a brief
description of the nature of the contingent liability and, where practicable:
(a) An estimate of its financial effect,
(b) An indication of the uncertainties relating to any outflow; and
(c) The possibility of any reimbursement.
Where any of the information required by above paragraph is not disclosed
because it is not practicable to do so, that fact should be stated.
In extremely rare cases, disclosure of some or all of the information required by
AS 29 can be expected to prejudice seriously the position of the enterprise in a
dispute with other parties on the subject matter of the provision or contingent
liability. In such cases, an enterprise need not disclose the information, but should
disclose the general nature of the dispute, together with the fact that, and reason
why, the information has not been disclosed.
Illustration 1
At the end of the financial year ending on 31st December, 20X1, a company finds
that there are twenty law suits outstanding which have not been settled till the date
of approval of accounts by the Board of Directors. The possible outcome as
estimated by the Board is as follows:
Probability Loss (` )
In respect of five cases (Win) 100% −
Next ten cases (Win) 50% −
Lose (Low damages) 40% 1,20,000
Lose (High damages) 10% 2,00,000
Remaining five cases
Win 50% −
Lose (Low damages) 30% 1,00,000
Lose (High damages) 20% 2,10,000
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.45
6.45
v
v
Outcome of each case is to be taken as a separate entity. Ascertain the amount of
v
contingent loss and the accounting treatment in respect thereof. v
Solution
According to AS 29 (Revised) ‘Provisions, Contingent Liabilities and Contingent
Assets’, contingent liability should be disclosed in the financial statements if
following conditions are satisfied:
(i) There is a present obligation arising out of past events but not recognized
as provision.
(ii) It is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation.
(iii) The possibility of an outflow of resources embodying economic benefits is
not remote.
(iv) The amount of the obligation cannot be measured with sufficient reliability
to be recognized as provision.
In this case, the probability of winning of first five cases is 100% and hence,
question of providing for contingent loss does not arise. The probability of
winning of next ten cases is 50% and for remaining five cases is 50%. As per AS
29 (Revised), we make a provision if the loss is probable. As the loss does not
appear to be probable and the possibility of an outflow of resources embodying
economic benefits is remote, therefore disclosure by way of note should be made.
For the purpose of the disclosure of contingent liability by way of note, amount
may be calculated as under:
Expected loss in next ten cases = 40% of ` 1,20,000 + 10% of ` 2,00,000
= ` 48,000 + ` 20,000 = ` 68,000
Expected loss in remaining five cases = 30% of ` 1,00,000 + 20% of ` 2,10,000
= ` 30,000 + ` 42,000 = ` 72,000
To disclose contingent liability on the basis of maximum loss will be highly
unrealistic. Therefore, the better approach will be to disclose the overall expected
loss of ` 10,40,000 (` 68,000 10 + ` 72,000 5) as contingent liability.
© The Institute of Chartered Accountants of India
6.46 ADVANCED ACCOUNTING
v
v
v 2
Illustration
v
EXOX Ltd. is in the process of finalising its accounts for the year ended 31 st March,
20X2. The company seeks your advice on the following:
(i) The Company’s sales tax assessment for assessment year 20X1-X2 has been
completed on 14 th February, 20X4 with a demand of ` 2.76 crore. The
company paid the entire due under protest without prejudice to its right of
appeal. The Company files its appeal before the appellate authority wherein
the grounds of appeal cover tax on additions made in the assessment order
for a sum of 2.10 crore.
(ii) The Company has entered into a wage agreement in May, 20X2 whereby the
labour union has accepted a revision in wage from June, 20X1. The
agreement provided that the hike till May, 20X2 will not be paid to the
employees but will be settled to them at the time of retirement. The company
agrees to deposit the arrears in Government Bonds by September, 20X2.
Solution
(i) Since the company is not appealing against the addition of ` 0.66 crore the
same should be provided for in its accounts for the year ended on
31st March, 20X4. The amount paid under protest can be kept under the
heading ‘Loans & Advances’ and disclosed as a contingent liability of
` 2.10 crore.
(ii) The arrears for the period from June, 20X1 to March, 20X2 are required to
be provided for in the accounts of the company for the year ended on
31st March, 20X2.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.47
6.47
v
v
TEST YOUR KNOWLEDGE v
v
Multiple Choice Questions
1. Which of the following best describes a provision?
(a) A provision is a liability of uncertain timing or amount.
(b) A provision is a possible obligation of uncertain timing.
(c) A provision is a credit balance set up to offset a contingent asset so that
the effect on the statement of financial position is nil.
(d) A provision is a possible obligation of uncertain amount.
2. X Co is a business that sells second hand cars. If a car develops a fault within
30 days of the sale, X Co will repair it free of charge. At 1 st March 20X1, X Co
had made a provision for repairs of ` 25,000. At 31 st March 20X1, X Co
calculated that the provision should be ` 20,000. What entry should be made
for the provision in X Co's income statement for the month 31 st March 20X1?
(a) A charge of ` 5,000
(b) A credit of ` 5,000
(c) A charge of ` 20,000
(d) A credit of ` 25,000
3. Which of the following item does the statement below describe?
“A possible obligation that arises from past events and whose existence will
be confirmed only by the occurrence or non-occurrence of one or more
uncertain future events not wholly within the entity's control”
(a) A provision
(b) A current liability
(c) A contingent liability
(d) Deferred tax liability
4. Z Ltd has commenced a legal action against Y Ltd claiming substantial
damages for supply of a faulty product. The lawyers of Y Ltd have advised
that the company is likely to lose the case, although the chances of paying the
claim is not remote. The estimated potential liability estimated by the lawyers
are:
© The Institute of Chartered Accountants of India
6.48 ADVANCED ACCOUNTING
v
v
v
Legal cost (to be incurred irrespective of the outcome of the case) ` 50,000
v
Settlement if the claim is required to be paid ` 5,00,000
What is the appropriate accounting treatment in the books of Z Ltd.?
(a) Create a Provision of ` 5,50,000
(b) Make a Disclosure of a contingent liability of ` 5,50,000
(c) Create a Provision of ` 50,000 and make a disclosure of contingent
liability of ` 5,00,000
(d) Create a Provision of ` 5,00,000
Theoretical Questions
5. When should provision be recognized as per provisions of AS 29? Explain in brief.
Scenario based Questions
6. Sun Ltd. has entered into a sale contract of ` 5 crores with X Ltd. during
20X1-20X2 financial year. The profit on this transaction is ` 1 crore. The
delivery of goods to take place during the first month of 20X2-20X3 financial
year. In case of failure of Sun Ltd. to deliver within the schedule, a
compensation of ` 1.5 crores is to be paid to X Ltd. Sun Ltd. planned to
manufacture the goods during the last month of 20X1-20X2 financial year.
As on balance sheet date (31.3.20X2), the goods were not manufactured, and
it was unlikely that Sun Ltd. will be able to meet the contractual obligation.
(i) Should Sun Ltd. provide for contingency as per AS 29?
(ii) Should provision be measured as the excess of compensation to be paid
over the profit?
7. An oil company has been contaminating land for several years. It does not
clean up because there is no legislation requiring cleaning up. At 31 st March
20X1, it is virtually certain that a law requiring a clean-up of land already
contaminated will be enacted shortly after the year end. Is provisioning
presently necessary?
8. A Ltd. provides after sales warranty for two years to its customers. Based on
past experience, the company has the following policy for making provision
for warranties on the invoice amount, on the remaining balance warranty
period.
© The Institute of Chartered Accountants of India
LIABILITIES BASED ACCOUNTING STANDARDS 6.49
6.49
v
v
Less than 1 year: 2% provision v
More than 1 year: 3% provision v
The company has raised invoices as under :
Invoice Date Amount (`)
11th Feb, 20X0 60,000
25th Dec, 20X0 40,000
04th Oct, 20X1 1,35,000
Calculate the provision to be made for warranty under AS-29 as at 31st March,
20X1 and 31st March, 20X2. Also compute amount to be debited to P & L
account for the year ended 31 st March, 20X2.
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (a) 2. (b) 3. (c) 4. (c)
Answer to the Theoretical Questions
5. A provision should be recognised only when: (a) An enterprise has a present
obligation as a result of a past event; (b) It is probable that an outflow of
resources embodying economic benefits will be required to settle the
obligation; and (c) A reliable estimate can be made of the amount of the
obligation.
Answer to the Scenario based Questions
6. (i) AS 29 “Provisions, Contingent Liabilities and Contingent Assets” provides
that when an enterprise has a present obligation, as a result of past
events, that probably requires an outflow of resources and a reliable
estimate can be made of the amount of obligation, a provision should be
recognized. Sun Ltd. has the obligation to deliver the goods within the
scheduled time as per the contract. It is probable that Sun Ltd. will fail to
deliver the goods within the schedule and it is also possible to estimate
the amount of compensation. Therefore, Sun Ltd. should provide for the
contingency amounting ` 1.5 crores as per AS 29.
© The Institute of Chartered Accountants of India
6.50 ADVANCED ACCOUNTING
v
v
(ii) v Provision should not be measured as the excess of compensation to be
v paid over the profit. The goods were not manufactured before
31st March, 20X2 and no profit had accrued for the financial year
20X1-20X2. Therefore, provision should be made for the full amount of
compensation amounting ` 1.50 crores.
7. As per para 29 of AS 29 ‘Provisions, Contingent Liabilities and Contingent
Assets’, a past event will lead to present obligation when the enterprise has
no realistic alternative to settle the obligation created by the past event.
However, when environmental damage is caused, there may be no
obligation to remedy the consequences. The causing of the damage will
become an obligating event when a new law requires the existing damage
to be rectified. Where details of a proposed new law have yet to be
finalised, an obligation arises only when the legislation is virtually certain to
be enacted.
In the given case it is virtually certain that law will be enacted requiring
clean-up of a land already contaminated. Therefore, an oil company has to
provide for such clean-up cost in the year in which the law is virtually
certain to be enacted.
8. Provision to be made for warranty under AS 29 ‘Provisions, Contingent
Liabilities and Contingent Assets’
As at 31 st March, 20X1 = ` 60,000 x .02 + ` 40,000 x .03
= ` 1,200 + ` 1,200 = ` 2,400
st
As at 31 March, 20X2 = ` 40,000 x .02 + ` 1,35,000 x .03
= ` 800 + ` 4,050 = ` 4,850
Amount debited to Profit and Loss Account for year ended 31 st March,
20X2
`
Balance of provision required as on 31.03.20X2 4,850
Less: Opening Balance as on 1.4.20X1 (2,400)
Amount debited to profit and loss account 2,450
Note: No provision will be made on 31 st March, 20X2 in respect of sales
amounting ` 60,000 made on 11 th February, 20X0 as the warranty period of
2 years has already expired.
© The Institute of Chartered Accountants of India
CHAPTER a
7
CHAPTER
ACCOUNTING STANDARDS
BASED ON ITEMS
IMPACTING FINANCIAL
STATEMENTS
UNIT 1: ACCOUNTING STANDARD 4
CONTINGENCIES AND EVENTS OCCURRING
AFTER THE BALANCE SHEET DATE
LEARNING OUTCOMES
After studying this unit, you will be able to elucidate the –
Meaning of Contingencies and accounting treatment of contingent
gains and contingent losses.
Events Occurring after the Balance Sheet Date: Adjusting and
Non-adjusting events
Necessary Disclosures required as per the standard.
1.1 INTRODUCTION
All paragraphs of AS 4 (Revised) that deal with contingencies are applicable only
to the extent not covered by other Accounting Standards prescribed by the
Central Government. For example, the impairment of financial assets such as
impairment of receivables (commonly known as provision for bad and doubtful
debts) is governed by this Standard. Thus, the present standard (AS 4 (Revised))
© The Institute of Chartered Accountants of India
7.2
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ADVANCED ACCOUNTING
deals with the treatment and disclosure requirements in the financial statements
of events occurring after the balance sheet.
1.2 CONTINGENCIES
Contingency is a condition or situation, the ultimate outcome of which, gain or
loss, will be known or determined only on the occurrence, or non-occurrence, of
one or more uncertain future events.
Accounting Treatment of Contingent Losses
The accounting treatment of a contingent loss is determined by the expected
outcome of the contingency. If it is likely that a contingency will result in a loss to
the enterprise, then it is prudent to provide for that loss in the financial
statements.
Example: ABC has filed case against a debtor for a recovery of ` 25 Lakhs.
According to the legal team, the chances of recovery is nil. Therefore, ABC should
make provision for doubtful debt.
The estimation of the amount of a contingent loss to be provided for in the
financial statements, may be based on judgement made, by the management. If
there is conflicting or insufficient evidence for estimating the amount of a
contingent loss, then disclosure is made of the existence and nature of the
contingency.
The estimates of the outcome and of the financial effect of contingencies are
determined by the judgment of the management of the enterprise. This judgment
is based on consideration of the information available up to the date on which
the financial statements are approved and will include a review of events
occurring after the balance sheet date, supplemented by experience of similar
transactions and, in some cases, reports from independent experts.
The existence and amount of guarantees, obligations arising from discounted bills
of exchange and similar obligations undertaken by an enterprise are generally
disclosed in financial statements by way of note, even though the possibility that
a loss to the enterprise will occur, is remote.
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AS BASED ON ITEMS IMPACTING FINANCIAL 7.3 a
STATEMENTS
Accounting Treatment of Contingent Gains
Contingent gains are not recognised in financial statements since their
recognition may result in the recognition of revenue which may never be realised.
However, when the realisation of a gain is virtually certain, then such gain is not a
contingency and accounting for the gain is appropriate.
The amount at which a contingency is stated in the financial statements is based
on the information which is available at the date on which the financial
statements are approved.
1.3 EVENTS OCCURRING AFTER THE BALANCE
SHEET DATE
Events occurring after the balance sheet date are those significant events, both
favourable and unfavourable, that occur between the balance sheet date and the
date on which the financial statements are approved by the Board of Directors in
the case of a company, and, by the corresponding approving authority in the case
of any other entity.
For example, for the year ending on 31 st March 20X1, financial statement is
finalized and approved by the Board of the directors of the company in its
meeting held on 04 th September 20X1. In this case the events taking place
between 01st April 20X1 to 04 th September 20X1 are termed as events occurring
after the balance sheet date.
Two types of events can be identified:
a. Adjusting events- those which provide further evidence of conditions that
existed at the balance sheet date. For example, a trade receivable declared
insolvent after reporting date and unable to pay full amount against whom
provision for doubtful debt was created.
b. Non-adjusting events- those which are indicative of conditions that arose
subsequent to the balance sheet date. For example, plant got damaged due
to occurrence of fire.
© The Institute of Chartered Accountants of India
7.4
a
ADVANCED ACCOUNTING
1.4 ADJUSTING EVENTS
Adjustments to assets and liabilities are required for events occurring after the
balance sheet date that provide additional information materially affecting the
determination of the amounts relating to conditions existing at the balance sheet
date. For example, an adjustment may be made for a loss on a trade receivable
account which is confirmed by the insolvency of a customer which occurs after
the balance sheet date.
1.5 NON-ADJUSTING EVENTS
Adjustments to assets and liabilities are not appropriate for events occurring after
the balance sheet date, if such events do not relate to conditions existing at the
balance sheet date. An example is the decline in market value of investments
between the balance sheet date and the date on which the financial statements
are approved. Ordinary fluctuations in market values do not normally relate to the
condition of the investments at the balance sheet date but reflect circumstances
which have occurred in the following period.
Events occurring after the balance sheet date which do not affect the figures
stated in the financial statements would not normally require disclosure in the
financial statements although they may be of such significance that they may
require a disclosure in the report of the approving authority to enable users of
financial statements to make proper evaluations and decisions.
Dividend declared after balance sheet date
There are events which, although take place after the balance sheet date, are
sometimes reflected in the financial statements because of statutory requirements
or because of their special nature. For example, if dividends are declared after the
balance sheet date but before the financial statements are approved, the
dividends are not recognised as a liability at the balance sheet date because no
obligation exists at that time unless a statute requires otherwise. Such dividends
are disclosed in the notes. Thus, no liability for proposed dividends needs to be
recognised in the financial statements for financial year ended 31 st March, 2017
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.5 a
STATEMENTS
and subsequent years. Such proposed dividends are to be disclosed in the notes
as per Companies (Accounting Standards) Amendment Rules, 2016 issued on 30
March 2016.
Events indicating going concern assumption inappropriate
Events occurring after the balance sheet date may indicate that the enterprise
ceases to be a going concern. A deterioration in operating results and financial
position, or unusual changes affecting the existence or substratum of the
enterprise after the balance sheet date (e.g., destruction of a major production
plant by a fire after the balance sheet date) may indicate a need to consider
whether it is proper to use the fundamental accounting assumption of going
concern in the preparation of the financial statements. In case the going concern
assumption is not valid (based on events occurring after the balance sheet date),
the financial statements are prepared on a liquidation basis.
Event occuring after the Balance
Sheet date
Evidence of such condition No evidence of such condition
been existed at the Balance been existed at the Balance
Sheet date Sheet date
Adjusting event Non-adjusting event
Adjustment to assets and Adjustment to assets and
liabilities is required liabilities is not required
Disclosure in the report of
Disclosure in the financial
the approving authority is
statements is required
required
© The Institute of Chartered Accountants of India
7.6
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ADVANCED ACCOUNTING
1.6 DISCLOSURE
Disclosure of events occurring after the balance sheet date requires the following
information be provided in the financial statements:
(a) The nature of the event;
(b) An estimate of the financial effect, or a statement that such an estimate
cannot be made.
Example
A company follows April-March as its financial year. The company recognises
cheques dated 31 st March or before, received from customers after the balance
sheet date but before approval of financial statement by debiting Cheques in hand
A/c and crediting the Debtors A/c. The Cheques in hand are shown in the balance
sheet as an item of cash and cash equivalents. All Cheques in hand are presented to
bank in the month of April and are also realised in the same month in the normal
course after deposit in the bank.
Even if the cheques bear the date 31 st March or before, the cheques received after
31st March do not represent any condition existing on 31 st March. Thus the
collection of cheques after balance sheet date is not an adjusting event. Recognition
of cheques in hand is therefore not consistent with the requirements of AS 4
(Revised). Moreover, the collection of cheques after balance sheet date does not
represent any material change or commitments affecting financial position of the
enterprise, and so no disclosure of such collections in the Directors’ Report is
necessary.
It should also be noted that, the Framework for Preparation and Presentation of
Financial Statement defines assets as resources controlled by an enterprise as a
result of past events from which economic benefits are expected to flow to the
enterprise. Since the company acquires custody of the cheques after 31 st March, it
does not have any control over the cheques on 31 st March and hence cheques in
hand do not qualify to be recognised as asset on 31 st March.
Illustration 1
In X Co. Ltd., theft of cash of ` 5 lakhs by the cashier in January, 20X1 was detected
only in May, 20X1. The accounts of the company were not yet approved by the
Board of Directors of the company.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.7 a
STATEMENTS
Decide whether the theft of cash has to be adjusted in the accounts of the company
for the year ended 31.3.20X1.
Solution
As per AS 4 (Revised) ‘Contingencies and Events occurring after the Balance Sheet
Date’, an event occurring after the balance sheet date may require adjustment to
the reported amounts of assets, liabilities, expenses or incomes.
If a fraud of the accounting period is detected after the balance sheet date but
before approval of the financial statements, it is necessary to recognise the loss
amounting ` 5,00,000 and adjust the accounts of the company for the year ended
31st March, 20X1.
Illustration 2
An earthquake destroyed a major warehouse of ACO Ltd. on 20.5.20X2. The
accounting year of the company ended on 31.3.20X2. The accounts were approved
on 30.6.20X2. The loss from earthquake is estimated at ` 30 lakhs. State with
reasons, whether the loss due to earthquake is an adjusting or non-adjusting event
and how the fact of loss is to be disclosed by the company.
Solution
AS 4 (Revised) “Contingencies and Events Occurring after the Balance Sheet Date”,
states that adjustments to assets and liabilities are not appropriate for events
occurring after the balance sheet date, if such events do not relate to conditions
existing at the balance sheet date. The destruction of warehouse due to
earthquake did not exist on the balance sheet date i.e. 31.3.20X2. Therefore, loss
occurred due to earthquake is not to be recognised in the financial year 20X1-
20X2.
However, according to the standard, unusual changes affecting the existence or
substratum of the enterprise after the balance sheet date may indicate a need to
consider the use of fundamental accounting assumption of going concern in the
preparation of the financial statements. As per the information given in the
question, the earthquake has caused major destruction; therefore, fundamental
accounting assumption of going concern would have to be evaluated.
Considering that the going concern assumption is still valid, the fact of
earthquake together with an estimated loss of ` 30 lakhs should be disclosed in
© The Institute of Chartered Accountants of India
7.8
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ADVANCED ACCOUNTING
the report of the approving authority for financial year 20X1-X2 to enable users of
financial statements to make proper evaluations and decisions.
Illustration 3
A company has filed a legal suit against the debtor from whom ` 15 lakh is
recoverable as on 31.3.20X1. The chances of recovery by way of legal suit are not
good as per legal opinion given by the counsel in April, 20X1. Can the company
provide for full amount of ` 15 lakhs as provision for doubtful debts? Discuss.
Solution
As per AS 4 (Revised) “Contingencies and Events Occurring After the Balance
Sheet Date”, assets and liabilities should be adjusted for events occurring after
the balance sheet date that provide additional evidence to assist the estimation of
amounts relating to conditions existing at the balance sheet date. In the given
case, company should make the provision for doubtful debts, as legal suit has
been filed on 31st March, 20X1 and the chances of recovery from the suit are not
good. Though, the actual result of legal suit will be known in future yet situation
of non-recovery from the debtors exists before finalisation of financial
statements. Therefore, provision for doubtful debts should be made for the year
ended on 31st March, 20X1.
Illustration 4
In preparing the financial statements of R Ltd. for the year ended 31st March, 20X1,
you come across the following information. State with reasons, how you would deal
with this in the financial statements:
The company invested 100 lakhs in April, 20X1 before approval of Financial
Statements by the Board of directors in the acquisition of another company doing
similar business, the negotiations for which had started during the year.
Solution
AS 4 (Revised) defines "Events Occurring after the Balance Sheet Date" as those
significant events, both favourable and unfavourable, that occur between the
balance sheet date and the date on which the financial statements are approved
by the Approving Authority in the case of a company. Accordingly, the acquisition
of another company is an event occurring after the balance sheet date. However,
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.9 a
STATEMENTS
no adjustment to assets and liabilities is required as the event does not affect the
determination and the condition of the amounts stated in the financial statements
for the year ended 31st March, 20X1. The disclosure should be made in the
report of the approving authority of those events occurring after the balance
sheet date that represent material changes and commitments affecting the
financial position of the enterprise, the investment of ` 100 lakhs in April, 20X1
for the acquisition of another company should be disclosed in the report of the
Approving Authority to enable users of financial statements to make proper
evaluations and decisions.
Illustration 5
A Limited Company closed its accounting year on 30.6.20X1 and the accounts for
that period were considered and approved by the board of directors on 20th August,
20X1. The company was engaged in laying pipeline for an oil company deep
beneath the earth. While doing the boring work on 1.9.20X1 it had met a rocky
surface for which it was estimated that there would be an extra cost to the tune of
` 80 lakhs. You are required to state with reasons, how the event would be dealt
with in the financial statements for the year ended 30.6.20X1.
Solution
AS 4 (Revised) on Contingencies and Events Occurring after the Balance Sheet
Date defines 'events occurring after the balance sheet date' as 'significant events,
both favourable and unfavourable, that occur between the balance sheet date
and the date on which financial statements are approved by the Board of
Directors in the case of a company'. The given case is discussed in the light of the
above-mentioned definition and requirements given in AS 4 (Revised). In this case
the incidence, which was expected to push up cost, became evident after the date
of approval of the accounts. So it is not an 'event occurring after the balance
sheet date'.
Illustration 6
While preparing its final accounts for the year ended 31st March, 20X1 a company
made a provision for bad debts @ 5% of its total trade receivables. In the last week
of February, 20X1 a trade receivable for ` 2 lakhs had suffered heavy loss due to an
earthquake; the loss was not covered by any insurance policy. In April, 20X1 the
trade receivable became a bankrupt. Can the company provide for the full loss
arising out of insolvency of the trade receivable in the final accounts for the year
ended 31st March, 20X1?
© The Institute of Chartered Accountants of India
7.10
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ADVANCED ACCOUNTING
Solution
As per Accounting Standard 4, Assets and Liabilities should be adjusted for events
occurring after the balance sheet date that provide additional evidence to assist
estimation of amounts relating to conditions existing at the balance sheet date.
So full provision for bad debt amounting to ` 2 lakhs should be made to cover
the loss arising due to the insolvency in the Final Accounts for the year ended 31 st
March, 20X1. It is because earthquake took place before the balance sheet date.
Had the earthquake taken place after 31 st March, 20X1, then this would have been
treated as non-adjusting event and only disclosure required as per AS 4 (Revised),
would have been sufficient.
Illustration 7
Y Ltd. has book debts and has a doubt over recoverability of some of the book
debts. The amount that cannot be recovered is not quantifiable. Thus, Y Ltd. is of
the opinion that provision for doubtful debts should not be created. Y Ltd. creates
provision for certain other expenses on estimated basis.
Whether contention of Y Ltd. is correct?
Solution
As per AS 4, "Contingencies and Events Occurring After the Balance Sheet
Date" if it is likely that a contingency will result in a loss to an entity then it
should create provision for that contingency on the estimated basis.
Based on the above, the contention that provision for doubtful debt is not be
created merely because the amount is not quantifiable is not correct. Hence Y Ltd.
should make provision in the books on the basis of estimation.
Reference: The students are advised to refer the full text of AS 4 (Revised)
“Contingencies and Events occurring after the Balance Sheet Date”.
Pursuant to AS 29 ‘Provisions, Contingent Liabilities and Contingent Assets’, becoming mandatory in respect of
accounting periods commencing on or after 1st April, 2004, all paragraphs of AS 4 (Revised) dealing with
contingencies stand withdrawn except to the extent they deal with impairment of assets not covered by any other
AS. However, as per the Companies (Accounting Standards) Amendment Rules, 2016–30 March 2016, all
paragraphs of this Standard that deal with contingencies are applicable only to the extent
not covered by other Accounting Standards prescribed by the Central Government. For
example, the impairment of financial assets such as impairment of receivables (commonly
known as provision for bad and doubtful debts) is governed by this Standard .
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.11 a
STATEMENTS
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Cash amounting to ` 4 lakhs, stolen by the cashier in the month of March
20X1, was detected in April, 20X1. The financial statements for the year ended
31st March, 20X1 were approved by the Board of Directors on 15th May,
20X1. As per Accounting Standards, this is _____ for the financial statements
year ended on 31st March, 20X1.
(a) An Adjusting event.
(b) Non-adjusting event.
(c) Contingency.
(d) Provision
2. As per Accounting Standards, events occurring after the balance sheet date
are
(a) Only favourable events that occur between the balance sheet date and
the date when the financial statements are approved by the Board of
directors.
(b) Only unfavourable events that occur between the balance sheet date
and the date when the financial statements are approved by the Board
of directors.
(c) Those significant events, both favourable and unfavourable, that occur
between the balance sheet date and the date on which the financial
statements are approved by the Board of directors.
(d) Those significant events, both favourable and unfavourable, that occur
between the balance sheet date and the date on which the financial
statements are not approved by the Board of directors.
© The Institute of Chartered Accountants of India
7.12
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ADVANCED ACCOUNTING
3. AS 4 does not apply to
(a) Obligation under retirement benefit plans.
(b) Commitments arising from long term lease contracts.
(c) liabilities of life assurance and general insurance enterprises arising
from policies issued
(d) All of the above.
4. A Ltd. sold its building for ` 50 lakhs to B Ltd. and has also given the
possession to B Ltd. The book value of the building is ` 30 lakhs. As on 31 st
March, 20X1, the documentation and legal formalities are pending. For the
financial year ended 31 st March, 20X1
(a) The company should record the sale.
(b) The company should recognise the profit of ` 20 lakhs in its profit and
loss account.
(c) Both (a) and (b).
(d) The company should disclose the profit of ` 20 lakhs in notes to
accounts.
Scenario based Questions
5. A Ltd. has sold its building for ` 50 lakhs to B Ltd. and has also given the
possession to B Ltd. The book value of the building is ` 30 lakhs. As on 31 st
March, 20X1, the documentation and legal formalities are pending. The
company has not recorded the sale and has shown the amount received as
advance. Do you agree with this treatment?
6. During the year 20X1-20X2, Raj Ltd. was sued by a competitor for ` 15 lakhs
for infringement of a trademark. Based on the advice of the company's legal
counsel, Raj Ltd. provided for a sum of ` 10 lakhs in its financial statements
for the year ended 31st March, 20X2. On 18th May, 20X2, the Court decided
in favour of the party alleging infringement of the trademark and ordered Raj
Ltd. to pay the aggrieved party a sum of ` 14 lakhs. The financial statements
were prepared by the company's management on 30th April, 20X2, and
approved by the board on 30th May, 20X2.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.13 a
STATEMENTS
ANSWERS/SOLUTION
Answer to the Multiple Choice Questions
1. (a) 2. (c) 3. (d) 4. (c)
Answer to the Scenario based Questions
5. The economic reality and substance of the transaction is that the rights and
beneficial interest in the property has been transferred although legal title
has not been transferred. A Ltd. should record the sale and recognise the
gain of ` 20 lakhs in its profit and loss account. The building should be
derecognized in the financial statements.
6. As per AS 4 (Revised), adjustments to assets and liabilities are required for
events occurring after the balance sheet date that provide additional
information materially affecting the determination of the amounts relating
to conditions existing at the balance sheet date.
In the given case, since Raj Ltd. was sued by a competitor for infringement
of a trademark during the year 20X1-X2 for which the provision was also
made by it, the decision of the Court on 18 th May, 20X2, for payment of the
penalty will constitute as an adjusting event because it is an event occurred
before approval of the financial statements. Therefore, Raj Ltd. should adjust
the provision upward by ` 4 lakhs to reflect the award decreed by the Court
to be paid by them to its competitor.
Had the judgment of the Court been delivered on 1 st June, 20X2, it
would be considered as an event occurring after the approval of the
financial statements which is not covered by AS 4 (Revised). In that
case, no adjustment in the financial statements of 20X1-X2 would have
been required.
© The Institute of Chartered Accountants of India
7.14 ADVANCED ACCOUNTING
UNIT 2: ACCOUNTING STANDARD 5 NET PROFIT OR
LOSS FOR THE PERIOD, PRIOR PERIOD ITEMS AND
CHANGES IN ACCOUNTING POLICIES
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the meaning
and accounting treatment for
♦ Net Profit or Loss for the Period
♦ Extraordinary Items
♦ Profit or Loss from Ordinary Activities
♦ Prior Period Items
♦ Changes in Accounting Estimates
♦ Changes in Accounting Policies.
2.1 INTRODUCTION
The objective of AS 5 is to prescribe the classification and disclosure of certain
items in the statement of profit and loss so that all enterprises prepare and
present such a statement on a uniform basis. This enhances the comparability of
the financial statements of an enterprise over time and with the financial
statements of other enterprises. Accordingly, AS 5 requires the classification and
disclosure of extraordinary and prior period items, and the disclosure of certain
items within profit or loss from ordinary activities. It also specifies the accounting
treatment for changes in accounting estimates and the disclosures to be made in
the financial statements regarding changes in accounting policies.
This Statement does not deal with the tax implications of extraordinary items,
prior period items, changes in accounting estimates, and changes in accounting
policies for which appropriate adjustments will have to be made depending on
the circumstances.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.15
STATEMENTS
2.2 NET PROFIT OR LOSS FOR THE PERIOD
All items of income and expense which are recognized in a period should be
included in the determination of net profit or loss for the period unless an
Accounting Standard requires or permits otherwise.
The net profit or loss for the period comprises the following components, each of
which should be disclosed on the face of the statement of profit and loss:
(a) Profit or loss from ordinary activities
Any activities which are undertaken by an enterprise as part of its business and
such related activities in which the enterprise engages in furtherance of,
incidental to, or arising from, these activities. For example, profit on sale of
merchandise, loss on sale of unsold inventory at the end of the season.
(b) Extraordinary items
Income or expenses that arise from events or transactions that are clearly distinct
from the ordinary activities of the enterprise and, therefore, are not expected to
recur frequently or regularly.
Extraordinary items should be disclosed in the statement of profit and loss as a
part of net profit or loss for the period.
The nature and the amount of each extraordinary item should be separately
disclosed in the statement of profit and loss or in notes to accounts in a manner
that its impact on current profit or loss can be perceived. Whether an event or
transaction is clearly distinct from the ordinary activities of the enterprise is
determined by the nature of the event or transaction in relation to the business
ordinarily carried on by the enterprise rather than by the frequency with which
such events are expected to occur. Therefore, an event or transaction may be
extraordinary for one enterprise but not so for another enterprise because of the
differences between their respective ordinary activities. For example, losses
sustained as a result of an earthquake may qualify as an extraordinary item for
many enterprises. However, claims from policyholders arising from an earthquake
do not qualify as an extraordinary item for an insurance enterprise that insures
against such risks.
© The Institute of Chartered Accountants of India
7.16 ADVANCED ACCOUNTING
Examples of events or transactions that generally give rise to extraordinary items
for most enterprises are:
– attachment of property of the enterprise
– an earthquake
(c) Exceptional items 1
When items of income and expense within profit or loss from ordinary activities
are of such size, nature or incidence that their disclosure is relevant to explain the
performance of the enterprise for the period, the nature and amount of such
items should be disclosed separately.
Circumstances which may give rise to the separate disclosure of items of income
and expense include:
(a) The write-down of inventories to net realisable value as well as the reversal
of such write-downs
(b) A restructuring of the activities of an enterprise and the reversal of any
provisions for the costs of restructuring
(c) Disposals of items of property, plant and equipment
(d) Disposals of long-term investments
(e) Legislative changes having retrospective application
(f) Litigation settlements
(g) Other reversals of provisions
1
There is no such term as ‘exceptional item’ under AS 5 and Schedule III to the Companies Act,
2013, however, the same has been used for better understanding of the requirement. Students
may provide a suitable note in this regard in the examination.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.17
STATEMENTS
Net Profit or Loss for the Period
Ordinary Items
Extra Ordinary Items
Prior Period Items
Changes in Accounting
Estimates
Changes in Accounting
Polices
2.3 PRIOR PERIOD ITEMS
Prior period items are income or expenses which arise in the current period as a
result of errors or omissions in the preparation of the financial statements of one
or more prior periods.
Errors may occur as a result of mathematical mistakes, mistakes in applying
accounting policies, mis-interpretation of facts, or oversight.
The nature and amount of prior period items should be separately disclosed in
the statement of profit and loss in a manner that their impact on the current
profit or loss can be perceived.
Prior period items are generally infrequent in nature and can be distinguished
from changes in accounting estimates. Accounting estimates by their nature are
approximations that may need revision as additional information becomes known.
For example, income or expense recognised on the outcome of a contingency
which previously could not be estimated reliably does not constitute a prior
period item.
Prior period items are normally included in the determination of net profit or loss
for the current period. An alternative approach is to show such items in the
statement of profit and loss after determination of current net profit or loss. In
either case, the objective is to indicate the effect of such items on the current
profit or loss.
© The Institute of Chartered Accountants of India
7.18 ADVANCED ACCOUNTING
Illustration
From the past 5 financial years, an old outstanding balance of `50,000 was still
appearing as sundry creditor in the current year balance sheet of People Ltd. The
company is certain that this amount is not payable due to one or more reasons.
Therefore, it decided to write off the said amount in its current year’s books of
accounts and recognize it as income. The company treated the amount of ` 50,000
written off as a prior period item and made the adjustments accordingly.
The company is of the view that since sundry balances were recognized in the prior
period(s), its related written-off amount should be treated as a prior period item.
Solution
No, the company is not correct in treating the amount written off as a prior
period item. As per AS 5, prior period items are income or expenses which arise in
a current year due to errors or omissions in the preparation of the financial
statements of one or more prior period(s).
Writing off an old outstanding balance in the current year which is appearing in
its books of accounts from the past 5 financial years does not mean that there has
been an error or omission in the preparation of financial statements of prior
period(s). It is just a practice adopted by the company to write off the old
outstanding balances of more than 5 years in its current year books of accounts.
Therefore, the amount written off is not treated as a prior period item.
Hence, adjusting the amount `50,000 written off as a prior period item on the
basis that sundry balances were recognized in prior period(s) is not in line with
AS 5.
2.4 CHANGES IN ACCOUNTING ESTIMATES
An estimate may have to be revised if changes occur in the circumstances based
on which the estimate was made, or as a result of new information, more
experience or subsequent developments. The revision of the estimate, by its
nature, does not bring the adjustment within the definitions of an extraordinary
item or a prior period item.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.19
STATEMENTS
Accounting estimates by their nature are approximations that may need revision
as additional information becomes known. For example, income or expense
recognised on the outcome of a contingency which previously could not be
estimated reliably does not constitute a prior period item.
For example, Sachin purchased a new machine costing ` 10 lacs. Useful life was
taken to be for 10 years, therefore, depreciation was charged at 10% on original
cost each year. After 5 years when carrying amount was ` 5 lacs for the machine,
management realises that machine can work for another 2 years only. In this case
machine will be depreciated by ` 2.5 lacs each year for next 2 years. This is not
an example of prior period item but change in accounting estimate.
In the same example, let us suppose there is no change in useful life of the
machine after 5 years. The management by mistake calculated the depreciation in
the fifth year as 10% of ` 6,00,000 i.e. ` 60,000 instead of ` 1,00,000 and in the
next year i.e. sixth year decides to charge depreciation of ` 1,40,000. In such a
case, ` 1,00,000 would be the depreciation of sixth year and ` 40,000 depreciation
charged by the management in the sixth year will be considered as a prior period
item.
As per AS 10 (Revised), Property, Plant and Equipment, 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 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’.
The effect of a change in an accounting estimate should be included in the
determination of net profit or loss in:
(a) The period of the change, if the change affects the period only; or
(b) The period of the change and future periods, if the change affects both.
For example, a change in the estimate of the amount of bad debts is recognised
immediately and therefore affects only the current period. However, a change in
the estimated useful life of a depreciable asset affects the depreciation in the
current period and in each period during the remaining useful life of the asset.
© The Institute of Chartered Accountants of India
7.20 ADVANCED ACCOUNTING
The effect of a change in an accounting estimate should be classified using the
same classification in the statement of profit and loss as was used previously for
the estimate.
To ensure the comparability of financial statements of different periods, the effect
of a change in an accounting estimate which was previously included in the profit
or loss from ordinary activities is included in the same component of net profit or
loss. The effect of a change in an accounting estimate that was previously
included as an extraordinary item is reported as an extraordinary item.
The nature and amount of a change in an accounting estimate which has a
material effect in the current period, or which is expected to have a material effect
in subsequent periods, should be disclosed. If it is impracticable to quantify the
amount, this fact should be disclosed.
Sometimes, it is difficult to distinguish between a change in an accounting policy
and a change in an accounting estimate. In such cases, the change is treated as a
change in an accounting estimate, with appropriate disclosure.
2.5 CHANGES IN ACCOUNTING POLICIES
Accounting policies are the specific accounting principles and the methods of
applying those principles adopted by an enterprise in the preparation and
presentation of financial statements.
Accounting Policies can be changed only:
• when the adoption of a different accounting policy is required by statute; or
• for compliance with an Accounting Standard; or
• when it is considered that the change would result in a more appropriate
presentation of the financial statements of the enterprise.
The following are not changes in accounting policies:
(a) The adoption of an accounting policy for events or transactions that differ in
substance from previously occurring events or transactions, e.g.,
introduction of a formal retirement gratuity scheme by an employer in place
of ad hoc ex-gratia payments to employees on retirement;
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.21
STATEMENTS
(b) The adoption of a new accounting policy for events or transactions which
did not occur previously or that were immaterial.
Any change in an accounting policy which has a material effect should be
disclosed. The impact of, and the adjustments resulting from, such change, if
material, should be shown in the financial statements of the period in which such
change is made, to reflect the effect of such change. Where the effect of such
change is not ascertainable, wholly or in part, the fact should be indicated. If a
change is made in the accounting policies which has no material effect on the
financial statements for the current period but which is reasonably expected to
have a material effect in later periods, the fact of such change should be
appropriately disclosed in the period in which the change is adopted.
A change in accounting policy consequent upon the adoption of an Accounting
Standard should be accounted for in accordance with the specific transitional provisions,
if any, contained in that Accounting Standard. However, disclosures required by
paragraph 32 of this Standard should be made unless the transitional provisions of any
other Accounting Standard require alternative disclosures in this regard.
Illustration 1
Fuel surcharge is billed by the State Electricity Board at provisional rates. Final bill
for fuel surcharge of ` 5.30 lakhs for the period October, 20X1 to September, 20X7
has been received and paid in February, 20X8. However, the same was accounted in
the year 20X8-X9. Comment on the accounting treatment done in the said case.
Solution
The final bill having been paid in February, 20X8 should have been accounted for
in the annual accounts of the company for the year ended 31st March, 20X8.
However, it seems that as a result of error or omission in the preparation of the
financial statements of prior period i.e., for the year ended 31st March 20X8, this
material charge has arisen in the current period i.e., year ended 31st March, 20X9.
Therefore, it should be treated as 'Prior period item' as per AS 5. As per AS 5,
prior period items are normally included in the determination of net profit or loss
for the current period. An alternative approach is to show such items in the
statement of profit and loss after determination of current net profit or loss. In
either case, the objective is to indicate the effect of such items on the current
profit or loss.
© The Institute of Chartered Accountants of India
7.22 ADVANCED ACCOUNTING
It may be mentioned that it is an expense arising from the ordinary course of
business. Although abnormal in amount or infrequent in occurrence, such an
expense does not qualify an extraordinary item as per AS 5. For better
understanding, the fact that power bill is accounted for at provisional rates billed
by the state electricity board and final adjustment thereof is made as and when
final bill is received may be mentioned as an accounting policy.
Illustration 2
(i) During the year 20X1-20X2, a medium size manufacturing company wrote
down its inventories to net realisable value by ` 5,00,000. Is a separate
disclosure necessary?
(ii) A company signed an agreement with the Employees Union on 1.9.20X2 for
revision of wages with retrospective effect from 30.9.20X1. This would cost the
company an additional liability of ` 5,00,000 per annum. Is a disclosure
necessary for the amount paid in 20X2-X3?
Solution
(i) Although the case under consideration does not relate to extraordinary
item, but the nature and amount of such item may be relevant to users of
financial statements in understanding the financial position and
performance of an enterprise and in making projections about financial
position and performance. AS 5 on ‘Net Profit or Loss for the Period, Prior
Period Items and Changes in Accounting Policies’ states that:
“When items of income and expense within profit or loss from ordinary
activities are of such size, nature or incidence that their disclosure is
relevant to explain the performance of the enterprise for the period, the
nature and amount of such items should be disclosed separately.”
Circumstances which may require separate disclosure of items of income
and expense in accordance with AS 5 include the write-down of inventories
to net realisable value as well as the reversal of such write-downs.
(ii) It is given that revision of wages took place on 1st September, 20X2 with
retrospective effect from 30.9.20X1. Therefore wages payable for the half
year from 1.10.20X2 to 31.3.20X3 cannot be taken as an error or omission in
the preparation of financial statements and hence this expenditure cannot
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.23
STATEMENTS
be taken as a prior period item. Additional wages liability of ` 7,50,000 (for
1½ years @ ` 5,00,000 per annum) should be included in current year’s
wages.
It may be mentioned that additional wages is an expense arising from the
ordinary activities of the company. Such an expense does not qualify as an
extraordinary item. However, as per AS 5, when items of income and
expense within profit or loss from ordinary activities are of such size, nature
or incidence that their disclosure is relevant to explain the performance of
the enterprise for the period, the nature and amount of such items should
be disclosed separately.
Illustration 3
The company finds that the inventory sheets of 31.3.20X1 did not include two pages
containing details of inventory worth ` 14.5 lakhs. State, how you will deal with the
following matters in the accounts of Omega Ltd. for the year ended 31st March,
20X2.
Solution
AS 5 on ‘Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies’, defines Prior Period items as "income or expenses which
arise in the current period as a result of errors or omissions in the preparation of
the financial statements of one or more prior periods”.
Rectification of error in inventory valuation is a prior period item vide AS 5.
Separate disclosure of this item as a prior period item is required as per AS 5.
Illustration 4
Explain whether the following will constitute a change in accounting policy or not
as per AS 5.
(i) Introduction of a formal retirement gratuity scheme by an employer in place
of ad hoc ex-gratia payments to employees on retirement.
(ii) Management decided to pay pension to those employees who have retired
after completing 5 years of service in the organisation. Such employees will
get pension of ` 20,000 per month. Earlier there was no such scheme of
pension in the organisation.
© The Institute of Chartered Accountants of India
7.24 ADVANCED ACCOUNTING
Solution
As per AS 5 ‘Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies’, the adoption of an accounting policy for events or
transactions that differ in substance from previously occurring events or
transactions, will not be considered as a change in accounting policy.
(i) Accordingly, introduction of a formal retirement gratuity scheme by an
employer in place of ad hoc ex-gratia payments to employees on retirement
is not a change in an accounting policy.
(ii) Similarly, the adoption of a new accounting policy for events or transactions
which did not occur previously or that were immaterial will not be treated as
a change in an accounting policy.
Illustration 5
In the current year, A Ltd. changed the depreciation method from the Straight Line
Method (SLM) to Written Down Value (WDV) method. When A Ltd. recomputed
depreciation retrospectively as per the new method, deficiency arose in
depreciation in respect of past years. Therefore, it reduced the carrying amount of
the asset by the amount of deficiency and such change in carrying amount
(deficiency amount) has been debited to the statement of profit and loss as an
extraordinary expense.
Whether the change in the carrying amount of assets due to the change in
depreciation method should be treated as an extraordinary item?
Solution
No.
As per AS 5, "Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies" extraordinary items are income or expenses that arise from
events or transactions that are clearly distinct from the ordinary activities of the
enterprise and, therefore, are not expected to recur frequently or regularly.
A change in the method of charging depreciation is not an event that is clearly
distinct from the ordinary activities of the entity. In the instant case, A Ltd. has
changed the depreciation method and treated the reduction in carrying amount
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.25
STATEMENTS
(or amount of deficiency in depreciation) of the asset as an extraordinary expense.
This is not correct. Such deficiency should be treated as a normal expense.
A change in the estimated useful life of a depreciable asset (i.e. change in
depreciation method) affects the depreciation in the current period and in each
period during the remaining useful life of the asset. In both cases, the effect of
the change relating to the current period is recognised as income or expense in
the current period. The effect, if any, on future periods, is recognised in future
periods.
The change in depreciation method is considered as a change in accounting
estimate as per the provisions of AS 5.
Reference: The students are advised to refer the full text of AS 5” Net Profit or
Loss for the Period, Prior Period Items and Changes in Accounting Policies”.
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. A change in the estimated life of the asset, which necessitates adjustment in
the depreciation is an example of
(a) Prior period item.
(b) Ordinary item.
(c) Extraordinary item.
(d) Change in accounting estimate.
2. Which of the following is considered as an extraordinary item as per AS 5?
(a) Write down or write-off of receivables, inventory and intangible assets.
(b) Gains and losses from sale or abandonment of equipment used in a
business.
(c) Effects of a strike, including those against competitors and major
suppliers.
(d) Flood damage from unusually heavy rain or a normally dry
environment.
© The Institute of Chartered Accountants of India
7.26 ADVANCED ACCOUNTING
3. Which one of the following is an example of extraordinary item?
(a) The write down of inventories to their net realisable value
(b) Reversal of write down of inventories
(c) Government grants become refundable
(d) Reversal of provisions.
4. Extraordinary items are income or expenses
(a) That arise from events clearly distinct from the ordinary activities of the
enterprise.
(b) That are not expected to recur frequently or regularly.
(c) Both (a) and (b).
(d) None of the three.
5. An audit stock verification during the year ended 31st March, 20X1 revealed
that opening stock of the year was understated by ` 5 lakhs due to wrong
counting. While finalizing accounts, your opinion will be
(a) It is not a prior period item and no separate disclosure is required
(b) It should be treated as a prior period adjustment and should be
separately disclosed in the current year’s financial statement
(c) The adjustment of ` 5 lakhs in both opening stock of current year and
profit brought forward from previous year should be made
(d) Both (b) and (c).
Answer to Scenario based Questions
6. A company (Z Ltd.) is engaged in the business of providing consultancy
services. A few days back, it received a notice from GST department raising a
demand of GST on consultancy services provided by it for ` 500,000. Recently
Z Ltd. paid the demand. In the books, the payment is recorded as an
extraordinary expenditure.
Whether payment of tax demand raised by the taxation authority can be
recognised as an extraordinary item?
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.27
STATEMENTS
ANSWERS/SOLUTION
Answer to the Multiple Choice Questions
1. (d) 2. (d) 3. (c) 4. (c) 5. (d)
Answer to the Scenario based Questions
6. No, payment of tax cannot be recognised as an extraordinary item.
As per AS 5, "Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies" an extraordinary item is income or expenses
that arise from events or transactions that are clearly distinct from ordinary
activities of the enterprise and, therefore, are not expected to recur
frequently or regularly.
In the given case, providing consultancy service is an ordinary activity of Z
Ltd. Thus, GST paid pursuant to the demand raised by GST department is
also a part of an ordinary activity of Z Ltd. Recognising such payments as an
extra-ordinary item is contrary to AS 5.
© The Institute of Chartered Accountants of India
7.28 ADVANCED ACCOUNTING
UNIT 3: ACCOUNTING STANDARD 11 THE EFFECTS
OF CHANGES IN FOREIGN EXCHANGE RATES
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the –
♦ Foreign Currency Transactions
• Initial Recognition
• Reporting at Subsequent Balance Sheet Dates
• Recognition of Exchange Differences
♦ Net Investment in a Non-integral Foreign Operation
♦ Classification of Foreign Operations
• Integral Foreign Operations
• Non-integral Foreign Operations
• Disposal of a Non-integral Foreign Operation
• Change in the Classification of a Foreign Operation
• Accounting for Forward Exchange Contracts
• Disclosures
3.1 INTRODUCTION
An enterprise may carry on activities involving foreign exchange in two ways. It
may have transactions in foreign currencies (e.g., export sales in denominated in
USD) or it may have foreign operations (e.g., foreign branch of reporting entity
outside India). At the time of preparing the financial statements, these
transactions and/or operations must be reported by the entity in the reporting
currency i.e., INR. Hence, such foreign currency transactions and foreign
operations should be translated into the reporting currency (i.e., INR) in order to
be included in the financial statements of the entity.
© The Institute of Chartered Accountants of India
7.29 13.29
AS BASED ON ITEMS IMPACTING FINANCIAL
STATEMENTS
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.
(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.
For example, all Indian companies are required to present their financial
statements in INR. Thus, for such entities, INR is the reporting currency.
Alternatively, in case an Indian company is a subsidiary of a company
located in the United States, the parent may require the company to present
the financial statements in USD. In such cases, the company is required to
disclose the reasons for presenting the financial statements in USD (a
currency other than INR, the currency of the place where the company is
domiciled i.e., India).
In both the cases discussed above, it may be pertinent to note that
Accounting Standard 11 does not prescribe the currency to be used to
present the financial statements. However, for all practical purposes (Income
Tax Act, Indirect Tax Requirements etc.), every company domiciled in India
will present financial statements in INR.
(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’.
© The Institute of Chartered Accountants of India
7.30 ADVANCED ACCOUNTING
(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.
Considering the example above, the Indian subsidiary of the US Parent will
present its financial statements in INR for the Indian regulators. However,
since the US parent needs to consolidate the Indian subsidiary, it will
require the Indian company to also restate the INR Financial Statements to
USD. Such restatement is not covered under Accounting Standard 11.
3.2 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, advances for purchase of goods / fixed assets, inventories
and investments in equity shares.
© The Institute of Chartered Accountants of India
7.31 13.31
AS BASED ON ITEMS IMPACTING FINANCIAL
STATEMENTS
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.
3.3 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.
© The Institute of Chartered Accountants of India
7.32 ADVANCED ACCOUNTING
3.4 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.
3.5 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
© The Institute of Chartered Accountants of India
7.33 13.33
AS BASED ON ITEMS IMPACTING FINANCIAL
STATEMENTS
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
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.
© The Institute of Chartered Accountants of India
7.34 ADVANCED ACCOUNTING
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
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.
3.6 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
© The Institute of Chartered Accountants of India
7.35 13.35
AS BASED ON ITEMS IMPACTING FINANCIAL
STATEMENTS
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 items held by the non-integral
foreign operation.
3.7 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.
© The Institute of Chartered Accountants of India
7.36 ADVANCED ACCOUNTING
3.8 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
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).
© The Institute of Chartered Accountants of India
7.37 13.37
AS BASED ON ITEMS IMPACTING FINANCIAL
STATEMENTS
(i) The translation of the financial statements of a non-integral foreign
operation results in the recognition of exchange differences arising from:
1. translating income and expense items at the exchange rates at the
dates of transactions and assets and liabilities at the closing rate;
2. translating the opening net investment in the non-integral foreign
operation at an exchange rate different from that at which it was
previously reported; and
3. other changes to equity in the non-integral foreign operation.
These 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) On the disposal of a non-integral foreign operation, the cumulative amount
of the exchange differences which have been deferred and which relate to
that operation should be recognised as income or as expenses.
(k) 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".
€
MCA amended this paragraph, by notification dated 18 th June, 2018, which is relevant for
companies.
© The Institute of Chartered Accountants of India
7.38 ADVANCED ACCOUNTING
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.
© The Institute of Chartered Accountants of India
7.39 13.39
AS BASED ON ITEMS IMPACTING FINANCIAL
STATEMENTS
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 $15,000 is paid at the rate of ` 73. As per AS 11,
exchange difference on settlement of the account should also be transferred to
Profit and Loss account. Therefore, ` 15,000 (i.e. 11,10,000 – 10,95,000) will be
credited to Profit and Loss account in the year ended 31st March, 20X2.
© The Institute of Chartered Accountants of India
7.40 ADVANCED ACCOUNTING
Illustration 3
Kalim Ltd. borrowed US$ 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
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 31 Foreign Exchange Difference Account Dr. 4,50,000
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
3.9 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.
© The Institute of Chartered Accountants of India
7.41 13.41
AS BASED ON ITEMS IMPACTING FINANCIAL
STATEMENTS
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.
3.10 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.
3.11 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 01st Feb. was ` 48.85. How will
you recognise the profit or loss on forward contract in the books of Rau Ltd.?
© The Institute of Chartered Accountants of India
7.42 ADVANCED ACCOUNTING
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.
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
© The Institute of Chartered Accountants of India
7.43 13.43
AS BASED ON ITEMS IMPACTING FINANCIAL
STATEMENTS
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
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 realizable value is translated applying exchange rate
when realizable 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’.
© The Institute of Chartered Accountants of India
7.44 ADVANCED ACCOUNTING
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
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
© The Institute of Chartered Accountants of India
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STATEMENTS
Solution
Trial Balance of the Foreign Branch converted into Indian Rupees as on
March 31, 20X4
Particulars £ (Dr.) £ (Cr.) Conversion Basis ` (Dr.) ` (Cr.)
Transaction date
Machinery 5,000 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
3.12 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.
© The Institute of Chartered Accountants of India
7.46 ADVANCED ACCOUNTING
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.
3.13 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 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.
© The Institute of Chartered Accountants of India
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STATEMENTS
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.
Illustration 9
A Ltd. has borrowed USD 10,000 in foreign currency on April 1, 20X1 at 5% p.a.
annual interest and acquired a depreciable asset. The exchange rates are as under:
01/04/20X1 1 US$ = ` 48.00
31/03/20X2 1 US$ = ` 51.00
You are required to pass the journal entries in the following cases:
(i) Option under Para 46A is not availed.
(ii) Option under Para 46A is availed.
(iii) The loan was taken to finance the operations of the entity (and not to procure
a depreciable asset).
In all cases, assume interest accrued on 31 March 20X2 is paid on the same date.
© The Institute of Chartered Accountants of India
7.48 ADVANCED ACCOUNTING
Solution
Journal Entries in the Books of A Ltd.
(i) Option under Para 46A is not availed
Date Particulars ` (Dr.) ` (Cr.)
20X1
Apr. 01 Bank Account (10,000 x 48) Dr. 4,80,000
To Foreign Loan Account 4,80,000
Mar 31 Finance Cost (USD 10,000 x 5% x ` 51) 25,500
To Bank Account 25,500
Mar 31 Foreign Exchange Difference Account (P/L) Dr. 30,000
To Foreign Loan Account [10,000 x (51-48)] 30,000
In this case, since the option under Para 46A is NOT availed, the Exchange Loss of
` 30,000 is recognised as an expense in the Statement of Profit and Loss for the
year ending 31 March 20X2.
(ii) Option under Para 46A is availed
Date Particulars ` (Dr.) ` (Cr.)
20X1
Apr. 01 Bank Account (10,000 x 48) Dr. 4,80,000
To Foreign Loan Account 4,80,000
Mar 31 Finance Cost (USD 10,000 x 5% x ` 51) 25,500
To Bank Account 25,500
Mar 31 Foreign Exchange Difference Account Dr. 30,000
To Foreign Loan Account [10,000 x (51-48)] 30,000
Mar 31 Property, Plant and Equipment Dr. 30,000
To Foreign Exchange Difference Account 30,000
© The Institute of Chartered Accountants of India
7.49 13.49
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In this case, since the option under Para 46A is availed, the Exchange Loss
of ` 30,000 is capitalized in the cost of Property, Plant and Equipment,
which will indirectly get recognized in the Profit & Loss A/c by way of
increased depreciation over the remaining useful life of the asset.
(iii) Option under Para 46A is availed
Date Particulars ` (Dr.) ` (Cr.)
20X1
Apr. 01 Bank Account (10,000 x 48) Dr. 4,80,000
To Foreign Loan Account 4,80,000
Mar 31 Finance Cost (USD 10,000 x 5% x ` 51) 25,500
To Bank Account 25,500
Mar 31 Foreign Exchange Difference Account Dr. 30,000
To Foreign Loan Account [10,000 x (51-48)] 30,000
Mar 31 Foreign Currency Monetary Item Translation 30,000
Difference A/c (FCMITDA) Dr.
To Foreign Exchange Difference Account 30,000
In this case, since the option under Para 46A is availed, the Exchange Loss of
` 30,000 is accumulated in the FCMITD A/c, which will be subsequently spread
over and debited to P&L A/c over the tenure of the loan.
Reference: The students are advised to refer the full text of AS 11 “The Effects
of Changes in Foreign Exchange Rates”.
© The Institute of Chartered Accountants of India
7.50 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. As per AS 11 assets and liabilities of non-integral foreign operations should
be converted at __________ rate.
(a) Opening
(b) Average
(c) Closing
(d) Transaction
2. 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” in the Balance Sheet
(d) Is shown as “Current Assets” in the Balance Sheet
3. 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
(d) Opening exchange rate
4. Which of the following can be classified as an integral foreign operation?
(a) Branch office serving as an extension of the head office in terms of
operations
(b) Independent subsidiary of the parent company
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STATEMENTS
(c) Branch office independent of the head office in terms of operational
decisions
(d) None of the above
5. Which of the following items should be converted to closing rate for the
purposes of financial reporting?
(a) Items of Property, Plant and Equipment
(b) Inventory
(c) Trade Payables, Trade Receivables and Foreign Currency Borrowings
(d) All of the above
Theoretical Questions
6. Explain “monetary item” as per Accounting Standard 11. How are foreign
currency monetary items to be recognized at each Balance Sheet date?
7. Distinguish Non-Integral Foreign Operation (NFO) with Integral Foreign
Operation (IFO) as per AS 11.
Scenario based Questions
8. 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.
ANSWERS/SOLUTION
Answer to the Multiple Choice Questions
1. (c) 2. (b) 3. (c) 4. (a) 5. (c)
© The Institute of Chartered Accountants of India
7.52 ADVANCED ACCOUNTING
Answer to the Theoretical Questions
6. 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 realized 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 realized from or required to disburse, such
item at the balance sheet date.
7. 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.
Answer to the Scenario based Questions
8. 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
© The Institute of Chartered Accountants of India
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STATEMENTS
reported in previous financial statements, in so far 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 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.
Trade receivables Foreign `
Currency Rate
Initial recognition US $8,547 1 US $ = ` 58.50 5,00,000
(5,00,000/58.50)
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 $ 6,04,317
1,07,913.67 X (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.
© The Institute of Chartered Accountants of India
7.54 ADVANCED ACCOUNTING
UNIT 4: ACCOUNTING STANDARD 22
ACCOUNTING FOR TAXES ON INCOME
LEARNING OUTCOMES
After studying this chapter, you will be able to comprehend the:
♦ What is the Objective of AS 22
♦ What is the Recognition criteria for Deferred Tax
♦ Re-assessment of Unrecognised Deferred Tax Assets
♦ Measurement of Deferred Tax
♦ Review of Deferred Tax Assets
♦ Presentation and Disclosure
♦ Solve the practical problems based on application of Accounting
Standards.
4.1 INTRODUCTION
This standard prescribes the accounting treatment of taxes on income and follows
the concept of matching expenses against revenue for the period. The concept of
matching is more peculiar in cases of income taxes since in a number of cases, the
taxable income may be significantly different from the income reported in the
financial statements due to the difference in treatment of certain items under
taxation laws and the way it is reflected in accounts.
4.2 OBJECTIVE
Matching of such taxes against revenue for a period poses special problems
arising from the fact that in a number of cases, taxable income may be
significantly different from the accounting income. This divergence between
taxable income and accounting income arises due to two main reasons.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.55
STATEMENTS
Firstly, there are differences between items of revenue and expenses as appearing
in the statement of profit and loss and the items which are considered as revenue,
expenses or deductions for tax purposes.
Secondly, there are differences between the amount in respect of a particular
item of revenue or expense as recognised in the statement of profit and loss and
the corresponding amount which is recognised for the computation of taxable
income.
4.3 DEFINITIONS
Accounting income (loss) is the net profit or loss for a period, as reported in the
statement of profit and loss, before deducting income-tax expense or adding
income tax saving.
Taxable income (tax loss) is the amount of the income (loss) for a period,
determined in accordance with the tax laws, based upon which income-tax
payable (recoverable) is determined.
Tax expense (tax saving) is the aggregate of current tax and deferred tax
charged or credited to the statement of profit and loss for the period.
Current Tax + Deferred Tax = Tax expense (Tax saving)
Current tax is the amount of income tax determined to be payable (recoverable)
in respect of the taxable income (tax loss) for a period.
Deferred tax is the tax effect of timing differences.
The differences between taxable income and accounting income can be classified
into permanent differences and timing differences.
Timing differences are the differences between taxable income and accounting
income for a period that originate in one period and are capable of reversal in
one or more subsequent periods.
For example, machinery purchased for scientific research related to business is
fully allowed as deduction in the first year for tax purposes whereas the same
would be charged to the statement of profit and loss as depreciation over its
useful life. The total depreciation charged on the machinery for accounting
purposes and the amount allowed as deduction for tax purposes will ultimately be
© The Institute of Chartered Accountants of India
7.56 ADVANCED ACCOUNTING
the same, but periods over which the depreciation is charged and the deduction
is allowed will differ. This may lead to recognition of deferred tax in the books.
Permanent differences are the differences between taxable income and
accounting income for a period that originate in one period and do not reverse
subsequently. Generally permanent differences leads to increase in current tax &
have no impact on Deferred Tax.
For Example, XYZ has been charged with the fine on the late payment of the tax
amount due to authorities. This would be considered as an expense in the profit
and loss account, however this is specifically a disallowed expense for
computation of taxable income. This will be treated as permanent difference as
this difference will never reverse.
4.4 RECOGNITION
Tax expense for the period, comprising current tax and deferred tax, should be
included in the determination of the net profit or loss for the period.
Taxes on income are considered to be an expense incurred by the enterprise in
earning income and are accrued in the same period as the revenue and expenses
to which they relate. Such matching may result into timing differences. The tax
effects of timing differences are included in the tax expense in the statement of
profit and loss and as deferred tax assets or as deferred tax liabilities, in the
balance sheet.
While recognising the tax effect of timing differences, consideration of prudence
cannot be ignored. Therefore, deferred tax assets are recognised and carried
forward only to the extent that there is a reasonable certainty of their realisation.
This reasonable level of certainty would normally be achieved by examining the
past record of the enterprise and by making realistic estimates of profits for the
future. Where an enterprise has unabsorbed depreciation or carry forward of
losses under tax laws, deferred tax assets should be recognised only to the extent
that there is virtual certainty supported by convincing evidence that sufficient
future taxable income will be available against which such deferred tax assets can
be realised.
Permanent differences do not result in deferred tax assets or deferred tax
liabilities.
© The Institute of Chartered Accountants of India
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STATEMENTS
4.5 MEASUREMENT
Current tax should be measured at the amount expected to be paid to (recovered
from) the taxation authorities, using the applicable tax rates and tax laws.
Deferred tax assets and liabilities are usually measured using the tax rates and tax
laws that have been enacted by the balance sheet date.
However, certain announcements of tax rates and tax laws by the government
may have the substantive effect of actual enactment. In these circumstances,
deferred tax assets and liabilities are measured using such announced tax rate
and tax laws.
Deferred tax assets and liabilities should not be discounted to their present
value.
4.6 RE-ASSESSMENT OF UNRECOGNISED
DEFERRED TAX ASSETS
At each balance sheet date, an enterprise re-assesses unrecognised deferred tax
assets. The enterprise recognises previously unrecognised deferred tax assets to
the extent that it has become reasonably certain or virtually certain, as the case
may be, that sufficient future taxable income will be available against which such
deferred tax assets can be realised.
4.7 REVIEW OF PREVIOUSLY RECOGNISED
DEFERRED TAX ASSETS
The carrying amount of deferred tax assets should be reviewed at each balance
sheet date. An enterprise should write-down the carrying amount of a deferred
tax asset to the extent that it is no longer reasonably certain or virtually certain, as
the case may be, that sufficient future taxable income will not be available against
which deferred tax asset can be realised. Any such write-down may be reversed to
the extent that it becomes reasonably certain or virtually certain, as the case may
be, that sufficient future taxable income will be available.
© The Institute of Chartered Accountants of India
7.58 ADVANCED ACCOUNTING
4.8 Virtual certainty supported by
CONVINCING EVIDENCE
Determination of virtual certainty that sufficient future taxable income will be
available is a matter of judgement and will have to be evaluated on a case-to-
case basis. Virtual certainty refers to the extent of certainty, which, for all practical
purposes, can be considered certain. Virtual certainty cannot be based merely on
forecasts of performance such as business plans. Virtual certainty is not a matter
of perception and it should be supported by convincing evidence. Evidence is a
matter of fact. To be convincing, the evidence should be available at the reporting
date in a concrete form, for example, a profitable binding export order,
cancellation of which will result in payment of heavy damages by the defaulting
party. On the other hand, a projection of the future profits made by an enterprise
based on the future capital expenditures or future restructuring etc., submitted
even to an outside agency, e.g., to a credit agency for obtaining loans and
accepted by that agency cannot, in isolation, be considered as convincing
evidence.
4.9 DISCLOSURE
Statement of profit and loss
Under AS 22, there is no specific requirement to disclose current tax and deferred
tax in the statement of profit and loss. However, considering the requirements
under the Companies Act, 2013, the amount of income tax and other taxes on
profits should be disclosed.
AS 22 does not require any reconciliation between accounting profit and the tax
expense.
Balance sheet
The break-up of deferred tax assets and deferred tax liabilities into major
components of the respective balance should be disclosed in the notes to
accounts.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.59
STATEMENTS
Deferred tax assets and liabilities should be distinguished from assets and
liabilities representing current tax for the period. Deferred tax assets and liabilities
should be disclosed under a separate heading in the balance sheet of the
enterprise, separately from current assets and current liabilities.
The nature of the evidence supporting the recognition of deferred tax assets
should be disclosed, if an enterprise has unabsorbed depreciation or carry
forward of losses under tax laws.
An enterprise should offset assets and liabilities representing current tax if the
enterprise:
a. Has a legally enforceable right to set off the recognised amounts and
b. Intends to settle the asset and the liability on a net basis.
An enterprise should offset deferred tax assets and deferred tax liabilities if:
a. The enterprise has a legally enforceable right to set off assets against
liabilities representing current tax; and
b. The deferred tax assets and the deferred tax liabilities relate to taxes on
income levied by the same governing taxation laws.
4.10 RELEVANT EXPLANATIONS TO AS 22
Accounting for Taxes on Income in the situations of Tax Holiday under
sections 80-IA and 80-IB of the Income Tax Act, 1961
The deferred tax in respect of timing differences which reverse during the tax
holiday period should not be recognised to the extent the enterprise’s gross total
income is subject to the deduction during the tax holiday period as per the
requirements of the Act. Deferred tax in respect of timing differences which
reverse after the tax holiday period should be recognised in the year in which the
timing differences originate. However, recognition of deferred tax assets should
be subject to the consideration of prudence as laid down in AS 22.
For the above purposes, the timing differences which originate first should be
considered to reverse first.
© The Institute of Chartered Accountants of India
7.60 ADVANCED ACCOUNTING
Accounting for Taxes on Income in the situations of Tax Holiday under
sections 10A and 10B of the Income Tax Act, 1961
The deferred tax in respect of timing differences which originate during the tax
holiday period and reverse during the tax holiday period, should not be
recognised to the extent deduction from the total income of an enterprise is
allowed during the tax holiday period as per the provisions of sections 10A and
10B of the Act. Deferred tax in respect of timing differences which originate
during the tax holiday period but reverse after the tax holiday period should be
recognised in the year in which the timing differences originate. However,
recognition of deferred tax assets should be subject to the consideration of
prudence as laid down in AS 22.
For the above purposes, the timing differences which originate first should be
considered to reverse first.
Accounting for Taxes on Income in the context of section 115JB of the
Income Tax Act, 1961
The payment of tax under section 115JB of the Act is a current tax for the period.
In a period in which a company pays tax under section 115JB of the Act, the
deferred tax assets and liabilities in respect of timing differences arising during
the period, tax effect of which is required to be recognised under AS 22, should
be measured using the regular tax rates and not the tax rate under section 115JB
of the Act. In case an enterprise expects that the timing differences arising in the
current period would reverse in a period in which it may pay tax under section
115JB of the Act, the deferred tax assets and liabilities in respect of timing
differences arising during the current period, tax effect of which is required to be
recognised under AS 22, should be measured using the regular tax rates and not
the tax rate under section 115JB of the Act.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.61
STATEMENTS
Illustration 1
Rama Ltd., has provided the following information:
`
Depreciation as per accounting records = 2,00,000
Depreciation as per income tax records = 5,00,000
Unamortised preliminary expenses as per tax record = 30,000
There is adequate evidence of future profit sufficiency. How much net deferred tax
asset/liability should be recognised as transition adjustment? Tax rate 50%.
Solution
Table showing calculation of deferred tax asset / liability
Particulars Amount Timing Deferred Amount
differences tax @ 50%
` `
Excess depreciation as per tax 3,00,000 Timing Deferred 1,50,000
records (` 5,00,000 – ` 2,00,000) tax liability
Unamortised preliminary 30,000 Timing Deferred
expenses as per tax records tax asset (15,000)
Net deferred tax liability 1,35,000
Illustration 2
From the following details of A Ltd. for the year ended 31-03-20X1, calculate the
deferred tax asset/ liability as per AS 22 and amount of tax to be debited to the
Profit and Loss Account for the year.
Particulars `
Accounting Profit 6,00,000
Book Profit as per MAT 3,50,000
Profit as per Income Tax Act 60,000
Tax rate 20%
MAT rate 7.50%
© The Institute of Chartered Accountants of India
7.62 ADVANCED ACCOUNTING
Solution
Tax as per accounting profit 6,00,000×20% = ` 1,20,000
Tax as per Income-tax Profit 60,000×20% = ` 12,000
Tax as per MAT 3,50,000×7.50% = ` 26,250
Tax expense= Current Tax +Deferred Tax
` 1,20,000 = ` 12,000+ Deferred tax
Therefore, Deferred Tax liability as on 31-03-20X1
= ` 1,20,000 – ` 12,000 = ` 1,08,000
Amount of tax to be debited in Profit and Loss account for the year 31-03-20X1
Current Tax + Deferred Tax liability + Excess of MAT over current tax
= ` 12,000 + ` 1,08,000 + ` 14,250 (26,250 – 12,000) = ` 1,34,250
Illustration 3
PQR Ltd.'s accounting year ends on 31st March. The company made a loss of
` 2,00,000 for the year ending 31.3.20X1. For the years ending 31.3.20X2 and
31.3.20X3, it made profits of ` 1,00,000 and ` 1,20,000 respectively. It is assumed
that the loss of a year can be carried forward for eight years and tax rate is 40%. By
the end of 31.3.20X1, the company feels that there will be sufficient taxable income
in the future years against which carry forward loss can be set off. There is no
difference between taxable income and accounting income except that the carry
forward loss is allowed in the years ending 20X2 and 20X3 for tax purposes. Prepare
a statement of Profit and Loss for the years ending 20X1, 20X2 and 20X3.
Solution
Statement of Profit and Loss
31.3.20X1 31.3.20X2 31.3.20X3
` ` `
Profit (Loss) (2,00,000) 1,00,000 1,20,000
Less: Current tax (20,000 x 40%) (8,000)
Deferred tax:
Tax effect of timing differences 80,000
originating during the year (2,00,000 x
40%)
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.63
STATEMENTS
Tax effect of timing differences
reversed/adjusted during the year (40,000) (40,000)
(1,00,000 x 40%)
Profit (Loss) After Tax Effect (1,20,000) 60,000 72,000
Illustration 4
Omega Limited is working on different projects which are likely to be completed
within 3 years period. It recognises revenue from these contracts on percentage of
completion method for financial statements during 20X0-20X1, 20X1-20X2 and
20X2-20X3 for ` 11,00,000, ` 16,00,000 and ` 21,00,000 respectively. However, for
Income-tax purpose, it has adopted the completed contract method under which it
has recognised revenue of ` 7,00,000, ` 18,00,000 and ` 23,00,000 for the years
20X0-20X1, 20X1-20X2 and 20X2-20X3 respectively. Income-tax rate is 35%.
Compute the amount of deferred tax asset/liability for the years 20X0-20X1, 20X1-
20X2 and 20X2-20X3.
Solution
Calculation of Deferred Tax Asset/Liability in Omega Limited
Year Accounting Taxable Timing Timing Deferred Deferred
Income Income Difference Difference Tax Tax
(balance) Liability
(balance)
20X0- 11,00,000 7,00,000 4,00,000 4,00,000 1,40,000 1,40,000
20X1
20X1- 16,00,000 18,00,000 (2,00,000) 2,00,000 (70,000) 70,000
20X2
20X2- 21,00,000 23,00,000 (2,00,000) NIL (70,000) NIL
20X3
48,00,000 48,00,000
Reference: The students are advised to refer the full text of AS 22 “Accounting
for Taxes on Income”
© The Institute of Chartered Accountants of India
7.64 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. As per AS 22 on ‘Accounting for Taxes on Income’, tax expense is:
(a) Current tax + deferred tax charged to profit and loss account
(b) Current tax-deferred tax credited to profit and loss account
(c) Either (a) or (b)
(d) Deferred tax charged to profit and loss account
2. G Ltd. has provided the following information:
Depreciation as per accounting records = ` 2,00,000
Depreciation as per tax records = ` 5,00,000
There is adequate evidence of future profit sufficiency.
How much deferred tax asset/liability should be recognized as transition
adjustment when the tax rate is 45%?
(a) Deferred Tax asset = ` 2,70,000.
(b) Deferred Tax asset = ` 1,35,000.
(c) Deferred Tax Liability = ` 2,70,000
(d) Deferred Tax Liability = ` 1,35,000.
3. State which of the followings statements are correct:
(1) There are no pre-conditions required to recognize deferred tax liability,
(2) Deferred tax asset under all circumstances can only be created if and
only if there is reasonable certainty that future taxable income will
arise.
(a) Both are correct.
(b) Only (1) is correct.
(c) Only (2) is correct.
(d) None of the statements are correct.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.65
STATEMENTS
4. Which of the following statement are incorrect:
(a) Only timing differences result in creation of deferred tax.
(b) Permanent differences do not result in recognition of deferred tax.
(c) The tax rate used for measurement of deferred tax is substantively
enacted tax rate.
(d) The entity has to recognize deferred tax liability/asset arising out of
timing difference. There are no conditions which are required to
evaluated for their recognition.
Theoretical Questions
5. Write short note on Timing differences and Permanent differences as per AS
22.
Scenario based Questions
6. Y Ltd. is a full tax free enterprise for the first ten years of its existence and is
in the second year of its operation. Depreciation timing difference is INR 200
lakhs and INR 400 lakhs respectively which will result in a tax liability in year
1 and 2. From the third year it is expected that the timing difference would
reverse each year by INR 10 lakhs. Assuming tax rate of 40%, find out the
deferred tax liability at the end of the second year and any charge to the
Profit and Loss account.
7. Ultra Ltd. has provided the following information:
Depreciation as per accounting records =INR 4,00,000
Depreciation as per tax records =INR 10,00,000
Unamortized preliminary expenses as per tax record = INR 30,000
There is adequate evidence of future profit sufficiency. How much deferred tax
asset/liability should be recognized as transition adjustment when the tax
rate is 50%?
8. Saras Ltd. closes its books as on 31st March 20X2. They have accrued
` 5,00,000 towards GST Liability for the month of March 20X2 by debiting
their Profit and loss statement which is expected to be paid off by 21st April
© The Institute of Chartered Accountants of India
7.66 ADVANCED ACCOUNTING
20X2 . As per the provisions of Section 43B of the Income Tax Act, 1961 – Any
expenditure of the nature mentioned in section 43B (e.g. taxes, duty, cess,
fees, etc.) accrued in the statement of profit and loss on mercantile basis will
be allowed for tax purposes in subsequent years on payment basis only.
Assuming a Tax rate of 30% determine the Deferred Tax Asset/Liability as at
31st March 20X2.
9. ABC Company limited had an investment in Venture Capital amounting ` 10
Crores. Venture capital in turn had invested in the below portfolio companies
(New Start- ups) on behalf of ABC Limited:
Amount of investment
Portfolio Companies (` in Crores)
Oscar Limited 2
Zee Limited 3
Star Limited 4
Sony Limited 1
Total 10
During the FY 2019-2020, Venture Capital had sold their investment in Star
Limited and realised an amount of ` 8 Crores on sale of shares of star Limited
and entire proceeds of ` 8 Crores have been transferred by Venture Capital to
ABC Company Limited.
The accounts manager has received the following additional information from
venture capital on 31.03.2020:
(1) 8 Crores has been deducted from the cost of investment and carrying
amount of investment as at year end is 2 Crores.
(2) Company had to pay a capital gain tax @ 20% on the net sale
consideration of ` 4 Crores.
(3) Due to COVID-19, the remaining start- ups (i.e. Oscar Limited, Zee
Limited, and Sony Limited) are not performing well and will soon wind
up their operations. Venture capital is monitoring the situation and if
required they will provide an impairment loss in June 2020 Quarter.
You need to suggest the accounts manager what should be the correct
accounting treatment as per AS 22 “Accounting for Taxes on Income”.
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.67
STATEMENTS
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (c) 2. (d) 3. (a) 4. (d)
Answer to the Theoretical Questions
5. In current practices, companies, in general, prepare books of accounts as
per Companies Act, 2013 generating Accounting Profit/Loss and Income-tax
Act, 1961 generating Taxable Profit/Loss. Accounting income and taxable
income for a period are seldom the same. Permanent differences are those
which arise in one period and do not reverse subsequently. For e.g., an
income exempt from tax or an expense that is not allowable as a deduction
for tax purposes. Timing differences are those which arise in one period and
are capable of reversal in one or more subsequent periods. For e.g.,
Depreciation etc.
Answer to the Scenario based Questions
6. As per AS 22, ‘Accounting for Taxes on Income’, deferred tax in respect of
timing differences which originate during the tax holiday period and reverse
during the tax holiday period, should not be recognised to the extent
deduction from the total income of an enterprise is allowed during the tax
holiday period as per the provisions of sections 10A and 10B of the Income-
tax Act. Deferred tax in respect of timing differences which originate during
the tax holiday period but reverse after the tax holiday period should be
recognised in the year in which the timing differences originate. However,
recognition of deferred tax assets should be subject to the consideration of
prudence. For this purpose, the timing differences which originate first
should be considered to reverse first.
Out of 200 lakhs timing difference due to depreciation, difference
amounting 80 lakhs (10 lakhs x 8 years) will reverse in the tax holiday period
and therefore, should not be recognised. However, for 120 lakhs (200 lakhs
– ` 80 lakhs), deferred tax liability will be recognised for 48 lakhs (40% of
120 lakhs) in first year. In the second year, the entire amount of timing
difference of ` 400 lakhs will reverse only after tax holiday period and
© The Institute of Chartered Accountants of India
7.68 ADVANCED ACCOUNTING
hence, will be recognised in full. Deferred tax liability amounting 160 lakhs
(40% of 400 lakhs) will be created by charging it to profit and loss account
and the total balance of deferred tax liability account at the end of second
year will be 208 lakhs (48 lakhs + 160 lakhs).
7. Calculation of difference between taxable income and
accounting income
Particulars Amount (` )
Excess depreciation as per tax ` (10,00,000 – 4,00,000) 6,00,000
Less: Expenses unamortized in tax records (30,000)
Timing difference 5,70,000
Tax expense is more than the current tax due to timing difference.
Therefore deferred tax liability = 50% x 5,70,000 = 2,85,000
8. Calculation of difference between taxable income and
accounting income
Particulars Amount
(`)
GST Liability debited in books 5,00,000
Less: GST Liability allowed under Income Tax Act (Section 43B) Nil
Timing difference 5,00,000
Tax expense is less than the current tax due to timing difference.
Therefore, deferred tax Asset = 30% x 5,00,000 = 1,50,000
9. As company had to pay capital gain tax @ 20% on the net sale
consideration as per income tax laws, the company has to recognise a
current tax liability of 0.8 Crores computed as under:
Particulars Amount (` in Crores)
Sales Consideration 8
Cost of Investment 4
Net gain on Sale 4
Tax @ 20% 0.8
© The Institute of Chartered Accountants of India
AS BASED ON ITEMS IMPACTING FINANCIAL 7.69
STATEMENTS
As per AS 22, Timing differences are those differences between taxable
income and accounting income for a period that originate in one period and
are capable of reversal in one or more subsequent periods.
Particulars Amount (` in Crores) Rationale
Taxable Income 4 As per income tax laws
Accounting Nil As the same is deducted
Income from the cost of investment
Timing Difference 4
As per AS 22, deferred tax assets should be recognised and carried forward
only to the extent that there is a reasonable certainty that sufficient future
taxable income will be available against which such deferred tax assets can
be realised.
Since in current scenario, due to Covid 19 the portfolio companies are not
performing well, thus the company may not have sufficient future taxable
income which will reverse deferred tax assets. Therefore, the company
should not recognise DTA of ` 0.8 Crores and company should recognise
only current tax liability of ` 0.8 Crores.
© The Institute of Chartered Accountants of India
© The Institute of Chartered Accountants of India
*
CHAPTER
CHAPTER a
8
REVENUE BASED
ACCOUNTING
STANDARDS
UNIT 1 : ACCOUNTING STANDARD 7
CONSTRUCTION CONTRACTS
LEARNING OUTCOMES
❑
After studying this unit, you will be able to comprehend the provisions
of AS 7 related with:
Introduction and Scope of Construction Contract
Combining and Segmenting Construction Contracts
What is included in Contract Revenue
What is included and excluded in Contract Costs
Recognition of Contract Revenue and Expenses
Recognition of Expected Losses
Changes in Estimates
Disclosures.
© The Institute of Chartered Accountants of India
8.2 ADVANCED ACCOUNTING
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1.1 SIGNIFICANCE OF THE STANDARD
The need to have a standard for construction contracts and their accounting
arises since the construction contracts generally cover more than one accounting
period. Common examples of construction include construction of flyovers, dams,
metro line, buildings etc. For example, if entity XY submits a tender to construct a
flyover for a state government, the construction of that flyover might take 2 to 3
years of time, depending on the scope of the contract. This standard addresses
the requirements for recognition & measurement (i.e., the timing and amount) of
construction revenue and construction costs.
Work in Progress
Start of construction End of construction
(Year 1) (Year 3)
The entity that is required to complete the construction is referred to as
Contractor and the customer who requires the construction to be completed is
referred to as Contractee/Customer.
Takes more than one
accounting year to
complete
Final outcome
determined after
Long term Peculiar no. of years from
projects Features of year of
Construction commencement of
construction
contracts
Allocation of contract
revenue and contract cost
tothe accounting period in
which construction work is
performed
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.3
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The above discussion clearly indicates that there are two parties to the
construction contract. Thus, if there is an entity which requires its engineering
division to construct a machine for the production division, this would not meet
the scope of AS 7. It will be addressed by AS 10 (Property, plant and equipment)
and will be accounted as a case of self-constructed asset.
1.2 INTRODUCTION
Accounting Standard 7 prescribes the principles of accounting for construction
contracts in the financial statements of contractors. The focus of the standard is
to determine when the contractor should recognise contract revenue and contract
costs in the statement of profit and loss.
A construction contract is a contract specifically negotiated for the construction
of an asset or a combination of assets that are closely interrelated or
interdependent in terms of their design, technology and function or their ultimate
purpose or use.
A construction contract may be negotiated for the construction of a single asset
such as a bridge, building, dam, pipeline, road, ship or tunnel. A construction
contract may also deal with the construction of a number of assets which are
closely interrelated or interdependent in terms of their design, technology and
function or their ultimate purpose or use; examples of such contracts include
those for the construction of refineries and other complex pieces of plant or
equipment.
For the purposes of this Standard, construction contracts also include:
(a) contracts for the rendering of services which are directly related to the
construction of the asset, for example, those for the services of project
managers and architects; and
(b) contracts for destruction or restoration of assets, and the restoration of the
environment following the demolition of assets.
© The Institute of Chartered Accountants of India
8.4 ADVANCED ACCOUNTING
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What are construction
Contracts?
Contracts specifically
Contracts for
negotiated for the Contracts for
rendering of services
construction of an asset or destruction or
related to
combination of assets that restoration of assets.
construction of assets
are closely interrelated
Example 1
Entity XY contracts with AB to construct 2 residential buildings in the same
premises. The construction of both buildings will begin simultaneously. Building
material, construction work, and other related activities will go on in parallel to
provide cost savings to entity XY. This also helps AB achieve a timely completion of
the two buildings and negotiate a consolidated price for the two buildings.
The above example suggests that there is a single contract negotiated to construct
two buildings that are closely interrelated and interdependent in terms of their
ultimate purpose and use. Therefore, this represents a Construction Contract.
Example 2
H, a sole-proprietor, contracts with M/s DM Construction, to dismantle his office
premises and construct it from scratch.
In the given case, the construction contract includes both demolition as well as
construction of a new building.
1.3 COMBINING AND SEGMENTING
CONSTRUCTION CONTRACTS
A contractor may undertake a number of contracts.
The standard identifies certain cases where for the purposes of accounting, it is
necessary to apply the Standard to the separately identifiable components of a
single contract or to a group of contracts together in order to reflect the
substance of a contract or a group of contracts.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.5
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(a) When a contract covers a number of assets, the construction of each asset
should be treated as a separate construction contract when:
(i) separate proposals have been submitted for each asset;
(ii) each asset has been subject to separate negotiation and the
contractor and customer have been able to accept or reject that part of the
contract relating to each asset; and
(iii) the costs and revenues of each asset can be identified.
(b) A group of contracts, whether with a single customer or with several
customers, should be treated as a single construction contract when:
(i) the group of contracts is negotiated as a single package;
(ii) the contracts are so closely interrelated that they are, in effect, part of
a single project with an overall profit margin; and
(iii) the contracts are performed concurrently or in a continuous sequence.
(c) A contract may provide for the construction of an additional asset at the
option of the customer or may be amended to include the construction of
an additional asset. The construction of the additional asset should be
treated as a separate construction contract when:
(i) the asset differs significantly in design, technology or function from
the asset or assets covered by the original contract; or
(ii) the price of the asset is negotiated without regard to the original
contract price.
Illustration 1
XYZ construction Ltd, a construction company undertakes the construction of an
industrial complex. It has separate proposals raised for each unit to be
constructed in the industrial complex. Since each unit is subject to separate
negotiation, he is able to identify the costs and revenues attributable to each
unit. Should XYZ Ltd, treat construction of each unit as a separate construction
contract according to AS 7?
© The Institute of Chartered Accountants of India
8.6 ADVANCED ACCOUNTING
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Solution
As per AS 7 ‘Construction Contracts’, when a contract covers a number of assets,
the construction of each asset should be treated as a separate construction
contract when:
(a) separate proposals have been submitted for each asset;
(b) each asset has been subject to separate negotiation and the contractor and
customer have been able to accept or reject that part of the contract
relating to each asset; and
(c) the costs and revenues of each asset can be identified.
Therefore, XYZ Ltd. is required to treat construction of each unit as a separate
construction contract.
1.4 TYPES OF CONSTRUCTION CONTRACTS
Types of construction contracts
Fixed price contract Cost plus contract
Contractor agrees to a fixed contract Contractor is reimbursed for allowable
price or fixed rate per unit of output, or otherwise defined costs, plus
which in some cases is subject to cost percentage of these costs or a fixed fee.
escalation.
In a fixed price contract, the price is agreed as fixed sum or a fixed rate per unit
of output. In some cases, the contract may require the customer to pay additional
sums to compensate the contractor against cost escalations.
Fixed price contracts are common in case of public tenders (construction of roads,
flyovers, office buildings). Such constructions usually have a budgeted costs and
the public entity does not intend to spend more than the tender amount. At the
same time, there can be various reasons where the cost of construction may
increase. For example, a sudden increase in wage rates, construction material
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.7
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costs, may require the contractor to add cost-escalation clauses and recover
from the contractee. These cost escalations still meet the category of fixed price
contracts.
A cost-plus contract is a construction contract in which the contractor is
reimbursed for allowable or otherwise defined costs, plus percentage of these
costs or a fixed fee.
Cost-plus contracts are common in case there is uncertainty of measurement of
costs or time of completion. In such cases, a contractor does not expect to bear
the loss due to those uncertainties. For example, if the scope of the contract
cannot be fully assessed in the contract, both parties may agree to cost-plus
contracts.
Under such contracts, the contractor is compensated for the costs incurred by
him plus agreed profit-margin.
1.5 CONTRACT REVENUE AND COSTS
(A) Contract revenue should comprise:
(i) the initial amount of revenue agreed in the contract; and
(ii) variations in contract work, claims and incentive payments to the
extent that it is probable that they will result in revenue and they are
capable of being reliably measured.
Contract revenue includes:
Agreed price (fixed / Cost-plus price)
Plus: Agreed Cost escalation
Plus: Claims (reimbursement for costs not included in the contract price)
Plus: Incentive payments (usually for early completion)
Less: Penalties (usually for late completion)
Adjusted for Variations
Claims are only included in contract revenue when it is probable that the customer will accept the
claim and such claim amount can be measured reliably
Incentives are only included in the contract revenue when it is probable that the specified
performance standards will be met or exceeded, and such incentive payment can be measured
reliably)
© The Institute of Chartered Accountants of India
8.8 ADVANCED ACCOUNTING
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Contract Revenue
Initially agreed amount
variations in contract work, claims and
incentive payments (if capable of being
recognized as revenue)
Illustration 2
AB contactors enters into a contract on 1 st January 20X1 with XY to construct a 5-
storied building. Under the contract, AB is required to complete the construction in
3 years (i.e., by 31st December 20X3). The following information is relevant:
Fixed price (agreed) ₹5 crore
Material cost escalation (to the extent of 20% of increase in material cost)
Labour cost escalation (up to 30% of increase in minimum wages)
In case AB is able to complete the construction in less than 2 years and 10 months,
it will be entitled for an additional incentive of ₹50 lakh. However, in case the
construction is delayed beyond 3 years and 2 months, XY will charge a penalty of
₹20 lakh. At the start of the contract, AB has a reason to believe that construction
will be completed in 2 years and 8 months. Assume that the construction was
actually completed in 2 years 9 months.
Labour cost was originally estimated to be ₹1.20 crore (based on initial minimum
wages). However, the costs have increased by 25% during the construction period.
Material costs have increased by 40% due to short-supply. The total increase in
material cost due to the 40% escalation is ₹80 lakh.
You are required to suggest what should be the contract revenue in above case?
Assume that in year 20X2, XY has requested AB to increase the scope of the
contract. An additional floor is required to be constructed and there is an increase
in contract fee by ₹1 crore.
AB has incurred a cost of ₹20 lakh for getting the local authority approvals which it
will be entitled to claim from XY in addition to the increase in the fixed fee.
Also measure the total contract revenue in this case.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.9
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Solution
Total Revenue after considering the escalation costs, claims and incentives:
`
Fixed Price: 5.00 crore
Incentive for early completion 0.50 crore
Material costs recovery (to the extent of 20%) 0.40 crore
Labour costs recovery (Actual increase is less than 30%) 0.30 crore
[1.20 crore x 25%]
Total Contract Revenue 6.20 crore
Add: Variation to the contract 1.00 crore
Add: Claims recoverable from XY 0.20 crore
Total Contract Revenue 7.40 crore
(B) Contract costs should comprise:
(i) costs that relate directly to the specific contract;
(ii) costs that are attributable to contract activity in general and can be
allocated to the contract; and
(iii) such other costs as are specifically chargeable to the customer under
the terms of the contract.
Contract Costs
costs that are
costs that other costs as are
attributable to contract
relate directly specifically
activity in general and
to the specific chargeable to the
can be allocated to the
contract; customer under the
contract;
terms of the contract.
NOTE:
1. Examples of costs that relate directly to a specific contract include:
(a) site labour costs, including site supervision
(b) costs of materials used in construction
© The Institute of Chartered Accountants of India
8.10 ADVANCED ACCOUNTING
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(c) depreciation of plant and equipment used on the contract
(d) costs of moving plant, equipment and materials to and from the
contract site
(e) costs of hiring plant and equipment
(f) costs of design and technical assistance that is directly related to the
contract
(g) the estimated costs of rectification and guarantee work, including
expected warranty costs
(h) claims from third parties
Note: Direct costs can be reduced by incidental income that is not included
in contract revenue, e.g., sale of surplus material and disposal of plant and
equipment.
2. Example of costs that may be attributable to contract activity in general and
can be allocated to specific contracts include:
(a) insurance
(b) costs of design and technical assistance that is not directly related to a
specific contract
(c) construction overheads
The allocation of indirect costs should be based on normal levels of
construction activity. The allocable costs may include borrowing costs
as per AS 16.
3. Examples of costs that cannot be attributed to contract activity or cannot be
allocated to a contract are excluded from the costs of a construction
contract. Such costs include:
(a) general administration costs for which reimbursement is not specified
in the contract
(b) selling costs
(c) research and development costs for which reimbursement is not
specified in the contract
(d) depreciation of idle plant and equipment that is not used on a
particular contract
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.11
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Example 3: Cost-Plus contract
The language can be changed as under (Entire Question):
ABC Constructions has a contract to build an office building.
The terms and conditions are as under:
1. ABC’s profit is agreed at:
• 25% on expected contract’s cost; For this purpose, the expected cost
cannot exceed ₹ 22 crores.
2. The agreed price will be revised depending upon the actual cost incurred.
• The cost for fixation will be taken actual cost or ₹ 22 crores whichever
is less.
Price fixation based on expected cost:
Assume that the costs expected to be incurred by ABC are ₹16 crore. Thus, ABC
can charge a profit of ₹ 4 crores (25% on actual cost).
The contract price will be ₹ 20 crores. (₹16 crores plus ₹ 4 crores)
Price fixation based on actual cost incurred – Scenario 1:
However, if cost incurred by ABC is ₹15 crore, in that case, it would be able to
charge a profit of:
= 25% on ₹15 crore = 15 x 25% = ₹ 3.75 crore
Thus, Total Value of the contract will stand revised as follows:
= Actual Costs + Profit (25% of costs) = ₹ 15 crore + ₹ 3.75 crore = ₹ 18.75
crores.
Price fixation based on actual cost incurred – Scenario 2:
For any unavoidable reasons, if total cost incurred by ABC is ₹ 25 crore, it can only
charge a profit on the expected costs of ₹22 crore as under:
Thus, Total Value of the contract will stand revised as follows:
= Expected Costs + Profit (20% of costs) = ₹ 22 crore + ₹ 5.50 crore = ₹ 27.50
crores.
Analysis of the above scenario:
Cost actually incurred by ABC = ₹ 25 crores.
Actual profit earned by ABC = Total Value of the contract – Actual costs incurred
= ₹ 27.50 Crores – ₹ 25 Crores = ₹ 2.50 Crores.
© The Institute of Chartered Accountants of India
8.12 ADVANCED ACCOUNTING
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1.6 PERCENTAGE COMPLETION METHOD
As discussed in the beginning, Construction contracts are mostly long term, i.e.,
they take more than one accounting year to complete. This means, the final
outcome (profit/ loss) of a construction contract can be determined only after a
number of years from the year of commencement of construction are over. It is
nevertheless possible to recognise revenue annually in proportion of progress of
work to be matched with corresponding construction costs incurred in that year.
This method of accounting, called the stage of completion method (percentage
completion method), provides useful information on the extent of contract
activity and performance during an accounting period.
The method is consistent with Accrual and Matching concepts of accounting.
AS 7 prescribes that the percentage completion method should not be used
unless it is possible to make a reasonable estimate of the final outcome of the
contract.
In reality, the actual profit or loss that is expected to be earned in such contracts
is not possible. Therefore, companies make use of different estimates to arrive at
the possible costs they are likely to incur for the construction. Large infra-
structure companies, builders expect to carry the required industry-experience.
On that basis, the pricing quoted by these companies for tenders take care of all
possible costs and expected profit. Therefore, in substance, a reasonable estimate
of the final outcome is possible in many such cases.
As per AS 7, the outcome of fixed price contracts can be estimated reliably when
all the following conditions are satisfied:
(i) total contract revenue can be measured reliably;
(ii) it is probable that the economic benefits associated with the contract will
flow to the enterprise;
(iii) both the contract costs to complete the contract and the stage of contract
completion at the reporting date can be measured reliably; and
(iv) the contract costs attributable to the contract can be clearly identified and
measured reliably so that actual contract costs incurred can be compared
with prior estimates.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.13
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The outcome of a cost-plus contract can be estimated reliably when all the
following conditions are satisfied:
(i) it is probable that the economic benefits associated with the contract will
flow to the enterprise; and
(ii) the contract costs attributable to the contract, whether or not specifically
reimbursable, can be clearly identified and measured reliably.
Flowchart depicting the conditions under which the outcome of a construction
contract can be reliably estimated:
Total contract revenue can be measured
reliably.
It is probable that the economic benefits
associated with the contract will flow to the
enterprise.
In fixed
price
contract
Both contract costs to complete the contract
and the stage of contract completion at the
reporting date can be measured reliably.
Outcome of Contract costs attributable to contract can be
clearly identified and measured reliably so that
contracts can be actual contract costs incurred can be
estimated reliably compared with prior estimates.
It is probable that the economic benefits
associated with the contract will flow to the
enterprise.
In cost
plus
contract
Contract costs attributable to the contract,
whether or not specifically reimbursable, can
be clearly identified and measured reliably.
© The Institute of Chartered Accountants of India
8.14 ADVANCED ACCOUNTING
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Also, AS 7 provides that whenever total contract cost is expected to exceed the
total contract revenue, the loss should be recognised as an expense immediately.
We may argue that why would an entity enter into a loss-making contract. It can
happen that after having entered into the construction contract, there is a sudden
rise in the costs which was not expected, nor are these covered under the cost-
escalation clause. Another reason, is that, an entity may enter into a loss-making
contract is to penetrate the market. Therefore, it is not uncommon for companies
to sometimes enter into loss-making contracts.
Under the prudence concept, we must always make a provision for all
expected losses.
If the final oucome of the
contract
Can be estimated Cannot be estimated
reliably reliably
Revenue and costs Contract costs should be recognised as an expense
recognised as per Revenue should be recognised in the period in which they are incurred
percantage of completion only to the extent of contrct and
costs incurred, of which An expected loss on the construction contract
method considering the recovery is probable should be recognised asan expense immediately in
stage of completion of accordance with paragraph 35.
contract at reporting date.
Illustration 3 (Percentage completion method)
X Ltd. commenced a construction contract on 01-04-20X1. The fixed contract price
agreed was ₹2,00,000. The company incurred ₹81,000 in 20X1-X2 for 45% work
and received ₹79,000 as progress payment from the customer. The cost incurred in
20X2-X3 was ₹89,000 to complete the rest of work. Show the extract of the Profit
and Loss Account and Customer’s Account for the related years.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.15
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Solution
Profit & Loss Account
Year ` 000 Year ` 000
20X1-X2 To Construction 81 20X1-X2 By Contract Price 90
Costs (for 45% (45% of Contract
work) Price)
To Net profit 9
(for 45% work)
90 90
20X2-X3 To Construction 89 20X2-X3 By Contract Price 110
costs (55% of Contract
(for 55% work) Price)
To Net Profit 21
(for 55% work)
110 110
Customer’s Account
Year ` 000 Year ` 000
20X1-X2 To Contract 90 20X1-X2 By Bank 79
Price
By Balance 11
c/d
90 90
20X2-X3 To Balance b/d 11 20X2-X3
To Contract 110 By Bank 121
Price
121 121
AS 7 provides that the percentage completion method should not be applied if
the outcome of a construction contract cannot be estimated reliably. In such
cases:
© The Institute of Chartered Accountants of India
8.16 ADVANCED ACCOUNTING
a
(a) revenue should be recognised only to the extent of contract costs incurred
of which recovery is probable; and
(b) contract costs should be recognised as an expense in the period in which
they are incurred.
An expected loss on the construction contract should be recognised as an
expense immediately in accordance with paragraph 35.
Illustration 4
PQ & Associates undertakes a construction contract the details of which are
provided below:
Total Contract Value ₹40 lakh
Costs incurred to date ₹3 lakh
Estimated future costs of completion ₹30 lakh
Work completed 10%
The work has started some time ago and there is an uncertainty with respect to the
outcome of the contract due to expected changes in regulations. PQ is certain that
it would be able to recover the costs incurred to date.
Solution
In the given case, revenue and costs can only be recognised to the extent of the
costs incurred and those which are expected to be recovered. Therefore, the
profit & loss statement would appear as under:
Contract Revenue ₹3 lakh
Contract Costs ₹3 lakh
Contract Profit Nil
When the uncertainties that prevented the outcome of the contract being
estimated reliably cease to exist, revenue and expenses associated with the
construction contract should be recognised by the percentage completion
method.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.17
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Example 4
X Ltd. commenced a construction contract on 01/04/X1. The contract price agreed was
reimbursable cost plus 10%. The company incurred ₹1,00,000 in 20X1-X2, of which cost
of ₹90,000 is reimbursable. The further non-reimbursable costs to be incurred to
complete the contract are estimated at ₹5,000. The other costs to complete the contract
could not be estimated reliably. The Profit & Loss A/c extract of X Ltd. for 20X1-X2 is
shown below:
Solution
Profit & Loss Account
` 000 ` 000
By Contract Price
To Construction Costs 100 99
(90+9)
To Provision for loss 5 Net loss 6
105 105
1.7 TREATMENT OF COSTS RELATING TO
FUTURE ACTIVITY
Under the percentage of completion method, contract revenue is recognised as
revenue in the statement of profit and loss in the accounting periods in which the
work is performed. Contract costs are usually recognised as an expense in the
statement of profit and loss in the accounting periods in which the work to which
they relate is performed. The contract costs that relate to future activity on the
contract are however recognised as an asset provided it is probable that they will
be recovered. Such costs represent an amount due from the customer and are
often classified as contract work in progress.
1.8 UNCOLLECTABLE CONTRACT REVENUE
When an uncertainty arises about the collectability of an amount already included
in contract revenue, and already recognised in the statement of profit and loss,
the uncollectable amount or the amount in respect of which recovery has ceased
© The Institute of Chartered Accountants of India
8.18 ADVANCED ACCOUNTING
a
to be probable is recognised as an expense rather than as an adjustment of the
amount of contract revenue.
1.9 STAGE OF COMPLETION
The stage of completion of a contract may be determined in a variety of ways.
The enterprise uses the method that measures reliably the work performed.
Depending on the nature of the contract, the methods may include:
(a) the proportion that contract costs incurred for work performed up to the
reporting date bear to the estimated total contract costs; or
(b) surveys of work performed; or
(c) completion of a physical proportion of the contract work.
Progress payments and advances received from customers may not necessarily
reflect the work performed.
Calculation of Stage of completion under proportion of costs incurred
method.
This method may be useful in case of contracts where cost is closely monitored by
the contractor. This method could be more commonly used in case of private
contracts to construct office buildings, machinery or equipment.
Actual cost incurred
= ×100
Estimated total cost
Actual cost incurred
= ×100
Actual cost incurred + Estimated future costs
Calculation of Stage of completion under Surveyor of work performed
method
Generally, in case of government projects, a surveyor is appointed to oversee
various parameters like quality of work, material used, etc. Based on these
parameters, the surveyor would assess the percentage of work completed. The
certification done by the appointed surveyor is used as the percentage of work
completed.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.19
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Calculation of Stage of completion of a physical proportion of the contract
work method
This method is commonly used in case of construction work which is not very
complicated. For example, a contract to place tiles can be regarded as complete
on the basis of area covered as a proportion of total area expected to be covered.
Thus, for example If the area to be covered is 1,000 sq. ft., and the total area
already covered is 300 sq.ft., this implies that 30% of the work is completed.
Illustration 5 (Stage of completion for a loss-making contract)
Show Profit & Loss A/c (Extract) in books of a contractor in respect of the following
data for Year 1.
Information for Year 1 ` 000
Contract price (Fixed) 600
Cost incurred to date 390
Estimated cost to complete 260
Assume that the contract period is 2 years. The contract is 100% completed by
Year 2. Actual costs incurred is the same as total estimated costs to complete
(Cost incurred to date plus estimated cost to complete).
Solution
Amount INR ` 000
Year Total up to Year 2
(1) Year2 (2) (2) – (1)
A. Cost incurred to date (390) (650) (260)
B. Estimate of cost to completion (260) - -
C. Estimated total cost (650) 650 650
D. Degree of completion (A/C) 60% 100% 40%
E. Revenue Recognised
(60% of 600) 360
(100% of 600) 600 240
© The Institute of Chartered Accountants of India
8.20 ADVANCED ACCOUNTING
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Total foreseeable loss (650 – 600) 50
Less: Loss for current year (E – A) (30)
Expected loss to be recognised immediately (20)
Reversal of Loss provision in Year 2 20
Profit & Loss A/c (Year 1)
` `
To Construction costs 390 By Contract Price 360
To Provision for loss 20 By Net Loss 50
410 410
Profit & Loss A/c (Year 2)
` `
To Construction costs 260 By Contract Price 240
By Reversal of Provision 20
for loss
260 260
1.10 CHANGES IN ESTIMATES
The percentage of completion method is applied on a cumulative basis in each
accounting period to the current estimates of contract revenue and contract
costs. Therefore, the effect of a change in the estimate of contract revenue or
contract costs, or the effect of a change in the estimate of the outcome of a
contract, is accounted for as a change in accounting estimate in accordance with
AS 5. The changed estimates are used in determination of the amount of revenue
and expenses recognised in the statement of profit and loss in the period in
which the change is made and in subsequent periods.
1.11 DISCLOSURE
(a) An enterprise should disclose:
(i) the amount of contract revenue recognised as revenue in the period;
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.21
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(ii) the methods used to determine the contract revenue recognised in
the period; and
(iii) the methods used to determine the stage of completion of contracts
in progress.
(b) An enterprise should disclose following in respect of contracts in progress at
the reporting date:
(i) the aggregate amount of costs incurred and recognised profits (less
recognised losses) upto the reporting date;
(ii) the amount of advances received; and
(iii) the amount of retentions.
• Retentions are amounts of progress billings which are not paid
until the satisfaction of conditions specified in the contract for
the payment of such amounts or until defects have been
rectified.
• Progress billings are amounts billed for work performed on a
contract whether or not they have been paid by the customer.
• Advances are amounts received by the contractor before the
related work is performed.
(c) An enterprise should present:
(i) the gross amount due from customers for contract work as an asset; and
(ii) the gross amount due to customers for contract work as a liability.
Particulars `
Costs incurred xxx
Plus: Recognised profits xxx
Less: Recognised losses xxx
Less: Progress billings xxx
Amount xxx
If above amount is positive- Gross amount due from
customers
If above amount is negative- Gross amount due to
© The Institute of Chartered Accountants of India
8.22 ADVANCED ACCOUNTING
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customers
Disclosures in Financial Statements
General Specific for contracts in progress
Amount of contract revenue recognised Aggregate amount of costs incurred
as revenue in the period and recognised profits (less recognised
losses) upto the reporting date
Methods used to determine the
contract revenue recognised in the
period Amount of advances received
Methods used to determine the stage
of completion of contracts in progress
Amount of retentions.
Illustration 6
A firm of contractors obtained a contract for construction of bridges across river
Revathi. The following details are available in the records kept for the year ended
31st March, 20X1.
( ` in lakhs)
Total Contract Price 1,000
Work Certified for the cost incurred 500
Work yet not Certified for the cost incurred 105
Estimated further Cost to Completion 495
Progress Payment Received 400
To be Received 140
The firm seeks your advice and assistance in the presentation of accounts keeping
in view the requirements of AS 7 issued by your institute.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.23
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Solution
(a) (` in lakhs)
Amount of foreseeable loss:
Total cost of construction (500 + 105 + 495) 1,100
Less: Total contract price (1,000)
Total foreseeable loss to be recognized as expense 100
According AS 7, when it is probable that total contract costs will exceed total
contract revenue, the expected loss should be recognized as an expense
immediately.
(b) (` in lakhs)
Contract work-in-progress i.e. cost incurred to date
are ₹ 605 lakhs
Work certified 500
Work not certified 105
605
This is 55% (605/1,100 100) of total costs of
construction.
(c) Proportion of total contract value recognized as revenue:
55% of ` 1,000 lakhs = ` 550 lakhs
(d) Gross Amount due from/to customers = (Contract costs + Recognized
profits – Recognized
Losses) – (Progress payments
received + Progress payments to be
received)
= (605 + Nil – 100) – (400 + 140)
` in lakhs
= [505 – 540] ` in lakhs
Amount due to customers = ` 35 lakhs
The amount of ` 35 lakhs will be shown in the balance sheet as liability.
© The Institute of Chartered Accountants of India
8.24 ADVANCED ACCOUNTING
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(e) The relevant disclosures under AS 7 are given below:
` in lakhs
Contract revenue 550
Contract expenses 605
Recognised profits less recognised losses (100)
Progress billings ` (400 + 140) 540
Retentions (billed but not received from contractee) 140
Gross amount due to customers 35
Method of revenue recognition (use of percentage completion method)
Method of determining state of completion (based on proportionate cost
Illustration 7
On 1st December, 20X1, Vishwakarma Construction Co. Ltd. undertook a contract
to construct a building for ` 85 lakhs. On 31st March, 20X2, the company found
that it had already spent ` 64,99,000 on the construction. Prudent estimate of
additional cost for completion was ` 32,01,000. What amount should be recognized
in the statement of profit and loss for the year ended 31st March, 20X2 as per
provisions of Accounting Standard 7 (Revised)?
Solution
`
st
Cost incurred till 31 March, 20X2 64,99,000
Prudent estimate of additional cost for completion 32,01,000
Total cost of construction 97,00,000
Less: Contract price (85,00,000)
Total foreseeable loss 12,00,000
According to AS 7, the amount of ` 12,00,000 is required to be recognised as an
expense.
` 64, 99, 000 ×100
Contract work in progress = = 67%
97, 00, 000
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.25
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Proportion of total contract value recognised as turnover:
= 67% of ` 85,00,000 = ` 56,95,000.
The amount of expected loss will be split as under:
Particulars Workings Amount
Expected Loss 97,00,000– 85,00,000 12,00,000
Contract revenue 67% of 85,00,000 56,95,000
Contract cost Given 64,99,000
Actual loss 56,95,000– 64,99,000 8,04,000
Amount of provision required 12,00,000– 8,04,000 3,96,000
[As per Para 35]
© The Institute of Chartered Accountants of India
8.26 ADVANCED ACCOUNTING
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TEST YOUR KNOWLEDGE
Multiple Choice Questions
The below information relates to Questions 1 – 3:
XY Ltd. agrees to construct a building on behalf of its client GH Ltd. on 1 st April
20X1. The expected completion time is 3 years. XY Ltd. incurred a cost of ` 30 lakh
up to 31 st March 20X2. It is expected that additional costs of ` 90 lakh. Total
contract value is ` 112 lakh. As at 31st March 20X2, XY Ltd. has billed GH Ltd. for
` 42 lakh as per the agreement. Assume that the work is completed to the extent of
75% by the end of Year 2.
1. Revenue to be recognized by XY Ltd. for the year ended 31st March 20X2 is
(a) ` 28 lakh
(b) ` 42 lakh
(c) ` 30 lakh
(d) ` 32 lakh
2. Total expense to be recognised in Year 1 is
(a) ` 30 lakh
(b) ` 120 lakh
(c) ` 38 lakh
(d) ` 36 lakh
3. Revenue to be recognised for year 2 is
(a) ` 84 lakh
(b) ` 42 lakh
(c) ` 56 lakh
(d) ` 28 lakh
Below information relates to Questions 4 – 5
M/s AV has presented the information for Contract No. XY123:
Total contract value ` 370 lakh
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.27
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Certified work completed ` 320 lakh
Costs incurred to date ` 360 lakh
Progress Payments received ` 300 lakh
Expected future costs to be incurred ` 50 lakh. The revenue to be recognised based on
the certified work completed.
4. Revenue to be recognised by M/s AV is
(a) ` 320 lakh
(b) ` 370 lakh
(c) ` 360 lakh
(d) ` 400 lakh
5. Total expense to be recognised by M/s AV is
(a) ` 380 lakh
(b) ` 400 lakh
(c) ` 320 lakh
(d) ` 360 lakh
6. LP Contractors undertakes a fixed price contract of ` 200 lakh. Transactions
related to the contract include:
Material purchased: ` 80 lakh
Unused material: ` 30 lakh
Labour charges: ` 60 lakh
Machine used for 3 years for the contract. Original cost of the machine is ` 100
lakh. Expected useful life is 15 years.
Estimated future costs to be incurred to complete the contract: ` 80 lakh.
Loss on contract to be recognised is:
(a) ` 40 lakh
(b) ` 10 lakh
(c) ` 90 lakh
(d) ` 50 lakh
© The Institute of Chartered Accountants of India
8.28 ADVANCED ACCOUNTING
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Theoretical Questions
7. It is argued that profit on construction contracts should not be recognised
until the contract is completed. Please explain whether you believe that this
suggestion would improve the quality of financial reporting for long-term
construction contracts.
8. A contractor has entered into a contract with a municipal body for
construction of a flyover. As per the contract terms, the contractor will receive
an additional ` 2 Crore as incentive if the construction of the flyover were to
be finished within a period of two years from the start of the contract. The
contractor wants to recognize this revenue since in the past he has been able
to meet similar targets very easily.
Explain whether the contractor’s view-point is correct?
Scenario based Questions
9. A construction contractor has a fixed price contract for ` 9,000 lakhs to
build a bridge in 3 years time frame. A summary of some of the
financial data is as under:
(Amount ` in lakhs)
Year 1 Year 2 Year 3
Initial Amount for revenue agreed in 9,000 9,000 9,000
contract
Variation in Revenue (+) - 200 200
Contracts costs incurred up to the reporting 2,093 6,168* 8,100**
date
Estimated profit for whole contract 950 1,000 1,000
*Includes ` 100 lakhs for standard materials stored at the site to be used in
year 3 to complete the work.
**Excludes ` 100 lakhs for standard material brought forward from year 2.
The variation in cost and revenue in year 2 has been approved by customer.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.29
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Compute year wise amount of revenue, expenses, contract cost to complete
and profit or loss to be recognized in the Statement of Profit and Loss as per
AS-7 (revised).
10. Akar Ltd. Signed on 01/04/X1, a construction contract for ` 1,50,00,000.
Following particulars are extracted in respect of contract, for the year ended
31/03/X2.
- Materials used ` 71,00,000
- Labour charges paid ` 36,00,000
- Hire charges of plant ` 10,00,000
- Other contract cost incurred ` 15,00,000
- Labour charges of ` 2,00,000 are still outstanding on 31.3.X2.
- It is estimated that by spending further ` 33,50,000 the work can be
completed in all respect.
You are required to compute profit/loss for the year to be taken to Profit &
Loss Account and any provision for foreseeable loss to be recognized as per
AS 7.
11. RT Enterprises has entered into a fixed price contract for construction of a
tower with its customer. Initial tender price agreed is ` 220 crore. At the start
of the contract, it is estimated that total costs to be incurred will be
` 200 crore. At the end of year 1, this estimate stands revised to ` 202 crore.
Assume that the construction is expected to be completed in 3 years.
During year 2, the customer has requested for a variation in the contract. As a
result of that, the total contract value will increase by ` 5 crore and the costs
will increase by ` 3 crore.
RT has decided to measure the stage of completion on the basis of the
proportion of contract costs incurred to the total estimated contract costs.
Contract costs incurred at the end of each year is:
Year 1: ` 52.52 crore
Year 2: ` 154.20 crore (including unused material of 2.5 crore)
Year 3: ` 205 crore.
© The Institute of Chartered Accountants of India
8.30 ADVANCED ACCOUNTING
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You are required to calculate:
(a) Stage of completion for each year.
(b) Profit to be recognised for each year.
12. On 1st December, 20X1, GR Construction Co. Ltd. undertook a contract to
construct a building for ` 45 lakhs. On 31 st March, 20X2, the company found
that it had already spent ` 32.50 lakhs on the construction. Additional cost of
completion is estimated at ` 15.10 lakhs. What amount should be charged to
revenue in the final accounts for the year ended 31 st March, 20X2 as per
provisions of AS-7?
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (a) 2. (c) 3. (c) 4. (a) 5. (d) 6. (b)
Answer to the Theoretical Questions
7. Usually, construction contracts are long term nature i.e., the contracts are entered
in one accounting period, however, the work performed will flow into more than
one accounting year. If the profit on construction contracts is not recognised over
the construction period, then the costs incurred during the earlier years of the
contract would be recognised without any corresponding revenue. This will result
in losses for initial years followed high profits in future years.
The current treatment under AS 7 results in matching of revenue and
associated costs as they are recognised during the same period. Also, the
current accounting incorporates the prudence concept as any foreseeable
losses are accounted for immediately.
Therefore, AS 7 results in a fair representation of the underlying financial
substance of the transaction.
8. The contractor’s view is not entirely correct in considering the variation as a
part of contract revenue. There is an argument that he has been able to
complete similar contracts within stipulated time. However, each contract
needs to be assessed in isolation with respect to the specific challenges
associated with the timing and uncertainty in completion.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.31
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Accordingly, the contractor needs to validate the assumptions with respect to
the specific contract. Only after that assessment is done, the incentive of ` 2
crore may be included within the contract revenue.
Answer to the Scenario based Questions
9. The amounts of revenue, expenses and profit recognized in the statement of
profit and loss in three years are computed below:
(Amount in ` lakhs)
Up to the Recognized in Recognized in
reporting previous years current year
date
Year 1
Revenue (9,000 x 26%) 2,340 - 2,340
Expenses (8,050 x 26%) 2,093 - 2,093
Profit 247 - 247
Year 2
Revenue (9,200 x 74%) 6,808 2,340 4,468
Expenses (8,200 x 74%) 6,068 2,093 3,975
Profit 740 247 493
Year 3
Revenue (9,200 x 100%) 9,200 6,808 2,392
Expenses (8,200 x 100%) 8,200 6,068 2,132
Profit 1,000 740 260
Working Note:
Year 1 Year 2 Year 3
Revenue after considering 9,000 9,200 9,200
variations 950 1,000 1,000
Less: Estimated profit for whole
contract
Estimated total cost of the 8,050 8,200 8,200
contract (A)
© The Institute of Chartered Accountants of India
8.32 ADVANCED ACCOUNTING
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Actual cost incurred upto the 2,093 6,068 8,200
reporting date (B) (6,168-100) (8,100+100)
Degree of completion (B/A) 26% 74% 100%
10. Statement showing the amount of profit/loss to be taken to Profit and Loss
Account and additional provision for the foreseeable loss as per AS 7
Cost of Construction ` `
Material used 71,00,000
Labour Charges paid 36,00,000
Add: Outstanding on 31.03.20X2 38,00,000
2,00,000
Hire Charges of Plant 10,00,000
Other Contract cost incurred 15,00,000
Cost incurred upto 31.03.20X2 1,34,00,000
Add: Estimated future cost 33,50,000
Total Estimated cost of construction 1,67,50,000
Degree of completion (1,34,00,000/1,67,50,000 x 100) 80%
Revenue recognized (80% of 1,50,00,000) 1,20,00,000
Total foreseeable loss (1,67,50,000 - 1,50,00,000) 17,50,000
Less: Loss for the current year (1,34,00,000 - 1,20,00,000) 14,00,000
Loss to be provided for 3,50,000
11. (a) Stage of completion = Costs incurred to date / Total estimated costs
Year 1: 52.52 crore / 202 crore = 26%
Year 2: (154.20 crore – 2.50 crore) / 205 crore = 74%
Year 3: 205 crore / 205 crore = 100%
(b) Profit for the year
Year 1 Year 2 Year 3
Contract 57.20 crore 109.30 crore 58.50 crore
Revenue (1)
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.33
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(220 crore x 26%) (225 crore x 74% - (225 crore x 100% -
57.20 crore) 109.30 crore –
57.20 crore)
Contract 52.52 crore 99.18 crore 53.30 crore
Cost (2)
(202 crore x 26%) (205 crore x 74% - (205 crore x 100% -
52.52 crore) 99.18 crore – 52.52
crore)
Contract 4.68 crore 10.12 crore 5.20 crore
Profit (1) –
(2)
12.
` in lakhs
Cost of construction incurred till date 32.50
Add: Estimated future cost 15.10
Total estimated cost of construction 47.60
Percentage of completion till date to total estimated cost of construction
= (32.50/47.60) 100 = 68.28%
Proportion of total contract value recognised as revenue for the year ended
31st March, 20X2 per AS 7 (Revised)
= Contract price x percentage of completion
= ` 45 lakh x 68.28% = ` 30.73 lakhs.
(` in lakhs)
Total cost of construction 47.60
Less: Total contract price (45.00)
Total foreseeable loss to be recognized as expense 2.60
According to of AS 7, when it is probable that total contract costs will
exceed total contract revenue, the expected loss should be recognized as an
expense immediately.
© The Institute of Chartered Accountants of India
a 8.34
8.34 ADVANCED ACCOUNTING
UNIT 2: ACCOUNTING STANDARD 9
REVENUE RECOGNITION
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the provisions
of AS 9 related with–
Recognition of revenue in case of:
▪ Sale of Goods
▪ Rendering of Services
▪ The Use by Others of Enterprise Resources Yielding Interest,
Royalties and Dividends
Effect of Uncertainties on Revenue Recognition
Required Disclosures.
2.1 INTRODUCTION
Revenue (also called as Top Line), or Sales is the backbone for any business. A
higher revenue would normally reflect an increase in market share, higher
prospects, and eventually an increased value of the business. You would notice
that many start-up entities are more focused to increase their market penetration
and revenue without initially focusing on the profitability.
As a result, it is critical to have a standard that addresses how entities must
recognised the revenue, with respect to the amount and timing in a particular
accounting period.
AS 9 deals with the bases for recognition of revenue in the statement of profit
and loss of an enterprise. AS 9 is mandatory for all enterprises. The Standard is
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.35 a
concerned with the recognition of revenue arising in the course of the ordinary
activities of the enterprise from
• the sale of goods
• the rendering of services
• the use by others of enterprise resources yielding interest, royalties and
dividends
AS 9 does not deal with the following aspects of revenue recognition to which
special considerations apply:
i. Revenue arising from construction contracts;
ii. Revenue arising from hire-purchase, lease agreements;
iii. Revenue arising from government grants and other similar subsidies;
iv. Revenue of insurance companies arising from insurance contracts.
Examples of items not included within the definition of “revenue” for the purpose
of AS 9 are:
i. Realized gains resulting from the disposal of, and unrealized gains resulting
from the holding of, non-current assets, e.g., appreciation in the value of
fixed assets;
ii. Unrealized holding gains resulting from the change in value of current
assets, and the natural increases in herds and agricultural and forest
products;
iii. Realized or unrealized gains resulting from changes in foreign exchange
rates and adjustments arising on the translation of foreign currency financial
statements;
iv. Realized gains resulting from the discharge of an obligation at less than its
carrying amount;
v Unrealized gains resulting from the restatement of the carrying amount of
an obligation.
© The Institute of Chartered Accountants of India
a 8.36
8.36 ADVANCED ACCOUNTING
2.2 DEFINITION OF REVENUE
Revenue is the gross inflow of cash, receivables or other consideration arising in
the course of the ordinary activities of an enterprise from the sale of goods, from
the rendering of services, and from the use by others of enterprise resources
yielding interest, royalties and dividends.
Revenue is the gross inflow of cash, receivables or other
consideration arising from
Use by others of
enterprise resources
Sale of goods Rendering of services
yielding Interest,
royalties and dividends
Example 1
Entity XY sells a machine being used at its factory at a price of ` 2 lakh. The
carrying value of the machine is ` 1.80 lakh. The sale of the machine does not
increase the revenue of XY but is an example of a capital receipt since transaction
does not take place in the normal course of business. Such gain on sale of
` 20,000 (` 2 lakhs – ` 1.80 lakhs) is recognised as a part of profit & loss statement
under Gain/(Loss) on disposal of asset.
Example 2
ST Ltd is a real-estate developer and builder. It is into the business of buying and
selling properties. In 20X1, ST Ltd purchased a unit of land for ₹ 150 crore. It sold
off that land after few months at a price of ₹ 240 crore.
In the above case, the sale of land is a transaction that happens in the ordinary
course of business (as he is a real estate developer and builder – properties will be
an item of inventory in the financial statements) for ST Ltd. Hence, it should
recognise a revenue of ₹ 240 crore when the land is sold.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.37 a
Example 3
DL Ltd, a pharma company, has been conducting research on new medicine since
last 2 years to increase the immunity levels of the people consuming it without any
side effects. During the current year, it decides to sell the outcome of the research
undertaken so far to another competitor, GH Ltd for ` 50 crore. DL has already
incurred ` 30 crore on the ongoing research.
In the above example, the sale of the research findings does not represent an
increase in revenue. This is because DL Ltd’s business is not to sell these research
findings in the ordinary course of business. The amount of ₹ 50 crore will be a part
of Other Income in the profit & loss statement.
2.3 AGENCY RELATIONSHIP
In an agency relationship, the revenue is the amount of commission and not the
gross inflow of cash, receivables or other consideration.
The criteria of principal-agency relationship is significant to understand how
much revenue can be recognised by an entity for a sale transaction. The key
principle is whether the sale transaction is made by an entity on its own, or on
behalf of someone else. Whether the risks and rewards pertaining to the goods or
services are with the entity or with someone else, would determine the seller’s
capacity as principal or agency (agent).
When another party is involved in providing goods or services to a customer, the
entity shall determine whether it has an obligation to sell or provide the specified
goods or services itself (i.e., the entity is a principal) or to arrange for those goods
or services to be sold or provided by the other party (i.e., the entity is an agent).
Illustration 1
Zigato runs a food-delivery business. As per the arrangement, Zigato allows
customers to order food from local restaurants and is responsible the delivery of the
food within stipulated time. During a particular year, it collects the money on
orders made online as under:
© The Institute of Chartered Accountants of India
a 8.38
8.38 ADVANCED ACCOUNTING
Total price for the food item - ` 200 lakhs
Delivery charges - ` 60 lakhs
GST - ` 40 lakhs
Total - ` 300 lakhs
Zigato has received ` 300 lakhs for the above orders from customers and the orders
were delivered to the customer in stipulated time.
How much revenue should be recognised by restaurants and how much revenue
should be recognised by Zigato for the year?
Solution
The risks and rewards associated with the food item are not with Zigato. When a
customer has ordered a food item, whether the item will be prepared or not is the
responsibility of the restaurant and not Zigato. Similarly, the responsibility to
deliver the food item is with Zigato and the restaurant does not undertake
responsibility for the same.
Therefore, the restaurant undertakes the principal’s responsibility to prepare the
food and ensure its quality. Zigato, on the other hand, is only responsible to
deliver the food. Thus, Zigato is acting as an agent. Hence, it can only recognize
revenue relating to that activity (which it does in the ordinary course of business).
The revenue for Zigato, therefore, is ` 60 lakhs, whereas, the revenue for
restaurants will be ` 200 lakhs.
It may be noted that the GST of ` 40 lakhs is a liability payable to the Government
(third party), hence it does not form part of revenue.
Example 4
Trip Deal is a website that allows people to book airlines tickets. As a part of the
business, it agrees to buys 100 tickets from an airline on a particular date and
resells those tickets to customers. However, Trip Deal bears the loss for any unsold
tickets.
In the above example, the risks and rewards relating to tickets are borne by Trip
Deal. Hence, sales made for the tickets will be fully recognized as part of its
revenue. Any unsold tickets will be charged as loss by the entity.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.39 a
2.4 SALE OF GOODS
Revenue from sales transactions should be recognised when the requirements as
to performance set out in below in para 2.5 ‘Timing of Recognition of Revenue
from Sale of Goods’ are satisfied, provided that at the time of performance it is
not unreasonable to expect ultimate collection. If at the time of raising of any
claim it is unreasonable to expect ultimate collection, revenue recognition should
be postponed.
Illustration 2
AB sells goods to CD on 1 st March 20X1. CD is having significant cash flows issues
since last few months. However, it is trying to raise funding through bank loan to be
able to run its operations in future. On 5th of May 20X1, CD is able to seek the
funding and is expected to be able to pay for the goods in future.
At the time of sale, it is difficult for AB to ascertain whether it will be able to collect
the amount from CD due to poor financial conditions.
Explain how the recognition of revenue be done by AB?
Solution
In the above case, AB should not recognise any revenue on 1st of March and until
that uncertainty of recovery is clear. Hence, the revenue can only be recognised
by AB on 5th of May 20X1. The inventory transferred to CD until that date is
required to be shown as its own inventory [inventory lying with customers].
2.5 TIMING OF RECOGNITION OF REVENUE
FROM SALE OF GOODS
In a transaction involving the sale of goods, performance should be regarded as
being achieved when the following conditions have been fulfilled:
(i) the seller of goods has transferred to the buyer the property in the goods
for a price or
(ii) all significant risks and rewards of ownership have been transferred to the
buyer and the seller retains no effective control of the goods transferred to
a degree usually associated with ownership; and
© The Institute of Chartered Accountants of India
a 8.40
8.40 ADVANCED ACCOUNTING
(iii) no significant uncertainty exists regarding the amount of the consideration
that will be derived from the sale of the goods.
Note:
The transfer of property in goods, in most cases, results in or coincides with the
transfer of significant risks and rewards of ownership to the buyer. However, there
may be situations where transfer of property in goods does not coincide with the
transfer of significant risks and rewards of ownership. Revenue in such situations
is recognised at the time of transfer of significant risks and rewards of ownership
to the buyer.
Such cases may arise where delivery has been delayed through the fault of either
the buyer or the seller and the goods are at the risk of the party at fault as
regards any loss which might not have occurred but for such fault. Further,
sometimes the parties may agree that the risk will pass at a time different from
the time when ownership passes
Illustration 3
AB sells goods to CD on 1 st January 20X1 for ` 2 lakhs. After the sale was made, CD
is having significant cash flows issues. It is trying to raise funding through bank
loan to be able to run its operations in future. However, it is unable to do so and
has gone under liquidation on 15 th of March 20 X1.
At the time of sale, there was no reason for AB to believe that it will not be able to
collect the amount from CD in future.
Explain how the recognition of revenue be done by AB for the year ended 31 st
March 20X1?
Solution
In the above case, at the time of sale, it was not unreasonable for AB to expect
ultimate collection from CD. Therefore, AB should recognise the revenue of ` 2
lakhs on 1 st of January 20X1 and recognise a receivable for the same amount.
Later, since CD went into liquidation, AB should write off the receivables and book
a loss in his books.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.41 a
Accounting in the books of AB
1st January 20X1
CD A/c (Receivables) Dr. ` 2 lakhs
To Revenue A/c ` 2 lakhs
(Being goods sold to CD Ltd)
15th March 20X1
Bad Debts A/c Dr. ` 2 lakhs
To CD A/c (Receivables)A/c ` 2 lakhs
(Being receivables from CD written off due
to its liquidation)
2.6 RENDERING OF SERVICES
Revenue from service transactions is usually recognised as the service is
performed. There are two methods of recognition of revenue from service
transaction, viz,
Methods of recognition of revenue
Proportionate completion Completed service contract
method method
Proportionate Completion Method is a method of accounting which recognises
revenue in the statement of profit and loss proportionately with the degree of
completion of services under a contract. Here performance consists of the
execution of more than one act. Revenue is recognised proportionately by
reference to the performance of each act.
Completed Service Contract Method is a method of accounting which
recognises revenue in the statement of profit and loss only when the rendering of
© The Institute of Chartered Accountants of India
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8.42 ADVANCED ACCOUNTING
services under a contract is completed or substantially completed. In this method
performance consists of the execution of a single act e.g., installation of a
machine, or repair service,
Alternatively, services are performed in more than a single act, and the services
yet to be performed are so significant in relation to the transaction taken that
performance cannot be deemed to have been completed until the execution of
those acts.
The completed service contract method is relevant to these patterns of
performance and accordingly revenue is recognised when the sole or final act
takes place and the service becomes chargeable.
Revenue from sales or service transactions should be recognised when the service
is performed provided that at the time of performance it is not unreasonable to
expect ultimate collection. If at the time of raising of any claim it is unreasonable
to expect ultimate collection, revenue recognition should be postponed.
2.7 INCOME FROM OTHER SOURCES - INTEREST,
ROYALTIES AND DIVIDENDS
Use by others of such enterprise resources gives rise to:
i. Interest: charges for the use of cash resources or amounts due to the
enterprise. Revenue is recognized on a time proportion basis taking into
account the amount outstanding and the rate applicable.
ii. Royalties: charges for the use of such assets as know-how, patents, trade
marks and copyrights. Revenue is recognized on an accrual basis in
accordance with the terms of the relevant agreement.
iii. Dividends: rewards from the holding of investments in shares. Revenue is
recognized when the owner’s right to receive payment is established.
Revenue arising from the use by others of enterprise resources yielding interest,
royalties and dividends should only be recognized when no significant uncertainty
as to measurability or collectability exists.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.43 a
Illustration 4
During the year ended 31 st March 20X1, ZX Enterprises has recognized ` 100 lakhs
on accrual basis income from dividend on units of mutual funds held by it. The
dividends on mutual funds were declared on 15th June, 20X1. The dividend was
proposed on 10th April, 20X1.
Whether the above treatment is as per the relevant Accounting Standard?
Solution
Dividends from investments in shares are not recognized in the statement of
profit and loss until a right to receive payment is established. In the given
situation, the dividend is proposed on 10th April, 20X1, while it is declared on
15th June, 20X1. Thus, the right to receive the payment of dividend gets
established on 15th June, 20X1.
The recognition of ` 100 lakhs on accrual basis in the financial year 20X0-20X1 is
not correct as per AS 9 'Revenue Recognition'.
Illustration 5
Y Ltd., used certain resources of X Ltd. In return X Ltd. received ₹ 10 lakhs and ₹ 15
lakhs as interest and royalties respective from Y Ltd. during the year 20 X1-X2. You
are required to state whether and on what basis these revenues can be recognized
by X Ltd.
Solution
As per AS 9 on Revenue Recognition, revenue arising from the use by others of
enterprise resources yielding interest and royalties should only be recognized
when no significant uncertainty as to measurability or collectability exists. These
revenues are recognized on the following bases:
(i) Interest: on a time proportion basis taking into account the amount
outstanding and the rate applicable. Therefore X Ltd. should recognize
interest revenue of ₹ 10 Lakhs
(ii) Royalties: on an accrual basis in accordance with the terms of the relevant
agreement. X Ltd. therefore should recognize royalty revenue of ₹ 15 Lakhs.
© The Institute of Chartered Accountants of India
a 8.44
8.44 ADVANCED ACCOUNTING
2.8 CONDITIONS FOR SALE OF GOODS
1. Delivery is delayed at buyer’s request and buyer takes title and
accepts billing
Sometimes, the buyer may purchase goods and requests the seller to hold the
goods on his behalf for some reason, for example, due to lack of storage or
transportation delays. In such cases, the risks and rewards associated with the
ownership seem to have been transferred to the buyer and the sale should be
considered as complete. This is true even if the physical possession of the goods
is with the seller. The conditions to be met to account for the sale are:
- the goods must be specifically identified, and cannot be transferred to
another customer;
- the delivery is delayed at buyer’s request; and
- the goods are ready to be delivered to the buyer
Example 5
XY Ltd sells goods worth ` 50 lakh on 20 February 20X1 to AB Ltd. AB Ltd is facing
storage capacity constraints at their warehouse. AB Ltd instructs XY Ltd to hold the
goods at XY Ltd’s warehouse and arrange for delivery on 15 March 20X1. However,
all the risks and rewards associated with the sold goods are deemed transferred to
AB Ltd.
In the current scenario, delivery of goods sold is delayed at the request of buyer. XY
Ltd can recognize revenue for sale of goods to AB Ltd on 20 February 20X1 provided
that the goods sold to AB Ltd are held in XY Ltd’s warehouse separately and are not
clubbed with other inventory.
2. Sale on approval basis
Revenue should not be recognized until the goods have been formally accepted
by the buyer or the buyer has done an act adopting the transaction or the time
period for rejection has elapsed or where no time has been fixed, a reasonable
time has elapsed.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.45 a
Example 6
M/s XY sells goods worth ` 5 lakh on 30th of March 20X1 to M/s FT under Sale on
approval basis. Under the arrangement, FT can return the goods back to XY within
next 3 months. XY cannot reasonably determine whether FT will give the
acceptance of goods before the expiry of 3 months.
Under these circumstances, XY cannot recognize revenue until the goods are
accepted by FT or on completion of 3 months, whichever is earlier.
3. Goods sold subject to inspection / installation
In case the installation is complex and is significant to be able to use the goods in
the intended manner, revenue should not be recognized until the installation is
satisfactorily completed. However, in case the installation is simple (for example, a
refrigerator needs to be plugged to a power connection after delivery to
customer’s place), revenue is recognized when the customer has agreed to
purchase the goods.
4. Sale and repurchase arrangement
Such arrangements are considered to be financing arrangement, and no sale can
be recognized. Instead, a borrowing should be recognized in the books of the
seller.
Example 7
On 1st January 20X1, M/s KJ sells goods at invoice value of ₹ 5 lakhs to M/s TH. At
the time of sale, M/s KJ has agreed to repurchase these goods back from M/s TH
on 31st March at a price of ` 6 Lac.
You are required to do the accounting for above transactions in the books of M/s
KJ.
Solution
1st Jan 20X1:
Bank A/c Dr. `5 lakhs
To Loan from M/s TH A/c `5 lakhs
(Being borrowing made under the Sale &
Repurchase arrangement)
© The Institute of Chartered Accountants of India
a 8.46
8.46 ADVANCED ACCOUNTING
31st March 20X1
Interest expense A/c Dr. `1 lakhs
To Loan from M/s TH A/c `1 lakhs
(Being interest cost recognised on the borrowing)
31st March 20X1:
Loan from M/s TH A/c Dr. `6 lakhs
To Bank A/c `6 lakhs
(Being repayment of loan taken from TH)
5. Trade discounts and volume rebates
Trade discounts and volume rebates received are not encompassed within the
definition of revenue, since they represent a reduction of cost. Trade discounts
and volume rebates given should be deducted in determining revenue.
6. Cash discounts
Definition of revenue under AS 9 represents the gross inflow of cash from sale of
goods or provision of services. Any cash discount given should not be deducted
in determining the revenue. Revenue is therefore recognized at gross amount and
cash discount is recorded as an expense as an when the seller receives the
payment net of discount.
7. Consignment Sale
Consignment sales is a sale where a delivery is made whereby the recipient
undertakes to sell the goods on behalf of the consignor.
In such case revenue should not be recognized until the goods are sold to a third
party
Example 8
In the year 20X1-X2, XYZ supplied goods on Consignment basis to ABC – a retail
outlet worth ` 10,00,000. As per the terms, ABC will only pay XYZ for the goods
which are sold by them to the third party. Rest of the goods can be returned back to
XYZ and ABC will not have any further liability for these goods.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.47 a
During the year 20X1-X2, ABC has sold goods worth ` 5,50,000 only and rest of the
goods are still lying in its store which may get sold by next year. Advise XYZ, how
much revenue it can recognize in its books for period 20X1-X2.
Solution
As per AS 9, consignment risk and rewards are not transferred to the customer on
just delivery of the goods and no revenue should be recognized until the goods are
sold to a third party. Therefore, XYZ can recognize revenue of ` 5,50,000 only.
2.9 EFFECT OF UNCERTAINTIES ON REVENUE
RECOGNITION
Where the ability to assess the ultimate collection with reasonable certainty is
lacking at the time of raising any claim, revenue recognition is postponed to the
extent of uncertainty involved.
When the uncertainty relating to collectability arises subsequent to the time of
sale or the rendering of the service, it is more appropriate to make a separate
provision to reflect the uncertainty rather than to adjust the amount of revenue
originally recorded.
An essential criterion for the recognition of revenue is that the consideration
receivable for the sale of goods, the rendering of services or from the use by
others of enterprise resources is reasonably determinable. When such
consideration is not determinable within reasonable limits, the recognition of
revenue is postponed.
© The Institute of Chartered Accountants of India
a 8.48
8.48 ADVANCED ACCOUNTING
Revenue Recognition
*Sale of *Rendering *Use by others of
Goods of Services Enterprise Resources
when seller proportionate Complete Dividends
Interest Royalties
has completion d service
transferred method method
the property Revenue is
Revenue is
to the buyer Revenue is recognised
performance recognised
generally recognised on when right to
consists of the time
performance the basis of receive the
for execution of basis
consists of the terms of payment is
consideration more than one
execution of a agreement established
act
single act
transfer of
significant practically
revenue is revenue is
risk &
recognised recognised when
rewards to
the buyer on SLM basis the final act is
completed &
services are
chargeable
* Provided there exists no significant uncertainty regarding the ultimate collection
of consideration
(A key criterion for determining when to recognise revenue from a transaction
involving the sale of goods is that the seller has transferred the property in the
goods to the buyer for a consideration and there exists no significant uncertainty
regarding the ultimate collection of consideration).
2.10 DISCLOSURE
In addition to the disclosures required by AS 1 on ‘Disclosure of Accounting
Policies’, an enterprise should disclose the circumstances in which revenue
recognition has been postponed pending the resolution of significant
uncertainties.
Illustration 6
The Board of Directors decided on 31.3.20X2 to increase the sale price of certain
items retrospectively from 1st January, 20X2. In view of this price revision with
effect from 1st January 20X2, the company has to receive ` 15 lakhs from its
customers in respect of sales made from 1st January, 20X2 to 31st March, 20X2.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.49 a
Accountant cannot make up his mind whether to include ` 15 lakhs in the sales for
20X1-20X2.Advise.
Solution
Price revision was effected during the current accounting period 20X1-20X2. As a
result, the company stands to receive ` 15 lakhs from its customers in respect of
sales made from 1st January, 20X2 to 31st March, 20X2. If the company is able to
assess the ultimate collection with reasonable certainty, only then additional
revenue arising out of the said price revision may be recognized in 20X1-20X2.
If the company is not reasonably certain on ultimate collection ` 15 lakhs from its
customers in respect of sales made from 1st January, 20X2 to 31st March, 20X2, it
shall postpone recognition of revenue and disclose it in financial statements for
year 20X1-20X2 as per AS 1
Illustration 7
A claim lodged with the Railways in March, 20X1 for loss of goods of ` 2,00,000 had
been passed for payment in March, 20X3 for ` 1,50,000. No entry was passed in the
books of the Company, when the claim was lodged. Advise P Co. Ltd. about the
treatment of the following in the Final Statement of Accounts for the year ended
31st March, 20X3.
Solution
AS 9 on ‘Revenue Recognition’ states that where the ability to assess the ultimate
collection with reasonable certainty is lacking at the time of raising any claim,
revenue recognition is postponed to the extent of uncertainty involved. When
recognition of revenue is postponed due to the effect of uncertainties, it is
considered as revenue of the period in which it is certain to be collected. In this
case it may be assumed that collectability of claim was not certain in the earlier
periods. This is supposed from the fact that only ` 1,50,000 were collected against
a claim of ` 2,00,000. So this transaction can not be taken as a Prior Period Item.
Hence receipt of ` 1,50,000 shall be recognized as revenue in year ended 31st
March, 20X3
In the light of AS 5, it will not be treated as extraordinary item. However, AS 5
states that when items of income and expense within profit or loss from ordinary
activities are of such size, nature, or incidence that their disclosure is relevant to
explain the performance of the enterprise for the period, the nature and amount
of such items should be disclosed separately. Accordingly, the nature and amount
of this item should be disclosed separately.
© The Institute of Chartered Accountants of India
a 8.50
8.50 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Which of the conditions mentioned below must be met to recognize revenue
from the sale of goods?
(i) the entity selling does not retain any continuing influence or control
over the goods;
(ii) when the goods are dispatched to the buyer;
(iii) revenue can be measured reliably;
(iv) the supplier is paid for the goods;
(v) it is reasonably certain that the buyer will pay for the goods;
(vi) the buyer has paid for the goods.
(a) (i), (ii) and (v)
(b) (ii), (iii) and (iv)
(c) (i), (iii) and (v)
(d) (i), (iv) and (v)
2. Consignment inventory is an arrangement whereby inventory is held by one
party but owned by another party. Which of the following indicates that the
inventory in question is a consignment inventory?
(a) Manufacturer cannot require the dealer to return the inventory
(b) Dealer has the right to return the inventory
(c) Manufacture is responsible for the pricing of goods and any changes in
the pricing can only be approved by the manufacturer .
(d) Manufacture is responsible for the holding the goods and any changes
in the pricing can only be approved by the dealer
3. Which of the following transactions qualify as revenue for M/s AB Enterprises?
(a) Sales of ` 20 lakhs made under consignment sales.
(b) Sale of an old machine amounting ` 5 lakhs
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.51 a
(c) Services provided to the customer in the normal course of business.
Sales recorded is ` 50,000.
(d) Sales of ` 25 lakhs made under consignment sales
4. The Accounting Club has 100 members who are required to pay an annual
membership fee of ` 5,000 each. During the current year, all members have
paid the fee. However, 5 members have paid an amount of ` 10,000 each. Of
these, 3 members paid the current year’s fee and also the previous year’s
dues. Remaining 2 members have paid next years’ fee of ` 5,000 in advance.
Revenue from membership fee for the current year to be recognised will be:
(a) ` 5,25,000
(b) ` 5,10,000
(c) ` 5,00,000
(d) ` 5,15,000
5. FlixNet International offers a subscription fee model to allow the paid
subscribers an annual viewing of movies, sports events and other content. It
allows users to register for free and have access to limited content for one
month without any charges. The customer has a right to cancel the
subscription within a month’s time but is required to pay for 1 year
subscription fee after the free period.
XY has subscribed for free viewing on 1 st March 20X1. After 1 month, he has
agreed to pay the annual membership and has paid ` 1,200 on 31st March
20X1 for the subscription that is valid up to 31 st of March 20X2.
Revenue that can be recognized by FlixNet for the year ended 31 st March
20X2 is
(a) ` 100
(b) ` 1,200
(c) Nil
(d) ` 1,100
© The Institute of Chartered Accountants of India
a 8.52
8.52 ADVANCED ACCOUNTING
Scenario based Questions
6. GH manufactures and sells televisions. The televisions are shipped to the
customer by sea. In order to transfer risk related to the shipment of the
televisions, GH also gets an insurance coverage for the goods while they are
in transit from the factory to customer’s location.
The insurance policy will reimburse GH for the value of the goods in the event
of loss or damage arising anytime up to these goods reaching customer’s
location. The legal title passes when the goods arrive at the customer’s
premises one month later.
When should Entity GH recognize revenue in its books?
7. The following information of Meghna Ltd. is provided:
(i) Goods of ` 60,000 were sold on 20-3-20X2 but at the request of the
buyer these were delivered on 10-4-20X2.
(ii) On 15-1-20X2 goods of ` 1,50,000 were sent on consignment basis of
which 20% of the goods unsold are lying with the consignee as on
31-3-20X2.
(iii) ` 1,20,000 worth of goods were sold on approval basis on 1-12-20X1.
The period of approval was 3 months after which they were considered
sold. Buyer sent approval for 75% goods up to 31-1-20X2 and no
approval or disapproval received for the remaining goods till 31-3-
20X2.
(iv) Apart from the above, the company has made cash sales of ` 7,80,000
(gross). Trade discount of 5% was allowed on the cash sales.
You are required to advise the accountant of Meghna Ltd., with valid reasons,
the amount to be recognized as revenue in above cases in the context of AS 9.
8. For the year ended 31 st March 20X1, KY Enterprises has entered into the
following transactions.
On 31 March 20X1, KY supplied two machines to its customer ST. Both
machines were accepted by ST on 31 March 20X1. Machine 1 was a machine
that was routinely supplied by KY to many customers and the installation
process was very simple.
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.53 a
Machine 1 was installed on 2 April 20X1 by ST’s employees.
Machine 2 being more specialised in nature requires an installation process
which is more complicated, requiring significant assistance from KY. Machine
2 was installed between 2 and 5 April 20X1. Details of costs and sales prices
are as follows:
Machine 1 Machine 2
Sale Price 3,20,000 3,00,000
Cost of production 1,60,000 1,50,000
Installation fee nil 10,000
How should above transactions be recognized by KY Enterprises for the
year ended 31 st March 20X1?
9 PQR Ltd., sells agriculture products to dealers. One of the conditions of sale
is that interest is at the rate of 2% p.m., for delayed payments. Percentage
of interest recovery is only 10% on such overdue outstanding due to various
reasons. During the year 20X1-X2 the company wants to recognize the
entire interest receivable. Do you agree?
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (a) 2. (c) 3. (c) 4. (c) 5. (b)
Answer to the Scenario based Questions
6. GH should recognize revenue for the sale when the goods arrive at the
customer’s premises. GH has not transferred the televisions’ significant risks
and rewards of ownership to the customer when the goods depart from the
factory. This is evidenced by the fact that any insurance proceeds received
from the goods’ damage or destruction will be repaid to GH. Further, the
legal title does not pass until the goods arrive at the customer’s premises.
© The Institute of Chartered Accountants of India
a 8.54
8.54 ADVANCED ACCOUNTING
7. As per AS 9 “Revenue Recognition”, in a transaction involving the sale of
goods, performance should be regarded as being achieved when the
following conditions are fulfilled:
(i) the seller of goods has transferred to the buyer the property in the
goods for a price or all significant risks and rewards of ownership have
been transferred to the buyer and the seller retains no effective
control of the goods transferred to a degree usually associated with
ownership; and
(ii) no significant uncertainty exists regarding the amount of the
consideration that will be derived from the sale of the goods.
Case (i) The sale is complete but delivery has been postponed at buyer’s
request. The entity should recognize the entire sale of ` 60,000 for the year
ended 31st March, 20X2.
Case (ii) 20% goods lying unsold with consignee should be treated as
closing inventory and sales should be recognized for ` 1,20,000 (80% of
` 1,50,000). In case of consignment sale revenue should not be recognized
until the goods are sold to a third party.
Case (iii) In case of goods sold on approval basis, revenue should not be
recognized until the goods have been formally accepted by the buyer or the
buyer has done an act adopting the transaction or the time period for
rejection has elapsed or where no time has been fixed, a reasonable time
has elapsed. Therefore, revenue should be recognized for the ` 90,000 upon
receipt of approval on 31-02-20X1 and for the balance ` 30,000 on 01-03-
20X1 as the time period for rejecting the goods had expired.
Case (iv) Trade discounts given should be deducted in determining revenue.
Thus ` 39,000 should be deducted from the amount of turnover of ₹
7,80,000 for the purpose of recognition of revenue.
Thus, revenue should be ` 7,41,000.
8. Machine 1: As the installation process is simple, revenue from Machine 1
will be recognized on 31 March 20X1.
Revenue (Machine 1) ` 3,20,000
Cost of Goods Sold ` 1,60,000
Profit during the period ` 1,60,000
© The Institute of Chartered Accountants of India
REVENUE BASED ACCOUNTING STANDARDS 8.55 a
Since the question specifies that the machine is already accepted by ST on
31 March 20X1, the revenue arising from sale of the machine needs to be
recognized for the year ending 31 March 20X1. This is because acceptance
of the machine indicates that the risks and rewards pursuant to the
ownership are transferred to ST.
Machine 2: Installation process for Machine 2 is more complicated,
requiring significant assistance from KY Ltd. However, question specifies
that the machine is already accepted by ST on 31 March 20X1. Assuming
that there is no further approval/acceptance required from the buyer for the
Machine sold, revenue from sale of Machine 2 can be recognized for the
year ending 31 March 20X1.
Revenue (Machine 2) ` 3,00,000
Cost of Goods Sold ` 1,50,000
Profit during the period ` 1,50,000
However, installation fee which is for rendering installation services cannot
be recognized until the installation is complete. Since the machine is
pending installation, the revenue in respect of installation charges `10,000
needs to be recognized on 5 April 20X1 once the installation process gets
completed.
9. As per AS 9 ‘Revenue Recognition’, where the ability to assess the ultimate
collection with reasonable certainty is lacking at the time of raising any
claim, e.g. for escalation of price, export incentives, interest etc., revenue
recognition is postponed to the extent of uncertainty involved. In such
cases, it may be appropriate to recognise revenue only when it is reasonably
certain that the ultimate collection will be made. Where there is no
uncertainty as to ultimate collection, revenue is recognised at the time of
sale or rendering of service even though payments are made by instalments.
Thus, PQR Ltd. cannot recognise the interest amount unless the company
actually receives it. 10% rate of recovery on overdue outstanding is also an
estimate based on previous record and is not certain. Hence, the company is
advised to recognise interest receivable only on receipt basis.
© The Institute of Chartered Accountants of India
© The Institute of Chartered Accountants of India
CHAPTER a
9 1.1
OTHER ACCOUNTING
STANDARDS
UNIT 1: ACCOUNTING STANDARD 12 ACCOUNTING
FOR GOVERNMENT GRANTS
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the –
Accounting Treatment of Government Grants
Capital Approach versus Income Approach
Recognition of Government Grants
Non-monetary Government Grants
Presentation of Grants:
▪ Related to Specific Fixed Assets
▪ Related to Revenue
▪ In the nature of Promoters’ contribution
Refund of Government Grants
Disclosures.
© The Institute of Chartered Accountants of India
a 9.2 ADVANCED ACCOUNTING
1.1. 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 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.
1.2 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.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.3 a
1.3 ACCOUNTING TREATMENT OF GOVERN-
MENT 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.
1.4 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.
Example:
X Ltd applies for a grant from the local authority towards a social cause. X Ltd. is
required to meet certain conditions to be eligible for the receipt of grant. There is
a reasonable assurance that X Ltd will receive the grant in time. However, after
having applied for the grant, there is a likelihood that X Ltd may not be able to
meet all the conditions attached to the grant.
In such case, X Ltd should not recognise the grant in its books until there is a
reasonable assurance that it would be able to meet all conditions attached to the
grant.
© The Institute of Chartered Accountants of India
a 9.4 ADVANCED ACCOUNTING
1.5 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.
Example
X Convent wishes to open a school in locality A. It applies to the State authority
for grant of land. The State authority grants the land for construction of the the
purposes of the school construction. The market value of the land is ` 20 crore
whereas However, the authority provides the land at a nominal cost of ` 50 lakhs
including cost of registration. The State authority requires that free education
must be provided to the poor children by way of reserving 20% of the seats in the
school for such children. There is a reasonable assurance that X Convent has a
reason to believe it can will meet that the above stated condition attached to the
grant.
Thus, X Convent needs to would recognise the cost of the land at its acquisition
cost of ` 50 lakhs.
1.6 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.
Example
The Central Government is planning to generate large employment in rural and
backward regions. Thus, it is planning to give grants for the same to entities who
will meet the required conditions. F Ltd applied for a grant to the Central
Government. The Government will give the grant on the condition that, F Ltd will
be required to construct a factory where it would need to employ at least 500
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.5 a
workers for 5 years. Total cost of the construction is expected to be ` 50 crore.
The amount of the grant is ` 30 crore.
F Ltd will be able to recognise the grant only if there is reasonable assurance that
it will meet o the condition of employing 500 workers for next 5 years.
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.
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)
© The Institute of Chartered Accountants of India
a 9.6 ADVANCED ACCOUNTING
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.
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.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.7 a
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
2nd Account)
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 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.
© The Institute of Chartered Accountants of India
a 9.8 ADVANCED ACCOUNTING
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.
1.7 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.
Illustration 4
X Ltd. runs a charitable hospital. It incurs salary of doctors, staff etc to the extent
of ` 30 lakhs per annum. As a support, the local Government grants a lumpsum
payment of `90 lakhs to meet the salary expense for a period of next 5 years.
You are required to pass the necessary journal entries in the books of the
company for first year of the grant and present in the statement of profit & loss
when the grant is:
(a) Shown separately as Other Income; and
(b) Deducted against the Salary costs.
Solution
Journal Entries
Particulars ` (Dr.) ` (Cr.)
Bank Account Dr. 90,00,000
To Deferred Income Account 90,00,000
(Being receipt of grant from government)
Salary Expense Account Dr. 30,00,000
To Bank Account 30,00,000
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.9 a
(Being Salary expense paid for the year)
Deferred Income Account Dr. 18,00,000
To Profit & loss Account 18,00,000
(Being Year 1 Grant income recognised in Profit &
Loss)
Note: The grant has been spread on a straight-line basis over a period of 5
years [`90,00,000/5 years = ` 18,00,000].
Statement of Profit & Loss Account (Extract)
(a) Shown separately as Other Income:
Particulars Notes (` )
Other Income 18,00,000
(b) Deducted against the Salary costs:
Particulars (` )
Salary cost 30,00,000
Less: Deferred Government Grant (18,00,000) 12,00,000
1.8 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 5
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,
© The Institute of Chartered Accountants of India
a 9.10 ADVANCED ACCOUNTING
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 6
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.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.11 a
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 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.
1.9 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.
© The Institute of Chartered Accountants of India
a 9.12 ADVANCED ACCOUNTING
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.
1.10 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
statements, including grants of non-monetary assets given at a concessional
rate or free of cost.
Illustration 7
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 2 nd 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 8
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.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.13 a
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))
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)
© The Institute of Chartered Accountants of India
a 9.14 ADVANCED ACCOUNTING
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
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
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.15 a
Illustration 9
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 –
` 300) 1,200.00
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)
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.
© The Institute of Chartered Accountants of India
a 9.16 ADVANCED ACCOUNTING
Illustration 10
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. 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.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.17 a
Therefore, on refund in the 3 rd 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.
© The Institute of Chartered Accountants of India
a 9.18 ADVANCED ACCOUNTING
Illustration 11
Co X runs a charitable hospital. It incurs salary of doctors, staff etc to the extent of `
30 lakhs per annum. As a support, the local govt grants a lumpsum payment of `90
lakhs to meet the salary expense for a period of next 5 years.
At the start of Year 4, Co X is unable to meet the conditions attached to the grant
and is required to refund the entire grant of 90 lakhs.
You are required to pass the necessary journal entries in the books of the company
for refund of the grant if the grant was shown separately as Other Income.
Solution
` `
Deferred Grant A/c Dr. 36 lakhs
Profit & Loss A/c Dr. 54 lakhs
To Bank A/c 90 lakhs
(Being Government grant refunded)
Workings:
Total grant received: ` 90 Lakhs
Grant recognised as income for first 3 years: ` 18 lakhs × 3
= ` 54 lakhs
Remaining Deferred Income = ` 90 Lakhs – 54 lakhs
= ` 36 lakhs
Reference: The students are advised to refer the full text of AS 12 “Accounting
for Government Grants”.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.19 a
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. To encourage industrial promotion, IDCI offers subsidy worth ` 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
(d) Credit it to general reserve
2. 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.
(d) disclosed in the Statement of Profit and Loss of the period in which they
are receivable, as an extraordinary item
3. Which of the following is an acceptable method of accounting presentation
for a government grant relating to an asset?
(a) Credit the grant immediately to Income statement
(b) Show the grant as part of Capital Reserve
(c) Reduce the grant from the cost of the asset or show it separately as a
deferred income on the Liability side of the Balance Sheet.
(d) Show the grant as part of general Reserve
© The Institute of Chartered Accountants of India
a 9.20 ADVANCED ACCOUNTING
4. X Ltd. has received a grant of ` 20 crore for purchase of a qualified machine
costing ` 80 crore. X Ltd has a policy to recognise the grant as a deduction
from the cost of the asset. The expected remaining useful life of the machine
is 10 years. Assume that there is no salvage value and the depreciation
method is straight-line. The amount of annual depreciation to be charged as
an expense in Profit and Loss Statement will be:
(a) ` 10 crore
(b) ` 6 crore
(c) ` 2 crore
(d) ` 8 crore
5. X Ltd has received a grant of ` 20 crore for purchase of a qualified machine
costing ` 80 crore. X Ltd. has a policy to recognise the grant as deferred
income. The expected remaining useful life of the machine is 10 years.
Assume that there is no salvage value and the depreciation method is
straight-line. The amount of other income to be to be recognised in Profit and
Loss Statement will be:
(a) ` 10 crore
(b) ` 6 crore
(c) ` 2 crore
(d) ` 8 crore
Theoretical Questions
6. AS 12 deals with recognition and measurement of government grants. Please
elaborate the parameters which are required to be met before an entity can
recognise government grants in its books?
Scenario based Questions
7. 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.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.21 a
Elucidate the current accounting treatment, with reference to the provisions of
AS-12
8. Hygiene Ltd. had received a grant of ` 50 lakh in 2012 from a State
Government towards installation of pollution control machinery on fulfilment
of certain conditions. The company, however, failed to comply with the said
conditions and consequently was required to refund the said amount in 2024.
The company debited the said amount to its machinery account in 2024 on
payment of the same. It also reworked the depreciation for the said machinery
from the date of its purchase and passed necessary adjusting entries in the
year 2024 to incorporate the retrospective impact of the same. State whether
the treatment done by the company is correct or not.
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (a) 2. (c) 3. (c) 4. (b) 5. (c)
Answer to the Theoretical Questions
6. A government grant is recognised when 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.
Answer to the Scenario based Questions
7. 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
© The Institute of Chartered Accountants of India
a 9.22 ADVANCED ACCOUNTING
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
first adjusted against the unamortised deferred income in the books and the
excess if any will be debited to profit & loss account of the company as an
extraordinary item in the year 20X2-20X3.
8. As per the facts of the case, Hygiene Ltd. had received a grant of ` 50 lakh
in 2012 from a State Government towards installation of pollution control
machinery on fulfilment of certain conditions. However, the amount of
grant has to be refunded since it failed to comply with the prescribed
conditions. In such circumstances, AS 12, “Accounting for Government
Grants”, requires that 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 capital reserve or the deferred income
balance, as appropriate, by the amount refundable. The Standard further
makes it clear that in the first alternative, i.e., where the book value of the
asset is increased, depreciation on the revised book value should be
provided prospectively over the residual useful life of the asset.
Accordingly, the accounting treatment given by Hygiene Ltd. of increasing
the value of the plant and machinery is quite proper. However, the
accounting treatment in respect of depreciation given by the company of
adjustment of depreciation with retrospective effect is improper and
constitutes violation of AS 12.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.23 a
UNIT 2: ACCOUNTING STANDARD 14 ACCOUNTING
FOR AMALGAMATIONS
LEARNING OUTCOMES
After studying this unit, you will be able to comprehend the –
Types of amalgamation – merger and purchase;
Accounting for amalgamation – Pooling of interest method and
purchase method;
Computation of Purchase consideration;
Amalgamation post balance sheet date;
Disclosure requirements of AS 14;
2.1 INTRODUCTION
AS 14 (Revised) deals with the accounting to be made in the books of Transferee
company in the case of amalgamation and the treatment of any resultant
goodwill or reserve.
An amalgamation may be either in the nature of merger or purchase. The
standard specifies the conditions to be satisfied by an amalgamation to be
considered as amalgamation in nature of merger or purchase.
An amalgamation in nature of merger is accounted for as per pooling of interests
method and in nature of purchase is dealt under purchase method.
Pooling of Interest
Merger
Method
Types of
Amalgamation
Purchase Purchase Method
© The Institute of Chartered Accountants of India
a 9.24 ADVANCED ACCOUNTING
The standard describes the disclosure requirements for both types of
amalgamations in the first financial statements. We will discuss the other
amalgamation aspects in detail in subsequent paragraphs of this unit.
Note:
AS 14 (Revised) does not deal with cases of acquisitions. The distinguishing
feature of an acquisition is that the acquired company is not dissolved and its
separate entity continues to exist.
2.2 DEFINITION OF THE TERMS USED IN THE
STANDARD
Amalgamation means an amalgamation pursuant to the provisions of the
Companies Act, 2013 or any other statute which may be applicable to
companies and includes ‘merger’.
Transferor company means the company which is amalgamated into
another company.
Transferee company means the company into which a transferor company is
amalgamated.
2.3 TYPES OF AMALGAMATIONS
Amalgamations fall into two broad categories.
Types of amalgamations
Merger Purchase
Merger - In amalgamations where there is a genuine pooling not merely of
the assets and liabilities of the amalgamating companies but also of the
shareholders’ interests and of the businesses of these companies.
Purchase - In amalgamations which are in effect a mode by which one
company acquires another company and as a consequence:
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.25 a
the shareholders of the company which is acquired normally do not
continue to have a proportionate share in the equity of the combined
company, or
the business of the company which is acquired is not intended to be
continued. Such amalgamations are amalgamations in the nature of
'purchase'.
2.4 AMALGAMATION IN THE NATURE OF
MERGER
Amalgamation in the nature of merger is an amalgamation which satisfies all the
following conditions.
(i) All the assets and liabilities of the transferor company become, after
amalgamation, the assets and liabilities of the transferee company.
(ii) Shareholders holding not less than 90% of the face value of the equity
shares of the transferor company (other than the equity shares already held
therein, immediately before the amalgamation, by the transferee company
or its subsidiaries or their nominees) become equity shareholders of the
transferee company by virtue of the amalgamation.
(iii) The consideration for the amalgamation receivable by those equity
shareholders of the transferor company who agree to become equity
shareholders of the transferee company is discharged by the transferee
company wholly by the issue of equity shares in the transferee company,
except that cash may be paid in respect of any fractional shares.
(iv) The business of the transferor company is intended to be carried on, after
the amalgamation, by the transferee company.
(v) No adjustment is intended to be made to the book values of the assets and
liabilities of the transferor company when they are incorporated in the
financial statements of the transferee company except to ensure uniformity
of accounting policies.
Example: X Ltd and Y Ltd are both in telecom business. As per the arrangement
X Ltd will get merged with Y Ltd and their shareholders will get shares in Y Ltd.
X Ltd operations will going to be continued under Y ltd.
© The Institute of Chartered Accountants of India
a 9.26 ADVANCED ACCOUNTING
2.5 AMALGAMATION IN THE NATURE OF
PURCHASE
Amalgamation in the nature of purchase is an amalgamation which does not
satisfy any one or more of the conditions specified above for “Amalgamation in
the nature of merger”.
2.6 METHODS OF ACCOUNTING FOR
AMALGAMATIONS
There are two main methods of accounting for amalgamations.
For an amalgamation in the nature of merger - pooling of interests method
and
For an amalgamation in the nature of purchase - purchase method.
2.6.1 Pooling of Interests Method
Pooling of interests is a method of accounting for amalgamations the object of
which is to account for the amalgamation as if the separate businesses of the
amalgamating companies were intended to be continued by the transferee
company. Accordingly, only minimal changes are made in aggregating the
individual financial statements of the amalgamating companies.
Under this method, the assets, liabilities and reserves of the transferor company
are recorded by the transferee company at their existing carrying amounts
If, at the time of the amalgamation, the transferor and the transferee companies
have conflicting accounting policies, a uniform set of accounting policies is
adopted following the amalgamation. The effects on the financial statements of
any changes in accounting policies are reported in accordance with AS 5.
2.6.2 Purchase Method
Under the purchase method, the transferee company accounts for the
amalgamation either
By incorporating the assets and liabilities at their existing carrying amounts or
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.27 a
By allocating the consideration to individual identifiable assets and liabilities
of the transferor company on the basis of their fair values at the date of
amalgamation. The identifiable assets and liabilities may include assets and
liabilities not recorded in the financial statements of the transferor company.
2.7 CONSIDERATION
Consideration for the amalgamation means the aggregate of the shares and other
securities issued and the payment made in the form of cash or other assets by the
transferee company to the shareholders of the transferor company. In
determining the value of the consideration, an assessment is made of the fair
value of its elements.
Clarification Chart:
Method I – Net Payment Method Method II – Net Assets Method
Note: We need to compute P.C. by Net Payment Method only. If it cannot be
computed by Net Payment Method – then Net Assets Method will be
applicable.
Situation I – If it is a Merger Situation I – if it is a Merger
Equity shares issued to ESH (cash may Assets at Book value
be paid in case fraction arises) -
+ Liabilities at Book value
Any form of payment given to PSH -
Reserves and Surplus
=
ESC + PSC
Situation II – If it is a case of Situation II – If it is a case of
Purchase Purchase
Any form of payment given to ESH Assets at agreed value
+ -
Any form of payment given to PSH Liabilities at agreed value
© The Institute of Chartered Accountants of India
a 9.28 ADVANCED ACCOUNTING
Many amalgamations recognise that adjustments may have to be made to the
consideration in the light of one or more future events. When the additional
payment is probable and can reasonably be estimated at the date of
amalgamation, it is included in the calculation of the consideration. In all other
cases, the adjustment is recognised as soon as the amount is determinable
2.8 TREATMENT OF RESERVES OF THE
TRANSFEROR COMPANY ON AMALGAMA-
TION
If the amalgamation is an ‘amalgamation in the nature of merger’, the identity of
the reserves is preserved and they appear in the financial statements of the
transferee company in the same form in which they appeared in the financial
statements of the transferor company.
Thus, for example, the General Reserve of the transferor company becomes the
General Reserve of the transferee company, the Capital Reserve of the transferor
company becomes the Capital Reserve of the transferee company and the
Revaluation Reserve of the transferor company becomes the Revaluation Reserve
of the transferee company. As a result of preserving the identity, reserves which
are available for distribution as dividend before the amalgamation would also be
available for distribution as dividend after the amalgamation.
2.9 ADJUSTMENTS TO RESERVES -
AMALGAMATION IN THE NATURE OF
MERGER
When an amalgamation is accounted for using the pooling of interests method,
the reserves of the transferee company are adjusted to give effect to the
following:
A uniform set of accounting policies should be adopted following the
amalgamation and, hence, the policies of the transferor and the transferee
are aligned.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.29 a
Difference between the amount recorded as share capital issued (plus any
additional consideration in the form of cash or other assets) and the amount
of share capital of the transferor company.
2.10 ADJUSTMENTS TO RESERVES -
AMALGAMATION IN THE NATURE OF
PURCHASE
If the amalgamation is an ‘amalgamation in the nature of purchase’, the identity
of the reserves, other than the statutory reserves is not preserved. The amount of
the consideration is deducted from the value of the net assets of the transferor
company acquired by the transferee company. If the result of the computation is
negative, the difference is debited to goodwill arising on amalgamation and if the
result of the computation is positive, the difference is credited to Capital Reserve.
Certain reserves may have been created by the transferor company pursuant to
the requirements of, or to avail of the benefits under, the Income-tax Act, 1961;
for example, Development Allowance Reserve, or Investment Allowance Reserve
or any other statutory reserve. The Act requires that the identity of the reserves
should be preserved for a specified period. Likewise, certain other reserves may
have been created in the financial statements of the transferor company in terms
of the requirements of other statutes. Though normally, in an amalgamation in
the nature of purchase, the identity of reserves is not preserved, an exception is
made in respect of reserves of the aforesaid nature (referred to hereinafter as
‘statutory reserves’) and such reserves retain their identity in the financial
statements of the transferee company in the same form in which they appeared in
the financial statements of the transferor company, so long as their identity is
required to be maintained to comply with the relevant statute. This exception is
made only in those amalgamations where the requirements of the relevant
statute for recording the statutory reserves in the books of the transferee
company are complied with.
In such cases the statutory reserves are recorded in the financial statements of
the transferee company by a corresponding debit to a suitable account head (e.g.,
‘Amalgamation Adjustment Reserve’) which is presented as a separate line item.
When the identity of the statutory reserves is no longer required to be
maintained, both the reserves and the aforesaid account are reversed.
© The Institute of Chartered Accountants of India
a 9.30 ADVANCED ACCOUNTING
The Standard gives a title, which reads as "Reserve". This gives rise to following
requirements.
1. The corresponding debit is "also" to a Reserve Account
2. That Reserve account will show a negative balance
3. But it has to be shown as a separate line item - Which implies, that this debit
"cannot be set off against Statutory reserve taken over".
So the presentation will be as follows:
Notes to Accounts for “Reserves and Surplus”
Description Amount Amount
(Current year) (Previous Year)
Statutory Reserve (taken over from
transferor company)
General Reserve
Profit and Loss or Retained Earnings
Amalgamation Adjustment Reserve (--) (--)
(negative balance)
2.11 TREATMENT OF GOODWILL ARISING ON
AMALGAMATION
Goodwill arising on amalgamation represents a payment made in anticipation of
future income and it is appropriate to treat it as an asset to be amortised to
income on a systematic basis over its useful life. Due to the nature of goodwill, it
is frequently difficult to estimate its useful life with reasonable certainty. Such
estimation is, therefore, made on a prudent basis. Accordingly, it is considered
appropriate to amortise goodwill over a period not exceeding five years unless a
somewhat longer period can be justified.
Factors which may be considered in estimating the useful life of goodwill arising
on amalgamation include:
(a) the foreseeable life of the business or industry
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.31 a
(b) the effects of product obsolescence, changes in demand and other
economic factors
(c) the service life expectancies of key individuals or groups of employees
(d) expected actions by competitors or potential competitors
(e) legal, regulatory or contractual provisions affecting the useful life
2.12 BALANCE OF PROFIT AND LOSS ACCOUNT
In the case of an ‘amalgamation in the nature of merger’, the balance of the Profit
and Loss Account appearing in the financial statements of the transferor company
is aggregated with the corresponding balance appearing in the financial
statements of the transferee company. Alternatively, it is transferred to the
General Reserve, if any.
In the case of an ‘amalgamation in the nature of purchase’, the balance of the
Profit and Loss Account appearing in the financial statements of the transferor
company, whether debit or credit, loses its identity.
2.13 DISCLOSURES
For all amalgamations, the following disclosures are considered appropriate in the
first financial statements following the amalgamation:
a. Names and general nature of business of the amalgamating companies;
b. Effective date of amalgamation for accounting purposes;
c. The method of accounting used to reflect the amalgamation; and
d. Particulars of the scheme sanctioned under a statute.
For amalgamations accounted for under the pooling of interests method, the
following additional disclosures are considered appropriate in the first financial
statements following the amalgamation:
a. Description and number of shares issued, together with the percentage of
each company’s equity shares exchanged to effect the amalgamation;
© The Institute of Chartered Accountants of India
a 9.32 ADVANCED ACCOUNTING
b. The amount of any difference between the consideration and the value of
net identifiable assets acquired, and the treatment thereof.
For amalgamations accounted for under the purchase method, the following
additional disclosures are considered appropriate in the first financial statements
following the amalgamation:
a. Consideration for the amalgamation and a description of the consideration
paid or contingently payable; and
b. The amount of any difference between the consideration and the value of
net identifiable assets acquired, and the treatment thereof including the
period of amortisation of any goodwill arising on amalgamation.
2.14 AMALGAMATION AFTER THE BALANCE
SHEET DATE
When an amalgamation is effected after the balance sheet date but before the
issuance of the financial statements of either party to the amalgamation
disclosure is made in accordance with AS 4 ‘Contingencies and Events Occurring
After the Balance Sheet Date’ but the amalgamation is not incorporated in the
financial statements. In certain circumstances the amalgamation may also
provide additional information affecting the financial statements themselves for
instance by allowing the going concern assumption to be maintained.
Illustration 1
A Ltd. take over B Ltd. on April 01, 20X1 and discharges consideration for the
business as follows:
(i) Issued 42,000 fully paid equity shares of ` 10 each at par to the equity
shareholders of B Ltd.
(ii) Issued fully paid up 15% preference shares of ` 100 each to discharge the
preference shareholders ( ` 1,70,000) of B Ltd. at a premium of 10%.
(iii) It is agreed that the debentures of B Ltd. ( ` 50,000) will be converted into
equal number and amount of 13% debentures of A Ltd.
Determine the amount of purchase consideration as per AS 14.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.33 a
Solution
Particulars `
Equity Shares (42,000 x 10) 4,20,000
15% Preference Share Capital 1,70,000
Add: Premium on Redemption 17,000
Purchase Consideration 6,07,000
Note: As per AS 14, consideration for the amalgamation means the aggregate of
the shares and other securities issued and the payment made in the form of cash
or other assets by the transferee company to the shareholders of the transferor
company. Thus, payment to debenture holders are not covered by the term
‘consideration’.
Illustration 2
A Ltd. and B Ltd. were amalgamated on and from 1st April, 20X1. A new company C
Ltd. was formed to take over the business of the existing companies. A Ltd. and
B Ltd. have the following ledger balances as on 31st March, 20X1:
A Ltd. B Ltd.
(` in lakhs) (` in lakhs)
Land and Building 550 400
Plant and Machinery 350 250
Investments (Non-current) 150 50
Inventory 350 250
Trade Receivables 300 350
Cash and Bank 300 200
Share Capital:
Equity Shares of ` 100 each 800 750
12% Preference shares of ` 100 each 300 200
Reserves and Surplus:
Revaluation Reserve 150 100
General Reserve 170 150
Investment Allowance Reserve 50 50
© The Institute of Chartered Accountants of India
a 9.34 ADVANCED ACCOUNTING
Profit and Loss Account 50 30
Secured Loans:
10% Debentures ( ` 100 each) 60 30
Trade Payables 420 190
Additional Information:
(1) 10% Debenture holders of A Ltd. and B Ltd. are discharged by C Ltd. issuing
such number of its 15% Debentures of ` 100 each so as to maintain the same
amount of interest.
(2) Preference shareholders of the two companies are issued equivalent number
of 15% preference shares of C Ltd. at a price of ` 150 per share (face value of
` 100).
(3) C Ltd. will issue 5 equity shares for each equity share of A Ltd. and 4 equity
shares for each equity share of B Ltd. The shares are to be issued @ ` 30 each,
having a face value of ` 10 per share.
(4) Investment allowance reserve is to be maintained for 4 more years.
Prepare the Balance Sheet of C Ltd. as on 1st April, 20X1 after the amalgamation
has been carried out on the basis of Amalgamation in the nature of purchase.
Solution
Balance Sheet of C Ltd. as at 1st April, 20X1
Particulars Note No. (` in lakhs)
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 1,200
(b) Reserves and Surplus 2 1,650
(2) Non-Current Liabilities
Long-term borrowings 3 60
(3) Current Liabilities
Trade payables 8 610
Total 3,520
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.35 a
II. Assets
(1) Non-current assets
(a) Property, Plant and 4 1,550
Equipment
(b) Intangible assets 5 20
(c) Non-current investments 6 200
(2) Current assets
(a) Inventory (350 + 250) 600
(b) Trade receivables 7 650
(c) Cash and bank balances
(300 + 200) 500
Total 3,520
Notes to Accounts
(` in lakhs) (` in lakhs)
1. Share Capital
Equity share capital (W.N.1)
70,00,0001 Equity shares of ` 10 each 700
5,00,0002 Preference shares of 500
` 100 each
(all the above shares are allotted as 1,200
fully paid-up pursuant to contracts
without payment being received in
cash)
2. Reserves and surplus
Securities Premium Account (W.N.3)
(950 + 700) 1,650
1
40,00,000 + 30,00,000
2
3,00,000 + 2,00,000
© The Institute of Chartered Accountants of India
a 9.36 ADVANCED ACCOUNTING
Investment Allowance Reserve (50 + 100
50)
Amalgamation Adjustment Reserve
(50 + 50) (100) 1,650
3. Long-term borrowings
15% Debentures 60
4. Property, Plant and Equipment
Land and Building (550 + 400) 950
Plant and Machinery (350 + 250) 600 1,550
5. Intangible assets
Goodwill [W.N. 2] (110 – 90) 20
6. Non-current Investments
Investments (150 + 50) 200
7. Trade receivables (300 + 350) 650
8. Trade payables (420 + 190) 610
Working Notes:
(` in lakhs)
A Ltd. B Ltd.
(1) Computation of Purchase consideration
(a) Preference shareholders:
3,00,00,000
i.e. 3,00,000 shares × ` 150 each 450
100
2,00,00,000
i.e. 2,00,000 shares × ` 150 each 300
100
(b) Equity shareholders:
8,00,00,000 × 5
i.e. 40,00,000 shares × ` 30 each 1,200
100
7,50,00,000 × 4
i.e. 30,00,000 shares × ` 30 each _____ 900
100
Amount of Purchase Consideration 1,650 1,200
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.37 a
(2) Net Assets Taken Over
Assets taken over:
Land and Building 550 400
Plant and Machinery 350 250
Investments 150 50
Inventory 350 250
Trade receivables 300 350
Cash and bank 300 200
2,000 1,500
Less: Liabilities taken over:
Debentures 40 20
Trade payables 420 190
460 210
Net assets taken over 1,540 1,290
Purchase consideration 1,650 1,200
Goodwill 110 ____
Capital reserve 90
(3) Computation of securities premium
On preference share capital
A Ltd.- 3,00,000 x 50 150
B Ltd.- 2,00,000 x 50 100
On equity share capital
A Ltd.- 40,00,000 x 20 800
B Ltd.- 30,00,000 x 20 ____ 600
Total 950 700
Note: For problems based on practical application of AS 14 (Revised)
students are advised to refer Chapter 14 ‘Accounting for Amalgamation of
Companies’ of the study material.
© The Institute of Chartered Accountants of India
a 9.38 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Which of the following statement is correct:
(a) In case of merger – ESH can be issued only equity shares as a part of
Purchase consideration.
(b) In case of purchase – ESH can be issued Preference shares also as a part
of Purchase consideration.
(c) Both (a) and (b) are correct.
(d) Both (a) and (b) are incorrect.
2. State which statement is correct:
(a) In case of merger – assets and liabilities can only be taken over at book
values.
(b) In case of purchase – assets and liabilities can be taken over at book
values or agreed values.
(c) Both (a) and (b) are correct.
(d) Both (a) and (b) are incorrect.
3. State which statement is correct:
(a) In case of merger – All Reserves and surplus of vendor company are
taken over by Purchasing company.
(b) In case of Purchase – None of the Reserves and surplus of vendor
company are taken over by Purchasing company.
(c) Both (a) and (b) are correct.
(d) Only (a) is correct.
4. State which statement is correct:
(a) In case of merger – We use pooling of interest method for accounting.
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.39 a
(b) In case of Purchase We use purchase method or pooling of interest
method depending upon whether it is take over at agreed values or
book values.
(c) Both (a) and (b) are correct.
(d) Only (a) is correct.
5. State which statement is incorrect:
(a) In case of merger – We can issue either preference shares or equity
shares to PSH.
(b) In case of Purchase – We can issue either preference shares or equity
shares to PSH.
(c) In case of merger – We can issue only preference shares to PSH.
(d) none of the above.
Theoretical Questions
6. Briefly describe the disclosure requirements for amalgamation including
additional disclosure, if any, for different methods of amalgamation as per AS
14 (Revised).
7. List the conditions to be fulfilled as per AS 14 (Revised) for an amalgamation
to be in the nature of merger, in the case of companies.
8. Briefly explain the methods of accounting for amalgamation as per
Accounting Standard-14.
Scenario based Questions
9. X Co. Ltd. having share capital of ` 50 lakhs divided into equity shares of ` 10
each was taken over by Y Co. Ltd. Y Co. Ltd. issued 11 equity shares of ` 10
each for every 10 shares of X Co. Ltd.
Explain how the difference will be adjusted in the books of Y Co. Ltd. for the
shares issued under the 'Pooling of interests method' of amalgamation as per
AS 14.
© The Institute of Chartered Accountants of India
a 9.40 ADVANCED ACCOUNTING
10. On 1st April, 2018, Tina Ltd. take over the business of Rina Ltd. and
discharged purchase consideration as follows:
(i) Issued 50,000 fully paid Equity shares of ` 10 each at a premium of ` 5
per share to the equity shareholders of Rina Ltd.
(ii) Cash payment of ` 50,000 was made to equity shareholders of Rina Ltd.
(iii) Issued 2,000 fully paid 12% Preference shares of ` 100 each at par to
discharge the preference shareholders of Rina Ltd.
(iv) Debentures of Rina Ltd. 20,000) will he converted into equal number
and amount of 10% debentures of Tina Ltd.
Calculate the amount of Purchase consideration as per AS-14 and pass
Journal Entry relating to discharge of purchase consideration in the books of
Tina Ltd.
ANSWERS/SOLUTIONS
Answer to the Multiple Choice Questions
1. (b) 2. (c) 3. (d) 4. (d) 5. (c)
Answer to the Theoretical Questions
6. The disclosure requirements for amalgamations have been prescribed in
paragraphs 43 to 46 of AS 14 (Revised) on Accounting for Amalgamation.
Refer Para 2.5 for details.
7. According to AS 14 "Accounting for Amalgamations", Amalgamation in the
nature of merger is an amalgamation which satisfies all the following
conditions:
(i) All the assets and liabilities of the transferor company become, after
amalgamation, the assets and liabilities of the transferee company.
(ii) Shareholders holding not less than 90% of the face value of the equity
shares of the transferor company (other than the equity shares already
held therein, immediately before the amalgamation, by the transferee
company or its subsidiaries or their nominees) become equity
© The Institute of Chartered Accountants of India
OTHER ACCOUNTING STANDARDS 9.41 a
shareholders of the transferee company by virtue of the
amalgamation.
(iii) The consideration for the amalgamation receivable by those equity
shareholders of the transferor company who agree to become equity
shareholders of the transferee company is discharged by the
transferee company wholly by the issue of equity shares in the
transferee company, except that cash may be paid in respect of any
fractional shares.
(iv) The business of the transferor company is intended to be carried on,
after the amalgamation, by the transferee company.
(v) No adjustment is intended to be made to the book values of the
assets and liabilities of the transferor company when they are
incorporated in the financial statements of the transferee company
except to ensure uniformity of accounting policies.
8. As per AS 14 on 'Accounting for Amalgamations', there are two main
methods of accounting for amalgamations:
The Pooling of Interest Method
Under this method, the assets, liabilities and reserves of the transferor
company are recorded by the transferee company at their existing carrying
amounts (after making the necessary adjustments).
If at the time of amalgamation, the transferor and the transferee companies
have conflicting accounting policies, a uniform set of accounting policies is
adopted following the amalgamation. The effects on the financial
statements of any changes in accounting policies are reported in
accordance with AS 5 on 'Net Profit or Loss for the Period, Prior Period
Items and Changes in Accounting Policies'.
The Purchase Method
Under the purchase method, the transferee company accounts for the
amalgamation either by incorporating the assets and liabilities at their
existing carrying amounts or by allocating the consideration to individual
identifiable assets and liabilities of the transferor company on the basis of
© The Institute of Chartered Accountants of India
a 9.42 ADVANCED ACCOUNTING
their fair values at the date of amalgamation. The identifiable assets and
liabilities may include assets and liabilities not recorded in the financial
statements of the transferor company.
Answer to the Scenario based Questions
9. Particulars `
Purchase consideration = 5,00,000 x 11/10 = 55,000 shares 55,00,000
of ` 10 each 50,00,000
Less: Share capital of X Co. Ltd.
Difference Adjusted through General Reserve 5,00,000
10. As per AS 14, consideration for the amalgamation means the aggregate of
the shares and other securities issued and the payment made in the form of
cash or other assets by the transferee company to the shareholders of the
transferor company.
Computation of Purchase Consideration
Particulars `
Equity Shares (50,000x 15) 7,50,000
Cash payment 50,000
12% Preference Share Capital 2,00,000
Purchase Consideration 10,00,000
Note: Payment to debenture holders are not covered by the term
‘consideration’.
Journal entry
Particulars ` `
Liquidation of Rina Ltd. A/c 10,00,000
To Equity share capital A/c 5,00,000
To 12% Preference share capital A/c 2,00,000
To Securities premium A/c 2,50,000
To Bank/Cash A/c 50,000
(Being payment of cash and issue of shares for
discharge of purchase consideration)
© The Institute of Chartered Accountants of India
CHAPTER 10
ACCOUNTING STANDARDS
FOR CONSOLIDATED
FINANCIAL
STATEMENTS
UNIT 1 ACCOUNTING STATDARD 21
CONSOLIDATED FINANCIAL STATEMENTS
LEARNING OUTCOMES
After studying this chapter, you will be able to:
♦ Understand the concepts of Group, holding company and subsidiary
company.
♦ Apply the consolidation procedures for consolidation of financial
statements of subsidiaries with the holding companies.
♦ Prepare the consolidated financial statements and solve related
problems
© The Institute of Chartered Accountants of India
10.2 ADVANCED ACCOUNTING
UNIT OVERVIEW
Concept of
Purpose and Minority
Group, Components Calculation Elimination of
method of Interests;
Holding of of Goodwill/ Intra-Group
preparing Profit or
Company Consolidated Transactions and
consolidated Capital Loss of
and Financial other
financial Reserve Subsidiary
Subsidiary Statements Adjustments
statements Company
Company
Note: As per the syllabus, the unit covers simple problems on consolidated financial
statements with single subsidiary and excludes problems involving acquisition of
Interest in Subsidiary at Different Dates, Cross holding, Disposal of a Subsidiary and
Foreign Subsidiaries.
1.1 CONCEPT OF GROUP, HOLDING COMPANY
AND SUBSIDIARY COMPANY
In an era of business growth, many organizations are growing into large
corporations by the process of acquisition, mergers, gaining control by one
company over the other company, restructuring etc. Acquisitions and mergers
ultimately lead to either cost reduction or controlling the market or sharing the
material supplies or product diversification or availing tax benefits or synergy.
Whatever the motto behind these ventures is, the ultimate result is the large-scale
corporation. Formation of holding company is the most popular device for
achieving these objectives.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.3
FINANCIAL STATEMENTS
Group of Companies
Many a time, a company expands by keeping intact its separate corporate identity.
In this situation, a company (i.e. holding company) gains control over the other
company (subsidiary company). This control is exercised by one company over the
other by-
1. Purchasing specified number of shares i.e. ownership through voting power
of that company or
2. Exercising control over the board of directors.
The companies connected in these ways are collectively called as a Group of
Companies.
Holding Company and Subsidiary Company have also been defined in Section 2 of
the Companies Act, 2013.
Holding company
As per Section 2(46) of the Companies Act, 2013,
“Holding company”, in relation to one or more other companies, means a company
of which such companies are subsidiary companies.
It may be defined as one, which has one or more subsidiary companies and enjoys
control over them. Legally a holding company and its subsidiaries are distinct and
separate entities. However, in substance holding and subsidiary companies work as
a group. Accordingly, users of holding company’s accounts need financial
information of subsidiaries also to understand the performance and financial
position of the group (i.e. holding company and subsidiaries on a consolidated
basis).
Subsidiary Company
Section 2(87) of the Companies Act, 2013 defines “subsidiary company” as a
company in which the holding company -
(i) controls the composition of the Board of Directors; or
(ii) exercises or controls more than one-half of the total share capital either at its
own or together with one or more of its subsidiary companies:
© The Institute of Chartered Accountants of India
10.4 ADVANCED ACCOUNTING
A company shall be deemed to be a subsidiary company of the holding company
even if there is indirect control through the subsidiary company (ies).
The control over the composition of a subsidiary company’s Board of Directors
means exercise of power to appoint or remove all or a majority of the directors of
the subsidiary company.
Section 19 of the Companies Act, 2013 prohibits a subsidiary company from
holding shares in the holding company. According to this section, no company
shall, either by itself or through its nominees, hold any shares in its holding
company and no holding company shall allot or transfer its shares to any of its
subsidiary companies and any such allotment or transfer of shares of a company to
its subsidiary company shall be void.
However, a subsidiary may continue to be a member of its holding company when
(a) the subsidiary company holds such shares as the legal representative of a
deceased member of the holding company; or
(b) the subsidiary company holds such shares as a trustee; or
(c) the subsidiary company is a shareholder even before it became a subsidiary
company of the holding company.
The subsidiary company shall have a right to vote at a meeting of the holding
company only in respect of the shares held by it as a legal representative or as a
trustee, as mentioned above in point (a) and (b).
Applicable Accounting Standard
Accounting Standard (AS) 21: Consolidated Financial Statements provides guidance
on preparation of Consolidated Financial Statements, the purpose of which is
discussed in Para 3 below.
This Standard came into effect in respect of accounting periods commenced on or
after 1-4-2001. AS 21 lays down principles and procedures for preparation and
presentation of consolidated financial statements. Consolidated financial
statements are presented by the parent (holding company) to provide financial
information about the economic activities of the group as a single economic entity.
The parent presenting consolidated financial statements should present such
statements in accordance with this standard but in its separate financial statements,
investments in subsidiaries would be accounted as per AS 13.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.5
FINANCIAL STATEMENTS
1.2 OBJECTIVES OF AS 21
The objective of this Standard is to lay down principles and procedures for
preparation and presentation of consolidated financial statements. Consolidated
Financial Statements are prepared by the holding/parent company to provide
financial information regarding the economic resources controlled by its group and
results achieved with these resources. These consolidated financial statements are
prepared by the parent company in addition to the financial statement prepared
by the parent company for only its own affairs. Hence parent company prepares
two financial statements, one for only its own affairs and one for taking the whole
group as one unit in the form of consolidated financial statements. Consolidated
financial statements usually comprise the following:
Consolidated Balance Sheet
Consolidated Profit & Loss Statement
Notes to Accounts, other statements and explanatory material
Consolidated Cash Flow Statement, if parent company presents its own cash
flow statement.
While preparing the consolidated financial statement, all other ASs and Accounting
Policies will be applicable as they are applied in parent company’s own financial
statements.
A parent which presents consolidated financial statements should consolidate all
subsidiaries, domestic as well as foreign. Where an enterprise does not have a
subsidiary but has an associate and/or a joint venture such an enterprise should
also prepare consolidated financial statements in accordance with Accounting
Standard (AS) 23, Accounting for Associates in Consolidated Financial Statements,
and Accounting Standard (AS) 27, Financial Reporting of Interests in Joint Ventures
respectively.
Definitions as per Accounting Standard (AS) 21
Parent:
A parent is an enterprise that has one or more subsidiaries.
Subsidiary is an enterprise that is controlled by another enterprise (known as the
parent).
© The Institute of Chartered Accountants of India
10.6 ADVANCED ACCOUNTING
Control:
(a) the ownership, directly or indirectly through subsidiary(ies), of more than
one-half of the voting power of an enterprise; or
(b) control of the composition of the board of directors in the case of a company
or of the composition of the corresponding governing body in case of any
other enterprise so as to obtain economic benefits from its activities.
Group:
A group is a parent and all its subsidiaries.
Minority interest is that part of the net results of operations and of the net assets
of a subsidiary attributable to interests which are not owned, directly or indirectly
through subsidiary(ies), by the parent.
Equity is the residual interest in the assets of an enterprise after deducting all its
liabilities.
Consolidated financial statements are the financial statements of a group
presented as those of a single enterprise.
Circumstances under which Consolidated Financial Statements are
prepared
AS 21 should be applied in the preparation and presentation of consolidated
financial statements for a group of enterprises under the control of a parent.
Consolidated financial statements are the financial statements of a group
presented as those of a single enterprise.
AS 21 does not mandate which enterprises are required to prepare consolidated
financial statements – but specifies the rules to be followed where such financial
statements are prepared.
Consolidated Financial Statements will be prepared by the parent company for all
the companies that are controlled by the parent company either directly or
indirectly, situated in India or abroad except in certain cases.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.7
FINANCIAL STATEMENTS
1.3 WHOLLY OWNED AND PARTLY OWNED
SUBSIDIARIES
S. No. Wholly owned subsidiary Partly owned subsidiary company
company
1. A wholly owned subsidiary In a partly owned subsidiary, all the
company is one in which all the shares of subsidiary company are not
shares are owned by the acquired by the holding company i.e.
holding company. only the majority of shares (i.e., more
than 50%) are owned by the holding
company.
2. 100% voting rights are vested Voting rights of more than 50% but
by the holding company. less than 100% are vested by the
holding company.
3. There is no minority interest There is a minority interest because
because all the shares with less than 50% shares with voting
voting rights are held by the rights are held by outsiders other
holding company. than the holding company.
1.4 PURPOSE OF PREPARING THE
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated financial statements (CFS) are the financial statements of a ‘group’
presented as those of a single enterprise, where a ‘group’ refers to a parent and all
its subsidiaries. Parent company needs to inform the users about the financial
position and results of operations of not only of their enterprise itself but also of
the group as a whole. For this purpose, consolidated financial statements are
prepared and presented by a parent/holding enterprise to provide financial
information about a parent and its subsidiary(ies) as a single economic entity.
CFS are intended to show the financial position of the group as a whole - by
showing the economic resources controlled by them, by presenting the obligations
of the group and the results the group achieves with its resources.
© The Institute of Chartered Accountants of India
10.8 ADVANCED ACCOUNTING
CFS normally include consolidated balance sheet, consolidated statement of profit
and loss, and notes, other statements and explanatory material that form an
integral part thereof. Consolidated cash flow statement is presented in case a
parent presents its own cash flow statement. The consolidated financial statements
are presented, to the extent possible, in the same format as that adopted by the
parent for its separate financial statements.
The logic for presentation of Consolidated Financial Statements can be appreciated
with the help of an example below:
Assume that you are holding 10 shares of Reliance Industries Limited, one of the
largest conglomerates in India. If you look at Reliance Industries Limited’s separate
(standalone) balance sheet, you can see investments in subsidiaries like Jio
Platforms Limited, Reliance Jio Infocomm Limited, Reliance Retail Limited etc. Now,
if we see the standalone financials of Reliance Industries Limited, the revenue is
generated from Oil & Gas Business. However, we all know that equally significant
for Reliance Industries Limited is the revenue generated from its subsidiary
companies. Further, being a holding company, all operational decisions of the
subsidiary companies are taken by Reliance Industries Limited. In other words,
though the holding company and its subsidiaries are legally different entities, in
substance, all the operations of the subsidiaries are merely an extension of the
holding company, and the assets and liabilities of the subsidiaries are controlled by
the holding company.
Technically, Investments appearing in the balance sheet of Reliance Industries
Limited represents proportionate share in the net worth of the respective subsidiary
as well as is also a proportionate share in the profits earned by such subsidiaries.
Accordingly, consolidating the incomes and expenses, as well as the assets and
liabilities of the subsidiary companies with that of the parent company will result
in a better presentation of the operations as well as the financial position of
Reliance Industries Limited.
Relevant provisions of the Companies Act 2013
Where a company has one or more subsidiaries or associate companies, it shall, in
addition to the standalone financial statements, prepare a consolidated financial
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.9
FINANCIAL STATEMENTS
statement of the company and of all the subsidiaries and associate companies in
the same form and manner as that of its own and in accordance with applicable
accounting standards, which shall also be laid before the annual general meeting
(AGM) of the company along with the laying of its financial statement.
The company shall also attach along with its financial statement, a separate
statement containing the salient features of the financial statement of its subsidiary
or subsidiaries in Form AOC-1 as per Rule 5 of the Companies (Accounts) Rules,
2014.
For the purpose of section 129, ‘subsidiary’ includes ‘associate company’ and ‘joint
venture’ which means that the company would be required to prepare consolidated
financial statements including associate/ joint venture even if there is no subsidiary
of a company.
The consolidation of financial statements of the company shall be made in
accordance with the provisions of Schedule III of the Companies Act 2013 and the
applicable accounting standards.
In case of a company covered under sub-section (3) of section 129 which is not
required to prepare consolidated financial statements under the Accounting
Standards, it shall be sufficient if the company complies with provisions of
consolidated financial statements provided in Schedule III of the Act.
Exemptions from preparation of CFS:
As per Companies (Accounts) Amendment Rules, 2016, preparation of consolidated
financial statements by a company is not required if it meets the following
conditions:
(i) it is a wholly-owned subsidiary, or is a partially-owned subsidiary of another
company and all its other members, including those not otherwise entitled to
vote, having been intimated in writing and for which the proof of delivery of
such intimation is available with the company, do not object to the company
not presenting consolidated financial statements;
(ii) it is a company whose securities are not listed or are not in the process of
listing on any stock exchange, whether in or outside India; and
© The Institute of Chartered Accountants of India
10.10 ADVANCED ACCOUNTING
(iii) its ultimate or any intermediate holding company files consolidated financial
statements with the Registrar which are in compliance with the applicable
Accounting Standards.
AS21 also lays down the accounting principles and procedures for preparation and
presentation of consolidated financial statements which have been covered in the
later part of this chapter.
It may be pertinent to note that in certain countries outside India, presentation of
standalone financial statements is not mandatory. In fact, it is the preparation and
presentation of consolidated financial statements that are mandatory, given the
reasoning behind Consolidated Financial Statements already discussed in the
example of Reliance Industries Limited above.
In India, the statutory framework (such as the Companies Act, 2013 or the Income
Tax Act, 1961) mandate presentation of standalone financial statements, thereby
making standalone financial statements equally important as consolidated financial
statements.
1.5 SCOPE OF AS 21
1. This Standard should be applied in the preparation and presentation of
consolidated financial statements for a group of enterprises under the control
of a parent.
2. This Standard should also be applied in accounting for investments in
subsidiaries in the separate financial statements of a parent.
3. In the preparation of consolidated financial statements, other Accounting
Standards also apply in the same manner as they apply to the separate
statements.
4. This Standard does not deal with:
a. methods of accounting for amalgamations and their effects on
consolidation, including goodwill arising on amalgamation (see AS 14,
Accounting for Amalgamations);
b. accounting for investments in associates (governed by AS 13,
Accounting for Investments); and
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.11
FINANCIAL STATEMENTS
c. accounting for investments in joint ventures (governed by AS 13,
Accounting for Investments).
Note: AS 21 is mandatory if an enterprise presents consolidated financial
statements. In other words, the accounting standard does not mandate an
enterprise to present consolidated financial statements but, if the enterprise
presents consolidated financial statements for complying with the requirements of
any statute or otherwise, it should prepare and present consolidated financial
statements in accordance with AS 21.
1.6 CONTROL
The consolidated financial statements are prepared on the basis of financial
statements of parent and all enterprises that are controlled by the parent, other
than those subsidiaries excluded for the reasons set out in paragraph 11 of AS 21.
Control exists when the parent owns, directly or indirectly through subsidiary(ies),
more than one-half of the voting power of an enterprise. Control also exists when
an enterprise controls the composition of the board of directors (in the case of a
company) or of the corresponding governing body (in case of an enterprise not
being a company) so as to obtain economic benefits from its activities.
An enterprise may control the composition of the governing bodies of entities such
as gratuity trust, provident fund trust etc. Since the objective of control over such
entities is not to obtain economic benefits from their activities, these are not
considered for the purpose of preparation of consolidated financial statements.
For the purpose of this Standard, an enterprise is considered to control the
composition of
(i) the board of directors of a company, if it has the power, without the consent
or concurrence of any other person, to appoint or remove all or a majority of
directors of that company. An enterprise is deemed to have the power to
appoint a director, if any of the following conditions is satisfied:
a. a person cannot be appointed as director without the exercise in his
favour by that enterprise of such a power as aforesaid; or
© The Institute of Chartered Accountants of India
10.12 ADVANCED ACCOUNTING
b. a person’s appointment as director follows necessarily from his
appointment to a position held by him in that enterprise; or
c. the director is nominated by that enterprise or a subsidiary thereof.
(ii) the governing body of an enterprise that is not a company, if it has the power,
without the consent or the concurrence of any other person, to appoint or
remove all or a majority of members of the governing body of that other
enterprise. An enterprise is deemed to have the power to appoint a member,
if any of the following conditions is satisfied:
a. a person cannot be appointed as member of the governing body
without the exercise in his favour by that other enterprise of such a
power as aforesaid; or
b. a person’s appointment as member of the governing body follows
necessarily from his appointment to a position held by him in that other
enterprise; or
c. the member of the governing body is nominated by that other
enterprise.
Note: It is possible that an enterprise is controlled by two enterprises – one controls
by virtue of ownership of majority of the voting power of that enterprise and the
other controls, by virtue of an agreement or otherwise, the composition of the
board of directors so as to obtain economic benefits from its activities. In such a
rare situation, when an enterprise is controlled by two enterprises as per the
definition of ‘control’, the first mentioned enterprise will be considered as
subsidiary of both the controlling enterprises within the meaning of AS 21 and,
therefore, both the enterprises need to consolidate the financial statements of that
enterprise.
1.7 EXCLUSION FROM PREPARATION OF
CONSOLIDATED FINANCIAL STATEMENTS
As per AS 21, a subsidiary should be excluded from consolidation when:
(a) control is intended to be temporary because the subsidiary is acquired and
held exclusively with a view to its subsequent disposal in the near future;
or
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.13
FINANCIAL STATEMENTS
(b) it operates under severe long-term restrictions which significantly impair its
ability to transfer funds to the parent.
In consolidated financial statements, investments in such subsidiaries should be
accounted for in accordance with AS 13 ‘Accounting for Investments’. The reasons
for not consolidating a subsidiary should be disclosed in the consolidated financial
statements.
Where an enterprise owns majority of voting power by virtue of ownership of the
shares of another enterprise and all the shares are held as ‘stock-in-trade’ and are
acquired and held exclusively with a view to their subsequent disposal in the near
future, the control by the first mentioned enterprise is considered to be temporary.
It would be pertinent to note that merely holding all the shares as 'stock-in-trade',
is not sufficient to be considered as temporary control. It is only when all the shares
held as 'stock-in-trade' are acquired and held exclusively with a view to their
subsequent disposal in the near future, that control would be considered to be
temporary within the meaning of point (a) above.
The period of time, which is considered as “near future” as mentioned above,
primarily depends on the facts and circumstances of each case. However, ordinarily,
the meaning of the words ‘near future’ is considered as not more than twelve
months from acquisition of relevant investments unless a longer period can be
justified on the basis of facts and circumstances of the case. The intention with
regard to disposal of the relevant investment is considered at the time of
acquisition of the investment. Accordingly if the relevant investment is acquired
without an intention to its subsequent disposal in near future, and subsequently, it
is decided to dispose off the investments, such an investment is not excluded from
consolidation, until the investment is actually disposed off.
Conversely, if the relevant investment is acquired with an intention to its
subsequent disposal in near future, but, due to some valid reasons, it could not be
disposed off within that period, the same will continue to be excluded from
consolidation, provided there is no change in the intention.
Exclusion of a subsidiary from consolidation on the ground that its business
activities are dissimilar from those of the other enterprises within the group is not
justified because better information is provided by consolidating such subsidiaries
and disclosing additional information in the consolidated financial statements
© The Institute of Chartered Accountants of India
10.14 ADVANCED ACCOUNTING
about the different business activities of subsidiaries. Extending the above Reliance
Industries Limited example, though the parent company is in the Oil and Gas
Business, and its subsidiaries operate in industries such as telecom, retail trade,
fashion and lifestyle, media etc., all the entities have to be consolidated as such
consolidated financial statements will then provide better picture of the business
and financial position of Reliance Industries Limited. For example, the disclosures
required by AS 17 ‘Segment Reporting’, help to explain the significance of different
business activities within the group.
Consolidation of a subsidiary which is a Limited Liability Partnership (LLP) or
a Partnership Firm
As per rule 6 of Companies (Accounts) Rules, 2014, under the heading ‘Manner of
consolidation of accounts’ it is provided that consolidation of financial statements
of a company shall be done in accordance with the provisions of Schedule III to the
Companies Act, 2013 and the applicable Accounting Standards.
It is noted that relevant Indian Accounting Standard i.e., Ind AS 110, Consolidated
Financial Statements provides that where an entity has control on one or more
other entities, the controlling entity is required to consolidate all the controlled
entities. Since, the word ‘entity’ includes a company as well as any other form of
entity, therefore, LLPs and partnership firms are required to be consolidated.
Similarly, under Accounting Standard (AS) 21, as per the definition of subsidiary, an
enterprise controlled by the parent is required to be consolidated. The term
‘enterprise’ includes a company and any enterprise other than a company.
Therefore, under AS also, LLPs and partnership firms are required to be
consolidated.
Accordingly, in the given case, holding company is required to consolidate its
subsidiary which is an LLP or a partnership firm.
Consolidation of Limited Liability Partnership (LLP) which is an Associate or
Joint Venture
If LLP or a partnership firm is an associate or joint venture of holding company,
even then the LLP and the partnership firm need to be consolidated in accordance
with the requirements of applicable Accounting Standards.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.15
FINANCIAL STATEMENTS
1.8 ADVANTAGES OF CONSOLIDATED
FINANCIAL STATEMENTS
Acquisition
of
Subsidiary
Evaluation
Single Advantages of of Holding
Source
Document Consolidation Company in
the market
Intrinsic
value of
share
The main advantages of consolidation are given below:
(i) Single source document: From the consolidated financial statements, the
users of accounts can get an overall picture of the Group (i.e. holding
company and its subsidiaries). Consolidated profit and loss account gives the
overall profitability of the group.
(ii) Intrinsic value of share: Intrinsic share value of the holding company can be
calculated directly from the Consolidated Balance Sheet.
(iii) Acquisition of subsidiary: The minority interest data of the consolidated
financial statement indicates that the amount payable to the outside
shareholders of the subsidiary company at book value which is used as the
starting point of bargaining at the time of acquisition of a subsidiary by the
holding company.
(iv) Evaluation of holding company in the market: The overall financial health
of the holding company can be judged using consolidated financial
statements. Those who want to invest in the shares of the holding company
or acquire it, need such consolidated statement for evaluation.
© The Institute of Chartered Accountants of India
10.16 ADVANCED ACCOUNTING
1.9 COMPONENTS OF CONSOLIDATED
FINANCIAL STATEMENTS
As per AS 21, consolidated financial statements normally include the following:
consolidated financial statements
Consolidated Balance Sheet
Consolidated Statement of
Profit and Loss Account
Consolidated Cash Flow
Statement (in case parent
presents cash flow statement)
Notes and statements and
explanatory schedules
♦ The consolidated financial statements are presented to the extent possible in
the same format as that adopted by the parent for its separate financial
statements.
All the notes appearing in the separate financial statements of the parent enterprise
and its subsidiaries need not be included in the notes to the consolidated financial
statement. For preparing consolidated financial statements, the following principles
may be observed in respect of notes and other explanatory material that form an
integral part thereof:
(a) Notes which are necessary for presenting a true and fair view of the
consolidated financial statements are included in the consolidated financial
statements as an integral part thereof.
(b) Only the notes involving items which are material need to be disclosed.
Materiality for this purpose is assessed in relation to the information
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.17
FINANCIAL STATEMENTS
contained in consolidated financial statements. In view of this, it is possible
that certain notes which are disclosed in separate financial statements of a
parent or a subsidiary would not be required to be disclosed in the
consolidated financial statements when the test of materiality is applied in
the context of consolidated financial statements.
(c) Additional statutory information disclosed in separate financial statements of
the subsidiary and/or a parent having no bearing on the true and fair view of
the consolidated financial statements need not be disclosed in the
consolidated financial statements.
In addition, the consolidated financial statements shall disclose the information as
per the requirements specified in the applicable Accounting Standards including
the following as per the requirements of Schedule III to the Companies Act, 2013
which contains the ‘General Instructions for Preparation of Consolidated Financial
Statements’:
(i) Profit or loss attributable to “minority interest” and to owners of the parent
in the statement of profit and loss shall be presented as allocation for the
period.
(ii) “Minority interests” in the balance sheet within equity shall be presented
separately from the equity of the owners of the parent.
Students are also advised to refer the Schedule III to the Companies Act, 2013.
It may be noted that companies do not maintain any separate set of journal entries
for ‘Consolidated Set of Accounts’. Continuing the example of Reliance Industries
Limited, Consolidated Financial Statements of Reliance Industries Limited is not
based on “double entry book-keeping in the ‘group books of accounts’”, as there
is no concept of ‘group books of accounts’. Practically, Consolidated Financial
Statements are prepared from the separate / standalone financial statements of
each entity (parent / subsidiary) to which consolidation adjustments are made in
accordance with AS 21. Accordingly, the financial statements of each entity are
finalized in accordance with the applicable Accounting Standards, and based on
such financial statements, consolidation procedures are performed in accordance
with AS 21.
© The Institute of Chartered Accountants of India
10.18 ADVANCED ACCOUNTING
1.10 CONSOLIDATION PROCEDURES
Rule 6 of the Companies (Accounts) Rules, 2014 states that the manner of
consolidation of financial statements of the company shall be in accordance with
the provisions of Schedule III of the Act and the applicable accounting standards.
AS 21, lays down the procedure for consolidation of financial statements of the
companies within the group.
When preparing consolidated financial statements, the individual balances of the
parent and its subsidiaries are combined or consolidated on a line-by-line basis,
and then certain consolidation adjustments are made.
For example, the cash, trade receivables and prepayments of the parent and each
subsidiary are added together to arrive at the cash, trade receivables and
prepayments of the group, before consolidation adjustments are made.
The objective is that the consolidated financial statements should present the
information contained in the consolidated financial statements of a parent and its
subsidiaries as if they were the financial statements of a single economic entity.
The various steps involved in the consolidation process are as follows:
1. the cost to the parent of its investment (cost of acquisition) in each subsidiary
and the parent’s portion of equity of each subsidiary (acquirer’s interest), at
the date on which investment in each subsidiary is made, should be
eliminated. In case, cost of acquisition exceeds or is less than the acquirer’s
interest, at the date on which investment in the subsidiary is made, goodwill
or capital reserve should be recognized respectively in the CFS.
2. intragroup transactions, including sales, expenses and dividends, are
eliminated, in full;
3. Adjustments in respect of unrealised profits/ losses should be made;
4. minority interest in the net income of consolidated subsidiaries for the
reporting period are identified and adjusted against the income of the group
in order to arrive at the net income attributable to the owners of the parent;
and
5. minority interests in the net assets of consolidated subsidiaries should be
identified and presented in the consolidated balance sheet separately from
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.19
FINANCIAL STATEMENTS
liabilities and the equity of the parent’s shareholders. Minority interests in the
net assets consist of:
(i) the amount of equity attributable to minorities at the date on which
investment in a subsidiary is made; and
(ii) the minorities share of movements in equity since the date the parent-
subsidiary relationship came in existence.
Note: Where the carrying amount of the investment in the subsidiary is
different from its cost, the carrying amount is considered for the purpose of
above computations.
6. The results of operations of a subsidiary are included in the CFS as from the
date on which parent-subsidiary relationship came in existence.
The results of operations of a subsidiary with which parent-subsidiary
relationship ceases to exist are included in the consolidated statement of
profit and loss until the date of cessation of the relationship.
The difference between the proceeds from the disposal of investment in a
subsidiary and the carrying amount of its assets less liabilities as of the date
of disposal is recognised in the consolidated statement of profit and loss as
the profit or loss on the disposal of the investment in the subsidiary.
In order to ensure the comparability of the financial statements from one
accounting period to the next, supplementary information is often provided
about the effect of the acquisition and disposal of subsidiaries on the financial
position at the reporting date and the results for the reporting period and on
the corresponding amounts for the preceding period.
7. An investment in an enterprise should be accounted for in accordance with
AS 13, Accounting for Investments, from the date that the enterprise ceases
to be a subsidiary and does not become an associate.
8. The carrying amount of the investment at the date that it ceases to be a
subsidiary is regarded as cost thereafter.
© The Institute of Chartered Accountants of India
10.20 ADVANCED ACCOUNTING
Thus, Consolidation Adjustments are broadly categorized as under:
Consolidation Adjustments
MAJOR ADJUSTMENTS INTRA-GROUP ADJUSTMENTS
Those which 'drive' the double entry: 1. Intra-group balances
1. Goodwill / Capital Reserve (i.e., 2. Unrealized profit
cost of Control) 3. Inventory
2. Minority Interests 4. Non-Current Asset transfers
3. Consolidated Reserves 5. Minority Interests
4. Disposal of Subsidiary*
* Disposal of Subsidiary is not examined at the Intermediate Level.
1.11.CALCULATION OF GOODWILL/CAPITAL
RESERVE (COST OF CONTROL)
As on the date of investment, the cost of investment and the equity in the subsidiary
needs to be calculated.
Equity is defined as the ‘residual interest in the assets of an enterprise after
deducting all its liabilities.’ In other words, it is equal to the net worth of the
enterprise.
Once the above is calculated, goodwill or capital reserve is calculated as under:
Goodwill = Cost of Investment - Parent’s share in the equity of the
subsidiary on date of investment
Capital Reserve = Parent’s share in the equity of the subsidiary on date of
investment – Cost of investment
The parent’s portion of equity in a subsidiary, at the date on which investment is
made, is determined on the basis of information contained in the financial
statements of the subsidiary as on the date of investment.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.21
FINANCIAL STATEMENTS
However, if the financial statements of a subsidiary as on the date of investment
are not available and if it is impracticable to draw the financial statements of the
subsidiary as on that date, financial statements of the subsidiary for the
immediately preceding period are used as a basis for consolidation.
Adjustments are made to these financial statements for the effects of significant
transactions or other events that occur between the date of such financial
statements and the date of investment in the subsidiary.
It may be mentioned that positive or negative differential is separately recognised
only in purchase method. This differential calculated as cost of control is shown in
the consolidated balance sheet.
A detailed illustration below will help in understanding the concept of goodwill /
capital reserve.
Example 1
The following information is given as at 31 March 20X1
P Ltd. S Ltd.
Non-current Assets:
PPE 2,000 500
Investment in Subsidiary 1,000
Net Current Assets 2,000 500
5,000 1,000
Issued Capital 500 1,000
Reserves and Surplus 4,500
5,000 1,000
P Ltd. acquired 100% of shares of S Ltd. on 31 March 20X1 for ` 1,000.
Since P Ltd. has acquired S Ltd., we will have to determine goodwill / capital reserve.
Let us understand why goodwill / capital reserve arises in case of consolidation, and
what would be the interpretation of the same.
In the given case, P Ltd. acquired all the shares of S Ltd. by paying ` 1,000. This
payment (i.e., purchase consideration) would be made by P Ltd. to the shareholder(s)
of S Ltd. (hence the transfer of this amount would not appear in the books of S Ltd.).
© The Institute of Chartered Accountants of India
10.22 ADVANCED ACCOUNTING
By paying ` 1,000, P Ltd. has acquired ‘control’ over S Ltd. This acquisition is quite
different from the concept of amalgamation done in accordance with AS 14, though
the concept of goodwill / capital reserve is similar. Under AS 14, the target company
would generally liquidate, and all assets and liabilities would be transferred from the
Selling Company to the Purchasing Company. In case of consolidation, P Ltd. is
acquiring ‘control’ i.e., by way of acquiring equity shares in S Ltd.. Thus, S Ltd.
continues to exist, and the assets and liabilities of S Ltd. are not transferred to P Ltd.,
but instead continue to remain with S Ltd. only. However, since in substance,
acquisition has taken place (albeit through transfer of control), the purchase
consideration of ` 1,000 will be compared with the net worth of
S Ltd., which is ` 1,000. Since amount paid (i.e., purchase consideration) equals the
net worth, no goodwill / capital reserve is recognized. In case the amount paid (i.e.,
purchase consideration) would be higher / lower than the net worth of S Ltd., such
difference would be recognized in Goodwill / Capital Reserve respectively.
The calculation of goodwill is presented below:
Tangible Assets 500
Net Current Assets 500
1,000
Less: Liabilities NIL
Net Worth of S Ltd. 1,000
Investment in S Ltd. (purchase consideration) 1,000
Goodwill / (Capital Reserve) NIL
Example 2
Modifying example 1, the following information is given as at 31 March 20X1
P Ltd. S Ltd.
Non-current Assets:
PPE 2,000 500
Investment in Subsidiary 1,000
Net Current Assets 2,000 500
5,000 1,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.23
FINANCIAL STATEMENTS
Issued Capital 500 700#
Reserves and Surplus 4,500 300#
5,000 1,000
# As compared to Example 1 – There is a difference in the break-up of net worth of S
Ltd. (Example 1 – Issued capital was 1,000 and Reserves and Surplus was Nil; The Net
worth is 1,000).
P Ltd. acquired 100% of shares of S Ltd. on 31 March 20X1 for ` 1,000.
Like Example 1 above P Ltd. has acquired ‘control’ over S Ltd. by paying ` 1,000.
Accordingly, the purchase consideration of ` 1,000 will be compared with the net
worth of S Ltd. which is ` 1,000. Since amount paid (i.e., purchase consideration)
equals the net worth, no goodwill / capital reserve is recognized. In case the amount
paid (i.e., purchase consideration) would be higher / lower than the net worth of S
Ltd., such difference would be recognized in Goodwill / Capital Reserve respectively.
The calculation of goodwill is presented below:
Tangible Assets 500
Net Current Assets 500
1,000
Less: Liabilities NIL
Net Worth of S Ltd. 1,000
Investment in S Ltd. (purchase consideration) 1,000
Goodwill / (Capital Reserve) NIL
Example 3
Modifying example 2, the following information is given as at 31 March 20X1
P Ltd. S Ltd.
Non-current Assets:
PPE 2,000 500
Investment in Subsidiary 1,200
© The Institute of Chartered Accountants of India
10.24 ADVANCED ACCOUNTING
Net Current Assets 2,000 500
5,200 1,000
Issued Capital 700 700
Reserves and Surplus 4,500 300
5,200 1,000
P Ltd. acquired 100% of shares of S Ltd. on 31 March 20X1 for ₹ 1,200.
Like Examples 1 and 2 above P Ltd. has acquired ‘control’ over S Ltd. by paying
` 1,200. Accordingly, the purchase consideration of ` 1,200 will be compared with
the net worth of S Ltd. which is ` 1,000. Since amount paid (i.e., purchase
consideration) exceeds the net worth, such excess of is recognized as goodwill. In case
the amount paid (i.e., purchase consideration) would be lower than the net worth of
S Ltd., such difference would be credited to Capital Reserve.
The calculation of goodwill is presented below:
Tangible Assets 500
Net Current Assets 500
1,000
Less: Liabilities NIL
Net Worth of S Ltd. 1,000
Investment in S Ltd. (purchase consideration) 1,200
Goodwill / (Capital Reserve) 200
1.12 MINORITY INTERESTS
Minority interest is that part of the net assets of a subsidiary attributable to interest
which is held by outsiders.
Minority interests in the net income of consolidated subsidiaries for the reporting
period are identified and adjusted against the income of the group in order to
arrive at the net income attributable to the shareholders of the holding company.
Minority interests should be presented in the consolidated balance sheet separately
from liabilities and the equity of the parent’s shareholders.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.25
FINANCIAL STATEMENTS
Minority interest in the income of the group should be separately presented in the
consolidated income statement.
Minority interests in the net assets consist of:
(i) The amount of equity attributable to minorities at the date on which
investment in a subsidiary is made and
(ii) The minorities’ share of movements in equity since the date the parent-
subsidiary relationship came in existence.
The losses applicable to the minority in a consolidated subsidiary may exceed the
minority interest in the equity of the subsidiary. The excess, and any further losses
applicable to the minority, are adjusted against the majority interest except to the
extent that the minority has a binding obligation to and is able to make good the
losses. If the subsidiary subsequently reports profit, all such profits are allocated to
the majority interest until the minority’s share of losses previously absorbed by the
majority has been recovered.
Example 4
Modifying Example 2, the following information is given as at 31 March 20X1:
P Ltd. S Ltd.
Non-current Assets:
Tangible Assets 2,000 500
Investment in Subsidiary 1,000
Net Current Assets 2,000 500
5,000 1,000
Issued Capital 500 700
Reserves and Surplus 4,500 300
5,000 1,000
P Ltd. acquired 80% of shares of S Ltd. on 31 March 20X1 for ` 1,000.
In the given case, P Ltd. acquired 80% of the shares of S Ltd. by paying ` 1,000. This
payment (i.e., purchase consideration) would be made by P Ltd. to the shareholder(s)
of S Ltd.
© The Institute of Chartered Accountants of India
10.26 ADVANCED ACCOUNTING
By paying ` 1,000, P Ltd. has acquired ‘control’ over S Ltd. We cannot say that P Ltd.
has acquired only ‘80% control’, since its shareholding in S Ltd. will enable it to take
all the decisions regarding S Ltd.’s operations and usage of assets and repayment of
liabilities. However, the fact remains that 20% stake does NOT belong to S Ltd. It
belongs to outsiders, who are called ‘Minority Interest’ in accordance with AS 21.
Accordingly, in this case, the purchase consideration of ` 1,000 will be compared with
80% of the net worth of S Ltd. Any excess or deficit would be recorded as goodwill /
capital reserve respectively. 20% of the net worth on the date of acquisition would be
recorded separately as Minority Interest.
AS 21 defines Minority Interest as that part of the net results of operations and of the
net assets of a subsidiary attributable to interests which are not owned, directly or
indirectly through subsidiary(ies), by the parent. As per Schedule III to the Companies
Act, 2013, “Minority Interests” in the balance sheet within equity shall be presented
separately from the equity of the owners of the parent.
In the given case, the calculation of goodwill is presented below:
Tangible Assets: 80% being share of parent 400
Net Current Assets: 80% being share of parent 400
800
Less: Liabilities NIL
Net Worth of S Ltd.: attributable to the parent's shareholding 800
Investment in S Ltd. (purchase consideration) 1,000
Goodwill / (Capital Reserve) 200
1.13.PROFIT OR LOSS OF SUBSIDIARY COMPANY
For the purpose of consolidated balance sheet preparation, all reserves and profits
(or losses) of subsidiary company should be classified into pre and post-
acquisition reserves and profits (or losses).
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.27
FINANCIAL STATEMENTS
Profits (or losses) earned (or incurred) by subsidiary company up to the date of
acquisition of the shares by the holding company are pre acquisition or capital
profits (or loss).
Similarly, all reserves of subsidiary company up to the date of acquisition are capital
reserves from the view point of holding company. If the holding interest in
subsidiary is acquired during the middle or some other period of the current year,
pre-acquisition profit should be calculated accordingly.
The minority interest in the reserves and profits (or losses) of subsidiary company
should be transferred to minority interest account which will also include share
capital of subsidiary company held by outsiders / minority shareholders.
Minority Interest = Share Capital of subsidiary belonging to outsiders + Minority
interest in reserves and profits of subsidiary company
The holding company’s interest in the pre-acquisition reserves and profits (or
losses) should be adjusted against cost of control to find out goodwill or capital
reserve on consolidation. The reserves and profits (or loss) of subsidiary company,
representing holding company’s interest in post-acquisition or revenue reserves
and profits (or losses), should be added to the reserves and profits (or losses) of
holding company.
1.14 CONSOLIDATION ADJUSTMENTS
A. Revaluation of Assets of Subsidiary Company
It may be possible that the fair value of the assets of the subsidiary may be different
from the book value. Hence, the parent may choose to perform a revaluation of the
assets of the subsidiary for the purposes of consolidation. It may be noted that
such revaluation is not performed in the standalone / separate financial statements
of the subsidiary. The profit or loss on revaluation of fixed assets of subsidiary
should also be treated as capital profit or loss. But if the fall in the value of the
asset occurs after the date of acquisition, the loss should be treated as revenue
loss. Adjustment for depreciation would be made in the profit and loss account of
the subsidiary.
© The Institute of Chartered Accountants of India
10.28 ADVANCED ACCOUNTING
Depreciation on changed value of the assets shall be given effect to. Depreciation
on revalued assets will be taken as capital or revenue depending on the period for
which the depreciation belongs to. Hence the period for depreciation is important
to be considered.
Property, Plant and Equipment (PPE)
Initial Recognition Subsequent Measurement
Fair Value (-) Carrying Amount Additional Depreciation would arise
in case of initial upward or Reversal of
(As on the date of acquisition)
excess depreciation would arise in
case of initial downward valuation.
PPE A/c Dr. xxx Post P/L Dr. xxx
To Pre- P/L xxx To PPE xxx
(In case of upward revaluation) (Additional depreciation)
Pre- P/L Dr. xxx PPE Dr. xxx
To PPE xxx To Post P/L xxx
(In case of downward revaluation) (Reversal of excess depreciation)
1. The above entries are not recorded in the standalone books of either the
subsidiary or the parent. These entries are only for understanding the impact
in the consolidated financial statements and as such, only the effect of such
entries will appear in the consolidated financial statements (and not the
standalone / separate financial statements).
2. It is presumed that the subsidiary does not follow the revaluation model for
accounting of fixed assets. If it had to follow, then the standalone balance
sheet of the subsidiary would already contain the impact of the revaluation.
The debit /credit on account of revaluation could alternatively be taken to the
Revaluation Reserve or the P/L depending on whether it is a first-time upward
/ downward revaluation. However, as ultimately the reserves have to be
analyzed between pre- and post-acquisition for the purposes of consolidation,
the nature of reserves is irrelevant.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.29
FINANCIAL STATEMENTS
Example 5
H Ltd. acquires 70% of the equity shares of S Ltd. on 1.1.20X1. On that date, paid up
capital of S Ltd. was 10,000 equity shares of ` 10 each; accumulated reserve balance
was ` 1,00,000. H Ltd. paid ` 1,60,000 to acquire 70% interest in the S Ltd. Assets of
S Ltd. were revalued on 1.1.20X1 and a revaluation loss of ` 20,000 was ascertained.
The book value of shares of S Ltd. is calculated as shown below:
`
70% of the Equity Share Capital ` 1,00,000 70,000
70% of Accumulated Reserve ` 1,00,000 70,000
70% of Revaluation Loss ` 20,000 (14,000)
1,26,000
So, H Ltd. paid a positive differential of ` 34,000 i.e. ` (1,60,000 – 1,26,000). This
differential is called goodwill and is shown in the balance sheet under the head
intangibles.
Example 6
A Ltd. acquired 70% interest in B Ltd. on 1.1.20X1. On that date, B Ltd. had paid-up
capital of ` 1,00,000 consisting of 10,000 equity shares of ` 10 each and accumulated
balance in reserve and surplus of `1,00,000. On that date, assets and liabilities of B
Ltd. were also revalued and revaluation profit of ` 20,000 was calculated. A Ltd. paid
` 1,30,000 to purchase the said interest.
In this case, the book value of Shares of B Ltd. is calculated as shown below:
`
70% of the Equity Share Capital `1,00,000 70,000
70% of Reserves and Surplus ` 1,00,000 70,000
70% of Revaluation Profit ` 20,000 14,000
1,54,000
In this case, a negative differential of ` 24,000 arises i.e. (1,54,000 – 1,30,000) which
is called and presented as capital reserve.
© The Institute of Chartered Accountants of India
10.30 ADVANCED ACCOUNTING
Example 7
H Ltd. acquired 16,000 equity shares of ` 10 each, in S Ltd. on October 1, 20X1 for
` 3,06,800. The profit and loss account of S Ltd. showed a balance of `10,000 on April
1,20X1. The plant and machinery of S Ltd. which stood in the books at
` 1,50,000 on April 1,20X1 was considered worth ` 1,80,000 on the date of
acquisition.
The information of the two companies as at 31-3-20X2 was as follows:
H Ltd.(` ) S Ltd. (` )
Shares capital (fully paid equity shares of ` 10 5,00,000 2,00,000
each)
General reserve 2,40,000 1,00,000
Profit and loss account 57,200 82,000
Current Liabilities 1,69,800 33,000
Land and building 1,80,000 1,90,000
Plant and machinery 2,40,000 1,35,000
Investments 3,06,800
Current assets 2,40,200 90,000
In this case,
Percentage of holding:
No. of Shares Percentage
Holding Co. : 16,000 (80%)
Minority shareholders : 4,000 (20%)
TOTAL SHARES : 20,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.31
FINANCIAL STATEMENTS
Impact of Revaluation of Plant and Machinery will be as -
`
Book value of Plant and Machinery as on 01-04-20X1 1,50,000
Depreciation Rate
(1,50,000-1,35,000)
= 15,000/1,50,000 X100 10%
1,50,000
Book value of Plant and Machinery as on 01-10-20X1 after six months 1,42,500
depreciation @10% (1,50,000-7,500)
Revalued at 1,80,000
Revaluation profit (1,80,000-1,42,500) 37,500
Share of H Limited in Revaluation Profit (80%) 30,000
Share of Minority in Revaluation profit (20%) 7,500
Additional Depreciation on appreciated value to be charged from post-
acquisition profits
(10% of ` 1,50,000 for 6 months) + (10% of ` 1,80,000 for 6 months) 1500
less ` 15,000 (as already charged)
Share of H Limited in additional depreciation that will reduce its share 1,200
(80%) in post-acquisition profit by
Share of Minority Interest in additional depreciation 300
B. Dividend Received From SubsidiarY(IES)
As per AS 13, ‘Accounting for Investments’, 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 of income.
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 (i.e. as mentioned above) may apply. If it is difficult to make such an
© The Institute of Chartered Accountants of India
10.32 ADVANCED ACCOUNTING
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 holding company receives dividend from a subsidiary company, it must
distinguish between the part received out of capital profits (i.e. pre-acquisition
profits) and revenue profits (i.e. post-acquisition profits); capital profits are credited
to Investment account (being capital receipts) and revenue profits are credited to
the Profit & Loss Account.
If the controlling interest was acquired during the course of a year, profit for that
year must be apportioned into the pre-acquisition and post-acquisition portions,
on the basis of time in the absence of information on the point.
It must be understood that the term ‘capital profit’, in this context, apart from the
generic meaning of the term, connotes profit earned by the subsidiary company till
the date of acquisition. As a result, profits which may be of revenue nature for the
subsidiary company may be capital profits so far as the holding company is
concerned.
Treatment in case of post-acquisition dividend
Post acquisition dividend
Accounted by the Not accounted by the
In the books of the
subsidiary subsidiary
holding company
No further adjustment Adjusted at the time of
required consolidation Accounted by crediting
P&L A/c of the holding
company
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.33
FINANCIAL STATEMENTS
Treatment in case of pre-acquisition dividend
Accounted by holding Not accounted by Not accounted by
company holding company subsidiary company
If correctly accounted If wrongly accounted Adjust the same at Adjust the same at
as reduction to the by crediting to P&L the time of the time of
cost of investment A/c consolidation consolidation
Reverse the entry Account for as Reduce the pre-
No further passed and credit reduction to cost of acquisition profit of
adjustment required investment in investment subsidiary and then
subsidiary distribute it into holding
and minority interest
Also reduce the cost
of investment
Dividends received out of profits earned before purchase of investments normally
also are credited to the Investment Account.
Example 8
If shares in X Ltd., are purchased in January 20X2 and in April 20X2, X Ltd., declares
a dividend in respect of 20X1, the dividend received by the holder of the shares
correctly should not be treated as income but as capital receipt and credited to
Investment Account.
Note: In case of issue of bonus shares by the subsidiary company, the holding
company, like other holders, record no entry; only the number of shares held is
increased.
Illustration 1
From the following data, determine in each case:
(1) Minority interest at the date of acquisition and at the date of consolidation.
(2) Goodwill or Capital Reserve.
© The Institute of Chartered Accountants of India
10.34 ADVANCED ACCOUNTING
(3) Amount of holding company’s profit in the consolidated Balance Sheet
assuming holding company’s own Profit & Loss Account to be ` 2,00,000 in
each case:
Subsidiary % Cost Date of Consolidation
Company shares acquisition Date
owned
1.1.20X1 31.12.20X1
Case Share Profit & Share Profit &
Capital Loss Capital Loss
Account Account
` ` ` ` `
Case 1 A 90% 1,40,000 1,00,000 50,000 1,00,000 70,000
Case 2 B 85% 1,04,000 1,00,000 30,000 1,00,000 20,000
Case 3 C 80% 56,000 50,000 20,000 50,000 20,000
Case 4 D 100% 1,00,000 50,000 40,000 50,000 55,000
Solution
(1) Minority Interest = Equity attributable to minorities
Equity is the residual interest in the assets of an enterprise after deducting all
its liabilities i.e. in this case it should be equal to Share Capital + Profit & Loss
A/c
Minority % Minority Minority interest
Shares interest as at as at the date of
Owned the date of consolidation
acquisition
[E] [E] x [A + B] ` [E] X [C + D] `
Case 1 [100-90] 10 % 15,000 17,000
Case 2 [100-85] 15 % 19,500 18,000
Case 3 [100-80] 20 % 14,000 14,000
Case 4 [100-100] NIL Nil Nil
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.35
FINANCIAL STATEMENTS
A = Share capital on 1.1.20X1
B = Profit & loss account balance on 1.1.20X1
C = Share capital on 31.12.20X1
D = Profit & loss account balance on 31.12.20X1
(2) Calculation of Goodwill or Capital Reserve
Shareholding Cost Total Equity Parent’s Goodwill Capital
Portion Reserve
of equity
% [F] [G] [A] + [B] = [F] x [C] ` [G] – ` [H] –
[C] =H [H] [G]
Case 1 90 % 1,40,000 1,50,000 1,35,000 5,000 —
Case 2 85 % 1,04,000 1,30,000 1,10,500 — 6,500
Case 3 80 % 56,000 70,000 56,000 Nil Nil
Case 4 100 % 1,00,000 90,000 90,000 10,000 —
(3) The balance in the Profit & Loss Account on the date of acquisition (1.1.20X1)
is Capital profit, as such the balance of Consolidated Profit & Loss Account
shall be equal to Holding Co.’s profit.
On 31.12.20X1 in each case the following amount shall be added or deducted
from the balance of holding Co.’s Profit & Loss account.
% Share P & L as on P & L as on P & L post Amount to be
holding 1.1.20X1 consolidati acquisition added /
on date (deducted) from
holding’s P & L
[M]
[K] [L] [N] = [M]-[L]
[O] = [K] x [N]
1 90 % 50,000 70,000 20,000 18,000
2 85 % 30,000 20,000 (10,000) (8,500)
3 80 % 20,000 20,000 NIL NIL
4 100 % 40,000 55,000 15,000 15,000
© The Institute of Chartered Accountants of India
10.36 ADVANCED ACCOUNTING
Illustration 2
XYZ Ltd. purchased 80% shares of ABC Ltd. on 1st January, 20X1 for ` 1,40,000. The
issued capital of ABC Ltd., on 1st January, 20X1 was ` 1,00,000 and the balance in
the Profit & Loss Account was ` 60,000.
During the year ended 31st December, 20X1, ABC Ltd. earned a profit of ` 20,000
and at year end, declared and paid a dividend of ` 15,000.
Show by an entry how the dividend should be recorded in the books of XYZ Ltd.
What is the amount of minority interest as on 1st January, 20X1 and
31st December, 20X1? Also please check whether there should be any goodwill/
capital reserve at the date of acquisition.
Solution
Total dividend paid is ` 15,000 (assumed to be out of post-acquisition profits),
hence dividend received by XYZ will be credited to P & L.
XYZ Ltd.’s share of dividend = ` 15,000 X 80% = ` 12,000
In the books of XYZ Ltd.
` `
Bank A/c Dr. 12,000
To Profit & Loss A/c 12,000
(Dividend received from ABC Ltd credited to
P&L A/c being out of post-acquisition profits –
as explained above)
Goodwill on consolidation (at the date of ` `
acquisition):
Cost of shares 1,40,000
Less: Face value of capital i.e. 80% of capital 80,000
Add: Share of capital profits [60,000X 80 %] 48,000 (1,28,000)
Goodwill 12,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.37
FINANCIAL STATEMENTS
Minority interest on:
- 1st January, 20X1:
20% of ` 1,60,000 [1,00,000 + 60,000] 32,000
- 31st December, 20X1: 33,000
20% of ` 1,65,000 [1,00,000 + 60,000 +
20,000 – 15,000]
Illustration 3
Exe Ltd. acquires 70% of equity shares of Zed Ltd. as on 31st March, 20X1 at a cost
of ` 70 lakhs. The following information is available from the balance sheet of Zed
Ltd. as on 31st March, 20X1:
` in lakhs
Property, plant and equipment 120
Investments 55
Current Assets 70
Loans & Advances 15
15% Debentures 90
Current Liabilities 50
The following revaluations have been agreed upon (not included in the above figures):
Property, plant and equipment Up by 20%
Investments Down by 10%
Zed Ltd. declared and paid dividend @ 20% on its equity shares as on 31st March,
20X1 (Face value - ` 10 per share). Exe Ltd. purchased the shares of Zed Ltd. @
` 20 per share.
Calculate the amount of goodwill/capital reserve on acquisition of shares of Zed Ltd.
© The Institute of Chartered Accountants of India
10.38 ADVANCED ACCOUNTING
Solution
Revalued net assets of Zed Ltd. as on 31st March, 20X1
` in lakhs ` in lakhs
Property, plant and equipment [120 X 120%] 144.0
Investments [55 X 90%] 49.5
Current Assets 70.0
Loans and Advances 15.0
Total Assets after revaluation 278.5
Less: 15% Debentures 90.0
Current Liabilities 50.0 (140.0)
Equity / Net Worth 138.5
Exe Ltd.’s share of net assets (70% of 138.5) 96.95
Exe Ltd.’s cost of acquisition of shares of Zed Ltd.
(` 70 lakhs – ` 7 lakhs*) 63.00
Capital reserve 33.95
* Total Cost of 70 % Equity of Zed Ltd ` 70 lakhs
Purchase Price of each share ` 20
Number of shares purchased [70 lakhs /` 20] 3.5 lakhs
Dividend @ 20 % i.e. ` 2 per share ` 7 lakhs
Since dividend received is for pre-acquisition period, it has been reduced from the
cost of investment in the subsidiary company.
Illustration 4
A Ltd. acquired 70% of equity shares of B Ltd. on 1.4.20X1 at cost of ` 10,00,000 when
B Ltd. had an equity share capital of ` 10,00,000 and reserves and surplus of
` 80,000. In the four consecutive years, B Ltd. fared badly and suffered losses of
` 2,50,000, ` 4,00,000, ` 5,00,000 and ` 1,20,000 respectively. Thereafter in 20X5-
X6, B Ltd. experienced turnaround and registered an annual profit of ` 50,000. In the
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.39
FINANCIAL STATEMENTS
next two years i.e. 20X6-X7 and 20X7-X8, B Ltd. recorded annual profits of
` 1,00,000 and ` 1,50,000 respectively. Show the minority interests and cost of
control at the end of each year for the purpose of consolidation.
Solution
The losses applicable to the minority in a consolidated subsidiary may exceed the
minority interest in the equity of the subsidiary. In such cases, AS 21 prescribes that
the excess, and any further losses applicable to the minority, are adjusted against
the majority interest except to the extent that the minority has a binding obligation
to, and is able to, make good the losses. If the subsidiary subsequently reports
profits, all such profits are allocated to the majority interest until the minority's
share of losses previously absorbed by the majority has been recovered.
Where the minority interest has a binding obligation (say by way of a shareholders’
agreement), then the share of losses will be attributed to the minority interest even
if it exceeds the minority interest in the equity (i.e., debit balance in minority
interest). Since information on the existence of a binding obligation is not given in
the question, we solve as if such obligation does not exist, and hence the minority
interests will be computed as follows:
Year Profit/(Loss) Minority Additional Minority's Share Cost of
Interest Consolidated of losses borne Control
(30%) P & L (Dr.) by A Ltd.
Cr. (for the
year ended
balance)
` Balance
At the time of -
acquisition in 3,24,000
20X1
-
(W.N.)
© The Institute of Chartered Accountants of India
10.40 ADVANCED ACCOUNTING
20X1-X2 (2,50,000) (75,000) (1,75,000) 2,44,000
(W.N.)
Balance 2,49,000
20X2-X3 (4,00,000) (1,20,000) (2,80,000) 2,44,000
Balance 1,29,000
20X3-X4 (5,00,000) (1,50,000) (3,50,000) 2,44,000
(21,000)
Loss of 21,000 (21,000) 21,000 21,000
minority
borne by
Holding Co.
Balance Nil (3,71,000)
20X4-X5 (1,20,000) (36,000) (84,000) 2,44,000
Loss of
minority 36,000 (36,000) 36,000 57,000
borne by
Holding Co.
Balance Nil (1,20,000)
20X5-X6 50,000 15,000 35,000 2,44,000
Profit share (15,000) 15,000 (15,000) 42,000
of minority
adjusted
against
losses of
minority
absorbed by
Holding Co.
Balance Nil 50,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.41
FINANCIAL STATEMENTS
20X6-X7 1,00,000 30,000 70,000
Profit share (30,000) 30,000 (30,000) 12,000 2,44,000
of minority
adjusted
against
losses of
minority
absorbed by
Holding Co.
Balance Nil 100,000
20X7-X8 1,50,000 45,000 1,05,000 (12,000) Nil 2,44,000
(12,000) 12,000
Balance 33,000 1,17,000
Working Note:
Calculation of Minority interest and Cost of control on 1.4.20X1
Share of Minority
Holding Interest
Co.
100% 70% 30%
(`) (`) (`)
Share Capital 10,00,000 7,00,000 3,00,000
Reserve 80,000 56,000 24,000
7,56,000 3,24,000
Less: Cost of investment (10,00,000)
Goodwill 2,44,000
Illustration 5
Variety Ltd. holds 46% of the paid-up share capital of VR Ltd. The shares were
acquired at a market price of ` 17 per share. The balance of shares of VR Ltd. are
© The Institute of Chartered Accountants of India
10.42 ADVANCED ACCOUNTING
held by a foreign collaborating company. A memorandum of understanding has been
entered into with the foreign company providing for the following:
(a) The shares held by the foreign company will be sold to Variety Ltd. The price
per share will be calculated by capitalising the yield at 15%. Yield, for this
purpose, would mean 40% of the average of pre-tax profits for the last 3 years,
which were ` 30 lakhs, ` 40 lakhs and ` 65 lakhs.
(b) The actual cost of the shares to the foreign company was ` 5,40,000 only. The
profit that would accrue to them would be taxable at an average rate of 30%.
The tax payable will be deducted from the proceeds and Variety Ltd. will pay it
to the Government.
(c) Out of the net consideration, 50% would be remitted to the foreign company
immediately and the balance will be an unsecured loan repayable after two
years.
The above agreement was approved by all concerned for being given effect to on
1.4.20X1. The total assets of VR Ltd. as on 31st March, 20X1 was ` 1,00,00,000. It
was decided to write down Property, Plant and Equipment by ` 1,75,000. Current
liabilities of VR Ltd. as on the same date were ` 20,00,000. The paid-up share capital
of VR Ltd. was ` 20,00,000 divided into 2,00,000 equity shares of ` 10 each.
Find out goodwill/capital reserve to Variety Ltd. on acquiring wholly the shares of VR
Ltd.
Solution
1. Computation of Purchase Consideration
(a) Yield of VR Ltd.: 40 × 30 + 40 +65 ` 18 lakhs
100 3
(b) Price per share of VR Ltd.:
Capitalized Yield: 18 lakhs ` 120 lakhs
0.15
No. of shares 2 lakhs
Therefore, price per share ` 60
(c) Purchase Consideration for 54% shares in VR Ltd.
2 lakh shares x 54% x ` 60 per shares ` 64.80 lakhs
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.43
FINANCIAL STATEMENTS
(d) Discharge of Purchase Consideration:
30
Tax at source (` 64.80 lakhs – ` 5.40 lakhs) × 100 ` 17.82 lakhs
50% of purchase consideration (net of tax) in cash ` 23.49 lakhs
[` (64.80 – 17.82) x 50%]
Balance – Unsecured Loan ` 23.49 lakhs
2. Goodwill / Capital Reserve to Variety Ltd.
` in lakhs
Total Assets 100.00
Less: Reduction in Value of Property, Plant and (1.75)
Equipment
98.25
Less: Current Liabilities (20.00)
Net Assets of VR Ltd. on Date of Acquisition 78.25
Purchase Consideration: 54% purchased from Foreign 64.80
Co.
Investment: 46% existing stake 15.64 (80.44)
Goodwill on Date of Acquisition 2.19
Illustration 6
A Ltd. acquired 60% shares of B Ltd. @ ` 20 per share. Following is the extract of
Balance Sheet of B Ltd.:
`
10,00,000 Equity Shares of ` 10 each 1,00,00,000
10% Debentures 10,00,000
Trade Payables 55,00,000
Property, Plant and Equipment 70,00,000
Investments 45,00,000
Current Assets 68,00,000
Loans and Advances 22,00,000
© The Institute of Chartered Accountants of India
10.44 ADVANCED ACCOUNTING
On the same day B Ltd. declared dividend at 20% and as agreed between both the
companies Property, Plant and Equipment were to be depreciated @ 10% and
investment to be taken at market value of ` 60,00,000. Calculate the Goodwill or
Capital Reserve to be recorded in Consolidated Financial Statements.
Solution
Since dividend is declared by B Ltd. on the date of acquisition itself, it would be out
of the divisible profits of B Ltd. existing on the date of acquisition i.e., pre-
acquisition profits from the perspective of A Ltd. Accordingly, as per AS 13, such
pre-acquisition dividend would be reduced from the cost of investment, as seen
below in the determination of Goodwill on the date of acquisition.
` `
Assets
Property, Plant and Equipment 70,00,000
Less: Value written off (` 70 lakhs x 10%) (7,00,000)
63,00,000
Investments at Market Value 60,00,000
Current Assets 68,00,000
Loans and Advances 22,00,000 2,13,00,000
Less: Liabilities
Trade Payables 55,00,000
10% Debentures 10,00,000 (65,00,000)
Net Assets of B Ltd. 1,48,00,000
Share of A Ltd. in Net Assets of B Ltd.: 60% 88,80,000
Less: Cost of Investment in B Ltd. (60% stake):
10,00,000 Equity Shares x 60% x ` 20 per share 1,20,00,000
Less: Pre-acquisition dividend: 6,00,000 shares x
`2 (12,00,000) (1,08,00,000)
Goodwill on Date of Acquisition 19,20,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.45
FINANCIAL STATEMENTS
Illustration 7
H Ltd. acquired 3,000 shares in S Ltd., at a cost of ` 4,80,000 on 31.7.20X1. The capital
of S Ltd. consisted of 5,000 shares of ` 100 each fully paid. The Profit & Loss Account
of this company for 20X1 showed an opening balance of ` 1,25,000 and profit for the
year was ` 3,00,000. At the end of the year, it declared a dividend of 40%. Record the
entry in the books of H Ltd., in respect of the dividend. Assume the profit is accruing
evenly and calendar year as financial year.
Solution
The profits of S Ltd., have to be divided between capital and revenue profits from
the point of view of the holding company:
Capital Revenue
Profit (Pre- Profit (Post-
acquisition) acquisition)
` `
Balance on 1.1.20X1 1,25,000 —
Profit for 20X1 (3,00,000 × 7/12) 1,75,000 (3,00,000×5/12) 1,25,000
Total 3,00,000 1,25,000
Proportionate share of H Ltd. (3/5) 1,80,000 75,000
Total dividend declared = ` 5,00,000 X 40 % = ` 2,00,000
H Ltd.’s share in the dividend = ` 2,00,000 X 3/5 = ` 1,20,000
There can be two situations as regards the treatment of dividend of ` 1,20,000:
(1) The profit for 20X1 has been utilised to pay the dividend.
The share of H Ltd in profit for the first seven months of S Ltd = ` 1,05,000
(i.e. ` 1,75,000 × 3/5)
Profit for the remaining five months = ` 75,000
(i.e.` 1,25,000 × 3/5).
© The Institute of Chartered Accountants of India
10.46 ADVANCED ACCOUNTING
The dividend of ` 1,20,000 will be adjusted in this ratio of 1,05,000: 75,000 =
` 70,000 out of profits up to 31.7.20X1 and ` 50,000 out of profits after that
date.
The dividend out of profits subsequent to 31.7.20X1 will be revenue income
and that out of earlier profits will be capital receipt. Hence the entry will be:
` `
Bank Dr. 1,20,000
To Investment Account 70,000
To Profit and Loss Account 50,000
(2) Later profits have been utilised first and then pre- acquisition profits.
In such a case, the whole of ` 75,000 (share of H Ltd. in profits of S Ltd., after
31.7.20X1) would be received and treated as revenue income; the remaining
dividend, `45,000 (`1,20,000 less ` 75,000) would be capital receipt. The entry
would be:
` `
Bank Dr. 1,20,000
To Investment Account 45,000
To Profit & Loss Account 75,000
Note: Point (2) discussed above can arise only if there is definite information
about the profits utilized. In practice, such treatment is rare.
Illustration 8
A Ltd. and B Ltd. provide the following information:
` ‘000s
A Ltd. B Ltd.
Equity Shares 6,000 5,000
6% Preference Shares NIL 1,000
General Reserve 1,200 800
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.47
FINANCIAL STATEMENTS
Profit and Loss Account 1,020 1,790
Trade Payables 3,850 3,410
Dividend Payable 600 500
Goodwill 100 20
Property, Plant and Equipment 3,850 2,750
Investment 1,620 1,100
Inventory 1,900 4,150
Trade Receivables 4,600 4,080
Cash & Bank 600 400
A Ltd. purchased 3/4th interest in B Ltd. at the beginning of the year at the premium
of 25%. Following other information is available:
a. Profit & Loss Account of B Ltd. includes ₹ 1,000 thousands bought forward from
the previous year.
b. The General Reserve balance is brought forward from the previous year.
c. The directors of both the companies have declared a dividend of 10% on equity
share capital for the previous and current year.
From the above information calculate Pre- and Post-acquisition Profits, Minority
Interest and Cost of Control.
Solution
Calculation of Pre- and Post-Acquisition Profits:
Pre-Acquisition Post-Acquisition
Profits (₹) Profits (₹)
Profit & Loss Account 10,00,000 7,90,000
General Reserve 8,00,000 NIL
18,00,000 7,90,000
Less: Share of Minority Interest: (¼) (4,50,000) (1,97,500)
Attributable to Parent 13,50,000 5,92,500
(Cost of Control) (Post-acquisition
Profits)
© The Institute of Chartered Accountants of India
10.48 ADVANCED ACCOUNTING
Calculation of Minority Interest:
Particulars ₹
Paid-up Equity Share Capital (₹ 50,00,000 x ¼) 12,50,000
Paid-up Preference Share Capital 10,00,000
Share in Reserves:
Profit & Loss Account: ₹ 17,90,000 x ¼ 4,47,500
General Reserve: ₹ 8,00,000 x ¼ 2,00,000
Minority Interest 28,97,500
Calculation of Goodwill/Capital Reserve
₹ ₹
Cost of Investment in Subsidiary: 46,87,500
₹ 50,00,000 x 75% x 125% (cost + 25% premium)
Less: Pre-acquisition dividend (3,75,000) 43,12,500
Less: Net Worth of B Ltd. on Date of Acquisition
(attributable to A Ltd.):
Paid-up Capital 37,50,000
Pre-acquisition Reserves 13,50,000 (51,00,000)
Capital Reserve 7,87,500
Illustration 9
On 31st March, 20X1, P Ltd. acquired 1,05,000 shares of Q Ltd. for ` 12,00,000. The
position of Q Ltd. on that date was as under:
`
Property, plant and equipment 10,50,000
Current Assets 6,45,000
1,50,000 equity shares of ` 10 each fully paid 15,00,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.49
FINANCIAL STATEMENTS
Pre-incorporation profits 30,000
Profit and Loss Account 60,000
Trade payables 1,05,000
P Ltd. and Q Ltd. give the following information on 31st March, 20X3:
P Ltd. Q Ltd.
` `
Equity shares of ` 10 each fully paid (before bonus issue) 45,00,000 15,00,000
Securities Premium 9,00,000 –
Pre-incorporation profits – 30,000
General Reserve 60,00,000 19,05,000
Profit and Loss Account 15,75,000 4,20,000
Trade payables 5,55,000 2,10,000
Property, plant and equipment 79,20,000 23,10,000
Investment: 1,05,000 Equity shares in Q Ltd. at cost 12,00,000 –
Current Assets 44,10,000 17,55,000
Directors of Q Ltd. made bonus issue on 31.3.20X3 in the ratio of one equity share of
` 10 each fully paid for every two equity shares held on that date. Bonus shares were
issued out of post-acquisition profits by using General Reserve.
Calculate as on 31st March, 20X3 (i) Cost of Control/Capital Reserve; (ii) Minority
Interest; (iii) Consolidated Profit and Loss Account in each of the following cases:
(a) Before issue of bonus shares;
(b) Immediately After issue of bonus shares.
Solution
Shareholding pattern
Particulars Number of Shares % of holding
a. P Ltd.
(i) Purchased on 31.03.20X1 1,05,000
(ii) Bonus Issue (1,05,000/2) 52,500
© The Institute of Chartered Accountants of India
10.50 ADVANCED ACCOUNTING
Total 1,57,500 70%
b. Minority Interest 67,500 30%
Calculations of (i) Cost of Control/Capital Reserve; (ii) Minority Interest; (iii)
Consolidated Profit and Loss Account as on 31st March, 20X3:
(a) Before issue of bonus shares
(i) Cost of control/capital reserve ` `
Investment in Q Ltd. 12,00,000
Less: Face value of investments (Share 10,50,000
Capital)
Capital profits (W.N.) 63,000 (11,13,000)
Cost of control (i.e., Goodwill) 87,000
(ii) Minority Interest `
Share Capital 4,50,000
Capital profits (W.N.) 27,000
Revenue profits (W.N.) 6,79,500
11,56,500
(iii) Consolidated profit and loss account – P `
Ltd.
Balance 15,75,000
Add: Share in revenue profits of Q Ltd. (W.N.) 15,85,500
31,60,500
(b) Immediately after issue of bonus shares
(i) Cost of control/capital reserve ` `
Face value of investments (` 10,50,000 +
` 5,25,000) 15,75,000
Capital Profits (W.N.) 63,000 16,38,000
Less: Investment in Q Ltd. (12,00,000)
Capital reserve 4,38,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.51
FINANCIAL STATEMENTS
(ii) Minority Interest `
Share Capital (` 4,50,000 + ` 2,25,000) 6,75,000
Capital Profits (W.N.) 27,000
Revenue Profits (W.N.) 4,54,500
11,56,500
(iii) Consolidated Profit and Loss Account – `
P Ltd.
Balance 15,75,000
Add: Share in revenue profits of Q Ltd.
(W.N.) 10,60,500
26,35,500
Working Note:
Analysis of Profits of Q Ltd.
Capital Profits Revenue Profits
(Pre-acquisition) (Post-acquisition)
(Before and after Before After Bonus
issue of bonus Bonus Issue
shares) Issue
` `
`
Pre-incorporation profits 30,000
Profit and loss account on 60,000
31.3.20X1
90,000
General reserve* 19,05,000 19,05,000
Less: Bonus shares (7,50,000)
11,55,000
Profit for period of 1st
April, 20X1 to 31st March, 3,60,000 3,60,000
© The Institute of Chartered Accountants of India
10.52 ADVANCED ACCOUNTING
20X3
(` 4,20,000 – ` 60,000)
22,65,000 15,15,000
P Ltd.’s share (70%) 63,000 15,85,500 10,60,500
Minority’s share (30%) 27,000 6,79,500 4,54,500
*Share of P Ltd. in General reserve has been adjusted in Consolidated Profit
and Loss Account.
Illustration 10
Prepare consolidated balance sheet of H Ltd. and its subsidiary as at 31 March, 20X1
from the following information:
H Ltd. S Ltd.
` `
PPE 5,00,000 3,00,000
Investments
(20,000 equity shares of S Ltd.) 2,20,000
Current Assets 1,55,000 1,00,000
Share capital (Fully paid equity shares of ` 10 each) 5,00,000 2,50,000
Profit and loss account 2,00,000 1,00,000
Trade Payables 1,75,000 50,000
H Ltd. acquired the shares of S Ltd. on 31 March, 20X1.
st
Solution
Percentage of holding:
No. of Shares Percentage
Holding Co : 20,000 (80%)
Minority shareholders : 5,000 (20%)
TOTAL SHARES : 25,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.53
FINANCIAL STATEMENTS
Consolidated Balance Sheet of H Ltd. and its subsidiary S Ltd.
as at 31st March,20X1
Note No Amount (`)
I EQUITY AND LIABILITIES
1 Shareholder’s Fund
(a) Share Capital 1 5,00,000
(b) Reserve and Surplus 2 2,60,000
2 Minority interest 3
3 Current Liabilities 70,000
(a) Trade payables 4 2,25,000
Total 10,55,000
II ASSETS
1. Non-Current Assets
PPE 5 8,00,000
2. Current Assets 6 2,55,000
Total 10,55,000
Notes to Accounts
Amounts (`)
1 Share capital
50,000 Equity Shares @ `10 each 5,00,000
2 Reserve and Surplus
Capital Reserve (W.N. ) 60,000
Profit and loss account 2,00,000
2,60,000
3 Minority Interest
Paid up value of shares 50,000
Add: Share in Profit and loss account 20,000 70,000
4 Trade payables
H Ltd. 1,75,000
S Ltd. 50,000
2,25,000
© The Institute of Chartered Accountants of India
10.54 ADVANCED ACCOUNTING
5 PPE
H Ltd. 5,00,000
S Ltd. 3,00,000
8,00,000
6 Current Assets
H Ltd. 1,55,000
S Ltd. 1,00,000
2,55,000
Working Note:
Determination of Goodwill/(Capital Reserve) (`)
Cost of investment 2,20,000
Less: Paid up value of shares (80% of 2,50,000) 2,00,000
Share in pre-acquisition profits (80% of 1,00,000) 80,000
(2,80,000)
Capital Reserve (60,000)
Illustration 11
H Ltd. and S Ltd. provide the following information as at 31st March,20X2:
H Ltd. S Ltd.
` `
PPE 1,00,000 1,30,000
Investments (8,000 equity shares of S Ltd.) 1,26,000
Current Assets 74,000 70,000
Share capital (Fully paid equity shares of `10 each) 1,50,000 1,00,000
Profit and loss account 50,000 40,000
Trade Payables 1,00,000 60,000
Additional information:
H Ltd. acquired the shares of S Ltd. on 1-7-20X1 and Balance of profit and loss
account of S Ltd. on 1-4-20X1 was 30,000.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.55
FINANCIAL STATEMENTS
Prepare consolidated balance sheet of H Ltd. and its subsidiary as at 31st March,
20X2.
Solution
Percentage of holding:
No. of Shares Percentage
Holding Co. : 8,000 (80%)
Minority shareholders : 2,000 (20%)
TOTAL SHARES : 10,000
Consolidated Balance Sheet of H Ltd. and its subsidiary S Ltd.
as at 31st March, 20X2
Note No Amount (`)
I EQUITY AND LIABILITYES
1 Shareholder’s Fund
(a) Share Capital 1 1,50,000
(b) Reserve and Surplus 2 56,000
2 Minority interest 3 28,000
3 Current Liabilities
(a) Trade payables 4 1,60,000
Total 3,94,000
II ASSETS
1 Non-Current Assets:
PPE 5 2,30,000
Intangible Asset 6 20,000
2 Current Assets 7 1,44,000
Total 3,94,000
© The Institute of Chartered Accountants of India
10.56 ADVANCED ACCOUNTING
Notes to Accounts
Amount
(`)
1 Share capital 1,50,000
15,000 Equity Shares @ `10 each
2 Reserve and Surplus
Profit and loss account (` 50,000+ 80% of 9/12 x 10,000) 56,000
3 Minority Interest
Share capital (20% of ` 1,00,000) 20,000
Share in Profit and loss account (` 40,000 X 20%) 8,000 28,000
4 Trade payables
H Ltd. 1,00,000
S Ltd. 60,000
1,60,000
5 PPE
H Ltd. 1,00,000
S Ltd. 1,30,000
2,30,000
6 Intangible Asset
Cost of Investment 1,26,000
Less: Paid up value of shares (80% of ` 1,00,000)
Share in pre-acquisition profits (80,000)
80% of [30,000+3/12(40,000-30,000)] (26,000)
Goodwill 20,000
7 Current Assets
H Ltd. 74,000
S Ltd. 70,000
1,44,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.57
FINANCIAL STATEMENTS
Illustration 12
From the Balance Sheets and information given below, prepare Consolidated Balance
Sheet of Virat Ltd. and Anushka Ltd. as at 31st March. Virat Ltd. holds 80% of Equity
Shares in Anushka Ltd. since its (Anushka Ltd.’s) incorporation.
Balance Sheet of Virat Ltd. and Anushka Ltd. as at 31st March, 20X1
Particulars Note Virat Ltd. Anushka Ltd.
No. (` ) (` )
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 6,00,000 4,00,000
(b) Reserves and Surplus 2 1,00,000 1,00,000
(2) Non-current Liabilities
Long Term Borrowings 2,00,000 1,00,000
(3) Current Liabilities
(a) Trade Payables 1,00,000 1,00,000
Total 10,00,000 7,00,000
II. Assets
(1) Non-current assets
(a) Property, Plant and 4,00,000 3,00,000
Equipment
(b) Non-current 3 3,20,000 -
investments
(2) Current Assets
(a) Inventories 1,60,000 2,00,000
(b) Trade Receivables 80,000 1,40,000
(c) Cash & Cash Equivalents 40,000 60,000
Total 10,00,000 7,00,000
© The Institute of Chartered Accountants of India
10.58 ADVANCED ACCOUNTING
Notes to Accounts
Particulars (`) Virat Ltd. Anushka Ltd.
(` ) (` )
1. Share capital
60,000 equity shares of ` 10 each fully
paid up
6,00,000 --
40,000 equity shares of ` 10 each fully
paid up
-- 4,00,000
Total 6,00,000 4,00,000
2. Reserves and Surplus
General Reserve 1,00,000 1,00,000
Total 1,00,000 1,00,000
3. Non-current investments
Shares in Anushka Ltd 3,20,000 --
Solution
Consolidated balance Sheet of Virat Ltd. and its Subsidiary Anushka Ltd.
as at 31st March, 20X1
Particulars Note Amount (`)
I EQUITY AND LIABILITIES:
(1) Shareholders’ Funds:
(a) Share Capital 1 6,00,000
(b) Reserve and Surplus 2 1,80,000
(2) Minority Interest 3 1,00,000
(3) Non-Current Liabilities:
Long Term Borrowings 4 3,00,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.59
FINANCIAL STATEMENTS
(4) Current Liabilities:
Trade Payables 5 2,00,000
Total 13,80,000
II ASSETS:
(1) Non-Current Assets
Property, Plant & Equipment 6 7,00,000
(2) Current Assets:
(a) Inventories
(b) Trade receivables 7 3,60,000
(c) Cash and Cash Equivalents 8 2,20,000
9 1,00,000
Total 13,80,000
Notes to Accounts
Particulars ` `
1. Share capital
60,000 equity shares of `10 each fully paid up 6,00,000
2. Reserves and Surplus
General Reserve 1,00,000
Add: General reserve of Anushka Ltd (80%) 80,000
Total 1,80,000
3. Minority interest
20% share in Anushka Ltd (WN 3) 1,00,000
4 Long term borrowings
Long term borrowings of Virat 2,00,000
Add: Long term borrowings of Anushka 1,00,000
Total 3,00,000
© The Institute of Chartered Accountants of India
10.60 ADVANCED ACCOUNTING
5. Trade payables
Trade payables of Virat 1,00,000
Add: Trade payables of Anushka 1,00,000
Total 2,00,000
6. Property, Plant and Equipment (PPE)
PPE of Virat Ltd 4,00,000
Add: PPE of Anushka Ltd 3,00,000
Total 7,00,000
7. Inventories
Inventories of Virat Ltd 1,60,000
Add: Inventories of Anushka Ltd 2,00,000
Total 3,60,000
8. Trade receivables
Trade receivables of Virat Ltd 80,000
Add: Trade receivables of Anushka Ltd 1,40,000
Total 2,20,000
9 Cash and cash equivalents
Cash and cash equivalents of Virat Ltd 40,000
Add: Cash and cash equivalents of Anushka Ltd 60,000
Total 1,00,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.61
FINANCIAL STATEMENTS
Working Notes:
1. Basic Information
Company Status Dates Holding Status
Holding Co. = Virat Ltd. Acquisition: Holding Company = 80%
Anushka’s
Subsidiary = Anushka Minority Interest = 20%
Incorporation
Ltd.
Consolidation:
31st March, 20X1
2. Analysis of General Reserves of Anushka Ltd
Since Virat holds shares in Anushka since its incorporation, the entire Reserve
balance of `1,00,000 will be Revenue.
3. Consolidation of Balances
Holding- 80%, Total Minority Holding Company
Minority - Interest
20%
Equity Capital 4,00,000 80,000 3,20,000 -
General
Reserves 1,00,000 20,000 Nil (pre-acq) 80,000 (post-acq)
Total 1,00,000 3,20,000 80,000
Cost of
Investment (3,20,000) -
Goodwill/capit
NIL
al reserve
Parent’s 1,00,000
Balance
Amount for 1,80,000
Consolidated
Balance Sheet
© The Institute of Chartered Accountants of India
10.62 ADVANCED ACCOUNTING
Illustration 13
From the following balance sheets of H Ltd. And its subsidiary S Ltd. drawn up at
31st March, 20X1, prepare a consolidated balance sheet as at that date, having regard
to the following:
(i) Reserves and Profit and Loss Account of S Ltd. stood at ` 25,000 and ` 15,000
respectively on the date of acquisition of its 80% shares by H Ltd. on 1st April,
20X0.
(ii) Machinery (Book-value ` 1,00,000) and Furniture (Book value ` 20,000) of
S Ltd. were revalued at ` 1,50,000 and ` 15,000 respectively on 1st April, 20X0
for the purpose of fixing the price of its shares. [Rates of depreciation computed
on the basis of useful lives: Machinery 10%, Furniture 15%.]
Balance Sheet of H Ltd. and S Ltd. as at 31st March, 20X1
Particulars Note H Ltd. (`) S Ltd. (`)
No.
I. Equity and Liabilities
(1) Shareholder’s Funds
(a) Share Capital 1 6,00,000 1,00,000
(b) Reserves and Surplus 2 3,00,000 1,00,000
(2) Current Liabilities
(a) Trade Payables 1,50,000 57,000
Total 10,50,000 2,57,000
II. Assets
(1) Non-current assets
(a) Property, Plant and 3 4,50,000 1,07,000
Equipment
(b) Other non- current 4 6,00,000 1,50,000
investments
Total 10,50,000 2,57,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.63
FINANCIAL STATEMENTS
Notes to Accounts
` H Ltd. S Ltd.
(` ) (` )
1. Share capital
6,000 equity shares of ` 100 each, fully paid up 6,00,000 --
1,000 equity shares of ` 100 each, fully paid up
Total -- 1,00,000
6,00,000 1,00,000
2. Reserves and Surplus
General reserves 2,00,000 75,000
Profit and loss account 25,000
1,00,000
Total 3,00,000 1,00,000
3. Property, Plant and Equipment
Machinery 3,00,000 90,000
Furniture 1,50,000 17,000
Total 4,50,000 1,07,000
4. Other Non-current investments
Non-current Investments 4,40,000 1,50,000
Shares in S Ltd.
1,60,000 --
(800 shares at `200 each)
6,00,000 1,50,000
Total
© The Institute of Chartered Accountants of India
10.64 ADVANCED ACCOUNTING
Solution
Consolidated Balance Sheet of H Ltd. and its Subsidiary S Ltd.
as at 31st March, 20X1
Particulars Note (`)
No.
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 6,00,000
(b) Reserves and Surplus 2 3,44,600
(2) Minority Interest 3 48,150
(3) Current Liabilities
(a) Trade Payables 2,07,000
Total 11,99,750
II. Assets
(1) Non-current assets
(a) Property, Plant and Equipment 4 5,97,750
(b) Intangible assets 5 12,000
(c) Other non-current investments 6 5,90,000
Total 11,99,750
Notes to Accounts
`
1. Share capital
6,000 equity shares of ` 100 each,
fully paid up
6,00,000
Total 6,00,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.65
FINANCIAL STATEMENTS
2. Reserves and Surplus
Reserves 2,00,000
Add: 4/5th share of S Ltd.’s post-
acquisition reserves (W.N.3) 40,000 2,40,000
Profit and Loss Account 1,00,000
Add: 4/5th share of S Ltd.’s post-
acquisition profits (W.N.4) 4,600 1,04,600
Total 3,44,600
3. Minority interest in S Ltd. (WN 5) 48,150
4. Property, plant and equipment
Machinery
H. Ltd. 3,00,000
S Ltd. 1,00,000
Add: Appreciation 50,000
1,50,000
Less: Depreciation (1,50,000 X 10%)* (15,000) 1,35,000
Furniture
H. Ltd. 1,50,000
S Ltd. 20,000
Less: Decrease in value (5,000)
15,000
Less: Depreciation (15,000 X 15%)* (2,250) 12,750 5,97,750
5. Intangible assets
Goodwill [WN 6] 12,000
6. Other non-current investments
H Ltd. 4,40,000
S Ltd. 1,50,000
Total 5,90,000
* As an alternative manner of presentation, the solution contains only the
‘additional depreciation’.
© The Institute of Chartered Accountants of India
10.66 ADVANCED ACCOUNTING
Working Notes:
1. Pre-acquisition profits and reserves of S Ltd. `
Reserves 25,000
Profit and Loss Account 15,000
40,000
H Ltd.’s = 4/5 (or 80%) × 40,000 32,000
Minority Interest= 1/5 (or 20%) × 40,000 8,000
2. Profit on revaluation of assets of S Ltd.
Profit on Machinery ` (1,50,000 – 1,00,000) 50,000
Less: Loss on Furniture ` (20,000 – 15,000) 5,000
Net Profit on revaluation 45,000
H Ltd.’s share 4/5 × 45,000 36,000
Minority Interest 1/5 × 45,000 9,000
3. Post-acquisition reserves of S Ltd.
Post-acquisition reserves (Total reserves less pre-acquisition 50,000
reserves = ` 75,000 – 25,000)
H Ltd.’s share 4/5 × 50,000 40,000
Minority interest 1/5 × 50,000 10,000
4. Post -acquisition profits of S Ltd.
Post-acquisition profits (Profit & loss account balance less 10,000
pre-acquisition profits = ` 25,000 – 15,000)
Add: Excess depreciation charged on furniture @ 15%
on ` 5,000 i.e. (20,000 – 15,000) 750
10,750
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.67
FINANCIAL STATEMENTS
Less: Under depreciation on machinery @ 10%
on ` 50,000 i.e. (1,50,000 – 1,00,000) (5,000)
Adjusted post-acquisition profits 5,750
H Ltd.’s share 4/5 × 5,750 4,600
Minority Interest 1/5 × 5,750 1,150
5. Minority Interest
Paid-up value of (1,000 – 800) = 200 shares
held by outsiders i.e. 200 × ` 100 (or 1,00,000 X 20%) 20,000
Add: 1/5th share of pre-acquisition profits and reserves 8,000
1/5th share of profit on revaluation 9,000
1/5th share of post-acquisition reserves 10,000
1/5th share of post-acquisition profit 1,150
48,150
6. Cost of Control or Goodwill
Price paid by H Ltd. for 800 shares (A) 1,60,000
Intrinsic value of the shares-
Paid-up value of 800 shares held by H Ltd. i.e. 800 × ` 100 80,000
(or 1,00,000 X 80%)
Add: 4/5th share of pre-acquisition profits and reserves 32,000
4/5th share of profit on the revaluation 36,000
Intrinsic value of shares on the date of acquisition (B) 1,48,000
Cost of control or Goodwill (A – B) 12,000
C. Elimination of Intra-Group Transactions
Consolidated Financial Statements reflect the financial position and operations of
the group as a single entity. Accordingly, the statements must contain only those
transactions and balances with entities ‘external’ to the group, thereby requiring
elimination of intra-group transactions.
© The Institute of Chartered Accountants of India
10.68 ADVANCED ACCOUNTING
In order to present financial statements for the group in a consolidated format, the
effect of transactions between group enterprises should be eliminated. Para 16 of
AS 21 states that intragroup balances and intragroup transactions and resulting
unrealized profits should be eliminated in full. Unrealized losses resulting from
intragroup transactions should also be eliminated unless cost cannot be recovered.
Liabilities due to one group enterprise by another will be set off against the
corresponding asset in the other group enterprise’s financial statements; sales
made by one group enterprise to another should be excluded both from turnover
and from cost of sales or the appropriate expense heading in the consolidated
statement of profit and loss.
To the extent that the buying enterprise has further sold the goods in question to
a third party, the eliminations to sales and cost of sales are all that is required, and
no adjustments to consolidated profit or loss for the period, or to net assets, are
needed. However, to the extent that the goods in question are still on hand at year
end, they may be carried at an amount that is in excess of cost to the group and
the amount of the intra-group profit must be eliminated, and assets are reduced
to cost to the group.
For transactions between group enterprises, unrealized profits resulting from intra-
group transactions that are included in the carrying amount of assets, such as
inventories and tangible fixed assets, are eliminated in full. The requirement to
eliminate such profits in full applies to the transactions of all subsidiaries that are
consolidated – even those in which the group’s interest is less than 100%.
Unrealized profit in inventories: Where a group enterprise sells goods to another,
the selling enterprise, as a separate legal enterprise, records profits made on those
sales. If these goods are still held in inventory by the buying enterprise at the year
end, the profit recorded by the selling enterprise, when viewed from the standpoint
of the group as a whole, has not yet been earned, and will not be earned until the
goods are eventually sold outside the group. On consolidation, the unrealized
profit on closing inventories will be eliminated from the group’s profit, and the
closing inventories of the group will be recorded at cost to the group.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.69
FINANCIAL STATEMENTS
Here, the point to be noted is that one has to see whether the intragroup
transaction is “upstream” or “down-stream”. Upstream transaction is a transaction
in which the subsidiary company sells goods to holding company. While in the
downstream transaction holding company is the seller and subsidiary company is
the buyer.
Sells goods Co.
Subsidiary
Holding Co. Downstream Sales
to Co.
Sells goods Co.
Subsidiary Holding Co. Upstream Sales
Co. to
In the case of upstream transaction, since the goods are sold by the subsidiary to
holding company; profit is made by the subsidiary company, which is ultimately
shared by the holding company and the minority shareholders. In such a
transaction, if some goods remain unsold at the balance sheet date, the unrealized
profit on such goods should be eliminated from minority interest as well as from
consolidated profit on the basis of their share-holding besides deducting the same
from unsold inventory.
But in the case of downstream transaction, the whole profit is earned by the holding
company, therefore, whole unrealized profit should be adjusted from unsold
inventory and consolidated profit and loss account only irrespective of the
percentage of the shares held by the parent.
Intra-group
transaction
Upstream Downstream
Unrealised profit
Unrealised profit Corresponding Corresponding
eliminated from
eliminated from decrease of holding decrease of
holding and inventories company’s P&L in inventories
minority interest full
© The Institute of Chartered Accountants of India
10.70 ADVANCED ACCOUNTING
Unrealized profit on transfer of non-current asset: Similar to the treatment
described above for unrealized profits in inventories, unrealized inter-company
profits arising from intra-group transfers of fixed assets are also eliminated from
the consolidated financial statements.
Unrealized losses: Unrealized losses resulting from intra-group transactions that
are deducted in arriving at the carrying amount of assets are also eliminated unless
cost cannot be recovered.
Example:
If net realizable value (NRV) expected from sale of such goods is more than the
actual cost of the goods, then unrealized loss should be reversed during
consolidation process. However, if it is expected that NRV would not be sufficient
to recover the loss incurred on transfer of goods from one entity to another, the
unrealized loss should not be reversed.
Illustration 14
a. A Ltd. holds 80% of the equity capital and voting power in B Ltd. A Ltd. sells
inventories costing ` 180 lacs to B Ltd at a price of ` 200 lacs. The entire
inventories remain unsold with B Ltd. at the financial year end i.e. 31 March
20X1.
b. A Ltd. holds 75% of the equity capital and voting power in B Ltd. A Ltd.
purchases inventories costing ` 150 lacs from B Ltd at a price of ` 200 lacs. The
entire inventories remain unsold with A Ltd. at the financial year end i.e. 31
March 20X1.
Suggest the accounting treatment for the above mentioned transactions in the
consolidated financial statements of A Ltd. giving reference of the relevant
guidance/standard.
Solution
As per para 16 and 17 of AS 21, intragroup balances and intragroup transactions
and resulting unrealized profits should be eliminated in full. Unrealized losses
resulting from intragroup transactions should also be eliminated unless cost cannot
be recovered.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.71
FINANCIAL STATEMENTS
Intragroup balances and intragroup transactions, including sales, expenses and
dividends, are eliminated in full. Unrealized profits resulting from intragroup
transactions that are included in the carrying amount of assets, such as inventory
and fixed assets, are eliminated in full. Unrealized losses resulting from intragroup
transactions that are deducted in arriving at the carrying amount of assets are also
eliminated unless cost cannot be recovered.
One also needs to see whether the intragroup transaction is “upstream” or “down-
stream”. Upstream transaction is a transaction in which the subsidiary company
sells goods to holding company. While in the downstream transaction, holding
company is the seller and subsidiary company is the buyer.
In the case of upstream transaction, since the goods are sold by the subsidiary to
holding company; profit is made by the subsidiary company, which is ultimately
shared by the holding company and the minority shareholders. In such a
transaction, if some goods remain unsold at the balance sheet date, the unrealized
profit on such goods should be eliminated from minority interest as well as from
consolidated profit on the basis of their share-holding besides deducting the same
from unsold inventory.
But in the case of downstream transaction, the whole profit is earned by the holding
company, therefore, whole unrealized profit should be adjusted from unsold
inventory and consolidated profit and loss account only irrespective of the
percentage of the shares held by the parent.
Using above mentioned guidance, following adjustments would be required:
a. This would be the case of downstream transaction. In the consolidated profit
and loss account for the year ended 31 March 20X1, entire transaction of sale
and purchase of ` 200 lacs each, would be eliminated by reducing both sales
and purchases (cost of sales).
Further, the unrealized profits of ` 20 lacs (i.e. ` 200 lacs – ` 180 lacs), would
be eliminated from the consolidated financial statements for financial year
ended 31 March 20X1, by reducing the consolidated profits/ increasing the
consolidated losses, and reducing the value of closing inventories as of 31
March 20X1.
© The Institute of Chartered Accountants of India
10.72 ADVANCED ACCOUNTING
b. This would be the case of upstream transaction. In the consolidated profit
and loss account for the year ended 31 March 20X1, entire transaction of sale
and purchase of ` 200 lacs each, would be eliminated by reducing both sales
and purchases (cost of sales).
Further, the unrealized profits of ` 50 lacs (i.e. ` 200 lacs – ` 150 lacs), would
be eliminated in the consolidated financial statements for financial year
ended 31 March 20X1, by reducing the value of closing inventories by ` 50
lacs as of 31 March 20X1. In the consolidated balance sheet as of 31 March
20X1, A Ltd.’s share of profit from B Ltd will be reduced by ` 37.50 lacs (being
75% of ` 50 lacs) and the minority’s share of the profits of B Ltd would be
reduced by ` 12.50 lacs (being 25% of ` 50 lacs).
D. ALIGNMENT OF REPORTING DATES
The financial statements used in the consolidation should be drawn up to the same
reporting date. If it is not practicable to draw up the financial statements of one or
more subsidiaries to such date and, accordingly, those financial statements are
drawn up to different reporting dates, adjustments should be made for the effects
of significant transactions or other events that occur between those dates and the
date of the parent’s financial statements.
In any case, the difference between reporting dates should not be more than six
months.
The financial statements of the parent and its subsidiaries used in the preparation
of the consolidated financial statements are usually drawn up to the same date.
When the reporting dates are different, the subsidiary often prepares, for
consolidation purposes, statements as at the same date as that of the parent.
When it is impracticable to do this, financial statements drawn up to different
reporting dates may be used provided the difference in reporting dates is not more
than six months.
The consistency principle requires that the length of the reporting periods and any
difference in the reporting dates should be the same from period to period.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.73
FINANCIAL STATEMENTS
1.15 PREPARATION OF CONSOLIDATED
STATEMENT OF PROFIT AND LOSS
All the items of profit and loss account are to be added on line by line basis and
inter-company transactions should be eliminated from the consolidated figures.
For example, a holding company may sell goods or services to its subsidiary, receive
consultancy fees, commission, royalty etc. These items are included in sales and
other income of the holding company and in the expense items of the subsidiary.
Alternatively, the subsidiary may also sell goods or services to the holding
company. These inter-company transactions are to be eliminated in full.
If there remains any unrealized profit in the inventory, of any of the Group
Company, such unrealized profit is to be eliminated from the value of inventory to
arrive at the consolidated profit.
Illustration 15
H Ltd and its subsidiary S Ltd provide the following information for the year ended
31st March, 20X3:
H Ltd. S Ltd.
(` in lacs) (` in lacs)
Sales and other income 5,000 1,000
Increase in Inventory (closing less opening) 1,000 200
Raw material consumed 800 200
Wages and Salaries 800 150
Production expenses 200 100
Administrative Expenses 200 100
Selling and Distribution Expenses 200 50
Interest 100 50
Depreciation 100 50
© The Institute of Chartered Accountants of India
10.74 ADVANCED ACCOUNTING
Other Information:
H Ltd. sold goods to S Ltd. of ` 120 lacs at cost plus 20%. Inventory of S Ltd. includes
such goods valuing ` 24 lacs. Administrative expenses of S Ltd. include
` 5 lacs paid to H Ltd. as consultancy fees. Selling and distribution expenses of
H Ltd. include ` 10 lacs paid to S Ltd. as commission.
H Ltd. holds 80% of equity share capital of ` 1,000 lacs in S Ltd. prior to 20X1-20X2.
H Ltd. took credit to its Profit and Loss Account, the proportionate amount of dividend
declared and paid by S Ltd. for the year 20X1-20X2.
Prepare a consolidated statement of profit and loss..
Solution
Consolidated statement of profit and loss of H Ltd. and its subsidiary S Ltd.
for the year ended on 31st March, 20X3
Particulars Note No. ` in Lacs
I. Revenue from operations 1 5,865
II. Total Income 5,865
III. Expenses
Cost of material purchased/consumed 2 1,180
Changes of inventories of finished goods 3 (1,196)
Employee benefit expense 4 950
Finance cost 5 150
Depreciation and amortization expense 6 150
Other expenses 7 535
Total expenses 1,769
IV. Profit before tax (II-III) 4,096
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.75
FINANCIAL STATEMENTS
Notes to Accounts
` in Lacs ` in Lacs
1. Revenue from operations
Sales and other income
H Ltd. 5,000
S Ltd. 1,000
6,000
Less: Inter-company sales (120)
Consultancy fees received by H Ltd. from S Ltd. (5)
Commission received by S Ltd. from H Ltd. (10) 5,865
2. Cost of material purchased/consumed
H Ltd. 800
S Ltd. 200
1,000
Less: Purchases by S Ltd. from H Ltd. (120) 880
Direct expenses (Production)
H Ltd. 200
S Ltd. 100 300
1,180
3. Changes of inventories of finished goods
H Ltd. 1,000
S Ltd. 200
20
Less: Unrealized profits ` 24 lacs × (4) 1,196
120
© The Institute of Chartered Accountants of India
10.76 ADVANCED ACCOUNTING
4. Employee benefits and expenses
Wages and salaries:
H Ltd. 800
S Ltd. 150 950
5. Finance cost
Interest:
H Ltd. 100
S Ltd. 50 150
6. Depreciation
H Ltd. 100
S Ltd. 50 150
7. Other expenses
Administrative expenses
H Ltd. 200
S Ltd. 100
Less: Consultancy fees received by H Ltd. from S Ltd. (5) 295
Selling and distribution Expenses:
H Ltd. 200
S Ltd. 50
Less: Commission received by S Ltd. from H Ltd. (10) 240
535
1.16 PREPARATION OF CONSOLIDATED CASH
FLOW STATEMENT
As per AS 21, Consolidated cash flow statement is presented in case a parent
presents its own cash flow statement.
For the purpose of preparation of consolidated cash flow statement, all the items
of cash flow from operating activities, investing activities and financing activities
are to be added on line by line basis and from the consolidated items, inter-
company transactions should be eliminated. Below given is an illustrative
consolidated cash flow statement with hypothetical figures:
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.77
FINANCIAL STATEMENTS
Consolidated Cash Flow Statement (Illustrative only)
(` in million)
A B Total
Company Company
Cash Flows from Operating Activities
Change in Reserve 8 2 10
Change in P & L A/c - 1 1
Dividend Paid 22 - 22
Tax Provision 20 1 21
Depreciation 10 5 15
Interest (10) 10 -
50 19 69
Less: Tax payment (20) (1) (21)
30 18 48
Working capital adjustment (13) 12 (1)
(A) 17 30 47
Cash Flows from Investment Activities
Sale of fixed assets 30 - 30
Purchase of fixed assets (30) (20) (50)
(B) - (20) (20)
Cash Flows from Financing Activities (5) (10) (15)
(C)
Net cash flows (A+B+C) 12 - 12
© The Institute of Chartered Accountants of India
10.78 ADVANCED ACCOUNTING
1.17 UNIFORM ACCOUNTING POLICIES
Para 20 of AS 21 states that consolidated financial statements shall be prepared
using uniform accounting policies for like transactions and other events in similar
circumstances.
If any company in the same group uses accounting policies other than those
adopted in consolidated financial statements for like transactions and events in
similar circumstances, appropriate adjustments are made to its financial statements
when they are used in preparing the consolidated financial statements.
If it is not practicable to use uniform accounting policies in preparing the
consolidated financial statements, the fact should be disclosed together with the
proportions of items to which different accounting policies have been applied.
For example, if the subsidiary company follows weighted average method for
valuation of inventories and the holding company follows FIFO method, the
financial statements of subsidiary company should be restated by adjusting the
value of inventories to bring the same in line with the valuation procedure adopted
by the holding company. After that consolidation should be done.
Illustration 16
Subsidiary B Ltd. provides the following balance sheet:
Particulars Note 20X0 20X1
No. (` ) (` )
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 5,00,000 5,00,000
(b) Reserves and Surplus 2 2,86,000 7,14,000
(2) Current Liabilities
(a) Short term borrowings 3 -- 1,70,000
(b) Trade Payables 4,90,000 4,94,000
(c) Short-term provisions 4 3,10,000 4,30,000
Total 15,86,000 23,08,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.79
FINANCIAL STATEMENTS
II. Assets
(1) Non-current assets
(a) Property, Plant and 5 2,72,000 2,24,000
Equipment
(b) Non-current Investment 4,00,000
(2) Current assets
(a) Inventories 5,97,000 7,42,000
(b) Trade Receivables 5,94,000 8,91,000
(c) Cash & Cash Equivalents 51,000 3,000
(d) Other current assets 6 72,000 48,000
Total 15,86,000 23,08,000
20X0 20X1
(` ) (` )
1. Share capital
5,000 equity shares of `10 each, fully paid up 5,00,000 5,00,000
2. Reserves and Surplus
General Reserves 2,86,000 7,14,000
3. Short term borrowings
Bank overdraft -- 1,70,000
4. Short term provisions
Provision for taxation 3,10,000 4,30,000
5. Property, plant and equipment
Cost 3,20,000 3,20,000
Less: Depreciation (48,000) (96,000)
Total 2,72,000 2,24,000
6. Other current Assets
Prepaid expenses 72,000 48,000
© The Institute of Chartered Accountants of India
10.80 ADVANCED ACCOUNTING
Also consider the following information:
(a) B Ltd. is a subsidiary of A Ltd. Both the companies follow calendar year as the
accounting year.
(b) A Ltd. values inventory on weighted average basis while B Ltd. used FIFO basis.
To bring B Ltd.’s values in line with those of A Ltd, its value of inventory is
required to be reduced by `12,000 at the end of 20X0 and ` 34,000 at the end
of 20X1.
(c) B Ltd. deducts 1% from Trade Receivables as a general provision against
doubtful debts.
(d) Prepaid expenses in B Ltd. include advertising expenditure carried forward of
` 60,000 in 20X0 and` 30,000 in 20X1, being part of initial advertising
expenditure of ` 90,000 in 20X0 which is being written off over three years.
Similar amount of advertising expenditure of A Ltd. has been fully written off
in 20X0.
Restate the balance sheet of B Ltd. as at 31st December, 20X1 after considering the
above information, for the purpose of consolidation. Would restatement be necessary
to make the accounting policies adopted by A Ltd. and B Ltd. uniform.
Solution
As per para 20 and 21 of AS 21, Consolidated financial statements:
Consolidated financial statements should be prepared using uniform accounting
policies for like transactions and other events in similar circumstances. If it is not
practicable to use uniform accounting policies in preparing the consolidated
financial statements, that fact should be disclosed together with the proportions of
the items in the consolidated financial statements to which the different accounting
policies have been applied.
If a member of the group uses accounting policies other than those adopted in the
consolidated financial statements for like transactions and events in similar
circumstances, appropriate adjustments are made to its financial statements when
they are used in preparing the consolidated financial statements.
Accordingly in the given case, restatement would be required to make the
accounting policies of A Ltd and B Ltd uniform.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.81
FINANCIAL STATEMENTS
Adjusted reserves of B Ltd.:
` `
Reserves as given 7,14,000
Add: Provision for doubtful debts
{[8,91,000 / 99 X 100]-8,91,000} 9,000
7,23,000
Less: Reduction in value of Inventory 34,000
Advertising expenditure to be written off 30,000 (64,000)
Adjusted reserves 6,59,000
Note: No adjustment would be required in respect of opening inventory of B Ltd
as that will not have any impact on P&L.
Restated Balance Sheet of B Ltd.
as at 31st December, 20X1
Particulars Note No. (`)
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 5,00,000
(b) Reserves and Surplus 2 6,59,000
(2) Current Liabilities
(a) Short term borrowings 3 1,70,000
(b) Trade Payables 4,94,000
(c) Short-term provision 4 4,30,000
Total 22,53,000
II. Assets
(1) Non-current assets
(a) Property, Plant and Equipment 5 2,24,000
(b) Non-current Investment 4,00,000
(2) Current assets
(a) Inventories 6 7,08,000
© The Institute of Chartered Accountants of India
10.82 ADVANCED ACCOUNTING
(b) Trade Receivables 7 9,00,000
(c) Cash & Cash Equivalents 3,000
(d) Other current assets 8 18,000
Total 22,53,000
Notes to Accounts
20X1
(`)
1. Share capital
5,000 equity shares of Rs 10 each, fully paid up 5,00,000
2. Reserves and Surplus
General Reserves (refer to WN) 6,59,000
3. Short term borrowings
Bank overdraft 1,70,000
4. Short term provisions
Provision for taxation 4,30,000
5. Property, plant and equipment
Cost 3,20,000
Less: Depreciation (96,000)
Total 2,24,000
6. Inventory
Actual inventory 7,42,000
Less: Change in method of valuation (34,000)
Total 7,08,000
7. Trade receivables
Actual trade receivables 8,91,000
Add: Adjustment for provision 9,000
Total 9,00,000
8. Other current Assets
Prepaid expenses 48,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.83
FINANCIAL STATEMENTS
1.18 TREATMENT OF SUBSIDIARY COMPANY
HAVING PREFERENCE SHARE CAPITAL
While preparing CFS, outstanding cumulative preference shares issued by a
subsidiary are considered in the same manner as any other liability, such as
debentures etc. Accordingly, the cost associated with such cumulative preference
shares needs to be adjusted for.
Therefore, while computing its share of profits or losses of the subsidiary, the
parent should make adjustments in respect of preference dividends on outstanding
cumulative preference shares issued by a subsidiary and held outside the group
since, for the group, such preference shares represent external liabilities. It would
be appropriate for the parent to compute its share of profits or losses after
adjusting for subsidiary’s cumulative preference dividends, whether or not profits
are available or dividends have been declared.
However, in case of non-cumulative preference shares, no such adjustment is
required unless the dividend is actually received.
SUMMARY
• “Holding company”, in relation to one or more other companies, means a
company of which such companies are subsidiary companies; “subsidiary
company” or “subsidiary”, in relation to any other company (that is to say the
holding company), means a company in which the holding company—
o controls the composition of the Board of Directors; or
o exercises or controls more than one-half of the total share capital either
at its own or together with one or more of its subsidiary companies:
Provided that such class or classes of holding companies as may be
prescribed shall not have layers of subsidiaries beyond such numbers
as may be prescribed.
• ‘Total share capital’, as defined in section 2(87) (ii) above, has been further
clarified by the Rule 2(1)(r) of the Companies (Specification of Definitions
Details) Rules, 2014. As per the Rule, total share capital includes
o paid up equity share capital
o convertible preference share capital.
© The Institute of Chartered Accountants of India
10.84 ADVANCED ACCOUNTING
• Consolidated financial statements are prepared and presented by a
parent/holding enterprise to provide financial information about a parent and
its subsidiary (ies) as a single economic entity.
• Distinction must be made from the point of view of the holding company,
between revenue and capital profit of the subsidiary. In the absence of
information, profits of a year may be treated as accruing from day to day.
Preparation of Consolidated Statement of Profit and Loss
• All the revenue items are to be added on line by line basis and from the
consolidated revenue items, inter-company transactions should be
eliminated.
• If there remains any unrealized profit in the inventory of goods, of any of the
Group Company, such unrealized profit should be eliminated from the value
of inventory to arrive at the consolidated profit.
Preparation of Consolidated Cash Flow Statement
All the items of Cash flow from operating activities, investing activities and
financing activities are to be added on line by line basis and from the consolidated
items, inter-company transactions should be eliminated.
The financial statements used in the consolidation should be drawn up to the same
reporting date. If it is not practicable to draw up the financial statements of one or
more subsidiaries to such date and, accordingly, those financial statements are
drawn up to different reporting dates, adjustments should be made for the effects
of significant transactions or other events that occur between those dates and the
date of the parent’s financial statements.
In any case, the difference between reporting dates should not be more than six
months.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.85
FINANCIAL STATEMENTS
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Minority interest should be presented in the consolidated balance sheet
(a) As a part of liabilities.
(b) As a part of equity of the parent’s shareholders.
(c) Separately from liabilities and the equity of the parent’s shareholders.
(d) As a part of assets.
2. Minority of the subsidiary is entitled to
(a) Capital profits of the subsidiary company.
(b) Revenue profits of the subsidiary company.
(c) Both capital and revenue profits of the subsidiary company.
(d) Neither capital nor revenue profits of the subsidiary..
3. In consolidation of accounts of holding and subsidiary company _________ is
eliminated in full.
(a) Current liabilities of subsidiary company.
(b) Reserves and surplus of both holding and subsidiary company.
(c) Mutual indebtedness.
(d) Nothing.
4. In consolidated balance sheet, the share of the outsiders in the net assets of the
subsidiary must be shown as
(a) Minority interest.
(b) Capital reserve.
(c) Current liability.
(d) Current assets.
© The Institute of Chartered Accountants of India
10.86 ADVANCED ACCOUNTING
5. Provision for Tax made by the subsidiary company will appear in the
consolidated balance sheet as an item of
(a) Current liability.
(b) Revenue profit.
(c) Capital profit.
(d) Current assets.
Scenario-based Questions
6. Hemant Ltd. purchased 80% shares of Power Ltd. on 1st January, 20X1 for
` 2,10,000. The issued capital of Power Ltd., on 1st January, 20X1 was ` 1,50,000
and the balance in the Profit & Loss Account was ` 90,000. During the year
ended 31st December, 20X1, Power Ltd. earned a profit of ` 30,000 and at year
end, declared and paid a dividend of ` 22,500. What is the amount of minority
interest as on 1st January, 20X1 and 31st December, 20X1? Also compute
goodwill/ capital reserve at the date of acquisition.
7. King Ltd. acquires 70% of equity shares of Queen Ltd. as on 31st March, 20X1
at a cost of ` 140 lakhs. The following information is available from the balance
sheet of Queen Ltd. as on 31st March, 20X1:
` in lakhs
Property, plant and equipment 240
Investments 110
Current Assets 140
Loans & Advances 30
15% Debentures 180
Current Liabilities 100
The following revaluations have been agreed upon (not included in the above
figures):
Property, plant and equipment- up by 20% and Investments- down by 10%.
King Ltd. purchased the shares of Queen Ltd. @ `20 per share (Face
value - `10).
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.87
FINANCIAL STATEMENTS
Calculate the amount of goodwill/capital reserve on acquisition of shares of
Queen Ltd.
8. From the following information, determine Minority Interest on the date of
acquisition and on the date of consolidation in each case:
Case Subsidiary % of Cost Date of Consolidation date
Company Share Acquisition
owned
01-01-20X1 31-12-20X1
Share Profit Share Profit and
Capital and Loss Capital Loss A/c
A/c
` ` ` `
Case-A X 90% 2,00,000 1,50,000 75,000 1,50,000 85,000
Case-B Y 75% 1,75,000 1,40,000 60,000 1,40,000 20,000
Case-C Z 70% 98,000 40,000 20,000 40,000 20,000
Case-D M 95% 75,000 60,000 35,000 60,000 55,000
9. A Ltd acquired 1,600 ordinary shares of `100 each of B Ltd on 1st July, 20X1.
On 31st December, 20X1, the balance sheets of the two companies were as
given below:
Balance Sheet of A Ltd. and its subsidiary, B Ltd.
as at 31st December, 20X1
Particulars Note A Ltd. B Ltd.
No. (` ) (` )
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 5,00,000 2,00,000
(b) Reserves and Surplus 2 2,97,200 1,82,000
(2) Current Liabilities
(a) Trade Payables 47,100 17,400
© The Institute of Chartered Accountants of India
10.88 ADVANCED ACCOUNTING
(b) Short term borrowings 3 80,000
Total 9,24,300 3,99,400
II. Assets
(1) Non-current assets
(a) Property, Plant and 4 3,90,000 3,15,000
Equipment
(b) Non-current 5 3,40,000 --
Investments
(2) Current assets
(a) Inventories 1,20,000 36,400
(b) Trade receivables 59,800 40,000
(c) Cash & Cash 6 14,500 8,000
equivalents
Total 9,24,300 3,99,400
Notes to Accounts
A Ltd. B Ltd.
` `
1. Share Capital
5,000 shares of ` 100 each, fully paid up 5,00,000 -
2,000 shares of ` 100 each, fully paid up - 2,00,000
Total 5,00,000 2,00,000
2. Reserves and Surplus
General Reserves 2,40,000 1,00,000
Profit & loss 57,200 82,000
Total 2,97,200 1,82,000
3. Short term borrowings
Bank overdraft 80,000 --
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.89
FINANCIAL STATEMENTS
4. Property plant and equipment
Land and building 1,50,000 1,80,000
Plant & Machinery 2,40,000 1,35,000
Total 3,90,000 3,15,000
5. Non-current Investments
Investment in B Ltd (at cost) 3,40,000 --
6. Cash & Cash equivalents
Cash 14,500 8,000
The Profit & Loss Account of B Ltd. showed a credit balance of `30,000 on
1st January, 20X1 out of which a dividend of 10% was paid on 1st August, 20X1;
A Ltd. credited the dividend received to its Profit & Loss Account. The Plant &
Machinery which stood at ` 1,50,000 on 1st January, 20X1 was considered as
worth ` 1,80,000 on 1st July, 20X1; this figure is to be considered while
consolidating the Balance Sheets. The rate of depreciation on plant &
machinery is 10% (computed on the basis of useful lives).
Prepare consolidated Balance Sheet as at 31st December, 20X1.
10. On 31st March, 20X1, the Balance Sheets of H Ltd. and its subsidiary S Ltd.
stood as follows:
Balance Sheet of H Ltd.
and its subsidiary S Ltd. as at 31st March, 20X1
Particulars Note H Ltd. S Ltd.
No. (` in Lacs) (` in Lacs)
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 12,000 4,800
(b) Reserves and Surplus 2 5,499 3,000
(2) Current Liabilities
(a) Trade payables 3 1,833 1,014
(b) Short term provisions 4 855 394
© The Institute of Chartered Accountants of India
10.90 ADVANCED ACCOUNTING
(c) Other current 1,200 -
liabilities (Dividend
payable)
Total 21,387 9,208
II. Assets
(1) Non-current assets
(a) Property, Plant and 5 9,468 5,486
Equipment
(b) Non-current 3,000
Investments
(Shares in S Ltd.)
(2) Current assets
(a) Inventories 3,949 1,956
(b) Trade receivables 6 2,960 1,562
(c) Cash and cash 1,490 204
equivalents
(d) Short term loans and 7 520
advances
Total 21,387 9,208
Notes to Accounts
H Ltd. S Ltd.
(` in lacs) (` in lacs)
1. Share Capital
Authorized share capital 15,000 6,000
Equity shares of ` 10 each, fully paid up
Issued and Subscribed:
Equity shares of ` 10 each, fully paid up 12,000 4,800
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.91
FINANCIAL STATEMENTS
2. Reserves and surplus
General Reserve 2,784 1,380
Profit and Loss Account: 2,715 1,620
Total 5,499 3,000
3. Trade Payables
Creditors 1,461 854
Bills Payable 372 160
1,833 1,014
4. Short term provisions
Provision for Taxation 855 394
5. Property, plant and equipment
Land and Buildings 2,718 -
Plant and Machinery 4,905 4,900
Furniture and Fittings 1,845 586
Total 9,468 5,486
6. Trade receivables
Debtors 2,600 1,363
Bills Receivable 360 199
Total 2,960 1,562
7. Short term loans and advances
Sundry Advances 520 --
The following information is also provided to you:
(a) H Ltd. purchased 180 lakh shares in S Ltd. on 31st March, 20X0 when the
balances of General Reserve and Profit and Loss Account of S Ltd. stood
at ` 3,000 lakh and ` 1,200 lakh respectively.
© The Institute of Chartered Accountants of India
10.92 ADVANCED ACCOUNTING
(b) On 1st April, 20X0, S Ltd. declared a dividend @ 20% for the year ended
31st March, 20X0. H Ltd. credited the dividend received by it to its Profit
and Loss Account.
(c) On 1st January, 20X1, S Ltd. issued 3 fully paid-up bonus shares for every
5 shares held out of balances of its general reserve as on
31st March, 20X0.
(d) On 31st March, 20X1, all the bills payable in S Ltd.’s balance sheet were
acceptances in favour of H Ltd. But on that date, H Ltd. held only ` 45
lakh of these acceptances in hand, the rest having been endorsed in
favour of its trade payables.
(e) On 31st March, 20X1, S Ltd.’s inventory included goods which it had
purchased for ` 100 lakh from H Ltd. which made a profit @ 25% on cost.
Prepare a Consolidated Balance Sheet of H Ltd. and its subsidiary S Ltd. as at
31st March, 20X1.
11. Chand Ltd. and its subsidiary Sitara Ltd. provided the following information for
the year ended 31st March, 20X4:
Particulars Chand Ltd (`) Sitara Ltd. (`)
Equity Share Capital 20,00,000 6,00,000
Finished Goods Inventory as 4,20,000 3,01,000
on 01.04.2022
Finished Goods Inventory as 8,57,500 3,76,250
on 31.03.2023
Dividend Income 1,68,000 43,750
Other non-operating Income 35,000 10,500
Raw material consumed 13,93,000 4,72,500
Selling and Distribution 3,32,500 1,57,500
Expenses
Production Expenses 3,15,000 1,40,000
Loss on sale of investments 26,250 Nil
Sales and other operating 33,25,000 19,07,500
income
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.93
FINANCIAL STATEMENTS
Wages and Salaries 13,30,000 2,45,000
General and Administrative 2,80,000 1,22,500
Expenses
Royalty paid Nil 5,000
Depreciation 31,500 14,000
Interest expense 17,500 5,250
Other information
♦ On 1st September 20X1 Chand Ltd., acquired 5,000 equity shares of
` 100 each fully paid up in Sitara Ltd.
♦ Sitara Ltd. paid a dividend of 10% for the year ended 31st March 20X3.
The dividend was correctly accounted for by Chand Ltd.
♦ Chand Ltd. sold goods of ` 1,75,000 to Sitara Ltd. at a profit of 20% on
selling price. Inventory of Sitara Ltd. includes goods of ` 70,000 received
from Chand Ltd.
♦ Selling and Distribution expenses of Sitara Ltd. include ` 21,250 paid to
Chand Ltd. as brokerage fees.
♦ General and Administrative expenses of Chand Ltd. include ` 28,000 paid
to Sitara Ltd. as consultancy fees.
♦ Sitara Ltd. used some resources of Chand Ltd., and Sitara Ltd. paid
` 5,000 to Chand Ltd. as royalty.
Consultancy fees, Royalty and brokerage received is to be considered as
operating revenues.
Prepare Consolidated Statement of Profit and Loss of Chand Ltd. and its
subsidiary Sitara Ltd. for the year ended 31st March, 20X4 as per Schedule III to
the Companies Act, 2013.
© The Institute of Chartered Accountants of India
10.94 ADVANCED ACCOUNTING
ANSWERS/SOLUTION
Answer to the Multiple Choice Questions
1. (c) 2. (c) 3. (c) 4. (a) 5. (a)
Answer to the Scenario-based Questions
6. Total dividend paid is ` 22,500 (out of post-acquisition profits), hence
dividend received by Hemant will be credited to P & L account. Hemant Ltd.’s
share of dividend = ` 22,500 X 80% = ` 18,000
Goodwill on consolidation (at the date of ` `
acquisition):
Cost of shares 2,10,000
Less: Face value of capital i.e. 80% of capital 1,20,000
Add: Share of capital profits [90,000 X 80 %] 72,000 (1,92,000)
Goodwill 18,000
Minority interest on:
- 1st January, 20X1:
20% of ` 2,40,000 [1,50,000 + 90,000] 48,000
- 31st December, 20X1:
49,500
20% of ` 2,47,500 [1,50,000 + 90,000 + 30,000 –
22,500]
7. Revalued net assets of Queen Ltd. as on 31st March, 20X1
` in lakhs ` in lakhs
PPE [240 X 120%] 288
Investments [110 X 90%] 99
Current Assets 140
Loans and Advances 30
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.95
FINANCIAL STATEMENTS
Total Assets after revaluation 557
Less: 15% Debentures 180.0
Current Liabilities 100.0 (280)
Equity / Net Worth 277
King Ltd.’s share of net assets (70% of 277) 193.9
King Ltd.’s cost of acquisition of shares of Queen
Ltd.
(`140 lakhs) (140)
Capital reserve 53.9
8. Minority Interest = Equity attributable to minorities
Equity is the residual interest in the assets of an enterprise after deducting all
its liabilities i.e. in this case, it should be equal to Share Capital + Profit &
Loss A/c
A = Share capital on 1.1.20X1
B = Profit & loss account balance on 1.1.20X1
C = Share capital on 31.12.20X1
D = Profit & loss account balance on 31.12.20X1
Minority Minority Minority interest as
% Shares interest as at the at the date of
Owned date of consolidation
acquisition
[E] [E] x [A + B] ` [E] X [C + D] `
Case A [100-90] 10 % 22,500 23,500
Case B [100-75] 25 % 50,000 40,000
Case C [100-70] 30 % 18,000 18,000
Case D [100-95] 5% 4,750 5,750
© The Institute of Chartered Accountants of India
10.96 ADVANCED ACCOUNTING
9. Consolidated Balance Sheet of A Ltd. and its subsidiary, B Ltd.
as at 31st December, 20X1
Particulars Note No. (`)
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 5,00,000
(b) Reserves and Surplus 2 3,08,800
(2) Minority Interest 83,600
(3) Current Liabilities
(a) Trade Payables 3 64,500
(b) Short term borrowings 4 80,000
Total 10,36,900
II. Assets
(1) Non-current assets
(a) Property, Plant and 5 7,41,000
Equipment
(b) Intangible assets 6 17,200
(2) Current assets
(a) Inventories 7 1,56,400
(b) Trade receivables 8 99,800
(c) Cash & Cash equivalents 9 22,500
Total 10,36,900
Notes to Accounts
`
1. Share Capital
5,000 shares of ` 100 each 5,00,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.97
FINANCIAL STATEMENTS
2. Reserves and Surplus
Reserves 2,40,000
Profit & loss (Refer to W.N 8) 68,800
Total 3,08,800
3. Trade Payables
A Ltd. 47,100
Add: B Ltd 17,400
Total 64,500
4. Short term borrowings
Bank overdraft 80,000
5. Property, plant and equipment
Land and building- A Ltd 1,50,000
Add: Land and building- B Ltd 1,80,000 3,30,000
Plant & Machinery (Refer to W.N 7) 4,11,000
Total 7,41,000
6. Intangible assets
Goodwill (refer to W.N 6) 17,200
7. Inventories
A Ltd. 1,20,000
B Ltd. 36,400
Total 1,56,400
8 Trade Receivables
A Ltd. 59,800
B Ltd. 40,000
Total 99,800
© The Institute of Chartered Accountants of India
10.98 ADVANCED ACCOUNTING
9 Cash & Cash equivalents
Cash of A Ltd 14,500
Add: cash of B Ltd. 8,000
Total 22,500
Share holding Pattern
Total Shares of B Ltd 2,000 shares
Shares held by A Ltd 1,600 shares i.e. 80 %
Minority Shareholding 400 shares i.e. 20 %
Working Notes:
1. The dividend @ 10% on 1,600 shares - ` 16,000 received by A Ltd.
should have been credited to the investment A/c, being out of
pre-acquisition profits. A Ltd., must pass a rectification entry, viz.
Profit & Loss Account Dr. ` 16,000
To Investment ` 16,000
2. The Plant & Machinery of B Ltd. would stand in the books at
` 1,42,500 on 1st July, 20X1, considering only six months’ depreciation
on ` 1,50,000 total depreciation being ` 15,000. The value put on the
assets being ` 1,80,000, there is an appreciation to the extent of
` 37,500 (1,80,000 – 1,42,500).
3. Capital profits of B Ltd.
` `
Reserve on 1st January, 20X1 (Assumed there 1,00,000
is no movement in reserves during the year and
hence balance as on 1st January 20X1 is same
as of 31st December 20X1)
Profit & Loss Account Balance on 1st January, 30,000
20X1
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.99
FINANCIAL STATEMENTS
Less: Dividend paid (20,000) 10,000
Profit for 20X1:
Total ` 82,000
Less: `10,000
` 72,000
Proportionate upto 1st July, 20X1 on time basis
(` 72,000/2) 36,000
Appreciation in value of Plant & Machinery 37,500
1,83,500
Less: 20% due to outsiders (36,700)
Holding company’s share 1,46,800
4. Revenue profits of B Ltd.:
Profit after 1st July, 20X1 [(82,000 – 10,000) x ½] 36,000
Less: Depreciation
10% depreciation on `1,80,000 for 6 months 9,000
Less: Depreciation already charged for 2nd half
year on 1,50,000 (7,500) (1,500)
34,500
Less: 1/5 due to outsiders (6,900)
Share of A Ltd. 27,600
5. Minority interest:
Par value of 400 shares (2,00,000 X 20%) 40,000
Add: 1/5Capital Profits [WN 3] 36,700
1/5 Revenue Profits [WN 4] 6,900
83,600
© The Institute of Chartered Accountants of India
10.100 ADVANCED ACCOUNTING
6. Cost of Control:
Amount paid for 1,600 shares 3,40,000
Less: Dividend out of pre-acquisition profits (16,000) 3,24,000
Par value of shares 1,60,000
Capital Profits –share of A Ltd. [WN 3] 1,46,800 (3,06,800)
Cost of Control or Goodwill 17,200
7. Value of plant & Machinery:
2,40,000
B Ltd. 1,35,000
Add: Appreciation on 1st July, 20X1 [1,80,000 –
(1,50,000 – 7,500)] 37,500
1,72,500
Add: Deprecation for 2nd half charged on pre-
revalued value 7,500
Less: Depreciation on `1,80,000 for 6 months (9,000) 1,71,000
4,11,000
8. Profit & Loss Account (Consolidated):
A Ltd. as given 57,200
Less: Dividend transferred to Investment A/c (16,000) 41,200
Share of A Ltd. in revenue profits of B Ltd. (WN 27,600
4)
68,800
10. Consolidated Balance Sheet of H Ltd.
and its subsidiary S Ltd. as at 31st March, 20X1
Particulars Note No. (` in Lacs)
I. Equity and Liabilities
(1) Shareholder's Funds
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.101
FINANCIAL STATEMENTS
(a) Share Capital 1 12,000
(b) Reserves and Surplus 2 7,159
(2) Minority Interest [W.N.6] 3,120
(3) Current Liabilities
(a) Trade payables 3 2,802
(b) Short term provisions 4 1,249
(c) Other current liabilities 5 1,200
Total 27,530
II. Assets
(1) Non-current assets
Property, Plant and Equipment 6 14,954
(2) Current assets
(a) Inventories 7 5,885
(b) Trade receivables 8 4,477
(c) Short term loans and advances 9 520
(d) Cash and cash equivalents 10 1,694
Total 27,530
Notes to Accounts
(` in lacs) (` in lacs)
1. Share Capital
Authorized share capital 15,000
Equity shares of `10 each, fully paid up
Issued and Subscribed:
Equity shares of ` 10 each, fully paid up 12,000
Total 12,000
2. Reserves and surplus
Capital Reserve (Note 5) 1,320
© The Institute of Chartered Accountants of India
10.102 ADVANCED ACCOUNTING
General Reserve (2,784 + 108) 2,892
Profit and Loss Account:
H Ltd. 2,715
Less: Dividend wrongly credited 360
Unrealized Profit 20 (380)
2,335
Add: Share in S Ltd.’s Revenue profits 612 2,947
Total 7,159
3. Trade payables
Creditors
H Ltd. 1,461
S Ltd. 854 2,315
Bills Payable
H Ltd. ` 372
S Ltd. ` 160
` 532
Less: Mutual owing ` (45) 487 2,802
4. Short term provisions
Provision for Taxation
H Ltd. 855
S Ltd. 394
Total 1,249
5. Other current liabilities
Dividend payable
H Ltd. 1,200
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.103
FINANCIAL STATEMENTS
6. Property, plant and equipment
Land and Buildings
H Ltd. 2,718
Plant and Machinery
H Ltd. ` 4,905
S Ltd. ` 4,900 9,805
Furniture and Fittings
H Ltd. ` 1,845
S Ltd. ` 586 2,431
Total 14,954
7. Inventories
Stock
H Ltd. 3,949
S Ltd. 1,956
5,905
Less: Unrealized profit (20) 5,885
8. Trade receivables
Debtors
H Ltd. ` 2,600
S Ltd. ` 1,363 3,963
Bills Receivable
H Ltd. ` 360
S Ltd. ` 199
` 559
Less: Mutual Owing ` (45) 514 4,477
© The Institute of Chartered Accountants of India
10.104 ADVANCED ACCOUNTING
9. Short term loans and advances
Sundry Advances 520
10. Cash and cash equivalents
Cash and Bank Balances 1,694
Share holding pattern of S Ltd.
Shares as on 31st March, 20X1 (Includes 480 lakh shares (4,800 lakhs/
bonus shares issued on 1st January, 20X1) ` 10)
H Ltd.’s holding as on 1st April, 20X0 180 lakhs
Add: Bonus received on 1st January, 20X1 108 lakhs (180 / 5 × 3)
Total H Ltd.’s holding as on 31st March, 20X1 288 lakhs i.e. 60 %
[288/480×100]
Minority Shareholding 40%
Working Notes:
1. S Ltd.’s General Reserve Account
` in lakhs ` in lakhs
To Bonus to equity By Balance b/d 3,000
shareholders (WN-8) 1,800 By Profit and Loss A/c 180
To Balance c/d 1,380 (Balancing figure) _
3,180 3,180
2. S Ltd.’s Profit and Loss Account
` in lakhs ` in lakhs
To General Reserve By Balance b/d 1,200
[WN 1] 180 By Net Profit for the
To Dividend paid year* 1,200
(20% on `3,000 lakhs) 600 (Balancing figure)
To Balance c/d 1,620
2,400 2,400
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.105
FINANCIAL STATEMENTS
*Out of ` 1,200 lakhs profit for the year, ` 180 lakhs has been transferred to
reserves.
3. Distribution of Revenue profits
` in lakhs
Revenue profits (W. N. 2) 1,200
Less: Share of H Ltd. 60% (General Reserve ` 108 + Profit (720)
and Loss Account ` 612)
Share of Minority Shareholders (40%) 480
Note: The question can also be solved by taking ` 1,020 lakhs as post
acquisition Profit and Loss balance and ` 180 lakhs as post acquisition
General Reserve balance. The final answer will be same.
4. Calculation of Capital Profits
` in lakhs
General Reserve on the date of acquisition less bonus shares 1,200
(` 3,000 – ` 1,800)
Profit and loss account on the date of acquisition less 600
dividend paid (` 1,200 – ` 600)
1,800
H Ltd.’s share = 60% of ` 1,800 lakhs = ` 1,080 lakhs
Minority interest = ` 1,800 – ` 1,080 = ` 720 lakhs
5. Calculation of capital reserve
` in lakhs
Paid up value of shares held (60% of `4,800) 2,880
Add: Share in capital profits [WN 4] 1,080
3,960
Less: Cost of shares less dividend received (` 3,000 – ` 360) (2,640)
Capital reserve 1,320
© The Institute of Chartered Accountants of India
10.106 ADVANCED ACCOUNTING
6. Calculation of Minority Interest
III III` in lakhs
40% of share capital (40% of ` 4,800) 1,920
Add: Share in revenue profits [WN 3] 480
Share in capital profits [WN 4] 720
3,120
7. Unrealized profit in respect of inventory
25
×
` 100 lakhs 125 = ` 20 lakhs
8. Computation of bonus to equity shareholders
` In lakhs
Shares as on 31 March 20X1 including bonus share
issued on 1 January 20X1 4,800
3 8
Or we can say these are 1 + or
5 5
4,800
i.e. Shares before bonus issue should have been = 3,000
8 /5
Accordingly, bonus issue would be (4,800-3,000) 1,800
11. Consolidated statement of profit and loss of Chand Ltd. and its
subsidiary Sitara Ltd. for the year ended on 31st March, 20X4
Particulars Note `
No.
Revenue from operations 1 50,03,250
Other Income 2 1,81,000
Total revenue (I) 51,84,250
Expenses:
Cost of material purchased/consumed 3 21,45,500
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.107
FINANCIAL STATEMENTS
Changes (Increase) in inventories of finished 4 (4,98,750)
goods
Employee benefit expense 5 15,75,000
Finance cost 6 22,750
Depreciation and amortization expense 7 45,500
Other expenses 8 8,43,250
Total expenses (II) 41,33,250
Profit before tax (II-III) 10,51,000
Notes to Accounts:
` `
1. Revenue from operations
Sales and other operating revenues
Chand Ltd. 33,25,000
Sitara Ltd. 19,07,500
52,32,500
Less: Inter-company sales (1,75,000)
Consultancy fees received by (28,000)
Sitara Ltd. from Chand Ltd.
Royalty received by Chand Ltd. (5,000)
from Sitara Ltd.
Brokage received by Chand Ltd. (21,250) 50,03,250
from Sitara Ltd.
2. Other Income
Dividend income:
Chand Ltd. 1,68,000
Sitara Ltd. 43,750 2,11,750
Loss on sale of investments Sitara (26,250)
Ltd.
Other Non-operating Income
Chand Ltd. 35,000
© The Institute of Chartered Accountants of India
10.108 ADVANCED ACCOUNTING
Sitara Ltd. 10,500
Less: Dividend realized from Sitara (50,000) 4,500 1,81,000
Ltd. (5,00,000 x 10%)
3. Cost of material
purchased/consumed
Chand Ltd. 13,93,000
Sitara Ltd. 4,72,500
18,65,500
Less: Purchases by Sitara Ltd. From
Chand Ltd. (1,75,000) 16,90,500
Direct expenses (Production)
Chand Ltd. 3,15,000
Sitara Ltd. 1,40,000 4,55,000 21,45,500
4. Changes (Increase) in inventories of
finished goods
Chand Ltd. 4,37,500
Sitara Ltd. 75,250
5,12,750
Less: Unrealized profits ` 7,00,00 ×
20/100 (14,000) 4,98,750
5. Employee benefits and expenses
Wages and salaries:
Chand Ltd. 13,30,000
Sitara Ltd. 2,45,000 15,75,000
6 Finance cost
Interest:
Chand Ltd. 17,500
Sitara Ltd. 5,250 22,750
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARD FOR CONSOLIDATED 10.109
FINANCIAL STATEMENTS
7. Depreciation
Chand Ltd. 31,500
Sitara Ltd. 14,000 45,500
8. Other expenses
General & Administrative expenses:
Chand Ltd. 2,80,000
Sitara Ltd. 1,22,500
4,02,500
Less: Consultancy fees received by (28,000) 3,74,500
Sitara Ltd. from Chand Ltd.
Royalty:
Sitara Ltd. 5,000
Less: Received by Chand Ltd. (5,000) Nil
Selling and distribution Expenses:
Chand Ltd. 3,32,500
Sitara Ltd. 1,57,500
4,90,000
Less: Brokerage received by Chand (21,250) 4,68,750 8,43,250
Ltd. from Sitara Ltd.
© The Institute of Chartered Accountants of India
10.110 ADVANCED ACCOUNTING
UNIT 2: ACCOUNTING STANDARD 23
ACCOUNTING FOR INVESTMENTS IN ASSOCIATES
IN CONSOLIDATED FINANCIAL STATEMENTS
LEARNING OUTCOMES
After studying this unit, you will be able to:
♦ Define the terms ‘Associates’, ‘Significant influence’, ‘Control’, ‘Equity
method’ and other related terms used in the standard.
♦ Examine the circumstances under which the Equity Method is used.
♦ Apply the Equity Method in the accounting of investments in the
associates.
♦ Disclose the contingences in the consolidated financial statements.
♦ Comply with other disclosure requirements as stated in the standard.
2.1 INTRODUCTION
AS 23, came into effect in respect of accounting periods commenced on or after
1-4-2002. AS 23 describes the principles and procedures for recognizing
investments in associates (in which the investor has significant influence, but not
a subsidiary or joint venture of investor) in the consolidated financial statements
of the investor. An investor which presents consolidated financial statements
should account for investments in associates as per equity method in accordance
with this standard but in its separate financial statements, AS 13 will be
applicable.
2.2 OBJECTIVE
The objective of this Standard is to lay down principles and procedures for
recognizing the investments in associates and its effect on the financial
operations of the group in the consolidated financial statements. Reference to AS
23 is compulsory for the companies following AS 21 and preparing consolidated
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.111
FINANCIAL STATEMENTS
financial statement for their group. For disclosing investment in associates in the
separate financial statement of the investor itself, one should follow AS 13.
2.3 DEFINITIONS OF THE TERMS USED IN THE
ACCOUNTING STANDARD
1. A subsidiary is an enterprise that is controlled by another enterprise
(known as the parent).
2. A parent is an enterprise that has one or more subsidiaries.
3. A group is a parent and all its subsidiaries.
4. The equity method is a method of accounting whereby the investment is
initially recorded at cost, identifying any goodwill/capital reserve arising at
the time of acquisition. The carrying amount of the investment is adjusted
thereafter for the post acquisition change in the investor’s share of net
assets of the investee. The consolidated statement of profit and loss reflects
the investor’s share of the results of the operations of the investee.
5. Equity is the residual interest in the assets of an enterprise after deducting
all its liabilities.
6. Consolidated financial statements are the financial statements of a group
presented as those of a single enterprise.
7. An associate is an enterprise in which the investor has significant influence
and which is neither a subsidiary nor a joint venture of the investor.
8. Significant influence is the power to participate in the financial and/or
operating policy decisions of the investee but not control over those
policies.
This definition excludes the subsidiaries or joint venture from the scope of an
associate but apart from these any other enterprises, which are significantly
influenced by the investor, is an associate for the purpose of this standard. Any
enterprise having 20% or more of the voting power or any interest directly or
indirectly in any other enterprise will be assumed to have significantly influence
the other enterprise unless proved otherwise. Significant influence may be gained
by share ownership, statute or agreement. Similarly any enterprise that does not
© The Institute of Chartered Accountants of India
10.112 ADVANCED ACCOUNTING
have 20% or more control then it is assumed not having significant influence on
the enterprise unless proved otherwise.
An enterprise can influence the significant economic decision making by many
ways like:
♦ Having some voting power.
♦ Representation on the board of directors or governing body of the investee.
♦ Participation in policy-making processes.
Material transactions between the investor and the investee (Influencing inter-
company transactions i.e. sale of goods and services, sharing technical knowledge
etc.
♦ Interchange of managerial personnel.
♦ Provision of essential technical information.
As a general rule, significant influence is presumed to exist when an investor
holds, directly or indirectly through subsidiaries, 20% or more of the voting power
of the investee.
As with the classification of any investment, the substance of the arrangement in
each case should be considered. If it can be clearly demonstrated that an investor
holding 20% or more of the voting power of the investee does not have
significant influence, the investment will not be accounted for as an associate.
A substantial or majority ownership by another investor does not necessarily
preclude an investor from having significant influence.
If the investor holds, directly or indirectly through subsidiaries, less than 20% of
the voting power of the investee, it is presumed that the investor does not have
significant influence, unless such influence can be clearly demonstrated. The
presence of one or more of the indicators as above may indicate that an investor
has significant influence over a less than 20% owned corporate investee.
Control exists when parent company has either:
a. The ownership, directly or indirectly through subsidiary(ies), of more than
one-half of the voting power of an enterprise.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.113
FINANCIAL STATEMENTS
b. Or control of the composition of the board of directors in the case of a
company or of the composition of the corresponding governing body in
case of any other enterprise so as to obtain economic benefits from
subsidiary company’s activities.
If any company is controlling the composition of governing body of gratuity trust,
provident fund trust etc., since the objective is not the economic benefit and
therefore it will not be included in consolidated financial statement.
An enterprise is considered to control the composition of the board of directors
of a company or governing body in case of an enterprise other than a company, if
it has the power, without the consent or concurrence of any other person, to
appoint or remove all or a majority of directors of that company or members of
the body. An enterprise is deemed to have the power to appoint a
director/member, if any of the following conditions is satisfied:
(i) A person cannot be appointed as director/member without the exercise in his
favour by that enterprise of such a power as aforesaid; or
(ii) A person’s appointment as director/member follows necessarily from his
appointment to a position held by him in that enterprise; or
(iii) The director/member is nominated by that enterprise or a subsidiary thereof.
To understand the above definitions let us take few examples:
Example 1
A Ltd. has 70% holding in C Ltd. and B Ltd. also has 28% holding in the same
company. So, A Ltd. with the majority holding i.e. more than 50% is the parent
company i.e. a holding company. Since B Ltd. holds more than 20% but not more
than 50% in C Ltd., C Ltd. will be an associate of B Ltd.
Example 2
A Ltd. is holding 90% share in B Ltd. and 10% shares in C Ltd., and B Ltd. is holding
11%shares in C Ltd. In this case, A Ltd. is parent of B Ltd.
As far as the relationship between A Ltd. and C Ltd. is concerned; A Ltd. has a total
of direct and indirect holding of (10 + 11) 21% in C Ltd., Thus, C Ltd. is an associate
of A Ltd. It may however be noted that for consolidated financial statement
purposes, the holding will be 19.9% (10% + 90% of 11%),.
© The Institute of Chartered Accountants of India
10.114 ADVANCED ACCOUNTING
2.4 ASSOCIATES ACCOUNTED FOR USING THE
EQUITY METHOD
The equity method is a method of accounting whereby the investment is initially
recorded at cost, identifying any goodwill/capital reserve arising at the time of
acquisition. The carrying amount of the investment is adjusted thereafter for the
post acquisition change in the investor’s share of net assets of the investee. The
consolidated statement of profit and loss reflects the investor’s share of the
results of operations of the investee.
Goodwill/capital reserve arising on the acquisition of an associate by an investor
should be included in the carrying amount of investment in the associate but
should be disclosed separately.
From the definition, following broad conclusions can be drawn:
a. In CFS, investment is to be recorded at cost.
b. Any surplus or deficit in cost and net asset to be recorded as goodwill or
capital reserve.
c. Distributions received from an investee reduce the carrying amount of the
investment.
d. Any subsequent change in share in net asset is adjusted in cost of
investment and goodwill/capital reserve.
e. Consolidated Profit & Loss shows the investor’s share in the results of
operations of the investee.
Illustration 1
A Ltd. acquire 45% of B Ltd. shares on April 01, 20X1, the price paid was
` 15,00,000. Following are the extracts of balance sheet of B Ltd. as of 1 April 20X1:
Paid up Equity Share Capital ` 10,00,000
Securities Premium ` 1,00,000
Reserve & Surplus ` 5,00,000
B Ltd. has reported net profits of ` 3,00,000 and paid dividends of ` 1,00,000 for the
year ended 31 March 20X2. Calculate the amount at which the investment in B Ltd.
should be shown in the consolidated balance sheet of A Ltd. as on March 31, 20X2.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.115
FINANCIAL STATEMENTS
Solution
Calculation of Goodwill/Capital Reserve under Equity Method
Particulars ` `
Investment in B Ltd. (A) 15,00,000
Equity Shares 10,00,000
Security Premium 1,00,000
Reserves & Surplus 5,00,000
Net Assets 16,00,000
45% of Net Asset (B) 7,20,000
Goodwill (A-B) 7,80,000
Calculation of Carrying Amount of Investment in the year ended on
31st March, 20X2
Particulars `
Investment in Associate as per AS 23:
Share of Net Assets on 1 April 20X1 7,20,000
Add: Goodwill 7,80,000
Cost of Investment 15,00,000
Add: Profit during the year (3,00,000 x 45%) 1,35,000
Less: Dividend paid (1,00,000 x 45%) (45,000)
Carrying Amount of Investment 15,90,000
2.5 CIRCUMSTANCES UNDER WHICH EQUITY
METHOD IS FOLLOWED
Equity method of accounting is to be followed by all the enterprises having
significant influence on their associates except in the following cases:
a. Control is intended to be temporary because the investment is acquired and
held exclusively with a view to its subsequent disposal in the near future.
The term ‘Near Future’ is explained with AS 21.
© The Institute of Chartered Accountants of India
10.116 ADVANCED ACCOUNTING
b. Or it operates under severe long-term restrictions, which significantly impair
its ability to transfer funds to the investor.
In both the above cases, investment of investor in the share of the investee
is treated as investment according to AS 13.
An investor should discontinue the use of the equity method from the date that:
a. It ceases to have significant influence in an associate but retains, either in
whole or in part, its investment.
b. The use of the equity method is no longer appropriate because the
associate operates under severe long-term restrictions that significantly
impair its ability to transfer funds to the investor.
From the date of discontinuing the use of the equity method, investments in such
associates should be accounted for in accordance with AS 13, Accounting for
Investments. For this purpose, the carrying amount of the investment at that date
should be regarded as cost thereafter. The reasons for not applying the equity
method in accounting for investments in an associate should be disclosed in the
consolidated financial statements.
2.6 APPLICATION OF THE EQUITY METHOD
♦ Many of the rules followed under equity method for an associate is similar
to consolidated financial statement rules as in case of subsidiary i.e. AS 21.
♦ Investment in an associate should be recorded as per the equity method
from the date when such relation comes in effect.
♦ Investment in the associate is recorded at cost and any difference in the
cost and investor’s share in equity on the date of acquisition is shown as
goodwill or capital reserve.
Case 1:
A Ltd. holds 22% share of B Ltd. on 1st April of the year and following are
the relevant information as available on the date are Cost of Investment
` 33,000 and Total Equity on the date of acquisition ` 2,00,000.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.117
FINANCIAL STATEMENTS
A Ltd.’s share in equity (2,00,000 x 22%) ` 44,000
Less: Cost of Investment ` (33,000)
Capital Reserve ` 11,000
Extract of Balance Sheet: ASSETS
Investment in Associate as per AS 23 ` `
Share of Net Assets as on 1 April 44,000
Less: Capital reserve (11,000) 33,000
Case 2:
A Ltd. holds 22% share of B Ltd. on 1st April of the year and following are
the relevant information as available on the date are Cost of Investment
` 55,000 and Total Equity on the date of acquisition ` 2,00,000.
Cost of Investment ` 55,000
Less: A Ltd.’s share in equity (2,00,000 x 22%) ` 44,000
Goodwill ` 11,000
Extract of Balance Sheet: ASSETS
Investment in Associate as per AS 23 ` `
Share of Net Assets as on 1 April 44,000
Add: Goodwill 11,000 55,000
♦ Step Acquisition in case of an associate:
An enterprise having share of profits of more than 50% in other company,
they are said to be in Parent-Subsidiary relationship. However, if the share
in profits is more than 20% but upto 50% then this relationship is termed as
of associate. This stake of 20% can be acquired either in one go or in more
than one transaction. This stake can be increased further say from 25% to
30%. Adjustment should be made with each transaction.
© The Institute of Chartered Accountants of India
10.118 ADVANCED ACCOUNTING
Case 1 Conversion from a passive investor to an associate in the same
year:
A Ltd. acquired 10% stake of B Ltd. on April 01 and further 15% on
October 01 during the same year. Other information is as follow:
Cost of Investment for 10% ` 1,00,000 and for 15% ` 1,45,000
Net asset on April 01 ` 8,50,000 and on October 01 ` 10,00,000.
Calculations for April 01:
`
Cost of investment (8,50,000 x 10%) 1,00,000
Less: 10% share in net asset ( 85,000)
Goodwill 15,000
Calculations for October 01:
`
15% share in net asset (10,00,000 x 15%) 1,50,000
Less: Cost of investment (1,45,000)
Capital Reserve 5,000
Total goodwill (15,000 – 5,000) 10,000
Case 2 - Conversion from a passive investor to an associate in the same
year:
A Ltd. acquired 10% stake of B Ltd. on April 01 and further 15% on October
01 of the same year. Other information is as follow:
Cost of Investment for 10% ` 1,00,000 and for 15% ` 1,55,000
Net asset on April 01 ` 8,50,000 and on October 01 ` 10,00,000.
Calculations for April 01:
`
Cost of investment 1,00,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.119
FINANCIAL STATEMENTS
Less: 10% share in net asset ( 85,000)
Goodwill 15,000
Calculations for October 01:
`
Cost of investment 1,55,000
Less: 15% share in net asset ( 1,50,000)
Goodwill 5,000
Total goodwill (15,000 + 5,000) 20,000
Case 3 – Further acquisition in an associate in the same year:
A Ltd. acquired 25% stake of B Ltd. on April 01 and further 5% on October
01 of the same year. Other information is as follow:
Cost of Investment for 25% ` 1,50,000 and for 5% ` 20,000
Net asset on April 01 ` 5,00,000.
Profit for the year ` 90,000 earned in the ratio 2:1 respectively.
Calculations for April 01:
`
Cost of investment 1,50,000
Less: 25% share in net asset (5,00,000 x2 5%) (1,25,000)
Goodwill 25,000
Calculations for October 01:
`
Profits for the first half (90,000/3) x 2 60,000
Additional share of A Ltd. 5%
Pre-acquisition profits i.e. capital reserve (60,000 x 5%) 3,000
5% share in net asset 25,000
© The Institute of Chartered Accountants of India
10.120 ADVANCED ACCOUNTING
Total share of net assets for 5% stake (5,00,000+60,000)x5% 28,000
Cost of investment 20,000
Capital Reserve 8,000
Cost of Investment on April 01 1,50,000
Less: Goodwill ` 25,000
1,25,000
Calculation of net assets of associates as on 31st March
Carrying Amount on April 01 1,25,000
Add: Additional Share in Net Asset on October 01 25,000
Add: Capital share of Profits for first half 3,000
Add: Revenue shares of Profits for first half (60,000 x 25%) 15,000
Add: Revenue shares of Profits for second half (30,000 x 9,000
30%)
Net Assets Of Associate As On 31st March 1,77,000
Alternatively
Balance sheet `
Investment in associate (inclusive of goodwill of 25,000) 1,25,000
Add: Further investment 28,000
Add: (90,000 x 25% + 30,000 x 5 %)
i.e (22,500+1,500) 24,000
or (60,000 x 25% +30,000 x30%) 1,77,000
♦ If there is any transaction between the Investor Company and investee
concern then the unrealised profits on such goods to the extent of
investor’s share should be eliminated from consolidated financial statement.
♦ Any loss on such transactions are not eliminated to the extent that such loss
is not recoverable. Otherwise such losses are written off from consolidated
financial statement fully.
© The Institute of Chartered Accountants of India
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FINANCIAL STATEMENTS
Illustration 2
A Ltd. acquired 40% share in B Ltd. on April 01, 20X1 for ` 10 lacs. On that date
B Ltd. had 1,00,000 equity shares of ` 10 each fully paid and accumulated profits of
` 2,00,000. During the year 20X1-20X2, B Ltd. suffered a loss of ` 10,00,000; during
20X2-20X3 loss of ` 12,50,000 and during 20X3-20X4 again a loss of ` 5,00,000.
Show the extract of consolidated balance sheet of A Ltd. on all the four dates
recording the above events.
Solution
Calculation of Goodwill/Capital Reserve under Equity Method
Particulars `
Equity Shares 10,00,000
Reserves & Surplus 2,00,000
Net Assets 12,00,000
40% share of Net Assets 4,80,000
Less: Cost of Investment (10,00,000)
Goodwill 5,20,000
Consolidated Balance Sheet (Extract) as on April 01, 20X1: ASSETS
Investment in Associate as per AS 23 ` `
Share of Net Assets on April 1 4,80,000
Add: Goodwill 5,20,000 10,00,000
Calculation of Carrying Amount of Investment as at 31 March 20X2:
Investment in Associate as per AS 23 `
Share of Net Assets on 1 April, 20X1 4,80,000
Add: Goodwill 5,20,000
Cost of Investment 10,00,000
© The Institute of Chartered Accountants of India
10.122 ADVANCED ACCOUNTING
Less: Loss for the year (10,00,000 x 40%) (4,00,000)
Carrying Amount of Investment 6,00,000
Consolidated Balance Sheet (Extract) as on March 31, 20X2: ASSETS
Investment in Associate as per AS 23 ` `
Share of Net Assets on 1 April, 20X1 4,80,000
Less: Share of Loss as above (4,00,000)
80,000
Add: Goodwill 5,20,000 6,00,000
Calculation of Carrying Amount of Investment as at 31 March 20X3:
Investment in Associate as per AS 23 `
Carrying Amount of Investment as on 31 March 20X2 6,00,000
Less: Loss for the year (12,50,000 x 40%) (5,00,000)
Carrying Amount of Investment 1,00,000
Consolidated Balance Sheet (Extract) as on March 31, 20X3: ASSETS
Investment in Associate as per AS 23 ` `
Share of Net Assets on 1 April, 20X1 4,80,000
Less: Share of Loss as above (` 4,00,000 +
` 5,00,000) (4,20,000)
Add: Goodwill 1,00,000
Calculation of Carrying Amount of Investment as at 31 March 20X4:
Investment in Associate as per AS 23 `
Carrying Amount of Investment 1,00,000
Less: Loss for the year (5,00,000 x 40% = 2,00,000, restricted to
Carrying amount of Investment in B Ltd.) -refer note below
Carrying Amount of Investment
© The Institute of Chartered Accountants of India
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FINANCIAL STATEMENTS
Consolidated Balance Sheet (Extract) as on March 31, 20X4: ASSETS
Investment in Associate as per AS 23 `
Investment in B Ltd. -
♦ If, under the equity method, an investor’s share of losses of an associate
equals or exceeds the carrying amount of the investment, the investor
ordinarily discontinues recognising its share of further losses and the
investment is reported at nil value. Additional losses are provided for to the
extent that the investor has incurred obligations or made payments on
behalf of the associate to satisfy obligations of the associate that the
investor has guaranteed or to which the investor is otherwise committed. If
the associate subsequently reports profits, the investor resumes including
its share of those profits only after its share of the profits equals the share
of net losses that have not been recognised.
♦ As far as possible the reporting date of the financial statements should be
same for consolidated financial statement. If practically it is not possible to
draw up the financial statements of one or more enterprise to such date
and, accordingly, those financial statements are drawn up to reporting dates
different from the reporting date of the investor, adjustments should be
made for the effects of significant transactions or other events that occur
between those dates and the date of the consolidated financial statements.
In any case, the difference between reporting dates of the concern and
consolidated financial statement should not be more than six months.
♦ Accounting policies followed in the preparation of the financial statements
of the investor, investee and consolidated financial statement should be
uniform for like transactions and other events in similar circumstances.
If accounting policies followed by different enterprises in the group are not
uniform, then adjustments should be made in the items of the individual
financial statements to bring it in line with the accounting policy of the
consolidated statement.
♦ The carrying amount of investment in an associate should be reduced to
recognise a decline, other than temporary, in the value of the investment,
such reduction being determined and made for each investment
individually.
© The Institute of Chartered Accountants of India
10.124 ADVANCED ACCOUNTING
2.7 CONTINGENCIES
In accordance with AS 4, the investor discloses in the consolidated financial
statements:
a. Its share of the contingencies and capital commitments of an associate for
which it is also contingently liable; and
b. Those contingencies that arise because the investor is severally liable for the
liabilities of the associate.
2.8 WHY IS EQUITY METHOD OF ACCOUNTING
ADOPTED FOR INVESTMENT IN
ASSOCIATES?
♦ Investments in associates cannot be treated as a normal investment under
AS 13. The intent of investing to such an extent (i.e.; 20% or more but less
than 50% of equity) in an associate is an expression of the fact that the
investor is not merely interested in the dividend distribution, but also is
interested in the participation of decision-making process in the associate.
♦ Thus, recognition of income on the basis of distributions received may not
be an adequate measure of the income earned by an investor on an
investment in an associate because the distributions received may bear little
relationship to the performance of the associate. As the investor has
significant influence over the associate, the investor has a measure of
responsibility for the associate’s performance and, as a result, the return on
its investment. The investor accounts for this stewardship by extending the
scope of its consolidated financial statements to include its share of results
of such an associate and so provides an analysis of earnings and investment
from which more useful ratios can be calculated. As a result, application of
the equity method in consolidated financial statements provides more
informative reporting of the net assets and net income of the investor.
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FINANCIAL STATEMENTS
2.9 DISCLOSURE
♦ In addition to the disclosures required above, an appropriate listing and
description of associates including the proportion of ownership interest
and, if different, the proportion of voting power held should be disclosed in
the consolidated financial statements.
♦ Investments in associates accounted for using the equity method should be
classified as long-term investments and disclosed separately in the
consolidated balance sheet. The investor’s share of the profits or losses of
such investments should be disclosed separately in the consolidated
statement of profit and loss. The investor’s share of any extraordinary or
prior period items should also be separately disclosed.
♦ The name(s) of the associate(s) of which reporting date(s) is/are different
from that of the financial statements of an investor and the differences in
reporting dates should be disclosed in the consolidated financial
statements.
♦ In case an associate uses accounting policies other than those adopted for
the consolidated financial statements for like transactions and events in
similar circumstances and it is not practicable to make appropriate
adjustments to the associate’s financial statements, the fact should be
disclosed along with a brief description of the differences in the accounting
policies.
♦ If an associate is not accounted for using the equity method the reasons for
not doing the same.
♦ Goodwill/capital reserve arising on the acquisition of an associate by an
investor should be disclosed separately though it is included in the carrying
amount of the investment.
© The Institute of Chartered Accountants of India
10.126 ADVANCED ACCOUNTING
2.10 RELEVANT EXPLANATIONS TO AS 23
2.10.1 Treatment of Proposed Dividend in Associates in
Consolidated Financial Statements
In case an associate has made a provision for proposed dividend (i.e. dividend
declared after the reporting period but it pertains to that reporting year) in its
financial statements, the investor's share of the results of operations of the
associate should be computed without taking into consideration the proposed
dividend.
2.10.2 Consideration of Potential Equity Shares for
Determining whether an Investee is an Associate
The potential equity shares of the investee held by the investor should not be
taken into account for determining the voting power of the investor.
Reference: The students are advised to refer the full text of AS 23 “Accounting
for Investments in Associates in Consolidated Financial Statements” (issued 2001).
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Identity which of the statements are correct.
An enterprise can influence the significant economic decision making by
many ways like:
(i) Representation on the board of directors or governing body of the
investee.
(ii) Participation in policy-making processes.
(iii) Interchange of managerial personnel.
(iv) Provision of essential technical information.
(a) Statement (i) and (ii) are correct.
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FINANCIAL STATEMENTS
(b) Statement (i), (ii) and (iii) are correct.
(c) Statement (i), (ii), (iii) and (iv) are correct.
(d) Statement (ii) and (iii) are correct.
2. A Ltd. is holding 90% share in B Ltd. and 10% shares in C Ltd., and B Ltd. is
holding 11% shares in C Ltd.
Identity which of the statements are incorrect.
(i) In this case, A Ltd. is parent of B Ltd.
(ii) As far as the relationship between A Ltd. and C Ltd. is concerned; A Ltd.
has a total of direct and indirect holding of (10% + 90% of 11%) 19.9 %
in C Ltd.
(iii) C Ltd. is an associate of A Ltd.
(a) Statement (ii) is incorrect.
(b) Statement (iii) is incorrect.
(c) Statement (ii) and (iii) both are incorrect.
(d) All statements are incorrect.
3. A Ltd. acquired 10% stake of B Ltd. on April 01 and further 15% on
October 01 of the same year. Other information is as follows:
Cost of Investment for 10% ` 1,00,000 and for 15% ` 1,55,000
Net asset on April 01 ` 8,50,000 and on October 01 ` 10,00,000.
What is the amount of goodwill or capital reserve arising on significant
influence?
(a) Goodwill = ` 10,000.
(b) Goodwill = ` 20,000.
(c) Capital Reserve = ` 10,000.
(d) Capital Reserve = ` 20,000.
4. A Ltd. acquired 10% stake of B Ltd. on April 01 and further 15% on October
01 during the same year. Other information is as follow:
© The Institute of Chartered Accountants of India
10.128 ADVANCED ACCOUNTING
Cost of Investment for 10% ` 1,00,000 and for 15% ` 1,45,000
Net asset on April 01 ` 8,50,000 and on October 01 ` 10,00,000.
What is the amount of goodwill or capital reserve arising on significant
influence?
(a) Goodwill = ` 10,000.
(b) Goodwill = ` 20,000.
(c) Capital Reserve = ` 10,000.
(d) Capital Reserve = ` 20,000.
5. Identity which of the statements are correct.
(i) In case an associate has made a provision for proposed dividend (i.e.
dividend declared after the reporting period but it pertains to that
reporting year) in its financial statements, the investor's share of the
results of operations of the associate should be computed without
taking into consideration the proposed dividend.
(ii) In case an associate has made a provision for proposed dividend (i.e.
dividend declared after the reporting period but it pertains to that
reporting year) in its financial statements, the investor's share of the
results of operations of the associate should be computed after taking
into consideration the proposed dividend.
(iii) The potential equity shares of the investee held by the investor should
not be taken into account for determining the voting power of the
investor.
(iv) The potential equity shares of the investee held by the investor should
be taken into account for determining the voting power of the investor.
(a) Statement (i) and (iii).
(b) Statement (ii) and (iv).
(c) Statement (i) only.
(d) Statement (iii) only.
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FINANCIAL STATEMENTS
Theoretical Questions
6. Describe the cases when AS 23 does not allow the use of equity method of
accounting?
7. When is an investor required to discontinue the use of the equity method of
accounting?
Scenario based Questions
8. Bright Ltd. acquired 30% of East India Ltd. shares for ` 2,00,000 on
01-06-20X1. By such an acquisition Bright can exercise significant influence
over East India Ltd. During the financial year ending on 31-03-20X1 East
India earned profits ` 80,000 and declared a dividend of ` 50,000 on
12-08-20X1. East India reported earnings of ` 3,00,000 for the financial year
ending on 31-03-20X2 (assume profits to accrue evenly) and declared
dividends of ` 60,000 on 12-06-20X2.
Calculate the carrying amount of investment in:
(i) Separate financial statements of Bright Ltd. as on 31-03-20X2;
(ii) Consolidated financial statements of Bright Ltd.; as on 31-03-20X2;
(iii) What will be the carrying amount as on 30-06-20X2 in consolidated
financial statements?
9. A Ltd. acquired 25% of shares in B Ltd. as on 31.3.20X1 for ` 3 lakhs. The
Balance Sheet of B Ltd. as on 31.3.20X1 is given below:
`
Share Capital 5,00,000
Reserves and Surplus 5,00,000
10,00,000
Property, Plant and Equipment 5,00,000
Investments 2,00,000
Current Assets 3,00,000
10,00,000
© The Institute of Chartered Accountants of India
10.130 ADVANCED ACCOUNTING
During the year ended 31.3.20X2 the following are the additional information
available:
(i) On 30.4.20X1 A Ltd. received a dividend from B Ltd. for the year ended
31.3.20X1 at 40% from the Reserves. The above balance sheet is before
the adjustment of dividend.
(ii) B Ltd. made a profit after tax of ` 7 lakhs for the year ended 31.3.20X2.
(iii) B Ltd. declared a dividend @ 50% for the year ended 31.3.20X2 on
30.4.20X2.
A Ltd. is preparing Consolidated Financial Statements for 20X1-X2 in
accordance with AS 21 for its various subsidiaries. Calculate:
(i) Goodwill if any on investment in shares of B Ltd.’s .
(ii) How the dividend received for 31.3.20X2 on 30.4.20X2 from B Ltd. will be shown in
the Consolidated Financial Statements?
(iii) How A Ltd. will reflect the value of investment in B Ltd., in its
Consolidated Financial Statements?
ANSWERS/SOLUTION
Answer to the Multiple Choice Questions
1. (c) 2. (a) 3. (b) 4. (a) 5. (a)
Answer to the Theoretical Questions
6. Equity method of accounting is to be followed by all the enterprises having
significant influence on their associates except in the following cases:
a. Control is intended to be temporary because the investment is
acquired and held exclusively with a view to its subsequent disposal in
the near future.
The term ‘Near Future’ is explained with AS 21.
Or;
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FINANCIAL STATEMENTS
b. It operates under severe long-term restrictions, which significantly
impair its ability to transfer funds to the investor.
In both the above cases, investment of investor in the share of the
investee is treated as investment according to AS 13.
7. An investor should discontinue the use of the equity method from the date
that:
a. It ceases to have significant influence in an associate but retains,
either in whole or in part, its investment.
b. The use of the equity method is no longer appropriate because the
associate operates under severe long-term restrictions that
significantly impair its ability to transfer funds to the investor.
From the date of discontinuing the use of the equity method, investments in
such associates should be accounted for in accordance with AS 13,
Accounting for Investments. For this purpose, the carrying amount of the
investment at that date should be regarded as cost thereafter.
Answer to the Scenario based Questions
8. (i) Carrying amount of investment in Separate Financial Statement of
Bright Ltd. as on 31.03.20X2
`
Amount paid for investment in Associate (on 1.06.20X1) 2,00,000
Less: Pre-acquisition dividend (` 50,000 x 30%) (15,000)
Carrying amount as on 31.3.20X2 as per AS 13 1,85,000
(ii) Carrying amount of investment in Consolidated Financial
Statements ∗ of Bright Ltd. as on 31.3.20X2 as per AS 23
Carrying amount as per separate financial statements 1,85,000
∗
It is assumed that Bright Ltd. has a subsidiary company and it is preparing Consolidated
Financial Statements.
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10.132 ADVANCED ACCOUNTING
Add: Proportionate share of 10-month profit of
investee as per equity method (30% of
` 3,00,000 x 10/12) 75,000
Carrying amount as on 31.3.20X2 2,60,000
(iii) Carrying amount of investment in Consolidated Financial
Statement of Bright Ltd. as on 30.6.20X2 as per AS 23
Carrying amount as on 31.3.20X2 2,60,000
Less: Dividend received (` 60,000 x 30%) (18,000)
Carrying amount as on 30.6.20X2 2,42,000
9. In terms of AS 23, B Ltd. will be considered as an associate company of
A Ltd. as shares acquired represent to more than 20%.
(i) Calculation of Goodwill (` in lakhs)
Amount paid towards acquisition of stake in B Ltd. 3.00
Less: Pre-acquisition dividend (` 5,00,000 x 40% x 25%) 0.50
Cost of Investment in B Ltd. 2.50
Less: Share in the value of Equity of B Ltd.
as at the date of investment
[25% of ` 8 lakhs (` 5 lakhs + ` 5 lakhs – ` 2 lakhs)] (2.00)
Goodwill 0.50
(ii) A Ltd.
Consolidated Profit and Loss Account for the year ended
31st March, 20X2 (An extract)
` in lakhs
Other income:
Share of profits in B Ltd. (7x 25%) 1.75
Pre-acquisition Dividend received from
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FINANCIAL STATEMENTS
B Ltd. 0.50
Transfer to investment A/c (0.50) Nil
(iii) A Ltd.
Consolidated Balance Sheet as on 31.3.20X2 (An extract)
` in lakhs
Non-current investments
Investment in B Ltd. 2.50
(including goodwill)
Share of profit for year 20X1 – 20X2 1.75 4.25
Working Notes:
1. Pre-acquisition dividend received from B Ltd. amounting to
` 0.50 lakhs will be reduced from investment value in the books
of A Ltd.
2. B Ltd. made a profit of ` 7 lakhs for the year ended 31st March,
20X2. A Ltd.’s share in the profits of ` 7 lakhs is ` 1.75 lakhs.
Investment in B Ltd. will be increased by ` 1.75 lakhs and
consolidated profit and loss account of A Ltd. will be credited
with ` 1.75 lakhs in the consolidated financial statement of A
Ltd.
3. Dividend declared on 30.4.20X2 will not be recognized in the
consolidated financial statement of A Ltd.
© The Institute of Chartered Accountants of India
10.134 ADVANCED ACCOUNTING
UNIT 3: ACCOUNTING STANDARD 27
FINANCIAL REPORTING OF INTERESTS
IN JOINT VENTURES
LEARNING OUTCOMES
After studying this unit, you will be able to:
♦ Define ‘Joint venture’ ‘joint Control’, ‘control’, ‘venturer’ and investor.
♦ Appreciate different forms of joint venture
♦ Examine the contractual arrangements which will differentiate the
control as of Associate or Joint venture
♦ Evaluate the nitty-gritty of different forms of Joint ventures and
differentiate among them
♦ Present the separate and consolidated financial statements of the
venturers
♦ Accounting for transactions between the venturer and Joint venture
♦ Comply with the disclosure requirements as stated in the standard.
3.1 INTRODUCTION
You would have come across many examples where 2 or more entities would have
worked together to achieve a certain purpose. Hindustan Unilever Ltd (HUL), Tata
Starbucks Ltd, Tata SIA Airlines Ltd. (Vistara), etc. are a few popular examples of
Joint Ventures. Entities enter into such arrangements considering sharing of risk
and expense, collaboration of know-how and skill-set, while also impacted by
different work-cultures and management style. Depending on the contractual
arrangement, the accounting and reporting for Joint Ventures is done.
AS 27, came into effect in respect of accounting periods commenced on or after
01.04.2002. This standard set out principles and procedures for accounting of
interests in joint venture and reporting of joint venture assets, liabilities, income
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FINANCIAL STATEMENTS
and expenses in the financial statements of venturers and investors regardless of
the structures or forms under which the joint venture activities take place.
The standard deals with three broad types of joint ventures –
1. Jointly controlled operations,
2. Jointly controlled assets and
3. Jointly controlled entities.
The requirements relating to accounting for joint ventures in consolidated
financial statements according to proportionate consolidation method, as
contained in AS 27, apply only when consolidated financial statements are
prepared by venturer Similarly existence of a contractual arrangement
distinguishes interests which involve joint control from investments in associates
in which the investor has significant influence (see Accounting Standard (AS) 23,
Accounting for Investments in Associates in Consolidated Financial Statements).
An investor in joint venture, which does not have joint control, should report its
interest in a joint venture in its consolidated financial statements in accordance
with AS 13, AS 21 and AS 23.
3.2 SCOPE
This Standard should be applied in accounting for interests in joint ventures and
the reporting of joint venture assets, liabilities, income and expenses in the
financial statements of venturers and investors, regardless of the structures or
forms under which the joint venture activities take place.
The provisions of this AS need to be referred to for consolidated financial
statement only when CFS is prepared and presented by the venturer.
3.3 DEFINITIONS
1. A joint venture is a contractual arrangement whereby two or more parties
undertake an economic activity, which is subject to joint control.
From the above definition we conclude that the essential conditions for any
business relation to qualify as joint venture are:
♦ Two or more parties coming together: Parties can be an individual
or any form of business organization say, BOI, AOP, Company, firm.
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10.136 ADVANCED ACCOUNTING
♦ Venturers undertake some economic activity: Economic activity
means activities with the profit-making motive. Joint venture is
separate from the regular identity of the venturers, it may be in the
form of independent and separate legal organization other than
regular concern of the venturer engaged in the economic activity.
♦ Venturers have joint control on the economic activity: The
operating and financial decisions are influenced by the venturers and
they also share the results of the economic activity.
♦ There exists a contractual agreement: The relationship between
venturers is governed by the contractual agreement. This agreement
can be in the form of written and signed agreement or as minutes of
venturer meeting or in any other written form.
2. Joint control is the contractually agreed sharing of control over an
economic activity.
3. Control is the power to govern the financial and operating policies of an
economic activity so as to obtain benefits from it.
4. A venturer is a party to a joint venture and has joint control over that joint
venture.
5. An investor in a joint venture is a party to a joint venture and does not have
joint control over that joint venture.
6. Proportionate consolidation is a method of accounting and reporting
whereby a venturer’s share of each of the assets, liabilities, income and
expenses of a jointly controlled entity is reported as separate line items in
the venturer’s financial statements.
3.4 CONTRACTUAL ARRANGEMENT
The joint venture covered under this statement is governed on the basis of
contractual agreement. Non-existence of contractual agreement will disqualify
an organization to be covered in AS 27. Joint ventures with contractual agreement
will be excluded from the scope of AS 27 only if the investment qualifies as
subsidiary under AS 21, in this case, it will be covered by AS 21. Contractual
agreement can be in the form of written contract, minutes of discussion between
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FINANCIAL STATEMENTS
parties (venturers), articles of the concern or by-laws of the relevant joint venture.
Irrespective of the form of the contract, the content of the contract ideally should
include the following points:
♦ The activity, duration and reporting obligations of the joint venture.
♦ The appointment of the board of directors or equivalent governing body of
the joint venture and the voting rights of the venturers.
♦ Capital contributions by the venturers.
♦ The sharing by the venturers of the output, income, expenses or results of
the joint venture.
The main object of contractual agreement is to distribute the economic control
among the venturers, it ensures that no venturer should have unilateral control.
The arrangement identifies those decisions in areas essential to the goals of the
joint venture which require the consent of all the venturers and those decisions
which may require the consent of a specified majority of the venturers. If
contractual agreement is signed by a party to safeguard its right, such agreement
will not make the party a venturer.
The contractual arrangement may identify one venturer as the operator or
manager of the joint venture. The operator does not control the joint venture but
acts within the financial and operating policies which have been agreed to by the
venturers in accordance with the contractual arrangement and delegated to the
operator
Example 1
IDBI gave loan to the joint venture entity of L&T and Tantia Construction, they
signed an agreement according to which IDBI will be informed for all important
decisions of the joint venture entity. This agreement is to protect the right of the
IDBI, hence just signing the contractual agreement will not make investor a
venturer.
Example 2
X Ltd invested ` 200 crore as initial capital along with Y Ltd and Z Ltd in GFH Ltd.
The purpose of X Ltd making this investment is to grow the business of GFH Ltd
along with the other investors. All investors have a right to attend to the meetings
© The Institute of Chartered Accountants of India
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and to take decisions with respect to the business of GFH Ltd. All investors are
actively involved in running the business of GFH Ltd and have a share in the returns
generated by GFH Ltd in an agreed proportion.
GFH Ltd is an example of a Joint Venture and X Ltd, Y Ltd and Z Ltd are all
Venturers.
Similarly, just because contractual agreement has assigned the role of a manager
to any of the venturer will not disqualify him as venturer.
Example 3
Mr. A, M/s. B & Co. and C Ltd. entered into a joint venture, where according to the
agreement, all the policies making decisions on financial and operating activities
will be taken in a regular meeting attended by them or their representatives.
Implementation and execution of these policies will be the responsibility of Mr. A.
Here Mr. A is acting as venturer as well as manager of the concern.
3.5 FORMS OF JOINT VENTURES
Joint ventures may take many forms and structures, this Statement identifies them
in three broad types –
• Jointly Controlled Operations (JCO),
• Jointly Controlled Assets (JCA) and
• Jointly Controlled Entities (JCE).
Any structure which satisfies the following characteristics can be classified as joint
ventures:
(a) Two or more venturers are bound by a contractual arrangement and
(b) The contractual arrangement establishes joint control.
3.6 JOINTLY CONTROLLED OPERATIONS (JCO)
Under this set up, venturers do not create a separate entity for their joint venture
business but they use their own resources for the purpose. They raise any funds
required for joint venture on their own, they incur any expenses and sales are also
realised individually. They use same set of assets and employees for joint venture
business and their own business. The joint venture agreement usually provides
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means by which the revenue from the jointly controlled operations and any
expenses incurred in common are shared among the venturers.
Since there is no separate legal entity and venturers don’t recognize the
transactions separately, they do not maintain a separate set of books for joint
venture. All the transactions of joint venture are recorded in their books only.
Following are the key features of JCO:
a. Each venturer has his own separate business.
b. There is no separate entity for joint venture business.
c. All venturers are creating their own assets and maintain them.
d. Each venturer record only his own transactions without any separate set of
books maintained for the joint venture business.
e. There is a common agreement between all of them.
f. Venturers use their assets for the joint venture business.
g. Venturers met the liabilities created by them for the joint venture business.
h. Venturers met the expenses of the joint venture business from their funds.
i. Any revenue generated or income earned from the joint venture is shared
by the venturers as per the contract.
Since the jointly controlled operation is not purchasing assets or raising finance in
its own right, the assets and liabilities used in the activities of the joint venture
are those of the ventures. As such, they are accounted for in the financial
statements of the venture to which they belong. The only accounting issue that
arises is that the output from the project is to be shared among the venturers
and, therefore, there must be some mechanism for specifying the allocation of
the proceeds and the sharing of any joint expenses.
In respect of its interests in jointly controlled operations, a venturer should
recognise in its separate financial statements and consequently in its consolidated
financial statements:
(a) the assets that it controls and the liabilities that it incurs; and
(b) the expenses that it incurs and its share of the income that it earns from the
joint venture.
© The Institute of Chartered Accountants of India
10.140 ADVANCED ACCOUNTING
Separate accounting records may not be required for the joint venture itself and
financial statements may not be prepared for the joint venture. However, the
venturers may prepare accounts for internal management reporting purposes so
that they may assess the performance of the joint venture.
Example 4
Mr. A (dealer in tiles and marbles), Mr. B (dealer in various building materials) and
Mr. C (Promoter) enters into a joint venture business, where any contract for
construction received will be completed jointly, say, Mr. A will supply all tiles and
marbles, Mr. B will supply other materials from his godown and Mr. C will look after
the completion of construction. As per the contractual agreement, they will share
any profit/loss in a predetermined ratio. None of them are using separate staff or
other resources for the joint venture business and neither do they maintain a
separate account. Everything is recorded in their personal business only.
Venturer doesn’t maintain a separate set of books but they record only their own
transactions of the joint venture business in their books. Any transaction of joint
venture recorded separately is only for internal reporting purpose. Once all
transactions recorded in venturer financial statement, they don’t need to be
adjusted for in consolidated financial adjustment.
Illustration 1
Mr. A, Mr. B and Mr. C entered into a joint venture to purchase a land, construct
and sell flats. Mr. A purchased a land for ` 60,00,000 on 01.01.20X1 and for the
purpose he took loan from a bank for ` 50,00,000 @ 8% interest p.a. He also paid
registering fees ` 60,000 on the same day. Mr. B supplied the materials for
` 4,50,000 from his godown and further he purchased the materials for
` 5,00,000 for the joint venture. Mr. C met all other expenses of advertising, labour
and other incidental expenses which turnout to be ` 9,00,000. On 30.06.20X1 each
of the venturer agreed to take away one flat each to be valued at ` 10,00,000 each
flat and rest were sold by them as follow: Mr. A for ` 40,00,000; Mr. B for
` 20,00,000 and Mr. C for ` 10,00,000. Loan was repaid on the same day by Mr. A
along with the interest and net proceeds were shared by the partners equally.
You are required to prepare the draft Consolidated Profit & Loss Account and Joint
Venture Account in the books of each venturer.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.141
10.141
FINANCIAL STATEMENTS
Solution
Draft Consolidated Profit & Loss Account
Particulars ` ` Particulars ` `
To Purchase of By Sale of
Land: Flats:
Mr. A 60,00,000 Mr. A 40,00,000
To Registration Mr. B 20,00,000
Fees:
Mr. A 60,000 Mr. C 10,00,000 70,00,000
To Materials: By Flats taken
by Venturers:
Mr. B 9,50,000 Mr. A 10,00,000
To Other Mr. B 10,00,000
Expenses:
Mr. C 9,00,000 Mr. C 10,00,000 30,00,000
To Bank
Interest:
Mr. A 2,00,000
To Profits:
Mr. A 6,30,000
Mr. B 6,30,000
Mr. C 6,30,000 18,90,000
1,00,00,000 1,00,00,000
© The Institute of Chartered Accountants of India
10.142 ADVANCED ACCOUNTING
In the Books of Mr. A
Joint Venture Account
Particulars ` Particulars `
To Bank Loan (Purchase of 50,00,000 By Bank (Sale of Flats) 40,00,000
Land)
To Bank:(Purchase of Land) By Land & Building 10,00,000
10,00,000
To Bank (Registration Fees) By Bank (Received from 14,20,000
60,000 Mr. B)
To Bank (Bank Interest) 2,00,000 By Bank (Received from 4,70,000
Mr. C)
To Profit on JV 6,30,000
68,90,000 68,90,000
In the Books of Mr. B
Joint Venture Account
Particulars ` Particulars `
To Purchases (Material 4,50,000 By Bank (Sale of
Supplied) Flats) 20,00,000
To Bank (Materials) 5,00,000 By Land & Building 10,00,000
To Profit on JV 6,30,000
To Bank (Paid to Mr. A) 14,20,000
30,00,000 30,00,000
In the Books of Mr. C
Joint Venture Account
Particulars ` Particulars `
To Bank (Misc. Expenses) 9,00,000 By Bank (Sale of 10,00,000
Flats)
To Profit on JV 6,30,000 By Land & Building 10,00,000
To Bank (Paid to Mr. A) 4,70,000
20,00,000 20,00,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.143
10.143
FINANCIAL STATEMENTS
3.7 JOINTLY CONTROLLED ASSETS (JCA)
Separate legal entity is not created in this form of joint venture but venturer owns
the assets jointly, which are used by them for the purpose of generating
economic benefit to each of them. They take up any expenses and liabilities
related to the joint assets as per the contract. We can conclude the following
points:
♦ There is no separate legal identity.
♦ There is a common control over the joint assets.
♦ Venturers use this asset to derive some economic benefit to themselves.
♦ Each venturer incurs separate expenses for their transactions.
♦ Expenses on jointly held assets are shared by the venturers as per the
contract.
♦ In their financial statement, venturer shows only their share of the asset and
total income earned by them along with total expenses incurred by them.
♦ Since the assets, liabilities, income and expenses are already recognised in
the separate financial statements of the venturer and consequently in its
consolidated financial statements, no adjustments or other consolidation
procedures are required in respect of these items when the venturer
presents consolidated financial statements.
♦ Financial statements may not be prepared for the joint venture, although
the venturers may prepare accounts for internal management reporting
purposes so that they may assess the performance of the joint venture.
Example 5
ABC Ltd., BP Ltd. and HP Ltd. having the same point of oil refinery and same place
of customers agreed to spread a pipeline from their unit to customers place jointly.
They agreed to share the expenditure on the pipeline construction and maintenance
in the ratio 3:3:4 respectively and the time allotted to use the pipeline was in the
ratio 4:3:3 respectively.
For the joint venture, each venturer will record his share of joint assets as classified
according to the nature of the assets rather than as an investment and any
expenditure incurred or revenue generated will be recorded with other items similar
to JCO.
© The Institute of Chartered Accountants of India
10.144 ADVANCED ACCOUNTING
Following are the few differences between JCO and JCA for better
understanding:
♦ In JCO, venturers use their own assets for joint venture business but in JCA
they jointly own the assets to be used in joint venture.
♦ JCO is an agreement to joint carry on the operations to earn income
whereas, JCA is an agreement to jointly construct and maintain an asset to
generate revenue to each venturer.
♦ Under JCO all expenses and revenues are shared at an agreed ratio, in JCA
only expenses on joint assets are shared at the agreed ratio.
Illustration 2
A Ltd., B Ltd. and C Ltd. decided to jointly construct a pipeline to transport the gas
from one place to another that was manufactured by them. For the purpose
following expenditure was incurred by them: Buildings ` 12,00,000 to be
depreciated @ 5% p.a., Pipeline for ` 60,00,000 to be depreciated @ 15% p.a.,
computers and other electronics for ` 3,00,000 to be depreciated @ 40% p.a. and
various vehicles of ` 9,00,000 to be depreciated @ 20% p.a.
They also decided to equally bear the total expenditure incurred on the
maintenance of the pipeline that comes to ` 6,00,000 each year.
You are required to show the consolidated balance sheet and the extract of
Statement of Profit & Loss and Balance Sheet for each venturer.
Solution
Consolidated Balance Sheet
Note (` )
I Equity and liabilities
Shareholders’ funds:
Share Capital 1 71,40,000
71,40,000
II Assets
Non-current Assets
Property, Plant and Equipment: 2 71,40,000
71,40,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.145
10.145
FINANCIAL STATEMENTS
Notes to Accounts
(`)
1. Share capital
A Ltd. 23,80,000
B Ltd. 23,80,000
C Ltd. 23,80,000 71,40,000
2. Property, Plant and Equipment
Land & Building:
A Ltd. 3,80,000
B Ltd. 3,80,000
C Ltd. 3,80,000 11,40,000
Plant & Machinery:
A Ltd. 17,00,000
B Ltd. 17,00,000
C Ltd. 17,00,000 51,00,000
Computers:
A Ltd. 60,000
B Ltd. 60,000
C Ltd. 60,000 1,80,000
Vehicles:
A Ltd. 2,40,000
B Ltd. 2,40,000
C Ltd. 2,40,000 7,20,000
© The Institute of Chartered Accountants of India
10.146 ADVANCED ACCOUNTING
In the Books of A Ltd.
Extract of statement of Profit & Loss
Particulars Note No. `
Depreciation and amortisation expense 1 4,20,000
Other operating Expenses (Pipeline Expenses) 200,000
Extract of Balance Sheet
Note No. `
Assets
Non-current assets
Property, Plant and Equipment 2 23,80,000
Notes to Accounts
` `
1. Depreciation and amortisation expense
Land & Building 20,000
Plant & Machinery 3,00,000
Computers 40,000
Vehicles 60,000 4,20,000
2. Land & Building 4,00,000
Less: Depreciation (20,000) 3,80,000
Plant & Machinery 20,00,000
Less: Depreciation (3,00,000) 17,00,000
Computers 1,00,000
Less: Depreciation (40,000) 60,000
Vehicles 3,00,000
Less: Depreciation (60,000) 2,40,000
23,80,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.147
10.147
FINANCIAL STATEMENTS
In the Books of B Ltd.
Extract of draft Profit & Loss Account
Particulars Note No. `
Depreciation and amortisation expense 1 4,20,000
Other operating Expenses (Pipeline Expenses) 200,000
Extract of Balance Sheet
Note No. `
Assets
Non-current assets
Property, Plant and Equipment 2 23,80,000
Notes to Accounts
` `
1. Depreciation and amortisation expense
Land & Building 20,000
Plant & Machinery 3,00,000
Computers 40,000
Vehicles 60,000 4,20,000
2. Land & Building 4,00,000
Less: Depreciation (20,000) 3,80,000
Plant & Machinery 20,00,000
Less: Depreciation (3,00,000) 17,00,000
Computers 1,00,000
Less: Depreciation (40,000) 60,000
Vehicles 3,00,000
Less: Depreciation (60,000) 2,40,000
23,80,000
© The Institute of Chartered Accountants of India
10.148 ADVANCED ACCOUNTING
In the Books of C Ltd.
Extract of Draft Profit & Loss Account Note No. `
Depreciation and amortisation expense 1 4,20,000
Other operating Expenses (Pipeline Expenses) 200,000
Extract of Balance Sheet
Note No. `
Assets
Non-current assets
Property, Plant and Equipment 2 23,80,000
Notes to Accounts
` `
1. Depreciation and amortisation expense
Land & Building 20,000
Plant & Machinery 3,00,000
Computers 40,000
Vehicles 60,000 4,20,000
2. Land & Building 4,00,000
Less: Depreciation (20,000) 3,80,000
Plant & Machinery 20,00,000
Less: Depreciation 17,00,000
(3,00,000)
Computers 1,00,000
Less: Depreciation (40,000) 60,000
Vehicles 3,00,000
Less: Depreciation (60,000) 2,40,000
23,80,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.149
10.149
FINANCIAL STATEMENTS
3.8 JOINTLY CONTROLLED ENTITIES (JCE)
This is the format where venturer creates a new entity for their joint venture
business. A jointly controlled entity is a joint venture which involves the
establishment of a corporation, partnership or other entity in which each venturer
has an interest. The entity operates in the same way as other enterprises, except
that a contractual arrangement between the venturers establishes joint control
over the economic activity of the entity. All the venturers pool their resources
under new banner and this entity purchases its own assets, create its own
liabilities, expenses are incurred by the entity itself and sales are also made by
this entity. The net result of the entity is shared by the venturers in the ratio
agreed upon in the contractual agreement. This contractual agreement also
determines the joint control of the venturer. Each venturer usually contributes
cash or other resources to the jointly controlled entity. These contributions are
included in the accounting records of the venturer and are recognised in its
separate financial statements as an investment in the jointly controlled entity.
A jointly controlled entity maintains its own accounting records and prepares and
presents financial statements in the same way as other enterprises in conformity
with the requirements applicable to that jointly controlled entity
Example
A Ltd and B Ltd are two infrastructure companies operating in City A. The local
authority has issued a tender to construct a metro stretch for ` 2,000 crore and had
invited bidders to apply for the tender. A Ltd and B Ltd, jointly form a new entity AB
Ltd that bids for the tender. All machinery and equipment will be the responsibility
of A Ltd. All funding will be managed and controlled by B Ltd. Revenue and
operating expenses will be shared jointly by A Ltd and B Ltd in the proportion of
60:40.
In the above example AB Ltd constitutes a Jointly Controlled Entity (JCE).
Example (Jointly Controlled Entity (JCE))
Three separate aerospace companies form a separate entity, Aero Ltd, to jointly
manufacture an aircraft. They carry responsibility for different areas of expertise,
such as: manufacturing engines; manufacturing fuselage and wings; and
aerodynamics.
© The Institute of Chartered Accountants of India
10.150 ADVANCED ACCOUNTING
The companies carry out different parts of the manufacturing process, each using
its own resources and expertise in order to manufacture, market and distribute
the aircraft jointly. The three entities share the revenues from the sale of aircraft
and jointly incur expenses.
The revenues and common costs are shared, as agreed in the consortium
contract. Parties also incur their own separate costs, such as labour costs,
manufacturing costs, supplies, inventory of unused parts and work in progress.
Each party recognises its separately incurred costs in full.
Aero Ltd maintains separate accounting records. The consortium agreement
comprises the following:
Aero Ltd will invoice the customers on the investors’ behalf. The allocation of
revenue from the aircraft’s sale is in proportion to the investors’ interests.
All administrative costs incurred by Aero Ltd are shared by the parties in
proportion to their interests; Aero Ltd will recharge these, with no additional
margin.
The companies carry out different parts of the manufacturing process, each using
its own resources and expertise to manufacture, market and distribute the aircraft
jointly.
Each company incurs its own separate costs, such as labour costs, manufacturing
costs, supplies, inventory of unused parts and work in progress. Each company
recognises its separately incurred costs in full.
Being a separate entity, separate set of books is maintained for the joint venture
and in the individual books of venturers the investment in joint venture is
recorded as investment (AS 13). Joint venture can be a foreign company
operating in India through an Indian concern say Gremo Insurance of Germany
contributes 49% of the assets in joint venture in India with Indo Bank Ltd. of India.
They agreed to share the net results in 1:1 ratio. The main objective of the joint
venture is to exploit the technical expertise of Gremo Insurance and Goodwill of
Indo Bank Ltd. It can also be two or more local concerns opening an organization
or firm or company contributing their assets to this new joint venture concern and
share the profits of the operation in the agreed ratio.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.151
10.151
FINANCIAL STATEMENTS
Illustration 3
A Ltd. a UK based company entered into a joint venture with B Ltd. in India,
wherein B Ltd. will import the goods manufactured by A Ltd. on account of joint
venture and sell them in India. A Ltd. and B Ltd. agreed to share the expenses &
revenues in the ratio of 5:4 respectively whereas profits are distributed equally. A
Ltd. invested 49% of total capital but has equal share in all the assets and is equally
liable for all the liabilities of the joint venture. Following is the trial balance of the
joint venture at the end of the first year:
Particulars Dr. (` ) Cr. (` )
Purchases 9,00,000
Other Expenses 3,06,000
Sales 13,05,000
Property, Plant and Equipment 6,00,000
Current Assets 2,00,000
Unsecured Loans 2,00,000
Current Liabilities 1,00,000
Capital 4,01,000
Closing inventory was valued at ` 1,00,000.
You are required to prepare the Consolidated Financial Statement.
Solution
Consolidated Profit & Loss Account
Particulars Note No. (` )
Revenue from operations 1 13,05,000
Total Revenue (A) 13,05,000
Less: Expenses
Purchases 2 9,00,000
Other expenses 3 3,06,000
© The Institute of Chartered Accountants of India
10.152 ADVANCED ACCOUNTING
Changes in inventories of finished goods 4 (1,00,000)
Total Expenses (B) 11,06,000
Profit Before Tax (A-B) 1,99,000
Consolidated Balance Sheet
Note No. (`)
I Equity and liabilities
1. Shareholders’ funds:
Share Capital 5 4,01,000
Reserves and Surplus 6 1,99,000
2. Non-current liabilities
Long term borrowings 7 2,00,000
3. Current Liabilities 8 1,00,000
9,00,000
II Assets
Non-current Assets
Property, Plant and Equipment 9 6,00,000
Current Assets
Inventories 10 1,00,000
Other current assets 11 2,00,000
9,00,000
Notes to Accounts
Particulars (` )
1. Revenue from operations
Sales:
A Ltd. 7,25,000
B Ltd. 5,80,000 13,05,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.153
10.153
FINANCIAL STATEMENTS
2. Purchases
A Ltd. 5,00,000
B Ltd. 4,00,000 9,00,000
3. Other expenses
A Ltd. 1,70,000
B Ltd. 1,36,000 3,06,000
4. Closing Inventory
A Ltd. 50,000
B Ltd. 50,000 1,00,000
5. Share Capital
A Ltd. 1,96,490
B Ltd. 2,04,510 4,01,000
6. Reserves and Surplus
Profit & Loss Account:
A Ltd. 99,500
B Ltd. 99,500 1,99,000
7. Long Term Borrowings
Unsecured Loans:
A Ltd. 1,00,000
B Ltd. 1,00,000 2,00,000
8. Current Liabilities
A Ltd. 50,000
B Ltd. 50,000 1,00,000
9. Property, Plant and Equipment
A Ltd. 3,00,000
B Ltd. 3,00,000 6,00,000
© The Institute of Chartered Accountants of India
10.154 ADVANCED ACCOUNTING
10. Inventories
A Ltd. 50,000
B Ltd. 50,000 1,00,000
11. Other Current Assets
A Ltd. 1,00,000
B Ltd. 1,00,000 2,00,000
3.9 CONSOLIDATED FINANCIAL STATEMENTS
OF A VENTURER
Proportionate consolidation is a method of accounting and reporting whereby a
venturer's share of each of the assets, liabilities, income and expenses of a jointly
controlled entity is reported as separate line items in the venturer's financial
statements.
Proportionate consolidation method of accounting is to be followed except in the
following cases:
a. Investment is intended to be temporary because the investment is acquired
and held exclusively with a view to its subsequent disposal in the near
future. And
b. joint venture operates under severe long-term restrictions, which
significantly impair its ability to transfer funds to the venturers.
In both the above cases, investment of venturer in the share of the investee
is treated as investment according to AS 13.
A venturer should discontinue the use of the proportionate consolidation method
from the date that:
a. It ceases to have joint control in the joint venture but retains, either in
whole or in part, its investment.
b. The use of the proportionate consolidation method is no longer appropriate
because the joint venture operates under severe long-term restrictions that
significantly impair its ability to transfer funds to the venturers.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.155
10.155
FINANCIAL STATEMENTS
From the date of discontinuing the use of the proportionate consolidation
method,
a. If interest in entity is more than 50%, investments in such joint ventures
should be accounted for in accordance with AS 21, Consolidated Financial
Statement.
b. If interest is 20% or more but upto 50%, investments are to be accounted
for in accordance with AS 23, Accounting for Investment in Associates in
Consolidated Financial Statement.
c. For all other cases investment in joint venture is treated as per AS 13,
Accounting for Investment.
d. For this purpose, the carrying amount of the investment at the date on
which joint venture relationship ceases to exist should be regarded as cost
thereafter.
Following are the features of Proportionate Consolidation Method:
a. Stress is given on substance over form i.e., more importance is given to the
share of venturers in the profit or loss of the venture from the share of
assets and liabilities rather than the nature and form of the joint venture.
b. Venturer’s share of joint assets, liabilities, expenses and income are shown
on the separate lines in the consolidated financial statement.
For example, Mr. A enters into a joint venture with Mr. B and has
contributed 33% of the total Property, Plant and Equipment and has share
of 40% in current assets and current liabilities. Its share in net result is 50%.
Consolidated Balance Sheet will be prepared by Mr. A as follow:
Consolidated Balance Sheet
Note No. (` )
I Equity and liabilities
1. Shareholders’ funds:
Share Capital 1 1,00,000
2. Current Liabilities 2 50,000
1,50,000
© The Institute of Chartered Accountants of India
10.156 ADVANCED ACCOUNTING
II Assets
Non-current Assets
Property, Plant and Equipment 3 75,000
Current Assets 4 75,000
1,50,000
Notes to Accounts
1. Share Capital *:
A (25,000 + 30,000 - 20,000) 35,000
B (50,000 + 45,000 - 30,000) 65,000 1,00,000
2. Current Liabilities:
A 20,000
B 30,000 50,000
3. Property, Plant and Equipment:
A 25,000
B 50,000 75,000
4. Current Assets:
A 30,000
B 45,000 75,000
* Contribution to Share capital taken as a balancing figure in absence of
information in this regard in the example
Similar to above all the items of expenses and income will also be classified
line by line for each item. The whole basis of this provision is to bring
transparency in the books of account. If there is any special clause for
sharing of expenses, income or any other item that should be clearly
disclosed in the consolidated financial statement.
c. Most of the provisions of Proportionate Consolidation Method are similar to
the provisions of AS 21.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.157
10.157
FINANCIAL STATEMENTS
d. As far as possible the reporting date of the financial statements of jointly
controlled entity and venturers should be same. If practically it is not
possible to draw up the financial statements to such date and, accordingly,
those financial statements are drawn up to different reporting dates,
adjustments should be made in joint venturer’s books for the effects of
significant transactions or other events that occur between the jointly
controlled entity’s date and the date of the venturer’s financial statements.
In any case, the difference between reporting dates should not be more
than six months.
e. Accounting policies followed in the preparation of the financial statements
of the jointly controlled entity and venturer should be uniform for like
transactions and other events in similar circumstances.
If accounting policies followed by venturer and jointly controlled entity are
not uniform, then adjustments should be made in the items of the venturer
to bring it in line with the accounting policy of the joint venture.
f. Any asset or liability should not be adjusted by another liability or asset.
Similarly any income or expense cannot be adjusted with another expense
or income. Such adjustment can be made only when legally it is allowed to
adjust them and such items does lead to settlement of obligation or writing
off of assets.
g. On the date when interest in joint entity is acquired, if the interest of
venturer in net assets of the entity is less than the cost of investment in joint
entity, the difference will be recognized as goodwill in the consolidated
financial statement and if net asset is more than cost of investment, then
the difference is recognized as capital reserve.
In case the carrying amount of investment is different than cost of
investment, we take carrying amount for the purpose of the above
calculation.
h. An investor who don’t have joint control in the entity is like associate as
discussed in AS 23, therefore the treatment of losses will be similar to AS 23.
If investor’s share in loss of the joint entity is in excess of his interest in net
asset, this excess loss will be recognized by the venturers. In future when
entity starts reporting profits, investor’s share of profits will be provided to
venturer till total amount is equivalent to absorbed losses.
© The Institute of Chartered Accountants of India
10.158 ADVANCED ACCOUNTING
Illustration 4
A Ltd. entered into a joint venture with B Ltd. on 1:1 basis and a new company C
Ltd. was formed for the same purpose and following is the balance sheet of all the
three companies:
Particulars A Ltd. B Ltd. C Ltd.
Share Capital 10,00,000 7,50,000 5,00,000
Reserve & Surplus 18,00,000 16,00,000 12,00,000
Loans 3,00,000 4,00,000 2,00,000
Current Liabilities 4,00,000 2,50,000 1,00,000
Property, Plant and Equipment 30,50,000 26,25,000 19,50,000
Investment in JV 2,50,000 2,50,000 -
Current Assets 2,00,000 1,25,000 50,000
Prepare the balance sheet of A Ltd. and B Ltd. under proportionate consolidation
method.
Solution
Balance Sheet of A Ltd.
Note No. (`)
I Equity and liabilities
1. Shareholders’ funds:
Share Capital 10,00,000
Reserves and Surplus 1 24,00,000
2. Non-current liabilities 2 4,00,000
3. Current Liabilities 3 4,50,000
TOTAL 42,50,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.159
10.159
FINANCIAL STATEMENTS
II Assets
Non-current Assets
Property, Plant and Equipment: 4 40,25,000
Current Assets 5 2,25,000
42,50,000
Notes to Accounts
` `
1. Reserves and Surplus
A Ltd. 18,00,000
C Ltd. 6,00,000 24,00,000
2. Long Term Borrowings
Loans:
A Ltd. 3,00,000
C Ltd. 1,00,000 4,00,000
3. Current Liabilities:
A Ltd. 4,00,000
C Ltd. 50,000 4,50,000
4. Property, Plant and Equipment:
A Ltd. 30,50,000
C Ltd. 9,75,000 40,25,000
5. Current Assets:
A Ltd. 2,00,000
C Ltd. 25,000 2,25,000
Balance Sheet of B Ltd.
Note No. (`)
I Equity and liabilities
1. Shareholders’ funds:
Share Capital 7,50,000
Reserves and Surplus 1 22,00,000
2. Non-current liabilities 2 5,00,000
3. Current Liabilities 3
3,00,000
37,50,000
© The Institute of Chartered Accountants of India
10.160 ADVANCED ACCOUNTING
II Assets
1. Non-current Assets
Property, Plant and Equipment 4 36,00,000
2. Current Assets 5
1,50,000
37,50,000
Notes to Accounts
` `
1. Reserves and Surplus
A Ltd. 16,00,000
C Ltd. 6,00,000 22,00,000
2. Long Term Borrowings
Loans:
A Ltd. 4,00,000
C Ltd. 1,00,000 5,00,000
3. Current Liabilities:
A Ltd. 2,50,000
C Ltd. 50,000 3,00,000
4. Property, Plant and Equipment:
A Ltd. 26,25,000
C Ltd. 9,75,000 36,00,000
5. Current Assets:
A Ltd. 1,25,000
C Ltd. 25,000 1,50,000
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.161
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FINANCIAL STATEMENTS
3.10 TRANSACTIONS BETWEEN A VENTURER
AND JOINT VENTURE
When venturer transfers or sells assets to Joint Venture, the venturer should
recognise only that portion of the gain or loss which is attributable to the
interests of the other venturers. The venturer should recognise the full amount of
any loss only when the contribution or sale provides evidence of a reduction in
the net realisable value of current assets or an impairment loss.
When the venturer from the joint venture purchases the assets, venturer will not
recognized his share of profits in the joint venture of such transaction unless he
disposes off the assets. A venturer should recognise his share of the losses
resulting from these transactions in the same way as profits except that losses will
be recognised in full immediately only when they represent a reduction in the net
realisable value of current assets or an impairment loss.
In case the joint venture is in the form of separate entity (i.e., JCE) then provisions
of above the Para will be followed only for consolidated financial statement and
not for venturer’s own financial statement. In the books of venturer, profit or loss
from such transactions are recognised in full.
Example
A and B established a separate vehicle i.e. entity J, wherein each operator has a
50% ownership interest and each takes 50% of the output. On formation of the joint
venture, A contributed a property with fair value of ` 110 crore and agreed to
contribute his experience over the years towards this venture; and
B contributed equipment with a fair value of ` 120 crore. The carrying values of the
contributed assets were ` 100 crore and ` 80 crore, respectively.
Answer
A – Gain in consolidated financial statements
A’s share in the fair value of assets contributed by entity
B (50% × 120) 60
A’s share in the carrying value of asset contributed by
A to the joint venture (50% × 100) (50)
Gain recognised by A 10
© The Institute of Chartered Accountants of India
10.162 ADVANCED ACCOUNTING
3.11 REPORTING INTERESTS IN JOINT
VENTURES IN THE FINANCIAL
STATEMENTS OF AN INVESTOR
The investors who don’t have joint control over the entity recognized his share of
net results and his investments in joint venture as per AS 13. In the consolidated
financial statement it is recognized as per AS 13, AS 21 or AS 23 as appropriate.
3.12 OPERATORS OF JOINT VENTURES
Payment to operators is recognized as expense in CFS and in the books of the
operators as per AS 9, Revenue Recognition. The operator may be any of the
venturers, in this case any amount received by him, as management fees for the
service will be recognized as stated above in this Para.
3.13 DISCLOSURE
A venturer should disclose the aggregate amount of the following contingent
liabilities, unless the probability of loss is remote, separately from the amount of
other contingent liabilities:
a. Any contingent liabilities that the venturer has incurred in relation to its
interests in joint ventures and its share in each of the contingent liabilities
which have been incurred jointly with other venturers;
b. Its share of the contingent liabilities of the joint ventures themselves for
which it is contingently liable; and
c. Those contingent liabilities that arise because the venturer is contingently
liable for the liabilities of the other venturers of a joint venture.
A venturer should disclose the aggregate amount of the following commitments
in respect of its interests in joint ventures separately from other commitments:
a. Any capital commitments of the venturer in relation to its interests in joint
ventures and its share in the capital commitments that have been incurred
jointly with other venturers; and
b. Its share of the capital commitments of the joint ventures themselves.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.163
10.163
FINANCIAL STATEMENTS
A venturer should disclose a list of all joint ventures and description of interests in
significant joint ventures. In respect of jointly controlled entities, the venturer
should also disclose the proportion of ownership interest, name and country of
incorporation or residence. A venturer should disclose, in its separate financial
statements, the aggregate amounts of each of the assets, liabilities, income and
expenses related to its interests in the jointly controlled entities.
Reference: The students are advised to refer the full text of AS 27 “Financial
Reporting of Interests in Joint Ventures”
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. State which of the following statements are incorrect.
(i) The requirements relating to accounting for joint ventures in
consolidated financial statements according to proportionate
consolidation method, as contained in AS 27, applies only when
consolidated financial statements are prepared by venturer.
(ii) The requirements relating to accounting for joint ventures in
consolidated financial statements according to proportionate
consolidation method, as contained in AS 27, applies irrespective
whether consolidated financial statements are prepared by venturer or
not.
(iii) An investor in joint venture, which does not have joint control, should
report its interest in a joint venture in its consolidated financial
statements in accordance with AS 13, AS 21 and AS 23as the case may
be.
(a) Point (i) is incorrect.
(b) Point (ii) is incorrect.
(c) Point (iii) is incorrect.
(d) None of the above.
© The Institute of Chartered Accountants of India
10.164 ADVANCED ACCOUNTING
2. Identify which of the following is not a feature of a Jointly controlled
operations (JCO):
(a) Each venturer has his own separate business.
(b) There is a separate entity for joint venture business.
(c) Each venturer record only his own transactions without any separately
set of books maintained for the joint venture business.
(d) There is a common agreement between all of them.
3. Identify which of the following is/are not a feature of a Jointly controlled
assets (JCA):
(i) There is a separate legal identity.
(ii) There is a common control over the joint assets.
(iii) Expenses on jointly held assets are shared by the venturers as per the
contract.
(iv) In their financial statement, venturer shows only their share of the asset
and total income earned by them along with total expenses incurred by
them.
(a) Point no. (i) only.
(b) Point no. (i) and (iii).
(c) Point no. (iii) and (iv).
(d) Point (i) and (ii).
4. Identify which is/ are features of a Jointly controlled entity (JCE):
(i) Venturer creates a new entity for their joint venture business.
(ii) All the venturers pool their resources under new banner and this entity
purchases its own assets, create its own liabilities, expenses are incurred
by the entity itself and sales are also made by this entity.
(iii) The revenues and expenses of the entity is shared by the venturers in
the equal ratio only.
(a) Point no. (i) only.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.165
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FINANCIAL STATEMENTS
(b) Point no. (i) and (ii).
(c) Point no. (ii).
(d) Point no. (iii).
5. Identify the correct statements.
From the date of discontinuing the use of the proportionate consolidation
method:
(i) If interest in entity is more than 50%, investments in such joint ventures
should be accounted for in accordance with AS 21, Consolidated
Financial Statements.
(ii) If interest is 20% or more but upto 50%, investments are to be
accounted for in accordance with AS 23, Accounting for Investment in
Associates in Consolidated Financial Statements.
(iii) For all other cases investment in joint venture is treated as per AS 13,
Accounting for Investments.
(iv) For this purpose, the fair value of the investment at the date on which
joint venture relationship ceases to exist should be regarded as cost
thereafter.
(a) Point no. 1 and 2.
(b) Point no. 1, 2 and 3.
(c) Point no. 1, 2, 3 and 4.
(d) None of the above.
Theoretical Questions
6. Describe the cases when AS 27 does not allow the use of Proportionate
consolidation method of accounting?
7. When is a venturer required to discontinue the use of the proportionate
consolidation method?
© The Institute of Chartered Accountants of India
10.166 ADVANCED ACCOUNTING
Scenario based Questions
8. JVR Limited has made investments of ` 97.84 crores in equity shares of
QSR Limited in pursuance of Joint Venture agreement till 20X1-X2 (i.e., more
than 12 months). The investment has been made at par. QSR Limited has
been in continuous losses for the last 2 years. JVR Limited is willing to
reassess the carrying amount of its investment in QSR Limited and wish to
provide for diminution in value of investments. However, QSR Limited has a
futuristic and profitable business plans and projection for the coming years.
Discuss whether the contention of JVR Limited to bring down the carrying
amount of investment in QSR Limited is in accordance with the Accounting
Standard.
ANSWERS/SOLUTION
Answer to the Multiple Choice Questions
1. (b) 2. (b) 3. (a) 4. ( b) 5. (b)
Answer to the Theoretical Questions
6. Proportionate consolidation method of accounting is to be followed except
in the following cases:
a. Investment is intended to be temporary because the investment is
acquired and held exclusively with a view to its subsequent disposal in
the near future.
The term ‘Near Future’ is explained with AS 21.
Or
b. joint venture operates under severe long-term restrictions, which
significantly impair its ability to transfer funds to the venturers.
In both the above cases, investment of venturer in the share of the investee
is treated as investment according to AS 13.
7. A venturer should discontinue the use of the proportionate consolidation
method from the date that:
a. It ceases to have joint control in the joint venture but retains, either in
whole or in part, its investment.
© The Institute of Chartered Accountants of India
ACCOUNTING STANDARDS FOR CONSOLIDATED 10.167
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FINANCIAL STATEMENTS
b. The use of the proportionate consolidation method is no longer
appropriate because the joint venture operates under severe long-
term restrictions that significantly impair its ability to transfer funds to
the venturers.
From the date of discontinuing the use of the proportionate consolidation
method,
a. If interest in entity is more than 50%, investments in such joint
ventures should be accounted for in accordance with AS 21,
Consolidated Financial Statement.
b. If interest is 20% or more but up to 50%, investments are to be
accounted for in accordance with AS 23, Accounting for Investment in
Associates in Consolidated Financial Statement.
c. For all other cases investment in joint venture is treated as per AS 13,
Accounting for Investment.
d. For this purpose, the carrying amount of the investment at the date on
which joint venture relationship ceases to exist should be regarded as
cost thereafter.
Answer to the Scenario based Questions
8. As per para 26 of AS 27 “Financial Reporting of Interests in Joint Ventures”,
in a venturer’s separate financial statements, interest in a jointly controlled
entity should be accounted for as an investment in accordance with AS 13
‘Accounting for Investments’.
As per para 17 of AS 13 “Accounting for Investments”, long-term
investments are usually carried at cost. However, when there is a decline,
other than temporary, in the value of a long-term investment, the carrying
amount is reduced to recognize the decline. 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. The
type and extent of the investor’s stake in the investee are also taken into
account. However, where there is a decline, other than temporary, in the
carrying amounts of long-term investments, the resultant reduction in the
carrying amount is charged to the profit and loss statement.
© The Institute of Chartered Accountants of India
10.168 ADVANCED ACCOUNTING
Since the investment was made in the year 20X1-20X2 i.e., more than a year,
it is a long-term investment. In the given case, though the QSR Ltd. is in
continuous losses for past 2 years, yet it has a futuristic and profitable
business plans and projections for the coming years. Here, one of the
indicators i.e. ‘losses incurred to the company’ may lead to diminution in
the value of the shares while the other indicator that ‘the company has
positive expected cash flows from its business plans’ does not lead to
decline in the value of shares.
Considering both the facts, in case the expectation of profitable business
plans and positive cash flows is based reliable presumptions (such as tender
in favour of QSR Ltd., strong order book etc.), the decline will be regarded
as temporary in nature and the investment in equity shares will continue to
be carried at cost only.
However, should the aforesaid presumptions be based on projections
without reasonable evidence backing the claims, the decline could be
regarded as non-temporary in nature in which case the write down of the
carrying amount become necessary in line with AS 13, thereby implying the
contention of QSR Ltd. to be correct.
© The Institute of Chartered Accountants of India
CASE SCENARIOS
Case Scenario 1
RTS Ltd, (“RTS” or the “Company”), is engaged in the business of manufacturing of
equipments/components. The Company has a contract with the Indian Railways for
a brake component which is structured such that:
♦ The Company’s obligation is to deliver the component to the Railways’
stockyard, while the delivery terms are ex-works, the Company is responsible
for engaging a transporter for delivery.
♦ Railways sends an order for a defined quantity.
♦ The Company manufactures the required quantity and informs Railways for
carrying out the inspection.
♦ Railways representatives visit the Company’s factory and inspect the
components, and mark each component with a quality check sticker.
♦ Goods once inspected by Railways, are marked with a hologram sticker to
earmark for delivery identification by the customer when they are delivered
to the customer’s location.
♦ The Company raises an invoice once it dispatches the goods.
The management of RTS is under discussion with the auditors of the Company in
respect of accounting of a critical matter as regards its accounting with respect
subsequent events i.e. events after the reporting period. They have been checking
as to which one of the following events after the reporting period provide evidence
of conditions that existed at the end of the reporting period?
© The Institute of Chartered Accountants of India
CS.2 ADVANCED ACCOUNTING
i. Nationalisation or privatization by government
ii. Out of court settlement of a legal claim
iii. Rights issue of equity shares
iv. Strike by workforce
v. Announcing a plan to discontinue an operation
The Company 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. The Company also received land, free of cost, from the State
Government but it has not recorded this at all in the books as no money has been
spent.
RTS has a subsidiary, A Ltd, which is evaluating its production process wherein
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 was ` 1,000. The entire quantity of waste
was on stock at the end of the financial year.
(i) When should RTS Ltd recognize revenue as per the Accounting Standards
notified under the Companies (Accounting Standards) Rules, 2006? Would
your answer be different if inspection is normally known to lead to no quality
rejections?
(a) Revenue should be recognized on dispatch of components. The
assessment would not change even in case where inspection is normally
known to lead to no quality rejections.
(b) Revenue should be recognized on completion of inspection of
components. The assessment would not change even in case where
inspection is normally known to lead to no quality rejections.
(c) Revenue should be recognized on dispatch of components. The
assessment would change where inspection is normally known to lead
to no quality rejections.
(d) Revenue should be recognized on delivery of the component to the
Railways’ stockyard. The assessment would change where inspection is
normally known to lead to no quality rejections.
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.3
(ii) In respect of A Ltd, state with reference to Accounting Standards notified
under the Companies (Accounting Standards) Rules, 2006, what would be
value of the inventory to be recorded in the books of accounts?
(a) ` 4,700,000.
(b) ` 5,000,000.
(c) ` 4,950,000.
(d) ` 4,947,368.
(iii) Please guide regarding the accounting treatment of both the grants
mentioned above in line with the requirements of Accounting Standard 12.
(a) Distribution of dividend out of grant is correct. In the second case also
not recording land in the books of accounts is correct.
(b) Distribution of dividend out of grant is incorrect. In the second case,
not recording land in the books of accounts is correct.
(c) Distribution of dividend out of grant is correct. In the second case, land
should be recorded in the books of accounts at a nominal value.
(d) Distribution of dividend out of grant is incorrect. In the second case,
land should be recorded in the books of accounts at a nominal value.
Answers
(i) (b) (ii) (d) (iii) (d)
Case Scenario 2
Suman Ltd. is in the business of manufacturing electronics equipment and selling
these at its various outlets. It provides installation services for the equipment sold
and also provide free 1 year warranty on all the sold products.
Beach Resorts are leading resorts in the city. It purchased 5 air conditioners (AC)
from Suman Ltd. for its resort. Suman Ltd. sold 5 AC to Beach resort for ` 45,000
each which includes installation fees of ` 1,000 for each AC. The Company also
offers 1 year warranty for any repair etc. The Company also offered ` 500 per AC
as trade discount. Beach resort placed order on March 15, 2024 and made payment
on March 20, 2024. The ACs were delivered on March 27, 2024 and the installation
was completed on April 5, 2024.
© The Institute of Chartered Accountants of India
CS.4 ADVANCED ACCOUNTING
(i) How much revenue should be recognised by the Company as on March 31,
2024:
(a) ` 2,25,000
(b) ` 2,17,500
(c) ` 2,00,000
(d) ` 2,30,000
(ii) How much revenue should be recognised by the Company in the financial
year 2024-25:
(a) ` 5000
(b) ` 2,20,000
(c) ` 10,000
(d) ` 2,40,000
(iii) What will be the accounting for trade discount:
(a) The same will be recognised separately in the profit and loss.
(b) The trade discounts are deducted in determining the revenue.
(c) Trade discount will be recognised after one year, when the warranty will
be over.
(d) Trade discount will be recognised after installation is complete.
(iv) Is the Company required to do any accounting for 1 year warranty provided
by it:
(a) No accounting treatment is required till some warranty claim is actually
received by the Company.
(b) As there exist a present obligation to provide warranty to customers for
1 year, the Company should estimate the amount that it may have to
incur considering various factors including past trends and create a
provision as per AS 29.
(c) Accounting for claims will be done on cash basis i.e. expense will be
recognised when expense is made.
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.5
(d) As the Company is not charging separately for the warranty provided,
there is no need to create any provision.
Answers
(i) (b) (ii) (a) (iii) (b) (iv) (b)
Case Scenario 3
Mars Ltd. is a manufacturing enterprise which is starting a new manufacturing plant
at X Village. It has commenced construction of the plant on April 1, 2023 and has
incurred following expenses:
♦ It has acquired land for installing Plant for ` 50,00,000
♦ It incurred ` 35,00,000 for material and direct labour cost for developing the
Plant.
♦ The Company incurred ` 10,00,000 for head office expenses at New Delhi
which included rent, employee cost and maintenance expenditure.
♦ The Company borrowed ` 25,00,000 for construction work of Plant @12% per
annum on April 1, 2023. Director finance of the Company incurred travel and
meeting expenses amounting to ` 5,00,000 during the year for arranging this
loan.
♦ On November 1, 2023, the construction activities of the plant were
interrupted as the local people alongwith the activists have raised issues
relating to environmental impact of plant being constructed. Due to agitation
the construction activities came to standstill for 3 months.
♦ With the help of Government and NGOs, the agitation was over by February
28, 2024 and the work resumed. However, to balance the impact on
environment, government ordered the company to install certain devices for
which the Company had to incur ` 6,00,000 in March 2024.
♦ The rate of depreciation on Plant is 10%.
Based on the above information, answer the following questions.
(i) Which of the following expenses cannot be included in the cost of plant:
(a) Cost of Land
© The Institute of Chartered Accountants of India
CS.6 ADVANCED ACCOUNTING
(b) Construction material and labour cost
(c) Head office expenses
(d) Borrowing cost
(ii) How much amount of borrowing cost can be capitalised with the plant:
(a) ` 300,000
(b) ` 2,00,000
(c) ` 7,00,000
(d) ` 6,00,000
(iii) The total cost of plant as on march 31, 2024 will be:
(a) ` 85,00,000
(b) ` 98,00,000
(c) ` 93,00,000
(d) ` 95,00,000
(iv) The amount of depreciation to be charged for the year end March 31, 2024
(a) ` 4,30,000
(b) ` 9,30,000
(c) ` 9,80,000
(d) Nil
Answers
(i) (c) (ii) (b) (iii) (c) (iv) (d)
Case Scenario 4
Beloved Finance Ltd. is a financial enterprise which is in the business of lending
loan to small businesses and earn interest on loans.
♦ During the year the Company has lend 50 crores and earned ` 1.5 crore as
interest on loans.
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.7
♦ The Company had surplus funds during the year and invested then in Fixed
Deposits with bank and earned interest on fixed deposits of ` 20 lacs.
♦ The Company also acquired a gold loan unit for ` 10 crore during the year
and the Company provided interest free loan of ` 15 crore to its wholly-
owned subsidiary.
♦ The Company paid a total income tax of ` 75 lacs for the year.
Based on the above information, answer the following questions.
(i) In the Cash Flow Statement as per AS 3, the interest income of ` 1.5 crore
earned on earned on loans given by the Company will be disclosed as:
(a) Cash Flow from Operating Activities
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Non-cash Items
(ii) In the Cash Flow Statement as per AS 3, the interest income of ` 20 Lacs
earned fixed deposits with bank will be disclosed as:
(a) Cash Flow from Operating Activities
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Non-cash Items
(iii) In the Cash Flow Statement as per AS 3, amount paid for acquiring gold loan
unit will be disclosed as:
(a) Cash Flow from Operating Activities
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Non-cash Items
(iv) In the Cash Flow Statement as per AS 3, total income tax of ` 75 lacs paid for
the year will be disclosed as:
(a) Cash Flow from Operating Activities
© The Institute of Chartered Accountants of India
CS.8 ADVANCED ACCOUNTING
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Non-cash Items
(v) Is any specific disclosures required to made in relation to the interest free
loan of ` 15 crore provided by the Company to its wholly-owned subsidiary,
if yes, as per which Accounting Standard:
(a) Yes, disclosure is required to be made as per AS 3, Cash Flow
Statements.
(b) Yes, disclosure is required to be made as per AS 18, Related Party
Disclosures
(c) Yes, disclosure is required to be made as per AS 13, Accounting for
Investments
(d) No specific disclosures are required.
Answers
(i) (a) (ii) (a) (iii) (b) (iv) (a) (v) (b)
Case Scenario 5
Venus Limited received a parcel of land at no cost from the government for the
purpose of developing a factory in an outlying area. The land is valued at ` 75 lakhs,
while the nominal value is ` 10 lakhs. Additionally, the company received a
government grant of ` 30 lakhs, which represents 25% of the total investment
needed for the factory development. Furthermore, the company received ` 15 lakhs
with the stipulation that it be used to purchase machinery. There is no expectation
from the government for the repayment of these grants.
Answer the following questions based on the above information:
(i) The land received from Government, free of cost should be presented at:
(a) ` 75 Lakhs
(b) ` 30 Lakhs
(c) ` 10 Lakhs
(d) ` 45 Lakhs
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.9
(ii) As per AS 12, how the Government Grant of ` 30 Lakhs should be presented:
(a) It should be recognised in the profit and loss statement as per the
related cost.
(b) It will be treated as capital reserve.
(c) It will be treated as deferred income.
(d) It will not be recognised in the financial statements.
(iii) As per AS 12, how the Government Grant of ` 15 Lakhs with a condition to
purchase machinery may be presented as:
(a) Capital Reserve
(b) Shareholders Fund
(c) Deferred Income
(d) Income in statement of profit and loss as received.
(iv) Which of the above grants are required to be recognised in the statement of
profit and loss on a systematic and rational basis over the useful life of the
asset:
(a) Land received as Grant
(b) Government Grant of ` 30 Lakhs
(c) Government Grant of ` 15 Lakhs with a condition to purchase machinery
(d) Noe of the above
Answers
(i) (c) (ii) (b) (iii) (c) (iv) (c)
Case Scenario 6
Axis limited is a manufacturing company. It purchased a machinery costing
` 10 Lakhs in April 2023. It paid ` 4 lakhs upfront and paid the remaining
` 6,00,000 as deferred payment by paying instalment of ` 1,05,000 for the next 6
months. During the year, the Company sold a land which was classified as its
‘property, plant and equipment’ for ` 25,00,000 and paid ` 1,00,000 as income tax
as long term capital gain on such sale. During the year, the Company also received
© The Institute of Chartered Accountants of India
CS.10 ADVANCED ACCOUNTING
income tax refund along with interest.
(i) As per the requirements of AS 3, ‘Cash Flow Statements’, how the amount for
purchase of machinery should be presented:
(a) ` 10 lakhs as ‘Cash flows from Investing Activities’ and ` 30,000 will
simply be booked in profit and loss with no presentation if Cash Flow
Statement.
(b) ` 10.30 lakhs as ‘Cash flows from Investing Activities’ as entire amount
is spend on purchase of machinery.
(c) ` 10 lakhs as ‘Cash flows from Investing Activities’ and ` 30,000 as ‘Cash
flows from Financing Activities’.
(d) ` 10.30 lakhs as ‘Cash flows from Financing Activities’ as the machinery
has been purchased on finance.
(ii) At what amount, the machinery should be recognised in the financial
statements:
(a) ` 400,000
(b) ` 10,30,000
(c) ` 600,000
(d) ` 10,00,000
(iii) How should the income tax paid on sale of land should be disclosed in the
Cash Flows Statement:
(a) Cash flows from Operating Activities
(b) Cash flows from Investing Activities
(c) Cash flows from Financing Activities
(d) No disclosure in Cash Flow Statement
(iv) How should the interest on income tax refunds should be disclosed in the
Cash Flows Statement:
(a) Cash flows from Operating Activities
(b) Cash flows from Investing Activities
(c) Cash flows from Financing Activities
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.11
(d) No disclosure in Cash Flow Statement
Answers
(i) (c) (ii) (d) (iii) (b) (iv) (b)
Case Scenario 7
SEAS Ltd., the “Company”, is in the business of tours and travels. It sells holiday
packages to the customers. The Company negotiates upfront with the Airlines for
specified number of seats in flight. The Company agrees to buy a specific number
of tickets and pay for those tickets regardless of whether it is able to resell all of
those in package.
The rate paid by the Company for each ticket purchased is negotiated and agreed
in advance. The Company also assists the customers in resolving complaints with
the service provided by airlines. However, each airline is responsible for fulfilling
obligations associated with the ticket, including remedies to a customer for
dissatisfaction with the service.
The Company bought a forward contract for three months of US$ 1,00,000 on 1
March 2024 at 1 US$ = INR 83.10 when exchange rate was US$ 1 = INR 83.02. On
31 March 2024, when the Company closed its books, exchange rate was US$ 1 =
INR 83.15. On 1 April 2024, the Company decided for premature settlement of the
contract due to some exceptional circumstances.
The Company is evaluating below mentioned schemes:
i. Introduction of a formal retirement gratuity scheme by an employer in place
of ad hoc ex-gratia payments to employees on retirement.
ii. Management decided to pay pension to those employees who have retired
after completing 5 years of service in the organization. Such employees will
get pension of ` 20,000 per month. Earlier there was no such scheme of
pension in the organization.
SEAS Ltd. has a subsidiary, ADI Ltd., which is in the business of construction
having turnover of ` 200 crores. SEAS Ltd. and ADI Ltd. hold 9% and 23%
respectively in an associate company, ASOC Ltd. Both SEAS Ltd. and ADI Ltd.
prepare consolidated financial statements as per Accounting Standards
notified under the Companies (Accounting Standards) Rules, 2021.
© The Institute of Chartered Accountants of India
CS.12 ADVANCED ACCOUNTING
(i) What would be the basis of revenue recognition for SEAS Ltd. as per the
requirements of Accounting Standards?
(a) Gross basis.
(b) Net basis.
(c) Depends on the accounting policy of the Company.
(d) Indian GAAP allows a choice to the Company to recognize revenue on
gross basis or net basis.
(ii) Please suggest accounting treatment of forward contract for the year ended
31 March 2024 as per Accounting Standard 11.
(a) MTM (marked to market value) of contract will be recorded on 31 March
2024.
(b) MTM (marked to market value) of contract will be computed as at 31
March 2024 and only if there is loss, it will be recorded during the year
ended 31 March 2024.
(c) No accounting will be done during the year ended 31 March 2024.
(d) Premium on contract will be amortized over the life of the contract.
(iii) You are requested to advise the Company in respect of the accounting
requirements of above schemes related to employee benefits as to which one
of those schemes should be considered as a change in accounting policy
during the year.
(a) 1 – Change in accounting policy. 2 – Change in accounting policy.
(b) 1– Not a change in accounting policy. 2 – Change in accounting policy.
(c) 1 – Not a change in accounting policy. 2 – Not a change in accounting
policy.
(d) 1– Change in accounting policy. 2 – Not a change in accounting policy.
(iv) Please comment regarding consolidation requirements for SEAS Ltd. and ADI
Ltd. using the below mentioned options as to which one should be correct.
(a) ADI Ltd. would using equity method of accounting for 23% in ASOC Ltd.
SEAS Ltd. would consolidate ADI Ltd. and consequently automatically
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.13
equity account 23% and separately account for the balance 9% as per
AS 13.
(b) ADI Ltd. would account for 23% in ASOC Ltd. as per AS 13. SEAS
Ltd. would consolidate ADI Ltd. and consequently automatically
account 23% and separately account for the balance 9%.
(c) ADI Ltd. would account for 23% share in ASOC Ltd using equity method
of accounting. SEAS Ltd. would consolidate ADI Ltd. and consequently,
automatically account for ASOC Ltd 23% share and separately account
for 9% share in ASOC Ltd. using equity method of accounting in
consolidated financial statements.
(d) ADI Ltd. would account for 23% in ASOC Ltd. as per AS 13. SEAS Ltd.
would consolidate ADI Ltd. and using equity method of accounting 23%
in ASOC Ltd. and separately account for the balance 9% as per AS 13.
Answers
(i) (a) (ii) (d) (iii) (c) (iv) (c)
Case Scenario 8
On 1st April, 2022, Shubham Limited purchased some land for ` 30 lakhs for the
purpose of constructing a new factory. This cost of 30 lakhs included legal cost of
` 2 lakhs incurred for the purpose of acquisition of this land. Construction work
could start on 1st May, 2022 and Shubham Limited provides you the details of the
following costs incurred in relation to its construction:
`
Preparation and levelling of the land 80,000
Employment costs of the construction workers (per month) 29,000
Purchase of materials for the construction 21,24,000
Cost of relocating employees to new factory for work 60,000
Costs of inauguration ceremony on 1 January, 2023 st
80,000
Overhead costs incurred directly on the construction of the factory 25,000
(per month)
© The Institute of Chartered Accountants of India
CS.14 ADVANCED ACCOUNTING
General overhead costs allocated to construction project by the Manager is `
30,000. However, as per company’s normal overhead allocation policy, it should
be ` 24,000. The auditor of the company has support documentation for the cost
of ` 15,000 only) and raised objection for the balance amount.
The construction of the factory was completed on 31st December, 2022 and
production could begin on 1st February, 2023. The overall useful life of the factory
building was estimated at 40 years from the date of completion. However, it was
estimated that the roof will need to be replaced 20 years after the date of
completion and that the cost of replacing the roof at current prices would be 25%
of the total cost of the building.
The construction of the factory was partly financed by a loan of ` 28 lakhs borrowed
on 1st April, 2022. The loan was taken at an annual rate of interest of 9%. During
the period when the loan proceeds had been fully utilized to finance the
construction, Shubham Limited received investment income of ` 25,000 on the
temporary investment of the proceeds.
You are required to assume that all of the net finance costs to be allocated to the
cost of factory (not land) and interest cost to be capitalized based on nine months’
period.
Based on the information given in the above scenario, answer the following
multiple choice questions:
(i) Which of the following cost (incurred directly on construction) will be
capitalized to the cost of factory building?
(a) ` 2,00,000 incurred as legal cost
(b) ` 60,000 – costs of relocating employees
(c) ` 80,000 costs of inauguration ceremony
(d) ` 24,000 – allocated general overhead cost
(ii) What amount of employment cost of construction workers will be capitalized
to the cost of factory building?
(a) ` 2,90,000
(b) ` 3,48,000
(c) ` 2,32,000
(d) ` 29,000
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.15
(iii) What is the amount of net borrowing cost capitalized to the cost of the
factory?
(a) ` 1,89,000
(b) ` 1,68,000
(c) ` 1,44,000
(d) ` 1,64,000
(iv) What will be the carrying amount (i.e. value after charging depreciation) of
the factory in the Balance Sheet of Shubham Limited as at 31st March, 2023?
(a) ` 30,00,000
(b) ` 57,78,125
(c) ` 27,78,125
(d) ` 58,00,000
Answers
(i) (a) (ii) (c) (iii) (d) (iv) (b)
© The Institute of Chartered Accountants of India
CHAPTER 11
FINANCIAL STATEMENTS
OF COMPANIES
UNIT 1: PREPARATION OF FINANCIAL
STATEMENTS
LEARNING OUTCOMES
After studying this unit, you will be able to–
♦ Know how to maintain books of account of a company.
♦ Learn about statutory books of a company.
♦ Prepare and present the financial statements of a company as per
Schedule III to the Companies Act, 2013
♦ Appreciate the term divisible profits and dividends.
© The Institute of Chartered Accountants of India
11.2 ADVANCED ACCOUNTING
UNIT OVERVIEW
Meaning of
Company, different Preparation of
types of companies financial
and maintenance of statements
books of accounts
Requisites of
Distributable profits financial
statements
Declaration and
payment of Transfer to Reserve
dividend
1.1 MEANING OF COMPANY
As per Section 2(20) of the Companies Act, 2013, “Company” means a company
incorporated under the Companies Act, 2013 or under any previous company law
(e.g., the Companies Act, 1956). Different types of companies have been defined
(under various sub-sections of the Companies Act, 2013) as follows:
2(21) “company limited by guarantee” means a company having the liability of
its members limited by the memorandum to such amount as the members
may respectively undertake to contribute to the assets of the company in
the event of its being wound up;
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.3
2(22) “Company limited by shares” means a company having the liability of its
members limited by the memorandum to the amount, if any, unpaid on the
shares respectively held by them;
2(42) “Foreign company” means any company or body corporate incorporated
outside India which –
(a) has a place of business in India whether by itself or through an agent
physically or through electronic mode; and
(b) conducts any business activity in India in any other manner.
2(45) “Government company” means any company in which not less than 51% of
the paid-up share capital is held by the Central Government, or by any State
Government or Governments, or partly by the Central Government and
partly by one or more State Governments, and includes a company which is
a subsidiary company of such a Government company;
2(62) “One Person Company” means a company which has only one person as a
member;
2(68) “Private company” means a company having a minimum paid-up share
capital as may be prescribed, and which by its articles,—
(i) restricts the right to transfer its shares;
(ii) except in case of One Person Company, limits the number of its
members to two hundred:
Provided that where two or more persons hold one or more shares in
a company jointly, they shall, for the purposes of this sub-clause, be
treated as a single member:
Provided further that—
(A) persons who are in the employment of the company; and
(B) persons who, having been formerly in the employment of the
company, were members of the company while in that
employment and have continued to be members after the
employment ceased,
shall not be included in the number of members; and
(iii) prohibits any invitation to the public to subscribe for any securities of
the company;
© The Institute of Chartered Accountants of India
11.4 ADVANCED ACCOUNTING
2(71) “Public Company” means a company which—
(a) is not a private company; and
(b) has a minimum paid-up share capital as may be prescribed:
Provided that a company which is a subsidiary of a company, not
being a private company, shall be deemed to be public company for
the purposes of this Act even where such subsidiary company
continues to be a private company in its articles;
2(85) “Small company” means a company, other than a public company, -
(i) paid-up share capital of which does not exceed ` 50 lakhs or such
higher amount as may be prescribed which shall not be more than `
10 crores; and
(ii) turnover of which as per profit and loss account for the immediately
preceding financial year does not exceed ` 2 crores or such higher
amount as may be prescribed which shall not be more than ` 100
crores:
Provided that nothing in this clause should apply to:
(A) a holding company or a subsidiary company
(B) a company registered under section 8
(C) a company or body corporate governed by any special Act
As per the Companies (Specification of Definitions Details) Rules, 2014 1, for
the purposes of sub-clause (i) and sub-clause (ii) of clause (85) of section 2
of the Act, paid up capital and turnover of the small company shall not
exceed ` 4 crores and ` 40 crores respectively.
2(92) “Unlimited company” means a company not having any limit on the
liability of its members;
2(46) “Holding company”, in relation to one or more other companies, means a
company of which such companies are subsidiary companies;
1
As amended by the Companies (Specification of Definitions Details) Amendment Rules,
2022 dated 15 September 2022.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.5
Explanation.–For the purposes of this clause, the expression “company”
includes any body corporate.
2(87) “Subsidiary company”, or “subsidiary”, in relation to any other company
(that is to say the holding company), means a company in which the holding
company-
(i) controls the composition of the Board of Directors; or
(ii) exercises or controls more than one-half of the total share capital
either at its own or together with one or more of its subsidiary
companies:
Provided that such class or classes of holding companies as may be
prescribed should not have layers of subsidiaries beyond such
numbers as may be prescribed.
Explanation – For the purposes of this clause, -
(a) a company should be deemed to be a subsidiary company of the
holding company even if the control referred to in sub-clause (i) or
sub-clause (ii) is of another subsidiary company of the holding
company;
(b) the composition of a company’s Board of Directors should be deemed
to be controlled by another company if that other company by
exercise of some power exercisable by it at its discretion can appoint
or remove all or a majority of the directors;
(c) the expression “company” includes any body corporate;
(d) “layer” in relation to a holding company means its subsidiary or
subsidiaries;
Companies (Accounting Standards) Rules, 2021 define Small and Medium
Sized Company as follows:
2(e) “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;
© The Institute of Chartered Accountants of India
11.6 ADVANCED ACCOUNTING
(iii) whose turnover (excluding other income) does not exceed two
hundred and fifty crore rupees in the immediately preceding
accounting year;
(iv) which does not have borrowings (including public deposits) in excess
of fifty crore rupees 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.
Explanation: For the purposes of this clause, a company shall qualify as a
Small and Medium Sized Company, if the conditions mentioned therein are
satisfied as at the end of the relevant accounting period.
1.2 MAINTENANCE OF BOOKS OF ACCOUNT
As per Section 128 of the Companies Act, 2013
Every company should prepare and keep
at its registered office
books of account and other relevant books and
financial statements
accrual basis and according to double entry system
of accounting.
for every financial year
giving a true and fair view of the state of the affairs
As per Section 128 of the Companies Act, 2013, every company shall prepare and
keep at its registered office books of account and other relevant books and
papers and financial statement for every financial year which give a true and fair
view of the state of the affairs of the company, including that of its branch office
or offices, if any, and explain the transactions effected both at the registered
office and its branches and such books should be kept on accrual basis and
according to the double entry system of accounting:
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.7
Provided further that the company may keep such books of account or other
relevant papers in electronic mode in such manner as may be prescribed.
Maintenance at Place other than Registered Office
It is a duty of the company to inform the Registrar of Companies within seven
days of the decision in case the Board of Directors decides to maintain books at
the place other than the registered office.
In Case of Branch Office
Where a company has a branch office in India or outside India, it should be
deemed to have complied with the provisions of the Act, if proper books of
account relating to the transactions effected at the branch office are kept at that
office and proper summarised returns periodically are sent by the branch office to
the company at its registered office or such other place as the Board of Directors
has decided.
Section 128 (3) further lays down that the books of account and other books and
papers maintained by the company within India should be open for inspection at
the registered office of the company or at such other place in India by any
director during business hours, and in the case of financial information, if any,
maintained outside the country, copies of such financial information should be
maintained and produced for inspection by any director subject to such
conditions as may be prescribed. Section 128(5) further states that the books of
account of every company relating to a period of not less than 8 financial years
immediately preceding a financial year, or where the company had been in
existence for a period less than 8 years, in respect of all the preceding years
together with the vouchers relevant to any entry in such books of account should
be kept in good order.
Books of Accounts maintained in electronic mode
A company may keep such books of account or other relevant papers in
electronic mode in such manner as may be prescribed.
The books of account and other relevant books and papers maintained in
electronic mode shall remain accessible in India, at all times, so as to be usable
for subsequent reference.
Provided that for the financial year commencing on or after the 1st day of April,
2022, every company which uses accounting software for maintaining its books of
© The Institute of Chartered Accountants of India
11.8 ADVANCED ACCOUNTING
account, shall use only such accounting software which has a feature of recording
audit trail of each and every transaction, creating an edit log of each change
made in books of account along with the date when such changes were made
and ensuring that the audit trail cannot be disabled.
The books of account and other relevant books and papers shall be retained
completely in the format in which they were originally generated, sent or
received, or in a format which shall present accurately the information generated,
sent or received and the information contained in the electronic records shall
remain complete and unaltered.
The information received from branch offices shall not be altered and shall be
kept in a manner where it shall depict what was originally received from the
branches.
The information in the electronic record of the document shall be capable of
being displayed in a legible form.
There shall be a proper system for storage, retrieval, display or printout of the
electronic records as the Audit Committee, if any, or the Board may deem
appropriate and such records shall not be disposed of or rendered unusable,
unless permitted by law;
Provided that the back-up of the books of account and other books and papers
of the company maintained in electronic mode, including at a place outside India,
if any, shall be kept in servers physically located in India on a daily basis.
The company shall intimate to the Registrar on an annual basis at the time of
filing of financial statement-
(a) the name of the service provider;
(b) the internet protocol address of service provider;
(c) the location of the service provider (wherever applicable);
(d) where the books of account and other books and papers are maintained on
cloud, such address as provided by the service provider.
Explanation.- For the purposes of this rule, the expression “electronic mode”
includes “electronic form” as defined in clause (r) of sub-section (1) of section 2
of Information Technology Act, 2000 and also includes an electronic record as
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.9
defined in clause (t) of sub-section (1) of section 2 of the Information Technology
Act, 2000 and "books of account " shall have the meaning assigned to it under
the Act.
Where the service provider is located outside India, the name and address of the
person in control of the books of account and other books and papers in India.
1.3 STATUTORY BOOKS
The following statutory books are required to be maintained by a company under
different sections of the Companies Act, 2013:
♦ Register of Investments of the company held in its own name (Section 187)
♦ Register of Charges (Section 85)
♦ Register of Members (Sections 88)
♦ Register of Debenture-holders and other Security holders (Section 88)
♦ Minute Books (Section 118)
♦ Register of Contracts, or arrangements in which directors are interested
(Section 189)
♦ Register of directors and key managerial personnel and their shareholding
(Section 170)
♦ Register of Loans and Investments by Company (Section 186)
In addition, a company usually maintains a number of statistical books to
keep a record of its transactions which have resulted either in the payment
of money to it or constitute the basis on which certain payments have been
made by it.
♦ Registers and documents relating to the issue of shares are:
(i) Share Application and Allotment Book;
(ii) Share Call Book
(iii) Certificate Book
(iv) Register of Members
(v) Share Transfer Book
(vi) Dividend Register.
© The Institute of Chartered Accountants of India
11.10 ADVANCED ACCOUNTING
1.4 ANNUAL RETURN
In accordance with Section 92 of the Companies Act, 2013, every company should
prepare an annual return in the form prescribed by the Companies Act, 2013
signed by a director and the company secretary, or where there is no company
secretary, by a company secretary in practice:
Provided that in relation to One Person Company and small company, the annual
return should be signed by the company secretary, or where there is no company
secretary, by the director of the company.
The annual return should be filed with the Registrar within 60 days from the day
on which each of the annual general meeting (AGM) is held or where no AGM is
held in any year, within 60 days from the date on which AGM should have been
held along with a statement showing the reasons why AGM was not held.
1.5 FINAL ACCOUNTS
Under Section 129 of the Companies Act, 2013, at the annual general meeting of
a company, the Board of Directors of the company should lay financial statements
before the company:
Financial Statements as per Section 2(40) of the Companies Act, 2013, inter-alia
include -
(i) a balance sheet as at the end of the financial year;
(ii) a profit and loss account, or in the case of a company carrying on any
activity not for profit, an income and expenditure account for the financial
year;
(iii) cash flow statement for the financial year;
(iv) a statement of changes in equity, if applicable; and
(v) any explanatory note annexed to, or forming part of, any document referred
to in (i) to (iv) above:
Provided that the financial statement, with respect to One Person Company, small
company and dormant company, may not include the cash flow statement.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.11
Statement of
Profit and
loss
Statement of Cash Flow
changes in Statement
Equity (if
applicable) Financial
statements
Notes and
Balance
other
sheet
statements
The financial statements of a one person company, small company, dormant
company or a private company (if such a private company is a start-up), may not
include the cash flow statement.
Periodic Financial Statements
The Central Government may, require such class or classes of unlisted companies,
as may be prescribed,—
(a) to prepare the financial results of the company on such periodical basis and
in such form as may be prescribed;
(b) to obtain approval of the Board of Directors and complete audit or limited
review of such periodical financial results in such manner as may be
prescribed; and
(c) file a copy with the Registrar within a period of thirty days of completion of
the relevant period with such fees as may be prescribed.
Requisites of Financial Statements
It should give a true and fair view of the state of affairs of the company as at the
end of the financial year.
© The Institute of Chartered Accountants of India
11.12 ADVANCED ACCOUNTING
Provisions Applicable
(1) Specific Act is Applicable
For instance, any
(a) insurance company
(b) banking company or
(c) any company engaged in generation or supply of electricity ∗ or
(d) any other class of company for which a Form of balance sheet or Profit
and loss account has been prescribed under the Act governing such
class of company
(2) In case of all other companies
Balance Sheet as per Form set out in Part I of Schedule III and Statement of
Profit and Loss as per Part II of Schedule III.
Division Applicable to:
Division I Companies that are required to apply Accounting
Standards notified under Section 133 of the Companies
Act, 2013.
Division II Companies that are required to apply Indian Accounting
Standards notified under Section 133 of the Companies
Act, 2013.
Division III Non-Banking Finance Companies (NBFCs) that are
required to apply Indian Accounting Standards notified
under Section 133 of the Companies Act, 2013.
∗
Section 1(4)(d) of the Companies Act, 2013 states that the provisions of the Companies Act shall
apply to companies engaged in the generation or supply of electricity, except in so far as the said
provisions are inconsistent with the provisions of the Electricity Act, 2003. Keeping this in view,
Schedule III may be followed by such companies till the time any other format is prescribed by the
relevant statute.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.13
Points to be kept in mind while preparing final accounts:
♦ Requirements of Schedule III to the Companies Act;
♦ Other statutory requirements;
♦ Accounting Standards notified by Ministry of Corporate Affairs (MCA) (AS 1
to AS 29 2);
♦ Statements and Guidance Notes issued by the Institute of Chartered
Accountants of India (ICAI); which are necessary for understanding the
accounting treatment/ valuation/ disclosure suggested by the ICAI.
Compliance with Accounting Standards
As per section 133 of the Companies Act, it is mandatory to comply with
accounting standards notified by the Central Government from time to time.
Schedule III of the Companies Act, 2013
As per section 129 of the Companies Act, 2013, Financial statements should give a
true and fair view of the state of affairs of the company or companies and comply
with the accounting standards notified under section133 and should be in the
form or forms as may be provided for different class or classes of companies in
Schedule III under the Act. Schedule III to the Companies Act, 2013 has been
given as Annexure at the end of this chapter.
Requirements of
Schedule III to
the Companies
Act, 2013
Financial
statements
Accounting
Other
Standards
statutory
notified by
requirements
MCA
2
AS 6 and AS 8 have been withdrawn
© The Institute of Chartered Accountants of India
11.14 ADVANCED ACCOUNTING
Example 1
In the financial statements of the financial year 20X1-20X2, Alpha Ltd. has
mentioned in the notes to accounts that during financial year, 24,000 equity shares
of ` 10 each were issued as fully paid bonus shares. However, the source from which
these bonus shares were issued has not been disclosed. Is such non-disclosure a
violation of the Schedule III to the Companies Act? Comment.
Solution
Schedule III has come into force for the Balance Sheet and Profit and Loss
Account prepared for the financial year commencing on or after 1st April, 20X1. As
per Part I of the Schedule III, a company should, inter alia, disclose in notes to
accounts for the period of 5 years immediately preceding the balance sheet date
(31st March, 20X2 in the instant case) the aggregate number and class of shares
allotted as fully paid-up bonus shares. Schedule III does not require a company to
disclose the source from which bonus shares have been issued. Therefore, non-
disclosure of source from which bonus shares have been issued does not violate
the Schedule III to the Companies Act.
Example 2
The management of Loyal Ltd. contends that the work in process is not valued since
it is difficult to ascertain the same in view of the multiple processes involved. They
opine that the value of opening and closing work in process would be more or less
the same. Accordingly, the management had not separately disclosed work in
process in its financial statements. Comment in line with Schedule III.
Solution
Schedule III to the companies Act does not require that the amounts of WIP at
the beginning and at the end of the accounting period to be disclosed in the
statement of profit and loss. Only changes in inventories of WIP need to be
disclosed in the statement of profit and loss. Non-disclosure of such change in
the statement of profit and loss by the company may not amount to violation of
Schedule III if the differences between opening and closing WIP are not material.
Example 3
Futura Ltd. had the following items under the head “Reserves and Surplus” in the
Balance Sheet as on 31st March, 20X1:
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.15
Amount ` in lakhs
Securities Premium Account 80
Capital Reserve 60
General Reserve 90
The company had an accumulated loss of ` 250 lakhs on the same date, which it
has disclosed under the head “Statement of Profit and Loss” as asset in its Balance
Sheet. Comment on accuracy of this treatment in line with Schedule III to the
Companies Act, 2013.
Solution
Part I of Schedule III to the Companies Act, 2013 provides that debit balance of
Statement of Profit and Loss (after all allocations and appropriations) should be
shown as a negative figure under the head ‘Surplus’. Similarly, the balance of
‘Reserves and Surplus’, after adjusting negative balance of surplus, should be
shown under the head ‘Reserves and Surplus’ even if the resulting figure is in the
negative. In this case, the debit balance of profit and loss i.e. ` 250 lakhs exceeds
the total of all the reserves i.e. ` 230 lakhs. Therefore, balance of ‘Reserves and
Surplus’ after adjusting debit balance of profit and loss is negative by ` 20 lakhs,
which should be disclosed on the face of the balance sheet. Thus, the
presentation by the company is incorrect.
Example 4
Sumedha Ltd. took a loan from bank for ` 10,00,000 to be settled within 5 years in
10 equal half yearly instalments with interest. First instalment is due on 30.09.20X1
of ` 1,00,000. Determine how the loan will be classified in preparation of Financial
Statements of Sumedha Ltd. for the year ended 31st March, 20X1 according to
Schedule III.
Solution
In the given case, instalments due on 30.09.20X1 and 31.03.20X2 will be shown
under the head ‘short term borrowings’ as current maturities of loan from bank as
per the amendment to Schedule III vide MCA notification dated 24th March, 2021.
Therefore, in the balance sheet as on 31.3.20X1, ` 8,00,000 (` 1,00,000 x 8
instalments) will be shown under the heading ‘Long term Borrowings’ and
` 2,00,000 (` 1,00,000 x 2 instalments) will be shown under the heading ‘short
term borrowings’.
© The Institute of Chartered Accountants of India
11.16 ADVANCED ACCOUNTING
Example 5
Prince Ltd. presents its provisions for contingencies under "Reserves and Surplus” in
Notes to Accounts in its financial statements. Whether this presentation is correct?
Solution
The ICAI’s Glossary of Terms Used in Financial Statements defines the term
‘Reserve’ as “the portion of earnings, receipts or other surplus of an enterprise
(whether capital or revenue) appropriated by the management for a general or a
specific purpose other than a provision for depreciation or diminution in the value
of assets or for a known liability.” ‘Reserves’ should be distinguished from
‘provisions’. For this purpose, reference may be made to the definition of the
expression `provision’ in AS-29 Provisions, Contingent Liabilities and Contingent
Assets.
As per AS-29, a `provision’ is “a liability which can be measured only by using a
substantial degree of estimation”. A ‘liability’ is “a present obligation of the
enterprise arising from past events, the settlement of which is expected to result
in an outflow from the enterprise of resources embodying economic benefits.”
Present obligation’ – “an obligation is a present obligation if, based on the
evidence available, its existence at the Balance Sheet date is considered probable,
i.e., more likely than not.”
Example 6
Anek Ltd. is a company that is required to present its financial statements as per the
Division I of Schedule III. The company has trade receivables at the balance sheet
date. What are the disclosures that are applicable with respect to trade receivables
in the financial statements?
Solution
Under Schedule III, trade receivables are required to be classified into long-term
(non-current) trade receivables and short-term (current) trade receivables. Trade
Receivables, shall be sub-classified as:
(i) (a) Secured, considered good;
(b) Unsecured considered good;
(c) Doubtful
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.17
(ii) Allowance for bad and doubtful debts shall be disclosed under the relevant
heads separately.
(iii) Debts due by directors or other officers of the company or any of them
either severally or jointly with any other person or debts due by firms or
private companies respectively in which any director is a partner or a
director or a member should be separately stated.
For trade receivables outstanding, following ageing schedule shall be given:
Particulars Outstanding for following periods from Total
due date of payment#
Less 6 1-2 2-3 More
than 6 months- years years than 3
months 1 year years
(i) Undisputed Trade
Receivables –
considered good
(ii) Undisputed Trade
Receivables –
considered doubtful
(iii) Disputed Trade
Receivables –
considered good
(iv) Disputed Trade
Receivables –
considered doubtful
#similar information shall be given where no due date of payment is specified in
that case disclosure shall be from the date of the transaction.
Note: Students may note that the questions based on preparation of Statement
of Profit and Loss and Balance Sheet and explanatory notes as per Schedule III
have been given in this Unit. However, questions requiring preparation of cash
flow statements have been separately given in the next unit of this chapter.
© The Institute of Chartered Accountants of India
11.18 ADVANCED ACCOUNTING
1.6 DISTRIBUTABLE PROFIT
One of the important functions of company accounting is to determine the
amount of profits which is available for distribution to the shareholders as
dividend. This is necessary since the amount of profits disclosed by the Profit &
Loss Account, in every case, is not available for distribution. The availability of
profits for distribution depends on a number of factors, e.g., their composition,
the amount of provisions and appropriations that must be made out of them in
priority, etc.
Meaning of Dividend
(a) A dividend is a distribution of divisible profit of a company among the
members according to the number of shares held by each of them in the
capital of the company and the rights attaching thereto.
(b) Such a distribution may or may not entail a release of assets; it would be
where a distribution involves payment of cash.
(c) But when profits are capitalised and the amount distributed is applied
towards payment of bonus shares, issued free to the shareholders, no part
of the assets of the company can be said to have been released since, in
such a case, profits are only capitalised, thereby increasing the paid up
capital of the company. The company does not give up any asset.
As per Section 2 (35) of the Companies Act, 2013, term “Dividend” includes
interim dividend also.
Under Section 123 (1) of the Companies Act, 2013, no dividend should be
declared or paid by a company for any financial year except-
(a) Out of the profits of the company for that financial year arrived at after
providing for depreciation in accordance with the provisions of section
123(2), or
(b) Out of the profits for any previous financial years arrived at after providing
for depreciation in accordance with the provisions of that sub section and
remaining undistributed; or
(c) Out of both the above;
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.19
(d) Out of the moneys provided by the Central Government or any State
Government for the payment of dividend by the Company in pursuance of
any guarantee given by that government
Provided that no dividend should be declared or paid by a company from its
reserves other than free reserves.
Declaration of a dividend presupposes that there is a trading profit or a surplus
available for distribution, arrived at after providing for depreciation on assets, not
only for the year in which the profits were earned but also for any arrears of
depreciation of the past years, calculated in the manner prescribed by sub-section
(2) of Section 123.
Sub-section (3) of Section 124 further states that the Board of Directors of a
company may declare interim dividend during any financial year out of the
surplus in the profit and loss account and out of profits of the financial year in
which such interim dividend is sought to be declared:
Provided that in case the company has incurred loss during the current financial
year up to the end of the quarter immediately preceding the date of declaration
of interim dividend, such interim dividend should not be declared at a rate higher
than the average dividends declared by the company during the immediately
preceding three financial years.
Dividends cannot be declared except out of profits.
Capital cannot be returned to the shareholders by way of dividend.
Dividend can be declared and paid by a company only out of the profits or free
reserves (other than moneys provided by Central or State Govt.) as the payment of
dividend from any other source will amount to payment of dividend from capital
units.
Section 123(2) states that depreciation must be provided to the extent specified in
Schedule II to the Companies Act, 2013.Further, when the assets are sold, discarded,
demolished or destroyed in any financial year, the excess of the written down value
over its sale proceeds as scrap, if any should be written off in the same financial year.
Declaration and Payment of Dividend
For the purpose of second proviso to sub-section (1) of section 123, a company
may declare dividend out of the accumulated profits earned by it in previous
years and transferred by it to the reserves, in the event of inadequacy or absence
© The Institute of Chartered Accountants of India
11.20 ADVANCED ACCOUNTING
of profits in any year, subject to the fulfilment of the following conditions as per
Companies (Declaration and Payment of Dividend) Rules, 2014:
(1) The rate of dividend declared should not exceed the average of the rates at
which dividend was declared by it in the three years immediately preceding
that year: provided that this sub-rule should not apply to a company, which
has not declared any dividend in each of the three preceding financial years.
(2) The total amount to be drawn from such accumulated profits should not
exceed one-tenth of the sum of its paid-up share capital and free reserves
as appearing in the latest audited financial statement.
(3) The amount so drawn should first be utilised to set off the losses incurred in
the financial year in which dividend is declared before any dividend in
respect of equity shares is declared.
(4) The balance of reserves after such withdrawal should not fall below 15% of
its paid up share capital as appearing in the latest audited financial
statement.
(5) No company should declare dividend unless carried over previous losses
and depreciation not provided in previous year are set off against profit of
the company of the current year the loss or depreciation, whichever is less,
in previous years is set off against the profit of the company for the year for
which dividend is declared or paid.
Transfer to Reserves
I The Board of Directors are free and can appropriate a part of the profits to
the credit of a reserve or reserves as per section 123 (1) of the Companies
Act, 2013.
II Appropriation of a part of profit is sometimes made under law.
(a) For example, under the Banking Regulation Act, a fixed percentage of
the profit of a banking company must first be transferred to the
General Reserve before any dividend can be distributed.
(b) Transfer of a part of profit to a reserve is also necessary where the
company has undertaken, at the time of raising of loan, that before
any part of its profit is distributed, a specified percentage of the profit
every year should be credited to a reserve for the repayment of the
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.21
loan and until the time for repayment arrives, the amount should
remain invested in a specified manner.
III Apart from appropriations aforementioned, it may also be necessary to
provide for losses and arrears of depreciation and to exclude capital profit,
as mentioned earlier, to arrive at the amount of divisible profit.
Declaration of Dividend
As per Section 123 of the Companies Act, 2013, Board of Directors of a company
may declare dividend including interim dividend during any financial year out of
the surplus in the profit and loss account and out of profits of the financial year in
which such interim dividend is sought to be declared:
Provided that in case the company has incurred loss during the current financial
year up to the end of the quarter immediately preceding the date of declaration
of interim dividend, such interim dividend should not be declared at a rate higher
than the average dividends declared by the company during the immediately
preceding three financial years.
The amount of the dividend, including interim dividend, should be deposited in a
scheduled bank in a separate account within five days from the date of
declaration of such dividend.
No dividend should be paid by a company in respect of any share therein except
to the registered shareholder of such share or to his order or to his banker and
should not be payable except in cash: Provided that nothing in Section 123
should be deemed to prohibit the capitalisation of profits or reserves of a
company for the purpose of issuing fully paid-up bonus shares or paying up any
amount for the time being unpaid on any shares held by the members of the
company:
Provided further that any dividend payable in cash may be paid by cheque or
warrant or in any electronic mode to the shareholder entitled to the payment of
the dividend.
Dividend on preference shares
(a) Holders of preference shares are entitled to receive a dividend at a fixed
rate before any dividend is declared on equity shares.
(b) But such a right can be exercised subject to there being profits and the
Directors recommending payment of the dividend.
© The Institute of Chartered Accountants of India
11.22 ADVANCED ACCOUNTING
Dividend on partly paid shares:
A company may if so authorised by its Article, pay a dividend in proportion
to the amount paid on each share (Section 51 of the Companies Act, 2013).
Calls in Advance
Calls paid in advance do not rank for payment of dividend.
Payment of Dividend
As per Section 124 of the Companies Act, 2013:
(1) Where a dividend has been declared by a company but has not been paid
or claimed within thirty days from the date of the declaration to any
shareholder entitled to the payment of the dividend, the company should,
within seven days from the date of expiry of the said period of thirty days,
transfer the total amount of dividend which remains unpaid or unclaimed to
a special account to be opened by the company in that behalf in any
scheduled bank to be called the Unpaid Dividend Account.
(2) The company should, within a period of ninety days of making any transfer
of an amount under this section to the Unpaid Dividend Account, prepare a
statement containing the names, their last known addresses and the unpaid
dividend to be paid to each person and place it on the website of the
company, if any, and also on any other website approved by the Central
Government for this purpose, in such form, manner and other particulars as
may be prescribed.
(3) If any default is made in transferring the total amount or any part thereof to
the Unpaid Dividend Account of the company, it should pay, from the date of
such default, interest on so much of the amount as has not been transferred to
the said account, at the rate of 12% per annum and the interest accruing on
such amount should ensure to the benefit of the members of the company in
proportion to the amount remaining unpaid to them.
(4) Any person claiming to be entitled to any money transferred to the Unpaid
Dividend Account of the company may apply to the company for payment
of the money claimed.
(5) Any money transferred to the Unpaid Dividend Account of a company in
pursuance of this section which remains unpaid or unclaimed for a period of
seven years from the date of such transfer should be transferred by the
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.23
company along with interest accrued, if any, thereon to the Fund “Investor
Education and Protection Fund” established section 125 and the company
should send a statement in the prescribed form of the details of such
transfer to the authority which administers the said Fund and that authority
should issue a receipt to the company as evidence of such transfer.
(6) All shares in respect of which unpaid or unclaimed dividend has been
transferred to “Investor Education and Protection Fund” should also be
transferred by the company in the name of Investor Education and
Protection Fund along with a statement containing such details as may be
prescribed:
Provided that any claimant of shares transferred above should be entitled to
claim the transfer of shares from Investor Education and Protection Fund in
accordance with such procedure and on submission of such documents as
may be prescribed.
(7) If a company fails to comply with any of the requirements of this section,
the company will be punishable with fine which will not be less than five
lakh rupees but which may extend to twenty-five lakh rupees and every
officer of the company who is in default will be punishable with fine which
will not be less than one lakh rupees but which may extend to five lakh
rupees.
Illustration 1
Due to inadequacy of profits during the year ended 31st March, 20X2, XYZ Ltd.
proposes to declare 10% dividend out of general reserves. From the following
particulars, ascertain the amount that can be utilised from general reserves,
according to the Companies (Declaration of dividend out of Reserves) Rules, 2014:
`
17,500 9% Preference shares of ` 100 each, fully paid up 17,50,000
8,00,000 Equity shares of ` 10 each, fully paid up 80,00,000
General Reserves as on 1.4.20X1 25,00,000
Capital Reserves as on 1.4.20X1 3,00,000
Revaluation Reserves as on 1.4.20X1 3,50,000
Net profit for the year ended 31 March, 20X2st
3,00,000
Average rate of dividend during the last three years has been 12%.
© The Institute of Chartered Accountants of India
11.24 ADVANCED ACCOUNTING
Solution
Amount that can be drawn from reserves for 10%
dividend
10% dividend on ` 80,00,000 ` 8,00,000
Profits available
Current year profit 3,00,000
Less: Preference dividend (1,57,500) (1,42,500)
Amount which can be utilised from reserves 6,57,500
Conditions as per Companies (Declaration of dividend out of Reserves) Rules,
20X1:
Condition I
Since 10% is lower than the average rate of dividend (12%), 10% dividend can be
declared.
Condition II
Maximum amount that can be drawn from the accumulated profits and reserves
should not exceed 10% of paid up capital plus free reserves ie. ` 12,25,000 [10%
of (80,00,000+17,50,000+25,00,000)]
Condition III
The balance of reserves after drawl ` 18,42,500 (` 25,00,000 - ` 6,57,500) should
not fall below 15 % of its paid up capital ie. ` 14,62,500 (15% of ` 97,50,000]
Since all the three conditions are satisfied, the company can withdraw ` 6,57,500
from accumulated reserves (as per Declaration and Payment of Dividend Rules,
2014.)
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.25
Illustration 2
The following is the Trial Balance of Omega Limited as on 31.3.20X2:
(Figures in ` ‘000)
Debit Credit
Land at cost 220 Equity Capital (Shares of ` 10 300
each)
Plant & Machinery at 770 10% Debentures 200
cost
Trade Receivables 96 General Reserve 130
Inventories (31.3.X2) 86 Profit & Loss A/c 72
Bank 20 Securities Premium 40
Adjusted Purchases 320 Sales 700
Factory Expenses 60 Trade Payables 52
Administration Expenses 30 Provision for Depreciation 172
Selling Expenses 30 Suspense Account 4
Debenture Interest 20
Interim Dividend Paid 18
1670 1670
Additional Information:
(i) The authorised share capital of the company is 40,000 shares of ` 10 each.
(ii) The company on the advice of independent valuer wish to revalue the land at
` 3,60,000.
(iii) Declared final dividend @ 10% on 2nd April, 20X2.
(iv) Suspense account of ` 4,000 represents cash received for the sale of some of
the machinery on 1.4.20X1. The cost of the machinery was ` 10,000 and the
accumulated depreciation thereon being ` 8,000.
(v) Depreciation is to be provided on plant and machinery at 10% on cost.
You are required to prepare Omega Limited’s Balance Sheet as on 31.3.20X2 and
Statement of Profit and Loss with notes to accounts for the year ended 31.3.20X2 as
per Schedule III. Ignore previous years’ figures & taxation.
© The Institute of Chartered Accountants of India
11.26 ADVANCED ACCOUNTING
Solution
Omega Limited
Balance Sheet as at 31st March, 20X2
Particulars Note No. (` in 000)
Equity and Liabilities
1. Shareholders' funds
A Share capital 1 300
B Reserves and Surplus 2 530
2. Non-Current liabilities
A Long term borrowings 3 200
3. Current liabilities
A Trade Payables 52
Total 1082
Assets
1. Non-current assets
A PPE (Property, Plant & Equipment) 4 880
2. Current assets
A Inventories 86
B Trade receivables 96
C Cash and bank balances 20
Total 1082
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.27
Omega Limited
Statement of Profit and Loss for the year ended 31st March, 20X2
Particulars Notes (` in 000)
I. Revenue from operations 700
II. Other Income 5 2
III Total Income 702
IV Expenses:
Purchases 320
Finance costs 6 20
Depreciation (10% of 760 ∗) 76
Other expenses 7 120
Total Expenses 536
V. Profit (Loss) for the period (III – IV) 166
Notes to accounts
(` in 000)
1. Share Capital
Equity share capital
Authorised
40,000 shares of ` 10 each 400
Issued & subscribed & called up
30,000 shares of ` 10 each 300
2. Reserves and Surplus
Securities Premium Account 40
Revaluation reserve (360 – 220) 140
General reserve 130
∗
770 (Plant and machinery at cost) – 10 (Cost of plant and machinery sold)
© The Institute of Chartered Accountants of India
11.28 ADVANCED ACCOUNTING
Profit & loss Balance
Opening balance 72
Profit for the period 166 238
Less: Appropriations
Interim Dividend (18) 220
530
3. Long term borrowing
10% Debentures 200
4. PPE
Land
Opening balance 220
Add: Revaluation adjustment 140
Closing balance 360
Plant and Machinery
Opening balance 770
Less: Disposed off (10)
760
Less: Depreciation (172-8+76) (240)
Closing balance 520
Total 880
5. Other Income
Profit on sale of machinery:
Sale value of machinery 4
Less: Book value of machinery (10-8) (2) 2
6. Finance costs
Debenture interest 20
7. Other expenses:
Factory expenses 60
Selling expenses 30
Administrative expenses 30 120
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.29
Note: The final dividend will not be recognized as a liability at the balance sheet
date (even if it is declared after reporting date but before approval of the
financial statements) as per Accounting Standards. Hence, it has not been
recognized in the financial statements for the year ended 31 March, 20X2. Such
dividends will be disclosed in notes only.
Illustration 3
You are required to prepare Balance sheet and statement of Profit and Loss from the
following trial balance of Haria Chemicals Ltd. for the year ended 31st March, 20X1.
Haria Chemicals Ltd.
Trial Balance as at 31st March, 20X1
Particulars ` Particulars `
Inventory 6,80,000 Equity Shares
Furniture 2,00,000 Capital (Shares of ` 10 each) 25,00,000
Discount 40,000 11% Debentures 5,00,000
Loan to Directors 80,000 Bank loans 6,45,000
Advertisement 20,000 Trade payables 2,81,000
Bad debts 35,000 Sales 42,68,000
Commission 1,20,000 Rent received 46,000
Materials consumed 23,19,000 Transfer fees 10,000
Plant and Machinery 8,60,000 Profit & Loss account 1,39,000
Rentals 25,000 Depreciation provision:
Current account 45,000 Machinery 1,46,000
Cash 8,000
Interest on bank loans 1,16,000
Preliminary expenses 10,000
Fixtures 3,00,000
Wages 9,00,000
Consumables 84,000
Freehold land 15,46,000
© The Institute of Chartered Accountants of India
11.30 ADVANCED ACCOUNTING
Tools & Equipment 2,45,000
Goodwill 2,65,000
Trade receivables 4,40,000
Dealer aids 21,000
Transit insurance 30,000
Trade expenses 37,000
Distribution freight 54,000
Debenture interest 55,000
85,35,000 85,35,000
Additional information: Closing Inventory on 31-3-20X1: ` 8,23,000.
Solution
Haria Chemicals Ltd.
Balance Sheet as at 31st March, 20X1
Schedule Rupees as at the
No. end of 31st March 20X1
(1) (2)
Equity and Liabilities
(1) Shareholders’ funds :
(a) Share Capital 1 25,00,000
(b) Reserves and Surplus 2 7,40,000
(2) Non Current Liabilities
(a) Long term borrowings 3 11,45,000
(3) Current Liabilities
(a) Trade payables 2,81,000
Total 46,66,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.31
Assets
(1) Non current assets
(a) PPE 4 30,05,000
(b) Intangible assets (goodwill) 2,65,000
(2) Current assets
(a) Inventories 8,23,000
(b) Trade receivables 4,40,000
(c) Cash and bank balances 5 53,000
(d) Short term loans and advances 6 80,000
Total 46,66,000
Haria Chemicals Ltd.
Statement of Profit and Loss for the year ended 31st March, 20X1
Schedule Figures
Revenue from operations 42,68,000
Other income 7 56,000
(A) 43,24,000
Expenses
Cost of materials consumed 23,19,000
Change in inventory of finished goods 8 (1,43,000)
Employee benefit expenses 9 9,00,000
Finance cost 10 1,71,000
Other expenses 11 4,76,000
(B) 37,23,000
Profit before tax (A – B) 6,01,000
Provision for tax —
Profit for the period 6,01,000
© The Institute of Chartered Accountants of India
11.32 ADVANCED ACCOUNTING
Notes to Accounts
1. Share capital `
Authorised:
Equity share capital of ` 10 each 25,00,000
Issued and Subscribed:
Equity share capital of ` 10 each 25,00,000
2. Reserves and Surplus
Balance as per last balance sheet 1,39,000
Balance in profit and loss account 6,01,000
7,40,000
3. Long term Borrowings
11% Debentures 5,00,000
Bank loans (assumed long-term) 6,45,000
11,45,000
4. PPE
Gross block Depreciation Net Block
Freehold land 15,46,000 15,46,000
Furniture 2,00,000 2,00,000
Fixtures 3,00,000 3,00,000
Plant & Machinery 8,60,000 1,46,000 7,14,000
Tools & Equipment 2,45,000 ________ 2,45,000
Total 31,51,000 1,46,000 30,05,000
5. Cash and bank balances
Cash and cash equivalents
Current account balance 45,000
Cash 8,000
Other bank balances Nil
53,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.33
6. Short-term loans and Advances
Loan to directors 80,000
7. Other Income
Rent received 46,000
Transfer fees 10,000
56,000
8. Changes in inventory of finished goods, WIP & Stock in trade
Opening inventory 6,80,000
Closing inventory (8,23,000) (1,43,000)
9. Employee benefit expense
Wages 9,00,000
10. Finance cost
Interest on bank loans 1,16,000
Debenture interest 55,000
1,71,000
11. Other Expenses
Consumables 84,000
Preliminary expenses 10,000
Bad debts 35,000
Discount 40,000
Rentals 25,000
Commission 1,20,000
Advertisement 20,000
Dealers’ aids 21,000
Transit insurance 30,000
Trade expenses 37,000
Distribution freight 54,000
4,76,000
© The Institute of Chartered Accountants of India
11.34 ADVANCED ACCOUNTING
Illustration 4
You are required to prepare a Statement of Profit and Loss and Balance Sheet from
the following Trial Balance extracted from the books of the International Hotels
Ltd., on 31st March, 20X2:
Dr. Cr.
` `
Authorised Capital-divided into 5,000 6% Preference Shares
of ` 100 each and 10,000 equity Shares of ` 100 each 15,00,000
Subscribed Capital -
5,000 6% Preference Shares of ` 100 each 5,00,000
Equity Capital 8,05,000
Purchases - Wines, Cigarettes, Cigars, etc. 45,800
- Foodstuffs 36,200
Wages and Salaries 28,300
Rent, Rates and Taxes 8,900
Laundry 750
Sales - Wines, Cigarettes, Cigars, etc. 68,400
- Food 57,600
Coal and Firewood 3,290
Carriage and Cooliage 810
Sundry Expenses 5,840
Advertising 8,360
Repairs 4,250
Rent of Rooms 48,000
Billiard 5,700
Miscellaneous Receipts 2,800
Discount received 3,300
Transfer fees 700
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.35
Freehold Land and Building 8,50,000
Furniture and Fittings 86,300
Inventory on hand, 1st April, 20X1
Wines, Cigarettes. Cigars, etc. 12,800
Foodstuffs 5,260
Cash in hand 2,200
Cash with Bankers 76,380
Preliminary and formation expenses 8,000
2,000 Debentures of ` 100 each (6%) 2,00,000
Profit and Loss Account 41,500
Trade payables 42,000
Trade receivables 19,260
Investments 2,72,300
Goodwill at cost 5,00,000
General Reserve 2,00,000
19,75,000 19,75,000
Wages and Salaries Outstanding 1,280
Inventory on 31st March, 20X2
Wines, Cigarettes and Cigars, etc. 22,500
Foodstuffs 16,400
Depreciation : Furniture and Fittings @ 5% p.a. : Land and Building @ 2% p.a.
The Equity capital on 1st April, 20X1 stood at ` 7,20,000, that is 6,000 shares fully
paid and 2,000 shares ` 60 paid. The directors made a call of ` 40 per share on 1st
October 20X1. A shareholder could not pay the call on 100 shares and his shares
were then forfeited and reissued @ ` 90 per share as fully paid. The Directors
declared a dividend of 8% on equity shares on 2nd April, 20X2, transferring any
amount that may be required from General Reserve. Ignore Taxation.
© The Institute of Chartered Accountants of India
11.36 ADVANCED ACCOUNTING
Solution
Balance Sheet of International Hotels Ltd. as at 31st March, 20X2
Particulars Note `
No
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 13,00,000
b Reserves and Surplus 2 2,68,745
2 Non-current liabilities
a Long-term borrowings 3 2,00,000
3 Current liabilities
a Trade Payables 4 42,000
b Other current liabilities 5 13,280
Total 18,24,025
ASSETS
1 Non-current assets
i PPE 6 9,14,985
ii Intangible assets (Goodwill) 5,00,000
iii Non-current investments 2,72,300
2 Current assets
i Inventories 7 38,900
ii Trade receivables 19,260
iii Cash and bank balances 8 78,580
Total 18,24,025
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.37
Statement of Profit and Loss of International Hotels Ltd.
for the year ended 31st March, 20X2
Particulars Notes Amount
I. Revenue from operations 9 1,79,700
II. Other income 10 6,800
III. Total Income (I + II) 1,86,500
IV. Expenses:
Cost of materials consumed 11 25,060
Purchases of Inventory-in-Trade 12 45,800
Changes in inventories of finished goods work- 13 (9,700)
in-progress and Inventory-in-Trade
Employee benefits expense 14 29,580
Finance costs 15 12,000
Other expenses 16 40,200
Depreciation and amortisation expense 17 21,315
Total expenses 1,64,255
V. Profit (Loss) for the period (III - IV) 22,245
Notes to accounts
`
1 Share Capital
Equity share capital
Authorised
10,000 Equity shares of ` 100 each 10,00,000
Issued & subscribed
8,000 Equity Shares of ` 100 each (A) 8,00,000
Preference share capital
Authorised
5,000 6% Preference shares of ` 100 each 5,00,000
© The Institute of Chartered Accountants of India
11.38 ADVANCED ACCOUNTING
Issued & subscribed
5,000 6% Preference shares of ` 100 each (B) 5,00,000
Total (A + B) 13,00,000
2 Reserves and Surplus
Capital reserve [100 x (90 – 40)] 5,000
General reserve 2,00,000
Surplus (Profit & Loss A/c) 22,245
Add: Balance from previous year 41,500 63,745
Total 2,68,745
3 Long-term borrowings
Secured
6% Debentures 2,00,000
Total 2,00,000
4 Trade Payables 42,000
5 Other current liabilities
Wages and Salaries Outstanding 1,280
Interest on debentures 12,000 13,280
Total 13,280
6 PPE
Freehold land & Buildings 8,50,000
Less: Depreciation (17,000) 8,33,000
Furniture and Fittings 86,300
Less: Depreciation (4,315) 81,985
Total 9,14,985
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.39
7 Inventories
Wines, Cigarettes & Cigars, etc. 22,500
Foodstuffs 16,400
Total 38,900
8 Cash and bank balances
Cash and cash equivalents
Cash at bank 76,380
Cash in hand 2,200
Other bank balances Nil
Total 78,580
9 Revenue from operations
Sale of products
Wines, Cigarettes, Cigars etc. 68,400
Food 57,600 1,26,000
Sale of services
Room Rent 48,000
Billiards 5,700 53,700
Total 1,79,700
10 Other Income
Transfer fees 700
Miscellaneous Receipts 2,800
Discount received 3,300
Total 6,800
11 Cost of materials consumed
Opening Inventory 5,260
Add: Purchases during the year 36,200
Less: Closing Inventory (16,400) 25,060
Total 25,060
© The Institute of Chartered Accountants of India
11.40 ADVANCED ACCOUNTING
12 Purchases of Inventory-in-Trade
Wines, Cigarettes etc. 45,800
Total 45,800
13 Changes in inventories of finished goods
work-in-progress and Inventory-in-Trade
Wines, Cigarettes etc.
Opening Inventory 12,800
Less: Closing Inventory (22,500) (9,700)
Total (9,700)
14 Employee benefits expense
Wages and Salaries 28,300
Add: Wages and Salaries Outstanding 1,280 29,580
Total 29,580
15 Finance costs
Interest on Debentures (2,00,000 x 6%) 12,000
16 Other expenses
operating expenses
Rent, Rates and Taxes 8,900
Coal and Firewood 3,290
Laundry 750
Carriage and Cooliage 810
Repairs 4,250 18,000
Selling and administrative expenses
Advertising 8,360
Sundry Expenses 5,840 14,200
Preliminary expenses written off 8,000
Total 40,200
17 Depreciation and amortisation expense
Land and Buildings (8,50,000 x 2%) 17,000
Furniture & Fittings (86,300 x 5%) 4,315 21,315
Total 21,315
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.41
Note: The final dividend will not be recognized as a liability at the balance sheet
date (even if it is declared after reporting date but before approval of the
financial statements) as per Accounting Standards. Hence, it has not been
recognized in the financial statements for the year ended 31 March, 20X2. Such
dividends will be disclosed in notes only.
Illustration 5
From the following particulars furnished by Pioneer Ltd., prepare the Balance Sheet
as at 31st March, 20X1 as required by Schedule III of the Companies Act. Give notes
at the foot of the Balance Sheet as may be found necessary -
Debit Credit
` `
Equity Capital (Face value of ` 100) 10,00,000
Calls in Arrears 1,000
Land 2,00,000
Building 3,50,000
Plant and Machinery 5,25,000
Furniture 50,000
General Reserve 2,10,000
Loan from State Financial Corporation 1,50,000
Inventory:
Finished Goods 2,00,000
Raw Materials 50,000 2,50,000
Provision for Taxation 68,000
Trade receivables 2,00,000
Advances 42,700
Dividend Payable 60,000
Profit and Loss Account 86,700
© The Institute of Chartered Accountants of India
11.42 ADVANCED ACCOUNTING
Cash Balance 30,000
Cash at Bank 2,47,000
Loans (Unsecured) 1,21,000
Trade payables (For Goods and Expenses) 2,00,000
18,95,700 18,95,700
The following additional information is also provided:
(1) 2,000 equity shares were issued for consideration other than cash.
(2) Trade receivables of ` 52,000 are due for more than six months.
(3) The cost of assets:
Building ` 4,00,000
Plant and Machinery ` 7,00,000
Furniture ` 62,500
(4) The balance of ` 1,50,000 in the loan account with State Finance Corporation
is inclusive of ` 7,500 for interest accrued but not due. The loan is secured by
hypothecation of the Plant and Machinery.
(5) Balance at Bank includes ` 2,000 with Perfect Bank Ltd., which is not a
Scheduled Bank.
(6) The company had contract for the erection of machinery at ` 1,50,000 which
is still incomplete.
Solution
Pioneer Ltd.
Balance Sheet as at 31st March, 20X1
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 9,99,000
b Reserves and Surplus 2 2,96,700
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.43
2 Non-current liabilities
a Long-term borrowings 3 2,63,500
3 Current liabilities
a Trade Payables 2,00,000
b Other current liabilities 4 67,500
c Short-term provisions 5 68,000
Total 18,94,700
Assets
1 Non-current assets
a PPE 6 11,25,000
2 Current assets
a Inventories 7 2,50,000
b Trade receivables 8 2,00,000
c Cash and bank balances 9 2,77,000
d Short-term loans and advances 42,700
Total 18,94,700
Notes to accounts
`
1 Share Capital
Equity share capital
Issued & subscribed & called up
10,000 Equity Shares of ` 100 each 10,00,000
(Of the above 2,000 shares have been
issued for consideration other than cash)
Less: Calls in arrears (1,000) 9,99,000
Total 9,99,000
2 Reserves and Surplus
General Reserve 2,10,000
Surplus (Profit & Loss A/c) 86,700
Total 2,96,700
© The Institute of Chartered Accountants of India
11.44 ADVANCED ACCOUNTING
3 Long-term borrowings
Secured- Term Loans
Loan from State Financial Corporation 1,42,500
(1,50,000 – 7,500)
(Secured by hypothecation of Plant and
Machinery)
Unsecured loan 1,21,000
Total 2,63,500
4 Other current liabilities
Interest accrued but not due on loans (SFC) 7,500
Dividend Payable 60,000
Total 67,500
5 Short-term provisions
Provision for taxation 68,000
Total 68,000
6 PPE
Land 2,00,000
Buildings 4,00,000
Less: Depreciation (50,000) (b.f.) 3,50,000
Plant & Machinery 7,00,000
Less: Depreciation (1,75,000) (b.f.) 5,25,000
Furniture & Fittings 62,500
Less: Depreciation (12,500) (b.f.) 50,000
Total 11,25,000
7 Inventories
Raw Material 50,000
Finished goods 2,00,000
Total 2,50,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.45
8 Trade receivables
Debts outstanding for a period exceeding six 52,000
months
Other Debts 1,48,000
Total 2,00,000
9 Cash and bank balances
Cash and cash equivalents
Cash at bank
with Scheduled Banks 2,45,000
with others (Perfect Bank Ltd.) 2,000 2,47,000
Cash in hand 30,000
Other bank balances Nil
Total 2,77,000
Note: Estimated amount of contract remaining to be executed on capital account
and not provided for ` 1,50,000. It has been assumed that the company had given
this contract for purchase of machinery.
Illustration 6
Following is the trial balance of Delta limited as on 31.3.20X2.
(Figures in ` ‘000)
Particulars Debit Particulars Credit
Land at cost 800 Equity share capital 500
(shares of
` 10 each)
Calls in arrears 5 10% Debentures 300
Cash in hand 2 General reserve 150
Plant & Machinery at cost 824 Profit & Loss A/c (balance 75
on 1.4.X1)
Trade receivables 120 Securities premium 40
Inventories (31-3-X2) 96 Sales 1200
© The Institute of Chartered Accountants of India
11.46 ADVANCED ACCOUNTING
Cash at Bank 28 Trade payables 30
Adjusted Purchases 400 Provision for depreciation 150
Factory expenses 80 Suspense Account 10
Administrative expenses 45
Selling expenses 25
Debenture Interest 30
2455 2455
Additional Information:
(i) The authorized share capital of the company is 80,000 shares of ` 10 each.
(ii) The company revalued the land at ` 9,60,000.
(iii) Equity share capital includes shares of ` 50,000 issued for consideration other
than cash.
(iv) Suspense account of ` 10,000 represents cash received from the sale of some
of the machinery on 1.4.20X1. The cost of the machinery was ` 24,000 and
the accumulated depreciation thereon being ` 20,000. The balance of Plant &
Machinery given in trial balance is before adjustment of sale of machinery.
(v) Depreciation is to be provided on plant and machinery at 10% on cost.
(vi) Balance at bank includes ` 5,000 with ABC Bank Ltd., which is not a Scheduled
Bank.
(vii) Make provision for income tax @30%.
(viii) Trade receivables of ` 50,000 are due for more than six months.
You are required to prepare Delta Limited's Balance Sheet as at 31.3.20X2 and
Statement of Profit and Loss with notes to accounts for the year ended 31.3.20X2 as
per Schedule Ill. Ignore previous year's figures & taxation.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.47
Solution
Delta Limited
Balance Sheet as at 31st March 20X2
Particulars Note No. (` in ‘000)
A. Equity and Liabilities
1. Shareholders’ funds
(a) Share Capital 1 495.00
(b) Reserves and Surplus 2 807.20
2. Non-Current Liabilities
(a) Long Term Borrowings 3 300.00
3. Current Liabilities
(a) Trade Payables 30.00
(b) Short- term provision 4 163.80
Total 1,796.00
B. Assets
1. Non-Current Assets
(a) Property, Plant and Equipment 5 1,550.00
2. Current Assets
(a) Inventories 96.00
(b) Trade Receivables 6 120.00
(c) Cash and Cash equivalents 7 30.00
Total 1,796.00
Statement of Profit and Loss for the year ended 31st March 20X2
Note
Particulars (` in ‘000)
No.
I. Revenue from Operations 1200.00
II. Other Income 8 6.00
III. Total Income (I +II) 1,206.00
IV. Expenses:
Purchases (adjusted) 400.00
© The Institute of Chartered Accountants of India
11.48 ADVANCED ACCOUNTING
Finance Costs 9 30.00
Depreciation (10% of 800) 80.00
Other expenses 10 150.00
Total Expenses 660.00
V. Profit / (Loss) for the period before tax (III – IV) 546.00
VI. Tax expenses @30% 163.80
VII Profit for the period 382.20
Notes to Accounts
Particulars (` in ‘000)
1 Share Capital
Equity Share Capital
Authorised
80,000 Shares of ` 10/- each 800
Issued, Subscribed and Called-up
50,000 Shares of ` 10/- each 500
(Out of the above 5,000 shares have been
issued for consideration other than cash)
Less: Calls in arrears (5) 495
2 Reserves and Surplus
Securities Premium 40.00
Revaluation Reserve ` (960 – 800) 160.00
General Reserve 150.00
Surplus i.e. Profit & Loss Account Balance
Opening Balance 75.00
Add: Profit for the period 382.20 457.20
807.20
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.49
3 Long-Term Borrowings
10% Debentures 300
4. Short – term provision
Provision for tax 163.80
5 Property, plant & equipment
Land
Opening Balance 800
Add: Revaluation adjustment 160
Closing Balance 960
Plant and Machinery
Opening Balance 824
Less: Disposed off (24)
800
Less: Depreciation ` (150 – 20 + 80) (210)
Closing Balance 590
Total 1,550
6 Trade receivables
Debits outstanding for a period exceeding six
50
months
Other debts 70 120
7 Cash and Cash Equivalents
Cash at Bank With scheduled banks 23
With others (ABC Bank Limited) 5
Cash in hand 2 30
8 Other Income
Profit on sale of machinery
Sale value of machinery 10
Less: Book value of machinery (24 – 20) (4) 6
9 Finance Costs
Debenture Interest 30
10 Other Expenses:
Factory expenses 80
Selling expenses 25
Administrative expenses 45 150
© The Institute of Chartered Accountants of India
11.50 ADVANCED ACCOUNTING
SUMMARY
Definitions of various types of companies as per the Companies Act, 2013.
Books of accounts should be maintained at Registered office of company.
Proper books are not deemed to be kept if they do not provide a true and
fair view of state of affairs of company.
A number of Statutory Books have been prescribed under Companies Act
which is to be maintained along with statistical books to keep a record of all
transactions.
Annual Return is to be filed by every company within 60 days of holding
Annual general meeting.
Financial statements of a company should be as per Schedule III to the
Companies Act, 2013 and they should give true and fair view.
Determining amount of profits available for distribution is an important
function and depends on a number of factors, like their composition, the
amount of provisions and appropriations that must be made out of them in
priority, etc.
Capital cannot be returned to shareholders by way of dividend.
Appropriating a part of profits may be done as a result of decision of Board
of directors or as per law.
Dividend may be declared out of reserves subject to certain conditions.
Dividends cannot be declared except out of profits.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.51
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. Trade payables as per Schedule III will include:
(a) Dues payable in respect to statutory obligation
(b) Interest accrued on trade payables
(c) Bills payables.
(d) Bills receivables
2. Securities Premium Account is shown on the liabilities side in the Balance
Sheet under the heading:
(a) Reserves and Surplus.
(b) Current Liabilities.
(c) Share Capital.
(d) Share application money pending allotment
3. “Fixed assets held for sale” will be classified in the company’s balance sheet as
(a) Current asset
(b) Non-current asset
(c) Capital work- in- progress
(d) Deferred tax assets
4. Current maturities of long- term debt will come under
(a) Current Liabilities.
(b) Short term borrowings.
(c) Long term borrowings.
(d) Short term provisions
© The Institute of Chartered Accountants of India
11.52 ADVANCED ACCOUNTING
5. Declaration of dividends for current year is made after providing for
(a) Depreciation of past years only.
(b) Depreciation on assets for the current year and arrears of depreciation
of past years (if any).
(c) Depreciation on current year only and by forgoing arrears of
depreciation of past years.
(d) Excluding current year depreciation
Theoretical Questions
6. State under which head these accounts should be classified in Balance Sheet,
as per Schedule III of the Companies Act, 2013:
(i) Share application money received in excess of issued share capital.
(ii) Share option outstanding account.
(iii) Unpaid matured debenture and interest accrued thereon.
(iv) Uncalled liability on shares and other partly paid investments.
(v) Calls unpaid.
(vi) Money received against share warrant.
Scenario based Questions
7. On 31st March, 20X1 Bose and Sen Ltd. provides to you the following ledger
balances after preparing its Profit and Loss Account for the year ended 31st
March, 20X1:
Credit Balances:
`
Equity shares capital, fully paid shares of ` 10 each 70,00,000
General Reserve 15,49,100
Loan from State Finance Corporation 10,50,000
(Secured by hypothecation of Plant & Machinery Repayable
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.53
within one year` 2,00,000)
Loans: Unsecured (Long term) 8,47,000
Sundry Creditors for goods &expenses 14,00,000
(Payable within 6 months)
Profit & Loss Account 7,00,000
Provision for Taxation 8,16,900
1,33,63,000
Debit Balances:
`
Calls in arrear 7,000
Land 14,00,000
Buildings 20,50,000
Plant and Machinery 36,75,000
Furniture& Fixture 3,50,000
Inventories: Finished goods 14,00,000
Raw Materials 3,50,000
Trade Receivables 14,00,000
Advances: Short-term 2,98,900
Cash in hand 2,10,000
Balances with banks 17,29,000
Preliminary Expenses 93,100
Patents & Trademarks 4,00,000
1,33,63,000
The following additional information is also provided in respect of the above
balances:
(i) 4,20,000 fully paid equity shares were allotted as consideration for land
& buildings.
(ii) Cost of Building ` 28,00,000
© The Institute of Chartered Accountants of India
11.54 ADVANCED ACCOUNTING
(iii) Cost of Plant & Machinery ` 49,00,000
Cost of Furniture & Fixture ` 4,37,500
(iv) Trade receivables for ` 3,80,000 are due for more than 6 months.
(v) The amount of Balances with Bank includes ` 18,000 with a bank which
is not a scheduled Bank and the deposits of ` 5 lakhs are for a period of
9 months.
(vi) Unsecured loan includes ` 2,00,000 from a Bank and ` 1,00,000 from
related parties.
(vii) Entire amount of Preliminary expenses to be written off, by adjusting
from opening balance of General Reserve.
You are not required to give previous year’s figures. You are required to
prepare the Balance Sheet of the Company as on 31stMarch, 20X1 as required
under Schedule III to the Companies Act, 2013.
8. From the following particulars furnished by Alpha Ltd., prepare the Balance
Sheet as on 31st March 20X1 as required by Part I, Schedule III to the
Companies Act, 2013.
Particulars Debit ` Credit `
Equity Share Capital (Face value of ` 50,00,000
100 each)
Call in Arrears 5,000
Land & Building 27,50,000
Plant & Machinery 26,25,000
Furniture 2,50,000
General Reserve 10,50,000
Loan from State Financial Corporation 7,50,000
Inventory:
Raw Materials 2,50,000
Finished Goods 10,00,000 12,50,000
Provision for Taxation 6,40,000
Trade receivables 10,00,000
Short term Advances 2,13,500
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.55
Profit & Loss Account 4,33,500
Cash in Hand 1,50,000
Cash at Bank 12,35,000
Unsecured Loan 6,05,000
Trade payables (for Goods and 8,00,000
Expenses)
Loans & advances from related parties 2,00,000
94,78,500 94,78,500
The following additional information is also provided:
(i) 10,000 Equity shares were issued for consideration other than cash.
(ii) Trade receivables of ` 2,60,000 are due for more than 6 months.
(iii) The cost of the Assets were:
Building ` 30,00,000, Plant & Machinery ` 35,00,000 and Furniture
` 3,12,500
(iv) The balance of ` 7,50,000 in the Loan Account with State Finance
Corporation is inclusive of ` 37,500 for Interest Accrued but not Due.
The loan is secured by hypothecation of Plant & Machinery.
(v) Balance at Bank includes ` 10,000 with Omega Bank Ltd., which is not a
Scheduled Bank.
(vi) Transfer ` 20,000 to general reserve is proposed by Board of directors.
(vii) Board of directors declared dividend of 5% on the paid up capital on 2nd April,
20X1.
9. Ring Ltd. was registered with a nominal capital of ` 10,00,000 divided into
shares of ` 100 each. The following Trial Balance is extracted from the books
on 31st March, 20X2:
Particulars ` Particulars `
Buildings 5,80,000 Sales 10,40,000
Machinery 2,00,000 Outstanding Expenses 4,000
Closing Stock 1,80,000 Provision for Doubtful 6,000
Loose Tools 46,000 Debts (1-4-20X1)
© The Institute of Chartered Accountants of India
11.56 ADVANCED ACCOUNTING
Purchases (finished 4,20,000 Equity Share Capital 4,00,000
goods)
Salaries 1,20,000 General Reserve 80,000
Directors’ Fees 20,000 Profit and Loss A/c 50,000
Rent 52,000 (1-4-20X1)
Depreciation 40,000 Creditors 1,84,000
Bad Debts 12,000 Provision for depreciation:
Investment 2,40,000 On Building 1,00,000
Interest accrued on 4,000 On Machinery 1,10,000 2,10,000
investment
Debenture Interest 56,000 14% Debentures 4,00,000
Advance Tax 1,20,000 Interest on Debentures 28,000
Sundry expenses 36,000 accrued but not due
Debtors 2,50,000 Interest on Investments 24,000
Bank 60,000 Unclaimed dividend 10,000
24,36,000 24,36,000
You are required to prepare statement of Profit and Loss for the year ending
31st March, 20X2 and Balance sheet as at that date after taking into
consideration the following information:
(a) Closing stock is more than opening stock by ` 1,60,000.
(b) Provide to doubtful debts @ 4% on Debtors.
(c) Make a provision for income tax @30%.
(d) Depreciation expense included depreciation of ` 16,000 on Building and
that of ` 24,000 on Machinery.
(e) The directors declared a dividend @ 25% on 2nd April, 20X2 and transfer
to General Reserve @ 10%.
(f) Bills Discounted but not yet matured ` 20,000.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.57
10. On 31st March, 20X1, SR Ltd. provides the following ledger balances after
preparing its Profit & Loss Account for the year ended 31st March, 20X1.
Particulars Amount (`)
Debit Credit
Equity Share Capital, fully paid shares of ` 50 80,00,000
each
Calls in arrear 15,000
Land 25,00,000
Buildings 30,00,000
Plant & Machinery 24,00,000
Furniture & Fixture 13,00,000
Securities Premium 15,00,000
General Reserve 9,41,000
Profit & Loss Account 5,80,000
Loan from Public Finance Corporation (Secured 26,30,000
by Hypothecation of Land)
Other Long Term Loans 22,50,000
Short Term Borrowings 4,60,000
Inventories: Finished goods 45,00,000
Raw materials 13,00,000
Trade Receivables 17,50,000
Advances: Short Term 3,75,000
Trade Payables 8,13,000
Provision for Taxation 3,80,000
Unpaid Dividend 70,000
Cash in Hand 70,000
Balances with Banks 4,14,000
Total 1,76,24,000 1,76,24,000
The following additional information was also provided in respect of the
above balances:
(1) 50,000 fully paid equity shares were allotted as consideration for land.
© The Institute of Chartered Accountants of India
11.58 ADVANCED ACCOUNTING
(2) The cost of assets were:
Building ` 32,00,000
Plant and Machinery ` 30,00,000
Furniture and Fixture ` 16,50,000
(3) Trade Receivables for ` 4,86,000 due for more than 6 months.
(4) Balances with banks include ` 56,000, the Naya bank, which is not a
scheduled bank.
(5) Loan from Public Finance Corporation repayable after 3 years.
(6) The balance of ` 26,30,000 in the loan account with Public Finance
Corporation is inclusive of `1,34,000 for interest accrued but not due.
The loan is secured by hypothecation of land.
(7) Other long term loans (unsecured) includes:
Loan taken from Nixes Bank ` 13,80,000
(Amount repayable within one year ` 4,80,000)
Loan taken from Directors ` 8,50,000
(8) Bills Receivable for ` 1,60,000 maturing on 15th June, 20X1 has been
discounted.
(9) Short term borrowings includes:
Loan from Naya bank ` 1,16,000 (Secured)
Loan from directors ` 48,000
(10) Transfer of ` 35,000 to general reserve has been proposed by the Board
of directors out of the profits for the year.
(11) Inventory of finished goods includes loose tools costing ` 5 lakhs (which
do not meet definition of property, plant & equipment as per AS 10)
You are required to prepare the Balance Sheet of the Company as on March 31st
20X1 as required under Part - I of Schedule III of the Companies Act, 2013.
You are not required to give previous year figures.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.59
ANSWERS/HINTS
Answer to the Multiple Choice Questions
1. (c) 2. (a) 3. (a) 4. (b) 5. (b)
Answer to the Theoretical Questions
6. (i) Current Liabilities/ Other Current Liabilities
(ii) Shareholders' Fund / Reserve & Surplus
(iii) Current liabilities/Other Current Liabilities
(iv) Contingent Liabilities and Commitments
(v) Shareholders' Fund / Share Capital
(vi) Shareholders' Fund / Money received against share warrants
Answer to the Scenario based Questions
7. Bose and Sen Ltd.
Balance Sheet as at 31st March, 20X1
Particulars Notes Figures at the
end of current
reporting period
(` )
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 69,93,000
b Reserves and Surplus 2 21,56,000
2 Non-current liabilities
a Long-term borrowings 3 16,97,000
3 Current liabilities
a Trade Payables 14,00,000
© The Institute of Chartered Accountants of India
11.60 ADVANCED ACCOUNTING
b Short term borrowings 4 2,00,000
c Short-term provisions 5 8,16,900
Total 1,32,62,900
Assets
1 Non-current assets
a PPE 6 74,75,000
b Intangible assets (Patents & Trade 4,00,000
Marks)
2 Current assets
a Inventories 7 17,50,000
b Trade receivables 8 14,00,000
c Cash and bank balances 9 19,39,000
d Short-term loans and advances 2,98,900
Total 1,32,62,900
Notes to accounts
`
1 Share Capital
Equity share capital
Issued, subscribed and called up
7,00,000 Equity Shares of ` 10 each 70,00,000
(Out of the above 4,20,000 shares
have been issued for consideration
other than cash)
Less: Calls in arrears (7,000) 69,93,000
Total 69,93,000
2 Reserves and Surplus
General Reserve 15,49,100
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.61
Less: Preliminary expenses (93,100) 14,56,000
Surplus (Profit & Loss A/c) 7,00,000
Total 21,56,000
3 Long-term borrowings
Secured
Term Loans
Loan from State Finance Corporation 8,50,000
(` 10,50,000 - ` 2,00,000) (Secured
by hypothecation of Plant and
Machinery)
Unsecured
Bank Loan 2,00,000
Loan from related parties 1,00,000
Others 5,47,000 8,47,000
Total 16,97,000
4 Short term borrowings
Current maturities of long-term 2,00,000
debt- loan Instalment repayable
within one year
5 Short-term provisions
Provision for taxation 8,16,900
6 Property, plant and equipment
Land 14,00,000
Buildings 28,00,000
Less: Depreciation (7,50,000) (b.f.) 20,50,000
Plant & Machinery 49,00,000
Less: Depreciation (12,25,000) 36,75,000
(b.f.)
Furniture & Fittings 4,37,500
© The Institute of Chartered Accountants of India
11.62 ADVANCED ACCOUNTING
Less: Depreciation (87,500) (b.f.) 3,50,000
Total 74,75,000
7 Inventories
Raw Material 3,50,000
Finished goods 14,00,000
17,50,000
8 Trade receivables
Debts outstanding for a period 3,80,000
exceeding six months
Other Debts 10,20,000
Total 14,00,000
9 Cash and bank balances
Cash and cash equivalents
Cash at bank with Scheduled Banks 12,11,000
with others 18,000 12,29,000
Cash in hand 2,10,000
Other bank balances
Bank deposits for period of 9 5,00,000
months
Total 19,39,000
8. Alpha Ltd.
Balance Sheet as at 31st March, 20X1
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 49,95,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.63
b Reserves and Surplus 2 14,83,500
2 Non-current liabilities
Long-term borrowings 3 13,17,500
3 Current liabilities
a Trade Payables 8,00,000
b Short-term provisions 5 6,40,000
c Short-term borrowings 4 2,00,000
d Other Current Liabilities: Interest accrued
but not due on loans (SFC) 37,500
Total 94,73,500
Assets
1 Non-current assets
PPE 6 56,25,000
2 Current assets
a Inventories 7 12,50,000
b Trade receivables 8 10,00,000
c Cash and bank balances 9 13,85,000
d Short-term loans and advances 2,13,500
Total 94,73,500
Notes to accounts
`
1 Share Capital
Equity share capital
Issued & subscribed & called up
50,000 Equity Shares of ` 100 each
(of the above 10,000 shares have been
issued for consideration other than cash) 50,00,000
© The Institute of Chartered Accountants of India
11.64 ADVANCED ACCOUNTING
Less: Calls in arrears (5,000) 49,95,000
Total 49,95,000
2 Reserves and Surplus
General Reserve 10,50,000
Add: current year transfer 20,000 10,70,000
Profit & Loss balance
Profit for the year 4,33,500
Less: Appropriations:
Transfer to General reserve (20,000) 4,13,500
Total 14,83,500
3 Long-term borrowings
Secured Term Loan
State Financial Corporation Loan
(7,50,000-37,500) 7,12,500
(Secured by hypothecation of Plant and
Machinery)
Unsecured Loan 6,05,000
Total 13,17,500
4 Short term Borrowings
Loans and advances 2,00,000
5 Short-term provisions
Provision for taxation 6,40,000
6 Property, plant and equipment
Land and Building 30,00,000
Less: Depreciation (2,50,000) (b.f.) 27,50,000
Plant & Machinery 35,00,000
Less: Depreciation (8,75,000) (b.f.) 26,25,000
Furniture & Fittings 3,12,500
Less: Depreciation (62,500) (b.f.) 2,50,000
Total 56,25,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.65
7 Inventories
Raw Materials 2,50,000
Finished goods 10,00,000
Total 12,50,000
8 Trade receivables
Outstanding for a period exceeding six 2,60,000
months
Other Amounts 7,40,000
Total 10,00,000
9 Cash and bank balances
Cash and cash equivalents
Cash at bank
with Scheduled Banks 12,25,000
with others (Omega Bank Ltd.) 10,000 12,35,000
Cash in hand 1,50,000
Other bank balances Nil
Total 13,85,000
Note: The final dividend will not be recognized as a liability at the balance
sheet date (even if it is declared after reporting date but before approval of
the financial statements) as per Accounting Standards. Hence, it has not
been recognized in the financial statements for the year ended 31 March,
20X1. Such dividends will be disclosed in notes only.
9. Ring Ltd.
Profit and Loss Statement for the year ended 31st March, 20X2
Particulars Note No. (` In lacs)
I Revenue from operations 10,40,000
II Other income (interest on investment) 24,000
III Total income [I + II] 10,64,000
© The Institute of Chartered Accountants of India
11.66 ADVANCED ACCOUNTING
IV Expenses:
Cost of purchase [4,20,000+ 1,60,000] 5,80,000
Changes in inventories [20,000-1,80,000] (1,60,000)
Employee Benefits Expense 1,20,000
Finance Costs (debenture interest) 56,000
Depreciation and Amortisation Expenses 40,000
Other Expenses 8 1,24,000
Total Expenses 7,60,000
V Profit before Tax (III-IV) 3,04,000
VI Tax Expenses @ 30% (91,200)
VII Profit for the period 2,12,800
Balance Sheet of Ring Ltd. as at 31ST March, 20X2
Particulars Note `
No.
I EQUITY AND LIABILITIES
(1) Shareholders’ Funds
(a) Share Capital 1 4,00,000
(b) Reserves and Surplus 2 3,42,800
(2) Non-Current Liabilities
(a) Long-term Borrowings (14% 4,00,000
debentures)
(3) Current Liabilities
(a) Trade Payable (Sundry Creditors) 1,84,000
(b) Other Current Liabilities 3 42,000
(c) Short-Term Provisions 4 91,200
Total 14,60,000
II ASSETS
(1) Non-Current Assets
(a) PPE 5 5,70,000
(b) Non-current Investments 2,40,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.67
(2) Current Assets
(a) Inventories 6 2,26,000
(b) Trade Receivables 7 2,40,000
(c) Cash and bank balances 60,000
(d) Short Term Loans and Advances 1,20,000
(Advance Payment of Tax)
(e) Other Current Assets 4,000
(Interest accrued on investments)
Total 14,60,000
Note: There is a Contingent Liability for bills discounted but not yet matured
amounting to ` 20,000.
Notes to Accounts:
1. Share Capital
Authorised Capital
10,000 Equity Shares of ` 100 each 10,00,000
Issued Capital
4,000 Equity Shares of ` 100 each 4,00,000
Subscribed Capital and fully paid
4,000 Equity Shares of ` 100 each 4,00,000
2. Reserve and Surplus
General Reserve [` 80,000 + ` 21,280] 1,01,280
Balance of Statement of Profit & Loss Account
Opening Balance 50,000
Add: Profit for the period 2,12,800
2,62,800
Appropriations
Transfer to General Reserve @ 10% (21,280) 2,41,520
3,42,800
© The Institute of Chartered Accountants of India
11.68 ADVANCED ACCOUNTING
3. Other Current Liabilities
Unclaimed Dividend 10,000
Outstanding Expenses 4,000
Interest accrued on Debentures 28,000
42,000
4. Short-Term Provision
Provision for Tax 91,200
5 Property, plant and equipment
Buildings 5,80,000
Less: Provision for Depreciation 1,00,000 4,80,000
Plant and Equipment 2,00,000
Less: Provision for Depreciation 1,10,000 90,000
5,70,000
6 Inventories
Closing Stock of Finished Goods 1,80,000
Loose Tools 46,000 2,26,000
7 Trade Receivables
Sundry Debtors 2,50,000
Less: Provision for Doubtful Debts (10,000) 2,40,000
8. Other Expenses
Rent 52,000
Directors’ Fees 20,000
Bad Debts 12,000
Provision for Doubtful Debts (4% of ` 2,50,000 4,000
less ` 6,000)
Sundry Expenses 36,000
1,24,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.69
Note: The final dividend will not be recognized as a liability at the balance
sheet date (even if it is declared after reporting date but before approval of
the financial statements) as per Accounting Standards. Hence, it has not
been recognized in the financial statements for the year ended 31 March,
20X2. Such dividends will be disclosed in notes only.
10. SR Ltd.
Balance Sheet as at 31st March, 20X1
Particulars Notes Figures at the end of
current reporting
period (`)
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 79,85,000
b Reserves and Surplus 2 30,21,000
2 Non-current liabilities
a Long-term borrowings 3 42,66,000
3 Current liabilities
a Short-term borrowings 4 9,40,000
b Trade Payables 8,13,000
c Other current liabilities 5 2,04,000
d Short-term provisions 6 3,80,000
Total 1,76,09,000
Assets
1 Non-current assets
a PPE 7 92,00,000
2 Current assets
a Inventories 8 58,00,000
b Trade receivables 9 17,50,000
c Cash and cash equivalents 10 4,84,000
d Short-term loans and advances 3,75,000
Total 1,76,09,000
© The Institute of Chartered Accountants of India
11.70 ADVANCED ACCOUNTING
Notes to accounts
`
1. Share Capital
Equity share capital
Issued, subscribed and called up
1,60,000 Equity Shares of ` 50 each 80,00,000
(Out of the above 50,000 shares have
been issued for consideration other than
cash)
Less: Calls in arrears (15,000) 79,85,000
2. Reserves and Surplus
General Reserve 9,41,000
Add: Transferred from Profit and loss
account 35,000 9,76,000
Securities premium 15,00,000
Surplus (Profit & Loss A/c) 5,80,000
Less: Appropriation to General Reserve
(proposed) (35,000) 5,45,000
30,21,000
3. Long-term borrowings
Secured: Term Loans
Loan from Public Finance 24,96,000
Corporation [repayable after 3years
(` 26,30,000 - ` 1,34,000 for interest
accrued but not due)]
(secured by hypothecation of land)
Unsecured
Bank Loan (Nixes bank) 9,00,000
(` 13,80,000 - ` 4,80,000
repayable within 1 year)
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.71
Loan from Directors 8,50,000
Others 20,000 17,70,000
Total 42,66,000
4. Short-term borrowings
Loan from Naya bank (Secured) 1,16,000
Loan from Nixes bank repayable 4,80,000
within one year (Current maturity of
Long term borrowing)
Loan from Directors 48,000
Others 2,96,000 9,40,000
5. Other current liabilities
Unpaid dividend 70,000
Interest accrued but not due on 1,34,000 2,04,000
borrowings
6. Short-term provisions
Provision for taxation 3,80,000
7. PPE
Land 25,00,000
Buildings 32,00,000
Less: Depreciation (2,00,000) 30,00,000
Plant & Machinery 30,00,000
Less: Depreciation (6,00,000) 24,00,000
Furniture & Fittings 16,50,000
Less: Depreciation (3,50,000) 13,00,000
Total 92,00,000
8. Inventories
Raw Material 13,00,000
Finished goods 40,00,000
© The Institute of Chartered Accountants of India
11.72 ADVANCED ACCOUNTING
Loose tools 5,00,000 58,00,000
9. Trade receivables
Outstanding for a period exceeding six 4,86,000
months
Others 12,64,000
Total 17,50,000
10. Cash and cash equivalents
Balances with banks
with Scheduled Banks 3,58,000
with others banks 56,000 4,14,000
Cash in hand 70,000
Total 4,84,000
Note: There is a contingent liability amounting to ` 1,60,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.73
UNIT 2: CASH FLOW STATEMENTS
LEARNING OUTCOMES
After studying this unit, you will be able to–
♦ Define cash flow statement as per AS 3 “Cash Flow Statements”.
♦ Differentiate operating, investing and financing activities.
♦ Learn the various elements of cash and cash equivalents.
♦ Prepare cash flow statement both by direct method and indirect
method.
UNIT OVERVIEW
Difference
Definition & Meaning of Cash between Preparation of
Significance of & cash operating, Cash Flow
cash flow equivalents and investing and Statement
statement Cash flow financing as per AS 3.
activities.
2.1 INTRODUCTION
Information about the cash flows of an enterprise is useful in providing users of
financial statements with a basis to assess the ability of the enterprise to generate
cash and cash equivalents and the needs of the enterprise to utilise those cash
flows. The economic decisions that are taken by users require an evaluation of the
ability of an enterprise to generate cash and cash equivalents and the timing and
certainty of their generation.
© The Institute of Chartered Accountants of India
11.74 ADVANCED ACCOUNTING
The Standard deals with the provision of information about the historical changes
in cash and cash equivalents of an enterprise by means of a cash flow statement
which classifies cash flows during the period from operating, investing and
financing activities.
This statement provides relevant information in assessing a company’s liquidity,
quality of earnings and solvency.
Cash receipts
Cash Flow
Statement is Cash
f payments
Benefits:
(a) Cash flow statement provides information about the changes in cash and
cash equivalents of an enterprise.
(b) Identifies cash generated from trading operations.
(c) The operating cash surplus which can be applied for investment in fixed
assets.
(d) Portion of cash from operations is used to pay dividend and tax and the
other portion is ploughed back.
(e) Very useful tool of planning.
Purpose:
Cash flow statements are prepared to explain the cash movements between two
points of time.
Sources of Cash:
1. Issue of shares and debentures and raising long-term loan.
2. Sale of investments and other fixed assets.
3. Cash from operations (Net Operating Profit).
Applications of Cash
1. Redemption of preference shares and debentures and repayment of long-
term loan.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.75
2. Purchase of investments and other fixed assets.
3. Payment of tax.
4. Payment of dividend.
5. Loss on Operation (Net Operating Loss)
Note: Cash includes Bank Account also. Increase in cash or decrease in cash is put
in the applications and the sources respectively just to balance the cash flow
statement. At this juncture, you may note that changes in all balance sheet items
are to be taken into consideration separately in cash flow statement for
explaining movement of cash.
2.2 ELEMENTS OF CASH
As per AS 3, issued by the Council of the ICAI,
‘Cash’ include:
(a) Cash in hand,
(b) Demand deposits with banks, and
Cash equivalents include:
(a) Components
Short term highly liquid investments that are readily convertible into
known amounts of cash and which are subject to an insignificant risk
of changes in value
Securities with short maturity period of, say, three months or less from
the date of acquisition
(b) Objective
Deploy, for a short period, idle cash required to meet short-term cash-
commitments.
(c) Examples
Acquisition of preference shares, shortly before their specified
redemption date, bank deposits with short maturity period, etc.
Conclusion: Thus, cash flow statement deals with flow of cash funds but does not
consider the movements among cash, bank balance payable on demand and
© The Institute of Chartered Accountants of India
11.76 ADVANCED ACCOUNTING
investment of excess cash in cash equivalents. Examples are cash withdrawn from
current account, cash deposited in bank for 60 days, etc.
2.3 CLASSIFICATION OF CASH FLOW
ACTIVITIES
AS 3 provides explanation for changes in cash position of the business entity. As
per Accounting Standard 3, cash flows during the period are classified as
Operating; Investing and Financing activities.
Cash Flow Activities
Inflow of Activities Outflow of Activities
Cash increase Cash decrease
Classification of Cash Flow Activities
Financing activities
Operating activities Investing activities
(changes in the size and
(principle revenue (acquisition and disposal
composition of the
generating) of long-term assets and owner’s capital and
other investments) borrowings)
2.3.1 Operating Activities
1. Definition: These are the principal revenue generating activities of the
enterprise.
2. Net Impact: Net impact of operating activities on flow of cash is reported as
‘Cash flows from operating activities’ or ‘cash from operations’.
3. Key Indicator: The amount of cash flows from operating activities is a key
indicator of the extent to which the operations of the enterprises have
generated sufficient cash flows to:
(a) Maintain the operating capability of the enterprise;
(b) Pay dividends, repay loans; and
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.77
(c) Make new investments without recourse to external sources of
financing.
4. Information Provided: It provides useful information about financing
through working capital.
5. Benefits: Information about the specific components of historical operating
cash flows is useful, in conjunction with other information, in forecasting
future operating cash flows.
Cash flows arising from operating activities
Key indicator of the extent to Example
which the operations of the entity
have generated sufficient cash (a) Cash receipts from the sale of goods and the
flows to rendering of services
(b) Cash receipts from royalties, fees,
• repay loans commissions, and other revenue
• maintain the operating
(c) Cash payments to suppliers for goods and
capability of the entity services
• pay dividends (d) Cash payments to and on behalf of employees
• make new investments without
(e) Cash receipts and cash payments of an
recourse to external sources of insurance entity for premiums and claims,
financing annuities, and other policy benefits
(f) Cash payments or refunds of income taxes
Primarily derived from the unless they can be specifically identified with
financing and investing activities
principal revenue-producing
(g) cash receipts and payments relating to futures
activities of the entity
contracts, forward contracts, option contracts
and swap contracts when the contracts are
held for dealing or trading purposes.
Generally, result from the
(h) Cash flows arising from the purchase and sale
transactions and other events that
of dealing or trading securities
have role in the determination of
(i) Cash advances and loans made by financial
net profit or loss institutions since they relate to their main
revenue-producing activity.
2.3.2 Investing activities
1. Definition: These are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
© The Institute of Chartered Accountants of India
11.78 ADVANCED ACCOUNTING
2. Separate Disclosure: Separate disclosure of cash flows arising from investing
activities is important because the cash flows represent the extent to which the
expenditures have been made for resources intended to generate future
incomes and cash flows.
Cash flows arising from investing activities
Represent the extent to
Examples
which expenditures have
been made for resources
intended to generate
future income and cash (a) cash payments to acquire fixed assets (including
intangibles). These payments include those relating to
flows
capitalised research and development costs and self-
constructed fixed assets;
(b) cash receipts from sales of property, plant and
equipment, intangibles and other long-term assets;
(c) cash payments to acquire equity or debt instruments
of other entities and interests in joint ventures (other
than payments for those instruments considered to be
cash equivalents or those held for dealing or trading
purposes);
(d) cash receipts from sales of equity or debt instruments
of other entities and interests in joint ventures (other
than receipts for those instruments considered to be
cash equivalents and those held for dealing or trading
purposes);
(e) cash advances and loans made to other parties (other
than advances and loans made by a financial
institution);
(f) cash receipts from the repayment of advances and
loans made to other parties (other than advances and
loans of a financial institution);
(g) cash payments for futures contracts, forward
contracts, option contracts and swap contracts except
when the contracts are held for dealing or trading
purposes, or the payments are classified as financing
activities; and
(h) cash receipts from futures contracts, forward
contracts, option contracts and swap contracts except
when the contracts are held for dealing or trading
purposes, or the receipts are classified as financing
activities.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.79
2.3.3 Financing activities
1. Definition: These are the activities that result in changes in the size and
composition of the owner’s capital (including preference share capital) and
borrowings of the enterprise.
2. Separate Disclosure: The separate disclosure of cash flows arising from
financing activities is important because it is useful in predicting claims on
future cash flows by providers of funds (both capital and borrowings) to the
enterprise.
Cash flows arising from financing activities
useful in predicting claims Examples
on future cash flows by
providers of capital to the
entity
(a) cash proceeds from issuing shares or
other equity instruments;
(b) cash payments to owners to acquire or
redeem the entity’s shares;
(c) cash proceeds from issuing debentures,
loans, notes, bonds, mortgages and other
short-term or long-term borrowings;
(d) cash repayments of amounts borrowed;
and
(e) cash payments by a lessee for the
reduction of the outstanding liability
relating to a finance lease.
© The Institute of Chartered Accountants of India
11.80 ADVANCED ACCOUNTING
2.4 CALCULATION OF CASH FLOWS FROM
OPERATING ACTIVITIES
1. Components: Cash flows from operating activities result from the
transactions and other events that enter into the determination of net profit
or loss.
2. Methods: An enterprise can determine cash flows from operating activities
using either:
Methods
Direct Method Indirect Method
(a) Direct Method: The direct method, whereby major classes of gross
cash receipts and gross cash payments are considered; or
(b) Indirect Method: The indirect method, whereby net profit or loss is
adjusted for the effects of transactions of a non-cash nature, deferrals
or accruals of past or future operating cash receipts or payments, and
items of income or expense associated with investing or financing
activities.
2.4.1 Direct Method
1. Information Required
(a) Gross receipts and gross cash payments may be obtained from the
accounting records to ascertain cash flows from operating activities.
(b) For example,
(i) information about cash received from trade receivables,
(ii) payment to trade payables, cash expenses etc., which may be
obtained by an analysis of cash book.
(c) In actual practice, the relevant information is obtained by adjusting
sales, cost of sales and other items in the profit and loss accounts for:
Changes during the period in inventories and operating
receivables and payables;
Other non-cash items such as depreciation on fixed assets,
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.81
goodwill written off, preliminary expenses written off, loss or
gain on sale of fixed assets etc.; and
Other items for which the cash effects are investing or financing
cash flows. Examples are interest received and paid, dividend
received and paid etc., which are related to financing or
investing activities and are shown separately in the cash flow
statement.
2. The direct method provides information which may be useful in estimating
future cash flows and which is not available under the indirect method and
is, therefore, considered more appropriate than the indirect method.
3. However, indirect method of determining the cash from operating activities
is more popular in actual practice.
2.4.2 Indirect Method
Under the indirect method, the net cash from operating activities is determined
by adjusting net profit or loss instead of individual items appearing in the profit
and loss account. Net profit or loss is also adjusted for the effect of:
(a) changes during the period in inventories and operating receivables and
payables;
(b) non-cash items such as depreciation; and
(c) all other items for which the cash effects are financing or investing cash
flows.
2.4.3 Conclusion
1. It is worth noting that both direct and indirect methods adjust current
assets and current liabilities related to operating activities to determine cash
from operating activities.
2. But direct method adjust individual items of profit and loss account and
indirect method adjusts overall net profit (or loss) to determine cash from
operation.
3. Therefore, indirect method fails to provide break-up of cash from
operations.
© The Institute of Chartered Accountants of India
11.82 ADVANCED ACCOUNTING
Proforma of ‘Cash Flow from Operating Activities’ by indirect method
`
Net Profit for the year -
Add: Non-Cash and Non-Operating Expenses: -
Depreciation -
Loss on Sale of Assets -
Provision for taxation, etc. -
Less: Non-Cash and Non-Operating Incomes:
Profit on Sale of Assets -
Net Profit after Adjustment for Non-Cash Items (-)
Cash from = Net Profit (after adjustment for Non-cash Items)
operation
- Increase in Current Assets
+ Decrease in Current Assets
+ Increase in Current Liabilities
- Decrease in Current Liabilities
2.5 CALCULATION OF CASH FLOWS FROM
INVESTING ACTIVITIES
1. These activities are related to the acquisition and disposal of long-term assets,
non-operating current assets and investments which results in outflow of cash.
2. Disposal of the aforesaid assets results in inflow of cash.
3. Thus, inflows and outflows related to acquisition and disposal of assets,
other than those related to operating activities, are shown under this
category.
2.6 CALCULATION OF CASH FLOWS FROM
FINANCING ACTIVITIES
1. These activities are basically related to the changes in capital and borrowing
of the enterprise which affect flow of cash.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.83
2. Redemption of shares and repayment of borrowings results in outflow of cash.
3. Thus inflows and outflows related to the amount of capital and borrowings
of the enterprise are shown under this head.
Note: Students are advised to refer full text of Accounting Standard on Cash
Flow Statements (AS 3) for the better understanding of the chapter.
2.7 ILLUSTRATIONS
Illustration 1
Intelligent 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
(vi) Insurance claim received against loss of fixed asset by fire
Discuss in the context of AS 3 Cash Flow Statement.
Solution
(i) Loans and advances given and interest earned
(1) to suppliers Operating Cash flow
(2) to employees Operating Cash flow
(3) to its subsidiary companies Investing Cash flow
© The Institute of Chartered Accountants of India
11.84 ADVANCED ACCOUNTING
(ii) Investment made in subsidiary company and dividend received
Investing Cash flow
(iii) Dividend paid for the year
Financing Cash Outflow
(iv) TDS on interest income earned on investments made
Investing Cash Outflow
(v) TDS on interest earned on advance given to suppliers
Operating Cash Outflow
(vi) Insurance claim received of amount loss of fixed asset by fire
Extraordinary item to be shown under a separate heading as ‘Cash inflow
from investing activities’.
Illustration 2
Following are extracts of the Balance Sheets of Ajay Ltd.:
Particulars Notes 31.3.20X1 31.3.20X2
` `
Equity and Liabilities
Shareholder’s funds
(a) Share capital 1 5,00,000 5,00,000
(b) Reserve & surplus 2 50,000 90,000
Non-current liabilities
(a) Long-term borrowings 3 5,00,000 7,50,000
Current liabilities
(a) Other current liabilities 4 --- 5,000
Assets
Non-current assets
(a) Intangible assets 5 2,05,000 1,80,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.85
Notes to accounts
31.3.20X1 31.3.20X2
` `
1 Share Capital
50,000 Equity Shares of `10 each 5,00,000 5,00,000
2 Reserve & surplus
Profit & Loss A/c 50,000 90,000
3 Long-term borrowings
10% Debentures 5,00,000 7,50,000
4 Other current liabilities
Unpaid interest --- 5,000
5 Intangible assets
Goodwill 2,05,000 1,80,000
You are required to show the related items in Cash Flow Statement.
Solution
An Extract of Cash Flow Statement for the year ending 31.3.20X2
`
Cash flows from operating activities:
Closing balance as per Profit & Loss A/c 90,000
Less: Opening balance as per Profit & Loss Alc (50,000)
Add: Goodwill amortisation 25,000
Add: Interest on Debentures (Refer Note 1) 75,000
Net Cash from Operating Activities 1,40,000
Note 1 : Interest has been computed on the closing balance of debentures as on
31.3.20X2 assuming that all the additions/ deletions were made, if any, at the
beginning of the year.
© The Institute of Chartered Accountants of India
11.86 ADVANCED ACCOUNTING
Cash flows from financing activities:
Proceeds from debentures (Refer Working Note) 2,50,000
Interest paid on Debentures [less unpaid] (70,000)
Net Cash from Financing Activities 1,80,000
Working Note:
10% Debentures Account
Particulars ` Particular `
To Balance c/d 7,50,000 By Balance b/d 5,00,000
By Bank A/c (Bal. fig.) 2,50,000
7,50,000 7,50,000
Illustration 3
From the following information, calculate cash flow from operating activities:
Summary of Cash Account
for the year ended March 31, 20X1
Particulars ` Particulars `
To Balance b/d 1,00,000 By Cash Purchases 1,20,000
To Cash sales 1,40,000 By Trade payables 1,57,000
To Trade receivables 1,75,000 By Office & Selling 75,000
Expenses
To Trade Commission 50,000 By Income Tax 30,000
To Sale of Investment 30,000 By Investment 25,000
To Loan from Bank 1,00,000 By Repayment of Loan 75,000
To Interest & Dividend 1,000 By Interest on loan 10,000
By Balance c/d 1,04,000
5,96,000 5,96,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.87
Solution
Cash Flow Statement of ……
for the year ended March 31, 20X1(Direct Method)
Particulars ` `
Operating Activities:
Cash received from sale of goods 1,40,000
Cash received from Trade receivables 1,75,000
Trade Commission received 50,000 3,65,000
Less: Payment for Cash Purchases 1,20,000
Payment to Trade payables 1,57,000
Office and Selling Expenses 75,000
Payment for Income Tax 30,000 (3,82,000)
Net Cash Flow used in Operating Activities (17,000)
Illustration 4
The following summary cash account has been extracted from the company’s
accounting records:
Summary Cash Account
(` ’000)
Balance at 1.3.20X1 35
Receipts from customers 2,783
Issue of shares 300
Sale of fixed assets 128
3,246
Payments to suppliers 2,047
Payments for property, plant & equipment 230
Payments for overheads 115
© The Institute of Chartered Accountants of India
11.88 ADVANCED ACCOUNTING
Wages and salaries 69
Taxation 243
Dividends 80
Repayments of bank loan 250 (3,034)
Balance at 31.3.20X2 212
Prepare Cash Flow Statement of this company Hills Ltd. for the year ended 31st
March, 20X2 in accordance with AS-3 (Revised).
The company does not have any cash equivalents.
Solution
Hills Ltd.
Cash Flow Statement for the year ended 31st March, 20X2
(Using direct method)
(` ’000)
Cash flows from operating activities
Cash receipts from customers 2,783
Cash payments to suppliers (2,047)
Cash paid to employees (69)
Other cash payments (for overheads) (115)
Cash generated from operations 552
Income taxes paid (243)
Net cash from operating activities 309
Cash flows from investing activities
Payments for purchase of fixed assets (230)
Proceeds from sale of fixed assets 128
Net cash used in investing activities (102)
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.89
Cash flows from financing activities
Proceeds from issuance of share capital 300
Bank loan repaid (250)
Dividend paid (80)
Net cash used in financing activities (30)
Net increase in cash and cash equivalents 177
Cash and cash equivalents at beginning of period 35
Cash and cash equivalents at end of period 212
Illustration 5
Prepare cash flow statement of M/s MNT Ltd. for the year ended 31st March, 20X1
with the help of the following information:
(1) Company sold goods for cash only.
(2) Gross Profit Ratio was 30% for the year, gross profit amounts to ` 3,82,500.
(3) Opening inventory was lesser than closing inventory by ` 35,000.
(4) Wages paid during the year ` 4,92,500.
(5) Office and selling expenses paid during the year ` 75,000.
(6) Dividend paid during the year ` 30,000.
(7) Bank loan repaid during the year ` 2,15,000 (included interest ` 15,000).
(8) Trade payables on 31st March, 20X0 exceed the balance on 31st March, 20X1
by ` 25,000.
(9) Amount paid to trade payables during the year ` 4,60,000.
(10) Tax paid during the year amounts to ` 65,000 (Provision for taxation as on
31.03.20X1` 45,000).
(11) Investments of ` 7,00,000 sold during the year at a profit of ` 20,000.
(12) Depreciation on fixed assets amounts to ` 85,000.
(13) Plant and machinery purchased on 15th November, 20X0 for ` 2,50,000.
(14) Cash and Cash Equivalents on 31st March, 20X0` 2,00,000.
(15) Cash and Cash Equivalents on 31st March, 20X1` 6,07,500.
© The Institute of Chartered Accountants of India
11.90 ADVANCED ACCOUNTING
Solution
M/s MNT Ltd.
Cash Flow Statement for the year ended 31st March, 20X1
(Using direct method)
Particulars ` `
Cash flows from Operating Activities
Cash sales (` 3,82,500/.30) 12,75,000
Less: Cash payments for trade payables (4,60,000)
Wages Paid (4,92,500)
Office and selling expenses (75,000) (10,27,500)
Cash generated from operations before taxes 2,47,500
Income tax paid (65,000)
Net cash generated from operating activities (A) 1,82,500
Cash flows from investing activities
Sale of investments (7,00,000 + 20,000) 7,20,000
Payments for purchase of Plant & machinery (2,50,000)
Net cash used in investing activities (B) 4,70,000
Cash flows from financing activities
Bank loan repayment (including interest) (2,15,000)
Dividend paid (30,000)
Net cash used in financing activities (C) (2,45,000)
Net increase in cash (A+B+C) 4,07,500
Cash and cash equivalents at beginning of the
period 2,00,000
Cash and cash equivalents at end of the period 6,07,500
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.91
Illustration 6
Ryan Ltd provides you the following information at the year-end, March 31, 20X1:
` `
Sales 6,98,000
Cost of Goods Sold (5,20,000)
1,78,000
Operating Expenses
(including Depreciation Expense of ` 37,000) (1,47,000)
31,000
Other Income / (Expenses):
Interest Expense paid (23,000)
Interest Income received 6,000
Gain on Sale of Investments 12,000
Loss on Sale of Plant (3,000)
(8,000)
23,000
Income tax (7,000)
16,000
Information available:
31st March 31st March
20X1 20X0
` `
Plant 7,15,000 5,05,000
Less: Accumulated Depreciation (1,03,000) (68,000)
6,12,000 4,37,000
© The Institute of Chartered Accountants of India
11.92 ADVANCED ACCOUNTING
Investments (Long term) 1,15,000 1,27,000
Inventory 1,44,000 1,10,000
Trade receivables 47,000 55,000
Cash 46,000 15,000
Prepaid expenses 1,000 5,000
Share Capital 4,65,000 3,15,000
Reserves and surplus 1,40,000 1,32,000
Bonds 2,95,000 2,45,000
Trade payables 50,000 43,000
Outstanding liabilities 12,000 9,000
Income taxes payable 3,000 5,000
Analysis of selected accounts and transactions during 20X0-X1
1. Purchased investments for ` 78,000.
2. Sold investments for ` 1,02,000. These investments cost ` 90,000.
3. Purchased plant assets for ` 1,20,000.
4. Sold plant assets that cost `10,000 with accumulated depreciation of ` 2,000
for ` 5,000.
5. Issued ` 1,00,000 of bonds at face value in an exchange for plant assets on
31st March, 20X1.
6. Repaid ` 50,000 of bonds at face value at maturity.
7. Issued 15,000 shares of ` 10 each.
8. Paid cash dividends ` 8,000.
Prepare Cash Flow Statement as per AS-3 (Revised), using indirect method.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.93
Solution
Ryan Ltd.
Cash Flow Statement
for the year ending 31st March, 20X1
` `
Cash flows from operating activities
Net profit before taxation 23,000
Adjustments for:
Depreciation 37,000
Gain on sale of investments (12,000)
Loss on sale of plant assets 3,000
Interest expense 23,000
Interest income (6,000)
Operating profit before working capital changes 68,000
Decrease in trade receivables 8,000
Increase in inventory (34,000)
Decrease in prepaid expenses 4,000
Increase in trade payables 7,000
Increase in outstanding liabilities 3,000
Cash generated from operations 56,000
Income taxes paid* (9,000)
Net cash generated from operating activities 47,000
Cash flows from investing activities
Purchase of plant (1,20,000)
Sale of plant 5,000
Purchase of investments (78,000)
© The Institute of Chartered Accountants of India
11.94 ADVANCED ACCOUNTING
Sale of investments 1,02,000
Interest received 6,000
Net cash used in investing activities (85,000)
Cash flows from financing activities
Proceeds from issuance of share capital 1,50,000
Repayment of bonds (50,000)
Interest paid (23,000)
Dividends paid (8,000)
Net cash from financing activities 69,000
Net increase in cash and cash equivalents 31,000
Cash and cash equivalents at the beginning of the 15,000
period
Cash and cash equivalents at the end of the 46,000
period
Note: Significant non-cash adjustments: Issued ₹ 1,00,000 of bonds at face value
for acquisition of plant on 31st March, 20X1.
*Working Note:
`
Income taxes paid:
Income tax expense for the year 7,000
Add: Income tax liability at the beginning of the year 5,000
12,000
Less: Income tax liability at the end of the year (3,000)
9,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.95
Illustration 7
The balance sheets of Sun Ltd. as at 31st March 20X1 and 20X0 were as:
Particulars Notes 20X1 20X0
` `
Equity and Liabilities
1 Shareholder’s funds
(a) Share capital 1 60,000 50,000
(b) Reserve & surplus 2 5,000 4,000
2 Current liabilities
(a) Trade Payables 4,000 2,500
(b) Other current liabilities 3 - 1,000
(c) Short term provision (provision for tax) 1,500 1,000
Total 70,500 58,500
Assets
1 Non-current assets
(a) Property, Plant & Equipment 4 39,500 29,000
2 Current assets
(a) Current investments 2,000 1,000
(b) Inventories 17,000 14,000
(c) Trade receivables 8,000 6,000
(d) Cash & cash equivalents 5 4,000 8,500
70,500 58,500
© The Institute of Chartered Accountants of India
11.96 ADVANCED ACCOUNTING
Notes to accounts
20X1 20X0
` `
1 Share Capital
Equity Shares of `10 each 60,000 50,000
2 Reserve & surplus
Profit and Loss Account 5,000 4,000
3 Other current liabilities
Dividend Payable - 1,000
4 Property, plant and equipment (at WDV)
Building 10,000 10,000
Fixtures 17,000 11,000
Vehicles 12,500 8,000
Total 39,500 29,000
5 Cash and cash equivalents
Cash and Bank 4,000 8,500
The profit and loss statement for the year ended 31st March, 20X1 disclosed:
Particulars `
Profit before tax 4,500
Tax expense: Current tax (1,500)
Profit for the year 3,000
Declared dividend (2,000)
Retained Profit 1,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.97
Further information is available:
Fixtures Vehicles
` `
Depreciation for the year 1,000 2,500
Disposals:
Proceeds on disposal of vehicles — 1,700
Written down value — (1,000)
Profit on disposal 700
Prepare a Cash Flow Statement for the year ended 31st March, 20X1.
Solution
Sun Ltd.
Cash Flow Statement
for the year ended 31st March, 20X1
` `
Cash flows from operating activities
Net Profit before taxation 4,500
Adjustments for:
Depreciation 3,500
Profit on sale of vehicles (1,700 – 1,000) (700)
Operating profit before working capital changes 7,300
Increase in Trade receivables (2,000)
Increase in inventories (3,000)
Increase in Trade payables 1,500
Cash generated from operations 3,800
Income taxes paid (W.N.1) (1,000)
Net cash generated from operating activities 2,800
© The Institute of Chartered Accountants of India
11.98 ADVANCED ACCOUNTING
Cash flows from investing activities
Sale of vehicles 1,700
Purchase of current investments (1,000)
Purchase of vehicles (W.N.3) (8,000)
Purchase of fixtures (W.N.3) (7,000)
Net cash used in investing activities (14,300)
Cash flows from financing activities
Issue of shares for cash 10,000
Dividends paid (W.N.2) (3,000)
Net cash generated from financing activities 7,000
Net decrease in cash and cash equivalents (4,500)
Cash and cash equivalents at beginning of period
(See Note) 8,500
Cash and cash equivalents at end of period
(See Note) 4,000
Note to the Cash Flow Statement
Cash and Cash Equivalents
31.3.20X1 31.3.20X0
Bank and Cash 4,000 8,500
Cash and cash equivalents 4,000 8,500
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.99
Working Notes:
`
1. Income taxes paid
Income tax expense for the year 1,500
Add: Income tax liability at the beginning of the year 1,000
2,500
Less: Income tax liability at the end of the year (1,500)
1,000
2. Dividend paid
Declared dividend for the year 2,000
Add: Amount payable at the beginning of the year 1,000
3,000
Less: Amount payable at the end of the year -
3,000
3. Property, plant and equipment acquisitions
Fixtures Vehicles
` `
W.D.V. at 31.3.20X1 17,000 12,500
Add back:
Depreciation for the year 1,000 2,500
Disposals — 1,000
18,000 16,000
Less: W.D.V. at 31.12.20X0 (11,000 (8,000)
)
Acquisitions during 20X0-20X1 7,000 8,000
Note: Current investments may not be readily convertible to a known amount of
cash and may not be subject to an insignificant risk of changes in value as per the
requirements of AS 3 and hence those have been considered as investing
activities.
© The Institute of Chartered Accountants of India
11.100 ADVANCED ACCOUNTING
Illustration 8
Ms. Jyoti of Star Oils Limited has collected the following information for the
preparation of cash flow statement for the year ended 31st March, 20X1:
(` in lakhs)
Net Profit 25,000
Dividend paid 8,535
Provision for Income tax 5,000
Income tax paid during the year 4,248
Loss on sale of assets (net) 40
Book value of the assets sold 185
Depreciation charged to the Statement of Profit and Loss 20,000
Profit on sale of Investments 100
Carrying amount of Investment sold 27,765
Interest income received on investments 2,506
Interest expenses of the year 10,000
Interest paid during the year 10,520
Increase in Working Capital (excluding Cash & Bank Balance) 56,081
Purchase of Fixed assets 14,560
Investment in joint venture 3,850
Expenditure on construction work in progress 34,740
Proceeds from calls in arrear 2
Receipt of grant for capital projects 12
Proceeds from long-term borrowings 25,980
Proceeds from short-term borrowings 20,575
Opening cash and bank balance 5,003
Closing cash and bank balance 6,988
Prepare the Cash Flow Statement for the year ended 31 March 20X1 in accordance
with AS 3. (Make necessary assumptions)
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.101
Solution
Star Oils Limited
Cash Flow Statement
for the year ended 31st March, 20X1
(` in lakhs)
Cash flows from operating activities
Net profit before taxation (25,000 + 5,000) 30,000
Adjustments for :
Depreciation 20,000
Loss on sale of assets (Net) 40
Profit on sale of investments (100)
Interest income on investments (2,506)
Interest expenses 10,000
Operating profit before working capital changes 57,434
Changes in working capital (Excluding cash and bank (56,081)
balance)
Cash generated from operations 1,353
Income taxes paid (4,248)
Net cash used in operating activities (2,895)
Cash flows from investing activities
Sale of assets (W.N.1) 145
Sale of investments (27,765 + 100) 27,865
Receipt of grant for capital projects 12
Interest income on investments 2,506
Purchase of fixed assets (14,560)
Investment in joint venture (3,850)
Expenditure on construction work-in progress (34,740)
Net cash used in investing activities (22,622)
© The Institute of Chartered Accountants of India
11.102 ADVANCED ACCOUNTING
Cash flows from financing activities
Proceeds from calls in arrear 2
Proceeds from long-term borrowings 25,980
Proceed from short-term borrowings 20,575
Interest paid (10,520)
Dividend (including dividend tax) paid (8,535) 27,502
Net increase in cash and cash equivalents 1,985
Cash and cash equivalents at the beginning of the 5,003
period
Cash and cash equivalents at the end of the period 6,988
Working note:
1. Book value of the assets sold 185
Less : Loss on sale of assets (40)
Proceeds on sale 145
Illustration 9
From the following Summary Cash Account of X Ltd. prepare Cash Flow Statement
for the year ended 31st March, 20X1 in accordance with AS 3 (Revised) using the
direct method. The company does not have any cash equivalents.
Summary Cash Account for the year ended 31.3.20X1
`’000 `’000
Balance on 1.4.20X0 50 Payment to Suppliers 2,000
Issue of Equity Shares 300 Purchase of Fixed Asset 200
Receipts from Customers 2,800 Overhead expense 200
Sale of Fixed Assets 100 Wages and Salaries 100
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.103
Taxation 250
Dividend 50
Repayment of Bank Loan 300
Balance on 31.3.20X1 150
3,250 3,250
Solution
X Ltd.
Cash Flow Statement for the year ended 31st March, 20X1
(Using direct method)
` ’000 ` ’000
Cash flows from operating activities
Cash receipts from customers 2,800
Cash payments to suppliers (2,000)
Cash paid to employees (100)
Cash payments for overheads (200)
Cash generated from operations 500
Income tax paid (250)
Net cash generated from operating activities 250
Cash flows from investing activities
Payments for purchase of fixed assets (200)
Proceeds from sale of fixed assets 100
Net cash used in investing activities (100)
Cash flows from financing activities
Proceeds from issuance of equity shares 300
Bank loan repaid (300)
Dividend paid (50)
Net cash used in financing activities (50)
Net increase in cash 100
Cash at the beginning of the year 50
Cash at the end of the year 150
© The Institute of Chartered Accountants of India
11.104 ADVANCED ACCOUNTING
Illustration 10
Given below are the relevant extracts of the Balance Sheet and the Statement of
Profit and Loss of ABC Ltd. along with additional information:
Extract of Balance sheet
Particulars Notes 31.3.20X1 31.3.20X0
(` in lakhs) (` in lakhs)
Equity and Liabilities
1 Current liabilities
(a) Trade Payables 250 230
(b) Short term Provisions 1 200 180
(c) Other current liabilities 2 70 50
Assets
1 Current assets
(a) Inventories 200 180
(b) Trade Receivables 400 250
(c) Other current assets 3 195 180
Statement of Profit and Loss of ABC Ltd.
for the year ended 31st March, 20X1
Particulars Notes ` in lakhs
I Revenue from operations 4,150
II Other income 4 100
III Total income (I + II) 4,250
Expenses:
Purchases of Stock-in-Trade 2,400
Change in inventories of finished goods (20)
Employee benefits expense 800
Depreciation expense 100
Finance cost 5 60
Other expenses 200
IV Total expenses 3,540
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.105
V Profit before tax (III – IV) 710
VI Tax expense:
Current tax 200
VII Profit for the year from 510
continuing operations
Appropriations
Balance of Profit and Loss account brought forward 50
Transfer to general reserve 200
Dividend paid 330
Notes to accounts:
20X1 20X0
(` in lakhs) (` in lakhs)
1 Short term Provisions:
Provision for Tax 200 180
2 Other current liabilities:
Outstanding wages 50 40
Outstanding expenses 20 10
Total 70 50
3 Other current assets:
Advance tax 195 180
4 Other income:
Interest and dividend 100
5 Finance cost:
Interest 60
Compute cash flow from operating activities using both direct and indirect method.
© The Institute of Chartered Accountants of India
11.106 ADVANCED ACCOUNTING
Solution
Cash Flows from Operating Activities
` in lakhs ` in lakhs
Using Direct Method
Cash Receipts:
Cash sales and collection from Trade
receivables
Sales + Opening Trade receivables – Closing 4,150 + 250 − 400 4,000
Trade receivables (A)
Cash payments:
Cash purchases & payment to Trade payables
Purchases + Opening Trade payables – 2,400 + 230 − 250 2,380
Closing Trade payables
Wages and salaries paid 800 + 40 − 50 790
Cash expenses 200 + 10 – 20 190
Taxes paid – Advance tax 195
(B) 3,555
Cash flow from operating activities (A – B) 445
Using Indirect Method
Profit before tax 710
Add: Non-cash items : Depreciation 100
Add: Interest : Financing cash inflow 60
Less: Interest and Dividend : Investment cash (100)
outflow
Less: Tax paid (195)
Working capital adjustments
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.107
Trade receivables 250−400 (150)
Inventories 180−200 (20)
Trade payables 250−230 20
Outstanding wages 50−40 10
Outstanding expenses 20−10 10 (130)
Cash flow from operating activities 445
Illustration 11
Prepare Cash flow for Gamma Ltd., for the year ending 31.3.20X1 from the
following information:
(1) Sales for the year amounted to ` 135 crores out of which 60% was cash sales.
(2) Purchases for the year amounted to ` 55 crores out of which credit purchase
was 80%.
(3) Administrative and selling expenses amounted to ` 18 crores and salary paid
amounted to ` 22 crores.
(4) The Company redeemed debentures of ` 20 crores at a premium of 10%.
Debenture holders were issued equity shares of ` 15 crores towards
redemption and the balance was paid in cash. Debenture interest paid during
the year was ` 1.5 crores.
(5) Dividend paid during the year amounted to ` 11.7 crores.
(6) Investment costing ` 12 crores were sold at a profit of ` 2.4 crores.
(7) ` 8 crores was paid towards income tax during the year.
(8) A new plant costing ` 21 crores was purchased in part exchange of an old
plant. The book value of the old plant was ` 12 crores but the vendor took
over the old plant at a value of ` 10 crores only. The balance was paid in
cash to the vendor.
© The Institute of Chartered Accountants of India
11.108 ADVANCED ACCOUNTING
(9) The following balances are also provided:
` in crores ` in crores
1.4.20X0 31.3.20X1
Debtors 45 50
Creditors 21 23
Bank 6 18.2
Solution
Gamma Ltd.
Cash Flow Statement for the year ended 31st March, 20X1
(Using direct method)
Particulars ` in crores ` in crores
Cash flows from operating activities
Cash sales (60% of 135) 81
Cash receipts from Debtors 49
[45+ (135x40%) - 50]
Cash purchases (20% of 55) (11)
Cash payments to suppliers (42)
[21+ (55x80%) – 23]
Cash paid to employees (22)
Cash payments for overheads (Adm. and selling) (18)
Cash generated from operations 37
Income tax paid (8)
Net cash generated from operating activities 29
Cash flows from investing activities
Sale of investments (12+ 2.40) 14.4
Payments for purchase of fixed assets (21 – 10) (11)
Net cash generated from investing activities 3.4
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.109
Cash flows from financing activities
Redemption of debentures (22-15) (7)
Interest paid (1.5)
Dividend paid (11.7)
Net cash used in financing activities (20.2)
Net increase in cash 12.2
Cash at beginning of the period 6.0
Cash at end of the period 18.2
Significant non-cash items:
(a) Debenture-holders received equity shares of ₹ 15 crores on redemption of
the debentures.
(b) Plant having book value of ₹ 12 crores was given in exchange of an asset
costing ₹ 21 crores. The said plant was transferred at a value of ₹ 10 crores
only, and ₹ 11 crores was paid for the balance dues towards the plant.
Illustration 12
From the following information of Mr. Zen, prepare a Cash flow statement as per
AS-3 for the year ended 31.3.20X1:
Ledger balances of Mr. Zen as of 20X0 and 20X1
As on 1.4.20X0 As on 1.4.20X1
` `
Zen’s Capital A/c 10,00,000 12,24,000
Trade payables 3,20,000 3,52,000
Mrs. Zen’s loan 2,00,000 --
Loan from Bank 3,20,000 4,00,000
Land 6,00,000 8,80,000
Plant and Machinery (net block) 6,40,000 4,40,000
Inventories 2,80,000 2,00,000
Trade receivables 2,40,000 4,00,000
Cash 80,000 56,000
© The Institute of Chartered Accountants of India
11.110 ADVANCED ACCOUNTING
Additional information:
A machine costing ` 80,000 (accumulated depreciation there on `24,000) was sold
for ` 40,000. The provision for depreciation on 1.4.20X0 was ` 2,00,000 and
31.3.20X1 was ` 3,20,000. The net profit for the year ended on 31.3.20X1 was
` 3,60,000.
Solution
Cash Flow Statement of Mr. Zen as per AS 3
for the year ended 31.3.20X1
(i) Cash flow from operating activities
Net Profit (given) 3,60,000
Adjustments for
Depreciation on Plant & Machinery (W.N.2) 1,44,000
Loss on Sale of Machinery (W.N.1) 16,000 1,60,000
Operating Profit before working capital 5,20,000
changes
Decrease in inventories 80,000
Increase in trade receivables (1,60,000)
Increase in trade payables 32,000 (48,000)
Net cash generated from operating activities 4,72,000
(ii) Cash flow from investing activities
Sale of Machinery (W.N.1) 40,000
Purchase of Land (8,80,000 – 6,00,000) (2,80,000)
Net cash used in investing activities (2,40,000)
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.111
(iii) Cash flow from financing activities
Repayment of Mrs. Zen’s Loan (2,00,000)
Drawings (W.N.3) (1,36,000)
Loan from Bank 80,000
Net cash used in financing activities (2,56,000)
Net decrease in cash (24,000)
Opening balance as on 1.4.20X0 80,000
Cash balance as on 31.3.20X1 56,000
Working Notes:
1. Plant & Machinery A/c
` `
To Balance b/d 8,40,000 By Cash – Sales 40,000
(6,40,000 + 2,00,000) By Provision for 24,000
Depreciation A/c
By Profit & Loss A/c – 16,000
Loss on Sale (80,000 –
64,000)
By Balance c/d
(4,40,000+3,20,000) 7,60,000
8,40,000 8,40,000
2. Provision for depreciation on Plant and Machinery A/c
` `
To Plant and 24,000 By Balance b/d 2,00,000
Machinery A/c
To Balance c/d 3,20,000 By Profit & Loss A/c 1,44,000
(Bal. fig.)
3,44,000 3,44,000
© The Institute of Chartered Accountants of India
11.112 ADVANCED ACCOUNTING
3. To find out Mr. Zen’s drawings:
`
Opening Capital 10,00,000
Add: Net Profit 3,60,000
13,60,000
Less: Closing Capital (12,24,000)
Drawings 1,36,000
Note: Students may note that in case there is an increase in the amount of
debentures/ loans during the year and the interest is required to be
computed, then in such a case, students may choose either to compute
interest on the closing balance of the debentures or may compute interest
on opening balance for full year (in case of no repayment) and
proportionate interest on additions. Suitable note for assumption may be
given in the solution for this.
SUMMARY
• Cash flow statement dealt under AS 3.
• Benefits include providing information relating to changes in cash and cash
equivalents of an enterprise.
• Cash include:
(a) Cash in hand and (b) Demand deposits with banks
• Cash equivalents are short term, highly liquid investments that are readily
convertible into known amounts of cash and which are subject to an
insignificant risk of changes in value.
• Cash flow activities may be classified as inflow and outflow but as per AS-3
they are classified as Operating Activities, Investing activities, Financing
activities.
• Operating activities are principal revenue generating activities.
• Investing Activities relate to acquisition and disposal of long-term assets
and other investments.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.113
• Financing Activities include the ones which result in changes in the size and
composition of the owner’s capital (including preference share capital) and
borrowings of the enterprise.
• Methods to calculate cash flow from operating activities include:
(a) Direct Method
(b) Indirect Method
• In order to calculate cash flow from investing activities inflows and outflows
related to acquisition and disposal of assets, other than those related to
operating activities, are shown under this category.
• In order to calculate cash flow from financing activities inflows and outflows
related to the amount of capital and borrowings of the enterprise are shown
under this head.
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. While preparing cash flow statement, conversion of debt to equity
(a) Should be shown as a financing activity.
(b) Should be shown as an investing activity.
(c) Should not be shown as it is a non-cash transaction
(d) Should not be shown as operating activity.
2. Which of the following would be considered a ‘cash-flow item from an
“investing" activity’?
(a) Cash outflow to the government for payment of taxes.
(b) Cash outflow to purchase bonds issued by another company.
(c) Cash outflow to shareholders as dividends
(d) Cash outflow to make payment to trade payables.
© The Institute of Chartered Accountants of India
11.114 ADVANCED ACCOUNTING
3. All of the following would be included in a company’s operating activities
except:
(a) Income tax payments
(b) Collections from customers or Cash payments to suppliers
(c) Dividend payments
(d) Office and selling expenses.
4. Hari Uttam, a stock broking firm, received ` 1,50,000 as premium for forward
contracts entered for purchase of equity shares. How will you classify this
amount in the cash flow statement of the firm?
(a) Operating Activities.
(b) Investing Activities.
(c) Financing Activities.
(d) Non-cash transaction
5. As per AS 3 on Cash Flow Statements, cash received by a manufacturing
company from sale of shares of ABC Company Ltd. should be classified as
(a) Operating activity.
(b) Financing activity.
(c) Investing activity.
(d) Non-cash transaction
Theoretical Questions
6. What is the significance of cash flow statement? Explain in brief.
7. Explain the difference between direct and indirect methods of reporting cash
flows from operating activities with reference to AS 3.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.115
Scenario based Questions
8. Classify the following activities as (a) Operating activities, (b) Investing
activities (c) Financing activities (d) Cash equivalents with reference to AS 3
(Revised).
(a) Brokerage paid on purchase of investments
(b) Underwriting commission paid
(c) Trading commission received
(d) Proceeds from sale of investment
(e) Purchase of goodwill
(f) Redemption of preference shares
(g) Rent received from property held as investment
(h) Interest paid on long-term borrowings
(i) Marketable securities (having risk of change in value)
(j) Refund of income tax received
9. How will you disclose following items while preparing Cash Flow Statement of
Gagan Ltd. as per AS-3 for the year ended 31st March, 20X2?
(i) 10% Debentures issued: As on 01-04-20X1 ` 1,10,000
As on 31-03-20X2 ` 77,000
(ii) Debentures were redeemed at 5% premium at the end of the year.
Premium was charged to the Profit & Loss Account for the year.
(iii) Unpaid Interest on Debentures: As on 01-04-20X1 ` 275
As on 31-03-20X2 ` 1,175
(iv) Debtors of ` 36,000 were written off against the Provision for Doubtful
Debts A/c during the year.
(v) 10% Bonds (Investments): As on 01-04-20X1 ` 3,50,000
As on 31-03-20X2 ` 3,50,000
(vi) Accrued Interest on Investments: As on 31-03-20X2 ` 10,500
© The Institute of Chartered Accountants of India
11.116 ADVANCED ACCOUNTING
10. From the following Balance sheet of Grow More Ltd., prepare Cash Flow
Statement for the year ended 31st March, 20X1 :
Particulars Notes 31st March, 31st March,
20X1 20X0
Equity and Liabilities
1 Shareholders’ funds
A Share capital 10,00,000 8,00,000
B Reserves and Surplus 1 3,00,000 2,10,000
2 Non-current liabilities
Long term borrowings 2 2,00,000 -
3 Current liabilities
A Trade Payables 7,00,000 8,20,000
B Other current liabilities 3 - 1,00,000
C Short term provision 1,00,000 70,000
(provision for tax)
Total 23,00,000 20,00,000
Assets
1 Non-current assets
A Property, plant and 13,00,000 9,00,000
Equipment 4
B Non-Current Investments 1,00,000 -
2 Current assets
A Inventories 4,00,000 2,00,000
B Trade receivables 5,00,000 7,00,000
C Cash and Cash equivalents - 2,00,000
Total 23,00,000 20,00,000
Notes to accounts
No. Particulars 31st March, 20X1 31st March, 20X0
1 Reserves and Surplus
General reserve 2,00,000 1,50,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.117
Profit and Loss account 1,00,000 60,000
Total 3,00,000 2,10,000
2 Long term borrowings
Debentures (issued at end of 2,00,000 --
year)
3. Other current liabilities
Dividend payable - 1,00,000
4 Property, plant and
equipment
Plant and machinery 7,00,000 5,00,000
Land and building 6,00,000 4,00,000
Net carrying value 13,00,000 9,00,000
(i) Depreciation @ 25% was charged on the opening value of Plant and
Machinery.
(ii) At the year end, one old machine costing ` 50,000 (WDV ` 20,000) was
sold for ` 35,000. Purchase was also made at the year end.
(iii) ` 50,000 was paid towards Income tax during the year.
(iv) Construction of the building got completed on 31.03.20X1 and hence no
depreciation may be charged on the same.
Prepare Cash flow Statement.
11. From the following Balance Sheets and information, prepare Cash Flow
Statement of Ryan Ltd. by Indirect method for the year ended 31st March,
20X1:
Particulars Notes 31st March 31st March
20X1` 20X0 `
Equity and Liabilities
1 Shareholders’ funds
© The Institute of Chartered Accountants of India
11.118 ADVANCED ACCOUNTING
A Share capital 1 6,00,000 7,00,000
B Reserves and Surplus 2 4,20,000 3,00,000
2 Non-current liabilities
Long term borrowings 3 2,00,000 -
3 Current liabilities
A Trade Payables 1,15,000 1,10,000
B Other current liabilities 4 30,000 80,000
C Short term provision (provision for
tax) 95,000 60,000
Total 14,60,000 12,50,000
Assets
1 Non-current assets
A Property, plant and Equipment 5 9,15,000 7,00,000
B Non-Current Investments 50,000 80,000
2 Current assets
A Inventories 95,000 90,000
B Trade receivables 2,50,000 2,25,000
C Cash and Cash equivalents 50,000 90,000
D Other Current assets 1,00,000 65,000
Total 14,60,000 12,50,000
Notes to accounts
No. 31st March, 31st March,
20X1 20X0
1. Share capital
Equity share capital 6,00,000 5,00,000
10% Redeemable Preference share
capital -- 2,00,000
Total 6,00,000 7,00,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.119
2 Reserves and Surplus
Capital redemption reserve 1,00,000 -
Capital reserve 70,000 -
General reserve 1,50,000 2,50,000
Profit and Loss account 1,00,000 50,000
Total 4,20,000 3,00,000
3 Long term borrowings
9% Debentures 2,00,000 --
4. Other current liabilities
Dividend payable - 60,000
Liabilities for expenses 30,000 20,000
Total 30,000 80,000
5 Property, plant and equipment
Plant and machinery 7,65,000 5,00,000
Land and building 1,50,000 2,00,000
Net carrying value 9,15,000 7,00,000
Additional Information:
(i) A piece of land has been sold out for `1,50,000 (Cost – `1,20,000) and
the balance land was revalued. Capital Reserve consisted of profit on
revaluation of land.
(ii) On 1st April, 20X0 a plant was sold for `90,000 (Original Cost – `70,000
and W.D.V. – ` 50,000) and Debentures worth `1 lakh were issued at
par as part consideration for plant of `4.5 lakhs acquired.
(iii) Part of the investments (Cost – `50,000) was sold for `70,000.
© The Institute of Chartered Accountants of India
11.120 ADVANCED ACCOUNTING
(iv) Pre-acquisition dividend received `5,000 was adjusted against cost of
investment.
(v) Interim dividend was declared and paid @ 15% during the current year.
(vi) Income-tax liability for the current year was estimated at `1,35,000.
(vii) Depreciation @ 15% has been charged on Plant and Machinery but no
depreciation has been charged on Building.
12. The Balance Sheet of New Light Ltd. as at 31st March, 20X1 and 20X0 (for the
years ended) are as follows:
` `
Notes 31 March
st
31 March
st
20X0 20X1
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 16,00,000 18,80,000
B Reserves and Surplus 2 8,40,000 11,00,000
2 Non-current liabilities
Long term borrowings 3 4,00,000 2,80,000
3 Current liabilities
A Other current liabilities 4 6,00,000 5,20,000
B Short term provision
(provision for tax) 3,60,000 3,40,000
Total 38,00,000 41,20,000
Assets
1 Non-current assets
A Property, plant and 22,80,000 26,40,000
Equipment 5
B Non-Current Investments 4,00,000 3,20,000
2 Current assets
A Cash and Cash equivalents 10,000 10,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.121
B Other Current assets 11,10,000 11,50,000
Total 38,00,000 41,20,000
Notes to accounts
No. Particulars 31st March, 31st March,
20X0
20X1
1. Share capital
Equity share capital 12,00,000 16,00,000
10% Preference share capital 4,00,000 2,80,000
Total 16,00,000 18,80,000
2 Reserves and Surplus
General reserve 6,00,000 7,60,000
Profit and Loss account 2,40,000 3,40,000
Total 8,40,000 11,00,000
3 Long term borrowings
9% Debentures 4,00,000 2,80,000
Total 4,00,000 2,80,000
4. Other current liabilities
Dividend payable 1,20,000 -
Current Liabilities 4,80,000 5,20,000
Total 6,00,000 5,20,000
5 Property, plant and
equipment
Property, plant and equipment 32,00,000 38,00,000
Less: Depreciation (9,20,000) (11,60,000)
Net carrying value 22,80,000 26,40,000
Additional information:
(i) The company sold one property, plant and equipment for ` 1,00,000, the
© The Institute of Chartered Accountants of India
11.122 ADVANCED ACCOUNTING
cost of which was ` 2,00,000 and the depreciation provided on it was
`80,000.
(ii) The company also decided to write off another item of property, plant
and equipment costing ` 56,000 on which depreciation amounting to
` 40,000 has been provided.
(iii) Depreciation on property, plant and equipment provided ` 3,60,000.
(iv) Company sold some investment at a profit of ` 40,000.
(v) Debentures and preference share capital redeemed at 5% premium.
Debentures were redeemed at the year end.
(vi) Company decided to value inventory at cost, whereas previously the
practice was to value inventory at cost less 10%. The inventory
according to books on 31.3.20X0 was ` 2,16,000. The inventory on
31.3.20X1 was correctly valued at ` 3,00,000.
Prepare Cash Flow Statement as per revised Accounting Standard 3 by indirect
method.
13. ABC Ltd. gives you the Balance sheets as at 31st March 20X0 and 31st March
20X1. You are required to prepare Cash Flow Statement by using indirect
method as per AS 3 for the year ended 31st March 20X1:
Particulars Notes ` `
31st March 31st March
20X0 20X1
Equity and Liabilities
1 Shareholders’ funds
A Share capital 50,00,000 50,00,000
B Reserves and Surplus 26,50,000 36,90,000
2 Non-current liabilities
Long term borrowings 1 - 9,00,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.123
3 Current liabilities
A Short-term borrowings 1,50,000 3,00,000
(Bank loan)
B Trade payables 8,80,000 8,20,000
C Other current liabilities 2 4,80,000 2,70,000
Total 91,60,000 1,09,80,000
Assets
1 Non-current assets
A Property, plant and 21,20,000 32,80,000
Equipment 3
2 Current assets
A Current Investments 11,80,000 15,00,000
B Inventory 20,10,000 19,20,000
C Trade receivables 4 22,40,000 26,40,000
D Cash and Cash equivalents 15,20,000 15,20,000
E Other Current assets (Prepaid 90,000 1,20,000
expenses)
Total 91,60,000 1,09,80,000
Notes to accounts
No. Particulars `20X0 20X1
1 Long term borrowings
9% Debentures (issued at the end of year) - 9,00,000
Total - 9,00,000
2. Other current liabilities
Dividend payable 1,50,000 -
Liabilities for expenses 3,30,000 2,70,000
Total 4,80,000 2,70,000
© The Institute of Chartered Accountants of India
11.124 ADVANCED ACCOUNTING
3 Property, plant and equipment
Plant and machinery 27,30,000 40,70,000
Less: Depreciation (6,10,000) (7,90,000)
Net carrying value 21,20,000 32,80,000
4 Trade receivables
Gross amount 23,90,000 28,30,000
Less: Provision for doubtful debts (1,50,000) (1,90,000)
Total 22,40,000 26,40,000
Additional Information:
(i) Net profit for the year ended 31st March, 20X1, after charging
depreciation ` 1,80,000 is ` 10,40,000.
(ii) Trade receivables of ` 2,30,000 were determined to be worthless and
were written off against the provisions for doubtful debts account
during the year.
14. Following is the Balance Sheet of Fox Ltd. You are required to prepare cash
flow statement using Indirect Method.
Particulars Note 31st 31st
No. March,20X2 March,20X1
(`) (`)
(I) Equity and Liabilities
1. Shareholders’ Funds
(a) Share capital 1 5,60,000 3,00,000
(b) Reserve and Surplus 2 35,000 25,000
2. Current Liabilities
(a) Trade payables 1,50,000 60,000
(b) Short-term 8,000 5,000
provisions
(Provision for taxation)
Total 7,53,000 3,90,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.125
(II) Assets
1. Non-current assets
(a) Property, Plant and 3,50,000 1,80,000
Equipment
2. Current assets
(a) Inventories 1,20,000 50,000
(b) Trade receivables 1,00,000 25,000
(c) Cash and cash 1,05,000 90,000
equivalents
(d) Other current assets 78,000 45,000
Total 7,53,000 3,90,000
Notes to Accounts
Particulars 31st 31st
March,20X2 (`) March,20X1
(`)
1. Share capital
(a) Equity share capital 4,10,000 2,00,000
(b) Preference share capital 1,50,000 1,00,000
5,60,000 3,00,000
2. Reserve and surplus
Surplus in statement of profit and 25,000
loss at the beginning of the year
Add: Profit of the year 20,000
Less: Dividend (10,000)
Surplus in statement of profit and 35,000 25,000
loss at the end of the year
Additional Information:
1. Dividend paid during the year ` 10,000
2. Depreciation charges during the year ` 40,000.
© The Institute of Chartered Accountants of India
11.126 ADVANCED ACCOUNTING
ANSWERS/ HINTS
Answer to the Multiple Choice Questions
1. (c) 2. (b) 3. (c) 4. (a) 5. (c)
Answer to the Theoretical Questions
6. Cash flow statement provides information about the changes in cash and
cash equivalents of an enterprise. It identifies cash generated from trading
operations and is very useful tool of planning.
7. As per Para 18 of AS 3 (Revised) on Cash Flow Statements, an enterprise
should report cash flows from operating activities using either:
(a) The direct method, whereby major classes of gross cash receipts and
gross cash payments are disclosed; or
(b) the indirect method, whereby net profit or loss is adjusted for the
effects of transactions of a non-cash nature, any deferrals or accruals
of past or future operating cash receipts or payments, and items of
income or expense associated with investing or financing cash flows.
Answer to the Scenario based Questions
8. Classification of activities with reference to AS 3
a. Brokerage paid on purchased of Investing Activities
investments
b. Underwriting Commission paid Financing Activities
c. Trading Commission received Operating Activities
d. Proceeds from sale of investment Investing Activities
e. Purchase of goodwill Investing Activities
f. Redemption of Preference shares Financing Activities
g. Rent received from property held as Investing Activities
investment
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.127
h. Interest paid on long term borrowings Financing Activities
i. Marketable securities Not a Cash equivalent
j. Refund of Income tax received Operating activities
9. Cash Flow Statement of M/s Gagan Ltd.
for the year ended March 31, 20X2
A Cash Flow from Operating Activities
Net Profit as per Profit & Loss A/c xxxxx
Add: Premium on Redemption of Debentures 1,650
Add: Interest on 10% Debentures 11,000
Less: Interest on 10% Investments (35,000)
B Cash Flow from Investing Activities
Interest on Investments [35,000-10,500] 24,500
C Cash Flow from Financing Activities
Interest on Debentures paid [11,000 - (1,175 - 275)] -
(10,100)
outflow
Redemption of Debentures [(1,10,000 - 77,000) at 5%
(34,650)
premium] - outflow
Note: Debtors written off against provision for doubtful debts does not
require any further adjustment in Cash Flow Statement.
10. Cash Flow Statement of Grow More Ltd.
for the year ended 31st March, 20X1
Cash Flow from Operating Activities
Increase in balance of Profit and Loss Account 40,000
(1,00,000 – 60,000)
Provision for taxation (W.N.1) 80,000
Transfer to General Reserve (2,00,000 – 1,50,000) 50,000
Depreciation (W.N.2) 1,25,000
© The Institute of Chartered Accountants of India
11.128 ADVANCED ACCOUNTING
Profit on sale of Plant and Machinery (15,000)
Operating Profit before Working Capital changes 2,80,000
Increase in Inventories (2,00,000)
Decrease in Trade receivables 2,00,000
Decrease in Trade payables (1,20,000)
Cash generated from operations 1,60,000
Income tax paid (50,000)
Net Cash generated from operating activities 1,10,000
Cash Flow from Investing Activities
Purchase of fixed assets (3,45,000)
Expenses on building (6,00,000 – 4,00,000) (2,00,000)
Increase in investments (1,00,000)
Sale of old machine 35,000
Net Cash used in investing activities (6,10,000)
Cash Flow from Financing activities
Proceeds from issue of shares 2,00,000
(10,00,000 – 8,00,000)
Proceeds from issue of debentures 2,00,000
Dividend paid (1,00,000)
Net cash generated from financing activities 3,00,000
Net decrease in cash and cash equivalents (2,00,000)
Cash and Cash equivalents at the beginning of 2,00,000
the year
Cash and Cash equivalents at the end of the year Nil
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.129
Working Notes:
1. Provision for taxation account
` `
To Cash (Paid) 50,000 By Balance b/d 70,000
To Balance c/d 1,00,000 By Profit and Loss 80,000
A/c
(Balancing
figure)
1,50,000 1,50,000
2. Plant and Machinery account
` `
To Balance b/d 5,00,000 By Depreciation 1,25,000
To Profit and Loss A/c 15000
(profit on sale of
machine)
To Cash (Balancing 3,45,000 By Cash (sale of 35,000
figure) machine)
_______ By Balance c/d 7,00,000
8,60,000 8,60,000
11. Cash Flow Statement of Ryan Limited
For the year ended 31st March, 20X1
` `
Cash flow from operating activities
2,75,000
Net Profit before taxation (W.N.1)
Adjustment for
Depreciation (W.N.3) 1,35,000
Profit on sale of land (30,000)
© The Institute of Chartered Accountants of India
11.130 ADVANCED ACCOUNTING
Profit on sale of plant (W.N.3) (40,000)
Profit on sale of investments (W.N.4) (20,000)
Interest on debentures (2,00,000 X 9%) 18,000
Operating profit before working capital 3,38,000
changes
Increase in inventory (5,000)
Increase in trade receivables (25,000)
Increase in Other current assets (W.N.9) (35,000)
Increase in Trade payables 5,000
Increase in liabilities for expenses 10,000
Cash generated from operations 2,88,000
Income taxes paid (W.N.8) (1,00,000)
Net cash generated from operating activities 1,88,000
Cash flow from investing activities
Proceeds from sale of land (W.N.2) 1,50,000
Proceeds from sale of plant (W.N.3) 90,000
Proceeds from sale of investments (W.N.4) 70,000
Purchase of plant (W.N.3) (3,50,000)
Purchase of investments (W.N.4) (25,000)
Pre-acquisition dividend received (W.N.4) 5,000
Net cash used in investing activities (60,000)
Cash flow from financing activities
Proceeds from issue of equity shares 1,00,000
(6,00,000 – 5,00,000)
Proceeds from issue of debentures 1,00,000
(2,00,000 – 1,00,000)
Redemption of preference shares (2,00,000)
Dividends paid (1,50,000)
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.131
Interest paid on debentures (18,000)
Net cash used in financing activities (1,68,000)
Net decrease in cash and cash equivalents (40,000)
Cash and cash equivalents at the beginning of 90,000
the year
Cash and Cash equivalents at the end of the 50,000
year
Significant Non-cash Items:
Debentures amounting to ` 1,00,000 have been issued as part consideration
for acquisition of plant of ` 4,50,000.
Working Notes:
1. `
Net profit before taxation
Retained profit 1,00,000
Less: Balance as on 31.3.20X0 (50,000)
50,000
Provision for taxation 1,35,000
Dividend 90,000
2,75,000
2. Land and Building Account
` `
To Balance b/d 2,00,000 By Cash (Sale) 1,50,000
To Profit and Loss A/c 30,000 By Balance c/d 1,50,000
(Profit on sale)
To Capital reserve
(Revaluation profit) 70,000
3,00,000 3,00,000
© The Institute of Chartered Accountants of India
11.132 ADVANCED ACCOUNTING
3. Plant and Machinery Account
` `
To Balance b/d 5,00,000 By Cash (Sale) 90,000
To Profit and loss By Depreciation 1,35,000
account 40,000
To Debentures 1,00,000 By Balance c/d 7,65,000
To Bank 3,50,000
9,90,000 9,90,000
4. Investments Account
` `
To Balance b/d 80,000 By Cash (Sale) 70,000
To Profit and loss By Dividend
To account 20,000 (Pre-
Bank (Balancing acquisition) 5,000
figure) 25,000
By Balance c/d 50,000
1,25,000 1,25,000
5. Capital Reserve Account
` `
To Balance c/d 70,000 By Profit on
revaluation
of land 70,000
70,000 70,000
6. General Reserve Account
` `
To Capital redemption By Balance b/d 2,50,000
reserve 1,00,000
T0 Balance c/d 1,50,000
2,50,000 2,50,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.133
7. Dividend payable Account
` `
To Bank (Balancing By Balance b/d 60,000
figure) 1,50,000
To Balance c/d - By Profit and
loss
account 90,000
1,50,000 1,50,000
8. Provision for Taxation Account
` `
To Bank (Balancing 1,00,000 B Balance b/d 60,000
figure) y
To Balance c/d 95,000 B Profit and loss 1,35,000
y account
1,95,000 1,95,000
9. Other Current Assets Account
` `
To Balance b/d 65,000 By Balance c/d 1,00,000
To Bank (Balancing
figure) 35,000
1,00,000 1,00,000
12. New Light Ltd.
Cash Flow Statement for the year ended 31st March, 20X1
A. Cash Flow from operating activities ` `
Profit after appropriation
Increase in profit and loss A/c after inventory
adjustment [`3,40,000 – (`2,40,000 + 76,000
`24,000)]
© The Institute of Chartered Accountants of India
11.134 ADVANCED ACCOUNTING
Transfer to general reserve 1,60,000
Provision for tax 3,40,000
Net profit before taxation and extraordinary 5,76,000
item
Adjustments for:
Depreciation 3,60,000
Loss on sale of property, plant and equipment 20,000
Decrease in value of property, plant and 16,000
equipment
Profit on sale of investment (40,000)
Premium on redemption of preference share 6,000
capital
Interest on debentures 36,000
Premium on redemption of debentures 6,000
Operating profit before working capital 9,80,000
changes
Increase in current liabilities
(`5,20,000 –`4,80,000) 40,000
Increase in other current assets
[`11,50,000 – (` 11,10,000 + `24,000)] (16,000)
Cash generated from operations 10,04,000
Income taxes paid (3,60,000)
Net Cash generated from operating activities 6,44,000
B. Cash Flow from investing activities
Purchase of property, plant and equipment (8,56,000)
(W.N.3)
Proceeds from sale of property, plant and 1,00,000
equipment (W.N.3)
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.135
Proceeds from sale of investments (W.N.2) 1,20,000
Net Cash used in investing activities (6,36,000)
C. Cash Flow from financing activities
Proceeds from issuance of share capital 4,00,000
Redemption of preference share capital (1,26,000)
(`1,20,000 + `6,000)
Redemption of debentures (1,26,000)
(` 1,20,000 +` 6,000)
Dividend paid (1,20,000)
Interest on debentures (36,000)
Net Cash generated from financing activities (8,000)
Net increase/decrease in cash and cash Nil
equivalent during the year
Cash and cash equivalent at the beginning of 10,000
the year
Cash and cash equivalent at the end of the 10,000
year
Working Notes:
1. Revaluation of inventory will increase opening inventory by ` 24,000.
2,16,000/90 x 10 = ` 24,000
Therefore, opening balance of other current assets would be as
follows:
` 11,10,000 + ` 24,000 = ` 11,34,000
Due to under valuation of inventory, the opening balance of profit and
loss account be increased by ` 24,000.
The opening balance of profit and loss account after revaluation of
inventory will be ` 2,40,000 + ` 24,000 = ` 2,64,000
© The Institute of Chartered Accountants of India
11.136 ADVANCED ACCOUNTING
2. Investment Account
` `
To Balance b/d 4,00,000 By Bank A/c 1,20,000
To Profit and Loss (balancing figure
A/c being investment
sold)
(Profit on sale 40,000 By
3,20,000
of investment) Balance c/d
4,40,000 4,40,000
3. Property, Plant and Equipment Account
` ` `
To Balance b/d 32,00,000 By Bank A/c (sale 1,00,000
of assets)
To Bank A/c 8,56,000 By Accumulated
depreciation
(balancing
A/c
figure being 80,000
By
assets Profit and loss
purchased) A/c (loss
on sale of
assets) 20,000 2,00,000
By Accumulated
depreciation
A/c
40,000
By Profit and loss
A/c
(assets written
off)
16,000 56,000
By Balance c/d 38,00,000
40,56,000 40,56,000
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.137
4. Accumulated Depreciation Account
` `
To Property, 80,000 By Balance b/d 9,20,000
plant and
equipment
A/c
To Property, 40,000 By Profit and loss 3,60,000
plant and A/c (depreciation
equipment for the year)
A/c
To Balance c/d 11,60,000
12,80,000 12,80,000
13. Cash Flow Statement of ABC Ltd. for the year ended 31.3.20X1
Cash flows from Operating Activities ` `
Net Profit 10,40,000
Add: Adjustment For Depreciation (`7,90,000 – 1,80,000
`6,10,000)
Add: Adjustment for Provision for Doubtful Debts 2,70,000
(` 4,20,000 – `1,50,000)
Operating Profit Before Working Capital Changes 14,90,000
Add: Decrease in Inventories 90,000
(` 20,10,000 – ` 19,20,000)
15,80,000
Less: Increase in Current Assets
Trade Receivables
(` 30,60,000 – `23,90,000) 6,70,000
Prepaid Expenses (` 1,20,000 – `90,000) 30,000
© The Institute of Chartered Accountants of India
11.138 ADVANCED ACCOUNTING
Decrease in Current Liabilities:
Trade Payables (` 8,80,000 – ` 8,20,000) 60,000
Expenses Outstanding
(` 3,30,000 – ` 2,70,000) 60,000 (8,20,000)
Net Cash generated from Operating Activities 7,60,000
Cash Flows from Investing Activities
Investment in Current Investments (3,20,000)
Purchase of Plant & Machinery
(` 40,70,000 – ` 27,30,000)
(13,40,000)
Net Cash Used in Investing Activities (16,60,000)
Cash Flows from Financing Activities
Bank Loan Raised (` 3,00,000 – ` 1,50,000) 1,50,000
Issue of Debentures 9,00,000
Payment of Dividend (1,50,000)
Net Cash Used in Financing Activities 9,00,000
Net Increase in Cash During the Year -
Add: Cash and Cash Equivalents as on 1.4.20X0 15,20,000
Cash and Cash Equivalents as on 31.3.20X1 15,20,000
Note:
1. Bad debts amounting ` 2,30,000 were written off against provision for
doubtful debts account during the year. In the above solution, Bad
debts have been added back in the balances of provision for doubtful
debts and trade receivables as on 31.3.20X1. Alternatively, the
adjustment of writing off bad debts may be ignored and the solution
can be given on the basis of figures of trade receivables and provision
for doubtful debts as appearing in the balance sheet on 31.3.20X1.
© The Institute of Chartered Accountants of India
FINANCIAL STATEMENTS OF COMPANIES 11.139
2. Current investments (i.e. Marketable securities) may not be readily
convertible to a known amount of cash and be subject to an
insignificant risk of changes in value as per the requirements of AS 3
and hence those have been considered as investing activities.
14. Fox Ltd.
Cash Flow Statement for the year ended 31st March, 20X2
` `
Cash flows from operating activities
Net Profit (35,000 less 25,000) 10,000
Add: Dividend 10,000
Provision for tax 8,000
Net profit before taxation and extraordinary 28,000
items
Adjustments for:
Depreciation 40,000
Operating profit before working capital changes 68,000
Increase in trade receivables (75,000)
Increase in inventories (70,000)
Increase in other current assets (33,000)
Increase in trade payables 90,000 (88,000)
Cash used in operating activities (20,000)
Less: Tax paid* (5,000)
Net cash used in operating activities (25,000)
Cash flows from investing activities
Purchase of PPE (2,10,000)
Net cash used in investing activities (2,10,000)
© The Institute of Chartered Accountants of India
11.140 ADVANCED ACCOUNTING
Cash flows from financing activities
Issue of equity shares for cash 2,10,000
Issue of preference shares 50,000
Dividends paid (10,000)
Net cash generated from financing activities 2,50,000
Net increase in cash and cash equivalents 15,000
Cash and cash equivalents at beginning of period 90,000
Cash and cash equivalents at end of period 1,05,000
*Provision for tax of last year considered to be paid in the current year.
Working Note:
Property, plant and equipment acquisitions
W.D.V. at 31.3.20X2 3,50,000
Add back:
Depreciation for the year 40,000
3,90,000
Less: W.D.V. at 31.12.20X1 1,80,000
Acquisitions during 20X1-20X2 2,10,000
© The Institute of Chartered Accountants of India
CHAPTER 12
BUY-BACK OF
SECURITIES
LEARNING OUTCOMES
After studying this chapter, you will be able to:
♦ Elucidate the meaning of buy-back of securities;
♦ Comprehend the Accounting Treatment buy-back of securities;
♦ Learn the provisions of the Companies Act regarding buy-back of
securities.
CHAPTER OVERVIEW
Buy-Back of Shares
• As per Section 68 (1) of the Companies Act 2013, buy-back of shares can be
made out of: its free reserves; or the securities premium account; or the
proceeds of any shares or other specified securities.
• The buy-back of equity shares in any financial year shall not exceed twenty-five
per cent of its total paid-up equity capital in that financial year.
• There shall be a minimum gap of one year in a buy-back offer from the date of
closure of the previous buy-back.
• The ratio of the debt owed by the company is not more than twice the capital
and its free reserves after such buy-back.
© The Institute of Chartered Accountants of India
12.2 ADVANCED ACCOUNTING
1. INTRODUCTION
Buy-back of shares means purchase of its own shares by a company. When shares
are bought back by a company, they have to be cancelled by the company. Thus,
shares buy-back results in decrease in share capital of the company. A company
cannot buy its own shares for the purpose of investment. A company having
sufficient cash may decide to buy-back its own shares. The following may be the
objectives/advantages of Buy-back of shares:
(a) to increase earnings per share if there is no dilution in company’s earnings
as the buy-back of shares reduces the outstanding number of shares.
(b) to increase promoters holding as the shares which are bought back are
cancelled.
(c) to discourage others to make hostile bid to take over the company as the
buy-back will increase the promoters holding.
(d) to support the share price on the stock exchanges when the share price, in
the opinion of company management, is less than its worth, especially in the
depressed market.
(e) to pay surplus cash to shareholders when the company does not need it for
business.
The Companies Act, 2013 under Section 68 (1) permits companies to buy-back
their own shares and other specified securities out of:
(i) its free reserves; or
(ii) the securities premium account; or
(iii) the proceeds of the issue of any shares or other specified securities.
Note: No buy-back of any kind of shares or other specified securities shall be
made out of the proceeds of an earlier issue of the same kind of shares or same
kind of other specified securities. For example, if equity shares are to be bought-
back, then, preference shares may be used for the purpose.
The other important provisions relating to the buy-back are:
(1) Section 68 (2) further states that no company shall purchase its own shares
or other specified securities unless—
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.3
(a) the buy-back is authorised by its articles;
(b) a special resolution has been passed in general meeting of the
company authorising the buy-back;
However, the above provisions do not apply where the buy-back is ten
percent or less of the paid-up equity capital + free reserves and is
authorized by a board resolution passed at a duly convened meeting
of the directors. Hence, in case the buy-back is up to 10% of paid up
equity + free reserves, the same may be done with the authorization
of the Board Resolution without the necessity of its being authorized
by the articles of association of the company and by a special
resolution of its members passed at a general meeting of the
company.
(c) the buy-back must be equal or less than twenty-five per cent of the
total paid-up capital and free reserves of the company: (Resource Test)
(d) Further, the buy-back of shares in any financial year must not exceed
25% of its total paid-up capital and free reserves: (Share Outstanding
Test)
(e) the ratio of the debt owed by the company (both secured and
unsecured) after such buy-back is not more than twice the total of its
paid-up capital and its free reserves: (Debt-Equity Ratio Test)
Note: Central Government may prescribe a higher ratio of the debt
than that specified under this clause for a class or classes of
companies. Debt here should include both long-term debt as well as
short term debt.
(f) all the shares or other specified securities for buy-back are fully paid-
up;
(g) the buy-back of the shares or other specified securities listed on any
recognised stock exchange is in accordance with the regulations made
by the Securities and Exchange Board of India in this behalf;
(h) the buy-back in respect of shares or other specified securities other
than those specified in clause (f) is in accordance with the guidelines
as may be prescribed.
© The Institute of Chartered Accountants of India
12.4 ADVANCED ACCOUNTING
Provided that no offer of the buy-back under this sub section shall be made
within a period of one year reckoned from the date of closure of a previous
offer of buy-back if any. This means that there cannot be more than one
buy-back in one year.
(2) The notice of meeting at which special resolution is supposed to be passed
must be accompanied by an explanatory statement stating-
(a) a full and complete disclosure of all material facts;
(b) the necessity of the buy-back;
(c) the class of security intended to be purchased under the buy-back;
(d) the amount to be invested under the buy-back;
(e) the time limit for completion of the buy-back.
(3) Every buy-back shall be completed within twelve months from the date of
passing the special resolution, or the resolution passed by the board of
directors.
(4) The buy-back may be—
(a) from the existing security holders on a proportionate basis; or
(b) from the open market; or
(c) by purchasing the securities issued to employees of the company
pursuant to a scheme of stock option or sweat equity.
(5) Where a company has passed a special resolution under clause (b) of Sub-
section (2) to buy-back its own shares or other securities under this section, it
shall, before making such buy-back, file with the Registrar and the Securities
and Exchange Board of India a declaration of solvency in the form as may be
prescribed and verified by an affidavit to the effect that the Board of Directors
has made a full inquiry into the affairs of the company as a result of which
they have formed an opinion that it is capable of meeting its liabilities and
will not be rendered insolvent within a period of one year of the date of
declaration adopted by the Board of Directors. It must be signed by at least
two directors of the company, one of whom shall be the managing director, if
any:
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.5
Note: No declaration of solvency shall be filed with the Securities and
Exchange Board of India by a company whose shares are not listed on any
recognised stock exchange.
(6) Where a company buys-back its own securities, it shall extinguish and
physically destroy the securities so bought-back within seven days of the
last date of completion of buy-back.
(7) Where a company completes a buy-back of its shares or other specified
securities under this section, it shall not make further issue of same kind of
shares (including allotment of further shares under clause (a) of Sub-section
(1) of Section (62) or other specified securities within a period of six months
except by way of bonus issue or in the discharge of subsisting obligations
such as conversion of warrants, stock option scheme, sweat equity or
conversion of preference shares or debentures into equity shares.
(8) Where a company buy-back its securities under this section, it shall maintain
a register of the securities so bought, the consideration paid for the
securities bought-back, the date of cancellation of securities, the date of
extinguishing and physically destroying of securities and such other
particulars as may be prescribed.
(9) A company shall, after the completion of the buy-back under this section,
file with the Registrar and the Securities and Exchange Board of India, a
return containing such particulars relating to the buy-back within thirty days
of such completion, as may be prescribed, provided that no return shall be
filed with the Securities and Exchange Board of India by a company whose
shares are not listed on any recognised stock exchange.
(10) If a company makes default in complying with the provisions of this section
or any regulations made by SEBI in this regard, the company may be
punishable with a fine which shall not be less than Rs One Lakh but which
may extend to three lakh rupees and every officer of the company who is in
default shall be punishable with imprisonment for upto 3 years or with a
fine of not less than one lakh rupees but which may extend to three lakh
rupees or with both.
(11) Section 69 (1) states that where a company purchases its own shares out of
the free reserves or securities premium account, a sum equal to the nominal
value of shares so purchased shall be transferred to the Capital Redemption
© The Institute of Chartered Accountants of India
12.6 ADVANCED ACCOUNTING
Reserve Account and details of such account shall be disclosed in the
Balance Sheet.
(12) The shares or other specified securities which are proposed to be bought-
back must be fully paid-up.
(13) The Capital Redemption Reserve Account may be applied by the company
in paying up unissued shares of the company to be issued to members of
the company as fully paid bonus shares.
(14) Premium (excess of buy-back price over the par value) paid on buy-back
should be adjusted against free reserves and/or securities premium account.
Revaluation reserve represents unrealized profit and hence it cannot be
used for buy-back of securities.
Some Important Terms
(a) “specified securities” includes employees’ stock option or other securities as
may be notified by the Central Government from time to time;
(b) “free reserves” means such reserves which, as per the latest audited balance
sheet of a company, are available for distribution as dividend:
Provided that-
(i) any amount representing unrealised gains, notional gains or revaluation of
assets, whether shown as a reserve or otherwise, or
(ii) any change in carrying amount of an asset or a liability recognised in equity,
including surplus in profit and loss account on measurement of the asset or
the liability at fair value, shall not be treated as free reserves.
2. PROVISIONS OF SECTION 70 OF THE
COMPANIES ACT 2013
(1) No company shall directly or indirectly purchase its own shares or other
specified securities—
(a) through any subsidiary company including its own subsidiary
companies; or
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.7
(b) through any investment company or group of investment companies;
or
(c) if a default is subsisting, in repayment of deposit or interest payable
thereon, redemption of debentures or preference shares or payment
of dividend to any shareholder or repayment of any term loan or
interest payable thereon to any financial institutions or bank. Provided
that the buy–back is not prohibited if the default is remedied and a
period of three years has elapsed since the cessation of the default.
(2) In accordance with schedule III, no company shall directly or indirectly
purchase its own shares or other specified securities in case such company
has not complied with provisions of Sections 92 (filling of annual return),
123 (payment of dividend within 30 days of declaration), 127 (failure to
distribute dividend) and 129 (preparation of financial statement of the
company).
Explanation I.— For the purposes of Section 68 and Section 70 of the companies Act,
2013 "specified securities" includes employees' stock option or other securities as
may be notified by the Central Government from time to time.
Explanation II. — For the purposes of Section 68, "free reserves" includes securities
premium account.
Note: In exercise of the powers conferred under section 30 of the Securities and
Exchange Board of India Act, 1992, SEBI made Securities and Exchange Board of
India (Buy-back of Securities) (Amendment) Regulations, 2013 to amend the
Securities and Exchange Board of India (Buy-back of Securities) Regulations, 1998.
The important provisions of the new regulations are: (i) No offer of buy-back for
fifteen per cent or more of the paid up capital and free reserves of the company
shall be made from the open market. (ii)A company shall not make any offer of
buy-back within a period of one year reckoned from the date of closure of the
preceding offer of buy-back, if any. (iii)The company shall ensure that at least fifty
per cent of the amount earmarked for buy-back is utilized for buying-back shares
or other specified securities.
© The Institute of Chartered Accountants of India
12.8 ADVANCED ACCOUNTING
Illustration 1
M Ltd. furnishes the following Balance Sheet as at 31st March, 20X1:
Particulars Notes ` (in 000)
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 5,000
B Reserves and Surplus 2 6,310
2 Non-current liabilities
Long term borrowings 3 400
3 Current liabilities
A Trade Payables 40
Total 11,750
Assets
1 Non-current assets
A Property, plant and Equipment 4 2,750
B Non-Current Investments (at cost) 5,000
2 Current assets
A Inventories 1,000
B Trade receivables 2,000
C Cash and Cash equivalents 1,000
Total 11,750
Notes to accounts
No. Particulars ` in (‘000)
1 Share Capital
Authorized, Issued and Subscribed Capital:
3,00,000 Equity shares of ` 10 each fully paid up 3,000
20,000 9% Preference Shares of 100 each 2,000
Total 5,000
2 Reserves and Surplus
Capital reserve 10
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.9
Revenue reserve 4,000
Securities premium 500
Profit and Loss account 1,800
Total 6,310
3 Long term borrowings
10% Debentures 400
4 Property, Plant and Equipment (PPE)
PPE: Cost 3,000
Less: Provision for depreciation (250)
Net carrying value 2,750
The company passed a resolution to buy-back 20% of its equity capital @ ` 15 per
share. For this purpose, it sold its investments of ` 30 lakhs for ` 25 lakhs.
You are required to pass necessary Journal entries.
Solution
Journal Entries in the books of M Ltd.
` in ‘000
Particulars Dr. Cr.
1. Bank A/c Dr. 2,500
Profit and Loss A/c Dr. 500
To Investment A/c 3,000
(Being investment sold for the purpose of buy-
back of Equity Shares)
2. Equity share capital A/c Dr. 600
Premium payable on buy-back Dr. 300
To Equity shares buy-back A/c 900
(Being the amount due on buy-back of equity
shares)
3. Equity shares buy-back A/c Dr. 900
To Bank A/c 900
(Being payment made for buy-back of equity
shares)
© The Institute of Chartered Accountants of India
12.10 ADVANCED ACCOUNTING
4. Securities Premium A/c Dr. 300
To Premium payable on buy-back 300
(Being premium payable on buy-back charged
from Securities premium)
5. Revenue reserve A/c Dr. 600
To Capital Redemption Reserve A/c 600
(Being creation of capital redemption reserve to
the extent of the equity shares bought back)
Illustration 2
Anu Ltd. (a non-listed company) furnishes you with the following balance sheet as
at 31st March, 20X1: (in crores `)
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 100
B Reserves and Surplus 2 300
2 Current liabilities
A Trade Payables 40
Total 440
Assets
1 Non-current assets
A Property, plant and equipment 3 -
B Non-Current Investments 4 100
2 Current assets
A Trade receivables 140
B Cash and Cash equivalents 200
Total 440
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.11
Notes to accounts
No. Particulars `
1 Share Capital
Authorized, issued and subscribed share capital:
12% Redeemable preference shares of ` 100 each, 75
fully paid up
Equity shares of ` 10 each, fully paid up 25
Total 100
2 Reserves and Surplus
Capital reserve 15
Securities premium 25
Revenue reserves 260
Total 300
3 Property, Plant and Equipment
PPE Cost 100
Less: Provision for depreciation (100)
Net carrying value NIL
4 Non-Current Investments
Non-current investments at cost (Market value ` 400 100
Cr.)
The company redeemed preference shares on 1st April, 20X1. It also bought back 50
lakhs equity shares of ` 10 each at ` 50 per share. The payments for the above
were made out of the huge bank balances, which appeared as a part of current
assets.
You are asked to:
(i) Pass journal entries to record the above.
(ii) Prepare balance sheet as at 1.4.20X1.
© The Institute of Chartered Accountants of India
12.12 ADVANCED ACCOUNTING
Solution
(i) Journal entries in the books of Anu Ltd.
` in crores
Particulars Dr. Cr.
1st 12% Preference share capital A/c Dr. 75
April, To Preference shareholders A/c 75
20X1 (Being preference share capital account
transferred to shareholders account)
Preference shareholders A/c Dr. 75
To Bank A/c 75
(Being payment made to shareholders)
Shares buy-back A/c Dr. 25
To Bank A/c 25
(Being 50 lakhs equity shares bought back @ ` 50
per share)
Equity share capital A/c (50 lakhs х ` 10) Dr. 5
Securities premium A/c (50 lakhs х ` 40) Dr. 20
To Shares buy-back A/c 25
(Being cancellation of shares bought back)
Revenue Reserve A/c Dr. 80
To Capital Redemption Reserve A/c (75+5) 80
(Being creation of capital redemption reserve
to the extent of the face value of preference
shares redeemed and equity shares bought
back)
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.13
(ii) Balance Sheet of Anu Ltd as at 1.4.20X1
(in crores `)
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 20
B Reserves and Surplus 2 280
2 Current liabilities
A Trade Payables 40
Total 340
Assets
1 Non-current assets
A Property, plant and equipment 3 -
B Non-Current Investments 4 100
2 Current assets
A Trade receivables 140
B Cash and Cash equivalents 5 100
Total 340
Notes to accounts
No. Particulars `
1 Share Capital
Authorized, issued and subscribed share capital
200 lakhs Equity shares of ` 10 each fully paid 20
Total 20
2 Reserves and Surplus
Capital reserve 15
Capital redemption reserve 80
© The Institute of Chartered Accountants of India
12.14 ADVANCED ACCOUNTING
Securities premium 25
Less: Utilization for buy-back of shares (20) 5
Revenue Reserve 260
Less: transfer to Capital redemption reserve (80) 180
Total 280
3 Property, plant and Equipment
PPE: cost 100
Less: Provision for depreciation (100)
Net carrying value -
4 Non-Current Investments
Non-current investments at cost 100
(Market value ` 400 Crores)
5 Cash and Cash Equivalents
Cash and Cash Equivalents as on 31.3.20X1 200
Less: Bank payment for redemption and buy-back (100)
Total 100
Illustration 3
Dee Limited (a non-listed company) furnishes the following Balance Sheet as at
31st March, 20X1:
(in thousand ` )
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 2,700
B Reserves and Surplus 2 9,700
2 Current liabilities
A Trade Payables 1,400
Total 13,800
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.15
Assets
1 Non-current assets
A Property, plant and Equipment 9,300
B Non-Current Investments 3,000
2 Current assets
A Inventories 500
B Trade receivables 200
C Cash and Cash equivalents 800
Total 13,800
Notes to accounts
No. Particulars `
1 Share Capital
Authorized, issued and subscribed capital:
2,50,000 Equity shares of ` 10 each fully paid up 2,500
2,000, 10% Preference shares of ` 100 each 200
(Issued two months back for the purpose of buy-back) _____
Total 2,700
2 Reserves and Surplus
Capital reserve 1,000
Revenue reserve 3,000
Securities premium 2,200
Profit and loss account 3,500
Total 9,700
The company passed a resolution to buy-back 20% of its equity capital @ ` 50 per
share. For this purpose, it sold all of its investment for ` 22,00,000.
You are required to pass necessary journal entries and prepare the Balance Sheet.
© The Institute of Chartered Accountants of India
12.16 ADVANCED ACCOUNTING
Solution
Journal Entries in the books of Dee Limited
(in thousand `)
Particulars Dr. Cr.
(i) Bank Account Dr. 2,200
Profit and Loss Account Dr. 800
To Investment Account 3,000
(Being the investments sold at loss for the purpose of
buy-back)
(ii) Equity Share buy-back Account Dr. 2,500
To Bank Account 2,500
(Being the payment made on buy-back)
(iii) Equity Share Capital Account Dr. 500
Premium Payable on Buy-Back Account Dr. 2,000
To Equity Shares Buy-Back Account 2,500
(Being the buy-back amount allocated to equity share
capital)
(iv) Securities premium Account Dr. 2,000
To Premium payable on buy-back Account 2,000
(Being the premium payable on buy-back adjusted
against securities premium account)
(v) Revenue reserve Account Dr. 300
To Capital Redemption Reserve Account 300
(Being the amount equal to nominal value of equity shares
bought back out of free reserves transferred to capital
redemption reserve account)
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.17
Balance Sheet of Dee Limited as at 1st April, 20X1
(After buy-back of shares)
(in thousand `)
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 2,200
B Reserves and Surplus 2 6,900
2 Current liabilities
A Trade Payables 1,400
Total 10,500
Assets
1 Non-current assets
A Property, plant and Equipment 9,300
2 Current assets
A Inventories 500
B Trade receivables 200
C Cash and Cash equivalents 500
Total 10,500
Notes to accounts
No. Particulars `
1 Share Capital
Authorized, issued and subscribed capital:
2,50,000 Equity shares of ` 10 each fully paid up 2,000
2,000, 10% Preference shares of ` 100 each 200
(Issued two months back for the purpose of buy-
back) _____
Total 2,200
© The Institute of Chartered Accountants of India
12.18 ADVANCED ACCOUNTING
2 Reserves and Surplus
Capital reserve 1,000
Capital redemption reserve 300
Securities Premium 2,200
Less: Premium payable on buy-back of shares (2,000) 200
Revenue reserve 3,000
Less: Transfer to Capital redemption reserve (300) 2,700
Profit and loss A/c 3,500
Less: Loss on investment (800) 2,700
Total 6,900
Illustration 4
Extra Ltd. (a non-listed company) furnishes you with the following Balance Sheet as
at 31st March, 20X1:
(in lakhs `)
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 120
B Reserves and Surplus 2 118
2 Non-current liabilities
Long term borrowings 3 4
3 Current liabilities
A Trade Payables 70
Total 312
Assets
1 Non-current assets
A Property, plant and Equipment 50
B Non-current Investments 120
2 Current assets
A Cash and Cash equivalents 142
Total 312
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.19
Notes to accounts
No. Particulars `
1 Share Capital
Authorized, issued and subscribed capital:
Equity shares of ` 10 each fully paid 100
9% Redeemable preference shares of ` 100 each fully 20
paid
Total 120
2 Reserves and Surplus
Capital reserves 8
Revenue reserves 50
Securities premium 60
Total 118
3 Long term borrowings
10% Debentures 4
(i) The company redeemed the preference shares at a premium of 10% on 1st
April, 20X1.
(ii) It also bought back 3 lakhs equity shares of ` 10 each at ` 30 per share. The
payment for the above was made out of huge bank balances.
(iii) Included in its investment were “investments in own debentures” costing ` 2
lakhs (face value ` 2.20 lakhs). These debentures were cancelled on 1st April,
20X1.
(iv) The company had 1,00,000 equity stock options outstanding on the above-
mentioned date, to the employees at ` 20 when the market price was `30
(This was included under current liabilities) On 1.04.20X1 employees exercised
their options for 50,000 shares.
(v) Pass the journal entries to record the above.
(vi) Prepare Balance Sheet as at 01.04.20X1.
© The Institute of Chartered Accountants of India
12.20 ADVANCED ACCOUNTING
Solution
(` in lakhs)
Date Particulars Debit Credit
20X1
1st April 9% Redeemable preference share capital A/c Dr. 20.00
Premium on redemption of preference shares A/c Dr. 2.00
To Preference shareholders A/c 22.00
(Being preference share capital transferred to
shareholders account)
Preference shareholders A/c Dr. 22.00
To Bank A/c 22.00
(Being payment made to shareholders)
Equity shares buy-back A/c Dr. 90.00
To Bank A/c 90.00
(Being 3 lakhs equity shares of ` 10 each
bought back @ ` 30 per share)
Equity share capital A/c Dr. 30.00
Securities premium A/c Dr. 60.00
To Equity Shares buy-back A/c 90.00
(Being cancellation of shares bought back)
Revenue reserve A/c Dr. 50.00
To Capital redemption reserve A/c 50.00
(Being creation of capital redemption reserve
account to the extent of the face value of
preference shares redeemed and equity
shares bought back as per the law)
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.21
10% Debentures A/c Dr. 2.20
To Investment (own debentures) A/c 2.00
To Profit on cancellation of own debentures 0.20
A/c
(Being cancellation of own debentures costing
` 2 lakhs, face value being ` 2.20 lakhs and the
balance being profit on cancellation of
debentures)
Bank A/c Dr. 10.00
Employees stock option outstanding (Current
liabilities) A/c Dr. 5.00
To Equity share capital A/c 5.00
To Securities premium A/c 10.00
(Being the allotment to employees, of 50,000
shares of ` 10 each at a premium of 20 per
share in exercise of stock options by
employees)
Securities premium A/c Dr. 2.00
To Premium on redemption of preference 2.00
shares A/c
(Being premium on redemption of preference
shares adjusted through securities premium)
Balance Sheet of Extra Ltd. as at 01.04.20X1
(in lakhs `)
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 75.00
B Reserves and Surplus 2 66.20
© The Institute of Chartered Accountants of India
12.22 ADVANCED ACCOUNTING
2 Non-current liabilities
Long term borrowings 3 1.80
3 Current liabilities
A Other Current Liabilities 4 65.00
Total 208
Assets
1 Non-current assets
A Property, plant and Equipment 50.00
B Non-current Investments 5 118.00
2 Current assets
A Cash and Cash equivalents 6 40.00
Total 208
Notes to accounts
No. Particulars `
1 Share Capital
Equity shares of ` 10 each fully paid 100
Less: Cancellation of bought back shares (30)
Add: Shares issued against ESOP 5
Total 75
2 Reserves and Surplus
Capital Reserve
Opening balance 8.00
Add: Profit on cancellation of debentures 0.20 8.20
Revenue reserves
Opening balance 50.00
Less: Creation of Capital Redemption Reserve (50.00) -
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.23
Securities Premium
Opening balance 60.00
Less: Adjustment for cancellation of equity (60.00)
shares
Less: Adjustment for premium on redemption (2.00)
of preference shares
Add: Shares issued against ESOP at premium 10.00 8.00
Capital Redemption Reserve 50.00
Total 66.20
3 Long term borrowings
10% Debentures 4.00
Less: Cancellation of own debentures (2.20)
Total 1.80
4. Other Current liabilities
Opening balance 70.00
Less: Adjustment for ESOP outstanding (5.00)
Total 65.00
5. Non-current investments
Opening balance 120.00
Less: Investment in own debentures (2.00)
Total 118.00
6. Cash and Cash Equivalents
Opening balance 142.00
Less: Payment to preference shareholders (22.00)
Less: Payment to equity shareholders (90.00)
Add: Share price received against ESOP 10.00
Total 40.00
© The Institute of Chartered Accountants of India
12.24 ADVANCED ACCOUNTING
Illustration 5
Pratham Ltd. (a non-listed company) has the following Capital structure as on
31st March, 20X1:
Particulars ` `
Equity Share Capital (shares of ` 10 each fully paid 30,00,000
Reserves & Surplus
General Reserve 32,50,000
Security Premium Account 6,00,000
Profit & Loss Account 4,30,000
Revaluation Reserve 6,20,000 49,00,000
Loan Funds 42,00,000
You are required to compute by Debt Equity Ratio Test, the maximum number of
shares that can be bought back in the light of above information, when the offer
price for buy-back is ` 30 per share.
Solution
Debt Equity Ratio Test
Particulars `
(a) Loan funds 42,00,000
(b) Minimum equity to be maintained after
buy-back in the ratio of 2:1 (` in crores) 21,00,000
(c) Present equity shareholders fund 72,80,000
(` in crores)
(d) Future equity shareholder fund (` in 59,85,000
crores) (See Note 2) (72,80,000-12,95,000)
(e) Maximum permitted buy-back of Equity 38,85,000 (by simultaneous
(` in crores) [(d) – (b)] (See Note 2) equation)
(f) Maximum number of shares that can be 1,29,500 (by simultaneous
bought back @ ` 30 per share (shares in equation)
crores) (See Note 2)
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.25
Working Note:
1. Shareholders’ funds
Particulars `
Paid up capital 30,00,000
Free reserves (32,50,000 +6,00,000+4,30,000) 42,80,000
72,80,000
2. As per section 68 of the Companies Act, 2013, amount transferred to CRR
and maximum equity to be bought back will be calculated by simultaneous
equation method.
Suppose amount equivalent to nominal value of bought back shares
transferred to CRR account is ‘x’ and maximum permitted buy-back of
equity is ‘y’.
Equation 1 : (Present equity – Nominal value of buy-back transfer to CRR) –
Minimum equity to be maintained = Maximum permissible buy-back of
equity.
(72,80,000 –x)-21,00,000 = y (1)
Since 51,80,000 – x = y
Maximum buy -back
Equation 2: ×Nominal Value
Offer price for buy -back
= Nominal value of the shares bought –back to be transferred to CRR
y
= × 10 = x
30
3x = y (2)
x = ` 12,95,000 crores and y
= ` 38,85,000 crores
© The Institute of Chartered Accountants of India
12.26 ADVANCED ACCOUNTING
Illustration 6
Perrotte Ltd. (a non-listed company) has the following Capital Structure as on
31.03.20X1:
Particulars (` in crores)
(1) Equity Share Capital (Shares of ` 10 each fully - 330
paid)
(2) Reserves and Surplus
General Reserve 240 -
Securities Premium Account 90 -
Profit & Loss Account 90 -
Infrastructure Development Reserve 180 600
(3) Loan Funds 1,800
The Shareholders of Perrotte Ltd., on the recommendation of their Board of Directors,
have approved on 12.09.20X1 a proposal to buy-back the maximum permissible number
of Equity shares considering the large surplus funds available at the disposal of the
company.
The prevailing market value of the company’s shares is ` 25 per share and in order
to induce the existing shareholders to offer their shares for buy-back, it was decided
to offer a price of 20% over market.
You are also informed that the Infrastructure Development Reserve is created to
satisfy Income-tax Act requirements.
You are required to compute the maximum number of shares that can be bought
back in the light of the above information and also under a situation where the
loan funds of the company were either ` 1,200 crores or ` 1,500 crores.
Assuming that the entire buy-back is completed by 09.12.20X1, show the
accounting entries in the company’s books in each situation.
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.27
Solution
Statement determining the maximum number of shares to be bought back
Number of shares
Particulars When loan fund is
` 1,800 crores ` 1,200 crores ` 1,500 crores
Shares Outstanding Test 8.25 8.25 8.25
(W.N.1)
Resources Test (W.N.2) 6.25 6.25 6.25
Debt Equity Ratio Test Nil 3.75 Nil
(W.N.3)
Maximum number of shares
that can be bought back Nil 3.75 Nil
[least of the above]
Journal Entries for the Buy-Back
(applicable only when loan fund is ` 1,200 crores)
` in crores
Particulars Debit Credit
(a) Equity share buy-back account Dr. 112.5
To Bank account 112.5
(Being buy-back of 3.75 crores equity shares of `
10 each @ ` 30 per share)
(b) Equity share capital account Dr. 37.5
Securities premium account Dr. 75
To Equity share buy-back account 112.5
(Being cancellation of shares bought back)
© The Institute of Chartered Accountants of India
12.28 ADVANCED ACCOUNTING
(c) General reserve account Dr. 37.5
To Capital redemption reserve account 37.5
(Being transfer of free reserves to capital
redemption reserve to the extent of nominal value
of share capital bought back out of redeemed
through free reserves)
Working Notes:
1. Shares Outstanding Test
Particulars (Shares in crores)
Number of shares outstanding 33
25% of the shares outstanding 8.25
2. Resources Test
Particulars
Paid up capital (` in crores) 330
Free reserves (` in crores) 420
Shareholders’ funds (` in crores) 750
25% of Shareholders fund (` in crores) ` 187.5 crores
Buy-back price per share ` 30
Number of shares that can be bought back 6.25 crores shares
(shares in crores)
3. Debt Equity Ratio Test
Particulars When loan fund is
` ` 1,200 ` 1,500
1,800 crores crores
crores
(a) Loan funds (` in crores) 1,800 1,200 1,500
(b) Minimum equity to be
maintained after buy-back in 900 600 750
the ratio of 2:1 (` in crores)
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.29
(c) Present equity shareholders 750 750 750
fund (` in crores)
(d) Future equity shareholder fund N.A. 712.5 N.A.
(` in crores) (See Note 2) (750-37.5)
(e) Maximum permitted buy-back Nil 112.5 (by Nil
of Equity (` in crores) [(d) – simultaneous
(b)] (See Note 2) equation)
(f) Maximum number of shares 3.75 (by
that can be bought back @ simultaneous
` 30 per share (shares in crores) Nil equation) Nil
(See Note 2)
Note:
1. Under Situations 1 & 3 the company does not qualify for buy-back of
shares as per the provisions of the Companies Act, 2013.
2. As per section 68 of the Companies Act, 2013, the ratio of debt owed
by the company should not be more than twice the capital and its free
reserve after such buy-back. In the question, it is stated that the
company has surplus funds to dispose of therefore, it is presumed that
buy- back is out of free reserves or securities premium and hence a
sum equal to the nominal value of the share bought back shall be
transferred to Capital Redemption Reserve (CRR). Utilization of CRR is
restricted to issuance of fully paid-up bonus shares only. It means
CRR is not available for distribution as dividend. Hence, CRR is not a
free reserve. Therefore, for calculation of future equity i.e. share
capital and free reserves, amount transferred to CRR on buy-back has
to be excluded from present equity.
Amount transferred to CRR and maximum equity to be bought back
will be calculated by simultaneous equation method.
Suppose amount equivalent to nominal value of bought back shares
transferred to CRR account is ‘x’ and maximum permitted buy-back of
equity is ‘y’.
© The Institute of Chartered Accountants of India
12.30 ADVANCED ACCOUNTING
Then
Equation 1 : (Present equity – Nominal value of buy-back transfer to
CRR) – Minimum equity to be maintained= Maximum permissible buy-
back of equity
(750 –x)-600 = y (1)
Since 150 – x = y
Maximum buy - back
Equation 2: x Nominal Value
Offer price for buy - back
= Nominal value of the shares bought –back to be transferred to CRR
y
= × 10 = x
30
[here (30 = 25% x 120]
Or 3x = y (2)
by solving the above two equations we get
x = ` 37.5 crores
y = ` 112.5 crores
SUMMARY
• Buy-back of shares can be made out of:
(i) its free reserves; or
(ii) the securities premium account; or
(iii) the proceeds of any shares or other specified securities.
• No company shall purchase its own shares or other specified securities
unless—
The buy-back is authorized by the Articles of Association and by a
special resolution passed at a general meeting. However, in case the
buy-back is for a sum less than or equal to ten percent of the paid-up
equity shares + free reserves the same may be authorized by the
resolution of the directors passed at a duly convened Board Meeting.
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.31
the buy-back is or less than or equal to twenty-five per cent of the
total paid-up capital and free reserves of the company:
Partly paid shares cannot be bought back by a company;
the buy-back of equity shares in any financial year shall not exceed
twenty-five per cent of its total paid-up equity capital in that financial
year.
No offer of buy-back will be made within a period of one year from
the date of closing of the previous buy-back if any. Hence, there can
be a maximum of one buy-back in one year.
the ratio of the debt owed by the company (both secured and
unsecured) is not more than twice the paid-up capital and its free
reserves after such buy-back:
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. As per section 68(1) of the Companies Act, buy-back of own shares by the
company, shall not exceed
(a) 25% of the total paid-up capital and free reserves of the company.
(b) 20% of the total paid-up capital and free reserves of the company.
(c) 15% of the total paid-up capital and free reserves of the company.
(d) 10% of the total paid-up capital and free reserves of the company.
2. The companies are permitted to buy-back their own shares out of
(a) Free reserves and Securities premium
(b) Proceeds of the issue of any shares.
(c) Both (a) and (b)
(d) Neither (a) nor (b).
© The Institute of Chartered Accountants of India
12.32 ADVANCED ACCOUNTING
3. When a company purchases its own shares out of free reserves; a sum equal
to nominal value of shares so purchased shall be transferred to
(a) Revenue redemption reserve.
(b) Capital redemption reserve.
(c) Buy-back reserve
(d) Special reserve
4. State which of the following statements is true?
(a) Buy-back is for more than twenty-five per cent of the total paid-up
capital and free reserves of the company.
(b) Partly paid shares cannot be bought back by a company.
(c) Buy-back of equity shares in any financial year shall exceed twenty-five
per cent of its total paid-up equity capital in that financial year.
(d) Partly paid shares can be bought back by a company.
5. Premium (excess of buy-back price over the par value) paid on buy-back
should be adjusted against
(a) Free reserves.
(b) Securities premium.
(c) Both (a) and (b).
(d) Neither (a) nor (b).
6. Advantages of Buy-back of shares include to
(a) Encourage others to make hostile bid to take over the company.
(b) Decrease promoters holding as the shares which are bought back are
cancelled.
(c) Discourage others to make hostile bid to take over the company as the
buy-back will increase the promoters holding.
(d) All of the above.
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.33
7. What are the conditions to be fulfilled by a Joint Stock Company to buy-back
its equity shares as per Companies Act, 2013? Explain in brief.
Scenario based Questions
8. SMM Ltd. has the following capital structure as on 31st March, 20X1:
` in crore
Particulars Situation I Situation II
(i) Equity share capital (shares of ` 10 1,200 1,200
each)
(ii) Reserves:
General Reserves 1,080 1,080
Securities Premium 400 400
Profit & Loss 200 200
Infrastructure Development Reserve 320 320
(Statutory Reserve)
(iii) Loan Funds 3,200 6,000
The company has offered buy-back price of ` 30 per equity share. You are
required to calculate maximum permissible number of equity shares that can
be bought back in both situations and also required to pass necessary Journal
Entries.
9. KG Limited furnishes the following Balance Sheet as at 31st March, 20X1:
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 1,200
B Reserves and Surplus 2 810
2 Non-current liabilities
Long term borrowings 750
3
© The Institute of Chartered Accountants of India
12.34 ADVANCED ACCOUNTING
3 Current liabilities
A Trade Payables 745
B Other Current Liabilities 195
Total 3,700
Assets
1 Non-current assets
A Property, plant and equipment 4 2,026
B Non-current Investments 74
2 Current assets
A Inventories 600
B Trade receivables 260
C Cash and Cash equivalents 740
Total 3,700
Notes to accounts
No. Particulars `
1 Share Capital
Authorized, issued and subscribed capital
Equity share capital (fully paid up shares of ` 10 1,200
each)
2 Reserves and Surplus
Securities premium 175
General reserve 265
Capital redemption reserve 200
Profit & loss A/c 170
Total 810
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.35
3 Long term borrowings
12% Debentures 750
4 Property, plant and equipment
Land and Building 1,800
Plant and machinery 226
Net carrying value 2,026
On 1st April, 20X1, the company announced the buy-back of 25% of its equity
shares @ ` 15 per share. For this purpose, it sold all of its investments for ` 75
lakhs.
On 5th April, 20X1, the company achieved the target of buy-back. On 30th
April, 20X1 the company issued one fully paid up equity share of ` 10 by way
of bonus for every four equity shares held by the equity shareholders.
You are required to:
(1) Pass necessary journal entries for the above transactions.
(2) Prepare Balance Sheet of KG Limited after bonus issue of the shares.
10. Following is the Balance Sheet of Competent Limited as at 31st March, 20X1:
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 12,50,000
B Reserves and Surplus 2 18,75,000
2 Non-current liabilities
Long term borrowings 3 28,75,000
3 Current liabilities
A Other Current Liabilities 16,50,000
Total 76,50,000
Assets
1 Non-current assets
A Property, plant and Equipment 4 46,50,000
© The Institute of Chartered Accountants of India
12.36 ADVANCED ACCOUNTING
2 Current assets
A Other Current Assets 30,00,000
Total 76,50,000
Notes to accounts
No. Particulars `
1 Share Capital
Authorized, issued and subscribed capital:
Equity share capital (fully paid up shares of ` 10 12,50,000
each)
2 Reserves and Surplus
Securities premium 2,50,000
Profit and loss account 1,25.000
Revenue reserve 15,00,000
Total 18,75,000
3 Long term borrowings
14% Debentures 18,75,000
Unsecured Loans 10,00,000
Total 28,75,000
4 Property, plant and equipment
Land and Building 19,30,000
Plant and machinery 18,00,000
Furniture and fitting 9,20,000
Net carrying value 46,50,000
The company wants to buy-back 25,000 equity shares of ` 10 each, on 1st
April, 20X1 at ` 20 per share. Buy-back of shares is duly authorized by its
articles and necessary resolution has been passed by the company towards
this. The payment for buy-back of shares will be made by the company out of
sufficient bank balance available shown as part of Current Assets.
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.37
Comment with your calculations, whether buy-back of shares by company is
within the provisions of the Companies Act, 2013. If yes, pass necessary
journal entries towards buy-back of shares and prepare the Balance Sheet
after buy-back of shares.
11. The following information from Balance Sheet of Z Ltd. as on 31st March
,20X1:
` Lakhs
Share Capital:
Equity shares of ` 10 each Fully Paid Up 16,000
10% Redeemable Pref. Shares of ` 10 each Fully Paid Up 5,000
Reserves & Surplus
Capital Redemption Reserve 2,000
Securities Premium 1,600
General Reserve 12,000
Profit & Loss Account 600
Secured Loans:
9% Debentures 10,000
Current Liabilities:
Trade payables 4,600
Sundry Provisions 2,000
Fixed Assets 28,000
Investments 4,700
Cash at Bank 4,600
Other Current Assets 16,500
On 1st April, 20X1 the Company redeemed all its Preference Shares at a
Premium of 10% and bought back 10% of its Equity Shares at ` 20 per Share.
In order to make cash available, the Company sold all the Investments for `
5,000 lakhs.
You are required to pass journal entries for the above and prepare the
Company’s Balance sheet immediately after buyback of equity shares and
redemption of preference shares.
© The Institute of Chartered Accountants of India
12.38 ADVANCED ACCOUNTING
ANSWERS/HINTS
Answer to the Multiple Choice Questions
1. (a) 2. (c) 3. (b) 4. (b) 5. (c) 6. (c)
Answer to the Theoretical Questions
7. Section 68 to 70 of the Companies Act, 2013 lays down the provisions for a
company to buy-back its own equity shares. For details, refer Para 1.1 and
1.2 of the chapter.
Answer to the Scenario based Questions
8. Statement determining the maximum number of shares to be bought back
Number of shares (in crores)
Particulars When loan fund is
` 3,200 crores ` 6,000 crores
Shares Outstanding Test (W.N.1) 30 30
Resources Test (W.N.2) 24 24
Debt Equity Ratio Test (W.N.3) 32 Nil
Maximum number of shares that can be 24 Nil
bought back [least of the above]
Journal Entries for the Buy-Back
(applicable only when loan fund is `3,200 crores)
` in crores
Particulars Debit Credit
(a) Equity shares buy-back account Dr. 720
To Bank account 720
(Being payment for buy-back of 24 crores
equity shares of ` 10 each @ ` 30 per share)
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.39
(b) Equity share capital account Dr. 240
Premium Payable on buy-back account Dr. 480
To Equity share buy-back account 720
(Being cancellation of shares bought back)
Securities Premium account Dr. 400
General Reserve / Profit & Loss A/c Dr. 80
To Premium Payable on buy-back 480
account
(Being Premium Payable on buy-back
account charged to securities premium and
general reserve/Profit & Loss A/c)
(c) General Reserve / Profit & Loss A/c Dr. 240
To Capital redemption reserve 240
account
(Being transfer of free reserves to capital
redemption reserve to the extent of nominal
value of share capital bought back out of
redeemed through free reserves)
Working Notes:
1. Shares Outstanding Test
Particulars (Shares in crores)
Number of shares outstanding 120
25% of the shares outstanding 30
2. Resources Test
Particulars
Paid up capital (` in crores) 1,200
Free reserves (` in crores) (1,080 + 400 +200) 1,680
Shareholders’ funds (` in crores) 2,880
© The Institute of Chartered Accountants of India
12.40 ADVANCED ACCOUNTING
25% of Shareholders fund (` in crores) ` 720 crores
Buy-back price per share ` 30
Number of shares that can be bought back 24 crores shares
3. Debt Equity Ratio Test: Loans cannot be in excess of twice the Equity
Funds post Buy-Back
Particulars When loan fund is
` 3,200 crores ` 6,000 crores
(a) Loan funds (`) 3,200 6,000
(b) Minimum equity to be 1,600 3,000
maintained after buy-back in
the ratio of 2:1 (`) (a/2)
(c) Present equity shareholders 2,880 2,880
fund (`)
(d) Future equity shareholders 2,560 (2,880- N.A.
fund (`) (see W.N.4) 320)
(e) Maximum permitted buy- 960 Nil
back of Equity (`) [(d) – (b)]
(f) Maximum number of shares 32 crore
that can be bought back @ shares Nil
` 30 per share
As per the provisions of the
Companies Act, 2013, Qualifies Does not
company Qualify
4. Amount transferred to CRR and maximum equity to be bought back
will be calculated by simultaneous equation method
Suppose amount transferred to CRR account is ‘x’ and maximum
permitted buy-back of equity is ‘y’ Then
Equation 1: (Present Equity - Transfer to CRR)- Minimum Equity to
be maintained = Maximum Permitted Buy-Back
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.41
= (2,880 – x) – 1,600 = y
= 1280 – x =y (1)
Equation 2: Maximum Permitted Buy-Back X Nominal Value Per
Share/Offer Price Per Share
y/30 x 10 = x
or
3x = y (2)
by solving the above two equations we get
x= ` 320
y = ` 960
9. In the books of KG Limited
Journal Entries
Date Particulars Dr. Cr.
20X1 (` in lakhs)
April 1 Bank A/c Dr. 75
To Investment A/c 74
To Profit on sale of investment 1
(Being investment sold on profit)
April 5 Equity share capital A/c Dr. 300
Securities premium A/c Dr. 150
To Equity shares buy-back A/c 450
(Being the amount due to equity shareholders
on buy-back)
Equity shares buy-back A/c Dr. 450
To Bank A/c 450
(Being the payment made on account of buy-
back of 30 Lakh Equity Shares)
April 5 General reserve A/c Dr. 265
Profit and Loss A/c Dr. 35
To Capital redemption reserve A/c 300
© The Institute of Chartered Accountants of India
12.42 ADVANCED ACCOUNTING
(Being amount equal to nominal value of buy-
back shares from free reserves transferred to
capital redemption reserve account as per the
law)
April 30 Capital redemption reserve A/c Dr. 225
To Bonus shares A/c (W.N.1) 225
(Being the utilization of capital redemption
reserve to issue bonus shares)
Bonus shares A/c Dr. 225
To Equity share capital A/c 225
(Being issue of one bonus equity share for
every four equity shares held)
Balance Sheet (After buy-back and issue of bonus shares)
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 1,125
B Reserves and Surplus 2 436
2 Non-current liabilities
Long term borrowings 3 750
3 Current liabilities
A Trade Payables 745
B Other Current Liabilities 195
Total 3,251
Assets
1 Non-current assets
A Property, plant and equipment 4 2,026
2 Current assets
A Inventories 600
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.43
B Trade receivables 260
C Cash and Cash equivalents 365
Total 3,251
Notes to accounts
No. Particulars `
1 Share Capital
Authorized, issued and subscribed capital:
Equity share capital (fully paid up shares of `
10 each) 1,125
2 Reserves and Surplus
General Reserve 265
Less: Transfer to CR (265) -
Capital Redemption Reserve 200
Add: Transfer due to buy-back of shares
from P/L 35
Add; Transfer due to buy-back of shares
from General Reserve 265
Less: Utilisation for issue of bonus shares (225) 275
Securities premium 175
Less: Adjustment for premium paid on buy-
back (150) 25
Profit & Loss A/c 170
Add: Profit on sale of investment 1
Less: Transfer to CRR (35) 136
Total 436
3 Long term borrowings
12% Debentures 750
4 Property, Plant and Equipment
Land and Building 1,800
Plant and machinery 226
Net carrying value 2,026
© The Institute of Chartered Accountants of India
12.44 ADVANCED ACCOUNTING
Working Notes:
1. Amount of bonus shares = 25% of (1,200 – 300) lakhs = ` 225 lakhs
2. Cash at bank after issue of bonus shares
Particulars ` in lakhs
Cash balance as on 1st April, 20X1 740
Add: Sale of investments 75
815
Less: Payment for buy-back of shares (450)
365
Note: In the given solution, it is possible to adjust transfer to capital
redemption reserve account or capitalization of bonus shares from any
other free reserves or securities premium (to the extent available) also.
10. Determination of Buy-back of maximum no. of shares as per the Companies
Act, 2013
1. Shares Outstanding Test
Particulars (Shares)
Number of shares outstanding 1,25,000
25% of the shares outstanding 31,250
2. Resources Test: Maximum permitted limit 25% of Equity paid up
capital + Free Reserves
Particulars
Paid up capital (`) 12,50,000
Free reserves (`) (15,00,000 + 2,50,000 + 1,25,000) 18,75,000
Shareholders’ funds (`) 31,25,000
25% of Shareholders fund (`) 7,81,250
Buy-back price per share ` 20
Number of shares that can be bought back (shares) 39,062
Actual Number of shares for buy-back 25,000
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.45
3. Debt Equity Ratio Test: Loans cannot be in excess of twice the Equity
Funds post Buy-Back
Particulars `
(a) Loan funds (`) (18,75,000 + 10,00,000 + 45,25,000
16,50,000)
(b) Minimum equity to be maintained after buy-
back in the ratio of 2:1 (`) (a/2) 22,62,500
(c) Present equity/shareholders fund (`) 31,25,000
(d) Future equity/shareholders fund (`) (see 28,37,500 ∗2F
W.N.) (31,25,000 – 2,87,500)
(e) Maximum permitted buy-back of Equity (`) 5,75,000
[(d) – (b)]
(f) Maximum number of shares that can be 28,750 shares
bought back @ ` 20 per share
(g) Actual Buy-Back Proposed 25,000 Shares
Summary statement determining the maximum number of shares to
be bought back
Particulars Number of
shares
Shares Outstanding Test 31,250
Resources Test 39,062
∗
As per Section 68 (2) (d) of the Companies Act 2013, the ratio of debt owed by the
company should not be more than twice the capital and its free reserves after such buy-
back. Further under Section 69 (1), on buy-back of shares out of free reserves a sum equal
to the nominal value of the share bought back shall be transferred to Capital Redemption
Reserve (CRR). As per section 69 (2) utilization of CRR is restricted to fully paying up
unissued shares of the Company which are to be issued as fully paid-up bonus shares only.
It means CRR is not available for distribution as dividend. Hence, CRR is not a free reserve.
Therefore, for calculation of future equity i.e. share capital and free reserves, amount
transferred to CRR on buy-back has to be excluded from the present equity.
© The Institute of Chartered Accountants of India
12.46 ADVANCED ACCOUNTING
Debt Equity Ratio Test 28,750
Maximum number of shares that can be bought 28,750
back [least of the above]
Company qualifies all tests for buy-back of shares and came to the
conclusion that it can buy maximum 28,750 shares on 1st April, 20X1.
However, company wants to buy-back only 25,000 equity shares
@ ` 20. Therefore, buy-back of 25,000 shares, as desired by the
company is within the provisions of the Companies Act, 2013.
Journal Entries for buy-back of shares
Particulars Debit (`) Credit (`)
(a) Equity shares buy-back account Dr. 5,00,000
To Bank account 5,00,000
(Being buy-back of 25,000 equity shares of
` 10 each @ ` 20 per share)
(b) Equity share capital account Dr. 2,50,000
Securities premium account Dr. 2,50,000
To Equity shares buy-back account 5,00,000
(Being cancellation of shares bought back)
(c) Revenue reserve account Dr. 2,50,000
To Capital redemption reserve account 2,50,000
(Being transfer of free reserves to capital
redemption reserve to the extent of
nominal value of capital bought back
through free reserves)
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.47
Balance Sheet of M/s. Competent Ltd.
as at 31st March, 20X1
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 10,00,000
B Reserves and Surplus 2 16,25,000
2 Non-current liabilities
Long term borrowings 3 28,75,000
3 Current liabilities
A Other Current Liabilities 16,50,000
Total 71,50,000
Assets
1 Non-current assets
A Property, plant and equipment 4 46,50,000
2 Current assets
Other Current Assets (30,00,000 – 25,00,000
A 5,00,000)
Total 71,50,000
Notes to accounts
No. Particulars `
1 Share Capital
Authorized, issued and subscribed
capital:
Equity share capital (fully paid up shares
of ` 10 each) 10,00,000
© The Institute of Chartered Accountants of India
12.48 ADVANCED ACCOUNTING
2 Reserves and Surplus
Profit and Loss A/c 1,25,000
Revenue reserves 15,00,000
Less: Transfer to CRR (2,50,000) 12,50,000
Securities premium 2,50,000
Less: Utilization for share buy-back (2,50,000) -
Capital Redemption Reserves 2,50,000
Total 16,25,000
3 Long term borrowings
14% Debentures 18,75,000
Unsecured Loans 10,00,000
Total 28,75,000
4 Property, plant and equipment
Land and Building 19,30,000
Plant and machinery 18,00,000
Furniture and fitting 9,20,000
Net carrying value 46,50,000
Working Note:
Amount transferred to CRR and maximum equity to be bought back will be
calculated by simultaneous equation method.
Suppose amount transferred to CRR account is ‘x’ and maximum permitted
buy-back of equity is ‘y’.
Then
(31,25,000 – x) – 22,62,500 = y (1)
y
× 10 = x or 2x = y (2)
20
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.49
by solving the above equation, we get
x = `2,87,500
y = ` 5,75,000
11. (i) Journal Entries in the books of Z Ltd. (` in lakhs)
Particulars
1 Bank A/c Dr. 5,000
To Investments A/c 4,700
To Profit and Loss A/c 300
(Being investment sold on profit for the
purpose of buy-back)
2 10% Redeemable Preference Share Capital Dr. 5,000
A/c Dr. 500
Premium on Redemption of Preference Shares 5,500
A/c
To Preference Shareholders A/c
(Being redemption of preference share capital
at premium of 10%)
3 Profit and Loss A/c Dr. 500
To Premium on Redemption of Preference 500
Shares A/c
(Being premium on redemption of preference
shares adjusted through securities premium)
4 Equity Share Capital A/c Dr. 1,600
Premium on buyback Dr. 1,600
To Equity buy-back A/c 3,200
(Being Equity Share bought back, Share
Capital cancelled, and Premium on Buyback
accounted for)
5 Securities Premium A/c (1,600) Dr. 1,600
To Premium on Buyback A/c
(Being premium on buyback provided out of 1,600
securities premium)
© The Institute of Chartered Accountants of India
12.50 ADVANCED ACCOUNTING
6. Preference Shareholders A/c 5,500
Equity buy-back A/c 3,200
To Bank A/c 8,700
(Being payment made to preference
shareholders and equity shareholders)
7 General Reserve Account 6,600
To Capital Redemption Reserve Account 6,600
(Being amount transferred to capital
redemption
reserve account towards face value of
preference shares redeemed and equity
shares bought back)
(ii) Balance Sheet of C Ltd. (after Redemption and Buyback)
(` Lakhs)
Particulars Note No Amount
EQUITY AND LIABILITIES `
(I) Shareholders’ Funds:
(a) Share Capital 1 14,400
(b) Reserves and Surplus 2 14,400
Non-Current Liabilities:
(2)
(a) Long Term Borrowings 3 10,000
Current Liabilities:
(3)
(a) Trade payables 4,600
(b) Short Term Provisions 2,000
Total 45,400
(II) ASSETS
Non-Current Assets
(1)
PPE 28,000
© The Institute of Chartered Accountants of India
BUY-BACK OF SECURITIES 12.51
Current Assets:
(a) Cash and Cash equivalents (W N) 900
(b) Other Current Assets 16,500
45,400
Notes to Accounts
` in Lakhs
1. Share Capital
1,440 lakh Equity Shares of ` 10 each
Fully Paid up (160 lakh Equity Shares
bought back) 14,400
2. Reserves and Surplus
General Reserve 12,000
Less: Transfer to CRR (6,600) 5,400
Capital Redemption Reserve 2,000
Add: Transfer due to buy-back of 6,600
shares from Gen. res. 8,600
Securities premium 1,600
Less: Adjustment for premium paid on (1,600)
buy back
Profit & Loss A/c 600
Add: Profit on sale of investment 300
Less: Adjustment for premium paid (500)
on redemption of preference
shares 400 14,400
3. Long-term borrowings
Secured
9 % Debentures 10,000
© The Institute of Chartered Accountants of India
12.52 ADVANCED ACCOUNTING
Working Note:
Bank Account
Amount Amount
(` Lakhs) (` Lakhs)
To balance b/d 4,600 By Preference 5,500
Shareholders A/c
To Investment A/c 5,000 By Equity buy back A/c 3,200
(sale
Proceeds)
By Balance c/d (Balancing
figure) 900
9,600 9,600
© The Institute of Chartered Accountants of India
CHAPTER 13
AMALGAMATION OF
COMPANIES
LEARNING OUTCOMES
After studying this chapter, you will be able to:
♦ Understand the term “Amalgamation” and the methods of accounting
for amalgamations.
♦ Appreciate the concept of transferee Company and the transferor
company.
♦ Meaning of purchase consideration and Calculation of Purchase
consideration under various Methods.
♦ Pass the entries to close the books of the vendor company.
♦ Pass the journal entries in the books of purchasing company to
incorporate the assets and liabilities of the vendor company and also
giving effect to other adjustments.
♦ Preparation of Balance sheet of transferee company after
Amalgamation.
© The Institute of Chartered Accountants of India
13.2 ADVANCED ACCOUNTING
CHAPTER OVERVIEW
This chapter deals with accounting for amalgamations and the treatment of any
resultant goodwill or reserves. Amalgamation means an amalgamation pursuant
to the provisions of the Companies Act 2013 or any other statute which may be
applicable to companies.
Types of Amalgamation
Amalgamation in the nature of Amalgamation in the nature of
merger purchase
1. INTRODUCTION
In today’s modern world, we are witnessing, the rise of different business ideas
every other day. This has attributed to the immense increase in the competition.
Some of the shrewd businesses survive through this cut throat competition,
whereas some of them are wiped out due to the dynamics of this very
competition.
Like the strategies to set up businesses, there has been wide increase in realizing
the need to stay in the business through the different difficult market situations.
Hence, the business world has also seen the growing importance of business-
saving strategies.
There can be different strategies to ensure the business continues to exist, or
existing companies find ways to increase market share by eliminating the
competitors or to come out of financial crisis by restructuring the present capital
structure and the like.
© The Institute of Chartered Accountants of India
13.3
AMALGAMATION OF COMPANIES
Such strategies are termed using different words like “corporate marriages”,
“strategic alliances”, “business partnering”, etc. The same has been defined in the
Accounting Standard 14 (AS 14).
In this chapter we shall understand the terms, meanings, methods, accounting
treatments related to amalgamation in detail.
2. MEANING OF AMALGAMATION
Amalgamation refers to the process of merger of two or more companies into a
single entity or where one company takes over the other by outright purchase.
Therefore, the term ‘amalgamation’ contemplates two kinds of activities:
(i) two or more companies join to form a new company (Popularly known as
Amalgamation) or
(ii) absorption and blending of one by the other (Popularly known as
Absorption).
As discussed, this arrangement is sought by companies to receive various
advantages such as economies of large-scale production, avoiding competition,
increasing efficiency, expansion, increase in market share, etc.
In amalgamation we have generally two companies called as – 1) vendor or
Transferor Company and 2) Vendee or Transferee Company. Let us understand
the concepts through the following examples-
Example 1- Company A and Company B amalgamate to form Company C.
Company A and Co B are called transferor companies and Company C is called as
the transferee company- this strategy is called as AMALGAMATION.
Example 2- Company A is taken over by Company B (purchased). Here, Company
A is called as Transferor Company and Company B is Transferee Company. This
strategy is called as ABSORPTION.
Example 3- Company A has been suffering from losses for past 5 years, a new
Company B is floated to take over the existing Company A. Here, Company A is
the transferor company and Company B is Transferee Company. This strategy is
termed as EXTERNAL RECONSTRUCTION.
© The Institute of Chartered Accountants of India
13.4 ADVANCED ACCOUNTING
The concept of the examples given above can be understood from the following
table of differences-
Basis Amalgamation Absorption External
Reconstruction
Meaning Two or more In this case an In this case, a newly
companies are existing company formed company
wound up and a takes over the takes over the
new company is business of one or business of an
formed to take over more existing existing company.
their business. companies.
Minimum At least three At least two Only two companies
number of companies are companies are are involved.
Companies involved. involved.
involved
Number of Only one resultant No new resultant Only one resultant
new resultant company is formed. company is formed. company is formed.
companies Two companies are Under this case a
wound up to form a newly formed
single resultant company takes over
company. the business of an
existing company.
Objective Amalgamation is Absorption is done External
done to cut to cut competition & reconstruction is
competition & reap reap the economies done to reorganize
the economies in in large scale. the financial
large scale. structure of the
company.
In every type of amalgamation, the assets and liabilities of the transferor company
are amalgamated or transferred to the transferee company. The accounting
treatment in the books of both the transferor and transferee is given in further
sections.
© The Institute of Chartered Accountants of India
13.5
AMALGAMATION OF COMPANIES
3. TYPES OF AMALGAMATION
The Institute of Chartered Accountants of India has introduced Accounting
Standard -14 (AS 14) on ‘Accounting for Amalgamations’. The standard
recognizes two types of amalgamation –
Amalgamation in the nature of merger is an amalgamation where there is a
genuine pooling not only of assets and liabilities of the transferor and transferee
companies but also of the shareholders’ interests and of the businesses of the
companies. The accounting treatment of such amalgamations should ensure that
the resultant figures of assets, liabilities, capital and reserves more or less
represent the sum of the respective figures of the transferor and transferee
companies.
Amalgamation in the nature of merger is an amalgamation, as per para 3(e) of
AS-14, which satisfies all the following conditions:
(i) All the assets and liabilities of the transferor company become, after
amalgamation, the assets and liabilities of the transferee company.
(ii) Shareholders holding not less than 90% of the face value of the equity
shares of the transferor company (other than the equity shares already held
therein, immediately before the amalgamation, by the transferee company
or its subsidiaries or their nominees) become equity shareholders of the
transferee company by virtue of the amalgamation.
(iii) The consideration for the amalgamation receivable by those equity
shareholders of the transferor company who agree to become equity
shareholders of the transferee company is discharged by the transferee
company wholly by the issue of equity shares in the transferee company,
except that cash may be paid in respect of any fractional shares.
(iv) The business of the transferor company is intended to be carried on, after
the amalgamation, by the transferee company.
(v) No adjustment is intended to be made to the book values of the assets and
liabilities of the transferor company when they are incorporated in the
financial statements of the transferee company except to ensure uniformity
© The Institute of Chartered Accountants of India
13.6 ADVANCED ACCOUNTING
of accounting policies. For example, if transferor company is following
weighted average method for inventory valuation, the book value of the
inventory of the transferor company will be revised by applying the FIFO
method (if the transferee company follows FIFO method for inventory
valuation).
If any one or more of the above conditions are not satisfied in an amalgamation,
such amalgamation is called amalgamation in the nature of purchase.
Difference between amalgamation in the nature of merger and
amalgamation in the nature of purchase
Best of Distinction Amalgamation in the Amalgamation in the
Nature of Merger Nature of Purchase
(a) Transfer of There is transfer of all There need not be transfer
Assets and assets & liabilities. for all assets & liabilities.
Liabilities
(b) Shareholders of Equity shareholders Equity shareholders need
transferor holding 90% equity not become shareholders
company shares in transferor of transferee company.
company become
shareholders of
transferee company.
(c) Purchase Purchase consideration is Purchase consideration
Consideration discharged wholly by need not be discharged
issue of equity shares of wholly by issue of equity
transferee company shares.
(except cash only for
fractional shares)
(d) Same Business The same business of the The business of the
transferor company is transferor company need
intended to be carried on not be intended to be
by the transferee carried on by the
company. transferee company.
© The Institute of Chartered Accountants of India
13.7
AMALGAMATION OF COMPANIES
(e) Recording of The assets & liabilities The assets & liabilities
Assets & taken over are recorded taken over are recorded at
Liabilities at their existing carrying their existing carrying
amounts except where amounts or the basis of
adjustment is required to their fair values.
ensure uniformity of
accounting policies.
(f) Method of Journal entries for Journal entries for
Accounting recording the merger are recording the purchase of
passed by pooling of business are passed by
interest method. purchase method.
4. PURCHASE CONSIDERATION
For purpose of accounting for amalgamations, we are essentially guided by AS 14
‘Accounting for Amalgamations’. Para 3(g) of AS 14 defines the term purchase
consideration as the “aggregate of the shares and other securities issued and the
payment made in the form of cash or other assets by the transferee company to the
shareholders of the transferor company”.
In simple words, it is the price payable by the transferee company to the
transferor company for taking over the business of the transferor company.
The important point to be noted here is the amount paid towards the equity
shareholders and preference shareholders is only considered as part of the
purchase consideration as per the definition under AS-14. Hence, it should be
noted that purchase consideration does not include the sum which the transferee
company will directly pay to the debenture-holders or creditors of the transferor
company. If a certain liability of the transferor company has not been taken over
by the transferee company it will be discharged by the transferor company.
The purchase consideration can be computed in the following methods-
1. Lumpsum method- Under this method, the transferee company agrees to
pay a lumpsum/fixed amount to shareholders of the transferor company.
© The Institute of Chartered Accountants of India
13.8 ADVANCED ACCOUNTING
2. Net payment method- Under this method the transferee company makes
individual payments to the equity shareholders and preference shareholders
either by way of cash, issue of shares and debentures.
3. Net assets method- Under this method, the purchase consideration is
arrived based on the value of the Assets less the outside liabilities
(excluding share capital and reserves) taken over by the transferee
company. As per AS 14, the value of the assets and liabilities shall be at the
value as agreed between the two parties. If there is no value agreed, then
assets and liabilities taken at the book value.
The purchase consideration essentially depends upon the fair value of its
elements. For example, when the consideration includes securities, the value
fixed by the statutory authority may be taken as the fair value. In case of
other assets, the fair value may be determined by reference to the market
value of the assets given up or in the absence of market value, net book
value of the assets (i.e. cost less accumulated depreciation) are considered.
4. Intrinsic value or share exchange method – Under this method, the
purchase consideration is calculated at the intrinsic value of shares of the
transferor or transferee company. The ratio of shares to be issued is
computed and multiplied with intrinsic value. Total share capital of the
transferor company shall be divided by the total number of shares
Sometimes adjustments may have to be made in the purchase consideration in
the light of one or more future events. When the additional payment is probable
and can be reasonably estimated it is to be included in the calculation of
purchase consideration.
Any of the methods or a combination of the above methods can be used by the
companies to calculate the purchase consideration.
Purchase consideration either recorded at Issue price or at Par value.
The above methods have been explained in the following illustrations.
© The Institute of Chartered Accountants of India
13.9
AMALGAMATION OF COMPANIES
Illustration 1
S. Ltd. is absorbed by P. Ltd. S ltd. gives the following information on the date of
absorption:
`
Sundry Assets 13,00,000
Share capital:
2,000 7% Preference shares of ` 100 each (fully paid-up) 2,00,000
5,000 Equity shares of ` 100 each (fully paid-up) 5,00,000
Reserves 3,00,000
6% Debentures 2,00,000
Trade payables 1,00,000
Additional information:
P. Ltd. has agreed:
(i) to issue 9% Preference shares of ` 100 each, in the ratio of 3 shares of P. Ltd.
for 4 preference shares in S. Ltd.
(ii) to issue to the debenture-holders in S Ltd. 8% Mortgage Debentures at ` 96 in
lieu of 6% Debentures in S. Ltd. which are to be redeemed at a premium of
20%;
(iii) to pay ` 20 per share in cash and to issue six equity shares of ` 100 each
issued at the market value ` 125 in lieu of every five shares held in S. Ltd.;
and
(iv) to assume the liability to trade payables.
You are required to calculate the purchase consideration.
Solution
The purchase consideration will be
` Form
Preference shareholders: 2,000 × 3/4 × 100 1,50,000 9% Pref. shares
Equity shareholders: 5,000 × 20 1,00,000 Cash
5,000 × 6/5 × 125 7,50,000 Equity shares
10,00,000
© The Institute of Chartered Accountants of India
13.10 ADVANCED ACCOUNTING
Note:
1. According to AS 14, ‘consideration’ excludes the any amount payable to
debenture-holders. The liability in respect of debentures of S Ltd. will be
taken by P Ltd., which will then be settled by issuing new 8% debentures.
2. The issue of the equity shares is done at ` 125 (market value) as it has been
mentioned in the question. The face value shall not be considered for this
purpose.
Illustration 2
Following is the balance sheet of A Ltd. as on 31st March, 20X1
Particulars Notes ` (000)
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 22,50
B Reserves and Surplus 2 9,00
2 Non-current liabilities
A Long-term borrowings 3 7,00
3 Current liabilities
A Trade Payables 5,00
Total 43,50
Assets
1 Non-current assets
A Property, Plant and Equipment 4 32,50
B Non-current investments 5 6,00
2 Current assets
a Inventories 2,00
b Trade receivables 2,00
c Cash and Cash equivalents 1,00
Total 43,50
© The Institute of Chartered Accountants of India
13.11
AMALGAMATION OF COMPANIES
Notes to accounts
1 Share Capital ` in (‘000)
Equity share capital
1,50,000 Equity Shares of ` 10 each 15,00
7,500 14% Preference Shares of ` 100 each 7,50
22,50
2 Reserves and Surplus
General reserve 9,00
3 Long-term borrowings
Secured
15% Debentures 7,00
4 Property, plant and Equipment
Land and Building 32,50
5 Non-current investments
Investments at cost 6,00
B Ltd agreed to take over the assets and liabilities on the following terms and
conditions:
(a) Discharge 15% debentures at a premium of 10% by issuing 15% debentures
of X Ltd.
(b) PPE at 10% above the book value and investments at par value.
(c) Current assets at a discount of 10% and Current liabilities at book value.
(d) Preference shareholders are discharged at a premium of 10% by issuing 15%
preference shares of Rs.100 each.
(e) Issue 3 equity shares of ` 10 each for every 2 equity shares in B Ltd. and pay
the balance in cash.
Calculate Purchase consideration.
© The Institute of Chartered Accountants of India
13.12 ADVANCED ACCOUNTING
Solution
Calculation of Purchase Consideration (Net Asset value Method)
PARTICULARS (` in ‘000’s)
Value of assets taken over:
Property, Plant and Equipment 35,75
Non-Current Investments 6,00
Current Assets 4,50
Total Assets (A) 46,25
Less: Liabilities taken over:
15% Debentures 7,70
Current Liabilities 5,00
Total Liabilities (B) 12,70
Purchase consideration (A -B) 33,55
Mode of Purchase Consideration
In the form of 15% Preference shares 8,25
In the form of Equity shares 22,50
In the form of Cash (Balance) 2,80
Total 33,55
Illustration 3
Let us consider the Balance Sheet of X Ltd. as at 31st March, 20X1:
Particulars Notes ` (000)
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 100,00
B Reserves and Surplus 2 12,50
2 Non-current liabilities
A Long-term borrowings 3 40,00
3 Current liabilities
A Trade Payables 20,00
Total 172,50
© The Institute of Chartered Accountants of India
13.13
AMALGAMATION OF COMPANIES
Assets
1 Non-current assets
A Property, Plant and Equipment 4 105,50
B Non-current investments 5 5,00
2 Current assets
a Inventories 23,00
b Trade receivables 24,00
c Cash and Cash equivalents 15,00
Total 172,50
Notes to accounts
` in (‘000)
1 Share Capital
Equity share capital
7,50,000 Equity Shares of ` 10 each 75,00
25,000 14% Preference Shares of ` 100 each 25,00
100,00
2 Reserves and Surplus
General reserve 12,50
12,50
3 Long-term borrowings
Secured
14% Debentures 40,00
40,00
4 Property, plant and Equipment
Land and Building 50,00
Plant and machinery 45,00
Furniture 10,50
105,50
5 Non-current investments
Investments at cost 5,00
5,00
© The Institute of Chartered Accountants of India
13.14 ADVANCED ACCOUNTING
Other Information:
(i) Y Ltd. takes over X Ltd. on 10th April, 20X1.
(ii) Debenture holders of X Ltd. are discharged by Y Ltd. at 10% premium by
issuing 15% own debentures of Y Ltd.
(iii) 14% Preference Shareholders of X Ltd. are discharged at a premium of 20% by
issuing necessary number of 15% Preference Shares of Y Ltd. (Face value ` 100
each).
(iv) Intrinsic value per share of X Ltd. is ` 20 and that of Y Ltd. ` 30. Y Ltd. will
issue equity shares to satisfy the equity shareholders of X Ltd. on the basis of
intrinsic value. However, the entry should be made at par value only. The
nominal value of each equity share of Y Ltd. is ` 10.
Compute the purchase consideration.
Solution
Computation of Purchase consideration (` in ’000) Form
For Preference Shareholders of X Ltd. 3,000 30,000
15% Preference
shares in Y Ltd.
For equity shareholders of X Ltd. 5,000 5,00,000 Equity
(20/30 × 7,50,000) × ` 10 shares of Y Ltd.
of ` 10 each
Total Purchase consideration 8,000
Note: According to AS 14, amount paid to the debenture holders should not be
included in the purchase consideration calculation. Such debentures will be taken
over by Y Ltd. and then discharged by them later.
Illustration 4
Neel Ltd. and Gagan Ltd. amalgamated to form a new company on 1.04.20X1.
Following is the Balance Sheet of Neel Ltd. and Gagan Ltd. as at 31.3.20X1:
© The Institute of Chartered Accountants of India
13.15
AMALGAMATION OF COMPANIES
Particulars Notes Neel Gagan
Equity and Liabilities
1 Shareholders’ funds
A Share capital 7,75,000 8,55,000
2 Current liabilities 6,23,500 5,57,600
Total 13,98,500 14,12,600
Assets
1 Non-current assets
A Property, Plant and Equipment 1 12,35,000 12,54,000
2 Current assets 1,63,500 1,58,600
Total 13,98,500 14,12,600
Notes to accounts:
1 Property, plant and Equipment
Land and Building 7,50,000 6,40,000
Plant and machinery 4,85,000 6,14,000
12,35,000 12,54,000
Following is the additional information:
(i) The assets of Neel Ltd. and Gagan Ltd. are to be revalued as under:
Neel Gagan
` `
Plant and machinery 5,25,000 6,75,000
Building 7,75,000 6,48,000
(ii) The purchase consideration is to be discharged as under:
(a) Issue 24,000 equity shares of ` 25 each fully paid up in the proportion
of their profitability in the preceding 2 years.
© The Institute of Chartered Accountants of India
13.16 ADVANCED ACCOUNTING
(b) Profits for the preceding 2 years are given below:
Neel Gagan
` `
1st year 2,62,800 2,75,125
IInd year 2,12,200 2,49,875
Total 4,75,000 5,25,000
(c) Issue 12% preference shares of ` 10 each fully paid up at par to provide
income equivalent to 8% return on net assets in the business as on
31.3.20X1 after revaluation of assets of Neel Ltd. and Gagan Ltd.
respectively.
You are required to compute the
(i) Equity and preference shares issued to Neel Ltd. and Gagan Ltd.,
(ii) Purchase consideration.
Solution
(i) Calculation of equity shares to be issued to Neel Ltd. and Gagan Ltd.
Profits of Neel Gagan
` `
I year 2,62,800 2,75,125
II year 2,12,200 2,49,875
Total 4,75,000 5,25,000
The total profits- ` 4,75,000+ ` 5,25,000= ` 10,00,000
No. of shares to be issued = 24,000 equity shares in the proportion of the
preceding 2 years’ profits.
Neel Gagan
24,000 x 475/1000 11,400 equity shares
24,000 x 525/1000 12,600 equity shares
© The Institute of Chartered Accountants of India
13.17
AMALGAMATION OF COMPANIES
Calculation of 12% Preference shares to be issued to Neel Ltd. and
Gagan Ltd.
Neel Gagan
` `
Net assets (Refer working note) 8,40,000 9,24,000
8% return on Net assets 67,200 73,920
12% Preference shares to be issued 56,000 shares
100
67,200 × 12 = 5,60,000 @ ` 10 each
100 61,600 shares
73,920 × 12 = 6,16,000 @ ` 10 each
(ii) Total Purchase Consideration
Neel Gagan
` `
Equity shares @ of ` 25 each 2,85,000 3,15,000
12% Preference shares @ of ` 10 each 5,60,000 6,16,000
Total 8,45,000 9,31,000
Working Note:
Calculation of Net assets as on 31.3.20X1
Neel Gagan
` `
Plant and machinery 5,25,000 6,75,000
Building 7,75,000 6,48,000
Current assets 1,63,500 1,58,600
Less: Current liabilities (6,23,500) (5,57,600)
8,40,000 9,24,000
© The Institute of Chartered Accountants of India
13.18 ADVANCED ACCOUNTING
Note: Since the income from the preference shares shall be equal to the 8%
return on assets, the shares are computed in such way that 12% dividend on them
shall be equal to 8% of the return on Net assets.
5. METHODS OF ACCOUNTING FOR
AMALGAMATIONS
There are two main methods of accounting for amalgamation viz,
Methods of accounting for Amalgamation
Pooling of interests method Purchase method
The first method is used in case of amalgamation in the nature of merger where the
conditions as per para 3(e) of AS-14, required are fulfilled and the second method is
used in case of amalgamation in the nature of purchase.
Pooling of Interest Method
Under pooling of interests method, the assets, liabilities and reserves of the
Transferor Company will be taken over by Transferee Company at existing
carrying amounts unless any adjustment is required due to different accounting
policies followed by these companies.
As a result the difference between the amount recorded as share capital issued
(plus any additional consideration in the form of cash or other assets) and the
amount of share capital of Transferor Company should be adjusted in the reserves
of the financial statements of Transferee company (recorded as deduction from
the reserves where the capital issued is more than the capital of the transferor
company).
In simple terms, where in case of pooling method- the amount to be adjusted
against the reserves- can be computed in the following 3 steps-
© The Institute of Chartered Accountants of India
13.19
AMALGAMATION OF COMPANIES
Step I- Equity Share capital + Preference share capital issued+ any other
additional consideration in form of cash and other assets by the Transferee
Company.
Step II- Existing Equity share capital + Existing Preference share capital in the
books of Transferor Company.
Step III- Step I- Step II= amount to be adjusted from the reserves of Transferee
company.
Purchase Method
Assets and Liabilities: the assets and liabilities of the transferor company should
be incorporated at their existing carrying amounts or the purchase consideration
should be allocated to individual identifiable assets and liabilities on the basis of
their fair values at the date of amalgamation.
Difference between the Purchase Consideration and Net Assets transferred:
Any excess of the amount of purchase consideration over the value of the net
assets of the transferor company acquired by the transferee company should be
recognized as goodwill in the financial statement of the transferee company. Any
short fall should be shown as capital reserve. Goodwill should be amortized over
period of five years unless a somewhat longer period can be justified.
In simple terms, where in case of purchase method- the amount to be transferred
to capital reserve or to be recorded as Goodwill- can be computed in the
following 3 steps-
Step I- Find out the Net assets amount using the following formula- Total assets-
Outside liabilities (Non-current liabilities + Current Liabilities)
Step II- Compute the purchase consideration using any of the methods as given
under Purchase consideration computation.
Step III- (a) If Step I- Step II= Positive amount- then it is capital reserve- since the
assets received more than the amount paid as purchase consideration to acquire
them.
© The Institute of Chartered Accountants of India
13.20 ADVANCED ACCOUNTING
(b) If Step I- Step II= Negative amount- then it is to be recorded as Goodwill
(intangible asset) - since the amount paid for acquiring business is more than the
Net assets, which is technically due to its goodwill.
Treatment of reserves under purchase method
No reserves, other than statutory reserves, of the transferor company should
be incorporated in the financial statements of transferee-company.
The balance of Profit and Loss account, general reserves of the transferor
company are not recorded at all.
Though, normally, in an amalgamation in the nature of purchase, the identity of
reserves is not preserved, an exception is made only in respect of statutory
reserves and such reserves shall retain their identity in the financial statements of
the transferee company in the same form in which they appeared in the financial
statements of the transferor company, till the time their identity is required to be
maintained to comply with the relevant statute.
This exception is made only in those amalgamations where the requirements of
the relevant statute for recording the statutory reserves in the books of the
transferee company are complied with. Statutory reserves of the transferor
company should be incorporated in the balance sheet of transferee company by
way of the following journal entry.
Amalgamation Adjustment Reserve A/c Dr.
To Statutory Reserves
‘Amalgamation Adjustment Reserve’ is debited to bring in the statutory
reserves of the transferor company. This is represented as deduction from the
reserves of the transferee company after amalgamation.
Once after the time period to show such statutory reserves is over, both the
reserves and the aforesaid account are reversed. Amalgamation Adjustment
Reserve’ has to be shown as a separate line item - which implies, that this debit
"cannot be set off against Statutory reserve taken over" and therefore, the
presentation will be as follows:
© The Institute of Chartered Accountants of India
13.21
AMALGAMATION OF COMPANIES
Reserves
Description Amount Amount
(Current year) (Previous Year)
Statutory Reserve (taken over from
transferor company)
General Reserve
Retained Earnings
Amalgamation Adjustment Reserve (--) (--)
(negative balance)
6. JOURNAL ENTRIES TO CLOSE THE BOOKS OF
VENDOR COMPANY
In case of amalgamation under any of the above methods, there shall be an
accounting treatment both in the books of vendor (transferor) and vendee
(transferee) companies.
We will now, understand the treatment in the books of vendor under this section-
Since the books of the vendor will be closed upon amalgamation- the assets and
the liabilities at the book values are transferred to a separate account called as
the “Realization account”.
The purchase consideration receivable is credited to the Realization account. On
the receipt of the purchase consideration, it is debited to equity shareholders and
preference shareholders’ account. The balance of realization account (either
profit/loss) is transferred to the equity shareholders’ account.
Those assets and liabilities which are not taken over by vendee company but
settled by the vendor company are also shown in the books of the vendor only.
© The Institute of Chartered Accountants of India
13.22 ADVANCED ACCOUNTING
The journal entries have been explained with the following illustration:
Illustration 5
Wye Ltd. acquires the business of Zed Ltd. whose balance sheet as at 31st March,
20X1 is as under:
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 12,00,000
B Reserves and Surplus 2 1,58,000
2 Non-current liabilities
A Long-term borrowings 3 2,00,000
3 Current liabilities
A Trade Payables 1,20,000
B Other current liabilities 12,000
(Interest payable on debentures)
Total 16,90,000
Assets
1 Non-current assets
A Property, Plant and Equipment 4 10,00,000
B Intangible assets 5 2,90,000
2 Current assets
A Inventories 1,50,000
B Trade receivables 1,80,000
C Cash and Cash equivalents 70,000
Total 16,90,000
© The Institute of Chartered Accountants of India
13.23
AMALGAMATION OF COMPANIES
Notes to accounts:
`
1 Share Capital
Equity Share capital (` 100 each) 8,00,000
6% Preference Share capital (` 100 each) 4,00,000
12,00,000
2 Reserves and Surplus
Capital reserve 1,00,000
Profit and loss A/c 50,000
Workmen compensation reserve
(Expected liability ` 5,000) 8,000
1,58,000
3 Long-term borrowings
6% Debentures 2,00,000
2,00,000
4 Property, Plant and Equipment
Land and Building 4,00,000
Plant and machinery 6,00,000
10,00,000
5 Intangible assets
Goodwill 2,40,000
Patents 50,000
2,90,000
Wye Ltd. was to take over all assets (except cash) and liabilities (except for interest
due on debentures) and to pay following amounts:
(i) ` 2,00,000 7% Debentures (` 100 each) in Wye Ltd. for the existing debentures
in Zed Ltd.; for the purpose, each debenture of Wye Ltd. is to be treated as
worth ` 105.
© The Institute of Chartered Accountants of India
13.24 ADVANCED ACCOUNTING
(ii) For each preference share in Zed Ltd. ` 10 in cash and one 9% preference
share of ` 100 each in Wye Ltd.
(iii) For each equity share in Zed Ltd. ` 20 in cash and one equity share in Wye
Ltd. of ` 100 each having the market value of ` 140.
(iv) Expense of liquidation of Zed Ltd. are to be reimbursed by Wye Ltd. to the
extent of ` 10,000. Actual expenses amounted to ` 12,500.
Wye Ltd. valued Land and building at ` 5,50,000 Plant and Machinery at ` 6,50,000
and patents at ` 20,000 of Zed Ltd for the purpose of amalgamation.
Solution
Purchase Consideration
` Form
(i) Preference Shares: ` 10 per share 40,000 Cash
Preference shares 4,00,000 4,40,000 Preference shares
(ii) Equity shares: ` 20 per share 1,60,000 Cash
8,000 equity shares in
Wye Ltd. @ ` 140 11,20,000 12,80,000 Equity shares
17,20,000
Steps to close the Books of the Vendor Company
1. Open Realization Account and transfer all assets at book value.
Exception: If cash is not taken over by the purchasing company, it should
not be transferred.
Note: Profit and Loss Account (Dr.) and expenses not written off are not
assets and should not be transferred to the Realization Account.
The journal entry in the above case is:
` `
Realization A/c Dr. 16,20,000
To Sundries —
Goodwill 2,40,000
Land & Building 4,00,000
© The Institute of Chartered Accountants of India
13.25
AMALGAMATION OF COMPANIES
Plant & Machinery 6,00,000
Patents 50,000
Inventory 1,50,000
Trade receivables 1,80,000
(Transfer of assets to Realization Account on sale of business to Wye Ltd.)
2. Transfer to the Realization Account the liabilities which the purchasing
company is to take over. In case of the provisions, the portion which represents
liability expected to arise in future should be so transferred and the portion
which is not required (i.e., the reserve portion) should be treated as profit.
Accordingly, the following entry will be recorded:
` `
6% Debentures in Wye Ltd. Dr. 2,00,000
Workmen’s Compensation Reserve Dr. 5,000
Trade payables Dr. 1,20,000
To Realization A/c 3,25,000
(Transfer of liabilities taken over by Wye Ltd.
to Realization A/c)
For liabilities not take over by the purchasing company, the profit or loss on
discharge of such liabilities shall be transferred to Realization Account.
3. Debit purchasing company and credit Realization Account with the purchase
consideration.
Wye Ltd.- Dr. 17,20,000
To Realization A/c 17,20,000
(Amount receivable from Wye Ltd. for sale of business)
4. On receipt of the purchase consideration debit what is received (cash,
debentures, shares etc.) and credit the purchasing company. Thus —
Cash Dr. 2,00,000
9% Preference shares in Wye Ltd. Dr. 4,00,000
© The Institute of Chartered Accountants of India
13.26 ADVANCED ACCOUNTING
Equity shares in Wye Ltd. Dr. 11,20,000
To Wye Ltd. 17,20,000
(Receipt of purchase consideration from
the purchase company)
5. Expenses of liquidation have to be dealt with according to the circumstances of
each case.
(a) If the vendor company has to bear and pay them:
Realization Account should be debited and Cash Account credited.
(b) If the expenses are to be borne by the purchasing company, the
question may be dealt within one of the two ways mentioned below:
(i) It may be ignored in the books of the vendor company.
(ii) If the expenses are to be paid first by the vendor company and
afterwards reimbursed by the purchasing company, the following
two entries will be passed:
(a) Debit Purchasing company and credit Cash Account when
expenses are paid by the vendor company; and
(b) Debit Cash Account and credit purchasing company (on
the expenses being reimbursed).
In the above mentioned case Wye Ltd. has to pay maximum of
` 10,000 only whereas, the amount spent is ` 12,500. Hence ` 2,500 is
to be borne by Zed Ltd.; the entries required will be :
` `
Wye Ltd. Dr. 10,000
Realization A/c Dr. 2,500
To Cash A/c 12,500
(Liquidation expenses out of which
` 10,000 is payable by Wye Ltd.)
© The Institute of Chartered Accountants of India
13.27
AMALGAMATION OF COMPANIES
Cash A/c Dr. 10,000
To Wye Ltd. 10,000
(Account reimbursed by Wye Ltd. for expense)
6. Liabilities not assumed by the purchasing company, have to be paid off. On
payment, debit the liability concerned and credit cash. Any difference between
the amount actually paid and the book figure must be transferred to the
Realization Account. Zed Ltd. shall pass the following entries in this respect:
` `
Interest Outstanding Dr. 12,000
To Debentureholders A/c 12,000
(Amount due to debenture holders
for debentures interest)
Debentureholders Dr. 12,000
To Cash A/c 12,000
(Debentureholders paid cash ` 12,000
for outstanding interest)
7. Credit the preference shareholders with the amount payable to them,
debiting Preference Share Capital with the amount shown in the books,
transferring the difference between the two, if any, to the Realization
Account. Thus —
6% Pref. Share Capital A/c Dr. 4,00,000
Realization A/c Dr. 40,000
To Preference Shareholders A/c 4,40,000
(The amount due to preference
shareholders for capital and the extra
amount payable under the scheme of
absorption)
© The Institute of Chartered Accountants of India
13.28 ADVANCED ACCOUNTING
Note: In the absence of any indication to the contrary, preference
shareholders will be entitled only to the capital contributed by them. But if
funds available after paying off creditors are not sufficient to satisfy the
claim of preference shareholders fully, they will have to suffer a loss to the
extent of the deficit.
8. Pay off preference shareholders by debiting them and crediting whatever is
given to them. The entry in the above case is :
` `
Preference shareholders A/c Dr. 4,40,000
To Cash A/c 40,000
To 9% Preference shares in Wye Ltd. 4,00,000
(Cash and preference shares in Wye
Ltd. given to preference shareholders)
9. Transfer equity share capital and account representing profit or loss (including
the balance in Realization Account) to Equity Shareholders Account. This will
determine the amount receivable by the equity shareholders. Zed Ltd. shall
pass the following entries in this regard :
` `
Equity Share Capital A/c Dr. 8,00,000
Capital Reserve A/c Dr. 1,00,000
Profit and Loss A/c Dr. 50,000
Workmen’s Compensation Reserve A/c Dr. 3,000
Realization A/c Dr. 3,82,500
To Equity Shareholders A/c 13,35,500
(Various accounts representing capital and
profit transferred to Equity Shareholders Account)
© The Institute of Chartered Accountants of India
13.29
AMALGAMATION OF COMPANIES
10. On satisfaction of the claims of the equity shareholders, debit their account
and credit whatever is given to them. Hence:
Equity Shareholders A/c Dr. 13,35,500
To Equity Shares in Wye Ltd. 11,20,000
To Cash A/c (W.N.2) 2,15,500
Working Notes
1. Realization Account
` `
To Sundry Assets 16,20,000 By Sundry Liabilities 3,25,000
To Cash (excess expenses of liquidation) 2,500 By Wye Ltd. 17,20,000
To Preference Shareholders 40,000
To Equity Shareholders A/c -
profit transferred 3,82,500
20,45,000 20,45,000
2. Cash Account
` `
To Balance b/d 70,000 By Realization 2,500
To Wye Ltd. 2,00,000 By Wye Ltd. 10,000
(consideration for amalgamation)
To Wye Ltd. 10,000 By Debenture-holders 12000
(liquidation expenses reimbursed) By Preference shareholder 40000
By Equity Shareholder (B/F) 215500
280000 280000
7. ENTRIES IN THE BOOKS OF PURCHASING
COMPANY
In the books of the purchasing/ vendee/ transferee company, the assets and
liabilities which are taken overs are recorded at the agreed values and where
there is no agreed value then at the book values.
© The Institute of Chartered Accountants of India
13.30 ADVANCED ACCOUNTING
Continuing with the information given in Illustration 5:
1. Debit Business Purchase Account and Credit Liquidator of the vendor
company with the account of the purchase consideration. Thus -
` `
Business Purchase A/c Dr. 17,20,000
To Liquidator of Zed Ltd. 17,20,000
(Amount payable to Zed Ltd. as per agreement dated....)
2. (i) Debit assets acquired (except goodwill) at the value placed on them
by the purchasing company;
(ii) Credit liabilities taken over at agreed values and credit Business
Purchase Account with the amount of purchase consideration; and
(iii) If the credits as per (ii) above exceed debits as per (i) above, the
difference should be debited to Goodwill Account, in the reverse
case, the difference should be credited to Capital Reserve.
Note: The amount of Goodwill or Capital Reserve that shall be included will
be the amount as has been arrived at only in foregoing manner.
In the above case the entry to be passed shall be:
` `
Land and Building A/c Dr. 5,50,000
Plant and Machinery A/c Dr. 6,50,000
Patents A/c Dr. 20,000
Inventory A/c Dr. 1,50,000
Trade receivables Dr. 1,80,000
Goodwill Dr. 5,05,000
© The Institute of Chartered Accountants of India
13.31
AMALGAMATION OF COMPANIES
To
Provision for Workmen’s Compensation A/c 5,000
Trade payables 1,20,000
Debentures in Z Ltd. 2,10,000
Business Purchases Account 17,20,000
(Various assets and liabilities taken over from Zed Ltd.Goodwill ascertained as
a balancing figure)
3. On the payment to the vendor company the balance at its credit, the entry
to be made by Wye Ltd. shall be:
` `
Liquidator of Zed Ltd. Dr. 17,20,000
To Cash 2,00,000
To 9% Preference Share Capital A/c 4,00,000
To Equity Share Capital A/c 8,00,000
To Securities Premium A/c 3,20,000
(Payment of cash and issue of shares in
satisfaction of purchase consideration)
4. Debentures in Z Ltd. A/c Dr. 2,10,000
To 7% Debentures A/c 2,00,000
To Premium on Debentures A/c 10,000
(Debentures issued)
5. If the purchasing company is required to pay the expenses of liquidation of the
vendor company, the amount should be debited to the Goodwill or Capital
Reserve Account, as the case may be. In the instant case, the entry shall be:
Goodwill Account Dr. 10,000
To Cash Account 10,000
(Amount paid towards liquidation expenses on Zed Ltd.)
© The Institute of Chartered Accountants of India
13.32 ADVANCED ACCOUNTING
Typical adjustments which shall be noted while working out the problems
Entries at par value - The students will note that purchasing company is left with
a large debit in the Goodwill Account (Step No. 2) accompanied by quite a large
amount in the Securities Premium Account (Step No. 3). The two cannot be
adjusted. However, it would be permissible to negotiate on the basis to the
market value of the shares but to make entries only on the basis of par of shares
of purchasing company. This will mean that Goodwill Account (or Capital Reserve)
will be automatically adjusted for the securities premium.
Inter Company-owing - Should the purchasing company owe an amount to the
vendor company or vice versa, the amount will be included in the book debts of
one company and trade payables of the other. This should be adjusted by the
entry:
Trade payables Dr.
To Trade receivables
The entry should be made after the usual acquisition entries have been passed. At
the time of preparing the Realization Account and passing the business purchase
entries, no attention need be paid to the fact that the two companies involved
owed money mutually.
Adjustment of the value of stock - Inter-company owings arise usually from
purchase and sale of goods; it is likely, therefore, that at the time, of the sale of
business, the debtor company also has goods in stock which it purchased from
the creditor company - the cost of the debtor company will include the profit
made by the creditor company. After the takeover of the business it is essential
that such a profit is eliminated. The entry for this will be made by the purchasing
company. If it is the vendor company which has such goods in stock, at the time
of passing the acquisition entries, the value of the stock should be reduced to its
cost to the company which is acquiring the business; automatically goodwill or
capital reserve, as the case may be, will be adjusted. But if the original sale was
made by the vendor company and the stock is with the company acquiring the
© The Institute of Chartered Accountants of India
13.33
AMALGAMATION OF COMPANIES
business, the latter company will have to debit Goodwill (or Capital Reserve) and
credit stock with the amount of the profit included in the stock.
Inter-company Loans- Where there is any loan taken by the transferor company
from the transferee company then the amount of the loan shall be taken over by
the transferee company and adjustment entry to be passed as follows-
Loan (liability of Transferor co) A/c Dr XXX
To Loans and advances (assets) XXX
(Elimination of the inter-company loans taken by
the transferor from transferee company).
Illustration 6
The following Balance Sheets are given as at 31st March, 20X1:
Particulars ` Best Ltd. ` Better Ltd.
(in lakhs) (in lakhs)
Equity and Liabilities
1 Shareholders’ funds
A Share capital 20 10
(shares of ` 100 each, fully pad)
B Reserves and Surplus 10 8
2 Current liabilities 20 2
Total 50 20
Assets
1 Non-current assets
A Property, Plant and Equipment 25 15
B Non-current investments 5 -
2 Current assets 20 5
Total 50 20
© The Institute of Chartered Accountants of India
13.34 ADVANCED ACCOUNTING
The following further information is given:
(a) Better Limited issued bonus shares on 1st April, 20X1, in the ratio of one share
for every two held, out of Reserves and Surplus.
(b) It was agreed that Best Ltd. will take over the business of Better Ltd., on the
basis of the latter’s Balance Sheet, the consideration taking the form of
allotment of shares in Best Ltd.
(c) The value of shares in Best Ltd. was considered to be ` 150 and the shares in
Better Ltd. were valued at ` 100 after the issue of the bonus shares. The
allotment of shares is to be made on the basis of these values.
(d) Liabilities of Better Ltd., included ` 1 lakh due to Best Ltd., for purchases from
it, on which Best Ltd., made profit of 25% of the cost. The goods of ` 50,000
out of the said purchases, remained in stock on the date of the above Balance
Sheet.
Make the closing ledger in the Books of Better Ltd. and the opening journal entries
in the Books of Best Ltd., and prepare the Balance Sheet as at 1st April, 20X1 after
the takeover.
Solution
LEDGER OF BETTER LIMITED
Property, Plant and Equipment (PPE) Account
` `
To Balance b/d 15,00,000 By Realization A/c (transfer)15,00,000
Current Assets Account
` `
To Balance b/d 5,00,000 By Realization A/c (transfer)5,00,000
Liabilities Account
` `
To Realization A/c 2,00,000 By Balance b/d 2,00,000
© The Institute of Chartered Accountants of India
13.35
AMALGAMATION OF COMPANIES
Realization Account
` `
To PPE A/c 15,00,000 By Liabilities A/c 2,00,000
” Current Assets A/c 5,00,000 ” Best Limited 15,00,000
(Purchase Consideration)
” Shareholders’ A/c 3,00,000
(Loss on Realization)
20,00,000 20,00,000
Share Capital Account
` `
To Sundry shareholders By Balance b/d 10,00,000
A/c - (transfer) 15,00,000 ” Reserves & Surplus A/c
(Bonus issue) 5,00,000
15,00,000 15,00,000
Reserves & Surplus Account
` `
To Share Capital (Bonus issue) 5,00,000 By Balance b/d 8,00,000
” Sundry Shareholders 3,00,000
8,00,000 8,00,000
Best Ltd.
` `
To Realization A/c - Purchase By Shares in Best Ltd 15,00,000
Consideration 15,00,000
15,00,000 15,00,000
© The Institute of Chartered Accountants of India
13.36 ADVANCED ACCOUNTING
Shares in Best Ltd.
` `
To Best Ltd. 15,00,000 By Sundry Shareholders A/c15,00,000
Sundry Shareholders Account
` `
To Realization A/c 3,00,000 By Share Capital A/c 15,00,000
(Loss) ” Reserves & Surplus A/c3,00,000
” Share in Best Ltd. 15,00,000
18,00,000 18,00,000
Journal of Best Ltd.
Dr. Cr.
20X1 ` `
Apr. 1 Property, Plant and Equipment A/c Dr. 15,00,000
Current Assets A/c Dr. 5,00,000
To Liabilities A/c 2,00,000
To Liquidator of Better Ltd. 15,00,000
To Capital Reserve A/c 3,00,000
(Assets & Liabilities of Better Ltd. taken over
for an agreed purchase consideration of `
15,00,000 as per agreement dated....)
Liquidator of Better Ltd. Dr. 15,00,000
To Share Capital A/c 10,00,000
To Securities Premium A/c 5,00,000
(Discharge of Purchase consideration by the
issue of equity shares of ` 10,00,000 at a
premium of ` 50 per share as per agreement)
© The Institute of Chartered Accountants of India
13.37
AMALGAMATION OF COMPANIES
Trade payables A/c Dr. 1,00,000
To Trade receivables A/c 1,00,000
(Amount due from Better Ltd., and included in
its creditors taken over, cancelled against own
Trade receivables)
Capital Reserve A/c Dr. 10,000
To Current Asset (Stock) A/c 10,000
(Unrealized profit on stock included in current
assets of Better Ltd. written off to Reserve
Account. 20% on sale value of `50,000 shall be
eliminated as unrealized profit)
Working Note :
Calculation of Purchase consideration:
Issued Capital of Better Ltd. (after bonus issue) at ` 100 per share ` 15,00,000
Purchase consideration has been discharged by Best Ltd. by the issue of shares
for ` 10,00,000 at a premium of ` 5,00,000. This gives the value of ` 150 per share.
Balance Sheet of Best Ltd. (After absorption)
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 30,00,000
b Reserves and Surplus 2 17,90,000
2 Current liabilities 21,00,000
Total 68,90,000
Assets
1 Non-current assets
a Property, Plant and Equipment 3 40,00,000
b Non-current investments 5,00,000
2 Current assets 23,90,000
Total 68,90,000
© The Institute of Chartered Accountants of India
13.38 ADVANCED ACCOUNTING
Notes to accounts
`
1 Share Capital
Equity share capital
Issued & Subscribed
30,000 shares of ` 100 (of the above 10,000
shares have been issued for consideration 30,00,000
other than cash)
Total 30,00,000
2 Reserves and Surplus
Capital Reserve (3,00,000 – 10,000) 2,90,000
Securities Premium 5,00,000
Other reserves and surplus 10,00,000
Total 17,90,000
3 Property, Plant and Equipment
PPE 25,00,000
Acquired during the year 15,00,000 40,00,000
Total 40,00,000
Illustration 7
K Ltd. and L Ltd. amalgamate to form a new company LK Ltd. The financial position
of these two companies as at the date of amalgamation was as under:
Particulars Notes ` K Ltd. ` L Ltd.
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 12,00,000 6,00,000
B Reserves and Surplus 2 3,71,375 1,97,175
© The Institute of Chartered Accountants of India
13.39
AMALGAMATION OF COMPANIES
2 Non-current liabilities
A Long-term borrowings 3 2,00,000 2,00,000
3 Current liabilities
A Trade Payables 1,00,000 2,10,000
Total 18,71,375 12,07,175
Assets
1 Non-current assets
A Property, Plant and Equipment 4 11,30,000 8,20,000
B Intangible assets 5 80,000 -
2 Current assets
A Inventories 2,25,000 1,40,000
B Trade receivables 2,75,000 1,75,000
C Cash and Cash equivalents 6 1,61,375 72,175
Total 18,71,375 12,07,175
Notes to accounts
1 Share Capital K Ltd. L Ltd.
Equity shares of ` 100 each 8,00,000 3,00,000
7% Preference Shares of ` 100 each 4,00,000 3,00,000
12,00,000 6,00,000
2 Reserves and Surplus
General reserve - 1,00,000
Profit and loss account 3,71,375 97,175
3,71,375 1,97,175
3 Long-term borrowings
5% Debentures 2,00,000 -
Secured loan - 2,00,000
2,00,000 2,00,000
© The Institute of Chartered Accountants of India
13.40 ADVANCED ACCOUNTING
4 Property, plant and Equipment
Land and Building 4,50,000 3,00,000
Plant and machinery 6,20,000 5,00,000
Furniture and fittings 60,000 20,000
11,30,000 8,20,000
5 Intangible assets
Goodwill 80,000 -
80,000 -
6 Cash and Cash Equivalents
Cash at Bank 1,20,000 55,000
Cash in hand 41,375 17,175
1,61,375 72,175
The terms of amalgamation are as under:
(A) (1) The assumption of liabilities of both the Companies.
(2) Issue of 5 Preference shares of ` 20 each in LK Ltd. @ ` 18 paid up at
premium of ` 4 per share for each preference share held in both the
Companies.
(3) Issue of 6 Equity shares of ` 20 each in LK Ltd. @ ` 18 paid up at a
premium of ` 4 per share for each equity share held in both the
Companies. In addition, necessary cash should be paid to the Equity
Shareholders of both the Companies as is required to adjust the rights
of shareholders of both the Companies in accordance with the intrinsic
value of the shares of both the Companies.
(4) Issue of such amount of fully paid 6% debentures in LK Ltd. as is sufficient
to discharge the 5% debentures in K Ltd. at a discount of 5% after takeover.
(B) (1) The assets and liabilities are to be taken at book values inventory and
trade receivables for which provisions at 2% and 2 ½ % respectively to
be raised.
(2) The trade receivables of K Ltd. include ` 20,000 due from L Ltd.
© The Institute of Chartered Accountants of India
13.41
AMALGAMATION OF COMPANIES
(C) The LK Ltd. is to issue 15,000 new equity shares of ` 20 each, ` 18 paid up at
premium of ` 4 per share so as to have sufficient working capital. Prepare
ledger accounts in the books of K Ltd. and L Ltd. to close their books.
Solution
Books of K Ltd.
Realization Account
` `
To Goodwill 80,000 By 5% Debentures 2,00,000
To Land & Building 4,50,000 By Trade payables 1,00,000
To Plant & Machinery 6,20,000 By LK Ltd. 15,60,000
To Furniture & Fitting 60,000 (Purchase consideration)
To Trade receivables 2,75,000 By Equity shareholders A/c 51,375
To Stores & inventory 2,25,000 (loss)
To Cash at Bank 1,20,000
To Cash in hand 41,375
To Preference shareholders
(excess payment) 40,000
19,11,375 19,11,375
Equity Shareholders Account
` `
To Realization A/c (loss) 51,375 By Share capital 8,00,000
To Equity Shares in LK Ltd. 10,56,000 By Profit & Loss A/c 3,71,375
To Cash 64,000
11,71,375 11,71,375
7% Preference Shareholders Account
` `
To Preference Shares in LK Ltd. 4,40,000 By Share capital 4,00,000
By Realization A/c 40,000
4,40,000 4,40,000
© The Institute of Chartered Accountants of India
13.42 ADVANCED ACCOUNTING
LK Ltd. Account
` `
To Realization A/c 15,60,000 By Equity Shares in LK Ltd.
For Equity 10,56,000
Pref. 4,40,000 14,96,000
By Cash 64,000
15,60,000 15,60,000
Books of L Ltd.
Realization Account
` `
To Land & Building 3,00,000 By Trade payables 2,10,000
To Plant & Machinery 5,00,000 By Secured loan 2,00,000
To Furniture & Fittings 20,000 By LK Ltd. (Purchase
To Trade receivables 1,75,000 consideration) 7,90,000
To Inventory of stores 1,40,000 By Equity shareholders A/c—
To Cash at bank 55,000 Loss 37,175
To Cash in hand 17,175
To Pref. shareholders 30,000
12,37,175 12,37,175
Equity Shareholders Account
` `
To Equity shares in LK Ltd. 3,96,000 By Share Capital 3,00,000
To Realization 37,175 By Profit & Loss A/c 97,175
To Cash 64,000 By Reserve 1,00,000
4,97,175 4,97,175
7% Preference Shareholders Account
` `
To Preference Shares in LK Ltd. 3,30,000 By Share capital 3,00,000
By Realization A/c 30,000
3,30,000 3,30,000
© The Institute of Chartered Accountants of India
13.43
AMALGAMATION OF COMPANIES
LK Ltd. Account
` `
To Realization A/c 7,90,000 By Equity shares in LK Ltd.
For Equity 3,96,000
Preference 3,30,000 7,26,000
By Cash 64,000
7,90,000 7,90,000
Working Notes:
(i) Purchase consideration
K Ltd. L Ltd.
` `
Payable to preference shareholders:
Preference shares at ` 22 per share 4,40,000 3,30,000
Equity Shares at ` 22 per share 10,56,000 3,96,000
Cash [See W.N. (ii)] 64,000 64,000
15,60,000 7,90,000
(ii) Value of Net Assets
K Ltd. L Ltd.
` `
Goodwill 80,000
Land & Building 4,50,000 3,00,000
Plant & Machinery 6,20,000 5,00,000
Furniture & Fittings 60,000 20,000
Trade receivables less 2.5% 2,68,125 1,70,625
Inventory less 2% 2,20,500 1,37,200
Cash at Bank 1,20,000 55,000
Cash in hand 41,375 17,175
18,60,000 12,00,000
© The Institute of Chartered Accountants of India
13.44 ADVANCED ACCOUNTING
Less : Debentures 2,00,000 –
Trade payables 1,00,000 2,10,000
Secured Loans – (3,00,000) 2,00,000 (4,10,000)
15,60,000 7,90,000
Payable in shares 14,96,000 7,26,000
Payable in cash 64,000 64,000
Illustration 8
Consider the following balance sheets of X Ltd. and Y Ltd. as at 31st March, 20X1:
Particulars Notes ` X Ltd ` Y Ltd.
(‘000) (‘000)
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 72,00 47,00
B Reserves and Surplus 2 15,50 10,50
2 Non-current liabilities
A Long-term borrowings 3 5,00 3,50
3 Current liabilities
A Trade Payables 4,50 3,50
B Other current liabilities 2,00 1,50
Total 99,00 66,00
Assets
1 Non-current assets
A Property, Plant and 4 63,25 36,00
Equipment
B Non-current investments 5 7,00 5,00
© The Institute of Chartered Accountants of India
13.45
AMALGAMATION OF COMPANIES
2 Current assets
A Inventories 12,50 9,50
B Trade receivables 9,00 10,30
C Cash and Cash equivalents 7,25 5,20
Total 99,00 66,00
Notes to accounts
X Ltd (‘000) Y Ltd (‘000)
1 Share Capital
Equity share capital (` 10 each) 50,00 30,00
14% Preference Shares capital ` 100 each 22,00 17,00
72,00 47,00
2 Reserves and Surplus
General reserve 5,00 2,50
Export profit reserve 3,00 2,00
Investment allowance reserve - 1,00
Profit and loss account 7,50 5,00
15,50 10,50
3 Long-term borrowings
13% Debentures of ` 100 each 5,00 3,50
5,00 3,50
4 Property, Plant and Equipment
Land and Building 25,00 15,50
Plant and machinery 32,50 17,00
Furniture 5,75 3,50
63,25 36,00
5 Non-current investments
Investments at cost 7,00 5,00
7,00 5,00
© The Institute of Chartered Accountants of India
13.46 ADVANCED ACCOUNTING
X Ltd. takes over Y Ltd. on 1st April, 20X1. X Ltd. discharges the purchase
consideration as below:
(i) Issued 3,50,000 equity shares of ` 10 each at par to the equity shareholders of
Y Ltd.
(ii) Issued 15% preference shares of ` 100 each to discharge the preference
shareholders of Y Ltd. at 10% premium.
The debentures of Y Ltd. will be converted into equivalent number of debentures of
X Ltd. The statutory reserves of Y Ltd. are to be maintained for 2 more years.
Show the (i) Journal entries and (ii) Balance sheet of X Ltd. after amalgamation on
the assumption that:
(a) the amalgamation is in the nature of merger.
(b) the amalgamation is in the nature of purchase.
Solution
(a) Amalgamation in the nature of merger:
(i) Journal Entries in the Books of X Ltd.
` ‘000 ` ‘ 000
Business Purchase Dr. 53,70
To Liquidator of Y Ltd. 53,70
(Consideration payable for business taken over from Y
Ltd)
Sundry Assets of Y Ltd Dr. 66,00
General Reserve (Related to X Ltd) 4,20
To Sundry Liabilities of Y Ltd 8,50
To Export profit Reserve 2,00
To Investment allowance Reserve 1,00
To Profit & Loss 5,00
To Business Purchase 53,70
(Incorporation of various assets and liabilities taken
over from Y Ltd. at book values and difference of share
capital and purchase consideration being adjusted with
free Reserves)
Liquidator of Y Ltd. Dr. 53,70
© The Institute of Chartered Accountants of India
13.47
AMALGAMATION OF COMPANIES
To Equity Share Capital 35,00
To 15% Preference Share Capital 18,70
(Discharge of consideration for Y Ltd.’ s business)
Sundry Liabilities in Y Ltd (13% Debentures in Y Ltd.) Dr. 3,50
To 13% Debentures 3,50
(Allotment of 13% Debentures to debenture holders of
Y Ltd. at Par)
(ii) Balance Sheet of X Ltd.
Particulars Notes ` in '000
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 12,570
b Reserves and Surplus 2 1,930
2 Non-current liabilities
a Long-term borrowings 3 850
3 Current liabilities
a Trade Payables 800
b Other current liabilities 350
Total 16,500
Assets
1 Non-current assets
a Property, Plant and Equipment 4 9,925
b Non-current investments 1,200
2 Current assets
a Inventories 2,200
b Trade receivables 1,930
c Cash and cash equivalents 1,245
Total 16,500
© The Institute of Chartered Accountants of India
13.48 ADVANCED ACCOUNTING
Notes to accounts
` in ‘ 000
1 Share Capital
Equity share capital
8,50,000 Equity Shares of ` 10 each 8,500
Preference share capital
18,700, 15% Preference Shares of ` 100 each 1,870
22,000, 14% Preference Shares of ` 100 each 2,200
Total 12,570
2 Reserves and Surplus
General Reserve of X Ltd. 500
Add: General reserve of Y Ltd. 250 750
Less: Adjustment for amalgamation* (670) 80
Export Profit Reserve of X Ltd. 300
Add: Export Profit Reserve of Y Ltd. 200 500
Investment Allowance Reserve 100
Profit & Loss A/c of X Ltd. 750
Add: Profit & Loss A/c of Y Ltd. 500 1,250
Total 1,930
3 Long-term borrowings
Secured
8,500 13% Debentures of ` 100 each 850
Total 850
4 Property, Plant and Equipment
Land & Buildings 4,050
Plant & Machinery 4,950
Furniture & Fittings 925
Total 9,925
© The Institute of Chartered Accountants of India
13.49
AMALGAMATION OF COMPANIES
*The difference between the amount recorded as share capital issued and the
amount of share capital of transferor-company should be adjusted in reserves.
Thus, Adjustment for amalgamation = ` ’000 (53,70 – 47,00) = ` (’000) 670
(b) Amalgamation in the nature of purchase:
(i) Journal Entries in the Books of X Ltd.
Dr. Cr.
` `
Business Purchase Dr. 53,70,000
To Liquidator of Y Ltd. 53,70,000
(Consideration payable for business taken over
from Y Ltd)
Sundry Assets of Y Ltd Dr. 66,00,000
To Sundry Liabilities of Y Ltd 8,50,000
To Capital Reserve 3,80,000
To Business Purchase 53,70,000
(Incorporation of various assets and liabilities taken
over from Y Ltd. at book values and difference of
Net assets and purchase consideration being
credited to Capital reserve)
Liquidator of Y Ltd. Dr. 53,70,000
To Equity Share Capital 35,00,000
To 15% Preference Share Capital 18,70,000
(Discharge of consideration for Y Ltd.’ s business)
13% Debentures in Y Ltd. Dr. 3,50,000
To 13% Debentures 3,50,000
(Allotment of 13% Debentures to debenture holders
of Y Ltd. at Par)
© The Institute of Chartered Accountants of India
13.50 ADVANCED ACCOUNTING
Balance Sheet of X Ltd.
Particulars Notes ` in'000
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 12,570
b Reserves and Surplus 2 1,930
2 Non-current liabilities
a Long-term borrowings 3 850
3 Current liabilities
a Trade Payables 800
b Other current liabilities 350
Total 16,500
Assets
1 Non-current assets
a Property, Plant and Equipment 4 9,925
b Non-current investments 1,200
2 Current assets
a Inventories 2,200
b Trade receivables 1,930
c Cash and cash equivalents 1,245
Total 16,500
Notes to accounts
` in'000
1 Share Capital
Equity share capital
8,50,000 Equity Shares of ` 10 each 8,500
Preference share capital
18,700, 15% Preference Shares of ` 100 each 1,870
22,000, 14% Preference Shares of ` 100 each 2,200
Total 12,570
© The Institute of Chartered Accountants of India
13.51
AMALGAMATION OF COMPANIES
2 Reserves and Surplus
Capital Reserve 380
General Reserve 500
Amalgamation adjustment reserve (300)
Export Profit Reserve 500
Investment Allowance Reserve 100
Surplus (Profit & Loss A/c) 750
Total 1,930
3 Long-term borrowings
Secured
8,500 13% Debentures of ` 100 each 850
Total 850
4 Property, Plant and Equipment
Land & Buildings 4,050
Plant & Machinery 4,950
Furniture & Fittings 925
Total 9,925
Workings Notes:
Capital Reserve arising on Amalgamation:
(A) Net Assets taken over: ` (’000) ` (’000)
Sundry Assets 66,00
Less: 13% Debentures 3,50
Trade payables 3,50
Other current liabilities 1,50 (8,50)
57,50
(B) Purchase consideration:
To Equity Shareholders of Y Ltd. 35,00
To Preference Shareholders of Y Ltd. 18,70
53,70
(C) Capital Reserve (A – B) 3,80
© The Institute of Chartered Accountants of India
13.52 ADVANCED ACCOUNTING
Illustration 9
The following are the Balance Sheets of P Ltd. and Q Ltd. as at 31st March, 20X1:
Particulars Notes ` P Ltd ` Q Ltd
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 8,00,000 4,00,000
B Reserves and Surplus 3,00,000 2,00,000
2 Non-current liabilities
A Long-term borrowings 2 2,00,000 1,50,000
3 Current liabilities
A Trade Payables 2,50,000 1,50,000
Total 15,50,000 9,00,000
Assets
1 Non-current assets
A Property, Plant and Equipment 7,00,000 2,50,000
B Non-current investments 80,000 80,000
2 Current assets
A Inventories 2,40,000 3,20,000
B Trade receivables 4,20,000 2,10,000
C Cash and Cash equivalents 1,10,000 40,000
Total 15,50,000 9,00,000
Notes to accounts
P Ltd. Q Ltd.
1 Share Capital
Equity shares of ` 10 each 6,00,000 3,00,000
10% Preference Shares of ` 100 each 2,00,000 1,00,000
8,00,000 4,00,000
2 Long term borrowings
12% Debentures 2,00,000 1,50,000
2,00,000 1,50,000
© The Institute of Chartered Accountants of India
13.53
AMALGAMATION OF COMPANIES
Details of Trade receivables and trade payables are as under:
P Ltd. (`) Q Ltd. (`)
Trade receivables
Debtors 3,60,000 1,90,000
Bills Receivable 60,000 20,000
4,20,000 2,10,000
Trade payables
Sundry Creditors 2,20,000 1,25,000
Bills Payable 30,000 25,000
2,50,000 1,50,000
Property, plant and equipment of both the companies are to be revalued at 15%
above book value. Both the companies are to pay 10% Equity dividend, but
Preference dividend having been already paid.
After the above transactions are given effect to, P Ltd. will absorb Q Ltd. on the
following terms:
(i) 8 Equity Shares of ` 10 each will be issued by P Ltd. at par against 6 shares of
Q Ltd.
(ii) 10% Preference Shareholders of Q Ltd. will be paid at 10% discount by issue
of 10% Preference Shares of ` 100 each at par in P Ltd.
(iii) 12% Debenture holders of Q Ltd. are to be paid at 8% premium by 12%
Debentures in P Ltd. issued at a discount of 10%.
(iv) ` 30,000 is to be paid by P Ltd. to Q Ltd. for Liquidation expenses. Sundry
Creditors of Q Ltd. include ` 10,000 due to P Ltd.
(v) Inventory in Trade and Debtors are taken over at 5% lesser than their book
value by P Ltd.
Prepare:
(a) Journal entries in the books of P Ltd.
(b) Statement of consideration payable by P Ltd.
© The Institute of Chartered Accountants of India
13.54 ADVANCED ACCOUNTING
Solution
(a) Journal Entries in the Books of P Ltd.
Dr. Cr.
` `
Property, Plant and Equipment Dr. 1,05,000
To Revaluation Reserve 1,05,000
(Revaluation of PPE at 15% above book value)
Reserve and Surplus Dr. 60,000
To Equity Dividend 60,000
(Declaration of equity dividend @ 10%)
Equity Dividend Dr. 60,000
To Bank Account 60,000
(Payment of equity dividend)
Business Purchase Account Dr. 4,90,000
To Liquidator of Q Ltd. 4,90,000
(Consideration payable for the business taken over from
Q Ltd.)
Property, Plant and Equipment (115% of ` 2,50,000) Dr. 2,87,500
Inventory (95% of ` 3,20,000) Dr. 3,04,000
Debtors Dr. 1,90,000
Bills Receivable Dr. 20,000
Investment Dr. 80,000
Cash at Bank Dr. 10,000
(` 40,000 –` 30,000 dividend paid)
To Provision for Bad Debts (5% of ` 1,90,000) 9,500
To Sundry Creditors 1,25,000
To 12% Debentures in Q Ltd. 1,62,000
To Bills Payable 25,000
© The Institute of Chartered Accountants of India
13.55
AMALGAMATION OF COMPANIES
To Business Purchase Account 4,90,000
To Capital Reserve (Balancing figure) 80,000
(Incorporation of various assets and liabilities taken over
from Q Ltd. at agreed values and difference of net assets
and purchase consideration being credited to capital
reserve)
Liquidator of Q Ltd. Dr. 4,90,000
To Equity Share Capital 4,00,000
To 10% Preference Share Capital 90,000
(Discharge of consideration for Q Ltd.’ s business)
12% Debentures in Q Ltd. (` 1,50,000 × 108%) Dr. 1,62,000
Discount on Issue of Debentures Dr. 18,000
To 12% Debentures 1,80,000
(Allotment of 12% Debentures to debenture holders of Q
Ltd. at a discount of 10%)
Sundry Creditors of Q Ltd. Dr. 10,000
To Sundry Debtors of P Ltd. 10,000
(Cancellation of mutual owing)
Goodwill Dr. 30,000
To Bank 30,000
(Being liquidation expenses reimbursed to Q Ltd.)
Capital Reserve Dr. 30,000
To Goodwill 30,000
(Being goodwill set off)
© The Institute of Chartered Accountants of India
13.56 ADVANCED ACCOUNTING
(b) Statement of Consideration payable by P Ltd. for 30,000 shares
(payment method)
30,000
Shares to be allotted × 8 = 40,000 shares of P Ltd.
6
Issued 40,000 shares of ` 10 each i.e. ` 4,00,000 (i)
For 10% preference shares, to be paid at 10% discount
1,00,000×90
` ` 90,000 (ii)
100
Consideration amount [(i) + (ii)] ` 4,90,000
Illustration 10
The financial position of two companies Hari Ltd. and Vayu Ltd. as at 31st March,
20X1 was as under:
Particulars Notes Hari Ltd. Vayu Ltd.
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 11,00,000 4,00,000
B Reserves and Surplus 2 70,000 70,000
2 Non-current liabilities
A Long term provisions 3 50,000 20,000
3 Current liabilities
A Trade Payables 1,30,000 80,000
Total 13,50,000 5,70,000
Assets
1 Non-current assets
A Property, Plant and Equipment 4 8,00,000 2,50,000
B Intangible assets 5 50,000 25,000
© The Institute of Chartered Accountants of India
13.57
AMALGAMATION OF COMPANIES
2 Current assets
A Inventories 2,50,000 1,75,000
B Trade receivables 2,00,000 1,00,000
C Cash and Cash equivalents 50,000 20,000
Total 13,50,000 5,70,000
Notes to accounts
Hari Ltd. Vayu Ltd.
1 Share Capital
Equity shares of ` 10 each 10,00,000 3,00,000
9% Preference Shares of ` 100 each 1,00,000 --
10% Preference Shares of ` 100 each -- 1,00,000
11,00,000 4,00,000
2 Reserves and Surplus
General reserve 70,000 70,000
70,000 70,000
3 Long term Provisions
Retirement gratuity fund 50,000 20,000
50,000 20,000
4 Property, plant and Equipment
Land and Building 3,00,000 1,00,000
Plant and machinery 5,00,000 1,50,000
8,00,000 2,50,000
5 Intangible assets
Goodwill 50,000 25,000
50,000 25,000
© The Institute of Chartered Accountants of India
13.58 ADVANCED ACCOUNTING
Hari Ltd. absorbs Vayu Ltd. on the following terms:
(a) 10% Preference Shareholders are to be paid at 10% premium by issue of 9%
Preference Shares of Hari Ltd.
(b) Goodwill of Vayu Ltd. is valued at ` 50,000, Buildings are valued at ` 1,50,000
and the Machinery at ` 1,60,000.
(c) Inventory to be taken over at 10% less value and Provision for Doubtful Debts
to be created @ 7.5%.
(d) Equity Shareholders of Vayu Ltd. will be issued necessary Equity Shares @ 5%
premium.
Prepare necessary Ledger Accounts to close the books of Vayu Ltd. and show the
acquisition entries in the books of Hari Ltd. Also draft the Balance Sheet after
absorption as at 31st March, 20X1.
Solution
In the Books of Vayu Ltd.
Realization Account
` `
To Sundry Assets 5,70,000 By Retirement 20,000
Gratuity Fund
To Preference Shareholders By Trade payables 80,000
(Premium on
Redemption) 10,000
To Equity Shareholders By Hari Ltd. (Purchase 5,30,000
(Profit on Realization) 50,000 Consideration) _______
6,30,000 6,30,000
© The Institute of Chartered Accountants of India
13.59
AMALGAMATION OF COMPANIES
Equity Shareholders Account
` `
To Equity Shares of Hari 4,20,000 By Share Capital 3,00,000
Ltd.
By General Reserve 70,000
By Realization
Account
(Profit on
_______ realization) 50,000
4,20,000 4,20,000
Preference Shareholders Account
` `
To 9% Preference Shares of 1,10,000 By Preference Share 1,00,000
Hari Ltd. Capital
By Realization
Account
(Premium on
Redemption of
Preference
____ Shares) 10,000
1,10,000 1,10,000
Hari Ltd. Account
` `
To Realization Account 5,30,000 By 9% Preference Shares 1,10,000
_______ By Equity Shares 4,20,000
5,30,000 5,30,000
© The Institute of Chartered Accountants of India
13.60 ADVANCED ACCOUNTING
In the Books of Hari Ltd.
Journal Entries
Dr. Cr.
` `
Business Purchase A/c Dr. 5,30,000
To Liquidators of Vayu Ltd. Account 5,30,000
(Being business of Vayu Ltd. taken over)
Goodwill Account Dr. 50,000
Building Account Dr. 1,50,000
Machinery Account Dr. 1,60,000
Inventory Account Dr. 1,57,500
Trade receivables Account Dr. 1,00,000
Bank Account Dr. 20,000
To Retirement Gratuity Fund Account 20,000
To Trade payables Account 80,000
To Provision for Doubtful Debts Account 7,500
To Business Purchase A/c 5,30,000
(Being Assets and Liabilities taken over as per
agreed valuation).
Liquidators of Vayu Ltd. A/c Dr. 5,30,000
To 9% Preference Share Capital A/c 1,10,000
To Equity Share Capital A/c 4,00,000
To Securities Premium A/c 20,000
(Being Purchase Consideration satisfied as
above).
© The Institute of Chartered Accountants of India
13.61
AMALGAMATION OF COMPANIES
Balance Sheet of Hari Ltd. (after absorption)
as at 31st March, 20X1
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
A Share capital 1 16,10,000
B Reserves and Surplus 2 90,000
2 Non-current liabilities
A Long-term provisions 3 70,000
3 Current liabilities
A Trade Payables 2,10,000
Total 19,80,000
Assets
1 Non-current assets
A Property, Plant and Equipment 4 11,10,000
B Intangible assets 5 1,00,000
2 Current assets
A Inventories 4,07,500
B Trade receivables 6 2,92,500
C Cash and cash equivalents 70,000
Total 19,80,000
Notes to accounts
`
1 Share Capital
Equity share capital
1,40,000 Equity Shares of ` 10 each fully 14,00,000
paid (Out of above 40,000 Equity Shares
were issued in consideration other than for
cash)
© The Institute of Chartered Accountants of India
13.62 ADVANCED ACCOUNTING
Preference share capital
2,100 9% Preference Shares of ` 100 each 2,10,000
(Out of above 1,100 Preference Shares were
issued in consideration other than for cash)
Total 16,10,000
2 Reserves and Surplus
Securities Premium 20,000
General Reserve 70,000
Total 90,000
3 Long-term provisions
Retirement Gratuity fund 70,000
Total 70,000
4 Property, Plant and Equipment
Buildings 4,50,000
Machinery 6,60,000
Total 11,10,000
5 Intangible assets
Goodwill 1,00,000
6 Trade receivables 3,00,000
Less: Provision for Doubtful Debts 7,500
2,92,500
Working Notes:
Purchase Consideration: `
Goodwill 50,000
Building 1,50,000
Machinery 1,60,000
Inventory 1,57,500
© The Institute of Chartered Accountants of India
13.63
AMALGAMATION OF COMPANIES
Trade receivables 92,500
Cash at Bank 20,000
6,30,000
Less: Liabilities:
Retirement Gratuity Fund (20,000)
Trade payables (80,000)
Net Assets/ Purchase Consideration 5,30,000
To be satisfied as under:
10% Preference Shareholders of Vayu Ltd. 1,00,000
Add: 10% Premium 10,000
1,100 9% Preference Shares of Hari Ltd. 1,10,000
Equity Shareholders of Vayu Ltd. to be satisfied by issue of
40,000 Equity Shares of Hari Ltd. at 5% Premium 4,20,000
Total 5,30,000
Illustration 11
The following are the Balance Sheets of A Ltd. and B Ltd. as at 31.3.20X1:
Particulars Notes ` A Ltd ` B Ltd
(in‘000) (in’000)
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 2,000 1,000
B Reserves and Surplus 2 1,000 (800)
2 Non-current liabilities
A Long-term borrowings 3 750 450
3 Current liabilities
A Trade Payables 300 300
B Short term Borrowings –
Bank overdraft -- 50
Total 4,050 1,000
© The Institute of Chartered Accountants of India
13.64 ADVANCED ACCOUNTING
Assets
1 Non-current assets
A Property, Plant and Equipment 2,700 850
B Non-current investments 700 --
2 Current assets
A Trade receivables 400 150
B Cash and Cash equivalents 250 --
(cash at bank)
Total 4050 1000
Notes to accounts
1 Share capital A Ltd. (‘000) B Ltd. (‘000)
Equity shares of ` 100 each 2000 1000
2000 1000
2 Reserves and Surplus
General reserve 1000 --
Profit and loss A/c (debit balance) -- (800)
1000 (800)
3 Long term borrowings
10% debentures 500 --
Loan from banks 250 450
750 450
B Ltd. has acquired the business of A Ltd. The following scheme of merger was
approved:
(i) Banks agreed to waive off the loan of ` 60 thousands of B Ltd.
(ii) B Ltd. will reduce its shares to ` 10 per share and then consolidate 10 such
shares into one share of ` 100 each (new share).
© The Institute of Chartered Accountants of India
13.65
AMALGAMATION OF COMPANIES
(iii) Shareholders of A Ltd. will be given one share (new) of B Ltd. in exchange of
every share held in A Ltd.
(iv) Trade payables of B Ltd. includes ` 100 thousands payable to A Ltd.
Pass necessary entries in the books of B Ltd. and prepare Balance Sheet after
merger.
Solution
Calculation of purchase consideration
One share of B Ltd. will be issued in exchange of every
share of A Ltd. (i.e. 20,000 equity shares of B Ltd. will be
issued against 20,000 equity shares of A Ltd.) 20,000 shares
Journal Entries in the books of B Ltd.
Date (` in
thousands)
20X1 Dr. Cr.
March,31 Loan from bank A/c Dr. 60
To Capital reduction A/c 60
(Being loan from bank waived off to the
extent of ` 60 thousand)
Equity share capital A/c (` 100) Dr. 1,000
To Equity share capital A/c (` 10) 100
To Capital reduction A/c 900
(Being equity shares of ` 100 each
reduced to ` 10 each)
Equity share capital A/c (` 10) Dr. 100
To Equity share capital A/c (` 100 100
each)
(Being 10 equity shares of ` 10 each
consolidated to one share of ` 100 each)
© The Institute of Chartered Accountants of India
13.66 ADVANCED ACCOUNTING
Capital reduction A/c Dr. 960
To Profit and loss A/c 800
To Capital reserve A/c 160
(Being accumulated losses set off against
reconstruction A/c and balance
transferred to capital reserve account)
Property, plant and equipment A/c Dr. 2,700
Investment A/c Dr. 700
Trade receivables A/c Dr. 400
Cash at bank A/c Dr. 250
To Trade payables A/c 300
To Loans from bank A/c 250
To 10% Debentures A/c 500
To Liquidator of A Ltd. A/c 2,000
To Reserves A/c 1,000
(Being assets, liabilities and reserves
taken over under pooling of interest
method and amount due to Liquidator)
Liquidator of A Ltd. A/c Dr. 2,000
To Equity share capital A/c 2,000
(Being payment made to liquidators of A
Ltd. by allotment of 20,000 new equity
shares)
Trade payables A/c Dr. 100
To Trade receivables A/c 100
(Being mutual owing cancelled)
© The Institute of Chartered Accountants of India
13.67
AMALGAMATION OF COMPANIES
Balance Sheet of B Ltd. after merger as at 31.3.20X1
Particulars Notes ` in ‘000
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 2,100
b Reserves and Surplus 2 1,160
2 Non-current liabilities
a Long term borrowings 3 1,140
3 Current liabilities
a Trade payables 500
b Short term borrowings 4 50
Total 4,950
Assets
1 Non-current assets
a Property, Plant and Equipment 3,550
b Non-current investments 700
2 Current assets
a Trade receivables 450
b Cash and cash equivalents 250
Total 4,950
Notes to accounts
` in ‘000
1 Share Capital
21,000, Equity shares of ` 100 each fully paid 2,100
(Out of the above, 20,000 shares have been
issued for consideration other than cash)
© The Institute of Chartered Accountants of India
13.68 ADVANCED ACCOUNTING
2 Reserves and Surplus
Capital reserve 160
General reserve 1,000
Total 1,160
3 Long Term Borrowings
10% Debentures 500
Loan from Bank (250+450-60) 640 1,140
4 Short term borrowings
Bank overdraft 50
SUMMARY
Amalgamation means joining of two or more existing companies into one
company, the joined companies lose their identity and form themselves
into a new company.
Amalgamation includes- absorption and external reconstruction within its
scope as per AS 14.
In absorption, an existing company takes over the business of another
existing company. Thus there is only one liquidation and that is of the
merged company.
A company which is merged into another company is called a transferor
company or a vendor company.
A company into which the vendor company is merged is called transferee
company or vendee company or purchasing company.
Amalgamation is of two types- in the nature of merger and in the nature
of purchase.
In amalgamation in the nature of merger there is genuine pooling of:
(a) Assets and liabilities of the amalgamating companies,
(b) Shareholders’ interest.
© The Institute of Chartered Accountants of India
13.69
AMALGAMATION OF COMPANIES
Also the business of the transferor company is intended to be carried on by
the transferee company. The conditions as laid down in para 3(e) of AS-14
should be satisfied in full. Even if one condition is not satisfied, then it will
be called as amalgamation in nature of purchase.
In amalgamation in the nature of purchase, one company acquires the
business of another company.
Purchase Consideration can be defined as the aggregate of the shares and
securities issued and the payment made in form of cash or other assets by
the transferee company to the shareholders of the transferor company.
There can be different methods to compute the purchase consideration-
Lumpsum payment method, Net Payment method, Net assets method,
Intrinsic value or share exchange method.
There are two main methods of accounting for amalgamation:
(a) The pooling of interests method, and
(b) The purchase method.
Under pooling of interests method, the assets, liabilities and reserves of
the transferor company will be taken over by transferee company at
existing carrying amounts and the difference between the share capital
issued by the transferee company to the transferor and the actual existing
share capital is adjusted with the reserves.
Under purchase method, the assets and liabilities of the transferor
company should be incorporated at their existing carrying amounts or the
purchase consideration should be allocated to individual identifiable
assets and liabilities on the basis of their fair values at the date of
amalgamation.
The difference between the purchase consideration and the net assets (at
agreed values) of the transferor company shall be recorded as goodwill or
capital reserve in the books of the transferee company.
All inter-company adjustments shall be eliminated from the books of the
transferee company after the amalgamation.
© The Institute of Chartered Accountants of India
13.70 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. In case of amalgamation, the entry for elimination of unrealized profit or loss
on stock is made
(a) By the vendor company
(b) By the purchasing company
(c) By the third party
(d) By the court
2. If expenses of liquidation of the vendor company are paid by the purchasing
company then, in purchasing company’s book, the account debited is
(a) Goodwill account.
(b) Liquidation expense account.
(c) Vendor company account.
(d) General reserve.
3. Amalgamation adjustment reserve is opened in the books of the
amalgamated company to incorporate
(a) Assets of the amalgamating company.
(b) Non- Statutory reserves of the amalgamating company.
(c) Statutory reserves of the amalgamating company.
(d) General reserve of the amalgamating company.
4. Amalgamation Adjustment Reserve is presented in the financial statements of
the transferee company as
(a) Other current asset.
(b) Separate line item with a negative sign under the head ‘Reserves and
Surplus’.
© The Institute of Chartered Accountants of India
13.71
AMALGAMATION OF COMPANIES
(c) Other non-current assets.
(d) Investment of the company
5. A company into which the vendor company is merged is called
(a) Transferee company.
(b) Transferor company.
(c) Selling company.
(d) Acquiree company.
6. If the purchase consideration is more than net assets (at agreed values) of the
transferor company, difference shall be recorded as __________ in the books of
the transferee company.
(a) Goodwill.
(b) Capital Reserve.
(c) Profit.
(d) Loss.
Theoretical Questions
7. What are the conditions, which, according to AS 14 on Accounting for
Amalgamations, must be satisfied for an amalgamation in the nature of
merger?
8. Distinguish between (i) the pooling of interests method and (ii) the purchase
method of recording transactions relating to amalgamation.
Scenario based Questions
9. The following are the Balance Sheets of Yes Ltd. and No Ltd. as at 31st March,
20X1:
Particulars Notes ` Yes Ltd ` No Ltd
(in crores) (in crores)
Equity and Liabilities
1 Shareholders’ funds
© The Institute of Chartered Accountants of India
13.72 ADVANCED ACCOUNTING
A Share capital 1 12 5
B Reserves and Surplus 88 10
2 Non-current liabilities
A Long term borrowings 2 -- 10
3 Current liabilities 33 15
Total 133 40
Assets
1 Non-current assets
A Property, Plant and Equipment 3 20 6
B Non-current investments 4 13 --
2 Current assets 100 34
Total 133 40
Notes of accounts
Yes Ltd. No Ltd.
1 Share Capital
Equity share capital
Authorized share capital 25 5
Issued and subscribed:
Equity shares of ` 10 each fully 12 5
paid
12 5
2 Long term borrowings
Unsecured loan from Yes -- 10
Ltd.
-- 10
© The Institute of Chartered Accountants of India
13.73
AMALGAMATION OF COMPANIES
3 Property, Plant and
Equipment
Gross value 70 30
Depreciation (50) (24)
20 6
4 Non-current investments
30 lakhs equity shares of ` 10 3 --
each
Long term loan to No Ltd. 10 --
13 --
On that day Yes Ltd. absorbed No Ltd. The members of No Ltd. are to get one
equity share of Yes Ltd. issued at a premium of ` 2 per share for every five
equity shares held by them in No Ltd. The necessary approvals are obtained.
You are asked to pass journal entries in the books of the two companies to
give effect to the above if the amalgamation is in the nature of merger.
10. The following are the Balance Sheets of X Ltd. and Y Ltd :
Particulars Notes ` X Ltd. ` Y Ltd.
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 1,00,000 50,000
B Reserves and Surplus 2 10,000 (10,000)
2 Non-current liabilities
A Long term borrowings 3 -- 15,000
3 Current liabilities
A Trade Payables 25,000 5,000
Total 135,000 60,000
Assets
1 Non-current assets
A Property, Plant and Equipment 1,20,000 60,000
© The Institute of Chartered Accountants of India
13.74 ADVANCED ACCOUNTING
B Non-current investments 4 15,000 --
Total 135,000 60,000
Notes to accounts
1 Share Capital X Ltd. Y Ltd.
Equity share capital 1,00,000 50,000
1,00,000 50,000
2 Reserves and Surplus
Profit and loss A/c 10,000 --
Profit and loss A/c (debit balance) -- (10,000)
10,000 (10,000)
3 Long term borrowings
Loan from X Ltd. -- 15,000
4 Non-current investments
Loan to Y Ltd. 15,000 --
15,000 --
A new company XY Ltd. is formed to acquire the sundry assets and trade
payables of X Ltd. and Y Ltd. and for this purpose, the sundry assets of X Ltd.
are revalued at ` 1,00,000. The debt due to X Ltd. is also to be discharged in
shares of XY Ltd.
Show the Ledger Accounts to close the books of X Ltd.
11. Super Express Ltd. and Fast Express Ltd. were in competing business. They
decided to form a new company named Super Fast Express Ltd. The balance
sheets of both the companies were as under:
Particulars Notes Super Fast
Express Express
Ltd. Ltd.
` `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 20,00,000 10,00,000
B Reserves and Surplus 2 1,00,000 2,60,000
© The Institute of Chartered Accountants of India
13.75
AMALGAMATION OF COMPANIES
2 Non-current liabilities
A Long term provisions 3 1,00,000 --
2 Current liabilities
A Trade Payables 60,000 40,000
Total 22,60,000 13,00,000
Assets
1 Non-current assets
A Property, Plant and 4 14,00,000 11,00,000
Equipment
B Intangible assets 5 -- 1,00,000
2 Current assets
A Inventories 3,00,000 40,000
B Trade receivables 2,40,000 40,000
C Cash and Cash equivalents 6 3,20,000 20,000
Total 22,60,000 13,00,000
Notes to accounts
Super Express Fast Express
Ltd. ` Ltd.`
1 Share Capital
Equity shares of ` 100 each 20,00,000 10,00,000
2 Reserves and Surplus
Insurance reserve 1,00,000 --
Employee profit sharing reserve -- 60,000
Reserve account -- 1,00,000
Surplus -- 1,00,000
1,00,000 2,60,000
3 Long term provisions
Provident fund 1,00,000 --
Total 1,00,000 --
© The Institute of Chartered Accountants of India
13.76 ADVANCED ACCOUNTING
4 Property, Plant and Equipment
Land and Building 10,00,000 6,00,000
Plant and machinery 4,00,000 5,00,000
14,00,000 11,00,000
5 Intangible assets
Goodwill -- 1,00,000
-- 1,00,000
6. Cash and Cash Equivalents
Cash at Bank 2,20,000 10,000
Cash in hand 1,00,000 10,000
3,20,000 20,000
The assets and liabilities of both the companies were taken over by the new
company at their book values. The companies were allotted equity shares of `
100 each in lieu of purchase consideration amounting to ` 30,000 (20,000 for
Super-Fast Express Ltd and 10,000 for Fast Express Ltd.).
Prepare opening balance sheet of Super Fast Express Ltd. considering pooling
method.
12. The following were the Balance Sheets of P Ltd. and V Ltd. as at 31st March,
20X1:
Particulars Notes ` P Ltd ` V Ltd
(` in Lakhs) (` in Lakhs)
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 15,000 6,000
B Reserves and Surplus 2 15,370 4,335
2 Non-current liabilities
Long term borrowings 3 -- 1,000
3 Current liabilities
A Trade Payables 1,200 463
© The Institute of Chartered Accountants of India
13.77
AMALGAMATION OF COMPANIES
B Short term provisions 1,830 702
Total 33,400 12,500
Assets
1 Non-current assets
A Property, Plant and 4 22,304 6,750
Equipment
2 Current assets
A Inventories 7,862 4,041
B Trade receivables 2,120 1,100
C Cash and Cash equivalents 1,114 609
Total 33,400 12,500
Notes to accounts
` P Ltd ` V Ltd
(` in (` in
Lakhs) Lakhs)
1 Share Capital 15,000 6,000
2 Reserves and Surplus
Securities premium 3,000 --
Foreign project reserve -- 310
General reserve 9,500 3,200
Profit and loss account 2,870 825
15,370 4,335
3 Long term borrowings
12% debentures -- 1,000
-- 1,000
4 Property, Plant and
Equipment
Land and Building 6,000 --
Plant and machinery 14,000 5,000
© The Institute of Chartered Accountants of India
13.78 ADVANCED ACCOUNTING
Furniture and fixtures 2,304 1,750
22,304 6,750
All the bills receivable held by V Ltd. were P Ltd.’s acceptances.
On 1st April 20X1, P Ltd. took over V Ltd in an amalgamation in the nature of
merger. It was agreed that in discharge of consideration for the business P Ltd.
would allot three fully paid equity shares of ` 10 each at par for every two
shares held in V Ltd. It was also agreed that 12% debentures in V Ltd. would be
converted into 13% debentures in P Ltd. of the same amount and
denomination.
Details of trade receivables and trade payables as under:
P Ltd. V Ltd.
(` in lakhs) (` in lakhs)
Trade payables
Bills Payable 120 -
Trade Creditors 1,080 463
1,200 463
Trade receivables
Trade debtors 2,120 1,020
Bills Receivable — 80
2,120 1,100
Expenses of amalgamation amounting to ` 1 lakh were borne by P Ltd.
You are required to: (i) pass journal entries in the books of P Ltd. and (ii)
prepare P Ltd.’s Balance Sheet immediately after the merger.
13. Sun and Neptune had been carrying on business independently. They agreed
to amalgamate and form a new company Jupiter Ltd. with an authorised
share capital of ` 4,00,000 divided into 80,000 equity shares of ` 5 each. On
31st March, 20X3 the respective information of Sun and Neptune were as
follows:
Sun (` ) Neptune (`)
Share capital 3,65,000 3,52,500
© The Institute of Chartered Accountants of India
13.79
AMALGAMATION OF COMPANIES
Current liabilities 5,97,000 1,80,250
Property, Plant and Equipment 6,35,000 3,65,000
Current assets 3,27,000 1,67,750
Additional Information:
(a) Revalued figures of non-current and Current assets were as follows:
Sun (` ) Neptune (`)
Property, Plant and Equipment 7,10,000 3,90,000
Current Assets 2,99,500 1,57,750
(b) The debtors and creditors include ` 43,350 owed by Sun to Neptune.
The purchase consideration is satisfied by issue of the following shares
and debentures.
(i) 60,000 equity shares of Jupiter Ltd. to Sun and Neptune in the
proportion to the profitability of their respective business based on
the average net profit during the last three years which were as
follows:
Sun (` ) Neptune (`)
20X1 Profit 4,49,576 2,73,900
20X2 (Loss)/Profit (2,500) 3,42,100
20X3 Profit 3,77,924 3,59,000
(ii) 15% debenture in Jupiter Ltd. at par to provide an income
equivalent to 8% return business as on capital employed in their
respective business as on 31st March, 20X3 after revaluation of
assets.
You are required to:
(1) Compute the amount of debentures and shares to be issued to Sun and
Neptune.
(2) A Balance sheet of Jupiter Ltd. showing the position immediately after
amalgamation.
© The Institute of Chartered Accountants of India
13.80 ADVANCED ACCOUNTING
14. The following information from Balance Sheet of X Ltd. as at 31st March,
20X1:
`
4,000 Equity shares of ` 100 each 4,00,000
10% Debentures 2,00,000
Loans 80,000
Trade payables 1,60,000
General Reserve 40,000
Building 1,70,000
Machinery 3,20,000
Inventory 1,10,000
Trade receivables 1,30,000
Bank 68,000
Patent 65,000
Share issue Expenses 17,000
Y Ltd. agreed to absorb X Ltd. on the following terms and conditions:
(1) Y Ltd. would take over all assets, except bank balance and Patent at
their book values less 10%. Goodwill is to be valued at 4 year’s
purchase of super profits, assuming that the normal rate of return be
8% on the combined amount of share capital and general reserve.
(2) Y Ltd. is to take over trade payables at book value.
(3) The purchase consideration is to be paid in cash to the extent of
` 3,00,000 and the balance in fully paid equity shares of ` 100 each at
` 125 per share.
The average profit is ` 62,200. The liquidation expenses amounted to ` 8,000.
Y Ltd. sold prior to 31st March, 20X1 goods costing ` 60,000 to X Ltd. for
` 80,000. ` 50,000 worth of goods are still in Inventory of X Ltd. on 31st
March, 20X1. Trade payables of X Ltd. include ` 20,000 still due to Y Ltd.
Show the necessary Ledger Accounts to close the books of X Ltd. and prepare
the Balance Sheet of Y Ltd. as at 1st April, 20X1 after the takeover.
© The Institute of Chartered Accountants of India
13.81
AMALGAMATION OF COMPANIES
ANSWERS/HINTS
Answer to the Multiple Choice Questions
1. (b) 2. (a) 3. (c) 4. (b) 5. (a) 6. (a)
Answer to the Theoretical Questions
7. Refer Para 3 of chapter.
8. Refer Para 5 of chapter.
Answer to the Scenario based Questions
9. Journal Entries in the books of No Ltd.
(Rupees in crores)
Dr. Cr.
Realization Account Dr. 64.00
To Property, plant and equipment Account 30.00
To Current Assets Account 34.00
(Being the assets taken over by Yes Ltd. transferred to
Realization Account)
Provision for depreciation Account Dr. 24.00
Current Liabilities Account Dr. 15.00
Unsecured Loan from Yes Ltd. Account Dr. 10.00
To Realization Account 49.00
(Being the transfer of liabilities and provision to
Realization Account)
Yes Ltd. Dr. 1.2
To Realization Account 1.2
(Being the amount of consideration due from Yes Ltd. credited
to Realization Account)
© The Institute of Chartered Accountants of India
13.82 ADVANCED ACCOUNTING
Equity Shareholders Account Dr. 13.80
To Realization Account 13.80
(Being the loss on Realization transferred to equity share-
holders account)
Equity Share Capital Account Dr. 5.00
Reserves and Surplus Account Dr. 10.00
To Equity Shareholders Account 15.00
(Being the amount of share capital, reserves and surplus
credited to equity shareholders account)
Equity shares of Yes Ltd. Dr. 1.20
To Yes Ltd. 1.20
(Being the receipt of 10 lakhs equity shares of
` 10 each at ` 12 per share for allotment to shareholders)
Equity shareholders Account Dr. 1.20
To Equity shares of Yes Ltd. 1.20
(Being the distribution of equity shares received from Yes
Ltd. to shareholders)
Journal Entries in the books of Yes Ltd.
(Rupees in crores)
Dr. Cr.
Business Purchase Account Dr. 1.2
To Liquidator of No Ltd. Account 1.2
(Being the amount of purchase consideration agreed under
approved scheme of amalgamation- W.N. 1)
© The Institute of Chartered Accountants of India
13.83
AMALGAMATION OF COMPANIES
Property, plant and equipment Dr. 6.00
Current Assets Dr. 34.00
To Current Liabilities 15.00
To Unsecured Loan (from Yes Ltd.) 10.00
To Business Purchase Account 1.20
To Reserve & Surplus A/c 10.00
To Profit & loss A/c ∗ 3.80
(Being the assets and liabilities taken over and the surplus
transferred to Profit and loss account)
Liquidator of No Ltd. Dr. 1.20
To Equity Share Capital Account 1.00
To Securities Premium Account 0.20
( Being the allotment to shareholders of No Ltd.
10 lakhs equity shares of ` 10 each at a premium of
` 2 per share)
Unsecured Loan (from Yes Ltd.) Dr. 10.00
To Loan to No. Ltd. 10.00
(Being the cancellation of unsecured loan given to No Ltd.)
Working Note:
Purchase Consideration ` in crores
50lakhs
× ` 12 i.e., 10 lakhs equity shares at ` 12 per share 1.20
5
Number of equity shares of ` 10 each to be issued 1.20 crores = 10 lakhs.
12
∗
As amalgamation in the nature of merger so balancing figure will be transferred to Profit
& Loss account.
© The Institute of Chartered Accountants of India
13.84 ADVANCED ACCOUNTING
10. Books of X Ltd.
Realization Account
` `
To Sundry Assets 1,20,000 By Trade payables 25,000
By XY Ltd. (Purchase consideration) 75,000
By Shareholders (Loss on realization) 20,000
1,20,000 1,20,000
Shareholders Account
` `
To Realization Account (Loss) 20,000 By Equity Share Capital 1,00,000
To Shares in XY Ltd. 90,000 By Profit and Loss Account 10,000
1,10,000 1,10,000
Loan Y Ltd.
` `
To Balance b/d 15,000 By Shares in XY Ltd. 15,000
Shares in XY Ltd.
` `
To XY Ltd. 75,000 By Shareholders 90,000
To Loan Y Ltd. 15,000
90,000 90,000
XY Ltd.
` `
To Realization Account 75,000 By Shares in XY Ltd. 75,000
11. Balance Sheet of Super Fast Express Ltd.
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 30,00,000
b Reserves and Surplus 2 3,60,000
© The Institute of Chartered Accountants of India
13.85
AMALGAMATION OF COMPANIES
2 Non-current liabilities
a Long-term provisions 3 1,00,000
3 Current liabilities
a Trade Payables 1,00,000
Total 35,60,000
Assets
1 Non-current assets
a Property, Plant and Equipment 4 25,00,000
b Intangible assets 5 1,00,000
2 Current assets
Inventories 3,40,000
Trade receivables 2,80,000
Cash and cash equivalents 6 3,40,000
Total 35,60,000
Notes to Accounts
`
1 Share Capital
Equity share capital
Issued, subscribed and paid up
30,000 Equity shares of ` 100 each 30,00,000
Total 30,00,000
2 Reserves and Surplus
Reserve account 1,00,000
Surplus 1,00,000
Insurance reserve 1,00,000
Employees profit sharing account 60,000
Total 3,60,000
3 Long-term provisions
Provident fund 1,00,000
Total 1,00,000
© The Institute of Chartered Accountants of India
13.86 ADVANCED ACCOUNTING
4 Property, Plant and Equipment
Buildings 16,00,000
Machinery 9,00,000
Total 25,00,000
5 Intangible assets
Goodwill 1,00,000
Total 1,00,000
6 Cash and cash equivalents
Balances with banks 2,30,000
Cash on hand 1,10,000
Total 3,40,000
12. Books of P Ltd.
Journal Entries
Dr. Cr.
(` in Lacs) (` in Lacs)
Business Purchase A/c Dr. 9,000
To Liquidator of V Ltd. 9,000
(Being business of V Ltd. taken over for
Consideration settled as per agreement)
Plant and Machinery Dr. 5,000
Furniture & Fittings Dr. 1750
Inventory Dr. 4,041
Debtors Dr. 1,020
Cash at Bank Dr. 609
Bills Receivable Dr. 80
© The Institute of Chartered Accountants of India
13.87
AMALGAMATION OF COMPANIES
To Foreign Project Reserve 310
To General Reserve (3,200 - 3,000) 200
To Profit and Loss A/c (825 ) 825
To Liability for 12% Debentures 1,000
To Creditors 463
To Provisions 702
To Business Purchase 9,000
(Being assets & liabilities taken over from V Ltd.)
Liquidator of V Ltd. A/c Dr. 9,000
To Equity Share Capital A/c 9,000
(Purchase consideration discharged in the
form of equity shares)
Goodwill A/c Dr. 1
To Bank A/c 1
(Liquidation expenses paid by P Ltd debited to Goodwill A/c)
Profit and loss A/c Dr. 1
To Goodwill A/c 1
(being the Goodwill charged to Profit and loss account)
Liability for 12% Debentures A/c Dr. 1,000
To 13% Debentures A/c 1,000
(12% debentures discharged by issue of
13% debentures)
Bills Payable A/c Dr. 80
To Bills Receivable A/c 80
(Cancellation of mutual owing on account of bills)
© The Institute of Chartered Accountants of India
13.88 ADVANCED ACCOUNTING
Balance Sheet of P Ltd. as at 1st April, 20X1 (after merger)
Particulars Notes ` (in lakhs)
Equity and Liabilities
1 Shareholders' funds
A Share capital 1 24,000
B Reserves and Surplus 2 16,704
2 Non-current liabilities
A Long-term borrowings 3 1,000
3 Current liabilities
A Trade Payables (1,543 + 40) 1,583
B Short-term provisions 2,532
Total 45,819
Assets
1 Non-current assets
A Property, Plant and Equipment 4 29,054
2 Current assets
A Inventories 11,903
B Trade receivables 3,140
C Cash and cash equivalents 1,722
Total 45,819
Notes to accounts
`
1. Share Capital
Equity share capital
Authorized, issued, subscribed and paid up
24 crores equity shares of ` 10 each 24,000
(Of the above shares, 9 crores shares have been issued
for consideration other than cash)
Total 24,000
© The Institute of Chartered Accountants of India
13.89
AMALGAMATION OF COMPANIES
2. Reserves and Surplus
General Reserve 9,700
Securities Premium 3,000
Foreign Project Reserve 310
Profit and Loss Account 3,694
Total 16,704
3. Long-term borrowings
Secured
13% Debentures 1,000
4. Property, Plant and Equipment
Land & Buildings 6,000
Plant & Machinery 19,000
Furniture & Fittings 4,054
Total 29,054
Working Note:
Computation of purchase consideration
The purchase consideration was discharged in the form of three equity
shares of P Ltd. for every two equity shares held in V Ltd.
3
Purchase consideration = ` 6,000 lacs × = ` 9,000 lacs.
2
13. (1) Computation of Amount of Debentures and Shares to be issued:
Sun Neptune
(i) Average Net Profit
` (4,49,576-2,500+3,77,924)/3 = 2,75,000
` (2,73,900+,3,42,100+3,59,000)/3 = 3,25,000
© The Institute of Chartered Accountants of India
13.90 ADVANCED ACCOUNTING
(ii) Equity Shares Issued
(a) Ratio of distribution
Sun: Neptune
275 325
(b) Number
Sun : 27,500
Neptune: 32,500
60,000
(c) Amount
27,500 shares of ` 5 each = 1,37,500
32,500 shares of ` 5 each = 1,62,500
(iii) Capital Employed (after revaluation of assets) ` `
Property, plant and equipment 7,10,000 3,90,000
Current Assets 2,99,500 1,57,750
10,09,500 5,47,750
Less: Current Liabilities (5,97,000) (1,80,250)
4,12,500 3,67,500
(iv) Debentures Issued
8% Return on capital employed 33,000 29,400
15% Debentures to be issued to provide
equivalent income:
100
Sun: 33,000 × = 2,20,000
15
100
Neptune: 29,400 × = 1,96,000
15
© The Institute of Chartered Accountants of India
13.91
AMALGAMATION OF COMPANIES
(2) Balance Sheet of Jupiter Ltd.
As at 31st March 20X3 (after amalgamation)
Particulars Note No `
I. Equity and Liabilities
(1) Shareholders’ Funds
(a) Share Capital 1 3,00,000
(b) Reserves and Surplus 2 64,000
(2) Non-Current Liabilities
(a) Long-term borrowings 3 4,16,000
(3) Current Liabilities
(a) Other current liabilities 7,33,900
Total 15,13,900
II. Assets
(1) Non-current assets
(a) PPE 11,00,000
(2) Current assets
(a) Other current assets 4,13,900
Total 15,13,900
Notes to Accounts
`
1 Share Capital
Authorized
80,000 Equity Shares of ` 5 each 4,00,000
Issued and Subscribed
60,000 Equity Shares of ` 5 each 3,00,000
(all the above shares are allotted as fully paid-up
pursuant to a contract without payment being
received in cash)
© The Institute of Chartered Accountants of India
13.92 ADVANCED ACCOUNTING
2 Reserve and Surplus
Capital Reserve 64,000
3 Long-term borrowings
Secured Loans
15% Debentures 4,16,000
Working Notes:
Sun Neptune Total
` ` `
(1) Purchase Consideration
Equity Shares Issued 1,37,500 1,62,500 3,00,000
15% Debentures Issued 2,20,000 1,96,000 4,16,000
3,57,500 3,58,500 7,16,000
(2) Capital Reserve
(a) Net Assets taken over
Property, plant & equipment 7,10,000 3,90,000 11,00,000
Current Assets 2,99,500 1,14,400* 4,13,900
10,09,500 5,04,400 15,13,900
Less: Current Liabilities (5,53,650**) (1,80,250) (7,33,900)
4,55,850 3,24,150 7,80,000
(b) Purchase Consideration 3,57,500 3,58,500 7,16,000
(c) Capital Reserve [(a) - (b)] 98,350
(d) Goodwill [(b) - (a)] 34,350
(e) Capital Reserve 64,000
[Final Figure(c) -(d)]
* 1,57,750–43,350= 1,14,400
** 5,97,000–43,350= 5,53,650
© The Institute of Chartered Accountants of India
13.93
AMALGAMATION OF COMPANIES
14. Books of X Limited
Realisation Account
` `
To Building 1,70,000 By Trade payables 1,60,000
To Machinery 3,20,000 By Y Ltd. 6,05,000
To Inventory 1,10,000 By Equity Shareholders 38,000
(Loss)
To Trade 1,30,000
receivables
To Patent 65,000
To Bank (Exp.) 8,000
8,03,000 8,03,000
Bank Account
To Balance b/d 68,000 By Realisation (Exp.) 8,000
To Y Ltd. 3,00,000 By 10% Debentures 2,00,000
By Loan 80,000
By Equity shareholders 80,000
3,68,000 3,68,000
10% Debentures Account
To Bank 2,00,000 By Balance b/d 2,00,000
2,00,000 2,00,000
Loan Account
To Bank 80,000 By Balance b/d 80,000
80,000 80,000
Share Issue Expenses Account
To Balance b/d 17,000 By Equity shareholders 17,000
17,000 17,000
General Reserve Account
To Equity 40,000 By Balance b/d 40,000
© The Institute of Chartered Accountants of India
13.94 ADVANCED ACCOUNTING
shareholders
40,000 40,000
Y Ltd. Account
To Realisation A/c 6,05,000 By Bank 3,00,000
By Equity share in Y Ltd.
(2,440 shares at ` 125 3,05,000
each)
6,05,000 6,05,000
Equity Shares in Y Ltd. Account
To Y Ltd. 3,05,000 By Equity shareholders 3,05,000
3,05,000 3,05,000
Equity Share Holders Account
To Realisation 38,000 By Equity share capital 4,00,000
To Share issue 17,000 By General reserve 40,000
Expenses
To Equity shares 3,05,000
in B Ltd.
To Bank 80,000
4,40,000 4,40,000
Y Ltd
Balance Sheet as on 1st April, 20X1 (An extract) ∗
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 2,44,000
b Reserves and Surplus 2 53,500
2 Current liabilities
a Trade Payables 3 1,40,000
∗
In the absence of the particulars of assets and liabilities (other than those of X Ltd.), the
complete Balance Sheet of Y Ltd. after takeover cannot be prepared.
© The Institute of Chartered Accountants of India
13.95
AMALGAMATION OF COMPANIES
b Bank overdraft 3,00,000
Total 7,37,500
Assets
1 Non-current assets
a Property, Plant and Equipment 4 4,41,000
Intangible assets 5 1,08,000
2 Current assets
a Inventories 6 91,500
b Trade receivables 7 97,000
7,37,500
Notes to Accounts
`
1 Share Capital
Equity share capital
2,440 Equity shares of ` 100 each (Shares
have been issued for consideration other 2,44,000
than cash)
Total 2,44,000
2 Reserves and Surplus (an extract)
Securities Premium 61,000
Profit and loss account …..
Less: Unrealised profit (7,500) (7,500)
Total 53,500
3 Trade payables
Opening balance 1,60,000
Less: Inter-company transaction cancelled
upon amalgamation (20,000) 1,40,000
© The Institute of Chartered Accountants of India
13.96 ADVANCED ACCOUNTING
4 Property, Plant and Equipments
Buildings 1,53,000
Machinery 2,88,000
Total 4,41,000
5 Intangible assets
Goodwill 1,08,000
6 Inventories
Opening balance 99,000
Less: Cancellation of profit upon (7,500) 91,500
amalgamation
7 Trade receivables
Opening balance 1,17,000
Less: Intercompany transaction cancelled (20,000) 97,000
upon amalgamation
Working Notes:
1. Valuation of Goodwill `
Average profit 62,200
Less: 8% of ` 4,40,000 (35,200)
Super profit 27,000
Value of Goodwill = 27,000 x 4 1,08,000
2. Net Assets for purchase consideration
Goodwill as valued in W.N.1 1,08,000
Building 1,53,000
Machinery 2,88,000
Inventory 99,000
Trade receivables (1,30,000-13,000) 1,17,000
Total Assets 7,65,000
© The Institute of Chartered Accountants of India
13.97
AMALGAMATION OF COMPANIES
Less: Trade payables (1,60,000)
Net Assets 6,05,000
Out of this ` 3,00,000 is to be paid in cash and remaining i.e.,
(6,05,000 – 3,00,000) ` 3,05,000 in shares of ` 125. Thus, the
number of shares to be allotted 3,05,000/125 = 2,440 shares.
3. Unrealised Profit on Inventory `
The Inventory of X Ltd. includes goods worth ` 50,000
which was sold by Y Ltd. on profit. Unrealized profit
on this Inventory will be [20,000/80,000 x 50,000] 12,500
As Y Ltd purchased assets of X Ltd. at a price 10% less
than the book value, 10% need to be adjusted from (5,000)
the Inventory i.e., 10% of
` 50,000.
Amount of unrealized profit 7,500
© The Institute of Chartered Accountants of India
© The Institute of Chartered Accountants of India
CHAPTER
14
INTERNAL
RECONSTRUCTION
LEARNING OUTCOMES
After studying this chapter, you will be able to:
♦ Understand the meaning of term “reconstruction” and the types of
reconstruction.
♦ Understand the concept of Sub-division and consolidation of shares,
conversion of shares into stock and vice versa
♦ Understand the meaning of Capital reduction account and rules
regarding the presentation of accounts post reconstruction in
accordance with the provisions of the Companies Act 2013.
© The Institute of Chartered Accountants of India
14.2 ADVANCED ACCOUNTING
CHAPTER OVERVIEW
Types of Reconstruction
Internal Reconstruction External reconstruction
(Sections of the Companies (AS14 Accounting for
Act 2013) Amalgamations)
Methods of Internal Reconstruction
Alteration Variation of Reduction
Compromise/ Surrender
of Share Shareholders’ of Share
Arrangement of Shares
Capital rights Capital
Sub-division and
Conversion of share into
Consolidation of
stock or vice-versa
Shares
1. MEANING OF RECONSTRUCTION
When a company has been making losses for several years, the financial position
does not present a true and fair view of the state of the affairs of the company. In
such a company the assets are generally overvalued, as the balance sheet consists
of fictitious assets, unrepresented intangible assets and debit balance in the profit
and loss account (showing the carry forward of losses). Such a situation always
leads the company to show a higher net worth and not depicting a true picture of
financial statements. In short, the company is over capitalized. Such a situation
brings the need for reconstruction/reorganization of the affairs.
© The Institute of Chartered Accountants of India
14.3
INTERNAL RECONSTRUCTION
Reconstruction is a process by which affairs of a company are reorganized by
revaluation of assets, reassessment of liabilities and by writing off the losses already
suffered, by reducing the paid up value of shares and/or varying the rights attached
to different classes of shares. The object of reconstruction is usually to reorganize
capital or to compound with creditors so that company can be bailed out from
present situation without winding up the existing company.
However, there may be external reconstruction. Wherever an undertaking is being
carried on by a company and is in substance transferred, not to an outsider, but
to another company consisting substantially of the same shareholders with a view
to its being continued by the transferee company, there is external reconstruction.
Such external reconstruction is essentially covered under the category of
‘amalgamation in the nature of merger’ in AS 14.
Difference Between Internal and External Reconstruction
Basis Internal Reconstruction External Reconstruction
Liquidation and The existing company is The existing company is
formation of not liquidated rather the liquidated to form a new
new company capital and debt structure company in which the existing
is changed to bring the shareholders become
company back to normalcy shareholders of new company
as well
Reduction of There is certain reduction There is no reduction of capital.
capital and of capital and sometimes In fact, there is a fresh share
varying rights the outside liabilities like capital of the company. The
debenture holders may shareholders need not vary
have to reduce their claim their rights in company
in this scheme.
Legal position Internal reconstruction is External reconstruction is
done as per provisions of regulated by section 232 of the
section 61 and 66 of the Companies Act, 2013.
Companies Act, 2013.
Legal formalities It requires court’s It can be affected without the
confirmation and other court’s interference and less
legal procedures before it time-consuming process.
can be implemented
© The Institute of Chartered Accountants of India
14.4 ADVANCED ACCOUNTING
2. METHODS OF INTERNAL RECONSTRUCTION
For properly deploying the process of internal reconstruction following methods
are generally employed or used simultaneously:
2.1 Alteration of Share Capital
According to Section 61 of the Companies Act 2013, a limited company can alter
its share capital, if so authorized by its Articles, by passing an ordinary resolution
in the general meeting. The provisions of the relevant sections of Companies Act
will be applicable, but in this chapter, we are going to focus on the accounting
treatment of the various conditions pertaining to internal reconstruction.
The following types of Alteration can be done under Section 61-
(a) Increase of authorized share capital;
(b) Consolidation and sub-division into shares of larger or smaller denominations;
(c) Conversion of all or any of the shares into stock or vice versa;
(d) Cancellation of shares which have not been taken or agreed to be taken by any
person.
Sub-division and Consolidation of Shares
The existing share capital can be sub-divided or consolidated into the shares into those
of a smaller or higher denomination than that fixed by the Memorandum of
Association, so long as the proportion between the paid up and unpaid amount, if any,
on the shares continues to be the same as it was in the case of the original shares.
For example, a company with a capital of ` 10,00,000 divided into 10,000 equity
shares of ` 100 each on which ` 75 is paid up decides to reorganize its capital by
splitting one equity share of ` 100 each into 10 such shares of ` 10 each. The
consequential entry to be passed in such a case would be—
Dr. Cr.
` `
Equity Share Capital (` 100) A/c Dr. 7,50,000
© The Institute of Chartered Accountants of India
14.5
INTERNAL RECONSTRUCTION
To Equity Share Capital (` 10) A/c 7,50,000
(Being the sub-division of 10,000 shares of ` 100 each
with ` 75 paid up thereon into 1,00,000 shares of ` 10
each with ` 7.50 paid up thereon as per the resolution of
shareholders passed in the General Meeting held on...)
Similar entries will be passed on consolidation of shares of a smaller amount into
those of a larger amount.
Illustration 1
On 31-12-20X1, B Ltd. had 20,000, ` 10 Equity Shares as authorized capital and the
shares were all issued on which ` 8 was paid up. In June, 20X2 the company in
general meeting decided to sub-divide each share into two shares of ` 5 with ` 4
paid up. In June, 20X3 the company in general meeting resolved to consolidate 20
shares of ` 5, ` 4 per share paid up into one share of ` 100 each, ` 80 paid up.
Pass entries and show how share capital will appear in notes to Balance Sheet as on
31-12-20X1, 31-12-20X2 and 31-12-20X3.
Solution
Journal Entries
20X2 ` `
June Equity Share Capital (` 10) A/c Dr. 1,60,000
To Equity Share Capital (` 5) A/c 1,60,000
(Being the sub-division of 20,000 shares
of ` 10 each with ` 8 paid up into 40,000
shares ` 5 each with ` 4 paid up by
resolution in general meeting dated....)
20X3 Equity Share Capital (` 5) A/c Dr. 1,60,000
June To Equity Share Capital (` 100) A/c 1,60,000
(Being consolidation of 40,000 shares of
` 5 with ` 4 paid up into 2,000 ` 100
shares with ` 80 paid up)
© The Institute of Chartered Accountants of India
14.6 ADVANCED ACCOUNTING
Notes to Balance Sheet
Liabilities: `
As on 31-12-20X1
1. Share Capital
Authorized:
20,000 Equity Shares of ` 10 each 2,00,000
Issued, Subscribed and Paid up:
20,000 Equity Shares of ` 10 each ` 8 per share paid up 1,60,000
As on 31-12-20X2
1. Share Capital
Authorized:
40,000 Equity Shares of ` 5 each 2,00,000
Issued, Subscribed and Paid up:
40,000 Equity Shares of ` 5 each ` 4 per share paid up 1,60,000
As on 31-12-20X3 `
1. Share Capital
Authorized:
2,000 Equity Shares of ` 100 each 2,00,000
Issued, Subscribed and Paid up:
2,000 Equity Shares of ` 100 each ` 80 per share paid up 1,60,000
Note: Some accountants prefer not to make any entry as the amount remains
same. Even when an entry is passed it applies only to the called-up portion, and
not to uncalled or unissued portion of share capital.
Conversion of Fully Paid Shares into Stock and Stock into Shares
According to section 61 of Companies Act, 2013, a company can convert its fully
paid shares into stock and reconversion of stock into shares. If authorized by its
Articles, a company may, in a general meeting by passing an ordinary resolution,
© The Institute of Chartered Accountants of India
14.7
INTERNAL RECONSTRUCTION
can convert its fully paid shares into stock and reconversion of stock into shares.
Stock is the consolidation of the share capital into one unit divisible into aliquot
parts. Stock is a bundle of fully paid shares put together for convenience so that it
may be divided into any amount and transferred into any fractions and sub-
divisions without regard to the original face value of the shares. While it is
impossible for share capital to be one share, any amount of stock may be
transferred. In practice, however, companies restrict the transfer of stock to
multiples say, ` 100.
A company can convert its fully paid shares into stock. Upon the company
converting its shares into stock, the book-keeping entries merely record the
transfer from share capital account to stock account. A separate Stock Register is
started in which details of members’ holdings are entered and the annual return is
modified accordingly.
Illustration 2
C Ltd. had ` 5,00,000 authorized capital on 31-12-20X1 divided into shares of ` 100
each out of which 4,000 shares were issued and fully paid up. In June 20X2 the
Company decided to convert the issued shares into stock. But in June, 20X3 the
Company re-converted the stock into shares of ` 10 each, fully paid up.
Pass entries and show how Share Capital will appear in Notes to Balance Sheet as
on 31-12-20X1, 31-12-20X2 and 31-12-20X3.
Solution
Journal Entries
` `
20X2
June Equity Share Capital A/c Dr. 4,00,000
To Equity Stock A/c 4,00,000
(Being conversion of 4,000 fully paid Equity
Shares of ` 100 into ` 4,00,000 Equity Stock
as per resolution in general meeting
dated…)
© The Institute of Chartered Accountants of India
14.8 ADVANCED ACCOUNTING
20X3
June Equity Stock A/c Dr. 4,00,000
To Equity Share Capital A/c 4,00,000
(Being re-conversion of ` 4,00,000 Equity
Stock into 40,000 shares of ` 10 fully paid
Equity Shares as per resolution in General
Meeting dated...)
Notes to Balance Sheet
`
As on 31-12-20X1
Share Capital
Authorized
5,000 Equity Shares of ` 100 each 5,00,000
Issued and Subscribed
4,000 Equity Shares of ` 100 each fully called up 4,00,000
As on 31-12-20X2 `
Share Capital
Authorized
5,000 Equity Shares of ` 100 each 5,00,000
Issued and Subscribed
Equity Stock- 4,000 Equity Shares of ` 100 converted into Stock 4,00,000
As on 31-12-20X3 `
Share Capital
Authorized
50,000 Equity Shares of ` 10 each 5,00,000
Issued and Subscribed
40,000 Equity Shares of ` 10 each fully called up 4,00,000
© The Institute of Chartered Accountants of India
14.9
INTERNAL RECONSTRUCTION
2.2 Variation of Shareholders Rights
Section 48 of the Companies Act, 2013 provides that when a company has issued
different classes of shares with different rights or privileges attached to such
shares e.g. rights as to dividend, voting rights etc., any of such right may be
changed in any manner. The provisions will be applicable as per the Companies
Act 2013 , the accounting treatment is discussed in detail here.
For example, the company may change rate of (a) dividend on preference shares
or (b) convert cumulative preference shares into non-cumulative preference
shares without changing the amount of share capital by passing the following
journal entries:
(a) Debit (Old)% Cum. Pref. Share Capital Account
Credit (New)% Cum. Pref. Share Capital Account
(b) Debit …% Cum. Pref. Share Capital Account
Credit …% Non-cum. Pref. Share Capital Account
2.3 Reduction of Share Capital
Section 66 of the Companies Act, 2013 lays down the procedure in respect of
reduction of share capital. Subject to confirmation by the Tribunal on an
application by the company, a company may, by a special resolution, reduce the
share capital in the following manner-
(a) Extinguishing or reducing the liability of the shareholders in respect of
unpaid amount on the shares held by them; or
(b) Paying off any paid-up share capital which is in excess of its requirements;
(c) Cancelling any paid-up share capital which is lost or is unrepresented by
available assets.
Generally, reduction in share capital is followed when a company has been
suffering losses continuously for a long time, is not truly represented by its assets.
In such a case, any scheme for capital reduction should write-off that portion of
capital which is already lost
© The Institute of Chartered Accountants of India
14.10 ADVANCED ACCOUNTING
This reduction is a sacrifice by the shareholders and the amount of reduction or
sacrifice is credited to a new account called Capital Reduction Account (or
Reconstruction Account). The accounting treatment is as follows:
(a) When liability of the shareholders is extinguished or reduced in respect
of unpaid amount on the shares held by them: Here the shareholders are
not called upon to pay the unpaid amount on shares held by them in future.
For example, a company decides to reduce ` 10 per share, into ` 7.5 per
share fully paid up, by cancelling the unpaid amount of ` 2.5 per share. The
entry in this case would be
Share Capital (Partly Paid-Up) Account Dr. (` 7.5 (Fv `10) X No. of Shares)
To Share Capital (Fully Paid-up) Account (` 7.5 (Fv- `7.5) X No. of Shares)
(b) When excess paid up capital is paid off: When its not possible for the
company to employ profitably its paid up capital, then in such case it may
decide to refund the excess capital to its shareholders. For example, a
company having fully paid-up share of ` 10 each, decides to pay-off ` 2 per
share to make it of ` 8 fully paid-up, entries in that case would be
Share Capital Account (` 10) Dr. (` 10 X No. of Shares)
To Share Capital Account (` 8) (` 8 X No. of Shares)
To Sundry Shareholders Account (` 2 X No. of Shares)
Sundry Shareholders Account Dr. (` 2 X No. of Shares)
To Bank Account (` 2 X No. of Shares)
(c) When the paid up capital which is lost or not represented is cancelled:
Reduction in paid up value only- Here the nominal value of the share remains
the same and only the paid value is reduced. For example, the shareholders
may agree to reduce the paid capital of ` 100 per share to paid value of ` 10
per share. The sacrifice is ` 90 and the entry will be
Share Capital Account Dr. (` 90 X No. of Shares)
To Capital Reduction Account (` 90 X No. of Shares)
© The Institute of Chartered Accountants of India
14.11
INTERNAL RECONSTRUCTION
Reduction in both nominal and paid up values- In this case, both the paid
up capital and nominal value of the shares are reduced. Continuing the
above example, the entry will be:
Share Capital Account (` 100 Share) Dr. (` 100 X No. of Shares)
To Share Capital (` 10 Share) (` 10 X No. of Shares)
To Capital Reduction Account (` 90 X No. of Shares)
Thus in such treatment we debit the original Share Capital Account so as to close
it, credit new Share Capital Account with the amount treated as paid up; and
credit Capital Reduction Account with the difference.
2.4 Compromise/Arrangements
A scheme of compromise and arrangement is an agreement between a company
and its members and outside liabilities when the company faces financial
problems. Such an arrangement therefore also involves sacrifices by shareholders,
or creditors or debenture holders or by all of them.
Accounting treatment for some of the cases is as follows:
a) When equity shareholders give up their right over the reserves and
accumulated profits of the company:
Reserves Account Dr. (With the amount of reserves)
To Reconstruction Account
b) Settlement of outside liabilities at lesser amount: Liabilities such as sundry
creditors may agree to accept less amount in lieu of final settlement.
Treatment will be as follows:
Outside Liabilities Account Dr. (With the amount of sacrifice)
Provision Account (if any) Dr. (made by creditors, debenture holders etc.)
To Reconstruction Account
© The Institute of Chartered Accountants of India
14.12 ADVANCED ACCOUNTING
2.5 Surrender of Shares
In this method, shares are divided into shares of smaller denominations and then
the shareholders are made to surrender their shares to the company. These shares
are then allotted to debenture holders and creditors so that their liabilities are
reduced. The unutilized surrendered shares are then cancelled by transferring
them to Reconstruction Account.
3. ENTRIES IN CASE OF INTERNAL
RECONSTRUCTION
On a scheme of internal reconstruction being adopted (through special resolution
confirmed by the Court), the accounting treatment of the different situations and
the entries to be passed are as follows:
1. Under the above-mentioned methods- the alteration of share capital and
the varying of the shareholders rights do not involve opening the capital
reduction/reconstruction account.
2. It is only under the reduction of share capital, unrepresented reserves,
compromise/ arrangements with the outsiders liabilities and surrender of
shares, there shall be capital reduction/reconstruction account used to which
the unrepresented assets/liabilities will be transferred as per the arrangement.
3. An appreciation in the value of an asset or reduction in the amount of a
liability should be debited to the account concerned and credited to Capital
Reduction Account (or Reconstruction Account).
4. Eliminate debit balance of profit and loss account and all over-valuation of
assets by crediting the accounts concerned and debiting the Capital
Reduction (or Reconstruction) Account. For this purpose, any reserve
appearing in the books of the company may be used. If any balance is left in
the Capital Reduction (or Reconstruction) Account, it should be transferred
to the Capital Reserve Account.
© The Institute of Chartered Accountants of India
14.13
INTERNAL RECONSTRUCTION
5. If there is any balance in the reconstruction account it is finally transferred
to the Capital reserve under Reserves and Surplus. But if the amount for
writing off the assets and accumulated losses is more than the
reconstruction amount, then reserves will be adjusted against the same.
While preparing the balance sheet of a reconstructed company, the following
points are to be kept in mind:
(a) After the name of the company, the words “and Reduced” should be added
only if the Court so orders.
(b) In case of fixed assets, the amount written off under the scheme of
reconstruction must be shown for five years.
Illustration 3
The Balance Sheet of A & Co. Ltd. as at 31-3-20X2 is as follows:
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 11,50,000
B Reserves and Surplus 2 (5,35,000)
2 Non-current liabilities
A Long-term borrowings 3 3,75,000
3 Current liabilities
A Trade Payables 3,00,000
B Short term borrowings - Bank Overdraft 1,95,000
C Other current liabilities 4 1,22,500
Total 16,07,500
Assets
1 Non-current assets
A Property, plant and equipment 5 4,75,000
B Intangible assets 6 1,67,500
C Non-current investments 7 55,000
© The Institute of Chartered Accountants of India
14.14 ADVANCED ACCOUNTING
2 Current assets
A Inventories 4,25,000
B Trade receivables 4,85,000
Total 16,07,500
Notes to accounts
`
1 Share Capital
Equity share capital:
75,000 Equity Shares of ` 10 each 7,50,000
Preference share capital:
4,000 6% Cumulative Preference Shares of ` 100 each 4,00,000
11,50,000
2 Reserves and Surplus
Debit balance of Profit and loss Account (5,35,000)
(5,35,000)
3 Long-term borrowings
Secured
6% Debentures (secured on the freehold property) 3,75,000
3,75,000
4 Other current liabilities
Loan from directors 1,00,000
Interest payable on 6% debentures 22,500
1,22,500
5 Property plant and Equipment
Freehold property 4,25,000
Plant 50,000
4,75,000
© The Institute of Chartered Accountants of India
14.15
INTERNAL RECONSTRUCTION
6 Intangible assets
Goodwill 1,30,000
Patents 37,500
1,67,500
7 Non-current investments
Investments at cost 55,000
55,000
The Court approved a Scheme of re-organization to take effect on 1-4-20X2,
whereby:
(i) The Preference shares to be written down to ` 75 each and Equity Shares to
` 2 each.
(ii) Of the Preference Share dividends which are in arrears for four years, three
fourths to be waived and Equity Shares of ` 2 each to be allotted for the
remaining quarter.
(iii) Interest payable on debentures to be paid in cash.
(iv) Debenture-holders agreed to take over freehold property, book value
` 1,00,000 at a valuation of ` 1,20,000 in part repayment of their holdings
and to provide additional cash of ` 1,30,000 secured by a floating charge on
company’s assets at an interest rate of 8% p.a.
(v) Patents and Goodwill to be written off.
(vi) Inventory to be written off by ` 65,000.
(vii) Amount of ` 68,500 to be provided for bad debts.
(viii) Remaining freehold property after giving to debenture holders, to be re-
valued at ` 3,87,500.
(ix) Investments be sold for ` 1,40,000.
(x) Directors to accept settlement of their loans as to 90% thereof by allotment of
equity shares of ` 2 each and as to 5% in cash, and balance 5% being waived.
© The Institute of Chartered Accountants of India
14.16 ADVANCED ACCOUNTING
(xi) There were capital commitments totalling ` 2,50,000. These contracts are to
be cancelled on payment of 5% of the contract price as a penalty.
(xii) Ignore taxation and cost of the scheme.
You are requested to show Journal entries reflecting the above transactions
(including cash transactions) and prepare the Balance Sheet of the company after
completion of the Scheme.
Solution
Journal of A & Co. Ltd.
Dr. Cr.
` `
20X2 Equity Share Capital A/c (` 10) Dr. 7,50,000
April 1 To Capital Reduction A/c 6,00,000
To Equity Share Capital A/c (` 2) 1,50,000
(Reduction of equity shares of ` 10 each to
shares of ` 2 each as per Reconstruction
Scheme dated...)
” 6% Cum. Preference Share Capital A/c Dr. 4,00,000
(` 100)
To Capital Reduction A/c 1,00,000
To Pref. Share Capital A/c (` 75) 3,00,000
(Reduction of preference shares of ` 100
each to shares of ` 75 each as per
reconstruction scheme)
” Capital Reduction Account Dr. 24,000
To Equity Share Capital Account 24,000
(Arrears of preference dividends satisfied by
the issue of equity shares, 25% of the amount
due, ` 96,000)
© The Institute of Chartered Accountants of India
14.17
INTERNAL RECONSTRUCTION
” Freehold Property A/c Dr. 82,500
To Capital Reduction A/c 82,500
(Appreciation in the value of property:
Book value Revalued Figure
` 1,00,000 ` 1,20,000
` 3,25,000 ` 3,87,500
Total ` 4,25,000 ` 5,07,500
Profit on revaluation: ` 82,500)
” 6% Debentures A/c Dr. 1,20,000
To Freehold Property A/c 1,20,000
(Claims of debenture-holders, in part, in
respect of principal discharged by transfer
of freehold property vide Scheme of
Reconstruction)
” Interest payable A/c Dr. 22,500
To Bank A/c 22,500
(Debenture interest paid)
” Bank A/c Dr. 1,30,000
To 8% Debentures A/c 1,30,000
(8% Debentures issued for cash)
” Bank A/c Dr. 1,40,000
To Investment A/c 55,000
To Capital Reduction A/c 85,000
(Sale of Investment for ` 1,40,000 cost being
` 55,000; profit credited to Capital Reduction
Account)
” Directors’ Loan A/c Dr. 1,00,000
To Equity Share Capital A/c 90,000
© The Institute of Chartered Accountants of India
14.18 ADVANCED ACCOUNTING
To Bank A/c 5,000
To Capital Reduction A/c 5,000
(Directors’ loan discharged by issue of
equity shares of ` 90,000, cash payments of
` 5,000 and surrender of ` 5,000, vide
Scheme of Reconstruction)
” Capital Reduction A/c Dr. 8,48,500
To Patents 37,500
To Goodwill 1,30,000
To Inventory 65,000
To Provision for Doubtful Debts 68,500
To Bank 12,500
To Profit & Loss Account 5,35,000
(Writing off patents, goodwill, profit and
loss account and reducing the value of
stock, making the required provision for
doubtful debts and payment for
cancellation of capital commitments)
Note: Penalty charges for cancellation of the contract amounts to ` 12,500
(2,50,000X5%) being paid in cash.
Balance Sheet of A & Co. Ltd. (And Reduced) as at 1st April, 20X2
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 5,64,000
2 Non-current liabilities
A Long-term borrowings 2 3,85,000
© The Institute of Chartered Accountants of India
14.19
INTERNAL RECONSTRUCTION
3 Current liabilities
A Trade Payables 3,00,000
Total 12,49,000
Assets
1 Non-current assets
A Property, plant and equipment 3 4,37,500
B Intangible assets 4 -
2 Current assets
A Inventories 3,60,000
B Trade receivables 5 4,16,500
C Cash and cash equivalents 35,000
Total 12,49,000
Notes to accounts
1 Share Capital
Equity share capital
1,32,000 Equity shares of ` 2 each (of the above 2,64,000
57,000 shares have been issued for consideration
other than cash)
Preference share capital
4,000 6% Preference shares of ` 75 each 3,00,000
Total 5,64,000
2 Long-term borrowings
Secured
6% Debentures 2,55,000
8% Debentures 1,30,000
Total 3,85,000
© The Institute of Chartered Accountants of India
14.20 ADVANCED ACCOUNTING
3 Property, plant and equipment
Freehold property 4,25,000
Add: Appreciation under scheme of Reconstruction 82,500
Less: Disposed of (1,20,000) 3,87,500
Plant 50,000
Net carrying value 4,37,500
4 Intangible assets
Goodwill 1,30,000
Less: Written off under scheme of Reconstruction (1,30,000)
Net carrying value NIL
Patents 37,500
Less:Written off under scheme of Reconstruction (37,500) -
Net carrying value - NIL
5 Trade Receivables 4,85,000
Less: Provision for doubtful debts 68,500
4,16,500
Illustration 4
Given below is the Balance sheet of Rebuilt Ltd. as at 31.3.20X1:
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 13,50,000
B Reserves and Surplus 2 (4,51,000)
2 Non-current liabilities
A Long-term borrowings (Loan) 3 5,73,000
© The Institute of Chartered Accountants of India
14.21
INTERNAL RECONSTRUCTION
3 Current liabilities
A Trade Payables 2,07,000
B Other current liabilities 35,000
Total 17,14,000
Assets
1 Non-current assets
A Property, plant and equipment 4 6,68,000
B Intangible assets 5 3,18,000
2 Current assets
A Inventories 4,00,000
B Trade receivables 3,28,000
Total 17,14,000
Notes to accounts
`
1 Share Capital
Equity share capital 7,50,000
15,000 Equity Shares of ` 50 each
Preference share capital
12,000, 7% Cumulative Preference Shares of ` 50 each
(Preference dividend is in arrears for five years) 6,00,000
Total 13,50,000
2 Reserves and Surplus
Debit balance of Profit and loss Account (4,51,000)
(4,51,000)
3 Long-term borrowings
Loan 5,73,000
5,73,000
© The Institute of Chartered Accountants of India
14.22 ADVANCED ACCOUNTING
4 Property, plant and Equipment
Building at cost less depreciation 4,00,000
Plant at cost less depreciation 2,68,000
6,68,000
5 Intangible assets
Trademarks and Goodwill at cost 3,18,000
3,18,000
The Company is not earning profits, short of working capital and a scheme of
reconstruction has been approved by both the classes of shareholders. A summary
of the scheme is as follows:
(a) The equity shareholders have agreed that their ` 50 shares should be reduced
to ` 2.50 by cancellation of ` 47.50 per share. They have also agreed to
subscribe for three new equity shares of ` 2.50 each for each equity share
held.
(b) The preference shareholders have agreed to cancel the arrears of dividends
and to accept for each ` 50 share, 4 new 5% preference shares of ` 10 each,
plus 6 new equity shares of ` 2.50 each, all credited as fully paid.
(c) Lenders to the company for ` 1,50,000 have agreed to convert their loan into
share and for this purpose they will be allotted 12,000 new preference shares
of ` 10 each and 12,000 new equity shares of ` 2.50 each.
(d) The directors have agreed to subscribe in cash for 40,000, new equity shares
of ` 2.50 each in addition to any shares to be subscribed by them under (a)
above.
(e) Of the cash received by the issue of new shares, ` 2,00,000 is to be used to
reduce the loan due by the company.
(f) The equity share capital cancelled is to be applied:
i. to write off the debit balance in the profit and loss A/c; and
ii. to write off ` 35,000 from the value of plant.
Any balance remaining is to be used to write down the value of trademarks and
goodwill.
© The Institute of Chartered Accountants of India
14.23
INTERNAL RECONSTRUCTION
Show by journal entries how the financial books are affected by the scheme and
prepare the balance sheet of the company after reconstruction. The nominal capital
as reduced is to be increased to ` 6,50,000 for preference share capital and
` 7,50,000 for equity share capital.
Solution
In the books of Rebuilt Ltd.
Journal Entries
Particulars Debit Credit
(`) (`)
1. Equity share capital A/c (` 50) Dr. 7,50,000
To Equity share capital A/c (` 2.50) 37,500
To Capital reduction A/c 7,12,500
(Being equity capital reduced to nominal
value of ` 2.50 each)
2. Bank A/c Dr. 1,12,500
To Equity share capital 1,12,500
(Being 3 right shares against each share was
issued and subscribed)
3. 7% Preference share capital A/c (` 50) Dr. 6,00,000
Capital reduction A/c Dr. 60,000
To 5% Preference share capital (` 10) 4,80,000
To equity share capital (` 50) 1,80,000
(Being 7% preference shares of ` 50 each
converted to 5% preference shares of ` 10
each and also given to them 6 equity shares
for every share held)
4. Loan A/c Dr. 1,50,000
To 5% Preference share capital A/c 1,20,000
To Equity share capital A/c 30,000
(Being loan to the extent of ` 1,50,000
converted into share capital)
© The Institute of Chartered Accountants of India
14.24 ADVANCED ACCOUNTING
5. Bank A/c Dr. 1,00,000
To Equity share application money A/c 1,00,000
(Being shares subscribed by the directors)
6. Equity share application money A/c Dr. 1,00,000
To Equity share capital A/c 1,00,000
(Being application money transferred to
capital A/c)
7. Loan A/c Dr. 2,00,000
To Bank A/c 2,00,000
(Being loan repaid)
8. Capital reduction A/c Dr. 6,52,500
To Profit and loss A/c 4,51,000
To Plant A/c 35,000
To Trademarks and Goodwill A/c (Bal.fig.) 1,66,500
(Being losses and assets written off to the
extent required)
Balance sheet of Rebuilt Ltd. (and reduced)
as at 31.3.20X1
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 10,60,000
2 Non-current liabilities
a Long-term borrowings 2,23,000
3 Current liabilities
a Trade Payables 2,07,000
b Other current liabilities 35,000
Total 15,25,000
© The Institute of Chartered Accountants of India
14.25
INTERNAL RECONSTRUCTION
Assets
1 Non-current assets
a Property, plant and equipment 2 6,33,000
b Intangible assets 3 1,51,500
2 Current assets
a Inventories 4,00,000
b Trade receivables 3,28,000
c Cash and cash equivalents 4 12,500
Total 15,25,000
Notes to accounts
`
1. Share Capital
Authorized capital:
65,000 Preference shares of ` 10 each 6,50,000
3,00,000 Equity shares of ` 2.50 each 7,50,000 14,00,000
Issued, subscribed and paid up:
1,80,000 equity shares of ` 2.5 each 4,60,000
60,000, 5% Preference shares of ` 10 each 6,00,000 10,60,000
2. Property plant and equipment
Building at cost less depreciation 4,00,000
Plant at cost less depreciation 2,33,000 6,33,000
3. Intangible assets
Trademarks and goodwill 1,51,500
4. Cash and cash equivalents
Bank (1,12,500+1,00,000-2,00,000) 12,500
© The Institute of Chartered Accountants of India
14.26 ADVANCED ACCOUNTING
Illustration 5
Vaibhav Ltd. gives the following ledger balances as at 31st March 20X1:
`
Property, Plant and Equipment 2,50,00,000
Investments (Market-value ` 19,00,000) 20,00,000
Current Assets 2,00,00,000
P & L A/c (Dr. balance) 12,00,000
Share Capital: Equity Shares of ` 100 each 2,00,00,000
6%, Cumulative Preference Shares of ` 100 each 1,00,00,000
5% Debentures of ` 100 each 80,00,000
Creditors 1,00,00,000
Provision for taxation 2,00,000
The following scheme of Internal Reconstruction is sanctioned:
(i) All the existing equity shares are reduced to ` 40 each.
(ii) All preference shares are reduced to ` 60 each.
(iii) The rate of Interest on Debentures increased to 6%. The Debenture holders
surrender their existing debentures of ` 100 each and exchange the same for
fresh debentures of ` 70 each for every debenture held by them.
(iv) Property, Plant and Equipment is to be written down by 20%.
(v) Current assets are to be revalued at ` 90,00,000.
(vi) Investments are to be brought to their market value.
(vii) One of the creditors of the company to whom the company owes
` 40,00,000 decides to forgo 40% of his claim. The creditor is allotted with
60000 equity shares of ` 40 each in full and final settlement of his claim.
(viii) The taxation liability is to be settled at ` 3,00,000.
(ix) It is decided to write off the debit balance of Profit & Loss A/c.
Pass journal entries and show the Balance Sheet of the company after giving effect
to the above.
© The Institute of Chartered Accountants of India
14.27
INTERNAL RECONSTRUCTION
Solution
Journal Entries in the books of Vaibhav Ltd.
` `
(i) Equity share capital (` 100) A/c Dr. 2,00,00,000
To Equity Share Capital (` 40) A/c 80,00,000
To Capital Reduction A/c 1,20,00,000
(Being conversion of equity share capital of
` 100 each into `40 each as per reconstruction
scheme)
(ii) 6% Cumulative Preference Share capital 1,00,00,000
(` 100) A/c Dr.
To 6% Cumulative Preference Share Capital 60,00,000
(` 60)A/c
To Capital Reduction A/c 40,00,000
(Being conversion of 6% cumulative preference
shares capital of ` 100 each into
` 60 each as per reconstruction scheme)
(iii) 5% Debentures (` 100) A/c Dr. 80,00,000
To 6% Debentures (` 70) A/c 56,00,000
To Capital Reduction A/c 24,00,000
(Being 6% debentures of ` 70 each issued to
existing 5% debenture holders. The balance
transferred to capital reduction account as per
reconstruction scheme)
(iv) Sundry Creditors A/c Dr. 40,00,000
To Equity Share Capital (` 40) A/c 24,00,000
To Capital Reduction A/c 16,00,000
(Being a creditor of ` 40,00,000 agreed to
surrender his claim by 40% and was allotted
60,000 equity shares of ` 40 each in full
settlement of his dues as per reconstruction
scheme)
© The Institute of Chartered Accountants of India
14.28 ADVANCED ACCOUNTING
(v) Provision for Taxation A/c Dr. 2,00,000
Capital Reduction A/c Dr. 1,00,000
To Liability for Taxation A/c 3,00,000
(Being conversion of the provision for taxation
into liability for taxation for settlement of the
amount due)
(vi) Capital Reduction A/c Dr. 199,00,000
To P & L A/c 12,00,000
To Property, Plant and Equipment A/c 50,00,000
To Current Assets A/c 110,00,000
To Investments A/c 1,00,000
To Capital Reserve A/c (Bal. fig.) 26,00,000
(Being amount of Capital Reduction utilized in
writing off P & L A/c (Dr.) Balance, PPE, Current
Assets, Investments and the Balance transferred
to Capital Reserve)
(vii) Liability for Taxation A/c Dr. 3,00,000
To Current Assets (Bank A/c) 3,00,000
(Being the payment of tax liability)
Balance Sheet of Vaibhav Ltd. (and reduced) as at 31st March, 20X1
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 164,00,000
b Reserves and Surplus 2 26,00,000
2 Non-current liabilities
Long-term borrowings 3 56,00,000
3 Current liabilities
Trade Payables (1,00,00,000 less 40,00,000) 60,00,000
Total 3,06,00,000
© The Institute of Chartered Accountants of India
14.29
INTERNAL RECONSTRUCTION
Assets
1 Non-current assets
a Property, plant and equipment 4 2,00,00,000
b Investments 5 19,00,000
2 Current assets 6 87,00,000
Total 3,06,00,000
Notes to accounts
`
1. Share Capital
Equity share capital
Issued, subscribed and paid up
2,60,000 equity shares of ` 40 each
(of the above 60,000 shares have been 1,04,00,000
issued for consideration other than cash)
Preference share capital
Issued, subscribed and paid up
1,00,000 6% Cumulative Preference shares of
60,00,000
` 60 each
Total 1,64,00,000
2. Reserves and Surplus
Capital Reserve 26,00,000
3. Long-term borrowings
Secured
6% Debentures 56,00,000
4. Property, Plant and Equipment
Carrying value 2,50,00,000
Adjustment under scheme of reconstruction (50,00,000) 2,00,00,000
5. Investments
20,00,000
Adjustment under scheme of reconstruction (1,00,000) 19,00,000
© The Institute of Chartered Accountants of India
14.30 ADVANCED ACCOUNTING
6. Current assets
2,00,00,000
Adjustment under scheme of reconstruction (1,10,00,000)
90,00,000
Taxation liability paid (3,00,000) 87,00,000
Working Note:
Capital Reduction Account
To Liability for taxation 1,00,000 By Equity share capital 1,20,00,000
A/c
To P & L A/c 12,00,000 By 6% Cumulative
To Property, plant and preferences
equipment 50,00,000
To Current assets 1,10,00,000 Share capital 40,00,000
To Investment 1,00,000 By 5% Debentures 24,00,000
To Capital Reserve
(Bal. fig.) 26,00,000 By Sundry creditors 16,00,000
2,00,00,000 2,00,00,000
Illustration 6
Following is the Balance Sheet of ABC Ltd. as at 31st March, 20X1:
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 26,00,000
B Reserves and Surplus 2 (4,05,000)
2 Non-current liabilities
A Long-term borrowings 3 12,00,000
3 Current liabilities
A Trade Payables 5,92,000
B Short term borrowings - Bank overdraft 1,50,000
Total 41,37,000
© The Institute of Chartered Accountants of India
14.31
INTERNAL RECONSTRUCTION
Assets
1 Non-current assets
A Property, plant and equipment 4 12,20,000
B Non-current investment 6 68,000
C
2 Current assets
A Inventory 14,00,000
B Trade receivables 14,39,000
C Cash and cash equivalents 10,000
Total 41,37,000
Notes to accounts:
`
1 Share Capital
Equity share capital:
2,00,000 Equity Shares of ` 10 each 20,00,000
6,000, 8% Preference shares of ` 100 each 6,00,000
26,00,000
2 Reserves and Surplus
Debit balance of Profit and loss A/c (4,05,000)
(4,05,000)
3 Long-term borrowings
9% debentures 12,00,000
12,00,000
4 Property, Plant and Equipment
Plant and machinery 9,00,000
Furniture and fixtures 3,20,000
12,20,000
© The Institute of Chartered Accountants of India
14.32 ADVANCED ACCOUNTING
5 Non-current investments
Investments (market value of ` 55,000) 68,000
68,000
The following scheme of reconstruction was finalized:
(i) Preference shareholders would give up 30% of their capital in exchange for
allotment of 11% Debentures to them.
(ii) Debenture holders having charge on plant and machinery would accept plant
and machinery in full settlement of their dues.
(iii) Inventory equal to ` 5,00,000 in book value will be taken over by trade
payables in full settlement of their dues.
(iv) Investment value to be reduced to market price.
(v) The company would issue 11% Debentures for ` 3,00,000 and augment its
working capital requirement after settlement of bank overdraft.
Pass necessary Journal Entries in the books of the company. Prepare Capital
Reduction account and Balance Sheet of the company after internal reconstruction.
Solution
In the Books of ABC Ltd.
Journal Entries
Particulars ` `
8% Preference share capital A/c Dr. 6,00,000
To 11% Debentures A/c 4,20,000
To Capital reduction A/c 1,80,000
[Being 30% reduction in liability of preference share
capital and issue of 11% debentures]
© The Institute of Chartered Accountants of India
14.33
INTERNAL RECONSTRUCTION
9% Debentures A/c Dr. 12,00,000
To Plant & machinery A/c 9,00,000
To Capital reduction A/c 3,00,000
[Settlement of debenture holders by allotment of
plant & machinery]
Trade payables A/c Dr. 5,92,000
To Inventory A/c 5,00,000
To Capital reduction A/c 92,000
[Being settlement of creditors by giving Inventories]
Bank A/c Dr. 3,00,000
To 11% Debentures A/c 3,00,000
[Being fresh issue of debentures]
Bank overdraft A/c Dr. 1,50,000
To Bank A/c 1,50,000
[Being settlement of bank overdraft]
Capital reduction A/c Dr. 5,72,000
To Investment A/c 13,000
To Profit and loss A/c 4,05,000
To Capital reserve A/c 1,54,000
[Being decrease in investment and profit and loss
account (Dr. bal.); and balance of capital reduction
account transferred to capital reserve]
Capital Reduction Account
` `
To Investments A/c 13,000 By Preference share capital A/c 1,80,000
To Profit and loss A/c 4,05,000 By 9% Debenture holders A/c 3,00,000
To Capital reserve A/c 1,54,000 By Trade payables A/c 92,000
5,72,000 5,72,000
© The Institute of Chartered Accountants of India
14.34 ADVANCED ACCOUNTING
Balance Sheet of ABC Ltd. (And Reduced)
As at 31st March 20X1
Particulars Note No `
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 20,00,000
(b) Reserves and Surplus 2 1,54,000
(2) Non-Current Liabilities
(a) Long-term borrowings 3 7,20,000
Total 28,74,000
II. Assets
(1) Non-current assets
(a) Property, plant and equipment 4 3,20,000
(b) Non-current investments 5 55,000
(2) Current assets
(a) Inventories (` 14,00,000 – ` 5,00,000) 9,00,000
(b) Trade receivables 14,39,000
(c) Cash and cash equivalents
Cash at Bank (W. N.) 1,60,000
Total 28,74,000
Notes to Accounts
`
1. Share Capital
2,00,000 Equity shares of ` 10 each fully paid-up 20,00,000
2. Reserve and Surplus
Capital Reserve 1,54,000
© The Institute of Chartered Accountants of India
14.35
INTERNAL RECONSTRUCTION
3. Long Term Borrowings
11% Debentures (` 4,20,000 + ` 3,00,000) 7,20,000
4. Property, Plant and Equipment
Plant & machinery 9,00,000
Less: Adjustment on scheme of reconstruction 9,00,000 -
Furniture & fixtures 3,20,000
5. Non-Current Investments
Investments (` 68,000 – ` 13,000) 55,000
Working Note:
Cash at bank = Opening balance + 11% Debentures issued – Bank overdraft paid
= ` 10,000 + ` 3,00,000 – ` 1,50,000 = ` 1,60,000
Illustration 7
The Balance Sheet of Revise Limited as at 31st March, 20X1 was as follows :
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 10,00,000
B Reserves and surplus 2 (6,00,000)
2 Non-current liabilities
A Long-term borrowings 3 2,00,000
3 Current liabilities
A Trade Payables 72,000
B Other current liabilities 4 24,000
C Short term provisions 5 24,000
Total 7,20,000
© The Institute of Chartered Accountants of India
14.36 ADVANCED ACCOUNTING
Assets
1 Non-current assets
A Property, Plant and Equipment 6 1,00,000
2 Current assets
A Inventory 3,20,000
B Trade receivables 2,70,000
C Cash and cash equivalents 30,000
Total 7,20,000
Notes to accounts
`
1 Share Capital
Equity share capital
10,000 Equity Shares of ` 100 each 10,00,000
10,00,000
2 Reserves and Surplus
Debit balance of Profit and loss Account (6,00,000)
(6,00,000)
3 Long-term borrowings
12% debentures 2,00,000
2,00,000
4 Other current liabilities
Interest payable on debentures 24,000
24,000
5 Short term provisions
Provision for taxation 24,000
24,000
6 Property, Plant and Equipment
Machinery 1,00,000
1,00,000
© The Institute of Chartered Accountants of India
14.37
INTERNAL RECONSTRUCTION
It was decided to reconstruct the company for which necessary resolution was
passed and sanctions were obtained from appropriate authorities. Accordingly, it
was decided that:
(a) Each share is sub-divided into ten fully paid up equity shares of ` 10 each.
(b) After sub-division, each shareholder shall surrender to the company 50% of
his holding, for the purpose of re-issue to debenture holders and trade
payables as necessary.
(c) Out of shares surrendered, 10,000 shares of ` 10 each shall be converted into
12% preference shares of ` 10 each, fully paid up.
(d) The claims of the debenture-holders shall be reduced by 75 per cent. In
consideration of the reduction, the debenture holders shall receive preference
shares of ` 1,00,000 which are converted out of shares surrendered.
(e) Trade payables claim shall be reduced to 50 per cent, it is to be settled by the
issue of equity shares of ` 10 each out of shares surrendered.
(f) Balance of profit and loss account to be written off.
(g) The shares surrendered and not re-issued shall be cancelled.
You are required to show the journal entries giving effect to the above and the
resultant Balance Sheet
Solution
Dr. Cr.
` `
Equity Share Capital (` 100) A/c Dr. 10,00,000
To Share Surrender A/c 5,00,000
To Equity Share Capital (` 10) A/c 5,00,000
(Subdivision of 10,000 equity shares of ` 100 each
into 1,00,000 equity shares of ` 10 each and
surrender of 50,000 of such subdivided shares as
per capital reduction scheme)
© The Institute of Chartered Accountants of India
14.38 ADVANCED ACCOUNTING
12% Debentures A/c Dr. 1,50,000
Interest payable A/c Dr. 18,000
To Reconstruction A/c 1,68,000
(Transferred 75% of the claims of the debenture
holders to reconstruction account in consideration
of which 12% preference shares are being issued
out of share surrender account as per capital
reduction scheme)
Trade payables A/c Dr. 72,000
To Reconstruction A/c 72,000
(Transferred claims of the trade payables to
reconstruction account, 50% of which is being clear
reduction and equity shares are being issued in
consideration of the balance)
Share Surrender A/c Dr. 5,00,000
To 12% Preference Share Capital A/c 1,00,000
To Equity Share Capital A/c 36,000
To Reconstruction A/c 3,64,000
(Issued preference and equity shares to discharge
the claims of the debenture holders and the trade
payables respectively as a per scheme and the
balance in share surrender account is being
transferred to reconstruction account)
Reconstruction A/c Dr. 6,04,000
To Profit and Loss A/c 6,00,000
To Capital Reserve A/c 4,000
(Adjusted debit balance of profit and loss account
against the reconstruction account and the balance
in the latter is being transferred to capital reserve)
© The Institute of Chartered Accountants of India
14.39
INTERNAL RECONSTRUCTION
Balance Sheet of Revise Limited (and reduced) as at...
Particulars Note No. `
I. Equity and Liabilities
(1) Shareholder's Funds
(a) Share Capital 1 6,36,000
(b) Reserves and Surplus 2 4,000
(2) Non-Current Liabilities
(a) Long-term borrowings 3 50,000
(3) Current Liabilities
(a) Other current liabilities 4 6,000
(b) Short-term provisions 5 24,000
Total 7,20,000
II. Assets
(1) Non-current assets
(a) Property, plant and equipment 6 1,00,000
(2) Current assets
(a) Inventories 3,20,000
(b) Trade receivables 2,70,000
(c) Cash and cash equivalents 30,000
Total 7,20,000
Notes to Accounts
`
1. Share Capital
Equity Share Capital
Issued Capital: 53,600 Equity Shares of ` 10 each 5,36,000
Preference Share Capital
Preference Shares 1,00,000
(Of the above shares all are allotted as fully paid up
pursuant to capital reduction scheme by conversion of
equity shares without payment being received in cash)
6,36,000
© The Institute of Chartered Accountants of India
14.40 ADVANCED ACCOUNTING
2. Reserve and Surplus
Capital Reserve 4,000
3. Long-term borrowings
Unsecured Loans
12% Debentures 50,000
4. Other current liabilities
Interest payable on debentures 6,000
5. Short-term provisions
Provision for Income-tax 24,000
6. Property, plant and Equipment
Machinery 1,00,000
Illustration 8
Recover Ltd. decided to reorganize its capital structure owing to accumulated losses
and adverse market condition. The Balance Sheet of the company as on 31st March
20X1 is as follows-
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 3,50,000
B Reserves and surplus 2 (70,000)
2 Non-current liabilities
A Long-term borrowings 3 50,000
3 Current liabilities
A Trade Payables 80,000
Short term Borrowings – Bank
B overdraft 90,000
Other Current Liabilities (Interest
C payable on Debentures) 5,000
5,05,000
© The Institute of Chartered Accountants of India
14.41
INTERNAL RECONSTRUCTION
Assets
1 Non-current assets
A Property, Plant Equipment 4 3,35,000
B Intangible assets 5 50,000
C Non-current investments 6 40,000
2 Current assets
A Inventories 30,000
B Trade receivables 50,000
5,05,000
Notes to accounts:
1 Share Capital `
Equity share capital:
20,000 Equity Shares of ` 10 each 2,00,000
Preference share capital:
15,000 8% Cumulative Preference Shares of ` 10
each (preference dividend has been in arrears for 1,50,000
4 years)
3,50,000
2 Reserves and surplus
Profit and loss account (debit balance) (70,000)
(70,000)
3 Long-term borrowings
Secured
10% Debentures (secured on the freehold 50,000
property)
50,000
4 Property, Plant and Equipment
Freehold property 1,20,000
Leasehold property 85,000
Plant and machinery 1,30,000
3,35,000
© The Institute of Chartered Accountants of India
14.42 ADVANCED ACCOUNTING
5 Intangible assets
Goodwill 50,000
50,000
6 Non-current investments
Non-Trade investments at cost 40,000
40,000
Subsequent to approval by court of a scheme for the reduction of capital, the
following steps were taken:
i. The preference shares were reduced to ` 2.5 per share, and the equity shares
to ` 1 per share.
ii. One new equity share of ` 1 was issued for the arrears of preferred dividend
for past 4 years.
iii. The debenture holders took over the freehold property at an agreed figure of
` 75,000 and paid the balance to the company after deducting the amount
due to them.
iv. Plant and Machinery was written down to ` 1,00,000.
v. Non-trade Investments were sold for ` 32,000.
vi. Goodwill and obsolete stock (included in the value of inventories) of ` 10,000
were written off.
vii. A contingent liability of which no provision had been made was settled at
` 7,000 and of this amount, ` 6,300 was recovered from the insurance.
You are required (a) to show the Journal Entries, necessary to record the above
transactions in the company’s books and (b) to prepare the Balance Sheet, after
completion of the scheme.
© The Institute of Chartered Accountants of India
14.43
INTERNAL RECONSTRUCTION
Solution
Journal entries in the books of Recover Ltd
Particulars Dr. Cr.
` `
8% Cumulative Preference share capital (` 10) A/c Dr. 1,50,000
To 8% Cumulative Preference share capital 37,500
(`2.5) A/c
To Reconstruction (` 7.5) A/c 1,12,500
(Preference shares being reduced to shares of `
2.5 per share and remaining transferred to
reconstruction account as per internal
reconstruction scheme)
Equity share capital A/c (`10) Dr. 2,00,000
To Equity Share capital A/c (` 1) 20,000
To Reconstruction A/c (` 9) 1,80,000
(Equity shares reduced to ` 1 per share with the
remaining amount transferred to reconstruction
account as a part of the internal reconstruction
scheme)
Reconstruction A/c Dr. 48,000
To Equity share capital A/c 48,000
(Equity shares of ` 1 issued in lieu of the arrears
of preference dividend for 4 years as a part of the
internal reconstruction scheme)
10% Debentures A/c Dr. 50,000
Interest payable on debentures A/c Dr 5,000
Bank A/c Dr. 20,000
Reconstruction A/c Dr. 45,000
To Freehold property A/c 1,20,000
(Debenture holders being paid by the sale of
property, which is sold at a loss debited to the
reconstruction account. Amount received in
excess being refunded to company by debenture
holders as a part of the internal reconstruction
scheme)
© The Institute of Chartered Accountants of India
14.44 ADVANCED ACCOUNTING
Reconstruction A/c Dr. 90,000
To Plant and Machinery Ac 30,000
To Goodwill A/c 50,000
To Inventory A/c 10,000
(The assets written off as a part of the internal
reconstruction scheme)
Bank A/c Dr. 32,000
Reconstruction A/c Dr. 8,000
To Investments A/c 40,000
(Investments sold at a loss debited to
reconstruction account as a part of the internal
reconstruction scheme)
Contingent Liability A/c Dr. 7,000
To Bank A/c 7,000
(Contingent liability paid as a part of the internal
reconstruction scheme)
Bank A/c Dr. 6,300
Reconstruction A/c Dr. 700
To Contingent Liability A/c 7,000
(The insurance company remitting part of the
contingency payment amount)
Reconstruction A/c Dr. 70,000
To Profit and loss A/c 70,000
(Accumulated losses written off to reconstruction
account as a part of the internal reconstruction
scheme)
Reconstruction A/c Dr. 30,800
To Capital reserve A/c 30,800
(The balance in reconstruction account
transferred to capital reserve as a part of the
internal reconstruction scheme)
© The Institute of Chartered Accountants of India
14.45
INTERNAL RECONSTRUCTION
Balance sheet of Recover Ltd. as at 31st March 20X1 (and reduced)
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 1,05,500
B Reserves and surplus 2 30,800
2 Non-current liabilities
A Long-term borrowings -
3 Current liabilities
A Trade Payables 80,000
B Short term borrowings - Bank Overdraft 90,000
Total 3,06,300
Assets
1 Non-current assets
A Property, Plant and Equipment 3 1,85,000
2 Current assets
A Inventories 20,000
B Trade receivables 50,000
C Cash and cash equivalents 4 51,300
Total 3,06,300
© The Institute of Chartered Accountants of India
14.46 ADVANCED ACCOUNTING
Notes to accounts:
1 Share Capital `
Equity share capital
68,000 Equity Shares of ` 1 each 68,000
Preference share capital
15,000 8% Cumulative Preference Shares of ` 2.5 each 37,500
1,05,500
2 Reserves and surplus
Capital reserve 30,800
3 Property, Plant and Equipment
Leasehold property 85,000
Plant and machinery 1,00,000
1,85,000
4 Cash and cash equivalents
Bank A/c (20,000+32,000-7000+6,300) 51,300
SUMMARY
1. Reconstruction is a process by which affairs of a company are reorganized
by revaluation of assets, reassessment of liabilities and by writing off the
losses already suffered and by reducing the paid up value of shares and/or
varying the rights attached to different classes of shares.
2. Reconstruction account is a new account opened to transfer the sacrifice
made by the shareholders for that part of capital which is represented by
lost assets.
3. Reconstruction account is utilized for writing-off fictitious assets, writing
down over-valued fixed assets, recording new liability etc.
© The Institute of Chartered Accountants of India
14.47
INTERNAL RECONSTRUCTION
4. If some credit balance remains in the reconstruction account, the same
should be transferred to the capital reserve account.
5. Methods of Internal reconstruction:
• Alteration of share capital:
Sub-divide or consolidate shares into smaller or higher
Denomination
Conversion of share into stock or vice-versa
• Variation of shareholders’ rights:
Only the specific rights are changed. There is no change in the
amount of capital.
• Reduction of share capital
• Compromise, arrangements etc.
• Surrender of Shares.
6. Under the Alteration and the variation of the shareholders rights, there is no
capital reduction account opened, only under the reduction of share capital,
compromises and surrender of shares- capital reduction account comes in
the journal entries.
The balance of the reconstruction account to be transferred to the Capital
reserve.
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. When the object of reconstruction is usually to re-organise capital or to
compound with creditors or to effect economies then such type of
reconstruction is called
(a) Internal reconstruction with liquidation
(b) Internal reconstruction without liquidation of the company
(c) External reconstruction
(d) None of the above.
© The Institute of Chartered Accountants of India
14.48 ADVANCED ACCOUNTING
2. The accumulated losses under scheme of internal reconstruction are written
off against
(a) Capital Reduction account
(b) Share Capital account
(c) Shareholders’ account
(d) Reserve and surplus.
3. A process of reconstruction, which is carried out without liquidating the
company and forming a new one is called
(a) Internal reconstruction.
(b) External reconstruction.
(c) Amalgamation in the nature of merger.
(d) Amalgamation in the nature of purchase.
4. Reconstruction is a process by which affairs of a company are reorganized by
(a) Revaluation of assets and Reassessment of liabilities.
(b) Writing off the losses already suffered by reducing the paid up value of
shares and/or varying the rights attached to different classes of shares.
(c) Both (a) and (b).
(d) None of the above.
5. For reduction of the share capital, the permission has to be sought from
(a) Court.
(b) Controller.
(c) State government.
(d) Shareholders.
6. In case of internal reconstruction
(a) Only one company is liquidated.
(b) Two or more companies are liquidated.
(c) No company is liquidated.
(d) Two companies amalgamated.
© The Institute of Chartered Accountants of India
14.49
INTERNAL RECONSTRUCTION
Theoretical Questions
7. What are the methods of internal reconstruction generally followed by
companies?
Scenario based Questions
8. Parth Ltd, had laid down the following terms upon the sanction of the
reconstruction plan by the court-
1. Furniture and Fixtures which stood at the books at ` 1,50,000 to be
written down to ` 95,000. The freehold premises which was valued at `
7,00,000 showed an appreciation of ` 55,000.
2. Plant and machinery showed fall in value of ` 89,000, to be recorded in
the books. Investment at ` 2,00,000 was brought down to the existing
market value at ` 1,05,000.
3. Debenture holders accepted to receive the following in lieu of their
present 9% debentures of ` 2,50,000-
a. 1/5th of the total to be paid in cash to them.
b. To take over the land and buildings of value ` 72,000.
c. To forgo the remaining unpaid portion as a policy of
reconstruction.
Write off the profit and loss A/c debit balance at ` 70,000 which had been
accumulated over the years. In case of any shortfall, the balance of the
General reserve of ` 1,50,000 can be utilized to write off the losses under
reconstruction scheme.
Show the necessary journal entries as part of the reconstruction process
considering that balance in general reserve utilized to write off the losses as
per reconstruction scheme.
9. The following scheme of reconstruction has been approved for Win Limited:
(i) The shareholders to receive in lieu of their present holding at 1,00,000
shares of ` 10 each, the following:
© The Institute of Chartered Accountants of India
14.50 ADVANCED ACCOUNTING
(a) New fully paid ` 10 Equity shares equal to 3/5th of their holding.
(b) 10% Preference shares fully paid to the extent of 1/5th of the
above new equity shares.
(c) ` 40,000, 8% Debentures.
(ii) An issue of ` 1 lakh 10% first debentures was made and allotted,
payment for the same being received in cash forthwith.
(iii) Goodwill which stood at ` 1,40,000 was completely written off.
(iv) Plant and machinery which stood at ` 2,00,000 was written down to
` 1,50,000.
(v) Freehold property which stood at ` 1,50,000 was written down by `
50,000.
You are required to draw up the necessary Journal entries in the Books of Win
Limited for the above reconstruction. Suitable narrations to Journal entries
should form part of your answer.
10. Green Limited had decided to reconstruct the Balance Sheet since it has
accumulated huge losses. The following is the Balance Sheet of the Company as
at 31.3.20X1 before reconstruction:
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 65,00,000
B Reserves and Surplus 2 (20,00,000)
2 Non-current liabilities
A Long-term borrowings 3 15,00,000
3 Current liabilities
A Trade Payables 5,00,000
Total 65,00,000
Assets
1 Non-current assets
A Property, plant and equipment 4 45,00,000
© The Institute of Chartered Accountants of India
14.51
INTERNAL RECONSTRUCTION
B Intangible assets 5 20,00,000
2 Current assets Nil
Total 65,00,000
Notes to accounts
`
1 Share Capital
Equity share capital
Authorized share capital
1,50,000 Equity shares of ` 50 each 75,00,000
Issued, subscribed and paid up capital
50,000 Equity Shares of ` 50 each 25,00,000
1,00,000 Equity shares of ` 50 each, ` 40 paid up 40,00,000
65,00,000
2 Reserves and Surplus
Debit balance of Profit and loss Account (20,00,000)
(20,00,000)
3 Long-term borrowings
Secured: 12% First debentures 5,00,000
12% Second debentures 10,00,000
15,00,000
4 Property, Plant and Equipment
Building 10,00,000
Plant 10,00,000
Computers 25,00,000
45,00,000
5 Intangible assets
Goodwill 20,00,000
20,00,000
The following is the interest of Mr. X and Mr. Y in Green Limited:
© The Institute of Chartered Accountants of India
14.52 ADVANCED ACCOUNTING
Mr. X Mr. Y
` `
12% First Debentures 3,00,000 2,00,000
12% Second Debentures 7,00,000 3,00,000
Trade payables 2,00,000 1,00,000
12,00,000 6,00,000
Fully paid up ` 50 shares 3,00,000 2,00,000
Partly paid up shares (` 40 paid up) 5,00,000 5,00,000
The following Scheme of Reconstruction is approved by all parties interested
and also by the Court:
(a) Uncalled capital is to be called up in full and such shares and the other
fully paid up shares be converted into equity shares of ` 20 each.
(b) Mr. X is to cancel ` 7,00,000 of his total debt (other than share amount)
and to pay ` 2 lakhs to the company and to receive new 14% First
Debentures for the balance amount.
(c) Mr. Y is to cancel ` 3,00,000 of his total debt (other than equity shares)
and to accept new 14% First Debentures for the balance.
(d) The amount thus rendered available by the scheme shall be utilised in
writing off of Goodwill, Profit and Loss A/c Loss and the balance to write
off the value of computers.
You are required to draw the Journal Entries to record the same and also
show the Balance Sheet of the reconstructed company.
11. The following is the Balance Sheet of Weak Ltd. as at 31.3.20X1:
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 1,50,00,000
B Reserves and Surplus 2 (6,00,000)
© The Institute of Chartered Accountants of India
14.53
INTERNAL RECONSTRUCTION
2 Non-current liabilities
A Long-term borrowings 3 40,00,000
3 Current liabilities
A Trade Payables 50,00,000
B Short term provisions 4 1,00,000
Total 2,35,00,000
Assets
1 Non-current assets
A Property, plant and equipment 1,25,00,000
B Non-current investment 5 10,00,000
2 Current assets 1,00,00,000
Total 2,35,00,000
Notes to accounts
`
1 Share Capital
Equity share capital
1,00,000 Equity Shares of ` 100 each 1,00,00,000
50,000, 12% Cumulative Preference shares of ` 100 50,00,000
each
1,50,00,000
2 Reserves and Surplus
Debit balance of Profit and loss Account (6,00,000)
(6,00,000)
3 Long-term borrowings
40,000, 10% debentures of `100 each 40,00,000
40,00,000
4 Short term provisions
Provision for taxation 1,00,000
1,00,000
© The Institute of Chartered Accountants of India
14.54 ADVANCED ACCOUNTING
5 Non-current investments
Investments (market value of ` 9,50,000) 10,00,000
10,00,000
The following scheme of reorganization is sanctioned:
(i) All the existing equity shares are reduced to ` 40 each.
(ii) All preference shares are reduced to ` 60 each.
(iii) The rate of interest on debentures is increased to 12%. The debenture
holders surrender their existing debentures of ` 100 each and exchange
the same for fresh debentures of ` 70 each for every debenture held by
them.
(iv) One of the creditors of the company to whom the company owes
` 20,00,000 decides to forgo 40% of his claim. He is allotted 30,000
equity shares of ` 40 each in full satisfaction of his claim.
(v) Property, plant and equipment are to be written down by 30%.
(vi) Current assets are to be revalued at ` 45,00,000.
(vii) The taxation liability of the company is settled at ` 1,50,000.
(viii) Investments to be brought to their market value.
(ix) It is decided to write off the debit balance of Profit and Loss account.
Pass Journal entries and show the Balance sheet of the company after giving
effect to the above.
12. The following is the Balance Sheet of X Ltd. as at 31st March, 20X1:
Particulars Notes `
Equity and Liabilities
1 Shareholders’ funds
A Share capital 1 36,00,000
B Reserves and Surplus 2 (14,40,000)
2 Non-current liabilities
A Long-term borrowings 3 6,00,000
© The Institute of Chartered Accountants of India
14.55
INTERNAL RECONSTRUCTION
3 Current liabilities
A Trade Payables 3,00,000
Short term borrowings - Bank 6,00,000
B overdraft
Total 36,60,000
Assets
1 Non-current assets
A Property, plant and equipment 4 30,00,000
B Intangible assets 5 90,000
2 Current assets
a Inventories 2,60,000
b Trade receivables 2,80,000
C Cash and cash equivalents 30,000
Total 36,60,000
Notes to accounts
`
1 Share capital
24,000 Equity Shares of ` 100 each 24,00,000
12,000, 10% Preference Shares of ` 100 12,00,000
each
Total 36,00,000
2 Reserves and Surplus
Debit balance of Profit and loss Account (14,40,000)
(14,40,000)
3 Long-term borrowings
10% debentures 6,00,000
6,00,000
4. Property, plant and Equipment
© The Institute of Chartered Accountants of India
14.56 ADVANCED ACCOUNTING
Land and Building 12,00,000
Plant and Machinery 18,00,000
30,00,000
5 Intangible assets
Goodwill 90,000
90,000
On the above date, the company adopted the following scheme of
reconstruction:
(i) The equity shares are to be reduced to shares of ` 40 each fully paid
and the preference shares to be reduced to fully paid shares of ` 75
each.
(ii) The debenture holders took over Inventories and Trade receivables in
full satisfaction of their claims.
(iii) The Land and Building to be appreciated by 30% and Plant and
machinery to be depreciated by 30%.
(iv) The debit balance of profit and loss account and intangible assets are to
be eliminated.
(v) Expenses of reconstruction amounted to ` 5,000.
Give journal entries incorporating the above scheme of reconstruction and
prepare the reconstructed Balance Sheet.
ANSWERS/HINTS
Answer to Multiple Choice Questions
1. (b) 2. (a) 3. (a) 4. (c) 5. (a) 6. (c)
© The Institute of Chartered Accountants of India
14.57
INTERNAL RECONSTRUCTION
Answer to Theoretical Questions
7. Methods of Internal reconstruction:
• Sub-division or consolidation of shares into smaller or higher
Denomination and Conversion of share into stock or vice-versa
• Variation of shareholders’ rights
• Reduction of share capital
• Compromise, arrangements etc.
• Surrender of Shares.
Answer to Scenario-based Questions
8. Journal entries in the books of Parth Ltd.
Dr. Cr.
` `
Reconstruction A/c Dr. 2,39,000
To Furniture and Fixtures A/c 55,000
To Plant and machinery A/c 89,000
To Investment A/c 95,000
(Writing off overvalued assets as per
Reconstruction Scheme dated.)
Freehold premises A/c Dr. 55,000
To Reconstruction A/c 55,000
(Being the increase in the premises credited
to reconstruction account as per
reconstruction scheme)
9% Debentures A/c Dr. 2,50,000
To Bank A/c 50,000
To Land and building A/c 72,000
To Reconstruction A/c 1,28,000
(Being the debenture holders claim settled
partly and foregone partly as per
reconstruction scheme)
© The Institute of Chartered Accountants of India
14.58 ADVANCED ACCOUNTING
Reconstruction A/c Dr. 70,000
To Profit and loss A/c 70,000
(Being the loss written off as per
reconstruction scheme)
General reserve A/c Dr. 1,26,000
To Reconstruction A/c 1,26,000
(Being the balance in general reserve utilized
to write off the losses as per reconstruction
scheme)
9. Journal Entries
` `
Equity Share Capital (old) A/c Dr. 10,00,000
To Equity Share Capital (` 10) A/c 6,00,000
To 10% Preference Share Capital A/c 1,20,000
To 8% Debentures A/c 40,000
To Capital Reduction A/c 2,40,000
(Being new equity shares, 10% Preference
Shares, 8% Debentures issued and the
balance transferred to Reconstruction
account as per the Scheme)
Bank A/c Dr. 1,00,000
To 10% First Debentures A/c 1,00,000
(Being allotment of 10% first Debentures)
Capital Reduction A/c Dr. 2,40,000
To Goodwill Account 1,40,000
To Plant and Machinery Account 50,000
To Freehold Property Account 50,000
(Being Capital Reduction Account utilized
for writing off of Goodwill, Plant and
Machinery and Freehold property as per
the scheme)
© The Institute of Chartered Accountants of India
14.59
INTERNAL RECONSTRUCTION
10. Journal Entries in books of Green Limited
Dr. Cr.
` `
Bank Account Dr. 10,00,000
To Equity Share Capital Account 10,00,000
(Balance of ` 10 per share on 1,00,000 equity shares
called up as per reconstruction scheme)
Equity Share Capital Account (` 50) Dr. 75,00,000
To Equity Share Capital Account (` 20) 30,00,000
To Capital Reduction Account 45,00,000
(Reduction of equity shares of ` 50 each to
shares of ` 20 each as per reconstruction scheme)
12% First Debentures Account Dr. 3,00,000
12% Second Debentures Account Dr. 7,00,000
Trade payables Account Dr. 2,00,000
To X 12,00,000
(The total amount due to X, transferred to
his account)
Bank Account Dr. 2,00,000
To X 2,00,000
(The amount paid by X under the reconstruction
scheme)
12% First Debentures Account Dr. 2,00,000
12% Second Debentures Account Dr. 3,00,000
Trade payables Account Dr. 1,00,000
To Y 6,00,000
(The total amount due to Y, transferred to
his account)
© The Institute of Chartered Accountants of India
14.60 ADVANCED ACCOUNTING
Y Dr. 6,00,000
To 14% First Debentures Account 3,00,000
To Capital Reduction Account 3,00,000
(The amount due to Y discharged by issue of
14% first debentures)
X Dr. 14,00,000
To 14% First Debentures Account 7,00,000
To Capital Reduction Account 7,00,000
(The cancellation of ` 7,00,000 out of total debt of
Mr. X and issue of 14% first debentures for the balance
amount as per reconstruction scheme)
Capital Reduction Account Dr. 55,00,000
To Goodwill Account 20,00,000
To Profit and Loss Account 20,00,000
To Computers Account 15,00,000
(The balance amount of capital reduction account utilised in
writing off goodwill, profit and loss account, and computers—
Working Note)
Balance Sheet of Green Limited (and reduced)
as at 31st March, 20X1
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 30,00,000
2 Non-current liabilities
a Long-term borrowings 2 10,00,000
3 Current liabilities
a Trade Payables 2,00,000
Total 42,00,000
© The Institute of Chartered Accountants of India
14.61
INTERNAL RECONSTRUCTION
Assets
1 Non-current assets
a Property, plant and equipment 3 30,00,000
2 Current assets
Cash and cash equivalents 12,00,000
Total 42,00,000
Notes to accounts
`
1. Share Capital
Equity share capital
Issued, subscribed and paid up
1,50,000 equity shares of ` 20 each 30,00,000
Total 30,00,000
2. Long-term borrowings
Secured
14% First Debentures 10,00,000
Total 10,00,000
3. Property, Plant and Equipment
Building 10,00,000
Plant 10,00,000
Computers 10,00,000
Total 30,00,000
Working Note:
Capital Reduction Account
` `
To Goodwill A/c 20,00,000 By Equity Share 45,00,000
© The Institute of Chartered Accountants of India
14.62 ADVANCED ACCOUNTING
Capital A/c
To P & L A/c 20,00,000 By X 7,00,000
To Computers (Bal. Fig.) 15,00,000 By Y 3,00,000
55,00,000 55,00,000
11. Journal Entries in the books of Weak Ltd.
` `
(i) Equity share capital (` 100) A/c Dr. 1,00,00,000
To Equity Share Capital (` 40) A/c 40,00,000
To Capital Reduction A/c 60,00,000
(Being conversion of equity share
capital of ` 100 each into ` 40 each as
per reconstruction scheme)
(ii) 12% Cumulative Preference Share Dr. 50,00,000
capital (` 100) A/c Dr.
To 12% Cumulative Preference 30,00,000
Share Capital (` 60) A/c
To Capital Reduction A/c 20,00,000
(Being conversion of 12% cumulative
preference share capital of ` 100 each
into ` 60 each as per reconstruction
scheme)
(iii) 10% Debentures A/c Dr. 40,00,000
To 12% Debentures A/c 28,00,000
To Capital Reduction A/c 12,00,000
(Being 12% debentures issued to 10%
debenture-holders for 70% of their
claims. The balance transferred to
capital reduction account as per
reconstruction scheme)
(iv) Trade payables A/c Dr. 20,00,000
To Equity Share Capital A/c 12,00,000
© The Institute of Chartered Accountants of India
14.63
INTERNAL RECONSTRUCTION
To Capital Reduction A/c 8,00,000
(Being a creditor of ` 20,00,000 agreed
to surrender his claim by 40% and was
allotted 30,000 equity shares of ` 40
each in full settlement of his dues as per
reconstruction scheme)
(v) Provision for Taxation A/c Dr. 1,00,000
Capital Reduction A/c Dr. 50,000
To current assets(bank A/c) A/c 1,50,000
(Being liability for taxation settled)
(vi) Capital Reduction A/c Dr. 99,00,000
To P & L A/c 6,00,000
To Property, plant and equipment 37,50,000
A/c
To Current Assets A/c 55,00,000
To Investments A/c 50,000
(Being amount of Capital Reduction
utilized in writing off P & L A/c (Dr.)
Balance, Property, plant and equipment,
Current Assets, Investments through
capital reduction account)
(vii) Capital Reduction A/c Dr. 50,000
To capital Reserve A/c 50,000
(Being balance in capital reduction
account transferred to capital reserve
account)
© The Institute of Chartered Accountants of India
14.64 ADVANCED ACCOUNTING
Balance Sheet of Weak Ltd. (and reduced) as at 31.3.20X1
Particulars Notes `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 82,00,000
b Reserves and Surplus 2 50,000
2 Non-current liabilities
a Long-term borrowings 3 28,00,000
3 Current liabilities
a Trade Payables 30,00,000
Total 1,40,50,000
Assets
1 Non-current assets
a Property, plant and equipment 4 87,50,000
b Investments 5 9,50,000
2 Current assets 6 43,50,000
Total 1,40,50,000
Notes to accounts
` `
1. Share Capital
Equity share capital
Issued, subscribed and paid up
1,30,000 equity shares of ` 40 each 52,00,000
Preference share capital
Issued, subscribed and paid up
50,000 12% Cumulative Preference shares of ` 60
30,00,000
each
Total 82,00,000
© The Institute of Chartered Accountants of India
14.65
INTERNAL RECONSTRUCTION
2. Reserves and Surplus
Capital Reserve 50,000
3. Long-term borrowings
Secured
12% Debentures 28,00,000
4. Property, plant and Equipment
Total PPE 1,25,00,000
Adjustment under scheme of reconstruction (37,50,000) 87,50,000
5. Investments 10,00,000
Adjustment under scheme of reconstruction (50,000) 9,50,000
6. Current assets 45,00,000
Adjustment under scheme of reconstruction (1,50,000) 43,50,000
Working Note:
Capital Reduction Account
` `
To Current Asset 50,000 By Equity share capital 60,00,000
To P & L A/c 6,00,000 By 12% Cumulative
To Property, plant preference share capital 20,00,000
and equipment 37,50,000 By 10% Debentures 12,00,000
To Current assets 55,00,000 By Trade payables 8,00,000
To Investment 50,000
To Capital Reserve
(bal. fig.) 50,000
1,00,00,000 1,00,00,000
© The Institute of Chartered Accountants of India
14.66 ADVANCED ACCOUNTING
12. In the books of X Ltd.
Journal Entries
31st March, 20X1 ` `
(i) Equity Share Capital A/c (` 100) Dr. 24,00,000
To Equity Share Capital A/c (` 40) 9,60,000
To Capital Reduction A/c 14,40,000
(Being 24,000 equity shares of ` 100 each
reduced to ` 40 each fully paid up)
(ii) 10% Preference Share Capital A/c (` 100) Dr. 12,00,000
To 10% Preference Share Capital A/c 9,00,000
(` 75)
To Capital Reduction A/c 3,00,000
(Being 12,000 Preference shares of ` 100
each reduced to ` 75 each fully paid up)
(iii) 10% Debentures A/c Dr. 6,00,000
To Inventories A/c 2,60,000
To Trade receivables A/c 2,80,000
To Capital Reduction A/c 60,000
(Being debenture holders given Inventories and
Trade receivables in full settlement of their
claims)
(iv) Land & Building A/c Dr. 3,60,000
To Capital Reduction A/c 3,60,000
(Being Land & Building appreciated by
30%)
(v) Capital reduction A/c Dr. 5,000
To Cash A/c 5,000
(Being expenses of reconstruction paid)
© The Institute of Chartered Accountants of India
14.67
INTERNAL RECONSTRUCTION
(vi) Capital Reduction A/c Dr. 20,70,000
To Goodwill A/c 90,000
To Profit and Loss A/c 14,40,000
To Plant & Machinery A/c 5,40,000
(Being various losses written off, assets
written down through Capital Reserve A/c)
(vii) Capital Reduction Dr. 85,000
To Capital Reserve A/c (Bal. Fig.) 85,000
(Being balance in Capital Reduction A/c
transferred to Capital Reserve A/c)
Balance Sheet (And Reduced) of X Ltd.
as at 31st March, 20X1
Particulars Notes No. `
Equity and Liabilities
1 Shareholders' funds
a Share capital 1 18,60,000
b Reserves and Surplus 2 85,000
2 Current liabilities
a Trade Payables 3,00,000
b Short term borrowings 6,00,000
Total 28,45,000
Assets
1 Non-current assets
a Property, plant and equipment 3 28,20,000
2 Current assets
Cash and cash equivalents (30,000 -
25,000
5,000)
Total 28,45,000
© The Institute of Chartered Accountants of India
14.68 ADVANCED ACCOUNTING
Notes to accounts
1. Share Capital `
Equity share capital
24,000 equity shares of ` 40 each fully paid up 9,60,000
Preference share capital
12,000, 10% Preference shares of ` 75 each
9,00,000
fully paid up
Total 18,60,000
2. Reserves and Surplus
Capital Reserve 85,000
3. Property, plant and Equipment
Land and Building 15,60,000
Plant and Machinery 12,60,000
Total 28,20,000
© The Institute of Chartered Accountants of India
CHAPTER 15
ACCOUNTING FOR
BRANCHES INCLUDING
FOREIGN BRANCHES
LEARNING OUTCOMES
After studying this chapter, you will be able to–
♦ Understand concept of branches and their classification from
accounting point of view.
♦ Distinguish between the accounting treatment of dependent branches
and independent branches.
♦ Learn various methods of charging goods to branches.
♦ Solve the problems, when goods are sent to branch at wholesale
price.
♦ Prepare the reconciliation statement of branch and head office
transactions after finding the reasons for their disagreement.
♦ Incorporate branch balances in the head office books.
♦ Differentiate between integral and non-integral foreign branches.
♦ Learn the techniques of foreign currency translation in case of foreign
branches.
© The Institute of Chartered Accountants of India
15.2 ADVANCED ACCOUNTING
CHAPTER OVERVIEW
Classification of Branches
Inland Branches Foreign Branches
Dependent Branches for which Independent Branches which
whole accounting records are maintain independent
kept at Head Office accounting records
Methods of maintaining accounts of Dependent Branches
Goods invoiced at cost or Goods invoiced at
selling price wholesale price
Stock and Trading and profit Whole sale branches
Debtors and loss account method
Debtors
Method method (Final
Method
Accounts method)
1. INTRODUCTION
A branch can be described as any establishment carrying on either the same or
substantially the same activity as that carried on by head office of the company. It
must also be noted that the concept of a branch means existence of a head office;
for there can be no branch without a head office - the principal place of business.
Branch offices are of a great utility in the sense that they allow business to be
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.3
FOREIGN BRANCHES
expanded closer to the clients and hence they facilitate face to face interaction
with customers.
From the accounting point of view, branches may be classified as follows:
• Inland Branches which can be further classified as:
(a) Independent Branches which maintain independent accounting
records
(b) Dependent Branches for which whole accounting records are kept at
Head Office
• Foreign Branches
Difference between branch and department
Branch: Establishment at location different from Head Office to carry either same
or substantially same activity as carried on by Head Office
Department: Division of a large organization dealing with a various kind of
activity at the same location.
Let’s take an example of a CA Firm working in the field of Auditing, Taxation and
Finance having office at Mumbai, Chennai and Delhi practicing such fields. The CA
firm has various branches in different cities, i.e., Mumbai, Chennai and Delhi, also
it has various department of Auditing, Taxation and Finance at one particular
branch (location).
2. DISTINCTION BETWEEN BRANCH
ACCOUNTS AND DEPARTMENTAL
ACCOUNTS
Basis of distinction Branch Accounts Departmental
Accounts
1. Maintenance of Branch accounts may be Departmental accounts
accounts maintained either at are maintained at one
branch or at head office. place only.
© The Institute of Chartered Accountants of India
15.4 ADVANCED ACCOUNTING
2. Apportionment of As expenses in respect of Common expenses are
common expenses each branch can be distributed among the
identified, so the departments concerned
apportionment problem on some equitable basis
never arises. considered suitable in
the case.
3. Reconciliation Reconciliation of head Such problem never
office and branch arises.
accounts is necessary in
case of Branches
maintaining independent
accounting records at the
end of the accounting
year.
4. Conversion of At the time of finalization Such problem never
foreign currency of accounts, conversion arises.
figures of figures of foreign
branch is necessary.
3. DEPENDENT BRANCHES
When the business policies and the administration of a branch are wholly
controlled by the head office and its accounts also are maintained by it, the
branch is described as Dependent branch. Branch accounts, in such a case, are
maintained at the head office out of reports and returns received from the
branch. Some of the significant types of branches that are operated in this
manner are described below:
(a) A branch set up merely for booking orders that are executed by the head
office. Such a branch only transmits orders to the head office;
(b) A branch established at a commercial center for the sale of goods supplied
by the head office, and under its direction all collections are made by the
H.O.; and
(c) A branch for the retail sale of goods, supplied by the head office.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.5
FOREIGN BRANCHES
Accounting in the case of first two types is simple. Only a record of expenses
incurred at the branch has to be maintained.
But however, a retail branch is essentially a sale agency that principally sells
goods supplied by the head office for cash and, if so authorized, also on credit to
approved customers. Generally, cash collected is deposited into a local bank to
the credit of the head office and the head office issues cheques or transfers funds
thereon for meeting the expenses of the branch. In addition, the Branch Manager
is provided with a ‘float’ for petty expenses which is replenished from time to
time on an imprest basis. If, however, the branch also sells certain lines of goods,
directly purchased by it, the branch retains a part of the sale proceeds to pay for
the goods so purchased.
4. METHODS OF CHARGING GOODS TO
BRANCHES
Goods may be invoiced to branches (1) at cost; or (2) at selling price; or (3) in case
of retail branches, at wholesale price.
Selling price method is adopted where the goods would be sold at a fixed price
by the branch. It is suitable for dealers in tea, petrol, ghee, etc. In this way, greater
control can be exercised over the working of a branch in as much as that the
branch balance in the head office books would always be composed of the value
of unsold stock at the branch and remittances or goods in transit.
Goods may be invoiced to branches
In case of retail
At cost At selling price branches, at wholesale
price
© The Institute of Chartered Accountants of India
15.6 ADVANCED ACCOUNTING
5. ACCOUNTING FOR DEPENDENT BRANCHES
Dependent branch does not maintain a complete record of its transactions. The
Head office may maintain accounts of dependent branches in any of the following
methods:
Methods
At cost or at selling price At wholesale price
Debtors method
Wholesale branch
Stock & Debtors method
method
Trading & P&L method
5.1 When goods are invoiced at cost
If goods are invoiced to the branch at cost, the trading results of branch can be
ascertained by following any of the three methods: (i) Debtors Method, (ii)Stock
and Debtors method, (iii) Trading and Profit and Loss Account (Final
Accounts) Method.
For finding out the trading results of branch, it is assumed that the branch is an
entity separate from the head office. On this basis, a Branch Account is stated in
the head office books to which the price of goods or services provided or
expenses paid out are debited and correspondingly, the value of benefits and
cash received from the branch are credited.
Debtors method This method of accounting is suitable for small sized branches.
Under this method, separate branch account is maintained for each branch to
compute profit or loss made by each branch. Various accounting adjustments to
respective branch account are as follows:
• The opening balance of stock, debtors (if any), petty cash (if any), are
debited to the Branch Account; the cost of goods sent to branch as well as
any direct purchases made by branch (for which Head Office makes the
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.7
FOREIGN BRANCHES
payment), expenses of the branch paid by the head office, e.g., salaries, rent,
insurance, etc., are also debited to it.
• Conversely, amounts remitted by the branch and the cost of goods returned
by the branch are credited.
• At the end of the year, the value of unsold stock, the total of customers’
balances outstanding and that of petty cash are brought into the branch
account on the credit side.
• Accordingly, the branch account will reveal profit or loss; Debit ‘balance’ will
be the loss suffered by the working of the branch and vice versa.
If the branch is allowed to make small purchases of goods locally as well as to
incur expenses out of its cash receipts, it will be necessary for the branch to
supply to the head office a copy of the Cash Account, showing details of cash
collections and disbursements. To illustrate the various entries which are made in
the Branch Account, the proforma of a Branch Account is shown below:
Proforma Branch Account
To Balance b/d By Bank A/c (Cash remitted)
Cash By Return to H.O.
Stock
Debtors By Balance c/d
Petty Cash Cash
Fixed Assets Stock
Prepaid Expenses Debtors
To Goods sent to Branch Petty Cash
To Bank A/c Fixed Assets
Salaries Prepaid Expenses
Rent
Sundry Expenses By Profit and Loss A/c—Loss
To Profit & Loss A/c—Profit (if debit side is larger)
(if credit side is larger)
© The Institute of Chartered Accountants of India
15.8 ADVANCED ACCOUNTING
Note:
1. Having credited the Branch Account by the actual cash received from
debtors, it would be incorrect to debit the Branch Account, in respect of
discount or allowances to debtors.
2. The accuracy of the trading results as disclosed by the Branch Account, so
maintained, if considered necessary, can be proved by preparing a
Memorandum Branch Trading and Profit & Loss Account, in the usual way,
from the balances of various items of income and expenses contained in the
Branch Account.
Example 1
XP Ltd opened a branch at Delhi and sent goods costing `50,000 to Delhi branch.
Delhi Branch sold entire goods on credit at ` 62,000. No other transaction occurred
at the branch. Prepare branch account in Head Office Books and find out the profit.
Solution
We know that branch earned net profit of `12,000, now see how same can be find
out by branch account.
Branch Account
Particulars Amount Particulars Amount
` `
To Opening branch assets Nil By Closing branch
assets
To Goods sent to branch 50,000 Stock Nil
To Net Profit 12,000 Debtor 62,000 62,000
62,000 62,000
Example 2
XP Ltd opened a new branch at Delhi. XP Ltd sent goods costing ` 50,000 to Delhi
branch. Delhi branch sold entire goods in cash at ` 70,000. Branch paid expenses
of ` 8,000. No other transaction occurred at the branch. Prepare branch account in
HO Books and find out the profit.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.9
FOREIGN BRANCHES
Solution
We know that branch earned net profit of `12,000 (i.e. Gross Profit ` 20,000 less
expenses of ` 8,000), Let’s see how same can be find out by branch account:
Branch Account
Particulars Amount Particulars Amount
To Opening branch assets Nil By Closing branch assets
Stock Nil
To Goods sent to branch 50,000 Debtor Nil
To Net Profit transferred to 12,000 Cash 62,000 62,000
General P&L A/c (70,000 - 8,000)
62,000 62,000
Example 3
Prepare branch account and find out profit earned by branch if transactions are as
under:
Goods sent to branch ` 50,000
Furniture sent to branch ` 10,000 (at the beginning of year)
Credit sales at branch ` 62,000
Bad Debts ` 1,000
Other information:
Closing stock at branch ` 10,000
Closing Debtor ` 61,000
Furniture (after depreciation@20%) ` 8,000
Solution
Branch Account
Particulars Amount Particulars Amount
To Opening branch assets-
(Furniture) 10,000 By Closing branch
assets-
© The Institute of Chartered Accountants of India
15.10 ADVANCED ACCOUNTING
To Goods sent to branch 50,000 Stock 10,000
To Net Profit transferred to 19,000 Debtor 61,000
General P&L A/c
Furniture 8,000 79,000
79,000 79,000
Illustration 1 (a)
Buckingham Bros, Bombay have a branch at Nagpur. They send goods at cost to
their branch at Nagpur. However, direct purchases are also made by the branch for
which payments are made at head office. All the daily collections are transferred
from the branch to the head office.
From the following, prepare Nagpur branch account in the books of head office by
Debtors method:
` `
Opening balance (1-1- Bad Debts 1,000
20X1) Imprest Cash 2,000
Sundry Debtors 25,000 Discount to Customers 2,000
Stock: Transferred from H.O. 24,000 Remittances to H.O.
Direct Purchases 16,000 (received by H.O.) 1,65,000
Cash Sales 45,000 Remittances to H.O.
Credit Sales 1,30,000 (not received by H.O. so far) 5,000
Direct Purchases 45,000 Branch Exp. directly paid 30,000
by H.O.
Returns from Customers 3,000 Closing Balance (31-12-
20X1)
Goods sent to branch from 60,000 Stock: Direct Purchase 10,000
H.O.
Transfer from H.O. for Petty 4,000 Transfer from H.O. 15,000
Cash expenses Debtors ?
Imprest Cash ?
Petty Cash expenses 4,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.11
FOREIGN BRANCHES
Solution
In the Books of Buckingham Bros, Bombay
Nagpur Branch Account
Particulars ` Particulars `
To Opening Branch Assets- By Bank –
Remittances received
from branch
Stock (24,000+16,000) 40,000 Cash Sales 45,000
Debtors 25,000 Cash from Debtors * 1,20,000
Cash in transit * 5,000 1,70,000
Imprest Cash 2,000 By Closing Branch
Assets
To Goods sent to Branch A/c 60,000 Stock (15,000 25,000
+10,000)
To Creditors (Direct 45,000 Debtors (W.N. 1) 24,000
Purchases) Imprest Cash (W.N. 2) 2,000
To Bank (Sundry exp.) 30,000
To Bank (Petty cash exp.) 4,000
To Net Profit transferred to 15,000
General Profit & Loss A/c
2,21,000 2,21,000
Working Notes:
1. Memorandum Debtors A/c
Particulars ` Particulars `
To To Bal b/d 25,000 By By Sales Return 3,000
To To Sales 130,000 By By Bad Debts 1,000
By By Discount 2,000
By By Cash * 125,000
By By Bal c/d 24,000
155,000 155,000
© The Institute of Chartered Accountants of India
15.12 ADVANCED ACCOUNTING
2. Memorandum Petty Cash
Particulars ` Particulars `
To Bal b/d 2,000 By Expenses 4,000
(met by Branch)
To Transfer from H.O. 4,000 By Bal c/d 2,000
6,000 6,000
* Collection from Debtors = Total Remittances (1,65,000+5,000) – Cash Sales
(45,000) = ` 1,25,000
Stock and Debtors method
If it is desired to exercise a more detailed control over the working of a branch,
the accounts of the branch are maintained under Stock and Debtors Method.
According to this method, the following accounts are maintained by the Head
Office:
Account Purpose
1. Branch Stock Account (or Ascertainment of shortage or surplus
Branch Trading Account)
2. Branch Debtors Account Ascertainment of closing balance of debtors
3. Branch Expenses Account Ascertainment of total expenses incurred
4. Goods sent to Branch Ascertainment of cost of goods sent to
Account branch
5. Branch Cash / Bank Know about cash flow at branch (eg: where
Account branch is allowed to incur expenses locally)
6. Branch Fixed Asset Control over branch Fixed Assets
Account
7. Branch Profit and Loss Calculation of net profit or loss
Account
The manner in which entries are recorded in the above method is shown below:
Transaction Account debited Account credited
(a) Cost of goods sent to Branch Stock A/c Goods sent to Branch
the Branch A/c
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.13
FOREIGN BRANCHES
(b) Remittances for Branch Cash A/c Cash A/c
expenses
(c) Any asset (e.g. Branch Asset (Furniture) Asset A/c
furniture) provided by A/c
H.O.
(d) Cost of goods returned Goods sent to Branch Branch Stock A/c
by the branch A/c
(e) Cash Sales at the Branch Cash A/c Branch Stock A/c
Branch
(f) Credit Sales at the Branch Debtors A/c Branch Stock A/c
Branch
(g) Return of goods by Branch Stock A/c Branch Debtors A/c
debtors
to the Branch
(h) Cash paid by debtors Branch Cash A/c Branch Debtors A/c
(i) Discount & allowance Branch Expenses A/c Branch Debtors A/c
to debtors, bad debts
(j) Remittances to H.O. Cash A/c Branch Cash A/c
(k) Branch Expenses Branch Expenses A/c Cash A/c
directly paid by H.O.
(l) Expenses met by Branch Expenses A/c Branch Cash A/c
Branch
(m) Closing Stock: Credit the Branch Stock Account with the value of closing
stock at cost. It will be carried down as opening balance (debit) for the next
accounting period. The Balance of the Branch Stock Account, (after
adjustment therein the value of closing stock), if in credit, will represent the
gross profit on sales and vice versa.
Other Steps:
(n) Transfer Balance of Branch Stock Account to the Branch Profit and Loss
Account.
© The Institute of Chartered Accountants of India
15.14 ADVANCED ACCOUNTING
(o) Transfer Balance of Branch Expenses Account to the debit of Branch Profit &
Loss Account.
(p) The balance in the Branch P&L A/c will be transferred to the (H.O.) Profit &
Loss Account.
(q) The credit balance in the Goods sent to Branch Account is afterwards
transferred to the Head Office Purchase Account or Trading Account (in
case of manufacturing concerns), it being the value of goods transferred to
the Branch.
Branch Trading and Profit and Loss Account (Final Accounts Method)
In this method, Trading and Profit and Loss accounts are prepared considering
each branch as a separate entity. The main advantage of this method is that, it is
easy to prepare and understand. It also gives complete information of all
transactions which are ignored in the other methods. It should be noted that
Branch Trading and Profit and Loss account is merely a memorandum account
and therefore, the entries made there in do not have double entry effect.
Illustration 1 (b)
From the information given in the illustration 1(a), prepare Nagpur Branch Trading
and Profit and Loss Account in the books of head office.
Solution
Buckingham Bros. Bombay
Nagpur Branch-Trading and Profit and Loss Account
for the year ending 31st December, 20X1
Particulars ` Particulars ` `
To Opening Stock 40,000 By Sales
To Goods transferred 60,000 Cash 45,000
from Head Office Credit sales 1,30,000
To Purchases 45,000 1,75,000
To Gross Profit c/d 52,000 Less: Returns (3,000) 1,72,000
By Closing Stock 25,000
1,97,000 1,97,000
To Expenses 30,000 By Gross Profit b/d 52,000
To Discounts 2,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.15
FOREIGN BRANCHES
To Bad Debts 1,000
To Petty Cash Expenses 4,000
To Net Profit 15,000
transferred to General
P&L A/c
52,000 52,000
The students may note that Gross Profit and Net Profit earned by the branch are
ascertainable in this method and also evaluating the performance of the branch is
very much easier in this method than in the ‘Debtors method’.
Solving Illustration by all three methods
Given below is a simple problem, the solution whereto has been prepared in all
the three methods so as to show the distinguishing features of these methods.
Illustration 2
The Bombay Traders invoiced goods to its Delhi branch at cost. Head Office paid all
the branch expenses from its bank account, except petty cash expenses which were
met by the Branch. All the cash collected by the branch was banked on the same
day to the credit of the Head Office. The following is a summary of the transactions
entered into at the branch during the year ended December 31, 20X1.
` `
Balances as on 1.1.20X1:
Stock 7,000 Bad Debts 600
Debtors 12,600 Goods returned by 500
customers
Petty Cash, 200 Salaries & Wages 6,200
Goods sent from H.O. 26,000 Rent & Rates 1,200
Goods returned to H.O. 1,000 Sundry Expenses 800
Cash Sales 17,500 Cash received from Sundry
Credit Sales 28,400 Debtors 28,500
Allowances to customers 200 Balances as on 31.12.20X1:
Discount to customers 1,400 Stock 6,500
Debtors 9,800
Petty Cash 100
© The Institute of Chartered Accountants of India
15.16 ADVANCED ACCOUNTING
Prepare: (a) Branch Account (Debtors Method), (b) Branch Stock Account, Branch
Profit & Loss Account, Branch Debtors and Branch Expenses Account by adopting
the Stock and Debtors Method and (c) Branch Trading and Profit & Loss Account to
prove the results as disclosed by the Branch Account.
Solution
(a) Debtors Method
Delhi Branch Account
20X1 ` ` 20X1 ` `
Jan. 1 To Opening Dec 24 Bank
branch 31
assets:
Stock 7,000 Cash Sales 17,500
Debtors 12,600 Cash from
Petty cash 200 19,800 sundry 28,500 46,000
Debtors
Dec. To Goods sent By Goods sent to
31 to Branch 26,000 Branch A/c –
A/c
To Bank: Returns to 1,000
H.O.
Salaries & 6,200 By Closing
Wages branch assets
Rent & Rates 1,200 Stock 6,500
Sundry Exp. 800 8,200 Debtors 9,800
Petty Cash 100 16,400
To Net profit 9,400
ts/f to
General P&L
A/c
63,400 63,400
Jan. 1, To Balance b/d 16,400
20X2
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.17
FOREIGN BRANCHES
(b) Stock and Debtors Method
Branch Stock Account
20X1 ` 20X1 `
Jan. 1 To Balance b/d - 7,000 Dec. 31 By Sales:
Opening
Stock
Dec. 31 To Goods Sent 26,000 Cash 17,500
to Branch A/c Credit 28,400
To Branch P&L 19,900 Less: Return (500) 45,400
A/c
By Goods sent to 1,000
Branch A/c -
Return
By Balance c/d - 6,500
Closing Stock
52,900 52,900
20X2 To Balance b/d - 6,500
Jan. 1 Opening
Stock
Delhi Branch Debtors Account
20X1 ` 20X1 `
Jan. 1 To Balance b/d 12,600 Dec. 31 By Cash 28,500
Dec. 31 To Sales 28,400 By Returns 500
By Allowances 200
By Discounts 1,400
By Bad debts 600
By Balance c/d 9,800
41,000 41,000
20X2 Jan. 1 To Balance b/d 9,800
© The Institute of Chartered Accountants of India
15.18 ADVANCED ACCOUNTING
Delhi Branch Expenses Account
20X1 ` 20X1 `
Dec. To Salaries & Wages 6,200 Dec. By Branch P&L 10,500
31 31 A/c
To Rent & Rates 1,200
To Sundry Expenses 800
To Petty Cash 100
expenses
(200-100)
To Allowance to 200
customers
To Discount 1,400
To Bad Debts 600
10,500 10,500
Delhi Branch Profit & Loss Account
20X1 ` 20X1 `
Dec. To Branch Exp. A/c 10,500 Dec. By Gross Profit 19,900
31 31 b/d
To Net Profit ts/f to
General P & L 9,400
A/c
19,900 19,900
(c) Branch Trading and Profit and Loss Account
` ` ` `
To Stock 7,000 By Sales:
To Goods sent Cash 17,500
from H.O. 26,000 Credit 28,400
Less: Returns (1,000) 25,000 Less:
to H.O. returns (500) 27,900 45,400
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.19
FOREIGN BRANCHES
To Gross profit 19,900 By Closing Stock 6,500
c/d
51,900 51,900
To Salaries & 6,200 By Gross 19,900
Wages Profit b/d
To Rent & Rates 1,200
To Sundry Exp. 800
To Petty Cash 100
Exp.
To Allowances to 200
Customers
To Discounts 1,400
To Bad Debts 600
To Net Profit 9,400
19,900 19,900
5.2 When goods are invoiced at selling price
Whenever, goods sent to branch are invoiced at selling price, certain
considerations need to be kept in mind such as:
(a) It would be obvious that, if Branch Account is debited with the sales price of
goods and subsequent to the debit being raised there is a change in the
sale price, the amount of debit either has to be increased or reduced on a
consideration of the quantity of unsold stock that was there at the branch at
the time the change took place. Such an adjustment will be necessary as
often as the change in sale price occurs.
(b) Moreover, the amount of anticipatory or unrealized profit, included in the
value of unsold stock with the branch at the close of the year will have to be
eliminated before the accounts of the branch are incorporated with that of
the head office. This will be done by creating a reserve.
It may also be necessary to adjust the value of closing stock on account of the
physical losses of stock due to either pilferage or wastages which may have
© The Institute of Chartered Accountants of India
15.20 ADVANCED ACCOUNTING
occurred during the year. This adjustment is made by debiting the cost of such
goods to Goods Lost Account and the amount of loading (included in the lost
goods), to the Branch Adjustment Account.
The three different methods that are usually adopted for maintaining accounts on
this basis are described below:
(i) Stock and Debtors Method
Under this method, when goods are invoiced at selling price, one additional
account i.e. ‘Branch Adjustment account’ is also prepared in addition to all the
accounts which are maintained on cost basis. (Refer para 5.1)
• When goods are invoiced at selling price, the following points should be kept
in mind under this method:
(i) Journal Entries:
Transaction Accounts debited Accounts credited
(a) Sale price of the Branch Stock A/c (at (i) Goods sent to
goods sent from selling price) Branches A/c with
H.O. to the cost of the goods
Branch sent.
(ii) Branch Adjustment
A/c (with the
loading i.e.,
Difference between
the selling and cost
price).
(b) Return of goods (i) Goods sent to Branch Branch Stock A/c
By the Branch to A/c (with the cost of
H.O. goods returned).
(ii) Branch Adjustment
A/c (with the loading)
(c) Cash sales at the Branch Cash/Bank A/c Branch Stock A/c
Branch
(d) Credit Sales at Branch Debtors A/c Branch Stock A/c
the Branch
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.21
FOREIGN BRANCHES
(e) Goods returned Branch Stock A/c Branch Debtors A/c
to
(at selling price)
Branch by
customers
(f) Goods lost in (i) Goods Lost in Transit Branch Stock A/c
A/c
Transit or stolen or Goods Stolen A/c
(with cost of the
goods)
(ii) Branch Adjustment
A/c
(with the loading)
(ii) Closing Stock
The balance in the Branch Stock Account at the close of the year normally should
be equal to the unsold stock at the Branch valued at sale price. But quite often
the value of stock actually held at the branch is either more or less than the
balance of the Branch Stock Account. In that event, as discussed earlier, it will be
necessary that the balance in the Branch Stock Account is increased or reduced by
debit or credit to Goods Lost Account (at cost price of goods) and Branch
Adjustment Account (with the loading). The Stock Account at selling price, thus
reveals loss of stock (or surplus) and serves as a check on the branch in this
respect.
The discrepancy in the amount of balance in the Branch Stock Account and the
value of stock actually in hand, valued at sale price, may be the result of one or
more of the under-mentioned factors:
• An error in applying the percentage of loading.
• Goods having been sold either below or above the established selling price.
• A Commission to adjust returns or allowances.
• Physical loss of stock due to natural causes or pilferage.
• Errors in Stock-taking.
© The Institute of Chartered Accountants of India
15.22 ADVANCED ACCOUNTING
For example, the balance brought down in the Branch Stock Account is ` 100 in
excess of the value of stock actually held by the branch when the goods were
invoiced by the head office to the branch at 25% above cost and the discrepancy is
either due to pilferage or loss by fire, the actual loss to the firm would be ` 80, since
20% of the invoice (same as 25% above cost) price would represent the element of
profit. The adjusting entry in such a case would be:
Dr. ` Cr. `
Goods Lost A/c Dr. 80
Branch Adjustment A/c Dr. 20
To Branch Stock A/c 100
If on the other hand, a part of the sale proceeds has been misappropriated, then in
that case Loss by Theft A/c would be debited, rest of the entry being same.
Rebates and allowances allowed to customers debited to P&L A/c & credited to
debtors A/c.
In the Goods Sent to Branch Account, the cost of the goods sent out to a branch
for sale is credited by debiting Branch Stock Account. Conversely, the cost of
goods returned by the branch is debited to this account. As such the balance in
the account at the end of the year will be the cost of goods sent to the branch;
therefore, it will be transferred either to the Trading Account or to Purchases
Account of the head office.
The amount of profit anticipated on sale of goods sent to the branch is credited
to the Branch Adjustment Account and conversely, the amount of profit not
realized in respect of goods returned by the branch to head office or that in
respect to stock remaining unsold with the branch at the close of the year is
debited to Branch Adjustment Account. The balance in this account, at the end of
year thus will consist of the amount of Gross Profit earned on sale by the branch.
On that account, it will be transferred to the Branch Profit and Loss Account.
(iii) Elimination of unrealized profit in the closing stock
The balance in the Branch Stock account would be at the sale price; therefore, it
would be necessary to eliminate the element of profit included in such closing
stock. This is done by creating a reserve against unrealized profit, by debiting the
Branch Adjustment Account and crediting Stock Reserve Account with an amount
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.23
FOREIGN BRANCHES
equal to the difference in the cost and selling price of unsold stock. Sometimes
instead of opening a separate account in respect of the reserve, the amount of
the difference is credited to Branch Stock Account. In that case, the credited
balance of such a reserve is also carried forward separately, along with the debit
balance in the Branch Stock Account; the difference between the two would be
the value of stock at cost. In either case, the credit balance will be deducted out
of the value of closing stock for the purpose of disclosure in the balance sheet, so
that the stock is shown at cost.
An Alternative method: Where the gross profit of each branch is not required to
be ascertained separately, although the selling price is uniform, the amount of
goods sent to the branch is recorded only in two accounts namely - Branch Stock
Account and Goods Sent to Branch A/c.
In this method, at the end of the year the Branch Stock Account is closed by
transfer of the balance representing the value of closing stock, at sale price, to the
Goods Sent to Branch Account. This has the effect of altogether eliminating
from the books the value of stock at the branch. The balance of Goods sent to
Branch Account is afterwards transferred to the Trading Account representing
the net sale price of goods sold at the branch. In that case, the value of closing
stock at the branch at cost will be subsequently introduced in the Trading
Account together with that of closing stock at the head office.
Illustration 3 (a)
Harrison of Chennai has a branch at New Delhi to which goods are sent @ 20%
above cost. The branch makes both cash and credit sales. Branch expenses are met
partly from H.O. and partly by the branch. The statement of expenses incurred by
the branch every month is sent to head office for recording.
Following further details are given for the year ended 31st December, 20X1:
`
Cost of goods sent to Branch at cost 2,00,000
Goods received by Branch till 31-12-20X1 at invoice price 2,20,000
Credit Sales for the year @ invoice price 1,65,000
Cash Sales for the year @ invoice price 59,000
Cash Remitted to head office 2,22,500
© The Institute of Chartered Accountants of India
15.24 ADVANCED ACCOUNTING
Expenses paid by H.O. 12,000
Bad Debts written off 750
Balances as on 1-1-20X1 31-12-20X1
` `
Stock 25,000 (Cost) 28,000 (invoice price)
Debtors 32,750 26,000
Cash in Hand 5,000 2,500
Show necessary ledger accounts in the books of the head office and determine the
Profit or Loss of the Branch for the year ended 31st December, 20X1.
Solution
Books of Harrison
Branch Stock Account
` `
To Balance b/d – Op Stock 30,000 By Branch Debtors (Sales) 1,65,000
To Goods Sent to Branch A/c 2,40,000 By Branch Cash 59,000
To Branch Adjustment A/c 2,000 By Balance c/d
(Balancing Figure – Goods in Transit
Excess of Sale over Invoice (` 2,40,000 – ` 2,20,000) 20,000
Price)
Closing Stock at 28,000
Branch
2,72,000 2,72,000
Branch Debtors Account
` `
To Balance b/d 32,750 By Bad debts written off 750
To Branch Stock A/c (Sales) 1,65,000 By Branch Cash (bal. 1,71,000
fig.)
By Balance c/d 26,000
1,97,750 1,97,750
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.25
FOREIGN BRANCHES
Branch Cash Account
` `
To Balance b/d 5,000 By Bank Remittance to 2,22,500
H.O.
To Branch Stock 59,000 By Branch Expenses 10,000
To Branch Debtors 1,71,000 [met by Branch (Bal.
fig.)]
By Balance c/d 2,500
2,35,000 2,35,000
Branch Adjustment Account
` `
By Stock Reserve opening 5,000
(25,000 × 20%)
To Branch P &L - Gross 39,000 By Goods sent to Branch 40,000
Profit (Bal. fig.) A/c
To Stock Reserve (on By Branch Stock A/c 2,000
closing stock (48,000 ×
1/6) 8,000
47,000 47,000
Branch Expenses
` `
To Cash (H.O) 12,000
To Branch Cash 10,000 By Branch P&L A/c 22,000
22,000 22,000
Branch Profit and Loss Account
` `
To Branch Expenses 22,000 By Gross Profit (from 39,000
Branch Adjustment A/c)
To Branch Debtors (bad debts) 750
To Net Profit 16,250
39,000 39,000
© The Institute of Chartered Accountants of India
15.26 ADVANCED ACCOUNTING
Goods Sent to Branch Account
` `
To Branch Adjustment A/c 40,000 By Branch to Stock A/c 2,40,000
To Purchase A/c - Transfer 2,00,000
2,40,000 2,40,000
(ii) Debtors Method
Under this method, the principal accounts that will be maintained are:
• The Branch Account;
• The Goods Sent to Branch Account; and
• The Stock Reserve Account.
Entries in these accounts will be made in the following manner:
Transaction Account debited Account credited
(a) Goods sent to Branch at Branch A/c Goods Sent to Branch
selling price A/c
(b) ‘Loading being the Goods Sent to Branch A/c
difference between selling Branch A/c
price and cost of goods
(c) Returns to H.O. at selling Goods Sent to Branch A/c
price Branch A/c
(d) ‘Loading’ in respect of Branch A/c Goods Sent to Branch
goods returned to H.O. A/c
(e) ‘Loading’ included in the Stock Reserve A/c Branch A/c
opening stock to reduce it
(f) Closing stock at selling Branch Stock A/c Branch A/c
price
(g) ‘Loading’ included in Branch A/c Stock Reserve A/c
closing stock to reduce it
to cost
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.27
FOREIGN BRANCHES
It will be observed that entries in the Branch Account in respect of goods sent to
a branch or returned by it, as well as those for the opening and closing stock, will
be at selling price. In consequence, the Branch Account is maintained at selling price.
Hence, the Branch Account will not correctly show the trading profit of the Branch
unless these amounts are adjusted to cost. Such an adjustment is effected by
making contra entries in ‘Goods Sent to Branch A/c’ and ‘Stock Reserve Account’.
In respect of closing stock at branch for the purpose of disclosure in the Balance
Sheet, the credit balance in the ‘Stock Reserve Account’ at the end of the year will
be deducted from the value of the closing stock, so as to reduce it to its cost; it
will be carried forward as a separate balance to the following year, for being
transferred to the credit of the Branch Account.
Illustration 3 (b)
Take figures from Illustration 3 (a) and prepare branch account following debtors’
method.
Solution
Books of Harrison
New Delhi Branch Account
` `
To Balance B/d
Stock 30,000 By Stock Reserve 5,000
Debtors 32,750
Cash 5,000
To Goods Sent to Branch A/c 2,40,000 By Goods Sent to Branch 40,000
(2,00,000 + 20%) A/c
To Cash (Exp. paid by 12,000 By Cash – Remittance from 2,22,500
H.O.) branch
To Net Profit ts/f to H.O. 16,250 By Balance c/d 26,000
Profit & Loss A/c Debtors
(Balancing Figure)
© The Institute of Chartered Accountants of India
15.28 ADVANCED ACCOUNTING
To Stock reserve 8,000 Stock (including Transit 48,000
(48,000X20/120) – W.N 2)
Cash 2,500
3,44,000 3,44,000
Working Note:
Closing Stock = Stock at branch + Stock in Transit (Goods sent by HO – Goods
Received by Branch) = ` 28,000 + (` 2,40,000 - ` 2,20,000) = ` 48,000.
Illustration 4
Sell Well who carried on a retail business opened a branch X on January 1st, 20X1
where all sales were on credit basis. All goods required by the branch were supplied
from the Head Office and were invoiced to the branch at 10% above cost.
The following were the transactions:
Jan. 20X1 Feb. 20X1 March 20X1
` ` `
Goods sent to Branch (Purchase Price) 40,000 50,000 60,000
Sales as shown by the branch monthly 38,000 42,000 55,000
report
Cash received from Debtors and 20,000 51,000 35,000
remitted to H.O.
Returns to H.O. (Invoice price to Branch) 1,200 600 2,400
The stock of goods held by the branch on March 31, 20X1 amounted to ` 53,400 at
invoice to branch.
Record these transactions in the Head Office books, showing balances as on
31st March, 20X1 and the branch gross profit for the three months ended on that
date.
All workings should form part of your solution.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.29
FOREIGN BRANCHES
Solution
Books of Sell Well
Branch Account
` `
To Goods sent to Branch 1,65,000 By Goods sent to 15,000
A/c (1,50,000+10%) Branch-Loading
To Goods sent to Branch 382 By Goods sent to 4,200
A/c Branch-returns
(4,200 X 10/110)
By Bank 1,06,000
By Balance c/d -
Closing Branch
Assets
To Stock Reserve (53,400 X 4,855 Stock 53,400
10/110)
To Net Profit (Bal fig) ts/f to 37,363 Debtors (Sales- 29,000 82,400
General P&L A/c Collection)
2,07,600 2,07,600
Working Note:
Memorandum Branch Debtors Account
` `
To Balance b/d --- By Cash/Bank 1,06,000
To Sales 1,35,000 By Balance c/d 29,000
1,35,000 1,35,000
© The Institute of Chartered Accountants of India
15.30 ADVANCED ACCOUNTING
Goods Sent to Branch Account
` `
To Branch A/c – Loading 15,000 By Branch A/c 1,65,000
To Branch A/c – Returns 4,200 By Branch A/c – Loading 382
To Purchases A/c 1,46,182 on returns
1,65,382 1,65,382
(iii) Trading and Profit and Loss Account (Final Accounts) Method
All items of memorandum Branch Trading and Profit and Loss Account are to be
converted into cost price if the goods are invoiced to branch at selling price.
Other points will remain same as already discussed in Para 5.1 for this method if
goods are invoiced at cost.
Illustration 5
Following is the information of the Jammu branch of Best New Delhi for the year
ending 31st March, 20X2 from the following:
(1) Goods are invoiced to the branch at cost plus 20%.
(2) The sale price is cost plus 50%.
(3) Other information:
Stock as on 01.04.20X1(invoice price) 2,20,000
Goods sent during the year (invoice price) 11,00,000
Sales during the year 12,00,000
Expenses incurred at the branch 45,000
Ascertain
(i) the profit earned by the branch during the year.
(ii) branch stock reserve in respect of unrealized profit.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.31
FOREIGN BRANCHES
Solution
(i) Calculation of profit earned by the branch
In the books of Jammu Branch
Trading Account and Profit and Loss Account
Particulars Amount Particulars Amount
` `
To Opening stock 2,20,000 By Sales 12,00,000
To Goods 11,00,000 By Closing stock 3,60,000
received by Head (Refer W.N.)
office
To Expenses 45,000
To Net profit (Bal 1,95,000
fig)
15,60,000 15,60,000
(ii) Stock reserve in respect of unrealised profit
= ` 3,60,000 x (20/120) = ` 60,000
Working Note:
`
Cost Price 100
Invoice Price 120
Sale Price 150
Calculation of closing stock at invoice `
price
Opening stock at invoice price 2,20,000
Goods received during the year at 11,00,000
invoice price
13,20,000
Less: Cost of goods sold at invoice price (9,60,000) [12,00,000 x (120/150)]
Closing stock 3,60,000
© The Institute of Chartered Accountants of India
15.32 ADVANCED ACCOUNTING
Illustration 6
Hindustan Industries Mumbai has a branch in Cochin to which office goods are
invoiced at cost plus 25%. The branch sells both for cash and on credit. Branch
Expenses are paid direct from head office, and the Branch has to remit all cash
received into the Head Office Bank Account.
From the following details, relating to calendar year 20X1, prepare the accounts in
the Head Office Ledger and ascertain the Branch Profit. Branch does not maintain
any books of account, but sends weekly returns to the Head Office:
`
Goods received from Head Office at invoice price 6,00,000
Returns to Head Office at invoice price 12,000
Stock at Cochin as on 1st Jan., 20X1 60,000
Sales in the year - Cash 2,00,000
Credit 3,60,000
Sundry Debtors at Cochin as on 1st Jan. 20X1 72,000
Cash received from Debtors 3,20,000
Discount allowed to Debtors 6,000
Bad debts in the year 4,000
Sales returns at Cochin Branch 8,000
Rent, Rates, Taxes at Branch 18,000
Salaries, Wages, Bonus at Branch 60,000
Office Expenses 6,000
Stock at Branch on 31st Dec. 20X1 at invoice price 1,20,000
Prepare Branch accounts in books of head office by Stock and debtors method.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.33
FOREIGN BRANCHES
Solution
Books of Hindustan Industries, Mumbai
Cochin Branch Stock Account
` `
To Balance b/d – Op Stock 60,000 By Bank A/c – Cash Sales 2,00,000
To Branch Debtors A/c – 8,000 By Branch Debtors A/c - 3,60,000
Sales Return Credit Sales
To Goods sent to Branch 6,00,000 By Goods sent to Branch 12,000
A/c (Returns to H.O.)
To Branch Adjustment A/c 24,000 By Balance c/d - Closing 1,20,000
(Excess of Selling Price stock
over Invoice Price)
6,92,000 6,92,000
Cochin Branch Stock Adjustment Account
` `
To Goods sent to Branch 2,400 By Balance b/d 12,000
A/c (1/5 of ` 60,000)
(1/5 of ` 12,000) (on
returns)
To Branch P & L A/c (Profit 1,29,600 By Goods sent to Branch 1,20,000
on sale) – Bal fig A/c (1/5 of
` 6,00,000)
To Balance c/d (1/5 of 24,000 By Branch Stock 24,000
` 1,20,000)
1,56,000 1,56,000
© The Institute of Chartered Accountants of India
15.34 ADVANCED ACCOUNTING
Goods Sent to Branch Account
` `
To Cochin Branch Stock 1,20,000 By Cochin Branch Stock 6,00,000
Adjustment A/c A/c
To Cochin Branch Stock 12,000 By Cochin Branch Stock 2,400
A/c (Returns) Adj. A/c
To Purchases A/c 4,70,400
6,02,400 6,02,400
Branch Debtors Account
` `
To Balance b/d 72,000 By Bank 3,20,000
To Branch Stock By Branch P&L A/c 6,000
Discount
A/c 3,60,000 By Branch P&L A/c - Bad 4,000
Debts
By Branch Stock - Sales 8,000
Returns
By Balance c/d 94,000
4,32,000 4,32,000
Branch Expenses Account
` `
To Bank A/c (Rent, Rates By Branch Profit & Loss
& Taxes) 18,000 A/c (Transfer) 84,000
To Bank A/c (Salaries &
Wages) 60,000
To Bank A/c (office exp.) 6,000
84,000 84,000
Branch Profit & Loss Account for the year ending 31st Dec. 20X1
` `
To Branch Expenses A/c 84,000 By Branch Stock Adj. A/c 1,29,600
To Branch Debtors A/c 6,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.35
FOREIGN BRANCHES
To Branch Debtors A/c 4,000
To Net Profit transferred to
Profit & Loss A/c 35,600
1,29,600 1,29,600
Illustration 7
Arnold of Delhi, trades in Ghee and Oil. It has a branch at Lucknow. He dispatches
25 tins of Oil @ ` 1,000 per tin and 15 tins of Ghee @ ` 1,500 per tin on 1st of every
month. The branch incurs some expenditure which is met out of its collections; this
is in addition to expenditure directly paid by Head Office.
Following are the other details:
Delhi Lucknow
` `
Purchases Ghee 14,75,000 -
Oil 29,32,000 -
Direct expenses 3,83,275 -
Expenses paid by H.O. - 14,250
Sales Ghee 18,46,350 3,42,750
Oil 27,41,250 3,15,730
Collection during the year (including Cash - 6,47,330
Sales)
Remittance by Branch to Head Office - 6,13,250
(Delhi)
Balance as on: 1-1-20X1 31-12-20X1
Stock: Ghee 1,50,000 3,12,500
Oil 3,50,000 4,17,250
Debtors 7,32,750 -
Cash on Hand 70,520 55,250
Furniture & Fittings 21,500 19,350
Plant/Machinery 3,07,250 7,73,500
© The Institute of Chartered Accountants of India
15.36 ADVANCED ACCOUNTING
(Lucknow)
Balance as on: 1-1-20X1 31-12-20X1
Stock: Ghee 17,000 13,250
Oil 27,000 44,750
Debtors 75,750 ?
Cash on Hand 7,540 12,350
Furniture & Fittings 6,250 5,625
Plant/Machinery -
Addition to Plant/Machinery on 1-1-20X1 ` 6,02,750.
Rate of Depreciation: Furniture / Fittings @ 10% and Plant / Machinery @ 15%
(already adjusted in the above figures).
The Branch Manager is entitled to 10% commission after charging such commission
whereas, the General Manager is entitled to 10% commission on overall company
profits after charging such commission. General Manager is also entitled to a salary
of ` 2,000 p.m. General expenses incurred by H.O. ` 24,000.
Prepare Branch Account in the head office books and also prepare the Arnold’s
Trading and Profit and Loss A/c (excluding branch transactions).
Solution
In the books of Arnold
Lucknow Branch Account
` `
To Balance b/d By Bank (Remittance) 6,13,250
-Opening Branch Assets By Closing Branch Assets
Opening stock: Closing stock:
Ghee 17,000 Ghee 13,250
Oil 27,000 Oil 44,750
Debtors 75,750 Debtors (W.N. 1) 86,900
Cash on hand 7,540 Cash on hand (W.N. 2) 12,350
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.37
FOREIGN BRANCHES
Furniture & fittings 6,250 Furniture & fittings 5,625
To Goods sent to Branch
A/c
Ghee (15 x 1500 x 12) 2,70,000
Oil (25 x 1000 x 12) 3,00,000
To Bank (Expenses paid) 14,250
To Branch Manager
commission
(` 58,335 × 1/11) 5,303
To Net Profit transferred
to General P & L A/c 53,032
7,76,125 7,76,125
Arnold
Trading and Profit and Loss account for the year ended 31st December, 20X1
(Excluding branch transactions)
` `
To Opening Stock: By Sales:
Ghee 1,50,000 Ghee 18,46,350
Oil 3,50,000 Oil 27,41,250
To Purchases: By Closing Stock:
Ghee 14,75,000 Ghee 3,12,500
Less: Goods sent Oil 4,17,250
to Branch (2,70,000) 12,05,000
Oil 29,32,000
Less: Goods sent
to Branch (3,00,000) 26,32,000
To Direct Expenses 3,83,275
To Gross Profit c/d 5,97,075
53,17,350 53,17,350
To Manager’s Salary 24,000 By Gross Profit b/d 5,97,075
© The Institute of Chartered Accountants of India
15.38 ADVANCED ACCOUNTING
To General Expenses 24,000 By Branch Profit
To Depreciation: transferred 53,032
Furniture @10% 2,150
Plant & Machinery
@ 15% (W.N.3) 1,36,500 1,38,650
To General Manager’s
Commission @ 10%
(i.e., 4,63,457 × 1/11) 42,132
To Net profit 4,21,325
6,50,107 6,50,107
Working Notes:
(1) Memorandum Branch Debtors Account
` `
To Balance b/d 75,750 By Cash Collections 6,47,330
(including Cash Sales)
To Sales (including By Balance c/d 86,900
Cash
Sales)
Ghee 3,42,750
Oil 3,15,730
7,34,230 7,34,230
(2) Memorandum Branch Cash Account
` `
To Balance b/d 7,540 By Remittance 6,13,250
To Collections 6,47,330 By Exp. (Balance fig.) 29,270
By Balance c/d 12,350
6,54,870 6,54,870
(3) Depreciation on Plant & Machinery
3,07,250 x 15% + 6,02,750 x 15% = `1,36,500
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.39
FOREIGN BRANCHES
5.3 Goods invoiced at wholesale price to retail branches
Under this method, the Head Office (particularly, the manufacturing concern)
supplies goods to its retail branches at wholesale price which is cost plus
wholesale profit.
Profit of branch = Sale proceeds at shop - wholesale price of the goods sold.
For this purpose, it is assumed that Manufacturer would always be able to sell the
goods on wholesale terms thereby Manufacturer profit = Wholesale price - Cost.
Many concerns, therefore, invoice goods to such shops at wholesale price and
determine profit or loss on sale of goods on this basis.
Branch Stock Account or the Trading Account is debited with:
(a) the value of opening stock at the Branch; and
(b) price of goods sent during the year at wholesale price.
It is credited by:
(a) sales effected at the shop; and
(b) closing stock of goods valued at wholesale price.
The value of goods lost due to accident, theft etc. also is credited to the Branch
Stock Account or Trading Account calculated at the wholesale price. At this
stage, the Branch Stock or Trading Account will reveal the amount of gross profit
(or loss). It is transferred to the Branch Profit and Loss Account. On further being
debited with the expenses incurred at the shop and the wholesale price of goods
lost, the Branch Profit and Loss Account will disclose the net profit (or loss) at the
shop.
Since the closing stock at the branch has to be valued at wholesale price, it would
be necessary to create a stock reserve equal to the difference between its
wholesale price and its cost (to the head office) by debiting the amount in the
Head Office Profit and Loss Account. This Stock Reserve is carried forward to the
next year and then transferred to the credit of the (Head Office) Profit and Loss
Account.
© The Institute of Chartered Accountants of India
15.40 ADVANCED ACCOUNTING
Illustration 8
M/s Rahul operates a number of retail outlets to which goods are invoiced at
wholesale price which is cost plus 25%. These outlets sell the goods at the retail
price which is wholesale price plus 20%.
Following is the information regarding one of the outlets for the year ended 31.3.20X2:
`
Stock at the outlet 1.4.20X1 30,000
Goods invoiced to the outlet during the year 3,24,000
Gross profit made by the outlet 60,000
Goods lost by fire ?
Expenses of the outlet for the year 20,000
Stock at the outlet 31.3.20X2 36,000
You are required to prepare the following accounts in the books of Rahul Limited
for the year ended 31.3.20X2:
(a) Outlet Stock Account.
(b) Outlet Profit & Loss Account.
(c) Stock Reserve Account.
Solution
Outlet Stock Account
` `
To Balance b/d 30,000 By Sales (Working Note 1) 3,60,000
To Goods sent to 3,24,000 By Goods lost by fire (b.f.) 18,000
outlet
To Gross Profit c/d 60,000 By Balance c/d 36,000
4,14,000 4,14,000
Outlet Profit & Loss Account
` `
To Expenses 20,000 By Gross Profit b/d 60,000
To Goods lost by fire (W.N.2) 18,000
To Profit transferred 22,000
60,000 60,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.41
FOREIGN BRANCHES
Stock Reserve Account
` `
To HO P & L A/c – Transfer 6,000 By Balance b/d 6,000
To Balance c/d (Stock Res. 7,200 By HO P&L A/c 7,200
required) (W.N. 3)
13,200 13,200
Working Notes:
`
(1) Wholesale Price 100+25 = 125
Retail Price 125 + 20% = 150
Gross Profit at the outlet
Wholesale Price – Retail Price (150 – 125) 25
150
Retail sales value = 60,000 × = ` 3,60,000
25
(2) Goods lost by fire
Opening Stock + Goods Sent + Gross Profit – Sales – Closing Stock
30,000 + 3,24,000 + 60,000 – 3,60,000 – 36,000 = ` 18,000
(3) Stock Reserve
25
Opening Stock = 30,000 × = ` 6,000
125
25
Closing Stock = 36,000 × = ` 7,200
125
6. ACCOUNTING FOR INDEPENDENT BRANCHES
When the size of the business is big, it is desirable that the branch maintains
complete records of its transactions. These branches are called independent
branches and each independent branch maintains comprehensive account books
for recording their transactions; therefore, a separate trial balance of each branch
can be prepared. The head office maintains one ledger account for each such
branch, wherein all transactions between the head office and the branches are
recorded.
© The Institute of Chartered Accountants of India
15.42 ADVANCED ACCOUNTING
Salient features of accounting system of an independent branch are as
follows:
1. Branch maintains its entire books of account under double entry system.
2. Branch opens in its books a Head Office account to record all transactions
that take place between Head Office and branch. The Head Office maintains
a Branch account to record these transactions.
3. Branch prepares its Trial Balance, Trading and profit and loss Account at the
end of the accounting period and sends copies of these statements to Head
Office for incorporation.
4. After receiving the final statements from branch, Head Office reconciles
between the two – Branch account in Head Office books and Head Office
account in Branch books.
5. Head office passes necessary journal entries to incorporate branch trial
balance in its books.
The Head Office Account in branch books and Branch Account in head office
books is maintained respectively.
Transactions Head office books Branch books
(i) Dispatch of goods Branch A/c Dr. Goods received from Dr.
to branch by H.O. To Good sent to H.O. A/c
Branch A/c To Head Office A/c
(ii) When goods are Goods sent to Branch Dr. Head Office A/c Dr.
returned by the A/c To Goods received
Branch to H.O. To Branch A/c from H.O. A/c
(iii) Branch Expenses are No Entry Expenses A/c Dr.
paid by the Branch To Bank or Cash
A/c
(iv) Branch Expenses Branch A/c Dr. Expenses A/c Dr.
paid by H.O. To Bank or cash To Head Office A/c
(v) Outside purchases No Entry Purchases A/c Dr.
made by the Branch To Bank (or)
Creditors A/c
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.43
FOREIGN BRANCHES
(vi) Sales effected by the No Entry Cash or Debtors A/c Dr.
Branch To Sales
(vii) Collection from Cash or Bank A/c Dr. Head office A/c Dr.
Debtors of the To Branch A/c To Sundry Debtors
Branch recd. by H.O. A/c
(viii) Payment by H.O. for Branch A/c Dr. Purchases (or) Sundry Dr.
purchase made by To Bank Creditors A/c
Branch To Head Office
(ix) Purchase of Asset No Entry Sundry Assets Dr.
by Branch To Bank (or)
Liability
(x) Asset purchased by Branch Asset A/c Dr. Head office Dr.
the Branch but Asset To Branch A/c To Bank (or)
A/c retained at H.O. Liability
books
(xi) Depreciation on (x) Branch A/c Dr. Depreciation A/c Dr.
above To Branch Asset To Head Office A/c
(xii) Remittance of funds Branch A/c Dr. Bank A/c Dr.
by H.O. to Branch To Bank To Head Office
(xiii) Remittance of funds Reverse entry of (xii) Reverse entry of (xii)
by Branch to H.O. above i.e. above
(xiv) Transfer of goods (Recipient) Branch A/c Supplying Branch Dr.
from one Branch to To Supplying Dr. H.O. A/c
another branch Branch A/c
To Goods sent to
H.O. A/c
Recipient Branch
Goods Received from Dr.
H.O. A/c
To Head Office
A/c
© The Institute of Chartered Accountants of India
15.44 ADVANCED ACCOUNTING
Students may find a few further practical situations and it is hoped that they can
pass entries on the basis of accounting principles explained above.
The final result of these adjustments will be that so far as the Head Office is
concerned, the branch will be looked upon either as a debtor or creditor, as a
debtor if the amount of its assets is in excess of its liabilities and as a creditor if
the position is reverse.
A debit balance in the Branch Account should always be equal to the net assets at
the branch. The important thing to remember, when independent sets of accounts
are maintained, is that the branch and head office books are connected with each
other only through the medium of the Branch and the Head Office Account which
are converse of each other. Also, when the accounts of branch and head office are
consolidated, both the Branch and Head Office Accounts will be eliminated.
7. ADJUSTMENT AND RECONCILIATION OF
BRANCH AND HEAD OFFICE ACCOUNTS
If the branch and the head office accounts, converse of each other, do not tally,
these must be reconciled before the preparation of the final accounts of the
concern as a whole.
For example, if Head Office has sent goods worth ` 50,000 but the branch has
received till the closing date goods only ` 40,000, then the branch should treat
` 10,000 as goods in transit and should pass the following entry :
Dr. Cr.
Goods in transit A/c Dr. 10,000
To Head Office A/c 10,000
However, there will be no entry in Head office books being the point where the
event has been recorded in full, hence no further entries in Head office books.
7.1 Reasons for Disagreement
Following are the possible reasons for the disagreement between Branch A/c in
Head office books and Head office A/c in Branch books on the closing date:
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.45
FOREIGN BRANCHES
Receipt of income or
Goods returned payment or expenses
Goods dispatched by the branch to relating to the
by the Head office Amount remitted
Head Office may Branch transacted
not received by by Head office to
have been directly by the head
the branch. These branch or vice
received by the office or vice versa,
goods may be in versa remaining
H.O. Again, these hence not recorded
transit or loss in in transit on the
goods may be in at the respective
closing date.
transit. transit or lost in ends wherein they
transit. are normally to be
recorded.
The technique of reconciliation has been illustrated through the example given
below :
Head office Branch
Dr. Cr. Dr. Cr.
Goods sent to Branch 1,50,000 -
Goods recd. from H.O. A/c - 1,40,000
Branch A/c 1,12,000
Head office A/c - - - 78,500
On analysis of Branch A/c in Head office books and Head office A/c in branch
books, you find:
• Goods valued `10,000 sent by head office has not been received by branch,
hence not recorded in the branch books.
• ` 15,000 remitted by the branch has not been received, hence not recorded
in the head office books.
• Direct collection of ` 10,500 from a customer of the branch by Head office
not informed to the branch, hence not recorded by the branch.
© The Institute of Chartered Accountants of India
15.46 ADVANCED ACCOUNTING
• A sum of ` 14,500 paid by branch to the suppliers of head office not
recorded at Head office.
• Head office expenditure allocation to the branch `12,000 not recorded in
the branch.
• ` 7,500 being FD interest of head office received by the branch on oral
instructions from H.O., not recorded in the head office books.
Head Office Branch Books
Books
Dr. Cr. Dr. Cr.
` ` ` `
(i) Goods in transit - - Goods in Transit 10,000
(` 10,000) A/c
To Head 10,000
office A/c
(ii) Cash in Transit: Cash in 15,000 (No Entry)
Transit A/c
To Branch 15,000
A/c
(iii) Direct Collection Head Office A/c 10,500
by H.O. on behalf To Debtors 10,500
of the Branch A/c
(iv) Direct payment of Sundry 14,500
` 14,500 by Creditors A/c
Branch on
behalf of H.O To Branch 14,500
A/c
(v) Expenditure Branch Exp. A/c 12,000
Allocated to
Branch
To H.O. A/c 12,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.47
FOREIGN BRANCHES
(vi) Fixed Deposit Branch A/c 7,500
interest of To Sundry 7,500
` 7,500 directly Income
received by the
Branch
In Branch Books
Head Office Account
` `
To Sundry Debtors A/c 10,500 By Balance b/d 78,500
To Balance c/d 90,000 By Goods in transit 10,000
By Branch expenses 12,000
1,00,500 1,00,500
By Balance b/d 90,000
In the Books of Head Office
Branch A/c
` `
To Balance b/d 1,12,000 By Cash in Transit 15,000
To Sundry Income 7,500 By Sundry Creditors 14,500
By Balance c/d 90,000
1,19,500 1,19,500
To Balance b/d 90,000
Important Points to be noted:
(i) the balance of Head Office A/c in Branch books and Branch A/c in Head
Office books have tallied.
(ii) Adjustment are made only at the point:
Where the recording has been omitted, and
Other than the point where action has already been effected.
© The Institute of Chartered Accountants of India
15.48 ADVANCED ACCOUNTING
7.2 Other points
(1) Inter-Branch Transactions
Inter-branch transactions (i.e. transaction between two branches) are usually
adjusted as if they were entered into only with the head office. It is a very
convenient method of treating such transaction especially where the number of
branches are large. Suppose Kolkata Branch incurred an expenditure on
advertisement of ` 1,000 on account of Delhi Branch, the entries that would be
made in such a case would be as follows:
Dr. Cr.
`
In Kolkata Books:
Head Office A/c Dr. 1,000
To Cash 1,000
In Delhi Books:
Advertisement A/c Dr. 1,000
To H.O. A/c 1,000
In H.O. Books:
Delhi Branch A/c Dr. 1,000
To Kolkata Branch A/c 1,000
(2) Fixed Assets
Often the accounts of fixed assets of a branch are kept in the head office books;
in such a case, at the end of the year, the amount of depreciation on the assets is
debited to the branch concerned by recording the following entry by head office:
Branch Account Dr.
To Branch Asset Account
The branch will pass the following entry:
Depreciation Account Dr.
To Head Office Account
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.49
FOREIGN BRANCHES
(3) Head office Expenses charged to Branch
Usually the head office devotes considerable time in attending to the affairs of
the branch; on that account, it may decide to raise a charge against the branch in
respect of the cost of such time. In such a case the amount is debited to the
branch (being receivable from branch) and is credited to appropriate expense
head such as Salaries Accounts, General Charges Account, Entertainment Account
etc (i.e. reducing the expense in head office books). The branch credits the H.O.
Account and debits Expenses Account.
Illustration 9
Give Journal Entries in the books of an independent Branch to rectify or adjust the
following:
(i) Branch paid ` 5,000 as salary to H.O supervisor, but the amount paid by
branch has been debited to salary account in the books of branch.
(ii) Asset Purchased by branch for ` 25,000, but the Asset account was retained in
H.O Books.
(iii) A remittance of `8,000 sent by the branch has not been received by H.O.
(iv) H.O collected ` 25,000 directly from the customer of Branch but fails to give
the intimation to branch.
(v) Remittance of funds by H.O to branch ` 5,000 not entered in branch books.
Solution
Journal Entries in Books of Branch
Particulars Dr. Cr.
Amount Amount
` `
(i) Head office account Dr. 5,000
To Salaries account 5,000
(Being the rectification of salary paid on
behalf of H.O.)
© The Institute of Chartered Accountants of India
15.50 ADVANCED ACCOUNTING
(ii) Head office account Dr. 25,000
To Bank / Liability A/c 25,000
(Being Asset purchased by branch but Asset
account retained at head office books)
(iii) No Entry in Branch Books
(iv) Head office account Dr. 25,000
To Debtors account 25,000
(Being the amount of branch debtors
collected by H.O.)
(v) Bank A/c Dr. 5,000
To Head Office 5,000
(Remittance of Funds by H.O. to Branch)
Illustration 10
The following Trial balances as at 31st December, 20X1 have been extracted from
the books of Major Ltd. and its branch at a stage where the only adjustments
requiring to be made prior to the preparation of a Balance Sheet for the
undertaking as a whole are to be done.
Head Office Branch
Dr. Cr. Dr. Cr.
` ` ` `
Share Capital 1,50,000
Fixed Assets 75,125 18,901
Current Assets 1,21,809 23,715 (Note 3)
Current Liabilities 34,567 9,721
Stock Reserve, 1st Jan., 20X1
(Note 2) 693
Revenue Account 43,210 10,250
Branch Account 31,536
Head Office Account 22,645
2,28,470 2,28,470 42,616 42,616
You are required to record the following in the appropriate ledger accounts in both
sets of books.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.51
FOREIGN BRANCHES
Note:
1. Goods transferred from Head Office to the Branch are invoiced at cost plus
10% and both Revenue Accounts have been prepared on the basis of the
prices charged.
2. Relating to the Head Office goods held by the Branch on 1st January, 20X1.
3. Includes goods received from Head Office at invoice price ` 4,565.
4. Goods invoiced by Head Office to Branch at ` 3,641 were in transit at
31st December, 20X1, as was also a remittance of ` 3,500 from the Branch.
5. At 31st December, 20X1, the following transactions were reflected in the Head
Office books but unrecorded in the Branch books.
The purchase price of lorry, ` 2,500, which reached the Branch on December 25th; a
sum received on December 30, 20X1 from one of the Branch debtors, ` 750.
Solution
H.O. Books
Branch Account
20X1 ` 20X1 `
Dec. 31 To Balance b/d 31,536 Dec. 31 By Cash in transit 3,500
By Balance c/d 28,036
31,536 31,536
Cash in transit Account
20X1 ` 20X1 `
Dec. 31 To Branch A/c 3,500 Dec. 31 By Balance c/d 3,500
Stock Reserve Account
20X1 ` 20X1 `
Dec. 31 To Balance c/d 746 Jan. 1 By Balance b/d 693
(4,565+3,641) x By Revenue A/c (b.f.) 53
10/110
746 746
© The Institute of Chartered Accountants of India
15.52 ADVANCED ACCOUNTING
Revenue Account
20X1 ` 20X1 `
Dec. 31 To Stock Reserve 53 Dec. 31 By Balance b/d 43,210
To Balance c/d 43,157
43,210 43,210
Branch Books
Head Office Account
20X1 ` 20X1 `
Dec. 31 To Current Assets 750 Dec. 31 By Balance b/d 22,645
By Goods in transit 3,641
To Balance c/d 28,036 By Motor Vehicle 2,500
28,786 28,786
Goods in Transit Account
20X1 ` 20X1 `
Dec. 31 To Head 3,641 Dec. 31 By Balance 3,641
Office c/d
Motor Vehicle Account
20X1 ` 20X1 `
Dec. 31 To Head 2,500 Dec. 31 By Balance 2,500
Office c/d
Sundry Current Assets A/c
20X1 ` 20X1 `
Dec. 31 To 23,715 Dec. 31 By H.O. 750
Balance (Remittance
b/d by Debtor)
By Balance c/d 22,965
23,715 23,715
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.53
FOREIGN BRANCHES
8. INCORPORATION OF BRANCH BALANCE IN
HEAD OFFICE BOOKS
The method that will be adopted for incorporating the trading result of the
branch with that of the head office would depend on whether it is desired to
prepare
(a) Standalone P&L & Balance Sheet for each Branch, or
(b) Consolidated statement of Branch & H.O.
Method I: Separate P&L & Balance Sheet for each Branch
Amount of P&L is shown by Branch & is transfer to H.O. in Branch books &
converse entry is passed in H.O. Books as:
Branch A/c Dr.
To Profit & Loss A/c
In such a case, not only P&L but also separate Balance Sheet for Branch & H.O. is to
be prepared. The Branch Balance Sheet would show the amount advanced by H.O.
to it as "Capital." In H.O. Books such amount would be shown as "Advance to
Branch"
Method II: Prepare a consolidated Profit & Loss Account and Balance Sheet
Individual balances of all the revenue accounts would be separately transferred to
the Head Office Account by debit or credit in the branch books and the converse
entries would be passed in the head office books. The effect thereof will be
similar to the amount of net profit or loss of the branch having been transferred
since it would be composed of the balances that have been transferred. In case it
is also desired that consolidated balance sheet of the branch and the head office
should be prepared, it will also be necessary to transfer the balance of assets and
liabilities of the branch to the head office. The adjusting entries that would be
passed in this respect in the books of branch are shown below:
(a) Head Office Account Dr.
To Asset (individual) Account
© The Institute of Chartered Accountants of India
15.54 ADVANCED ACCOUNTING
(b) (Individual) Liability Account Dr.
To Head Office Account
Converse entries are passed in the head office books.
It is obvious that after afore-mentioned entries have been passed, the Branch
Account in the Head Office books and Head Office Account in the branch books
will be closed and it will be necessary to restart them at the beginning of the next
year.
In consequence, at the beginning of the following year, the under-mentioned
entry is recorded by the branch:
Asset Account (In Detail) Dr.
To Liability Accounts (In Detail)
To H.O. Account (The difference between assets and liabilities)
Illustration 11
KP manufactures a range of goods which it sells to wholesale customers only from
its head office. In addition, the H.O. transfers goods to a newly opened branch at
factory cost plus 15%. The branch then sells these goods to the general public on
only cash basis.
The selling price to wholesale customers is designed to give a factory profit which
amounts to 30% of the sales value. The selling price to the general public is
designed to give a gross margin (i.e., selling price less cost of goods from H.O.) of
30% of the sales value.
KP operates from rented premises and leases all other types of fixed assets. The rent
and hire charges for these are included in the overhead costs shown in the trial
balances.
From the information given below, you are required to prepare for the year ended
31st Dec., 20X1 in columnar form.
(a) A Profit & Loss account for (i) H.O. (ii) the branch (iii) the entire business.
(b) Balance Sheet as on 31st Dec., 20X1 for the entire business.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.55
FOREIGN BRANCHES
H.O. Branch
` ` ` `
Raw materials purchased 35,000
Direct wages 1,08,500
Factory overheads 39,000
Stock on 1-1-20X1
Raw materials 1,800
Finished goods 13,000 9,200
Debtors 37,000
Cash 22,000 1,000
Administrative Salaries 13,900 4,000
Salesmen Salaries 22,500 6,200
Other administrative &
selling overheads 12,500 2,300
Inter-unit accounts 5,000 2,000
Capital 50,000
Sundry Creditors 13,000
Provision for unrealized 1,200
profit in stock
Sales 2,00,000 65,200
Goods sent to Branch 46,000
Goods received from 44,500
H.O.
3,10,200 3,10,200 67,200 67,200
© The Institute of Chartered Accountants of India
15.56 ADVANCED ACCOUNTING
Note:
(1) On 28th Dec., 20X1 the branch remitted ` 1,500 to the H.O. and this has not
yet been recorded in the H.O. books. Also, on the same date, the H.O.
dispatched goods to the branch invoiced at ` 1,500 and these too have not
yet been entered into the branch books. It is the company’s policy to adjust
items in transit in the books of the recipient.
(2) The stock of raw materials held at the H.O. on 31st Dec., 20X1 was valued at
` 2,300.
(3) You are advised that:
there were no stock losses incurred at the H.O. or at the branch.
it is KP’s practice to value finished goods stock at the H.O. at factory
cost.
there were no opening or closing stock of work-in-progress.
(4) Branch employees are entitled to a bonus of ` 156 under a bilateral
agreement.
Solution
In the books of KP
Trading and Profit & Loss Account for the year ended 31st Dec., 20X1
H.O. Branch Total H.O. Branch Total
` ` ` ` ` `
To Opening stock of 13,000 9,200 22,200 By Sales 2,00,000 65,200 2,65,200
finished goods
To Material consumed
(W.N.1) 34,500 - 34,500
To Wages 1,08,500 - 1,08,500 By Goods Sent 46,000 - -
To Factory Overheads 39,000 - 39,000 to Branch
To Goods from H.O. 46,000 By Closing 15,000 9,560 24,560
stock including (Bal Fig)
transit (W.N.2)
To Gross Profit c/d 66,000 19,560 85,560
(W.N.3)
(Bal Fig)
2,61,000 74,760 2,89,760 2,61,000 74,760 2,89,760
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.57
FOREIGN BRANCHES
To Admn. Salaries 13,900 4,000 17,900 By Gross Profit 66,000 19,560 85,560
b/d
To Salesmen Salaries 22,500 6,200 28,700
To Other Admn. & selling
Overheads 12,500 2,300 14,800
To Stock Reserve 47 - 47
(W.N.4)
To Bonus to Staff - 156 156
To Net Profit 17,053 6,904 23,957
66,000 19,560 85,560 66,000 19,560 85,560
Balance Sheet as on 31st Dec., 20X1
H.O. Branch Total H.O. Branch Total
` ` ` ` ` ` `
Capital 50,000 - 50,000 Fixed Assets - - -
Profit: H.O. 17,053 Current Assets:
Branch 6,904 23,957 23,957 Raw material 2,300 2,300
Trade 13,000 13,000 Finished Goods 15,000 9,560 23,313*
Creditors
Bonus Payable 156 156 (Less Stock Res.)
H.O. Account* 10,404 Debtors 37,000 - 37,000
Stock Reserve Cash (including 23,500 1,000 24,500
(W.N.4) 1,247 transit item)
Branch A/c 10,404**
88,204 10,560 87,113 88,204 10,560 87,113
*9,560 × 100/115 i.e., (8,313 + 15,000) = ` 23,313 or (15,000 + 9,560) – 1,247 (Stock reserve)
** (5,000 + 6,904) – 1500 = ` 10,404.
Working Notes:
(1) Material consumed
Opening raw material + Raw Material Purchased – Closing raw material
= 1,800 + 35,000 - 2,300 = 34,500
© The Institute of Chartered Accountants of India
15.58 ADVANCED ACCOUNTING
(2) Closing stock at head office
(a) Calculation of total factor cost = Material consumed + Wages +
Factory overhead
= 34,500 + 1,08,500 + 39,000 = 1,82,000
(b) Cost (factory cost) of goods sold = Sales – Gross profit
= 2,00,000 – 2,00,000 x 30% = 1,40,000
(c) Stock transferred to branch = 46,000 x 100/115 = 40,000
(d) Closing stock = 13,000 (Opening Stock) + 1,82,000 – 1,40,000 – 40,000
= 15,000
(3) Gross profit of Branch = Sales x Gross profit ratio
= 65,200 x 30% = 19,560
(4) Closing stock reserve = 9,560 x 15/115 = 1,247
Charge to profit and loss = 1,247 – 1,200 (existing) = 47
Illustration 12
AFFIX of Kolkata has a branch at Delhi to which the goods are supplied from
Kolkata but the cost thereof is not recorded in the Head Office books.
On 31st March, 20X1 the Branch Balance Sheet was as follows:
Liabilities ` Assets `
Creditors Balance 40,000 Debtors Balance 2,00,000
Head Office 1,68,000 Building Extension A/c closed —
by transfer to H.O. A/c
Cash at Bank 8,000
2,08,000 2,08,000
During the six months ending on 30-9-20X1, the following transactions took place
at Delhi.
` `
Sales 2,40,000 Manager’s Salary 4,800
Purchases 48,000 Collections from Debtors 1,60,000
Wages paid 20,000 Discounts allowed 8,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.59
FOREIGN BRANCHES
Salaries (inclusive of advance Discount earned 1,200
of ` 2,000) 6,400 Cash paid to Creditors 60,000
General Expenses 1,600 Building Account 4,000
(further payment)
Fire Insurance (paid for one 3,200 Cash in Hand 1,600
year)
Remittance to H.O. 38,400 Cash at Bank 28,000
Set out the Head Office Account in Delhi books and the Branch Balance Sheet as on
30-9-20X1. Also give journal entries in the Delhi books.
Solution
Journal Entries
20X1 Dr. Cr.
30 Sept. ` `
Salary Advance A/c Dr. 2,000
To Salaries A/c 2,000
(The amount paid as advance adjusted by debit to
Salary Advance Account)
Prepared Insurance A/c (3,200 x 6/12) Dr. 1,600
To Fire Insurance A/c 1,600
(Six months premium transferred to the Prepaid
Insurance A/c)
Head Office Account Dr. 88,400
To Purchases A/c 48,000
To Wages A/c 20,000
To Salaries A/c (6,400 – 2,000) 4,400
To General Expenses A/c 1,600
To Fire Insurance A/c (3,200 x 6/12) 1,600
To Manager’s Salary A/c 4,800
To Discount Allowed A/c 8,000
(Transfer of various revenue accounts (Dr.) to the
H.O. Account for closing the accounts)
© The Institute of Chartered Accountants of India
15.60 ADVANCED ACCOUNTING
Sales Accounts Dr. 2,40,000
Discount Earned A/c Dr. 1,200
To Head Office A/c 2,41,200
[Revenue accounts (Cr.) transferred to H.O.]
Head Office Account Dr. 4,000
To Building Account 4,000
(Transfer of amounts spent on building extension
to H.O. A/c)
Head Office Account
20X1 ` 20X1 `
Sep. 30 To Cash-remittance 38,400 April 1 By Balance b/d 1,68,000
To Sundries 88,400 Sep. 30 By Sundries 2,41,200
(Revenue A/cs) (Revenue A/cs)
To Building A/c 4,000
To Balanced c/d 2,78,400
4,09,200 4,09,200
Balance Sheet of Delhi Branch as on Sept. 30, 20X1
Liabilities ` Assets `
Creditors Balances 26,800 Debtors Balances 2,72,000
Head Office Account 2,78,400 Salary Advance 2,000
Prepaid Insurance 1,600
Building Extension A/c
transferred to H.O. —
Cash in Hand 1,600
Cash at Bank 28,000
3,05,200 3,05,200
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.61
FOREIGN BRANCHES
Cash and Bank Account
` `
To Balance b/d 8,000 By Wages 20,000
To Collection from 1,60,000 By Salaries 6,400
Debtors
By Insurance 3,200
By General Exp. 1,600
By H.O. A/c 38,400
By Manager’s Salary 4,800
By Creditors 60,000
By Building A/c 4,000
By Balance c/d
By Cash in Hand 1,600
By Cash at Bank 28,000 29,600
1,68,000 1,68,000
Debtors Account
` `
To Balance b/d 2,00,000 By Cash Collection 1,60,000
To Sales 2,40,000 By Discount (allowed) 8,000
By Balance c/d 2,72,000
4,40,000 4,40,000
To Balance b/d 2,72,000
Creditors Account
` `
To Cash 60,000 By Balance b/d 40,000
To Discount (earned) 1,200 By Purchases 48,000
To Balance c/d 26,800
88,000 88,000
By Balance b/d 26,800
© The Institute of Chartered Accountants of India
15.62 ADVANCED ACCOUNTING
Illustration 13
Ring Bell Ltd. Delhi has a Branch at Bombay where a separate set of books is used.
The following is the trial balance extracted on 31st December, 20X1.
Head Office Trial Balance
` `
Share Capital (Authorised: 10,000 Equity Shares of ` 100
each):
Issued: 8,000 Equity Shares 8,00,000
Profit & Loss Account - 1-1-20X1 25,310
General Reserve 1,00,000
Fixed Assets 5,30,000
Stock 2,22,470
Debtors and Creditors 50,500 21,900
Profit for 20X1 52,200
Cash Balance 62,730
Branch Current Account 1,33,710
9,99,410 9,99,410
Branch Trial Balance
` `
Fixed Assets 95,000
Profit for 20X1 31,700
Stock 50,460
Debtors and Creditors 19,100 10,400
Cash Balance 6,550
Head Office Current Account 1,29,010
1,71,110 1,71,110
The difference between the balances of the Current Account in the two sets of books
is accounted for as follows:
(a) Cash remitted by the Branch on 31st December, 20X1, but received by the
Head Office on 1st January 20X2 - ` 3,000.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.63
FOREIGN BRANCHES
(b) Stock stolen in transit from Head Office and charged to Branch by the Head
Office, but not credited to Head Office in the Branch books as the Branch
Manager declined to admit any liability (not covered by insurance) - ` 1,700.
Give the Branch Current Account in Head Office books after incorporating Branch Trial
Balance through journal.
Solution
The Branch Current Account in the Head Office Books and Head Office Current
Account in the Branch Books do not show the same balances. Therefore, in order
to reconcile them, the following journal entries will be passed in the Head Office
books:
Journal Entries
Dr. Cr.
20X1 ` `
Dec., 31 Cash in Transit A/c Dr. 3,000
To Branch Current A/c 3,000
(Cash sent by the Branch on 31st Dec., 20X1
but received at H.O. on 1st Jan., 20X2)
Loss by theft A/c Dr. 1,700
To Branch Current A/c 1,700
(Stock lost in transit from H.O. to Branch)
In order to incorporate, in the H.O. books, the given Branch trial balance which
has been drawn up after preparing the Branch Profit & Loss Account, the
following journal entries will be necessary:
Journal Entries
20X1 ` `
Dec. 31 Branch Current Account Dr. 31,700
To Profit & Loss Account 31,700
(Branch Profit for the year)
Branch Fixed Assets Dr. 95,000
Branch Stock Dr. 50,460
Branch Debtors Dr. 19,100
© The Institute of Chartered Accountants of India
15.64 ADVANCED ACCOUNTING
Branch Cash Dr. 6,550
To Branch Current Account 1,71,110
(Branch assets brought into H.O. Books)
Branch Current A/c Dr. 10,400
To Branch Creditors 10,400
(Branch creditors brought into H.O.
Books)
Branch Current Account
` `
To Balance b/d 1,33,710 By Cash in transit 3,000
To Profit & Loss A/c 31,700 By Loss of theft 1,700
To Branch Creditors 10,400 By Sundry Branch Assets 1,71,110
1,75,810 1,75,810
Profit and Loss Account for 20X1
` `
To Loss by Theft 1,700 By Balance b/d 25,310
To Balance c/d 1,07,510 By Year’s Profit: H.O. 52,200
Branch 31,700
1,09,210 1,09,210
9. INCOMPLETE INFORMATION IN BRANCH
BOOKS
If it is desired that profitability of the branch should be kept secret from the branch
staff, the head office would hold back some key information from the branch, e.g.,
amount of opening stock, cost of goods sent to the branch, etc. The head office, in
such a case would maintain a record of goods sent to the branch by passing the
entry:
Goods Supplied to the Branch Account Dr.
To Purchases Account
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.65
FOREIGN BRANCHES
The value of the closing stock will also be adjusted only in head office books.
In such a case, for closing its books at the end of the year, the branch will simply
transfer various revenue accounts to the head office without drawing up a
Trading and Profit & Loss Account.
On that basis, supplemented by the record of transactions maintained at the head
office, it will be possible to construct the Trading and Profit & Loss Account of the
branch.
Illustration 14
Messrs Ramchand & Co., Hyderabad has a branch in Delhi. The Delhi Branch deals
not only in the goods from Head Office but also buys some auxiliary goods and
deals in them. They, however, do not prepare any Profit & Loss Account but close all
accounts to the Head Office at the end of the year and open them afresh on the
basis of advice from their Head Office. The fixed assets accounts are also
maintained at the Head Office.
The goods from the Head Office are invoiced at selling prices to give a profit of 20
per cent on the sale price. The goods sent from the branch to Head Office are at
cost. From the following prepare Branch Trading and Profit & Loss Account and
Branch fixed Assets Account in the Head Office Books.
Trial Balance of the Delhi Branch as on 31-12-20X1
Debit ` Credit `
Head office opening balance on 15,000 Sales 1,00,000
1-1-20X1
Goods from H.O. 50,000 Goods to H.O. 3,000
Purchases 20,000 Head Office Current A/c 15,000
Opening Stock Sundry Creditors 3,000
(H.O. supplies goods at invoice 4,000
prices)
Opening Stock of other goods 500
Salaries 7,000
© The Institute of Chartered Accountants of India
15.66 ADVANCED ACCOUNTING
Rent 3,000
Office expenditure 2,000
Cash on Hand 500
Cash at Bank 4,000
Sundry Debtors 15,000
1,21,000 1,21,000
The Branch balances as on 1st January, 20X1, were as under: Furniture ` 5,000;
Sundry Debtors ` 9,500; Cash ` 1,000, Creditors ` 30,000. The closing stock at
branch of the head office goods at invoice price is ` 3,000 and that of purchased
goods at cost is ` 1,000. Depreciation is to be provided at 10 per cent on branch
assets.
Solution
Delhi Branch Trading and Profit & Loss Account
for the year ended 31st Dec., 20X1
` `
To Opening By Sales 1,00,000
Stock:
Head office 3,200 By Goods from 3,000
Goods Branch
(4,000 x 80%) By Closing Stock:
Others 500 3,700 Head Office 2,400
goods
(3,000 x 80%)
To Goods to 40,000 Others 1,000 3,400
Branch
(50,000 x 80%)
To Purchases 20,000
To Gross Profit 42,700
c/d
1,06,400 1,06,400
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.67
FOREIGN BRANCHES
To Salaries 7,000 By Gross profit 42,700
b/d
To Rent 3,000
To Office 2,000
Expenses
To Dep. on 500
furniture @
10%
To Net profit 30,200
42,700 42,700
Branch (Fixed) Assets Account (In Head Office Books)
20X1 ` 20X1 `
Jan. 1 To Balance b/d 5,000 Dec. 31 By Delhi Branch A/c 500
(Depreciation)
By Balance c/d 4,500
5,000 5,000
20X2
Jan. 1 To Balance b/d 4,500
Note: Furniture A/c is maintained in Head office books; it is not a part of either
opening or closing balance.
10. FOREIGN BRANCHES
Foreign branches generally maintain independent and complete record of
business transacted by them in currency of the country in which they operate.
Thus, problems of incorporating balances of foreign branches relate mainly to
translation of foreign currency into Indian rupees. This is because exchange rate
of Indian rupee is not stable in relation to foreign currencies due to international
demand and supply effects on various currencies. The accounting principles which
apply to inland branches also apply to a foreign branch after converting the trial
balance of the foreign branch in the Indian currency.
© The Institute of Chartered Accountants of India
15.68 ADVANCED ACCOUNTING
11. ACCOUNTING FOR FOREIGN BRANCHES
For the purpose of accounting, AS 11 (revised 2003) classifies the foreign
branches may be classified into two types:
• Integral Foreign Operation;
• Non- Integral Foreign Operation.
Let us discuss these two types of foreign branches in detail.
11.1. Integral Foreign Operation (IFO)
It is a foreign operation, the activities of which are an integral part of those of the
reporting enterprise. The business of IFO is carried on as if it were an extension of
the reporting enterprise’s operations. For example, sale of goods imported from
the reporting enterprise and remittance of proceeds to the reporting enterprise.
11.2. Non-Integral Foreign Operation (NFO)
It is a foreign operation that is not an Integral Foreign Operation. The business of
a NFO is carried on in a substantially independent way by accumulating cash and
other monetary items, incurring expenses, generating income and arranging
borrowing in its local currency. An NFO may also enter into transactions in foreign
currencies, including transactions in the reporting currency. An example of NFO
may be production in a foreign currency out of the resources available in such
country independent of the reporting enterprise.
The following are the indicators of Non- Integral Foreign Operation-
• Control by reporting enterprises - While the reporting enterprise may control
the foreign operation, the activities of foreign operation are carried
independently without much dependence on reporting enterprise.
• Transactions with the reporting enterprises are not a high proportion of the
foreign operation’s activities.
• Activities of foreign operation are mainly financed by its operations or from
local borrowings. In other words, it raises finance independently and is in
no way dependent on reporting enterprises.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.69
FOREIGN BRANCHES
• Foreign operation sales are mainly in currencies other than reporting
currency.
• All the expenses by foreign operations are primarily paid in local currency,
not in the reporting currency.
• Day-to-day cash flow of the reporting enterprises is independent of the
foreign enterprises cash flows.
• Sales prices of the foreign enterprises are not affected by the day-to-day
changes in exchange rate of the reporting currency of the foreign operation.
• There is an active sales market for the foreign operation product.
The above are only indicators and not decisive/conclusive factors to classify the
foreign operations as non-integral, much will depend on factual information,
situations of the particular case and, therefore, judgment is necessary to
determine the appropriate classification.
Controversies may arise in deciding the foreign branches of the enterprises into
integral or non-integral. However, there may not be any controversy that
subsidiary associates and joint ventures are non-integral foreign operation.
In case of branches classified as independent for the purpose of accounting are
generally classified as non-integral foreign operations.
12. TECHNIQUES FOR FOREIGN CURRENCY
TRANSLATION
12.1 Integral Foreign Operation (IFO)
Following are the standard recommendations for foreign currency translation:
(1) All transactions of IFO be translated at the rate prevailing on the date of
transaction. This will require date wise details of the transaction entered by
that operation together with the rates. Weekly or monthly average rate is
permitted if there are no significant variations in the rate.
© The Institute of Chartered Accountants of India
15.70 ADVANCED ACCOUNTING
(2) Translation at the balance sheet date-
(i) Monetary items 1 at closing rate;
(ii) Non-monetary items 2: 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 tangible fixed asset is carried at
fair value, translation should be done using the rate existed on the
date of the valuation.
(iii) The cost of inventories is translated at the exchange rates that existed
when the cost of inventory was incurred and realizable value is
translated applying exchange rate when realizable value is determined
which is generally closing rate.
(iv) Exchange difference arising on the translation of the financial
statement of integral foreign operation should be charged to profit
and loss account.
12.2 Non-Integral Foreign Operation
Accounts of non-integral foreign operation are translated using the following
principles:
• Balance sheet items i.e. Assets and Liabilities both monetary and non-
monetary – apply closing exchange rate.
• Items of income and expenses – At actual exchange rates on the date of
transactions. However, accounting standard allows average rate subject to
materiality.
• Resulting exchange rate difference should be accumulated in a “foreign
currency translation reserve” until the disposal of “net investment in non-
integral foreign operation”.
1
Monetary items are money held and assets and liabilities to be received or paid in fixed or
determinable amounts of money. Cash, receivables and payables are examples of monetary
items.
2
Non-monetary items are assets and liabilities other than monetary items. Fixed assets,
investments in equity shares, inventories are examples of non-monetary assets.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.71
FOREIGN BRANCHES
Items Integral Foreign Non Integral Foreign
Operations Operations
Monetary Items (Cash, Closing rate Closing rate
Bank Balance, Debtor,
Creditor, Loans, Bills
receivable, Bills Payable)
Non-Monetary Items Rate on date of purchase Closing rate
(Fixed Assets)
Inventory Generally, closing rate Closing rate
(but if rate on the date
of purchase of inventory
is available, then that
rate)
Profit and Loss items Average rate Average rate
(revenue items)
(but if rate on the date (but if rate on the date
of transaction is of transaction is
available, then that rate) available, then that rate)
Exchange Difference Charge to P&L account. Accumulated in Foreign
Currency Translation
reserve.
13. CHANGE IN CLASSIFICATION
When there is a change in classification, accounting treatment is as under-
13.1 Integral to Non-Integral
(i) Translation procedure applicable to non-integral shall be followed from the
date of change.
© The Institute of Chartered Accountants of India
15.72 ADVANCED ACCOUNTING
(ii) Exchange difference arising on the translation of non-monetary assets at
the date of re-classification is accumulated in foreign currency translation
reserve.
13.2 Non-Integral to Integral
(i) Translation procedure as applicable to integral should be applied from the
date of change.
(ii) Translated amount of non-monetary items at the date of change is treated as
historical cost.
(iii) Exchange difference lying in foreign currency translation reserve is not to be
recognized as income or expense till the disposal of the operation even if
the foreign operation becomes integral.
Illustration 15
On 31st December, 20X2 the following balances appeared in the books of Chennai
Branch of an English firm having its HO office in New York:
Amount in` Amount in`
Stock on 1st Jan., 20X2 2,34,000
Purchases and Sales 15,62,500 23,43,750
Debtors and Creditors 7,65,000 5,10,000
Bills Receivable and Payable 2,04,000 1,78,500
Salaries and Wages 1,00,000 -
Rent, Rates and Taxes 1,06,250 -
Furniture 91,000 -
Bank A/c 5,68,650
New York Account - 5,99,150
36,31,400 36,31,400
Stock on 31st December, 20X2 was ` 6,37,500.
Branch account in New York books showed a debit balance of $ 13,400 on
31st December, 20X2 and Furniture appeared in the Head Office books at $ 1,750.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.73
FOREIGN BRANCHES
The rate of exchange for 1 $ on 31st December, 20X1 was ` 52 and on 31st
December, 20X2 was ` 51. The average rate for the year was ` 50.
Prepare in the Head Office books the Profit and Loss a/c and the Balance Sheet of the
Branch assuming integral foreign operation.
Solution
In the books of English Firm (Head Office in New York)
Chennai Branch Profit and Loss Account
for the year ended 31st December, 20X2
$ $
To Opening stock 4,500 By Sales 46,875
To Purchases 31,250 By Closing stock 12,500
To Gross profit c/d 23,625 (6,37,500 / 51)
59,375 59,375
To Salaries 2,000 By Gross profit b/d 23,625
To Rent, rates and taxes 2,125
To Exchange translation loss 2,000
To Net Profit c/d 17,500
23,625 23,625
Balance Sheet of Chennai Branch
as on 31st December, 20X2
Liabilities $ $ Assets $
Head Office A/c 13,400 Furniture 1,750
Add: Net profit 17,500 30,900 Closing Stock 12,500
Trade creditors 10,000 Trade Debtors 15,000
Bills Payable 3,500 Bills Receivable 4,000
Cash at bank 11,150
44,400 44,400
© The Institute of Chartered Accountants of India
15.74 ADVANCED ACCOUNTING
Working Note:
Calculation of Exchange Translation Loss
Chennai Branch Trial Balance (converted in $)
as on 31st December, 20X2
Dr. Cr. Conversion Dr. Cr.
` ` Rate ($) ($)
Stock on 1st Jan., 20X2 2,34,000 52 4,500
Purchases & Sales 15,62,500 23,43,750 50 31,250 46,875
Debtors & creditors 7,65,000 5,10,000 51 15,000 10,000
Bills Receivable and Bills 2,04,000 1,78,500 51 4,000 3,500
Payable
Salaries and wages 1,00,000 50 2,000
Rent, Rates and Taxes 1,06,250 50 2,125
Furniture 91,000 1,750
Bank A/c 5,68,650 51 11,150
New York Account 5,99,150 13,400
Exchange translation loss (bal.
fig.) 2,000
36,31,400 36,31,400 73,775 73,775
Illustration 16
S & M Ltd., Bombay, have a branch in Sydney, Australia. Sydney branch is an
integral foreign operation of S & M Ltd.
At the end of 31st March, 20X2, the following ledger balances have been extracted
from the books of the Bombay Office and the Sydney Office:
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.75
FOREIGN BRANCHES
Bombay Sydney
(` thousands) (Austr dollars
thousands)
Debit Credit Debit Credit
Share Capital – 2,000 – –
Reserves & Surplus – 1,000 – –
Land 500 – – –
Buildings (Cost) 1,000 – – –
Buildings Dep. Reserve – 200 – –
Plant & Machinery (Cost) 2,500 – 200 –
Plant & Machinery Dep. – 600 – 130
Reserve
Debtors / Creditors 280 200 60 30
Stock (1.4.20X1) 100 – 20 –
Branch Stock Reserve – 4 – –
Cash & Bank Balances 10 – 10 –
Purchases / Sales 240 520 20 123
Goods sent to Branch – 100 5 –
Managing Director’s salary 30 – – –
Wages & Salaries 75 – 45 –
Rent – – 12 –
Office Expenses 25 – 18 –
Commission Receipts – 256 – 100
Branch / H.O. Current A/c 120 – – 7
4,880 4,880 390 390
The following information is also available:
(1) Stock as at 31.3.20X2:
Bombay ` 1,50,000
Sydney A $ 3,125
© The Institute of Chartered Accountants of India
15.76 ADVANCED ACCOUNTING
You are required to convert the Sydney Branch Trial Balance into rupees;
Use the following rates of exchange :
Opening rate A $ = ` 20
Closing rate A $ = ` 24
Average rate A $ = ` 22
For Fixed Assets A $ = ` 18
Solution
Sydney Branch Trial Balance (in Rupees)
As on 31st March, 20X2
(` ‘000)
Conversion Rate per A$ Dr. Cr.
Plant & Machinery (cost) ` 18 36,00
Plant & Machinery Dep. Reserve ` 18 23,40
Debtors / Creditors ` 24 14,40 7,20
Stock (1.4.20X1) ` 20 4,00
Cash & Bank Balances ` 24 2,40
Purchase / Sales ` 22 4,40 27,06
Goods received from H.O. – 1,00
Wages & Salaries ` 22 9,90
Rent ` 22 2,64
Office expenses ` 22 3,96
Commission Receipts ` 22 22,00
H.O. Current A/c 1,20
78,70 80,86
Exchange loss (balancing figure) 2,16
80,86 80,86
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.77
FOREIGN BRANCHES
Illustration 17
M/s Carlin has head office at New York (U.S.A.) and branch at Mumbai (India).
Mumbai branch is an integral foreign operation of Carlin & Co.
Mumbai branch furnishes you with its trial balance as on 31st March, 20X2 and the
additional information given thereafter:
Dr. Cr.
Rupees in thousands
Stock on 1st April, 20X1 300 –
Purchases and sales 800 1,200
Sundry Debtors and creditors 400 300
Bills of exchange 120 240
Wages and salaries 560 –
Rent, rates and taxes 360 –
Sundry charges 160 –
Computers 240
Bank balance 420 –
New York office a/c – 1,620
3,360 3,360
Additional information:
(a) Computers were acquired from a remittance of US $ 6,000 received from New
York head office and paid to the suppliers. Depreciate computers at 60% for
the year.
(b) Unsold stock of Mumbai branch was worth ` 4,20,000 on 31st March, 20X2.
(c) The rates of exchange may be taken as follows:
• on 1.4.20X1 @ ` 40 per US $
• on 31.3.20X2 @ ` 42 per US $
• average exchange rate for the year @ ` 41 per US $
• conversion in $ shall be made upto two decimal accuracy.
© The Institute of Chartered Accountants of India
15.78 ADVANCED ACCOUNTING
You are asked to prepare in US dollars the revenue statement for the year ended
31st March, 20X2 and the balance sheet as on that date of Mumbai branch as
would appear in the books of New York head office of Carlin & Co. You are
informed that Mumbai branch account showed a debit balance of US $ 39609.18 on
31.3.20X2 in New York books and there were no items pending reconciliation.
Solution
M/s Carlin
Mumbai Branch Trial Balance in (US $)
as on 31st March, 20X2
Conversion Dr. Cr.
rate per US $ US $ US $
(`)
Stock on 1.4.X1 40 7,500.00 –
Purchases and sales 41 19,512.20 29,268.29
Sundry debtors and creditors 42 9,523.81 7,142.86
Bills of exchange 42 2,857.14 5,714.29
Wages and salaries 41 13,658.54 –
Rent, rates and taxes 41 8,780.49 –
Sundry charges 41 3,902.44 –
Computers – 6,000.00 –
Bank balance 42 10,000.00 –
New York office A/c – – 39,609.18
81,734.62 81,734.62
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.79
FOREIGN BRANCHES
Trading and Profit & Loss Account
for the year ended 31st March, 20X2
US $ US $
To Opening Stock 7,500.00 By Sales 29,268.29
To Purchases 19,512.20 By Closing stock 10,000.00
(4,20,000/42)
To Wages and salaries 13,658.54 By Gross Loss c/d 1,402.45
40,670.74 40,670.74
To Gross Loss b/d 1,402.45 By Net Loss 17,685.38
To Rent, rates and taxes 8,780.49
To Sundry charges 3,902.44
To Depreciation on 3,600.00
computers
(US $ 6,000 × 0.6)
17,685.38 17,685.38
Balance Sheet of Mumbai Branch
as on 31st March, 20X2
Liabilities US $ Assets US $ US $
New York Office 39,609.18 Computers 6,000.00
A/c
Less: Net Loss (17,685.38) 21,923.80 Less: Depreciation (3,600.00) 2,400.00
Sundry creditors 7,142.86 Closing stock 10,000.00
Bills payable 5,714.29 Sundry debtors 9,523.81
Bank balance 10,000.00
Bills receivable 2,857.14
34,780.95 34,780.95
© The Institute of Chartered Accountants of India
15.80 ADVANCED ACCOUNTING
SUMMARY
• Types of branches
Dependent branches
Independent branches
• Classification of Branches from accounting point of view
Branches in respect of which the whole of the accounting records are
kept at the head office (Dependent Branches)
Branches which maintain independent accounting records
(Independent Branches), and
Foreign Branches.
• Systems of accounting followed by Dependent Branches
Debtors System: under this system head office makes a branch
account. Anything given to branch is debited and anything received
from branch would be credited.
Branch trading and profit and loss account (Final accounts)
method/branch account method: Under this system head office
prepares (a) profit and loss account (b) branch account taking each
branch as a separate entity.
Stock and debtors system: Under this system head office opens:
Branch Stock Account
Branch Profit and Loss Account
Branch Debtors Account
Branch Expenses Account
Goods sent to Branch Account
Branch Asset Account
• Maintenance of comprehensive account books by Independent
Branches Preparation of separate trial balance of each branch in H.O.
books.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.81
FOREIGN BRANCHES
• Types of Foreign branches
Integral Foreign Operation (IFO): It is a foreign operation, the activities
of which are an integral part of those of the reporting enterprise.
Non-Integral Foreign Operation (NFO): It is a foreign operation that is
not an Integral Foreign Operation. The business of a NFO is carried on
in a substantially independent way by accumulating cash and other
monetary items, incurring expenses, generating income and arranging
borrowing in its local currency.
• Non-Integral Foreign Operation -translation
Balance sheet items i.e. Assets and Liabilities both monetary and non-
monetary – apply closing exchange rate.
Items of income and expenses – At actual exchange rates on the date
of transactions
Resulting exchange rate difference should be accumulated in a
“foreign currency translation reserve” until the disposal of “net
investment in non-integral foreign operation”.
• Integral Foreign Operation (IFO) - translation
All transactions at the rate prevailing on the date of transaction
Translation at the balance sheet date-
Monetary items at closing rate;
Non-monetary items: 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 tangible 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 realizable value is
translated applying exchange rate when realizable value is determined
which is generally closing rate.
Exchange difference arising on the translation of the financial
statement of integral foreign operation should be charged to profit
and loss account.
© The Institute of Chartered Accountants of India
15.82 ADVANCED ACCOUNTING
TEST YOUR KNOWLEDGE
Multiple Choice Questions
1. If goods are invoiced to branches at cost, trading results of branch can be
ascertained by
(a) Debtors method.
(b) Stock and debtors method.
(c) Either (a) or (b).
(d) Both (a) and (b).
2. Under branch trading and profit loss account method
(a) H.O prepares profit and loss account.
(b) Each branch is treated separate entity.
(c) Both (a) and (b).
(d) Either (a) or (b).
3. Goods may be invoiced to branch at
(a) Cost or Selling price.
(b) Wholesale price.
(c) Both (a) and (b).
(d) Either (a) or (b).
4. Under debtors method, opening balance of debtors is
(a) Debited to branch account.
(b) Credited to branch account.
(c) Debited to H.O account.
(d) Credited to H.O account.
5. Cost of goods returned by branch will have the following effect
(a) Goods sent to branch account will be debited.
(b) Branch stock account will be credited.
(c) Both (a) and (b).
(d) Either (a) or (b).
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.83
FOREIGN BRANCHES
Theoretical Questions
6. Why goods are marked on invoice price by the head office while sending
goods to the branch?
7. Differentiate Branch Accounts with Departmental accounts.
Scenario based Questions
8. Goods worth ` 50,000 sent by head office but the branch has received till the
closing date goods for worth ` 40,000 only. Give journal entry in the books of
H.O. and branch for goods in transit.
9. Alphs having head office in Mumbai has a branch in Nagpur. The branch at
Nagpur is an independent branch maintaining separate books of account. On
31.3.20X1, it was found that the goods dispatched by head office for `
2,00,000 was received by the branch only to the extent of ` 1,50,000. The
balance goods are in transit. What is the accounting entry to be passed by
the branch for recording the goods in transit, in its books?
10. Show adjustment journal entry in the books of head office at the end of April,
20X1 for incorporation of inter-branch transactions assuming that only head
office maintains different branch accounts in its books.
A. Delhi branch:
(1) Received goods from Mumbai – ` 35,000 and ` 15,000 from
Kolkata.
(2) Sent goods to Chennai – ` 25,000, Kolkata – ` 20,000.
(3) Bill Receivable received – ` 20,000 from Chennai.
(4) Acceptances sent to Mumbai – ` 25,000, Kolkata – ` 10,000.
B. Mumbai Branch (apart from the above) :
(5) Received goods from Kolkata – ` 15,000, Delhi – ` 20,000.
(6) Cash sent to Delhi – ` 15,000, Kolkata – ` 7,000.
C. Chennai Branch (apart from the above) :
(7) Received goods from Kolkata – ` 30,000.
© The Institute of Chartered Accountants of India
15.84 ADVANCED ACCOUNTING
(8) Acceptances and Cash sent to Kolkata – ` 20,000 and `10,000
respectively.
D. Kolkata Branch (apart from the above) :
(9) Sent goods to Chennai – ` 35,000.
(10) Paid cash to Chennai – `15,000.
(11) Acceptances sent to Chennai – `15,000.
11. Give Journal Entries in the books of Branch A to rectify or adjust the following:
(i) Head Office expenses ` 3,500 allocated to the Branch, but not recorded
in the Branch Books.
(ii) Depreciation of branch assets, whose accounts are kept by the Head
Office not provided earlier for ` 1,500.
(iii) Branch paid ` 2,000 as salary to a H.O. Inspector, but the amount paid
has been debited by the Branch to Salaries account.
(iv) H.O. collected ` 10,000 directly from a customer on behalf of the
Branch, but no intimation to this effect has been received by the Branch.
(v) A remittance of ` 15,000 sent by the Branch has not yet been received
by the Head Office.
(vi) Branch A incurred advertisement expenses of ` 3,000 on behalf of
Branch B.
12. Widespread invoices goods to its branch at cost plus 20%. The branch sells
goods for cash as well as on credit. The branch meets its expenses out of cash
collected from its debtors and cash sales and remits the balance of cash to
head office after withholding ` 10,000 necessary for meeting immediate
requirements of cash. On 31st March, 20X1 the assets at the branch were as
follows:
` (‘000)
Cash in Hand 10
Trade Debtors 384
Stock, at Invoice Price 1,080
Furniture and Fittings 500
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.85
FOREIGN BRANCHES
During the accounting year ended 31st March, 20X2 the invoice price of
goods dispatched by the head office to the branch amounted to ` 1 crore 32
lakhs. Out of the goods received by it, the branch sent back to head office
goods invoiced at ` 72,000. Other transactions at the branch during the year
were as follows:
(` ‘000)
Cash Sales 9,700
Credit Sales 3,140
Cash collected by Branch from Credit Customers 2,842
Cash Discount allowed to Debtors 58
Returns by Customers 102
Bad Debts written off 37
Expenses paid by Branch 842
On 1st January, 20X2 the branch purchased new furniture for ` 1 lakh for
which payment was made by head office through a cheque.
On 31st March, 20X2 branch expenses amounting to ` 6,000 were
outstanding and cash in hand was again ` 10,000. Furniture is subject to
depreciation @ 16% per annum on diminishing balance method.
Prepare Branch Account in the books of head office for the year ended 31st
March, 20X2.
13. On 31st March, 20X2 Kanpur Branch submits the following Trial Balance to its
Head Office at Lucknow :
Debit Balances ` in lacs
Furniture and Equipment 18
Depreciation on furniture 2
Salaries 25
Rent 10
Advertising 6
Telephone, Postage and Stationery 3
© The Institute of Chartered Accountants of India
15.86 ADVANCED ACCOUNTING
Sundry Office Expenses 1
Stock on 1st April, 20X1 60
Goods Received from Head Office 288
Debtors 20
Cash at bank and in hand 8
Carriage Inwards 7
448
Credit Balances
Outstanding Expenses 3
Goods Returned to Head Office 5
Sales 360
Head Office 80
448
Additional Information:
Stock on 31st March, 20X2 was valued at ` 62 lacs. On 29th March, 20X2 the
Head Office dispatched goods costing ` 10 lacs to its branch. Branch did not
receive these goods before 1st April, 20X2. Hence, the figure of goods received
from Head Office does not include these goods. Also, the head office has
charged the branch ` 1 lac for centralized services for which the branch has not
passed the entry.
You are required to:
(i) Pass Journal Entries in the books of the Branch to make the necessary
adjustments
(ii) Prepare Final Accounts of the Branch including Balance Sheet, and
(iii) Pass Journal Entries in the books of the Head Office to incorporate the
whole of the Branch Trial Balance.
14. M/s Marena, Delhi has a branch at Bangalore to which office goods are
invoiced at cost plus 25%. The branch sells both for cash and on credit.
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.87
FOREIGN BRANCHES
Branch Expenses are paid direct from head office and the Branch has to remit
all cash received into the Head Office Bank Account.
From the following details, relating to calendar year 20X1, prepare the
accounts in the Head Office Ledger and ascertain the Branch Profit under
Stock and Debtors Method’.
Branch does not maintain any books of account, but sends weekly returns to
the Head Office.
`
Goods received from Head Office at invoice price 45,00,000
Returns to Heads Office at invoice price 90,000
Stock at Bangalore as on 1st January, 20X1 4,50,000
Sales during the year - Cash 15,00,000
- Credit 27,00,000
Sundry Debtors at Bangalore as on 1st January, 20X1 5,40,000
Cash received from Debtors 24,00,000
Discount allowed to Debtors 45,000
Bad Debts in the year 30,000
Sales returns at Bangalore Branch 60,000
Rent, Rates and Taxes at Branch 1,35,000
Salaries, Wages and Bonus at Branch 4,50,000
Office Expenses 45,000
Stock at Branch on 31st December, 20X1 at invoice price 9,00,000
15. Beta, having head office at Mumbai has a branch at Nagpur. The head office
does wholesale trade only at cost plus 80%. The goods are sent to branch at
the wholesale price viz., cost plus 80%. The branch at Nagpur is wholly
engaged in retail trade and the goods are sold at cost to H.O. plus 100%.
Following details are furnished for the year ended 31st March, 20X1:
Head Office Branch
(` ) (` )
Opening stock 2,25,000
Purchases 25,50,000
© The Institute of Chartered Accountants of India
15.88 ADVANCED ACCOUNTING
Goods sent to branch (Cost to H.0. plus 80%) 9,54,000
Sales 27,81,000 9,50,000
Office expenses 90,000 8,500
Selling expenses 72,000 6,300
Staff salary 65,000 12,000
You are required to prepare Trading and Profit and Loss Account of the head
office and branch for the year ended 31st March, 20X1.
16. Pass necessary Journal entries in the books of an independent Branch of a
business entity to rectify or adjust the following:
(i) Income of ` 2,800 allocated to the Branch by Head Office but not
recorded in the Branch books.
(ii) Branch paid `3,000 as salary to a Head Office Manager, but the amount
paid has been debited by the Branch to Salaries Account.
(iii) Branch incurred travelling expenses of `5,000 on behalf of other
Branches, this was not recorded in the books of Branch.
(iv) A remittance of ` 1,50,000 sent by the Branch has not received by Head
Office on the date of reconciliation of Accounts.
(v) Head Office allocates `75,000 to the Branch as Head Office expenses,
which has not yet been recorded by the Branch.
(vi) Head Office collected `30,000 directly from a Branch Customer. The
intimation of the fact has been received by the Branch only now, not
recorded till now.
(vii) Goods dispatched by the Head office amounting to `10,000, but not
received by the Branch till date of reconciliation. The Goods have been
received subsequently.
17. The Washington branch of XYZ Mumbai sent the following trial balance as on
31st December, 20X1:
$ $
Head office A/c _ 22,800
Sales _ 84,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.89
FOREIGN BRANCHES
Debtors and creditors 4,800 3,400
Machinery 24,000 _
Cash at bank 1,200 _
Stock, 1 January, 20X1 11,200 _
Goods from H.O. 64,000 _
Expenses 5,000 _
1,10,200 1,10,200
In the books of head office, the Branch A/c stood as follows:
Washington Branch A/c
` `
To Balance b/d 8,10,000 By Cash 28,76,000
To Goods sent to By Balance c/d
branch 29,26,000 8,60,000
37,36,000 37,36,000
Goods are sent to the branch at cost plus 10% and the branch sells goods at
invoice price plus 25%. Machinery was acquired in past, when $ 1.00 = ` 40.
Rates of exchange were:
1st January, 20X1 $ 1.00 = ` 46
31st December, 20X1 $ 1.00 = `48
Average $ 1.00 = ` 47
Machinery is depreciated @ 10% and the branch manager is entitled to a
commission of 5% on the profits of the branch.
You are required to:
(i) Prepare the Branch Trading & Profit & Loss A/c in dollars.
(ii) Convert the Trial Balance of branch into Indian currency and prepare
Branch Trading & Profit and Loss A/c and the Branch A/c in the books
of head office.
© The Institute of Chartered Accountants of India
15.90 ADVANCED ACCOUNTING
ANSWERS/HINTS
Answer to the Multiple Choice Questions
1. (c) 2. (c) 3. (c) 4. (a) 5. (c)
Answer to the Theoretical Questions
6. Goods are marked on invoice price to achieve the following objectives:
(i) To keep secret from the branch manager, the cost price of the goods
and profit made, so that the branch manager may not start a rival and
competitive business with the concern; and
(ii) To have effective control on stock i.e. stock at any time must be equal
to opening stock plus goods received from head office minus sales
made at branch.
(iii) To dictate pricing policy to its branches, as well as save work at branch
because prices have already been decided.
7. Branch accounts may be maintained either at branch or at head office and
no allocation problem arises since the expenses in respect of each branch
can be identified However, Departmental accounts are maintained at one
place only. Common expenses are distributed among the departments
concerned on some equitable basis considered suitable in the case. For
details, refer Para 2 of the Chapter to know the differences.
Answer to Scenario based Questions
8. Journal entry in the books of Head Office
No entry
Journal entry in the books of Branch
` `
Goods-in-transit account Dr. 10,000
To Head Office account 10,000
(Being goods sent by head office is still in transit)
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.91
FOREIGN BRANCHES
9.
Nagpur branch must include the inventory in its books as goods in
transit.
The following journal entry must be made by the branch:
Goods in transit A/c Dr. 50,000
To Head office A/c 50,000
[Being Goods sent by Head office is still in transit on the closing
date]
10. Journal entry in the books of Head Office
Date Particulars Dr. Cr.
` `
30th Mumbai Branch Account Dr.
April, 3,000
20X1
Chennai Branch Account Dr. 70,000
To Delhi Branch Account 15,000
To Kolkata Branch Account 58,000
(Being adjustment entry passed by head
office in respect of inter-branch
transactions for the month of April, 20X1)
Working Note:
Inter – Branch transactions
Delhi Mumbai Chennai Kolkata
` ` ` `
A. Delhi Branch
(1) Received goods 50,000 (Dr.) 35,000 (Cr.) 15,000 (Cr.)
(2) Sent goods 45,000 (Cr.) 25,000 (Dr.) 20,000 (Dr.)
© The Institute of Chartered Accountants of India
15.92 ADVANCED ACCOUNTING
(3) Received Bills 20,000 (Dr.) 20,000 (Cr.)
receivable
(4) Sent acceptance 35,000 (Cr.) 25,000 (Dr.) 10,000 (Dr.)
B. Mumbai Branch
(5) Received goods 20,000 (Cr.) 35,000 (Dr.) 15,000 (Cr.)
(6) Sent cash 15,000 (Dr.) 22,000 (Cr.) 7,000 (Dr.)
C. Chennai Branch
(7) Received goods 30,000 (Dr.) 30,000 (Cr.)
(8) Sent cash and 30,000 (Cr.) 30,000 (Dr.)
acceptances
D. Kolkata Branch
(9) Sent goods 35,000 (Dr.) 35,000 (Cr.)
(10) Sent cash 15,000 (Dr.) 15,000 (Cr.)
(11) Sent acceptances 15,000 (Dr.) 15,000 (Cr.)
15,000 (Cr.) 3,000 (Dr.) 70,000 (Dr.) 58,000 (Cr.)
11. Books of Branch A
Journal Entries
Particulars Dr. Cr.
Amount Amount `
`
(i) Expenses account Dr. 3,500
To Head office account 3,500
(Being the allocated expenditure by the
head office recorded in branch books)
(ii) Depreciation account Dr. 1,500
To Head office account 1,500
(Being the depreciation provided)
(iii) Head office account Dr. 2,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.93
FOREIGN BRANCHES
To Salaries account 2,000
(Being the rectification of salary paid on
behalf of H.O.)
(iv) Head office account Dr. 10,000
To Debtors account 10,000
(Being the adjustment of collection
from branch debtors)
(v) No entry in branch books
(vi) Head Office account Dr. 3,000
To Cash account 3,000
(Being the expenditure on account of
Branch B, recorded in books)
Note: Entry (vi) Inter branch transactions are routed through Head Office.
12. In the Head Office Books
Branch Account
for the year ended 31st March, 20X2
` ‘000 `’000
To Balance b/d By Balance b/d
Cash in hand 10 Stock reserve ` 1,080 × 180
Trade debtors 384 1
6
Stock 1,080 By Goods sent to branch 72
Furniture and fittings 500 A/c (Returns to H.O.)
To Goods sent to branch 13,200 By Goods sent to branch 2,188
A/c 100 A/c (Loading on net
To Bank A/c (Payment for goods sent to branch –
furniture) 245 1
To Balance c/d Stock By
13,128 × 6
1 Bank A/c (Remittance
reserve 1,470 ×
6 from branch to H.O.) 11,700
(W.N.5)
© The Institute of Chartered Accountants of India
15.94 ADVANCED ACCOUNTING
To Net profit transferred By Balance c/d
to General P/L
account 1,096 Cash in hand 10
To Balance c/d - Trade debtors (W.N.3) 485
Outstanding 6 Stock (W.N.1) 1,470
expenses
Furniture and fittings
(W.N.4) 516
16,621 16,621
Working Notes:
1. Invoice price and cost
Let cost be 100
So, invoice price 120
Loading 20
Loading: Invoice price= 20 : 120 =1:6
2. Memorandum Branch Stock Account
` ‘000 ` ‘000
To Balance b/d 1,080 By Goods sent to 72
branch
To Goods sent to 13,200 By Branch Cash 9,700
branch
To Branch debtors 102 By Branch debtors 3,140
By Balance c/d 1,470
14,382 14,382
3. Memorandum Branch Debtors Account
` ‘000 ` ‘000
To Balance b/d 384 By Branch cash 2,842
To Branch stock 3,140 By Branch expenses 58
discount
By Branch stock 102
(Returns)
By Branch expenses
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.95
FOREIGN BRANCHES
(Bad debts) 37
By Balance b/d 485
3,524 3,524
4. Memorandum Branch Furniture and Fittings Account
` ‘000 ` ‘000
To Balance b/d 500 By Depreciation 84
[(500x16%) + (100
x 16% x 3/12)]
To Bank 100 By Balance c/d 516
600 600
Note: Since the new furniture was purchased on 1st Jan 20X2
depreciation will be for 3 months.
5. Memorandum Branch Cash Account
` ‘000 ` ‘000
To Balance b/d 10 By Branch expenses 842
To Branch stock 9,700 By Remittances to 11,700
H.O. (b.f)
To Branch debtors 2,842 By Balance b/d 10
12,552 12,552
13. (i) Books of Branch
Journal Entries
(` in lacs)
Dr. Cr.
Goods in Transit A/c Dr. 10
To Head Office A/c 10
(Goods dispatched by head office but not
received by branch before 1st April, 20X2)
Expenses A/c Dr. 1
© The Institute of Chartered Accountants of India
15.96 ADVANCED ACCOUNTING
To Head Office A/c 1
(Amount charged by head office for
centralised services)
(ii) Trading and Profit & Loss Account of the Branch
for the year ended 31st March, 20X2
` in lacs ` in lacs
To Opening Stock 60 By Sales 360
To Goods received from By Closing Stock 72
including
transit
Head Office 288+10
Less: Returns (5) 293
To Carriage Inwards 7
To Gross Profit c/d 72
432 432
To Salaries 25 By Gross Profit 72
b/d
To Depreciation on 2
Furniture
To Rent 10
To Advertising 6
To Telephone, Postage & 3
Stationery
To Sundry Office Expenses 1
To Head Office Expenses 1
(centralised services)
To Net Profit Transferred to
Head Office A/c 24
72 72
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.97
FOREIGN BRANCHES
Balance Sheet as on 31st March, 20X2
Liabilities ` in lacs Assets ` in lacs
Head Office 80 Furniture & Equipment 20
Add: Goods in 10 Less: Depreciation (2) 18
transit Stock in hand 62
Head Office Goods in Transit 10
Expenses 1 Debtors 20
Net Profit 24 115 Cash at bank and in
Outstanding hand 8
Expenses 3
118 118
(iii) Books of Head Office
Journal Entries
` `
Dr. Dr.
Branch Trading Account Dr. 365
To Branch Account 365
(The total of the following items in branch trial
balance debited to branch trading account:
` in lacs
Opening Stock 60
Goods received from Head Office 288
Goods purchased but not received 10
Carriage Inwards 7
© The Institute of Chartered Accountants of India
15.98 ADVANCED ACCOUNTING
Branch Account Dr. 437
To Branch Trading Account 437
(Total sales, closing stock and goods returned to
Head Office credited to branch trading account,
individual amount being as follows:
` in lacs
Sales 360
Closing Stock 62
Goods in transit 10
Goods returned to Head Office 5)
Branch Trading Account Dr. 72
To Branch Profit and Loss Account 72
(Gross profit earned by branch credited to Branch
Profit and Loss Account)
Branch Profit and Loss Account Dr. 48
To Branch Account 48
(Total of the following branch expenses debited to
Branch Profit & Loss Account:
` in lacs
Salaries 25
Rent 10
Advertising 6
Telephone, Postage & Stationery 3
Sundry Office Expenses 1
Head Office Expenses 1
Depreciation on furniture 2)
Branch Profit & Loss Account Dr. 24
To Profit and Loss Account 24
(Net profit at branch credited to general Profit &
Loss A/c)
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.99
FOREIGN BRANCHES
Branch Furniture & Equipment Dr. 18
Branch Stock Dr. 62
Branch Debtors Dr. 20
Branch Cash at Bank and in Hand Dr. 8
Goods in Transit Dr. 10
To Branch 118
(Incorporation of different assets at the branch in
H.O. books)
Branch Dr. 3
To Branch Outstanding Expenses 3
(Incorporation of Branch Outstanding Expenses in
H.O. books)
14. Bangalore Branch Stock Account
Particulars Amount (`) Particulars Amount (`)
To Balance b/d 4,50,000 By Goods sent to 90,000
Goods sent to branch A/c
(Returns)
branch A/c 45,00,000 By Bank A/c (Cash 15,00,000
sales)
To Branch debtors 60,000 By Branch debtors A/c 27,00,000
A/c (Returns) (credit sales)
To Branch By Balance c/d 9,00,000
adjustment A/c
(Surplus over
invoice price)* 1,80,000
51,90,000 51,90,000
*Alternatively, this may directly be transferred to Branch P&L A/c without
routing it through Branch Adjustment Account.
© The Institute of Chartered Accountants of India
15.100 ADVANCED ACCOUNTING
Bangalore Branch Adjustment Account
Particulars Amount Particulars Amount
(`) (`)
To Stock reserve - 20% 1,80,000 By Stock reserve - 20% 90,000
of ` 9,00,000 of ` 4,50,000
(closing stock) (Opening stock)
To Branch profit & loss 9,72,000 By Goods sent to 8,82,000
A/c (Gross profit) branch A/c – 20%
of ` 44,10,000
(45,00,000 – 90,000)
__ By Branch stock A/c 1,80,000
11,52,000 11,52,000
Branch Profit & Loss Account
Particulars Amount Particulars Amount
(`) (`)
To Branch expenses A/c 6,30,000 By Branch adjustment 9,72,000
A/c
To Branch debtors A/c 45,000 (Gross Profit)
(Discount)
To Branch Debtors A/c 30,000
(Bad debts)
To Net profit
(transferred to Profit
& Loss A/c) 2,67,000
9,72,000 9,72,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.101
FOREIGN BRANCHES
Branch Expenses Account
Particulars Amount Particulars Amount
(`) (`)
To Bank A/c (Rent, 1,35,000 By Branch profit and 6,30,000
rates & taxes) loss A/c (Transfer)
To Bank A/c (Salaries, 4,50,000
wages& bonus)
To Bank A/c (Office
expenses) 45,000
6,30,000 6,30,000
Branch Debtors Account
Particulars Amount Particulars Amount
(`) (`)
To Balance b/d 5,40,000 By Bank A/c 24,00,000
To Branch stock A/c 27,00,000 By Branch profit and 75,000
loss A/c (Bad debts
and discount)
By Branch stock A/c 60,000
(Sales returns)
By Balance c/d (bal.
fig.) 7,05,000
32,40,000 32,40,000
Goods sent to Branch Account
Particulars Amount Particulars Amount
(`) (`)
To Branch stock A/c 90,000 By Branch stock 45,00,000
A/c
To Branch adjustment 8,82,000
A/c
To Purchases A/c 35,28,000
45,00,000 45,00,000
© The Institute of Chartered Accountants of India
15.102 ADVANCED ACCOUNTING
15. Trading and Profit and Loss A/c
For the year ended 31st March 20X1
Head Branch Head Branch
office office
` ` ` `
To Opening 2,25,000 - By Sales 27,81,000 9,50,000
stock
To Purchases 25,50,000 - By Goods 9,54,000 _
sent to
branch
To Goods - 9,54,000 By 7,00,000 99,000
received Closi
from head ng
office stock
(W.N.1
& 2)
To Gross 16,60,000 95,000
profit c/d
44,35,000 10,49,000 44,35,000 10,49,000
To Office 90,000 8,500 By Gross 16,60,000 95,000
expenses profit
b/d
To Selling 72,000 6,300
expenses
To Staff 65,000 12,000
salaries
To Branch 44,000 _
Stock
Reserve
(W.N.3)
To Net Profit 13,89,000 68,200
16,60,000 95,000 16,60,000 95,000
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.103
FOREIGN BRANCHES
Working Notes:
(1) Calculation of closing stock of head office: `
Opening Stock of head office 2,25,000
Goods purchased by head office 25,50,000
27,75,000
Less: Cost of goods sold [37,35,000 x 100/180] (20,75,000)
7,00,000
(2) Calculation of closing stock of branch: `
Goods received from head office [At invoice value] 9,54,000
Less: Invoice value of goods sold [9,50,000 x 180/200] (8,55,000)
99,000
(3) Calculation of unrealized profit in branch stock:
Branch stock ` 99,000
Profit included 80% of cost
Hence, unrealized profit would be = ` 99,000 x 80/180 ` 44,000
16. Books of Branch
Journal Entries
Sr. Amount in `
No Particulars Dr. Cr.
(i) Head Office Account Dr. 2,800
To Income Account 2,800
(Being the income allocated by the Head office
not recorded earlier, now recorded)
(ii) Head Office Account Dr. 3,000
To Salaries Account 3,000
(Being rectification of salary paid on behalf of
Head Office)
(iii) Head Office Account Dr. 5,000
To Cash Account 5,000
(Being expenditure incurred on account of
other branch, now recorded in books)
© The Institute of Chartered Accountants of India
15.104 ADVANCED ACCOUNTING
(iv) No entry in Branch Books is required.
(v) Expenses Account Dr. 75,000
To Head Office Account 75,000
(Being allocated expenses of Head Office
recorded)
(vi) Head Office Account Dr. 30,000
To Debtors Account 30,000
(Being adjustment entry for collection from
Branch Debtors directly by Head Office)
(vii) Goods -in- transit Account Dr. 10,000
To Head Office Account 10,000
(Being goods sent by Head Office still in-
transit)
17. (i) In the Books of Head Office
Branch Trading and Profit & Loss A/c (in Dollars)
for the year ended 31st December, 20X1
Particulars $ Particulars $
To Opening stock 11,200 By Sales 84,000
To Goods from H.O. 64,000 By Closing stock 8,000
(W.N.2)
To Gross profit c/d 16,800
92,000 92,000
To Expenses 5,000 By Gross profit b/d 16,800
To Depreciation (24,000 x 2,400
10%)
To Manager’s commission 470
(W.N.1)
To Net profit c/d 8,930
16,800 16,800
© The Institute of Chartered Accountants of India
ACCOUNTING FOR BRANCHES INCLUDING 15.105
FOREIGN BRANCHES
(ii) (a) Converted Branch Trial Balance (into Indian Currency)
Particulars Rate per $ Dr. (`) Cr. (`)
Machinery 40 9,60,000 _
Stock January 1, 20X1 46 5,15,200 _
Goods from head office Actual 29,26,000 _
Sales 47 _ 39,48,000
Expenses 47 2,35,000 _
Debtors & creditors 48 2,30,400 1,63,200
Cash at bank 48 57,600 _
Head office A/c Actual _ 8,60,000
Difference in exchange rate (b.f.) 47,000 _
49,71,200 49,71,200
Closing stock $ 8,000 (W.N. 2) 48 `
3,84,000
(b) Branch Trading and Profit & Loss A/c for the year ended
31st December, 20X1
` `
To Opening stock 5,15,200 By Sales 39,48,000
To Goods from 29,26,000 By Closing stock 3,84,000
head office (W.N.2)
To Gross profit c/d 8,90,800
43,32,000 43,32,000
To Expenses 2,35,000 By Gross profit b/d 8,90,800
To Depreciation @
10% on ` 96,000
9,60,000
To Exchange 47,000
difference
To Manager’s
commission 22,560
(W.N.1)
To Net Profit c/d 4,90,240
8,90,800 8,90,800
© The Institute of Chartered Accountants of India
15.106 ADVANCED ACCOUNTING
(c) Branch Account
` `
To Balance b/d 8,60,000 By Machinery 9,60,000
To Net profit 4,90,240 Less: Depreciation (96,000)
To Creditors 1,63,200 8,64,000
To Outstanding By Closing stock 3,84,000
commission By Debtors 2,30,400
22,560
By Cash at bank 57,600
15,36,000 15,36,000
Working Notes:
1. Calculation of manager’s commission @ 5% on profit
i.e. 5% of $[16,800 – (5,000 + 2,400)]
Or 5% × $9,400 = $ 470
Manager’s commission in Rupees = $ 470 × ` 48 = ` 22,560
2. Calculation of closing stock
$
Opening stock 11,200
Add: Goods from head office 64,000
75,200
Less: Cost of goods sold (at invoice price)
100
i.e. × 84,000
125 (67,200)
Closing stock 8,000
Closing stock in Rupees = $8,000 x ` 48 = ` 3,84,000.
Note: Manager is entitled to commission on profits earned at the end
of the year.
© The Institute of Chartered Accountants of India
CASE SCENARIOS
Case Scenario 1
RTS Ltd, (“RTS” or the “Company”), is engaged in the business of manufacturing of
equipments/components. The Company has a contract with the Indian Railways for
a brake component which is structured such that:
♦ The Company’s obligation is to deliver the component to the Railways’
stockyard, while the delivery terms are ex-works, the Company is responsible
for engaging a transporter for delivery.
♦ Railways sends an order for a defined quantity.
♦ The Company manufactures the required quantity and informs Railways for
carrying out the inspection.
♦ Railways representatives visit the Company’s factory and inspect the
components, and mark each component with a quality check sticker.
♦ Goods once inspected by Railways, are marked with a hologram sticker to
earmark for delivery identification by the customer when they are delivered
to the customer’s location.
♦ The Company raises an invoice once it dispatches the goods.
The management of RTS is under discussion with the auditors of the Company in
respect of accounting of a critical matter as regards its accounting with respect
subsequent events i.e. events after the reporting period. They have been checking
as to which one of the following events after the reporting period provide evidence
of conditions that existed at the end of the reporting period?
© The Institute of Chartered Accountants of India
CS.2 ADVANCED ACCOUNTING
i. Nationalisation or privatization by government
ii. Out of court settlement of a legal claim
iii. Rights issue of equity shares
iv. Strike by workforce
v. Announcing a plan to discontinue an operation
The Company 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. The Company also received land, free of cost, from the State
Government but it has not recorded this at all in the books as no money has been
spent.
RTS has a subsidiary, A Ltd, which is evaluating its production process wherein
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 was ` 1,000. The entire quantity of waste
was on stock at the end of the financial year.
(i) When should RTS Ltd recognize revenue as per the Accounting Standards
notified under the Companies (Accounting Standards) Rules, 2006? Would
your answer be different if inspection is normally known to lead to no quality
rejections?
(a) Revenue should be recognized on dispatch of components. The
assessment would not change even in case where inspection is normally
known to lead to no quality rejections.
(b) Revenue should be recognized on completion of inspection of
components. The assessment would not change even in case where
inspection is normally known to lead to no quality rejections.
(c) Revenue should be recognized on dispatch of components. The
assessment would change where inspection is normally known to lead
to no quality rejections.
(d) Revenue should be recognized on delivery of the component to the
Railways’ stockyard. The assessment would change where inspection is
normally known to lead to no quality rejections.
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.3
(ii) In respect of A Ltd, state with reference to Accounting Standards notified
under the Companies (Accounting Standards) Rules, 2006, what would be
value of the inventory to be recorded in the books of accounts?
(a) ` 4,700,000.
(b) ` 5,000,000.
(c) ` 4,950,000.
(d) ` 4,947,368.
(iii) Please guide regarding the accounting treatment of both the grants
mentioned above in line with the requirements of Accounting Standard 12.
(a) Distribution of dividend out of grant is correct. In the second case also
not recording land in the books of accounts is correct.
(b) Distribution of dividend out of grant is incorrect. In the second case,
not recording land in the books of accounts is correct.
(c) Distribution of dividend out of grant is correct. In the second case, land
should be recorded in the books of accounts at a nominal value.
(d) Distribution of dividend out of grant is incorrect. In the second case,
land should be recorded in the books of accounts at a nominal value.
Answers
(i) (b) (ii) (d) (iii) (d)
Case Scenario 2
Suman Ltd. is in the business of manufacturing electronics equipment and selling
these at its various outlets. It provides installation services for the equipment sold
and also provide free 1 year warranty on all the sold products.
Beach Resorts are leading resorts in the city. It purchased 5 air conditioners (AC)
from Suman Ltd. for its resort. Suman Ltd. sold 5 AC to Beach resort for ` 45,000
each which includes installation fees of ` 1,000 for each AC. The Company also
offers 1 year warranty for any repair etc. The Company also offered ` 500 per AC
as trade discount. Beach resort placed order on March 15, 2024 and made payment
on March 20, 2024. The ACs were delivered on March 27, 2024 and the installation
was completed on April 5, 2024.
© The Institute of Chartered Accountants of India
CS.4 ADVANCED ACCOUNTING
(i) How much revenue should be recognised by the Company as on March 31,
2024:
(a) ` 2,25,000
(b) ` 2,17,500
(c) ` 2,00,000
(d) ` 2,30,000
(ii) How much revenue should be recognised by the Company in the financial
year 2024-25:
(a) ` 5000
(b) ` 2,20,000
(c) ` 10,000
(d) ` 2,40,000
(iii) What will be the accounting for trade discount:
(a) The same will be recognised separately in the profit and loss.
(b) The trade discounts are deducted in determining the revenue.
(c) Trade discount will be recognised after one year, when the warranty will
be over.
(d) Trade discount will be recognised after installation is complete.
(iv) Is the Company required to do any accounting for 1 year warranty provided
by it:
(a) No accounting treatment is required till some warranty claim is actually
received by the Company.
(b) As there exist a present obligation to provide warranty to customers for
1 year, the Company should estimate the amount that it may have to
incur considering various factors including past trends and create a
provision as per AS 29.
(c) Accounting for claims will be done on cash basis i.e. expense will be
recognised when expense is made.
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.5
(d) As the Company is not charging separately for the warranty provided,
there is no need to create any provision.
Answers
(i) (b) (ii) (a) (iii) (b) (iv) (b)
Case Scenario 3
Mars Ltd. is a manufacturing enterprise which is starting a new manufacturing plant
at X Village. It has commenced construction of the plant on April 1, 2023 and has
incurred following expenses:
♦ It has acquired land for installing Plant for ` 50,00,000
♦ It incurred ` 35,00,000 for material and direct labour cost for developing the
Plant.
♦ The Company incurred ` 10,00,000 for head office expenses at New Delhi
which included rent, employee cost and maintenance expenditure.
♦ The Company borrowed ` 25,00,000 for construction work of Plant @12% per
annum on April 1, 2023. Director finance of the Company incurred travel and
meeting expenses amounting to ` 5,00,000 during the year for arranging this
loan.
♦ On November 1, 2023, the construction activities of the plant were
interrupted as the local people alongwith the activists have raised issues
relating to environmental impact of plant being constructed. Due to agitation
the construction activities came to standstill for 3 months.
♦ With the help of Government and NGOs, the agitation was over by February
28, 2024 and the work resumed. However, to balance the impact on
environment, government ordered the company to install certain devices for
which the Company had to incur ` 6,00,000 in March 2024.
♦ The rate of depreciation on Plant is 10%.
Based on the above information, answer the following questions.
(i) Which of the following expenses cannot be included in the cost of plant:
(a) Cost of Land
© The Institute of Chartered Accountants of India
CS.6 ADVANCED ACCOUNTING
(b) Construction material and labour cost
(c) Head office expenses
(d) Borrowing cost
(ii) How much amount of borrowing cost can be capitalised with the plant:
(a) ` 300,000
(b) ` 2,00,000
(c) ` 7,00,000
(d) ` 6,00,000
(iii) The total cost of plant as on march 31, 2024 will be:
(a) ` 85,00,000
(b) ` 98,00,000
(c) ` 93,00,000
(d) ` 95,00,000
(iv) The amount of depreciation to be charged for the year end March 31, 2024
(a) ` 4,30,000
(b) ` 9,30,000
(c) ` 9,80,000
(d) Nil
Answers
(i) (c) (ii) (b) (iii) (c) (iv) (d)
Case Scenario 4
Beloved Finance Ltd. is a financial enterprise which is in the business of lending
loan to small businesses and earn interest on loans.
♦ During the year the Company has lend 50 crores and earned ` 1.5 crore as
interest on loans.
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.7
♦ The Company had surplus funds during the year and invested then in Fixed
Deposits with bank and earned interest on fixed deposits of ` 20 lacs.
♦ The Company also acquired a gold loan unit for ` 10 crore during the year
and the Company provided interest free loan of ` 15 crore to its wholly-
owned subsidiary.
♦ The Company paid a total income tax of ` 75 lacs for the year.
Based on the above information, answer the following questions.
(i) In the Cash Flow Statement as per AS 3, the interest income of ` 1.5 crore
earned on earned on loans given by the Company will be disclosed as:
(a) Cash Flow from Operating Activities
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Non-cash Items
(ii) In the Cash Flow Statement as per AS 3, the interest income of ` 20 Lacs
earned fixed deposits with bank will be disclosed as:
(a) Cash Flow from Operating Activities
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Non-cash Items
(iii) In the Cash Flow Statement as per AS 3, amount paid for acquiring gold loan
unit will be disclosed as:
(a) Cash Flow from Operating Activities
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Non-cash Items
(iv) In the Cash Flow Statement as per AS 3, total income tax of ` 75 lacs paid for
the year will be disclosed as:
(a) Cash Flow from Operating Activities
© The Institute of Chartered Accountants of India
CS.8 ADVANCED ACCOUNTING
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Non-cash Items
(v) Is any specific disclosures required to made in relation to the interest free
loan of ` 15 crore provided by the Company to its wholly-owned subsidiary,
if yes, as per which Accounting Standard:
(a) Yes, disclosure is required to be made as per AS 3, Cash Flow
Statements.
(b) Yes, disclosure is required to be made as per AS 18, Related Party
Disclosures
(c) Yes, disclosure is required to be made as per AS 13, Accounting for
Investments
(d) No specific disclosures are required.
Answers
(i) (a) (ii) (a) (iii) (b) (iv) (a) (v) (b)
Case Scenario 5
Venus Limited received a parcel of land at no cost from the government for the
purpose of developing a factory in an outlying area. The land is valued at ` 75 lakhs,
while the nominal value is ` 10 lakhs. Additionally, the company received a
government grant of ` 30 lakhs, which represents 25% of the total investment
needed for the factory development. Furthermore, the company received ` 15 lakhs
with the stipulation that it be used to purchase machinery. There is no expectation
from the government for the repayment of these grants.
Answer the following questions based on the above information:
(i) The land received from Government, free of cost should be presented at:
(a) ` 75 Lakhs
(b) ` 30 Lakhs
(c) ` 10 Lakhs
(d) ` 45 Lakhs
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.9
(ii) As per AS 12, how the Government Grant of ` 30 Lakhs should be presented:
(a) It should be recognised in the profit and loss statement as per the
related cost.
(b) It will be treated as capital reserve.
(c) It will be treated as deferred income.
(d) It will not be recognised in the financial statements.
(iii) As per AS 12, how the Government Grant of ` 15 Lakhs with a condition to
purchase machinery may be presented as:
(a) Capital Reserve
(b) Shareholders Fund
(c) Deferred Income
(d) Income in statement of profit and loss as received.
(iv) Which of the above grants are required to be recognised in the statement of
profit and loss on a systematic and rational basis over the useful life of the
asset:
(a) Land received as Grant
(b) Government Grant of ` 30 Lakhs
(c) Government Grant of ` 15 Lakhs with a condition to purchase machinery
(d) Noe of the above
Answers
(i) (c) (ii) (b) (iii) (c) (iv) (c)
Case Scenario 6
Axis limited is a manufacturing company. It purchased a machinery costing
` 10 Lakhs in April 2023. It paid ` 4 lakhs upfront and paid the remaining
` 6,00,000 as deferred payment by paying instalment of ` 1,05,000 for the next 6
months. During the year, the Company sold a land which was classified as its
‘property, plant and equipment’ for ` 25,00,000 and paid ` 1,00,000 as income tax
as long term capital gain on such sale. During the year, the Company also received
© The Institute of Chartered Accountants of India
CS.10 ADVANCED ACCOUNTING
income tax refund along with interest.
(i) As per the requirements of AS 3, ‘Cash Flow Statements’, how the amount for
purchase of machinery should be presented:
(a) ` 10 lakhs as ‘Cash flows from Investing Activities’ and ` 30,000 will
simply be booked in profit and loss with no presentation if Cash Flow
Statement.
(b) ` 10.30 lakhs as ‘Cash flows from Investing Activities’ as entire amount
is spend on purchase of machinery.
(c) ` 10 lakhs as ‘Cash flows from Investing Activities’ and ` 30,000 as ‘Cash
flows from Financing Activities’.
(d) ` 10.30 lakhs as ‘Cash flows from Financing Activities’ as the machinery
has been purchased on finance.
(ii) At what amount, the machinery should be recognised in the financial
statements:
(a) ` 400,000
(b) ` 10,30,000
(c) ` 600,000
(d) ` 10,00,000
(iii) How should the income tax paid on sale of land should be disclosed in the
Cash Flows Statement:
(a) Cash flows from Operating Activities
(b) Cash flows from Investing Activities
(c) Cash flows from Financing Activities
(d) No disclosure in Cash Flow Statement
(iv) How should the interest on income tax refunds should be disclosed in the
Cash Flows Statement:
(a) Cash flows from Operating Activities
(b) Cash flows from Investing Activities
(c) Cash flows from Financing Activities
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.11
(d) No disclosure in Cash Flow Statement
Answers
(i) (c) (ii) (d) (iii) (b) (iv) (b)
Case Scenario 7
SEAS Ltd., the “Company”, is in the business of tours and travels. It sells holiday
packages to the customers. The Company negotiates upfront with the Airlines for
specified number of seats in flight. The Company agrees to buy a specific number
of tickets and pay for those tickets regardless of whether it is able to resell all of
those in package.
The rate paid by the Company for each ticket purchased is negotiated and agreed
in advance. The Company also assists the customers in resolving complaints with
the service provided by airlines. However, each airline is responsible for fulfilling
obligations associated with the ticket, including remedies to a customer for
dissatisfaction with the service.
The Company bought a forward contract for three months of US$ 1,00,000 on 1
March 2024 at 1 US$ = INR 83.10 when exchange rate was US$ 1 = INR 83.02. On
31 March 2024, when the Company closed its books, exchange rate was US$ 1 =
INR 83.15. On 1 April 2024, the Company decided for premature settlement of the
contract due to some exceptional circumstances.
The Company is evaluating below mentioned schemes:
i. Introduction of a formal retirement gratuity scheme by an employer in place
of ad hoc ex-gratia payments to employees on retirement.
ii. Management decided to pay pension to those employees who have retired
after completing 5 years of service in the organization. Such employees will
get pension of ` 20,000 per month. Earlier there was no such scheme of
pension in the organization.
SEAS Ltd. has a subsidiary, ADI Ltd., which is in the business of construction
having turnover of ` 200 crores. SEAS Ltd. and ADI Ltd. hold 9% and 23%
respectively in an associate company, ASOC Ltd. Both SEAS Ltd. and ADI Ltd.
prepare consolidated financial statements as per Accounting Standards
notified under the Companies (Accounting Standards) Rules, 2021.
© The Institute of Chartered Accountants of India
CS.12 ADVANCED ACCOUNTING
(i) What would be the basis of revenue recognition for SEAS Ltd. as per the
requirements of Accounting Standards?
(a) Gross basis.
(b) Net basis.
(c) Depends on the accounting policy of the Company.
(d) Indian GAAP allows a choice to the Company to recognize revenue on
gross basis or net basis.
(ii) Please suggest accounting treatment of forward contract for the year ended
31 March 2024 as per Accounting Standard 11.
(a) MTM (marked to market value) of contract will be recorded on 31 March
2024.
(b) MTM (marked to market value) of contract will be computed as at 31
March 2024 and only if there is loss, it will be recorded during the year
ended 31 March 2024.
(c) No accounting will be done during the year ended 31 March 2024.
(d) Premium on contract will be amortized over the life of the contract.
(iii) You are requested to advise the Company in respect of the accounting
requirements of above schemes related to employee benefits as to which one
of those schemes should be considered as a change in accounting policy
during the year.
(a) 1 – Change in accounting policy. 2 – Change in accounting policy.
(b) 1– Not a change in accounting policy. 2 – Change in accounting policy.
(c) 1 – Not a change in accounting policy. 2 – Not a change in accounting
policy.
(d) 1– Change in accounting policy. 2 – Not a change in accounting policy.
(iv) Please comment regarding consolidation requirements for SEAS Ltd. and ADI
Ltd. using the below mentioned options as to which one should be correct.
(a) ADI Ltd. would using equity method of accounting for 23% in ASOC Ltd.
SEAS Ltd. would consolidate ADI Ltd. and consequently automatically
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.13
equity account 23% and separately account for the balance 9% as per
AS 13.
(b) ADI Ltd. would account for 23% in ASOC Ltd. as per AS 13. SEAS
Ltd. would consolidate ADI Ltd. and consequently automatically
account 23% and separately account for the balance 9%.
(c) ADI Ltd. would account for 23% share in ASOC Ltd using equity method
of accounting. SEAS Ltd. would consolidate ADI Ltd. and consequently,
automatically account for ASOC Ltd 23% share and separately account
for 9% share in ASOC Ltd. using equity method of accounting in
consolidated financial statements.
(d) ADI Ltd. would account for 23% in ASOC Ltd. as per AS 13. SEAS Ltd.
would consolidate ADI Ltd. and using equity method of accounting 23%
in ASOC Ltd. and separately account for the balance 9% as per AS 13.
Answers
(i) (a) (ii) (d) (iii) (c) (iv) (c)
Case Scenario 8
On 1st April, 2022, Shubham Limited purchased some land for ` 30 lakhs for the
purpose of constructing a new factory. This cost of 30 lakhs included legal cost of
` 2 lakhs incurred for the purpose of acquisition of this land. Construction work
could start on 1st May, 2022 and Shubham Limited provides you the details of the
following costs incurred in relation to its construction:
`
Preparation and levelling of the land 80,000
Employment costs of the construction workers (per month) 29,000
Purchase of materials for the construction 21,24,000
Cost of relocating employees to new factory for work 60,000
Costs of inauguration ceremony on 1 January, 2023 st
80,000
Overhead costs incurred directly on the construction of the factory 25,000
(per month)
© The Institute of Chartered Accountants of India
CS.14 ADVANCED ACCOUNTING
General overhead costs allocated to construction project by the Manager is `
30,000. However, as per company’s normal overhead allocation policy, it should
be ` 24,000. The auditor of the company has support documentation for the cost
of ` 15,000 only) and raised objection for the balance amount.
The construction of the factory was completed on 31st December, 2022 and
production could begin on 1st February, 2023. The overall useful life of the factory
building was estimated at 40 years from the date of completion. However, it was
estimated that the roof will need to be replaced 20 years after the date of
completion and that the cost of replacing the roof at current prices would be 25%
of the total cost of the building.
The construction of the factory was partly financed by a loan of ` 28 lakhs borrowed
on 1st April, 2022. The loan was taken at an annual rate of interest of 9%. During
the period when the loan proceeds had been fully utilized to finance the
construction, Shubham Limited received investment income of ` 25,000 on the
temporary investment of the proceeds.
You are required to assume that all of the net finance costs to be allocated to the
cost of factory (not land) and interest cost to be capitalized based on nine months’
period.
Based on the information given in the above scenario, answer the following
multiple choice questions:
(i) Which of the following cost (incurred directly on construction) will be
capitalized to the cost of factory building?
(a) ` 2,00,000 incurred as legal cost
(b) ` 60,000 – costs of relocating employees
(c) ` 80,000 costs of inauguration ceremony
(d) ` 24,000 – allocated general overhead cost
(ii) What amount of employment cost of construction workers will be capitalized
to the cost of factory building?
(a) ` 2,90,000
(b) ` 3,48,000
(c) ` 2,32,000
(d) ` 29,000
© The Institute of Chartered Accountants of India
CASE SCENARIOS CS.15
(iii) What is the amount of net borrowing cost capitalized to the cost of the
factory?
(a) ` 1,89,000
(b) ` 1,68,000
(c) ` 1,44,000
(d) ` 1,64,000
(iv) What will be the carrying amount (i.e. value after charging depreciation) of
the factory in the Balance Sheet of Shubham Limited as at 31st March, 2023?
(a) ` 30,00,000
(b) ` 57,78,125
(c) ` 27,78,125
(d) ` 58,00,000
Answers
(i) (a) (ii) (c) (iii) (d) (iv) (b)
