Study Material

INTEGRATED PROFESSIONAL COMPETENCE COURSE

ADVANCED ACCOUNTINGVol. I

The Institute of Chartered Accountants of India(Set up by an Act of Parliament) New Delhi

PAPER

5

ADVANCED ACCOUNTINGVOLUME I

BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

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

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIAAll rights reserved. No part of this book may be reproduced, stored in retrieval system, or transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior permission in writing from the publisher. Website E-mail Committee / Department ISBN No. Published by : : : www.icai.org bosnoida@icai.org Board of Studies

: : The Publication Department on behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100, Indraprastha Marg, New Delhi 110 002 Typeset and designed at Board of Studies.

Printed by

:

Sahitya Bhawan Publications, Hospital Road, Agra 282 003. January / 2010 / 0,000 Copies

FOREWORDThe Institute of Chartered Accountants of India, the second largest professional accountancy body in the world, occupies a pivotal position in the Indian economy. As compared to other leading professional accountancy bodies in the world, the Institute enjoys a unique position since it is endowed with the authority not only to conduct examinations and grant license to qualified members but it also imparts theoretical education through diverse methods such as provision of study material, conducting revisionary classes, etc. In fact, the Institute is a pioneer in imparting the education to students through distance education mode since its inception in 1949. Keeping in view the fact that the students of chartered accountancy course are dispersed geographically in the entire world, it is imminent that the Institute must make all efforts to retain its primacy in this particular area. While all out efforts are being made to leverage the technology for the benefit of students through e-learning, Shiksha Portal, etc. by the Institute, it must continue to serve students through comprehensive study material with the aim to inculcate the self-learning experience. In this direction, I am happy to note that the study material has been thoroughly revised and made user friendly by improving presentation, emphasis on significant issues, illustrations explaining the concept step by step, etc. The inclusion of practical case studies intends to make it more application-oriented and aims to enhance the knowledge of students in the practical environment. A separate Practice Manual shall also enable the students to practice the subject on their own. It is hoped that the revised study material would prove to be very useful for students and their reliance on other external sources shall go down considerably. I am confident that the provision of such education literature shall enable our potential chartered accountants to compete with the best in the world.

January, 2010 Mumbai

CA. Uttam Prakash Agarwal President

PREFACEWith the fast changing business dynamics, fierce competition, globalization, complicated laws and transactions, there is tremendous pressure on the Chartered Accountancy students to acquire knowledge not only to clear examinations but also to build strong foundation for future endeavours. To strengthen knowledge of students and further build confidence for examination, the Board of Studies has developed the new study material. The new study material is comprehensive enough so that the students dispersed not only within the country but in other parts of the world as well can learn, understand and assimilate the subject through self-learning process. With this avid objective, the study material has been divided in two volumes namely Volume I dealing with the conceptual theoretical framework in detail and Volume II comprising of practice manual. Volume I of the study material provides the basic concepts, theories and techniques relating to Advanced Accounting and aims to develop the students ability in understanding the different concepts and their application in the real life situations. The entire study material has been written in a simple language. A number of self-examination questions are given at the end of each chapter for practice by students. There are also a number of illustrations in each chapter to help students to have a better grasp of the subject. Certain special features have been added in the study material like charts, diagrams, and learning objectives to help the students in understanding the concepts in a simple manner. The significant changes that have taken place in the area of finance have also been incorporated. Volume II of the study material comprises the Practice Manual. It aims to provide guidance to the students in writing an answer in the examination. Basic concepts in the form of definitions, equations and formulae have been given before each chapter for a quick review. Students are expected to attempt the questions and then compare it with the actual answers. Exercises have also been given at the end of each topic for independent practice. It also contains a matrix showing the analysis of the past examinations. This matrix will help the students in getting an idea about the trend of questions being asked and relative weightage of each topic in the past examinations. The revised study material also contains tips for students to prepare for the examinations. We acknowledge the contributions made by CA. Parveen Kumar of M/s ASA & Associates, Delhi and his team including CA. Prateet Mittal, CA. Akriti Gomber and CA. Babita Rana towards the improvement of the study material. The concerned faculty members of Board of Studies Ms. Seema Gupta and Ms. Shilpa Agrawal have put in their best efforts in making this study material lucid and student-friendly.

30th January, 2010 New Delhi

CA. Jaydeep Narendra Shah Chairman, Board of Studies

A WORD ABOUT STUDY MATERIALThe study material has been divided into two parts, namely, Volume I dealing with conceptual theoretical framework; and Volume II comprising of practice manual. The Study Material has been designed having regard to the needs of home study and distance learning students in mind. The students are expected to cover the entire syllabus and also do practice on their own while going through the practice manual. Volume I of the study material deals with the conceptual theoretical framework in detail. The main features of Volume I are as under: The entire syllabus has been divided into nine chapters. In each chapter, learning objectives have been stated. The learning objectives would enable you to understand the sequence of various aspects dealt within the chapter before going into the details so that you know the direction of your studies. In each chapter, the topic has been covered in a step by step approach. The text has been explained, where appropriate, through illustrations and practical problems. You should go through the chapter carefully ensuring that you understand the topic and then can tackle the exercises. A question bank has been included after each chapter in Volume I as well as many questions for practice in Volume II.

Volume II of the Study Material comprises the Practice Manual. It aims to provide guidance as to the manner of writing an answer in the examination. Main features of Volume II are as under: Important Definition, equation and formulae have been given before each topic for quick recapitulation. Students are expected to attempt the questions and then compare it with the actual answers. Compilation of questions appearing during last twenty examinations. Exercises have been given at the end of each topic for independent practice.

STUDY TIPS AND EXAMINATION TECHNIQUEThe aim of this section is to provide general guidance as to how to study for your exams. The guidance given herein is supplementary to the manner of study followed by you and is intended to improve your existing technique, but aims to give ideas on how to improve your existing study techniques, as it is essential that you adopt methods and techniques with which you feel comfortable. Passing exams is partly a matter of intellectual ability, but however accomplished you are in that respect you can improve your chances significantly by the use of appropriate study and revision techniques. In this section we briefly outline some tips for effective study during the earlier stages. Know your Syllabus

Go through the syllabus carefully. Volume I has been divided in nine chapters/topics based on syllabus. Main topics are as under:Ch. No. 1 2 3 Unit 1 Unit 2 4 Unit 1 Unit 2 Unit 3 Unit 4 5 6 Topics Conceptual framework for presentation and preparation of financial statements Problems based on Accounting Standards Advanced issues in Partnership Accounts Dissolution of firms Amalgamation, conversion and sale of partnership firm Company Accounts ESOPs Underwriting of shares and debentures Redemption of Debentures Amalgamation and Reconstruction Financial Statements of Insurance companies Financial Statements of Banking Companies

7 8 9

Financial Statements of Electricity Supply Companies Departmental Accounts Accounting for Branches including Foreign Branch Accounts

Understand the linkages between chapters at macro-level. Make a study plan covering the entire syllabus and then decide how much time you can allocate to the subject on daily/weekly basis. Allocation of time must be done keeping in view your office commitments as well as social needs and personal hobbies. Maintain the time balance amongst various subjects such as purely descriptive type and numerical-based papers. Allocate time in such a manner that your interest is well sustained and you are able to score well in the final examination as well. Always assess your preparation periodically, say, on monthly basis. If necessary, revise your plan and allocate more time for the subject in which you feel deficient. Read, understand and assimilate each chapter. First of all, have an overview of the chapter to understand the broad contents and sequence of various sub-topics. Do the introspection while going through the chapter and ask various questions to yourself. Read each chapter slowly to ensure that you understand and assimilate the main concept. If need be, read once again with concentration and then try to attempt exercise at the end of the chapter or given in the Practice Manual. Recapitulate the main concept after going through each chapter by way of brief notes. Prepare notes in the manner you feel comfortable covering all key points. Use mnemonic form e.g. C V P denoting cost, valuation and price. One may use highlighter/underlining the significant points or writing down in the margin. The fact that how well you have understood the topic is your ability to attempt the questions given in the exercises as well as in the practice manual. Make a serious attempt at producing your own answers but at this stage do not be much concern

Plan your Study

Preparing Study Strategy

about attempting the questions in examination based conditions. In particular, at initial stages, it is more important to understand and absorb the material thoroughly rather than to observe the time limits that would apply in the actual examination conditions.

Always try to attempt the past year examination question paper under examination conditions. Revision of material should never be selective in any case. Because broad coverage of the syllabus is more important than preparing 2-3 chapters exhaustively. Read through the text along with notes carefully. Try to remember the definition and important formulae. Reach examination hall well in time. Plan your time so that equal time is awarded for each mark. Keep sometime for revision as well. Always attempt to do all questions. Remember that six average answers fetch more marks than five best answers. Therefore, it is important that you must finish each question within allocated time. Read the question carefully more than once before starting the answer to understand very clearly as to what is required by the paper-setter. Always be concise and write to the point and do not try to fill pages unnecessarily. In case a question is not clear, you may state your assumptions and then answer the question. While writing answers in respect of essay-type questions, try to make sub-readings so that it catches the examiners eye. In case of case-study, be very precise and write your conclusion in a clear manner. Reference to standards, guidance notes, section of various legislation, etc be done in a clear-cut manner. Revise your answers carefully underline important points before leaving the examination hall.

Examination Technique

Best of Reading and Luck !

SYLLABUSGROUP II PAPER 5: ADVANCED ACCOUNTING (One paper Three hours 100 Marks) Level of Knowledge: Working Knowledge Objectives: (a) To have an understanding of the conceptual framework for the preparation and presentation of financial statements, (b) To gain working knowledge of the professional standards and application of accounting principles to different practical situations, and (c) To gain the ability to solve advanced problems in the case of different entities. Contents : 1. Conceptual Framework for Preparation and Presentation of Financial 2. Accounting Standards Working knowledge of: AS 4 : AS 5 : Contingencies and Events occurring after the Balance Sheet Date Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies Statements

AS 11 : The Effects of Changes in Foreign Exchange Rates (Revised 2003) AS 12 : Accounting for Government Grants AS 16 : Borrowing Costs AS 19 : Leases AS 20 : Earnings Per Share AS 26 : Intangible Assets AS 29 : Provisions, Contingent Liabilities and Contingent Assets.

3. Advanced Issues in Partnership Accounts Dissolution of partnership firms including piecemeal distribution of assets; Amalgamation of partnership firms; Conversion into a company and Sale to a company. 4. Company Accounts (a) Accounting for employee stock option plan, Buy back of securities, Equity shares with differential rights, Underwriting of shares and debentures, Redemption of debentures Advanced problems for business acquisition, Amalgamation and reconstruction (excluding problems of amalgamation of inter-company holding) Accounting involved in liquidation of companies, Statement of Affairs (including deficiency/surplus accounts) and Iiquidators statement of account of the winding up. Financial Reporting of Insurance, Banking and Electricity Companies and legal and regulatory requirements thereof

(b) (c)

(d) 5.

Accounting for Special Transactions Departmental and branch accounts including foreign branches Note If either old Accounting Standards (ASs), Announcements and Limited Revisions to ASs are withdrawn or new ASs, Announcements and Limited Revisions to ASs are issued by the Institute of Chartered Accountants of India in place of existing ASs, Announcements and Limited Revisions to ASs, the syllabus will accordingly include/exclude such new developments in place of the existing ones with effect from the date to be notified by the Institute.

CONTENTSCHAPTER 1 : CONCEPTUAL FRAMEWORK FOR PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1. 2. Introduction .....................................................................................................1.1 Purpose of the framework ................................................................................1.2 Status and Scope of the Framework .................................................................1.3 Components of Financial Statements ...............................................................1.3 Objectives of Financial Statements...................................................................1.4 Fundamental Accounting Assumptions .............................................................1.5 Qualitative Characteristics ...............................................................................1.9 Elements of Financial Statements .................................................................. 1.10 Measurement of Elements of Financial Statements ......................................... 1.17 Capital Maintenance ...................................................................................... 1.21 Introduction .....................................................................................................2.1 Overview .........................................................................................................2.1

CHAPTER 2: ACCOUNTING STANDARDS

CHAPTER 3 : ADVANCED ISSUES IN PARTNERSHIP ACCOUNTS Unit 1 : Dissolution of Partnership Firms 1.1 1.2 1.3 1.4 1.5 1.6 1.7 Introduction .....................................................................................................3.1 Circumstances Leading to Dissolution of Partnership........................................3.1 Consequences of Dissolution ...........................................................................3.2 Closing of Partnership Books on Dissolution.....................................................3.4 Consequences of Insolvency of a Partner ....................................................... 3.11 Loss arising from Insolvency of a Partner ....................................................... 3.11 Piecemeal Payments...................................................................................... 3.25

Unit 2 : Amalgamation, Conversion and Sale of Partnership Firms 2.1 2.2 Unit 1 1.1 1.2 1.3 2.1 2.2 2.3 2.4 2.5 3.1 3.2 3.3 3.4 4.1 5.1 5.2 5.3 5.4 5.5 5.6 Employees stock option plan ............................................................................4.1 Buy-back of securities .................................................................................... 4.11 Equity shares with differential rights ............................................................... 4.16 Introduction ................................................................................................... 4.20 Provision in the Companies Act affecting underwriting .................................... 4.21 Determination of liability in respect of an underwriting contract ....................... 4.21 Determination of liability where only part of the issue has been underwritten........ 4.23 Firm underwriting ........................................................................................... 4.24 Introduction ................................................................................................... 4.35 Redemption of debentures ............................................................................. 4.36 Purchase of debentures in open market.......................................................... 4.38 Liability of the company to create security and debenture redemption reserve ........ 4.67 Advanced Problems ....................................................................................... 4.75 Statement of affairs...................................................................................... 4.121 Deficiency account....................................................................................... 4.122 Overriding preferential payments.................................................................. 4.123 Preferential creditors.................................................................................... 4.123 Liquidators final statement of account.......................................................... 4.138 B list contributories ...................................................................................... 4.139 Amalgamation of Partnership firms ................................................................. 3.42 Conversion of Partnership firm into a Company .............................................. 3.50

CHAPTER 4 : COMPANY ACCOUNTS

Unit 2 : Underwriting of shares and debentures

Unit 3 : Redemption of Debentures

Unit 4 : Amalgamation and Reconstruction Unit 5 : Liquidation of Companies

CHAPTER 5 : FINANCIAL STATEMENTS OF INSURANCE COMPANIES Unit 1 : Introduction to Insurance Business 1.1 1.2 1.3 1.4 1.5 1.6 1.7 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 3.1 3.2 3.3 3.4 3.5 Introduction .....................................................................................................5.1 Various types of insurance ...............................................................................5.2 Distinction between life insurance and other forms of insurance........................5.3 Important terms to be remembered...................................................................5.4 Various types of general insurance...................................................................5.6 Some relevant provisions of the Insurance Act, 1938 ...................................... 5.12 Insurance Regulatory and Development Authority Act, 1999 ........................... 5.14 Functional divisions and books of account maintained therein......................... 5.20 Claims provision at divisional offices .............................................................. 5.22 Claims paid.................................................................................................... 5.22 Co-insurance ................................................................................................. 5.23 Outstanding premium ..................................................................................... 5.24 Commission ................................................................................................... 5.24 Loans ............................................................................................................ 5.24 Investments ................................................................................................... 5.25 Unexpired risk reserve ................................................................................... 5.27 Re-insurance ................................................................................................. 5.28 Introduction ................................................................................................... 5.32 Structure of Schedules A and B...................................................................... 5.32 Financial statements ...................................................................................... 5.33 IRDA Regulations, 2002 ................................................................................. 5.33 Preparation of financial statements ................................................................ 5.94

Unit 2 : Accounting Technique of General Insurance Business

Unit 3 : Financial Statements of Insurance Companies

CHAPTER 6 : FINANCIAL STATEMENTS OF BANKING COMPANIES Unit 1 : Some relevant provisions of Banking Regulations Act, 1949 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 1.14 1.15 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 Meaning of banking..........................................................................................6.1 Prohibition of trading........................................................................................6.3 Disposal of non-banking assets ........................................................................6.3 Management ....................................................................................................6.3 Capital and reserve..........................................................................................6.4 Reserve funds..................................................................................................6.5 Restriction as to payment of dividend ...............................................................6.5 Cash reserve ...................................................................................................6.6 Licensing of banking companies .......................................................................6.6 Liquidity norms ................................................................................................6.7 Restriction on acquisition of shares in other company.......................................6.7 Restriction on loans and advances ...................................................................6.7 Prohibition of charge on unpaid capital and floating charge on assets ...............6.8 Unclaimed deposits..........................................................................................6.8 Accounts and audit ..........................................................................................6.8 Main characteristics of a banks book-keeping system .................................... 6.11 Principal books of accounts............................................................................ 6.12 Subsidiary books ........................................................................................... 6.12 Other subsidiary registers .............................................................................. 6.13 Departmental Journals ................................................................................... 6.14 Other memorandum books ............................................................................. 6.14 Statistical books............................................................................................. 6.16 Returns filed by banking companies ............................................................... 6.16 Forms of balance sheet and profit and loss account........................................ 6.17

Unit 2 : Books of Accounts, Returns and Forms of Financial Statements

2.10 2.11 3.1 3.2 3.3 3.4 3.5 3.6 4.1 4.2 4.3 4.4 4.5 5.1 5.2 5.3 5.4 5.5 6.1

Note Containing Guidelines of Reserve Bank of India For Compilation of Financial Statements ..................................................................................... 6.33 Disclosure of Accounting Policies ................................................................... 6.49 Capital framework of bank functioning in India ................................................ 6.54 Definition of Capital Funds ............................................................................. 6.54 Tier I and Tier II Capital for Indian Banks ....................................................... 6.55 Ratio of tier I and tier II capital ....................................................................... 6.56 Tier I and Tier II capital for foreign banks ....................................................... 6.56 Reporting for capital adequacy norms ............................................................ 6.64 Income recognition......................................................................................... 6.72 Classification of Bank advances on the basis of asset performance for determining loss provisions ............................................................................ 6.77 Provisions...................................................................................................... 6.80 Classification of investments .......................................................................... 6.87 Valuation of investments ................................................................................ 6.88 Functions of a commercial bank ..................................................................... 6.92 Discounting and collection of bills................................................................... 6.93 Acceptance and endorsement ........................................................................ 6.97 Statutory liquidity ratio ................................................................................. 6.102 Cash reserve ratio ....................................................................................... 6.102 Introduction ................................................................................................. 6.105

Unit 3 : Capital Adequacy Norms

Unit 4 : Income Recognition, Classification of Assets and Provisions

Unit 5 : Some Special Transactions of Banks

Unit 6 : Preparation of Financial Statements of Banks CHAPTER 7 : FINANCIAL STATEMENTS OF ELECTRICITY COMPNIES Unit 1 : Relevant Legal Provisions 1.1 Introduction .....................................................................................................7.1

1.2 1.3 1.4 1.5 1.6 1.7 1.8

Central electricity authority...............................................................................7.1 State electricity board ......................................................................................7.3 Generating companies .....................................................................................7.4 State electricity consultative council .................................................................7.5 Licensee and bulk licensee ..............................................................................7.6 Grid tariff .........................................................................................................7.6 Inter-state agreement.......................................................................................7.6

Unit 2 : Accounts and audit 2.1 2.2 2.3 2.4 2.5 2.6 Introduction .....................................................................................................7.9 General principles for boards finance ............................................................ 7.17 Annual financial statements ........................................................................... 7.17 Final accounts ............................................................................................... 7.18 Annual report and accounts of generating company ........................................ 7.19 Forms of accounts ......................................................................................... 7.19

Unit 3 : Accounting Terms relating to Electricity Companies and Final Accounts 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 Introduction ................................................................................................... 7.53 Depreciation .................................................................................................. 7.53 Reasonable Return ........................................................................................ 7.54 Disposal of surplus ........................................................................................ 7.57 Contingencies reserve ................................................................................... 7.65 Development reserve ..................................................................................... 7.65 Restrictions on dividend ................................................................................. 7.65 Annual accounts to shareholders.................................................................... 7.83

CHAPTER 8 : Departmental Accounts 1. 2. Introduction .....................................................................................................8.1 Basis of allocation of common expenditure among different departments ..........8.2

3. 4. 5.

Types of Departments ......................................................................................8.2 Inter-departmental transfers .............................................................................8.3 Advantages of Departmental Accounting ..........................................................8.3

CHAPTER 9 : Accounting for Branches Including Foreign Branches 1 2 3 4 5 6 7 8 9 10 11 Introduction .....................................................................................................9.1 Dependent branches ........................................................................................9.2 Methods of charging goods to branches ...........................................................9.2 Independent branches.................................................................................... 9.30 Adjustment and reconciliation of branch and head office accounts .................. 9.32 Incorporation of branch balance in head office books...................................... 9.35 Incomplete information in branch books.......................................................... 9.46 Foreign branches ........................................................................................... 9.53 Accounting for foreign branches ..................................................................... 9.53 Change in classification ................................................................................. 9.55 Techniques for foreign currency translation .................................................... 9.55 I.1 to I.22 II.1 to II.133 III.1 to III.7

Appendix I Appendix II Appendix III

CHAPTER 1

CONCEPTUAL FRAMEWORK FOR PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTSLearning ObjectivesAfter studying this chapter, you will be able to: Understand the meaning of Conceptual Framework for the Preparation and Presentation of Financial Statements. Significance of the Conceptual Framework for the Preparation and Presentation of Financial Statements.

1.1 INTRODUCTIONThe development of accounting standards or any other accounting guidelines need a foundation of underlying principles. The Accounting Standards Board of the ICAI has issued a framework which provides the fundamental basis for development of new standards as also for review of existing standards. The principal areas covered by the framework are as follows: (a) Components of financial statements (b) Objectives of financial statements I Assumptions underlying financial statements

(d) Qualitative characteristics of financial statements (e) Elements of financial statements (f) Criteria for recognition of an element in financial statements

(g) Principles of measurement of financial elements (h) Concepts of Capital and Capital Maintenance

Advanced Accounting

1.2 PURPOSE OF THE FRAMEWORKThe framework sets out the concepts underlying the preparation and presentation of generalpurpose financial statements prepared by enterprises for external users. The main purpose of the framework is: (i) o assist enterprises in preparation of their financial statements in compliance with the accounting standards and in dealing with the topics not yet covered by any accounting standard. Example Shares or other securities held as stock-in-trade by dealers of shares or securities are neither inventory nor investments. At present there is no accounting standard to cover valuation of shares or other securities held as stock-in-trade. However paragraph 37 of the conceptual framework requires exercise of prudence in preparation of financial statements. It is therefore advisable to value shares or other securities held as stock-in-trade as lower of cost and fair value, such the losses are anticipated but gains are not. (b) To assist ASB in its task of development and review of accounting standards. I To assist ASB in promoting harmonisation of regulations, accounting standards and procedures relating to the preparation and presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by accounting standards. T

Example Exchange losses arising on increase in foreign currency liability incurred for acquisition of fixed assets can (i) either be capitalised (ii) or be recognised as expense in the statement of profit and loss in the accounting period in which the loss is incurred. The accounting standards (Ass) permit the second alternative only. The reason appears to be that the paragraph 93 of the framework states that expenses are recognised in the statement of profit and loss when a decrease in future economic benefit related to decrease in an asset or an increase in liability has arisen that can be measured reliably. Also, as per paragraph 96 of the framework, an expense is recognised immediately in the statement of profit and loss when it produces no future economic benefits. The exchange losses increases the rupee payment required to settle the foreign currency liability but definitely does not increase the service potential of the asset. In view of this, the relevant accounting standard requires such exchange losses to be recognised as expense immediately.

1.2

Conceptual Framework for Preparation and Presentation of Financial Statements It may be noted that Schedule VI of Companies Act requires capitalisation of exchange losses arising on increase in foreign currency liability incurred for acquisition of fixed assets. The Institute has taken up the matter with the government, and amendment of Schedule VI is expected. (d) To assist auditors in forming an opinion as to whether financial statements conform to the accounting standards. (e) To assist the users in interpretation of financial statements. Example As per the framework, three assumptions underlying a financial statement are (a) Going Concern (b) Accrual basis of accounting (c) Consistency. Unless contrary is disclosed, a user may assume (ii) the enterprise has no plan of liquidation or significant curtailment of its activities (iii) he expenses and income recognised coincide with the concerned event, rather than with the time of cash payments or receipts and (iv) the enterprise did not change its accounting policies from those followed in previous accounting periods.

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

1.4 COMPONENTS OF FINANCIAL STATEMENTSA complete set of financial statements normally consists of a Balance Sheet, a Profit & Loss A/c and a Cash Flow Statement together with notes, statements and other explanatory materials that form integral parts of the financial statements.

1.3

Advanced Accounting The component parts of financial statements are interrelated because they reflect different aspects of same transactions or other events. Although each statement provides information that is different from each other, none in isolation is likely to serve any single purpose nor can any one provide all information needed by a user. The major information contents of different components of financial statements are as below: Balance Sheet portrays value of economic resources controlled by an enterprise and the way they are financed. Profit & Loss A/c presents the result of operations of an enterprise for an accounting period. Cash Flow Statement shows the way an enterprise has generated cash and the way they have been used in an accounting period. Notes and Schedules present supplementary information explaining different items of financial statements. They may include disclosures about the risks and uncertainties affecting the enterprise and such items as disclosure of accounting policies, segmental reports, report on operations in the process of discontinuation and do on.

1.5 OBJECTIVES OF FINANCIAL STATEMENTSThe framework identifies seven broad groups of users of financial statements, namely, (a) Investors (b) Employees I Lenders

(d) Suppliers and other trade creditors (e) Customers (f) Governments and their agencies (g) Public. Users of financial statements expect the statements to provide useful information needed to make economic decisions. The financial statements provide information to suit the common needs of most users. However, they cannot and do not intend to provide all information that may be needed, e.g. they do not provide non-financial data even if they may be relevant for making decisions. The financial statements also show the results of stewardship or accountability of the management in respect of resources entrusted to it.

1.4

Conceptual Framework for Preparation and Presentation of Financial Statements

1.6 FUNDAMENTAL ACCOUNTING ASSUMPTIONSThese are assumptions, the users of financial statements take for granted. As long as financial statements are prepared in accordance with these assumptions, no separate disclosure in financial statements would be necessary. There are three fundamental accounting assumptions: (i) (ii) (iii) Going Concern Consistency Accrual

If nothing has been written about the fundamental accounting assumption in the financial statements then it is assumed that they have already been followed in their preparation of financial statements. However, if any of the above mentioned fundamental accounting assumption is not followed then this fact should be specifically disclosed. Let us discuss these assumptions in detail. Going Concern The financial statements are normally prepared on the assumption that an enterprise will continue in operation in the foreseeable future and neither there is intention, nor there is need to materially curtail the scale of operations. Going concern assumption is not likely to be compatible with the intention or necessity to enter into a scheme of arrangement with the enterprises creditors or to liquidate in near future. Financial statements prepared on going concern basis recognise among other things the need for sufficient retention of profit to replace assets consumed in operation and for making adequate provision for settlement of its liabilities. If any financial statement is prepared on a different basis, e.g. when assets of an enterprise are stated at net realisable values in its financial statements, the basis used should be disclosed. Example Balance sheet of a trader on 31/03/07 is given below: Liabilities Capital Profit & Loss A/c 10% Loan Trade creditors Rs. 60,000 25,000 35,000 10,000 1,30,000 1.5 Assets Fixed Assets Stock Trade debtors Deferred costs Bank Rs. 65,000 30,000 20,000 10,000 5,000 1,30,000

Advanced Accounting Additional information (a) The remaining life of the fixed assets is 5 years. The use pattern of the asset is even. The net realisable value of fixed assets on 31/03/08 was Rs. 60,000. (b) The traders purchases and sales in 2007-08 amounted to Rs. 4 lakh and Rs. 4.5 lakh respectively. (c) The cost and net realisable value of stock at the end of 31/03/05 were Rs. 32,000 and Rs. 40,000 respectively. (d) Expenses for the year amounted to Rs. 14,900. (e) Deferred cost is amortised equally over 4 years (f) Closing debtors is Rs. 25,000, of which Rs. 2,000 is doubtful. Collection of another Rs. 4,000 depends on successful re-installation of certain product supplied to the customer.

(g) Closing trade creditors is Rs. 12,000, which is likely to be settled at 5% discount. (h) Balance of closing cash is Rs. 37,100. (i) There is an early repayment penalty for the loan Rs. 2,500.

The Profit and Loss Accounts and Balance Sheets of the trader are shown below in two cases (i) assuming going concern (ii) not assuming going concern. Profit & Loss A/c for the year ended 31/03/08 Case (i) Case (ii) Rs. To Opening Stock To Purchases To Expenses To Depreciation To Provision for doubtful debt To Deferred cost To Loan To Net Profit 30,000 4,00,000 14,900 13,000 2,000 2,500 19,600 4,82,000 Rs. 30,000 4,00,000 14,900 5,000 6,000 10,000 2,500 22,200 4,90,600 4,82,000 4,90,600 By Sales By Closing Stock By Creditors Case (i) Rs. 32,000 Case (ii) Rs. 40,000 600

4,50,000 4,50,000

1.6

Conceptual Framework for Preparation and Presentation of Financial Statements Balance Sheet as at 31/03/08 Liabilities Capital Profit A/c & Loss Case (i) Rs. 60,000 44,600 35,000 12,000 1,51,600 Consistency The principle of consistency refers to the practice of using same accounting policies for similar transactions in all accounting periods. The consistency improves comparability of financial statements through time. An accounting policy can be changed if the change is required (i) by a statute (ii) by an accounting standard (iii) for more appropriate presentation of financial statements. Accrual basis of accounting Under this basis of accounting, transactions are recognised as soon as they occur, whether or not cash or cash equivalent is actually received or paid. Accrual basis ensures better matching between revenue and cost and profit/loss obtained on this basis reflects activities of the enterprise during an accounting period, rather than cash flows generated by it. While accrual basis is a more logical approach to profit determination than the cash basis of accounting. It exposes an enterprise to the risk of recognising an income before actual receipt. The accrual basis can therefore overstate the divisible profits and dividend decisions based on such overstated profit lead to erosion of capital. For this reason, accounting standards require that no revenue should be recognised unless the amount of consideration and actual realisation of the consideration is reasonably certain. Despite the possibility of distribution of profit not actually earned, accrual basis of accounting is generally followed because of its logical superiority over cash basis of accounting as illustrated below. Case (ii) Rs. 60,000 47,200 37,500 11,400 1,56,100 Assets Fixed Assets Stock Trade debtors provision) Deferred costs Bank (Less 23,000 7,500 37,100 1,51,600 19,000 Nil 37,100 1,56,100 Case (i) Rs. 52,000 32,000 Case (ii) Rs. 60,000 40,000

10% Loan Trade creditors

1.7

Advanced Accounting Section 209(3)(b) of the Companies Act makes it mandatory for companies to maintain accounts on accrual basis only. It is not necessary to expressly state that accrual basis of accounting has been followed in preparation of a financial statement. In case, any income/expense is recognised on cash basis, the fact should be stated. Example (a) A trader purchased article A on credit in period 1 for Rs. 50,000 (b) He also purchased article B in period 1 for Rs. 2,000 cash (c) The trader sold article A in period 1 for Rs. 60,000 in cash (d) He also sold article B in period 1 for Rs. 2,500 on credit Profit & Loss A/c of the trader by two basis of accounting are shown below. A look at the cash basis Profit & Loss A/c will convince any reader of the irrationality of cash basis of accounting. Cash basis of accounting Recognised cash purchase of article B and cash sale of article A in period 1 Recognised purchase of article A on payment and sale of article B on receipt in period 2 Profit & Loss A/c Rs. Period 1 To Purchase To Net Profit 2,000 58,000 60,000 Period 2 To Purchase 50,000 Period 2 By Sale By Net Loss 50,000 Accrual basis of accounting: Recognised credit purchase of article A and cash purchase of article B in period 1 Recognised cash sale of article A and credit sale of article B in period 1 60,000 2,500 47,500 50,000 Period 1 By Sale Rs. 60,000

1.8

Conceptual Framework for Preparation and Presentation of Financial Statements Profit & Loss A/c Rs. Period 1 To Purchase To Net Profit 52,000 10,500 62,500 62,500 Period 1 By Sale Rs. 62,500

1.7 QUALITATIVE CHARACTERISTICSThe qualitative characteristics are attributes that improve the usefulness of information provided in financial statements. The framework suggests that the financial statements should observe and maintain the following five qualitative characteristics as far as possible within limits of reasonable cost/ benefit. 1. 2. 3. 4. 5. 1. Understandability Relevance Reliability Comparability True & Fair View Understandability : The financial statements should present information in a manner as to be readily understandable by the users with reasonable knowledge of business and economic activities. It is not right to think that more one discloses better it is. A mass of irrelevant information creates confusion and can be even more harmful than non-disclosure. No relevant information can be however withheld on the grounds of complexity. Relevance: The financial statements should contain relevant information only. Information, which is likely to influence the economic decisions by the users, is said to be relevant. Such information may help the users to evaluate past, present or future events or may help in confirming or correcting past evaluations. The relevance of a piece of information should be judged by its materiality. A piece of information is said to be material if its omission or misstatement can influence economic decisions of a user. Reliability : To be useful, the information must be reliable; that is to say, they must be free from material error and bias. The information provided are not likely to be reliable unless: (a) Transactions and events reported are faithfully represented.

2.

3.

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Advanced Accounting (b) Transactions and events are reported in terms of their substance and economic reality not merely on the basis of their legal form. This principle is called the principle of 'substance over form'. (c) The reporting of transactions and events are neutral, i.e. free from bias. (d) Prudence is exercised in reporting uncertain outcome of transactions or events. 4. Comparability :Comparison of financial statements is one of the most frequently used and most effective tools of financial analysis. The financial statements should permit both inter-firm and intra-firm comparison. One essential requirement of comparability is disclosure of financial effect of change in accounting policies. True and Fair View :Financial statements are required to show a true and fair view of the performance, financial position and cash flows of an enterprise. The conceptual framework does not deal directly with this concept of true and fair view, yet the application of the principal qualitative characteristics and of appropriate accounting standards normally results in financial statements portraying true and fair view of information about an enterprise.

5.

1.8 ELEMENTS OF FINANCIAL STATEMENTSThe framework classifies items of financial statements in five broad groups depending on their economic characteristics. These five financial elements are:i. ii. iii. iv. v. Assets, Liabilities, Equity Income/gains and Expenses/ losses.

Paragraph 49 of the framework defines assets, liabilities and equity. Paragraph 69 of the framework defines income and expenses. Gains and losses differ from income and expenses in the sense that they do not arise in the ordinary course of business. Except for the way they arise, economic characteristics of gains are same as income and those of losses are same as expenses. For these reasons, gains and losses are not recognised as separate elements of financial statements. An item of financial element, (asset, liability, equity, expense or income) is recognised in financial statements if both the following criteria are met: 1.10

Conceptual Framework for Preparation and Presentation of Financial Statements (a) It is probable that any future economic benefit associated with the item will flow to or from the enterprise. Concept of probability is used to ascertain the degree of uncertainty associated with the flow of economic benefits, and (b) It has a cost or value that can be measured reliably. In assessing whether an item of financial element meets the recognition criteria regard should be given to the materiality consideration. An item is material if misstatement or omission of the item can influence economic decision of the user. For example, an expense even if small, should be recognised if it is not tax-deductible, because one of the users of the financial statements is the taxation authority. The recognition criteria of financial elements are inter-related. For example recognition of an asset implies that corresponding liability, income or equity should also be recognised. In other words, recognition is possible only when both of the related financial elements satisfy the specified recognition criteria. For example, in case of credit sale, the income (i.e. Sales) and asset (i.e. Debtors) can be recognised if on the basis of evidence available on balance sheet date, it is probable that the customer shall not return the goods and cash shall actually be realised. The failure to recognise an item of financial element that meets the above criteria, is not rectified by disclosure of accounting policies used nor by notes or explanatory material. 1.8.1 Assets : An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise. The readers may note the following points. (a) The resource regarded as asset, need not have a physical substance. The resource may represent a right generating future economic benefit, e.g. patents, copyrights, debtors and bills receivable. An asset without physical substance can be either intangible asset, e.g. patents and copyrights or monetary assets, e.g. debtors and bills receivable. The monetary assets are money held assets to be received fixed or determinable amounts of money. An asset is a resource controlled by the enterprise. This means it is possible to recognise a resource not owned but controlled by the enterprise as an asset. Such is the case of financial lease, where lessee recognises the asset taken on lease, even if ownership lies with the lessor. Likewise, the lessor do not recognise the asset given on finance lease as asset in his books, because despite of ownership, he does not control the asset.

(b)

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Advanced Accounting (c) A resource cannot be recognised as an asset if the control is not sufficient. For this reason specific management or technical talent of an employee cannot be recognised because of insufficient control. When the control over a resource is protected by a legal right, e.g. copyright, the resource can be recognised as an asset. To be considered as asset, it must be probable that the resource generates future economic benefit. If the economic benefit from a resource is expected to expire within the current accounting period, it is not an asset. For example, economic benefit, i.e. profit on sale, from machinery purchased by a machinery dealer is expected to expire within the current accounting period. Such purchases of machinery is therefore booked as expense (Purchase A/c) rather than Machinery A/c. However, if the articles purchased by a dealer remains unsold at the end of accounting period, the unsold items are recognised as asset, i.e. closing stock, because the sale of the article and resultant economic benefit, i.e. profit is expected to be earned in the next accounting period. To considered as asset, the resource must have a cost or value that can be measured reliably. When flow of economic benefit to the enterprise beyond the current accounting period is considered improbable, the expenditure incurred is recognised as expense rather than as asset.

(d)

(e) (f)

1.8.2 Liabilities : A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow of a resource embodying economic benefits. The following points may be noted: (a) A liability is a present obligation, i.e. an obligation the existence of which, based on the evidence available on the balance sheet date is considered more probable than not. For example, an enterprise may have to pay compensation if it loses a damage suit filed against it. The damage suit is pending on the balance sheet date. The enterprise should recognise a liability for damages payable by a charge against profit if possibility of losing the suit is reasonably certain and if the amount of damages payable can be ascertained with reasonable accuracy. The enterprise should create a provision for damages payable by charge against profit, if possibility of losing the suit is more than not losing it and if the amount of damages payable cannot be ascertained with reasonable accuracy. In other cases, the company reports the damages payable as contingent liability, which does not meet the definition of liability. AS 29 defines, that a provision is a liability, which can be measured only by using a substantial degree of estimation. A provision created under AS 29 is therefore a type of liability. It may be noted that certain provisions, e.g. provisions for doubtful debts, provisions for depreciation and provisions for impairment losses, represent diminution in value of 1.12

(b)

Conceptual Framework for Preparation and Presentation of Financial Statements assets rather than obligations. These provisions are outside the scope of AS 29 and hence should not be considered as liability. (c) A liability is recognised when outflow of economic resources in settlement of a present obligation can be anticipated and the value of outflow can be reliably measured. Obligations under contracts equally unperformed (for example obligations against inventory ordered but not received) are not usually recognised as liabilities. If in some circumstances such an obligation is recognised as liability, the related asset / expense should also be recognised.

Example A company has entered into a binding agreement with P Ltd. to buy a custom-made for Rs. 40,000. At the end of 2004-05, before delivery of the machine, the company had to change its method of production. The new method will not require the machine ordered and shall be scrapped after delivery. The expected scrap value is nil. A liability is recognised when outflow of economic resources in settlement of a present obligation can be anticipated and the value of outflow can be reliably measured. The company should recognise a liability of Rs. 40,000 to P Ltd. When flow of economic benefit to the enterprise beyond the current accounting period is considered improbable, the expenditure incurred is recognised as expense rather than as asset. In the present case, flow of future economic benefit from the machine to the enterprise is improbable. The entire amount of purchase price of the machine should be recognised as expense. The accounting entry is suggested below: Rs. Loss due to Change in Production Method To P Ltd. 40,000 40,000 Rs.

1.8.3 Equity : Equity is defined as residual interest in the assets of an enterprise after deducting all its liabilities. It is important to avoid mixing up liabilities with equity. Equity is the excess of aggregate assets of an enterprise over its aggregate liabilities. In other words, equity represents owners claim consisting of items like capitals and reserves, which are clearly distinct from liabilities, which are claims of parties other than owners. The value of equity may change either through contribution from / distribution to equity participants or due to income earned /expenses incurred. The definition of income and expense makes use of this fact.

1.13

Advanced Accounting 1.8.4 Income: Income is increase in economic benefits during the accounting period in the form of inflows or enhancement of assets or decreases of liabilities that result in increases in equity other than those relating to contributions from equity participants. The definition of income encompasses revenue and gains. Revenue is an income that arises in the ordinary course of activities of the enterprise, e.g. sales by a trader. Gains are income, which may or may not arise in the ordinary course of activity of the enterprise, e.g. profit on disposal of fixed assets. Gains are shown as a separate line item in the statement of income because knowledge of them is useful in assessing performance of the enterprise. Income earned is always associated with either increase of asset or reduction of liability. This means, no income can be recognised unless the corresponding increase of asset or decrease of liability can be recognised by application of the recognition criteria stated above. Example Balance sheet of an enterprise can be written in form of: A L = E. Where: A = Aggregate value of asset B = Aggregate value of liabilities C = Aggregate value of equity Suppose at the beginning of an accounting period, aggregate values of assets, liabilities and equity of a trader are Rs. 5 lakh, Rs. 2 lakh and Rs. 3 lakh respectively. Also suppose that the trader had the following transactions during the accounting period. (a) Introduced capital Rs. 20,000 (b) Earned income from investment Rs. 8,000 (c) A liability of Rs. 31,000 was finally settled on payment of Rs. 30,000. Balance sheets of the trader after each transaction are shown below: Transactions Opening (a) Capital introduced (b) Income from investments (c) Settlement of liability Assets Rs. lakh 5.00 5.20 5.28 4.98 Liabilities Rs. lakh 2.00 2.00 2.00 1.69 = = = = = Equity Rs. lakh 3.00 3.20 3.28 3.29

1.14

Conceptual Framework for Preparation and Presentation of Financial Statements The example given above explains the definition of income. The equity increased by Rs. 29,000 during the accounting period, due to (i) Capital introduction Rs. 20,000 and (ii) Income earned Rs. 9,000 (Income from investment + Discount earned). Incomes are therefore increases in equity without introduction of capital. Also note that income earned is accompanied by either increase of asset (Cash received as investment income) or by decrease of liability (Discount earned). Example A bank does not recognise interest earned on non-performing assets because the corresponding asset (increase in advances) cannot be recognised, as flow of economic benefit to the bank beyond current accounting period is not probable. 1.8.5 Expense : Paragraph 69(b) of the conceptual framework defines expense as decrease in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decrease in equity other than those relating to distributions to equity participants. The definition of expenses encompasses expenses that arise in the ordinary course of activities of the enterprise, e.g. wages paid, the losses may or may not arise in the ordinary course of activity of the enterprise, e.g. loss on disposal of fixed assets. Losses are shown as a separate line item in the statement of income because knowledge of them is useful in assessing performance of the enterprise. Expenses are always incurred simultaneously with either reduction of asset or increase of liability. Thus, expenses are recognised when the corresponding decrease of asset or increase of liability are recognised by application of the recognition criteria stated above. Expenses are recognised in Profit & Loss A/c by matching them with the revenue generated. However, application of matching concept should not result in recognition of an item as asset (or liability), which does not meet the definition of asset or liability as the case may be. Where economic benefits are expected to arise over several accounting periods, expenses are recognised in the Profit & Loss A/c on the basis of systematic and rational allocation procedures. The obvious example is that of depreciation. An expense is recognised immediately in the Profit & Loss A/c when it does not meet or ceases to meet the definition of asset or when no future economic benefit is expected. An expense is also recognised in the Profit & Loss A/c when a liability is incurred without recognition of an asset, as is the case when a liability under a product warranty arises. Example Continuing with the same example given under para 1.8.4, suppose the trader had the following further transactions during the period:

1.15

Advanced Accounting (a) Wages paid Rs. 2,000. (b) Rent outstanding Rs. 1,000 (c) Drawings Rs. 4,000. Balance sheets of the trader after each transaction are shown below: Transactions Opening (a) Capital introduced (b) Income from investments (c) Settlement of liability (d) Wages paid (e) Rent Outstanding (f) Drawings Assets Rs. lakh 5.00 5.20 5.25 4.95 4.93 4.93 4.89 Liabilities Rs. Lakh 2.00 2.00 2.00 1.69 1.69 1.70 1.70 = = = = = = = = Equity Rs. lakh 3.00 3.20 3.25 3.26 3.24 3.23 3.19

The example given above explains the definition of expense. The equity decreased by Rs. 7,000 from Rs. 3.26 lakh to Rs. 3.19 lakh due to (i) Drawings Rs. 4,000 and (ii) expenses incurred Rs. 3,000 (Wages paid + Rent). Expenses are therefore decreases in equity without drawings. Also note that expenses incurred is accompanied by either decrease of asset (Cash paid for wages) or by increase in liability (Rent outstanding). Note: The points discussed above leads us to the following relationships: Let us take: Closing equity = CE = Closing Assets (CA) Closing Liabilities (CL) Opening Equity = OE = Opening Assets (OA) Opening Liabilities (OL) Capital Introduced = C Drawings = D Income = I Expenses = E CE = OE + C + (I E) D Or CE = OE + C + Profit D 1.16

Conceptual Framework for Preparation and Presentation of Financial Statements Or Or Profit = CE OE C + D Profit = (CA CL) (OA OL) C + D

From above one can clearly see that profit depends on values of assets and liabilities. Since historical costs are mostly used for valuation, the reported profits are mostly based on historical cost conventions. The framework recognises other methods of valuation of assets and liabilities. The point to note that reported figures of profit change with the changes in the valuation basis. Conceptually, this is the foundation of idea of Capital Maintenance.

1.9 MEASUREMENT OF ELEMENTS OF FINANCIAL STATEMENTSMeasurement is the process of determining money value at which an element can be recognised in the balance sheet or statement of profit and loss. The framework recognises four alternative measurement bases for the purpose. These bases relate explicitly to the valuation of assets and liabilities. The valuation of income or expenses, i.e. profit is implied, by the value of change in assets and liabilities. (i) Historical Cost

(ii) Current Cost (iii) Realisable (Settlement) Value and (iv) Present Value. In preparation of financial statements, all or any of the above can be used in varying combinations to assign money values to financial items. A brief explanation of each follows. 1.9.1 Historical Cost : Historical cost means acquisition price. For example, the businessman paid Rs. 7,00,000 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%.

1.17

Advanced Accounting 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. Historical cost of an asset is cash or cash equivalent paid or fair value of other consideration given at the time acquisition of the asset. By historical cost convention liabilities are recorded the amount of proceeds received in exchange of the obligation or in some cases (for example liability for income tax) the amount that is likely to be paid for settlement of liability in the normal course of business. Example A machine was acquired in exchange of an old car and Rs. 20,000 paid in cash. The carrying amount of the car was Rs. 1,75,000. The fair value of the car on the date of exchange was Rs. 1,50,000. The accounting entry to record the exchange is suggested below: Rs. Machinery Loss on disposal of Car To Car 1,70,000 25,000 1,75,000 Rs. Rs. 1,50,000 + Rs. 20,000 Rs. 1,75,000 Rs. 1,50,000 Carrying amount

To Bank 20,000 Historical cost of the machine = Fair value of car given on exchange + Cash paid 1.9.2 Current Cost : 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. 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 15 th year together with interest. As on 1.1.2006 the bank announces 1% prepayment 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. 1.18

Conceptual Framework for Preparation and Presentation of Financial Statements Example A machine was acquired for $ 10,000 on deferred payment basis. The rate of exchange on the date of acquisition was Rs. 49/$. The payments are to be made in 5 equal annual instalments together with 10% interest per year. The current market value of similar machine in India is Rs. 5 lakh. Rs. Machinery To Deferred Payment Obligation To Revaluation Reserves (Note 1) Current cost of the machine = Current market price = Rs. 5,00,000. By historical cost convention, the machine would have been recorded at Rs. 4,90,000. To settle the deferred payment on current date one must buy dollars at Rs. 49/$. The liability is therefore recognised at Rs. 4,90,000 ($ 10,000 Rs. 49). Note that the amount of liability recognised is not the present value of future payments. This is because, in current cost convention, liabilities are recognised at undiscounted amount. Note 1: Paragraph 80 of the conceptual framework provides that revaluation or restatement of assets and liabilities gives rise to increases or decreases in equity. While these increases or decreases meet the definition of income and expenses, they are not included in the Profit & Loss A/c under certain concepts of capital maintenance. Instead these items are included in equity as capital maintenance adjustments or revaluation reserves. 1.9.3 Realisable (Settlement) Value: For assets, this is the amount currently realisable on sale of the asset in an orderly disposal. For liabilities, this is the undiscounted amount expected to be paid on settlement of liability in the normal course of business. 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. 1.9.4 Present Value : Present value of an amount A, after n years is the amount P, one has to invest on current date to have A after n years. If the rate if interest is R: A = P(1 + R)n 5,00,000 4,90,000 10,000 Rs.

1.19

Advanced AccountingA 1 = A n (1 + R ) (1 + R )n

Or P (Present value of A after n years) =

The process of obtaining present value of future cash flow is called discounting. The rate of interest used for discounting is called the discounting rate. The expression [1/(1+R) n], called discounting factor depends on values of R and n. Let us take a numerical example assuming interest 10%, A = Rs. 11,000 and n = 1 year 11,000 = 10,000(1 + 0.1)1 Or Present value of Rs. 11,000 after 1 year =11,000 1 = 11,000 1 (1,10) (1.10)1

Or Present value of Rs. 11,000 after 1 year = 11,000 0.909 = Rs. 10,000 Note that a receipt of Rs. 10,000 (present value) now is equivalent of a receipt of Rs. 11,000 (future cash inflow) after 1 year, because if one gets Rs. 10,000 now he can invest to collect Rs. 11,000 after 1 year. Likewise, a payment of Rs. 10,000 (present value) now is equivalent of paying of Rs. 11,000 (future cash outflow) after 1 year. Thus if an asset generates Rs. 11,000 after 1 year, it is actually contributing Rs. 10,000 at the current date if the rate of earning required is 10%. In other words the value of the asset is Rs.10, 000. which is the present value of net future cash inflow it generates. If an asset generates Rs. 11,000 after 1 year, and Rs. 12,100 after two years, it is actually contributing Rs. 20,000 at the current date if the rate of earning required is 10% (Rs. 11,000 0.909 + Rs. 12,100 0.826). In other words the value of the asset is Rs. 20,000, i.e. the present value of net future cash inflow it generates. Under present value convention, assets are carried at present value of future net cash flows generated by the concerned assets in the normal course of business. Liabilities under this convention are carried at present value of future net cash flows that are expected to be required to settle the liability in the normal course of business. Example Carrying amount of a machine is Rs. 40,000 (Historical cost less depreciation). The machine is expected to generate Rs. 10,000 net cash inflow. The net realisable value (or net selling price) of the machine on current date is Rs. 35,000. The enterprises required earning rate is 10% per year. The enterprise can either use the machine to earn Rs. 10,000 for 5 years. This is equivalent of receiving present value of Rs. 10,000 for 5 years at discounting rate 10% on current date. The 1.20

Conceptual Framework for Preparation and Presentation of Financial Statements value realised by use of the asset is called value in use. The value in use is the value of asset by present value convention. Value in use = Rs. 10,000 (0.909 + 0.826 + 0.751 + 0.683 + 0.621) = Rs. 37,900 Net selling price = Rs. 35,000 The company should use the asset to realise Rs. 37,900 The value of the asset is Rs. 37,900, which is called its recoverable value. It is obviously not appropriate to carry any asset at a value higher than its recoverable value. The asset is currently overstated by Rs. 2,100 (Rs. 40,000 Rs. 37,900). The overstatement of the asset is called impairment loss. The accounting entries to recognise the impairment loss and to bring down the asset to its recoverable value are suggested below: Rs. Impairment Loss To Machinery Profit & Loss A/c To Impairment Loss 2,100 2,100 2,100 2,100 Rs.

1.10 CAPITAL MAINTENANCECapital refers to net assets of a business. Since a business uses its assets for its operations, a fall in net assets will usually mean a fall in its activity level. It is therefore important for any business to maintain its net assets in such a way, as to ensure continued operations at least at the same level year after year. In other words, dividends should not exceed profit after appropriate provisions for replacement of assets consumed in operations. For this reason, the Companies Act does not permit distribution of dividend without providing for depreciation on fixed assets. Unfortunately, this may not be enough in case of rising prices. The point is explained below: WE have already observed: P = (CA CL) (OA OL) C + D Where: Profit = P Opening Assets = OA and Opening Liabilities = OL Closing Assets = CA and Closing Liabilities = CL

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Advanced Accounting Introduction of capital = C and Drawings / Dividends = D Retained Profit = P D = (CA CL) (OA OL) C Or Retained Profit = Closing Equity (Opening Equity + Capital Introduced) A business must ensure that retained profit (RP) is not negative, i.e. closing equity should not be less than capital to be maintained, which is sum of opening equity and capital introduced. It should be clear from above that the value of retained profit depends on the valuation of assets and liabilities. In order to check maintenance of capital, i.e. whether or not retained profit is negative, we can use any of the following three bases. Financial capital maintenance at historical cost : Under this convention, opening and closing assets are stated at respective historical costs to ascertain opening and closing equity. If retained profit is greater than zero, the capital is said to be maintained at historical costs. This means the business will have enough funds to replace its assets at historical costs. This is quite right as long as prices do not rise. Financial capital maintenance at current purchasing power : Under this convention, opening and closing equity at historical costs are restated at closing prices using average price indices. For example, suppose opening equity at historical cost is 3,00,000 and opening price index is 100. The opening equity at closing prices is Rs. 3,60,000 if closing price index is 120. A positive retained profit by this method means the business has enough funds to replace its assets at average closing price. This may not serve the purpose because in reality prices of all assets do not change at average rate. For example, price of a machine can increase by 30% while the average increase is 20%. Physical capital maintenance at current costs: Under this convention, the historical costs of opening and closing assets are restated at closing prices using specific price indices applicable to each asset. The liabilities are also restated at a value of economic resources to be sacrificed to settle the obligation at current, i.e. closing date. The opening and closing equity at closing current costs are obtained as excess of aggregate of current cost values of assets over aggregate of current cost values of liabilities. A positive retained profit by this method ensures retention of funds for replacement of each asset at respective closing prices. Example (Financial capital maintenance at historical costs) A trader commenced business on 01/01/05 with Rs. 12,000 represented by 6,000 units of a certain product at Rs. 2 per unit. During the year 2005 he sold these units at Rs. 3 per unit and had withdrawn Rs.6, 000. Thus: Opening Equity = Rs. 12,000 represented by 6,000 units at Rs. 2 per unit.

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Conceptual Framework for Preparation and Presentation of Financial Statements Closing Equity = Rs. 12,000 (Rs. 18,000 Rs. 6,000) represented entirely by cash. Retained Profit = Rs. 12,000 Rs. 12,000 = Rs. 0 The trader can start year 2006 by purchasing 6,000 units at Rs. 2 per unit once again for selling them at Rs. 3 per unit. The whole process can repeat endlessly if there is no change in purchase price of the product. Example (Financial capital maintenance at current purchasing power) In the previous example, suppose that the average price indices at the beginning and at the end of year are 100 and 120 respectively. Opening Equity = Rs. 12,000 represented by 6,000 units at Rs. 2 per unit. Opening equity at closing price = (Rs. 12,000 / 100) x 120 = Rs. 14,400 (= 6,000 x Rs. 2.40) Closing Equity at closing price = Rs. 12,000 (Rs. 18,000 Rs. 6,000) represented entirely by cash. Retained Profit = Rs. 12,000 Rs. 14,400 = (-) Rs. 2.400 The negative retained profit indicates that the trader has failed to maintain his capital. The available fund Rs. 12,000 is not sufficient to buy 6,000 units again at increased price Rs. 2.40 per unit. In fact, he should have restricted his drawings to Rs. 3,600 (Rs. 6,000 Rs. 2,400). Had the trader withdrawn Rs. 3,600 instead of Rs. 6,000, he would have left with Rs. 14,400, the fund required to buy 6,000 units at Rs. 2.40 per unit. Example (Physical capital maintenance) In the previous example, suppose that the price of the product at the end of year is Rs. 2.50 per unit. In other words, the specific price index applicable to the product is 125. Current cost of opening stock = (Rs. 12,000 / 100) x 125 = 6,000 x Rs. 2.50 = Rs. 15,000 Current cost of closing cash = Rs. 12,000 (Rs. 18,000 Rs. 6,000) Opening equity at closing current costs = Rs. 15,000 Closing equity at closing current costs = Rs. 12,000 Retained Profit = Rs. 12,000 Rs. 15,000 = (-) Rs. 3,000

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Advanced Accounting The negative retained profit indicates that the trader has failed to maintain his capital. The available fund Rs. 12,000 is not sufficient to buy 6,000 units again at increased price Rs. 2.50 per unit. The drawings should have been restricted to Rs. 3,000 (Rs. 6,000 Rs. 3,000). Had the trader withdrawn Rs. 3,000 instead of Rs. 6,000, he would have left with Rs. 15,000, the fund required to buy 6,000 units at Rs. 2.50 per unit. The three ideas of capital maintenance are summarised below for convenience Financial Capital Maintenance at historical costs Rs. Closing capital (At historical cost) Less: Capital to be maintained Opening capital (At historical cost) Introduction (At historical cost) Retained profit Financial Capital Maintenance at current purchasing power Rs. Closing capital (At closing price) Less: Capital to be maintained Opening capital (At closing price) Introduction (At closing price) Retained profit Physical Capital Maintenance Rs. Closing capital (At current cost) Less: Capital to be maintained Opening capital (At current cost) Introduction (At current cost) Retained profit 1.24 15,000 Nil 15,000 (3.000) Rs. 12,000 14,400 Nil 14,400 (2,400) Rs. 12,000 12,000 Nil 12,000 Nil Rs. 12,000

Conceptual Framework for Preparation and Presentation of Financial Statements

SUMMARY Components of Financial Statements i) ii) iii) iv) i) ii) iii) iv) v) vi) Balance Sheet Profit & Loss A/c Cash Flow Statement Notes and Schedules Investors Employees Lenders Suppliers and other trade creditors Customers Governments and their agencies

Users of Financial Statements

vii) public. Fundamental Accounting Assumptions i) ii) iii) i) ii) iii) iv) v) i) ii) Going Concern Consistency Accrual Understandability Relevance Reliability Comparability True & Fair View Assets, Liabilities,

Qualitative Characteristics of Financial Statements

Elements of Financial Statements

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Advanced Accounting

iii) iv) v) i) ii) iii) iv)

Equity Income/gains and Expenses/ losses. Historical Cost Current Cost Realisable (Settlement) Value and Present Value. Financial capital maintenance at historical cost opening and closing assets are stated at respective historical costs to ascertain opening and closing equity. Financial capital maintenance at current purchasing power Opening and closing equity at historical costs are restated at closing prices using average price indices Physical capital maintenance at current costs The historical costs of opening and closing assets are restated at closing prices using specific price indices

Measurement of Elements in Financial Statements

Capital Maintenance

P = (CA CL) (OA OL) C + D Where: Profit = P Opening Assets = OA and Opening Liabilities = OL Closing Assets = CA and Closing Liabilities = CL Introduction of capital = C and Drawings / Dividends = D Retained Profit = P D = (CA CL) (OA OL) C or Retained Profit = Closing Equity (Opening Equity + Capital Introduced)

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Conceptual Framework for Preparation and Presentation of Financial Statements

SELF-EXAMINATION QUESTIONSI. Objective Type Questions Choose the most appropriate answer from the given options: 1. All of the following are fundamental accounting assumptions except (a) Accrual. (b) Going concern. (c) Consistency. (d) Business entity. 2. Two primary qualitative characteristics of financial statements are (a) Understandability and materiality. (b) Relevance and reliability. (c) Relevance and understandability. (d) Materiality and reliability 3. 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. 4. Financial statements show (a) Results of business entity over a period of time. (b) Financial information of business entity as on a particular date. (c) Portray the financial effects of past events. (d) All of the above. [ Ans.1(i) (d); 2. (c); 3. (d); 4. (d)] II. Short Answer Type Questions 5. 6. What are the objectives of preparing financial statements? Discuss. What is meant by Fundamental accounting assumptions? Explain in brief.

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Advanced Accounting 7. 8. 9. Write short note on historical basis of valuation. Write short note on Consistency. Discuss the fundamental accounting assumptions.

III. Long Answer Type Questions 10. Define capital maintenance. Explain physical and financial capital maintenance in detail with the help of an example. 11. . Explain the purpose and status of the conceptual framework for the preparation and presentation of financial statements in brief. 12. What are the qualitative characteristics of financial statements? Discuss in detail. 13. Describe the elements of financial statements. IV. Practical Problem 14. A proprietor, Mr. A has reported a profit of Rs. 1,25,000 at the end of the financial year after taking into consideration the following amount: (i) The cost of an asset of Rs. 25,000 has been taken as en expense.

(ii) Mr. A is anticipating a profit of Rs. 10,000 on the future sale of a car shown as an asset in his books. (iii) Salary of Rs. 7,000 payable in the financial year has not been taken into account. (iv) Mr. A purchased an asset for Rs.75,000 but its fair value on the date of purchase was Rs. 85,000. Mr. A recorded the value of asset in his books by Rs. 85,000. On the basis of the above facts answer the following questions from the given choices: (i) What is the correct amount of profit to be reported in the books? (a) (c) (a) (c) Rs. 1,25,000 Rs. 1,50,000 Historical cost Replacement cost 1.28 (b) (d) (b) (d) Rs.1,35,000 Rs. 1,33,000 Current cost resent value

(ii) Which measurement base should be followed in the statement (iv)?

Conceptual Framework for Preparation and Presentation of Financial Statements (iii) Which concept should be followed in the statement (ii)? (a) (c) (a) (c) Conservatism Historical cost, Materiality Current cost (b) (d) (b) (d) Materiality Accrual Historical cost Accrual

(iv) Which concept should be followed in the statement (iii)?

[Ans. (i) (d); (ii) (a); (iii) (b); (iv) (d),]

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CHAPTER 2

ACCOUNTING STANDARDSLearning objectivesAfter studying this chapter, you will be able to: Understand the provisions of the given Accounting Standards. Solve the practical problems based on application of Accounting Standards.

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INTRODUCTION

Accounting Standards (ASs) are written policy documents issued by expert accounting body or by government or other regulatory body covering the aspects of recognition, measurement, presentation and disclosure of accounting transactions in the financial statements. The accounting standards aim at improving the quality of financial reporting by promoting comparability, consistency and transparency, in the interests of users of financial statements. Good financial reporting not only promotes healthy financial markets, it