Financial Accounting Theories
Financial Accounting Theories
Financial Accounting
Theory Questions
from Past Papers
CA BISHNU KEDIA
FINANCIAL ACCOUNTING
Answer
a) The Accrual Concept:
The accrual concept is based on recognition of both cash and credit transactions. In case
of a cash transaction, owner's equity is instantly affected as cash either is received or
paid. In a credit transaction, however, a mere obligation towards or by the business is
created. When credit transactions exist (which is generally the case), revenues are not
the same as cash receipts and expenses are not same as cash paid during the period.
When goods are sold on credit as per normally accepted trade practices, the business
gets the legal right to claim the money from the customer. Acquiring such right to claim
the consideration for sale of goods or services is called accrual of revenue. The actual
collection of money from customer could be at a later date. Similarly, when the business
procures goods or services with the agreement that the payment will be made at a future
date, it does not mean that the effect of expense should not be recognized. Because an
obligation to pay for goods or services is created upon the procurement thereof, the
expense effect also must be recognized. Today's accounting systems based on accrual
concept are called as Accrual System or Mercantile System of Accounting.
Answer
Eric Kohler defined depreciation as "the lost usefulness, expired utility, the diminution
in service yield." Its measurement and charging are necessary for cost recovery. It is
treated as a part of the expired cost for an asset. For determination of revenue, that part
or cost should be matched against revenue. The objects or necessities of charging
depreciation are:
1. Correct calculation of cost of production: Depreciation is an allocated cost of a fixed
asset. It is to be calculated and charged correctly against the revenue of an
accounting period. It must be correctly included within the cost of production.
2. Correct calculation of profits: Costs incurred for earning revenues must be charged
properly for correct calculation of profits. The consumed cost of assets
(depreciation) has to be provided for correct matching of revenues with expenses.
3. Correct disclosure of fixed assets at reasonable value: Unless depreciation is
charged, the depreciable asset cannot be correctly valued and presented in the
Balance Sheet. Depreciation is charged so that the Balance Sheet exhibits a true and
fair view of the affairs of the business.
4. Provision of replacement cost: Depreciation is a non-cash expense. But net profit,
is calculated after charging it. Through annual' depreciation cash resources are
saved and accumulated to provide replacement cost at the end of the useful life of
an asset.
5. Maintenance of capital: A significant portion of capital has to be invested for
purchasing fixed assets. The values of such assets are gradually reduced due to their
regular use and passage of time. Depreciation on the assets is treated as an expired
cost and it is matched against revenue. It is charged against profits. If it is not
charged the profits will remain inflated. This will cause capital erosion.
6. Compliance with technical and legal requirements: Depreciation has to be charged
to comply with the relevant provisions of the Companies Act and Income Tax Act.
Answer
1. Advantages of Double Entry System
It helps the trade know about his debtors and creditors from to time
It helps the trader to prepare the final accounts to reflect the true trading results
at the end of period
It provides a Balance Sheet on a particular date to know the true value of assets,
liabilities and capital
It helps the trader who can have a comparative study of working results and
financial position over a number of years
It helps to find out and prevent errors and frauds
It provides ready-made information to be sent to Sales tax and Income Tax
Authorities
It provides good guidance on which management take new decisions to increase
the profit and correct losses into profit
To keep intact the capital invested in depreciable assets and to make provision
for the replacement, modernization and expansion on most favourable terms. It
is process of allocation and helps the management to retain this amount of profit
in business for replacing asset. Otherwise this profit would have gone to the
Government in the form of tax.
To match the cost with revenue, depreciation is necessary to measure the cost
incurred during a given period. Thus, know correct net income and financial
condition for external reporting.
Depreciation helps to measure managerial performance. But, charging it on
historical cost or replacement cost basis is again a controversial issue and will
affect the managerial decisions to be taken by the top management. Differences
in costs because of charge of depreciation under different methods, tend to
mislead management in selecting their operational alternativefor more profitable
for the firm as a whole.
Withdraw of asset before the end of its useful life is not up to standard to cope
with the increasing competition in the market but due to the external factor of
technological improvements in the existing asset is refereed to obsolescence. In
such atmosphere the asset is depreciated quickly otherwise profit and loss account
will be over burdened with the amount of loss on account of obsolescence in the
year in which the asset obsoletes.
Serving consistently to follow a particular method of depreciation otherwise
would make the financial statements unreliable to the stakeholders. It means
convention of consistency.
Depreciation makes to retain funds for replacement asset at the end of its working
life
Apportioning total cost of the asset over its useful life is achieved by charging
depreciation; and investing such amount of depreciation the public may not
misled and correct investment decision may be made.
Answer
Bad debts Doubtful Debts
The debts which cannot be realized The debts which may or may not
are known as Bad Debts. become bad are known as Doubtful Debts.
Bad Debts are immediately written off. Doubtful debts are not written off but
provided for.
A bad debt is a known loss. A doubtful debt is an anticipated loss.
In case of bad debt, the Debtor’s In case of doubtful debt, the Debtor’s
Amount is brought down by the Account remains as it is since, debtor’s
amount of bad debt. Account and provision for Doubtful Debts
Account are two separate accounts. But
provision is made against expected loss.
Answer
Stages of Accounting Cycle.
The accounting cycle consists of the following sequential steps:
1. Identifying transactions: The first step in the accounting cycle is to analyze events
to determine if they are " transactions ". Transactions are the starting point from
which the rest of the accounting cycle follows.
2. Recording transactions in books of original entry: The second step in the accounting
cycle is to record the identified transactions in the relevant books of original entry as
journal entries.
3. Posting to the Ledger: The next step is to record a summary of the activities in the
relevant account in the Ledger ( referred to as posting).
4. Drafting of unadjusted Trial Balance: At the end of an accounting period, data from
the Ledger Accounts may be taken to draft a Trial Balance. It is prepared for
identifying any errors that may have occurred during the initial stages of the
accounting cycle. However, this step is not mandatory.
5. Passing of adjustment entry: Identification of necessary adjustment and passing of
adjusting entries make up the fifth step in the cycle.
6. Drafting of Adjusted Trial Balance: Once all adjusting entries are completed, then an
adjusted trial balance can be prepared. This happens to be the last step before the
preparations of Financial Statements.
7. Closing of books: In this stage of the accounting cycle, the Ledger Accounts are
closed and balanced. (also refers to as zeroed out) at the end of every accounting
period.
8. Drafting the financial statements: In the last stage of the accounting cycle, the income
statement is prepared with the closing balances of the Nominal Accounts, While the
balances of real and personal accounts gets reflected in the Balance Sheet. Financial
Statements are prepared in the following order: Income statement, Statements of
retained earnings, Balance Sheet and statements of cash flows.
Answer
1. Distinction between fundamental accounting assumptions and accounting
Policy
Fundamental Accounting Assumptions Accounting policy
There are only three fundamental They are in no simple list of accounting
accounting assumptions viz. going policies which are applied in all
concern, consultancy, and accrual circumstances. As a result, there may be
different accounting policies adopt by
different enterprises
No disclosure is required if all the Disclosure is required if the particular
fundamental assumptions have been accounting policy have been followed
followed
power and not the breakup value of evolution, the continuing enterprise.
Answer
Following are the features of Trial Balance:
i. It is a list of debit and credit balances which are extracted from various ledger
accounts.
ii. It is a statement of debit and credit balances.
iii. The purpose is to establish arithmetical accuracy of the transactions recorded in the
Books of Accounts.
iv. It does not prove arithmetical accuracy which can be determined by audit.
v. It is not an account. It is only a statement of account.
vi. It is not a part of the final statements.
vii. It is usually prepared at the end of the accounting year but it can also be prepared
anytime as and when required like weekly, monthly, quarterly or half-yearly.
viii. It is a link between books of accounts and the Profit and Loss Account and Balance
Sheet.
Answer:
1. Usually the benefit of this type of advertisement is enjoyed over more than one
accounting period. As such it is deferred revenue expenditure. As per AS-26, it is a
2. The accrued interest or dividend must be related to a period before the date of
purchase of the investment. For this it has been included in the cost price of
investment. The cost of Investment minus accrued Interest or Dividend is a capital
Expenditure. It is the cost of acquisition of asset. The payment for the accrued
interest or dividend is a revenue expenditure.
3. It is a revenue loss. It has arisen in course of the normal business activities. Though
it is an abnormal loss which is non-regular and non-recurring in nature.
4. It will cause an addition to the College building, a fixed asset. Hence, it is Capital
Expenditure in nature.
Answer
The amount which is receivable from a person or a concern for supplying goods or
services is called Debt. Debts may be classified into:
a) Bad debts;
b) Doubtful debts and
c) Good debts
Bad Debts: Bad debts are uncollectable or irrecoverable debt or debts which are
impossible to collect. If it is definitely known that amount recoverable from a customer
cannot be realized at all, it should be treated as a business loss and should be adjusted
against profit. In short, the amount of bad debt should be transferred to Profit and Loss
Account for the current year to confirm the principles of matching.
Doubtful Debts: The debts which will be receivable or cannot be ascertainable at the
date of preparing the final accounts (i.e., the debts which are doubtful to realise) is
known as doubtful debts. Practically it cannot be treated as a loss on that particular date,
as such, it cannot be written off. But, it should be charged against Profit and Loss
Account on the basis of past experience of the firm.
Good Debts: The debts which are not bad i.e., there is neither any possibility of bad
debts nor any doubts about its realization, is called good debts. As such, no provision is
necessary for it.
Answer
S.N Revenue Receipt Capital Receipt
1 It has short-term effect. The benefit is It has long-term effect. The benefit is
enjoyed within one accounting enjoyed for many years in future.
period.
2 It occurs repeatedly. It is recurring It does not occur again and again. It is
and regular. nonrecurring and irregular
3 It is shown in Profit and Loss Account It is shown in the Balance Sheet on the
on the credit side, as an income for the liability side.
year
4 It does not produce capital receipt. Capital receipt, when invested,
produces revenue receipt e.g. when
capital is invested by the owner,
business gets revenue receipt (i.e. sale
proceeds of goods etc.)
5 This does not increase or decrease the The capital receipt decreases the value
value of asset or liability. of asset or increases the value of
liability e.g. sale of a fixed asset, loan
from bank etc.
6 Sometimes, expenses of capital Sometimes expenses of revenue nature
nature are to be incurred for revenue are to be incurred for such receipt e.g.
receipt, on obtaining loan (a capital receipt)
e.g. purchase of shares of a company interest is paid until its repayment.
is capital expenditure but dividend
received on shares is a revenue
receipt.
Answer
Single Entry System has the following features.
1. Maintenance of books by a sole trader or partnership firm: The books which are
maintained according to this system can be kept only by a sole trader or by a
partnership firm.
Answer
a) Expenses incurred for extension of railway tracks in the factory area should be
treated as a Capital Expenditure because it will yield benefit for more than one
accounting period.
b) Wages paid to machine operators should be treated as a Revenue Expenditure as it
will yield benefit for the current period only.
c) Installation costs of new production machine should be treated as a Capital
Expenditure because it will benefit the business for more than one accounting period.
d) Materials for extension to foremen’s offices in the factory should be treated as a
Capital Expenditure because it will benefit the business for more than one accounting
period.
e) Rent paid for the factory should be treated as a Revenue Expenditure because it will
benefit the Company only during the current period.
f) Payment for computer time to operate a new stores control system should be treated
as Revenue Expenditure because it has been incurred to carry on the normal business.
g) Wages paid for building foremen’s offices should be treated as a Capital Expenditure
because it will benefit the business for more than one accounting period.
Answer
1. According to the Convention of Full Disclosure, all significant information relating
to the economic affairs of the entity should be reported in the financial statements
in an understandable manner.
2. According to the Convention of Consistency, accounting practices once selected and
adopted should be consistently applied year after year.
3. According to the Convention of Materiality, a transaction should be reported in the
financial statements on the basis of its materiality. An item is material if it can
influence the decision of the user.
4. According to the Convention of Conservatism, anticipated losses should be
accounted for while anticipated incomes should not be accounted.
Answer
As per Section 5 of the Negotiable Instruments Act, a bill of exchange is an instrument
In writing containing an unconditional order, signed by the maker, directing a certain
person, to pay a certain sum of money only to, or to the order of a certain person or to
the bearer of the instrument. The essential of bill ofexchange are as:
There are three parties the “Maker‟ is termed as the „Drawer‟ in Bill of Exchange.
He is the creditor. The person liable to pay the money is called the „Drawee‟. The
person entitled to get the money is termed as the „Payee‟. It should be noted that
drawer himself can also be the payee. It must be drawn on a specific person
The bill drawer being the creditor, orders the drawee to pay a certain of sum money.
A Time Bill of Exchange can be made payable to the bearer.
It is an instrument in writing and unconditional
It must be in writing, dated, stamped and signed by Drawer
It must be payable in demand or after a definite period of time, and for a certain amount
of money
Answer
Renewal of Bills
Sometimes the drawee of a bill is not able to meet the bill on due date. He may request
the drawer to draw a new Bill for the amount due. Sometimes he pays a certain amount
out and accepts a first bill for the balance for which he has to pay a certain amount of
interest which is either paid in cash or is included with the fresh bill. This bill is known
as Renewal of Bills. That, the amount of the new bill will be face value of the original
bill minus cash payment, if any, plus interest for the renewed period.
Retirement of Bill
Sometimes the drawee pays the bill before the date of maturity. Under the
circumstances, the drawer allows certain amount of rebate or discount which is
calculated on certain percentage p.a. basis. The rebate is calculated from the date of
payment to the date of maturity.
Answer:
Difference between Sale and Consignment
1. In sale the property in goods is transferred to the buyer immediately whereas in
consignment the property is transferred to the buyer only when goods are sold by
the consignee. The ownership of goods remains with the consignor when goods are
transferred to the consignee by the consignor.
2. In sale, the risk attaching to the goods passes with ownership to the buyer. In case
of a consignment, the risk attaching to the goods does not pass to the consignee who
acts as a mere agent. If there is any damage or loss to the goods it is borne by the
consignor provided the consignee has taken reasonable care of the goods and the
damage or loss is not due to his negligence.
3. The relationship of consignor and consignee is that of a principal, and an agent as
in a contract of agency whereas the relationship of buyer and seller is governed by
the Sale of Goods Act.
4. Unsold goods on consignment are the property of the consignor and may be returned
if not saleable in the market whereas goods sold on sale basis are normally not
returnable unless there is some defect in them.
Answer
Features of Income and Expenditure Account:
1. It follows Nominal Account.
2. All expenses of revenue nature for the particular period are debited to this Account
on accrual basis.
3. Similarly all revenue incomes related to the particular period are credited to this
account on accrual basis.
4. All Capital Incomes and Expenditures are excluded.
5. Only current year's incomes and expenses are recorded. Amounts related to other
periods are deducted. Amounts outstanding for the current year are added.
6. Profit on Sale of Asset is credited. Loss on Sale of Asset is debited. Annual
Depreciation on Assets is also debited.
7. If income is more than expenditure, it is called a Surplus, and is added with Capital
or General Fund etc. in the Balance Sheet.
8. If expenditure is more than income, it is a deficit, and is deducted from Capital or
General Fund etc. in the Balance Sheet.
Answer:
Goodwill cannot be seen or touched. It can only be felt. Hence it is treated an intangible
asset. But it is not a fictitious asset because fictitious do not have a value. Whereas
Goodwill has value and it can be purchased or sold with any other asset.
Answer:
Differences between Receipts and Payments Account and Income and Expenditure
Account
S No Receipts & Payments Account Income & Expenditure Account
1 It is a summarised Cash Book It closely resembles the Profit & Loss
Account of a Trading concern
2 Receipts are debited and Payments Incomes are credited and
are credited. Expenditures are debited.
3 Transactions are recorded on Cash Transactions are recorded on Accrual
basis. Basis
4 Amounts related to previous period or Transactions are recorded on accrual
future period may remain included. basis. All amounts not related to the
Outstanding amount for current year is current period are excluded.
excluded. Outstanding amounts of current
period are added.
5 It records both Capital and Revenue It records Revenue transactions only.
transactions
6 It serves the purpose of a Real It serves the purpose of a Nominal
Account. Account
7 It starts with opening Cash and Bank It does not record such
Balances and ends with closing Cash balances, rather its final balance
and Bank Balances shows a surplus or a deficit for the
period
8 It does not record notional loss or It considers all such expenses for
noncash expenses like bad debts, matching against revenues
depreciations etc.
9 Its closing balance is carried forward Its closing balance is transferred to
to the same account of the next Capital Fund or General Fund or
accounting Period. Accumulated Fund in the same
period’s Balance Sheet.
10 It helps to prepare an Income & It helps to prepare a Balance Sheet
Expenditure A/c.
Answer
The amount of premium will be shared by the old partners in sacrificing ratio.
i. The entry will be:
Cash A/c ................ Dr.
To Premium for Goodwill A/c
Premium for Goodwill A/c .........Dr.
To Old Partners’ Capital A/c
ii. The amount of premium will be shared by the old partners in sacrificing ratio. The
amount for premium due from New Partner will be debited to Loan A/c. The entry
will be:
Loan to New Partner A/c .............. Dr.
To Premium for Goodwill A/c
Premium for Goodwill A/c ................ Dr.
To Old Partners’ Capital A/c
iii. The Goodwill A/c will be raised in the books by crediting Old Partners’ Capital A/c
in old ratio.
Goodwill A/c ............................. Dr.
To Old Partners’ Capital A/c
iv. The Goodwill A/c will be raised in the books by crediting Old Partners’ Capital A/c
in old ratio and then written off by debiting All Partners’ Capital A/c in new ratio.
Alternatively, a capital adjustment entry may be made by debiting the New Partners’
Capital A/c and crediting the Old Partners’ Capital A/c in sacrificing ratio.
New Partner’s Capital A/c ............................. Dr.
To Old Partners’ Capital A/c
Answers
Maximum loss method
Steps:
1. Prepare a statement showing distribution of cash
2. Pay off the external Liabilities
3. After all the payment is made for the external liabilities, the partners will be paid off.
Total Due of Partners xxx
Less: Net/Balance of Realisation (x) Maximum Loss xxx
4. The maximum loss shall be shared amongst the partners in their profit sharing ratio,
as if, there will be no further realisation.
5. If any of the partner capitals, after step (4) is negative, that partner shall be treated
like an insolvent partner.
6. The deficiency of the insolvent partner as per step (5) shall be shared by the other
solvent partners (i.e. those partners who has positive capital balances) in their capital
contribution ratio as per Garner vs. Murray Rule.
7. Repeat the steps (3) to (6) till final realisation.
Answers
Factor Hire-Purchase System Installment Purchase System
Transfer of Ownership in the goods sold passes Ownership in the goods passes to
Ownership to the buyer only on payment of the the buyer immediately at the time
last installment of sale
Recovery of If the buyer fails to pay any The seller cannot recover the
Goods installment, the seller can recover goods but he can sue for recovery
the goods back from buyer of price and damages
Forfeiture of If the buyer default in payment, the Money paid by the buyer will be
installments seller can forfeit money paid by the taken as a payment towards part of
paid buyer so far selling price and the seller can sue
only for the balance
Accounting In the books of purchaser, vendor is In the books of vendor, the
Entries debited with full purchase price once purchaser is credited with full
contract signed. Amount due, if any, price. Purchased goods become
is shown separately as a liability of property of the buyer and shown
the purchaser and not a deduction in his Balance Sheet at cost less
from the asset depreciation
Answer
Calculation of the amount of claim under “loss of Profit” Policy:
1. Find out the rate of Gross Profit [after considering trend of business etc.]
2. Find out the short sales [Standard turnover – Actual turnover of the period of
dislocation]
3. Find out Gross Profit on short sales.
4. Find out the Amount Admissible for Additional Expenses
It should be the minimum of: (a) Actual expenses (b) Gross profit on additional sales
generated by additional expenditure and
Additional expenses × Net Profit + Insured Standing Charges
a. Net Profit + All Standing Charges
ii. or
Additional Expenses ×Gross Profit on Annual Turnover
1. Gross Profit on Annual Turnover + Uninsured Standing
Charges
5. Add (3) and (4). From the total deduct saving in any insured standing charge during
the period of indemnity. The result is gross claim.
6. Under average clause: Net Claim = Gross Claim × Policy Value
Gross Profit on Annual Turnover
Answer
Points Branch Account Departmental Account
Allocation of In case of branch accounting Allocation of common wealth is
expenses allocation of common expenses the fundamental consideration
does not arise. here.
Result of the It shows that trading result of each It shows the trading result of each
operation individual branch. individual department.
Maintenance Method of Branch Accounting It is centrally maintained.
of accounts depends on the nature and type of
branch whether dependent or
independent.
Types of It is practically a condensation of It is a segment of accounts.
accounting accounts.
Control It is not possible to control all Effective control is possible by
branch by the Head Office the departmental supervisors who
is closely related and who is to
keep a constant watch over the
departments.
Answer
Substance over form means the transactions should be accounted for in accordance with
actual happening over the economic reality of the transactions, not by its legal form.
Answer
As per AS1, the disclosure of Accounting policies are:
All significant accounting policies adopted in the preparation and presentation of
financial statements should be disclosed.
The disclosure of the significant accounting policies as such should form part of the
financial statements and the significant accounting policies should normally be
disclosed in one place. Any change in the accounting policies which has a material
effect in the current 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. 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 to 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.
5. There is no single list of accounting policies which are applicable to all
circumstances.
Answer:
1. False, As per AS1 “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.
2. False, As per AS1 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.
3. 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 a financial statement and they should be
disclosed at one place.
4. 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.
5. True, As per AS1,There is no single list of accounting policies which are applicable
to all circumstances. The differing circumstances in which enterprises operate in a
situation of diverse and complex economic activity make alternative accounting
principles and methods of applying those principles acceptable
Answer
Factors governing the selection and application of accounting policies are:
Prudence: Generally maker of financial statement has to face uncertainties at the time
of preparation of financial statement. These uncertainties may be regarding collectability
of receivables, number of warranty claims that may occur. Prudence means making of
estimates, which is required under conditions of uncertainty.
Materiality: Financial Statement should disclose all the items and facts which are
sufficient enough to influence the decisions of reader or/user of financial statement.
a) As to the disclosure of all material items, individually or in aggregate in the context
of fair presentation of financial statements as a whole if its omission or
misstatement could influence the economic or financial decision of the user relying
upon the financial statements.
b) Depends on the size of the items or errors judged in the particular circumstances
of its omissions or misstatements.
c) Is a cut-off point rather than being a primary qualitative characteristic which
information must have.
This is a matter of judgment, varies from one entity to another and over one period to
another.
Answer
1. Meaning of materiality principle
a. According to the maturity principle, all relatively relevant item, the knowledge
of which might influence the decision of the user of the financial statements,
should be disclosed in the financial statement.
b. Which information is more relevant than? Others are largely a matter of
judgement For instance, accounting and recording of a small calculator of an asset
in the balance sheet may Justified due to the excess cost of recording over the
benefit in terms of usefulness of recording and the accounting of calculators as
assets.
2. What is materiality
The materiality depend not only upon the amount of item, but also upon the size of
business level and nature of information. Level of the person department who makes
the judgement about materiality for instance, a worker reporting to his foreman
Question 32
1. Entity A carried plant and machinery in its books at 2,00,000 which were destroyed
in a fire. These machines were insured ‘New For Old’ and were replaced by the
insurance company with new machines of fair value ₹ 20,00,000. The old destroyed
machines were acquired by the insurance company and the company did not receive
any cash compensation. State, how Entity A should account for the same.
2. Omega Ltd, a supermarket chain, is renovating one of its major stores. The store will
have more available space for store promotion outlets after the store will have more
available space for store promotion outlets after the renovation and will include a
restaurant. Management is preparing the budgets for the year after store reopens,
which include the cost of remodeling and the expectation of a 15% increase in sales
resulting from the store renovations, which will attract new customers
Decide whether Omega Ltd can capitalize the remodeling cost or not as per provision
of AS-10 ‘Property Plant & Equipment
Answers
1. 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
on Property, Plant and Equipment. Entity A should separately recognize a receivable
and a gain in the income statement resulting from the insurance proceeds once receipt
is virtually certain. The receivable should be measured at the fair value of assets
provided by the insurer.
Question 33
ABC Ltd is setting up a new refinery outside the city limits. In order to facilitate the
construction of the refinery and its operations, ABC Ltd. Is required to incur expenditure
on the construction/development of railway siding, road and bridge. Though ABC Ltd
incurs (or contributes to) the expenditure on the construction/development, it will not
have ownership rights on these items and they are also available for use to other entities
and publics at large. Whether ABC Ltd can capitalize expenditure incurred on these
items as property, plant and equipment (PPE)? If yes, how should these items be
depreciated and presented in the financial statements of ABC Ltd?
Answer
Paragraph 7 of AS 10 states that the cost of an item of property, plant and equipment
shall be recognised as an asset if, and only if:
i. it is probable that future economic benefits associated with the item will flow to the
entity; and
ii. the cost of the item can be measured reliably. measure for recognition, i.e., what
constitutes an item of property, plant and Further, paragraph 9 provides that the
standard does not prescribe the unit of equipment. Thus, judgment is required in
applying the recognition criteria to an entity's specific circumstances.
Paragraph 17, inter alia, states that the cost of an item of property, plant and equipment
comprise 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.
In the given case, railway siding, road and bridge are required to facilitate the
construction of the refinery and for its operations. Expenditure on these items is
required to be incurred in order to get future economic benefits from the project as a
whole which can be considered as the unit of measure for the purpose of capitalisation
of the said expenditure even though the company cannot restrict the access of others
for using the assets individually. It is apparent that the aforesaid expenditure is 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.
In view of this, even though ABC Ltd. may not be able to recognize expenditure
incurred on these assets as an individual item of property, plant and equipment in many
cases (where it cannot restrict others from using the asset), expenditure incurred may
be capitalized as a part of overall cost of the project. From this, it can be concluded
that, in the extant case the expenditure incurred on these assets, i.e., railway siding,
road and bridge, should be considered as the cost of constructing the refinery and
accordingly, expenditure incurred on these items should be allocated and capitalized
as part of the items of property, plant and equipment of the refinery.
Depreciation
As per paragraph 45 and 47 of AS 10, if these assets have a useful life which is different
from the useful life of the item of property, plant and equipment to which they relate,
it should be depreciated separately. However, if these assets have a useful life and the
depreciation method that are the same as the useful life and the depreciation method of
the item of property, plant and equipment to which they relate, these assets may be
grouped in determining the depreciation charge. Nevertheless, if it has been included
in the cost of property, plant and equipment as a directly attributable cost, it will be
depreciated over the useful lives of the said property, plant and equipment.
The useful lives of these assets should not exceed that of the asset to which it relates.
Presentation
These assets should be presented within the class of asset to which they relate.
Answer:
As per AS-10, each part of an item of Property Plant and Equipment that has a cost that
is significant when compared to the total cost of the item should be depreciated
separately. As it appears that imported asset of ` 1,000 lakhs, which is component of
plant and machinery, has significant cost as compared to the total cost. Therefore, it
should be depreciated separately. The company's policy to write off over two years is
correct.
How should ABC Ltd recognize the government grants in its books of accounts.
Answer
ABC Ltd. should recognise the grants in the following manner:
As per para 6.4 of AS 12, in certain circumstances, a government grant is awarded
for the purpose of giving immediate financial support to an enterprise rather than
as an incentive to undertake specific expenditure. Such grants may be confined to
an individual enterprise and may not be available to a whole class of enterprises.
These circumstances may warrant taking the grant.
To income in the period in which the enterprise qualifies to receive it, as an Prior
Period Items and Changes in Accounting Policies). Therefore, 20 lakhs has been
received for immediate start-up of business. This should be recognised in the
statement of Profit and Loss immediately as there are no conditions attached to the
grant.
As per para 9.1, 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.
50 lakhs should be recognised in profit or loss on a systematic basis over the
periods which the entity recognises as expense the related costs for which the
grants are intended to compensate provided that there is reasonable assurance that
ABC Ltd. will comply with the conditions attached to the grant.
As per para 7.1, 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. Accordingly, land should be
recognised at nominal value in the balance sheet.
The standard provides the option to treat the grant either as a deduction from the
gross value of the asset or to treat it as deferred income as per para 8.3 and 8.4 of
the standard. Under the first method, 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. Accordingly, the grant of 2 lakhs is
deducted from the cost of the machinery. Machinery will be recognised in the books
at ₹10 lakhs - ₹2 lakhs = 8 lakhs and depreciation will be charged on it as follows:
₹ 8 lakhs/5 years = 1.60 lakhs per year.
Under the second method, 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. Such allocation depreciation on related assets is
charged. Income is usually made over the periods and in the proportions in which
depreciation on related assets is charged.
₹2 lakhs should be recognised as deferred income and will be transferred to profit and
loss over the useful life of the asset. In this case, 40,000 [2 lakhs / 5 years] should be
credited to profit and loss each year over the period of 5 years.
Answer
There are two broad approaches which can be adopted for the accounting treatment of
Government grants. They are:
1. Capital approach; and
2. Income approach.