FUNDAMENTALS OF ACCOUNTING - CHAPTER 1

Sl. Number of the TITLE OF THE ACCOUNTING STANDARD No. Accounting Standard (AS) 23. AS 23 Accounting for Investments in Associates in Consolidated Financial Statements 24. AS 24 Discontinuing Operations 25. AS 25 Interim Financial Reporting 26. AS 26 Intangible Assets 27. AS 27 Financial Reporting of Interests in Joint Ventures 28. AS 28 Impairment of Assets 29 AS 29 Provisions, Contingent Liabilities & Contingent Assets 30. AS 30 Financial Instruments: Recognition & Measurement 31. AS 31 Financial Instruments: Presentation 32. AS 32 Financial Instruments: Disclosures A brief overview of the above mentioned accounting standards is given below: AS 1 Disclosure of Accounting Policies (Issued 1979) This Standard is related with presentation/disclosure requirements of the significant accounting policies (specific accounting policies and the methods of applying those principles) followed in preparing financial statements. The true and fair state of affairs and the financial results of an entity is significantly affected by the accounting policies followed in accounting. The areas in which different accounting policies can be followed are accounting for depreciation, revaluation of inventories, valuation of fixed assets etc. The disclosure of the significant accounting policies should form part of the financial statement and 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 the later periods should be disclosed. If any of the fundamental accounting assumptions viz. going concern, consistency and accrual is not followed in financial statements, the fact should be specifically disclosed. AS 2 Valuation of Inventories (Revised 1999) AS 2 is a measurement related standard and specifies the methods of computation of cost of inventories and the method of determination of the value of inventory to be shown in the financial statements. As per the standard, the cost of inventories should comprise costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Inventory is valued by following conservatism principle i.e., at lower of the cost or the market price. With a view to bring about uniformity in inventory valuation practices, the revised AS 2 drastically reduces the alternative choices. The revised standard permits the use of only FIFO or weighted average cost formula for determining the cost of inventories where the specific identification of cost of inventories is not possible. The standard also dispenses with the direct costing method and permits only the absorption costing method for arriving at the cost of finished goods. AS 3 Cash Flow Statements (Revised 1997) This 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 FUNDAMENTALS OF ACCOUNTING 1.51 Copyright -The Institute of Chartered Accountants of India ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS during the period into operating, investing and financing activities. The cash flow statement is an important part of financial statement and helps in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of future cash flows of different enterprises. The requirement of presentation of cash flow statement would force the management to strive to improve the actual cash flows rather than the profits, which is ultimate goal of any business entity. AS 4 Contingencies and Events occurring after the Balance Sheet date (Revised 1995) 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 dealing with contingencies stand withdrawn except to the extent they deal with impairment of assets not covered by any other Indian AS. The project of revision of this standard by ASB in the light of newly issued AS 29 is under progress. Thus, the present standard (AS 4) deals with the treatment and disclosure requirements in the financial statements of events occurring after the balance sheet. Events occurring after the balance sheet date are those significant events (favourable as well as unfavourable) that occur between the balance sheet date and the date on which financial statements are approved by the approving authority (i.e. board of directors in case of a company) of any entity. The concept of events occurring after the balance sheet date with their treatment and disclosure in the financial statements have been discussed in detail under Unit 8 of Chapter 5. AS 5 Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies (Revised 1997) This statement should be applied by an enterprise in presenting profit and loss from ordinary activities, extraordinary items and prior period items in the statement of profit and loss, in accounting for changes in accounting estimates, and disclosure of changes in accounting policies. As per AS 5, prior period items are income or expenses which arise in the current period as a result of errors or omissions in the preparation of financial statements of one or more prior periods. 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. The prior period and extraordinary items are required to be disclosed in the profit and loss statement as part of the net profit for the period with separate disclosure of the nature and amount to show its impact on current year’s profit or loss. AS 6 Depreciation Accounting (Revised 1994) This standard requires that the depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset and the depreciation method selected should be applied consistently from period to period. If there is a change in the method of providing depreciation, such a change should be treated as a change in accounting policy and its effect (deficiency or surplus arising from retrospective recomputation of depreciation as per new method) should be quantified and disclosed. In case any depreciable asset is disposed off, discarded or demolished, the net surplus/deficiency, if material, should be disclosed separately. The depreciation method used and depreciation rates are also required to be disclosed in the financial statements. 1.52 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India AS 7 Construction Contracts (Revised 2002) The standard prescribes the accounting treatment of revenue and costs associated with construction contracts by laying down the guidelines regarding allocation of contract revenue and contract costs to the accounting periods in which the construction work is performed, since the construction activity is generally contracted and completed in more than one accounting period. An enterprise is required to disclose the amount of recognised contract revenue with the methods used to determine that revenue and the methods applied in determining the stages of completion of contracts in progress. As per the standard, the gross amount due from and to customers for contract work are shown as asset and liability respectively. AS 8 Accounting for Research and Development This standard stands withdrawn w.e.f. 1st April, 2003 i.e. the date from which AS 26 on Intangible Assets becomes mandatory. AS 9 Revenue Recognition (Issued 1985) The standard deals with the basis for recognition of revenue arising in the course of ordinary activities, from the sale of goods; rendering of services; and income from interest, royalties and dividends in the profit and loss statement of an enterprise. According to the standard, 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, royalty and dividends. The revenue arising from construction contracts, hire purchase and lease agreements, government grants and subsidies and revenue of insurance companies from insurance contracts are outside the purview of AS 9. In addition to disclosures required by AS 1, AS 9 requires an enterprise to disclose the circumstances in which revenue recognition has been postponed pending the resolution of significant uncertainties. AS 10 Accounting for Fixed Assets (Issued 1985) The standard deals with the disclosure of the status of the fixed assets in terms of value. The standard does not take into consideration the specialised aspect of accounting for fixed assets reflected with the effects of price escalations but applies to financial statements on historical cost basis. It is important to note that from the date of AS 26 on Intangible Assets, becoming applicable, the relevant paragraphs of this standard (AS 10) dealing with patents and know- how have been withdrawn. An entity should disclose the following information relating to (i) the gross and net book values of fixed assets at beginning and end of an accounting period showing additions, disposals, acquisitions and other movements, (ii) expenditure incurred on account of fixed assets in the course of construction or acquisition, and (iii) revalued amounts substituted for historical costs of fixed assets with the method applied in computing the revalued amount in the financial statements: AS 11 Effects of Changes in Foreign Exchange Rates (Revised 2003, Applicable w.e.f. 1st April, 2004) An enterprise may carry on activities involving foreign exchange in two ways – by transacting in foreign currencies or by indulging in foreign operations. In order to include foreign currency FUNDAMENTALS OF ACCOUNTING 1.53 Copyright -The Institute of Chartered Accountants of India ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS transactions and foreign operations in the financial statements of an enterprise, transactions must be expressed in the enterprise’s reporting currency and the financial statements of foreign operations must be translated into the enterprise’s reporting currency. 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 recognize the financial effects of changes in exchange rates in the financial statements. The standard requires the enterprises to disclose (i) the amount of exchange differences included in the net profit or loss for the period (ii) the amount of exchange differences adjusted in the carrying amount of fixed assets, (iii) the amount of exchange differences in respect of forward exchange contracts to be recognised in the profit or loss in one or more subsequent accounting periods (over the life of the contract). AS 12 Accounting for Government Grants (Issued 1991) AS 12 deals with accounting for government grants 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, related to revenue, related to promoters’ contribution; treatment for refund of government grants etc. The enterprises are required to disclose (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 non-monetary grants of assets given either at a concessional rate or free of cost. AS 13 Accounting for Investments (Issued 1993) The statement deals with accounting for investments in the financial statements of enterprises and related disclosure requirements. The enterprises are required to disclose the current investments (realisable in nature and intended to be held for not more than one year from the date of its acquisition) and long terms investments (other than current investments) distinctly in their financial statements. An investment property should account for as long-term investments. The cost of investments should include all acquisition costs (including brokerage, fees and duties) and on disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to profit and loss statement. AS 14 Accounting for Amalgamations (Issued 1994) AS 14 deals with accounting for amalgamation and the treatment of any resultant goodwill or reserves and is directed principally to companies although some of its requirements also apply to financial statements of other enterprises. 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. 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. The standard also describes the disclosure requirements for both types of amalgamations in the first financial statements. AS 15 Employee Benefits (Revised 2005) The standard requires enterprises to recognise (i) a liability when an employee has provided services in exchange for employee benefits to be paid in future, and (ii) an expense when enterprise consumes the economic benefit arising from services provided by an employee in 1.54 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India exchange for employee benefits. Employee benefits can be classified under (i) short-term employee benefits (e.g. wages, salaries etc.), (ii) post-employment benefits (e.g. gratuity, pension etc.), (iii) long-term employee benefits (e.g. long-term leave, long-term disability benefits etc.), and (iv) termination benefits (e.g. VRS payments). The standard lays down recognition and measurement criteria and disclosure requirement for all the four types of employee benefits. AS 16 Borrowing Costs (Issued 2000) The standard prescribes the accounting treatment for borrowing costs (i.e. interest and other costs) incurred by an enterprise in connection with the borrowing of funds. This standard deals with the issues related to identification of asset which qualifies for capitalisation of interest, determination of the period for which interest can be capitalized and determination of the amount that can be capitalised. The amount of borrowing costs eligible for capitalisation should be determined in accordance with provisions of AS 16 and other borrowing costs (not eligible for capitalisation) should be recognised as expenses in the period in which they are incurred. AS 17 Segment Reporting (Issued 2000) This standard requires that the accounting information should be reported on segment basis. AS 17 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 information helps users of financial statements, to better understand the performance and assess the risks and returns of the enterprise and make more informed judgements about the enterprise as a whole. The standard is more relevant for assessing risks and returns of a diversified or multilocational enterprise which may not be determinable from the aggregated data. AS 18 Related Party Disclosures (Issued 2000) This standard prescribes the requirements for certain disclosures which must be made in the financial statements of reporting enterprise for 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. Since the standard is more subjective, particularly with respect to identification of related parties, obtaining corroborative evidence becomes very difficult for the auditors. Thus successful implementation of AS 18 is dependent upon how transparent the management is and how vigilant the auditors are. AS 19 Lease (Issued 2001) AS 19 prescribes the accounting and disclosure requirements for both finance leases and operating leases in the books of the lessor and lessee. The classification of leases adopted in this standard is based on the extent to which risks and rewards incident to ownership of a leased asset lie with the lessor and the lessee. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. An operating lease is a lease other than finance lease. At the inception of the lease, assets under finance lease are capitalised in the books of lessee with corresponding liability for lease obligations as against the operating lease, wherein lease payments are recognised as an expense in profit and loss account on a systematic basis (i.e. straight line) over the lease term without capitalizing the asset. The lessor should recognize receivable at an amount equal to net investment in the lease in case of finance FUNDAMENTALS OF ACCOUNTING 1.55 Copyright -The Institute of Chartered Accountants of India ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS lease, whereas under operating lease, the lessor will present the leased asset under fixed assets in his balance sheet besides recognizing the lease income on a systematic basis (i.e. straight line) over the lease term. The person (lessor/lessee) presenting the leased asset in his balance sheet should also consider the additional requirements of AS 6 and AS 10. AS 20 Earnings Per Share (Issued 2001) The objective of this standard is to describe principles for determination and presentation 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. 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. AS 21 Consolidated Financial Statements (Issued 2001) AS 21 deals with preparation and presentation of consolidated financial statements with an intention to provide information about the activities of group (parent company and companies under its control referred to as subsidiary companies). Consolidated financial statements are presented by a parent (holding company) to provide financial information about the economic activities of the group as a single economic entity. A parent which presents consolidated financial statements should present their statements in accordance with this standard but in its separate financial statements, investments in subsidiaries should be accounted as per AS 13. AS 22 Accounting for Taxes on Income (Issued 2001) AS 22 seeks to reconcile the taxes on income calculated as per the books of account with the actual taxes payable on the taxable income as per the provisions applicable to the entity for the time being in force. 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. AS 23 Accounting for Investments in Associates in Consolidated Financial Statements (Issued 2001) AS 23 describes the principles and procedures for recognising 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. AS 24 Discontinuing Operations (Issued 2002) The objective of this statement 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 capacities, and financial position by segregating information about discontinuing operations from information about continuing operations. This standard is applicable to all discontinuing operations, representing separate major line of business or geographical area of operations of an enterprise. 1.56 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India AS 25 Interim Financial Reporting (Issued 2002) An enterprise may be required or may elect to present information at interim dates as compared with its annual financial statements due to timeliness and cost considerations. 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 and others to understand an enterprise’s capacity to generate earnings and cash flows, its financial condition and liquidity. AS 26 Intangible Assets (Issued 2002) The standard prescribes the accounting treatment for intangible assets that are not dealt with specifically under other accounting standards, and requires an enterprise to recognise an intangible asset if, and only if, certain criteria are met. The standard specifies how to measure the carrying amount of intangible assets and requires certain disclosures about intangible assets. This standard should be applied by all enterprises in accounting intangible assets, except (a) intangible assets that are covered by another AS, (b) financial assets, (c) rights and expenditure on the exploration for or development of minerals, oil, natural gas and similar non-regenerative resources, (d) intangible assets arising in insurance enterprise from contracts with policyholders, (e) expenditure in respect of termination benefits. AS 27 Financial Reporting of Interests in Joint Ventures (Issued 2002) AS 27 set out principles and procedures for accounting of interests in joint venture and 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 standard deals with three broad types of joint ventures – jointly controlled operations, jointly controlled assets and jointly controlled entities. 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. AS 28 Impairment of Assets (Issued 2002) AS 28 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 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. This standard should be applied in accounting for impairment of all assets except inventories (AS 2), assets arising under construction contracts (AS 7), financial assets including investments covered under AS 13, and 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. FUNDAMENTALS OF ACCOUNTING 1.57 Copyright -The Institute of Chartered Accountants of India AACCCCOOUUNNTTIINNGG SSTTAANNDDAARRDDSS--CCOONNCCEEPPTTSS,, OOBBJJEECCTTIIVVEESS,, BBEENNEEFFIITTSS AS 29 Provisions, Contingent Liabilities and Contingent Assets (Issued 2003) The objective of AS 29 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. This standard applies in accounting for provisions and contingent liabilities and contingent assets resulting from financial instruments (not carried at fair value) and insurance enterprises (other than those arising from contracts with policyholders). The standard will not apply to provisions/liabilities resulting from executing controls and those covered under any other accounting standard. AS 30 Financial Instruments: Recognition and Measurement (Issued 2008) Accounting Standard 30 is issued by the Council of the Institute of Chartered Accountants of India, which comes into effect in respect of accounting periods commencing on or after 1.4.2009 and will be recommendatory in nature for an initial period of two years. This Accounting Standard will become mandatory in respect of accounting periods commencing on or after 1.4.2011 for all commercial, industrial and business entities except to a Small and Medium- sized Entity, as defined in the standard. The objective of this Standard is to establish principles for recognising and measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items. AS 31 Financial Instruments: Presentation (Issued 2008) Accounting Standard 31 is issued by the Council of the Institute of Chartered Accountants of India, which comes into effect in respect of accounting periods commencing on or after 1-4- 2009 and will be recommendatory in nature for an initial period of two years. This Accounting Standard will become mandatory in respect of accounting periods commencing on or after 1- 4-2011 for all commercial, industrial and business entities except to a small and medium-sized entity, as defined in the standard. The objective of this Standard is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. It applies to the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments; the classification of related interest, dividends, losses and gains; and the circumstances in which financial assets and financial liabilities should be offset. AS 32 Financial Instruments: Disclosures (Issued 2008) Accounting Standard 32 is issued by the Council of the Institute of Chartered Accountants of India, which comes into effect in respect of accounting periods commencing on or after 1-4- 2009 and will be recommendatory in nature for an initial period of two years. This Accounting Standard will become mandatory in respect of accounting periods commencing on or after 1- 4-2011 for all commercial, industrial and business entities except to a small and medium-sized entity, as defined in the standard. The objective of this Standard is to require entities to provide disclosures in their financial 1.58 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India statements that enable users to evaluate the significance of financial instruments for the entity’s financial position and performance and the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks. SELF EXAMINATION QUESTIONS I. Pick up the correct answer from the given choices: 1. (i) Accounting Standards in India are issued by (a) Central Govt. (b) State Govt. (c) Institute of Chartered Accountants of India. (d) Reserve Bank of india. (ii) Accounting Standards (a) Harmonise accounting policies. (b) Eliminate the non-comparability of financial statements. (c) Improve the reliability of financial statements. (d) All of the above. (iii) How many Accounting Standards have been issued by ICAI ? (a) 25. (b) 20. (c) 32. (d) 2. (iv) It is essential to standardize the accounting principles and policies in order to ensure (a) Transparency. (b) Consistency. (c) Comparability. (d) All of the above. (v) All of the following are limitations of Accounting Standards except (a) The choice between different alternative accounting treatments is difficult. (b) There may be trend towards rigidity. (c) Accounting Standards cannot override the statute. (d) All of the above. [Ans. 1. (i) (c), (ii) (d), (iii) (c), (iv) (d), (v) (d)] FUNDAMENTALS OF ACCOUNTING 1.59 Copyright -The Institute of Chartered Accountants of India ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS CHAPTER - 1 ACCOUNTING : AN INTRODUCTION Unit 4 Accounting Policies 1.60 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Learning Objectives After studying this unit, you will be able to: (cid:2) Understand the meaning of ‘Accounting Policies’. (cid:2) Familiarise with the situations under which selection from different accounting policies is required. (cid:2) Grasp the conditions where change in accounting policy can be made and the consequences arising from such changes. 1. MEANING Accounting Policies refer to specific accounting principles and methods of applying these principles adopted by the enterprise in the preparation and presentation of financial statements. Policies are based on various accounting concepts, principles and conventions that have already been explained in Unit 2 of Chapter 1. There is no single list of accounting policies, which are applicable to all enterprises in all circumstances. Enterprises operate in diverse and complex environmental situations and so they have to adopt various policies. The choice of specific accounting policy appropriate to the specific circumstances in which the enterprise is operating, calls for considerate judgement by the management. ICAI has been trying to reduce the number of acceptable accounting policies through Guidance Notes and Accounting Standards in its combined efforts with the government, other regulatory agencies and progressive managements. Already it has achieved some progress in this respect. The areas wherein different accounting policies are frequently encountered can be given as follows: (1) Methods of depreciation, depletion and amortisation; (2) Valuation of inventories; (3) Treatment of goodwill; (4) Valuation of investments; (5) Valuation of fixed assets. This list should not be taken as exhaustive but is only illustrative. As the course will progress, students will see the intricacies of the various accounting policies. Suppose an enterprise holds some investments in the form of shares of a company at the end of an accounting period. For valuation of shares, the enterprise may adopt FIFO, LIFO, average method etc. The method selected by that enterprise for valuation is called an accounting policy. Different enterprises may adopt different accounting policies. Likewise, different methods of providing depreciation on fixed assets, i.e. Straight line, written down, etc. are available to the business enterprises which will lead to different depreciation amounts. FUNDAMENTALS OF ACCOUNTING 1.61 Copyright -The Institute of Chartered Accountants of India ACCOUNTING POLICIES 2. SELECTION OF ACCOUNTING POLICIES Choice of accounting policy is an important policy decision which affects the performance measurement as well as financial position of the business entity. Selection of inappropriate accounting policy may lead to understatement or overstatement of performance and financial position. Thus, accounting policy should be selected with due care after considering its effect on the financial performance of the business enterprise from the angle of various users of accounts. It is believed that no unified an exhaustive list of accounting policies can be suggested which has universal application. Three major characteristics which should be considered for the purpose of selection and application of accounting policies. viz.,Prudence, Substance over form, and Materiality. All these three characteristics have already been explained in Unit 2 of Chapter 1. The financial statements should be prepared on the basis of such accounting policies, which exhibit true and fair view of state of affairs of Balance Sheet and the Profit & Loss Account. The basis for selecting accounting policies can be shown in the following chart as : Selection of Accounting Policies Based on Prudence Substance over Form Materiality Examples wherein selection from a set of accounting policies is made, can be given as follows:– 1. Inventories are valued at cost except for finished goods and by-products. Finished goods are valued at lower of cost or market value and by-products are valued at net realisable value. 2. Investments (long term) are valued at their acquisition cost. Provision for permanent diminution in value has been made wherever necessary. Sometimes a wrong or inappropriate treatment is adopted for items in Balance Sheet, or Profit & Loss Account, or other statement. Disclosure of the treatment adopted is necessary in any case, but disclosure cannot rectify a wrong or inappropriate treatment. 1.62 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India 3. CHANGE IN ACCOUNTING POLICIES A change in accounting policies should be made in the following conditions: (a) It is required by some statute or for compliance with an Accounting Standard. (b) Change would result in more appropriate presentation of financial statement. Change in accounting policy may have a material effect on the items of financial statements. For example, if depreciation method is changed from straight-line method to written-down value method, or if cost formula used for inventory valuation is changed from weighted average to FIFO, or if interest is capitalised which was earlier not in practice, or if proportionate amount of interest is changed to inventory which was earlier not the practice, all these may increase or decrease the net profit. Unless the effect of such change in accounting policy is quantified, the financial statements may not help the users of accounts. Therefore, it is necessary to quantify the effect of change on financial statement items like assets, liabilities, profit/loss. The examples in this regard may be given as follows: 1. Omega Enterprises revised its accounting policy relating to valuation of inventories to include applicable production overheads. The change has resulted in an increase in value of inventory and consequently profit before tax by Rs. 58.43 lakhs. 2. Alpha Enterprises changed the method of depreciation from straight-line method to written-down value method, with effect from 1.4.2005. The depreciation has been recomputed from the date of commissioning of these assets at WDV rates applicable to those years. Consequent to this there has been an additional charge for depreciation during the year of Rs. 350.12 crore due to said change which relates to the previous years and an equal amount has been withdrawn from the General Reserve and credited to Profit & Loss Account. Had there been no change in the method of depreciation, the charge for the year would have been lower by Rs. 95.42 crore excluding the charge relating to the previous years. Consequently, the Net Block of Fixed Assets and Reserves and Surplus are lower by Rs. 445.54 crore. SELF EXAMINATION QUESTIONS I. Pick up the correct answer from the given choices: (i) A change in accounting policy is justified (a) To comply with accounting standard. (b) To ensure more appropriate presentation of the financial statement of the enterprise. (c) To comply with law. (d) All of the above. (ii) Accounting policy for inventories of Xeta Enterprises states that inventories are valued at the lower of cost determined on weighted average basis or not realizable value. Which accounting principle in followed in adopting the above policy? (a) Materiality. FUNDAMENTALS OF ACCOUNTING 1.63 Copyright -The Institute of Chartered Accountants of India ACCOUNTING POLICIES (b) Prudence. (c) Substance over form. (d) All of the above. (iii) The areas wherein different accounting policies can be adopted are (a) Providing depreciation. (b) Valuation of inventories. (c) Valuation of investments. (d) All of the above. (iv) Selection of an inappropriate accounting policy decision may (a) Overstate the performance and financial position of a business entity. (b) Understate/overstate the performance and financial position of a business entity. (c) Overstate the performance a business entity. (d) Understate financial position a business entity. (v) Accounting policies refer to specific accounting (a) Principles. (b) Methods of applying those principles. (c) Both (a) and (b). (d) None of the above. [Ans. 1. (i) (d), (ii) (b), (iii) (d), (iv) (b), (v) (c)] 1.64 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India CHAPTER - 1 ACCOUNTING : AN INTRODUCTION Unit 5 Accounting as a Measurement Discipline - Valuation Principles, Accounting Estimates Copyright -The Institute of Chartered Accountants of India ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES Learning Objectives After going through this unit, you will be able to : (cid:2) Understand the meaning of measurement and its basic elements. (cid:2) Know how far accounting is a measurement discipline if considered from the standpoint of the basic elements of measurement. (cid:2) Distinguish measurement with valuation. (cid:2) Learn the different measurement bases namely historical cost, realisable value and present value. (cid:2) Understand the measurement bases which can give objective valuation to transactions and events. (cid:2) Understand that the traditional accounting system mostly uses historical cost as measurement base although in some cases other measurement bases are also used. 1. MEANING OF MEASUREMENT Measurement is vital aspect of accounting. Primarily transactions and events are measured in terms of money. Any measurement discipline deals with three basic elements of measurement viz., identification of objects and events to be measured, selection of standard or scale to be used, and evaluation of dimension of measurement standards or scale. Prof. R. J. Chambers defined ‘measurement’ as “assignment of numbers to objects and events according to rules specifying the property to be measured, the scale to be used and the dimension of the unit”. (R.J. Chambers, Accounting Evaluation and Economic Behaviour, Prentice Hall, Englewood Cliffs, N.J. 1966, P.10). Kohler defined measurement as the assignment of a system of ordinal or cardinal numbers to the results of a scheme of inquiry or apparatus of observations in accordance with logical or mathematical rules – [A Dictionary of Accountant]. Ordinal numbers, or ordinals, are numbers used to denote the position in an ordered sequence: first, second, third, fourth, etc., whereas a cardinal number says ‘how many there are’: one, two, three, four, etc. Chambers’ definition has been widely used to judge how far accounting can be treated as a measurement discipline. According to this definition, the three elements of measurement are: (1) Identification of objects and events to be measured; (2) Selection of standard or scale to be used; (3) Evaluation of dimension of measurement standard or scale. 1.66 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India Elements of Measurement Identification Selection of Evaluation of of Objects and Standards or Dimension of Events Scale Measurement Standards or Scale 2. OBJECTS OR EVENTS TO BE MEASURED We have earlier defined Accounting as the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by the users of the information. So accounting essentially includes measurement of ‘information’. Decision makers need past, present and future information. For external users, generally the past information is communicated. There is no uniform set of events and transactions in accounting which are required for decision making. For example, in cash management, various cash receipts and expenses are the necessary objects and events. Obviously the decision makers need past cash receipts and expenses data along with projected receipts and expenses. For giving loan to a business one needs information regarding the repayment ability (popularly called debt servicing) of principal and interest. This also includes past information, current state of affairs as well as future projections. It may be mentioned that past and present objects and events can be measured with some degree of accuracy but future events and objects are only predicted, not measured. Prediction is an essential part of accounting information. Decision makers have to take decisions about the unseen future for which they need suitable information. 3. STANDARD OR SCALE OF MEASUREMENT In accounting, money is the scale of measurement (see money measurement concept), although now-a-days quantitative information is also communicated along with monetary information. Money as a measurement scale has no universal denomination. It takes the shape of currency ruling in a country. For example, in India the scale of measurement is rupee, in the U.K. Pound- Sterling, in Germany Deutschmark (DM), in the United States Dollar and so on. Also there is no constant exchange relationship among the currencies. If one businessman in India took loan $5,000 from a businessman of the U.S.A., he would enter the transaction in his books in terms of rupees. Suppose at the time of loan agreement exchange rate was US $ = Rs. 50. Then loan amounted to Rs. 2,50,000. Afterwards the exchange rate has been changed to $ 1 = Rs. 55. At the changed exchange rate the loan amount becomes Rs. 2,75,000. So money as a unit of measurement lacks universal applicability across the boundary of a country unless a common currency is in vogue. Since the rate of exchange fluctuates between two currencies over the time, money as a measurement scale also becomes volatile. FUNDAMENTALS OF ACCOUNTING 1.67 Copyright -The Institute of Chartered Accountants of India ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES 4. DIMENSION OF MEASUREMENT SCALE An ideal measurement scale should be stable over time. For example, if one buys 1 kg. cabbage today, the quantity he receives will be the same if he will buy 1 kg. cabbage one year later. Similarly the length of 1 metre cloth will not change if it is bought a few days later. That is to say a measurement scale should be stable in dimension. Money as a scale of measurement is not stable. There occurs continuous change in the input output prices. The same quantity of money may not have the ability to buy same quantity of identical goods at different dates. Thus information of one year measured in money terms may not be comparable with that of another year. Suppose production and sales of a company in two different years are as follows: Year 1 Year 2 Qty Rs. Qty Rs. 5,000 pcs 5,00,000 4,500 pcs 5,40,000 Looking at the monetary figures one may be glad for 8% sales growth. In fact there was 10% production and sales decline. The growth envisaged through monetary figures is only due to price change. Let us suppose further that the cost of production for the above mentioned two years is as follows: Year 1 Year 2 Qty Rs. Qty Rs. 5,000 pcs 4,00,000 4,500 pcs 4,50,000 Take Gross profit = Sales – Cost of Production. Then in the first year profit was Rs. 1,00,000 while in the second year the profit was Rs. 90,000. There was 10% decline in gross profit. So money as a unit of measurement is not stable in the dimension. Thus Accounting measures information mostly in money terms which is not a stable scale having universal applicability and also not stable in dimension for comparison over the time. So it is not an exact measurement discipline. 5. ACCOUNTING AS A MEASUREMENT DISCIPLINE How do you measure a transaction or an event? Unless the measurement base is settled we cannot progress to the record keeping function of book-keeping. It has been explained that accounting is meant for generating information suitable for users’ judgments and decisions. But generation of such information is preceded by recording, classifying and summarising data. By that process it measures performance of the business entity by way of profit or loss and shows its financial position. Thus measurement is an important part of accounting discipline. But a set of theorems governs the whole measurement sub-system. These theorems should be carefully understood to know how the cogs of the ‘accounting-wheel’ work. Now-a-days accounting profession earmarked three theorems namely going concern, consistency and accrual as fundamental accounting assumptions, i.e. these assumptions are taken for granted. Also while measuring, classifying, summarising and also presenting, various policies are adopted. Recording, classifying summarising and communication of information are also important 1.68 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India part of accounting, which do not fall within the purview of measurement discipline. Therefore we cannot simply say that accounting is a measurement discipline. But in accounting money is the unit of measurement. So, let us take one thing for granted that all transactions and events are to be recorded in terms of money only. Quantitative information is also required in many cases but such information is only supplementary to monetary information. 6. VALUATION PRINCIPLES There are four generally accepted measurement bases or valuation principles. These are: (i) Historical Cost: It means acquisition price. For example, the businessman paid Rs. 7,00,000 Valuation Principles Historical Current Realisable Present Cost Cost Value Value to purchase the machine, its acquisition price including installation charges is Rs. 8,00,000. The historical cost of machine would be Rs. 7,00,000. According to this base, 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 some circumstances a liability is recorded at the amount of cash or cash equivalent expected to be paid to satisfy it in the normal course of business. When one Mr. X a businessman, takes Rs. 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 Rs. 5,00,000 - it is historical cost of the transactions. Take another case regarding payment of income tax liability. You know 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 some time later, which is technically called assessment year. Then how does he record this liability? As per historical cost base it is to be recorded at an amount expected to be paid to discharge the liability. (ii) Current Cost: Take that Mr. X purchased a machine on 1st January, 1995 at Rs. 7,00,000. As per historical cost base he has to record it at Rs. 7,00,000 i.e. the acquisition price. As on 1.1.2006, Mr. X found that it would cost Rs. 25,00,000 to purchase that machine. Take also that Mr. X took loan from a bank as on 1.1.95 Rs. 5,00,000 @ 18% p.a repayable at the end of 15th year together with interest. As on 1.1.2006 the bank announces 1% prepayment FUNDAMENTALS OF ACCOUNTING 1.69 Copyright -The Institute of Chartered Accountants of India ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES penalty on the loan amount if it is paid within 15 days starting from that day. As per historical cost the liability is recorded at Rs. 5,00,000 at the amount or proceeds received in exchange for obligation and asset is recorded at Rs. 7,00,000. Current cost gives an alternative measurement base. Assets are carried out 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. So as per current cost base, the machine value is Rs. 25,00,000 while the value of bank loan is Rs. 5,05,000. (iii) Realisable Value: Suppose Mr. X found that he can get Rs. 20,00,000 if he would sell the machine purchased, on 1.1.95 paying Rs. 7,00,000 and which would cost Rs. 25,00,000 in case he would buy it currently. Take also that Mr. X found that he had no money to pay off the bank loan of Rs. 5,00,000 currently. As per realisable value, assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the assets in an orderly disposal. Haphazard disposal may yield something less. Liabilities are carried at their settlement values; i.e. the undiscounted amount of cash or cash equivalents expressed to be paid to satisfy the liabilities in the normal course of business. So the machine should be recorded at Rs. 20,00,000 the realisable value in an orderly sale while the bank loan should be recorded at Rs. 5,00,000 the settlement value in the normal course of business. (iv) Present Value: Suppose we are talking as on 1.1.2003 - take it as time for reference. Now think the machine purchased by Mr. X on 1.1.93 can work for another 10 years and is supposed to generate cash @ Rs. 1,00,000 p.a. Also take that bank loan of Rs. 5,00,000 taken by Mr. X is to be repaid as on 31.12.2007. Annual interest is Rs. 90,000. As per present value, an asset is carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. The term ‘discount’, ‘cash inflow’ and ‘cash outflow’ need a little elaboration. Rs. 100 in hand as on 1.1.2003. is not equivalent to Rs. 100 in hand as on 31.12.2003. There is a time gap of one year. If Mr. X had Rs. 100 as on 1.1.03 he could use it at that time. If he received it only on 31.12.2003, he had to sacrifice his use for a year. The value of this sacrifice is called ‘time value of money’. Mr. X would sacrifice i.e. he would agree to take money on 31.12.2003 if he had been compensated for the sacrifice. So a rational man will never exchange Rs. 100 as on 1.1.2003 with Rs. 100 to be received on 31.12.2003 Then Rs. 100 of 1.1.2003 is not equivalent to Rs. 100 of 31.12.2003. To make the money receivable at a future date equal with the money of the present date it is to be devalued. Such devaluation is called discounting of future money. Perhaps you know the compound interest rule: A = P (1+ i)n 1.70 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India A = Amount P = Principal i = interest / 100 n = Time This equation gives the relationship between present money, principal and the future money amount. If A, i and n are given, to find out P, the equation is to be changed slightly. A P = (1+i)n Using the equation one can find out the present value if he knows the values of A, i and n. Suppose i = 20%, now what is the present value of Rs. 1,00,000 to be received as on 31.12.2003 (Take 1.1.2003 as the time of reference). 1,00,000 P = (1+.2)1 = Rs. 83,333 Similarly, Time of Receipt Money Value Present Value Rs. Rs. 31.12.2004 1,00,000 69,444 31.12.2005 1,00,000 57,870 31.12.2006 1,00,000 48,225 31.12.2007 1,00,000 40,188 31.12.2008 1,00,000 33,490 31.12.2009 1,00,000 27,908 31.12.2010 1,00,000 23,257 31.12.2011 1,00,000 19,381 31.12.2012 1,00,000 16,150 Total of all these present values is Rs. 4,19,246. Since the machine purchased by Mr. X will produce cash equivalent to Rs. 4,19,246 in terms of present value, it is to be valued at such amount as per present value measurement basis. Here, Mr. X will receive Rs. 1,00,000 at different points of time-these are cash inflows. In the other example, he has to pay interest and principal of bank loan-these are cash outflows. FUNDAMENTALS OF ACCOUNTING 1.71 Copyright -The Institute of Chartered Accountants of India ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES Perhaps you also know the annuity rule: Present value of an Annuity or Re. A for n periods is A = Annuity i = interest t = time 1, 2, 3, ..........n. 1 1− (1+i)n A× i Applying this rule one can derive the present value of Rs. 1,00,000 for 10 years @ 20% p.a. 1 1− (1+.2)10 1,00,000× = Rs. 4,19,246 .2 Similarly, the present value of bank loan is 1 1− (1+.2)5 5,00,000 90,000× + .2 (1+.2)5 = Rs. 2,69,155 + Rs. 2,00,939 = Rs. 4,70,094 Thus we get the four measurements Historical Current Realisable Present cost cost value value Rs. Rs. Rs. Rs. Asset: Machine 7,00,000 25,00,000 20,00,000 4,19,246 Liability: Bank Loan 5,00,000 4,50,000 5,00,000 4,70,094 The accounting system which we shall discuss in the remaining chapters is also called historical cost accounting. However, this need not mean that one shall follow only historical cost basis of accounting. In the later stages of the CA course, we shall see that the accounting system uses all types of measurement bases although under the traditional system most of the transactions and events are measured in terms of historical cost. 7. MEASUREMENT AND VALUATION Value relates to the benefits to be derived from objects, abilities or ideas. To the economist, value is the utility (i.e; satisfaction) of an economic resource to the person contemplating or enjoying its use. In accounting, to mean value of an object, abilities or ideas, a monetary 1.72 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India surrogate is used. That is to say, value is measured in terms of money. Suppose, an individual purchased a car paying Rs. 2,50,000. Its value lies in the satisfaction to be derived by that individual using the car in future. Economists often use ordinal scale to indicate the level of satisfaction. But accountants use only cardinal scales. If the value of car is taken as Rs. 2,50,000 it is only one type of value called acquisition cost or historical cost. So value is indicated by measurement. In accounting the value is always measured in terms of money. 8. ACCOUNTING ESTIMATES Earlier in this unit we have learned how to measure a transaction, which had already taken place and for which either some value/money has been paid or some valuation principles are to be adopted for their measurement. But there are certain items, which are not occurred therefore cannot be measured using valuation principles still they are necessary to record in the books of account. For example, provision for doubtful debts on debtors. For such items, we need some value. In such a situation reasonable estimates based on the existing situation and past experiences are made. The measurement of certain assets and liabilities is based on estimates of uncertain future events. As a result of the uncertainties inherent in business activities, many financial statement items cannot be measured with precision but can only be estimated. Therefore, the management makes various estimates and assumptions of assets, liabilities, incomes and expenses as on the date of preparation of financial statements. Such estimates are made in connection with the computation of depreciation, amortisation and impairment losses as well as, accruals, provisions and employee benefit obligations. Also estimates may be required in determining the bad debts, useful life and residual value of an item of plant and machinery and inventory obsolescence. The process of estimation involves judgements based on the latest information available. An estimate may require revision if changes occur regarding circumstances on which the estimate was based, or as a result of new information, more experience or subsequent developments. Change in accounting estimate means difference arises between certain parameters estimated earlier and re-estimated during the current period or actual result achieved during the current period. Few examples of situations wherein accounting estimates are needed can be given as follows: (1) A company incurs expenditure of Rs. 10,00,000 on development of patent. Now the company has to estimate that for how many years the patent would benefit the company. This estimation should be based on the latest information and logical judgement. (2) A company dealing in long-term construction contracts, uses percentage of completion method for recognizing the revenue at the end of the accounting year. Under this method the company has to make adequate provisions for unseen contingencies, which can take place while executing the remaining portion of the contract. Since provisioning for unseen contingencies requires estimation, there may be excess or short provisioning, which is to be adjusted in the period when it is recognised. (3) Company has to provide for taxes which is also based on estimation as there can be some interpretational differences on account of which tax authorities may either accept the expenditure or refuse it. This will ultimately lead to different tax liability. FUNDAMENTALS OF ACCOUNTING 1.73 Copyright -The Institute of Chartered Accountants of India ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES SELF EXAMINATION QUESTIONS Pick up the correct answer from the given choices: 1. (i) Measurement discipline deals with (a) Identification of objects and events. (b) Selection of scale. (c) Evaluation of dimension of measurement scale. (d) All of the above. (ii) All of the following are valuation principles except (a) Historical cost. (b) Present value. (c) Future value. (d) Realisable value. (iii) Book value of machinery on 31st March, 2010 10,00,000 Market value as on 31st March, 2006 11,00,000 As on 31st March, 2006, if the company values the machinery at Rs. 11,00,000, which of the following valuation principle is being followed? (a) Historical Cost. (b) Present Value. (c) Realisable Value. (d) Current Cost. 2. Mohan purchased a machinery amounting Rs. 10,00,000 on 1st April, 2000. On 31st March, 2010, similar machinery could be purchased for Rs. 20,00,000 but the realizable value of the machinery (purchased on 1.4.2000) was estimated at Rs. 15,00,000. The present discounted value of the future net cash inflows that the machinery was expected to generate in the normal course of business, was calculated as Rs. 12,00,000. (i) The current cost of the machinery is (a) Rs. 10,00,000. (b) Rs. 20,00,000. (c) Rs. 15,00,000. (d) Rs. 12,00,000. (ii) The present value of machinery is (a) Rs. 10,00,000. (b) Rs. 20,00,000. (c) Rs. 15,00,000. (d) Rs. 12,00,000. 1.74 COMMON PROFICIENCY TEST Copyright -The Institute of Chartered Accountants of India (iii) The historical cost of machinery is (a) Rs. 10,00,000. (b) Rs. 20,00,000. (c) Rs. 15,00,000. (d) Rs. 12,00,000. (iv) The realizable value of machinery is (a) Rs. 10,00,000. (b) Rs. 20,00,000. (c) Rs. 15,00,000. (d) Rs. 12,00,000. [Ans 1. (i) (d), (ii) (c), (iii) (c), 2. (i) (b), (ii) (d), (iii) (a), (iv) (c)] FUNDAMENTALS OF ACCOUNTING 1.75 Copyright -The Institute of Chartered Accountants of India