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Accounting for Managers - Accounting Standards

A PROJECT REPORT ON

ACCOUNTING STANDARDS (AS-1, AS-6, AS-10, AS12)

PRESENTED BY: SUSHIL KUMAR SURANA GEORGE JOSEPH PALLAVI DIKXIT ROBIN JAGWAYAN RASIKA SATAM ABHISEKH SINGHAL PRAKASH BIJOUR 1|Page

Accounting for Managers - Accounting Standards

UNDER GUIDANCE OF: PROF. ANIL TILAK

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Accounting for Managers - Accounting Standards

CONTENTS ACCOUNTING STANDARD-1

3

ACCOUNTING STANDARD-6

15

ACCOUNTING STANDARD-10

30

ACCOUNTING STANDARD-13

42

BIBLIOGRAPHY

53

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Accounting for Managers - Accounting Standards

ACCOUNTING STANDARD-1 Accounting is the art of recording transactions in the best manner possible, so as to enable the reader to arrive at judgments/come to conclusions, and in this regard it is utmost necessary that there are set guidelines. These guidelines are generally called accounting policies. The intricacies of accounting policies permitted Companies to alter their accounting principles for their benefit. This made it impossible to make comparisons. In order to avoid the above and to have a harmonised accounting principle, Standards needed to be set by recognised accounting bodies. This paved the way for Accounting Standards to come into existence. Accounting Standards in India are issued By the Institute of Chartered Accountants of India (ICAI). At present there are 30 Accounting Standards issued by ICAI. INTRODUCTION 1. This statement deals with the disclosure of significant accounting policies followed in preparing and presenting financial statements. 2. The view presented in the financial statements of an enterprise of its state of affairs and of the profit or loss can be significantly affected by the accounting policies followed in the preparation and presentation of the financial statements. The accounting policies followed vary from enterprise to enterprise. Disclosure of significant accounting policies followed is necessary if the view presented is to be properly appreciated. 3. The disclosure of some of the accounting policies followed in the preparation and presentation of the financial statements is required by law in some cases.

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Accounting for Managers - Accounting Standards 4. The Institute of Chartered Accountants of India has, in Statements issued by it, recommended the disclosure of certain accounting policies, e.g.,translation policies in respect of foreign currency items. 5.A few enterprises in India have adopted the practice of including in their annual reports to shareholders a separate statement of accounting policies followed in preparing and presenting the financial statements. 6. In general, however, accounting policies are not at present regularly and fully disclosed in all financial statements. Many enterprises include in the Notes on the Accounts, descriptions of some of the significant accounting policies. But the nature and degree of disclosure vary considerably between the corporate and the non-corporate sectors and between units in the same sector. 7. Even among the few enterprises that presently include in their annual reports a separate statement of accounting policies, considerable variation exists. The statement of accounting policies forms part of accounts in some cases while in others it is given as supplementary information. 8. The purpose of this Statement is to promote better understanding of financial statements by establishing through an accounting standard the disclosure of significant accounting policies and the manner in which accounting policies are disclosed in the financial statements. Such disclosure would also facilitate a more meaningful comparison between financial statements of different enterprises. OBJECTIVE OF ACCOUNTING STANDARDS Objective of Accounting Standards is to standardize the diverse accounting policies and practices with a view to eliminate to the extent possible the noncomparability of financial statements and the reliability to the financial statements. 5|Page

Accounting for Managers - Accounting Standards Accounting Standards are formulated with a view to harmonise different accounting policies and practices in use in a country. The objective of Accounting Standards is, therefore, to reduce the accounting alternatives in the preparation of financial statements within the bounds of rationality, thereby ensuring comparability of financial statements of different enterprises with a view to provide meaningful information to various users of financial statements to enable them to make informed economic decisions. The Companies Act, 1956, as well as many other statutes in India require that the financial statements of an enterprise should give a true and fair view of its financial position and working results. This requirement is implicit even in the absence of a specific statutory provision to this effect. The Accounting Standards are issued with a view to describe the accounting principles and the methods of applying these principles in the preparation and presentation of financial statements so that they give a true and fair view. The Accounting Standards not only prescribe appropriate accounting treatment of complex business transactions but also foster greater transparency and market discipline. Accounting Standards also helps the regulatory agencies in benchmarking the accounting accuracy. NATURE OF ACCOUNTING POLICIES 1. The accounting policies refer to the specific accounting principles and the methods of applying those principles adopted by the enterprise in the preparation and presentation of financial statements. 2. There is no single list of accounting policies which are applicable to all circumstances. The differing circumstances in which enterprises operate in a situation of diverse and complex economic activity make alternative accounting principles and methods of applying those principles acceptable. The choice of the appropriate accounting principles and the methods of applying those 6|Page

Accounting for Managers - Accounting Standards principles in the specific circumstances of each enterprise calls for considerable judgement by the management of the enterprise. 3. The various statements of the Institute of Chartered Accountants of India combined with the efforts of government and other regulatory agencies and progressive managements have reduced in recent years the number of acceptable alternatives particularly in the case of corporate enterprises. While continuing efforts in this regard in future are likely to reduce the number still further, the availability of alternative accounting principles and methods of applying those principles is not likely to be eliminated altogether in view of the differing circumstances faced by the enterprises. AREAS IN WHICH DIFFERING ACCOUNTING POLICIES ARE ENCOUNTERED The following are examples of the areas in which different accounting policies may be adopted by different enterprises. • Methods of depreciation, depletion and amortisation • Treatment of expenditure during construction • Conversion or translation of foreign currency items • Valuation of inventories • Treatment of goodwill • Valuation of investments • Treatment of retirement benefits • Recognition of profit on long-term contracts • Valuation of fixed assets 7|Page

Accounting for Managers - Accounting Standards • Treatment of contingent liabilities. The above list of examples is not intended to be exhaustive. Accounting Standards establish rules relating to recognition, measurement and disclosures, thereby ensuring that all enterprises that follow them are and that their financial statements are true, fair and transparent. High quality accounting standards are a necessary and important element of a sound capital market system. In Public capital markets such as those in United States, high quality accounting standards reduce uncertainty and increase overall efficiency. ACCOUNTING STANDARDS-SETTING IN INDIA The institute of Chartered Accountants of India, recognizing the need to harmonize the diverse accounting policies and practices, constituted at Accounting Standard Board (ASB) on 21st April, 1977. The Institute of Chartered Accountants of India (ICAI) being a member body of the IASC, constituted the Accounting Standards Board (ASB) on 21st April, 1977, with a view to harmonise the diverse accounting policies and practices in use in India. After the avowed adoption of liberalization and globalisation as the corner stones of Indian economic policies in early ‘90s, and the growing concern about the need of effective corporate governance of late, the Accounting

Standards

have

increasingly

assumed

importance.

While

formulating accounting standards, the ASB takes into consideration the applicable laws, customs, usages and business environment prevailing in the country. The ASB also gives due consideration to International Financial Reporting Standards (IFRSs)/ International Accounting Standards (IASs) issued by IASB and tries to integrate them, to the extent possible, in the light of conditions and practices prevailing in India.

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Accounting for Managers - Accounting Standards COMPOSITION OF THE ACCOUNTING STANDARDS BOARD: The composition of the ASB is broad-based with a view to ensuring participation of all interest groups in the standard-setting process. These interest-groups include industry, representatives of various departments of government and regulatory authorities, financial institutions and academic and professional bodies. Industry is represented on the ASB by their apex level associations,

viz.,

Associated

Chambers

of

Commerce

&

Industry

(ASSOCHAM), Confederation of Indian Industries (CII) and Federation of Indian Chambers of Commerce and Industry (FICCI). As regards government departments and regulatory authorities, Reserve Bank of India, Ministry of Company Affairs, Comptroller & Auditor General of India, Controller General of Accounts and Central Board of Excise and Customs are represented on the ASB. Besides these interest-groups, representatives of academic and professional institutions such as Universities, Indian Institutes of Management, Institute of Cost and Works Accountants of India and Institute of Company Secretaries of India are also represented on the ASB. Apart from these interest groups, certain elected members of the Central Council of ICAI are also on the ASB. THE ACCOUNTING STANDARDS-SETTING PROCESS The accounting standard setting, by its very nature, involves reaching an optimal balance of the requirements of financial information for various interest-groups having a stake in financial reporting. With a view to reach consensus, to the extent possible, as to the requirements of the relevant interestgroups and thereby bringing about general acceptance of the Accounting Standards among such groups, considerable research, consultations and discussions with the representatives of the relevant interest-groups at different stages of standard formulation becomes necessary. The standard-setting 9|Page

Accounting for Managers - Accounting Standards procedure of the ASB, as briefly outlined below, is designed in such a way so as to ensure such consultation and discussions: Identification of the broad areas by the ASB for formulating the Accounting Standards. Constitution of the study groups by the ASB for preparing the preliminary drafts of the proposed Accounting Standards. Consideration of the preliminary draft prepared by the study group by the ASB and revision, if any, of the draft on the basis of deliberations at the ASB. Circulation of the draft, so revised, among the Council members of the

ICAI

and 12 specified outside bodies such as Standing Conference of Public Enterprises (SCOPE), Indian Banks’ Association, Confederation of Indian Industry (CII), Securities and Exchange Board of India (SEBI), Comptroller and Auditor General of India (C& AG), and Department of Company Affairs, for comments. Meeting with the representatives of specified outside bodies to ascertain their views on the draft of the proposed Accounting Standard. Finalisation of the Exposure Draft of the proposed Accounting Standard on the basis of comments received and discussion with the representatives of specified outside bodies. Issuance of the Exposure Draft inviting public comments. Consideration of the comments received on the Exposure Draft and finalisation of the draft Accounting Standard by the ASB for submission to the Council of the ICAI for its consideration and approval for issuance.

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Accounting for Managers - Accounting Standards Consideration of the draft Accounting Standard by the Council of the Institute, and if found necessary, modification of the draft in consultation with the ASB. THE PRINCIPLES GOVERNING SELECTION OF AN ACCOUNTING POLICY: The primary consideration in the selection of accounting policies by an enterprise is that the financial statements prepared and presented on the basis of such accounting policies should present a true and fair view of the state of affairs of the enterprise as at the balance sheet date and of the profit and loss for the period ended on that date. For this purpose , the major considerations governing the selection and application of accounting policies are : 1. PRUDENCE In the view of the uncertainty attached to future event, profits are not anticipated but recognised only when realised though not necessarily in cash. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information. 2. SUBSTANCE AND FORM The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and merely by the legal form. A typical example where substance takes precedence over form is in the case of finance leases. In finance leases, the lessee in substance is the owner of the asset whilst the less or is merely the legal owner. The accounting of finance leases is based on the substance rather than form of the transaction.

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Accounting for Managers - Accounting Standards 3. MATERIALITY Financial statements should disclose all “material” items, i.e. items the statements. The concept of materiality recognizes that some matters individually or in the aggregate, are important for the fair presentation of the financial statements taken as a whole. The IASC (International Accounting Standards Committee) defines audit materiality as follows: ‘Information is the if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statement.’ Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus materiality provides a threshold or cut-off point rather being primary qualitative characteristics which information must have, if it is to be useful. There are no hard and fast rules for determining materiality. What is material is a matter of professional judgment. For example, an amount material to the financial statements of one entity may not be material to financial statements of another entity of a difference size or nature. Further, what is material to the financial statements of a particular entity might change from one period to another. THE FUNDAMENTAL ACCOUNTING ASSUMPTIONS Certain fundamentals accounting assumptions underlie the preparations and presentation of financial statements. They are usually not specifically stated because there acceptance and use are assumed. Disclosure is necessary if they are not followed, otherwise disclosure is not required. The following have been generally accepted as fundamental accounting assumptions:

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Accounting for Managers - Accounting Standards A. Going Concern The enterprise is normally viewed as going concern, that is, as continuing in operation for the foreseeable future. It is assumed the enterprise has neither the intention nor the necessity of liquidation or of curtailing materiality the scale of the operations. B. Consistency It is assumed that accounting policies are consistent from one period to another. C. Accrual Revenues and cost are accrued, that is, recognised as they are earned or incurred (and not as money received or paid) and recorded in the financial statements of the period which they relate. The accrual concept forces the matching of revenues against relevant cost, for example, though warranty expenses are incurred much after the turnover takes place, it has to be estimated and provided for when the turnover is affected, as it is a cost incurred to achieve that turnover. PRINCIPLES FOLLOWING A “NOT GOING CONCERN” The company should prepare the accounts on the basis that it is not a going concern or that it will be closed in the near future. All the assets of such a company should be valued as its net realisable value. All the liabilities should be valued at the expected settlement price. In addition, further liabilities may have to be provided in respect of employee termination or premature termination of various contracts including the lease of the premises. Adequate disclosure/adjustments should be made in financial statements about the impending closure and the fact that accounts are prepared on the basis. Since the accounts would be true and fair, there no need for the auditor to make a 13 | P a g e

Accounting for Managers - Accounting Standards qualification. The auditor should however add a paragraph in his report detailing the going situation (matter of emphasis and not qualification). If the financial statement is not prepared on the above basis, the auditor will have to qualify the financial statements. DIFFERENT ACCOUNTING POLICIES FOR SIMILAR ITEMS This is the contrary to the fundamental accounting assumptions of consistency, which require use consistence policies year after year and also in the same year for all similar items. In the case of depreciation, Expert Advisory Committee (EAC) of ICAI has given an opinion that different methods of depreciation for the for the same class of assets used in different plants of company can be applied if the management considers it appropriate to do so after taking into account important factors such as the type of assets, the nature of the use of such assets and circumstances prevailing in the business. Whilst such exceptions may be justifiable it would be difficult to justify valuing the same type of inventory at to different factories by applying to different accounting policies. DISCLOSURE OF ACCOUNTING STANDARDS To ensure proper understanding of financial statements, it is necessarythat all significant accounting policies adopted in the preparation and presentation of financial statements should be disclosed. Such disclosure should form part of the financial statements. It would be helpful to the reader of financial statements if they are all disclosed as such in one place instead of being scattered over several statements, schedules and notes. Examples of matters in respect of which disclosure of accounting policies adopted will be required are contained in paragraph 14. This list of examples is not, however, intended to be exhaustive. Any change in an accounting policy 14 | P a g e

Accounting for Managers - Accounting Standards which has a material effect should be disclosed. The amount by which any item in the financial statements is affected by such change should also be disclosed to the extent ascertainable. Where such amount is not ascertainable, wholly or in part, the fact should be indicated. If a change is made in the accounting policies which has no material effect on the financial statements for the current period but which is reasonably expected to have a material effect in later periods, the fact of such change should be appropriately disclosed in the period in which the change is adopted. Disclosure of accounting policies or of changes therein cannot remedy a wrong or inappropriate treatment of the item in the accounts. All significant accounting policies adopted in the preparation and presentation of financial statements should be disclosed. The disclosure of the significant accounting policies as such should form part of the financial statements and the significant accounting policies should normally be disclosed in one place. Any change in the accounting policies which has a material effect in the current period or which is reasonably expected to have a material effect in later periods should be disclosed. In the case of a change in accounting policies which has a material effect in the current period, the amount by which any item in the financial statements is affected by such change should also be disclosed to the extent ascertainable. Where such amount is not ascertainable, wholly or in part, the fact should be indicated. If the fundamental accounting assumptions, viz. Going Concern, Consistency and Accrual are followed in financial statements, specific disclosure is not required. If a fundamental accounting assumption is not followed, the fact should be disclosed

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Accounting for Managers - Accounting Standards

AS- 6: DEPRECIATION THE SCOPE AND OBJECTIVE OF AS-6 & DEPRECIABLE ASSETS Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, efflux of time or obsolescence through technology and market changes. Depreciation includes amortization of assets whose useful life is pre-determined. Different accounting policies for depreciation are adopted by different enterprises. Disclosure of accounting policies for depreciation followed by enterprise is necessary to appreciate the view presented in the financial statements of the enterprise. Depreciation has a significant in determining and presenting the financial position and result of operation of an enterprise. Depreciable assets are assets which • Are Expected To Be Used More Than One Accounting Period • Have a limited useful life, and •

Are held by an enterprise for use in the production or supply of goods and services for rental and others, or for administrative purpose and not for the purpose of sale in the ordinary course of business. To qualify as a depreciable asset all there conditions are required to be fulfilled. Even if a single condition is not fulfilled the same will not qualify as a depreciable asset. For e.g. though land will fulfill two of the above conditions, it does not fulfill the condition of a limited useful life and therefore is not a depreciable asset AS-6 deals with depreciable accounting and applies to all depreciable assets except the following items to which special consideration apply: •

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Forest plantation and similar regenerative natural resources

Accounting for Managers - Accounting Standards •

Wasting asset including expenditure on the exploration for

an extraction of minerals, oil, natural gases and similar nonregenerative resources. •

Expenditure on research and development



Goodwill



Livestock

As already stated AS-6 does not apply to Land unless it has a limited useful life for the Enterprise. Land and Buildings are separable assets and are dealt with separately for accounting purposes, even when they are acquired together. Land normally has an unlimited life and therefore is not depreciated. Building has a limited life and therefore is depreciable asset. An increase in the value of land on which the building stands does not affect the determination of the useful life of the building. DEPRECIATION CHARGES RECOGNIZED IN FINANCIAL STATEMENTS The depreciation charges for a period are usually recognized as an expense. However in some circumstances, the economic benefit embodies in an asset are absorbed by the enterprise in producing other asset rather than giving rise to an expense. In this case, the depreciation charged comprises part of the cost of the other asset as is included in its carrying amount. For e.g. the depreciation of manufacturing plant and equipment is included in the cost of conversion of inventories. Simi9larly depreciation of property plant and equipment used for development activities may be included in the cost of an intangible asset or as a capital research and development item.

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Accounting for Managers - Accounting Standards

THE QUANTUM OF DEPRECIATION DETERMINED UNDER AS-6 Depreciation is allotted so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciable amount of a depreciable asset is its historical cost, or other amount substituted for historical cost in the financial statement, less the estimated residual value. Assessment of depreciation and the amount to be charged in respect thereof in an accounting period are usually based on the following three factors • Historical cost or other amount substituted for the historical cost of the depreciable asset when the asset has been revalued • Expected useful value of the depreciable value and • Estimated residual value of the depreciable asset. The quantum of depreciation is provided in an accounting period involves the exercise of judgment by management in light of technical, commercial, accounting and legal requirements and accordingly may need periodical review. If it is considered that the original useful life of an asset and any revision, the unamortized depreciable amount of the asset is charged to the revenue over the revised remaining useful life. The useful life of major depreciable assets or classes of depreciable asset should therefore be reviewed periodically. In the case the depreciable assets are revalued, the provision for depreciation is based on the revalued amount on the estimate of the remaining useful life of such assets. Depreciation is charged in each accounting period by reference of the depreciable amount irrespective of an increase in the market value of the asset. This is based on the concept of historical cost. Historical cost of a depreciable asset represents its money outlay or its equivalent connection with its acquisition, installation and commissioning as well as for additions to or 18 | P a g e

Accounting for Managers - Accounting Standards improvement thereof. The historical cost of a depreciable asset may undergo subsequent changes arising as a result of increase or decrease in long term liability on account of exchange fluctuations, price adjustments, change in duties or similar factors. DETERMINATION OF AN USEFUL LIFE OF AN ASSET As the economic benefits embodied in an asset is reduced are consumed by the enterprise, the carrying amount of an asset is reduced to reflect this consumption, normally by charging an expense for depreciation .A depreciation charge is made even if the value of the asset exceeds its carrying amount. The economic benefits embodied in an item of property, plant and equipment are consumed by the enterprise principally through the use of the asset. However other factors such as technical obsolescence and wear and tear while an asset remains idle often result in diminution of the economic benefits that might have been expected to be available from the assets. Useful life is either (1) the period over which a depreciable asset is expected to be used by the enterprise or (2) the number of production or similar units expected to be obtained from the use of assets by the enterprise. The useful life of a depreciable asset is shorter than its physical life and is 1. Predetermined by legal or contractual limits, such as the expiry dates of related leases, 2. Directly governed by extraction or consumption 3. Dependent on the extent of use and physical deterioration on account of wear and tear which again depends on operational factors such as the number of shifts for which the asset is to be used, repair and maintenance policy of the enterprise etc. and

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Accounting for Managers - Accounting Standards 4. Reduced by obsolescence arising from such factors as: a. Technological changes b. Improvement in production methods c. Change in market demand for the product or service output of the assets d. Legal or other restrictions. Determination of a useful life of a depreciable asset is a matter of estimation and is normally based on various facts including experience with similar types of assets. Such estimation is more difficult for an asset using new technology or used in the production of new product or in the provision of a new service but is nevertheless required on some reasonable basis. The useful life of an asset is defined in terms of the asset’s expected utility to the enterprise. The asset management policy of an enterprise may involve the disposal of assets after a specified time or after consumption of a certain proportion of the economic benefits embodied in the assets. Therefore the useful life of an asset may be shorter than its economic life. The estimation of the useful life of an item of property, plant and equipment is a matter of judgment based on the experience of the enterprise with similar assets AS-6

OR

COMPANIES

ACT

SHOULD

BE

FOLLOWED

BY

COMPANIES FOR DETERMINING DEPRECIABLE AMOUNT The statute governing an enterprise may provide the basis for computation of the depreciation. For example the companies act 1965 lays down the rates of depreciation in respect of various assets. Where the management’s estimate of the useful life of an asset of the enterprise is shorter than that envisaged under the relevant statutes, the depreciation provision is appropriately computed y 20 | P a g e

Accounting for Managers - Accounting Standards applying a higher rate. If the managements estimate of the useful life of the asset is longer than that envisaged under the statute, depreciation rate lower than that envisaged by the statute can be applied only in accordance with requirements of the statute. In a large number of cases, the rates of depreciation under schedule 14 of companies are lowland therefore enterprises have a nose for good corporate governance and accountant practices ,use much higher rates than that prescribed under schedule 14.for example Infosys uses much higher rates than that prescribed under schedule 14 on computers owned by them. It is important for the financial statements to be true and fair that management estimates the useful lives of assets and determines depreciation at higher rates. If the useful lives are lower than one set out in schedule 14. Rates higher than schedule 14 should be used provided such rates are based on sound commercial and technical considerations. For example a factory building situated in a coastal area may be subject to higher depreciation due to corrosion. In such a case the auditor should broadly satisfy himself that the rates are determined in an appropriate manner. Since the determination of commercial life of an asset is a technical matter, the decision of the Board of Directors is normally accepted by the auditors unless he has reason to believe that such decision is grossly incorrect. There could be instances where a company adopts accelerated depreciation rates in respect class of assets i.e. depreciation rates are higher than rates prescribed under schedule14 of the companies act. For the other assets the company charges depreciation at the rates lower than the schedule 14 of the companies act. However aggregate depreciation charge on all assets as per the companies policy is higher than the aggregate depreciation had the company followed schedule 14 rates for all the assets.

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Accounting for Managers - Accounting Standards If the managements estimate of the useful life of the asset is longer than that envisaged, under the statute, depreciation rate lower than that envisaged by the statute can be applied only in accordance with requirement of the statute.

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Accounting for Managers - Accounting Standards Department of Company affairs vide circular no.2/89 has clarified that: It may be clarified that the rates as contained in schedule 14 should be viewed as the minimum rates and therefore a company shall not be permitted to charge depreciation at rates lower than those specified in schedule in relations to assets purchased. After the date of applicability of the schedule. The conclusion is: • Compliance with AS-6 and the companies act should be viewed based on each type of asset for example buildings, plant and machinery, furniture etc and not on all the assets taken together. • In the given case, accounting policy followed by the company is not in agreement with the accounting standard 6 and provisions of the companies act. USEFUL LIVES OF ASSETS REQUIRED TO BE REVIEWED The useful life of an item if property, plant and equipment should be reviewed periodically and if expectations are significantly different from previous estimates, the unamortised depreciable amount should be charged over the revised remaining useful life. During the life of an asset it may become apparent that the estimate of the useful life is inappropriate. For example the useful life may be extended by subsequent expenditure on the asset which improves the condition of the asset beyond its originally assessed standard of performance. Alternatively, technological changes or changes in the market for the products may reduce its useful life of the asset. For example due to certain changes in the design of the finished product, a company may intend to discontinue using the moulds much before the expiry of their useful life, the repair and maintenance policy of the enterprise may also affect the useful life of 23 | P a g e

Accounting for Managers - Accounting Standards an asset. The policy may result in an extension of the useful life of the asset or an increase in its residual value. However the adoption of such a policy does not negate the need to charge depreciation. It is important that the above reassessment of useful does not result in depreciation lower than the required under schedule 14, as that would result in contravention of section 205(2) of the companies act. ADDITION OR EXTENSION TO AN EXISTING ASSET Any addition or extension to an existing asset which is of a capital nature and which becomes an integral part of the existing asset is depreciated over the useful remaining life of that asset. As a practical measure, however depreciation is sometimes provided on such addition or extension at the rate which is applied to an existing asset. Any addition or extension which retains a separate identity and is capable of being used after the existing asset is disposed of, is depreciated independently on the basis of an estimate of its own useful life. Where the historical cost of a depreciable asset may undergo subsequent changes arising as a result of increase or decrease in long term liability on account of exchange fluctuations, price adjustments, changes in duties or similar factors the depreciation on the revised unamortised depreciable amount is provided prospectively over the residual useful life of the asset. For example let’s say the useful life of an asset of Rs. 600000 is 5 years. In the second year when the net value of the asset was Rs. 480000 an additional amount of Rs. 20000 nibs capitalised on account of foreign exchange difference. The revised unamortised amount of Rs. 500000 would be depreciated over the remaining useful life of 4 years. therefore deprecation each year for the next 4 years would be Rs. 125000.if the company was using the written down value method then depreciation would be provided on the revised unamortised amount of Rs. 500000 at the WDV depreciation rate.

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Accounting for Managers - Accounting Standards DEPRECIATION ON IDLE ASSETS Sec 205 (2) of the companies act 1956 does not deal with the manner of provision for depreciation on assets remaining idle owing to labor trouble etc. However since depreciation also arises out of efflux of time it would be necessary for the purpose of section 205 to provide for depreciation even in respect of assets which are not in use during any financial year if it plans to declare any dividend. It may be possible that due to assets lying idle the remaining usable life is extended, in which case a reassessment of useful life can be made. On this basis the unamortised depreciable amount should be charged over the revised remaining useful life, which would result in a lower annual charge of depreciation in the future years. However as cautioned above depreciation amount should not be lower than that determined under schedule 14 for the purposes of section 205 of the companies act. Full depreciation is provided for even if the asset is kept in the best working condition or its market price is gone up, since depreciation is also a factor of efflux of time. RESIDUAL VALUE Determination of residual value of an asset is normally a difficult matter. If such value is considered as insignificant, it is normally regarded as nil. On the contrary, if the value is considered as insignificant, it is estimated at the time of acquisition / installation, or at the time of subsequent revaluation of the asset. One of the basis for determining the residual value would be the realizable value of similar assets, which have reached the end of their useful lives and have operated under conditions similar to those in which the asset will be used PRINCIPLE GOVERNING TO CHOOSE THE DEPRECIATION METHOD There are several methods of allocating depreciation over the useful life of the assets. Those most commonly employed in industrial and commercial 25 | P a g e

Accounting for Managers - Accounting Standards enterprises are the straight line method and reducing balance method. The management of a business selects the most appropriate method based on the various important factors e.g. (i) type of asset, (ii) the nature of the use of such asset and (iii) circumstances prevailing in the business. A combination of more than one method is sometimes used. The method used for an asset is selected based on the expected pattern of economic benefits and is consistently applied from period to period unless there is a change in the expected pattern of economic benefits from that asset. For example, a motor vehicle may provide uniform economic benefits over several years. Therefore some enterprises may choose to apply WDV method in the case of motor vehicle and SLM method in the case of buildings. DIFFERENT DEPRECIATION METHODS APPLIED FOR THE SAME CLASS OF FIXED ASSETS The management of a business selects the most appropriate depreciation methods based on various important factors e.g. , (i) type of asset , (ii) the nature of the use of such asset and (iii) circumstances prevailing in the business. A combination of more than one method is sometimes used. It is therefore possible that plant and machinery be depreciated on WDV basis and all the other assets on SLM basis. Sometimes different methods of depreciation of the same class of assets used in different plants of the company can be applied if the management considers it appropriate to do so, after taking into account important factors such as type of assets, the nature of the use of such assets and circumstances prevailing in the business. For example, if an enterprise is in the business of letting out vehicles on hire it may depreciate the hired vehicles at higher rate than compared to the vehicles which are used by its employees fro office purposes.

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Accounting for Managers - Accounting Standards

CHANGING OF DEPRECIATION METHODS Compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements of the enterprise. When such a change in the method of depreciation is made, depreciation is recalculated in accordance with the new method from the date of the asset coming into use. The deficiency or surplus arising from retrospective recomputation of depreciation in accordance with the new method is adjusted in the accounts in the year in which the method of depreciation is changed. In case the change in the method results in deficiency in depreciation in respect of past years, the deficiency is charged in the statement of profit and loss. In case the change in the method results in surplus, the surplus is credited to the statement of profit and loss. Such a change is treated as a change in accounting policy and its effect is quantified and disclosed. DEPRECAITION PROVIDED ON DELETION DURING THE YEAR

FIXED

ASSETS

ADDITION/

Schedule XIV to the Companies Act 1956, prescribed that “where during the year, any addition has been made to any assets, or any asset has been sold, discarded, demolished or destroyed, the depreciation on such assets shall be calculated on a pro rata basis from the date of such addition or, as the case may be, up to the date on which such asset has been sold, discarded, demolished or destroyed”. Depreciation should be provided when the asset is installed even though not in use (but ready to use) for the whole or part of any financial year, due to reasons like strike, lock-out, shortage of raw materials etc. However, if the asset is not installed and is thus not ready for being put to use, depreciation should not be provided on them. If the company has purchased certain equipments which are

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Accounting for Managers - Accounting Standards in capital WIP, since civil work has been delayed for along period, the company should not provide depreciation on the equipments. PROVISIONS FOR THE DEPRECIATION ON FIXED ASSETS ITEMS BELOW Rs. 5000 As per the Schedule XIV of the Companies Act, individual items below rupees five thousands (Rs. 5000) should be depreciated 100 %. An item of furniture such as chair or table is capable of being used independently, therefore each chair or table will have to be provided 100 % depreciation if its individual value does not exceed Rs. 5000. The 100 % depreciation provision cannot be avoided by arguing that the furniture can be used only as a set, for example, asset of chairs, which cost Rs. 5000 (unless they are attached and fixed to each other and one chair cannot be moved without simultaneously moving the other). When these items are purchased during the year, the 100 % depreciation should be pro- rated based on date of addition. In the case of plant and machinery where the aggregated actual cost of individual items of plant and machinery costing Rs. 5000 constituents more than 10 % of the total actual cost of plant and machinery, normal Schedule XIV rates should be used. INCOME TAX BASIS OF DETERMINING DEPRECIATION ACCEPTABLE IN THE FINANCIAL ACCOUNTS UNDER COMPANIES ACT 1956 After Schedule XIV coming into the force, rates higher than those under that schedule can also be adopted on the basis of bona fide determination of the commercial life of an asset in accordance with AS-6, which is a technical matter. Also in such a case, proper disclosure has to be made. Therefore, a company can follow rates prescribed under the Income Tax Act/ rules only if these rates represent bona fide commercial depreciation.

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Accounting for Managers - Accounting Standards AS-6 and schedule XIV require pro-rata depreciation to be charged in respect of addition/ deletion to fixed assets. Therefore for purposes of Companies Act financial accounts, it is not appropriate to determine depreciation, after crediting profit on sale of assets against the concerned block of assets, like it is done for income-tax purpose. Infact profit on sale of assets needs separate recognition and disclosure in the Companies Act financial statements. CONTINUOUS AND NON-CONTINUOUS DEPRCIATION DISTINGUISH

PRCOCESS

PLANT’s

The distinction between a continuous process and non continuous process plant is important because the continuous plant carries a depreciation rate of 5.28 % SLM (15.33 % WDV) without any requirement to provide extra shift depreciation as the plant has to be continuously in operation. Non continuous process plant carries depreciation rate of 4.75 % SLM (13.91 % WDV), plus extra-shift depreciation. Therefore treating the plant as non continuous would result in high depreciation where a plant has worked extra-shift. Schedule XIV, note 7 defines continuous process plant which is required and designed to operate 24 hours a day. Guidance note on schedule XIV issued by ICAI further clarifies that the technical design of a continuous process plant is such that there is a requirement to run it continuously for 24 hours a day, if it is not so run, there are significant energy loss. It is however possible that due to various reasons, for example, lack of demand, maintenance; etc such a plant may be shut down for some time. The shut down does not change the inherent technical nature of the plant , for instance a blast furnace which is required and designed to operate 24 hours a day may be shut down due to various reasons; it would still be considered as a continuous process plant. In contrast a textile unit may be operated for 24 hours a day, yet they are not continuous process plant because their technical design is not such that they have to be operated for 24 hours. 29 | P a g e

Accounting for Managers - Accounting Standards In integrated steel plants, coke ovens, blast furnace, steel melting shops and rolling mills are main plants of a steel mill. In coke ovens, blast furnaces, and steel melting shops there is a technological compulsion to operate 24 hours a day, i.e., if such plants are shut down costs also. But there is no such technological compulsion in case of rolling mills. When this matter was referred to the EAC for opinion, it gave the following opinion: “the committee is of the view that whether a particular rolling mill is a continuous prices plant should be determined on the basis of the facts and technical evaluation that whether it is both designed and required to operate 24 hours a day. The committee notes that the argument advanced by the querist primarily emphasize the “technical compulsion” to operate certain mills 24 hours a day. However apart from fulfilling the aforesaid condition the plant should also be designed to operate 24 hours a day. Whether a plant is designed to operate 24 hours a day is also a question of fact of a technical nature. In case of a cement plant the process are lime stone minning, lime stone crusher, raw mill/coal mill, klin and cement mill. The lime and stone are heated in the klin, and the output generated is klinker (small particles). The klin is designed to operate for 24 hours a day, as it operates under high temperature. Any closure of the klin results in high power loss and thermal shock. The klinker is processed in the cement mill too generate cement. The clinker and the cement mill can be operated separately (non continuous) though since output of one is input of the other, there capacities and operation have to be balanced. However, such balancing can be done also by purchasing/selling clinker from/to third parties the klin is designed to operate for 24 hours a day but not the other plants in the cement factory, for example, the lime stone crusher, cement mill, coal mill etc are not designed to operate 24 hours a day, though from capacity balancing point of view it may be beneficial to operate them for 24 hours a day. 30 | P a g e

Accounting for Managers - Accounting Standards Therefore whereas the kiln plant may satisfy the definition of a continuous process plant the other plants in the cement fulfill ICAI’s definition of a continuous process plant. DISCLOSURE REQUIRED UNDER AS-6 The following information should be disclosed in the financial statements: (i)

The historical cost or other amount substituted for historical cost of each class of depreciable assets;

(ii)

Total depreciation for the period for each class of assets; and

(iii)

The related accumulated depreciation. The following information should also be disclosed in the financial statements along with the disclosure of other accounting policies: (i) depreciation methods used; and (ii)

depreciation rates or the useful lives of the assets, if they are different from the principal rates specified in the statute governing the enterprise.

In case the depreciable assets are revalued, the provision for depreciation is based on the revalued amount on the estimate of the remaining useful life of such assets. In case the revaluation has a material effect on the amount of depreciation, the same is disclosed separately in the year in which revaluation is carried out. A change in the method of depreciation is treated as a change in an accounting policy and is disclosed accordingly. Where depreciable assets are disposed of, discarded, demolished or destroyed, the net surplus or deficiency, if material, is disclosed separately.

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AS-10: ACCOUNTING FOR FIXED ASSETS OBJECTIVE AND SCOPE OF AS-10 Fixed Assets often comprise a significant portion of the total assets of an enterprise, and therefore are important in the presentation of financial position. Furthermore, the determination of whether expenditure represents an assets or an expense can have a material effect on an enterprise’s reported results of operations. This standard is mandatory in nature. The provisions relating to borrowing costs, intangible assets and leases that were originally contained in this standard were withdrawn once new accounting standards were developed in these areas. This statement does not deal with accounting for the following items to which special consideration apply; • Forests, plantations and similar regenerative natural resources; • Wasting assets including mineral rights, expenditure on exploration for and extraction of minerals, oil, natural gas and similar non-regenerative resources; • Expenditure on real estate development; and • Livestock Expenditure on individual items of fixed assets used to develop or maintain the activities covered in (i) to (iv) above, but separable from those activities, are to be accounted for in accordance with this statement. WHAT ARE FIXED ASSETS? 32 | P a g e

Accounting for Managers - Accounting Standards Fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business. This statement deals with accounting for fixed assets such as land, buildings, plant and machinery, vehicles, furniture and fittings, goodwill, patens, trademarks and designs. This statement however does not deal with specialised aspects of accounting for fixed assets that arise under a comprehensive system reflecting the effects of changing prices but applies to financial statements prepared on historical cost bases. It may be appropriate to aggregate individually insignificant items, such as moulds, tools and dies, and to apply the criteria to the aggregate value. ACCOUNTING FOR MACHINERY SPARES The accounting of machinery spares is done in accordance with this statement and not in accordance with AS-2 on ‘Inventories”. Stand-by equipment and servicing equipment are normally capitalized. Machinery spares are usually charged to the profit and loss statement as and when consumed. However, if such spares can be used only in connection with an item of fixed asset and their use is expected to be irregular, it may be appropriate to allocate the total cost on a systematic basis over a period not exceeding the useful life of the principal item. In certain circumstances, the accounting for an item of fixed asset may be improved if the total expenditure thereon is allocated to its component parts, provided they are in practice separable, and estimates are made of the useful lives of these components. For example, rather than treat an aircraft and its engines as one unit, it may be better to treat the engines as a separate unit if it is likely that their useful life is shorter than that of the aircraft as a whole COMPONENTS OF COSTS OF FIXED ASSETS

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Accounting for Managers - Accounting Standards The cost of an item of fixed asset comprise its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price. MODVAT credit can be considered to be of the nature of a refundable tax. Therefore, MODVAT credit should be reduced from the purchase cost of capital goods concerned. Examples of directly attributable cost are • Sites preparation; • Initial delivery and handling costs; • Installation costs, such as special foundation for plant; and • Professional fees, for example fees of architects and engineers. •

The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, change in duties of similar factors.

Administration and other general overhead expenses are usually excluded from the cost of fixed assets because they do not relate to a specific fixed asset. However, in some circumstances, such expenses as are specifically attributable to construction of a project or to the acquisition of a fixed asset or bringing it to its working condition, may be included as part of the cost of the construction project or as a part of the cost of the fixed asset. The expenditure incurred on start-up and commissioning of the project, including the expenditure incurred on test runs and experimental production is usually capitalized as an indirect element of the construction cost. However, the expenditure incurred after the plant has begun commercial production, i.e. production intended for sale or captive consumptions, is not capitalised and is treated as revenue expenditure even though the contract may stipulate that the 34 | P a g e

Accounting for Managers - Accounting Standards plant will not be finally taken over until after the satisfactory completion of the guarantee period. Amount paid for know-how for the plans, layout and designs of buildings and/or design of the machinery should be capitalised under the relevant asset heads such as buildings, plants and machinery, etc. Depreciation should be calculated on the total cost of those assets, including the cost of the know-how capitalised. Know-how related to the manufacturing process is usually expensed in the year in which it is incurred. Where the amount paid for know-how is a composite sum in respect of both the manufacturing process as well as plans, drawings and designs for buildings, plant and machinery, etc., the management should apportion such consideration into two parts on a reasonable bases. If the said costs are not directly attributable to bringing the assets concerned to their working condition for their intended use, it should not be capitalised as part of the cost the asset. SELF-CONSTRUCTED FIXED ASSETS In arriving at the gross book value of self-constructed fixed assets, the above principles apply. Included in the gross book value are costs of construction that relate directly to the specific asset and costs that are attributable to the construction activity in general and can be allocated to the specific asset. Any internal profits are eliminated in arriving at such costs. ACCOUNTING OF COST INCURRED DURING PROJECT DELAYS AND WASTAGES If the interval between the date a project is ready to commence commercial production and the date at which commercial production actually begins is prolonged, all expenses (other than borrowing costs) incurred during this period are charged to the profit and loss statement. However, the expenditure incurred during this period is also sometimes treated as deferred revenue expenditure to 35 | P a g e

Accounting for Managers - Accounting Standards be amortised over a period not exceeding to 3 to 5 years after the commencement of commercial production. Normal wastages are capitalised. Abnormal wastages are not capitalised but charged to the profit and loss account.

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Accounting for Managers - Accounting Standards NON MONETARY CONSIDERATION FOR FIXED ASSETS: When a fixed asset is acquired in exchange for another asset, its cost is usually determined by reference to the fair market value of the consideration given. Fair market value is the price that would be agreed to in an open and unrestricted market between knowledgeable and willing parties dealing at arm’s length who are fully informed and are not under any compulsion to transact. It may be appropriate to consider also the fair market value of the asset acquired if this is more clearly evident. An alternative accounting treatment that is sometimes used for an exchange of assets, particularly when the assets exchanges are similar, is to record the asset acquired at eh net book value of the asset given up in each case; an adjustment is made for any balancing receipt or payment of cash or other consideration. When a fixed asset is acquired in exchange for share or other securities in the enterprise, it is usually recorded at its fair market value, or the fair market value of the securities issued, whichever is more clearly evident. SUBSEQUENT EXPENDITURE INCURRED ON FIXED ASSETS AFTER INITIAL CAPITALISATION ACCOUNTED Frequently, it is difficult to determine whether subsequent expenditure related to fixed asset represents improvements that ought to be added to the gross book value or repair that ought to be charged to the profit and loss statement. Only expenditure that increases the future benefits from the existing asset beyond its previously assessed standard of performance is included in the gross book value, e.g., an increase in capacity or structural alteration to a building that increases the strength of the building beyond its original strength. Examples of improvements which result in increased future economic benefits include: • Modification of an item of plant to extend its useful life, including an increase in its capacity;

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Accounting for Managers - Accounting Standards • Upgrading machine parts to achieve a substantial improvement in the quality of output; and • Adoption of new production processes enabling a substantial reduction in previously assessed operating costs While deciding whether subsequent expenditure resulted in an increase in the future benefits from the asset or not, recognition should be given both to the increase in the benefits ‘per annum’ as well as increase in benefits through extension of the life of the asset. Thus, even if there was no increase in the annual capacity, but the life of the asset was substantially increased, it would be taken as an increase in the future benefits from the concerned asset beyond its previously assessed standard of performance. The expenditure on regular overhauling only results in maintaining the previously estimated standard of performance and it does not have the effect of improving the previously assessed of performance. Lets consider an example, where a land right is in dispute when it was acquired by an enterprise. The enterprise subsequently incurred legal expenses and got all the land rights transferred in its favour. This expenditure should be capitalised because it increases the value of the land beyond its original assessed standard of performance. Lets consider another example. An enterprise purchases a land on which there is not dispute. Subsequent to the acquisition there is encroachment of land. The enterprise incurs legal expenses to vacate the encroachers. This expenditure cannot be capitalised because it does not increase the value of the land beyond its original assessed standard of performance. The cost of an addition or extension to an existing asset which is of a capital nature and which becomes an integral part of the existing asset is usually added to its gross books value. Expenditure on repairs or maintenance of property, plant and equipment is made to restore or maintain the future economic benefits that an enterprise can 38 | P a g e

Accounting for Managers - Accounting Standards expect from the originally assessed standard of performance of the asset. As such, it is usually recognised as an expense when incurred. For example, the cost of servicing or overhauling plant and equipment is usually an expense since it restores, rather than increase, the originally assessed standard performance. BASIS FOR REVALUATION OF FIXED ASSETS AND USE OF REVALUATION RESERVE FOR DECLARING DIVIDENDS OR ISSUING BONUS SHARES Sometimes financial statements that are otherwise prepared on a historical cost basis include part or all of the fixed assets at a valuation in substitution for historical costs and depreciation is calculated accordingly. A commonly accepted and preferred method of restating assets is by appraisal, normally undertaken by competent valuer’s. Other methods are used are indexation and reference o the current prices which when applied across checked periodically by appraisal method. According to Schedule VI of Companies Act, every balance sheet susbsequent to revaluation shall disclose the increased figure with the date of increase in place of original cost for all the first 5 years. The fact of revaluation will be disclosed in all the future balance sheets till such time the revalued assets appear in the company’s balance sheet. Revaluation reserve is a reserve that represents the excess of the estimated replacement cost or estimated market values over the book values thereof. As the revaluation reserve is a not a realized gain, it is not available for distribution of dividends or issue of bonus shares , or writing off accumulated losses or profit and loss debit balance or clearing backlog of depreciation of arrears etc. SEBI also prohibits use of revaluation reserve for purpose of declaring bonus shares.

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Accounting for Managers - Accounting Standards PRINCIPLES FOR REVALUATION

SELECTION

OF

FIXED

ASSETS

FOR

When a fixed asset is revalued in financial statements, an entire class of assets should be revalued, or the selection of assets for revaluation should be made on a systematic basis. This basis should be disclosed. Selective revaluation of assets can lead to unrepresentative amounts being reported in financial statements. Accordingly, when revaluations do not cover all assets of given class, it is appropriate that the selection of assets to be made on a systematic basis. e.g an enterprise may be revalued a whole class of assets within a unit. ACCOUNTING TREATMENT FOR REVALUATION It is not appropriate for the revaluation of a class of assets to result in the net book value of that class being greater than the recoverable amount of the assets of that class. Therefore revaluation would be restricted to the recoverable amount of the fixed assets. The revalued amounts of fixed assets are presented in financial statements either by restating both the gross book value and accumulated depreciation so as to give a net book value equal to the net revalued amount or by restating the net book value by adding therein the net increase on account revaluation. An upward revaluation does not provide a basis for crediting to the profit and loss statement the accumulated depreciation existing at the date of revaluation. As increase in net book value arising on revaluation of fixed assets should credited directly to owner’s interests under the head of revaluation reserves, except that, to the extent that such increase is related to and not greater than a decrease arising on revaluation previously recorded as a charge to the profit and loss statement, it may be credited to the profit and loss statement. A decrease in net book value arising on revaluation of fixed asset should be charged directly to the profit and loss statement except that to the extent that such a decrease is related to an increase which was previously recorded as a credit to revaluation 40 | P a g e

Accounting for Managers - Accounting Standards reserve and which has not been subsequently reserved or utilised, it may be charged directly to that account. Depreciation under AS-6 should be provided on the total value of the fixed asset including the revalued protion. Depreciation on the revalued portion of the fixed asset can either be charged to the profit and loss account or alternatively charged to the profit and loss account and at the same time compensated from the revaluation reserve such that the net charge to the profit and loss account is nil. ACCOUNTING OF RETIREMENTS AND DISPOSALS Fixed asset should be eliminated from the financial statements on disposal or when no further benefit is expected from its use and disposal. Items of fixed assets that have been retired from active use and are held for disposal are stated at the lower of their net book value and realisable value and are shown separately in the financial statements. Any expected loss is recognized immediately in the profit and loss statements. In historical cost financial statements, gains or losses arising on disposal are recognised in the profit and loss statement. Paragraph 24 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’ states that “Material items retired from active use and held for disposal should be stated at the lower of their net book value and net realisable value and shown separately in the financial statements.” The fixed assets which are retired from active use and dismantled and are not actually sold off, should be disclosed appropriately at the lower of net realisable value and net book value in the Schedule of Fixed Assets or on the face of the balance sheet under the head Fixed Assets. These items cannot be disclosed under the caption ‘inventories’ On disposal of a previously revalued item of fixed asset, the difference between net disposal proceeds and the net book value should be charged or credited to the profit and loss statement except that to the extent that such a loss is related 41 | P a g e

Accounting for Managers - Accounting Standards to an increase which was previously recorded or utilised, it may be charged directly to that account. The amount standing in revaluation reserve following the retirement or disposal of an asset which relates to that asset may be transferred to general reserves. TREATMENT FOR JOINTLY OWNED FIXED ASSETS Where an enterprise owns fixed assets jointly with other (otherwise than as a part in a firm), the extent of its share in such assets, and the proportion in the original cost, accumulated depreciation and written down values are stated in the balance sheet. Alternatively, the pro rata cost of such jointly owned assets is grouped together with similar fully owned assets with an appropriate disclosure thereof. Details of such jointly owned assets are indicated separately in the fixed assets register. AMORTISATION/ DEPRECIATION OF GOODWILL Goodwill, in general, is recorded in the books only when some consideration in money or money’s worth has been paid for it. Whenever, a business is acquired for a price (payable either in cash or in shares or otherwise) which is in excess of the value of the net assets of the business taken over, the excess is termed as ‘goodwill’. Goodwill arises from business connections, trade name or reputation of an enterprise or from other intangible benefits enjoyed by an enterprises. Where several fixed assets are purchased for a consolidated price, the consideration should be apportioned to the various assets on a fair basis as determined by competent value. As a matter of financial prudence, goodwill is written off over a period of 3-5 years.

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Accounting for Managers - Accounting Standards DISCLOSURES OF FIXED ASSETS In addition to disclosures required to be made under AS-1 and AS-6, further disclosures under AS-10 are as follows: (i)

Gross and net book values of fixed assets at the 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 amount substituted for historical costs of fixed assets, the basis of selection of fixed assets for revaluation, the method adopted to compute the revalued amount, the nature of any indices used, the year of any appraisal made, and whether an external valuer was involved, in case where fixed assets are stated at revalued amounts. For purposes of Schedule VI, the revalued amounts of each class of fixed assets are presented in the balance sheet separately, by restating both the gross book value and accumulated depreciation so as to give a net book value to a new revalued amount. It is not correct to net off the increase/decrease in net-book value arising from revaluation of various classes of fixed assets, for example, machinery and building. SIGNIFICANT DIFFERENCES BETWEEN AS-10, IAS AND US GAAP Fixed assets are more elaborately defined under IAS and US GAAP. For example according to IAS-16, an item of property, plant and equipment should be recognised as an asset when (a) it is probable that future economic benefits associated with the asset will flow to the enterprise; and (b) the cost of the asset to the enterprise can be measured reliably. Though these provision not

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Accounting for Managers - Accounting Standards contained in AS-10 it is assumed that they would apply even in the Indian situation. US GAAP does not permit revaluation of fixed assets. As regards upward revaluation of fixed assets, IAS-16 permits it as an alternative treatment. Revaluation is also permitted under AS-10, such as (a) IAS provides more detail guidelines than AS-10 on revaluation principles (b) Under IAS-16, revaluations are required to be done with sufficient regularity such that their carrying amount do not differ materially from the fair values. There is no such requirement in AS-10. IAS-16 also states that annual revaluations are important where fixed asset fair values are subject to significant volatility, otherwise a revaluation every three or five year is sufficient.

Under AS-10 if the interval between the date a project is ready to commence commercial production and the date at which commercial production actually begins is prolonged, all expenses (other than borrowing costs) incurred during this period are charged to the profit and loss statement. However, the expenditure incurred during this period is also sometimes treated as deferred revenue expenditure to be amortised over a period not exceeding 3 to 5 years after the commencement of commercial production. Under IAS/US GAAP deferral of expenditure is not permitted, and all expenses incurred in these circumstances are charged to the profit and loss account.

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AS-12 : GOVERNMENT GRANTS Accounting for Government Grants • Capital Approach versus Income Approach • Recognition of Government Grants • Non-monetary Government Grants • Presentation of Grants Related to Specific Fixed Assets • Presentation of Grants Related to Revenue • Presentation of Grants of the nature of Promoters’ contribution • Refund of Government Grants • Disclosure Statements of Accounting Standards The following is the text of the Accounting Standard (AS) 12 issued by the Council of the Institute of Chartered Accountants of India on ‘Accounting for Government Grants’. The Standard comes into effect in respect of accounting periods commencing on or after 1.4.1992 and will be recommendatory in nature for an initial period of two years. Accordingly, the Guidance Note on ‘Accounting for Capital Based Grants’ issued by the Institute in 1981 shall stand with drawn from this date. This

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Accounting for Managers - Accounting Standards Standard will become mandatory in respect of accounts for periods commencing on or after 1.4.1994.2

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Accounting for Managers - Accounting Standards Introduction 1. This Statement deals with accounting for government grants. Government grants are sometimes called by other names such as subsidies, cash incentives, duty drawbacks, etc. 2. This Statement does not deal with: • The special problems arising in accounting for government grants in financial statements reflecting the effects of changing prices. Accounting Standards are intended to apply only to items which are material. • Reference may be made to the section titled ‘Announcements of the Council Regarding status of various documents issued by the Institute of Chartered Accountants of India’ appearing at the beginning of this Compendium for a detailed discussion on the implications of the mandatory status of an accounting standard. Definitions The following terms are used in this Statement with the meanings Specified: •

Government refers to government, government agencies and similar bodies whether local, national or international.



Government grants are assistance by government in cash or kind to an enterprise for past or future compliance with certain conditions.

• They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the enterprise. 47 | P a g e

Accounting for Managers - Accounting Standards Explanation The receipt of government grants by an enterprise is significant for Preparation of the financial statements for two reasons. Firstly, if a government grant has been received, an appropriate method of accounting there for is necessary. Secondly, it is desirable to give an indication of the extent to which the enterprise has benefited from such grant during the reporting period. This facilitates comparison of an enterprise’s financial statements with those of prior periods and with those of other enterprises. Accounting Treatment of Government Grants Capital Approach versus Income Approach • Two broad approaches may be followed for the accounting treatment of government grants: the ‘capital approach’, under which a grant is treated as part of shareholders’ funds, and the ‘income approach’, under which a grant is taken to income over one or more periods. Those in support of the ‘capital approach’ argue as follows: • Many government grants are in the nature of promoters’ contribution, i.e., they are given with reference to the total investment in an undertaking or by way of contribution towards its total capital outlay and no repayment is ordinarily expected in the case of such grants. These should, therefore, be credited directly to shareholders’ funds. • It is inappropriate to recognise government grants in the profit and loss statement, since they are not earned but represent an incentive provided by government without related costs.

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Arguments in support of the ‘income approach’ are as follows: • Government grants are rarely gratuitous. The enterprise earns them through compliance with their conditions and meeting the envisaged obligations. They should therefore be taken to income and matched with the associated costs which the grant is intended to compensate. • As income tax and other taxes are charges against income, it is logical to deal also with government grants, which are an extension of fiscal policies, in the profit and loss statement. • In case grants are credited to shareholders’ funds, no correlation is done between the accounting treatment of the grant and the accounting treatment of the expenditure to which the grant relates. • It is generally considered appropriate that accounting for government grant should be based on the nature of the relevant grant. Grants which have the characteristics similar to those of promoters’ contribution should be treated as part of shareholders’ funds. Income approach may be more appropriate in the case of other grants. • It is fundamental to the ‘income approach’ that government grants be recognised in the profit and loss statement on a systematic and rational basis over the periods necessary to match them with the related costs. Income recognition of government grants on a receipts basis is not in accordance with the accrual accounting assumption.

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Accounting for Managers - Accounting Standards Recognition of Government Grants Government grants available to the enterprise are considered for inclusion in accounts: • Where there is reasonable assurance that the enterprise will comply with the conditions attached to them; and • Where such benefits have been earned by the enterprise and it is reasonably certain that the ultimate collection will be made. • Mere receipt of a grant is not necessarily a conclusive evidence that condition attaching to the grant have been or will be fulfilled. Non-monetary Government Grants Government grants may take the form of non-monetary assets, such as land or other resources, given at concessional rates. In these circumstances, it is usual to account for such assets at their acquisition cost. Non-monetary assets given free of cost are recorded at a nominal value. Presentation of Grants Related to Specific Fixed Assets • Grants related to specific fixed assets are government grants whose primary condition is that an enterprise qualifying for them should purchase, construct or otherwise acquire such assets. Other conditions may also be attached restricting the type or location of the assets or the periods during which they are to be acquired or held. • Two methods of presentation in financial statements of grants (or the appropriate portions of grants) related to specific fixed assets are regarded as acceptable alternatives.

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Accounting for Managers - Accounting Standards • Under one method, the grant is shown as a deduction from the gross value of the asset concerned in arriving at its book value. The grant is thus recognised in the profit and loss statement over the useful life of a depreciable asset by way of a reduced depreciation charge. Where the grant equals the whole, or virtually the whole, of the cost of the asset, the asset is shown in the balance sheet at a nominal value. • Under the other method, grants related to depreciable assets are treated 4 AS 5 has been revised in February 1997. The title of revised AS 5 is ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’. as deferred income which is recognised in the profit and loss statement on a systematic and rational basis over the useful life of the asset. Such allocation to income is usually made over the periods and in the proportions in which depreciation on related assets is charged. Grants related to non- depreciable assets are credited to capital reserve under this method, as there is usually no charge to income in respect of such assets. However, if a grant related to a non-depreciable asset requires the fulfillment of certain obligations, the grant is credited to income over the same period over which the cost of meeting such obligations is charged to income. The deferred income is suitably disclosed in the balance sheet pending its apportionment to profit and loss account. For example, in the case of a company, it is shown after ‘Reserves and Surplus’ but before ‘Secured Loans’ with a suitable description. • The purchase of assets and the receipt of related grants can cause major movements in the cash flow of an enterprise. For this reason and in order to show the gross investment in assets, such movements are often disclosed as separate items in the statement of changes in financial 51 | P a g e

Accounting for Managers - Accounting Standards position regardless of whether or not the grant is deducted from the related asset for the purpose of balance sheet presentation. Presentation of Grants Related to Revenue • Grants related to revenue are sometimes presented as a credit in the profit and loss statement, either separately or under a general heading such as ‘Other Income’. Alternatively, they are deducted in reporting the related expense. • Supporters of the first method claimt hat it is inappropriate to net income and expense items and that separation of the grant from the expense facilitate comparison with other expenses not affected by a grant. For the second method, it is argued that the expense might well not have been incurred by the enterprise if the grant had not been available and presentation of the expense without offsetting the grant may therefore be misleading. Presentation of Grants of the nature of Promoters’ contribution • Where the government grants are of the nature of promoters’ contribution, i.e., they are given with reference to the total investment in an undertaking or by way of contribution towards its total capital outlay (for example, central investment subsidy scheme) and no repayment is ordinarily expected in respect thereof, the grants are treated as capital reserve which can be neither distributed as dividend nor considered as deferred income. Refund of Government Grants • Government grants sometimes become refundable because certain conditions are not fulfilled. A government grant that becomes refundable 52 | P a g e

Accounting for Managers - Accounting Standards is treated as an extraordinary item (see Accounting Standard (AS) 5, Prior Period and Extraordinary Items and Changes in Accounting Policies5). • The amount refundable in respect of a government grant related to revenue is applied first against any unamortised deferred credit remaining in respect of the grant. To the extent that the amount refundable exceeds any such deferred credit, or where no deferred credit exists, the amount is charged immediately to profit and loss statement. • The amount refundable in respect of a government grant related to a specific fixed asset is recorded by increasing the book value of the asset or by reducing the capital reserve or the deferred income balance, as appropriate, by the amount refundable. In the first alternative, i.e., where the book value of the asset is increased, depreciation on the revised book value is provided prospectively over the residual useful life of the asset. • Where a grant which is in the nature of promoters’ contribution becomes refundable, in part or in full, to the government on non-fulfillment of some specified conditions, the relevant amount recoverable by the government is reduced from the capital reserve. Disclosure The following disclosures are appropriate: •

The accounting policy adopted for government grants, including the methods of presentation in the financial statements; the nature and extent of government grants recognised in the financial statements, including grants of non-monetary assets given at a concessional rate or free of cost.

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Accounting for Managers - Accounting Standards • Government grants should not be recognised until there is reasonable assurance that (i) the enterprise will comply with the conditions attached to them, and (ii) the grants will be received. • Government grants related to specific fixed assets should be presented in the balance sheet by showing the grant as a deduction from the gross value of the assets concerned in arriving at their book value. Where the grant related to a specific fixed asset equals the whole or virtually the whole, of the cost of the asset, the asset should be shown in the balance sheet at a nominal value. Alternatively, government grants related to depreciable fixed assets may be treated as deferred income which should be recognised in the profit and loss statement on a systematic and rational basis over the useful life of the asset, i.e., such grants should be allocated to income over the periods and in the proportions in which depreciation on those assets is charged. Grants related to non-depreciable assets should be credited to capital reserve under this method. However, if a grant related to a non-depreciable asset requires the fulfillment of certain obligations, the grant should be credited to income over the same period over which the cost of meeting such obligations is charged to income. The deferred income balance should be separately disclosed in the financial statements. • Government grants related to revenue should be recognised on a systematic basis in the profit and loss statement over the periods necessary to match them with the related costs which they are intended to compensate. Such grants should either be shown separately under ‘other income’ or deducted in reporting the related expense. • Government grants of the nature of promoters’ contribution should be credited to capital reserve and treated as a part of shareholders’ funds. 54 | P a g e

Accounting for Managers - Accounting Standards • Government grants in the form of non-monetary assets, given at a concessional rate, should be accounted for on the basis of their acquisition cost. In case a non-monetary asset is given free of cost, it should be recorded at a nominal value. • Government grants that are receivable as compensation for expenses or losses incurred in a previous accounting period or for the purpose of giving immediate financial support to the enterprise with no further related costs, should be recognised and disclosed in the profit and loss statement of the period in which they are receivable, as an extraordinary item if appropriate. • A contingency related to a government grant, arising after the grant has been recognised, should be treated in accordance with Accounting Standard (AS) 4, Contingencies and Events Occurring After the Balance Sheet Date.7 • Government grants that become refundable should be accounted for as an extraordinary item. • The amount refundable in respect of a grant related to revenue should be applied first against any unamortised deferred credit remaining in respect of the grant. To the extent that the amount refundable exceeds any such deferred credit, or where no deferred credit exists, the amount should be charged to profit and loss statement. • The amount refundable in respect of a grant related to a specific fixed asset should be recorded by increasing the book value of the asset or by reducing the capital reserve or the deferred income balance, as appropriate, by the amount refundable. In the first alternative, i.e., where the book value of the asset is increased, depreciation on the revised book 55 | P a g e

Accounting for Managers - Accounting Standards value should be provided prospectively over the residual useful life of the asset. • Government grants in the nature of promoters’ contribution that become refundable should be reduced from the capital reserve.

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Accounting for Managers - Accounting Standards Bibliography

• Compendium of Accounting Standards • ICAI – Institute of Chartered Accountants of India •

Student Guide to Indian Accounting Standard & GAAP

• www.icai.org

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