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FINAL COURSE STUDY MATERIAL

PAPER 1

Financial Reporting

Volume – 2

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 book(s). 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 India

All rights reserved. No part of this book may be reproduced, stored in a retrieval system,
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Published by Dr. T.P. Ghosh, Director of Studies, ICAI, C-1, Sector-1, NOIDA-201301
Typeset and designed at Board of Studies, The Institute of Chartered Accountants of India.
PREFACE

The paper of Financial Reporting in the Final Course concentrates on understanding of the crucial
aspects of preparing and analyzing financial statements. Students are expected to acquire
advanced knowledge in this paper. The importance of the subject of financial reporting is growing
over the years due to various factors like liberalization, flow of cross-border capital, emergence of
global corporations and movement towards better corporate governance practices.
Standardization of accounting policies and financial reporting norms are significant aspects that
make the subject more interesting in the recent years. Various new Accounting Standards,
Guidance Notes and Accounting Standards Interpretations have been formulated by the Institute of
Chartered Accountants of India keeping in mind the growing importance of financial reporting in
corporate scenario.
The students are required to develop understanding of the Accounting Standards, Accounting
Standards Interpretations and the relevant Guidance notes and should gain ability to apply the
provisions contained therein under the given practical situations. The last decade has witnessed a
sea change in the global economic scenario. The emergence of transnational corporations in
search of money, not only for fuelling growth, but to sustain ongoing activities has necessitated
raising of capital from all parts of the world. When an enterprise decides to raise capital from the
foreign markets, the rules and regulations of that country will apply and the enterprise should be
able to understand the differences between the rules governing financial reporting in the foreign
country as compared to that of its own country. Thus translations and re-instatements of financial
statements are of great significance. Therefore, chapter based on overview of Indian Accounting
Standards, International Accounting Standards/International Financial Reporting Standard and US
GAAPs has also been introduced in the Final Course curriculum.
The book is divided into two volumes for ease of handling by the students. Volume – 1 contains
Chapters 1 – 7 and Volume – 2 contains Chapters 8 – 10. Appendices containing text of
Accounting Standards, Guidance Notes and Accounting Standards Interpretations have also been
included in Volume – 2. Care has been taken to present the chapters in the same sequence as
prescribed in the syllabus to facilitate easy understanding by the students. Small illustrations have
been incorporated in each chapter/unit to explain the concepts/principles covered in the
chapter/unit. Another helpful feature is the addition of self-examination questions which will help
the students in preparing for the Final Course Examination.
Students are advised to practise the practical problems thoroughly. They are also advised to
update themselves with the latest changes in the area of financial reporting. For this they may refer
to academic updates in the monthly journal ‘The Chartered Accountant’ and the Students
‘Newsletter’ published by the Board of Studies, financial newspapers, SEBI and Corporate Law
Journal , published financial statements of companies etc.
The concerned Faculty members of Board of Studies of Accounting have put their best efforts in
making this study material lucid and student friendly. The Board has also received valuable inputs
from CA. Yash Arya, Dr. Satyajit Dhar, CA. Prasun Rakshit, Dr. S. K. Chowdhry for which the
Board is thankful to them.
In case students have any suggestions to make this study material more helpful, they are welcome
to write to the Director of Studies, The Institute of Chartered Accountants of India, C-I, Sector-I,
Noida-201 301.
VOLUME 2

CONTENTS

Note : Chapters 1 – 7 of Financial Reporting are available in Volume 1.

CHAPTER 8 – FINANCIAL REPORTING FOR FINANCIAL INSTITUTIONS

Unit 1: Mutual Funds


1.1 Introduction .................................................................................................. 8.1
1.2 Organisation of Mutual funds ........................................................................ 8.1
1.3 Mutual Fund Schemes ................................................................................... 8.3
1.4 Evaluation of Mutual Funds ............................................................................ 8.3
1.5 Valuation of Portfolio ..................................................................................... 8.5
1.6 Annual Reporting........................................................................................... 8.5
1.7 Accounting Policies ....................................................................................... 8.6
1.8 Contents of Balance Sheet and Revenue Account ........................................... 8.9
1.9 Making investments to market ...................................................................... 8.12
1.10 Disposal of investments ............................................................................... 8.13
1.11 Recognition of dividend income .................................................................... 8.15
1.12 Cost of Investments ..................................................................................... 8.14
1.13 Date of recording of transactions.................................................................. 8.15
1.14 Dividend Equalisation .................................................................................. 8.16
Unit 2: Non-Banking Finance Company
2.1 Introduction ................................................................................................. 8.19
2.2 Definition of NBFC....................................................................................... 8.19
2.3 Registration and Regulation of NBFC ........................................................... 8.19
2.4 Minimum Net owned fund ............................................................................. 8.20
2.5 Types of NBFC regulated by RBI .................................................................. 8.20
2.6 Public Deposits ........................................................................................... 8.22
2.7 Liquid Asset Requirements .......................................................................... 8.23
2.8 Prudential Accounting Norms ....................................................................... 8.23

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2.9 Income Recognition ..................................................................................... 8.24
2.10 Accounting for Investments .......................................................................... 8.24
2.11 Asset Classification ..................................................................................... 8.25
2.12 Non-Performing Asset.................................................................................. 8.26
2.13 Provisioning Requirements .......................................................................... 8.26
2.14 Disclosures in the Balance-Sheet ................................................................. 8.28
2.15 Requirements as to Capital Adequacy .......................................................... 8.28
2.16 Asset Liability Management ......................................................................... 8.29
2.17 NBFC Prudential Norms (RBI) Direction, 1998 .............................................. 8.30
Unit 3: Merchant Bankers
3.1 Introduction ................................................................................................. 8.41
3.2 Capital Adequacy Requirement .................................................................... 8.41
3.3 Maintenance of Books of Account, Records .................................................. 8.42
Unit 4: Stock and Commodity Market Intermediaries
4.1 Introduction ................................................................................................. 8.45
4.2 Stock Brokers.............................................................................................. 8.46
4.3 Maintenance of Proper Books of Account, Records ....................................... 8.47
4.4 Presentation of Books of Account and Records ............................................. 8.49
4.5 Board’s Right to Inspect............................................................................... 8.50
4.6 Procedure for Inspection .............................................................................. 8.50
4.7 Obligations of Stock Broker on Inspection by the Board................................. 8.50
4.8 Submission of Report to the Board ............................................................... 8.51
4.9 Action on Inspection or Investigation Report ................................................. 8.51
4.10 Appointment of Auditor ................................................................................ 8.51
4.11 Regulation of Transactions between Clients and Brokers............................... 8.51
4.12 Member Broker to keep Accounts ................................................................. 8.51
4.13 Obligation to pay Money into Clients Accounts .............................................. 8.51
4.14 Accounts for Client’s Securities .................................................................... 8.52
4.15 Payment and Delivery of Securities .............................................................. 8.53
4.16 Margin ........................................................................................................ 8.53
4.17 Closing Out ................................................................................................. 8.53

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CHAPTER 9 – VALUATION

Unit 1: Concept of Valuation


1.1 Introduction .................................................................................................. 9.1
1.2 Concept of Valuation ..................................................................................... 9.2
1.3 Need for Valuation......................................................................................... 9.2
1.4 Bases of Valuation......................................................................................... 9.3
1.5 Types of Value .............................................................................................. 9.4
1.6 Approaches of Valuation ................................................................................ 9.6
Unit 2: Valuation of Tangible Fixed Assets
2.1 Introduction ................................................................................................... 9.7
2.2 Meaning of Original Cost ............................................................................... 9.7
2.3 Change in Original Cost ................................................................................. 9.9
2.4 Change of Original Cost -Improvements, Revaluation, Impairment ................... 9.9
2.5 Valuation Approaches .................................................................................. 9.10
2.6 Net Valuation .............................................................................................. 9.10
2.7 Disposal and Retirement .............................................................................. 9.10
2.8 Depreciation................................................................................................ 9.11
Unit 3: Valuation of Intangibles
3.1 Definition of Intangibles ............................................................................... 9.17
3.2 Recognition ................................................................................................. 9.17
3.3 Definition of goodwill ................................................................................... 9.18
3.4 Nature and Types of Goodwill ...................................................................... 9.19
3.5 Factors Contributing to Goodwill................................................................... 9.20
3.6 Relevant Provisions of the Accounting Standards.......................................... 9.21
3.7 Valuation of Goodwill ................................................................................... 9.22
3.8 Determination of Capital Employed............................................................... 9.24
3.9 Future Maintainable profit ............................................................................ 9.28
3.10 Normal Rate of Return ................................................................................. 9.32
3.11 Brand Valuation........................................................................................... 9.35
3.12 Identification of brands as an Asset .............................................................. 9.36
3.13 Objectives of Corporate Branding ................................................................. 9.37

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3.14 Corporate Brand Accounting ........................................................................ 9.37
3.15 Objectives of Brand Accounting.................................................................... 9.38
3.16 Difficulties in Brand Accounting .................................................................... 9.39
3.17 Valuation of Brands ..................................................................................... 9.40
3.18 Human Resources as a Brand ...................................................................... 9.45
3.19 Corporate Brand Strength ............................................................................ 9.47
Unit 4: Valuation of Liabilities......................................................................................
4.1 Introduction ................................................................................................. 9.49
4.2 Base of Valuation ........................................................................................ 9.49
4.3 Carrying Value ............................................................................................ 9.49
4.4 Leases ........................................................................................................ 9.49
4.5 Provisions ................................................................................................... 9.50
Unit 5: Valuation of Shares ..........................................................................................
5.1 Introduction ................................................................................................. 9.51
5.2 Purposes of Valuation.................................................................................. 9.51
5.3 Relevance of Valuation ................................................................................ 9.51
5.4 Limitation of Stock Exchange Price as a Basis for Valuation .......................... 9.52
5.5 Methods ...................................................................................................... 9.53
5.6 Statutory Valuation ...................................................................................... 9.60
5.7 Valuation of Preference Shares .................................................................... 9.67
5.8 Miscellaneous Problems for Practice ............................................................ 9.67
Unit 6: Valuation of Business.......................................................................................
6.1 Introduction ................................................................................................. 9.76
6.2 Need for Valuation of Business .................................................................... 9.76
6.3 Valuation Approaches .................................................................................. 9.76
6.4 Valuation Methods ....................................................................................... 9.76
6.5 Book Value ................................................................................................. 9.78
6.6 Fair Value ................................................................................................... 9.79
6.7 Earning Based Valuation of Business ........................................................... 9.80
6.8 Market Value Model ..................................................................................... 9.80
6.9 Valuation of Investments.............................................................................. 9.80
6.10 Valuation of Current Assets, Loans and Advances ........................................ 9.81
6.11 Value of Control of the Business .................................................................. 9.87

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CHAPTER 10 - DEVELOPMENTS IN FINANCIAL REPORTING

Unit 1: Value Added Statement


1.1 Historical Background .................................................................................. 10.1
1.2 Definitions................................................................................................... 10.1
1.3 Reporting Value Added ................................................................................ 10.3
1.4 Necessity of preparing VA Statements .......................................................... 10.3
1.5 Value Added Statement ............................................................................... 10.5
1.6 Limitations of VA ......................................................................................... 10.7
1.7 Interpretation of VA ....................................................................................10.12
Unit 2: Economic Value Added
2.1 Introduction ................................................................................................10.15
2.2 Cost of Capital ...........................................................................................10.15
2.3 Capital Asset Pricing Model ........................................................................10.16
2.4 Beta...........................................................................................................10.16
2.5 Equity Risk Premium ..................................................................................10.17
Unit 3: Market Value Added
3.1 Introduction ................................................................................................10.21
3.2 Relationship between EVA and Market Value Added ....................................10.21
3.3 Benefits of Market Value Added ..................................................................10.22
3.4 Limitations of Market Value Added ..............................................................10.24
Unit 4: Shareholders’ Value Added ..............................................................................
4.1 Introduction ................................................................................................10.25
4.2 Implications................................................................................................10.25
Unit 5: Human Resource Reporting
5.1 Introduction ................................................................................................10.26
5.2 Models of HRA ...........................................................................................10.26
5.3 Implications of Human Capital Reporting .....................................................10.30
5.4 HRA in India...............................................................................................10.31
Unit 6: Inflation Accounting
6.1 Introduction ................................................................................................10.35
6.2 Primary Purpose of Financial Statements ....................................................10.35

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6.3 Limitations of Historical Cost based Accounts ..............................................10.36
6.4 Need for Inflation Accounting ......................................................................10.36
6.5 Current Purchasing Power Method ..............................................................10.36
6.6 Current Cost Accounting .............................................................................10.39
6.7 Evaluation of CCA ......................................................................................10.46
6.8 Miscellaneous Illustrations ..........................................................................10.46

APPENDICES
APPENDIX I .................................................................................................... I.1 – I.412
APPENDIX II ...................................................................................................II.1 – II.53
APPENDIX III .............................................................................................. III.1 – III.204

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8
FINANCIAL REPORTING FOR FINANCIAL INSTITUTIONS

UNIT 1
MUTUAL FUNDS

1.1 INTRODUCTION
Mutual funds are trusts, which pool resources from large number of investors through issue of
units under specified schemes. The funds raised are invested in capital market instruments
such as shares, debentures and bonds and money-market instruments, such as commercial
papers, certificates of deposits and treasury bonds. The fund earns income from these
investments by way of dividends, interests and capital gains. The income from investments,
less specified expenses for managing the funds, are distributed among unit holders in
proportion of number of units held. The investments are made under expert guidance to allow
unit holders to earn highest possible return for lowest possible risk. Risk reduction is achieved
through planned diversification of investment portfolio and also by judicious use of various
hedging techniques. The selection investments for a scheme should be within the investment
objectives and other parameters set for the scheme.

1.2 ORGANISATION OF MUTUAL FUNDS


In India, mutual funds are regulated by SEBI (Mutual Funds) Regulations, 1996. According to
the SEBI (Mutual Funds) Regulations, 1996, a ‘mutual fund’ means a fund established in the
form of a trust to raise monies through the sale of units to the public under one or more
schemes for investing in securities including money market instruments.
The management of mutual fund comprises of a sponsor, trustee company and an Asset
Management Company (AMC). Typically, a mutual fund is promoted by a sponsor who
appoints trustee, asset management company and custodian. A mutual fund should be
registered with SEBI.
“Asset management company” means a company formed and registered under the Companies
Act, 1956 and approved as such by the Securities and Exchange Board of India to manage the
8.2 Financial Reporting

funds of a mutual fund.


“Unit” means the interest of the unitholders in a scheme, which consists of each unit
representing one undivided share in the assets of a scheme;
“Money market instruments” includes commercial papers, commercial bills, treasury bills,
Government Securities having an unexpired maturity up to one year, call or notice money,
certificate of deposit, usance bills, and any other like instruments as specified by the Reserve
Bank of India from time to time;
A mutual fund invests the money received from investors in instruments which are in line with
the objectives of the respective schemes. Regular expenses like custodial fee, cost of
dividend warrants, registrar’s fee, asset management fee, etc., are borne by the respective
schemes. Balance every thing is given back to the investors in full.
In a mutual fund, the resources of many investors are pooled to create a diversified port folio
of securities. After collecting the funds from investors, daily operations are managed by
experts and professional fund managers. They take investment decisions regarding what,
how much, when and where to invest and disinvest so as to get maximum return as well as
higher capital appreciation. The purchase and repurchase price of mutual funds are generally
fixed and also vary in stock exchanges if the security is quoted on the basis of its net asset
value (NAV). The investment pattern of mutual funds is governed partly by Government
guidelines and partly by nature and objective of mutual fund.
A mutual fund shall be constituted in the form of a trust and the instrument of trust shall be in
the form of a deed, duly registered under the provisions of the Indian Registration Act, 1908
(16 of 1908), executed by the sponsor in favour of the trustees named in such an instrument.
Under regulation 50, every asset management company for each scheme shall keep and
maintain proper books of account, records and documents, for each scheme so as to explain
its transactions and to disclose at any point of time the financial position of each scheme and
in particular give a true and fair view of the state of affairs of the fund and intimate to the
Board the place where such books of account, records and documents are maintained.
The mutual funds are set up as registered trusts. Any body corporate, if approved by SEBI can
sponsor such trusts. The sponsor appoints the trustees. The trustees hold assets of the trust
for the benefit of unit holders. The sponsor, or if the trust deed permits, the trustees, appoint
an Asset Management Company (AMC) for creation and maintenance of investment portfolios
under different schemes. The AMC is a company formed and registered under the Companies
Act 1956. It must obtain approval from the SEBI to act as AMC.
The AMC acts under broad superintendence of the board of trustees. The trustees have the
duty to monitor actions of the AMC to ensure compliance with the SEBI regulations. The AMC
may charge the mutual fund with Investment Management and Advisory Fees subject to
prescribed ceiling. The fees to be paid to the AMC must be disclosed fully in the offer
Financial Reporting for Financial Institutions 8.3

document. In addition to the fees, the AMC may recover prescribed expenses from the Mutual
Fund.

1.3 MUTUAL FUND SCHEMES


In terms of investment objectives, mutual fund schemes can be classified as the growth funds
and income funds. The growth funds invest major parts of their corpus in equity instruments
and hence are exposed to comparatively higher risks. These schemes are expected to provide
higher return in form of dividends and capital appreciation. Income funds invest in fixed
income debt instruments, e.g. corporate debentures, Government securities and money
market instruments and hence are also called the debt funds. They provide steady flow of
comparatively lower return for lower risks.
Depending on the type of entry and exit routes available, the mutual fund schemes can be
classified as open ended and close ended. The open-ended schemes permit entry by
subscription or exit by sale of units on a continuous basis. The mutual fund announces daily
sale and repurchase prices of units for the purpose. The numbers of units outstanding under
these schemes keep on changing. The sale and repurchase prices announced by a mutual
fund are based on Net Asst Value (NAV) and hence are called the NAV related prices. (The
NAV per unit is the value of net assets of a mutual fund scheme divided by the total number of
units outstanding.)
The close-ended funds have fixed maturity periods e.g. 5-7 years. These schemes are kept
open for subscription only during a specified period at the time of launch of the scheme. To
provide liquidity, the units are however listed on stock exchanges.

1.4 EVALUATION OF MUTUAL FUNDS


Mutual funds sell their shares to public and redeem them at current net Assets Value (NAV)
which is calculated as under –
Total market value of all MF holdings - All MF liabilities
Unit size

The net asset value of a mutual fund scheme is basically the per unit market value of all the
assets of the scheme. To illustrate this better, a simple example will help.
Scheme name : XYZ
Scheme size : Rs. 50,00,00,000 (Rupees Fifty crores)
Face value of units : Rs. 10
No. of units : 5,00,00,000
Scheme size
Face value of units
8.4 Financial Reporting

Investments : In shares

Market value of shares Rs. 75,00,00,000 (Rupees seventy five crores)


Market value of investments
=
No. of units
Rs. 75,00,00,000
=
5,00,00,000

= Rs. 15
Thus, each unit of Rs. 10 is worth Rs. 15.
Simply stated, NAV is the value of the assets of each unit of the scheme, or even simpler
value of one unit of the scheme. Thus, if the NAV is more than the face value (Rs. 10), it
means your money has appreciated and vice versa.
NAV also includes dividends, interest accruals and reduction of liabilities and expenses,
besides market value of investments.The Net Asset Value (NAV) is the value of net assets
under a mutual fund scheme. The NAV per unit is NAV of the scheme divided by number of
units outstanding. NAV of a scheme keep on changing with change in market value of portfolio
under the scheme. The day of valuation of NAV is called the valuation day.
Illustration 1
A mutual fund raised Rs. 100 lakh on April 1, 2006 by issue of 10 lakh units at Rs. 10 per unit.
The fund invested in several capital market instruments to build a portfolio of Rs. 90 lakh. The
initial expenses amounted to Rs. 7 lakh. During April 2006, the fund sold certain securities of
cost 38 lakh for Rs. 40 lakh and purchased certain other securities for Rs. 28.2 lakh. The fund
management expenses for the month amounted to Rs. 4.5 lakh of which Rs. 25,000 was in
arrears. The dividend earned was Rs. 1.2 lakh. 75% of the realised earnings were distributed.
The market value of the portfolio on 30/04/06 was Rs. 101.90 lakh.
Determine NAV per unit.
Solution

Rs. lakh Rs. Lakh Rs. lakh


Opening bank (100 – 90 – 7) 3.00
Add: Proceeds from sale of securities 40.00
Add: Dividend received 1.20 44.20
Deduct:
Cost of securities purchased 28.20
Financial Reporting for Financial Institutions 8.5

Fund management expenses paid (4.50 – 0.25) 4.25


Capital gains distributed = 75% of (40.00 – 38.00) 1.50
Dividend distributed = 75% of 1.20 0.90 34.85
Closing bank 9.35
Closing market value of portfolio 101.90
111.25
Less: Arrears of expenses 0.25
Closing net assets 111.00
Number of units (Lakh) 10.0
Closing NAV (Rs.) 11.10

1.5 VALUATION OF PORTFOLIO


Market value of portfolio has a direct bearing on the NAV and consequently on portfolio
performance. The market value of portfolio is the aggregate market value of different
investments. Marker value of a traded security is the last closing price quoted in a stock
exchange immediately before the valuation day. In case, a security is traded in more than one
stock exchange, the price quoted in an exchange where the security is mostly traded is taken
as market value of the security.
Non-traded securities, i.e. securities not traded in a period of 30 days prior to the valuation
day, should be valued in the spirit of good faith subject to SEBI regulations. For example, a
non-traded debt instrument can be valued by discounting cash flows by YTM of a comparable
debt instrument as increased for lack of liquidity. The discounting rate for non-traded
government securities should the prevailing market rate.

1.6 ANNUAL REPORTING


Every mutual fund or the asset management company is required to prepare in respect of
each financial year an annual report and annual statement of accounts of the schemes and
the fund as specified in Eleventh Schedule.
As per Regulation 51 the financial year for all the schemes shall end as of March 31st of each
year.
The schemewise Annual Report of a mutual fund or an abridged summary thereof shall be
published through an advertisement [and an abridged schemewise annual report shall be
mailed to all unitholders] as soon as may be but not later than six months from the date of
closure of the relevant accounts year.
According to Eleventh Schedule, the annual report shall contain –
(i) Report of the board of Trustees on the operations of the various schemes of the fund and
8.6 Financial Reporting

the fund as a whole during the year and the future outlook of the fund;
(ii) Balance Sheet and Revenue Account in accordance with paras 2, 3 and 4, respectively
of this Schedule;
(iii) Auditor’s Report in accordance with paragraph 5 of this Schedule;
(iv) Brief statement of the Board of Trustees on the following aspects, namely:-
(a) Liabilities and responsibilities of the Trustees and the Settlor;
(b) Investment objective of each scheme;
(c) Basis and policy of investment underlying the scheme;
(d) If the scheme permits investment partly or wholly in shares, bonds, debentures and
other Scrips or securities whose value can fluctuate, a statement on the following
lines :
“The price and redemption value of the units, and income from them, can go up as
well as down with the fluctuations in the market value of its underlying investments;”
(e) Comments of the Trustees on the performance of the scheme, with full justification.
(v) Statement giving relevant perspective historical ‘per unit’ statistics in accordance with
paragraph 6 of this Schedule;
(vi) Statement on the following lines :
“On written request, present and prospective unitholder/investors can obtain copy of the
trust deed, the annual report [at a price] and the text of the relevant scheme.”

1.7 ACCOUNTING POLICIES


The annual report of a mutual fund consists of (a) Balance Sheet (b) Revenue Account (c)
Report of the Board of Trustees (d) Auditor’s Report and (e) Statement of the Board of
Trustees on specified matters. As per regulation 50(3) of SEBI (Mutual Funds) Regulations,
1996, the Asset Management Companies are required to follow the accounting policies and
standards specified in the Ninth Schedule of the Regulations. The requirements of the said
schedule are as below:
Following accounting policies shall be followed by Mutual Funds for the preparation of
accounts :
(i) The realised gains or losses on sale or redemption of investment, as well as unrealised
appreciation or depreciation shall be recognised in all financial statements. For the
purpose of all financial statements, all investments shall be marked to market and
investments shall be carried out in the balance sheet at market value. However, till
necessary guidance notes are issued by the Institute of Chartered Accountants of India
to their members , in the above matter, investments may be continued to be valued at
cost, with the market value shown separately and the reconciliation statement for the
Financial Reporting for Financial Institutions 8.7

changes in investments valued in the two different ways shall be provided.


Where the financial statement are prepared on a marked to market basis, there need not
be a separate provision for depreciation. Since unrealised gain arising out of the
appreciation on investments cannot be distributed, provision has to be made for its
exclusion and for calculating distributable income.
(ii) Non-traded investments shall be valued in good faith in accordance with the norms
specified in Seventh Schedule.
(iii) For quoted shares, the dividend income earned by the scheme shall be recognised, not
on the date the dividend is declared, but on the date the share is quoted on an ex-
dividend basis. For investments in shares which are not quoted on the stock exchanges,
the dividend income must be recognised on the date of declaration.
(iv) In respect of all interest-bearing investments, income shall be accrued on a day to day
basis as it is earned. Therefore when such investments are purchased, interest paid for
the period from the last interest due date upto the date of purchase, shall not be treated
as a cost of purchase, but shall be treated to Interest Recoverable Account. Similarly,
interest received at the time of sale for the period from the last interest due date upto the
date of sale must not be treated as an addition to sale value but shall be credited to
Interest Recoverable Account.
(v) In determining the holding cost of investments and the gains or loss on sale of
investments, the “average cost” method shall be followed.
(vi) Transactions for purchase or sale of investments shall be recognised as of the trade date
and not as of the settlement date, so that the effect of all investments traded during a
financial year are recorded and reflected in the financial statements for that year. Where
investment transactions take place outside the stock market, for example, acquisitions
through private placement or purchases or sales through private treaty, the transaction
shall be recorded, in the event of a purchase, as of the date on which the scheme obtains
in enforceable obligation to pay the price or, in the event of a sale, when the scheme
obtains an enforceable right to collect the proceeds of sale or an enforceable obligation
to deliver the instruments sold.
(vii) Bonus shares to which the scheme becomes entitled shall be recognised only when the
original shares on which the bonus entitlement accrues are traded on the stock exchange
on an ex-bonus basis. Similarly, rights entitlements shall be recognised only when the
original shares on which the right entitlement accrues are traded on the stock exchange
on an ex-rights basis.
(viii) Where income receivable on investments has been accrued and has not been received
for a period of 12 months beyond the due date, provision shall be made by debit to the
revenue account for the income so accrued and no further accrual of income should be
8.8 Financial Reporting

made in respect of such investment.

(ix) When the units of an open-ended scheme* are sold, the difference between the sale
price and the face value of the unit, if positive, shall be credited to Reserves and if
negative is debited to reserve, the face value being credited to Capital Account.
Similarly, when units of an open-ended scheme are repurchased, the difference between
the purchase price and face value of the unit, if positive should be debited to reserves
and, if negative, should be credited to reserves, the face value being debited to the
capital account.
(x) (a) In the case of an open-ended scheme, when units are sold an appropriate part of
the sale proceeds shall be credited to an Equalisation Account and when units are
repurchased an appropriate amount shall be debited to Equalisation Account. The
net balance on this Account should be credited or debited to the revenue account.
The balance on equalisation account debited or credited to the Revenue Account
shall not decrease or increase the net income of the fund but is only an adjustment
to the distributable surplus. It shall, therefore, be reflected in the Revenue Account
only after the net income of the fund is determined.
(b) The Trustees of the Board of the Trustee Company may, if necessary, transfer a
portion of the distributable profits to a dividend equalisation reserve. Such a transfer
would be independent of the requirement to operate an Equalisation Account as
provided in (x)(a).
(xi) In a close-ended scheme** which provide to the unitholders the option for an early
redemption or repurchase their own units, the par value of the unit shall be 1[debited] to
Capital Account and the difference between the purchase price and the par value, if
positive, should be debited to reserves and, if negative, should be credited to reserves. A
proportionate part of the unamortized initial issue expenses shall also be transferred to
the reserves so that the balance carried forward on that account is proportional to the
number of units remaining outstanding.
(xii) The cost of investments acquired or purchased shall [inter alia] include brokerage, stamp
charges and any charge customarily included in the broker’s bought note. In respect of
privately placed debt instruments any front-end discount offered shall be reduced from
the cost of the investment.
(xiii) Underwriting commission shall be recognised as revenue only when there is no
development on the scheme. Where there is development on the scheme, the full
underwriting commission received and not merely the portion applicable to the
devolvement shall be reduced from the cost of the investment.
Financial Reporting for Financial Institutions 8.9

1.8 CONTENTS OF BALANCE SHEET AND REVENUE ACCOUNT


Contents of Balance Sheet
(i) The Balance Sheet shall give schemewise particulars of its assets and liabilities. These
particulars shall contain information enumerated in Annexures 1A and 1B hereto. It shall
also disclose, inter alia, accounting policies relating to valuation of investments and other
important areas.
(ii) If investments are carried at costs or written down cost, their aggregate market value
shall be stated separately in respect of each type of investment, such as equity shares,
preference shares, convertible debentures listed on recognised stock exchange, non-
convertible debentures or bonds further differentiating between those listed on
recognised stock exchange and those privately placed.
(iii) The Balance Sheet shall disclose under each type of investment the aggregate carrying
value and market value of non-performing investments. An investment shall be regarded
as non-performing if it has provided no returns in the form of dividend or interest for more
than 2 years as at the end of the accounting year of the mutual fund. However,
disclosure of such non-performing investments shall not be necessary if all investments
are valued at marked to market.
(iv) The Balance Sheet shall indicate the extent of provision made in the Revenue Account
for the depreciation/loss in the value of non-performing investments. However, if the
investments are valued at marked to market, provisions for depreciation shall not be
necessary.
(v) The Balance Sheet shall disclose the per-unit net asset value (NAV) as at the end of the
accounting year.
(vi) As in case of companies, the Balance Sheet shall give against each item, the
corresponding figures as at the end of the preceding accounting year.
(vii) The notes to the balance sheet should disclose the following information regarding
investments :-
(a) all investments shall be grouped under the major classification given in the balance
sheet;
(b) under each major classification, the total value of investments falling under each
major industry group (which constitutes not less than 5% of the total investment in
the major classification) shall be disclosed together with the percentage thereof in
relation to the total investment within the classification;
(c) full schemewise portfolio of investments of a mutual fund :
Provided that a mutual fund may publish particulars of its full portfolio in the
8.10 Financial Reporting

advertisements of abridged annual report or full annual reports in newspapers;


(d) a full list of investments of the scheme shall be made available for inspection with
the Asset Management Company;
(e) the basis on which management fees have been paid to the Asset Management
Company and the computation thereof;
(f) if brokerage, custodial fees or any other payment for services are paid to or payable
to any entity in which the Asset Management Company or its major shareholders
have a substantial interest (being not less than 10% of the equity capital), the
amounts debited to the revenue account or amounts treated as cost of investments
in respect of such services shall be separately disclosed together with details of the
interest of the Asset Management Company or its major shareholders;
(g) aggregate value of purchases and sales of investments during the year and
expressed as a percentage of average weekly net asset value;
(h) where the non-traded investments which have been valued “in good faith” exceed
5% of the NAV at the end of the year, the aggregate value of such investments; and
(i) movement in unit capital should be stated.
An example of the manner in which the movement in unit capital may be disclosed
is given below :
No. of units (Rs. in lakhs)
Balance as on 1st April, 1994 1250,00,000 12,500.00
Units sold during the year 127,50,000 1,275.00
Units repurchased during the year (15,40,000) (154.00)
1362,10,000 13,621.00
(j) the name of the company including the amount of investment made in each
company of the group by each scheme and the aggregate investments made by all
schemes in the group companies of the sponsor;
(k) if the investments are marked to market, the total income of the scheme shall
include unrealised depreciation or appreciation on investment. There should be
disclosure and unrealised appreciation deducted before arriving at the distributable
income in the following manner, e.g.
Rs. in lakh Rs. in lakh
Net income as per Revenue Account 100
Add:Balance of undistributed income
as at 1st April, 1994 brought forward 20 120
Less:Unrealised appreciation on investments
As on 31st March, 1995 30
Financial Reporting for Financial Institutions 8.11

As on 1st April, 1994 15 (15) 105


Less:Distributed to unitholders 80
Transfer to reserve 5 (85)
20
(viii) Provisions for doubtful deposits, doubtful debts and for doubtful outstandings and
accrued income shall not be included under provisions on the liability side of the balance
sheet, but shall be shown as a deduction from the aggregate value of the relevant asset.
(ix) Disclosure shall be made of all contingent liabilities showing separately underwriting
commitments, uncalled liability on partly paid shares and other commitments with
specifying details.
Contents of Revenue Account
(i) The Revenue Account shall give schemewise particulars of the income, expenditure and
surplus of the mutual fund. These particulars shall contain information enumerated in
Annexure 2 of this Schedule.
(ii) If profit on sale of investments shown in the Revenue Account includes profit/loss on
inter-scheme transfer of investments within the same mutual fund the aggregate of such
profit recognised as realised, shall be disclosed separately without being clubbed with
the profit/loss on sale of investments to third parties.
(iii) Unprovided depreciation in value of investments representing the difference between
their aggregate market value and their carrying cost shall be disclosed by way of a note
forming part of the Revenue Account. Conversely, unrealised profit on investment
representing the difference between their aggregate market value and carrying cost, shall
be disclosed by way of note to accounts. The Revenue Account shall indicate the
appropriation of surplus by way of transfer to reserves and dividend distributed.
However, if investments are marked to market, depreciation may not be provided.
(iv) The Revenue Account shall indicate the appropriation of surplus by way of transfer to
reserves and dividend distributed.
(v) The following disclosures shall also be made in the revenue accounts:
(a) provision for aggregate value of doubtful deposits, debts and outstanding and
accrued income;
(b) profit or loss in sale and redemption of investment may be shown on a net basis;
(c) custodian and registrar fees;
(d) total income and expenditure expressed as a percentage of average net assets,
calculated on a weekly basis.
8.12 Financial Reporting

1.9 MARKING INVESTMENTS TO MARKET


For the purposes of the financial statements, mutual funds shall mark all investments to
market and carry investments in the balance sheet at market value. However, since the
unrealized gain arising out of appreciation on investments cannot be distributed, provision has
to be made for exclusion of this item when arriving at distributable income.
Clause 2(i) of Eleventh Schedule of the regulations provides that in carrying investments at
market values, the asset management companies should follow the Guidance Note issued by
the Institute of Chartered Accountants of India.
As per paragraph 10 of the Guidance Note on Accounting for Investments in the Financial
Statements of Mutual Funds, issued by the Institute of Chartered Accountants of India, while
marking investments to market on balance sheet date, the excess of cost of acquisition over
market value of securities on valuation day is treated as depreciation (unrealized loss).
Likewise, the excess of market value of securities on valuation day over cost of acquisition is
treated as appreciation, which is unrealized gain.
The provision for depreciation in the value of investments is created in the books by debiting
the Revenue Account. The provision so created is shown as a deduction from the value of
investments in the balance sheet. However, unrealised appreciations are directly transferred
to the Unrealised Appreciation Reserve, (i.e., without routing it through the Revenue Account)
with the corresponding debit to the Investments Account. The Guidance Note recommends
reversal of the Unrealised Appreciation Reserve at the beginning of the next accounting year.
Paragraph 11 of the Guidance Note recommends that the gross value of depreciation on
investments should be reflected in the Revenue Account rather than the same being netted off
with the appreciation in the value of other investments. In other words,
depreciation/appreciation on investments should be worked out on an individual investment
basis or by category of investment basis, but not on an overall (or global) basis for the entire
investment portfolio.
Illustration 2
The investment portfolio for a mutual fund scheme includes 10,000 shares of A Ltd. and 8,000
shares of B Ltd. acquired on 30/10/2005. The cost of A Ltd. shares is Rs. 20 while that of B
Ltd. shares is Rs. 30. The market values of these shares at the end of 2005-06 were Rs. 19
and Rs. 32 respectively. Show important accounting entries in books of the fund in the
accounting year 2005-06.
Solution
Rs. 000 Rs. 000
Investment in A Ltd. shares 200
Investment in B Ltd. shares 240
To Bank 440
Financial Reporting for Financial Institutions 8.13

Revenue A/c 10
To Provision for Depreciation 10

Investment in B Ltd. shares 16


To Unrealised Appreciation Reserve 16

1.10 DISPOSAL OF INVESTMENTS


The profit/loss arising on the disposal of investment is the difference between the selling price
and the cost. The profit arising on disposal of investment is recognised fully in the Revenue
Account.
The loss on disposal of investment is recognised fully in the revenue account, if the
investments are sold in the same year in which they are purchased. However, if an investment
is sold in any year subsequent to year of purchase, loss on disposal is charged first against
provision for depreciation to the extent of balance available, and the balance of loss, if any,
should be charged directly to the Revenue Account.
Illustration 3
In the previous example, suppose that shares of both of the companies were disposed off on
31/05/06 realizing Rs. 18.50 per A Ltd. shares and Rs. 33.50 per B Ltd. shares. Show
important accounting entries in books of the fund in the accounting year 2006-07
Solution

Rs. 000 Rs. 000


Unrealised Appreciation Reserve 16
To Investment in B Ltd. shares 16
Bank 185
Loss on disposal of Investment 15
To Investment in A Ltd. shares 200
Provision for Depreciation 10
Revenue A/c 5
To Loss on disposal of Investment 15
Bank 268
To Investment in B Ltd. shares 240
To Profit on disposal of investments 28
Profit in disposal of Investments 28
To Revenue A/c 28
8.14 Financial Reporting

1.11 RECOGNITION OF DIVIDEND INCOME


Dividend income earned by a scheme should be recognized, not on the date the dividend is
declared, but on the date the share is quoted on an ex-dividend basis. For investments, which
are not quoted on the stock exchange, dividend income must be recognized on the date of
declaration.
Where income receivable on investments has accrued but has not been received for the
period specified in the SEBI guidelines, the income accrued should be debited to Revenue A/c
as provision.
Bonus shares to which the scheme becomes entitled should be recognized only when the
original shares on which the bonus the bonus entitlement accrues are traded on the stock
exchange on an ex-bonus basis. Similarly, rights entitlements should be recognized only when
the original shares on which the right entitlement accrues are traded on the stock exchange on
an ex-rights basis.

1.12 COST OF INVESTMENTS


The cost of investments acquired or purchased should include brokerage, stamp charges and
any charge customarily included in the broker’s bought note. In respect of privately placed
debt instruments any front – end discount offered should be deducted from the cost of the
investment.
In respect of all interest – bearing investments, income must be accrued on a day-to-day basis
as it is earned. Therefore, when such investments are purchased, interest paid for the period
from the last interest due date upto the date of purchase must not be treated as a cost of
purchase but must be debited to Interest Recoverable Account. Similarly interest received at
the time of sale for the period from the last interest due date upto the date of sale must not be
treated as an addition to sale value but must be credited to Interest Recoverable Account.
In determining the holding cost of investments and the gains or loss on sale of investments,
the “average cost” method must be followed.
Illustration 2
A fund purchased 10,000 debentures of a company on June 1, 2006 for 10.7 lakh and further
5,000 debentures on November 1, 2006 for Rs. 5.45 lakh. The debentures carry fixed annual
coupon of 12%, payable on Every 31 March and 30 September. On February 28, 2007 the
fund sold 6,000 of these debentures for Rs. 6.78 lakh. Nominal value per debenture is Rs.
100.
Show Investment in Debentures A/c in books of the fund.
Financial Reporting for Financial Institutions 8.15

Solution
Investment in Debentures A/c

Rs. Rs.
Lakh Lakh
June 1, To Bank 10.70 June 1, By Interest Recoverable 0.20
2006 2006 (Note 1)
Nov. 1, To Bank 5.45 Nov. 1, By Interest Recoverable 0.05
2006 2006 (Note 2)
Feb. 28, To Interest Recoverable 0.30 Feb. 28, By Bank 6.78
2007 (Note 3) 2007
Feb. 28, To Profit on disposal 0.12 March 31, By Balance c/d 9.54
2007 (Note 4) 2007
16.57 16.57

1.13 DATE OF RECOGNITION OF TRANSACTIONS


Transaction for purchase or sale of investments should be recognized as of the trade date and
not as of the settlement date, so that the effect of all investments traded during a financial
year are recorded and reflected in the financial statements for that year. Where investment
transactions take place outside the stock market, for example, acquisitions through private
placement or purchases or sales through private treaty, the transaction should be recorded in
the event of a purchase, as of the date on which the scheme obtains in enforceable obligation
to pay the price or, in the event of a sale, when the scheme obtains an enforceable right to
collect the proceeds of sale or an enforceable obligation to deliver the instruments sold.
(a) When in the case of an open – ended scheme units are sold, the difference between the
sale price and the face value of the unit, if positive, should be credited to reserves and if
negative be debited to reserves, the face value being credited to Capital Account.
Similarly, when in respect of such a scheme, units are repurchased, the difference
between the purchase price and face value of the unit, if positive should be debited to
reserves and, if negative, should be credited to reserves, the face value being debited to
the capital account.
(b) In the case of an open – ended scheme, when units are sold an appropriate part of the
sale proceeds should be credited to an Equalisation Account and when units are
repurchased an appropriate amount should be debited to Equalisation Account. The net
balance on this account should be credited or debited to the Revenue Account. The
balance on the Equalisation Account debited or credited to the Revenue Account should
not decease or increase the net income of the fund but is only an adjustment to the
distributable surplus. It should, therefore, be reflected in the Revenue Account only after
8.16 Financial Reporting

the net income of the fund is determined.


(c) In a close – ended scheme which provide to the unit holders the option for an early
redemption or repurchase their own units, the par value of the unit has to be debited to
Capital Account and the difference between the purchase price and the par value, if
positive, should be credited to reserves and, if negative, should be debited to reserves. A
proportionate part of the unamortized initial issue expenses should also be transferred to
the reserves so that the balance carried forward on that account is proportional to the
number of units remaining outstanding.
(d) Underwriting commission should be recognized as revenue only when there is no
devolvement on the scheme. Where there is devolvement on the scheme, the full
underwriting commission received and not merely the portion applicable to the
devolvement should be reduced from the cost of the investment.

1.14 DIVIDEND EQUALISATION


New investors are not entitled to any share of the income of a mutual fund scheme which
arose before they bought their units. However, at the end of each distribution period the fund
management allocates the same amount from the income of the fund to each unit. To
compensate for this an equalisation payment is added to the cost of new units. This is the
amount of income that has arisen up to the date of purchase of the unit. Because these
payments are included in the amount available for distribution they are effectively repaid to the
purchaser. The purchaser's dividend voucher at the end of the first distribution period should
show the amount of the returned equalisation payment.
Illustration 2
On April 1, 2006 a mutual fund scheme had 9 lakh units of face value Rs. 10 outstanding. The
scheme earned Rs. Rs. 81 lakh in 2006-07, out of which Rs. 45 lakh was earned in first half-
year. 1 lakh units were sold on 30/09/06 at NAV Rs. 60. Show important accounting entries for
sale of units and distribution of dividend at the end of 2006-07.
Solution
Allocation of earnings
Old unit New unit
holders holders Total
earning
(9 lakh units) (1 lakh units)
Rs. Lakh Rs. lakh Rs. Lakh
First half-year (Rs. 5.00/ unit ) 45.0 Nil 45
Second half-year (Rs. 3.60 / unit) 32.4 3.6 36
Financial Reporting for Financial Institutions 8.17

77.4 3.6 81.0


Add: Equalisation payment recovered 5.0
Total available for distribution 86.0

Note: Equalisation payment = Rs. 45 lakh / 9 lakh = Rs.5 per unit.


Distribution of earning per unit

Old unit holders New unit holders


Rs. Rs.
Dividend distributed 8.60 8.60
Less: Equalisation payment 5.00
Net distributed income 8.60 3.60

Date Rs. lakh Rs. lakh


30/09/06 Bank 65 1 lakh x Rs. 65
To Unit Capital 10 1 lakh x Rs. 10
To Reserves 50 1 lakh x Rs. 50
To Dividend Equalisation 5 1 lakh x Rs. 5

31/03/07 Dividend Equalisation 5


To Revenue A/c 5

31/03/07 Revenue A/c 86


To Bank 86 10 lakh x Rs. 8.60
Reference: Students are advised to refer the Guidance Note issued by ICAI on Accounting for
Investments in the Financial Statements of Mutual Funds
Self -examination Questions
1. Define the following terms in the context of a mutual fund:
(a) Asset management company.
(b) Unit.
(c) Money market instruments.
2. What do you mean by “Open-ended scheme” and Close-ended scheme” ?
8.18 Financial Reporting

3. What should be the minimum components of an annual report of a mutual fund?


4. The following particulars are available for a scheme of a mutual fund. Calculate current
asset value (NAV) of each unit of the scheme.
Scheme size Rs. 10,00,000
In shares Rs. 10
Investments In shares
Market value of shares Rs. 25,00,000
5. Prudential XYZ Mutual Funds have introduced a scheme ‘ABC Premier’. Its major details
are as follows:
Scheme Name : ABC Premier
Scheme Size : Rs.1,00,00,00,000 (Rupees One hundred crores)
Face value of units : Rs.20
Investments : in shares
Market value of Shares : Rs.1,50,00,00,000 (Rupees One hundred and fifty crores)
Computed the net assets value per unit of ABC Premier. Is there an appreciation of the
value invested in units of ABC Premier.
Financial Reporting for Financial Institutions 8.19

UNIT 2
NON-BANKING FINANCE COMPANY

2.1 INTRODUCTION
A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act,
1956, engaged in the business of providing loans and advances, acquisition of shares,
debentures and other securities, leasing, hire-purchase, insurance business and chit business.
The term NBFC does not include any institution whose principal business is that of agriculture
activity, industrial activity or sale/purchase/construction of immovable property.
Non Banking Financial Companies (NBFC) play a crucial role in broadening access to financial
services, enhancing competition and diversification of the financial sector. They are
increasingly being recognised as complementary to the banking system, capable of absorbing
shocks and spreading risks at times of financial distress. Simplified sanction procedures,
orientation towards customers, attractive rates of return on deposits and flexibility and
timeliness in meeting the credit needs of specified sectors (like equipment leasing and hire
purchase), are some of the factors that enhanced the attractiveness of NBFCs.

2.2 DEFINITION OF NBFC


Section 45I(f) of Reserve Bank of India (Amendment) Act, 1997 defines a non-banking
financial company as:
(i) A financial institution which is a company;
(ii) A non banking institution which is a company with principal business of receiving of
deposits, under any scheme or arrangement or in any other manner, or lending in any
manner;
(iii) Such other non-banking institution or class of such institutions, as the Reserve Bank with
the previous approval of the Central Government may specify by notification in the
Official Gazette.
For purposes of RBI Directions relating to Acceptance of Public Deposits, non-banking
financial company means only the non-banking institution which is a –¨Loan
company,¨Investment company, Hire purchase finance company, Equipment leasing
company and Mutual benefit financial company”.

2.3 REGISTRATION AND REGULATION OF NBFC


Under Section 45–IA of the Reserve Bank of India (Amendment) Act, 1997, no non-banking
financial company is allowed to commence or carry on the business of a non-banking financial
institution without obtaining a certificate of registration issued by the Reserve Bank of India.
8.20 Financial Reporting

A company incorporated under the Companies Act, 1956 and desirous of commencing
business of non-banking financial institution as defined under Section 45–IA of the RBI Act,
1934 can apply to Reserve Bank of India in prescribed form along with necessary documents
for registration. The RBI issues Certificate of Registration after satisfying itself that the
conditions as enumerated in Section 45-IA of the RBI Act, 1934 are satisfied.
Functions of Non-Banking Financial Companies are similar to banks. However there are a few
differences:
(a) A NBFC cannot accept demand deposits;
(b) Non-Banking Financial Companies do not take part in the payment and settlement
system and hence cannot issue cheques to its customers; and
(c) Deposit Insurance and Credit Guarantee Corporation (DICGC) does not insure the NBFC
deposits.
The Reserve Bank of India has issued directions to non-banking financial companies on
acceptance of public deposits, prudential norms like capital adequacy, income recognition,
asset classification, provision for bad and doubtful debts, risk exposure norms and other
measures to monitor the financial solvency and reporting by NBFCs. Directions were also
issued to auditors to report non-compliance with the RBI Act and regulations to the Reserve
Bank, Board of Directors and shareholders.

2.4 MINIMUM NET OWNED FUND


The minimum net owned fund of a registered NBFC is Rs 200 lakh. The term net owned fund
(NOF) is given in the explanation to Section 45-IA of the Reserve Bank of India Act, 1934. As
per the definition:
Owned Fund = Aggregate of the paid-up equity capital + Free reserves as disclosed in the
latest balance sheet of the company – Accumulated balance of loss – Deferred revenue
expenditure – Other intangible assets.
Net Owned Fund = Owned Fund – Investments in shares of subsidiaries/ companies in same
group/Other NBFC. – Book value of debentures, bonds, outstanding loans and advances
made to and deposits with subsidiaries and companies in the same group (to the extent such
sum exceeds 10% of owned fund)

2.5 TYPES OF NBFC REGULATED BY RBI


Depending on the type of business, non-banking financial companies regulated by the
Reserve Bank of India, have been classified as:
(a) Equipment leasing company;
(b) Hire-purchase company;
Financial Reporting for Financial Institutions 8.21

(c) Loan company;


(d) Investment company;
(e) Residuary Non-Banking Company.
(f) Mutual benefit financial company (MBFC) i.e. Nidhi Company
(g) Mutual Benefit Company (MBC), i.e., potential Nidhi Company
(h) Miscellaneous non-banking company (MNBC), i.e., Chit Fund Company
The first four types of companies may be further classified into those accepting deposits and
those not accepting deposits.
Equipment Leasing Company is a financial institution with principal business of offering
equipment on leases.
Hire Purchase Company is a financial institution with principal business of offering assets
under hire purchase schemes.
Loan company is a financial institution with principal business of providing finance whether by
making loans or advances or otherwise for any activity other than its own but does not include
an equipment leasing company or a hire-purchase finance company.
Investment Company is a financial institution with principal business of acquisition of
securities.
Residuary Non-Banking Company is a class of NBFC, which is a company with principal
business of receiving of deposits, under any scheme or arrangement or in any other manner.
In addition to liquid assets as prescribed, these companies are required to maintain
investments as per directions of RBI.
Mutual benefit financial company (MBFC) i.e. Nidhi Company is any company which is notified
by the Central Government under Section 620A of the Companies Act1956.
Mutual Benefit Company (MBC), i.e., potential Nidhi Company, is a company, which works on
the lines of a Nidhi company, but has not yet been so declared by the Central Government.
Minimum Net Owned Fund of a MBC is Rs.10 lakh. A company treated as MBC, must be one,
which has applied to the Reserve Bank for Certificate of Registration and also to Department
of Company Affairs (DCA) for declaration as Nidhi Company, which has not contravened
direction/ regulation of Reserve Bank/DCA.
Miscellaneous non-banking company (MNBC), i.e., Chit Fund Company is a company, which
enters into an agreement with a specified number of subscribers that every one of them shall
subscribe a certain sum in instalments over a definite period and that every one of such
subscribers shall in turn, as determined by lot or by auction or by tender or in such manner as
may be provided for in the arrangement, be entitled to a prize amount.
8.22 Financial Reporting

2.6 PUBLIC DEPOSITS


(a) No mutual benefit financial company mutual benefit company can accept or renew any
public deposit except from its shareholders. Such deposits shall not be in the nature of
current account
(b) All NBFCs are not entitled to accept public deposits. Only those NBFCs holding a valid
Certificate of Registration with authorization to accept Public Deposits can accept/hold
public deposits. The NBFCs accepting public deposits should have minimum stipulated
Net Owned Fund and comply with the Directions issued by the Reserve Bank.
(c) The ability of a NBFC to raise public deposits depends on its credit rating, Capital to Risk
Asset Ratio (CRAR). A NBFC with credit rating lower than investment grade is not
allowed to accept public deposits. A NBFC with credit rating of investment grade and
above, can accept public deposits subject to specified maximum ceiling. The ceiling
depends on the rating, CRAR and the nature of business. (Minimum credit rating for
investment grade is adequate safety, such as A for CRISIL).
The norms are as below:
♦ Equipment Leasing and Hire Purchase Companies maintaining Capital to Risk Asset
Ratio (CRAR) of 15% without credit rating can raise public deposits to the extent of
1.5 times of net owned fund or Rs. 10 crores, whichever is less.
♦ Equipment Leasing and Hire Purchase Companies maintaining Capital to Risk Asset
Ratio (CRAR) of 12% with minimum investment grade credit rating can raise public
deposits to the extent of 4 times of net owned fund.
♦ Loan companies and Investment Companies maintaining Capital to Risk Asset Ratio
(CRAR) of 15% with minimum investment grade credit rating can raise public
deposits to the extent of 1.5 times of net owned fund.
♦ There is no ceiling on maximum deposits that residuary non-banking company can
raise. However, such companies have to ensure that the amounts deposited and
investments made by the company are not less than the aggregate amount of
liabilities to the depositors. To secure the interests of depositor, residuary non-
banking companies are required to invest in a portfolio comprising of highly liquid
and secured instruments viz. Central/State Government securities, fixed
deposit/certificates of deposits of scheduled commercial banks, units of Mutual
Funds, etc.
♦ If rating of a NBFC is downgraded to below minimum investment grade rating, it
must stop accepting further public deposit and report the position within 15 working
days to the RBI. The amount of public deposit already accepted must also be
reduced within three years from the date of such downgrading of credit rating, nil or
to the permissible level.
Financial Reporting for Financial Institutions 8.23

♦ The maximum interest that a NBFC can pay on its deposits is restricted to 14% per
annum. The maximum frequency of compounding is month.
♦ The rate of brokerage that a NBFC can pay for collecting deposits is 2%. The
maximum re-imbursement of actual expenses allowed is 0.5% of deposits collected.
♦ The NBFCs are allowed to accept/renew public deposits for a minimum period of 12
months and maximum period of 60 months. They cannot accept deposits repayable
on demand.
♦ NBFCs cannot offer gifts/incentives or any other additional benefit to the depositors.
♦ Public deposits are unsecured. The deposits with NBFCs are neither insured nor the
RBI guarantees their repayments.
♦ The non-banking financial companies accepting public deposits are required to file
annual returns and financial statements with the Reserve Bank of India.

2.7 LIQUID ASSET REQUIREMENTS


Section 45-IB of the Reserve Bank of India Act requires non-banking financial companies
accepting public deposits to maintain liquid assets at the minimum level of 15% of public
deposits outstanding as on the last working day of the second preceding quarter. Of this
minimum level, not less than 10% must be invested in approved securities i.e. in Government
securities or Government guaranteed bonds. The liquid assets in form of investments in
approved securities must be maintained in dematerialised form only. The remaining 5% of
minimum liquid assets can be invested in unencumbered term deposits with any scheduled
commercial bank.
The liquid assets maintained as above are utilised for payment of claims of depositors.
However, the deposits being unsecured, the depositors do not have any direct claim on liquid
assets.

2.8 PRUDENTIAL ACCOUNTING NORMS


In order to ensure that NBFCs function on sound and healthy lines, the Reserve Bank issued
its Non-banking Financial Companies Prudential Norms Directions in January 1998. All
NBFCs, accepting public deposits and residuary non-banking companies are required to
comply the norms. They are also to comply with the Accounting Standards and Guidance
Notes issued by the Institute of Chartered Accountants of India, so far as these are not
inconsistent with the prudential norms directions of the Reserve Bank of India.
The provisions of the prudential norm directions regarding capital adequacy and credit
concentration does not apply to (i) a loan company; (ii) an investment company; (iii) a hire
purchase finance company; and (iv) an equipment leasing company, unless they accept/hold
public deposit.
8.24 Financial Reporting

An investment company not accepting public deposits need not comply with the prudential
norms, provided it holds investments in the securities of its group/holding/subsidiary
companies and book value of such holding is not less than 90% of its total assets and if it
does not trade in such securities.
Prudential norms directions prescribe principles of income recognition, asset classification,
provisioning, capital adequacy and disclosures.

2.9 INCOME RECOGNITION


(a) The income recognition shall be based on recognised accounting principles.
(b) Income on non-performing assets (NPA) shall be recognised only when it is actually
realised.
(c) Income relating to hire purchase asset, where instalments are overdue for more than 12
months, shall be recognised only when the hire charge is actually received.
(d) Income relating to leased asset, where lease rentals are overdue for more than 12
months, shall be recognised only when the lease rental is actually received.
(e) Income from dividend on shares of corporate bodies and units of mutual funds shall be
taken into account on cash basis. However, income from dividend on shares of corporate
bodies may be taken into account on accrual basis when such dividend has been
declared by the corporate body in its annual general meeting and the NBFC's right to
receive payment is established.
(f) Income from bonds and debentures of corporate bodies and from Government
securities/bonds may be taken into account on accrual basis:, provided that the interest
rate on these instruments is pre-determined and that interest is serviced regularly and is
not in arrears.
(g) Income on securities of corporate bodies or public sector undertakings, the payment of
interest and repayment of principal of which have been guaranteed by Central
Government or a State Government may be taken into account on accrual basis.

2.10 ACCOUNTING FOR INVESTMENTS


(a) Investments in securities shall be classified into current investments and long-term
investments. Current investment means an investment, which is by its nature readily
realisable and is intended to be held for not more than one year from the date on which
such investment is made. An investment, other than current investment is long-term
investment.
(b) Current investments shall be valued at cost or market value whichever is lower. Each
category of such investments shall be valued scrip-wise and depreciation or appreciation
be aggregated under each category. Net depreciation, if any, for each category of
Financial Reporting for Financial Institutions 8.25

investments shall be provided for or charged to profit and loss account. Net appreciation,
if any, shall be ignored. The depreciation in one category of investments shall not be set
off against appreciation in another category.
(c) A long term quoted investment shall be valued in accordance with the accounting
standards issued by ICAI.
(d) Unquoted equity shares shall be valued at cost or break up value, whichever is lower.
However, NBFCs can substitute fair value for the break-up value of the shares if
considered necessary. In case of non-availability of balance sheet for two years, such
shares shall be valued at one rupee only.
(e) Unquoted preference shares are to be valued at lower of cost and or face value.
Investments in unquoted Government securities or Government guaranteed bonds shall be
valued at carrying cost.
Investments in units of mutual funds shall be valued at market rates, or if such market rate is
not available, at the net asset value declared by the mutual fund in respect of each particular
scheme.
Commercial papers and treasury bills shall be valued at carrying cost.

2.11 ASSET CLASSIFICATION


Every NBFC shall, after taking into account the degree of well defined credit weaknesses and
extent of dependence on collateral security for realisation, classify its lease/hire purchase
assets, loans and advances and any other forms of credit into the following classes namely, -
(a) Standard assets;
(b) Sub-standard assets;
(c) Doubtful assets; and
(d) Loss assets.
Standard asset means an asset in respect of which, no default in repayment of principal or
payment of interest is perceived and which does not disclose any problem nor carry more than
normal risk attached to the business.
Sub-standard asset means (i) an asset, which has been classified as non-performing asset for
a period of not exceeding two years (ii) an asset, where the terms of the agreement regarding
interest and/or principal have been renegotiated or rescheduled after commencement of
operations, until the expiry of one year of satisfactory performance under the renegotiated or
rescheduled terms.
Doubtful asset means (i) a term loan or (ii) a lease asset or (iii) a hire purchase asset or (iv)
any other asset, which remains a substandard asset for a period exceeding two years.
8.26 Financial Reporting

Loss asset means (i) an asset which has been identified as loss asset by the NBFC or its
internal or external auditor or by the Reserve Bank during the inspection of the NBFC, to the
extent it is not written off by the NBFC; and (ii) an asset which is adversely affected by a
potential threat of non-recoverability due to either erosion in the value of security or non
availability of security or due to any fraudulent act or omission on the part of the borrower.
The class of assets referred to above shall not be upgraded merely as a result of
rescheduling, unless it satisfies the conditions required for the upgrdation.

2.12 NON-PERFORMING ASSET (NPA)


Non-performing asset (NPA) means:
Any asset, in respect of which, interest has remained past due for six months.
(a) A term loan inclusive of unpaid interest, when the instalment is overdue for more than six
months or on which interest amount remained past due for six months.
(b) A bill, which remains overdue for six months.
(c) The interest in respect of a debt or the income on a receivable under the head `Other
Current Assets' in the nature of short term loans/advances, which facility remained over
due for a period of six months.
(d) Any dues on account of sale of assets or services rendered or reimbursement of
expenses incurred, which remained overdue for a period of six months.
(e) The lease rental and hire purchase instalment, which has become overdue for a period of
more than twelve months.
(f) Balance outstanding under the credit facilities (including accrued interest) made available
to the borrower/beneficiary in the same capacity, when any of the credit facilities to the
same borrower becomes non-performing asset.

2.13 PROVISIONING REQUIREMENTS


Every NBFC shall, after taking into account the time lag between an account becoming
doubtful of recovery, its recognition as such, the realisation of the security and the erosion
over time in the value of security charged, make provision against sub-standard assets,
doubtful assets and loss assets as provided hereunder :-
Loans, advances and other credit facilities including bills purchased and discounted
The provisioning requirement in respect of loans, advances and other credit facilities including
bills purchased and discounted shall be as under :
Financial Reporting for Financial Institutions 8.27

Loss Assets
The entire asset shall be written off. If the assets are permitted to remain in the books for any
reason, 100% of the outstanding should be provided for.
Doubtful Assets
(a) 100% provision to the extent to which the advance is not covered by the realisable value
of the security to which the NBFC has a valid recourse shall be made. The realisable
value is to be estimated on a realistic basis.
(b) In addition to item (a) above, depending upon the period for which the asset has
remained doubtful, provision to the provision to the extent of 20% to 50% of the secured
portion (i.e. estimated realisable value of the outstanding) shall be made on the following
basis : -
Period for which the asset has been considered as doubtful % of provision
Upto one year 20
One to three years 30
More than three years 50
Sub-standard asset
A general provision of 10% of total outstanding shall be made.
Lease and hire purchase assets
The provisioning requirements in respect of the lease and hire purchase assets shall be as
under:-
Where any amount of lease rental or
hire charges are overdue upto 12 Nil
months
a) Entire amount of overdue taken to the credit of
Where any amount is overdue for profit and loss account in earlier year shall be
more than 12 months but upto 24 provided for; and
months b) in addition, provision shall be made at not less than
10% of the net book value.

Where any amount is overdue for (a) entire amount of overdue taken to the credit of
more than 24 months but upto 36 profit and loss account earlier shall be provided for,
months and
8.28 Financial Reporting

(b) in addition, provision shall be made at not less


than 50% of the net book value
(a) entire amount of overdue taken to the credit of
profit and loss account earlier shall be provided for,
Where any amount is overdue for and
more than 36 months
(b) in addition, provision shall be equivalent to
unprovided balance of net book value (i.e.100% )

2.14 DISCLOSURE IN THE BALANCE SHEET


(a) Every NBFC shall, separately disclose in its balance sheet the provisions made as per
requirements above without netting them from the income or against the value of assets.
(b) The provisions shall be distinctly indicated under separate heads of accounts as
provisions for bad and doubtful debts and provisions for depreciation in investments.
(c) Such provisions shall not be appropriated from the general provisions and loss reserves
held, if any, by the NBFC.
(d) Such provisions for each year shall be debited to the profit and loss account. The excess
of provisions, if any, held under the heads general Provisions and loss reserves may be
written back without making adjustment against them.

2.15 REQUIREMENT AS TO CAPITAL ADEQUACY


Every NBFC shall, maintain a minimum capital ratio consisting of Tier I and Tier II capital
which shall not be less than 12% of its aggregate risk-weighted assets.
The total of Tier II capital, at any point of time, shall not exceed 100% of Tier I capital.
Tier-I Capital" means owned fund as reduced by investment in shares of other NBFCs and in
shares, debenture, bonds, outstanding loans and advances including hire purchase and lease
finance made to and deposits with subsidiaries and companies in the same group exceeding,
in aggregate, 10% of the owned fund;
Tier-II capital" includes the following :-
(a) Preference shares.
(b) Revaluation reserves at discounted rate of 55%.
(c) General provisions and loss reserves to the extent these are not attributable to actual
diminution in value or identifiable potential loss in any specific asset and are available to
meet unexpected losses, to the extent of one and one fourth percent of risk weighted
assets.
Financial Reporting for Financial Institutions 8.29

(d) Hybrid debt and


(e) Subordinated debt
Subordinated debt means a fully paid up capital instrument, which is unsecured and is
subordinated to the claims of other creditors and is free from restrictive clauses and is not
redeemable at the instance of the holder or without the consent of the supervisory authority of
the NBFC. The book value of such instrument shall be subjected to discounting as provided
hereunder:
Remaining maturity of the instrument Rate of discounting
(a) Upto one year 100%
(b) More than one year but upto two years 80%
(c) More than two years but upto three years 60%
(d) More than three years but upto four years 40%
(e) More than four years but upto five years 20%

2.16 ASSET-LIABILITY MANAGEMENT (ALM)


ALM is a risk management tool that helps a bank/NBFC to manage its liquidity risk and
interest rate risk. This is a powerful tool that helps banks/NBFCs plan long term financial,
funding, and capital strategy using present value analysis. With ALM, a bank/NBFC can model
interest income and expenses for analysis and re-price assets and liabilities. Based on ALM
position, banks/NBFCs can also model effect of competitive pricing to create innovative and
imaginative new banking products. ALM also helps regulatory compliance for banks/NBFCs by
through appropriate investment / disinvestment decisions to maintain the required statutory
liquidity ratio (SLR), credit reserve ratio (CRR) and other ratios as per Reserve Bank of India
(RBI) guidelines. ALM involves the analysis of Structural Liquidity Gap Analysis, Interest Rate
Gap Analysis, Net Interest Income (NII) Analysis, Net Interest Margin (NIM) Analysis,
Tolerance Analysis, Cost to Close Analysis, Duration Gap Analysis, Trend Analysis,
Comparative Analysis, Present Value Analysis, Forward Analysis and Scenario Analysis
The Reserve Bank of India has announced its ALM guidelines for NBFCs for effective risk
management. As per the guidelines, all NBFCs with asset size of Rs.100 crore or above or
with public deposits of Rs.20 crore or above, as per their balance sheet as on March 31, 2001,
were required to implement the ALM system within March 31, 2002. They were also required
to constitute an ALM Committee (ALCO), under the charge of Chief Executive Officer or other
Senior Executive and other specialist members, for formalising ALM systems and to install a
supervisory framework for its maintenance. The NBFCs covered under the system are
required to submit half-yearly ALM return comprising of statements on structural liquidity,
short-term dynamic liquidity and interest rate sensitivity, to the Reserve Bank of India. The
8.30 Financial Reporting

Chit Funds and Nidhi companies are outside the scope of the ALM guidelines.

2.17 NON-BANKING FINANCIAL COMPANIES PRUDENTIAL NORMS (RESERVE BANK)


DIRECTIONS, 1998
Notification NO. DFC. 119/DG(SPT) - 98 Dated January 31, 1998
The Reserve Bank of India, having considered it necessary in the public interest, and being
satisfied that, for the purpose of enabling the Bank to regulate the credit system to the
advantage of the country, is necessary to issue the directions relating to the prudential norms
as set out below hereby, in exercise of the powers conferred by section 45JA of the Reserve
Bank of India Act, 1934 (2 of 1934), and of all the powers enabling it in this behalf, and in
supersession of the earlier directions contained in Notification No. DFC. 115/DG(SPT)/98,
dated January 2, 1998, gives to every non-banking financial company the directions
hereinafter specified.
Short title, commencement and applicability of the directions
1. (1) These directions shall be known as the ‘Non-Banking Financial Companies
Prudential Norms (Reserve Bank) Directions, 1998’.
(2) These directions shall come into force with immediate effect.
(3) (i) All the provisions of these directions save as provided for in clauses (ii) and
(iii) hereinafter, shall apply to –
(a) a non-banking financial company (referred to in these directions as “NBFC”),
except a mutual benefit financial company, 1[and a mutual benefit company]
as defined in the Non-Banking Financial Companies Acceptance of Public
Deposits (Reserve Bank) Directions, 1998, which is having a net owned fund
(referred to in these directions as “NOF”) of rupees twenty-five lakhs and
above and accepting/holding public deposit;
(b) a residuary non-banking company (referred to in these directions as “RNBC”),
as defined in the Residuary Non-Banking Companies (Reserve Bank)
Directions, 1987.
(ii) The provisions of paragraphs 10 and 12 of these directions shall not apply to –
(a) a loan company;
(b) an investment company;
(c) a hire purchase finance company; and
(d) an equipment leasing company,
which is having NOF of rupees twenty-five lakhs and above but not
accepting/holding public deposit.
(iii) These directions shall not apply to an NBFC being an investment company:
Financial Reporting for Financial Institutions 8.31

Provided that it is–


(a) holding investments in the securities of its group/holding/subsidiary companies
and the book value of such holding is not less than ninety per cent of its total
assets and it is not trading in such securities; and
(b) not accepting/holding public deposit.
[(iv) These directions shall not apply to an NBFC being a Government company as
defined under section 617 of the Companies Act, 1956 (1 of 1956).]
Definitions
2. (1) For the purpose of these directions, unless the context otherwise requires :
(i) “break up value” means the equity capital and reserves as reduced by intangible
assets and revaluation reserves, divided by the number of equity shares of the
investee company;
(ii) “carrying cost” means book value of the assets and interest accrued thereon but not
received;
(iii) “current investment” means an investment which is by its nature readily realisable
and is intended to be held for not more than one year from the date on which such
investment is made;
(iv) “doubtful asset” means–
(a) a term loan, or
(b) a lease asset, or
(c) a hire purchase asset, or
(d) any other asset, which remains a substandard asset for a period exceeding
two years;
(v) “earning value” means the value of an equity share computed by taking the average
of profits after tax as reduced by the preference dividend and adjusted for
extraordinary and non-recurring items, for the immediately preceding three years
and further divided by the number of equity shares of the investee company and
capitalised at the following rate:
(a) in the case of a predominantly manufacturing company, eight per cent;
(b) in the case of a predominantly trading company, ten per cent; and
(c) in the case of any other company, including an NBFC, twelve per cent.
Note: If an investee company is a loss making company, the earning value will be
taken at zero;
(vi) “fair value” means the mean of the earning value and the break up value;
(vii) “hybrid debt” means capital instrument which possesses certain characteristics of
8.32 Financial Reporting

equity as well as of debt;


(viii) “loss asset” means –
(a) an asset which has been identified as loss asset by the NBFC or its internal or
external auditor or by the Reserve Bank of India during the inspection of the
NBFC, to the extent it is not written off by the NBFC; and
(b) an asset which is adversely affected by a potential threat of non-recoverability
due to either erosion in the value of security or non-availability of security or
due to any fraudulent act or omission on the part of the borrower;
(ix) “long term investment” means an investment other than a current investment;
(x) “net asset value” means the latest declared net asset value by the concerned
mutual fund in respect of that particular scheme;
(xi) “net book value” means :
(a) in the case of hire purchase asset, the aggregate of overdue and future
instalments receivable as reduced by the balance of unmatured finance
charges and further reduced by the provisions made as per paragraph 8(2)(i)
of these directions;
(b) in the case of leased asset, aggregate of capital portion of overdue lease
rentals accounted as receivable and depreciated book value of the lease asset
as adjusted by the balance of lease adjustment account;
(xii) “non-performing asset” (referred to in these directions as “NPA”) means :
(a) an asset, in respect of which, interest has remained past due for six months;
(b) a term loan inclusive of unpaid interest, when the instalment is overdue for
more than six months or on which interest amount remained past due for six
months;
(c) a bill which remains overdue for six months;
(d) the interest in respect of a debt or the income on receivables under the head
‘Other current assets’ in the nature of short term loans/advances, which facility
remained overdue for a period of six months;
(e) any dues on account of sale of assets or services rendered or reimbursement
of expenses incurred, which remained overdue for a period of six months;
(f) the lease rental and hire purchase instalment, which has become overdue for a
period of more than twelve months;
(g) in respect of loans, advances and other credit facilities (including bills
purchased and discounted), the balance outstanding under the credit facilities
(including accrued interest) made available to the same borrower/beneficiary
when any of the above credit facilities becomes a non-performing asset :
Provided that in the case of lease and hire purchase transactions, an NBFC may
Financial Reporting for Financial Institutions 8.33

classify each such account on the basis of its record of recovery;


(xiii) “owned fund” means paid-up equity capital, preference shares which are
compulsorily convertible into equity, free reserves, balance in share premium
account and capital reserves representing surplus arising out of sale proceeds of
asset, excluding reserves created by revaluation of asset, as reduced by
accumulated loss balance, book value of intangible assets and deferred revenue
expenditure, if any;
(xiv) “past due” means an amount of income or interest which remains unpaid for a
period of thirty days beyond the due date;
(xv) “standard asset” means the asset in respect of which, no default in repayment of
principal or payment of interest is perceived and which does not disclose any
problem nor carry more than normal risk attached to the business;
(xvi) “sub-standard assets” means –
(a) an asset, which has been classified as a non-performing asset for a period of
not exceeding two years;
(b) an asset, where the terms of the agreement regarding interest and/or principal
have been renegotiated or rescheduled after commencement of operations,
until the expiry of one year of satisfactory performance under the renegotiated
or rescheduled terms;
(xvii) “subordinated debt” means a fully paid-up capital instrument, which is unsecured
and is subordinated to the claims of other creditors and is free from restrictive
clauses and is not redeemable at the instance of the holder or without the consent
of the supervisory authority of the NBFC. The book value of such instrument shall
be subjected to discounting as provided hereunder :
Remaining Maturity Rate of
of the instruments discount
(a) Upto one year 100%
(b) More than one year but upto two years 80%
(c) More than two years but upto three years 60%
(d) More than three years but upto four years 40%
(e) More than four years but upto five years 20%
to the extent such discounted value does not exceed fifty per cent of Tier-I capital;
(xviii) “substantial interest” means holding of a beneficial interest by an individual or his
spouse or minor child, whether singly or taken together in the shares of a company,
the amount paid up on which exceeds ten per cent of the paid up capital of the
company; or the capital subscribed by all the partners of a partnership firm;
(xix) “Tier-I Capital” means owned fund as reduced by investment in shares of other
8.34 Financial Reporting

NBFCs and in shares, debentures, bonds, outstanding loans and advances


including hire purchase and lease finance made to and deposits with subsidiaries
and companies in the same group exceeding, in aggregate, ten per cent of the
owned fund;
(xx) “Tier-II capital” includes the following :
(a) preference shares other than those which are compulsorily convertible into
equity;
(b) revaluation reserves at discounted rate of fifty-five per cent;
(c) general provisions and loss reserves to the extent these are not attributable to
actual diminution in value or identifiable potential loss in any specific asset and
are available to meet unexpected losses, to the extent of one and non-fourth
per cent of risk weighted assets;
(d) hybrid debt capital instruments; and
(e) subordinated debt,
to the extent the aggregate does not exceed Tier-I capital.
(2) Other words or expressions used but not defined herein and defined in the Reserve
Bank of India Act, 1934 (2 of 1934), or the Non-Banking Financial Companies
Acceptance of Public Deposits (Reserve Bank) Directions, 1998, or the Residuary
Non-Banking Companies (Reserve Bank) Directions, 1987, shall have the same
meaning as assigned to them in that Act or those Directions. Any other words or
expressions not defined in that Act or those Directions, shall have the same
meaning assigned to them in the Companies Act,1956 (1 of 1956).
Income recognition
3. (1) The income recognition shall be based on recognised accounting principles.
(2) Income including interest/discount or any other charges on NPA shall be recognised
only when it is actually realised. Any such income recognised before the asset
became non-performing and remaining unrealised shall be reversed.
(3) In respect of hire purchase assets, where instalments are overdue for more than 12
months, income shall be recognised only when hire charges are actually received.
Any such income taken to the credit of profit and loss account before the asset
became non-performing and remaining unrealised, shall be reversed.
(4) In respect of lease assets, where lease rentals are overdue for more than 12
months, the income shall be recognised only when lease rentals are actually
received. The net lease rentals taken to the credit of profit and loss account before
the asset became non-performing and remaining unrealised shall be reversed.
Explanation: For the purpose of this paragraph, ‘net lease rentals’ mean gross lease rentals as
adjusted by the lease adjustment account debited/credited to the profit and loss account and
as reduced by depreciation at the rate applicable under Schedule XIV of the Companies Act,
Financial Reporting for Financial Institutions 8.35

1956 (1 of 1956).*
Income from investments
4. [1] Income from dividend on shares of corporate bodies and units of mutual funds shall
be taken into account on cash basis:
Provided that the income from dividend on shares of corporate bodies may be
taken into account on accrual basis when such dividend has been declared by the
corporate body in its annual general meeting and the NBFC’s right to receive
payment is established.
[2] Income from bonds and debentures of corporate bodies and from Government
securities/bonds may be taken into account on accrual basis:
Provided that the interest rate on these instruments is pre-determined and interest i
s serviced regularly and is not in arrears.
[3] Income on securities of corporate bodies or public sector undertakings, the payment
of interest and repayment of principal of which have been guaranteed by the Central
Government or a State Government may be taken into account on accrual basis.
Accounting standards
5. Accounting Standards and Guidance Notes issued by the Institute of Chartered
Accountants of India (referred to in these directions as “ICAI”) shall be followed insofar
as they are not inconsistent with any of these directions.
Accounting for investments
6. [1] Investments in securities shall be classified as current and long-term investments
[2] Quoted current investments shall, for the purposes of valuation, be grouped into the
following categories, viz.,
(a) equity shares,
(b) preferences shares,
(c) debentures and bonds,
(d) Government securities including treasury bills,
(e) units of mutual fund, and
(f) others.
Quoted current investments for each category shall be valued at cost or market
value, whichever is lower. For this purpose, the investments in each category shall
be considered scrip-wise and the cost and market value aggregated for all
investments in each category. If the aggregate market value for the category is less
than the aggregate cost for that category, the net depreciation shall be provided for
8.36 Financial Reporting

or charged to the profit and loss account. If the aggregate market value for the
category exceeds the aggregate cost for the category, the net appreciation shall be
ignored. Depreciation in one category of investments shall not be set off against
appreciation in another category.
[3] Unquoted equity shares in the nature of current investments shall be valued at cost
or break-up value, whichever is lower. However, NBFCs may substitute fair value
for the break-up value of the shares, if considered necessary. Where the balance
sheet of the investee company is not available for two years, such shares shall be
valued at one rupee only.
[4] Unquoted preference shares in the nature of current investments shall be valued at
cost or face value, whichever is lower.
[5] Investments in unquoted Government securities or Government guaranteed bonds
shall be valued at carrying cost.
[6] Unquoted investments in the units of mutual funds in the nature of current
investments shall be valued at the net asset value declared by the mutual fund in
respect of each particular scheme.
[7] Commercial papers shall be valued at carrying cost.
[8] A long-term investment shall be valued in accordance with the Accounting Standard
issued by ICAI.
Note : Unquoted debentures shall be treated as term loans or other type of credit
facilities depending upon the tenure of such debentures for the purpose of income
recognition and asset classification.
Asset classification
7. [1 Every NBFC shall, after taking into account the degree of well defined credit
weaknesses and extent of dependence on collateral security for realisation, classify
its lease/hire purchase assets, loans and advances and any other forms of credit
into the following classes, namely :
(i) Standard assets;
(ii) Sub-standard assets;
(iii) Doubtful assets; and
(iv) Loss assets.
[2] The class of assets referred to above shall not be upgraded merely as a result of
rescheduling, unless it satisfies the conditions required for the upgradation.
Provisioning requirements
8. Every NBFC shall, after taking into account the time lag between an account becoming
Financial Reporting for Financial Institutions 8.37

non-performing, its recognition as such, the realisation of the security and the erosion
over time in the value of security charged, make provision against sub-standard assets,
doubtful assets and loss assets as provided hereunder :
Loans, advances and other credit facilities including bills purchased and discounted
[1] The provisioning requirement in respect of loans, advances and other credit
facilities including bills purchased and discounted shall be as under :
(i) Loss Assets The entire asset shall be written off. If the assets
are permitted to remain in the books for any
reason, 100% of the outstanding should be
provided for;
(ii) Doubtful Assets (a) 100% provision to the extent to which the
advance is not covered by the realisable value
of the security to which the NBFC has a valid
recourse shall be made. The realisable value
is to be estimated on a realistic basis;
(b) in addition to item (a) above, depending upon
the period for which the asset has remained
doubtful, provision to the extent of 20% to 50%
of the secured portion (i.e., estimated
realisable value of the outstandings) shall be
made on the following basis :
Period for which the asset % of provision
has been considered as
doubtful :
Up to one year 20
One to three years 30
More than three years 50
(iii) sub-standard assets A general provision of 10% of total outstandings
shall be made.
Lease and hire purchase assets
[2] The provisioning requirements in respect of hire purchase and leased assets shall
be as under:–
HIRE PURCHASE ASSETS
[i] In respect of hire purchase assets, the total dues (overdue and future
instalments taken together) as reduced by
(a) the finance charges not credited to the profit and loss account and carried
forward as unmatured finance charges; and
8.38 Financial Reporting

(b) the depreciated value of the underlying asset, shall be provided for.
Explanation:– For the purpose of this paragraph,
(1) the depreciated value of the asset shall be notionally computed as
the original cost of the asset to be reduced by depreciation at the
rate of twenty per cent per annum on a straight line method; and
(2) in the case of second hand asset, the original cost shall be the
actual cost incurred for acquisition of such second hand asset.
ADDITIONAL PROVISION FOR THE HIRE PURCHASE AND LEASED ASSETS
[ii] In respect of hire purchase and leased assets, additional provision shall be
made as under :
(a) where any amounts of hire charges or lease Nil
rentals are overdue upto 12 months
SUB-STANDARD ASSETS :
(b) where any amount of hire charges or lease 10 per cent of the net book
rentals are overdue for more than 24 months value
but upto 24 months
DOUBTFUL ASSETS :
(c) where any amounts of hire charges or lease 40 per cent of the net book
rentals are overdue for more than 24 months value
but upto 36 months
(d) where any amounts of hire charges or lease 70 per cent of the net
overdue for more than 36 months book rentals are but
upto 48 months value
LOSS ASSETS:
(e) where any amounts of hire charges or lease 100 per cent of the
net book
rentals are overdue for more than 48 months value
[iii] On expiry of a period of 12 months after the due date of the last instalment of
hire purchase/leased asset, the entire net book value shall be fully provided
for.
Notes :
[1] The amount of caution money/margin money or security deposits kept by the borrower
with the NBFC in pursuance of the hire purchase agreement may be deducted against
Financial Reporting for Financial Institutions 8.39

the provisions stipulated under clause (i) above, if not already taken into account while
arriving at the equated monthly instalments under the agreement. The value of any other
security available in pursuance to the hire purchase agreement may be deducted only
against the provisions stipulated under clause (ii) above.
[2] The amount of security deposits kept by the borrower with the NBFC in pursuance to the
lease agreement together with the value of any other security available in pursuance to
the lease agreement may be deducted only against the provisions stipulated under
clause (ii) above.
[3] It is clarified that income recognition on and provisioning against NPAs are two different
aspects of prudential norms and provisions as per the norms are required to be made on
NPAs on total outstanding balances including the depreciated book value of the leased
asset under reference after adjusting the balance if any, in the lease adjustment account.
The fact that income on an NPA has not been recognised cannot be taken as reason for
not making provision.
[4] An asset which has been renegotiated or rescheduled as referred to in paragraph (2)
(xvi) (b) of these directions shall be a sub-standard asset or continue to remain in the
same category in which it was prior to its renegotiation or reschedulement as a doubtful
asset or a loss asset as the case may be. Necessary provision is required to be made as
applicable to such asset till it is upgraded.
[5] The balance sheet for the year 1999-2000 to be prepared by the NBFC may be in
accordance with the provisions contained in sub-paragraph (2) of paragraph 8.
Disclosure in the balance sheet
9. [1] Every NBFC shall, separately disclose in its balance sheet the provisions made as
per paragraph 8 above without netting them from the income or against the value of
assets.
[2] The provisions shall be distinctly indicated under separate heads of accounts as
under :–
(i) provisions for bad and doubtful debts; and
(ii) provisions for depreciation in investments.
[3] Such provisions shall not be appropriated from the general provisions and loss
reserves held, if any, by the NBFC.
[4] Such provisions for each year shall be debited to the profit and loss account. The
excess of provisions, if any, held under the heads general provisions and loss
reserves may be written back without making adjustment against them.
Constitution of Audit Committee by NBFCs
9A. An NBFC having the assets of Rs. 50 crores and above as per its last audited balance
8.40 Financial Reporting

sheet shall constitute an Audit Committee, consisting of not less than three members of its
Board of Directors.
Accounting year
9B. Every NBFC shall prepare its balance sheet and profit and loss account as on March 31
every year with effect from its accounting year ending with 31st March, 2001:
Provided that if the accounting year of any NBFC ends on any date other than 31st March,
2001 such NBFC shall prepare its balance sheet and profit and loss account for any fraction of
the year ending on 31st March, 2001.
Self- examination Questions
1. Define the following terms;
(a) Break up value.
(b) Subordinated debt.
2. What is meant by non-performing assets as per NBFC prudential norms.
3. What disclosures are required to be made in the balance sheet of ABC Co., being a non-
banking finance company?
4. On what basis income from investments is recognized by NBFC?
5. While closing its books of account on 31st March, 2005 a non banking finance company
has it’s advances classified as follows:
Rs. In lakhs
Standard assets 8,400
Sub-standard assets 910
Secured portions of doubtful debts:
-up to one year 160
-one year to three years 70
- More than three years 20
Unsecured portion of doubtful debts 87
Loss Assets 24

Calculate the amount of provision which must be made against the advances.
Financial Reporting for Financial Institutions 8.41

UNIT 3
MERCHANT BANKERS

3.1 INTRODUCTION
Dictionary meaning of 'merchant bank' refers to an organisation that underwrites corporate
securities and advises clients on issues like corporate mergers, etc. involved in the ownership
of commercial ventures. The organisation may be a bank, corporate body, firm or proprietary
concern.
In Indian context, this definition suits well. Merchant banking in India started with management
of public issues and loan syndication and has been gradually covering activities like project
counselling, portfolio management, investment counselling and mergers and amalgamation of
the corporate firms. A 'merchant banker' has been defined under the Securities & Exchange
Board of India (Merchant Banker) Rules, 1992 as "any person who is engaged in the business
of issue management either by making arrangements regarding selling, buying or subscribing
to securities as manager, consultant, advisor or rendering corporate advisory service in
relation to such issue management." Merchant bankers are the specialised agency which
manage the capital issues. They are also called the managers to the issue.
A merchant banker is an organisation that acts as an intermediary between the issuers and
the ultimate purchasers of securities in the primary security market. In addition to managing an
issue for a client, the services offered by a merchant banker includes underwriting and
providing advice on complex financings arrangements, mergers and acquisitions, and at times
direct equity investments in corporations. In exercise of the powers conferred vide Section 30
of the Securities and Exchange Board of India Act, 1992 (15 of 1992), the Board, with the
previous approval of the Central Government made the SEBI (Merchant Bankers) Regulations,
1992 which specify various requirements. These regulations specify the norms which SEBI
takes into account for considering the grant of a certificate of registration and its renewal. The
code of conduct has been given in schedule III. For General obligations and responsibilities
have been specified under chapter III of these regulations for keeping a control on the
activities of merchant bankers.

3.2 CAPITAL ADEQUACY REQUIREMENT


The capital adequacy requirement specified in regulation 7 shall not be less than the net worth
of the person making the application for grant of registration.
8.42 Financial Reporting

For the purpose, the net worth shall be as follows :


Category Minimum Amount
Rs.
Category I 5,00,00,000
(Merchant bankers who carry on activity of the issue management,
which will, inter alia, consist of preparation of prospectus and other
information relating to the issue, determining financial structure, tie
up of financiers and final allotment and refund of subscriptions; and
act as advisor, consultant, manager, underwriter, portfolio manager)
Category II 50,00,000
(Merchant bankers who act as advisor, consultant, co-manager,
underwriter, portfolio manager)
Category III 20,00,000
(Merchant bankers who act as underwriter, advisor, consultant to
an issue)
Category IV NIL
(Merchant bankers who act only as advisor or consultant to an issue)

3.3 MAINTENANCE OF BOOKS OF ACCOUNT, RECORDS ETC.


Every merchant banker shall keep and maintain the following books of account, records and
documents as per regulation 14 :
(a) a copy of balance sheet as at the end of the each accounting period;
(b) a copy of profit and loss account for that period;
(c) a copy of the auditor's report on the accounts for that period;
(d) a statement of financial position.
Every merchant banker shall intimate to the SEBI the place where the books of account,
records and documents are maintained. Every merchant banker shall, after the end of each
accounting period furnish to the Board copies of the balance sheet, profit and loss account
and such other documents for any other preceding five accounting years when required by the
SEBI. The merchant banker shall preserve the books of account and other records and
documents maintained under regulation 14 for a minimum period of five years.
Financial Reporting for Financial Institutions 8.43

As per Regulation 28 of the SEBI (Merchant Banker) Regulations 1992, a merchant banker
shall disclose to the Board, as and when required, the following information, namely :–
(i) his responsibilities with regard to the management of the issue;
(ii) any change in the information or particulars previously furnished, which have a bearing
on the certificate granted to it.
(iii) the names of the body corporate whose issue he has managed or has been associated
with;
(iv) the particulars relating to the breach of the capital adequacy requirements as specified in
regulation 7;
(v) relating to the activities as manager, underwriter, consultant or advisor to an issue, as
the case may be.
SEBI has the right to appoint one or more persons as inspecting authority to undertake
inspection of the books of account, records and documents of the merchant banker for any of
the following purposes :
(i) to ensure that the books of account are being maintained in the required manner;
(ii) that the provisions of the Act, rules, regulations are complied with;
(iii) to investigate into the complaints received from investors, other merchant bankers or any
other person on any matter having a bearing on the activities of the merchant banker;
and
(iv) to investigate suo motu in the interest of securities business or investors' interest into the
affairs of the merchant banker.
As per regulation 31, it shall be the duty of the merchant banker to allow the inspecting
authority to have reasonable access to the premises occupied by such merchant banker or by
any other person on his behalf and also extend reasonable facility for examining any books,
records, documents and computer data in the possession of the merchant banker or any such
other person and also provide copies of documents or other materials which, in the opinion of
the inspecting authority, are relevant for the purposes of the inspection.
The SEBI may also appoint a qualified auditor to investigate into the books of account or the
affairs of the merchant bankers.
SEBI Disclosure & Investor Protection Guidelines, 1999 has specified a format for half yearly
report to be submitted by merchant bankers.
Self-examination Questions
1. What is meant by merchant bankers? What books of accounts are required to be
maintained by a merchant banker?
8.44 Financial Reporting

2. Under what circumstances SEBI has the right to order inspection of records of a
merchant banker?
3. What capital adequacy norms are specified for merchant bankers.
Financial Reporting for Financial Institutions 8.45

UNIT 4
STOCK AND COMMODITY MARKET INTERMEDIARIES

4.1 INTRODUCTION
With the removal of the ban on forward trading in all commodities, the Indian commodities
futures market has been totally liberalised. Participants in the securities and other financial
markets can now think of exploring the opportunities offered by the emerging commodities
market. There are, however, some basic issues relating to the securities and commodity
derivative markets and the likely impact of any moves for unifying the two on participant
institutions, players and regulatory bodies. Neither convergence nor divergence may
necessarily mean a win-win situation for the existing stock and commodity exchanges in the
present situation. However, it must be conceded that any action taken must bring optimum
benefits with minimum discomfort to the various intermediaries in the markets. On the
commodities side, the task force has found that a key element in strengthening the agricultural
produce markets is to have an efficient derivatives market for the various commodities. This
will help in more efficient price-risk management. The futures market introduced in select
commodities recently will play a vital role in shaping the decisions of the market
intermediaries.
Even though there are differences between commodity and financial derivatives markets, they
also have some close link in so far as trading practices and mechanisms are concerned. The
reforms in the securities market over the past two decades were carried out both in the
primary and secondary markets. The Securities and Exchange Board of India has introduced
in the past decade a number of measures to streamline the capital market, professionalise
trading and protect the interests of the small investor. There is complete automation of trading
in the securities market. Proper risk management, governance principles and regulatory
measures are in place. In the commodities markets too the situation is changing. Some
commodity exchanges are specialising in specific areas with varying degrees of success. The
task force has stressed the need to have at least a third of each exchange board manned by
independent directors. Licences have been given for a multiple commodities exchange and
single commodity exchanges and for conducting trading on-line. Even a single commodity
exchange can trade in multiple commodities after obtaining permission from the Forward
Markets Commission (FMC).
Commodity exchanges are promoted by institutions and associations. With convergence, there
will be an opportunity to speed up the development of the commodity markets. Because of the
economies of scale in operations there will be scope for further improvement However, there
are certain differences. Financial futures generally draw their strength from actively traded
cash markets. The exchanges oversee the operations. While organised trading in commodities
8.46 Financial Reporting

may closely resemble financials (as in bullion), one area of concern in the former case is the
impact of price volatility on the market; also, commodities markets require specialised
knowledge that is different from securities trading. More agricultural reforms to ensure free
marketing and minimal price volatility will be needed to ensure orderly growth of the
commodities markets. The task force has identified many legal and regulatory hurdles in the
way of convergence of securities and commodities markets. The securities market is governed
by the Securities Contracts Regulation Act, 1956 whereas the forward market is regulated by
the Forward Contracts Regulation Act 1952. Another basic consideration is that stock
exchanges and futures markets for financials are Central subjects whereas agriculture is
under the jurisdiction of States and futures trading in commodities is with the Union
Government. In reality, policies for the securities market and development of the commodities
market are of different nature. Even though the volume of trading in commodities is much
higher than in securities, it is better to keep them apart in the initial stages. Clearing members
of a stock exchange would like to trade in a commodity exchange as it provides them another
avenue for making money. The Securities Contracts Regulation Act has therefore been
amended whereby members of a stock exchange can be members of a commodity exchange
by forming a separate company. This is essential because at present there are two regulators
and each one will exercise his supervisory powers as provided under the rules in the
respective market. The net worth for becoming a clearing member can be fixed separately for
the two exchanges and this will play an important role in risk management. Even if there is a
risk in one market, no cascading effect will be felt in the other. There is also the fact that net
worth from one market cannot be moved to another. This will provide the necessary firewall
between the two markets and will benefit all the participants.

4.2 STOCK BROKERS


In this unit of the chapter, we will concentrate on stock brokers which are considered as part of
stock and commodity market intermediaries. A stock broker is a member of a recognised stock
exchange(s) and is engaged in buying, selling and dealing in securities. A stock broker can
deal in securities only after getting registration with SEBI. A stock broker can function as a
proprietorship firm, partnership firm or a corporate. Brokers are subject to capital adequacy
requirements comprising of a basic minimum capital and additional volume related capital.
Stock brokers are also eligible to act as underwriters without obtaining a separate registration
as an underwriter. He may or may not appoint sub-brokers. A sub-broker is subordinate to
main stock broker and acts on behalf of a stock broker as an agent or otherwise, for assisting
the investors in buying, selling or dealing in securities through such stock brokers. The stock
broker as a principal, is responsible to the investor for his sub-brokers' conduct and acts.
In exercise of the powers conferred by section 30 of the Securities and Exchange Board of
India Act ,1992 the SEBI Board made the SEBI (Stock-Brokers and Sub-Brokers) Regulations,
1992 to exercise the control on the activities of stock brokers and their sub-brokers. In a
contract for buying and selling securities, stock brokers act as agents for investors. In return
Financial Reporting for Financial Institutions 8.47

for this service they charge commission or brokerage at a specified percentage on contract
value. In addition to acting as agents for others, a stockbroker may also trade directly by
buying and selling securities as principals. If a stockbroker enters into a contract to buy or sale
securities as principal with any person other than another stockbroker, he must secure the
consent or authorization from the other party and must disclose in the agreement for buying or
selling of securities that he is acting as a principal.
A sub-broker is any person not being a member of a recognised stock exchange who acts on
behalf of a stock-broker as an agent or otherwise for assisting the investors in buying, selling
or dealing in securities through such stockbroker.
The Securities and Exchange Board of India (Stockbrokers and sub-brokers) Rules, 1992
provides that no stockbroker or sub-broker can buy, sell or deal in securities, unless he holds
a certificate of registration granted by the Securities and Exchange Board of India (SEBI). The
certification of registration is granted by SEBI on an application made to it in prescribed form,
subject to fulfillment of conditions specified in the Securities and Exchange Board of India
(Stockbrokers and sub-brokers) Rules, 1992.
The Securities and Exchange Board of India (Stockbrokers and sub-brokers)
Regulations, 1992 provides inter-alia, for the obligations and responsibilities of stock brokers
regarding maintenance of proper books of accounts, records and documents and other allied
matters. In the regulations, board means, the Securities and Exchange Board of India (SEBI).

4.3 MAINTENANCE OF PROPER BOOKS OF ACCOUNT, RECORDS ETC. (REGULATION 17)


Every stock boker is required to maintain the following books of account and records as per
Rule 15 of the Securities Contracts (Regulation) Rules, 1957 and Regulation 17 of the SEBI
(Stock Brokers and Sub-Brokers) Rules, 1992 :
(a) Register of transactions (Sauda Book)/Daily Transaction List;
(b) Clients Ledger;
(c) General Ledger;
(d) Journals;
(e) Cash book;
(f) Bank Pass book;
(g) Documents register/Inward-Outward register showing full particulars of shares and
securities received and delivered;
(h) Member’s contract books showing details of all contracts entered into by him with other
members of the stock exchange or counterfoils or duplicates of memos of confirmaton
issued to such other members;
8.48 Financial Reporting

(i) Counterfoils or duplicates of contract notes issued to clients;


(j) Written consent of clients in respect of contracts entered into as principals;
(k) Margin deposit book;
(l) Register of accounts of sub-brokers;
(m) An agreement with a sub-broker specifying the scope of authority and responsibilities of
the stock-broker and such sub-brokers.
In addition to the above statutory requirements, they are also required to maintain the
following records/documents :
(a) Scripwise clientwise list in respect of scrips of specified group, i.e., 'A' Group (inclusive of
brought forward positions);
(b) Client upla statement (i.e. carry forward position of all clients);
(c) Duplicate copies of self-certificates submitted on monthly basis (i.e., that the daily and
badla break-up have been reported correctly without netting positions of two different
clients in the same scrip);
(d) Copies of all margin statements downloaded by the Stock Exchange;
(e) Copies of Valan Balance Sheet (Form 31) along with all relevant assets;
(f) Details of spot delivery transactions entered into (including securities delivered and
payments made to the members);
(g) Client database and broker client agreement;
(h) Copy of registration certificate of each sub-broker issued by SEBI;
(i) Copy of approval for each remisier given by the exchange;
(j) Copy of the power of attorney/board resolution authoritizing directors, employees to sign
the contract note;
(k) Copies of pool account statements.
Every stock broker shall intimate to the SEBI the place where the books of account, records
and documents are maintained. Every stock broker shall, after the close of each accounting
period furnish to the SEBI if so required as soon as possible but not later than six months from
the close of the said period a copy of the audited balance sheet and profit and loss account as
at the end of the said accounting period; provided that if, it is not possible to furnish the above
documents within the time specified, the stock broker shal keep the SEBI informed of the
same together with the reasons for delay and the period of time by which such documents
would be furnished. Every stock broker is required to preserve the books of account and other
records maintained under regulation 17 for a minimum period of five years.
Financial Reporting for Financial Institutions 8.49

SEBI may appoint one or more persons as inspecting authority to undertake inspection of the
books of account, other records and documents of the stock brokers for any of the following
purposes :
(a) to ensure that the books of the account and other books are being maintained in the
manner required;
(b) that the provisions of the Act, rules, regulations and the provisions of the Securities
Contract (Regulation) Act, and the rules made thereunder are being complied with;
(c) to investigate into the complaints received from investors, other stock brokers, sub-
brokers or any other person on any matter having a bearing on the activities of the stock
brokers; and
(d) to investigate suo motu, in the interest of securities business or investors' interest into
the affaris of the stock-brokers.
The SEBI may appoint a qualified auditor to investigate into the books of account or the affairs
of the stock-broker.
A stock broker who fails to comply with any of the conditions subject to which registration has
been granted; contravenes any of the provisions of the Act, rules or regulations; or the
contravenes the provisions of the Securities Contracts (Regulation) Act, or the rules made
thereunder or contravenes the rules, regulations or bye-laws of the stock exchange shall be
liable to any of the following penalities as per regulation 25 :
(a) suspension of registration, after the inquiry, for a specified period; or
(b) cancellation of registration.
Without prejudice to the requirements above, every stock- broker must, after the close of each
accounting period furnish to the Board if so required as soon as possible but not later than six
months from the close of the said period a copy of the audited balance sheet and profit and
loss account, as at the end of the said accounting period:
If it is not possible to furnish the above documents within the time specified, the stock-broker
shall keep the Board informed of the same together with the reasons for the delay and the
period of time by which such documents would be furnished.
Every stockbroker has a duty to intimate the Board of the place where the books of accounts,
records and documents are maintained.

4.4 PRESERVATION OF BOOKS OF ACCOUNTS AND RECORDS (REGULATION 18)


Every stockbroker shall preserve the books of account and other records maintained under
regulation 17 for a minimum period of five years.
8.50 Financial Reporting

4.5 BOARD'S RIGHT TO INSPECT (REGULATION 19)


Where it appears to the Board so to do, it may appoint one or more persons as inspecting
authority to undertake inspection of the books of accounts, other records and documents of
the stock- brokers for any of the following purposes.
(a) To ensure that the books of accounts and other books are being maintained in the
manner required;
(b) That the provisions of the Act, rules, regulations and the provisions of the Securities
Contracts (Regulation) Act and the rules made there under are being complied with;
(c) To investigate into the complaints received from investors, other stock brokers, sub-
brokers or any other person on any matter having a bearing on the activities of the stock-
brokers; and
(d) To investigate suo-moto, in the interest of securities business or investors' interest, into
the affairs of the stock- broker.

4.6 PROCEDURE FOR INSPECTION (REGULATION 20)


Before undertaking any inspection under regulation 19, the Board shall give a reasonable
notice to the stock- broker for that purpose. However, where the Board is satisfied that in the
interest of the investors or in public interest no such notice should be given, it may by an order
in writing direct that the inspection of the affairs of the stockbroker be taken up without such
notice.
On being empowered by the Board, the inspecting authority shall undertake the inspection and
the stock-broker against whom an inspection is being carried out shall be bound to discharge
his obligations as provided under regulation 21.

4.7 OBLIGATIONS OF STOCKBROKER ON INSPECTION BY THE BOARD


(REGULATION 21)
It shall be the duty of broker on inspection by the Board every director, proprietor, partner,
officer and employee of the stock-broker, who is being inspected, to produce to the inspecting
authority such books, accounts and other documents in his custody or control and furnish him
with the statements and information relating to the transactions in securities market within
such time as the said officer may require.
The stock-broker shall allow the inspecting authority to have reasonable access to the
premises occupied by such stock- broker or by any other person on his behalf and also extend
reasonable facility for examining any books, records, documents and computer data in the
possession of the stock- broker or any other person and also provide copies of documents or
other materials which, in the opinion of the inspecting authority are relevant.
The inspecting authority, in the course of inspection, shall be entitled to examine or record
Financial Reporting for Financial Institutions 8.51

statements of any member, director, partner, proprietor and employee of the stock- broker.
It shall be the duty of every director proprietor, partner, officer and employee of the stock
broker to give to the inspecting authority all assistance in connection with the inspection,
which the stock broker may be reasonably expected to give.

4.8 SUBMISSION OF REPORT TO THE BOARD (REGULATION 22)


The inspecting authority shall, as soon as may be possible submit an inspection report to the
Board.

4.9 ACTION ON INSPECTION OR INVESTIGATION REPORT (REGULATION 23)


The Board or the Chairman shall after consideration of inspection or investigation report take
such action as the Board or Chairman may deem fit and appropriate including action under the
Securities and Exchange Board of India (Procedure for Holding Enquiry by Enquiry Officer and
Imposing Penalty) Regulations, 2002.

4.10 APPOINTMENT OF AUDITOR (REGULATION 24)


Notwithstanding anything contained above, the Board may appoint a qualified auditor to
investigate into the books of account or the affairs of the stockbroker. The auditor so
appointed shall have the same powers of the inspecting authority as mentioned in regulation
19 and the obligations of the stock- broker in regulation 21 shall be applicable to the
investigation under this regulation.

4.11 REGULATION OF TRANSACTIONS BETWEEN CLIENTS AND BROKERS


The SEBI, in its letter dated November 18, 1993 had directed all stock exchanges to insert the
following norms regarding transactions between clients and brokers in their byelaws.
It shall be compulsory for all member brokers to keep the money of the clients in a separate
account and their own money in a separate account. No payment for transactions in which the
member broker is taking a position as a principal will be allowed to be made from the client’s
account. The above principles and the circumstances under which transfer from client’s
account to member broker’s account would be allowed are enumerated below.

4.12 MEMBER BROKER TO KEEP ACCOUNTS


Every member broker shall keep such books of accounts, as will be necessary, to show and
distinguish in connection with his business as a member –
(a) Moneys received from or on account of each of his clients and,
(b) The moneys received and the moneys paid on Member’s own account.

4.13 OBLIGATION TO PAY MONEY INTO "CLIENTS ACCOUNTS"


Every member broker who holds or receives money on account of a client shall forthwith pay
8.52 Financial Reporting

such money to current or deposit account at bank to be kept in the name of the member in the
title of which the word "clients" shall appear (hereinafter referred to as "clients account").
Member broker may keep one consolidated clients account for all the clients or accounts in the
name of each client, as he thinks fit. If a Member broker receives a cheque or draft
representing in part money belonging to the client and in part money due to the Member, he
shall pay the whole of such cheque or draft into the clients account and effect subsequent
transfer.
Nothing in the above paragraph shall deprive a Member broker of any recourse or right,
whether by way of lien, set-off, counter-claim charge or otherwise against moneys standing to
the credit of clients account.
Moneys to be paid into "clients account"
No money shall be paid into clients account other than –
(a) Money held or received on account of clients;
(b) Such money belonging to the Member as may be necessary for the purpose of opening
or maintaining the account;
(c) Money for replacement of any sum, which may by mistake or accident have been drawn
from the account.
(d) A cheque or draft received by the Member representing in part money belonging to the
client and in part money due to the Member.
Moneys to be withdrawn from "clients account"
No money shall be drawn from clients account other than -
(a) Money properly required for payment to or on behalf of clients or for or towards payment
of a debt due to the Member from clients or money drawn on client’s authority, or money
in respect of which there is a liability of clients to the Member, provided that money so
drawn shall not in any case exceed the total of the money so held for the time being for
such each client;
(b) Such money belonging to the Member as may have been paid into the client account;
(c) Money, which may by mistake or accident have been paid into such account.

4.14 ACCOUNTS FOR CLIENT’S SECURITIES


It shall be compulsory for all Member brokers to keep separate accounts for client’s securities
and to keep such books of accounts, as may be necessary, to distinguish such securities from
his/their own securities. Such accounts for client’s securities shall, inter-alia provide for the
following:
(a) Securities received for sale or kept pending delivery in the market;
Financial Reporting for Financial Institutions 8.53

(b) Securities fully paid for, pending delivery to clients;


(c) Securities received for transfer or sent for transfer by the Member, in the name of client
or his nominees;
(d) Securities that are fully paid for and are held in custody by the Member as
security/margin etc. Proper authorization from client for the same shall be obtained by
Member;
(e) Fully paid for client’s securities registered in the name of Member, if any, towards margin
requirements etc.;
(f) Securities given on Vyaj-badla. Member shall obtain authorization from clients for the
same.

4.15 PAYMENT AND DELIVERY OF SECURITIES


Member Brokers shall make payment to their clients or deliver the securities purchased within
two working days of payout unless the client has requested otherwise. Stock Exchange shall
issue a Press Release immediately after the payout.
Member brokers shall issue the contract note for purchase/sale of securities to a client within
24 hours of the execution of the contract.

4.16 MARGIN
Member Brokers shall buy securities on behalf of client only on receipt of margin of minimum
20% on the price of the securities proposed to be purchased, unless the client already has an
equivalent credit with the broker. Member may not, if they so desire, collect such a margin
from Financial Institutions, Mutual Funds and FII’s.
Member brokers shall sell securities on behalf of client only on receipt of a minimum margin of
20% on the price of securities proposed to be sold, unless the member has received the
securities to be sold with valid transfer documents to his satisfaction prior to such sale.
Member may not, if they so desire, collect such a margin from Financial Institutions, Mutual
Funds and FII’s.

4.17 CLOSING OUT


In case of purchases on behalf of clients, Member brokers shall be a liberty to close out the
transactions by selling the securities, in case the client fails to make the full payment to the
Member Broker for the execution of the contract within two days of contract note having been
delivered for cash shares and seven days for specified shares or before pay-in day (as fixed
by Stock Exchange for the concerned settlement period), whichever is earlier; unless the client
already has an equivalent credit with the Member. The loss incurred in this regard, if any, will
be met from the margin money of that client.
8.54 Financial Reporting

In case of sales on behalf of clients, Member broker shall be at liberty to close out the contract
by effecting purchases if the client fails to deliver the securities sold with valid transfer
documents within 48 hours of the contract note having been delivered or before delivery day
(as fixed by Stock Exchange authorities for the concerned settlement period), whichever is
earlier. Loss on the transaction, if any, will be deductible from the margin money of that client.
Self-examination Questions
1. What is meant by stock broker?
2. What books of accounts are required to be maintained by a stock broker?
3. For what purposes inspection of records and documents of merchant banker is ordered
by SEBI?
9
VALUATION

UNIT 1
CONCEPT OF VALUATION

1.1 INTRODUCTION
Valuation is the process that links risk and return to estimate the worth i.e. value of an asset or
a firm. Valuation of a company at a given point in time should be understood as the expected
payout value of that enterprise when a liquidity event presents itself at that moment. There is a
common misconception that the valuation calculation for enterprises is usually performed at
points of capital inflow or outflow. Valuation can be used as a very effective business tool by
management for better decision making throughout the life of the enterprise. A discussion on
valuation can be made philosophical in nature by arguing the assumptions. Companies are
governed and valuations are influenced by the market supply-demand lifecycles along with
product and technology supply-demand lifecycles. Correspondingly, the value of an enterprise
over the course of its life peaks with the market and product/ technology factors. Both financial
investors such as venture capitalists and entrepreneurs involved in a venture would ideally like
to exit the venture in some form near the peak to maximize their return on investment. Thus,
valuation helps determine the exit value of an enterprise at that peak. This exit value typically
includes the tangible and intangible value of the company’s assets. Tangible value would
typically include balance sheet items recorded as the book value of the enterprise. Intangibles
would typically include intellectual property, human capital, brand and customers, among
others. In more traditional companies considering the private equity markets, the value of
intangibles is much higher than the value of the tangible assets. Therefore, an effective
enterprise valuation methodology needs to be developed.
One can also define valuation as Measurement of value in monetary terms. Measurement of
income and valuation of wealth are two interdependent core aspects of financial accounting
and reporting. Wealth comprises of assets and liabilities. Valuation of assets and liabilities are
made to portray the wealth position of a firm through a balance sheet and to supply logistics to
the measure of the periodical income of the firm through a profit and loss account. Again
9.2 Financial Reporting

valuation of business and valuation of share are made through financial statement analysis for
management appraisal and investment decisions. Valuation is pivotal in strategic, long term or
short term decision making process in cases like reorganization of company, merger and
acquisition, extension or diversification, or for launching new schemes or projects. As the
application area of valuation moves from financial accounting to financial management, the
role of accountant also undergoes a transition. That order of transition in the concept and use
of valuation process is followed in the subsequent units of this chapter.

1.2 CONCEPT OF VALUATION


Valuation means measurement of value in monetary term. The subjects of valuation are varied
as stated below:
♦ Valuation of Tangible Fixed Assets
♦ Valuation of Intangibles including brand valuation and valuation of goodwill
♦ Valuation of Shares
♦ Valuation of Business
The objectives of valuation are again different in different areas of application in financial
accounting and in financial management.

1.3 NEED FOR VALUATION


Financial statements must give a “true and fair view” of the state of affairs of a company as
per Section 211 of the Companies Act. Proper valuation of all assets and liabilities is required
to ensure true and fair financial position of the business entity. In other words, all matters
which affect the financial position of the business has to be disclosed. Under- or over-
valuation of assets may not only affect the operating results and financial position of the
current period but will also affect theses for the next accounting period The present unit deals
with different principles involved in the valuation of different types of assets.
For the purposes of Part I, Schedule VI, assets are classified as (i) fixed assets, (ii)
investments and (iii) current assets, loans and advances and (iv) miscellaneous expenditure
like preliminary expenses, commission, brokerage on underwriting or subscription of shares or
debentures, discount allowed on the issue of shares or debentures, interest paid out of capital
during construction, development expenditure, debit balance of profit and loss account to the
extent not written off or adjusted. These are called fictitious assets. Prudence suggests writing
off these miscellaneous expenditure against revenue as early as possible. Particularly, debit
balance of profit and loss account does not remain if there is adequate credit balance to cover
it up.
The students are expected to learn the essence and modalities of valuation, a core function in
financial accounting and financial management. The different approaches to valuation of
different kinds of assets and liabilities in different perspectives have pushed the role of
Valuation 9.3

accountant to a complex position. This chapter is aimed to differentiate the objectives,


approaches and methods of valuation in order to integrate them in a comprehensive logical
frame. In this chapter, we shall discuss valuation of tangible fixed assets following the
requirement of the Companies Act and guidelines of AS-6 (revised) ‘Depreciation Accounting’
and AS-10 ‘Accounting for Fixed Assets’, AS-12 ‘Accounting for Government Grants’, AS-14
‘Accounting for Amalgamations’ and Guidance Note on Treatment of Reserve created on
Revaluation of Fixed Assets.

1.4 BASES OF VALUATION


A number of different measurement bases are employed to different degrees and in varying
combinations in valuation of different assets in different areas of application. They include the
following:
(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the
fair value of the other consideration given to acquire them at the time of their acquisition.
(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have
to be paid if the same or an equivalent asset were acquired currently.
(c) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents
that could currently be obtained by selling the asset in an orderly disposal.
(d) Present value. Assets are carried at the present value of the future net cash inflows that
the item is expected to generate in the normal course of business.
Other valuation bases:
Net Realisable Value (NRV): This is same as the Realisable ( settlement) value. This is the
value (net of expenses) that can be realized by disposing off the assets in an orderly manner.
Net selling price or exit values also convey the same meaning.
Economic value: This is same as the present value. The other name of it is value to business.
Replacement (cost) value: This is also same as the current cost.
Recoverable (amount) value: This is the higher of the net selling price and value in use.
Deprival value: This is the lower of the replacement value and recoverable (amount) value.
Liquidation value: this is the value (net of expenses), that a business can expect to realize by
disposing of the assets in the event of liquidation. Such a value is usually lower than the NRV
or exit value. This is also called break up value.
Fair value: This is not based on a particular method of valuation. It is the acceptable value
based on appropriate method of valuation in context of the situation of valuation. Thus fair
value may represent current cost, NRV or present value as the case may be.
In financial accounting ‘An asset is recognised in the balance sheet when it is probable that
the future economic benefits associated with it will flow to the enterprise and the asset has a
9.4 Financial Reporting

cost or value that can be measured reliably.’ ‘The measurement basis most commonly
adopted by enterprises in preparing their financial statements is historical cost. This is usually
combined with other measurement bases. For example, inventories are usually carried at the
lower of cost and net realisable value and pension liabilities are carried at their present value.
Furthermore, the current cost basis may be used as a response to the inability of the historical
cost accounting model to deal with the effects of hanging prices of non-monetary assets.’
(Framework, Issued 2000, Para 100)
The requirements of regulations and accounting standards as to recognition of assets,
reliability of measurement and disclosure in financial reports have set certain limitations to the
freedom of valuation so far as financial accounting is concerned.

1.5 TYPES OF VALUE


The following are six types of value:
♦ Going-concern value is the value of a firm as an operating business.
♦ Liquidation value is the projected price that a firm would receive by selling its assets if it
were going out of business.
♦ Book value is the value of an asset as carried on a balance sheet. In other words, it
means i) the cost of an asset minus accumulated depreciation ii) the net asset value of a
company, calculated by total assets minus intangible assets (patents, goodwill) and
liabilities iii) the initial outlay for an investment. This number may be net or gross of
expenses such as trading costs, sales taxes, service charges and so on. It is the total
value of the company’s assets that shareholders would theoretically receive if a company
were liquidated. By being compared to the company’s market value, the book value can
indicate whether a stock is under- or overpriced. In personal finance, the book value of
an investment is the price paid for a security or debt investment. When a stock is sold,
the selling price less the book value is the capital gain (or loss) from the investment.
♦ Market value is the price at which buyers and sellers trade similar items in an open
market place. The current quoted price at which investors buy or sell a share of common
stock or a bond at a given time. The market capitalization plus the market value of debt.
Sometimes referred to as “total market value”. In the context of securities, market value
is often different from book value because the market takes into account future growth
potential. Most investors who use fundamental analysis to picks stocks look at a
company’s market value and then determine whether or not the market value is adequate
or if it’s undervalued in comparison to its book value, net assets or some other measure.
♦ Fair market Value is the price that a given property or asset would fetch in the
marketplace, subject to the following conditions: i) Prospective buyers and sellers are
reasonably knowledgeable about the asset; they are behaving in their own best
interests and are free of undue pressure to trade. ii). A reasonable time period is given
for the transaction to be completed. Given these conditions, an asset’s fair market value
Valuation 9.5

should represent an accurate valuation or assessment of its worth. Fair market values
are widely used across many areas of commerce. For example, municipal property taxes
are often assessed based on the fair market value of the owner’s property. Depending
upon how many years the owner has owned the home, the difference between the
purchase price and the residence’s fair market value can be substantial. Fair market
values are often used in the insurance industry as well. For example, when an insurance
claim is made as a result of a car accident, the insurance company covering the damage
to the owner’s vehicle will usually cover damages up to the fair market value of the
automobile.
♦ Intrinsic value∗ is the value at which an asset should sell based on applying data inputs
to a valuation theory or model. The actual value of a company or an asset based on an
underlying perception of its true value including all aspects of the business, in terms of
both tangible and intangible factors. This value may or may not be the same as the
current market value. Value investors use a variety of analytical techniques in order to
estimate the intrinsic value of securities in hopes of finding investments where the true
value of the investment exceeds its current market value. For call options, this is the
difference between the underlying stock’s price and the strike price. For put options, it is
the difference between the strike price and the underlying stock’s price. In the case of
both puts and calls, if the respective difference value is negative, the intrinsic value is
given as zero. For example, value investors that follow fundamental analysis look at both
qualitative (business model, governance, target market factors etc.) and quantitative
(ratios, financial statement analysis, etc.) aspects of a business to see if the business is
currently out of favour with the market and is really worth much more than its current
valuation.
These types of values can differ from one another. For example, a firm’s going-concern value
is likely to be higher than its liquidation value. The excess of going-concern value over
liquidation value represents the value of the operating firm as distinct from the value of its
assets. Book value can differ substantially from market value. For example, a piece of
equipment appears on a firm’s books at cost when purchased but decreases each year due to
depreciation charges. The price that someone is willing to pay for the asset in the market may
have little relationship with its book value. Market value reflects what someone is willing to pay
for an asset whereas intrinsic value shows what the person should be willing to pay for the
same asset.


* Extrinsic value is another variety. It is the difference between an option’s price and the intrinsic
value. For example, an option that has a premium price of Rs.10 and an intrinsic value of Rs.5
would have an extrinsic value of Rs.5. Denoting the amount that the option’s price is greater than
the intrinsic value, the extrinsic or time value of the option declines as the expiration date of an
option draws closer.
9.6 Financial Reporting

1.6 APPROACHES OF VALUATION


Three General Approaches to Valuation are as follows:
1) Cost Approach: e.g. Adjusted Book Value
2) Market Approach: e.g. Comparables
3) Income Approach: e.g. Discounted Cash Flow
Each approach has advantages and disadvantages. Generally there is no “right” answer to a
valuation problem. Valuation is very much an art as much as a science!
Adjusted Book Value or Cost of Assets
This technique involves restating the value of individual assets to reflect their fair market
values. It is useful for valuing holding companies where assets are easy to value (for example,
securities) and less useful for valuing operating businesses. The value of an operating
company is generally greater than that of its assets. The difference between that value of the
expected cash flows and that of its assets is called the “going concern value”. It is a useful
approach when the purpose of the valuation is that the business will be liquidated and
creditors must be satisfied.
While doing this valuation following adjustments to book value can be made:
♦ Inventory undervaluation
♦ Bad debt reserves
♦ Market value of plant and equipment
♦ Patents and franchises
♦ Investments in affiliates
♦ Tax-loss carried forward
Valuation 9.7

UNIT 2
VALUATION OF TANGIBLE FIXED ASSETS

2.1 INTRODUCTION
Tangible Fixed Assets are valued for presenting them in the balance sheet with due reference
to the relevant portions of the “Framework for the Preparation and Presentation of Financial
Statements”, Schedule VI, Part I to the Companies Act, AS 10, AS 11, AS 12, AS 14, AS 16,
AS 26 and AS 28 we shall discuss the different approaches to and procedural aspects of
valuation of tangible fixed assets.
Schedule VI, Part I to the Companies Act requires the following classification of fixed assets:
(a) goodwill (b) land (c) building (d) leasehold (e) railway slidings (f) plant and machinery (g)
furniture and fittings (h) development of property (i) patents, trademarks and designs (j)
livestock and (k) vehicles etc. Of these, goodwill, patents, trademarks and designs are special
type of fixed assets called intangibles, the valuation whereof would be discussed in the next
unit.
The said Part I of the Schedule VI also requires that:
Gross Block i.e., the original cost for each head and the additions thereto and deductions
there from during the year, the accumulated depreciation i.e., the total depreciation written
off or provided for up to the end of the year and net block i.e., gross block less accumulated
depreciation are to be stated.
The value at which these assets stood in company’s book at the commencement of the Act
are to be shown in case the original cost is not available.
Adjustment in original cost is necessary for change in foreign exchange rate resulting in
increase or decrease in liability if the fixed assets are acquired from any country outside India.
Revaluation of the original cost is permissible.
As per the requirements of the said Part I of the Schedule VI of the Companies Act, under
each head the original cost and the additions thereto and deductions therefrom during the
year, and the total depreciation written off or provided for upto the end of the year are to be
stated.

2.2 MEANING OF ORIGINAL COST


The Para 9 of the AS10 has stated the components of cost as below (a to e):
(a) The cost of an item of fixed asset comprises its purchase price, including import duties and
other non-refundable taxes or levies, any trade discounts and rebates are deducted in arriving
at the purchase price.
9.8 Financial Reporting

(b) Any directly attributable cost of bringing the asset to its working condition for its intended
use; Examples of directly attributable costs are:
(i) Site preparation;
(ii) Initial delivery and handling costs;
(iii) Installation cost, such as special foundations for plant; and
(iv) Professional fees, for example fees of architects and engineers.
(c) 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.
(d) The expenditure incurred on start-up and commissioning of the project, including the
expenditure incurred on test runs and experimental production, is usually capitalised 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 consumption, is not
capitalized and is treated as revenue expenditure even though the contract may stipulate that
the plant will not be finally taken over until after the satisfactory completion of the guarantee
period.
(e) 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 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.
(f) The AS 16 stated on capitalization of borrowing costs (i.e., interest and other costs incurred
by an enterprise in connection with the borrowing of funds) that are directly attributable to the
acquisition, construction or production of a qualifying asset.
(g) Self constructed fixed assets: The same principles that apply to value purchased fixed
assets at original cost will apply to self constructed assets also.(AS10, Para 10)
It may be remembered that administration and general overhead expenses are usually
excluded from the cost of fixed assets unless they are specifically attributable to financing cost
incurred on deferred credit or borrowed fund in relation to acquisition of fixed assets, and they
do not form part of original cost after such fixed assets are ready for use. Similarly,
expenditure incurred on start-up and commissioning of the project after the plant has begun
commercial production is not considered as a part of the original cost.
Valuation 9.9

2.3 CHANGE IN ORIGINAL COST


The cost of a fixed asset may undergo changes subsequent to its acquisition or construction
on account of exchange fluctuations, price adjustments, and changes in duties or similar
factors.
Adjustment in original cost is necessary for change in foreign exchange rate resulting in
increase or decrease in liability if the fixed assets are acquired from any country outside India.
However Para 13 of AS 11 stated that Exchange differences arising on the settlement of
monetary items or on reporting an enterprise’s monetary items at rates different from those at
which they were initially recorded during the period, or reported in previous financial
statements, should be recognised as income or as expenses in the period in which they arise.
It may be noted that the requirement with regard to treatment of exchange differences
contained in AS 11 (revised 2003) is different from Schedule VI to the Companies Act, 1956,
since AS 11 (revised 2003) does not require the adjustment of exchange differences in the
carrying amount of the fixed assets, in the situations envisaged in Schedule VI. It has been
clarified that pending the amendment, if any, to Schedule VI to the Companies Act, 1956, in
respect of the matter, a company adopting the treatment described in Schedule VI will still be
considered to be complying with AS 11 (revised 2003) for the purposes of section 211 of the
Act.
Government Grants related to specific fixed assets, as per AS 12, can be deducted from the
cost of the said assets. Alternatively the Grant can be shown as deferred income.

2.4 CHANGE OF ORIGINAL COST - IMPROVEMENTS, REVALUATION, IMPAIRMENT


Improvement: Expenditure which increase the future benefits from the existing asset is treated
as cost of improvement. This cost of improvement or of any addition or extension which
becomes integral part of the existing fixed asset is to be added to the value of the asset.
Revaluation: Revaluation of fixed assets may be made to show the assets at their current
costs, particularly in context of the historical cost loosing relevance in inflationary situation.
Increase in value of fixed assets is shown as revaluation reserve which is not distributable.
The loss on revaluation, however, transferred to profit and loss account.
Impairment of assets: When the recoverable amount of an asset falls below its carrying
amount, as per AS 28, the carrying amount has to be reduced to the recoverable amount and
the loss on impairment should be charged to profit and loss account in addition to the
depreciation. If subsequently the recoverable amount rises the reversal, i.e., addition shall be
made to the already reduced carrying amount. However the reversed carrying amount should
never exceed the original carrying amount which would have been had there been no
impairment.
9.10 Financial Reporting

2.5 VALUATION APPROACHES


From the discussion in the above paragraphs we clearly observe that:
(a) In most of the cases the basis of valuation is historical cost.
(b) In case of revaluation the current cost basis (3.1 b) is applied.
(c) In case of impairment of assets we get another value called ‘recoverable amount’.
Recoverable amount is the higher of an asset’s net selling price and its value in use. Value in
use is the present value of estimated future cash flows expected to arise from the continuing
use of an asset and from its disposal at the end of its useful life. Net selling price is the
amount obtainable from the sale of an asset in an arm’s length transaction between
knowledgeable, willing parties, less the costs of disposal. (AS 28)
(d) 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. 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 exchanged are similar, is to record the asset acquired at
the net book value of the asset given up; When a fixed asset is acquired in exchange for
shares 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. (AS 10,Para 11)
(Note: We find different terms in different references viz., Realisable (settlement) value, Net
selling price and fair market value connoting the same meaning. Again, Present value and
Value in use are also carrying the same meaning.)

2.6 NET VALUATION


After arriving at the gross book value (gross block) based on any or combination of the
different approaches, accumulated depreciation is deducted there from to get the Net Book
Value (net block). Thus net valuation is dependent on the amount of depreciation accumulated
through annual depreciation, which, again, differs with different methods of depreciation.

2.7 DISPOSAL AND RETIREMENT


An item of fixed assets is eliminated from financial statements on disposal. If any fixed asset is
retired from active use and held for disposal, it should be valued at the lower of the net book
value and net realisable value. This means expected loss arising out of retirement of the fixed
assets is immediately accounted for. Such loss should be charged to Profit and Loss Account.
Similarly, gain or loss arising out of disposal of fixed assets is generally charged to Profit and
Loss Account.
If any fixed asset was revalued earlier and the revaluation reserve remains unutilised partly or
fully any loss arising out of sale of such fixed assets can be adjusted with the unutilised
balance of revaluation reserve.
Valuation 9.11

2.8 DEPRECIATION
Assessment of depreciation and the amount to be charged is based on three factors;
(i) Value of fixed assets (already discussed);
(ii) Useful life of fixed assets; and
(iii) Estimated residual value.
There are several methods for charging depreciation of which straight line method and written
down value method are used.
Regarding depreciation, AS 6 suggests adoption of the following principle:
(i) Consistency in application of the depreciation method.
(ii) If there is change in method, unamortised amount of the fixed assets should be charged
to revenue following the new method from the date of the asset coming into use.
(iii) If useful life is revised, the unamortised value of the fixed assets should be charged to
revenue over the revised remaining period of useful life.
(iv) If the value of the fixed asset is revised, the depreciation should be charged to write off
the unamortised value of the fixed assets including revaluation profit/loss over the
remaining useful life. In case the revaluation has a material effect on the amount of
depreciation, the same should be disclosed separately in the year in which revaluation is
carried out.
Illustration 1
Fixed Assets of XYZ Ltd:
Purchased as on 1.4.2001 Rs. 7,50,000
Revaluation + 20% on 1.4.2003.
Expected life 15 years.
The company charged straight line depreciation.
The fixed asset was sold on 1.4.2006for Rs. 5,60,000
The company also charged the excess depreciation to revaluation reserve.
Show Fixed Assets A/c, Depreciation A/c, Revaluation Reserve A/c in the book of XYZ Ltd.
Solution Fixed Assets A/c
Rs. Rs.
1.4.01 To Bank 7,50,000 31.3.02 By Depreciation 50,000
By Balance c/d 7,00,000
7,50,000 7,50,000
9.12 Financial Reporting

1.4.02 To Balance b/d 7,00,000 31.3.03 By Depreciation 50,000


By Balance c/d 6,50,000
7,00,000 7,00,000
1.4.03 To Balance b/d 6,50,000 31.3.04 By Depreciation 60,000
To Revaluation Reserve 1,30,000 By Balance c/d 7,20,000
7,80,000 7,80,000
1.4.04 To Balance b/d 7,20,000 31.3.05 By Depreciation 60,000
By Balance c/d 6,60,000
7,20,000 7,20,000
1.4.05 To Balance b/d 6,60,000 31.3.06 By Depreciation 60,000
By Balance c/d 6,00,000
6,60,000 6,60,000
1.4.06 To Balance b/d 6,00,000 1.4.06 By Bank 5,60,000
By Revaluation
Reserve A/c 40,000
6,00,000 6,00,000
Depreciation A/c
Rs. Rs.
31.3.02 To Fixed Assets A/c 50,000 31.3.02 By P & L A/c 50,000
31.3.03 To Fixed Assets A/c 50,000 31.3.03 By P & L A/c 50,000
31.3.04 To Fixed Assets A/c 60,000 31.3.04 By P & L A/c 60,000
31.3.05 To Fixed Assets A/c 60,000 31.3.05 By P & L A/c 60,000
31.3.06 To Fixed Assets A/c 60,000 31.3.06 By P & L A/c 60,000
Revaluation Reserve A/c
31.3.04 To P & L A/c -transfer 10,000 1.4.03 By Fixed Assets A/c 1,30,000
To Balance c/d 1,20,000
1,30,000 1,30,000
31.3.05 To P & L A/c -transfer 10,000 1.4.04 By Balance b/d 1,20,000
To Balance c/d 1,10,000
1,20,000 1,20,000
31.3.06 To P & L A/c -transfer 10,000 1.4.05 By Balance b/d 1,10,000
To Balance c/d 1,00,000
1,10,000 1,10,000
1.4.06 To Fixed Assets A/c 40,000 1.4.06 By Balance b/d 1,00,000
- Loss on disposal
To General Reserve 60,000
1,00,000 1,00,000
Valuation 9.13

Note: The company should in the first place, charge full depreciation to profit and loss
account. Thereafter, amount representing relevant portion of the depreciation resulting from
the revaluation may be transferred from the revaluation reserve. The balance on revaluation
reserve after adjustment of the loss on disposal should be transferred to general reserve.
Illustration 2
Vidarva Chemical Ltd. purchased a machinery from Madras Machine Manufacturing Ltd.
(MMM Ltd.) on 30.9.2006. Quoted price was Rs.162 lakhs. MMM Ltd. offers 1% trade
discount. Sales tax on quoted price is 5%. Vidarva Chemical Ltd. spent Rs. 42,000 for
transportation and Rs.30,000 for architect’s fees. They borrowed money from ICICI Rs.
150 lakhs for acquisition of the assets @ 20% p.a. Also they spent Rs. 18,000 for material in
relation to trial run. Wages and overheads incurred during trial run were Rs l2,000 and
Rs.8,000 respectively. The machinery was ready for use on 15.11.2006. It was put to use on
15.4.2007. Find out the original cost. Also suggest the accounting treatment for the cost
incurred in the interval between the date the machine was ready for commercial production
and the date at which commercial production actually begins.
Solution
(1) Determination of the original cost of the machine
Rs. in lakhs Rs. in lakhs
Quoted price 162.00
Less: 1% Trade discount 1.62
160.38
Add: Sales tax 8.10 168.48
Transportation 0.42
Architect’s fees 0.30
Financing cost 3.75
@ 20% on Rs. 150 lakhs for
30.9.06— 15.11.06
Expenditure for start-up:
Material 0.18
Wages 0.12
Overhead 0.08 0.38
173.33
9.14 Financial Reporting

(2) Cost incurred in the interval


Financing cost @ 20% on Rs. 150 lakhs for 15.11.06 – 15.4.2007 12.50
This may either be charged to P & L A/c or deferred for amortisation within 3 to 5 years.
Illustration 3
The original cost of the machine shown in the books of PK Ltd. as on lst Jan.,2005 is Rs. 180
lakhs which they revalued upward by 20% during 2005. In the year 2007, it appears that a 5%
downward revaluation should be made to arrive at the true value of the asset in the changed
economic and industry conditions. They charged 15% depreciation on W.D.V. of the asset.
Show the value of the asset at which it should appear in the Balance Sheet dated 31st Dec.
2007and show the Revaluation Reserve Account.
Solution
(1) Determination of Cost Rs. in lakhs
W.D.V as on 1.1.2005 180.00
Add: Revaluation profit 36.00
216.00
Less: Depreciation for 2005 32.40
W.D.V as on 1.1.2006 183.60
Less: Depreciation for 2006 27.54
W.D.V as on 1.1.2007 156.06
Less : Revaluation loss 7.80
148.26
Less: Depreciation for 2007 22.24
W.D.V as on 31.12.2007 126.02
(2) Revaluation Reserve Account
Dr. Cr.
Rs. in lakhs Rs. in lakhs
31.12.05 To Balance c/d 36.00 31.12.05 By Machinery A/c 36.00
31.12.06 To Balance c/d 36.00 01.01.06 By Balance b/d 36.00
31.12.07 To Machinery A/c 7.80 01.01.07 By Balance b/d 36.00
To Balance c/d 28.20
36.00 36.00
Illustration 4
X Ltd. purchased fixed assets for Rs. 10 lakhs for which it got grants from an international
agency (which comes within the definition of government as mentioned in AS–12) Rs. 8 lakhs.
Valuation 9.15

X Ltd. decides to treat the grant as deferred income. Suggest appropriate basis for taking
credit of the grant to Profit and Loss A/c. Take life of the assets 10 years. The company
followed W.D.V method. Scrap value Rs. 2.5 lakhs.
Solution
Deferred income on account of grant should be taken credit at the proportion by which
depreciation is charged.
Calculation of Depreciation and taking Credit of Deferred Grant (Depreciation Rate 12.95
Original Cost /W. D. V Depreciation Recovery of Grant
(Rs. in Lakhs) (Rs. in Lakhs) (Rs. in Lakhs)
t0 10.000 – –
t1 10.000 1.295 1.381
t2 8.705 1.127 1.202
t3 7.578 0.981 1.046
t4 6.597 0.854 0.912
t5 5.743 0.744 0.794
t6 4.999 0.647 0.690
t7 4.352 0.564 0.602
t8 3.788 0.491 0.524
t9 3.297 0.427 0.455
t10 2.870 0.370 0.394
1
⎡ 2.5 ⎤ 10
Notes: (i) Rate of Depreciation = 1 – ⎢ ⎥ = 12.95%
⎣ 10 ⎦
Depreciation for the year
(ii) Recovery of grant = Amount of grant ×
Total depreciation
For t01, Rs. 8 lakhs × 1.295 / 7.5 = 1.381 lakhs.

Self-examination Questions
1. Define tangible fixed assets. State the circumstances under which the need for valuation
of such assets arises.
2 A company purchased on 01.04.2005 a special purpose machinery for Rs. 25 lakhs. It
received a Central Government Grant for 20% of the price. The machine has an effective
life of 10 years.. You are required to advise the company on the following items from
the viewpoint of finalisation of accounts, taking note of the mandatory accounting
standards.
9.16 Financial Reporting

3. J Ltd. purchased machinery from K Ltd. on 30.09.2005. The price was Rs. 370.44 lakhs
after charging 8% Sales-tax and giving a trade discount of 2% on the quoted price.
Transport charges were 0.25% on the quoted price and installation charges come to 1%
on the quoted price.
A loan of Rs. 300 lakhs was taken from the bank on which interest at 15% per annum
was to be paid.
Expenditure incurred on the trial run was Materials Rs. 35,000, Wages Rs. 25,000 and
Overheads Rs. 15,000.
Machinery was ready for use on 1.12.2005. However, it was actually put to use only on
1.5.2006. Find out the cost of the machine and suggest the accounting treatment for the
expenses incurred in the interval between the dates 1.12.2005 to 1.5.2006. The entire
loan amount remained unpaid on 1.5.2006.
Valuation 9.17

UNIT 3
VALUATION OF INTANGIBLES

3.1 DEFINITION OF INTANGIBLES


An intangible asset is an identifiable non-monetary asset, without physical substance, held for
use in the production or supply of goods or services , for rental to others, or for administrative
purposes. Enterprises frequently expend resources, or incur liabilities, on the acquisition,
development, maintenance or enhancement of intangible resources such as scientific or
technical knowledge, design and implementation of new processes or systems, licences,
intellectual property, market knowledge and trademarks (including branch names and
publishing titles). Common examples of items encompassed by these broad headings are
computer software, patents, copyrights, motion picture films, customer lists, mortgate servicing
rights, finishing licences, import quotas, franchises, customer or supplier relationships,
customer loyalty, market share and marketing rights. Goodwill is another example of an item
of intangible nature which either arises on acquisition or is internally generated. Intangible
fixed assets can be classified as identifiable intangibles and not identifiable intangibles. The
identifiable intangibles include patents, trademarks and designs and brands whereas the not
identifiable intangibles are clubbed together as goodwill. To be identifiable, it is necessary that
the intangible asset is clearly distinguished from goodwill. An intangible asset can be clearly
distinguished from goodwill if the asset is separable.

3.2 RECOGNITION
An intangible asset should be recognised if, and only if:
(a) It is probable that the future economic benefits that are attributable to the asset will flow to
the enterprise; and
(b) The cost of the asset can be measured reliably.
If an intangible asset is acquired separately, the cost of the intangible asset can usually be
measured reliably and such intangible asset is recognized and valued at cost in the same
manner as in case if the tangible fixed assets.
If the intangible asset is internally generated:
Para 50 of the AS 26 clearly stated that ‘Internally generated brands, mastheads, publishing
titles, customer lists and items similar in substance should not be recognized as intangible
assets’.
For other types of intangible assets Para 41(AS26) stated that ‘No intangible asset arising
from research (or from the research phase of an internal project) should be recognised’ and
Para 44 requires that ‘An intangible asset arising from development (or from the development
9.18 Financial Reporting

phase of an internal project) should be recognised if, and only if, all of the conditions specified
therein are satisfied’.
When not recognized the expenditure on intangible item would be treated as expense and
when reconised the expenditure on the intangible item would be capitalized.
Subsequent expenditure on an intangible asset after its purchase or its completion should be
added to the cost of the intangible asset if:
(a) It is probable that the expenditure will enable the asset to generate future economic
benefits in excess of its originally assessed standard of performance; and (b) the expenditure
can be measured and attributed to the asset reliably.
No valuation shall be made for internally generated brand. When the brand is acquired
separately the valuation would be made at initial cost of acquisition (with subsequent addition
to cost, if any).
All identifiable intangible assets including Patents, Copyrights, Know-how and Designs which
are acquired separately valuation would be made at initial cost of acquisition(with subsequent
addition to cost, if any). If they are generated internally and are not recognized as per 5.5 no
valuation shall be made. However for internally generated recognized intangibles valuation
would be made at cost (with subsequent addition to cost, if any).
The depreciable amount of an intangible asset should be allocated on a systematic basis over
the best estimate of its useful life. There is a rebuttable presumption that the useful life of an
intangible asset will not exceed ten years from the date when the asset is available for use.
Amortisation should commence when the asset is available for use.

3.3 DEFINITION OF GOODWILL


The following are some judicial definitions of goodwill:
(1) “The goodwill of a business is the advantage, whatever it may be, which a person gets by
continuing to carry on, and being entitled to represent to the outside world that he is carrying
on a business which has been carried on for some time previously” - Warrington. In J. Hill v.
Fearis (1905).
(2) “Goodwill is a thing very easy to describe, very difficult to define. It is the benefit and
advantage of the good name, reputation and connection of a business. It is the attractive
force which brings in custom. It is one thing which distinguishes an old established business
from a new business at its first start... Goodwill is composed of a variety of elements. It differs
in its composition in different trades and in different businesses in the same trade. One
element may preponderate here and another there.” - Lord Macnaughton In IRC Vs. Muller
(1901).
From the accountant’s point of view, goodwill, in the sense of attracting custom, has little
Valuation 9.19

significance unless it has a saleable value. To the accountant, therefore, goodwill is said to be
that element arising from reputation, connection or other advantages possessed by a business
which enables it to earn greater profits than the return normally to be expected on the capital
represented by net tangible assets employed in the business. In considering the return
normally to be expected, regard must be had to the nature of the business, the risk involved,
fair management remuneration and other relevant circumstances.
SSAP-22, UK Accounting Standard on Accounting for goodwill defines the term goodwill as
follows:
“Goodwill is the difference between the value of a business as a whole and the aggregate of
the fair values of its separable net assets.” Separable net assets are those assets which can
be identified and sold (or discharged) separate without necessarily disposing off the business
as a whole. They include the identifiable intangibles. Fair value is the amount for which an
asset (or liability) could be exchanged in an arm’s length transaction.

3.4 NATURE AND TYPES OF GOODWILL


It is usual for the value of a business as a whole to differ from the value of its separable net
assets.The difference, which may be positive or negative is described as goodwill. Goodwill
is, therefore, for definition incapable of realisation separately from the business as a whole;
this characteristics of goodwill distinguishes it from all other items in the accounts. Its other
characteristics are that:
(1) the value of goodwill has no reliable or predictable relationship to any costs which may
have been incurred;
(2) individual intangible factors which may contribute to goodwill cannot be valued;
(3) the value of goodwill may fluctuate widely according to internal and external
circumstances over relatively short periods of time;
(4) assessment of the value of goodwill is highly subjective.
Thus, any amount contributed to goodwill is unique to the valuer and to the specific point in
time at which it is measured and is valued only at that time and only in that circumstances
then prevailing.
Goodwill of a business may arise in two ways; it may be inherent to the business, that is
generated internally. It may be acquired while purchasing any concern. Purchased goodwill
can be defined as being the excess of fair value of the purchase consideration over the fair
value of the separable net assets acquired. The value of purchased goodwill is not necessarily
equal to the inherent goodwill of the business acquired as the purchase price may reflect the
future prospects of the entity as a whole. This point has been elaborated in Unit 2: Valuation
of Business. Non-purchased goodwill is any goodwill other than purchased goodwill. Para 36
of AS-10 Accounting for Fixed Assets’ states that only purchased goodwill should be
recognised in the accounts.
9.20 Financial Reporting

3.5 FACTORS CONTRIBUTING TO GOODWILL


A large number of factors contribute to goodwill or influence its value: These are
given below:
Inherent and purchased goodwill Purchased goodwill only
1. Superior management team 1. Market dominance
2. Outstanding sales manager or or- 2. Economies of scale (production,
ganisation advertising, distribution, research,
management)
3. Weakness in the management of a 3. Cost savings (employing technology,
competitor transaction costs, co-ordinating activities,
stock-holding savings)
4. Effective advertising 4. Cost of financing (reduction in cost of
borrowings and lender’s risk)
5. Secret or patented manufacturing 5. Fiscal advantages (tax losses,
investment credits, government
incentives)
6. Good labour relations 6. Strong liquid resources
7. Outstanding credit rating 7. Preliminary expense savings
8. Top-flight training programme for 8. Ability to guarantee supplies
employees
9. Good public ‘image’ 9. Ability to guarantee market
10. Unfavourable developments in 10. Investors’collective evaluation of
operation of a competitor political, economic or social position
11. Favourable association with another 11. Opinions of acquirer’s directors as to
company future policy of acquirer
12. Strategic location 12. Costs of acquisition
13. Discovery of talent or resources
14. Favourable tax conditions
15. Favourable government regulations
16. Favourable attitudes of customers
17. Excellent reputation for quality and reliability of products
18. Number of outlets for products
19. Number of service locations for products
20. Favourable agency agreements
21. Established list of customers
22. Established licence to trade
23. Experienced workforce
24. Good relations with suppliers
25. Superior pension fund resources
Valuation 9.21

3.6 RELEVANT PROVISIONS OF THE ACCOUNTING STANDARDS


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 enterprise.
As a matter of financial prudence, goodwill is written off over a period. However, many
enterprises do not write off goodwill and retain it as an asset. (AS 10)
In case of amalgamation under purchase method any excess of the amount of the
consideration over the value of the net assets of the transferor company acquired by the
transferee company should be recognised in the transferee company’s financial statements as
goodwill arising on amalgamation. (AS 14)
If Expenditure on an intangible item acquired in an amalgamation in the nature of purchase
cannot be recognised as an intangible asset, this expenditure (included in the cost of
acquisition) should form part of the amount attributed to goodwill at the date of acquisition.
(Para 55, AS 26)
Again in case of consolidation of balance sheet in the books of the parent company any
excess of the cost to the parent of its investment in a subsidiary over the parent’s portion of
equity of the subsidiary, at the date on which investment in the subsidiary is made, should be
described as goodwill to be recognised as an asset in the consolidated financial
statements;(AS 21)
Internally generated goodwill should not be recognised as an asset (AS 26). Thus in corporate
financial accounting the scope for valuation of goodwill is limited to the measurements stated
in the above circumstances. In case of amalgamation in the nature of merger, there does not
arise any goodwill. In case of amalgamation in the nature of purchase, the excess of purchase
consideration over the net asset value is computed as goodwill. In case of consolidation of
final accounts, the excess of cost of investment in subsidiary over the parent’s share in
subsidiary’s equity at the date of acquisition is computed as goodwill. Thus for determining the
value of goodwill to be shown in the financial statements, one has to find the amount of
purchase consideration, net asset value, cost to the parent of its investment in subsidiary and
parent’s share in subsidiary’s equity.
If we assume that the purchase consideration or the cost of investment in subsidiary is
inclusive of the price for goodwill, if any, then question may arise whether the valuation
process is a circular one as stated below. The purchase consideration/ cost of investment in
subsidiary are determined on the basis of valuation of business or valuation of share of
transferor/subsidiary. The purchase consideration/cost of investment determines value of
goodwill in amalgamation in the nature of purchase or in consolidation of financial statements.
9.22 Financial Reporting

Thus in the above mentioned situations value of goodwill is the resultant figure derived from
purchase consideration or cost of acquisition. Then this purchase consideration/cost of
acquisition cannot again be derived from the valuation of goodwill. This inconsistency can be
removed if we recognize that goodwill has no identity separable from the business and there
need be no separate valuation of goodwill. The valuation of business as a whole would
automatically include the value of goodwill. The fact that purchase consideration in excess of
net asset value of business taken over is recorded as goodwill also suggests that goodwill
value should not be a part of net asset value of business.
However, for the purpose of management information brand valuation and goodwill valuation
may be done by applying any of the alternative methods available although that may not be in
line with the requirements of Accounting Standards.

3.7 VALUATION OF GOODWILL


There are basically two accounting methods for goodwill valuation. These are - (i)
Capitalisation Method and (ii) Super Profit Method. A third method called annuity method is a
refinement of the super profit method of goodwill valuation.
3.7.1 Capitalisation method: Under this method future maintainable profit is capitalised
applying normal rate of return to arrive at the normal capital employed. Goodwill is taken as
the excess of normal capital employed over the actual capital employed.
Future ma int ainable profit
Normal Capital employed =
Normal rate of return
Goodwill = Normal Capital Employed – Actual Closing Capital Employed
Factors considered in this method are:
(i) Future maintainable profit;
(ii) Actual capital employed in the business enterprise for which goodwill is to be computed;
(iii) Normal rate of return in the industry to which the business enterprise belongs.
For example, Capital employed in X Ltd. is Rs. 17,00,000, future maintainable profit is
Rs. 3,00,000 and normal rate of return is 15%.
Rs.3,00,000
So goodwill = – Rs. 17,00,000 = Rs. 3,00,000
0.15
Naturally, if normal capital employed becomes less than actual capital employed there arises
negative goodwill.
It is to be noted that under Capitalisation method the actual capital employed is to be taken at
(closing) balance sheet date.
3.7.2 Super profit method: Excess of future maintainable profit over normally expected profit
Valuation 9.23

is called super profit. Under this method goodwill is taken as the aggregate super profit of the
future years for which such super profit is expected to be maintained.
Factors considered in this method are:
(i) Future maintainable profit;
(ii) Actual capital employed;
(iii) Normal rate of return;
(iv) Period for which super profit is projected.
Super profit = Future maintainable profit minus (Actual Capital employed ×
Normal rate of return)
Goodwill = Super profit × No. of years for which Super Profit can be maintained.
Example
Capital employed by X Ltd. Rs. 17,00,000, Future maintainable profit Rs.3,50,000, Normal rate
of return 15%, Super profit can be maintained for 5 years.
Future maintainable profit Rs. 3,50,000
⎡ 15 ⎤
Less: Normal Profit ⎢Rs.17,00,000 × Rs. 2,55,000
⎣ 100 ⎥⎦
Super Profit Rs. 95,000
Goodwill = Super profit × No. of years for which the super profit can be maintained.
= Rs. 95,000 × 5 = Rs. 4,75,000
3.7.3 Annuity method: It is a refinement of the super profit method. Since super profit is
expected to arise at different future time periods, it is not logical to simply multiply super profit
into number of years for which that super profit is expected to be maintained. Further future
values of super profits should be discounted using appropriate discount factor. The annuity
method got the nomenclature because of suitability to use annuity table in the discounting
process of the uniform super profit. In other words, when uniform annual super profit is
expected, annuity factor can be used for discounting the future values for converting into the
present value. Here in addition to the factors considered in super profit method, appropriate
discount rate is to be chosen for discounting the cash flows.
Example
Super Profit of X Ltd. Rs. 95,000 p.a. can be maintained for 5 years. Discount rate is 15%.
Goodwill = Rs. 95,000 × 3.352 = Rs. 3,18,440
There are atleast two frequently used approaches for arriving at the Capital employed: (i)
based on a particular Balance Sheet and (ii) average of Capital employed at different balance
sheet dates.
9.24 Financial Reporting

Capital employed is determined using historical cost values available at the balance sheet
date. However if revalued figures are given that should be considered.

3.8 DETERMINATION OF CAPITAL EMPLOYED


Conventionally ‘Capital Employed’ means Total Assets Minus non-trading assets i.e. assets
not used in the business Minus miscellaneous expenditure and losses Minus all outside
liabilities.
As per this concept capital employed becomes equivalent to net worth less non-trading assets.
But this concept has its own shortcomings:
(i) This approach ignores other long term fund in the business;
(ii) On the other hand, it considers preference share capital which bears fixed rate of
dividend.
The argument in favour of adopting this approach is to count only such fund which is
attributable to the shareholders. Alternatively, by capital employed one can mean long term
capital employed. However, leverage gives some advantage as well as riskiness. Use of
lower amount of owned fund results in higher return because of using borrowed fund
advantageously. This is called leverage effect. By taking only ‘shareholders fund’ as capital
employed, one can give weightage to leverage while calculating goodwill.
Example
Balance Sheet of X Ltd.
Liabilities Rs. in Assets Rs. in
Lakhs Lakhs
Share Capital 80 Sundry fixed Assets 1,80
P & L A/c 20 Stock 40
13% Debentures 1,20 Debtors 20
Sundry Creditors 40 Cash & Bank 20
2,60 2,60
Capital employed (shareholders’ fund approach)
Rs. 260 lakhs – 160 lakhs outside liabilities = Rs. 100 lakhs.
Capital employed (long term fund approach):
Rs. 260 Lakhs – Rs. 40 lakhs Sundry Creditors = Rs. 220 lakhs
Suppose normal return on shareholders’ fund is 20% and normal return on long term fund is
18%
Also suppose Future Maintainable Profit (before interest) of X Ltd. is Rs. 38.4 lakhs.
Future Maintainable Profit (after interest) of X Ltd. is Rs. 22.8 lakhs. (Rs. 38.4 lakhs –Rs.15.6
Valuation 9.25

lakhs debenture interest)


If long term fund approach is followed value of goodwill as per Capitalisation method is i.e.,
Rs.38.4 lakhs
− Rs.220 lakhs
0.18
Rs. 213.33 lakhs – Rs. 220 lakhs
i.e., (-) Rs. 6.67 lakhs, negative goodwill.
If shareholders’ fund approach is followed, value of goodwill as per capitalisation method is,
Rs.22.8 lakhs
- Rs.100 lakhs
0.20
Rs. 114 lakhs – Rs.100 lakhs
i.e., Rs. 14 lakhs, positive goodwill.
In this example, when long term capital employed was considered there was negative
goodwill, but it became positive when shareholders’ fund was considered. In the second
approach leverage advantage has been taken into consideration. Thus in goodwill valuation
generally shareholders’ fund approach is preferred.
Non-trading assets are ignored while computing capital employed. This is because surplus
fund invested outside does not influence the future maintainable profit. Particularly, Non-trade
investments are not counted while computing capital employed, but trade investments should
be taken into consideration.
Another important aspect is often discussed regarding valuation of capital employed. What
value should the accountant put for fixed assets and stock. Since historical cost is not true
indicator of the value of these assets, then it is suggested to take current cost of such assets.
Current cost represents the cost for which asset can be replaced at its present state.
However, if the asset cannot be replaced at its present state because of obsolescence, then
cost at which its best substitute is available may be taken as current cost.
Capital employed may be determined using the value given by the latest balance sheet or
taking simple average of the capitals employed at the beginning of the accounting period as
well as at the end.
Illustration 1
Balance Sheets of X Ltd.
As on 31st March 20X5 and 31st March 20X6
Liabilities 31.3.X5 31.3.X6 Assets 31.3.X5 31.3.X6
Share Capital 18,00 18,00 Sundry fixed Assets 24,00 26,00
General Reserve 6,00 6,00 Investments 1,00 2,00
9.26 Financial Reporting

Profit & Loss A/c 7,50 9,50 Stock 6,00 5,50


12% Debentures 2,00 2,00 Sundry Debtors 3,00 3,50
18% Term Loan 3,00 3,20 Cash and Bank 4,00 3,40
Cash Credit 1,20 80 Preliminary Expenses 70 10
Sundry Creditors 70 60
Tax Provision 30 40
38,70 40.50 38,70 40.50

Non-trade investments were 75% of the total investments. Find capital employed as on
31.3.X5 and as on 31.3.X6 and average capital employed.
Solution
Computation of capital employed
(Rs. in Lakhs)
31.3.X5 31.3.X6
Total Assets as per
Balance Sheet 38,70 40,50
Less: Preliminary Expenses 70 10
Non-trade Investments 75 1,50
145 160
37,25 38,90
Less: Outside Liabilities:
12% Debentures 2,00 2,00
18% Term Loan 3,00 3,20
Cash Credit 1,20 80
Sundry Creditors 70 60
Tax Provision 30 40
7,20 7,00
Capital employed 30,05 31,90

Rs.30.05 lakhs + 31.90 lakhs


Average capital employed =
2

= Rs. 30,97.50 Lakhs


Valuation 9.27

Illustration 2
Balance Sheet of AP Ltd. as on 31st March, 2006
Liabilities Rs. in Assets Rs. in
Lakhs Lakhs
Share Capital Land & Building 51,20
Equity Shares of Rs.10 each 90,00 Plant & Machinery 108,70
8½% Pref. Shares 20,00 Furniture 27,00
General Reserve 10,50 Vehicles 2,00
Profit & Loss A/c 30,00 Stock 7,00
18% Term Loan 45,00 Debtors 4,50
Cash Credit 5,80 Cash & Bank 23,40
Sundry Creditors 2,00 Preliminary Expenses 20
Provision for Taxation
(net of advance tax) 1,00
Proposed Dividend:
Equity 18,00
Preference 1,70 _____
224,00 224,00

Other information
(i) Balance as on 1.4.05
Profit and Loss A/c Rs. 4,80 Lakhs
Reserve Rs. 4,50 Lakhs
Find out average capital employed of AP Ltd.
Solution
Computation of Average Capital Employed
Rs.in Lakhs Rs.in Lakhs
Total of Assets as per Balance Sheet as on 31.3.2006 224,00
Less: Preliminary Expenses 20
223,80
Less: Outside Liabilities:
18% Term Loan 45,00
Cash Credit 5,80
Sundry Creditors 2,00
Provision for Taxation 1,00 53,80
Capital employed as on 31.3.06 170,00
9.28 Financial Reporting

Less: 1/2 of profit earned:


Increase in Reserve balance 6,00
Increase in P & L A/c 25,20
Proposed Dividend 19,70
50,90 25,45
Average capital employed 144,55

3.9 FUTURE MAINTAINABLE PROFIT


We have seen earlier while discussing various methods of goodwill valuation that estimation of
average maintainable profit is another important step in goodwill valuation. Future
maintainable profit is ascertained taking either simple or weighted average of the past profits
or by fitting trend line. Generally, profit of past three to five years are considered.
(i) Simple Average of Past Profits: If the past profits do not have any definite trend, average
is taken to arrive at the future maintainable profit.
Example
Profits of the past five years of XX Ltd. are given below:
Year ’000 Rs.
2006 71,20
2007 87,20
2008 75,70
2009 82,70
2010 78,90
In this case no trend of past profit is available. So simple average is best suitable method to
arrive at a figure which may be taken as future maintainable profit.
7,120 + 87,20 + 75,70 + 82,70 + 78,90
Future maintainable profit (Rs. in ’000) = = 79,14
5
(ii) Trend Equation: If the past profits show increasing or decreasing trend, linear trend
equation gives better estimation of the future maintainable profit.
Example
B K Ltd. gives the following profit figures for the last five years:
Year Profits
’000 Rs.
2006 37,20
2007 42,00
2008 47,50
2009 53,50
2010 57,20
Valuation 9.29

Since past profits show increasing trend, time series trend may be used to determine future
maintainable profit. Applying Linear trend equation three to five years profit may be predicted
and average of such future profits may be taken as future maintainable profit.
2
Year X Y XY X
2006 –2 37,20 –74,40 4
2007 –1 42,00 –42,00 1
2008 0 47,50 0 0
2009 1 53,50 53,50 1
2010 2 57,20 114,40 4
0 237,40 51,50 10

A=
∑Y = 237,40
=47,48
n 5

b=
∑ XY =
51,50
= 51,5
∑ XY 2
10

Trend Equation is given by:


Y = 4748 + 515 X
(iii) Weighted average of past profits: If the past profits show increasing or decreasing
trend, then more weights are given to the profit figures of the immediate past years and less
weight to the profit figures of the furthest past.
Example
Profits of the past five years of BB Ltd. are given below:
Year Profits
(’000 Rs.)
2006 71,20
2007 82,50
2008 87,00
2009 92,00
2010 95,00

In this example past profits showed an increasing trend. Weighted average of past profits may
be used in such cases to arrive at future maintainable profit.
9.30 Financial Reporting

Derivation of weighted average of the past profits:


Year Profits (P) Weight (W) PW
’000 Rs.
2006 71,20 1 71,20
2007 82,50 3 247,50
2008 87,00 5 435,00
2009 92,00 7 644,00
2010 95,00 9 855,00
25 22,52,70

Weighted average profit =


∑ PW = 22,52,70
∑W 25

i.e. Rs. 9010.80 thousand.


Alternatively, using trend equation, estimated profit will be:
Estimated Profit:
2011 4748 + 515 (3) = 62,93
2012 4748 + 515 (4) = 68,08
2013 4748 + 515 (5) = 73,23
Average of the Future Profit 68,08
i.e., Future Maintainable Profit 68,00 (say)
Illustration 3
PPX Ltd. gives the following information about past profits:
Year Profits
(’000 Rs.)
2006 21,70
2007 22,50
2008 23,70
2009 24,50
2010 21,10
On scrutiny it is found (i) that upto 2008, PPX Ltd. followed FIFO method of finished stock
valuation thereafter adopted LIFO method, (ii) that upto 2009 it followed straight line
depreciation and thereafter adopted written down value method.
Valuation 9.31

Given below the details of stock valuation: (Figures in Rs. ’000)


Year Opening Stock Closing Stock
FIFO LIFO FIFO LIFO
2006 40,00 39,80 46,00 41,20
2007 46,00 41,20 49,20 47,90
2008 49,20 47,90 38,90 39,10
2009 38,90 39,10 42,00 38,50
2010 42,00 38,50 45,00 43,10
Straight line and written down value depreciation were as follows:
Year Straight Line W.D. V
(’000 Rs.) (’000 Rs.)
2006 12,10 17,00
2007 14,15 18,10
2008 15,00 19,25
2009 16,70 19,60
2010 18,00 19,40
Determine future maintainable profits that can be used for valuation of goodwill.
Solution
Past profits of PPX Ltd. showed an increasing trend excepting in year 2000. But the effects of
changes in accounting policies should be eliminated to ascertain the true nature of trend.
Since the company has adopted LIFO method of stock valuation and W.D.V method of
depreciation, profits may be recomputed applying these policies consistently in all the past
years. Recomputation of profits following uniform accounting policies are shown below:
(Figures in ’000 Rs.)
Book Effect of LIFO Effect of Profits after elimination
Year Profits Valuation of Stock W.D. V Depn. of the effect of change in
Accounting policies
2006 21,70 – 4,60 – 4,90 12,20
2007 22,50 + 3,50 – 3,95 22,05
2008 23,70 + 1,50 – 4,25 20,95
2009 24,50 –20 – 2,90 21,40
2010 21,10 — — 21,10
After elimination of the effect of change in accounting policies increasing trend disappeared.
Rather profits were oscillating during the last four years excepting 2006. So a simple average
may be taken of the last 4 years profits to arrive at the futur maintainable profits:
9.32 Financial Reporting

22,05 + 20,95 + 21,40 + 21,10


Future Maintainable Profit (’000 Rs.) = = 21,37.50
4
Working Note:
Effect of LIFO Valuation:
2006: Increase in stock as per FIFO valuation 6,00
Less: Increase in stock per LIFO valuation 1,40
Reduction in profit 4,60
2007: Increase in stock as per FIFO valuation 3,20
Increase in stock as per LIFO valuation 6,70
Increase in profit 3,50
2008: Decrease in stock as per FIFO valuation 10,30
Decrease in Stock as per LIFO valuation 8,80
Increase in profit 1,50
2009: Opening stock as per FIFO valuation 38,90
Opening stock as per LIFO valuation 39,10
Reduction in profit 20
3.9.1 Adjustments needed with past profits: Since past profits are used to make an
estimation about the future maintainable profit, it is necessary to make appropriate
adjustments for better projection. The following adjustments generally become necessary:
(i) Elimination of abnormal loss arising out of strikes, lock-out, fire, etc. Profit/loss figures
which contain abnormal loss should either be ignored or eliminated. Similarly, if there is
any abnormal gain included in past profits, that needs elimination.
(ii) Interest/dividend or any other income from non-trading assets needs elimination because
‘capital employed’ used for valuation of goodwill comprises only of trading assets.
(iii) If there is a change in rate of tax, tax charged at the old rate should be added back and
tax should be charged at the new rate.
(iv) Effect of change in accounting policies should be neutralised to have profit figures which
are arrived at on the basis of uniform policies.

3.10 NORMAL RATE OF RETURN


Apart from capital employed and future maintainable profit, the third important step in
valuation of goodwill is determination of normal rate of return. It comprises of:
(i) the risk-free rate, i.e., the pure interest rate prevailing in the concerned economy; (the
rate of return on long term government securities or fixed deposit in bank may be taken
as risk-free rate)
(ii) the premium for business risks appropriate for the industry to which the firm/company
belongs.
Valuation 9.33

If the industry is well established and yielding profits steadily the rate of return that will satisfy
entrepreneurs will be rather low though higher than the risk- free rate. Higher the business
risk, higher will be the normal rate of return.
For practical purposes industry average return is taken as normal rate of return.
Illustration 4
On the basis of the following information, calculate the value of goodwill of Gee Ltd. at three
years’ purchase of super profits, if any, earned by the company in the previous four completed
accounting years.

Balance Sheet of Gee Ltd. as at 31st March, 2004


Liabilities Rs. in lakhs Assets Rs. in lakhs
Share Capital: Goodwill 310
Authorised 7,500 Land and Buildings 1,850
Issued and Subscribed Machinery 3,760
5 crore equity shares of Rs. Furniture and Fixtures 1,015
10 each, fully paid up 5,000 Patents and Trade Marks 32
Capital Reserve 260 9% Non-trading Investments 600
General Reserve 2,543 Stock 873
Surplus i.e. credit balance of Profit Debtors 614
and Loss (appropriation) A/c 477 Cash in hand and at Bank 546
Trade Creditors 568 Preliminary Expenses 20
Provision for Taxation (net) 22
Proposed Dividend for 2002-2003 750 _____
9,620 9,620
The profits before tax of the four years have been as follows:
Year ended 31st March Profit before tax in lakhs of Rupees
2000 3,190
2001 2,500
2002 3,108
2003 2,900

The rate of income tax for the accounting year 1999-2000 was 40%. Thereafter it has been
38% for all the years so far. But for the accounting year 2003-2004 it will be 35%.
In the accounting year 1999-2000, the company earned an extraordinary income of Rs. 1 crore
9.34 Financial Reporting

due to a special foreign contract. In August, 2000 there was an earthquake due to which the
company lost property worth Rs. 50 lakhs and the insurance policy did not cover the loss due
to earthquake or riots.
9% Non-trading investments appearing in the above mentioned Balance Sheet were
purchased at par by the company on 1st April, 2001.
The normal rate of return for the industry in which the company is engaged is 20%. Also note
that the company’s shareholders, in their general meeting have passed a resolution
sanctioning the directors an additional remuneration of Rs. 50 lakhs every year beginning from
the accounting year 2003-2004.
Solution
(1) Capital employed as on 31st March, 2004
(Refer to ‘Note’)
Rs. in lakhs
Land and Buildings 1,850
Machinery 3,760
Furniture and Fixtures 1,015
Patents and Trade Marks 32
Stock 873
Debtors 614
Cash in hand and at Bank 546
8,690
Less: Trade creditors 568
Provision for taxation (net) 22 590
8,100
(2) Future maintainable profit
(Amounts in lakhs of rupees)
1999-2000 2000-2001 2001-2002 2002-2003
Rs. Rs. Rs. Rs.
Profit before tax 3,190 2,500 3,108 2,900
Less: Extra-ordinary income due to
foreign contract 100
Add: Loss due to earthquake 50
Less: Income from non-trading
investments 54 54
3,090 2,550 3,054 2,846
Valuation 9.35

As there is no trend, simple average profits will be considered for calculation of goodwill.
Total adjusted trading profits for the last four years = Rs. (3,090 + 2,550 + 3,054 + 2,846)
= Rs. 11,540 lakhs
Rs. in lakhs
⎛ Rs. 11,540 lakhs ⎞
Average trading profit before tax = ⎜ ⎟ 2,885
⎝ 4 ⎠
Less: Additional remuneration to directors 50
2,835
Less: Income tax @ 35%(approx.) 992 (Approx)
1,843
(3) Valuation of Goodwill on Super Profits Basis
Future maintainable profits 1,843
Less: normal profits (20% of rs. 8,100 lakhs) 1,620
Super profits 223
Goodwill at 3 years’ purchase of super profits = 3 x Rs. 223 lakhs = Rs. 669 lakhs
Note: In the above solution, goodwill has been calculated on the basis of closing capital
employed (i.e. on 31st March, 2004). Goodwill should be calculated on the basis of ‘average
capital employed’ and not ‘actual capital employed’ as no trend is being observed in the
previous years’ profits. The average capital employed cannot be calculated in the absence of
details about profits for the year ended 31st March, 2004. Since the current year’s profit has
not been given in the question, goodwill has been calculated on the basis of capital employed
as on 31st March, 2004.

3.11 BRAND VALUATION


The asset structure of corporate entities consists of both tangible and intangible assets.
Traditionally, accountants regarded tangible assets like land, building, plant and machinery,
cash and bank balances etc. as the only productive or earning generating assets and gave
undue importance in their maintenance and accounting. Accounting principles and standards
also laid stress on accounting for these tangibles.
In modern competitive environment, the corporate value and earning power are decided and
generated by both the classes of assets, often more by intangibles than tangibles. In a
turbulent marketing environment, brand gives tremendous competitive advantage to corporate.
It can be said that rather than product selling itself, it is brand that sells the product. Vast
sums are being spent by corporate to propagate and perpetuate the brand identity among
product or service users. Brands are strategic assets. The key to survival of companies is their
brands in the modern world of complex and competitive business environment.
9.36 Financial Reporting

3.11.1 Concept of Brand : According to American Marketing Association, brand means a


name, term, sign, symbol or design or a combination of these intended to identify the goods or
services of one seller or group of sellers and to differentiate them from those of competitors.
Corporate branding can be taken to mean the strategic exercise, by managerial decision
making, of creating, developing, maintaining and monitoring the identity, image and ownership
of a product corporate entity. Among various intangibles such as goodwill, patents, copyrights,
brands etc., brands comprise an important item in that they greatly determine the corporate
market value of a firm.
Brand achieves a significant value in commercial operation through the tangible and intangible
elements. Brands may be that which is acquired from outside source while acquiring business
or may also be nurtured internally by a company, which are known as ‘Home-grown brands’.
By assigning a brand name to the product, the manufacturer distinguishes it from rival
products and helps the customers to identity it while going in for it. The necessity of branding
of products has increased enormously due to influence of various factors like growth of
competition, increasing importance of advertising etc.
Power brands make such a lasting impact on the consumers that it is almost impossible to
change his preferences even if cheaper and alternative products are available in the market.
Brands have major influence on takeover decisions as the premium paid on takeover is almost
always in respect of the strong brand portfolio of the acquired company and of its long-term
effect on the profits of the acquiring company in the post-acquisition period.

3.12 IDENTIFICATION OF BRANDS AS AN ASSET


There are various definitions of the term asset. Asset as a concept, is characterised by the
following features:
1. For an asset there must exist some specific right to future benefits or service potentials.
2. Rights over asset must accrue to a specific individual or firm.
3. There must be a legally enforceable claim to the rights or services over the asset.
4. The asset must be the result of a past transaction or event.
Based on the above characteristics, brands would be considered as an asset. The sole
purpose of establishing brand names is to incur future economic benefits, through increased
sale to loyal customers or through an increased sale price of the brand itself or the business
that owns the brand.
The companies with valuable brands register those names and are legally entitled to sole
ownership and use of them. Brands are created through marketing efforts over time, they are
the result of several past transactions and events
Valuation 9.37

3.13 OBJECTIVES OF CORPORATE BRANDING


Corporate managers have to continuously monitor the brand strengths in terms of various
brand attributes. Brand identification, market share, competitive strength, international
acceptance, brand availability, market stability etc. are some of the attributes which build the
brand strengths.
The cost incurred to propagate and popularise the brand does not automatically guarantee the
brand ‘value. A proper linkage should always be envisaged between cost and attributes. A
cost in the form of advertisements etc. which strengthens the brand attributes should add to
the brand value and brand equity. The important objectives of corporate branding are as
follows:
1. Corporate Identity:
Brands help companies in creating and maintaining an identity for them in the market
place. This is chiefly facilitated by brand popularity and the eventual customer loyalty
attached to the brands.
2. TQM:
By building brand image, it is possible for a body corporate to adopt and practice Total
Quality Management (TQM). Brands help in building a lasting relationship between the
brand owner and the brand user.
3. Customer Preference:
The need for branding a product or service arises on account of the perceived choice and
preferences which are built up psychologically by the customers. In fact, branding gives
them the advantage of status fulfillment.
4. Market Segmentation:
Segmenting a market requires classification of markets into more strategic areas on a
homogeneous pattern for efficient operations to enable firms to effectively target
consumers and to meet the competition. This segmenting of a market is facilitated
through the built-up strong brand values.
5. Strong Market:
By building strong brands, firms can enlarge and strengthen their market base. This
would also facilitate programmes, designed to achieve maximum market share.

3.14 CORPORATE BRAND ACCOUNTING


The term brand accounting refers to “the practice of valuation and reporting of the value of
brand of a product or service in the financial statements of a corporate entity, the value of a
brand being ascertained either as a result of revaluation in the case of home-grown brands or
as a result of acquisition/ merger in the case of newly acquired brands.
Accounting is basically a measurement and communication system. Corporate brand
9.38 Financial Reporting

accounting can be defined as a process of identification, measurement and communication of


brand value and brand equity to permit informed judgment and decisions by the users of the
information.
It is a system designed to determine the brand value with a view to reflect the brands as
assets in the corporate balance sheet. However, brand accounting goes beyond valuation of
corporate brand. It is the process of total brand management through accounting information.

3.15 OBJECTIVES OF BRAND ACCOUNTING


The accounting for brands is motivated by the following reasons:
1. Real Economic Value:
By showing brand value in the Balance Sheet of a firm, an objective and realistic
assessment of the company’s real economic value could be made possible. This would
facilitate the ascertainment of correct Net Asset Value (NAV) which would be useful in
times of business acquisitions and mergers.
2. Future Profitability:
A brand generated or purchased, could be very useful for ascertaining the future income
making ability of companies. In fact, enormous sums of money spent on promoting and
supporting brands would go to appreciate the value of the firm. Companies which enjoy
brand equity will have the market value of their share enhanced. Brand equity refers to
the value added to the equity of a firm by the brand popularity and loyalty.
3. Preventing Predation:
By building and explicitly disclosing brands in financial statements, companies could put
up a powerful defense against potential predators and thereby ward off possible
acquisition and take-over bids.
4. Leverage Benefits: By enhancing the NAVs through brand disclosure separately in the
Balance sheet, it is possible for companies to resort to easy debt borrowings as this
causes an increase in NAV. In fact, the borrowing limits a firm enhances with the
increase in NAV. This ultimately paves the way for sound capital structure and an
improved gearing ratio.
5. Quality Decisions: Inclusion of brand values not only enhances NAV, ensure fair
valuation of the firm. This promotes quality managerial decision making. Brand valuation
may help managers in placing importance on brand promotion and strategic brand
positioning which hold the key for corporate marketing success.
6. Quality Accounting: Brand value inclusion enhances the quality of accounting practice
since the value added by corporate brands are considered significant in financial
statements. This could ultimately improve the financial accounting system and
management control.
7. Social Obligation: Brand valuation and its disclosure would help managers and
shareholders alike appreciate the significant role of brands in maintaining and enhancing
Valuation 9.39

the market value of firms. This could help especially the shareholders in making an
objective evaluation of companies (rating) before investing their money. This exercise, in
a way, helps firms fulfill their social obligations.
8. Other Benefits: Brand accounting provides a strong basis for self-evaluation of its value
by corporate. This could help firms in making a perfect estimate of the ability to take on
the competitors. It not only helps in tackling competitors locally, but could be of much
greater advantage to the foreign joint ventures and collaborations.

3.16 DIFFICULTIES IN BRAND ACCOUNTING


Intangibles are not easily measurable and it poses severe challenges in valuation of brands
also. Some of the difficulties faced by the accountants in brand valuation are as follows:
1. Distinctiveness:
Brands need to be valued distinctively as different from other intangibles such as
Goodwill etc. For instance, any attempt to commonly treat brand as a part of Goodwill as
is done at present may create serious distortions in accounting position. Besides, this
would create handicaps in brand accounting. This is because, a brand cannot be treated
like any other item such as patents and copyrights. In fact, a brand needs to be
separately disclosed in the Balance sheet, because of its significant contribution to
corporate image and identity.
2. Disclosure:
There is always a problem of making disclosure of brand values in financial statements.
This is because, there is no standard accounting practice requiring statement and
disclosure of brand values in a particular way.
3. Uncertainty:
The problem that is associated with the brand, as an item of intangibles, is that its
possible returns are uncertain, immeasurable and non-current in nature. Any expected on
such intangibles are usually either written off or treated as Deferred Revenue
Expenditure.
4. The Dilemma:
Another area of challenge posing brand accounting is whether to amortise or capitalise
the value of brand. There is no question of amortising brand values as either the
economic life of the brand cannot be determined in advance or its value depreciates over
time. In fact, it is “to be noted that a brand can be purchased or generated and
maintained, thus enhancing the corporate future income earnings capacity. The
challenge could, however, be overcome by categorising the brand expenditure into
Maintenance and Investment. Whereas the maintenance expenditure could be charged to
Profit and Loss Account and the Capital Expenditures be shown in the Balance Sheet
and where the brand value is shown separately and explicitly in the Balance Sheet, the
leverage position of the company can be shown enhanced.
9.40 Financial Reporting

5. No Market:
The prevailing practice is that the intangibles are not required to be revalued according to
some accounting standards on account of the non-existence of an active secondary
market for them. In fact, the need for brand accounting arises mainly on account of
conditions warranted by acquisition and merger.
6. New Brands:
A related problem, in accounting for such intangibles as brands is that it is often difficult
to determine whether a new one is being gradually substituted for an existing brand. This
raises the issue as to how to account for it in subsequent years. In such case, the
relevant question is: Should the original cost of brand be written-down as it erodes? It
may be difficult to determine whether a brand remains the same asset overtime as it is
subtly reshaped to meet new market opportunities.
7. Joint Costs:
The contribution to the value of a brand is made not simply by investing a desirable
product with a customer seductive name, but by building market share by the skilful
exploitation of the product in a whole host of ways of general efficiency with which a
business is conducted by expending money on a joint cost basis. It is very difficult to
segregate and account for joint costs that are incurred and the cost of brand developed
as a result of general operations of the business.

3.17 VALUATION OF BRANDS


The methods of brand valuation would depend on one or more of the following variables:
1. Exclusive earning power of brand.
2. Product as a brand and hence, product life cycle.
3. Separating a brand from other less important value drivers
4. Cost of acquisition of brand.
5. Expenses incurred on nurturing a home grown brand.
6. Impact of other brands as new entrants to the market.
7. Intrinsic strength of the people and process handling the brand.
8. Accuracy in projecting the super or extra earnings offered by a brand and rate of
discounting such cash flows.
9. The cost of withdrawing or replacing the brand.
10. Internationalisation of a brand and therefore, local earning power of a brand in various
countries or markets.
The valuation of brands is discussed from the angle of (i) Acquired brands, and (ii) Self
generated brands.
Valuation 9.41

Valuation of Acquired Brands


A purchased brand is one, which is acquired from other existing concerns. The acquiring
company may acquire only the brand name(s). The value of acquired brands is given below:
Brand value = Price paid for acquisition
On the other hand, a company may acquire an existing business concern along with its
brands. These are the cases of business mergers and amalgamations. The sum involved in
these transactions provides an indication of the financial value of the brands. At the maximum
this value is equal to the difference between the price and the value of the net assets
indicated on the acquired company’s balance sheet.
Brand value = Purchase consideration - Net assets taken over
However, it is questionable to say that the excess price paid always represents the brand
value. The excess is only an amount of purchased goodwill and the acquiring company may
have paid the excess price for varied factors also, location of the factory, long term contracts
with suppliers, better employee morale, better manufacturing technology etc. besides for
brands.
It would be difficult to say what part of the excess price paid is attributable to brands. Besides,
the price r payable is always decided by forces of demand and supply conditions of mergers
and amalgamations I market. Competitive force may make the acquirer to increase the bid
price thereby increasing the amount I Of purchased goodwill. This inseparability of brand from
other intangible assets makes it difficult to value the brands.
Valuation of Self-generated Brands
Several approaches have been evolved over a period of time for determining the brand
values. The important methods in valuation of self-generated brands are discussed below:
Historical Cost Model –
According to this approach, the valuation of a brand is determined by taking into account the
actual expenses incurred in the creation, maintenance and growth of corporate brands. The
value of the brand computed as follows:
Brand value = Brand Development Cost + Brand Marketing and Distribution Cost + Brand
Promotion Costs including advertising and other costs.
The historical cost method is specifically applicable to home-grown brands for which various
costs like development costs, marketing costs, advertising and general communication costs
etc. are incurred. The sum total of all these costs would represent the value of brands.
However, the entire advertisement costs cannot be regarded as incurred for brand. Further,
several heavily advertised brands today show hardly any value or presence.
The chief advantage of this model is that the various types of costs that are actually incurred
9.42 Financial Reporting

are considered. This facilitates easy computation of brand values. However, it does not
explain the impact of brand value on the profitability of a firm.
Replacement Cost Model-
Under this model, the brands are valued at the costs, which would be required to recreate the
existing brands. The method is based on the assumption that the existing brands can be
recreated exactly by new brands. It is the opportunity cost of investments made for the
replacement of the brand.
Brand value = Replacement Brand Cost
The main disadvantage with this model is that this model gives an estimation of brand value
but it is near impossible to replace the existing brands by new brands. Further, such values
are only subjective ones.
Market Price Model-
The probable value that a company would get for sale of its brands is taken as the value of the
brands under this model. Therefore, the brand value is given by:
Brand value = Net Realisable Value
However, this value is only an assumed value because there exist no ready-made market for
many brands. Further, brands are created or bought by corporate not for sale or resale. Value
payable by the purchaser depends upon the benefits expected from the purchase of brand.
But the method determines the value from the seller’s point of view.
Current Cost Model-
According to this approach, the current corporate brands are valued at the current value
(current costs) to the Group, which is reviewed annually and is not subject to amortisation.
This basis of valuation ignores any possible alternative use of brand, any possible extension
to the range of products currently marketed under a brand, any element of hope value and any
possible increase in value of a brand due to either a special investment or a financial
transaction (e.g. licensing) which would leave the Group with different interest from the one
being valued.
Potential Earning Model –
The Potential Earnings (PE) model is based on the estimated potential earnings that would be
generated by a brand and their capitalisation by using appropriate discount rate, the volume of
revenues raised by a brand in the market, determines its value. Accordingly, the value of a
brand at any one point of time is given by:
Total Market value of brand = Net Brand Revenue/Capitalisation Rate,
Valuation 9.43

Where
Net Brand Revenues = (Brand units × Unit brand price) - (Brand units × Unit brand
cost) (Marketing cost + R & D cost + Tax costs).
Though the model sounds objective, problem lies in ascertaining the actual marketing cost
incurred for I particular brand of a product. Moreover, it is difficult to select an appropriate
capitalisation rate.
Present Value Model –
According to present value model, the value of a brand is the sum total of present value of
future estimated flow of brand revenues for the entire economic life of the brand plus the
residual value attached to the brand. This model is also called Discounted Cash Flow model
which has been wisely used by considering the year wise revenue attributable to the brand
over a period of 5, 8 or l0 years. The discounting rate is the weighted average capital cost, this
being increased where necessary to account the risks arising out of a week brand. The
residual value is estimated on the basis of a perpetual income, assuming that such revenue is
constant or increased at a constant rate.
Rt Re sidual value
Brand value = +
(1 + r ) t
(1 + r )N
Where,
R1 = Anticipated revenue in year t, attributable to the brand.
t = Discounting rate
Residual value beyond year N
Brands supported by strong customer loyalty, may be visualised as a kind of an ‘annuity’,
since, mathematically, an annuity is a series of equal payments made at equal intervals of
time. Brands backed Body the loyalty of hard-core customers offer strong probability of having
steady long-term incomes. Great care must be taken to estimate as much correctly as
possible, the future cash flow likely to emanate from a strongly positioned specific brand. A
realistic present value of a particular brand having strong loyalty of customers can thus be
obtained from summation of discounted values of the expected future incomes from it.
The DCF model for evaluating brand values has got three sources of failure: (i) Anticipation of
cash flow, (ii) Choice of period, and (iii) Discounting rate.
Sensitivity Model –
According to this approach, the brand revenues are determined as a functional inflow of such
market factors as level of awareness of brand (AB), level of customer influence P) and level of
brand autonomy (BA) in the market, all these factors in the first place predominating the sales
revenues and then the brand revenues or the brand value. In other words, sensitivity of each
9.44 Financial Reporting

of the above forces determines the brand value.


Brand value = (Brand units sold x Unit Brand price) x AB x BI x BA
(-)
(BDC + BMDC + BPC)
Where,
AB, BI and BA are sensitivity index of brand values
BDC = Brand Development Cost
BMD = Brand Marketing and Distribution Cost
BPC = Brand Promotion Cost
The demerit of this model is that it gives more importance to subjective variables in the
estimation of brand value and this renders the whole exercise less reliable.
Life Cycle Model –
Under this approach, the brand value is indicated by means of relating the brand dimensions
to the brand strength. This model is applicable to home-grown brands, where the brands are
generated, nurtured and developed throughout their life which resembles a product life cycle.
The model is so called because the various brand dimensions behave in a way over a period
of time thus forming the brand value, to its life. This results in the formation of S-curve. The
model merely gives diagrammatic representation of formation and behaviour of brand strength.
The various dimension assumed in this approach are difficult to be quantified. The figure
depicts the life cycle model of corporate brand strength
Incremental Model –
Under this approach, the value of a brand is measured in terms o| incremental benefits
accruing to a firm on account of additions made to the brand value as a result of acquisition or
revaluation of brands. The brand value is computed as follows:
Brand value
= Total expected benefits after acquiring or revaluing brands – Total benefits of brands owned
Super Profits Model –
This is the most commonly used method for brand valuation. The simple formula of valuation
under this method is as follows:
Brand value = Discounting Factor × (Total profit of an enterprise in ‘n’ years × Profit of an
enterprise without the brand in ‘n’ years)
Valuation 9.45

The disadvantages in this method are as follows:


1. How many years (‘n’) profits to be considered?
2. What should be the discounting rate?
3. How do we decide the profit of an enterprise without the brand?
Market Oriented Approach –
This method is much outward looking and emphasises on the market forces and competition,
to arrive at a brand’s value. The method requires very good understanding of the market, new
entrants, exit of old competitors, market expansion and shrinkage and impact of other macro-
level variables on the market. The valuation process demands due amount of conservatism; in
projecting the market-size and the company’s market share.
Brand value = Discounting Factor × Company’s profitability ratio × (Cumulative market’s
size in next ten years - Cumulative total of market share enjoyed by other
branded and non-branded products in next 10 years)
The advantage of this method is, it looks at macro aspects governing the brand’s growth or
shrinkage. It also takes the cognizance of non-branded products and their threat to the
company’s brand. Company’s profitability ratio and the accounting factor are a matter of
strategic benchmarking.
Whole Organisation as a brand
Normally one cannot identify a product or process or programme as an exclusive brand. All
the value drivers bring together and make the enterprise a big integrated brand, the premium
enjoyed by such enterprise becomes the value of the brand.
Brand value = Intrinsic value of an enterprise - Net asset value of the assets of an enterprise
This method is useful under the following circumstances:
1. The buyer acquires the whole of the enterprise.
2. A going concern values itself and exhibits such premium enjoyed by it, in its Balance
Sheet.
3. One company becomes the brand equity or brand name for whole of the group.
4. Valuation of an enterprise as a brand is to be used as a base for computing the brand
value of each value driver in the value chain of the enterprise.
This method is a very accurate choice of performance indicators and their weight ages which
together decide the intrinsic value of the enterprise.

3.18 HUMAN RESOURCES AS A BRAND


Defining or recognising human resources as a brand could be a very complex process. The
leading value drivers in an organisation could effectively be the brand. These value drivers
9.46 Financial Reporting

may be the top executives or divisional heads. They could be from the most sensitive division
of the organisation. Such sensitive division may also be the brand for the whole of the
organisation. For example, many CEOs of most profitable corporations who enjoy the
maximum brand value in the market.
The valuation of entrepreneurial employees goes parallel with the intrinsic valuation of the
enterprise, for an obvious reason that most of the value addition is done these employees.
The approaches to valuation may be as follows:
(a) Cost Approach: The total cost incurred on developing these key employees may be
capitalised as an ‘asset’ and shown in the Balance sheet with yearly alternations on account of
recurring development costs incurred further.
(b) Compensation Approach: Discounted value of the total future compensation payable to
the key employees for their remaining tenure with the organisation may be the ultimate
valuation. The main drawback of this approach is that employees of a high profile organisation
may be unnecessarily valued at a much higher price. Hence, it may not be a genuine
representation of the employees brand-equity enjoyed by the organisation.
(c) Intrinsic Approach: The total discounted value of future compensation payable is further
increased (or decreased) by the ‘performance index’ of the enterprise. This performance index
explains the overall intrinsic value of an enterprise’s potentials.
(d) Remainder Approach: This approach would be very notional and subjective, as it
depends upon, the computation of ‘non-branded employees’ in an organization
Brand value = Discounting Factor × (Total profits of the organisation in next 10 years - Profit
of the organisation without the branded employees in next 10 years)
Assuming that the branded employees are not there and then notionally computing the ‘non-
branded employees’ performance’ would require accurate benchmarking. Treating key
employees as brands and valuing them, has some good advantages:
1. Entrepreneurial wages can be determined, based on ‘brand value’.
2. Strategy of taking over an enterprise with branded employees can be better handled, if
such valuation is done.
3. Empowerment for growth and diversification becomes easy, when different benchmarks
are available on the valuation of the employees to be empowered.
4. Branded employees and their valuation make the enterprise’s Balance sheet distinctive
strong and much more transparent.
5. Products, processes and programmes can be distinguished from the important value
driven employees, valuation becomes easy. Exclusively of the products and processes
from the employees becomes clear, when the branding of employees is done.
Valuation 9.47

(e) Value Chain Approach: The outsourcing approach can be used considerably to find out
the cost and contribution associated with every value driver or factor of production. The sum
total of such contributions, if deducted from the total contribution achieved by the organisation
should give the brand value of the organisation. The surplus offered by the brand for ten years
may be discounted at rate applicable to average market conditions.

3.19 CORPORATE BRAND STRENGTH


The brand valuation models lay emphasis on methods of ascertaining the ‘Brand Strength’
product or service of a corporate entity, which is defined as the sum total of all benefits flowing
from different dimensions of a brand such as quality of market leadership (ML) of the brand,
relative stability* of market (SM) enjoyed by the brand, the extent of market share (MS) of the
brand, the levels oi’ international acceptance (IA) of the brand, ability of the brand to meet the
changing modern marketing trends (MT), the extent of strategic support (SS) provided by the
brand to the corporate’s survival and growth, competitive strength (CS) offered by the brand
and above all the legal and social brand protection (BP). The composition of corporate brand
strength is shown in the following figure
Thus, the brand value/strength can be stated as follows:
Brand value = (ML + MS + SM + IA + MT + SS + CS + BP)
Self-examination Questions
1. Define goodwill. Distinguish between purchased goodwill and inherent goodwill.
2. Discuss briefly the contributing factor of goodwill.
3. Discuss with examples various methods of goodwill valuation.
4. How do you find out capital employed for goodwill valuation? Would you prefer ‘long
term fund’ approach to ‘shareholders’ fund’ approach?
5. Given below the assets and liabilities of X Pro Y Pro Ltd. as on 31st March
2004 2005 2006
Assets: (Rs. in lacs)
Sundry Fixed Assets:
Gross Value 15,29 17,22 19,21
Less: Accumulated depreciation 4,25 5,10 6,10
11,04 12,12 13,11
Investments:
Trade 1,12 1,27 1,40
Non-trade 85 1,12 1,40
Current Assets 7,15 10,15 11,12
Misc. Expenditure 25 20 15
20,41 24,86 27,18
9.48 Financial Reporting

Liabilities:
Share Capital and Reserves 9,46 10,41 9,91
12% Debentures 5,50 7,50 9,50
18% Term loan 2,50 3,00 3,50
Cash credit 1,00 80 60
Sundry creditors 75 1,85 2,12
Provision for taxation (net of advance tax) 40 50 55
Proposed dividend 80 80 1,00
20,41 24,86 27,18
Find out average capital employed.
6. Current cost of capital employed Rs. 10,40,000
Profit earned after current cost adjustments Rs. 1,72,000
20% Long term loan Rs. 4,50,000
Normal rate of return:
Equity capital employed 22%
Long term capital employed 25%
Find out leverage effect on the value of goodwill.
7. Given future maintainable profit Rs. 15 lacs
Capital employed Rs. 60 lacs
Normal rate of return 22%
Find out value of goodwill. Super profit can be maintained for 5 years.
8. Define Brands. What is the need for their valuation.
9. Discuss some of the important methods of brand valuation.
Valuation 9.49

UNIT 4
VALUATION OF LIABILITIES

4.1 INTRODUCTION
Proper valuation of all assets and liabilities is required to ensure true and fair financial position
of the business entity. In other words, all matters which affect the financial position of the
business has to be disclosed. Under- or over-valuation of liabilities may not only affect the
operating results and financial position of the current period but will also affect theses for the
next accounting period The present unit deals with different principles involved in the valuation
of different types of liabilities.

4.2 BASE OF VALUATION


The different bases of valuation of liabilities are depicted below:
(a) Historical cost. Liabilities are recorded at the amount of proceeds received in exchange
for the obligation, or in some circumstances (for example, income taxes), at the amounts
of cash or cash equivalents expected to be paid to satisfy the liability in the normal
course of business.
(b) Current cost. Liabilities are carried at the undiscounted amount of cash or cash
equivalents that would be required to settle the obligation currently.
(c) Realisable (settlement) value. Liabilities are carried at their settlement values, that is, the
undiscounted amounts of cash or cash equivalents expected to be required to settle the
liabilities in the normal course of business.
(d) Present value. Liabilities are carried at the present value of the future net cash outflows
that are expected to be required to settle the liabilities in the normal course of business.
(Framework, Issued 2000)

4.3 CARRYING VALUE


The liability items of the balance sheet are generally carried at the settlement values. However
for shares and debentures if the book value is measured including the premium or loss on
issue, that comprehensive book value should match with the historical cost value. For certain
items like income received in advance, liability for tax the historical cost basis is generally
applicable. In such cases the historical cost and settlement value should be similar. Liabilities
may be carried at the present value in case of finance lease.

4.4 LEASES
In case of a finance lease, the lessee should recognize a liability equal to the fair value of the
leased asset at the inception of the lease.
9.50 Financial Reporting

If the fair value of the leased asset exceeds the present value of the minimum lease payments
from the standpoint of the lessee, the amount recorded as an asset and a liability should be
the present value of the minimum lease payments from the standpoint of the lessee. In
calculating the present value of the minimum lease payments the discount rate is the interest
rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental
borrowing rate should be used. (AS 19 Para 11)

4.5 PROVISIONS
In regard provision, the valuation is based on settlement value and not on present value. AS
29 stated in Para 35 that the amount recognised as a provision should be the best estimate of
the expenditure required to settle the present obligation at the balance sheet date. The
amount of a provision should not be discounted to its present value.
Valuation 9.51

UNIT 5
VALUATION OF SHARES

5.1 INTRODUCTION
The considerations governing share valuation are varied, intricate and numerous of which
some are accounting and others non-accounting; some are objective, others are subjective.
As a result, very often accountants fail to come to agreement on the valuation to be placed on
shares. Valuation calls for judicious assessment of the rights, advantages, interests,
expectations, hazards and difficulties of the parties involved in it, having conflicting interests.
If the purpose of valuation is known, the valuer should arrive at the same value whether he is
appointed by the seller or the buyer. However, the valuer’s approach to the question is
influenced by the purpose for which the valuation is requested. For example, though the
underlying principles are the same, a valuer may apply them in a liberal way in cases of
valuation for compensation purposes, while a more conservative test may be applied in
valuation for tax-purposes.

5.2 PURPOSES OF VALUATION


Purposes of share valuation can be given as follows :
(i) Assessments under the Wealth Tax or Gift Tax Acts.
(ii) Purchase of a block of shares which may or may not give the holder thereof a controlling
interest in the company.
(iii) Purchase of shares by employees of the company where the retention of such shares is
limited to the period of their employment.
(iv) Formulation of schemes of amalgamation, absorption, etc.
(v) Acquisition of interest of dissenting shareholders under a scheme of reconstruction.
(vi) Compensating shareholders, on the acquisition of their shares, by the Government under
a scheme of nationalisation.
(vii) Conversion of shares, say, preference into equity shares.
(viii) Advancing a loan on the security of shares.
(ix) Resolving a deadlock in the management of a private limited company on the basis of the
controlling block of shares given to either of the parties.

5.3 RELEVANCE OF VALUATION


Valuation by an expert is generally called for when parties involved in the
transaction/deal/scheme, etc. fail to arrive at a mutually acceptable value or agreement or
when the Articles of Association etc. provide for valuation by experts. For transactions
9.52 Financial Reporting

concerning relatively small blocks of shares which are quoted on the stock exchange,
generally the ruling stock exchange price (average price) provides the basis. But valuation, by
a valuer becomes necessary when:
(i) shares are not quoted;
(ii) shares relate to private limited companies;
(iii) the court so directs;
(iv) Articles of Association or relevant agreements so provide;
(v) a large block of shares is under transfer; and
(vi) statutes so require (like Wealth Tax, Gift Tax Acts).

5.4 LIMITATION OF STOCK EXCHANGE PRICE AS A BASIS FOR VALUATION


A rough classification of buyers at the stock exchange may be made as: (a) informed or
analytical investors; (b) informed speculators; and (c) the un-informed. Similarly, a rough
classification of sellers is: (a) informed; and (b) those with an urgent need to sell. It is
sufficient to say that in a stock exchange numerous people collect-some to deal, some to
watch and some to rig. Consequently, depending on the motivation they react and the result of
such reactions come out as the market price, which is partly an outcome of reasoned
investments or sales policy, partly embodying the effect of speculative motives. Thus it is not
reasonable to use stock exchange price as share value - one should consider other factors
too. The Council of the London Stock Exchange has opined: “We desire to state
authoritatively that stock exchange quotations are not related directly to the value of a
company’s assets, or to the amount of its profits and consequently these quotations, no matter
what date may be chosen for reference, cannot form a fair and equitable, or rational basis for
compensation. The stock exchange, does not determine the prices of which the official list is
the record. The stock exchange may be likened to a scientific recording instrument which
registers, not its own actions and opinions, but the actions and opinions of private and
institutional investors all over the country and, indeed the world. These actions and opinions
are the results of hope, fear, guesswork, intelligent or otherwise, good or bad investment
policy and many other considerations. The quotations that result definitely do not represent a
valuation of a company by reference to its assets and its earning potential”.
On a summarisation, it may be stated that stock exchange price is mostly determined by bull
and bear effects rather than fundamental factors like net assets, earnings, yield, etc. Stock
exchange price is basically determined on the inter-action of demand and supply and may not
reflect a true value of shares.
Factors: Two factors stand out to be basically important: assets employed and the profit
earned; mostly both are considered. The following has general acceptance:
(i) For a company destined to be liquidated, assets will constitute the basis for valuing the
shares of the company.
Valuation 9.53

(ii) Where assets play a relatively unimportant role, for example in the case of professional
practice of architects and engineering consultants, valuation may depend wholly on the
earning capacity.
(iii) Earning power and assets both may be considered in valuation of the shares of a going
concern, earning power playing a major role while assets are considered only to indicate
safety margin i.e. asset backing.

5.5 METHODS
Principally two basic methods are used for share valuation; one on the basis of net assets and
the other on the basis of earning capacity or yield (which, nevertheless, must take into
consideration net assets used).
5.5.1 Net Asset Basis: According to this method, value of equity share is determined as
follows:
Net assets available to equity shareholders
Number of equity shares
The following important aspects are to be considered while arriving at the net assets available
to the equity shareholders:
(i) Value of tangible fixed assets: Tangible fixed assets like plant, machinery, building, land,
furniture, etc. should be taken at their current cost. Current cost implies current entry
price, i.e., the price to be paid by the enterprise if it wants to acquire such assets at their
present locations and conditions.
(ii) Value of intangibles: Intangibles like goodwill, patents and know-how should also be
taken at their current cost. Inherent goodwill is not shown in the books of accounts. For
asset based valuation of share, valuation of goodwill is essential and valuation should be
made following any of the methods (depending upon the circumstances) discussed in
Unit 3. If purchased goodwill appears in the books of account it should be eliminated and
new valuation should be taken into consideration.
(iii) Investments: Shares and securities which are quoted in the stock exchange and traded
on a regular basis, market price of them should be used as current value of investments.
For other investments book value may be taken after adjustments for known loss or gain.
(iv) Inventories : The stock of finished goods may be taken at the market price. But other
stocks like raw material, stores and work-in-progress should be taken at cost following
conservative approach. Due allowance should be made for any obsolete, unusable or
unmarketable stocks held by the company.
(v) Sundry Debtors: Appropriate allowance should be made for bad and doubtful debts.
(vi) Development expenses: These arise (i) in the case of a new company, when it is in the
process of executing its project and (ii) in the case of an old company, when either there
is an expansion of the existing production lines or diversifications with a view to entering
new lines.
9.54 Financial Reporting

Such expenses generally appear in the balance sheet as Capital Work-in-Progress. It


may not be advisable to take whole of the expenses as asset while valuing equity shares.
Rather a conservative approach may be followed to assess the current ‘entry’ value of
such Capital Work-in-Progress.
(vii) Miscellaneous expenditure and losses: All fictitious assets appearing under this head
should not be taken into consideration.
From the value of assets arrived at as per the criteria discussed above the liabilities are
deducted to arrive at net assets. These liabilities are:
♦ All short term and long term liabilities including outstanding and accrued interest;
♦ Tax provisions;
♦ All liabilities not provided for in the account;
♦ All prior period adjustments which would reduce profit of the earlier years net of items
which would increase profit;
♦ Preference share capital including arrear of dividends and proposed preference dividend.
If the objective is to determine ex-dividend value of equity shares, proposed equity dividend is
also to be deducted.
However, if some shares are partly paid up, a notional call equivalent to the calls unpaid
added with the net assets. And value of shares is determined taking partly paid up shares as
notionally fully paid up. Thereafter value of partly paid up shares is arrived at after deducting
unpaid call or uncalled amount from value of fully paid up shares.
5.5.2 Yield Basis: Yield based valuation may take the form of valuation based on rate of
return. The rate of return may imply rate of earning or rate of dividend. If a block of shares is
sufficiently large, so as to warrant virtual control over the company the rate of earning should
be the basis; for small blocks the rate of dividend basis will be appropriate. It is necessary to
determine (i) the (after tax) maintainable profit or dividend for the company in the foreseeable
future, and (ii) the normal rate of yield or earning of dividend, as the case may be, for the
company. After the rate of yield or earning of dividend has been determined, the capitalisation
factor, or the multiplier, should be determined for applying the same to the adjusted
maintainable profit of business to arrive at the total value. If the yield expected in the market is
8% the capitalisation factor would be 100/8 or 12.5. On this basis the value of an undertaking
earning Rs. 4,00,000 p.a. would be Rs. 4,00,000 × l2.5 or Rs. 50,00,000. Total value of the
undertaking divided by the number of equity shares gives the value for each equity share.
Similar is the process for dividend yield basis.
Stages for yield-based Valuation : Broadly, the following steps are envisaged in a yield based
valuation considering the rate of return:
(i) Determination of future maintainable profit;
Valuation 9.55

(ii) Ascertaining the normal rate of return;


(iii) Finding out the capitalisation factor or the multiplier;
(iv) Multiplying the future maintainable profit, by the multiplier; and
(v) Dividing the results obtained in (iv) by the number of shares.
Determination of the normal rate of return and capitalisation factor: This obviously has
tremendous bearing on the ultimate result but, unfortunately, it is subjective and therefore,
valuers differ more widely in this area than in any other in the whole valuation process. As a
general rule, the nature of investment would decide the rate of return. Companies, investment
in which is more risky, would call for a higher rate of return and consequently they will have
lower capitalisation factor and lower valuation than companies with assured profits. For
investment in government securities, the risk is least and consequently, the investor would be
content with a very low rate of return. In a logical order, we find that mortgage debentures,
being riskier than government paper, require slightly higher rate of return. Preference shares
are less risky than equity shares but more risky than mortgage debentures; preference shares
rank in between debentures and equity shares in the matter of rate of return. Equity shares
are exposed to the highest risk and, consequently, the normal rate of return is highest in the
case of equity shares, though, in the case of equity shares of progressive and efficiently
managed companies, such a risk is rather low. In fact, shares of such companies provide a
safeguard against inflation - equity share prices are likely to rise sufficiently high to counteract
the effect of a rise in prices.
The above also applies to companies and industries–the normal rate of return will always
depend on the attendant risk. In this respect, net tangible asset backing is also relevant. The
higher the net tangible asset backing for each share, the greater would be the confidence of
the investor. Normally 1.5 to 2 times backing is considered satisfactory. This ratio should be
reviewed carefully to ascertain whether shares are adequately covered or too much covered
which may indicate over-capitalisation in the form of idle funds or inadequate use of productive
resources. Symptoms suggesting idle assets would be holding of large cash and bank
balances, high current ratio, unutilised land and machinery, etc. The normal rate of return
should be increased suitably in either case.
Adjustment necessary for the determination of future maintainable profit : Determination of
future maintainable profits, based on past record, is a delicate and complicated task as it
involves not only objective consideration of the available financial information but also
subjective evaluation of many other factors, such as capabilities of the company’s
management, general economic conditions, future government policies, etc. Guiding principles
can be laid down only in respect of the former and the valuer will have to give due
consideration to the other matters according to his reading of the situation in each individual
case. The steps necessary to arrive at the future maintainable profits of a company are: (a)
calculation of past average taxed earnings, (b) projection of the future maintainable taxed
profits, and (c) adjustment of preferred rights.
9.56 Financial Reporting

Calculation of past average earnings: In order to calculate the past average earnings, it is
necessary to decide upon the number of years whose results should be taken for averaging:
select the years and adjust their profits to make them acceptable for averaging.
The number of years to be selected must be large enough so as to cover generally the length
of a business cycle, as an average for a shorter period might not be suitable. But it should not
go too far back: results in the early 80’s may have bearing on the results expected in the 90’s.
In inflationary conditions, that are present today, it is considered that a relatively short period
may be more representative since it reveals more recent results. Similarly, for companies
having steady growth, average of a rather short period, is more useful. In some unusual
circumstances, average of a still shorter period, even only one year’s profit may be more
significant in estimating future earning, such as where a change in the business or a change in
trading conditions forces the valuer to discard all earlier years and to rely upon the current
year only or to select certain normal years and exclude others. In all these matters, a sound
reasoning would alone aid the valuer. Whether a 3-yearly, 5- yearly or longer average would
reflect the correct future earnings of a company depend upon the nature of concerned
industry.
The following are some items which generally require adjustment in arriving at the average of
the past earnings:
(i) Elimination of material non-recurring items such as loss of exceptional nature through
strikes, fires, floods and theft, etc., profit and loss of any isolated transaction not being
part of the business of the company, Lump-sum compensation or retiring allowances and
cost in legal actions, abnormal repair charges in a particular year, etc.
(ii) Elimination of income and profits and losses from non-trading assets.
(iii) Elimination of any capital profit or loss or receipt or expense included in the profit and
loss account.
(iv) Adjustment for any interest, remuneration, commission, etc., foregone or overcharged by
directors and any other managerial personnel.
(v) Adjustment for any matters suggested by notes, appended to the accounts, or by
qualification in the auditor’s report such as provisions for taxation and gratuities, bad
debts, under or over provision for depreciation, inconsistency in the valuation of stocks,
etc.
(vi) Taxation: The tax rates may be such as were ruling for the respective years or the latest
ruling rate may be deducted from the average profit. However, the consensus of opinion
is for adjusting tax payable rather than tax paid because so many short- term reliefs and
tax holidays might have temporarily reduced the effective tax burden.
(vii) Depreciation: It is a significant item that calls for careful review. The valuer may adopt
book depreciation provided he is satisfied that the rate was realistic and the method was
suitable for the nature of the company and they were consistently applied from year to
year. But imbalances do arise in cases where consistently written down value method
Valuation 9.57

was in use and heavy expenditure in the recent past has been made in rehabilitating or
expanding fixed assets, since the depreciation charges would be unfairly heavy and
would prejudice the seller. Under such circumstances, it would be desirable to readjust
depreciation on a straight line basis to bring a more equitable charge on the profits meant
for averaging.
In averaging past earnings, another important factor comes up for consideration and that is
the trend of profits earned. It is indeed imperative that estimation of maintainable profits be
based on the only available record, i.e., the record of past earnings. But indiscreet use of past
results may lead to an entirely fallacious and unrealistic result. In this regard, three situations
may have to be faced. Where the past profits of a company are widely fluctuating from year to
year, the average fails to aid future projection. In such cases, a study of the whole history of
the company and of earnings of a fairly long period may be necessary. If the profits of a
company do not show a regular trend upward or downward, the average of the cycle can
usefully be employed for projection of future earnings. In some companies, profits may record
a distinct rising or falling trend, from year to year; in these circumstances, a simple average
fails to consider the significant factor, namely trend in earning. The share of a company which
records a clear upward trend of past profits would certainly be more valuable than that of a
company whose trend of past earnings indicate a static or down-trend. In such cases, a
weighted average, giving more weight to the recent years than to the past, is appropriate. A
simple way of weighting is to multiply the profits by the respective number of the years
arranged chronologically so that the largest weight is associated with the most recent past
year and the least for the remotest (If net worth is under consideration, the respective years’
average net worth may be weighted in a similar way). However, if the profits have been
consistently coming down, even weighted average may be misleading-fitting a trend line may
be more appropriate.
Projection of future maintainable taxed profits: Projection is more a matter of intelligent guess
work since it is essentially an estimation of what will happen in the risky and uncertain future.
The average profit earned by a company in the past could be normally taken as the average
profit that would be maintainable by it in the future, if the future is considered basically as a
continuation of the past. If future performance of the company is viewed as departing
significantly from the past, then appropriate adjustment will be called for before accepting the
past average profit as the future maintainable profit of the company. The factors requiring
consideration may be as stated below:
(i) Discontinuance of a part of the business;
(ii) Under-utilisation of installed capacity;
(iii) Expansion programmes;
(iv) Major change in the policy of the company; and
(v) Adjustment for rehabilitation and replacement.
9.58 Financial Reporting

In arriving at the average profits and their future projection all charges including interest
on debentures and other borrowings are deducted. But the dividend on preference
shares depends upon the availability of divisible profits and, therefore, should be
considered after the estimate of future profits has been arrived at. Dividends payable to
preference shareholders, according to the terms of their issue, should be deducted from
the maintainable profit.
5.5.3 Factors having a bearing on valuation: In addition to what has already been stated,
consideration of the following factors is also necessary in a valuation:
(a) Nature of industry, its history and risks to which it is subject;
(b) Prospects of the industry in the future;
(c) The company’s history-its past performance and its record of past dividends;
(d) The basis of valuation of assets of the company and their value;
(e) The ratio of liabilities to capital;
(f) The nature of management and chance for its continuation;
(g) Capital structure or gearing;
(h) Size, location and reputation of the company’s products;
(i) Incidence of taxation;
(j) The number of shareholders;
(k) Yield on shares of companies engaged in the same industry, which are listed on the
stock exchanges;
(1) Composition of purchasers of the products of the company; and
(m) Size of the block of shares offered for sale since, for large blocks, very few buyers would
be available and that has a depressing effect on the valuation. Question of control,
however, may become important when large blocks are involved.
Special Factors: Valuation of equity shares must take note of special features in the company
or in the particular task. These are briefly stated below:
(a) Importance of the size of the block of shares: Valuation of the identical shares of a
company may vary quite significantly at the same point of time on a consideration of the
size of the block of shares under negotiation. It is common knowledge that the holder of
75% of the voting power in a company can always alter the provisions of the articles of
association to suit himself; a holder of voting power exceeding 50% and less than 75%
can substantially influence the operations of the company even to alter the articles of
association or comfortably pass a special resolution.
Even persons holding much less than 50% of the total voting strength in a public limited
company may control the affairs of the company, if the shares carrying the rest of the
voting power are widely scattered; such shareholders rarely combine to defeat a
determined block. Usually a person holding 50% of the total voting power is in a position
Valuation 9.59

to have his way in the company, even to change the provision of the articles of
association or pass any special resolution. A controlling interest, according to most
authorities, carries a separate substantial value.
(b) Restricted transferability: Along with principal consideration of yield and safety of capital,
another important factor is easy exchangeability or liquidity. Shares of reputed
companies generally enjoy the advantage of easy marketability which is of great
significance to the holder. At the time of need, he may get cash in exchange of shares
without being required to hunt out a willing buyer or without being required to go through
a process of protracted negotiation and valuation. Generally, quoted shares of good
companies are preferred for the purpose. On the other hand, holders of shares of
unquoted public companies or of private companies do not enjoy this advantage;
therefore, such shares, however good, are discounted for lack of liquidity at rates which
may be determined on the basis of circumstances of each case. The discount may be
either in the form of a reduction in the value otherwise determined or an increase in the
normal rate of return. Generally, the articles of private companies contain provision for
offering shares to one who is already a member of the company and this necessarily
restricts the ready market for the shares. These are discounted for limited transferability.
But exceptions are also there; by acquisition of a small block, if one can extend his
holding in the company to such an extent as to effectively control the company, the share
values may not be discounted in that case.
(c) Dividends and Valuation: Generally, companies paying dividends at steady rates enjoy
greater popularity and the prices of their shares are high while shares of companies with
unstable dividends do not enjoy confidence of the investing public as to returns they
expect to get and, consequently, they suffer in valuation. For companies paying
dividends at unsteady rates, the question of risk also becomes great and it depresses the
price. The question of risk may be looked upon from another angle. A company which
pays only a small proportion of its profits as dividend and thus builds up reserves is less
risky than the one which has a high pay out ratio. The dividend rate is also likely to
fluctuate in the latter case. Investors, however, do not like a company whose pay-out
ratio is too small.
Shares are generally quoted high immediately before the declaration of dividend if the
dividend prospect is good; or immediately after the declaration of dividend to take care of
the dividend money that the prospective holder would get.
(d) Bonus and Right Issue: Shares values have been noticed to go up when bonus or right
issues are announced, since they indicate an immediate prospect of gain to the holder
although in the ultimate analysis, it is doubtful whether really these can alter the
valuation. Bonus issues are made out of the accumulated reserves in the employment of
the business. Such shares in no way contribute to the increased earning capacity of the
business and ultimately depress the dividend rate since the same quantum of profit
would be distributed over a large number of shares which in turn also would depress the
market value of the shares. A progressive company may sometimes pick up the old rate
of dividend after a short while but this is in no way a result of the bonus issue; it is the
9.60 Financial Reporting

contribution of natural growth potential of the company. Good companies, however, try to
maintain the rate of dividend even after the bonus issue. In such a case, the total
holdings of shareholders will increase in value.
In the case of right issues, existing holders are offered shares forming part of a new issue;
more funds flow into the company for improving the earning capacity. Share value will
naturally depend on the effectiveness with which new funds will be used.
5.5.4 Mean between asset and yield based valuation: This is, in fact, no valuation, but a
compromise formula for bringing the parties to an agreement. This presents averaging two
results obtained on quite different basis. It is argued that average of book value and yield
based value incorporates the advantages of both the methods. That is why such average is
called the fair value of share.

5.6 STATUTORY VALUATION


Valuation of shares may be necessary under the provision of Gift- tax Act,* Wealth tax Act,
Companies Act and Income-tax Act. Excepting the Companies where Act valuation may be
called for on amalgamation, and such other purposes and the Income-tax Act for capital gains
the other enactments, as mentioned above, have laid down rules for valuation of shares. The
rules generally imply acceptance of open market price (i.e., Stock exchange price) for quoted
shares and asset based valuation for unquoted equity shares and average of yield and asset
methods in valuing shares of investment companies. These are discussed in the study
material on Taxation.
In the Companies (Central Government’s) General Rules and Forms, 1956 methods of
determining break-up value of share and yield based valuation have been illustrated.
Annexure-I of Form No. 7D and Form No. 7E illustrates the method of determining break-up
value of shares. Annexure-II of Form No. 7D and 7E illustrates the method of determining
value of shares based on yield. It may be mentioned that Form No. 7D is meant for
‘application for approval of the Central government for acquisition of shares under section
108A’ and Form No. 7E is meant for ‘intimation to the Central Government of the proposal to
transfer shares under section 108-B’ and ‘application for approval of the Central Government
for transfer of shares of foreign Companies under section 108-C’.
Illustration 1
Balance Sheet of John Engg. Ltd. as on 31.12.2006 is given below:
Balance Sheet (Figures in 000)

Liabilities Rs. Assets Rs.


Share Capital -
1,50,000 Equity Shares of Rs.10 each 15,00 Sundry Fixed Assets 22,00
2,00,000 Equity Shares of Rs. 10 Investments 4,00
Valuation 9.61

each Rs. 6 paid up 12,00 Stock 8,00


9% Cum Pref. Shares 6,00 Debtors 4,00
18% Term Loan 14,00 Cash & Bank 4,00
Sundry Creditors 8,00 P & L A/c 13,00
55,00 55,00
Other Information:
(1) Current Cost of Sundry Fixed Assets Rs. 37,00 thousand and stock Rs.10,00 thousand,
(2) Investments could fetch only Rs. 100 thousand,
(3) 50% debtors are doubtful,
(4) Preference dividend was in arrear for the last five years.
Find out the intrinsic value per share of John Engg. Ltd.
Solution
(i) Net assets available to the equity shareholders
Amount in Rs.’000
Sundry fixed assets 37,00
Investments 1,00
Stock 10,00
Debtors 2,00
Cash & Bank 4,00
54,00
Less: Outside liabilities & 9% cumulative pref shares:
Sundry Creditors 8,00
18% Term Loan 14,00
9% Cumulative Pref. Shares 6,00
Arrear Pref. Dividend 2,70 30,70
Net Assets 23,30
(ii) Valuation of Equity Shares
Net assets as per (i) above 23,30
Add: Notional call on 2,00,000 partly paid up equity shares @ Rs. 4 each 8,00
31,30
Number of equity shares 350 thousand
Value per fully paid up equity share = Rs. 31,30thousand / 3,50thousand = Rs.8.94
Value per partly paid up equity share = Rs. 8.94 – Rs. 4 = Rs. 4.94
9.62 Financial Reporting

Illustration 2
Balance Sheet of Mcneil Ltd.
as on 31.12.06
(Figure in ‘000 Rs.)
Liabilities Rs. Assets Rs.
Share Capital Sundry fixed assets 280,20
5,00,000 Equity Shares Investments in subsidiaries 60,40
of Rs. 10 each fully paid up 50,00 Other non-trade investments 50,00
8,00,000 Equity Shares Stock 80,60
of Rs. 10 each Rs. 8 paid up 64,00 Debtors 80,40
10,00,000 Equity Shares Advances 50,60
of Rs. 5 each fully paid up 50,00 Cash & Bank 16,60
Share suspense A/c 20,00 Preliminary expenses 40
General reserve 102,00
P & L A/c 84,00
13% Debentures 60,00
(50% Convertible at the
beginning of next year)
18% Term Loan 40,00
Sundry creditors 20,00
Tax Provision 80,00
Proposed dividend 49,20 _____
619,20 619,20
Other Information:
(1) Profit before tax (and before deducting interest on convertible debentures) of Mcneil Ltd.
for the last five years were as follows (’000 Rs.): 2002 – 132,00, 2003 – 244,00, 2004 –
274,00, 2005 – 315,00, 2006 – 332,00.
(2) Non-trade investments earned @ 20% on an average.
(3) Expected increase in expenditure without commensurate increase in selling price Rs.
60,000.
(4) Annual R & D expenses in future Rs. 1,00,000.
(5) Expected foreign currency loss in future (annualised) Rs.120,000.
(6) Expected tax rate 45%. Tax rate in 2006: 52%
(7) Normal return 15% (on the basis of closing capital employed)
Required:
(1) Find out intrinsic value for different categories of equity shares. For this purpose goodwill
may be taken as 3 years’ purchase of super profit.
Valuation 9.63

(2) Value of share as per dividend yield. Normal dividend in the industry is 18%.
(3) Value of share as per EPS. Average EPS is Rs. 3 for Rs. 10 share.
Solution
Calculation of intrinsic value of equity shares of Mcneil Ltd.
1. Calculation of Goodwill:
Rs. in ’000 Rs. in ’000
(i) Capital Employed:
Total of asset side of the Balance-Sheet 6,19,20
Less: Preliminary expenses 40
Non-trade investment 50,00 50,40
5,68,80
Less: Outside liabilities:
Sundry creditors 20,00
18% Term loan 40,00
Tax provision 80,00
13% Debenture – net of conversion 30,00 1,70,00
Capital employed 3,98,80
(ii) Future Maintainable Profit:
Year Profit Before Tax Weight Product
(in ’000 Rs.) (in ’000 Rs.)
2002 1,32,00 1 1,32,00
2003 2,44,00 2 4,88,00
2004 2,74,00 3 8,22,00
2005 3,15,00 4 12,60,00
2006 3,32,00 5 16,60,00
15 43,62,00
Rs. in ’000 Rs. in ’000
Weighted average profit before tax = 43,62,00 /15 2,90,80
Less : Income from non-trade investments 10,00
Expected increase in expenditure 60
Annual R & D expenses 1,00
Expected increase in
Foreign currency liability 1,20 12,80
2,78,00
Less : Tax @ 45% 1,25,10
Expected Profit After Tax 1,52,90
9.64 Financial Reporting

(iii) Normal Return:


15% on capital employed
i.e. 15% on Rs. 3,98,80 thousand = Rs. 59,82 thousand
(iv) Super profit:
Expected profit - normal profit
Rs. 152,90 thousand – Rs. 59,82 thousand = Rs. 93,08 thousand
(v) Goodwill:
3 years’ purchase of super profit
Rs. 93,08 thousand × 3 = Rs. 279,24 thousand
II. Net assets available to equity shareholders
Amount in Rs. ’000
Goodwill as calculated in I (v) above 2,79,24
Sundry fixed assets 2,80,20
Investment in subsidiaries 60,40
Non-trade investment 50,00
Stock 80,60
Debtors 80,40
Advances 50,60
Cash & Bank 16,60
8,98,04
Less: Outside liabilities 1,70,00
7,28,04
III. Valuation of equivalent number of equity shares:
No. in ’000
5,00,000 equity shares of Rs. 10 each fully paid up 5,00
8,00,000 equity shares of Rs. 10 each Rs.8 paid up (notional call to be adjusted) 8,00
10,00,000 equity shares of Rs. 5 each fully paid up 5,00
Share suspense A/c equivalent shares for Rs. 20,00 thousand 2,00
Shares for convertible debenture amounting to Rs. 30,00 thousand 3,00
23,00
IV. Valuation of equity shares
Net assets as per (II) above + Notional call on 8,00,000 equity shares @ Rs. 2
each i.e. Rs. 16,00 thousand = 744,04 thousand
Value per equivalent share of Rs.10 = RS. 7,44,04 thousand / 23,00 thousand
Value per share of Rs. 10 Rs. 8 paid up = Rs. 32.35 – Rs. 2 = Rs.30.35
Value per share of Rs.5 fully paid up = Rs. 32.35 × 1/2 = Rs. 16.18
Valuation 9.65

V. Valuation of equity shares on dividend yield basis


Proposed dividend for the year ended 31.12.2006 Rs. 49,20 thousand
Paid up value of equity share Rs. 1,64,00 thousand
Rate of dividend 49,20 /1164,00 X 100 30%
Value per fully paid up share of Rs.10
30%
X Rs. 10 = Rs. 16.67
18%
Value per share of Rs. 5
30%
X Rs. 5 = Rs. 8.33
18%
Value per share of Rs. 10, Rs.8 paid up
30%
X Rs. 8 = Rs. 13.33
18%
Note: It has been assumed that the company will be able to maintain 30% dividend in future
despite an increase in the number of equity shares arising out of share suspense account and
conversion of debentures.
VI. Valuation of equity shares as per EPS yield
Amount in Rs.
Profit before tax 3,32,00,000
Less: Interest on convertible debentures 3,90,000
3,28,10,000
Less: Tax @ 52% 1,70,61,200
Profit after tax 1,57,48,800

Equity Share Capital 1,64,00,000


(in thousand 50,00 + 64,00 + 50,00)
1,57,48,800
Earning per rupee of share capital = Rs .
1,64,00,000
= Rs. 0.96
(i) EPS during 2006:
Share of Rs. 10 fully paid up 0.96 × 10 = Rs. 9.60
Share of Rs. 10, Rs. 8 paid up 0.96 × 8 = Rs. 7.68
Share of Rs. 5 fully paid up 0.96 × 5 = Rs. 4.80
(ii) Value of shares:
Value per share of Rs. 10 fully paid up
9.6
Rs. X Rs. 10 = Rs. 32
3
9.66 Financial Reporting

Value per share of Rs. 10, Rs. 8 paid up


7.68
Rs. X Rs. 10 = Rs. 25.6
3

Value per share of Rs. 5 fully paid up


4.8
Rs. X Rs. 10 = Rs. 16
3
Illustration 3
From the following figures calculate the value of the share of Rs.100 on (i) yield on
capital employed basis, and (ii) dividend basis, the market expectation being 12%.
Year Capital employed (Rs.) Profit (Rs.) Dividend %
2007 5,50,000 88,000 12
2008 8,00,000 1,60,000 15
2009 10,00,000 2,20,000 18
2010 15,00,000 3,75,000 20
Solution
The dividend rate on the simple average is 65/4 or 16¼%. But since the dividend
has been rising it would be better to take the weighted average which comes to
17.6%:
Year Rate Weight Product
2007 12 1 12
2008 15 2 30
2009 18 3 54
2010 20 4 80
10 176

The value of the share on the basis of dividend (weighted average) should be 17.6/12 ×
Rs.100 or Rs. 146.67
The yield on capital employed for each year and its weighted average is as follows:
Year Yield or capital employed (%) Weight Product
2007 16 1 16
2008 20 2 40
2009 22 3 66
2010 25 4 100
10 222
Weighted average is 22.2%: on this basis the value should be 22.2/12 × Rs.100 or Rs.185.
Valuation 9.67

5.7 VALUATION OF PREFERENCE SHARES


For valuation of preference shares the following factors are generally considered:
(i) Risk free rate plus small risk premium (i.e. market expectation rate).
(ii) Ability of the company to pay dividend on a regular basis.
(iii) Ability of the company to redeem preference share capital.
Market expectation about return from preference shares and equity shares cannot be identical
because nature of these financial instruments are altogether different. Preference shares are
fixed dividend bearing instruments whereas equity shares bear residual right on company’s
profit. The market expectation rate for preference shares may be influenced by the ability of
the company to pay preference dividend. Ability to pay preference dividend may be judged by
using the following ratio:
Profit after tax
Preference dividend
The value of each preference shares can be derived as below:
Preference dividend rate
X 100
Market expectation rate

5.8 MISCELLANEOUS PROBLEMS FOR PRACTICE


Illustration 4
Capital structure of Lot Ltd. as at 31.3.2007as under:
(Rs. in lakhs)
Equity share capital 10
10% preference share capital 5
15% debentures 8
Reserves 4
Lot Ltd. earns a profits of Rs. 5 lakhs annually on an average before deduction of interest on
debentures and income tax which works out to 40%.
Normal return on equity shares of companies similarly placed is 12% provided:
(a) Profit after tax covers fixed interest and fixed dividends at least 3 times.
(b) Capital gearing ratio is .75.
(c) Yield on share is calculated at 50% of profits distributed and at 5% on undistributed
profits.
Lot Ltd. has been regularly paying equity dividend of 10%.
9.68 Financial Reporting

Solution

(i) Profit for calculation of interest and fixed dividend coverage: Rs.
Average profit of the Company (before interest and taxation) 5,00,000
Less: Debenture interest (15% on Rs. 8,00,000) 1,20,000
3,80,000
Less: Tax @ 40% 1,52,000
Profit after interest and taxation 2,28,000
Add back: Debenture interest 1,20,000
Profit before interest but after tax 3,48,000

(ii) Calculation of interest and fixed dividend coverage: Rs.


Fixed interest and fixed dividend:
Debenture interest 1,20,000
Preference dividend 50,000
1,70,000

3,48,000
Fixed interest and fixed dividend coverage = = 2.05 times
1,70,000
Interest and fixed dividend coverage 2.05 times is less than the prescribed three times.
(iii) Capital gearing ratio:
Equity share capital + reserves = Rs. 10,00,000 + Rs. 4,00,000
= Rs. 14,00,000
Preference share capital + debentures = Rs. 5,00,000 + Rs. 8,00,000
= Rs. 13,00,000
13,00,000
Capital Gearing Ratio = = 0.93 (approximately)
14,00,000
Ratio 0.93 is more than the prescribed ratio of 0.75.
(iv) Yield on equity shares: Rs.
Average profit after interest and tax 2,28,000
Less: Preference Dividend 50,000
Equity Dividend (10% on Rs. 10,00,000) 1,00,000 1,50,000
Undistributed profit 78,000
Valuation 9.69

50% of distributed profit (50% of Rs. 1,00,000) 50,000


5% of undistributed profit (5% of Rs. 78,000) 3,900
53,900

53,900
Yield on equity shares = × 100 = 5.39%
10,00,000
(v) Expected yield of equity shares:
%
Normal return 12.00
Add: For low coverage of fixed interest and fixed dividends (2.05 < 3) 0.50*
Add: For high capital gearing ratio (0.93 > 0.75) 0.50**
13.00

(vi) Value per equity share:


5.39
= × Rs.100 * * * = Rs. 41.46
13.00
Notes: * When interest and fixed dividend coverage is low, riskiness of equity investors is
high. So they should claim additional risk premium over and above the normal rate of return.
Here, the additional risk premium is assumed to be 0.50%. Students may make any other
reasonable assumption.
** Similarly, higher the ratio of fixed interest and dividend bearing capital to equity share
capital plus reserves, higher is the risk and so higher should be risk premium. Here also the
additional risk premium has been taken as 0.50%. The students may make any other
reasonable assumption.
*** Paid up value of a share has been taken as Rs. 100.
Illustration 5
Following are the information of two companies for the year ended 31st March, 2006 :
Particulars Company A Company B
Equity Shares of Rs. 10 each 8,00,000 10,00,000
10% Pref. Shares of Rs. 10 each 6,00,000 4,00,000
Profit after tax 3,00,000 3,00,000
Assume the Market expectation is 18% and 80% of the Profits are distributed.
(i) What is the rate you would pay to the Equity Shares of each Company ?
9.70 Financial Reporting

(a) If you are buying a small lot.


(b) If you are buying controlling interest shares.
(ii) If you plan to invest only in preference shares which company’s preference shares would
you prefer ?
(iii) Would your rates be different for buying small lot, if the company ‘A’ retains 30% and
company ‘B’ 10% of the profits?
Solution
(i) (a) Buying a small lot of equity shares: If the purpose of valuation is to provide data base
to aid a decision of buying a small (non-controlling) position of the equity of the
companies, dividend capitalisation method is most appropriate. Under this method,
value of equity share is given by:
Dividend per share
× 100
Market capitalisation rate

240
Company A : Rs. × 100 = Rs. 13.33
18

208
Company B : Rs. × 100 = Rs. 11.56
18
(b) Buying controlling interest equity shares
If the purpose of valuation is to provide data base to aid a decision of buying controlling
interest in the company, EPS capitalisation method is most appropriate. Under this
method, value of equity is given by:
Earning per share (EPS)
× 100
Market capitalisation rate
3
Company A : Rs. × 100 = Rs. 16.67
18
2. 6
Company B : Rs. × 100 = Rs. 14.44
18
(ii) Preference Dividend coverage ratios of both companies are to be compared to make
such decision.
Preference dividend coverage ratio is given by:
Profit after tax
Preference Dividend
Rs. 3,00,000
Company A : = 5 times
Rs. 60,000
Valuation 9.71

Rs. 3,00,000
Company B : = 7.5 times
Rs. 40,000

If we are planning to invest only in preference shares, we would prefer shares of B


Company as there is more coverage for preference dividend.
(iii) Yes, the rates will be different for buying a small lot of equity shares, if the company ‘A’
retains 30% and company ‘B’ 10% of profits.
The new rates will be calculated as follows:
2.1
Company A : Rs. × 100 = Rs. 11.67
18
2.34
Company B : Rs. × 100 = Rs. 13.00
18
Working Notes:
1. Computation of earning per share and dividend per share (companies distribute 80% of
profits)
Company A Company B
Profit before tax 3,00,000 3,00,000
Less: Preference dividend 60,000 40,000
Earnings available to equity shareholders (A) 2,40,000 2,60,000
Number of Equity Shares (B) 80,000 1,00,000
Earning per share (A/B) 3.0 2.60
Retained earnings 20% 48,000 52,000
Dividend declared 80% (C) 1,92,000 2,08,000
Dividend per share (C/B) 2.40 2.08
2. Computation of dividend per share (Company A retains 30% and Company B 10% of
profits)
Earnings available for Equity Shareholders 2,40,000 2,60,000
Number of Equity Shares 80,000 1,00,000
Retained Earnings 72,000 26,000
Dividend Distribution 1,68,000 2,34,000
Dividend per share 2.10 2.34
9.72 Financial Reporting

Illustration 6
The Capital Structure of M/s XYZ Ltd., on 31st March, 2006 was as follows:
Rs.
Equity Capital 18,000 Shares of Rs. 100 each 18,00,000
12% Preference Capital 5,000 Shares of Rs. 100 each 5,00,000
12% Secured Debentures 5,00,000
Reserves 5,00,000
Profit earned before Interest and Taxes during the year 7,20,000
Tax Rate 40%
Generally the return on equity shares of this type of Industry is 15%.
Subject to:
(a) The profit after tax covers Fixed Interest and Fixed Dividends at least 4 times.
(b) The Debt Equity ratio is at least 2;
(c) Yield on shares is calculated at 60% of distributed profits and 10% of undistributed
profits;
The Company has been paying regularly an Equity dividend of 15%.
The risk premium for Dividends is generally assumed at 1%.
Find out the value of Equity shares of the Company.
Solution

Calculation of profit after tax (PAT) Rs.


Profit before interest & tax (PBIT) 7,20,000
Less: Debenture interest (Rs. 5,00,000 × 12/100) 60,000
Profit before tax (PBT) 6,60,000
Less: Tax @ 40% 2,64,000
Profit after tax (PAT) 3,96,000
⎛ 12 ⎞
Less: Preference dividend ⎜ Rs. 5,00,000 × ⎟
⎝ 100 ⎠ 60,000
⎛ 15 ⎞
Equity dividend ⎜ Rs. 18,00,000 × ⎟
⎝ 100 ⎠ 2,70,000 3,30,000
Retained earnings (undistributed profit) 66,000
Valuation 9.73

Calculation of Interest and Fixed Dividend Coverage


PAT + Debenture interest
=
Debenture interest + Preference dividend
Rs. 3,96,000 + 60,000
=
Rs. 60,000 + 60,000
Rs. 4,56,000
= = 3.8 times
Rs. 1,20,000
Calculation of Debt Equity Ratio
Debt (long term loans)
Debt Equity Ratio =
Equity (shareholders' funds)
Debentures
=
Preference share capital + Equity share capital + Reserves
Rs. 5,00,000
=
Rs. 5,00,000 + 18,00,000 + 5,00,000
Rs. 5,00,000
Debt Equity Ratio = = .179
Rs. 28,00,000
The ratio is less than the prescribed ratio.

Calculation of Yield on Equity Shares


Yield on equity shares is calculated at 60% of distributed profits and 10% of undistributed
profits:

60% of distributed profits (60% of Rs. 2,70,000) 1,62,000


10% of undistributed profits (10% of Rs. 66,000) 6,600
1,68,600
Yield on shares
Yields on equity shares = × 100
Equity share capital
Rs. 1,68,600
= × 100
Rs. 18,00,000
= 9.37%
9.74 Financial Reporting

Calculation of Expected Yield on Equity Shares


Normal return expected 15%
Add: Risk premium for low interest and fixed dividend 1%*
coverage (3.8 < 4)
Risk for debt equity ratio not required Nil**
16%
Value of an Equity Share
Actual yield
= × Paid up value of a share
Expected yield
9.37
= × 100 = Rs. 58.56
16

* When interest and fixed dividend coverage is lower than the prescribed norm, the
riskiness of equity investors is high. They should claim additional risk premium over and
above the normal rate of return. Hence, the additional risk premium of 1% has been
added.
** The debt equity ratio is lower than the prescribed ratio, that means outside funds (Debts)
are lower as compared to shareholders’ funds. Therefore, the risk is less for equity
shareholders. Therefore, no risk premium.
Self-examination Questions
1. Write short note on capital market information- P/E ratio and Yield ratio and market / book
value of shares.
2. Judge, on the basis of following information, the capitalisation rate for companies A and
B when for the industry as a whole it is 9%.
Company A Company B
Dividend for past five years 40%, 5%, 25%, 10%, 13%, 16%, 17½%.
20% 17½’%. 17½%
Intrinsic value of share Rs. 175 Rs. 300.
Future plans None Expanding capacity by 50%,
partly by using reserves and
partly by using borrowing.
Evaluate the shares of the companies.
3. Ascertain the value of a 6% Participating Preference Share of Rs. 100 with a normal
market yield of 8%. The Preference share holders are entitled to 1/4th of the dividend in
Valuation 9.75

excess of 10% paid on equity shares. In the year the equity shareholders were paid 30%
(this rate was likely to be maintained).
4. Compute values of equity shares of the companies A and B on the basis of dividend and
that of yield on capital employed. The following information is provided:
Company A Company B
Rs. Rs.
Profit per year 1,00,000 1,00,000
7½% Preference Capital 2,00,000 6,00,000
Equity capital (Rs. 200 each) 8,00,000 4,00,000
Assume that all the profits were distributed. Market expectation is 10%.

5. Compute the values of a preference share and an equity share of each of the companies
A and B on the basis of following information:
Company A Company B
Rs. Rs.
Profit after tax 10,00,000 10,00,000
12% Preference share capital (shares of Rs.100 each) 10,00,000 20,00,000
Equity share capital (shares of Rs.10 each) 50,00,000 40,00,000
Assume that market expectation is 15% and that 80% of profits are distributed
9.76 Financial Reporting

UNIT 6
VALUATION OF BUSINESS

6.1 INTRODUCTION
The business is a composite asset. So valuation technique applied for any single asset can
not be applied for valuation of business. A business is comprised of fixed assets, investments
and current assets, loans and advances. A popular misconception is that the gross value of
business is the aggregate of the value of various assets. In fact, value of business is different
from that of the aggregate value of assets. Moreover, it is dependent on the circumstances for
which such valuation is necessary.
In this section we shall discuss the need for the valuation of business and different,
approaches and methods thereto.

6.2 NEED FOR VALUATION OF BUSINESS


The following represent the need for business valuation:
(i) Merger and Take-over: Companies in merger need valuation of business as a going
concern to settle the purchase consideration. In case of take-over also the acquirer
needs the information about total value of the business such that he can determine the
value of the proportion which he intends to buy.
(ii) Sale of Business : For selling the whole business or any division of it, both the seller and
buyer want to know the value of business to fix up the bargaining limit.
(iii) Liquidation: In case of liquidation, the shareholders want to know the value of business
from the liquidator to understand how much they would get by liquidation.

6.3 VALUATION APPROACHES


Two alternative approaches are available for business valuation: (i) going concern and (ii)
liquidation. Under the first approach, it is important to understand what benefit the business is
able to generate in future out of its existing stock of assets although value of existing assets is
not ignored by the accountants. But in liquidation approach, the emphasis is what can be
fetched by selling the assets either on piecemeal basis or taking as a whole.

6.4 VALUATION METHODS


The following methods are used for business valuation taking it as a going concern:
(i) Historical cost valuation
(ii) Current cost valuation
(iii) Economic valuation
Valuation 9.77

(iv) Asset valuation.


For piecemeal sale of the business, only ‘net realisable value’ basis is appropriate.
¨ Historical cost valuation: It is also called book value method. All assets are taken at their
respective historical cost. Value of goodwill is ascertained and added to such historical cost of
assets.
Historical cost value of business = Historical cost of all assets + Value of goodwill.
¨ Current cost valuation: Current cost of assets are taken for this purpose instead of
historical cost. Current cost of various assets can be ascertained as follows:
♦ Tangible fixed Assets: Price to be paid to replace such assets at their present
condition. If replacement price of the same type of tangible assets is not available, then
replacement price of the next best substitute may be taken.
♦ Investments: Quoted investments are valued at current market price. Unquoted
investments are taken at cost unless the available information is sufficient to determine
their current market value.
♦ Stock :Current market value of the stock-in-hand is taken up.
♦ Debtors : At their net collection amount.
♦ Intangibles: Trade marks , Patents, Copyright, etc. are valued at current acquisition price
less the proportionate value already expired.
¨ Economic valuation: Under this method value of the business is given by the sum of
discounted value of future earnings or cash flows.
(i) Capitalisation of Future Maintainable Profit: Value of business as a going concern is
dependent on its future earnings. By earning we may mean ‘earnings before interest but
after tax’.
Future Maintainable Profit
Value of Business =
Capitalisation rate
In case of listed company inverse of the price-earning ratio may be used for determining
capitalisation rate. For example, if P/E ratio is 12, Capitalisation rate becomes 8.33%,
i.e. 100/12
(ii) Present value of future earnings : Under this approach,

Et
Vo = ∑ (1 + k )
t =1
t
Where Vo = Value of business at the present time or zero time, E is
t
the Earnings at time t, k = appropriate discount factor, t = 1, 2, .... ∞
E1 E2 E
Thus Vo = + + ....... n n + .......
(1+ k) (1+ k)
1 2
(1+ k)
9.78 Financial Reporting

(iii) Present value of future cash flows: Frequently in valuation model cash flows from
operations are used instead of earnings. Under this approach value of business is given
by
C1 C2 Cn
+ + ..... + .....
(1 + k ) (1 + k )
1 2
(1 + k ) n
Where Vo = Value of business.
Cl, C2, Cn etc. are cash flows from operations at different point of time.
k = Discount rate.

6.5 BOOK VALUE


NAV (book value)/break up value of business share are computed as below:
When the calculation starts from the liability side:

Paid up value of equity and preference shares ******


Add Reserves(excluding reserves not created out of ******
Revenue profit or not realized in cash)
Less Miscellaneous expenditure not written off ******
,, Accumulated losses ******
,, Arrears of depreciation ******
,, Contingent liabilities ****** ******
Net Asset Value of the business (A) ******

When the calculation starts from the asset side the balance sheet values are considered:

Tangible fixed assets ******


Intangible assets ******
Trade investments ******
Non-trade investments ******
Net current assets ******
Less Secured and unsecured loans
,, Unrealised reserves ******
,, Contingent liabilities ******
Valuation 9.79

,, Arrears of depreciation ****** ******


Net Asset Value of the business (A) ******

NAV of equity is NAV of business less preference share capital.

6.6 FAIR VALUE


NAV on the basis of fair value of assets and liabilities is computed in the same way as
computed on the basis of book value except that the fair values of assets and liabilities are
considered instead of balance sheet values. The implication of fair value also varies with the
objective of valuation, whether the objective is to find the going concern value or the
liquidation value. The methods of computation are shown in the following table:
Going concern basis Liquidation basis
Tangible fixed assets Current cost NRV ******
Intangible assets Cost NRV ******
Trade investments Cost NRV ******
Non-trade investment Market value if quoted, NRV
otherwise book value
Finished goods Market value NRV
WIP Cost NRV
Raw Materials Cost NRV
Debtors NRV NRV
Other assets Cost/book value NRV ******
Fictitious assets NIL NIL
Less Secured and unsecured Actual amount payable Actual amount ******
loans payable
,, Other liabilities Actual amount payable Actual amount ******
(Including current payable
liabilities)
,, Contingent liabilities Actual amount payable Actual amount ****** ******
payable
Net Asset Value of the ******
business (A)
,, Preference share capital Book value Book value ******
(B)
Net Asset Value of ******
equity (A - B)
9.80 Financial Reporting

Here cost means historical cost based value and book value means balance sheet value. NRV
means Net Realisable Value which is market value less further costs to be incurred including
cost of disposal.

6.7 EARNING BASED VALUATION OF BUSINESS


Earning based valuation of business = Earning capacity value per share X number of equity
shares + Preference share capital + Debt capital.
(Book values of preference capital and debt capital should be taken)

6.8 MARKET VALUE MODEL


This is simply the aggregate of the market capitalization and market value of preference
capital and debt capital. Market capitalization means market value of equity multiplied by the
number of outstanding share. The quoted price of the stock exchanges provides the market
value of equity at any moment.
When valuation is done in the field of financial management, present value of future net cash
flows is generally taken as the valuation basis. Based on going concern assumption the cash
flows are assumed to generate for infinite time in future and the value of the firm is calculated
by finding the present value of future cash flows. The discounting rate applied to find the
present value is the weighted average cost of capital to the firm (cost of equity in certain
cases).

6.9 VALUATION OF INVESTMENTS


Part I, Schedule VI to the Companies Act requires classification of investments into:
(a) investments in government or trust securities,
(b) Investments in shares, debentures or bonds,
(c) Investments in immovable properties,
(d) Investments in the capital of partnership firms, and
(e) *balance of unutilised monies raised by issue
Under each category, valuation may be at cost or market value. To arrive at the cost, the
price paid to acquire the assets, brokerage and commission paid and other related expenses
are taken into consideration. Sometimes, ‘bonus’ and ‘right’ are received with respect to a
share or unit. Cost of such shares and units are determined with reference to the investment
in such shares or units as a whole and not isolately. For quoted investments, stock exchange
quotation provides market value information.
* All unutilised monies out of the issue must be separately disclosed in the Balance Sheet of
the company indicating the form in which such unutilised funds have been invested,
Disclosure requirement of Schedule VI: It is necessary to disclose aggregate amount of
Valuation 9.81

company’s quoted investment and value thereof and also the unquoted investments.
A statement of investments is to be annexed to the balance sheet showing:
(i) trade investments and non-trade investments of the company separately;
(ii) names of the bodies corporate (including separately the names of bodies corporate
under the same management) in whose shares and debentures investments have been
made.
All investments are to be included in the statement which have been acquired after the
previous balance sheet date whether these are existing or not at the date of current balance
sheet. However, for an investment company it is sufficient to give details of the existing
shares or debentures at the balance sheet date. In case of investment in the partnership firm it
is necessary to give names of all the partners, their share in the partnership and total capital
of the partnership.
It may be noted that ICAI has issued AS 13 on Accounting for Investment. AS 13 contains
explanation relating to classification of investments, determination of cost of investments,
carrying amount of investments, disposal of investments and disclosure requirements.

6.10 VALUATION OF CURRENT ASSETS, LOANS AND ADVANCES


The conservatism principle is applied in valuation of current assets, loans and advances. By
this principle, lower of the cost or market value is preferred. This means if the realisable value
of these assets is lower than cost, such value is preferred. In other words, all possible losses
are accounted for but no estimated profit is taken until it is realised. So in case of current
assets like sundry debtors, loans and advances, adequate provision is necessary for doubtful
debts. Here cost means current dues from sundry debtors or amount of loans and advances
given.
Inventory is an important component of current assets which needs elaboration. ICAI has
recently issued a revised AS-2 on Valuation of Inventories. This Standard comes into effect in
respect of accounting periods commencing on or after April 1, 2009 and is mandatory in
nature. This revised standard supersedes Accounting Standard on Valuation of Inventories,
issued in June, 1981.
The basic principle of inventory valuation is valuation at lower of the cost and net realisable
value. Students are advised to refer AS 2 (Revised). As per pre-revised Standard, either direct
costing or absorbtion costing technique could be followed.
In direct costing method, cost of inventory includes only appropriate proportion of variable
costs but fixed costs are being charged against revenue in the period to which they relate
while in abosrption costing method, cost of inventories is determined so as to include the
appropriate share of both variable costs and fixed costs. However as per revised AS 2, both
fixed and variable overheads that are incurred in converting materials into finished goods are
to be allocated.
9.82 Financial Reporting

Rational for using historical cost: Inventories are held for deriving revenue directly or
indirectly from their sale or use.
In historical cost accounting system ‘cost’ means acquisition cost. Although the value of
inventories is more than acquisition cost, by following conservative path, no profit is taken until
it is realised.
Techniques of determining historical cost: Several formulae used to arrive at inventory
costs are :
(a) First in first out (FIFO), (b) Average cost, (c) Last in first out (LIFO), (d) Base stock, (e)
Specific identification, (f) Standard cost, (g) Adjusted selling price and (h) Latest
purchase price.
(b) Of these FIFO, LIFO, Base stock and specific identification formulae are based on costs
which have been incurred by the enterprise at one time or another.
(c) However, as per AS 2 (Revised) the cost of inventories should be assigned by using only
first-in-first-out or weighted average cost formula where the specific identification of cost
of inventories is not possible.
Valuation of inventories at net realisable value : If the cost of inventories is higher than net
realisable value, the inventories should be valued at lower than cost. Such circumstances may
occur due to decline in selling price or obsolescence of the inventory items. Moreover, in some
cases inventory piling up may be of high is not possible to be sold within the normal turnover
period. That apart there may be risk of physical deterioration of inventory items.
Sometimes by-product cost cannot be determined separately. In such circumstances by-
products are valued at their net realisable value.
Inclusion of overheads in Inventory Cost: Production overheads are part of the inventory cost.
Since as per AS 2 (Revised) absorption costing method is followed, fixed as well as variable
production overheads become part of inventory cost. Fixed production overheads are
absorbed on the basis of normal capacity of the production facilities.
General administration overheads, selling and distribution overheads, and interest are not
usually treated as expenses related to putting the inventories to their present location and
condition. So these are excluded while computing inventory cost. The abnormal amounts of
wasted materials, labour, or other production costs and storage costs, unless these costs are
necessary in the production process prior to a further production stage, are also excluded.
But overheads other than production overheads should be included as part of the inventory
cost only to the extent they are clearly related to put the inventories to their present location
and condition.
Comparison of cost and net realisable value: Comparison of historical cost and net
realisable value should be made for each item or a group of items separately. Comparison of
aggregate values of dissimilar items may lead to setting off loss against unrealised profit.
Valuation 9.83

Example
Given cost and net realisable value of five groups of inventory items:
Group Cost (Rs.) Net realisable Valuation
Value (Rs.) (Rs.)
A 15,000 5,000 5,000
B 27,000 52,000 27,000
C 54,000 74,000 54,000
D 1,10,000 85,000 85,000
E 68,000 62,000 62,000
2,74,000 2,78,000 2,33,000
If aggregate values are taken, inventories should be valued at Rs. 2,74,000 instead of Rs.
2,33,000 which would overvalue the inventories. Prudence suggests elimination of all sorts of
overvaluation.
Illustration 1
MICO Ltd. gives the following cash flows estimate:
2003 Rs. 20,00 lakhs
2004 to 2006 Compound Growth Rate 6.5%
2007 to 2010 Compound growth rate 9.5%
Apply 20% discount rate and determine the value of business.
Solution
Year Cash Flows Discount Discounted
Rs. in lakhs factor cash flows (Rs.)
2003 20,00.00 0.8333 16,66.60
2004 21,30.00 0.6944 14,79.07
2005 22,68.45 0.5787 13,12.75
2006 24,15.90 0.4823 11,65.19
2007 26,45.41 0.4019 10,63.19
2008 28,96.72 0.3349 9,70.11
2009 31,71.91 0.2791 8,85.28
2010 34,73.24 0.2326 8,07.88
93,50.07
Value of Business Rs. 93,50.07 lakhs based on discounted value of eight years’ cash flows.
The deficiencies of economic valuation are
(i) difficulties involved in estimating future cash flows;
9.84 Financial Reporting

(ii) subjectivity involved in choice of the future period for which cash flows to be estimated;
(iii) subjectivity involved in the selection of discount rate.
Asset valuation method: It may be argued that if a business is acquiring or retaining an
asset, the value of that asset to the business must, in the case of acquisition of the asset, be
greater than the cost of that asset and, in the case of retention of the asset, be greater than
the net realisable value of the asset. If, therefore, all the assets of the business are valued at
their net realisable value, the aggregate will be clearly less than value of the business as a
whole. It gives the lower bound to the range of values based on the asset valuation approach.
The upper bound of the range of assets will be the sum of the current costs of the company’s
assets so long as it is recognised that the assets include intangibles such as goodwill.
Thus under asset valuation approach, one can get lower bound of the business value using
net realisable value of the assets and the upper bound by the current costs of the assets
including goodwill.
Valuation of business for amalgamation with another: The valuation of business which is
to be amalgamated with the another business is a more complex process because it cannot be
made in isolation. From the point of view of the potential purchaser, the maximum price that
he will be prepared to pay is the difference between the value of the combined business and
the value of his existing business.
If the amalgamation gives rise to positive synergy, the value of the amalgamated business will
be greater than the sum of the values of the individual business taken in isolation. The
purchaser will usually not only have to consider the tangible assets, which can be valued with
relative ease, but also the intangible assets which may be particularly influenced by the
synergical effect of the amalgamation.
In many amalgamations, all the assets of the acquired business are not retained in the new
business. So, the first step in valuing business for acquisition will be to determine the asset
structure of the business and to identify the assets which will not be required in the future.
Such assets must be valued at their net realisable value at the time at which they are
expected to be sold and these figures discounted to the present time to ascertain the present
value of the superfluous assets. In many cases, the sale of the superfluous assets will take
place immediately and therefore, no discounting becomes necessary and the value of these
may be considered to be a deduction from the purchase price of the business.
In practice, the valuation figure is the net realisable value of the surplus assets which are to be
sold plus the present value of the additional earnings which will accrue to the acquirer of the
business as a result of the acquisition. It is of course, apparent that a major problem arises in
determining the rate of interest at which the earnings of the business should be discounted as
well as the period for which such earning of estimation should be considered. Also it is
possible to take cash flows instead of earnings as discussed earlier.
Valuation 9.85

Illustration 2
Shyam Garments Ltd. is a company which produces and sells to retailers a certain range of
fashion clothings. They have made the following estimates of potential cash flows for the next
10 years.
Year 1 2 3 4 5 6 7 8 9 10
Cash flows
(Rs. in lacs) 15,00 17,00 20,00 25,00 30,00 34,00 38,00 45,00 50,00 60,00

Kiddies Wear Ltd. is a company which owns a series of boutiques in a certain locality. The
boutiques buy clothes from various suppliers and retail them. Each boutique has a manager
and an assistant but all purchasing and policy decisions are taken centrally. Independent cash
flow estimates of Kiddies Wear Ltd. was as follows:
Year 1 2 3 4 5 6 7 8 9 10
Cash flows
(Rs. in lacs) 1,20 1,60 2,00 2,80 3,40 4,60 5,20 6,00 6,60 8,00

Shyam Garments Ltd. is interested in acquiring Kiddies Wear Ltd. in order to get some
additional retail outlets. They make the following cost-benefit calculations:
(i) Net value of assets of Kiddies Wear Ltd.
Rs in lacs
Sundry Fixed Assets 800
Investments 200
Stock 400
1400
Less: Sundry Creditors 400
Net Assets 1000
(ii) Sundry Fixed Assets amounting to Rs. 50 lacs cannot be used and their net realisable
value is Rs. 45 lacs.
(iii) Stock can be realised immediately at Rs. 470 lacs.
(iv) Investments can be disposed off for Rs. 212 lacs.
(v) Some workers of Kiddies Wear Ltd. are to be retrenched for which estimated
compensation is Rs. 1,30 lacs.
(vi) Sundry creditors are to be discharged immediately.
(vii) Liabilities on account of retirement benefits not accounted for in the Balance Sheet by
Kiddies Wear Ltd. is Rs. 48 lacs.
9.86 Financial Reporting

(viii) Expected cash flows of the combined business will be as follows:

Year 1 2 3 4 5 6 7 8 9 10
Cash flow
(Rs. in lacs)18,00 19,00 23,00 29,50 35,00 40,00 45,00 53,00 58,00 69,00
Find out the maximum value of Kiddies Wear Ltd. which Shyam Garments Ltd. can quote. Also
show the difference in valuation had there been no merger. Use 20% as discount factor.
Solution
(1) Calculation of operational synergy expected to arise out of merger
Year 1 2 3 4 5 6 7 8 9 10
(Rs. in lacs)
Projected cash
flows of Shyam
Garments after
merger with
Kiddies Wear
Limited 18,00 19,00 23,00 29,50 35,00 40,00 45,00 53,00 58,00 69,00
Less: Projected
cash flows of
Shyam Gar-
ments Ltd.
without merger 15,00 17,00 20,00 25,00 30,00 34,00 38,00 45,00 50,00 60,00
3,00 2,00 3,00 4,50 5,00 6,00 7,00 8,00 8,00 9,00
(2) Valuation of Kiddies Wear Ltd. ignoring merger
Year Cash Flows Discount Factor Discounted Cash Flow
(Rs. in lacs) (Rs. in lacs)
1 120 0.8333 99.996
2 160 0.6944 111.104
3 200 0.5787 115.740
4 280 0.4823 135.044
5 340 0.4019 136.646
6 460 0.3349 154.054
7 520 0.2791 145.132
8 600 0.2326 139.560
9 660 0.1938 127.908
10 800 0.1615 129.200
1294.384
Valuation 9.87

(3) Valuation of Kiddies Wear Ltd. in case of merger


Year Cash Flows Discount Factor Discounted
From operations Cash Flow
(Rs. in lacs) (Rs. in lacs)
1 300 0.8333 249.990
2 200 0.6944 138.880
3 300 0.5787 173.610
4 450 0.4823 217.035
5 500 0.4019 200.950
6 600 0.3349 200.94
7 700 0.2791 195.370
8 800 0.2326 186.080
9 800 0.1938 155.040
10 900 0.1615 145.350
1863.245
(4) Maximum value to be quoted
Rs. in. lacs Rs. in lacs
Value as per discounted cash flows
from operations 1863.245
Add: Cash to be collected immediately by disposal of assets:
Sundry Fixed Assets 45.000
Investments 2,12.000
Stock 4,70.000 7,27.000
25,90.245
Less: Sundry Creditors 400.000
Provision for retirement benefits 48.000
Retrenchment compensations 130.000 5,78.000
20,12.245
So, Shyam Garments Ltd. can quote as high as Rs. 20,12,24,500 for taking over the business
of Kiddies Wear Ltd. Here value arrived at in isolation i.e. Rs. 12,94,38,400 is not providing
reasonable value estimate.

6.11 VALUE OF CONTROL OF THE BUSINESS


The main difference between the value of a business compared with a minority holding of
shares is the value of voting control. The value of control is the present value of the change in
cash flows which will be realised from exercising control. The main obvious reason for this
higher valuation is that the controlling interest enables the owner of that interest to arrange the
affairs of the business in a way that best suits his own circumstances. If a company is
efficiently managed at present, the value of control may be very low. If however, it is thought
9.88 Financial Reporting

that the company is inefficiently managed, then, obtaining control may enable operations and
financing to be changed thereby substantially increasing the present value of cash flows
generated by a firm.
Illustration 3
The Balance Sheets of R Ltd. for the years ended on 31.3.2004, 31.3.2005 and 31.3.2006 are
as follows:
31.3.2004 31.3.2005 31.3.2006
Liabilities Rs. Rs. Rs.
3,20,000 Equity Shares of Rs. 10
each fully paid 32,00,000 32,00,000 32,00,000
General Reserve 24,00,000 28,00,000 32,00,000
Profit and Loss Account 2,80,000 3,20,000 4,80,000
Creditors 12,00,000 16,00,000 20,00,000
70,80,000 79,20,000 88,80,000

31.3.2004 31.3.2005 31.3.2006


Assets Rs. Rs. Rs.
Goodwill 20,00,000 16,00,000 12,00,000
Building and Machinery
(Less: Depreciation) 28,00,000 32,00,000 32,00,000
Stock 20,00,000 24,00,000 28,00,000
Debtors 40,000 3,20,000 8,80,000
Bank Balance 2,40,000 4,00,000 8,00,000
70,80,000 79,20,000 88,80,000
Actual valuation were as under:
31.3.2004 31.3.2005 31.3.2006
Rs. Rs. Rs.
Building and Machinery 36,00,000 40,00,000 44,00,000
Stock 24,00,000 28,00,000 32,00,000
Net Profit (including opening balance)
after writing off depreciation and goodwill,
tax provision and transfer to General
Reserve 8,40,000 12,40,000 16,40,000
Capital employed in the business at market values at the beginning of 2003-2004 was Rs.
73,20,000, which included the cost of goodwill. The normal annual return on Average Capital
Valuation 9.89

employed in the line of business engaged by R Ltd. is 12½%.


The balance in the General Reserve account on 1st April, 2004 was Rs. 20 lakhs.
The goodwill shown on 31.3.2004 was purchased on 1.4.2004 for Rs. 20,00,000 on which date
the balance in the Profit and Loss Account was Rs. 2,40,000. Find out the average capital
employed each year.
Goodwill is to be valued at 5 years purchase of super profits (Simple average method). Also
find out the total value of the business as on 31.3.2006.
Solution
Note:
1. Since goodwill has been paid for, it is taken as part of capital employed. Capital
employed at the end of each year is shown below.
2. Assumed that the building and machinery figure as revalued is after considering
depreciation.
31.3.2004 31.3.2005 31.3.2006
Rs. Rs. Rs.
Goodwill 20,00,000 16,00,000 12,00,000
Building and Machinery (revalued) 36,00,000 40,00,000 44,00,000
Stock (revalued) 24,00,000 28,00,000 32,00,000
Debtors 40,000 3,20,000 8,80,000
Bank Balance 2,40,000 4,00,000 8,00,000
Total Assets 82,80,000 91,20,000 1,04,80,000
Less: Creditors 12,00,000 16,00,000 20,00,000
Closing Capital 70,80,000 75,20,000 84,80,000
Opening Capital 73,20,000 70,80,000 75,20,000
1,44,00,000 1,46,00,000 1,60,00,000
Average Capital 72,00,000 73,00,000 80,00,000

Maintainable profit has to be found out after making adjustments as given below:
31.3.2004 31.3.2005 31.3.2006
Rs. Rs. Rs.
Net Profit as given 8,40,000 12,40,000 16,40,000
Less: Opening Balance 2,40,000 2,80,000 3,20,000
9.90 Financial Reporting

6,00,000 9,60,000 13,20,000


Add: Under valuation of closing stock 4,00,000 4,00,000 4,00,000
10,00,000 13,60,000 17,20,000
Less: Adjustment for valuation in opening stock ________ 4,00,000 4,00,000
10,00,000 9,60,000 13,20,000
Add: Goodwill written-off ________ 4,00,000 4,00,000
10,00,000 13,60,000 17,20,000
Add: Transfer to Reserves 4,00,000 4,00,000 4,00,000
14,00,000 17,60,000 21,20,000
Less: 12½% Normal Return 9,00,000 9,12,500 10,00,000
Super Profit 5,00,000 8,47,500 11,20,000

Average super profits = (Rs.5,00,000 + Rs.8,47,500 + Rs.11,20,000) / 3


= 24,67,500 / 3 = Rs 8,22,500
Goodwill = 5 years purchase = Rs. 8,22,500 × 5 = Rs. 41,12,500.

Rs.
Total Net Assets (31/3/2006) 84,80,000
Less: Goodwill 12,00,000
72,80,000
Add: Goodwill 41,12,500
Value of Business 1,13,92,500
Self-examination Questions
1. What valuation base should you adopt while valuing a business as going concern?
Explain briefly the relative advantages and disadvantages of valuation of business
following
(i) Capitalisation of future maintainable profit method (ii) Present value of future earnings
and (iii) Present value of future cash flows method.
2 Why does valuation of business differ if done in isolation as compared to that when done
in combination of another business? What is meant by value of control?
3. A Ltd. gives the following information:
Current profit Rs. 210 lakhs
Compound growth rate of profit 7.5% p.a.
Valuation 9.91

Current Cash Flows from operations Rs. 270 lakhs


Compound growth rate of Cash flows 6.5% p.a.
Current price-earning ratio 12
Discount factor 20%
Find out the value of A Ltd. taking 10 years projected profit or cash flows. You may use
(i) future maintainable profit method, (ii) present value of future earnings method and (iii)
present value of future cash flow method.
4. XX Ltd. plans to take over YY Ltd. Independent Cash Flow forecasts of the companies
are as follows:
Year 1 2 3 4 5
XX Ltd. (Rs. in lakhs) 2,00 2,25 2,50 2,70 2,85
YY Ltd. (Rs. in lakhs) 50 65 80 95 110
Year 6 7 8 9 10
XX Ltd. (Rs. in lakhs) 3,10 3,50 6,00 6,10 6,50
YY Ltd. (Rs. in lakhs) 1,20 1,30 1,50 1,70 1,80
Following further information is available from the latest Balance Sheet of YY Ltd.
Assets: Rs. in lacs Rs. in lacs
Fixed Assets 5,00
Stock 1,15
Debtors 50
6,65
Less: Liabilities:
Sundry Creditors 1,65
Long term Loan 2,00 3,65
Net Assets 3,00

XX Ltd. finds that fixed assets of book value Rs. 75 lakhs will not be used which will fetch
Rs. 50 lakhs on immediate disposal. Moreover, stock will fetch Rs. 140 lakhs and
debtors Rs. 48 lakhs immediately. But XX Ltd. has to pay off the liabilities immediately.
Also it has to pay Rs. 110 lakhs to workers of YY Ltd. whose service cannot be used. It
appears that after merger the XX Ltd. has to invest Rs. 210 lakhs for renovation of the
plant and machinery at the end of lst year and Rs.50 lakhs for modernisation at the end
of 2nd year after merger. Forecast Cash Flows of XX Ltd. after merger:
9.92 Financial Reporting

Year 1 2 3 4 5
Cash Flows (Rs. in lakhs) 2,40 2,80 3,50 4,00 4,10
Year 6 7 8 9 10
Cash Flows (Rs. in lakhs) 4,80 5,50 8,00 8,80 9,50
Determine the maximum value of YY Ltd. which its management should ask from XX Ltd.,
you may use 20% discount rate.
10
DEVELOPMENTS IN FINANCIAL REPORTING

UNIT 1
VALUE ADDED STATEMENT

1.1 HISTORICAL BACKGROUND


The concept of value added is considerably old. It originated in the U.S. Treasury in the 18th
Century and periodically accountants have deliberated upon whether the concept should be
incorporated in financial accounting practice. But actually, the value added statement has
come to be seen with greater frequency in Europe and more particularly in Britain. The
discussion paper ‘Corporate Report’ published in 1975 by the then Accounting Standard
Steering Committee (now known as Accounting Standards Board) of the U.K. advocated the
publication of value added statement along with the conventional annual corporate report. In
1977, the Department of Trade, U.K. published ‘The Future of Company Reports’ which stated
that all substantially large British companies should include a value added (V.A.) statement in
their annual reports. Also, a few companies in the Netherlands include V.A. information in their
annual reports, but the disclosures often fall short of being a full V.A. statement and also the
method of arriving at V.A. is grossly non-standardised. In India, Britannia Industries Limited
and some others prepare value added statement as supplementary financial statement in its
annual report.

1.2 DEFINITIONS
1.2.1 Value Added (VA): VA is the wealth a reporting entity has been able to create through
the collective effort of capital, management and employees. In economic terms, value added is
the market price of the output of an enterprise less the price of the goods and services
acquired by transfer from other firms. VA can provide a useful measure in gauging
performance and activity of the reporting entity.
1.2.2 Gross Value Added (GVA): GVA is arrived at by deducting from sales revenue the cost
of all materials and services which were brought in from outside suppliers. We know that the
retained profit of a company for a given accounting year is derived as below:
R = S – B – Dep – W – I – T – Div ... (1)
10.2 Financial Reporting

Where R = Retained profit, S = Sales revenue, B = Bought in cost of materials and services,
Dep = annual depreciation charge, W = Annual wage cost, I = Interest payable for the year, T
= Annual corporate tax and Div = Total dividend payable for the year. Rearranging the
equation (1) we get GVA as below:
S – B = R + Dep + W + I + T + Div .. (2)
Each side of equation (2) represents GVA. However this is a very simple definition of GVA. In
practice GVA includes many other things.
Besides sales revenue, any direct income, investment income and extraordinary incomes or
expenses are also included in calculation of GVA. Including these items in the above equation
No. 2, we get
(S + Di) – B + Inv + EI = R + Dep + W + T + I + Div. ... (3)
Where Di = Direct incomes, Inv = Investment incomes, EI = Extraordinary items.
The above equation can be shown by way of the following statement.
Gross value added of a manufacturing company
Sales X
Add: Royalties and other direct income X
Less: Materials and Services used X
Value added by trading activities X
Add : Investment Income X
Add/Less: Extraordinary items X X
Gross Value Added X

Applied as follows:
To employees as salaries, wages, etc. X
To government as taxes, duties, etc. X
To financiers as interest on borrowings X
To shareholders as dividends X
To retained earnings including depreciation X
1.2.3 Net Value Added (NVA) : NVA can be defined as GVA less depreciation. Rearranging
the equation (1) we can get NVA as below :
S – B – Dep = R + W + I + T + Div.
Developments in Financial Reporting 10.3

1.3 REPORTING VALUE ADDED


The ‘Corporate Report’ of the U.K. advised the British companies to report Gross Value Added
(GVA). The ‘Report’ did not consider the possibility of the alternative Net Value Added (NVA).
As a result the majority of British companies prefer to set forth their VA statement as a report
on GVA, so that depreciation is an application of VA rather than a cost to be deducted in
calculating VA. In India also GVA is more popular among reporting companies than NVA. The
reasons for reporting GVA are as follows:
(a) GVA can be derived more objectively than NVA. This is because depreciation is more
prone to subjective judgement than are bought-in costs.
(b) GVA format involves reporting depreciation along with retained profit. The resultant sub-
total usefully shows the portion of the year’s VA which has become available for re-
investment.
(c) The practice of reporting GVA would lead to a closer correspondence between VA and
national income figures. This is because economists generally prefer gross measures of
national income to net one.
However, there are also valid reasons for reporting NVA. They are:
(a) Wealth Creation (i.e. VA) will be overstated if no allowance is made for the wearing
out or loss of value of fixed assets which occurs as new assets are created.
(b) NVA is a firmer base for calculating productivity bonus than is GVA. The productivity
of a company may increase because of additional investments in modernisation of
plant and machinery. Consequently, the value added component may improve
significantly. The employees of the company will naturally claim and be given some
share of additional VA as productivity bonus. But if the share is based on GVA then
no recognition is given to the need for an increased depreciation charge.
(c) The concept of matching demands that depreciation be deducted along with bought-
in costs to derive NVA. GVA is inconsistent, for costs would be charged under the
bought-in heading if the item has a life of under one year. But if the item has a
longer life it would be treated as a depreciable fixed asset and its cost would never
appear as a charge while arriving at GVA.
From the above discourse it can be said that it is better to report on NVA rather than on GVA.

1.4 NECESSITY OF PREPARING VA STATEMENTS?


The advantages claimed for the VA statement are considerable. The main thrust of financial
accounting development in the recent decades has been in the area of ‘how’ we measure
income rather than ‘whose’ income we measure. The common belief of the traditional
accountants that net income or profit is the reward of the proprietors (shareholders in the case
of a company) had been considered as a very narrow definition of income. In fact, proponents
of the proprietary theory argued that the proprietor is the centre of interest. The assets were
assumed to be owned by the proprietor and the liabilities were the proprietor’s obligations. The
10.4 Financial Reporting

notion of proprietorship was accepted and practised so long as the nature of business did not
experience revolutionary changes. The proprietary theory did hold good for a sole
proprietorship or a partnership kind of business. But with the emergence of corporate entities
and the legal recognition of the existence of business entity separate from the personal affairs
and other interests of the owners led to the rejection of the proprietary theory and formulation
of other theories like entity theory, enterprise theory and fund theory. The entity theory has its
main application in the corporate form of business enterprise. The entity theory is based on
the basic accounting equation and it suggests that the net income of the reporting entity is
generally expressed in terms of the net change in the stockholders’ equity. It represents the
residual change in equity position after deducting all outsiders’ claims. The enterprise theory is
a broader concept than the entity theory. For entity theory, the reporting entity is considered to
be a separate economic unit operating primarily for the benefit of the equity shareholders,
whereas in the enterprise theory, the reporting entity is a social institution, operating for the
benefit of many interested groups. The most relevant concept of income in this broad social
responsibility concept of the enterprise is the value added concept. Therefore, the origin of
concept of value added lies in the enterprise theory. Proponents of VA argue that there are
advantages in defining income in such a way as to include the rewards of a much wider group
than just the shareholders. The various advantages of the VA statement are as follows:
(a) Reporting on VA improves the attitude of employees towards their employing companies.
This is because the VA statement reflects a broader view of the company’s objectives and
responsibilities.
(b) VA statement makes it easier for the company to introduce a productivity linked bonus
scheme for employees based on VA. The employees may be given productivity bonus on
the basis of VA/Payroll ratio.
(c) VA-based ratios (e.g. VA/Payroll, Taxation/VA, VA/Sales etc.) are useful diagnostic and
predictive tools. Trends in VA ratios, comparisons with other companies and international
comparisons may be useful. In India, the VA statement of Britannia Industries Limited for
the two years 1992-93 and 1993-94 showed that almost 50% of the value addition is
applied in payment of various taxes and duties. The employees and shareholders get
almost and constant share of value added of 35% and 5% respectively. The value added
as a percentage of sales revenue has increased from 23.8% to 25.6% over the two years
period. However, it may be noted that the VA ratios can be made more useful if the ratios
are based on inflation adjusted VA data.
(d) VA provides a very good measure of the size and importance of a company. To use sales
figures or capital employed figures as a basis for company rankings can cause distortion.
This is because sales may be inflated by large bought-in expenses or a capital-intensive
company with a few employees may appear to be more important than a highly skilled
labour intensive company.
(e) VA statement links a company’s financial accounts to national income. A company’s VA
indicates the company’s contribution to national income.
Developments in Financial Reporting 10.5

(f) Finally VA statement is built on the basic conceptual foundations which are currently
accepted in balance sheets and income statements. Concepts such as going concern,
matching, consistency and substance over form are equally applicable to the VA statement.

1.5 VALUE ADDED STATEMENT (VA STATEMENT)


The VA statement shows the value added for a business for a particular period and how it is
arrived at and apportioned to the following stakeholders:
The workforce – for wages, salaries and related expenses;
The financiers – for interest on loans and for dividends on share capital.
The government – for corporation tax.
The business – for retained profits.
A statement of VA represents the profit and loss account in different and possibly more useful
manner.
The conventional VA statement is divided into two parts – the first part shows how VA is
arrived at and the second part shows the application of such VA.

Illustration 1
Given below is the Profit and Loss Account of Creamco Ltd.:
Profit and Loss Account
for the year ended 31st March, 2006
Notes Amount
(Rs. ’000)
Income
Sales 1 28,525
Other Income 756
29,281
Expenditure
Operating cost 2 25,658
Excise duty 1,718
Interest on Bank overdraft 3 93
Interest on 10% Debentures 1,157
28,626
Profit before Depreciation 655
Less: Depreciation 255
Profit before tax 400
10.6 Financial Reporting

Provision for tax 4 275


Profit after tax 125
Less: Transfer to Fixed Asset Replacement Reserve 25
100
Less: Dividend paid and payable 45
Retained profit 55
Notes:
1. This represents the invoice value of goods supplied after deducting discounts, returns and
sales tax.
2. Operating cost includes Rs. (’000) 10,247 as wages, salaries and other benefits to
employees.
3. The bank overdraft is treated as a temporary source of finance.
4. The charge for taxation includes a transfer of Rs. (’000) 45 to the credit of deferred tax
account.
You are required to:
(a) Prepare a value added statement for the year ended 31st March, 2006.
(b) Reconcile total value added with profit before taxation.

Solution
(a)
CREAMCO LTD.
VALUE ADDED STATEMENT
for the year ended March 31, 2006
Rs. (’000) Rs. (’000) %
Sales 28,525
Less: Cost of bought in material and services:
Operating cost 15,411
Excise duty 1,718
Interest on bank overdraft 93 17,222
Value added by manufacturing and trading activities 11,303
Add: Other income 756
Total value added 12,059
Developments in Financial Reporting 10.7

Application of value added:


To pay employees:
Wages, salaries and other benefits 10,247 84.97
To pay government:
Corporation tax 230 1.90
To pay providers of capital:
Interest on 10% Debentures 1,157
Dividends 45 1,202 9.98
To provide for the maintenance and
expansion of the company:
Depreciation 255
Fixed Assets Replacement Reserve 25
Deferred Tax Account 45
Retained profit 55 380 3.15
12,059 100.0
(b) Reconciliation between Total Value Added and Profit Before Taxation
Rs. (’000) Rs. (’000)
Profit before tax 400
Add back:
Depreciation 255
Wages, salaries and other benefits 10,247
Debenture interest 1,157 11,659
Total Value added 12,059
Notes :
(1) Deferred tax could alternatively be shown as a part of ‘To pay government’.
(2) Bank overdraft, being a temporary source of finance, has been considered as the provision
of a banking service rather than of capital. Therefore, interest on bank overdraft has been
shown by way of deduction from sales and as a part of ‘cost of bought in material and
services’.

1.6 LIMITATION OF VA
It is argued that although the VA statement shows the application of VA to several interest
groups (like employees, government, shareholders, etc.), the risk associated with the
company is only borne by the shareholders. In other words, employees, government and
outside financiers are only interested in getting their share on VA but when the company is in
10.8 Financial Reporting

trouble, the entire risk associated therein is borne only by the shareholders. Therefore, the
concept of showing value added as applied to several interested groups is being questioned
by many academics. They advocated that since the shareholders are the ultimate risk takers,
the residual profit remaining after meeting the obligations of outside interest groups should
only be shown as value added accruing to the shareholders. However, academics have also
admitted that from overall point of view value added statement may be shown as
supplementary statement of financial information. But in no case can the VA statement
substitute the traditional income statement (i.e. Profit & Loss Account).
Another contemporary criticism of VA statement is that such statements are non-standardised.
One area of non-standardisation is the inclusion or exclusion of depreciation in the calculation
of value added. Another major area of non-standardisation in current VA practice is taxation.
Some companies report only tax levied on profits under the heading of “VA applied to
governments”. Other companies prefer to report on extensive range of taxes and duties under
the same heading. In the case of Britannia Industries Limited, it has shown taxes and duties
paid under the heading “VA applied to Government”. In the illustration given in para 1.5 excise
duty has been shown as a part of bought-in cost and deducted while calculating value added.
Some academics argued that such excise duty should be shown as an application of VA.
However, this practice of non-standardisation can be effectively eliminated by bringing out an
accounting standard on value added. Therefore, this criticism is a temporary phenomenon.
We have stated in para 1.3, the reasons for preferring NVA to GVA. We prepare the NVA
statement on the basis of the information given in Illustration in para 1.5. It can be mentioned
here that in preparing VA statement on NVA basis excise duty has been shown as an
application of VA.
(a) CREAMCO LTD.
VALUE ADDED STATEMENT
for the year ended March 31, 2006
Rs. (’000) Rs. (’000) %
Sales 28,525
Less: Cost of bought in material and services:
Operating cost 15,411
Interest on bank overdraft 93 15,504
Gross Value Added 13,021
Less: Depreciation 255
Net Value Added 12,766
Add: Other income 756
Available for application 13,522
Applied as follows:
To pay employees:
Developments in Financial Reporting 10.9

Wages, salaries and other benefits 10,247 75.78


To pay government:
Corporation tax & excise duty 1948 14.41
To pay providers of capital:
Interest on 10% Debentures 1,157
Dividends 45 1,202 8.89
To provide for the maintenance
and expansion of the company:
Fixed Assets Replacement Reserve 25
Deferred Tax Account 45
Retained profit 55 125 0.92
13,522 100.00
(b) Reconciliation between Total Value Added and Profit Before Taxation
Rs. (’000) Rs. (’000)
Profit before tax 400
Add back:
Excise duty 1,718
Wages, salaries and other benefits 10,247
Debenture interest 1,157 13,122
Total Value Added 13,522
We can see that VA based ratios have changed significantly particularly with respect to
payments to employees and government (i.e., Payroll/VA and taxation /VA). Taxation/VA ratio
has increased from a meagre 1.9% to a significant 14.41%, whereas payroll/VA ratio has
come down from 84.97% to 75.78%. It suggests that although the employees are enjoying the
major share of VA, government’s share has also increased significantly. As a result the
retained profit of the company has significantly come down.

Illustration 2
Prepare a Gross Value Added Statement from the following Profit and Loss Account of Strong
Ltd. Show also the reconciliation between Gross Value Added and Profit before Taxation:
Profit & Loss Account for the year ended 31st March, 2006
Income Notes Amount
(Rs. in lakhs) (Rs. in lakhs)
Sales 610
Other Income 25
635
10.10 Financial Reporting

Expenditure
Production & Operational Expenses 1 465
Administration Expenses 2 19
Interest and Other Charges 3 27
Depreciation 14 525
Profit before Taxes 110
Provision for Taxes 16
94
Balance as per Last Balance Sheet 7
101
Transferred to:
General Reserve 60
Proposed Dividend 11 71
Surplus Carried to Balance Sheet 30
101
Notes :
1. Production & Operational Expenses (Rs. in lakhs)
Increase in Stock 112
Consumption of Raw Materials 185
Consumption of Stores 22
Salaries, Wages, Bonus & Other Benefits 41
Cess and Local Taxes 11
Other Manufacturing Expenses 94
465
2. Administration expenses include inter-alia audit fees of Rs.4.80 lakhs, salaries &
commission to directors Rs.5 lakhs and provision for doubtful debts Rs.5.20 lakhs.
3. Interest and Other Charges: (Rs. in lakhs)
On Working Capital Loans from Bank 8
On Fixed Loans from IDBI 12
Debentures 7
27
Developments in Financial Reporting 10.11

Solution
Strong Limited
Value Added Statement
for the year ended 31st March, 2006
Rs. in lakhs Rs. in lakhs %
Sales 610
Less: Cost of bought-in material and services:
Production and operational expenses 413
Administration expenses 14
Interest on working capital loans 8
435
Value added by manufacturing and
trading activities 175
Add : Other income 25
Total Value Added 200

Application of Value Added:


To Pay Employees :
Salaries, Wages, Bonus and
Other Benefits 41 20.50
To Pay Directors :
Salaries and Commission 5 2.50
To Pay Government :
Cess and Local Taxes 11
Income Tax 16
27 13.50
To Pay Providers of Capital:
Interest on Debentures 7
Interest on Fixed Loans 12
Dividend 11
30 15.00
To Provide for Maintenance and
Expansion of the Company :
Depreciation 14
10.12 Financial Reporting

General Reserve 60
Retained Profit (30–7) 23
97 48.50
200 100.00
Reconciliation Between Total Value Added And Profit Before Taxation:
Rs. in lakhs Rs. in lakhs
Profit before Tax 110
Add back :
Depreciation 14
Salaries, Wages, Bonus and
other Benefits 41
Directors’ Remuneration 5
Cess and Local Taxes 11
Interest on Debentures 7
Interest on Fixed Loans 12
Total Value Added 90
200

1.7 INTERPRETATION OF VA
While the absolute value of net VA and its proportion to gross output are very important, the
factor components of value addition reveal more information. It is generally found that value
addition is highest for service companies and lowest for a trading business. Consider a
hypothetical situation. There are three companies A, B and C. Each sells the finished product
for Rs. 1,000. Company A buys a lump of metal in the market for Rs. 500, performs four
operations on it – annealing, forging, trimming and polishing - and sells the finished product
for Rs. 1,000. Company B buys the semi-finished product in the market for Rs. 800, performs
certain operations and sells the finished product at the said price of Rs. 1,000. Company C
buys the finished product from another company for Rs. 950 and sells it for Rs. 1,000.
Thus, even though all the three companies have the same turnover, company A has added
highest net value to its product and Company C the least. As a percentage of the gross
output, company A’s value addition is 50%, company B’s 20% and company C’s a meagre 5%.
At this point it appears that company A, having highest value addition, will give highest returns
to shareholders. But if it so happens that out of total value addition of Rs. 500 by company A,
almost 90% goes out for meeting wage bill, the position is entirely different. Therefore,
considering the ratio of net value added to gross output does not yield a complete picture. If
much of a company’s net value added comes from an unproductive labour force, there will be
little left over for future investments or for addition to reserves. Hence, besides considering
Developments in Financial Reporting 10.13

the ratio of net value addition to gross output, one must consider the contribution of various
factor costs to the net value added.

Self-examination Questions
1. What is a Value Added Statement? Why such statement is needed?
2. State the advantage of Net Value Added over Gross Value Added.
3. What information can we gather from value added statements?
4. From the following information in respect of Pretext Ltd. prepare a value added statement
on the basis of :
(i) Gross Value Added
(ii) Net Value Added
Profit and Loss Account
for the year ended 31st March, 2006
(Rs. ’000) Notes Amount
(Rs. ’000)
Sales 8,540
Trading Profit 1 766
Less: Depreciation 121
Interest 56 2 (177)
Add: Rent from let-
out properties 33
Profit before tax 622
Provision for tax 3 275
Profit after tax 347
Less: Extraordinary items 4 7
340
Less: Dividend paid and payable 136
Retained profit 204
10.14 Financial Reporting

Notes:
1. Trading profit is arrived at after charging the following:
(Rs. ’000)
Salaries, wages etc. to employees 1,475
Directors’ remuneration 145
Audit fees 90
Hire of equipment 115
2. Interest figure is ascertained as below:
Interest paid on bank loans and overdrafts 65
Interest received (9)
(56)
3. Provision for tax includes a transfer of Rs. (’000) 57 to the credit of deferred tax account.
4. Extraordinary items:
Surplus on sale and lease back of properties 8
Loss of cash by theft (15)
(7)
Developments in Financial Reporting 10.15

UNIT 2
ECONOMIC VALUE ADDED

2.1 INTRODUCTION
Economic Value Added, EVA for short, is primarily a benchmark to measure earnings
efficiency. Though the term “Economic Profit” was very much there since the inception of
“Economics”, Stern Stewart & Co., of USA has got a registered Trade Mark for this by the
name “EVA”, an acronym for Economic Value Added.
EVA as a residual income measure of financial performance, is simply the operating profit
after tax less a charge for the capital, equity as well as debt, used in the business.
Because EVA includes both profit and loss as well as balance sheet efficiency as well as the
opportunity cost of investor capital – it is better linked to changes in shareholder wealth and is
superior to traditional financial metrics such as PAT or percentage rate of return measures
such as ROCE, or ROE.
In addition, EVA is a management tool to focus managers on the impact of their decisions in
increasing shareholder wealth. These include both strategic decisions such as what
investments to make, which businesses to exit, what financing structure is optimal; as well as
operational decisions involving trade-offs between profit and asset efficiency such as whether
to make in house or outsource, repair or replace a piece of equipment, whether to make short
or long production runs etc.
Most importantly the real key to increasing shareholder wealth is to integrate the EVA
framework in four key areas: to measure business performance; to guide managerial decision
making; to align managerial incentives with shareholders’ interests; and to improve the
financial and business literacy throughout the organisation.
To better align managers interests with Shareholders – the EVA framework needs to be
holistically applied in an integrated approach – simply measuring EVAs is not enough it must
also become the basis of key management decisions as well as be linked to senior
management’s variable compensation.

2.2 COST OF CAPITAL


The term ‘Cost of Capital’ means the cost of long term funds of a company. It is the multiple
of ‘Capital Employed’ and Weighted Average Rate of Cost of Debt Capital, Cost of Equity
Capital and Cost of Preference Share Capital. This is why cost of capital is known as
Weighted Average Cost of Capital (WACC). WACC is post tax. Capital Employed represents
the total of Debt Capital, Equity Capital and Preference Share Capital. The mix of Debt and
Equity Capital has a vital role in the cost of capital. Equity Capital is generally more costlier
than Debt Capital. Use of Debt Capital increases interest payment risk, reduces WACC and
increases Equity Shareholder’s return. Optimum Debt Equity mix should always be aimed at
considering the trade-off in between risk and return.
10.16 Financial Reporting

Cost of Debt Capital


Cost of Debt Capital is the discount rate that equates the present value of after tax interest
payment cash outflows to the current market value of the Debt Capital. Due to the tax-benefit
on interest payment on debt capital, Cost of Debt is, generally, lower than the cost of Equity
Capital, that is why, many companies go for capital gearing through Debt Capital in order to
increase the earnings of their equity shareholders. In case of banking companies
subordinated Debt is considered as debt but not deposits. Because unlike subordinated debt
it is not contractual and repayable on demand. That is, debts raised for funding capital
requirement should only be considered as debt. Debts/Bonds/Time deposits raised by
financial institutions for funding their lending should not be considered as debt capital.

Cost of Equity Capital


Cost of Equity Capital is the market expected rate of return. Equity capital and accumulated
reserves and surpluses which are free to equity share holders carry the same cost. Because
the reserves and surplus are created out of appropriation of profit, that is, by retention of profit
attributable to equity share holders. As it is shareholders money, the expectation of the
shareholders to have value appreciation on this money will be same as in case of equity share
capital. Hence, it bears the same cost as the cost of equity share capital.
Cost of Preference Capital is the discount rate that equates the present value of after tax
interest payment cash outflows to the current market value of the Preference Share Capital.

2.3 CAPITAL ASSET PRICING MODEL


Cost of Debt Capital and cost of Preference Share Capital are easy to calculate as they
depend on actual after tax cash outflows on account of interest payment but calculation of cost
of Equity Capital is little tough as it depends on market expected rate of return. There are
many theories to calculate cost of Equity Capital. Out of all those theories Capital Asset
Pricing Model (CAPM) is the most widely used method of calculating the Cost of Equity
Capital. Under CAPM cost of Equity Capital is expressed as
Risk Free Rate + Specific Risk Premium = Risk Free Rate + Beta X Equity Risk Premium
= Risk Free Rate + Beta X (Market Rate - Risk Free Rate)
The risk free rate represents the most secure return that can be achieved. There is no
consensus among the practitioners regarding risk free rate.
Specific Risk Premium is a multiple of Beta and Equity Risk Premium. Equity Risk Premium is
almost same for all the listed companies in the stock market. Unless the volatility of share
prices and share market indices of two companies are same, their Beta will be different.

2.4 BETA
Beta is a relative measure of volatility that is determined by comparing the return on a share to
the return on the stock market. In simple terms, the greater the volatility, the more risky the
share and the higher the Beta. If a company is affected by the macroeconomic factors in the
Developments in Financial Reporting 10.17

same way as the market is, then the company will have a Beta of one and will be expected to
have returns equal to the market. A company having a Beta of 1.2 implies that it stock market
increases by 10% the company’s share price will increase by 12% (i.e., 10% × 1.2) and if the
stock market decreases by 10% the company’s share price will decrease by 12%. Beta is a
statistical measure of volatility and is calculated as the Covariance of daily return on stock
market indices and the return on daily share prices of a particular company divided by the
Variance of the return on daily Stock Market indices. While considering market index a broad
based index like S & P 500 should be considered.
For the companies, which are not listed in stock exchanges, beta of the similar industry may
be considered after transforming it to un-geared beta and then re-gearing it according to the
debt equity ratio of the company. The formula for un-gearing and gearing beta is shown
below.
Ungeared Beta = Industry Beta / [1 + (1–Tax Rate) (Industry Debt Equity Ratio)]
Geared Beta = Ungeared Beta/[1 = (1 – tax rate) (Debt Equity Ratio)]

2.5 EQUITY RISK PREMIUM


Equity Risk Premium is the excess return above the risk free rate that investors demand for
holding risky securities. It is calculated as “Market rate of Return (MRR) minus Risk Free
Rate”. Market rate may be calculated from the movement of share market indices over a
period of an economic cycle basing on moving average to smooth out abnormalities.
Practitioners do not have a consensus on the methodology of calculation of MRR. Many of
them do not calculate the MRR but on an ad-hoc basis they assume 8% to 12% as the equity
risk premium.

Example :
An hypothetical example of computing cost of capital of a company with a 12.5% Debt Capital
of Rs.2,000 crores (redeemable in 10 years), Equity Capital of Rs. 500 crores, Reserves &
Surplus of Rs. 7,500 crores, and without taking Preference Share Capital is shown below.
Assuming the return on Tax-free Government Bonds at 11%, a Beta of 1.06, market rate at
18% and corporate tax rate at 30%, the cost of capital of the company works out as shown
below:
Capital employed (Rs. 10,000 crores) = Debt Capital (Rs. 2,000 crores) + Equity Capital
(Rs. 500 crores + Rs. 7,500 crores)
Equity to Capital Employed = 8,000 / 10,000 = 0.80
Debt to Capital Employed = 2,000 / 10,000 = 0.20
Weighted Average Cost of Capital (WACC)
(0.80 × 18.42% + 0.20 × 8.75% = 16.49%)
Equity to Capital Employed = 0.80 Debt to Capital Employed = 0.20
10.18 Financial Reporting

Cost of Equity Capital (11% + 7.42% = 18.42%)


Risk Free Specific Risk Premium (1.06 × 7% = 7.42%)Cost of Debt Capital
Rate Beta Equity Risk Premium 18% − 11% = 7%
(11%) 1.06 Market Rate of Return Risk Free Rate (8.75%)*
(18%) (11%)
*Payment of interest (after tax) is Rs. 175 crores (Rs. 250 crores – Rs. 75 crores). So, upto
9th year net cash outflow is Rs. 175 crores per year and on 10th year with repayment of
principal cash outflow stands at Rs. 2175 crores.
In the above hypothetical example total cost of capital comes to Rs. 1649 crores i.e., 16.49%
× Rs. 10,000 crores. Maintenance of shareholders’ value will require the company to earn a
NOPAT over Rs. 1649 crores i.e., over its cost of capital. In other words, to maintain
shareholders’ value the % of NOPAT to capital Employed should be greater or at least be
equal to the % of WACC. For the sake of simplicity, if we presume NOPAT is equal to
Accounting Profit then, to maintain shareholder’s value, Return on Capital employed (ROCE)
has to be more than or equal to WACC. In case of a banking and financial company, return on
Tier I and Tier II capital has to be more than WACC to generate a positive EVA.
Extracts from Annual Report of NIIT Limited :
NIIT Limited – Economic Value Added Statement
Year ending 30th September (Rs. Million)* 1997 1998 1999
Average Capital Employed 2793 3503 3859
Average Debt/Total Capital (%) 40% 35% 13%
Beta Variant 1.14 1.17 1.18
Risk free Rate (%) 12.5% 12.5% 12.5%
Market Risk Premium (%) 10.0% 10.0% 8.0%
Cost of Equity (%) 23.9% 24.2% 21.9%
Cost of Debt (post tax) (%) 12% 10% 10%
Weighted Average Cost of Capital (WACC) (%) 19% 19% 20%
Economic Value Added
Opening Profit 857 1,253 1,618
Less: Economic Taxes 87 74 124
NOPAT 770 1,179 1,494
Less: Capital Charge (Av. Capital Employed × WACC) 531 666 772
Developments in Financial Reporting 10.19

Economic Value Added 239 513 723


* 1 million = 10 lakhs
Notes: *Economic Taxes have been computed after taking the effect of Tax savings on
Interest expense* Operating Profit is before interest but after depreciation * Beta for the
Company is based on the Price movement of the Company’s stock vis-a-vis the BSE sensex
for the last 77 months
Source : ICICI Securities, Corporate Finance Research Note: July 1999
We confirm that NIIT has performed their EVA calculation in accordance with Stern Stewart’s
suggested method.
Signed: ___________________________________
................, Managing Director UK & Ireland, Stern Stewart Europe Limited
Conclusion: EVA companies typically find benefits come from three main areas: better asset
efficiency; improved business and financial literacy at all levels, and more owner-like
behaviour by managers. The EVA approach to management has been endorsed by many
influential investors and independent experts. EVA has already become the primary focus in
many companies around the world across a wide range of industry sectors. In India NIIT, Tata
Consultancy Services and the Godrej Group and number of other companies have formally
adopted the EVA framework.
However, the practitioners differ with one another in regard to the methodology of calculation
of adjustments required for conversion of accounting profit to NOPAT, market rate, beta and
risk free rate.
The technique of computing EVA requires making several adjustments in arriving at the
NOPAT. The developers of the concept have identified 164 potential adjustments to obtain a
‘real’ reflection of a company’s performance.
Omitting even a few may lead to serious errors. A large number of adjustments tend to
complicate the concept and put off the management. Thus, it has been suggested that
companies identify four-five critical adjustments that are simple to implement.
There are also no standard ways or statutory guidelines – such as the FASB or the Accounting
Standards – for making the adjustments. Consequently, different companies can adopt ways
of adjusting the NOPAT. This could impair seriously the comparability of EVA figures of
different companies. Though a useful measure, until proper standards are evolved, EVA will
remain at best an internal measure of shareholder value.

Self -examination Questions


1. What is a Economic Value Added Statement? Why such statement is needed?
2. Explain the concept of ‘Economic value added’ (EVA for short) and its uses.
3. What is economic value added and how is it calculated? Discuss.
10.20 Financial Reporting

4. The following information is available of a concern; calculate E.V.A:


Debt capital 12% Rs. 2,000 crores
Equity capital Rs. 500 crores
Reserve and surplus Rs. 7,500 crores
Capital employed Rs. 10,000 crores
Risk-free rate 9%
Beta factor 1.05
Market rate of return 19%
Equity (market) risk premium 10%
Operating profit after tax Rs.2,100 crores
Tax rate 30%
Developments in Financial Reporting 10.21

UNIT 3
MARKET VALUE ADDED

3.1 INTRODUCTION
Market Value Added (MVA) is the difference between the current market value of a firm and
the capital contributed by investors. If MVA is positive, the firm has added value. If it is
negative the firm has destroyed value.
To find out whether management has created or destroyed value since its inception, the firm's
MVA can be used:
MVA = Market Value of Capital - Capital employed
This calculation shows the difference between the market value of a company and the capital
contributed by investors (both bondholders and shareholders). In other words, it is the sum of
all capital claims held against the company plus the market value of debt and equity.
Calculated as:
The higher the MVA, the better. A high MVA indicates the company has created substantial
wealth for the shareholders. A negative MVA means that the value of the actions and
investments of management is less than the value of the capital contributed to the company by
the capital markets, meaning wealth or value has been destroyed.
The aim of the company should be to maximize MVA. The aim should not be to maximize the
value of the firm, since this can be easily accomplished by investing ever-increasing amounts
of capital.

3.2 RELATIONSHIP BETWEEN EVA AND MARKET VALUE ADDED


• The relationship between EVA and Market Value Added is more complicated than the
one between EVA and Firm Value.
• The market value of a firm reflects not only the Expected EVA of Assets in Place but also
the Expected EVA from Future Projects
• To the extent that the actual economic value added is smaller than the expected EVA the
market value can decrease even though the EVA is higher.
This does not imply that increasing EVA is bad from a corporate finance standpoint. In fact,
given a choice between delivering a "below-expectation" EVA and no EVA at all, the firm
should deliver the "below-expectation" EVA. It does suggest that the correlation between
increasing year-to-year EVA and market value will be weaker for firms with high anticipated
growth (and excess returns) than for firms with low or no anticipated growth. It does suggest
also that "investment strategies"based upon EVA have to be carefully constructed, especially
for firms where there is an expectation built into prices of "high" surplus returns.
10.22 Financial Reporting

3.3 BENEFITS OF MARKET VALUE ADDED


MVA, or Market Value Added, is a measure of the value added by the company's management
over and above the capital invested in the company by its investors.To return from mundane
finance-speak to the exciting prospect of companies like HLL and Infosys being among the
best in the world in terms of market value added (or wealth created) per unit of capital
employed: the Indian infotech sector creates nearly Rs 4 for every Re 1 used; the US infotech
sector does less than Rs 2.5. And the Indian FMCG (Fast Moving Consumer Goods) sector
does around Rs 5 of wealth for every Re 1 capital employed; the US FMCG sector does
approximately Rs 2. That's the good news. The bad news is that 314 of India's top 500
companies did not add market value in 2001; they destroyed it. And many of India Inc's most
valuable companies- like ONGC, IOC, SAIL and TISCO- sit closer to the bottom of the wealth-
creation list. Does that mean much? Actually, yes: the MVA-EVA framework not only provides
a far more accurate report- card on corporate performance than conventional measures, but
also has significant implications for companies on how to make strategic decisions and
manage performance in their pursuit of shareholder value.
The fundamental premise of capitalism is that companies are expected to take financial capital
from shareholders and make it worth more. Unfortunately, in the real world- especially in the
Indian economy- this principle doesn't seem to be hold. "Maximising shareholder value" is a
popular refrain, especially among CEOs. But few companies go about measuring their
'shareholder value added' scientifically. For, managing a business to maximise shareholder-
interests isn't just about being the biggest company around. Or the most efficient one. Doing
so requires a balance between size and efficiency. Lay investors, and even most companies,
tend to focus far too much on size and income- based metrics such as share price (Market
Value or Market Capitalisation), earnings, earnings growth, and earnings per share. Such
metrics do not take into account how much additional capital has been poured into the
business to generate the additional income, so it is relatively easy to improve such measures
simply by investing more. However, to add wealth, managers should focus on increasing the
value added to the shareholders' investment- a perspective provided by MVA.
This isn't mere semantics. While companies such as HLL, Reliance, Wipro, Infosys, and ITC
are on top in both the MV and MVA list, nearly a third of India's most valuable companies
appear at the bottom of the MVA hustings. With the exception of Tata Steel, the nether regions
of the MVA rankings are populated by public sector enterprises. Privatisation, of course, is the
preferred long-term solution. Given the speed at which the process is going, though, India's
public sector could do with a crash course in managing shareholder value. Not only will this
boost their economic performance, it could help them fetch a better valuation.
Together, India Inc. created around Rs 80,500 crore of wealth in 2001 (total market The good
news is that our wealth creators are world class. But the bad news is that the relative to other
economies we continue to have far too much capital tied up in wealth destroyers. This sad tale
is true not only for the overall economy but also for key sectors such as banking and financial
services.The even more depressing news is that over the past five years, wealth destroyers
have grown worse (they destroy 30 paise for each rupee of capital today, up from 14 paise five
years ago) while the creators have improved their performance (from Rs 1.50 to Rs
1.75).Ideally, shareholders would like to see some of the wealth destroyers harvest and return
Developments in Financial Reporting 10.23

capital back to them so that they can re-deploy it to more productive part of the economy. But
in the Indian context, where both shareholder- orientation and corporate governance are still
perceived as esoteric concepts, that hasn't happened. The result? Capital, which can
otherwise productively be used in sectors that create wealth, lies in a state of near- atrophy in
sectors and companies that exist, but just for the sake of being.

The More Appropriate Measure


Accepted, MVA is an ideal measure of wealth creation in the long term. But it suffers from the
short- term vagaries of stockmarket sentiments. If the markets are in the midst of a ball run,
companies find their MVA zooming up to stratospheric proportions; if they do a sudden flip and
enter the bear- mode, companies find their MVA plummeting. That is one reason why
companies should focus on improving their fundamental economic performance as measures
by EVA. Over the long- term, it is improvement in EVA- not accounting results- that drives
wealth creation. For the mathematically inclined, the MVA of a company is the net present
value (NPV) of all its future EVAs. Thus, a company that continues to improve economic value
added, year after year will, sooner than latter, find favour with investors.EVA tells us how
much shareholder wealth the business has created in a given time period (this is usually a
year, but companies can and do use shorter time periods to aid the decision- making process)
and provides a road- map to creating wealth at a business unit level within a company. Simply
defined, EVA is the economic profit that remains after deducting the cost of all the capital
employed (both debt and equity). The power of EVA comes from the fact that it marries both
the income statement and the balance sheet and reflects the economic reality after eliminating
accounting distortions.The role EVA in driving a company's ability to create wealth is evident
in a comparison of Reliance Industries Ltd (RIL) and Indian Oil Corporation (IOC).Indian Oil
Corporation employs around twice as much capital as RIL, has five times the revenues, and is
comparable in terms of market value (RIL ranks second, IOC, fourth). Purely from this
perspective, there seems to be nothing very different between the two companies. However,
RIL, with is MVA of Rs 19,346 crore ranks fourth on the wealth- creators list while IOC, with its
MVA of a negative Rs 8,153 crore, comes in at number 499. The difference in their wealth
creation is driven by their fundamental economic performance. RIL has an EVA of Rs 308
crore while IOC's is a negative 1,500 crore. EVA is superior to conventional measures
because it replicates the discipline of the capital markets within the firm by explicitly
measuring Return on Capital Employed (ROCE) relative to the cost of capital.ROCE is, in turn,
driven by a company's net profit margin and the efficiency of asset use. It is not a surprise to
see that the wealth- creator's ROCE is nearly one- and- a- half times higher than that of wealth
destroyers. However, it is interesting to note that the profit margins earned by both the wealth
creators and the destroyers are pretty much the same and it is the ability to utilise capital
efficiently that differentiates these two groups. That's why investors who choose where to put
their money by simply looking at net profits often go wrong. And that's why wealth destroyers
would greatly benefit from the discipline of making EVA- maximising tradeoffs between
margins and capital efficiency in their various strategic and operational decisions.
10.24 Financial Reporting

3.4 LIMITATIONS OF MARKET VALUE ADDED


1. MVA does not into account the opportunity costs of the invested capital.
2. MVA does not consider the interim cash returns to the shareholders.
3. MVA can not be calculated at divisional or business unit levels.

Self-examination Questions
1. What is a Market Value Added?
2. Explain the concept of ‘Market value added’ (MVA for short) and its uses.
3. What is Market value added and how is it calculated? Discuss.
Developments in Financial Reporting 10.25

UNIT 4
SHAREHOLDERS’ VALUE ADDED

4.1 INTRODUCTION
Shareholders’ Value Added is a value-based performance measure of a company's worth to
shareholders. The basic calculation is net operating profit after tax (NOPAT) minus the cost of
capital from the issuance of debt and equity, based on the company's weighted average cost
of capital (WACC).

4.2 IMPLICATIONS
Shareholder value is a term used in many ways:
• To refer to the market capitalization of a company (rarely used)
• To refer to the concept that the primary goal for a company is to enrich its shareholders
(owners) by paying dividends and/or causing the stock price to increase
• To refer to the more specific concept that planned actions by management and the
returns to shareholders should outperform certain bench-marks such as the cost of
capital concept. In essence, the idea that shareholders money should be used to earn a
higher return then they could earn themselves by investing in risk free bonds for
example.
For a publicly traded company, SV is the part of its capitalization that is equity as opposed to
long-term debt. In the case of only one type of stock, this would roughly be the number of
outstanding shares times current shareprice. Things like dividends augment shareholder value
while issuing of shares (stock options) lower it. This Shareholder value added should be
compared to average/required increase in value, ie. cost of capital.
For a privately held company,the value of the firm after debt must be estimated using one of
several valuation methods, such as. discounted cash flow or others.
This management principle, also known under value based management, states that
management should first and foremost consider the interests of shareholders in its business
decisions. Although this is built into the legal premise of a publicly traded company, this
concept is usually highlighted in opposition to alleged examples of CEO's and other
management actions which enrich themselves at the expense of shareholders. Examples of
this include acquisitions which are dilutive to shareholders, that is, they may cause the
combined company to have twice the profits for example but these might have to be split
amongst three times the shareholders

Self- examination Questions


1. Define the concept of shareholder value added in brief?
2. Differentiate shareholder value added with market value added.
3. Discuss the comparison of economic value added with shareholder value added.
10.26 Financial Reporting

UNIT 5
HUMAN RESOURCE REPORTING

5.1 INTRODUCTION
Human beings are considered central to achievement of productivity, well above equipment,
technology and money. Human Resource Reporting is an attempt to identify, quantify and
report investments made in human resources of an organisation that are not presently
accounted for under conventional accounting practice. The committee on HRA of the
American Accounting Association defined HRA as “the process of identifying and measuring
data about human resources and communicating this information to interested parties”.
However “Human Resources” are not yet recognised as ‘assets’ in the Balance Sheet. The
measures of net income which are provided in the conventional financial statement do not
accurately reflect the level of business performance. Expenses relating to the human
organisation are charged to current revenue instead of being treated as investments to be
amortised over the economic service life, with the result that the magnitude of net income is
significantly distorted.
The necessity of Human resource reporting arose primarily as a result of the growing concern
for human relations management in industry since the sixties of this century. Behavioural
scientists (like R Likert, 1960), concerned with the management of organisations, pointed out
that the failure of accountants to value human resources was a serious handicap for effective
management.
Many people pointed out that it is very difficult to value human resources. Some others have
cautioned that people are sensitive to the value others place on them. A machine never reacts
to an over or under-valuation of its capacity, but an employee will certainly react to such
distortion. Conventionally human resources are treated just as any other services purchased
from outside the business unit. As a result conventional balance sheets fail to reflect the value
of human assets and hence distort the value of the business. The treatment of human
resources as assets is desirable with a view to ensuring comparability and completeness of
financial statements and more efficient allocation of funds as well as providing more useful
information to management for decision-making purposes.

5.2 MODELS OF HRA


Quite a few models have been suggested from time to time for the measurement and valuation
of human assets. Some of these models are briefly discussed below:

(A) Cost Based Models


(1) Capitalisation of historical costs: R. Likert and his associates at R.G. Barry
Corporation in Ohio, Columbia (USA) developed this model in 1967. It was first adopted for
managers in 1968 and then extended to other employees of R.G. Barry Corporation. The
method involves capitalising all costs related with making an employee ready for providing
Developments in Financial Reporting 10.27

service – recruitment training, development etc. The sum of such costs for all the employees
of the enterprise is taken to represent the total value of human resources. The value is
amortised annually over the expected length of service of individual employees. The
unamortised cost is shown as investment in human assets. If an employee leaves the firm
(i.e. human assets expire) before the expected service life period, the net asset value to that
extent is charged to current revenue.
This model is simple and easy to understand and satisfies the basic principle of matching cost
and revenues. But historical costs are sunk costs and are irrelevant for decision- making. This
model was severely criticised because it failed to provide a reasonable value to human assets.
It capitalises only training and development costs incurred on employees and ignores the
future expected cost to be incurred for their maintenance. This model distorts the value of
highly skilled human resources. Skilled employees require less training and therefore,
according to this model, will be valued at a lesser cost. For all these reasons, this model has
now been totally rejected.
(2) Replacement Cost: The Flamholtz Model (1973): Replacement cost indicates the value
of sacrifice that an enterprise has to make to replace its human resource by an identical one.
Flamholtz has referred to two different concepts of replacement cost viz. ‘individual
replacement cost’ and ‘positional replacement cost’. The ‘individual replacement cost’ refers to
the cost that would have to be incurred to replace an individual by a substitute who can
provide the same set of services as that of the individual being replaced. The ‘positional
replacement cost’, on the other hand, refers to the cost of replacing the set of services
required of any incumbent in a defined position. Thus the positional replacement cost takes
into account the position in the organisation currently held by an employee and also future
positions expected to be held by him.
However, determination of replacement cost of an employee is highly subjective and often
impossible. Particularly at the management cadre, finding out an exact replacement is very
difficult. The exit of a top management person may substantially change the human asset
value.

(B) Economic Value Models


(1) Opportunity Cost: The Hekimian and Jones Model (1967): This model uses the
opportunity cost, that is the value of an employee in his alternative use, as a basis for
estimating the value of human resources. The opportunity cost value may be established by
competitive bidding within the firm, so that in effect, managers must bid for any scarce
employee. A human asset, therefore, will have a value only if it is a scarce resource, that is,
when its employment in one division denies it to another division.
One of the serious drawbacks of this method is that it excludes employees of the type which
can be ‘hired’ readily from outside the firm, so that the approach seems to be concerned with
only one section of a firm’s human resources, having special skills within the firm or in the
labour market. Secondly, circumstances in which managers may like to bid for an employee
would be rare, in any case, not very numerous.
10.28 Financial Reporting

(2) Discounted wages and salaries: The Lev and Schwartz Model (1971): This model
involves determining the value of human resources as the present value of estimated future
earnings of employees (in the form of wages, salaries etc.) discounted by the rate of return on
investment (cost of capital). According to Lev and Schwartz, the value of human capital
embodied in a person of age τ is the present value of his remaining future earnings from
employment. Their valuation model for a discrete income stream is given by the following:

T I( t )
Vτ = ∑
t =τ (1 + r ) r − τ
Where,
Vτ = the human capital value of a person τ years old.
I(t) = the person’s annual earnings upto retirement.
r = a discount rate specific to the person.
T = retirement age.
However, the above expression is an ex-post computation of human capital value at any age
of the person, since only after retirement can the series I(t) be known. Lev and Schwartz,
therefore, converted their ex-post valuation model to an ex-ante model by replacing the
observed (historical) values of I(t) with estimates of future annual earnings denoted by I*(t).
Accordingly, the estimated value of human capital of a person years old is given by:

T I * (t )
V τ* = ∑
t =τ (1 + r ) t − τ

Lev and Schwartz again pointed out the limitation of the above formulation in the sense that
the above model ignored the possibility of death occurring prior to retirement age. They
suggested that the death factor can be incorporated into the above model with some
modification and accordingly they recommended the following expression for calculating the
expected value of a person’s human capital:

T
Ii *
∑ P (t + 1)
T
E(Vτ* ) = τ ∑
t =τ
t =τ (1 + r ) t − τ

where P (t) is the probability of a person dying at age ‘t’.


Lev and Schwartz have shown in the form of a hypothetical example the method of computing
the firm’s value of human capital. Employees of the hypothetical firm have been decomposed
by age groups and degress of skill and the average annual earnings for each age and skill
group have been ascertained. Finally the present values of future earnings for each group of
employees have been calculated on the basis of a capitalisation rate. The sum of all such
present value of future earnings was taken as the firm’s value of human capital.
Developments in Financial Reporting 10.29

In this model, wages and salaries are taken as surrogate for the value of human assets and
therefore it provides a measure of ‘future estimated cost’. Although according to economic
theory, the value of an asset to a firm lies in the rate of return to be derived by the firm from its
employment, Lev and Schwartz model surrogated wages and salaries of the employees for the
income to be derived from their employment. They felt that income generated by the workforce
is very difficult to measure because income is the result of group effort of all factors of
production.
However, this model is subject to the following criticisms:
(a) A person’s value to an organisation is determined not only by the characteristics of the
person himself (as suggested by Lev and Schwartz) but also by the organisational role in
which the individual is utilised. An individual’s knowledge and skill is valuable only if these
are expected to serve as a means to given organisational ends.
(b) The model ignores the possibility and probability that the individual may leave an
organisation for reasons other than death or retirement. The model’s expected value of
human capital is actually a measure of the expected ‘conditional value’ of a person’s
human capital – the implicit condition is that the person will remain in an organisation until
death or retirement. This assumption is not practically social.
(c) It ignores the probability that people may make role changes during their careers. For
example, an Assistant Engineer will not remain in the same position throughout his
expected service life in an organisation.
In spite of the above limitations, this model is the most popular measure of human capital both
in India and abroad.
(3) Stochastic process with service rewards: Flamholtz (1971) Model: Flamholtz (1971)
advocated that an individual’s value to an organisation is determined by the services he is
expected to render. An individual moves through a set of mutually exclusive organisational
roles or service states during a time interval. Such movement can be estimated
probabilistically. The expected service to be derived from an individual is given by:

n
E (S) = ∑
i =1
Si P (Si)

Where Si represent the quantity of services expected to be derived in each state and P(Si) is
the probability that they will be obtained.
However, economic valuation requires that the services of the individuals are to be presented
in terms of a monetary equivalent. This monetary representation can be derived in one of the
two ways:
(a) by determining the product of their quantity and price, and
(b) by calculating the income expected to be derived from their use.
10.30 Financial Reporting

The present worth of human capital may be derived by discounting the monetary equivalent of
expected future services at a specified rate (e.g. interest rate).
The major drawback of this model is that it is difficult to estimate the probabilities of likely
service states of each employee. Determining monetary equivalent of service states is also
very difficult and costly affair. Another limitation of this model arises from the narrow view
taken of an organisation. Since the analysis is restricted to individuals, it ignores the added
value element of individuals operating as groups.
(4) Valuation on group basis: Jaggi and Lau Model: Jaggi and Lau realised that proper
valuation of human resources is not possible unless the contributions of individuals as a group
are taken into consideration. A group refers to homogeneous employees whether working in
the same department or division of the organisation or not. An individual’s expected service
tenure in the organisation is difficult to predict but on a group basis it is relatively easy to
estimate the percentage of people in a group likely to leave the organisation in future. This
model attempted to calculate the present value of all existing employees in each rank. Such
present value is measured with the help of the following steps:
(i) Ascertain the number of employees in each rank.
(ii) Estimate the probability that an employee will be in his rank within the organisation or
terminated/promoted in the next period. This probability will be estimated for a specified
time period.
(iii) Ascertain the economic value of an employee in a specified rank during each time period.
(iv) The present value of existing employees in each rank is obtained by multiplying the above
three factors and applying an appropriate discount rate.
Jaggi and Lau tried to simplify the process of measuring the value of human resources by
considering a group of employees as valuation base. But in the process they ignored the
exceptional qualities of certain skilled employees. The performance of a group may be
seriously affected in the event of exit of a single individual.

5.3 IMPLICATIONS OF HUMAN CAPITAL REPORTING


The relevance of the human resource information lies in the fact that it concerns
organisational changes in the firm’s human resources. The ratio of human to non-human
capital indicates the degree of labour intensity of the enterprise. Reported human capital
values provide information about changes in the structure of labour force. Difference between
general and specific values of human capital is another source for management analysis – the
specific value of human capital is based on firm’s wage scale while the general value is based
on industry-wise wage scale. The difference between the two is an indicator of the level of the
firm’s wage scale as compared to the industry.
Developments in Financial Reporting 10.31

5.4 HRA IN INDIA


HRA is a recent phenomena in India. Leading public sector units like OIL, BHEL, NTPC,
MMTC, SAIL etc. have started reporting ‘Human Resources’ in their Annual Reports as
additional information from late seventies or early eighties. The Indian companies basically
adopted the model of human resource valuation advocated by Lev and Schwartz (1971). This
is because the Indian companies focussed their attention on the present value of employee
earnings as a measure of their human capital. However, the Indian companies have suitably
modified the Lev and Schwartz model to suit their individual circumstances. For example
BHEL applied Lev and Schwartz model with the following assumptions:
(i) Present pattern of employee compensation including direct and indirect benefits;
(ii) Normal career growth as per the present policies, with vacancies filled from the levels
immediately below;
(iii) Weightage for changes in efficiency due to age, experience and skills;
(iv) Application of a discount factor of 12% per annum on the future earnings to arrive at the
present value.
However, the application of Lev and Schwartz model by the public sector companies has in
many cases, led to over ambitious and arbitrary value of the human assets without giving any
scope for interpreting along with the financial results of the corporation. In the Indian context,
more particularly in the Public Sector, the payments made to the employees are not directly
linked to productivity. The fluctuations in the value of employees’ contributions to the
organisation are seldom proportional to the changes in the payments to employees. All
qualitative factors like the attitude and morale of the employees are out of the purview of Lev
and Schwartz model of human resource valuation.

Illustration 1
From the following information in respect of Exe Ltd., calculate the total value of human capital
by following Lev and Schwartz model:
Distribution of employees of Exe Ltd.
Age Unskilled Semi-skilled Skilled
No . Av. Annual No. Av. Annual No. Av. annual
earnings earnings earnings
(Rs. ’000 ) (Rs. ’000) (Rs.’000)
30-39 70 3 50 3.5 30 5
40-49 20 4 15 5 15 6
50-54 10 5 10 6 5 7
Apply 15% discount factor.
10.32 Financial Reporting

Solution
The present value of earnings of each category of employees is ascertained as below:
(A) Unskilled employees:
Age group 30-39. Assume that all 70 employees are just 30 years old:
Present value
Rs.
Rs. 3,000 p.a. for next 10 years 15,057
Rs. 4,000 p.a. for years 11 to 20 4,960
Rs. 5,000 p.a. for years 21 to 25 1,025
21,042
Age group 40-49. Assume that all 20 employees are just 40 years old:
Rs. 4,000 p.a. for next 10 years 20,076
Rs. 5,000 p.a. for years 11 to 15 4,140
24,216
Age group 50-54: Assume that all 10 employees are just 50 years old:
Rs. 5,000 p.a. for next 5 years 16,760
Similarly, present value of each employee under other categories will be calculated.
(B) Semi-skilled employees:
Present value
Rs.
Age group 30-39.
3,500 p.a. for next 10 years 17,567
Rs. 5,000 p.a. for years 11 to 20 6,200
Rs. 6,000 p.a. for years 21 to 25 1,230
24,997
Age group 40-49.
Rs. 5,000 p.a. for next 10 years 25,095
Rs. 6,000 p.a. for years 11 to 15 4,968
30,063
Developments in Financial Reporting 10.33

Age group 50-54.


Rs. 6,000 p.a. for next 5 years 20,112
(C) Skilled employees: Present value
Rs.
Age group 30-39.
Rs. 5,000 p.a. for next 10 years 25,095
Rs. 6,000 p.a. for years 11 to 20 7,440
Rs. 7,000 p.a. for years 21 to 25 1,435
33,970
Age group 40-49.
Rs. 6,000 p.a. for next 10 years 30,114
Rs. 7,000 p.a. for years 11 to 15 5,796
35,910
Age group 50-54.
Rs. 7,000 p.a. for next 5 years 23,464

Total value of Human Capital


Age Unskilled Semi-skilled Skilled Total

No. Av. annual No. Av.annual No. Av.annual No. Av.annual


earnings. earnings earnings earnings
(Rs. ‘000) (Rs. ‘000) (Rs. ‘000) (Rs. ‘000)
30-39 70 14,72,940 50 12,49,850 30 10,19,100 150 37,41,890

40-49 20 4,94,320 15 4,50,945 15 5,38,650 50 14,73,915

50-54 10 1,67,600 10 2,01,120 5 1,17,320 25 4,86,040

100 21,24,860 75 19,01,915 50 16,75,070 57,01,845

The central problem in HRA is not what kind of resources should be treated, but rather when
the resources should be recognised. This timing issue is particularly important because human
resources are not owned by the firm, while many physical resources are. However, the firm
also uses many services from physical resources which it does not own. The accounting
treatment for such services should, therefore, be the same as the treatment used for human
10.34 Financial Reporting

resources. Traditional accounting involves treatment of human capital and non-human capital
differently. While non-human capital is represented by the recorded value of assets, the only
reference to be found in financial statement about human resources are entries in the income
statement in respect of wages and salaries, directors’ fees etc. But it should be kept in mind
that measuring and reporting the value of human assets in financial statements would prevent
management from liquidating human resources or overlooking profitable investments in human
resources in a period of profit squeeze. But while valuing human assets one should not lose
sight of the fact that human beings are highly sensitive to external forces and human skills in
an organisation do not remain static. Skill formation, skill obsolescence or utilisation may take
a continuous process. Besides, employee attitude, loyalty, commitment, job satisfaction etc.
may also influence the way in which human resource skills are utilised. Therefore human
resources should be valued in such a way so as to cover the qualitative aspects of human
beings. As human beings are highly susceptible to certain behavioural factors (unlike physical
assets), any human resource valuation model without behavioural features can hardly present
the value of human assets in an objective manner. However while attaching respective
weightage to behavioural factors, care should be taken to avoid excessive subjectiveness.

Self-examination Questions
1. Is Human Resource Accounting essential?
2. Why R. Likert’s model of human resource valuation is now totally rejected?
3. Comment upon the Lev and Schwartz model.
4. From the following information in respect of Pathetic Ltd., Calculate the total value of
human capital by following Lev and Schwartz model:
Distribution of employees:
Unskilled Semi-skilled Skilled
Age No. Average No. Average No. Average
Annual Annual
Annual
earnings earning earnings
(Rs. ’000) (Rs. ’000) (Rs. ’000)
25–34 150 2.5 100 4 56 5
35–44 110 3.5 75 5.5 42 7
45–54 50 5 40 7 25 9
55–58 20 7 15 8.5 10 12
Apply 20% discount factor.
5. Discuss critically two Flamholtz’s model on human resource valuation. Which model is
better?
Developments in Financial Reporting 10.35

UNIT 6
INFLATION ACCOUNTING
6.1 INTRODUCTION
Inflation accounting is an accounting system that adjusts values for changes in purchasing
power. The system of inflation accounting should be such that, with minor modifications, it will
yield the necessary information to moderate proper management. As all of us are already
aware from the fact that Money Measurement Concept is a fundamental accounting
assumption of Accounting. According to this assumption, only those business transactions
which are capable of being expressed in terms of money are recorded by the accounting
system. It is also assumed that monetary unit, recording the business transactions, is stable
in nature. This is, however, not true in practical situations as all the countries-developing as
well as developed have been experiencing/have experienced inflation of a very high
magnitude during different time spans. Inflation brings downward changes in the purchasing
power of the monetary unit and thus makes its stability a myth. It is obvious that financial
statements prepared without any regard to the current purchasing power of the monetary unit
lose much of their significance and can not be properly appreciated by their various users,
such as investors, lenders, Government, Employees and Management, who are interested in
them, in a meaningful manner. They, therefore, lose their utilty. However, their utility can be
restored by making adjustments for the changes in the purchasing power of the monetary unit.
In India, though the post-independence era has seen high rate of inflation, not much
awareness seems to have developed about this problem. The present chapter on inflation
accounting concentrates on accounting for current purchasing power of rupee (i.e., the
monetary unit prevalent in India) and seeks to suggest an acceptable solution to the problem
in the Indian context.

6.2 PARIMARY PURPOSE OF THE FINANCIAL STATEMENTS


The primary purpose of the financial statements of a company* is to provide a true and fair
view:
I. In the case of the Profit and Loss Account, of the profit (or loss) of the company for a given
period and;
II In the case of the Balance Sheet, of the state of affairs of the company as on a given date.
It is common knowledge that transactions leading to the preparation of the financial
statements are recorded at their historical costs which makes the statements almost free from
the personal bias of the accountants and also verifiable with reference to the relevant
documentary evidence.
10.36 Financial Reporting

6.3 LIMITATIONS OF HISTORICAL COST BASED ACCOUNTS


Historical Cost Based Accounting (HCBA), however, suffers from a major limitation. It is well
known that the purchasing power of rupee has been persistently shrinking due to inflationary
trends observed in the economy since late fifties., and more alarmingly since early seventees.
Thus HCBA overstates the profit by undercharging depreciation and materials cost.
Depreciation is undercharged since it is based on the historical cost of fixed assets instead of
their current cost. Similar is the case of materials cost as the stocks purchased at historical
costs are matched against revenues expressed at current prices. Again, HCBA reflects assets
at their historical cost instead of current cost. It results in understatement of the net worth of
an enterprise. HCBA thus fails to serve the primary purpose of the financial statements. It
presents a distorted view of the profitability by overstating it and of intrinsic worth by
understating it.

6.4 NEED FOR INFLATION ACCOUNTING


Inflation Accounting, therefore, becomes necessary to enable the financial statements
maintain their utility. It is an attempt to account for the price-level changes* and adjust the
financial statements accordingly. There are two ways in which the financial statements may
be so adjusted:
I. Historical cost based accounts may be restated in terms of current purchasing power of
rupee. This method may be called “Accounting For Current Purchasing Power of Rupee”
(ACPP).
II. Historical cost based accounts may be restated in terms of current costs adjusting changes
in the prices of specific assets. This method may be called “Current Cost Accounting”
(CCA).
We will discuss these methods in detail.

6.5 CURRENT PURCHASING POWER METHOD


Under this method any established and approved general price index is used to convert the
values of various items in the balance-sheet and the profit and loss account. The main
argument is that a change in the price level reflects change in the value of the rupee. This
change is denoted by a general price index. In India, we may take a general price index like
the Wholesale Price Index of the Reserve Bank of India which would show the changes in the
value of the rupee in the past years. Thus, if we want to add up the values of certain assets
purchased in 1992, to those of some other assets purchased in 2000, we can do so only after
we have converted the rupee values of 2000 in terms of rupees of 1992.
The CPP Method accounts for changes in the value of money. It does not account for
changes in the value of the individual assets. Thus, a particular machine may have become
cheaper over the last few years, whereas the general price level may have risen; the value of
Developments in Financial Reporting 10.37

the machine will also be raised in accordance with the general price index. This is because
we are not trying to work out the current values of the various assets in the possession of the
business. What we are trying to achieve is that the financial statements should be stated in
terms of rupees of uniform value.
The basic aspects of the CPP Method can be explained as follows:
1. Inflation, which is the decline in the purchasing power of money as the general price of
goods and services rises, affects most aspects of economic life, including investment
decisions wage negotiations, pricing policies, international trade and government taxation
policy.
2. It is important that managements and other users of financial accounts should be in a
position to appreciate the effects of inflation on the business entities with which they are
concerned – for example, the effects on costs, profits distribution policies, dividend cover, the
exercise of borrowing powers, returns on funds and future cash needs etc. The purpose of
this statement is the limited one of establishing a standard practice for disclosing the effect of
changes in the purchasing power of money on accounts prepared on the basis of existing
conventions. It does not suggest the abandonment of the historical cost convention, but
simply that historical costs should be converted from an aggregation of historical rupees of
many different purchasing powers into approximate figure of current purchasing power and
that this information should be given in a supplement to the basic accounts prepared on the
historical cost basis.

Monetary and Non-Monetary Items:


In converting the figures in the basic historical cost accounts into those in the supplementary
current purchasing power statement a distinction is drawn between:
(a) monetary items; and
(b) non-monetary items.
Monetary items are those whose amounts are fixed by contract or otherwise in terms of
specified rupees, regardless of changes in general price level. Examples of monetary items
are cash, debtors, creditors and loan capital. Holders of monetary assets lose general
purchasing power during a period of inflation to the extent that any income from the assets
does not adequately compensate for the loss; the reverse applies to those having monetary
liabilities. A company with a material excess on average over the year of long, and short-term
debts (e.g., debentures and creditors) over debtors and cash will show, in its supplementary
current purchasing power statement, a gain in purchasing power during the year.
It has been argued that the gain on long-term borrowing should not be shown as profit in the
supplementary statement because it might not bepossible to distribute it without raising
additional finance. This argument, however, confuses the measurement of profitability, with
10.38 Financial Reporting

the measurement of liquidity. Even in the absence of inflation, the whole of a company’s profit
may not be distributable without raising additional finance for example because it has been
invested in, or earmarked for, investment in non-liquid assets.
Moreover, it is inconsistent to exclude such gain when profit has been debited with the cost of
borrowing (which must be assumed to reflect anticipation of inflation by the lender during the
currency of the loan) and with depreciation on the converted value of fixed assets.
Non-monetary items include such assets as stock, plant and buildings. The retention of the
historical cost concept requires that holders of non-monetary assets are assumed neither to
gain nor to lose purchasing power of the rupee.
The owners of a company’s equity capital have the residual claim on its net monetary and
non-monetary assets. The equity interest is therefore neither a monetary nor a non-monetary
item.

CONVERSION PROCESS
20. In converting from basic historical cost accounts to supplementary current purchasing
power statements for any particular period.
(a) monetary items in the balance sheet at the end of the period remain the same;
(b) non-monetary items are increased in proportion to the inflation that has occurred since their
acquisition or revaluation (and conversely, reduced in times of deflation)
In the conversion process, after increasing non-monetary items by the amount of inflation, it is
necessary to apply the test of lower of cost (expressed in rupees of current purchasing power)
and net realizable value to relevant current assets, e.g., stocks, and further to adjust the
figures if necessary. Similarly, after restating fixed assets in terms of pounds of current
purchasing power, the question of the value of the business needs to be reviewed in that
context and provision made if necessary.
In applying these tests, and during the whole process of conversion, it is important to balance
the effort involved against the materiality of the figures concerned. The supplementary current
purchasing power statement can be no more than an approximation, and it is pointless to
strive for over-elaborate precision.
Example 1. A company bought investments at a cost of Rs.6,00,000 on July 1, 2005 when
the price index stood at 300. On 31st March, 2006 the index had moved to 320 and the market
value of the investments was Rs.6,10,000. On CPP basis, what is the loss or profit on the
investment?
Developments in Financial Reporting 10.39

Solution
Rs.
The “Cost” on CPP basis on 31st March, 2006, Rs.6,00,000 x 320/300 6,40,000
Market Value 6,10,000
Loss 30,000
Example 2 Ess Ltd. made a sale of Rs.67,50,000 during the year ended 31st March, 2006.
The price indices were 250 in the beginning of the year, 270 in the middle of year and 300 at
the end. Using year-end price adjustment basis, what is the sale under the CPP Method?
Answer. Sale for CPP purpose: Rs.67,50,000 x 300/270 or Rs.75,00,000.

6.6 CURRENT COST ACCOUNTING


This system takes into account price changes relevant to the particular firm or industry rather
than the economy as a whole. It seeks to arrive at a profit which can be safely distributed as
dividend without ipairing the operational capability of the firm. In addition to adjustments for
depreciation and cost of sales, it deals with the working capital and also loans raised. The
ambit is operation profit and operating capital employed.
Current cost accounting has the following important features:
(a) Fixed assets are to be shown in the balance sheet at their value to the business and not at
the lower of their original cost and realizable value.
(b) Stocks are to be shown in the balance sheet at their value to the business and not at the
lower of their original cost and realizable value.
(c) Depreciation for the year is to be calculated on the current value of the relevant fixed
assets.
(d) The cost of stock consumed during the year is to be calculated on the value to the business
of the stock at the date of consumption and not at the date of purchase.
(e) The effects of the loss orgain from loans will be computed and set off against interest.
The increased replacement cost of fixed assets and of stocks, the increased requirements for
monetary working capital and the under provision of depreciation in the past years may be
adjusted through a revaluation reserve.
Fixed assets in the balance sheet should be shown at their ‘value of the business’, which is
defined as the amount which the company would lose if it were deprived of the assets. The
value to the business can be defined in one of the following three ways:
(a) Net Replacement Value: This refers to the money now required to buy a new asset of
10.40 Financial Reporting

the same type as the existing one less an amount of depreciation that recognizes the fact
that the true replacement of the asset would not be a new asset but an asset which has
the same remaining useful life as the existing asset. Suppose, a machine whose total life
is 10 years can now be procured for Rs.80,000. Suppose further that the machine is 5
years old. Assuming that the machine has no scrap value, the net replacement cost of
the machine would be Rs.80,000 minus depreciation for 5 years, i.e., Rs.40,000.
(b) Net Realisable Value: This is the value which is represented by the net cash proceeds
which would be received if the existing asset is sold now.
(c) Economic Value: This refers to the present value of the net income that will be earned
from using the existing asset during the rest of its life. Suppose, the net cash inflow (gross
income minus expenditure of the machine in our example) is Rs.8,000 per annum. This
means that in the 5 years of its remaining life it will yield Rs.40,000 in all. Since the sum
(Rs.40,000) will be accruing over the next 5 years and not immediately, it should be
discounted and the present value of the future net cash inflows worked out.
The three values discussed above represent the purchase, sale and the holding value of the
asset. The net replacement cost is usually the best indicator of the value to the business of
an asset.
The value to the business of the self-occupied land and buildings will normally be the open
market value for their existing use plus estimated attributable acquisition costs. The
depreciated replacement cost of the buildings and the open market value of land, including the
estimated acquisition costs for the existing use, should be taken as their value to the
business. Such as valuation should be made by a professionally qualified valuer at intervals
of not more than 5 years.
Plant and machinery should be valued at their net current replacement costs. For this
purpose, the gross current replacement cost of plant and machinery should be worked out.
This is the cost that would have to be incurred to obtain and install at the date of the
valuation, a substantially identical replacement assets in new condition. Since the plant and
machinery is not new, the gross replacement cost arrived at as above should be written down
with reference to the number of years that the existing plant and machinery has already
served. In other words, depreciation should be charged on the gross current replacement cost
on the basis of the expired service potential of the asset in question.
Investments held by the company, not as current assets, should be valued at their value to
business. This implies that the quoted investments should be based on the stock market mid
prices and the unquoted investments should be based on the directors’ valuation of, on the
basis of the current cost, net asset value of the company in which the investments have been
made or on the basis of the present value of the likely future income from the unquoted
investments.
In case investments are held as current assets, their treatment should be the same as that of
Developments in Financial Reporting 10.41

stock and work in progress.


In case of investments in subsidiaries, the cost of the shares should be adjusted to the
movement in reserves or net assets of the subsidiaries after the shares have been acquired.
Stocks and work in progress should be shown in the balance sheet at their value to the
business on the balance sheet date. The value to the business of a company’s stock is lower
of the replacement cost of that stock and its net realizable value. in other words, both the
replacement cost of the stock and the net realizable value of the stock should be worked out.
The lower of these two amounts would be the value which should be put to the stock in the
balance sheet.
Debtors, cash and current liabilities in the current cost balance sheet are shown at their value
to the business which is their net realizable value. It is obvious that these amounts would be
the same in the historical cost balance sheet and the current cost balance sheet.
The depreciation charge in the current cost profit and loss account should be based on the
current value of fixed assets. Thus, the depreciation charge may be based on the average of
the opening current value and the closing current value. Further, as the gross value of the
asset increases in an inflationary period due to it being at its replacement cost, the
accumulated depreciation will not be sufficient. Hence, additional depreciation should be
charged to provide for this backlog. However, this additional depreciation should be set off
against the surplus arising on the revaluation of the assets. Suppose, a machine is purchased
for Rs.10 lakh on 1st April, 2000 Suppose further that on 1st April, 1999, the current value of
the machine is Rs.20 lakh and on 31st March, 2005, the current value of the machine is Rs.22
lakh. The depreciation for the year ended 31st March, 2005 will be charged on Rs.21 lakh. If
the life of the machine is 10 years, the depreciation for the year 2004-2005 would be
Rs.2,10,000. Suppose, the accumulated depreciation is Rs.7 lakh. The total accumulated
depreciation now becomes Rs.9,10,000. This is not enough at the gross replacement cost of
the asset on 31st March, 2005. Depreciation on Rs.22 lakhs for five years at 10%, straightline
basis, would be Rs.11 lakh. Hence, a further depreciation charge of Rs.1.90,000 should be
made. The depreciation of Rs.2,10,000 will be debited to the profit and loss account and the
depreciation of Rs.1,90,000 will be set off against the revaluation surplus.
The figure for sales remains the same in the historical cost account and the current cost
accounts. However, the cost of sales is different in the historical cost accounts and the
current cost accounts. This is because in historical cost accounts each item of stock sold or
consumed is included at FIFO cost. The objective of current cost accounts is to charge
against sales revenue, the value to the business of the costs consumed at the date they are
consumed. The date of consumption of stock is normally the date of sale and to arrive at the
current cost of sale it is necessary to substitute the current replacement cost of stock sold at
the date of sale in place of the historical cost of stock sold. Since it may not be possible to
know the current cost of sale of each individual item of stock, it is suggested that an overall
cost of sales adjustment may be made. This adjustment is based on the approximation
10.42 Financial Reporting

through the averaging method.


It would thus be seen that the current profit and loss account requires two adjustments from
the historical profit and loss account – firstly, additional depreciation and, secondly, cost of
sales adjustment (including working capital adjustment). The total adjustment are again
adjusted for loans taken.

Features
The system concerns operating profits and, naturally, operating capital employed and seeks to
make a clear distinction between profits that emerge according to present day terms through
operations and profits and those that arise only because of increase in prices, i.e., holding
gains. This distinction is of vital importance for judging the efficiency of a firm – the profit and
loss account on historical cost basis mixes up the two profits and hence, makes judgment
about operational efficiency very difficult.
The following are the main features of CCA:
(i) Ascertaining the present day values of fixed assets on the basis of either specific price
indices for various fixed assets (different types of production equipment being treated as
different assets), or if indices are not available, replacement cost or recoverable value
whichever is lower.
(ii) Charging the correct or real depreciation to the profit and loss account. In the HC accounts
(iii) Arriving at the current cost of materials consumed (at the time of consumption) and other
costs incurred that enter into the computation of cost of sales, i.e., making a Cost of Sales
Adjustment (COSA). Taking a very simple example, suppose on 1st April, 2005), a firm had
1,000 tonnes of materials which it had acquired at a cost of Rs.30 per tonne and that in
2005-2006 it consumed 800 tonnes, making no purchases. The price on April 1, 2005 was
Rs.35, the average price during 2005-2006 was Rs.40 and that on March 31, 2006, it was
Rs.45. On historical cost basis, the amount debited to the profit and loss account would be
Rs.24,000, i.e., 800 tonnes @ Rs.30. On CCA basis, the amount charged would be
Rs.32,000, i.e,, @ 40 per tonne. The HC balance sheet on 31st March, 2006 will show the
stock at Rs.6,000, i.e., 200 tonnes @ Rs.30; the CCA balance sheet will record the value
@ Rs.9,000 i.e., Rs.45 per tonne – the increase of Rs.3,000 over the HC basis will be
credited to the Current Cost Accounting Reserve.
(iv) Ascertaining the additional requirement of monetary working capital purely because of
movement in prices and making an adjustment therefore (MWCA, or Monetary Working
Capital Adjustment).

Important Characteristics of Current Cost Accounting


1. Fixed Assets are shown in the balance sheet at their current values and not at their
depreciated original costs.
Developments in Financial Reporting 10.43

2. Stocks are shown in the balance sheet at their value to the business, i.e., at the value
prevailing on the date of the balance sheet. These are not shown at cost or market price
whichever is lower as is done in case of historical accounting.
3. To find out profit for the year, depreciation is calculated on the current values of the
relevant fixed assets.
4. The difference between the current values and the depreciated original costs of fixed
assets is transferred to Revaluation Reserve Account and is written on the liabilities side of
the balance sheet. The revaluation reserve is not available f or distribution as dividend but
is utilised for increased replacement cost of fixed assets and under provision of
depreciation in the past years.
5. The cost of stock consumed during the year is taken at curr4ent value of the stock at the
date of consumption and not the purchase price of the stock consumed.
6. Monetary assets and liabilities a re not adjusted under this method because they a re
always recorded at their value to the business. The values of these items do not change
with changes in price level because we are not going to receive more or pay less on
account of these items.
7. Under current cost accounting approach of inflation accounting, accounting profit is divided
into three parts: (i) current operating profit, (ii) realised holding gain, and (iii) unrealised
holding gain. The above classification is made to show separately the effect of holding
non-monetary assets (i.e., holding activities) during inflation. It will also help to assess
properly the result of operating activities. Now, we may give below the meaning of these
types of profits.
Realised holding Gain. It is the excess of the replacement cost of a non-monetary asset on
the closing date over its historical cost. Such a gain is shown separately in the balance sheet
as revaluation reserve and is not available for distribution as dividend but is utilised for
increased replacement cost of the non-monetary asset.
Current Operating Profit. It is the excess of the sale proceeds of goods and services sold
during a particular accounting period over the replacement cost of the goods or services sold
on the dates the sales were effect.
For calculating current operating profit, following adjustments are to be made in the current
cost accounting method:
(a) Depreciation adjustment
(b) Cost of sales adjustment (COSA)
(c) Monetary working capital adjustment (MWCA)
(d) Gearing adjustment.
10.44 Financial Reporting

(a) Depreciation adjustment: Profit and Loss Account should be debited for depreciation
calculated on the basis of current value of the fixed asset to the business. Depreciation
should not be calculated on the basis of historical cost of the fixed asset; rather it should be
calculated on the replacement cost of the asset (i.e., current value of the asset to the
business). The current depreciation charge under CCA method is obtained by apportioning
the average net replacement cost over the expected remaining useful life of the fixed asset at
the beginning of the period. When fixed assets are revalued every year, there will be a
shortfall of depreciation known as backlog depreciation representing the effect of price rise
during the period. Backlog depreciation can be taken as the additional amount required to
increase the total of the accummulated depreciation at the beginning of any accounting year
and the charge for depreciation for that year to the amount required to equal the difference
between the gross and net replacement cost of an asset at the end of the year.
For example, a concern uses a fixed asset which has a historical gross value of Rs.50,000
and the accumulated depreciation of Rs.20,000 including Rs.5,000 depreciation for the current
year. The gross repalceme3nt cost of the machine is Rs.1,00,000 and it is estimated that its
remaining useful life will not change. In this case, depreciation and backlog depreciation
under CCA method will be calculated as given below:
Historical Cost Current Cost
Accounting Accounting
Rs. Rs.
Value of the asset 50,000 1,00,000
Current depreciation 5,000 10,000
Previous accumulated depreciation 15,000 30,000
Total accumulated depreciation 20,000 40,000
Balance sheet value 30,000 60,000
Backlog depreciation = Gross replacement cost – net replacement cost
- (previous accumulated depreciation+depreciation for the
current year)
= 1,00,000- 60,000 – (15,000 + 10,000)
= 40,000 – 25,000 = Rs.15,000

The amount of backlog depreciation should be charged to current cost reserve or it should be
adjusted against revaluation surplus on the fixed assets.
In the above example, the current cost depreciation is Rs.10,000 against the historic cost
Developments in Financial Reporting 10.45

depreciation of Rs.5,000. Therefore, depreciation adjustment required is Rs.5,000 (i.e.,


Rs.10,000 – Rs.5,000)
(c) Cost of Sales Adjustment (COSA): This adjustment is made for determining current cost
operating profit and represents the difference between value to the business and the historical
cost of stock consumed in the period. It is determined as given below:

⎛C O⎞
COSA = (C – O) - I a ⎜⎜ − ⎟⎟
⎝ Ic Io ⎠
Where
O = Historical cost of opening stock
C = Historical cost of closing stock
Ia = Average index number for the period
Io = Index number appropriate to opening MWC.
Ic = Index number of appropriate to closing MWC.
(d) Gearing Adjustment. Gearing is the ratio of borrowed capital and shareholders’ funds.
Fixed assets and working capital are partly financed by borrowed capital and partly by
shareholders’ funds. But the amount of borrowed capital to be repaid will not change on
account of changing prices because it is fixed by agreement. During inflation the value to the
business of assets exceeds the amount of borrowings that has financed them. Thus,
shareholders enjoy an advantage in the period of rising prices because the benefit of increase
in prices is fully given to shareholders. Reverse effect is experienced when prices decline. As
a result the profit attributable to shareholders would be understated/overstated if the whole of
additional depreciation, cost of sales adjustment and monetary working capital adjustment
were charged in the profit and loss account. The total of these adjustments is abated by
another adjustment known as gearing adjustment. After gearing adjustment, current cost
operating profit will be abated and this abated profit will be attributable to shareholders would
be understated/overstated if the whole of additional depreciation, cost of sales adjustment and
monetary working capital adjustment were charged in the profit and loss account. The total of
these adjustments is abated by another adjustment known as gearing adjustment. After
gearing adjustment, current cost operating profit will be abated and this abated profit will be
attributable to shareholders which will reflect the result of adjustment to the historical cost
trading profit. Gearing adjustment is calculated by applying the following formula:

L
Gearing Adjustment = ×A
L+S

Where L = Average net borrowing


10.46 Financial Reporting

S = Average shareholders’ funds


A = Total of current cost adjustments.
It may be noted that in the calculation of net borrowing, cash or any monetary asset which is
not considered in the calculation of monetary working capital adjustment must be deducted
from the total borrowings.

6.7 EVALUATION OF CCA


The following points of criticism against the CCA can still, however, be made:-
(a) The system ignores, in reality, the question of backlog deprecation; even if from the very
beginning inflation is kept in view, the accumulated depreciation will not be equal to the
funds ultimately required for replacement. Properly, the backlog depreciation should be
charged against revenue reserves available for dividend – only then will management be
restrained from disposing of profits required really for replacement of funds.
(b) Even if the depreciation funds are adequate for replacement, they will be adequate for
replacement for similar assets; they may not suffice for moving into another industry. It is
surely the duty of management to do constant and serious thinking about its business
policies and take stock of its resources, including financial resources, and husband them
properly.

6.8 MISCELLANEOUS ILLUSTRATIONS

Illustration 1
On 31st March, 1996, when the general price index was say 100, Forward Ltd. purchased fixed
assets of Rs. one crore. It had also permanent working capital of Rs.40 lakh. The entire
amount required for purchase and permanent working capital was financed by 10%
redeemable preference share capital. Forward Ltd. wants to maintain its physical capital
On 31st March, 2006, the company had reserves of Rs.1.75 crore. The general price index on
this day was 200. The written down value of fixed assets was Rs.10 lakh and they were sold
for Rs.1.5 crore. The proceeds were utilized for redemption of preference shares.
On the same day (31st March, 2006) the company purchased a new factory for Rs.10 crore.
The ratio of permanent working capital to cost of assets is to be maintained at 0.4:1.
The company raised the additional funds required by issue of equity share.
Based on the above information (a) Quantify the amount of equity capital raised and (b) Show
the Balance Sheet as on 1.4.2006.
Developments in Financial Reporting 10.47

Solution

(Rs. in crores)
(i) Preference share capital on 31st March, 2006:
Fixed assets 1.0
Working capital 0.4
10% Redeemable preference share capital 1.4
=====
To maintain physical capital, the company needs to evaluate the financial capital on 31st
March, 2006 which is required to maintain the existing operating capability of the physical
assets. On the basis of price index data available, it has been worked out as follows:

200
Rs. 1.4 crore × = Rs. 2.8 crore
100
The actual amount has been moré than this minimum capital required to be maintained as can
be seen below:

(ii) Working capital on 31st March, 2006:


before the given transactions or events: (Rs. in crores)
Preference share capital 1.40
Add: Reserves 1.75
3.15
Less: Written down value of fixed assets 0.10
3.05
(iii) Position as on 31st March, 2006
after sale of fixed assets and redemption of preference
shares:
Liabilities: 1.75
Reserves 1.40 3.15
Assets:
Fixed assets 3.15
Working capital (Rs.3.05 + 1.50 – 1.40) crore 3.15
=====
10.48 Financial Reporting

(iv) Amount of equity capital raised:


Amount required for purchase of new factory 10.00
Permanent working capital requirement at 40% 4.00
14.00
Less: Existing working capital 3.15
10.85
======
(b) Balance Sheet as on 1st April, 2006
(Rs. in crores)

Liabilities Rs. Assets Rs.


Equity Share Capital 10.85 Fixed Assets 10.00
Reserves and Surplus 3.15 Working Capital 4.00
14.00 14.00
====== =====
Illustration 2
Zero Limited commenced its business on 1st April, 2006, 2,00,000 equity shares of Rs.10 each
at par and 12.5% debentures of the aggregate value of Rs.2,00,000 were issued and fully
taken up. The proceeds were utilized as under:
Rs.
Fixtures and Equipments 16,00,000
(Estimated life 10 years, no scrap value)
Goods purchased for resale at Rs.200 per unit 6,00,000
The goods were entirely sold by 31st January, 2006 at a profit of 40% on selling price.
Collections from debtors outstanding on 31st March, 2006 amounted to Rs.60,000, goods sold
were replaced at a cost of Rs.7,20,000, the number of units purchased being the same as
before. A payment of Rs.40,000 to a supplier was outstanding as on 31st March, 2006.
The replaced goods remained entirely in stock on 31st March, 2006.
Replacement cost as at 31st March, 2006 was considered to be Rs.280 per unit.
Replacement cost of fixtures and equipments (depreciation on straight line basis) was
Rs.20,00,000 as at 31st March, 2006.
Draft the Profit and Loss Account and the Balance Sheet on replacement cost (entry value)
Developments in Financial Reporting 10.49

basis and on historical cost basis.

Solution
Profit and Loss Account for the year ended 31st March, 2006
Historical Cost Replacement
Basis Cost Basis
Rs. Rs.
Sales 10,00,000 10,00,000
Less: Cost of Sales 6,00,000 7,20,000
Gross Profit 4,00,000 2,80,000
Less: Depreciation 1,60,000 1,80,000
Profit before interest 2,40,000 1,00,000
Less: Debenture Interest 25,000 25,000
Net Profit 2,15,000 75,000
Balance Sheet of Zero Limited as at 31st March, 2006
Historical Cost Replacement Cost
Basis Basis
Rs. Rs.
Liabilities
Equity Share Capital 20,00,000 20,00,000
Profit and Loss Account 2,15,000 75,000
Replacement Reserve ---- 6,20,000
12.5% Debentures 2,00,000 2,00,000
Creditors 40,000 40,000
24,55,000 29,35,000

Rs. Rs.
Assets
Fixtures and Equipment 14,40,000 18,00,000
Stock 7,20,000 8,40,000
Debtors 60,000 60,000
10.50 Financial Reporting

Cash and Bank 2,35,000 2,35,000

Working Notes:
(i) Replacement cost of sales on the basis of replacement cost on the date of sale = Rs. 240 x
3,000 = Rs.7,20,000.

(ii) Under replacement cost basis, depreciation, calculated on the average basis = 10% of

Rs.16,00,000 + Rs.20,000
= Rs.1,80,000
2

(iii) Fixtures and equipments at net current replacement cost.

Rs.
Gross replacement cost 20,00,000
Less: Depreciation, 10% of Rs.20,00,000 2,00,000
18,00,000
(iv) Replacement Reserve = Realised holding gains + Unrealised holding gains

Realised Unrealised
holding gains holding gains
Rs. Rs.
Stocks:
Sold [replacement cost at the date of
sale – historical cost]
Rs.[7,20,000 – 6,00,000) 1,20,000
Unsold [closing stock x (closing rate – rate at the
date of purchase)]
= 3,000 x Rs.280 – 240)] 1,20,000
Fixtures and Equipments:
Depreciation Rs. (1,80,000 – 1,60,000) 20,000
Net book value at year end,
Rs.(18,00,000 – 14,40,000) 3,60,000
1,40,000 4,80,000
Developments in Financial Reporting 10.51

======= ========
Replacement + Reserve = Rs.1,40,000 + Rs.4,80,000 = Rs.6,20,000.

Illustration 3
The following data relate to Bearing Ltd:
On 1.4.2005 On 31.3.2006
(Rs.’000) (Rs.’000)
(a) Net long-term borrowing 25,000 28,000
Creditors 15,000 5,000
Bank overdraft 6,000 10,600
Taxation 2,000 2,000
Cash (9,000) (14,800)
39,000 30,800
====== =====
(b) Share capital and reserves from current cost 74,000 94,000
balance sheet
Proposed dividend 1,160 1,312
75,160 95,312
===== =====
(c) Current cost adjustment depreciation 3,400
Fixed assets disposal 3,600
Cost of sales adjustments 3,240
Monetary working capital adjustment 2,240
12,480
Compute:
(i) Gearing adjustment ratio; and
(ii) Current cost adjustment after abating gearing adjustment.
10.52 Financial Reporting

Solution
On1.4.2005 On 31.3.2006
(Rs. ‘ 000) (Rs.’000)
Average Net Borrowing 39,000 30,800
Total Shareholders Interest (Average 75,160 95,312
Total 1,14,160 1,26,112
======= =======

(39,000 + 30,800)/2 x 100 = 29.05%


Gearing Adjustment Ratio –
(1,14,160 + 1,26,112)/2

Total Current Cost Adjustment 12,480


Less: Gearing (29.05% of 12,480) 3,625
Current Cost Adjustment after abating 8,855
Gearing Adjustment

Illustration 4
A company had the following monetary items on January 1:

Rs.
Debtors 41,000
Bills Receivable 10,000
Cash 20,000
71,000
Less: Bills Payable 10,000
Creditors 25,000 35,000
Net Monetary Assets 36,000
The transactions affecting, monetary items during the year were:
(a) Sales of Rs.1,40,000 made evenly throughout the year.
(b) Purchases of goods of Rs.1,05,000 made evenly during the year.
(c) Operating expenses of Rs.35,000 were incurred evenly throughout the year.
Developments in Financial Reporting 10.53

(d) One machine was sold for Rs.18,000 on July 1.


(e) One machine was purchased for Rs.25,000 on December 31.
The general price index was as follows:

On January 1 300
Average for the year 350
On July 1 360
On December 31 400
You are required to compute the general purchasing power, gain or loss, for the year stated in
terms of the current year end rupee.

Solution

STATEMENT OF GENERAL PURCHASING POWER GAIN OR LOSS


Historical Adjusted Price Level Purchasing
Amount Factor Adjusted Power Gain
Amount or Loss
Rs. Rs. Rs. Rs.
Conversion of Monetary Assets:
Net monetary assets at the 36,000 400/300 48,000
beginning of the year
Increase in net monetary assets
during the year
Sales 1,40,000 400/350 1.60,000
Sale of machine 18,000 400/360 20,000
Total 1,94,000 2,28,000
Purchasing power loss 34,000
(2,28,000-1,94,000)
Decrease in net monetary assets:
Purchases 1,05,000 400/350 1,20,000
Operating expenses 35,000 400/350 40,000
Purchase of machine 25,000 400/400 25,000
Total 1,65,000 1,85,000
Purchasing power gain (1,85,000- 20,000
1,65,000)
Net Purchasing Power Loss 14,000
10.54 Financial Reporting

Net Monetary assets at the end of


the year:
Price level adjusted amount of net
monetary assets
(2,28,000- 1,85,000) 43,000
Less: Purchasing power
Loss 14,000
Net Monetary assets at the
End of the year
(1,94,000 – 1,65,000) 29,000
Illustration 5
Ascertain net monetary result as at 31st December, 2006 from the data given below:
1st Jan. 2006 31st Dec. 2006
Rs. Rs.
Cash at Bank 15,000 21,000
Accounts Receivable 45,000 54,000
Accounts Payable 75,000 50,000
General Price Index Number:
1st January, 2006 100
31st December, 2006 125
2006 Average 120

Solution
STATEMENT SHOWING NET MONETARY RESULT
Historical Adjusted Price Level Adjusted Purchasing
Amount Factor .Amount Power
Gain or
Loss
Rs. Rs. Rs. Rs.

Monetary assets at the


beginning of 2006:

Cash at Bank 15,000 125/100 18,750


Developments in Financial Reporting 10.55

⎛ 125 ⎞
⎜15,000 × ⎟
⎝ 100 ⎠

Accounts Receivable 45,000 125/100 56,250

⎛ 125 ⎞
⎜ 45,000 × ⎟
⎝ 100 ⎠

Add: Increase in
monetary assets during
the year

Cash at Bank 6,000 125/120 6,250

(21,000- ⎛ 125 ⎞
15,000) ⎜ 6,000 × ⎟
⎝ 120 ⎠

Accounts Receivable 9,000 125/120 9,375

(54,000 – ⎛ 125 ⎞
45,000) ⎜ 9,000 × ⎟
⎝ 120 ⎠

Total 75,000 90,625

Purchasing Power Loss

(90,625 – 75,000) 15,625

Monetary liabilities a t the


beginning of 2006:

Accounts Payable 75,000 125/100 93,750

⎛ 125 ⎞
⎜ 75,000 × ⎟
⎝ 100 ⎠

Less: Decrease in 25,000 125/120 26,042


Accounts Payable
⎛ 125 ⎞
⎜ 25,000 × ⎟
⎝ 120 ⎠
10.56 Financial Reporting

50,000 67,708

Purchasing Power Gain

(67,708 – 50,000) 17,708

Net Purchasing Power 2,083


Gain

Illustration. 6
From the information given below, ascertain the cost of sales and closing inventory under
Current Purchasing Power Method if the organisation follows (i) first-in First-out (i.e., FIFO)
system, and (ii) Last-in-First-out (i.e., LIFO) system.

Historical Cost General Price Index


Rs.
Inventory on 31-12-2005 40,000 200
Purchases during 2006 3,10,000 220 (Average for 1996)
Inventory on 31.12.2006 50,000 230

Solution
Cost of Sales is: Rs.
Opening inventory 40,000
Add: Purchases 3,10,000
3,50,000
Less: Closing inventory 50,000
Cost of sales 3,00,000
Self-examination Questions
1. What is meant by inflation accounting?
2. What are the limitations of historical accounting in a period of inflation?
3. Explain Current Cost Accounting.
Developments in Financial Reporting 10.57

4. The fixed assets of a company were stated as follows in the balance sheet:

31.3.2005 31.3.2006
Rs. Rs.
Land at cost 5,00,000 5,00,000
Building at cost 20,00,000 20,00,000
Plant and Machinery 1,00,00,000 1,25,00,000
1,25,00,000 1,50,00,000
The depreciation provision was:
Buildings 2,50,000 3,00,000
Plant and Machinery 50,00,000 62,50,000
The depreciation was provided on straight line basis @ 2½% p.a. on building and 10% p.a.
on plant and machinery ignoring scrap value.
The following price indices can be confidently applied to the assets of the company to
arrive at present day prices, the base year being 2005-2006.

31.3.2005 31.3.2006
Land 200 250
Buildings 150 180
Plant and Machinery 200 225
Show the adjustments to be made under the CCA resulting from the information given
above.
5. The balance sheet of Wye Ltd revealed the following among other things:

31.3.2005 31.3.2006
Rs. Rs.
Inventories 5,50,000 6,10,000
Book debts 4,50,000 5,50,000
Cash at Bank 60,000 80,000
Advances for supply of materials 1,00,000 1,26,500
Due to suppliers 2,50,000 3,22,000
During 2005-2006 material prices rose by 15% and those of finished goods by 10%.
Calculate the Monetary Working Capital Adjustment to be made under the Current Cost
Accounting system.
APPENDIX I

AS 1 : DISCLOSURE OF ACCOUNTING POLICIES∗

The following is the text of the Accounting Standard 1(AS-1) issued by the Accounting Standards
Board, the Institute of Chartered Accountants of India on “Disclosure of Accounting Policies”. The
Standard deals with the disclosure of significant accounting policies followed in preparing and
presenting financial statements.
In the initial years, this accounting standard will be recommendatory in character. During this
period, this standard is recommended for use by companies listed on a recognised stock
exchange and other large commercial, industrial and business enterprises in the public and
private sectors.

INTRODUCTION
1. This statement deals with the disclosure of significant accounting policies followed in
preparing 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 accounting policies followed in the preparation and
presentation of the financial statements is required by law in some cases.
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. In recent years, 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,


Issued in November, 1979
I.2 Financial Reporting

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 form 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.

Explanation

Fundamental Accounting Assumptions


9. Certain fundamental accounting assumptions underlie the preparation and presentation
of financial statements. They are usually not specifically stated because their acceptance and
use are assumed. Disclosure is necessary if they are not followed.
10. The following have been generally accepted as fundamental accounting
assumptions :
(a) Going Concern
The enterprise is normally viewed as a going concern, that is as continuing in operation for the
foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity
of liquidation or of curtailing materially the scale of the operations.
(b) Consistency
It is assumed that accounting policies are consistent from one period to another.
(c) Accrual
Revenues and costs are accrued, that is recognised as they are earned or incurred (and not
as money is received or paid) and recorded in the financial statements of the periods to which
they relate (The considerations affecting the process of matching costs with revenues under
the accrual assumption are not dealt with in this statement).

Nature of Accounting Policies


11. 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.
Appendix I : Accounting Standards I.3

12. 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 principles in the specific circumstances of each enterprise calls for
considerable judgment by the management of the enterprise.
13. 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


14. 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
♦ Treatment of contingent liabilities
15. The above list of examples is not intended to be exhaustive.

Considerations in the Selection of Accounting Policies


16. 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 represent a true and fair view of the state of affairs of the enterprise as at the Balance
Sheet date and of the profit or loss for the period ended on that date.
17. For this purpose, the major considerations governing the selection and application of
I.4 Financial Reporting

accounting policies are :—


(a) Prudence
In view of the uncertainty attached to future events, profits are not anticipated but recognised
only when realised though not necessarily in cash. Provision is made for all known liabilities
and losses even though the amount cannot be determined with certainty and represents only a
best estimate in the light of available information.
(b) Substance over Form
The accounting treatment and presentation in financial statements of transactions and events
should be governed by their substance and not merely by the legal form.
(c) Materiality
Financial statements should disclose all “material” items, i.e., items the knowledge of which
might influence the decisions of the user of financial statements.

Disclosure of Accounting Policies


18. To ensure proper understanding of financial statements, it is necessary that all significant
accounting policies adopted in the preparation and presentation of financial statements should
be disclosed.
19. Such disclosure should form part of the financial statements.
20. 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.
21. 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.
22. Any change in an accounting policy 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.
23. Disclosure of accounting policies or of changes therein cannot remedy a wrong or
inappropriate treatment of the item in the accounts.

Accounting Standard
(The Accounting Standard comprises paragraphs 24-27 of this Statement. The Standard
should be read in the context of paragraphs 1-23 of this Statement and of the Preface to the
Appendix I : Accounting Standards I.5

Statements of Accounting Standards.)


24. All significant accounting policies adopted in the preparation and presentation of
financial statements should be disclosed.
25. 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.
26. 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.
27. 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.

AS 2 (REVISED) : VALUATION OF INVENTORIES

The following is the text of the revised Accounting Standard (AS) 2, ‘Valuation of Inventories’,
issued by the Council of the Institute of Chartered Accountants of India. This revised Standard
supersedes Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued in June, 1981. The
revised standard comes into effect in respect of accounting periods commencing on or after
1.4.1999 and is mandatory in nature.

Objective
A primary issue in accounting for inventories is the determination of the value at which
inventories are carried in the financial statements until the related revenues are recognised.
This Statement deals with the determination of such value, including the ascertainment of cost
of inventories and any write-down thereof to net realisable value.

Scope
1. This Statement should be applied in accounting for inventories other than:
(a) work in progress arising under construction contracts, including directly related
I.6 Financial Reporting

service contracts (see Accounting Standard (AS) 7, Accounting for Construction 1


Contracts);
(b) work in progress arising in the ordinary course of business of service providers;
(c) shares, debentures and other financial instruments held as stock-in-trade; and
(d) producers’ inventories of livestock, agricultural and forest products, and mineral
oils, ores and gases to the extent that they are measured at net realisable value in
accordance with well established practices in those industries.
2. The inventories referred to in paragraph 1 (d) are measured at net realisable value at
certain stages of production. This occurs, for example, when agricultural crops have been
harvested or mineral oils, ores and gases have been extracted and sale is assured under a
forward contract or a government guarantee, or when a homogenous market exists and there
is a negligible risk of failure to sell. These inventories are excluded from the scope of this
Statement.

Definitions
3. The following terms are used in this Statement with the meanings specified:
Inventories are assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or
in the rendering of services.
Net realisable value is the estimated selling price in the ordinary course of business
less the estimated costs of completion and the estimated costs necessary to make the
sale.
4. Inventories encompass goods purchased and held for resale, for example, merchandise
purchased by a retailer and held for resale, computer software held for resale, or land and
other property held for resale. Inventories also encompass finished goods produced, or work
in progress being produced, by the enterprise and include materials, maintenance supplies,
consumables and loose tools awaiting use in the production process. Inventories do not
include machinery spares which can be used only in connection with an item of fixed asset
and whose use is expected to be irregular; such machinery spares are accounted for in
accordance with Accounting Standard (AS) 10, Accounting for Fixed Assets.2

1
This standard has been revised and titled as ‘Construction Contracts.’
2
Refer to Accounting Standards interpretation (ASI)2.
Appendix I : Accounting Standards I.7

Measurement of Inventories
5. Inventories should be valued at the lower of cost and net realisable value.

Cost of Inventories
6. The cost of inventories should comprise all costs of purchase, costs of conversion
and other costs incurred in bringing the inventories to their present location and
condition.

Costs of Purchase
7. The costs of purchase consist of the purchase price including duties and taxes (other
than those subsequently recoverable by the enterprise from the taxing authorities), freight
inwards and other expenditure directly attributable to the acquisition. Trade discounts,
rebates, duty drawbacks and other similar items are deducted in determining the costs of
purchase.

Costs of Conversion
8. The costs of conversion of inventories include costs directly related to the units of
production, such as direct labour. They also include a systematic allocation of fixed and
variable production overheads that are incurred in converting materials into finished goods.
Fixed production overheads are those indirect costs of production that remain relatively
constant regardless of the volume of production, such as depreciation and maintenance of
factory buildings and the cost of factory management and administration. Variable production
overheads are those indirect costs of production that vary directly, or nearly directly, with the
volume of production, such as indirect materials and indirect labour.
9. The allocation of fixed production overheads for the purpose of their inclusion in the
costs of conversion is based on the normal capacity of the production facilities. Normal
capacity is the production expected to be achieved on an average over a number of periods or
seasons under normal circumstances, taking into account the loss of capacity resulting from
planned maintenance. The actual level of production may be used if it approximates normal
capacity. The amount of fixed production overheads allocated to each unit of production is not
increased as a consequence of low production or idle plant. Unallocated overheads are
recognised as an expense in the period in which they are incurred. In periods of abnormally
high production, the amount of fixed production overheads allocated to each unit of production
is decreased so that inventories are not measured above cost. Variable production overheads
are assigned to each unit of production on the basis of the actual use of the production
facilities.
10. A production process may result in more than one product being produced
simultaneously. This is the case, for example, when joint products are produced or when there
is a main product and a by-product. When the costs of conversion of each product are not
I.8 Financial Reporting

separately identifiable, they are allocated between the products on a rational and consistent
basis. The allocation may be based, for example, on the relative sales value of each product
either at the stage in the production process when the products become separately
identifiable, or at the completion of production. Most by-products as well as scrap or waste
materials, by their nature, are immaterial. When this is the case, they are often measured at
net realisable value and this value is deducted from the cost of the main product. As a result,
the carrying amount of the main product is not materially different from its cost.

Other Costs
11. Other costs are included in the cost of inventories only to the extent that they are
incurred in bringing the inventories to their present location and condition. For example, it may
be appropriate to include overheads other than production overheads or the costs of designing
products for specific customers in the cost of inventories.
12. Interest and other borrowing costs are usually considered as not relating to bringing the
inventories to their present location and condition and are, therefore, usually not included in
the cost of inventories.

Exclusions from the Cost of Inventories


13. In determining the cost of inventories in accordance with paragraph 6, it is appropriate to
exclude certain costs and recognise them as expenses in the period in which they are
incurred. Examples of such costs are:
(a) abnormal amounts of wasted materials, labour, or other production costs;
(b) storage costs, unless those costs are necessary in the production process prior to a
further production stage;
(c) administrative overheads that do not contribute to bringing the inventories to their
present location and condition; and
(d) selling and distribution costs.

Cost Formulas
14. The cost of inventories of items that are not ordinarily interchangeable and goods
or services produced and segregated for specific projects should be assigned by
specific identification of their individual costs.
15. Specific identification of cost means that specific costs are attributed to identified items of
inventory. This is an appropriate treatment for items that are segregated for a specific project,
regardless of whether they have been purchased or produced. However, when there are large
numbers of items of inventory which are ordinarily interchangeable, specific identification of
costs is inappropriate since, in such circumstances, an enterprise could obtain predetermined
Appendix I : Accounting Standards I.9

effects on the net profit or loss for the period by selecting a particular method of ascertaining
the items that remain in inventories.
16. The cost of inventories, other than those dealt with in paragraph 14, should be
assigned by using the first-in, first-out (FIFO), or weighted average cost formula. The
formula used should reflect the fairest possible approximation to the cost incurred in
bringing the items of inventory to their present location and condition.
17. A variety of cost formulas is used to determine the cost of inventories other than those
for which specific identification of individual costs is appropriate. The formula used in
determining the cost of an item of inventory needs to be selected with a view to providing the
fairest possible approximation to the cost incurred in bringing the item to its present location
and condition. The FIFO formula assumes that the items of inventory which were purchased or
produced first are consumed or sold first, and consequently the items remaining in inventory at
the end of the period are those most recently purchased or produced. Under the weighted
average cost formula, the cost of each item is determined from the weighted average of the
cost of similar items at the beginning of a period and the cost of similar items purchased or
produced during the period. The average may be calculated on a periodic basis, or as each
additional shipment is received, depending upon the circumstances of the enterprise.

Techniques for the Measurement of Cost


18. Techniques for the measurement of the cost of inventories, such as the standard cost
method or the retail method, may be used for convenience if the results approximate the
actual cost. Standard costs take into account normal levels of consumption of materials and
supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if
necessary, revised in the light of current conditions.
19. The retail method is often used in the retail trade for measuring inventories of large
numbers of rapidly changing items that have similar margins and for which it is impracticable
to use other costing methods. The cost of the inventory is determined by reducing from the
sales value of the inventory the appropriate percentage gross margin. The percentage used
takes into consideration inventory which has been marked down to below its original selling
price. An average percentage for each retail department is often used.

Net Realisable Value


20. The cost of inventories may not be recoverable if those inventories are damaged, if they
have become wholly or partially obsolete, or if their selling prices have declined. The cost of
inventories may also not be recoverable if the estimated costs of completion or the estimated
costs necessary to make the sale have increased. The practice of writing down inventories
below cost to net realisable value is consistent with the view that assets should not be carried
in excess of amounts expected to be realised from their sale or use.
I.10 Financial Reporting

21. Inventories are usually written down to net realisable value on an item-by-item basis. In
some circumstances, however, it may be appropriate to group similar or related items. This
may be the case with items of inventory relating to the same product line that have similar
purposes or end uses and are produced and marketed in the same geographical area and
cannot be practicably evaluated separately from other items in that product line. It is not
appropriate to write down inventories based on a classification of inventory, for example,
finished goods, or all the inventories in a particular business segment.
22. Estimates of net realisable value are based on the most reliable evidence available at the
time the estimates are made as to the amount the inventories are expected to realise. These
estimates take into consideration fluctuations of price or cost directly relating to events
occurring after the balance sheet date to the extent that such events confirm the conditions
existing at the balance sheet date.
23. Estimates of net realisable value also take into consideration the purpose for which the
inventory is held. For example, the net realisable value of the quantity of inventory held to
satisfy firm sales or service contracts is based on the contract price. If the sales contracts are
for less than the inventory quantities held, the net realisable value of the excess inventory is
based on general selling prices. Contingent losses on firm sales contracts in excess of
inventory quantities held and contingent losses on firm purchase contracts are dealt with in
accordance with the principles enunciated in Accounting Standard (AS) 4, Contingencies and
Events Occurring After the Balance Sheet Date∗.
24. Materials and other supplies held for use in the production of inventories are not written
down below cost if the finished products in which they will be incorporated are expected to be
sold at or above cost. However, when there has been a decline in the price of materials and it
is estimated that the cost of the finished products will exceed net realisable value, the
materials are written down to net realisable value. In such circumstances, the replacement
cost of the materials may be the best available measure of their net realisable value.
25. An assessment is made of net realisable value as at each balance sheet date.

Disclosure
26. The financial statements should disclose:
(a) the accounting policies adopted in measuring inventories, including the cost
formula used; and


Pursuant to AS 29, Provisions, Contingent Liabilities and Contingent Assets, becoming
mandatory in respect of accounting periods commencing on or after 1.4.2004, all
paragraphs of AS 4 that deal with contingencies stand withdrawn except to the extent
they deal with impairment of assets not covered by other Indian Accounting Standards
Appendix I : Accounting Standards I.11

(b) the total carrying amount of inventories and its classification appropriate to the
enterprise.
27. Information about the carrying amounts held in different classifications of inventories and
the extent of the changes in these assets is useful to financial statement users. Common
classifications of inventories are raw materials and components, work in progress, finished
goods, stores and spares, and loose tools.

AS-3 (REVISED 1997) CASH FLOW STATEMENTS

The following is the text of the revised Accounting Standard (AS 3), Cash Flow Statements,
issued by the Council of the Institute of Chartered Accountants of India. This Standard
supersedes Accounting Standard (AS 3), Changes In Financial Position, issued in June,
1981.This standard is mandatory in nature in respect of accounting periods commencing on or
after 1-4-2004 for the enterprises which fall in any one or more of the following categories, at
any time during the accounting period:
(i) Enterprises whose equity or debt securities are listed whether in India or outside India.
(ii) Enterprises which are in the process of listing their equity or debt securities as evidence by
the board of directors’ resolution in this regard.
(iii) Banks including co-operative banks.
(iv) Financial institutions.
(v) Enterprises carrying on insurance business.
(vi) All commercial, industrial and business reporting enterprises, whose turnover for the
immediately preceding accounting period on the basis of audited financial statements
exceeds Rs.50 crore. Turnover does not include ‘other income’.
(vii) All commercial, industrial and business reporting enterprises having borrowings, including
public deposits, in excess of Rs.10 crore at any time during the accounting period.
(viii) Holding and subsidiary enterprises of any one of the above at any time during the accounting
period.
The enterprises which do not fall in any of the above categories are encouraged, but are not
required, to apply this Standard.
Where an enterprise has been covered in any one or more of the above categories and
subsequently, ceases to be so covered, the enterprise will not qualify for exemption from
application of this Standard, until the enterprise ceases to be covered in any of the above
I.12 Financial Reporting

categories for two consecutive years.


Where an enterprise has previously qualified for exemption from application of this Standard
(being not covered by any of the above categories) but no longer qualifies for exemption in the
current accounting period, this Standard becomes applicable from the current period.
However, the corresponding previous period figures need not be disclosed.
An enterprise, which, pursuant to the above provisions, does not present a cash flow
statement, should disclose the fact.
The following is the text of the Accounting Standard.

Objective
Information about the cash flows of an enterprise is useful in providing users of financial
statements with a basis to assess the ability of the enterprise to generate cash and cash
equivalents and the needs of the enterprise to utilise those cash flows. The economic
decisions that are taken by users require an evaluation of the ability of an enterprise to
generate cash and cash equivalents and the timing and certainty of their generation.
The Statement deals with the provision of information about the historical changes in cash and
cash equivalents of an enterprise by means of a cash flow statement which classifies cash
flows during the period from operating, investing and financing activities.

Scope
1. An enterprise should prepare a cash flow statement and should present it for each
period for which financial statements are presented.
2. Users of an enterprise’s financial statements are interested in how the enterprise
generates and uses cash and cash equivalents. This is the case regardless of the nature of
the enterprise’s activities and irrespective of whether cash can be viewed as the product of the
enterprise, as may be the case with financial enterprise. Enterprises need cash for essentially
the same reasons, however different their principal revenue-producing activities might be.
They need cash to conduct their operations, to pay their obligations, and to provide returns to
their investors.

Benefits of Cash Flow Information


3. A cash flow statement, when used in conjunction with the other financial statements,
provides information that enables users to evaluate the changes in net assets of an enterprise,
its financial structure (including its liquidity and solvency), and its ability to affect the amounts
and timing of cash flows in order to adapt to changing circumstances and opportunities. Cash
flow information is useful in assessing the ability of the enterprise to generate cash and cash
equivalents and enables users to develop models to assess and compare the present value of
the future cash flows of different enterprises. It also enhances the comparability of the
Appendix I : Accounting Standards I.13

reporting of operating performance by different enterprises because it eliminates the effects of


using different accounting treatments for the same transactions and events.
4. Historical cash flow information is often used as an indicator of the amount, timing and
certainty of future cash flows. It is also useful in checking the accuracy of past assessments of
future cash flows and in examining the relationship between profitability and net cash flow and
the impact of changing prices.

Definitions
5. The following terms are used in this Statement with the meanings specified :
Cash comprises cash on hand and demand deposits with banks.
Cash equivalents are short-term, highly liquid investments that are readily convertible
into known amounts of cash and which are subject to an insignificant risk of changes in
value.
Cash flows are inflows and outflows of cash and cash equivalents.
Operating activities are the principal revenue-producing activities of the enterprise and
other activities that are not investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
Financing activities are activities that result in changes in the size and composition of
the owners’ capital (including preference share capital in the case of a company) and
borrowings of the enterprise.)

Cash and Cash Equivalents


6. Cash equivalents are held for the purpose of meeting short-term cash commitments
rather than for investment or other purposes. For an investment to qualify as a cash
equivalent, it must be readily convertible to a known amount of cash and be subject to an
insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash
equivalent only when it has a short maturity of, say, three months or less from the date of
acquisition. Investments in shares are excluded from cash equivalents unless they are, in
substance, cash equivalents; for example, preference shares of a company acquired shortly
before their specified redemption date (provided there is only an insignificant risk of failure of
the company to repay the amount at maturity).
7. Cash flows exclude movements between items that constitute cash or cash equivalents
because these components are part of the cash management of an enterprise rather than part
of its operating, investing and financing activities. Cash management includes the investment
of excess cash in cash equivalents.
I.14 Financial Reporting

Presentation of a Cash Flow Statement


8. The cash flow statement should report cash flows during the period classified by
operating, investing and financing activities.
9. An enterprise presents its cash flows from operating, investing and financing activities in
a manner which is most appropriate to its business. Classification by activity provides informa-
tion that allows users to assess the impact of those activities on the financial position of the
enterprise and the amount of its cash and cash equivalents. This information may also be
used to evaluate the relationships among those activities.
10. A single transaction may include cash flows that are classified differently. For example,
when the instalment paid in respect of a fixed asset acquired on deferred payment basis
includes both interest and loan, the interest element is classified under financing activities and
the loan element is classified under investing activities.

Operating Activities
11. The amount of cash flows arising from operating activities is a key indicator of the extent
to which the operations of the enterprise have generated sufficient cash flows to maintain the
operating capability of the enterprise, pay dividends, repay loans, and make new investments
without recourse to external sources of financing. Information about the specific components
of historical operating cash flows is useful, in conjunction with other information, in forecasting
future operating cash flows.
12. Cash flows from operating activities are primarily derived from the principal revenue-
producing activities of the enterprise. Therefore, they generally result from the transactions
and other events that enter into the determination of net profit or loss. Examples of cash flows
from operating activities are :
(a) cash receipts from the sale of goods and the rendering of services;
(b) cash receipts from royalties, fees, commissions, and other revenue;
(c) cash payments to suppliers for goods and services;
(d) cash payments to and on behalf of employees;
(e) cash receipts and cash payments of an insurance enterprise for premiums and claims,
annuities and other policy benefits;
(f) cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities; and
(g) cash receipts and payments relating to futures contracts, forward contracts, option
contracts, and swap contracts when the contracts are held for dealing or trading purposes.
13. Some transactions, such as the sale of an item of plant, may give rise to a gain or loss
Appendix I : Accounting Standards I.15

which is included in the determination of net profit or loss. However, the cash flows relating to
such transactions are cash flows from investing activities.
14. An enterprise may hold securities and loans for dealing or trading purposes, in which
case they are similar to inventory acquired specifically for resale. Therefore, cash flows arising
from the purchase and sale of dealing or trading securities are classified as operating
activities. Similarly, cash advances and loans made by financial enterprises are usually
classified as operating activities since they relate to the main revenue-producing activity of
that enterprise.

Investing Activities
15. The separate disclosure of cash flows arising from investing activities is important
because the cash flows represent the extent to which expenditures have been made for
resources intended to generate future income and cash flows. Examples of cash flows arising
from investing activities are :
(a) cash payments to acquire fixed assets (including intangibles). These payments include
those relating to capitalised research and development costs and self-constructed fixed
assets;
(b) cash receipts from disposal of fixed assets (including intangibles);
(c) cash payments to acquire shares, warrants, or debt instruments of other enterprises and
interests in joint ventures (other than payments for those instruments considered to be cash
equivalents and those held for dealing or trading purposes);
(d) cash receipts from disposal of shares, warrants, or debt instruments of other enterprises
and interests in joint ventures (other than receipts from those instruments considered to be
cash equivalents and those held for dealing or trading purposes);
(e) cash advances and loans made to third parties (other than advances and loans made by
a financial enterprise);
(f) cash receipts from the repayment of advances and loans made to third parties (other
than advances and loans of a financial enterprise);
(g) cash payments for futures contracts, forward contracts, option contracts, and swap
contracts except when the contracts are held for dealing or trading purposes, or the payments
are classified as financing activities; and
(h) cash receipts from futures contracts, forward contracts, option contracts, and swap
contracts except when the contracts are held for dealing or trading purposes, or the receipts
are classified as financing activities.
16. When a contract is accounted for as a hedge of an identifiable position, the cash flows of
the contract are classified in the same manner as the cash flows of the position being hedged.
I.16 Financial Reporting

Financing Activities
17. The separate disclosure of cash flows arising from financing activities is important
because it is useful in predicting claims on future cash flows by providers of funds (both
capital and borrowings) to the enterprise. Examples of cash flows arising from financing
activities are :
(a) cash proceeds from issuing shares or other similar instruments;
(b) cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-
term borrowings; and
(c) cash repayments of amounts borrowed.

Reporting Cash Flows from Operating Activities


18. An enterprise should report cash flows from operating activities using either :
(a) the direct method, whereby major classes of gross cash receipts and gross cash
payments are disclosed; or
(b) the indirect method, whereby net profit or loss is adjusted for the effects of
transactions of a non-cash nature, any deferrals or accruals of past or future operating
cash receipts or payments, and items of income or expense associated with investing
or financing cash flows.
19. The direct method provides information which may be useful in estimating future cash
flows and which is not available under the indirect method and is, therefore, considered more
appropriate than the indirect method. Under the direct method, information about major
classes of gross cash receipts and gross cash payments may be obtained either :
(a) from the accounting records of the enterprise; or
(b) by adjusting sales, cost of sales (interest and similar income and interest expense and
similar charges for a financial enterprise) and other items in the statement of profit and loss
for:
(i) changes during the period in inventories and operating receivables and payables;
(ii) other non-cash items; and
(iii) other items for which the cash effects are investing or financing cash flows.
20. Under the indirect method, the net cash flow from operating activities is determined by
adjusting net profit or loss for the effects of :
(a) changes during the period in inventories and operating receivables and payables;
(b) non-cash items such as depreciation, provisions, deferred taxes, and unrealised foreign
exchange gains and losses; and
Appendix I : Accounting Standards I.17

(c) all other items for which the cash effects are investing or financing cash flows.
Alternatively, the net cash flow from operating activities may be presented under the indirect
method by showing the operating revenues and expenses, excluding non-cash items disclosed
in the statement of profit and loss and the changes during the period in inventories and
operating receivables and payables.

Reporting Cash Flows from Investing and Financing Activities


21. An enterprise should report separately major classes of gross cash receipts and
gross cash payments arising from investing and financing activities, except to the
extent that cash flows described in Paragraphs 22 and 24 are reported on a net basis.

Reporting Cash Flows on a Net Basis


22. Cash flows arising from the following operating, investing or financing activities
may be reported on a net basis :
(a) cash receipts and payments on behalf of customers when the cash flows reflect
the activities of the customer rather than those of the enterprise; and
(b) cash receipts and payments for items in which the turnover is quick, the amounts
are large, and the maturities are short.
23. Examples of cash receipts and payments referred to in Paragraph 22(a) are :
(a) the acceptance and repayment of demand deposits by a bank;
(b) funds held for customers by an investment enterprise; and
(c) rents collected on behalf of, and paid over to, the owners of properties.
Examples of cash receipts and payments referred to in Paragraph 22(b) are advances made
for, and the repayments of :
(a) principal amounts relating to credit card customers;
(b) the purchase and sale of investments; and
(c) other short-term borrowings, for example, those which have a maturity period of three
months or less.
24. Cash flows arising from each of the following activities of a financial enterprise
may be reported on a net basis :
(a) cash receipts and payments for the acceptance and repayment of deposits with a
fixed maturity date;
(b) the placement of deposits with and withdrawal of deposits from other financial
enterprises; and
I.18 Financial Reporting

(c) cash advances and loans made to customers and the repayment of those advances
and loans.

Foreign Currency Cash Flows


25. Cash flows arising from transactions in a foreign currency should be recorded in
an enterprise’s reporting currency by applying to the foreign currency amount the
exchange rate between the reporting currency and the foreign currency at the date of
the cash flow. A rate that approximates the actual rate may be used if the result is
substantially the same as would arise if the rates at the dates of the cash flows were
used. The effect of changes in exchange rates on cash and cash equivalents held in a
foreign currency should be reported as a separate part of the reconciliation of the
changes in cash and cash equivalents during the period.
26. Cash flows denominated in foreign currency are reported in a manner consistent with
Accounting Standard (AS) 11, Accounting for the Effects of Changes in Foreign Exchange
Rates∗. This permits the use of an exchange rate that approximates the actual rate. For
example, a weighted average exchange rate for a period may be used for recording foreign
currency transactions.
27. Unrealised gains and losses arising from changes in foreign exchange rates are not cash
flows. However, the effect of exchange rate changes on cash and cash equivalents held or
due in foreign currency is reported in the cash flow statement in order to reconcile cash and
cash equivalents at the beginning and the end of the period. This amount is presented
separately from cash flows from operating, investing and financing activities and includes the
differences, if any, had those cash flows been reported at the end-of-period exchange rates.

Extraordinary Items
28. The cash flows associated with extraordinary items should be classified as arising
from operating, investing or financing activities as appropriate and separately
disclosed.
29. The cash flows associated with extraordinary items are disclosed separately as arising
from operating, investing or financing activities in the cash flow statement, to enable users to
understand their nature and effect on the present and future cash flows of the enterprise.
These disclosures are in addition to the separate disclosures of the nature and amount of
extraordinary items required by Accounting Standard (AS) 5, Net Profit or loss for the Period,
Prior Period Items, and Changes in Accounting Policies.


This standard has been revised in 2003, and titled as ‘The Effects of Changes in
Foreign Exchange Rates’.
Appendix I : Accounting Standards I.19

Interest and Dividends


30. Cash flows from interest and dividends received and paid should each be
disclosed separately. Cash flows arising from interest paid and interest and dividends
received in the case of a financial enterprise should be classified as cash flows arising
from operating activities. In the case of other enterprises, cash flows arising from
interest paid should be classified as cash flows from financing activities while interest
and dividends received should be classified as cash flows from investing activities.
Dividends paid should be classified as cash flows from financing activities.
31. The total amount of interest paid during the period is disclosed in the cash flow statement
whether it has been recognised as an expense in the statement of profit and loss or
capitalised in accordance with Accounting Standard (AS) 10, Accounting for Fixed Assets.∗
32. Interest paid and interest and dividends received are usually classified as operating cash
flows for a financial enterprise. However, there is no consensus on the classification of these
cash flows for other enterprises. Some argue that interest paid and interest and dividends
received may be classified as operating cash flows because they enter into the determination
of net profit or loss. However, it is more appropriate that interest paid and interest and
dividends received are classified as financing cash flows and investing cash flows
respectively, because they are cost of obtaining financial resources or returns on investments.
33. Some argue that dividends paid may be classified as a component of cash flows from
operating activities in order to assist users to determine the ability of an enterprise to pay
dividends out of operating cash flows. However, it is considered more appropriate that
dividends paid should be classified as cash flows from financing activities because they are
cost of obtaining financial resources.

Taxes on Income
34. Cash flows arising from taxes on income should be separately disclosed and
should be classified as cash flows from operating activities unless they can be
specifically identified with financing and investing activities.
35. Taxes on income arise on transactions that give rise to cash flows that are classified as
operating, investing or financing activities in a cash flow statement. While tax expense may be
readily identifiable with investing or financing activities, the related tax cash flows are often
impracticable to identify and may arise in a different period from the cash flows of the under-
lying transactions. Therefore, taxes paid are usually classified as cash flows from operating
activities. However, when it is practicable to identify the tax cash flow with an individual


Pursuant to the issuance of AS 16, Borrowing Costs, which came into effect in respect
of accounting periods commencing on or after 1.4.2004, accounting for borrowing costs is
governed by As 16 from that date.
I.20 Financial Reporting

transaction that gives rise to cash flows that are classified as investing or financing activities,
the tax cash flow is classified as an investing or financing activity as appropriate. When tax
cash flows are allocated over more than one class of activity, the total amount of taxes paid is
disclosed.

Investments in Subsidiaries, Associates, and Joint Ventures


36. When accounting for an investment in an associate or a subsidiary or a joint
venture, an investor restricts its reporting in the cash flow statement to the cash flows
between itself and the investee/joint venture, for example, cash flows relating to
dividends and advances.
Acquisitions and Disposals of Subsidiaries and Other Business Units
37. The aggregate cash flows arising from acquisitions and from disposals of
subsidiaries or other business units should be presented separately and classified as
investing activities.
38. An enterprise should disclose, in aggregate, in respect of both acquisition and
disposal of subsidiaries or other business units during the period each of the
following :
(a) the total purchase or disposal consideration; and
(b) the portion of the purchase or disposal consideration discharged by means of cash
and cash equivalents.
39. The separate presentation of the cash flow effects of acquisitions and disposals of
subsidiaries and other business units as single line items helps to distinguish those cash flows
from other cash flows. The cash flow effects of disposals are not deducted from those of
acquisitions.

Non-Cash Transactions
40. Investing and financing transactions that do not require the use of cash or cash
equivalents should be excluded from a cash flow statement. Such transactions should
be disclosed elsewhere in the financial statements in a way that provides all the rele-
vant information about these investing and financing activities.
41. Many investing and financing activities do not have a direct impact on current cash flows
although they do affect the capital and asset structure of an enterprise. The exclusion of non-
cash transactions from the cash flow statement is consistent with the objective of a cash flow
statement as these items do not involve cash flows in the current period. Examples of non-
cash transactions are :
(a) the acquisition of assets by assuming directly related liabilities;
Appendix I : Accounting Standards I.21

(b) the acquisition of an enterprise by means of issue of shares; and


(c) the conversion of debt to equity.

Components of Cash and Cash Equivalents


42. An enterprise should disclose the components of cash and cash equivalents and
should present a reconciliation of the amounts in its cash flow statement with the
equivalent items reported in the balance sheet.
43. In view of the variety of cash management practices, an enterprise discloses the policy
which it adopts in determining the composition of cash and cash equivalents.
44. The effect of any change in the policy for determining components of cash and cash
equivalents is reported in accordance with Accounting Standard (AS) 5, Net Profit or Loss for
the Period, Prior Period Items, and Changes in Accounting Policies.

Other Disclosures
45. An enterprise should disclose, together with a commentary management, the
amount of significant cash and cash equivalent balances held by the enterprise that are
not available for use by it.
46. There are various circumstances in which cash and cash equivalent balances held by an
enterprise are not available for use by it. Examples include cash and cash equivalent balances
held by a branch of the enterprise that operates in a country where exchange controls or other
legal restrictions apply as a result of which the balances are not available for use by the
enterprise.
47. Additional information may be relevant to users in understanding the financial position
and liquidity of an enterprise. Disclosure of this information, together with a commentary by
management, is encouraged and may include :
(a) the amount of undrawn borrowing facilities that may be available for future operating
activities and to settle capital commitments, indicating any restrictions on the use of these
facilities; and
(b) the aggregate amount of cash flows that represent increases in operating capacity
separately from those cash flows that are required to maintain operating capacity.
48. The separate disclosure of cash flows that represent increases in operating capacity and
cash flows that are required to maintain operating capacity is useful in enabling the user to
determine whether the enterprise is investing adequately in the maintenance of its operating
capacity. An enterprise that does not invest adequately in the maintenance of its operating
capacity may be prejudicing future profitability for the sake of current liquidity and distributions
to owners.
I.22 Financial Reporting

Appendix I

Cash flow statement for an enterprise other than a financial enterprise


The appendix is illustrative only and does not form part of the accounting standard. The
purpose of this appendix is to illustrate the application of the accounting standard.
1. The example shows only current period amounts.
2. Information from the statement of profit and loss and balance sheet is provided to show
how the statements of cash flows under the direct method and the indirect method have been
derived. Neither the statement of profit and loss nor the balance sheet is presented in
conformity with the disclosure and presentation requirements of applicable laws and
accounting standards. The working notes given towards the end of this appendix are intended
to assist in understanding the manner in which the various figures appearing in the cash flow
statement have been derived. These working notes do not form part of the cash flow
statement and, accordingly, need not be published.
3. The following additional information is also relevant for the preparation of the statement
of cash flows (figures are in Rs. ’000).
(a) An amount of 250 was raised from the issue of share capital and a further 250 was raised
from long-term borrowings.
(b) Interest expense was 400 of which 170 was paid during the period. 100 relating to
interest expense of the prior period was also paid during the period.
(c) Dividends paid were 1,200.
(d) Tax deducted at source on dividends received (included in the tax expense of 300 for the
year) amounted to 40.
(e) During the period, the enterprise acquired fixed assets for 350. The payment was made
in cash.
(f) Plant with original cost of 80 and accumulated depreciation of 60 was sold for 20.
(g) Foreign exchange loss of 40 represents the reduction in the carrying amount of a short-
term investment in foreign currency designated bonds arising out of a change in exchange
rate between the date of acquisition of the investment and the balance sheet date.
(h) Sundry debtors and sundry creditors include amounts relating to credit sales and credit
purchases only.
Appendix I : Accounting Standards I.23

Balance Sheet as at 31-12-1996

(Rs. ’000)
1996 1995
Assets
Cash on hand and balances with banks 200 25
Short-term investments 670 135
Sundry debtors 1,700 1,200
Interest receivable 100 -
Inventories 900 1,950
Long-term investments 2,500 2,500
Fixed assets at cost 2,180 1,910
Accumulated depreciation (1,450) (1,060)
Fixed assets (net) 730 850
Total Assets 6,800 6,660
Liabilities
Sundry creditors 150 1,890
Interest payable 230 100
Income taxes payable 400 1,000
Long-term debt 1,110 1,040
Total liabilities 1,890 4,030
Shareholders’ Funds
Share capital 1,500 1,250
Reserves 3,410 1,380
Total shareholders funds 4,910 2,630
Total liabilities and Shareholders’ funds 6,800 6,660

Statement of Profit and Loss for the period ended 31-12-1996

(Rs. ’000)
Sales 30,650
Cost of sales (26,000)
Gross profit 4,650
I.24 Financial Reporting

Depreciation (450)
Administrative and selling expenses (910)
Interest expense (400)
Interest income 300
Dividend income 200
Foreign exchange loss (40)
Net profit before taxation and extraordinary item 3,350
Extraordinary item - Insurance proceeds from earthquake
disaster settlement 180
Net profit after extraordinary item 3,530
Income tax (300)
Net Profit 3,230
Direct Method Cash Flow Statement [Paragraph 18(a)]

(Rs. ’000)
1996
Cash flows from operating activities
Cash receipts from customers 30,150
Cash paid to suppliers and employees (27,600)
Cash generated from operations 2,550
Income taxes paid (860)
Cash flow before extraordinary item 1,690
Proceeds from earthquake disaster settlement 180
Net cash from operating activities 1,870
Cash flows from investing activities
Purchase of fixed assets (350)
Proceeds from sale of equipment 20
Interest received 200
Dividend received 160 30
Net cash from investing activities
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long-term borrowings 250
Appendix I : Accounting Standards I.25

Repayments of long-term borrowings (180)


Interest paid (270)
Dividend paid (1,200)
Net cash used in financing activities (1,150)
Net increase in cash and cash equivalents 750
Cash and cash equivalents at beginning of period (See Note 1) 160
Cash and cash equivalents at end of the period (see Note 1) 910

Indirect Method Cash Flow Statement [Paragraph 18 (b)]


(Rs. ’000)
1996
Cash flows from operating activities
Net profit before taxation, and extraordinary item 3,350
Adjustments for :
Depreciation 450
Foreign exchange loss 40
Interest income (300)
Dividend income (200)
Interest expense 400
Operating profit before working capital changes 3,740
Increase in sundry debtors (500)
Decrease in inventories 1,050
Decrease in sundry creditors (1,740)
Cash generated from operations 2,550
Income taxes paid (860)
Cash flow before extraordinary item 1,690
Proceeds from earthquake disaster settlement 180
Net cash from operating activities 1,870
Cash flows from investing activities
Purchase of fixed assets (350)
Proceeds from sale of equipment 20
Interest received 200
I.26 Financial Reporting

Dividends received 160


Net cash from investing activities 30
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long-term borrowings 250
Repayment of long-term borrowings (180)
Interest paid (270)
Dividends paid (1,200)
Net cash used in financing activities (1,150)
Net increase in cash and cash equivalents 750
Cash and cash equivalents at beginning
of period (See Note 1) 160
Cash and cash equivalents at end of period 910
(See note 1)

Notes to the cash flow statement


(direct method and indirect method)
1. Cash and Cash Equivalents
Cash and cash equivalents consist of cash on hand and balances with banks, and investments
in money-market instruments. Cash and cash equivalents included in the cash flow statement
comprise the following balance sheet amounts.

1996 1995
Cash on hand and balances with banks 200 25
Short-term investments 670 135
Cash and cash equivalents 870 160
Effect of exchange rate changes 40 -
Cash and cash equivalents as restated 910 160
Cash and cash equivalents at the end of the period include deposits with banks of 100 held by
a branch which are not freely remissible to the company because of currency exchange
restrictions.
The company has undrawn borrowing facilities of 2,000 of which 700 may be used only for
future expansion.
Appendix I : Accounting Standards I.27

2. Total tax paid during the year (including tax deducted at source on dividends received)
amounted to 900.

Alternative Presentation (indirect method)


As an alternative, in an indirect method cash flow statement, operating profit before working
capital changes is sometimes presented as follows :

Revenues excluding investment income 30,650


Operating expense excluding depreciation (26, 910)
Operating profit before working capital changes 3,740
Working Notes
The working notes given below do not form part of the cash flow statement and, accordingly
need not be published. The purpose of these working notes is merely to assist in
understanding the manner in which various figures in the cash flow statement have been
derived.

(Figures are in Rs. ’000)


1. Cash receipts from customers
Sales 30,650
Add : Sundry debtors at the beginning of the year 1,200
31,850
Less : Sundry debtors at the end of the year 1,700
30,150
2. Cash paid to suppliers and employees
Cost of sales 26,000
Administrative and selling expenses 910
26,910
Add : Sundry creditors at the beginning of the year 1,890
Inventories at the end of the year 900 2,790
29,700
Less : Sundry creditors at the end of the year 150
Inventories at the beginning of the year 1,950 2,100
27,600
I.28 Financial Reporting

3. Income taxes paid (including tax deducted at source from dividends received)
Income tax expense for the year (including tax
deducted at source from dividends received) 300
Add : Income tax liability at the beginning of the year 1,000
1,300
Less : Income tax liability at the end of the year 400
900
Out of 900, tax deducted at source on dividends received (amounting to 40) is included in cash
flows from investing activities and the balance of 860 is included in cash flows from operating
activities (See Paragraph 34).
4. Repayment of long-term borrowings
Long-term debt at the beginning of the year 1,040
Add : Long-term borrowings made during the year 250
1,290
Less : Long-term borrowings at the end of the year 1,110
180
5. Interest paid
Interest expense for the year 400
Add : Interest payable at the beginning of the year 100
500
Less : Interest payable at the end of the year 230
270
Appendix I : Accounting Standards I.29

Appendix II
Cash Flow Statement for a Financial Enterprise
The appendix is illustrative only and does not form part of the accounting standard. The
purpose of this appendix is to illustrate the application of the accounting standard.
1. The example shows only current period amounts.
2. The example is presented using the direct method.

(Rs. ’000)
1996
Cash flows from operating activities
Interest and commission receipts 28,447
Interest payments (23,463)
Recoveries on loans previously written off 237
Cash payments to employees and suppliers (997)
Operating profit before changes in operating assets 4,224
(Increase) decrease in operating assets :
Short-term funds (650)
Deposits held for regulatory or monetary control purposes234
Funds advanced to customers (288)
Net increase in credit card receivables (360)
Other short-term securities (120)
Increase (decrease) in operating liabilities :
Deposits from customers 600
Certificates of deposit (200)
Net cash from operating activities before income tax 3,440
Income taxes paid (100)
Net cash from operating activities 3,340
Cash flows from investing activities
Dividends received 250
Interest received 300
Proceeds from sales of permanent investments 1,200
Purchase of permanent investments (600)
I.30 Financial Reporting

Purchase of fixed assets (500)


Net cash from investing activities 650
Cash flows from financing activities
Issue of shares 1,800
Repayment of long-term borrowings (200)
Net decrease in other borrowings (1,000)
Dividends paid (400)
Net cash from financing activities 200
Net increase in cash and cash equivalents 4,190
Cash and cash equivalents at beginning of period 4,650
Cash and cash equivalents at end of the period 8,840

AS 4 (REVISED) : CONTINGENCIES AND EVENTS OCCURRING AFTER THE BALANCE


SHEET DATE

The following is the text of the revised Accounting Standard (AS) 4, ‘Contingencies and Events
Occurring after the Balance Sheet Date’ issued by the Council of the Institute of Chartered Ac-
countants of India.
This revised standard comes into effect in respect of accounting periods commencing on or
after 1-4-1995 and is mandatory in nature.1 It is clarified that in respect of accounting periods
commencing on a date prior to 1-4-1995, Accounting Standard 4 as originally issued in
November, 1982 (and subsequently made mandatory) applies.

INTRODUCTION
1. This Statement deals with the treatment in financial statements of
(a) contingencies, and
(b) events occurring after the balance sheet date.

1
Pursuant to AS 29, Provisions, Contingent Liabilities and Contingent Assets, becoming
mandatory in respect of accounting periods commencing on or after 1.4.2004, all
paragraphs of AS 4 that deal with contingencies stand withdrawn except to the extent
they deal with impairment of assets not covered by other Indian Accounting Standards
Appendix I : Accounting Standards I.31

2. The following subjects, which may result in contingencies, are excluded from the scope
of this Statement in view of special considerations applicable to them :
(a) liabilities of life assurance and general insurance enterprises arising from policies issued;
(b) obligations under retirement benefit plans; and
(c) commitments arising from long-term lease contracts.

Definitions
3. The following terms are used in this Statement with the meanings specified :
3.1 A contingency2 is a condition or situation, the ultimate outcome of which, gain or loss, will
be known or determined only on the occurrence, or non-occurrence, of one or more uncertain
future events.
3.2 Events occurring after the balance sheet date are those significant events, both
favourable and unfavourable, that occur between the balance sheet date and the date on
which the financial statements are approved by the Board of Directors in the case of a
company, and, by the corresponding approving authority in the case of any other entity.
Two types of events can be identified :
(a) those which provide further evidence of conditions that existed at the balance sheet date;
and
(b) those which are indicative of conditions that arose subsequent to the balance sheet date.

Explanation

4. CONTINGENCIES
4.1 The term “contingencies” used in this Statement is restricted to conditions or situations at
the balance sheet date, the financial effect of which is to be determined by future events which
may or may not occur.
4.2 Estimates are required for determining the amount to be stated in the financial
statements for many ongoing and recurring activities of an enterprise. One must, however,
distinguish between an event which is certain and one which is uncertain. The fact that an
estimate is involved does not, of itself, create the type of uncertainty which characterises a
contingency. For example, the fact that estimates of useful life are used to determine
depreciation, does not make depreciation a contingency; the eventual expiry of the useful life
of the asset is not uncertain. Also, amounts owed for services received are not contingencies

2
See footnote 1.
I.32 Financial Reporting

as defined in paragraph 3.1, even though the amounts may have been estimated, as there is
nothing uncertain about the fact that these obligations have been incurred.
4.3 The uncertainty relating to future events can be expressed by a range of outcomes. This
range may be presented as quantified probabilities, but in most circumstances, this suggests a
level of precision that is not supported by the available information. The possible outcomes
can, therefore, usually be generally described except where reasonable quantification is
practicable.
4.4 The estimates of the outcome and of the financial effect of contingencies are determined
by the judgment of the management of the enterprise. This judgment is based on
consideration of information available up to the date on which the financial statements are
approved and will include a review of events occurring after the balance sheet date,
supplemented by experience of similar transactions and, in some cases, reports from
independent experts.

5. ACCOUNTING TREATMENT OF CONTINGENT LOSSES


5.1 The accounting treatment of a contingent loss is determined by the expected outcome of
the contingency. If it is likely that a contingency will result in a loss to the enterprise, then it is
prudent to provide for that loss in the financial statements.
5.2 The estimation of the amount of a contingent loss to be provided for in the financial
statements may be based on information referred to in paragraph 4.4.
5.3 If there is conflicting or insufficient evidence for estimating the amount of a contingent
loss, then disclosure is made of the existence and nature of the contingency.
5.4 A potential loss to an enterprise may be reduced or avoided because a contingent liability
is matched by a related counter-claim or claim against a third party. In such cases, the amount
of the provision is determined after taking into account the probable recovery under the claim
if no significant uncertainty as to its measurability or collectability exists. Suitable disclosure
regarding the nature and gross amount of the contingent liability is also made.
5.5 The existence and amount of guarantees, obligations arising from discounted bills of
exchange and similar obligations undertaken by an enterprise are generally disclosed in
financial statements by way of note, even though the possibility that a loss to the enterprise
will occur, is remote.
5.6 Provisions for contingencies are not made in respect of general or unspecified
business risks since they do not relate to conditions or situations existing at the balance sheet
date.

6. ACCOUNTING TREATMENT OF CONTINGENT GAINS


Contingent gains are not recognised in financial statements since their recognition may result
Appendix I : Accounting Standards I.33

in the recognition of revenue which may never be realised. However, when the realisation of a
gain is virtually certain, then such gain is not a contingency and accounting for the gain is
appropriate.

7. DETERMINATION OF THE AMOUNTS AT WHICH CONTINGENCIES ARE INCLUDED


IN FINANCIAL STATEMENTS
7.1 The amount at which a contingency is stated in the financial statements is based on the
information which is available at the date on which the financial statements are approved.
Events occurring after the balance sheet date that indicate that an asset may have been
impaired, or that a liability may have existed, at the balance sheet date are, therefore, taken
into account in identifying contingencies and in determining the amounts at which such
contingencies are included in financial statements.
7.2 In some cases, each contingency can be separately identified, and the special
circumstances of each situation considered in the determination of the amount of contingency.
A substantial legal claim against the enterprise may represent such a contingency. Among the
factors taken into account by management in evaluating such a contingency are the progress
of the claim at the date on which the financial statements are approved, the opinions,
wherever necessary, of legal experts or other advisers, the experience of the enterprise in
similar cases and the experience of other enterprises in similar situations.
7.3 If the uncertainties which created a contingency in respect of an individual transaction
are common to a large number of similar transactions, then the amount of the contingency
need not be individually determined, but may be based on the group of similar transactions.
An example of such contingencies may be the estimated uncollectable portion of accounts
receivable. Another example of such contingencies may be the warranties for products sold.
These costs are usually incurred frequently and experience provides a means by which the
amount of the liability or loss can be estimated with reasonable precision although the
particular transactions that may result in a liability or a loss are not identified. Provision for
these costs results in their recognition in the same accounting period in which the related
transactions took place.

8. EVENTS OCCURRING AFTER THE BALANCE SHEET DATE


8.1 Events which occur between the balance sheet date and the date on which the financial
statements are approved, may indicate the need for adjustments to assets and liabilities as at
the balance sheet date or may require disclosure.
8.2 Adjustments to assets and liabilities are required for events occurring after the balance
sheet date that provide additional information materially affecting the determination of the
amounts relating to conditions existing at the balance sheet date. For example, an adjustment
may be made for a loss on a trade receivable account which is confirmed by the insolvency of
I.34 Financial Reporting

a customer which occurs after the balance sheet date.


8.3 Adjustments to assets and liabilities are not appropriate for events occurring after the
balance sheet date, if such events do not relate to conditions existing at the balance sheet
date. An example is the decline in market value of investments between the balance sheet
date and the date on which the financial statements are approved. Ordinary fluctuations in
market values do not normally relate to the condition of the investments at the balance sheet
date, but reflect circumstances which have occurred in the following period.
8.4 Events occurring after the balance sheet date which do not affect the figures stated in the
financial statements would not normally require disclosure in the financial statements although
they may be of such significance that they may require a disclosure in the report of the
approving authority to enable users of financial statements to make proper evaluations and
decisions.
8.5 There are events which, although they take place after the balance sheet date, are
sometimes reflected in the financial statements because of statutory requirements or because
of their special nature. Such items include the amount of dividend proposed or declared by the
enterprise after the balance sheet date in respect of the period covered by the financial
statements.
8.6 Events occurring after the balance sheet date may indicate that the enterprise ceases to
be a going concern. A deterioration in operating results and financial position, or unusual
changes affecting the existence or substratum of the enterprise after the balance sheet date
(e.g., destruction of a major production plant by a fire after the balance sheet date) may
indicate a need to consider whether it is proper to use the fundamental accounting assumption
of going concern in the preparation of the financial statements.

9. DISCLOSURE
9.1 The disclosure requirements herein referred to apply only in respect of those
contingencies or events which affect the financial position to a material extent.
9.2 If a contingent loss is not provided for, its nature and an estimate of its financial effect
are generally disclosed by way of note unless the possibility of a loss is remote (other than the
circumstances mentioned in paragraph 5.5). If a reliable estimate of the financial effect cannot
be made, this fact is disclosed.
9.3 When the events occurring after the balance sheet date are disclosed in the report of the
approving authority, the information given comprises the nature of the events and an estimate
of their financial effects or a statement that such an estimate cannot be made.
Appendix I : Accounting Standards I.35

Accounting Standard
(The Accounting Standard comprises paragraphs 10-17 of this Statement. The Standard
should be read in the context of paragraphs 1-9 of this Statement and of the ‘Preface to the
Statements of Accounting Standards’.)
Contingencies
10. The amount of a contingent loss should be provided for by a charge in the
statement of profit and loss if :
(a) it is probable that future events will confirm that, after taking into account any
related probable recovery, an asset has been impaired or a liability has been incurred
as at the balance sheet date, and
(b) a reasonable estimate of the amount of the resulting loss can be made.
11. The existence of a contingent loss should be disclosed in the financial statements
if either of the conditions in paragraph 10 is not met, unless the possibility of a loss is
remote.
12. Contingent gains should not be recognised in the financial statements.
Events Occurring after the Balance Sheet Date
13. Assets and liabilities should be adjusted for events occurring after the balance
sheet date that provide additional evidence to assist the estimation of amounts relating
to conditions existing at the balance sheet date or that indicate that the fundamental
accounting assumption of going concern (i.e., the continuance of existence or
substratum of the enterprise) is not appropriate.
14. Dividends stated to be in respect of the period covered by the financial
statements, which are proposed or declared by the enterprise after the balance sheet
date but before approval of the financial statements, should be adjusted.
15. Disclosure should be made in the report of the approving authority of those events
occurring after the balance sheet date that represent material changes and
commitments affecting the financial position of the enterprise.
Disclosure
16. If disclosure of contingencies is required by paragraph 11 of this Statement, the
following information should be provided :
(a) the nature of the contingency;
(b) the uncertainties which may affect the future outcome;
(c) an estimate of the financial effect, or a statement that such an estimate cannot be
made.
I.36 Financial Reporting

17. If disclosure of events occurring after the balance sheet date in the report of the
approving authority is required by paragraph 15 of this Statement, the following
information should be provided :
(a) the nature of the event;
(b) an estimate of the financial effect, or a statement that such an estimate cannot be
made.

AS 5 (REVISED) NET PROFIT OR LOSS FOR THE PERIOD,


PRIOR PERIOD ITEMS AND CHANGES IN
ACCOUNTING POLICIES*

The following is the text of the revised Accounting Standard (AS) 5, Net Profit or Loss for the
Period, Prior Period Items and Changes in Accounting Policies, issued by the Council of the
Institute of Chartered Accountants of India.
This revised standard comes into effect in respect of accounting periods commencing on or
after 1-4-1996, and is mandatory in nature. It is clarified that in respect of accounting periods
commencing on a date prior to 1-4-1996, Accounting Standard (AS) 5 as originally issued in
November, 1982 (and subsequently made mandatory), will apply.

Objective
The objective of this Statement is to prescribe the classification and disclosure of certain items
in the statement of profit and loss so that all enterprises prepare and present such a statement
on a uniform basis. This enhances the comparability of the financial statements of an
enterprise over time and with the financial statements of other enterprises. Accordingly, this
Statement requires the classification and disclosure of extraordinary and prior period items,
and the disclosure of certain items, within profit or loss from ordinary activities. It also
specifies the accounting treatment for changes in accounting estimates and the disclosures to
be made in the financial statements regarding changes in accounting policies.

Scope
1. This Statement should be applied by an enterprise in presenting profit or loss from
ordinary activities, extraordinary items and prior period items in the statement of profit
and loss, in accounting for changes in accounting estimates, and in disclosure of
changes in accounting policies.
2. This Statement deals with, among other matters, the disclosure of certain items of net
profit or loss for the period. These disclosures are made in addition to any other disclosures
required by other Accounting Standards.
Appendix I : Accounting Standards I.37

3. This Statement does not deal with the tax implications of extraordinary items, prior period
items, changes in accounting estimates, and changes in accounting policies for which
appropriate adjustments will have to be made depending on the circumstances.

Definitions
4. The following terms are used in this Statement with the meanings specified :
Ordinary activities are any activities which are undertaken by an enterprise as part of its
business and such related activities in which the enterprise engages in furtherance of,
incidental to, or arising from, these activities.
Extraordinary items are income or expenses that arise from events or transactions that
are clearly distinct from the ordinary activities of the enterprise and, therefore, are not
expected to recur frequently or regularly.
Prior period items are income or expenses which arise in the current period as a result
of errors or omissions in the preparation of the financial statements of one or more
prior periods.
Accounting policies are the specific accounting principles and the methods of applying
those principles adopted by an enterprise in the preparation and presentation of
financial statements.

Net Profit or Loss for the Period


5. All items of income and expenses which are recognised in a period should be
included in the determination of net profit or loss for the period unless an Accounting
Standard requires or permits otherwise.
6. Normally, all items of income and expense which are recognised in a period are included
in the determination of the net profit or loss for the period. This includes extraordinary items
and the effects of changes in accounting estimates.
7. The net profit or loss for the period comprises the following components, each of
which should be disclosed on the face of the statement of profit and loss :
(a) Profit or loss from ordinary activities; and
(b) Extraordinary items.

Extraordinary Items
8. Extraordinary items should be disclosed in the statement of profit and loss as a
part of net profit or loss for the period. The nature and the amount of each extraordinary
item should be separately disclosed in the statement of profit and loss in a manner that
its impact on current profit or loss can be perceived.
I.38 Financial Reporting

9. Virtually all items of income and expense included in the determination of net profit or
loss for the period arise in the course of the ordinary activities of the enterprise. Therefore,
only on rare occasions does an event or transaction give rise to an extraordinary item.
10. Whether an event or transaction is clearly distinct from the ordinary activities of the
enterprise is determined by the nature of the event or transaction in relation to the business
ordinarily carried on by the enterprise rather than by the frequency with which such events are
expected to occur. Therefore, an event or transaction may be extraordinary for one enterprise
but not for another enterprise because of the differences between their respective ordinary
activities. For example, losses sustained as a result of an earthquake may qualify as an
extraordinary item for many enterprises. However, claims from policy-holders arising from an
earthquake do not qualify as an extraordinary item for an insurance enterprise that insures
against such risks.
11. Examples of events or transactions that generally give rise to extraordinary items for
most enterprises are :—
- attachment of property of the enterprise; or
- an earthquake.

Profit or Loss from Ordinary Activities


12. When items of income and expense within profit or loss from ordinary activities
are of such size, nature, or incidence that their disclosure is relevant to explain the
performance of the enterprise for the period, the nature and amount of such items
should be disclosed separately.
13. Although the items of income and expense described in Paragraph 12 are not
extraordinary items, the nature and amount of such items may be relevant to users of financial
statements in understanding the financial position and performance of an enterprise and in
making projections about financial position and performance. Disclosure of such information is
sometimes made in the notes to the financial statements.
14. Circumstances which may give rise to the separate disclosure of items of income and
expense in accordance with Paragraph 12 include :
(a) the write-down of inventories to net realisable value as well as the reversal of such write-
downs;
(b) a restructuring of the activities of an enterprise and the reversal of any provisions for the
costs of restructuring;
(c) disposals of items of fixed assets;
(d) disposals of long-term investments;
(e) legislative changes having retrospective application;
Appendix I : Accounting Standards I.39

(f) litigation settlements; and


(g) other reversals of provisions.

Prior Period Items


15. The nature and amount of prior period items should be separately disclosed in the
statement of profit and loss in a manner that their impact on the current profit or loss
can be perceived.
16. The term ‘prior period items’, as defined in this Statement, refers only to income or
expenses which arise in the current period as a result of errors or omissions in the preparation
of the financial statements of one or more prior periods. The term does not include other
adjustments necessitated by circumstances, which though related to prior periods, are
determined in the current period e.g., arrears payable to workers as a result of revision of
wages with retrospective effect during the current period.
17. Errors in the preparation of the financial statements of one or more prior periods may be
discovered in the current period. Errors may occur as a result of mathematical mistakes,
mistakes in applying accounting policies, misinterpretation of facts, or oversight.
18. Prior period items are generally infrequent in nature and can be distinguished from
changes in accounting estimates. Accounting estimates by their nature are approximations
that may need revision as additional information becomes known. For example, income or
expense recognised on the outcome of a contingency which previously could not be estimated
reliably does not constitute a prior period item.
19. Prior period items are normally included in the determination of net profit or loss for the
current period. An alternative approach is to show such items in the statement of profit and loss
after determination of current net profit or loss. In either case, the objective is to indicate the effect
of such items on the current profit or loss.

Changes in Accounting Estimates


20. As a result of the uncertainties inherent in business activities, many financial statement
items cannot be measured with precision but can only be estimated. The estimation process
involves judgments based on the latest information available. Estimates may be required, for
example, of bad debts, inventory obsolescence, or the useful lives of depreciable assets. The
use of reasonable estimates is an essential part of the preparation of financial statements and
does not undermine their reliability.
21. An estimate may have to be revised if changes occur regarding the circumstances on
which the estimate was based, or as a result of new information, more experience, or
subsequent developments. The revision of the estimate, by its nature, does not bring the
adjustment within the definitions of an extraordinary item or a prior period item.
I.40 Financial Reporting

22. Sometimes, it is difficult to distinguish between a change in an accounting policy and a


change in an accounting estimate. In such cases, the change is treated as a change in an
accounting estimate, with appropriate disclosure.
23. The effect of a change in an accounting estimate should be included in the
determination of net profit or loss in :
(a) the period of the change; if the change affects the period only; or
(b) the period of the change and future periods, if the change affects both.
24. A change in an accounting estimate may affect the current period only or both the current
period and future periods. For example, a change in the estimate of the amount of bad debts
is recognised immediately and therefore affects only the current period. However, a change in
estimated useful life of a depreciable asset affects the depreciation in the current period and in
each period during the remaining useful life of the asset. In both cases, the effect of the
change relating to the current period is recognised as income or expense in the current period.
The effect, if any, on future periods, is recognised in future periods.
25. The effect of a change in an accounting estimate should be classified using the
same classification in the statement of profit and loss as was used previously for the
estimate.
26. To ensure the comparability of financial statements of different periods, the effect of a
change in an accounting estimate which was previously included in the profit or loss from
ordinary activities is included in that component of net profit or loss. The effect of a change in
an accounting estimate that was previously included as an extraordinary item is reported as an
extraordinary item.
27. The nature and amount of a change in an accounting estimate which has a material
effect in the current period, or which is expected to have a material effect in subsequent
periods, should be disclosed. If it is impracticable to quantify the amount, this fact
should be disclosed.

Changes in Accounting Policies


28. Users need to be able to compare the financial statements of an enterprise over a period
of time in order not identify trends in its financial position, performance, and cash flows. There-
fore, the same accounting policies are normally adopted for similar events or transactions in
each period.
29. A change in an accounting policy should be made only if the adoption of a different
accounting policy is required by statute or for compliance with an accounting standard
or if it is considered that the change would result in a more appropriate presentation of
the financial statements of the enterprise.
30. A more appropriate presentation of events or transactions in the financial statements
Appendix I : Accounting Standards I.41

occurs when the new accounting policy results in more relevant or reliable information about
the financial position, performance, or cash flows of the enterprise.
31. The following are not changes in accounting policies :
(a) the adoption of an accounting policy for events or transactions that differ in substance
from previously occurring events or transactions e.g., introduction of a formal retirement
gratuity scheme by an employer in place of ad hoc ex-gratia payments to employees on
retirement; and
(b) the adoption of a new accounting policy for events or transactions which did not occur
previously or that were immaterial.
32. Any change in an accounting policy which has a material effect should be
disclosed. The impact of, and the adjustments resulting from, such change, if material,
should be shown in the financial statements of the period in which such change is
made, to reflect the effect of such change. Where the effect of such change is not
ascertainable, wholly or in part, the fact should be indicated. If a change is made in the
accounting policies which has no material effect on the financial statements for the
current period but which is reasonably expected to have a material effect in later
periods, the fact of such change should be appropriately disclosed in the period in
which the change is adopted.
“33. A change in accounting policy consequent upon the adoption of an Accounting
Standard should be accounted for in accordance with the specific transitional
provisions, if any, contained in that Accounting Standard. However, disclosures
required by paragraph 32 of this Statement should be made unless the transitional
provisions of any other Accounting Standard require alternative disclosures in this
regard. ”∗

AS 6 (REVISED) : DEPRECIATION ACCOUNTING

Accounting Standard (AS) 6, ‘Depreciation Accounting’, was issued by the Institute in 1985.
Subsequently, in the context of insertion of Schedule XIV in the Companies Act in 1988, the
Institute brought out a Guidance Note on Accounting for Depreciation in Companies. The
Guidance Note differed from AS-6 in respect of accounting treatment of (a) change in the


The Council of the Institute of Chartered Accountants of India decided to add this
paragraph after paragraph 32 of AS 5.
The above revision comes into effect in respect of accounting periods commencing on or
after 1.4.2001.
I.42 Financial Reporting

method of depreciation, and (b) change in the rates of depreciation.


Based on the recommendations of the Accounting Standards Board, the Council of the
Institute at its 168th meeting held on May 26-29, 1994, decided to bring AS-6 in line with the
Guidance Note in respect of the aforementioned matters. Accordingly, it was decided to
modify paragraphs 11, 15, 22 and 24 and delete paragraph 19 of AS-6. Also, in the context of
delinking of rates of depreciation under the Companies Act from those under the Income-tax
Act/Rules by the Companies (Amendment) Act, 1988, the Council decided to suitably modify
paragraph 13 of AS 6. From the date of AS26 ‘Intangible Assets’ becoming mandatory for the
concerned enterprises, the standard stands withdrawn in so far as it relates to the
amortization(depreciation of intangible assets).
The complete text of the revised AS-6, which incorporates the above changes, is given below.

Introduction
1. This Statement deals with depreciation accounting and applies to all depreciable assets,
except the following items to which special considerations apply :
(i) forests, plantations and similar regenerative natural resources;
(ii) wasting assets including expenditure on the exploration for and extraction of minerals,
oils, natural gas and similar non-regenerative resources;
(iii) expenditure on research and development;
(iv) goodwill;
(v) live stock.
This statement also does not apply to land unless it has a limited useful life for the enterprise.
2. Different accounting policies for depreciation are adopted by different enterprises.
Disclosure of accounting policies for depreciation followed by an enterprise is necessary to
appreciate the view presented in the financial statements of the enterprise.

Definitions
3. The following terms are used in this statement with the meanings specified :
3.1 ‘Depreciation’ is a measure of the wearing out, consumption or other loss of value of a
depreciable asset arising from use, effluxion of time or obsolescence through technology and
market changes. Depreciation is allocated so as to charge a fair proportion of the depreciable
amount in each accounting period during the expected useful life of the asset. Depreciation
includes amortisation of assets whose useful life is predetermined.
3.2 ‘Depreciable assets’ are assets which :
(i) are expected to be used during more than one accounting period;
Appendix I : Accounting Standards I.43

(ii) have a limited useful life; and


(iii) are held by an enterprise for use in the production or supply of goods and services, for
rental to others, or for administrative purposes and not for the purpose of sale in the ordinary
course of business.
3.3 ‘Useful life’ is either (i) the period over which a depreciable asset is expected to be used
by the enterprise; or (ii) the number of production or similar units expected to be obtained from
the use of the asset by the enterprise.
3.4 ‘Depreciable amount’ of a depreciable asset is its historical cost, or other amount
substituted for historical cost∗ in the financial statements, less the estimated residual value.

Explanation
4. Depreciation has a significant effect in determining and presenting the financial position
and results of operations of an enterprise. Depreciation is charged in each accounting period
by reference to the extent of the depreciable amount, irrespective of an increase in the market
value of the assets.
5. Assessment of depreciation and the amount to be charged in respect thereof in an
accounting period are usually based on the following three factors:
(i) historical cost or other amount substituted for the historical cost of the depreciable asset
when the asset had been revalued;
(ii) expected useful life of the depreciable asset; and
(iii) estimated residual value of the depreciable asset.
6. Historical cost of a depreciable asset represents its money outlay or its equivalent in
connection with its acquisition, installation and commissioning as well as for additions to or
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, changes in duties or similar factors.
7. The useful life of a depreciable asset is shorter than its physical life and is :
(i) pre-determined by legal or contractual limits, such as the expiry dates of related leases;
(ii) directly governed by extraction or consumption;
(iii) dependent on the extent of use and physical deterioration on account of wear and tear


This statement does not deal with the treatment of the revaluation difference which
may arise when historical costs are substituted by revaluations.
I.44 Financial Reporting

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
(iv) 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 asset; or
(d) legal or other restrictions.
8. Determination of the useful life of a depreciable asset is a matter of estimation and is
normally based on various factors including experience with similar types of assets. Such
estimation is more difficult for an asset using new technology or used in the production of a
new product or in the provision of a new service but is nevertheless required on some
reasonable basis.
9. 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 remaining useful 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.
10. 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 residual value
is likely to be significant, it is estimated at the time of acquisition/installation, or at the time of
subsequent revaluation of the asset. One of the bases for determining the residual value
would be the realisable 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.
11. The quantum of depreciation to be provided in an accounting period involves the exercise
of judgment by management in the light of technical, commercial, accounting and legal
requirements and accordingly may need periodical review. If it is considered that the original
estimate of useful life of an asset requires any revision, the unamortised depreciable amount
of the asset is charged to revenue over the revised remaining useful life.
12. There are several methods of allocating depreciation over the useful life of the assets.
Those most commonly employed in industrial and commercial enterprises are the straightline
method and the reducing balance method. The management of a business selects the most
appropriate method(s) 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. In respect of depreciable assets which do not have
Appendix I : Accounting Standards I.45

material value depreciation is often allocated fully in the accounting period in which they are
acquired.
13. The statute governing an enterprise may provide the basis for computation of the
depreciation. For example, the Companies Act, 1956 lays down the rates of depreciation in
respect of various assets. Where the managements’ estimate of the useful life of an asset of
the enterprise is shorter than that envisaged under the provisions of the relevant statute, the
depreciation provision is appropriately computed by applying a higher rate. If the manage-
ment’s 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.
14. Where depreciable assets are disposed of, discarded, demolished or destroyed, the net
surplus or deficiency, if material, is disclosed separately.
15. The method of depreciation is applied consistently to provide comparability of the results
of the operations of the enterprise from period to period. A change from one method of
providing depreciation to another is made only if the adoption of the new method is required
by statute or for 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.
16. Where the historical cost of an asset has undergone a change due to circumstances
specified in para 6 above, the depreciation on the revised unamortised depreciable amount is
provided prospectively over the residual useful life of the asset.

Disclosure
17. The depreciation methods used, the total depreciation for the period for each class of
assets, the gross amount of each class of depreciable assets and the related accumulated
depreciation are disclosed in the financial statements along with the disclosure of other
accounting policies. The depreciation rates or the useful lives of the assets are disclosed only
if they are different from the principal rates specified in the statute governing the enterprise.
18. 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
I.46 Financial Reporting

revaluation has a material effect on the amount of depreciation, the same is disclosed
separately in the year in which revaluation is carried out.
19. A change in the method of depreciation is treated as a change in an accounting policy
and is disclosed accordingly.∗
Accounting Standard
(The Accounting Standard comprises paragraphs 20-29 of this Statement. The Standard
should be read in the context of paragraphs 1-19 of this Statement and of the ‘Preface to the
Statements of Accounting Standards’.)
20. The depreciable amount of a depreciable asset should be allocated on a
systematic basis to each accounting period during the useful life of the asset.
21. The depreciation method selected should be applied consistently from period to
period. A change from one method of providing depreciation to another should be made
only if the adoption of the new method is required by statute or for 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 should be
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 should be 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 should be charged
in the statement of profit and loss. In case the change in the method results in surplus,
the surplus should be credited to the statement of profit and loss. Such a change
should be treated as a change in accounting policy and its effect should be quantified
and disclosed.
22. The useful life of a depreciable asset should be estimated after considering the
following factors:
(i) expected physical wear and tear;
(ii) obsolescence;
(iii) legal or other limits on the use of the asset.
23. The useful lives of major depreciable assets or classes of depreciable assets may
be reviewed periodically. Where there is a revision of the estimated useful life of an
asset, the unamortised depreciable amount should be charged over the revised
remaining useful life.


Refer to AS 5
Appendix I : Accounting Standards I.47

24. Any addition or extension which becomes an integral part of the existing asset
should be depreciated over the remaining useful life of that asset. The depreciation on
such addition or extension may also be provided at the rate applied to the existing
asset. Where an addition or extension retains a separate identity and is capable of
being used after the existing asset is disposed of, depreciation should be provided
independently on the basis of an estimate of its own useful life.

25. Where the historical cost of a depreciable asset has undergone a change due to
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 should be provided prospectively over the residual
useful life of the asset.
26. Where the depreciable assets are revalued, the provision for depreciation should
be based on the revalued amount and on the estimate of the remaining useful lives of
such assets. In case the revaluation has a material effect on the amount of depreciation,
the same should be disclosed separately in the year in which revaluation is carried out.
27. If any depreciable asset is disposed of, discarded, demolished or destroyed, the
net surplus or deficiency, if material, should be disclosed separately.
28. 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.
29. 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.


Refer to AS 11 (Revised 2003), “The Effects of Changes in Foreign Exchange Rates”.
I.48 Financial Reporting

AS 7 (REVISED)3 : CONSTRUCTION CONTRACTS

Construction Contracts
Accounting Standard (AS) 7, Construction Contracts (revised), issued by the Council of the
Institute of Chartered Accountants of India, comes into effect in respect of all contracts
entered into during accounting periods commencing on or after 1-4-2003 and is mandatory in
nature from that date. Accordingly, Accounting Standard (AS) 7, ‘Accounting for Construction
Contracts’, issued by the Institute in December 1983, is not applicable in respect of such
contracts. Early application of this Standard is, however, encouraged.
The following is the text of the revised Accounting Standard.

Objective
The objective of this Statement is to prescribe the accounting treatment of revenue and costs
associated with construction contracts. Because of the nature of the activity undertaken in
construction contracts, the date at which the contract activity is entered into and the date
when the activity is completed usually fall into different accounting periods. Therefore, the
primary issue in accounting for construction contracts is the allocation of contract revenue and
contract costs to the accounting periods in which construction work is performed. This
Statement uses the recognition criteria established in the Framework for the Preparation and
Presentation of Financial Statements to determine when contract revenue and contract costs
should be recognised as revenue and expenses in the statement of profit and loss. It also
provides practical guidance on the application of these criteria.

Scope
1. This Statement should be applied in accounting for construction contracts in the
financial statements of contractors.

Definitions
2. The following terms are used in this Statement with the meanings specified:
A construction contract is a contract specifically negotiated for the construction of an
asset or a combination of assets that are closely interrelated or interdependent in terms
of their design, technology and function or their ultimate purpose or use.
A fixed price contract is a construction contract in which the contractor agrees to a
fixed contract price, or a fixed rate per unit of output, which in some cases is subject to

3
Revised in 2002
Appendix I : Accounting Standards I.49

cost escalation clauses.


A cost plus contract is a construction contract in which the contractor is reimbursed for
allowable or otherwise defined costs, plus percentage of these costs or a fixed fee.
3. A construction contract may be negotiated for the construction of a single asset such as
a bridge, building, dam, pipeline, road, ship or tunnel. A construction contract may also deal
with the construction of a number of assets which are closely interrelated or interdependent in
terms of their design, technology and function or their ultimate purpose or use; examples of
such contracts include those for the construction of refineries and other complex pieces of
plant or equipment.
4. For the purposes of this Statement, construction contracts include:
(a) contracts for the rendering of services which are directly related to the construction of the
asset, for example, those for the services of project managers and architects; and
(b) contracts for destruction or restoration of assets, and the restoration of the environment
following the demolition of assets.
5. Construction contracts are formulated in a number of ways which, for the purposes of this
Statement, are classified as fixed price contracts and cost plus contracts. Some construction
contracts may contain characteristics of both a fixed price contract and a cost plus contract,
for example, in the case of a cost plus contract with an agreed maximum price. In such
circumstances, a contractor needs to consider all the conditions in paragraphs 22 and 23 in
order to determine when to recognise contract revenue and expenses.

Combining and Segmenting Construction Contracts


6. The requirements of this Statement are usually applied separately to each construction
contract. However, in certain circumstances, it is necessary to apply the Statement to the
separately identifiable components of a single contract or to a group of contracts together in
order to reflect the substance of a contract or a group of contracts.
7. When a contract covers a number of assets, the construction of each asset should
be treated as a separate construction contract when:
(a) separate proposals have been submitted for each asset;
(b) each asset has been subject to separate negotiation and the contractor and
customer have been able to accept or reject that part of the contract relating to each
asset; and
(c) the costs and revenues of each asset can be identified.
8. A group of contracts, whether with a single customer or with several customers,
should be treated as a single construction contract when:
I.50 Financial Reporting

(a) the group of contracts is negotiated as a single package;


(b) the contracts are so closely interrelated that they are, in effect, part of a single
project with an overall profit margin; and
(c) the contracts are performed concurrently or in a continuous sequence.
9. A contract may provide for the construction of an additional asset at the option of
the customer or may be amended to include the construction of an additional asset. The
construction of the additional asset should be treated as a separate construction
contract when:
(a) the asset differs significantly in design, technology or function from the asset or
assets covered by the original contract; or
(b) the price of the asset is negotiated without regard to the original contract price.
Contract Revenue
10. Contract revenue∗ should comprise:
(a) the initial amount of revenue agreed in the contract; and
(b) variations in contract work, claims and incentive payments:
(i) to the extent that it is probable that they will result in revenue; and
(ii) they are capable of being reliably measured
11. Contract revenue is measured at the consideration received or receivable. The
measurement of contract revenue is affected by a variety of uncertainties that depend on the
outcome of future events. The estimates often need to be revised as events occur and
uncertainties are resolved. Therefore, the amount of contract revenue may increase or
decrease from one period to the next. For example:
(a) a contractor and a customer may agree to variations or claims that increase or decrease
contract revenue in a period subsequent to that in which the contract was initially agreed;
(b) the amount of revenue agreed in a fixed price contract may increase as a result of cost
escalation clauses;
(c) the amount of contract revenue may decrease as a result of penalties arising from delays
caused by the contractor in the completion of the contract; or
(d) when a fixed price contract involves a fixed price per unit of output, contract revenue
increases as the number of units is increased.
12. A variation is an instruction by the customer for a change in the scope of the work to be


See also ASI 29.
Appendix I : Accounting Standards I.51

performed under the contract. A variation may lead to an increase or a decrease in contract
revenue. Examples of variations are changes in the specifications or design of the asset and
changes in the duration of the contract. A variation is included in contract revenue when:
(a) it is probable that the customer will approve the variation and the amount of revenue
arising from the variation; and
(b) the amount of revenue can be reliably measured.
13. A claim is an amount that the contractor seeks to collect from the customer or another
party as reimbursement for costs not included in the contract price. A claim may arise from, for
example, customer caused delays, errors in specifications or design, and disputed variations
in contract work. The measurement of the amounts of revenue arising from claims is subject to
a high level of uncertainty and often depends on the outcome of negotiations. Therefore,
claims are only included in contract revenue when:
(a) negotiations have reached an advanced stage such that it is probable that the customer
will accept the claim; and
(b) the amount that it is probable will be accepted by the customer can be measured reliably.
14. Incentive payments are additional amounts payable to the contractor if specified
performance standards are met or exceeded. For example, a contract may allow for an
incentive payment to the contractor for early completion of the contract. Incentive payments
are included in contract revenue when:
(a) the contract is sufficiently advanced that it is probable that the specified performance
standards will be met or exceeded; and
(b) the amount of the incentive payment can be measured reliably.

Contract Costs
15. Contract costs should comprise:
(a) costs that relate directly to the specific contract;
(b) costs that are attributable to contract activity in general and can be allocated to
the contract; and
(c) such other costs as are specifically chargeable to the customer under the terms of
the contract.
16. Costs that relate directly to a specific contract include:
(a) site labour costs, including site supervision;
(b) costs of materials used in construction;
(c) depreciation of plant and equipment used on the contract;
I.52 Financial Reporting

(d) costs of moving plant, equipment and materials to and from the contract site;
(e) costs of hiring plant and equipment;
(f) costs of design and technical assistance that is directly related to the contract;
(g) the estimated costs of rectification and guarantee work, including expected warranty
costs; and
(h) claims from third parties.
These costs may be reduced by any incidental income that is not included in contract revenue,
for example income from the sale of surplus materials and the disposal of plant and equipment
at the end of the contract.
17. Costs that may be attributable to contract activity in general and can be allocated to
specific contracts include:
(a) insurance;
(b) costs of design and technical assistance that is not directly related to a specific contract;
and
(c) construction overheads.
Such costs are allocated using methods that are systematic and rational and are applied
consistently to all costs having similar characteristics. The allocation is based on the normal
level of construction activity. Construction overheads include costs such as the preparation
and processing of construction personnel payroll. Costs that may be attributable to contract
activity in general and can be allocated to specific contracts also include borrowing costs as
per Accounting Standard (AS) 16, Borrowing Costs.
18. Costs that are specifically chargeable to the customer under the terms of the contract
may include some general administration costs and development costs for which
reimbursement is specified in the terms of the contract.
19. Costs that cannot be attributed to contract activity or cannot be allocated to a contract
are excluded from the costs of a construction contract. Such costs include:
(a) general administration costs for which reimbursement is not specified in the contract;
(b) selling costs;
(c) research and development costs for which reimbursement is not specified in the contract;
and
(d) depreciation of idle plant and equipment that is not used on a particular contract.
20. Contract costs include the costs attributable to a contract for the period from the date of
securing the contract to the final completion of the contract. However, costs that relate directly
Appendix I : Accounting Standards I.53

to a contract and which are incurred in securing the contract are also included as part of the
contract costs if they can be separately identified and measured reliably and it is probable that
the contract will be obtained. When costs incurred in securing a contract are recognised as an
expense in the period in which they are incurred, they are not included in contract costs when
the contract is obtained in a subsequent period.

Recognition of Contract Revenue and Expenses


21. When the outcome of a construction contract can be estimated reliably, contract
revenue and contract costs associated with the construction contract should be
recognised as revenue and expenses respectively by reference to the stage of
completion of the contract activity at the reporting date. An expected loss on the
construction contract should be recognised as an expense immediately in accordance
with paragraph 35.
22. In the case of a fixed price contract, the outcome of a construction contract can be
estimated reliably when all the following conditions are satisfied:
(a) total contract revenue can be measured reliably;
(b) it is probable that the economic benefits associated with the contract will flow to
the enterprise;
(c) both the contract costs to complete the contract and the stage of contract
completion at the reporting date can be measured reliably; and
(d) the contract costs attributable to the contract can be clearly identified and
measured reliably so that actual contract costs incurred can be compared with prior
estimates.
23. In the case of a cost plus contract, the outcome of a construction contract can be
estimated reliably when all the following conditions are satisfied:
(a) it is probable that the economic benefits associated with the contract will flow to
the enterprise; and
(b) the contract costs attributable to the contract, whether or not specifically
reimbursable, can be clearly identified and measured reliably.
24. The recognition of revenue and expenses by reference to the stage of completion of a
contract is often referred to as the percentage of completion method. Under this method,
contract revenue is matched with the contract costs incurred in reaching the stage of
completion, resulting in the reporting of revenue, expenses and profit which can be attributed
to the proportion of work completed. This method provides useful information on the extent of
contract activity and performance during a period.
25. Under the percentage of completion method, contract revenue is recognised as revenue
I.54 Financial Reporting

in the statement of profit and loss in the accounting periods in which the work is performed.
Contract costs are usually recognised as an expense in the statement of profit and loss in the
accounting periods in which the work to which they relate is performed. However, any
expected excess of total contract costs over total contract revenue for the contract is
recognised as an expense immediately in accordance with paragraph 35.
26. A contractor may have incurred contract costs that relate to future activity on the
contract. Such contract costs are recognised as an asset provided it is probable that they will
be recovered. Such costs represent an amount due from the customer and are often classified
as contract work in progress.
27. When an uncertainty arises about the collectability of an amount already included in
contract revenue, and already recognised in the statement of profit and loss, the uncollectable
amount or the amount in respect of which recovery has ceased to be probable is recognised
as an expense rather than as an adjustment of the amount of contract revenue.
28. An enterprise is generally able to make reliable estimates after it has agreed to a
contract which establishes:
(a) each party’s enforceable rights regarding the asset to be constructed;
(b) the consideration to be exchanged; and
(c) the manner and terms of settlement.
It is also usually necessary for the enterprise to have an effective internal financial budgeting
and reporting system. The enterprise reviews and, when necessary, revises the estimates of
contract revenue and contract costs as the contract progresses. The need for such revisions
does not necessarily indicate that the outcome of the contract cannot be estimated reliably.
29. The stage of completion of a contract may be determined in a variety of ways. The
enterprise uses the method that measures reliably the work performed. Depending on the
nature of the contract, the methods may include:
(a) the proportion that contract costs incurred for work performed upto the reporting date
bear to the estimated total contract costs; or
(b) surveys of work performed; or
(c) completion of a physical proportion of the contract work.
Progress payments and advances received from customers may not necessarily reflect the
work performed.
30. When the stage of completion is determined by reference to the contract costs incurred
upto the reporting date, only those contract costs that reflect work performed are included in
costs incurred upto the reporting date. Examples of contract costs which are excluded are:
(a) contract costs that relate to future activity on the contract, such as costs of materials that
Appendix I : Accounting Standards I.55

have been delivered to a contract site or set aside for use in a contract but not yet installed,
used or applied during contract performance, unless the materials have been made specially
for the contract; and
(b) payments made to subcontractors in advance of work performed under the subcontract.
31. When the outcome of a construction contract cannot be estimated reliably:
(a) revenue should be recognised only to the extent of contract costs incurred of
which recovery is probable; and
(b) contract costs should be recognised as an expense in the period in which they are
incurred.
An expected loss on the construction contract should be recognised as an expense
immediately in accordance with paragraph 35.
32. During the early stages of a contract it is often the case that the outcome of the contract
cannot be estimated reliably. Nevertheless, it may be probable that the enterprise will recover
the contract costs incurred. Therefore, contract revenue is recognised only to the extent of
costs incurred that are expected to be recovered. As the outcome of the contract cannot be
estimated reliably,no profit is recognised. However, even though the outcome of the contract
cannot be estimated reliably, it may be probable that total contract costs will exceed total
contract revenue. In such cases, any expected excess of total contract costs over total
contract revenue for the contract is recognised as an expense immediately in accordance with
paragraph 35.
33. Contract costs recovery of which is not probable are recognised as an expense
immediately. Examples of circumstances in which the recoverability of contract costs incurred
may not be probable and in which contract costs may, therefore, need to be recognised as an
expense immediately include contracts:
(a) which are not fully enforceable, that is, their validity is seriously in question;
(b) the completion of which is subject to the outcome of pending litigation or legislation;
(c) relating to properties that are likely to be condemned or expropriated;
(d) where the customer is unable to meet its obligations; or
(e) where the contractor is unable to complete the contract or otherwise meet its obligations
under the contract.

34. When the uncertainties that prevented the outcome of the contract being estimated
reliably no longer exist, revenue and expenses associated with the construction
contract should be recognised in accordance with paragraph 21 rather than in
accordance with paragraph 31.
I.56 Financial Reporting

Recognition of Expected Losses


35. When it is probable that total contract costs will exceed total contract revenue, the
expected loss should be recognised as an expense immediately.
36. The amount of such a loss is determined irrespective of:
(a) whether or not work has commenced on the contract;
(b) the stage of completion of contract activity; or
(c) the amount of profits expected to arise on other contracts which are not treated as a
single construction contract in accordance with paragraph 8.

Changes in Estimates
37. The percentage of completion method is applied on a cumulative basis in each
accounting period to the current estimates of contract revenue and contract costs. Therefore,
the effect of a change in the estimate of contract revenue or contract costs, or the effect of a
change in the estimate of the outcome of a contract, is accounted for as a change in
accounting estimate (see Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior
Period Items and Changes in Accounting Policies). The changed estimates are used in
determination of the amount of revenue and expenses recognised in the statement of profit
and loss in the period in which the change is made and in subsequent periods.

Disclosure
38. An enterprise should disclose:
(a) the amount of contract revenue recognised as revenue in the period;
(b) the methods used to determine the contract revenue recognised in the period; and
(c) the methods used to determine the stage of completion of contracts in progress.
39. An enterprise should disclose the following for contracts in progress at the
reporting date:
(a) the aggregate amount of costs incurred and recognised profits (less recognised
losses) upto the reporting date;
(b) the amount of advances received; and
(c) the amount of retentions.
40. Retentions are amounts of progress billings which are not paid until the satisfaction of
conditions specified in the contract for the payment of such amounts or until defects have
been rectified. Progress billings are amounts billed for work performed on a contract whether
or not they have been paid by the customer. Advances are amounts received by the contractor
before the related work is performed.
Appendix I : Accounting Standards I.57

41. An enterprise should present:


(a) the gross amount due from customers for contract work as an asset; and
(b) the gross amount due to customers for contract work as a liability.
42. The gross amount due from customers for contract work is the net amount of:
(a) costs incurred plus recognised profits; less
(b) the sum of recognised losses and progress billings
for all contracts in progress for which costs incurred plus recognised profits (less recognised
losses) exceeds progress billings.
43. The gross amount due to customers for contract work is the net amount of:
(a) the sum of recognised losses and progress billings; less
(b) costs incurred plus recognised profits for all contracts in progress for which progress
billings exceed costs incurred plus recognised profits (less recognised losses).
44. An enterprise discloses any contingencies in accordance with Accounting Standard (AS)
4, Contingencies and Events Occurring After the Balance Sheet Date. Contingencies may
arise from such items as warranty costs, penalties or possible losses.∗

APPENDIX
The appendix is illustrative only and does not form part of the Accounting Standard. The
purpose of the appendix is to illustrate the application of the Accounting Standard to assist in
clarifying its meaning.

Disclosure of Accounting Policies


The following are examples of accounting policy disclosures:
Revenue from fixed price construction contracts is recognised on the percentage of
completion method, measured by reference to the percentage of labour hours incurred upto
the reporting date to estimated total labour hours for each contract.
Revenue from cost plus contracts is recognised by reference to the recoverable costs incurred
during the period plus the fee earned, measured by the proportion that costs incurred upto the
reporting date bear to the estimated total costs of the contract.


Pursuant to AS 29, Provisions, Contingent Liabilities and Contingent Assets, becoming
mandatory in respect of accounting periods commencing on or after 1.4.2004, all
paragraphs of AS 4 that deal with contingencies stand withdrawn except to the extent
they deal with impairment of assets not covered by other Indian Accounting Standards
I.58 Financial Reporting

The Determination of Contract Revenue and Expenses


The following example illustrates one method of determining the stage of completion of a
contract and the timing of the recognition of contract revenue and expenses (see paragraphs
21 to 34 of the Standard). (Amounts shown herein below are in Rs. lakhs)

A construction contractor has a fixed price contract for Rs. 9,000 to build a bridge. The initial
amount of revenue agreed in the contract is Rs. 9,000. The contractor’s initial estimate of
contract costs is Rs. 8,000. It will take 3 years to build the bridge.
By the end of year 1, the contractor’s estimate of contract costs has increased to Rs. 8,050.
In year 2, the customer approves a variation resulting in an increase in contract revenue of Rs.
200 and estimated additional contract costs of Rs. 150. At the end of year 2, costs incurred
include Rs. 100 for standard materials stored at the site to be used in year 3 to complete the
project.
The contractor determines the stage of completion of the contract by calculating the proportion
that contract costs incurred for work performed upto the reporting date bear to the latest
estimated total contract costs. A summary of the financial data during the construction period
is as follows:

(amount in Rs. lakhs)

Year 1 Year 2 Year 3

Initial amount of revenue agreed in contract 9,000 9,000 9,000


Variation —— 200 200
Total contract 9,000 9,200 9,200
Contract costs incurred upto the reporting date 2,093 6,168 8,200
Contract costs to complete 5,957 2,032 ——
Total estimated contract costs 8,050 8,200 8,200
Estimated Profit 950 1,000 1,000
Stage of completion 26% 74% 100%
The stage of completion for year 2 (74%) is determined by excluding from contract costs
incurred for work performed upto the reporting date, Rs. 100 of standard materials stored at
the site for use in year 3.
The amounts of revenue, expenses and profit recognised in the statement of profit and loss in
the three years are as follows:
Appendix I : Accounting Standards I.59

Upto the Recognised in Recognised in


Reporting Date Prior years current year

Year 1

Revenue (9,000x .26) 2,340 2,340


Expenses (8,050x .26) 2,093 2,093

Profit 247 247

Year 2

Revenue (9,200x .74) 6,808 2,340 4,468


Expenses (8,200x .74) 6,068 2,093 3,975

Profit 740 247 493

Year 3

Revenue (9,200x 1.00) 9,200 6,808 2,392


Expense 8,200 6,068 2,132

Profit 1,000 740 260

Contract Disclosures
A contractor has reached the end of its first year of operations. All its contract costs incurred
have been paid for in cash and all its progress billings and advances have been received in
cash. Contract costs incurred for contracts B, C and E include the cost of materials that have
been purchased for the contract but which have not been used in contract performance upto
the reporting date. For contracts B, C and E, the customers have made advances to the
contractor for work not yet performed.
The status of its five contracts in progress at the end of year 1 is as follows:

Contract

(amount in Rs. lakhs)

A B C D E Total

Contract Revenue recognised in 145 520 380 200 55 1,300


accordance with paragraph 21
Contract Expenses recognised in 110 450 350 250 55 1,215
accordance with paragraph 21
I.60 Financial Reporting

Expected Losses recognised in — — — 40 30 70


accordance with paragraph 35
Recognised profits less recognised 35 70 30 (90) (30) 15
losses

Contract Costs incurred in the period 110 510 450 250 100 1,420
Contract Costs incurred recognised
as contract expenses in the period
in accordance with paragraph 21 110 450 350 250 55 1,215

Contract Costs that relate to future


activity recognised as an asset in
accordance with paragraph 26 — 60 100 — 45 205
Contract Revenue (see above) 145 520 380 200 55 1,300
Progress Billings (paragraph 40) 100 520 380 180 55 1,235
Unbilled Contract Revenue 45 — — 20 — 65
Advances (paragraph 40) — 80 20 — 25 125
The amounts to be disclosed in accordance with the Standard are as follows:

Contract revenue recognised as revenue in the period (paragraph 38(a)) 1,300


Contract costs incurred and recognised profits (less recognised losses)
upto the reporting date (paragraph 39(a)) 1,435
Advances received (paragraph 39(b)) 125
Gross amount due from customers for contract work—
presented as an asset in accordance with paragraph 41(a) 220
Gross amount due to customers for contract work—
presented as a liability in accordance with paragraph 41(b) (20)
The amounts to be disclosed in accordance with paragraphs 39(a), 41(a) and 41(b) are
calculated as follows:

(amount in Rs. lakhs)

A B C D E TOTAL

Contract Costs incurred 110 510 450 250 100 1,420


Appendix I : Accounting Standards I.61

Recognised profits less 35 70 30 (90) (30) 15


recognised losses
145 580 480 160 70 1,435
Progress billings 100 520 380 180 55 1,235
Due from customers 45 60 100 — 15 220
Due to customers — — — (20) — (20)
The amount disclosed in accordance with paragraph 39(a) is the same as the amount for the
current period because the disclosures relate to the first year of operation.

AS 9 : REVENUE RECOGNITION

The following is the ‘text of the Accounting Standard 9 (AS 9) issued by the Institute of
Chartered Accountants of India on “Revenue Recognition1 ”.
In the initial years, this accounting standard will be recommendatory in character. During this
period, this standard is recommended for use by companies listed on a recognised stock
exchange and other large commercial, industrial and business enterprises in the public and
private sectors.

INTRODUCTION
1. This Statement deals with the bases for recognition of revenue in the statement of profit
and loss of an enterprise. The Statement is concerned with the recognition of revenue arising
in the course of the ordinary activities of the enterprise from
— the sale of goods∗
— the rendering of services, and
— the use by others of enterprise resources yielding interest, royalties and dividends.
2. This Statement does not deal with the following aspects of revenue recognition to which
special considerations apply :

1
It is reiterated that this AS (as in the case of other AS) assumes that the three
fundamental accounting assumptions i.e. going concern, consistency and accrual
have been followed in the preparation and presentation of financial statements.

Refer to ASI 14.
I.62 Financial Reporting

(i) Revenue arising from construction contracts;


(ii) Revenue arising from hire-purchase, lease agreements;
(iii) Revenue arising from government grants and other similar subsidies;
(iv) Revenue of insurance companies arising from insurance contracts.
3. Examples of items not included within the definition of “revenue” for the purpose of this
Statement are :
(i) Realised gains resulting from the disposal of, and unrealised gains resulting from the
holding of non-current assets e.g. appreciation in the value of fixed assets;
(ii) Unrealised holding gains resulting from the change in value of current assets, and the
natural increases in herds and agricultural and forest products;
(iii) Realised or unrealised gains resulting from changes in foreign exchange rates and
adjustments arising on the translation of foreign currency financial statements;
(iv) Realised gains resulting from the discharge of an obligation at less than its carrying
amount;
(v) Unrealised gains resulting from the restatement of the carrying amount of an obligation.

Definitions
4. The following terms are used in this Statement with the meanings specified:
4.1 Revenue is the gross inflow of cash, receivables or other consideration arising in the
course of the ordinary activities of an enterprise€ from the sale of goods, from the rendering of
services, and from the use by others of enterprise resources yielding interest, royalties and
dividends. Revenue is measured by the charges made to customers or clients for goods
supplied and services rendered to them and by the charges and rewards arising from the use
of resources by them. In an agency relationship, the revenue is the amount of commission and
not the gross inflow of cash, receivables or other consideration.
4.2 Completed Service contract method is a method of accounting which recognises revenue
in the statement of profit and loss only when the rendering of services under a contract is
completed or substantially completed.
4.3 Proportionate completion method is a method of accounting which recognises revenue in the
statement of profit and loss proportionately with the degree of completion of services under a
contract.


the Institute has issued an announcement in 2005 titled ‘Treatment of Inter-divisional
Transfers’. As per this announcement, the recognition of inter divisional transfers as sales
is an inappropriate treatment and is inconsistent with AS 9.
Appendix I : Accounting Standards I.63

Explanation
5. Revenue recognition is mainly concerned with the timing of recognition of revenue in the
statement of profit and loss of an enterprise. The amount of revenue arising on a transaction is
usually determined by agreement between the parties involved in the transaction. When
uncertainties exist regarding the determination of the amount, or its associated costs, these
uncertainties may influence the timing of revenue recognition.

6. SALE OF GOODS
6.1 A key criterion for determining when to recognise revenue from a transaction involving
the sale of goods is that the seller has transferred the property in the goods to the buyer for a
consideration. The transfer of property in goods, in most cases, results in or coincides with the
transfer of significant risks and rewards of ownership to the buyer. However, there may be
situations where transfer of property in goods, does not coincide with the transfer of significant
risks and rewards of ownership. Revenue in such situations is recognised at the time of
transfer of significant risks and rewards of ownership to the buyer. Such cases may arise
where delivery has been delayed through the fault of either the buyer or the seller and the
goods are at the risk of the party at fault as regards any loss which might not have occurred
but for such fault. Further, sometimes the parties may agree that the risk will pass at a time
different from the time when ownership passes.
6.2 At certain stages in specific industries, such as when agricultural crops have been
harvested or mineral ores have been extracted, performance may be substantially complete
prior to the execution of the transaction generating revenue. In such cases when sale is
assured under a forward contract or a government guarantee or where market exists and there
is a negligible risk of failure to sell, the goods involved are often valued at net realisable value.
Such amounts, while not revenue as defined in this Statement, are sometimes recognised in
the statement of profit and loss and appropriately described.

7. RENDERING OF SERVICES
7.1 Revenue from service transactions is usually recognised as the service is performed,
either by the proportionate completion method or by the completed service contract method.
(i) Proportionate completion method : Performance consists of the execution of more than
one act. Revenue is recognised proportionately by reference to the performance of each act.
The revenue recognised under this method would be determined on the basis of contract
value, associated costs, number of acts or other suitable basis. For practical purposes, when
services are provided by an indeterminate number of acts over a specific period of time,
revenue is recognised on a straight line basis over the specific period unless there is evidence
that some other method better represents the pattern of performance.
(ii) Completed service contract method : Performance consists of the execution of a single
I.64 Financial Reporting

act. Alternatively, services are performed in more than a single act, and the services yet to be
performed are so significant in relation to the transaction taken as a whole that performance
cannot be deemed to have been completed until the execution of those acts. The completed
service contract method is relevant to these patterns of performance and accordingly revenue
is recognised when the sole or final act takes place and the service becomes chargeable.

8. THE USE BY OTHERS OF ENTERPRISE RESOURCES YIELDING INTEREST,


ROYALTIES AND DIVIDENDS
8.1 The use by others of such enterprise resources gives rise to :
(i) interest - charges for the use of cash resources or amounts due to the enterprise;
(ii) royalties - charges for the use of such assets as know how, patents, trade marks and
copyrights;
(iii) dividends - rewards from the holding of investments in shares.
8.2 Interest accrues, in most circumstances, on the time basis determined by the amount
outstanding and the rate applicable. Usually, discount or premium on debt securities held is
treated as though it were accruing over the period to maturity.
8.3 Royalties accrue in accordance with the terms of the relevant agreement and are usually
recognised on that basis unless, having regard to the substance of the transactions, it is more
appropriate to recognise revenue on some other systematic and rational basis.
8.4 Dividends from investments in shares are not recognised in the statement of profit and
loss until a right to receive payment is established.
8.5 When interest, royalties and dividends from foreign countries require exchange
permission and uncertainty in remittance is anticipated, revenue recognition may need to be
postponed.

9. EFFECT OF UNCERTAINTIES ON REVENUE RECOGNITION


9.1 Recognition of revenue requires that revenue is measurable and that at the time of sale
of goods or the rendering of the service it would not be unreasonable to expect ultimate collec-
tion.
9.2 Where the ability to assess the ultimate collection with reasonable certainty is lacking at
the time of raising any claim, e.g., for escalation of price, export incentives, interest etc.,
revenue recognition is postponed to the extent of uncertainty involved. In such cases, it may
be appropriate to recognise revenue only when it is reasonably certain that the ultimate
collection will be made. Where there is no uncertainty as to ultimate collection, revenue is
recognised at the time of sale or rendering of service even though payments are made by
instalments.
Appendix I : Accounting Standards I.65

9.3 When the uncertainty relating to collectability arises subsequent to the time of sale or the
rendering of the service, it is more appropriate to make a separate provision to reflect the
uncertainty rather than to adjust the amount of revenue originally recorded.
9.4 An essential criterion for the recognition of revenue is that the consideration receivable
for the sale of goods,the rendering of services or from the use by others of enterprise
resources is reasonably determinable. When such consideration is not determinable within
reasonable limits, the recognition of revenue is postponed.
9.5 When recognition of revenue is postponed due to the effect of uncertainties, it is
considered as revenue of the period in which it is properly recognised.
Accounting Standard
(Accounting Standard comprises paragraphs 10-14 of this Statement. ‘The Standard should
be read in the context of paragraphs 1-9 of this Statement and of the Preface to the
Statements of Accounting Standards’.)
10. Revenue from sales or service transactions should be recognised when the
requirements as to performance set out in paragraphs 11 and 12 are satisfied, provided
that at the time of performance it is not unreasonable to expect ultimate collection. If at
the time of raising of any claim it is unreasonable to expect ultimate collection, revenue
recognition should be postponed.
11. In a transaction involving the sale of goods, performance should be regarded as
being achieved when the following conditions have been fulfilled :
(i) the seller of goods has transferred to the buyer the property in the goods for a
price or all significant risks and rewards of ownership have been transferred to the
buyer and the seller retains no effective control of the goods transferred to a degree
usually associated with ownership; and
(ii) no significant uncertainty exists regarding the amount of the consideration that
will be derived from the sale of the goods.
12. In a transaction involving the rendering of services, performance should be
measured either under the completed service contract method or under the
proportionate completion method, whichever relates revenue to the work accomplished.
Such performance should be regarded as being achieved when no significant
uncertainty exists regarding the amount of the consideration that will be derived from
rendering the service.
13. Revenue arising from the use by others of enterprise resources yielding interest,
royalties and dividends should only be recognised when no significant uncertainty as to
measurability or collectability exists. These revenues are recognised on the following
bases :
I.66 Financial Reporting

(i) Interest : on a time proportion basis taking into account the


amount outstanding and the rate applicable;
(ii) Royalties : on an accrual basis in accordance with the terms
of the relevant agreement; and
(iii) Dividends from : when the owner’s right to receive payment is
Investments in shares established.

Disclosure
14. In addition to the disclosures required by Accounting Standard 1 on Disclosure of
Accounting Policies (AS 1), an enterprise should also disclose the circumstances in
which revenue recognition has been postponed pending the resolution of significant
uncertainties.
APPENDIX
This appendix is illustrative only and does not form part of the accounting standard set forth in
this Statement. The purpose of the appendix is to illustrate the application of the Standard to a
number of commercial situations in an endeavour to assist in clarifying application of the
Standard.

A. Sale of goods
1 Delivery is delayed at buyer’s request and buyer takes title and accepts billing
Revenue should be recognised not withstanding that physical delivery has not been
completed so long as there is every expectation that delivery will be made. However, the
item must be on hand, identified and ready for delivery to the buyer at the time the sale is
recognised rather than there being simply an intention to acquire or manufacture the
goods in time for delivery.
2 Delivered subject to conditions
(a) installation and inspection i.e., goods are sold subject to installation, inspection etc.
Revenue should normally not be recognised until the customer accepts delivery and
installation and inspection are complete. In some cases, however, the installation
process may be so simple in nature that it may be appropriate to recognise the sale
notwithstanding that installation is not yet completed (e.g. installation of a factory
tested television receiver normally only requires unpacking and connecting of power
of antennae).
(b) on approval
Revenue should not be recognised until the goods have been formally accepted by
the buyer or the buyer has done an act adopting the transaction or the time period
Appendix I : Accounting Standards I.67

for rejection has elapsed or where no time has been fixed, a reasonable time has
elapsed.
(c) guaranteed sales i.e., delivery is made giving the buyer an unlimited right of return
Recognition of revenue in such circumstances will depend on the substance of the
agreement. In the case of retail sales offering a guarantee of “money back if not
completely satisfied” it may be appropriate to recognise the sale but to make a
suitable provision for returns based on previous experience. In other cases, the
substance of the agreement may amount to a sale on consignment, in which case it
should be treated as indicated below.
(d) consignment sales i.e., a delivery is made whereby the recipient undertakes to sell
the goods on behalf of the consignor
Revenue should not be recognised until the goods are sold to a third party.
(e) cash on delivery sales
Revenue should not be recognised until cash is received by the seller or his agent.
3. Sales where the purchaser makes a series of instalment payments to the seller and the
seller delivers the goods only when the final payment is received
Revenue from such sales should not be recognised until goods are delivered. However,
when experience indicates that most such sales have been consummated, revenue may
be recognised when a significant deposit is received.
4. Special orders and shipments, i.e. where payment (or partial payment) is received for
goods not presently held in stock, e.g. the stock is still to be manufactured or is to be
delivered directly to the customer from a third party.
Revenue from such sales should not be recognised until goods are manufactured, identified
and ready for delivery to the buyer by the third party.
5. Sale - repurchase agreements, i.e. where seller concurrently agrees to repurchase the
same goods at a later date
For such transactions that are in substance a financing agreement, the resulting cash
inflow is not revenue as defined and should not be recognised as revenue.
6. Sales to intermediate parties, i.e. where goods are sold to distributors, dealers or others
for resale
Revenue from such sales can generally be recognised if significant risks of ownership
have passed; however, in some situations the buyer may in substance be an agent and
in such cases the sale should be treated as a consignment sale.
7. Subscriptions for publications
Revenue received or billed should be differed and recognised either on a straight line
I.68 Financial Reporting

basis over time or, where the items delivered vary in value from period of period, revenue
should be based on the sales value of the item delivered in relation to the total sales
value of all items covered by the subscription.
8. Instalment sales
When the consideration is receivable in instalments, revenue attributable to the sales
price exclusive of interest should be recognised at the date of sale. The interest element
should be recognised as revenue, proportionately to the unpaid balance due to the seller.
9. Trade discounts and volume rebates
Trade discounts and volume rebates received are not encompassed within the definition
of revenue, since they represent a reduction of cost. Trade discounts and volume rebates
given should be deducted in determining revenue.

B. Rendering of services
1. Installation fees
In cases where installation fees are other than incidental to the sale of a product, they
should be recognised as revenue only when the equipment is installed and accepted by
the customer.
2. Advertising and insurance agency commissions
Revenue should be recognised when the service is completed. For advertising agencies,
media commissions will normally be recognised when the related advertisement or
commercial appears before the public and the necessary intimation is received by the
agency, as opposed to production commission, which will be recognised when the project
is completed. Insurance agency commissions should be recognised on the effective
commencement or renewal dates of the related policies.
3. Financial service commissions
A financial service may be rendered as a single act or may be provided over a period of
time. Similarly, charges for such services may be made as a single amount or in stages
over the period of the service or the life of the transaction to which it relates. Such
charges may be settled in full when made, or added to a loan or other account and
settled in stages. The recognition of such revenue should therefore have regard to :
(a) whether the service has been provided “once and for all” or is on a “continuing”
basis;
(b) the incidence of the costs relating to the service; and
(c) when the payment for the service will be received. In general, commissions charged
for arranging or granting loan or other facilities should be recognised when a
binding obligation has been entered into. Commitment, facility or loan management
Appendix I : Accounting Standards I.69

fees which relate to continuing obligations or services should normally be


recognised over the life of the loan or facility having regard to the amount of the
obligation outstanding, the nature of the services provided and the timing of the
costs relating thereto.
4. Admission fees
Revenue from artistic performances, banquets and other special events should be
recognised when the event takes place. When a subscription to a number of events is
sold, the fee should be allocated to each event on a systematic and rational basis.
5. Tuition fees
Revenue should be recognised over the period of instruction.
6. Entrance and membership fees
Revenue recognition from these sources will depend on the nature of the services being
provided. Entrance free received is generally capitalised. If the membership fee permits
only membership and all other services or products are paid for separately, or if there is
a separate annual subscription, the fee should be recognised when received. If the
membership fee entitles the member to services or publications to be provided during the
year, it should be recognised on a systematic and rational basis having regard to the
timing and nature of all services provided.

AS 10 : ACCOUNTING FOR FIXED ASSETS

The following is the text of the Accounting Standard 10 (AS 10) issued by the Institute of
Chartered Accountants of India on “Accounting for fixed assets”.
In the initial years, this accounting standard will be recommendatory in character. During this
period, this standard is recommended for use by companies listed on a recognised stock
exchange and other large commercial, industrial and business enterprises in the public and
private sectors.

INTRODUCTION
1. Financial statements disclose certain information relating to fixed assets. In many
enterprises these assets are grouped into various categories, such as land and buildings,
plant and machinery, vehicles, furniture and fittings, goodwill, patents, trademarks and
designs. This Statement deals with accounting for such fixed assets except as described in
I.70 Financial Reporting

paragraphs 2 to 5 below. ∗
2. This statement does not deal with the 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 basis.
3. This statement does not deal with accounting for the following items to which special
considerations apply :
(i) forests, plantations and similar regenerative natural resources ;
(ii) wasting assets including mineral rights, expenditure on the exploration for and extraction
of minerals, oil, natural gas and similar non-regenerative resources ;
(iii) expenditure on real estate development ; and
(iv) 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.
4. This statement does not cover the allocation of the depreciable amount of fixed assets to
future periods since this subject is dealt with in Accounting Standard 6 on “Depreciation
Accounting”.
5. This statement does not deal with the treatment of Government grants and subsidies,
and assets under leasing rights. It makes only a brief reference to the capitalisation of
borrowing costs£ and assets acquired in an amalgamation or merger. These subjects require
more extensive consideration than can be given within the statement.

Definitions
6. The following terms are used in this Statement with their meanings specified :
6.1 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.
6.2 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


From the date of AS 26, becoming mandatory for the concerned enterprises, the
relevant paragraphs of the standard that deal with patents and know-how, stand
withdrawn and therefore, the same are omitted from this standard.
£
The relevant requirements in this regard are omitted from this standard pursuant to As
16, Borrowing Costs, becoming mandatory in respect of accounting periods commencing
on or after 1.4.2004.
Appendix I : Accounting Standards I.71

informed and are not under any compulsion to transact.


6.3 Gross book value of a fixed asset is its historical cost or other amount substituted for
historical cost in the books of account or financial statements. When this amount is shown net
of accumulated depreciation, it is termed as net book value.

Explanation
7. 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 an expenditure represents an asset or an expense can have a
material effect on an enterprise’s reported results of operations.

8. IDENTIFICATION OF FIXED ASSETS


8.1 The definition in paragraph 6.1 gives criteria for determining whether items are to be
classified as fixed assets. Judgment is required in applying the criteria to specific
circumstances or specific types of enterprises. It may be appropriate to aggregate individually
insignificant items, and to apply the criteria to the aggregate value. An enterprise may decide
to expense an item which could otherwise have been included as fixed assets, because the
amount of the expenditure is not material.
8.2 Stand-by equipment and servicing equipment are normally capitalised. 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 assets 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.€
8.3 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.

9. COMPONENTS OF COST
9.1 The cost of an item of fixed assets comprises 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. Examples of directly attributable costs are :
(i) site preparation ;


See also ASI 2
I.72 Financial Reporting

(ii) initial delivery and handling costs ;


(iii) installation cost, such as special foundations for plant ; and
(iv) 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, changes in duties or similar factors.
9.21 Financing costs relating to deferred credits or to borrowed funds attributable to
construction or acquisition of fixed assets for the period up to the completion of construction or
acquisition of fixed assets are also sometimes included in the gross book value of the asset to
which they relate. However, financing costs (including interest) on fixed assets purchased on a
deferred credit basis or on monies borrowed for construction or acquisition of fixed assets are
not capitalised to the extent that such costs relate to periods after such assets are ready to be
put to use.
9.3 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 circum-
stances, 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.
9.4 The expenditure incurred on start-up and commissioning of the project, including the
expenditure incurred on test runs and experimental production, is usually capitalised 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 consumption, is not
capitalised and is treated as revenue expenditure even though the contract may stipulate that
the plant will not be finally taken over until after the satisfactory completion of the guarantee
period.
9.5 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
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 production2.

1
Pursuant to the issuance of AS 16, Borrowing costs, which comes into effect in respect of
accounting periods commencing on or after 1.4.2000, this paragraph stands withdrawn from
the aforesaid date.
2
It may be noted that this paragraph relates to "all expenses" incurred during the period. This
expenditure would also include borrowing costs incurred during the said period. Since AS 16,
Borrowing Costs, specifically deals with the treatment of borrowing costs, the treatment provided
by AS 16 would prevail over the provisions in this respect contained in this paragraph as these
provisions are general in nature and apply to "all expenses". Accordingly, this paragraph stands
withdrawn in so far as borrowing costs are concerned.
Appendix I : Accounting Standards I.73

10. SELF-CONSTRUCTED FIXED ASSETS


10.1 In arriving at the gross book value of self-constructed fixed assets, the same principles
apply as those described in paragraphs 9.1 to 9.5. 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.

11. NON-MONETARY CONSIDERATION


11.1 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. 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 exchanged are similar, is to record the asset acquired at
the net book value of asset given up. In each case an adjustment is made for any balancing
receipt or payment of cash or other consideration.
11.2 When a fixed asset is acquired in exchange for shares 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.

12. IMPROVEMENTS AND REPAIRS


12.1 Frequently, it is difficult to determine whether subsequent expenditure related to fixed
assets represents improvements that ought to be added to the gross book value or repairs 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.
12.2 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 book value.
Any addition or extension which has a separate identity and is capable of being used after the
existing asset is disposed of, is accounted for separately.

13. AMOUNT SUBSTITUTED FOR HISTORICAL COST


13.1 Sometimes financial statements that are otherwise prepared on a historical cost basis
include part or all of fixed assets at a valuation in substitution for historical costs and
I.74 Financial Reporting

depreciation is calculated accordingly. Such financial statements are to be distinguished from


financial statements prepared on a basis intended to reflect comprehensively the effects of
changing prices.
13.2 A commonly accepted and preferred method of restating fixed assets is by appraisal,
normally undertaken by competent valuers. Other methods sometimes used are indexation
and reference to current prices which when applied are cross checked periodically by
appraisal method.
13.3 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 of 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.
13.4 Different bases of valuation are sometimes used in the same financial statements to
determine the book value of the separate items within each of the categories of fixed assets or
for the different categories of fixed assets. In such cases, it is necessary to disclose the gross
book value included on each basis.
13.5 Selective revaluation of assets can lead to unrepresentative amounts being reported in
financial statements. Accordingly, when revaluations do not cover all the assets of a given
class, it is appropriate that the selection of assets to be revalued be made on a systematic
basis. For example, an enterprise may revalue a whole class of assets within a unit.
13.6 It is not appropriate for the revaluation of 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.
13.7 An increase in net book value arising on revaluation of fixed assets is normally credited
directly to owner’s interests under the heading of revaluation reserves and is regarded as not
available for distribution. A decrease in net book value arising on revaluation of fixed assets is
charged to profit and loss statement except that, to the extent that such a decrease is
considered to be related to a previous increase on revaluation that is included in revaluation
reserve, it is sometimes charged against that earlier increase. It sometimes happens that an
increase to be recorded is a reversal of a previous decrease arising on revaluation which has
been charged to profit and loss statement in which case the increase is credited to profit and
loss statement to the extent that it offsets the previously recorded decrease.

14. RETIREMENTS AND DISPOSALS


14.1 An item of fixed asset is eliminated from the financial statements on disposal.
14.2 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 net realisable value and are shown separately
Appendix I : Accounting Standards I.75

in the financial statements. Any expected loss is recognised immediately in the profit and loss
statement.
14.3 In historical cost financial statements, gains or losses arising on disposal are generally
recognised in the profit and loss statement.
14.4 On disposal of a previously revalued item of fixed asset, the difference between net
disposal proceeds and the net book value is normally charged or credited to the profit and loss
statement except that to the extent such a loss is related to an increase which was previously
recorded as a credit to revaluation reserve and which has not been subsequently reversed or
utilised, it is 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 reserve.

15. VALUATION OF FIXED ASSETS IN SPECIAL CASES


15.1 In the case of fixed assets acquired on hire purchase terms, although legal ownership
does not vest in the enterprise, such assets are recorded at their cash value, which if not
readily available, is calculated by assuming an appropriate rate of interest. They are shown in
the balance sheet with an appropriate narration to indicate that the enterprise does not have
full ownership thereof.3
15.2 Where an enterprise owns fixed assets jointly with others (otherwise than as a partner in
a firm), the extent of its share in such assets, and the proportion in the original cost, accumu-
lated depreciation and written down value are stated in the balance sheet. Alternatively, the
pro rata cost of such jointly owned assets is grouped together with similar fully owned assets.
Details of such jointly owned assets are indicated separately in the fixed assets register.
15.3 Where several assets are purchased for a consolidated price, the consideration is
apportioned to the various assets on a fair basis as determined by competent valuers.

16. FIXED ASSETS OF SPECIAL TYPES


16.1 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

3
AS 19, Leases has come into effect in respect of assets leased during accounting
periods commencing on or after 1.4.2001. AS 19 also applies to assets acquired on
hire purchase during accounting periods commencing on or after 1.4.2001.
Accordingly, this paragraph is not applicable in respect of assets acquired on hire
purchase during accounting periods commencing on or after 1.4.2001.
I.76 Financial Reporting

enjoyed by an enterprise.
16.2 As a matter of financial prudence, goodwill is written off over a period. However, many
enterprises do not write off goodwill and retain it as an asset.
4

17. DISCLOSURE
17.1 Certain specific disclosures on accounting for fixed assets are already required by
Accounting Standard 1 on “Disclosure of Accounting Policies” and Accounting Standard-6 on
“Depreciation Accounting”.
17.2 Further disclosures that are sometimes made in financial statements include :
(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 amounts substituted for historical costs of fixed assets, the method adopted to
compute the revalued amounts, 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.
Accounting Standard
(The Accounting Standard comprises paragraphs 18 to 39 of this Statement. The Standard
should be read in the context of paragraphs 1 to 17 of this Statement and of the ‘Preface to
the Statements of Accounting Standards’.)
18. The items determined in accordance with the definition in paragraph 6.1 of this
statement should be included under fixed assets in financial statements.
19. The gross book value of a fixed asset should be either historical cost or a
revaluation computed in accordance with this Standard. The method of accounting for
fixed assets included at historical cost is set out in paragraphs 20 to 26 ; the method of
accounting for revalued assets is set out in paragraphs 27 to 32.
20. The cost of a fixed asset should comprise its purchase price and any attributable
costs of bringing the asset to its working condition for its intended use. [Financing
costs relating to deferred credits or to borrowed funds attributable to construction or
acquisition of fixed assets for the period up to the completion of construction or

4
From the date of AS 26 becoming mandatory for the concerned enterprises, paragraphs
16.3 to 16.7 stand withdrawn and hence not given here.
Appendix I : Accounting Standards I.77

acquisition of fixed assets should also be included in the gross book value of the asset
to which they relate. However, the financing costs (including interest) on fixed assets
purchased on a deffered credit basis or on monies borrowed for construction or
acquisition of fixed assets should not be capitalised to the extent that such costs relate
to periods after such assets are ready to be put to use.]∗
21. The cost of a self-constructed fixed asset should comprise those costs that relate
directly to the specific asset and those that are attributable to the construction activity
in general and can be allocated to the specific asset.
22. When a fixed asset is acquired in exchange or in part exchange for another asset,
the cost of the asset acquired should be recorded either at fair market value or at the
net book value of the asset given up, adjusted for any balancing payment or receipt of
cash or other consideration. For these purposes fair market value may be determined
by reference either to the asset given up or to the asset acquired, whichever is more
clearly evident. Fixed asset acquired in exchange for shares or other securities in the
enterprise should be recorded at its fair market value, or the fair market value of the
securities issued, whichever is more clearly evident.
23. Subsequent expenditures related to an item of fixed asset should be added to its
book value only if they increase the future benefits from the existing asset beyond its
previously assessed standard of performance.
24. 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.
25. Fixed asset should be eliminated from the financial statements on disposal or
when no further benefit is expected from its use and disposal.
26. Losses arising from the retirement or gains or losses arising from disposal of fixed
asset which is carried at cost should be recognised in the profit and loss statement.
27. 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.
28. The revaluation in financial statements of a class of assets should not result in the
net book value of that class being greater than the recoverable amount of assets of that
class.
29. When a fixed asset is revalued upwards, any accumulated depreciation existing at


The marked portion of this paragraph has been withdrawn after issuance of AS16,
‘Borrowing Costs’.
I.78 Financial Reporting

the date of the revaluation should not be credited to the profit and loss statement.
30. An increase in net book value arising on revaluation of fixed assets should be
credited directly to owner’s interests under the head of revaluation reserve, 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 reserve and which has not been
subsequently reversed or utilised, it may be charged directly to that account.
31. The provisions of paragraphs 23,24 and 25 are also applicable to fixed assets
included in financial statements at a revaluation.
32. 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 to an increase
which was previously recorded as a credit to revaluation reserve and which has not
been subsequently reversed or utilised, it may be charged directly to that account.
33. Fixed assets acquired on hire purchase terms should be recorded at their cash
value, which, if not readily available, should be calculated by assuming an appropriate
rate of interest. They should be shown in the balance sheet with an appropriate
narration to indicate that the enterprise does not have full ownership thereof6.
34. In the case of fixed assets owned by the enterprise jointly with others, the extent of
the enterprise’s shares in such assets, and the proportion of the original cost,
accumulated depreciation and written down value should be stated in the balance
sheet. Alternatively, the pro rata cost of such jointly owned assets may be grouped
together with similar fully owned assets with an appropriate disclosure thereof.
35. 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 valuers.
36. Goodwill should be 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 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 should be termed as “goodwill”.

6
Refer footnote 3.
Appendix I : Accounting Standards I.79

37. {}∗
38. { } ∗

Disclosure
39. The following information should be disclosed in the financial statements :
(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 method
adopted to compute the revalued amounts, the nature of 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.

AS 11 (Revised 2003): THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES

(In this Accounting Standard, the standard portions have been set in bold italic type. These
should be read in the context of the background material which has been set in normal type,
and in the context of the ‘Preface to the Statements of Accounting Standards1'.)
Accounting Standard (AS) 11, The Effects of Changes in Foreign Exchange Rates (revised
2003), issued by the Council of the Institute of Chartered Accountants of India, comes into
effect in respect of accounting periods commencing on or after 1-4-2004 and is mandatory in
nature2 from that date. The revised Standard supersedes Accounting Standard (AS) 11,


From the date of AS 26 becoming mandatory for the concerned enterprises, paragraphs
37 and 38 stand withdrawn and hence not given here.

1
Attention is specifically drawn to paragraph 4.3 of the Preface, according to which
accounting standards are intended to apply only to material items.
2
This implies that, while discharging their attest function, it will be the duty of the
members of the Institute to examine whether this Accounting Standard is complied with in
the presentation of financial statements covered by their audit. In the event of any
deviation from this Accounting Standard, it will be their duty to make adequate
disclosures in their audit reports so that the users of financial statements may be aware
of such deviations.
I.80 Financial Reporting

Accounting for the Effects of Changes in Foreign Exchange Rates (1994), except that in
respect of accounting for transactions in foreign currencies entered into by the reporting
enterprise itself or through its branches before the date this Standard comes into effect, AS 11
(1994) will continue to be applicable.
The following is the text of the revised Accounting Standard.

Objective
An enterprise may carry on activities involving foreign exchange in two ways. It may have
transactions in foreign currencies or it may have foreign operations. In order to include foreign
currency transactions and foreign operations in the financial statements of an enterprise,
transactions must be expressed in the enterprise's reporting currency and the financial
statements of foreign operations must be translated into the enterprise's reporting currency.
The principal issues in accounting for foreign currency transactions and foreign operations are
to decide which exchange rate to use and how to recognise in the financial statements the
financial effect of changes in exchange rates.

Scope
1. This Statement should be applied:
(a) in accounting for transactions in foreign currencies; and
(b) in translating the financial statements of foreign operations.
2. This Statement also deals with accounting for foreign currency transactions in the nature
of forward exchange contracts.∗
3. This Statement does not specify the currency in which an enterprise presents its financial
statements. However, an enterprise normally uses the currency of the country in which it
is domiciled. If it uses a different currency, this Statement requires disclosure of the
reason for using that currency. This Statement also requires disclosure of the reason for


It may be noted that on the basis of a decision of the Council at its meeting held on
June 24-26, 2004, an Announcement title “Applicability of Accounting Standard (AS) 11
(revised 2003), The Effects of Changes in Foreign Exchange Rates, in respect of
exchange differences arising on a forward exchange contract entered into to hedge the
foreign currency risk of a firm commitment or a highly probable forecast transaction’ has
been issued. The Announcement clarifies that AS 11 (revised 2003) does not deal with
the accounting of exchange difference arising on a forward exchange contract entered
into to hedge the foreign currency risk of a firm commitment or a highly probable forecast
transaction. It has also been separately clarified that AS 11 (revised 2003) continues to
be applicable to exchange differences on all other forward exchange contracts.
Appendix I : Accounting Standards I.81

any change in the reporting currency.


4. This Statement does not deal with the restatement of an enterprise's financial statements
from its reporting currency into another currency for the convenience of users
accustomed to that currency or for similar purposes.
5. This Statement does not deal with the presentation in a cash flow statement of cash
flows arising from transactions in a foreign currency and the translation of cash flows of a
foreign operation (see AS 3, Cash Flow Statements).
6. This Statement does not deal with exchange differences arising from foreign currency
borrowings to the extent that they are regarded as an adjustment to interest costs (see
paragraph 4(e) of AS 16, Borrowing Costs).

Definitions
7. The following terms are used in this Statement with the meanings specified:
Average rate is the mean of the exchange rates in force during a period.
Closing rate is the exchange rate at the balance sheet date.
Exchange difference is the difference resulting from reporting the same number of
units of a foreign currency in the reporting currency at different exchange rates.
Exchange rate is the ratio for exchange of two currencies.
Fair value is the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arm's length transaction.
Foreign currency is a currency other than the reporting currency of an enterprise.
Foreign operation is a subsidiary3, associate4, joint venture5 or branch of the
reporting enterprise, the activities of which are based or conducted in a country
other than the country of the reporting enterprise.
Forward exchange contract means an agreement to exchange different currencies
at a forward rate.
Forward rate is the specified exchange rate for exchange of two currencies at a
specified future date.

3
As defined in AS 21, Consolidated Financial Statements.
4
As defined in AS 23, Accounting for Investments in Associates in Consolidated
Financial Statements.
5
As defined in AS 27, Financial Reporting of Interests in Joint Ventures.
I.82 Financial Reporting

Integral foreign operation is a foreign operation, the activities of which are an


integral part of those of the reporting enterprise.
Monetary items are money held and assets and liabilities to be received or paid in
fixed or determinable amounts of money.
Net investment in a non-integral foreign operation is the reporting enterprise’s
share in the net assets of that operation.
Non-integral foreign operation is a foreign operation that is not an integral foreign
operation.
Non-monetary items are assets and liabilities other than monetary items.
Reporting currency is the currency used in presenting the financial statements.

Foreign Currency Transactions

Initial Recognition
8. A foreign currency transaction is a transaction which is denominated in or requires
settlement in a foreign currency, including transactions arising when an enterprise either:
(a) buys or sells goods or services whose price is denominated in a foreign currency;
(b) borrows or lends funds when the amounts payable or receivable are denominated in
a foreign currency;
(c) becomes a party to an unperformed forward exchange contract; or
(d) otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated
in a foreign currency.

9. A foreign currency transaction should be recorded, on initial recognition in the


reporting currency, by applying to the foreign currency amount the exchange rate
between the reporting currency and the foreign currency at the date of the
transaction.
10. For practical reasons, a rate that approximates the actual rate at the date of the
transaction is often used, for example, an average rate for a week or a month might be
used for all transactions in each foreign currency occurring during that period. However,
if exchange rates fluctuate significantly, the use of the average rate for a period is
unreliable.

Reporting at Subsequent Balance Sheet Dates


11. At each balance sheet date:
(a) foreign currency monetary items should be reported using the closing rate.
However, in certain circumstances, the closing rate may not reflect with
Appendix I : Accounting Standards I.83

reasonable accuracy the amount in reporting currency that is likely to be


realised from, or required to disburse, a foreign currency monetary item at the
balance sheet date, e.g., where there are restrictions on remittances or where
the closing rate is unrealistic and it is not possible to effect an exchange of
currencies at that rate at the balance sheet date. In such circumstances, the
relevant monetary item should be reported in the reporting currency at the
amount which is likely to be realised from, or required to disburse, such item
at the balance sheet date;
(b) non-monetary items which are carried in terms of historical cost denominated
in a foreign currency should be reported using the exchange rate at the date
of the transaction; and
(c) non-monetary items which are carried at fair value or other similar valuation
denominated in a foreign currency should be reported using the exchange
rates that existed when the values were determined.
12. Cash, receivables, and payables are examples of monetary items. Fixed assets,
inventories, and investments in equity shares are examples of non-monetary items. The
carrying amount of an item is determined in accordance with the relevant Accounting
Standards. For example, certain assets may be measured at fair value or other similar
valuation (e.g., net realisable value) or at historical cost. Whether the carrying amount is
determined based on fair value or other similar valuation or at historical cost, the
amounts so determined for foreign currency items are then reported in the reporting
currency in accordance with this Statement. The contingent liability denominated in
foreign currency at the balance sheet date is disclosed by using the closing rate.

Recognition of Exchange Differences£


13. Exchange differences arising on the settlement of monetary items or on reporting
an enterprise's monetary items at rates different from those at which they were
initially recorded during the period, or reported in previous financial statements,

£
It may be noted that the Institute has issued in 2003 an Announcement titled ‘Treatment
of exchange differences under Accounting Standard (AS) 11 (revised 2003), The Effects
of Changes in Foreign Exchange Rates vis-à-vis Schedule VI to the Companies Act,
1956’. As per the Announcement, the requirement with regard to treatment of exchange
differences contained in AS 11 (revised 2003), is different from Schedule VI to the
Companies Act, 1956, since AS 11 (revised 2003) does not require the adjustment of
exchange differences in the carrying amount of the fixed assets, in the situations
envisaged in Schedule VI. It has been clarified that pending the amendment, if any, to
Schedule VI to the Companies Act, 1956, in respect of the matter, a company adopting
the treatment described in Schedule VI will still be considered to be complying with AS
11(revised 2003) for the purpose of section 211 of the act.
I.84 Financial Reporting

should be recognised as income or as expenses in the period in which they arise,


with the exception of exchange differences dealt with in accordance with
paragraph 15.
14. An exchange difference results when there is a change in the exchange rate between the
transaction date and the date of settlement of any monetary items arising from a foreign
currency transaction. When the transaction is settled within the same accounting period
as that in which it occurred, all the exchange difference is recognised in that period.
However, when the transaction is settled in a subsequent accounting period, the
exchange difference recognised in each intervening period up to the period of settlement
is determined by the change in exchange rates during that period.

Net Investment in a Non-integral Foreign Operation


15. Exchange differences arising on a monetary item that, in substance, forms part of
an enterprise's net investment in a non-integral foreign operation should be
accumulated in a foreign currency translation reserve in the enterprise's financial
statements until the disposal of the net investment, at which time they should be
recognised as income or as expenses in accordance with paragraph 31.
16. An enterprise may have a monetary item that is receivable from, or payable to, a non-
integral foreign operation. An item for which settlement is neither planned nor likely to
occur in the foreseeable future is, in substance, an extension to, or deduction from, the
enterprise's net investment in that non-integral foreign operation. Such monetary items
may include long-term receivables or loans but do not include trade receivables or trade
payables.

Financial Statements of Foreign Operations

Classification of Foreign Operations


17. The method used to translate the financial statements of a foreign operation depends on
the way in which it is financed and operates in relation to the reporting enterprise. For
this purpose, foreign operations are classified as either “integral foreign operations” or
“non-integral foreign operations”.
18. A foreign operation that is integral to the operations of the reporting enterprise carries on
its business as if it were an extension of the reporting enterprise's operations. For
example, such a foreign operation might only sell goods imported from the reporting
enterprise and remit the proceeds to the reporting enterprise. In such cases, a change in
the exchange rate between the reporting currency and the currency in the country of
foreign operation has an almost immediate effect on the reporting enterprise's cash flow
from operations. Therefore, the change in the exchange rate affects the individual
monetary items held by the foreign operation rather than the reporting enterprise's net
Appendix I : Accounting Standards I.85

investment in that operation.


19. In contrast, a non-integral foreign operation accumulates cash and other monetary items,
incurs expenses, generates income and perhaps arranges borrowings, all substantially in
its local currency. It may also enter into transactions in foreign currencies, including
transactions in the reporting currency. When there is a change in the exchange rate
between the reporting currency and the local currency, there is little or no direct effect on
the present and future cash flows from operations of either the non-integral foreign
operation or the reporting enterprise. The change in the exchange rate affects the
reporting enterprise's net investment in the non-integral foreign operation rather than the
individual monetary and non-monetary items held by the non-integral foreign operation.
20. The following are indications that a foreign operation is a non-integral foreign operation
rather than an integral foreign operation:
(a) while the reporting enterprise may control the foreign operation, the activities of the
foreign operation are carried out with a significant degree of autonomy from those of
the reporting enterprise;
(b) transactions with the reporting enterprise are not a high proportion of the foreign
operation's activities;
(c) the activities of the foreign operation are financed mainly from its own operations or
local borrowings rather than from the reporting enterprise;
(d) costs of labour, material and other components of the foreign operation's products
or services are primarily paid or settled in the local currency rather than in the
reporting currency;
(e) the foreign operation's sales are mainly in currencies other than the reporting
currency;
(f) cash flows of the reporting enterprise are insulated from the day-to-day activities of
the foreign operation rather than being directly affected by the activities of the
foreign operation;
(g) sales prices for the foreign operation’s products are not primarily responsive on a
short-term basis to changes in exchange rates but are determined more by local
competition or local government regulation; and
(h) there is an active local sales market for the foreign operation’s products, although
there also might be significant amounts of exports.
The appropriate classification for each operation can, in principle, be established from
factual information related to the indicators listed above. In some cases, the classification
of a foreign operation as either a non-integral foreign operation or an integral foreign
operation of the reporting enterprise may not be clear, and judgement is necessary to
determine the appropriate classification.
Integral Foreign Operations
I.86 Financial Reporting

21. The financial statements of an integral foreign operation should be translated


using the principles and procedures in paragraphs 8 to 16 as if the transactions of
the foreign operation had been those of the reporting enterprise itself.
22. The individual items in the financial statements of the foreign operation are translated as
if all its transactions had been entered into by the reporting enterprise itself. The cost and
depreciation of tangible fixed assets is translated using the exchange rate at the date of
purchase of the asset or, if the asset is carried at fair value or other similar valuation,
using the rate that existed on the date of the valuation. The cost of inventories is
translated at the exchange rates that existed when those costs were incurred. The
recoverable amount or realisable value of an asset is translated using the exchange rate
that existed when the recoverable amount or net realisable value was determined. For
example, when the net realisable value of an item of inventory is determined in a foreign
currency, that value is translated using the exchange rate at the date as at which the net
realisable value is determined. The rate used is therefore usually the closing rate. An
adjustment may be required to reduce the carrying amount of an asset in the financial
statements of the reporting enterprise to its recoverable amount or net realisable value
even when no such adjustment is necessary in the financial statements of the foreign
operation. Alternatively, an adjustment in the financial statements of the foreign operation
may need to be reversed in the financial statements of the reporting enterprise.
23. For practical reasons, a rate that approximates the actual rate at the date of the
transaction is often used, for example, an average rate for a week or a month might be
used for all transactions in each foreign currency occurring during that period. However,
if exchange rates fluctuate significantly, the use of the average rate for a period is
unreliable.

Non-integral Foreign Operations


24. In translating the financial statements of a non-integral foreign operation for
incorporation in its financial statements, the reporting enterprise should use the
following procedures:
(a) the assets and liabilities, both monetary and non-monetary, of the non-integral
foreign operation should be translated at the closing rate;
(b) income and expense items of the non-integral foreign operation should be
translated at exchange rates at the dates of the transactions; and
(c) all resulting exchange differences should be accumulated in a foreign
currency translation reserve until the disposal of the net investment.
25. For practical reasons, a rate that approximates the actual exchange rates, for example
an average rate for the period, is often used to translate income and expense items of a
foreign operation.
Appendix I : Accounting Standards I.87

26. The translation of the financial statements of a non-integral foreign operation results in
the recognition of exchange differences arising from:
(a) translating income and expense items at the exchange rates at the dates of
transactions and assets and liabilities at the closing rate;
(b) translating the opening net investment in the non-integral foreign operation at an
exchange rate different from that at which it was previously reported; and
(c) other changes to equity in the non-integral foreign operation.
These exchange differences are not recognised as income or expenses for the period
because the changes in the exchange rates have little or no direct effect on the present
and future cash flows from operations of either the non-integral foreign operation or the
reporting enterprise. When a non-integral foreign operation is consolidated but is not
wholly owned, accumulated exchange differences arising from translation and
attributable to minority interests are allocated to, and reported as part of, the minority
interest in the consolidated balance sheet.
27. Any goodwill or capital reserve arising on the acquisition of a non-integral foreign
operation is translated at the closing rate in accordance with paragraph 24.
28. A contingent liability disclosed in the financial statements of a non-integral foreign
operation is translated at the closing rate for its disclosure in the financial statements of
the reporting enterprise.
29. The incorporation of the financial statements of a non-integral foreign operation in those
of the reporting enterprise follows normal consolidation procedures, such as the
elimination of intra-group balances and intra-group transactions of a subsidiary (see AS
21, Consolidated Financial Statements, and AS 27, Financial Reporting of Interests in
Joint Ventures). However, an exchange difference arising on an intra-group monetary
item, whether short-term or long-term, cannot be eliminated against a corresponding
amount arising on other intra-group balances because the monetary item represents a
commitment to convert one currency into another and exposes the reporting enterprise to
a gain or loss through currency fluctuations. Accordingly, in the consolidated financial
statements of the reporting enterprise, such an exchange difference continues to be
recognised as income or an expense or, if it arises from the circumstances described in
paragraph 15, it is accumulated in a foreign currency translation reserve until the
disposal of the net investment.
30. When the financial statements of a non-integral foreign operation are drawn up to a
different reporting date from that of the reporting enterprise, the non-integral foreign
operation often prepares, for purposes of incorporation in the financial statements of the
reporting enterprise, statements as at the same date as the reporting enterprise. When it
is impracticable to do this, AS 21, Consolidated Financial Statements, allows the use of
financial statements drawn up to a different reporting date provided that the difference is
I.88 Financial Reporting

no greater than six months and adjustments are made for the effects of any significant
transactions or other events that occur between the different reporting dates. In such a
case, the assets and liabilities of the non-integral foreign operation are translated at the
exchange rate at the balance sheet date of the non-integral foreign operation and
adjustments are made when appropriate for significant movements in exchange rates up
to the balance sheet date of the reporting enterprises in accordance with AS 21. The
same approach is used in applying the equity method to associates and in applying
proportionate consolidation to joint ventures in accordance with AS 23, Accounting for
Investments in Associates in Consolidated Financial Statements and AS 27, Financial
Reporting of Interests in Joint Ventures.

Disposal of a Non-integral Foreign Operation


31. On the disposal of a non-integral foreign operation, the cumulative amount of the
exchange differences which have been deferred and which relate to that operation
should be recognised as income or as expenses in the same period in which the
gain or loss on disposal is recognised.
32. An enterprise may dispose of its interest in a non-integral foreign operation through sale,
liquidation, repayment of share capital, or abandonment of all, or part of, that operation.
The payment of a dividend forms part of a disposal only when it constitutes a return of
the investment. In the case of a partial disposal, only the proportionate share of the
related accumulated exchange differences is included in the gain or loss. A write-down of
the carrying amount of a non-integral foreign operation does not constitute a partial
disposal. Accordingly, no part of the deferred foreign exchange gain or loss is recognised
at the time of a write-down.

Change in the Classification of a Foreign Operation


33. When there is a change in the classification of a foreign operation, the translation
procedures applicable to the revised classification should be applied from the date of
the change in the classification.
34. The consistency principle requires that foreign operation once classified as integral or
non-integral is continued to be so classified. However, a change in the way in which a
foreign operation is financed and operates in relation to the reporting enterprise may lead
to a change in the classification of that foreign operation. When a foreign operation that
is integral to the operations of the reporting enterprise is reclassified as a non-integral
foreign operation, exchange differences arising on the translation of non-monetary assets
at the date of the reclassification are accumulated in a foreign currency translation
reserve. When a non-integral foreign operation is reclassified as an integral foreign
operation, the translated amounts for non-monetary items at the date of the change are
treated as the historical cost for those items in the period of change and subsequent
Appendix I : Accounting Standards I.89

periods. Exchange differences which have been deferred are not recognised as income
or expenses until the disposal of the operation.

All Changes in Foreign Exchange Rates

Tax Effects of Exchange Differences


35. Gains and losses on foreign currency transactions and exchange differences arising on
the translation of the financial statements of foreign operations may have associated tax
effects which are accounted for in accordance with AS 22, Accounting for Taxes on
Income.

Forward Exchange Contracts


36. An enterprise may enter into a forward exchange contract or another financial
instrument that is in substance a forward exchange contract, which is not intended
for trading or speculation purposes, to establish the amount of the reporting
currency required or available at the settlement date of a transaction. The premium
or discount arising at the inception of such a forward exchange contract should be
amortised as expense or income over the life of the contract. Exchange differences
on such a contract should be recognised in the statement of profit and loss in the
reporting period in which the exchange rates change. Any profit or loss arising on
cancellation or renewal of such a forward exchange contract should be recognised
as income or as expense for the period.
37. The risks associated with changes in exchange rates may be mitigated by entering into
forward exchange contracts. Any premium or discount arising at the inception of a
forward exchange contract is accounted for separately from the exchange differences on
the forward exchange contract. The premium or discount that arises on entering into the
contract is measured by the difference between the exchange rate at the date of the
inception of the forward exchange contract and the forward rate specified in the contract.
Exchange difference on a forward exchange contract is the difference between (a) the
foreign currency amount of the contract translated at the exchange rate at the reporting
date, or the settlement date where the transaction is settled during the reporting period,
and (b) the same foreign currency amount translated at the latter of the date of inception
of the forward exchange contract and the last reporting date.
38. A gain or loss on a forward exchange contract to which paragraph 36 does not
apply should be computed by multiplying the foreign currency amount of the
forward exchange contract by the difference between the forward rate available at
the reporting date for the remaining maturity of the contract and the contracted
forward rate (or the forward rate last used to measure a gain or loss on that
contract for an earlier period). The gain or loss so computed should be recognised
I.90 Financial Reporting

in the statement of profit and loss for the period. The premium or discount on the
forward exchange contract is not recognised separately.
39. In recording a forward exchange contract intended for trading or speculation purposes,
the premium or discount on the contract is ignored and at each balance sheet date, the
value of the contract is marked to its current market value and the gain or loss on the
contract is recognised.

Disclosure
40. An enterprise should disclose:
(a) the amount of exchange differences included in the net profit or loss for the
period; and
(b) net exchange differences accumulated in foreign currency translation reserve
as a separate component of shareholders’ funds, and a reconciliation of the
amount of such exchange differences at the beginning and end of the period.
41. When the reporting currency is different from the currency of the country in which
the enterprise is domiciled, the reason for using a different currency should be
disclosed. The reason for any change in the reporting currency should also be
disclosed.
42. When there is a change in the classification of a significant foreign operation, an
enterprise should disclose:
(a) the nature of the change in classification;
(b) the reason for the change;
(c) the impact of the change in classification on shareholders' funds; and
(d) the impact on net profit or loss for each prior period presented had the change in
classification occurred at the beginning of the earliest period presented.
43. The effect on foreign currency monetary items or on the financial statements of a foreign
operation of a change in exchange rates occurring after the balance sheet date is
disclosed in accordance with AS 4, Contingencies and Events Occurring After the
Balance Sheet Date.
44. Disclosure is also encouraged of an enterprise's foreign currency risk management
policy.

Transitional Provisions
45. On the first time application of this Statement, if a foreign branch is classified as a
non-integral foreign operation in accordance with the requirements of this
Statement, the accounting treatment prescribed in paragraphs 33 and 34 of the
Appendix I : Accounting Standards I.91

Statement in respect of change in the classification of a foreign operation should be


applied.

Appendix
Note: This Appendix is not a part of the Accounting Standard. The purpose of this appendix is
only to bring out the major differences between Accounting Standard 11 (revised 2003) and
corresponding International Accounting Standard (IAS) 21 (revised 1993).
Comparison with IAS 21, The Effects of Changes in Foreign Exchange Rates (revised 1993)
Revised AS 11 (2003) differs from International Accounting Standard (IAS) 21, The Effects of
Changes in Foreign Exchange Rates, in the following major respects in terms of scope,
accounting treatment, and terminology.
1. Scope

Inclusion of forward exchange contracts


Revised AS 11 (2003) deals with forward exchange contracts both intended for hedging and
for trading or speculation. IAS 21 does not deal with hedge accounting for foreign currency
items other than the classification of exchange differences arising on a foreign currency
liability accounted for as a hedge of a net investment in a foreign entity. It also does not deal
with forward exchange contracts for trading or speculation. The aforesaid aspects are dealt
with in IAS 39, Financial Instruments: Recognition and Measurement. Although, an Indian
accounting standard corresponding to IAS 39 is under preparation, it has been decided to deal
with accounting for forward exchange contracts in the revised AS 11 (2003), since the existing
AS 11 deals with the same. Thus, accounting for forward exchange contracts would not
remain unaddressed untill the issuance of the Indian accounting standard on financial
instruments.
2. Accounting treatment

Recognition of exchange differences resulting from severe currency devaluations


IAS 21, as a benchmark treatment, requires, in general, that exchange differences on
transactions be recognised as income or as expenses in the period in which they arise. IAS
21, however, also permits as an allowed alternative treatment, that exchange differences that
arise from a severe devaluation or depreciation of a currency be included in the carrying
amount of an asset, if certain conditions are satisfied. In line with the preference of the Council
of the Institute of Chartered Accountants of India, to eliminate alternatives, where possible,
revised AS 11 (2003) adopts the benchmark treatment as the only acceptable treatment.
3. Terminology
I.92 Financial Reporting

Foreign operation
The revised AS 11 (2003) uses the terms, integral foreign operation and non-integral foreign
operation respectively for the expressions “foreign operations that are integral to the
operations of the reporting enterprise” and “foreign entity” used in IAS 21. The intention is to
communicate the meaning of these terms concisely. This change has no effect on the
requirements in revised AS 11 (2003). Revised AS 11 (2003) provides additional
implementation guidance by including two more indicators for the classification of a foreign
operation as a non-integral foreign operation.

AS 12 : ACCOUNTING FOR GOVERNMENT GRANTS

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 withdrawn from this date. This Standard will become mandatory in respect of accounts
for periods commencing on or after 1-4-1994.1

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 :
(i) The special problems arising in accounting for government grants in financial statements
reflecting the effects of changing prices or in supplementary information of a similar nature;
(ii) Government assistance other than in the form of government grants ; and
(iii) Government participation in the ownership of the enterprise.

Definitions
3. The following terms are used in this Statement with the meanings specified :
3.1 Government refers to government, government agencies and similar bodies whether
local, national or international.
3.2 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
Appendix I : Accounting Standards I.93

government which cannot be distinguished from the normal trading transactions of the
enterprise.

Explanation
4. The receipt of government grants by an enterprise is significant for preparation of the
financial statements for two reasons. Firstly, if a government grant has been received, an
appropriate method of accounting therefore is necessary. Secondly, it is desirable to give an
indication of the extent to which the enterprise has benefited from such grant during the
reporting period.
This facilitates comparison of an enterprise’s financial statements with those of prior periods
and with those of other enterprises.

Accounting Treatment of Government Grants


5. Capital Approach versus Income Approach
5.1 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 shareholder’s funds,
and the ‘income approach’ under which a grant is taken to income over one or more periods.
5.2 Those in support of the ‘capital approach’ argue as follows :
(i) 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.
(ii) 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.
5.3 Arguments in support of the ‘income approach’ are as follows :
(i) Government grants are rarely gratuitous. The enterprise earns them through compliance
with their conditions and meeting the envisaged obligation. They should therefore be taken to
income and matched with the associated costs which the grant is intended to compensate.
(ii) 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.
(iii) 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.
5.4 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
I.94 Financial Reporting

approach may be more appropriate in the case of other grants.


5.5 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 [see Accounting Standard
(AS) 1, Disclosure of Accounting policies).
5.6 In most cases, the periods over which an enterprise recognises the costs or expenses
related to a government grant are readily ascertainable and thus grants in recognition of
specific expenses are taken to income in the same period as the relevant expenses.

6. RECOGNITION OF GOVERNMENT GRANTS


6.1 Government grants available to the enterprise are considered for inclusion in
accounts :
(i) where there is reasonable assurance that the enterprise will comply with the conditions
attached to them ; and
(ii) 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 conditions attaching to
the grant have been or will be fulfilled.
6.2 An appropriate amount in respect of such earned benefits, estimated on a prudent basis,
is credited to income for the year even though the actual amount of such benefits may be
finally settled and received after the end of the relevant accounting period.
6.3 A contingency related to a government grant, arising after the grant has been recognised,
is treated in accordance with Accounting Standard (AS) 4, Contingencies and Events
Occurring After the Balance Sheet Date.5
6.4 In certain circumstances, a government grant is awarded for the purpose of giving
immediate financial support to an enterprise rather than as an incentive to undertake specific
expenditure. Such grants may be confined to an individual enterprise and may not be available
to a whole class of enterprises. These circumstances may warrant taking the grant to income
in the period in which the enterprise qualifies to receive it, as an extraordinary item if
appropriate [see Accounting Standard (AS) 5, Prior Period and Extraordinary Items and

5
Pursuant to AS 29, becoming mandatory in respect of accounting periods commencing
on or afer 1.4.2004, all paragraphs of As 4 that deal with contingencies stand withdrawn
except to the extent they deal with impairment of assets not covered by other Indian
Accounting Standard.
Appendix I : Accounting Standards I.95

Changes in Accounting Policies]6.


6.5 Government grants may become receivable by an enterprise as compensation for
expenses or losses incurred in a previous accounting period. Such a grant is recognised in the
income statement of the period in which it becomes receivable, as an extraordinary item if
appropriate [see Accounting Standard (AS) 5, Prior Period and Extraordinary Items and
Changes in Accounting policies].

7. NON-MONETARY GOVERNMENT GRANTS


7.1 Government grants may take the form of non-monetary assets, such as land or other
resources, given at concessional rates. In these circumstances, it is usual to account for such
assets at their acquisition cost. Non-monetary assets given free of cost are recorded at a nominal
value.

8. PRESENTATION OF GRANTS RELATED TO SPECIFIC FIXED ASSETS


8.1 Grants related to specific fixed assets are government grants whose primary condition is
that an enterprise qualifying for them should purchase, construct or other- wise 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.
8.2 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.
8.3 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.
8.4 Under the other method, grants related to depreciable assets are treated as deferred
income which is recognised in the profit and loss statement on a systematic and rational basis
over the useful life of the asset. Such allocation 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 fulfilment of certain obligations, the grant is credited to income
over the same period over which the cost of meeting such obligations is charged to income.
The deferred income is suitably disclosed in the balance sheet pending its apportionment to

6
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’.
I.96 Financial Reporting

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, e.g., ‘Deferred
government grants’.
8.5 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 position regardless of whether or not the grant is deducted from the related asset for
the purpose of balance sheet presentation.

9. PRESENTATION OF GRANTS RELATED TO REVENUE


9.1 Grants related to revenue are sometimes presented as a credit in the profit and loss
statement, either separately or under a general heading such as ‘Other Income’. Alternatively,
they are deducted in reporting the related expense.
9.2 Supporters of the first method claim that it is inappropriate to net income and expense
items and that separation of the grant from the expense facilitates 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.

10. PRESENTATION OF GRANTS OF THE NATURE OF PROMOTERS’ CONTRIBUTION


10.1 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.

11. REFUND OF GOVERNMENT GRANTS


11.1 Government grants sometimes become refundable because certain conditions are not
fulfilled. A government grant that becomes refundable is treated as an extraordinary item [see
Accounting Standard (AS) 5, Prior Period Extraordinary Items and Changes in Accounting
Policies]1.
11.2 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

1
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’.
Appendix I : Accounting Standards I.97

exists, the amount is charged immediately to profit and loss statement.


11.3 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.
11.4 Where a grant which is in the nature of promoters’ contribution becomes refundable, in
part or in full, to the government on non-fulfilment of some specified conditions, the relevant
amount recoverable by the government is reduced from the capital reserve.

12. DISCLOSURE
12.1 The following disclosures are appropriate :
(i) the accounting policy adopted for government grants, including the methods of
presentation in the financial statement;
(ii) the nature and extent of government grants recognised in the financial statements,
including grants of non-monetary assets given at a concessional rate or free of cost.
Accounting Standard
(The Accounting Standard comprises paragraphs 13 to 23 of this Statement. The Standard should
be read in the context of paragraphs 1 to 12 of this Statement and of the ‘Preface to the State-
ments of Accounting Standards’.)
13. 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.
14. 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 fulfilment 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.
I.98 Financial Reporting

15. 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 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.
16. Government grants of the nature of promoters’ contribution should be credited to
capital reserve and treated as a part of shareholders’ funds.
17. 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.
18. 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 cost, 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 [see Accounting Standard (AS) 5,
Prior Period and Extraordinary Items and Changes in Accounting Policies]2.
19. 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.
20. Government grants that become refundable should be accounted for as an
extraordinary item [see Accounting Standard (AS) 5, Prior Period and Extraordinary
Items and Changes in Accounting Policies]3.
21. 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 value should be provided prospectively over the residual useful life of the
asset.
22. Government grants in the nature of promoters’ contribution that become

2
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’.
3
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’.
Appendix I : Accounting Standards I.99

refundable should be reduced from the capital reserve.

Disclosure
23. The following should be disclosed :
(i) the accounting policy adopted for government grants, including the methods of
presentation in the financial statements;
(ii) the nature and extent of government grants recognised in the financial statements,
including grants of non-monetary assets given at a concessional rate or free of cost.

AS 13∗ : ACCOUNTING FOR INVESTMENTS

Introduction
1. This statement deals with accounting for investments in the financial statements of
enterprises and related diclosure requirements.1
2. This statement does not deal with :
(a) the bases for recognition of interest, dividends and rentals earned on investments which
are covered by Accounting Standard 9 on Revenue Recognition;
(b) operating or finance leases;
(c) investments of retirement benefit plans and life insurance enterprises; and


A limited revision to this standard has been made in 2003, pursuant to which paragraph
2(d) of this standard has been revised (See footnote 2 to this standard)
1
Shares, debentures and other securities held as stock-in-trade (i.e. for sale in the
ordinary course of business) are not ‘investments’ as defined in this statement. However,
the manner in which they are accounted for and disclosed in the financial statements is
quite similar to that applicable in respect of current investments. Accordingly, the
provisions of this statement, to the extent that they relate to current investments, are also
applicable to shares, debentures and other securities held as stock-in-trade, with suitable
modifications as specified in this statement.
I.100 Financial Reporting

(d) mutual funds and venture capital funds2 and/or the related asset management
companies, banks and public financial institutions formed under a Central or State
Government Act or so declared under the Companies Act, 1956.

Definitions
3. The following terms are used in this Statement with the meanings assigned :
Investments are assets held by an enterprise for earning income by way of dividends, interest,
and rentals, for capital appreciation, or for other benefits to the investing enterprise. Assets
held as stock-in-trade are not ‘investments’.
A current investment is an investment that is by its nature readily realisable and is intended to
be held for not more than one year from the date on which such investment is made.
A long-term investment is an investment other than a current investment.
An investment property is an investment in land or buildings that are not intended to be
occupied substantially for use by, or in the operations of, the investing enterprise.
Fair value is the amount for which an asset could be exchanged between a knowledgeable,
willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Under
appropriate circumstances, market value or net realisable value provides an evidence of fair
value.
Market value is the amount obtainable from the sale of an investment in an open market, net
of expenses necessarily to be incurred on or before disposal.

Explanation

Forms of Investments
4. Enterprises hold investments for diverse reasons. For some enterprises, investment
activity is a significant element of operations, and assessment of the performance of the
enterprise may largely, or solely, depend on the reported results of this activity.
5. Some investments have no physical existence and are represented merely by certificates
or similar documents (e.g., shares) while others exist in a physical form (e.g., buildings). The
nature of an investment may be that of a debt, other than a short or long- term loan or a trade
debt, representing a monetary amount owing to the holder and usually bearing interest,
alternatively, it may be a stake in the results and net assets of an enterprise such as an equity

2
The Council of the Institute decided to make the limited revision to AS 13 in 2003
pursuant to which the words ‘and venture capital funds’ have been added in paragraph
2(d) of AS 13. This revision comes into effect in respect of accounting periods
commencing on or after 1.4.2002.
Appendix I : Accounting Standards I.101

share. Most investments represent financial rights, but some are tangible, such as certain
investments in land or buildings.
6. For some investments, an active market exists from which a market value can be
established. For such investments, market value generally provides the best evidence of fair
value. For other investments, an active market does not exist and other means are used to
determine fair value.
I.102 Financial Reporting

Classification of Investments
7. Enterprises present financial statements that classify fixed assets, investments and
current assets into separate categories. Investments are classified as Long Term Investments
and Current Investments. Current investments are in the nature of current assets, although the
common practice may be to include them in investments.3
8. Investments other than current investments are classified as long-term investments, even
though may be readily marketable.

Cost of Investments
9. The cost of an investment includes acquisition charges such as brokerage, fees and
duties.
10. If an investment is acquired, or partly acquired, by the issue of shares or other securities,
the acquisition cost is the fair value of the securities issued (which, in appropriate cases, may
be indicated by the issue price as determined by statutory authorities). The fair value may not
necessarily be equal to the nominal or par value of the securities issued.
11. If an investment is acquired in exchange, or part exchange, for another asset, the
acquisition cost of the investment is determined by reference to the fair value of the asset
given up. It may be appropriate to consider the fair value of the investment acquired if it is
more clearly evident.
12. Interest, dividends and rentals receivables in connection with an investment are generally
regarded as income, being the return on the investment. However, in some circumstances,
such inflows represent a recovery of cost and do not form part of income. For example, when
unpaid interest has accrued before the acquisition of an interest-bearing investment and is
therefore included in the price paid for the investment, the subsequent receipt of interest is
allocated between pre-acquisition and post-acquisition periods; the pre-acquisition portion is
deducted from cost. When dividends on equity are declared from pre-acquisition profits, a
similar treatment may apply. If it is difficult to make such an allocation except on an arbitrary
basis, the cost of investment is normally reduced by dividends receivable only if they clearly
represent a recovery of a part of the cost.
13. When rights shares offered are subscribed for, the cost of the rights shares is added to
the carrying amount of the original holding. If rights are not subscribed for but are sold in the
market, the sale proceeds are taken to the profit and loss statement. However, where the
investments are acquired on cum-right basis and the market value of investments immediately
after their becoming ex-right is lower than the cost for which they were acquired, it may be

3
Shares, debentures and other securities held for sale in the ordinary course of
business are disclosed as ‘stock-in-trade’ under the head ‘current assets’.
Appendix I : Accounting Standards I.103

appropriate to apply the sale proceeds of rights to reduce the carrying amount of such
investments to the market value.

Carrying Amount of Investments


Current Investments
14. The carrying amount for current investments is the lower of cost and fair value. In respect
of investments for which an active market exists, market value generally provides the best
evidence of fair value. The valuation of current investments at lower of cost and fair value
provides a prudent method of determining the carrying amount to be stated in the balance
sheet.
15. Valuation of current investments on overall (or global) basis is not considered
appropriate. Sometimes, the concern of an enterprise may be with the value of a category of
related current investments and not with each individual investment, and accordingly the
investments may be carried at the lower of cost and fair value computed categorywise (i.e.
equity shares, preference shares, convertible debentures, etc.). However, the more prudent
and appropriate method is to carry investments individually at the lower of cost and fair value.
16. For current investments, any reduction to fair value and any reversals of such reductions
are included in the profit and loss statement.
Long-Term Investments
17. Long-term investments are usually carried at cost. However, when there is a decline,
other than temporary, in the value of a long-term investment, the carrying amount is reduced
to recognise the decline. Indicators of the value of an investment are obtained by reference to
its market value, the investee’s assets and results and the expected cash flows from the
investment. The type and extent of the investor’s stake in the investee are also taken into
account. Restrictions on distributions by the investee or on disposal by the investor may affect
the value attributed to the investment.
18. Long-term investments are usually of individual importance to the investing enterprise.
The carrying amount of long-term investments is therefore determined on an individual
investment basis.
19. Where there is a decline, other than temporary, in the carrying amounts of long-term
investments, the resultant reduction in the carrying amount is charged to the profit and loss
statement. The reduction in carrying amount is reversed when there is a rise in the value of
the investment, or if the reasons for the reduction no longer exist.

Investment Properties
20. The cost of any shares in co-operative society or a company, the holding of which is
directly related to the right to hold the investment property, is added to the carrying amount of the
I.104 Financial Reporting

investment property.

Disposal of Investments
21. On disposal of an investment, the difference between the carrying amount and the
disposal proceeds, net of expenses, is recognised in the profit and loss statement.
22. When disposing of a part of the holding of an individual investment, the carrying amount
to be allocated to that part is to be determined on the basis of the average carrying amount of
the total holding of the investment4.

Reclassification of Investments
23. Where, long-term investments are reclassified as current investments, transfers are
made at the lower of cost and carrying amount at the date of transfer.
24. Where investments are reclassified from current to long-term, transfers are made at the
lower of cost and fair value at the date of transfer.

Disclosure
25. The following disclosures in financial statements in relation to investments are
appropriate :
(a) the accounting policies for the determination of carrying amount of investments;
(b) the amounts included in profit and loss statement for :
(i) interest, dividends (showing separately dividends from subsidiary companies), and
rentals on investments showing separately such income from long-term and current
investments, Gross income should be stated, the amount of income tax deducted at
source being included under Advance Taxes Paid;
(ii) profits and losses on disposal of current investments and changes in carrying
amount of such investments;
(iii) profits and losses on disposal of long-term investments and changes in the carrying
amount of such investments;
(c) significant restrictions on the right of ownership, realisability of investments or the
remittance of income and proceeds of disposal;

4
In respect of shares, debentures and other securities held as stock-in-trade. The
cost of stocks disposed of is determined by applying an appropriate cost formula (e.g.
first-in, first-out, average cost, etc.). These cost formulae are the same as those
specified in AS 2 in respect of Valuation of Inventories.
Appendix I : Accounting Standards I.105

(d) the aggregate amount of quoted and unquoted investments, giving the aggregate market
value of quoted investments;
(e) other disclosures as specifically required by the relevant statute governing the enterprise.
Accounting Standard
(The Accounting Standard comprises paragraphs 26-35 of this Statement. The Standard
should be read in the context of paragraphs 1-25 of this Statement and of the ‘Preface to the
Statements of Accounting Standards’.)

Classification of Investments
26. An enterprise should disclose current investments and long-term investments
distinctly in its financial statements.
27. Further classification of current and long-term investments should be as specified
in the statute governing the enterprise. In the absence of a statutory requirement, such
further classification should disclose, where applicable, investments in :
(a) Government or Trust securities;
(b) Shares, debentures or bonds;
(c) Investment properties; and
(d) Others - specifying nature.
Cost of Investments
28. The cost of an investment should include acquisition charges such as brokerage,
fees and duties.
29. If an investment is acquired, or partly acquired, by the issue of shares or other
securities the acquisition cost should be the fair value of the securities issued (which in
appropriate cases may be indicated by the issue price as determined by statutory
authorities). The fair value may not necessarily be equal to the nominal or par value of
the securities issued. If an investment is acquired in exchange for another asset, the
acquisition cost of the investment should be determined by reference to the fair value
of the asset given up. Alternatively, the acquisition cost of the investment may be
determined with reference to the fair value of the investment acquired if it is more
clearly evident.
Investment Properties
30. An enterprise holding investment properties should account for them as long-term
investments.
Carrying Amount of Investments
I.106 Financial Reporting

31. Investments classified as current investments should be carried in the financial


statements at the lower of cost and fair value determined either on an individual
investment basis or by category of investment, but not on an overall (or global) basis.
32. Investments classified as long-term investments should be carried in the financial
statements at cost. However, provision for diminution shall be made to recognise a
decline, other than temporary, in the value of the investments, such reduction being
determined and made for each investment individually.
Changes in Carrying Amounts of Investments
33. Any reduction in the carrying amount and any reversals of such reductions should
be charged or credited to the profit and loss statement.
Disposal of Investments
34. On disposal of an investment, the difference between the carrying amount and net
disposal proceeds should be charged or credited to the profit and loss statement.
Disclosure
35. The following information should be disclosed in the financial statements :
(a) the accounting policies for determination of carrying amount of investments;
(b) classification of investments as specified in paragraphs 26 and 27 above;
(c) the amounts included in profit and loss statement for:
(i) interest, dividends (showing separately dividends from subsidiary
companies), and rentals on investments showing separately such income
from long-term and current investments. Gross income should be stated, the
amount of income tax deducted at source being included under Advance
Taxes Paid;
(ii) profits and losses on disposal of current investments and changes in the
carrying amount of such investments; and
(iii) profits and losses on disposal of long term investments and changes in the
carrying amount of such investments;
(d) significant restrictions on the right of ownership, realisability of investments or the
remittance of income and proceeds of disposal;
(e) the aggregate amount of quoted and unquoted investments, giving the aggregate
market value of quoted investments;
(f) other disclosures as specifically required by the relevant statute governing the
enterprise.
Appendix I : Accounting Standards I.107

Effective Date
36. This Accounting Standard comes into effect for financial statements covering
periods commencing on or after April 1, 1995.
AS 14 : ACCOUNTING FOR AMALGAMATIONS∗

The following is the text of Accounting Standard (AS) 14, ‘Accounting for Amalgamations’,
issued by the council of the Institute of Chartered Accountants of India.
This standard will come into effect in respect of accounting periods commencing on or after 1-
4-1995 and will be mandatory in nature. The Guidance Note on Accounting Treatment of
Reserves in Amalgations issued by the Institute in, 1983 will stand withdrawn from the
aforesaid date.

INTRODUCTION
1. This statement deals with accounting for amalgamations and the treatment of any
resultant goodwill or reserves. This statement is directed principally to companies although
some of its requirements also apply to financial statements of other enterprises.
2. This statement does not deal with cases of acquisitions which arise when there is a
purchase by one company (referred to as the acquiring company) of the whole or part of the
shares, or the whole or part of the assets, of another company (referred to as the acquired
company) in consideration for payment in cash or by issue of shares or other securities in the
acquiring company or partly in one form and partly in the other. The distinguishing feature of
an acquisition is that the acquired company is not dissolved and its separate entity continues
to exist.

Definitions
3. The following terms are used in this statement with the meanings specified :
(a) Amalgamation means an amalgamation pursuant to the provisions of the
Companies Act, 1956, or any other statute which may be applicable to companies.
(b) Transferor company means the company which is amalgamated into another
company.
(c) Transferee company means the company into which a transferor company is
amalgamated.


A limited revision to the standard has been mad I 2004, pursuant to ehich paragraphs
23 and 42 of the standard have been revised.
I.108 Financial Reporting

(d) Reserve means the portion of earnings, receipts or other surplus of an enterprise
(whether capital or revenue) appropriated by the management for a general or a
specific purpose other than a provision for depreciation or diminution in the value of
assets or for a known liability.
(e) Amalgamation in the nature of merger is an amalgamation which satisfies all the
following conditions :
(i) All the assets and liabilities of the transferor company become, after
amalgamation, the assets and liabilities of the transferee company.
(ii) Shareholders holding not less than 90% of the face value of the equity shares
of the transferor company (other than the equity shares already held therein,
immediately before the amalgamation, by the transferee company or its
subsidiaries or their nominees) become equity shareholders of the transferee
company by virtue of the amalgamation.
(iii) The consideration for the amalgamation receivable by those equity
shareholders of the transferor company who agree to become equity
shareholders of the transferee company is discharged by the transferee
company wholly by the issue of equity shares in the transferee company,
except that cash may be paid in respect of any fractional shares.
(iv) The business of the transferor company is intended to be carried on, after the
amalgamation, by the transferee company.
(v) No adjustment is intended to be made to the book values of the assets and
liabilities of the transferor company when they are incorporated in the financial
statements of the transferee company except to ensure uniformity of
accounting policies.
(f) Amalgamation in the nature of purchase is an amalgamation which does not satisfy
any one or more of the conditions specified in sub-paragraph (e) above.
(g) Consideration for the amalgamation means the aggregate of the shares and other
securities issued and the payment made in the form of cash or other assets by the
transferee company to the shareholders of the transferor company.
(h) Fair value is the amount for which an asset could be exchanged between a
knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length
transaction.
(i) Polling of interests is a method of accounting for amalgamations the object of which
is to account for the amalgamations as if the separate businesses of the
amalgamating companies were intended to be continued by the transferee
company. Accordingly, only minimal changes are made in aggregating the individual
financial statements of the amalgamating companies.
Appendix I : Accounting Standards I.109

Explanation

Types of Amalgamations
4. Generally speaking, amalgamations fall into two broad categories. In the first category
are those amalgamations where there is a genuine pooling not merely of the assets and
liabilities of the amalgamating companies but also of the shareholders’ interests and of the
businesses of these companies. Such amalgamations are amalgamations which are in the
nature of ‘merger’ and the accounting treatment of such amalgamations should ensure that the
resultant figures of assets, liabilities, capital and reserves more or less represent the sum of
the relevant figures of the amalgamating companies. In the second category are those
amalgamations which are in effect a mode by which one company acquires another company
and, as a consequence, the shareholders of the company which is acquired normally do not
continue to have a proportionate share in the equity of the combined company or the business
of the company which is acquired is not intended to be continued. Such amalgamations are
amalgamations in the nature of ‘purchase’.
5. An amalgamation is classified as an ‘amalgamation in the nature of merger’ when all the
conditions listed in paragraph 3(e) are satisfied. There are, however, differing views regarding
the nature of any further conditions that may apply. Some believe that, in addition to an
exchange of equity shares, it is necessary that the shareholders of the transferor company
obtain a substantial share in the transferee company even to the extent that it should not be
possible to identify any one party as dominant therein. This belief is based in part on the view
that the exchange of control of one company for an insignificant share in a larger company
does not amount to a mutual sharing or risks and benefits.
6. Others believe that the substance of an amalgamation in the nature of merger is
evidenced by meeting certain criteria regarding the relationship of the parties, such as the
former independence of the amalgamating companies, the manner of their amalgamation, the
absence of planned transactions that would undermine the effect of the amalgamation, and
the continuing participation by the management of the transferor company in the management
of the transferee company after the amalgamation.

Methods of Accounting for Amalgamations


7. There are two main methods of accounting for amalgamations :
(a) the pooling of interests method; and
(b) the purchase method.
8. The use of the pooling of interests method is confined to circumstances which meet the
criteria referred to in paragraph 3(e) for an amalgamation in the nature of merger.
9. The object of the purchase method is to account for the amalgamation by applying the
same principles as are applied in the normal purchase of assets. This method is used in
I.110 Financial Reporting

accounting for amalgamations in the nature of purchase.

The Pooling of Interests Method


10. Under the pooling of interests method, the assets, liabilities and reserves of the
transferor company are recorded by the transferee company at their existing carrying amounts
(after making the adjustments required in paragraph 11).
11. If, at the time of the amalgamation, the transferor and the transferee companies have
conflicting accounting policies, a uniform set of accounting policies is adopted following the
amalgamation. The effects on the financial statements of any changes in accounting policies
are reported in accordance with Accounting Standard (AS) 5, ‘Prior Period and Extraordinary
Items and Changes in Accounting Policies’1.
The Purchase Method
12. Under the purchase method, the transferee company accounts for the amalgamation
either by incorporating the assets and liabilities at their existing carrying amounts or by
allocating the consideration to individual identifiable assets and liabilities of the transferor
company on the basis of their fair values at the date of amalgamation. The identifiable assets
and liabilities may include assets and liabilities not recorded in the financial statements of the
transferor company.
13. Where assets and liabilities are restated on the basis of their fair values, the
determination of fair values may be influenced by the intentions of the transferee company.
For example, the transferee company may have a specialised use for an asset, which is not
available to other potential buyers. The transferee company may intend to effect changes in
the activities of the transferor company which necessitate the creation of specific provisions
for the expected costs, e.g. planned employee termination and plant relocation costs.

Consideration
14. The consideration for the amalgamation may consist of securities, cash or other assets.
In determining the value of the consideration, an assessment is made of the fair value of its
elements. A variety of techniques is applied in arriving at fair value. For example, when the
consideration includes securities, the value fixed by the statutory authorities may be taken to
be the fair value. In case of other assets, the fair value may be determined by reference to the
market value of the assets given up. Where the market value of the assets given up cannot be
reliably assessed, such assets may be valued at their respective net book values.
15. Many amalgamations recognise that adjustments may have to be made to the

1
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’.
Appendix I : Accounting Standards I.111

consideration in the light of one or more future events. When the additional payment is
probable and can reasonably be estimated at the date of amalgamation, it is included in the
calculation of the consideration. In all other cases, the adjustment is recognised as soon as
the amount is determinable [see Accounting Standard (AS) 4, Contingencies and Events
Occurring after the Balance Sheet Date].

Treatment of Reserves on Amalgamation


16. If the amalgamation is an ‘amalgamation in the nature of merger’, the identity of the
reserves is preserved and they appear in the financial statements of the transferee company
in the same form in which they appeared in the financial statements of the transferor company.
Thus, for example, the General Reserve of the transferor company becomes the General
Reserve of the transferee company, the Capital Reserve of the transferor company becomes
the Capital Reserve of the transferee company and the Revaluation Reserve of the transferor
company becomes the Revaluation Reserve of the transferee company. As a result of preserv-
ing the identity, reserves which are available for distribution as dividend before the
amalgamation would also be available for distribution as dividend after the amalgamation. The
difference between the amount recorded as share capital issued (plus any additional
consideration in the form of cash or other assets) and the amount of share capital of the
transferor company is adjusted in reserves in the financial statements of the transferee
company.
17. If the amalgamation is an ‘amalgamation in the nature of purchase’,the identity of the
reserves, other than the statutory reserves dealt with in paragraph 18, is not preserved. The
amount of the consideration is deducted from the value of the net assets of the transferor
company acquired by the transferee company. If the result of the computation is negative, the
difference is debited to goodwill arising on amalgamation and dealt with in the manner stated
in paragraphs 19-20. If the result of the computation is positive, the difference is credited to
Capital Reserve.
18. Certain reserves may have been created by the transferor company pursuant to the
requirements of, or to avail of the benefits under the Income-tax Act, 1961; for example,
Development Allowance Reserve, or Investment Allowance Reserve. The Act requires that the
identity of the reserves should be preserved for a specified period. Likewise, certain other
reserves may have been created in the financial statements of the transferor company in
terms of the requirements of other statutes. Though, normally, in an amalgamation in the
nature of purchase, the identity of reserves is not preserved, an exception is made in respect
of reserves of the aforesaid nature (referred to hereinafter as ‘statutory reserves’) and such
reserves retain their identity in the financial statements of the transferee company in the same
form in which they appeared in the financial statements of the transferor company, so long as
their identity is required to be maintained to comply with the relevant statute. This exception is
made only in those amalgamations where the requirements of the relevant statute for
recording the statutory reserves in the books of the transferee company are complied with. In
I.112 Financial Reporting

such cases, the statutory reserves are recorded in the financial statements of the transferee
company by a corresponding debit to a suitable account head (e.g. ‘Amalgamation Adjustment
Account’) which is disclosed as a part of “miscellaneous expenditure” or other similar category
in the balance sheet. When the identity of the statutory reserves is no longer required to be
maintained, both the reserves and the aforesaid account are reversed.

Treatment of Goodwill arising on Amalgamation


19. Goodwill arising on amalgamation represents a payment made in anticipation of future
income and it is appropriate to treat it as an asset to be amortised to income on a systematic
basis over its useful life. Due to the nature of goodwill, it is frequently difficult to estimate its
useful life with reasonable certainty. Such estimation is, however, made on a prudent basis.
Accordingly, it is considered appropriate to amortise goodwill over a period not exceeding five
years unless a somewhat longer period can be justified.
20. Factors which may be considered in estimating the useful life of goodwill arising on
amalgamation include :
♦ the foreseeable life of the business or industry;
♦ the effects of product obsolescence, changes in demand and other economic factors;
♦ the service life expectancies of key individuals or groups of employees;
♦ expected actions by competitors or potential competitors; and
♦ legal, regulatory or contractual provisions affecting the useful life.

Balance of Profit and Loss Account


21. In the case of an ‘amalgamation in the nature of merger’, the balance of the Profit and
Loss Account appearing in the financial statements of the transferor company is aggregated
with the corresponding balance appearing in the financial statements of the transferee
company. Alternatively, it is transferred to the General Reserve, if any.
22. In the case of an ‘amalgamation in the nature of purchase’, the balance of the Profit and
Loss Account appearing in the financial statements of the transferor company, whether debit
or credit, loses its identity.

Treatment of Reserves Specified in a Scheme of Amalgamation


23. The scheme of amalgamation sanctioned under the provisions of the Companies Act,
1956 or any other statute may prescribe the treatment to be given to the reserves of the
transferor company after its amalgamation. Where the treatment is so prescribed, the same is
followed. In some cases, the scheme of amalgamation sanctioned under a statute may
prescribe a different treatment to be given to the reserves of the transferor company after
amalgamation as compared to the requirements of this Statement that would have been
Appendix I : Accounting Standards I.113

followed had no treatment been prescribed by the scheme. In such cases, the following
disclosures are made in the first financial statements following the amalgamation:
(a) A description of the accounting treatment given to the reserves and the reasons for
following the treatment different from that prescribed in this Statement.
(b) Deviations in the accounting treatment given to the reserves as prescribed by the
scheme of amalgamation sanctioned under the statute as compared to the requirements of
this Statement that would have been followed had no treatment been prescribed by the
scheme.
(c) The financial effect, if any, arising due to such deviation.”€

Disclosure
24. For all amalgamations, the following disclosures are considered appropriate in the first
financial statements following the amalgamation :
(a) names and general nature of business of amalgamating companies;
(b) effective date of amalgamation for accounting purposes;
(c) the method of accounting used to reflect the amalgamation; and
(d) particulars of the scheme sanctioned under a statute.
25. For amalgamations accounted for under the pooling of interests method, the following
additional disclosures are considered appropriate in the first financial statements following the
amalgamation :
(a) description and number of shares issued, together with the percentage of each
company’s equity shares exchanged to effect the amalgamation;
(b) the amount of any difference between the consideration and the value of net identifiable
assets acquired, and the treatment thereof.
26. For amalgamations accounted for under the purchase method, the following additional
disclosures are considered appropriate in the first financial statements following the
amalgamation :


As a limited revision to AS 14, the council of the Institute decided to rvise this paragraph
in 2004. the erstwhile para was as under:
The scheme of amalgamation sanctioned under the provisions of the Companies Act,
1956 or any other statute may prescribe the treatment to be given to the reserves of the
transferor company after its amalgamation. Where the treatment is so prescribed, the
same is followed.
I.114 Financial Reporting

(a) consideration for the amalgamation and a description of the consideration paid or
contingently payable; and
(b) the amount of any difference between the consideration and the value of net identifiable
assets acquired, and the treatment thereof including the period of amortisation of any good-
will arising on amalgamation.

Amalgamation after the Balance Sheet Date


27. When an amalgamation is effected after the balance sheet date but before the issuance
of the financial statements of either party to the amalgamation, disclosure is made in
accordance with AS 4, ‘Contingencies and Events Occurring after the Balance Sheet Date’,
but the amalgamation is not incorporated in the financial statements. In certain circumstances,
the amalgamation may also provide additional information affecting the financial statements
themselves, for instance, by allowing the going concern assumption to be maintained.
Accounting Standard
(The Accounting Standard comprises paragraphs 28 to 46 of this statement. The ‘Standard
should be read in the context of paragraphs 1 to 27 of this Statement and of the Preface to
the Statements of Accounting Standards’.)
28. An amalgamation may be either :
(a) an amalgamation in the nature of merger, or
(b) an amalgamation in the nature of purchase.
29. An amalgamation should be considered to be an amalgamation in the nature of
merger when all the following conditions are satisfied :
(i) All the assets and liabilities of the transferor company become, after
amalgamation, the assets and liabilities of the transferee company.
(ii) Shareholders holding not less than 90% of the face value of the equity shares of
the transferor company (other than the equity shares already held therein, immediately
before the amalgamation, by the transferee company or its subsidiaries or their
nominees) become equity shareholders of the transferee company by virtue of the
amalgamation.
(iii) The consideration for the amalgamation receivable by those equity shareholders of
the transferor company who agree to become equity shareholders of the transferee
company is discharged by the transferee company wholly by the issue of equity shares
in the transferee company, except that cash may be paid in respect of any fractional
shares.
(iv) The business of the transferor company is intended to be carried on, after the
amalgamation, by the transferee company.
Appendix I : Accounting Standards I.115

(v) No adjustment is intended to be made to the book values of the assets and
liabilities of the transferor company when they are incorporated in the financial
statements of the transferee company except to ensure uniformity of accounting
policies.
30. An Amalgamation should be considered to be an amalgamation in the nature of
purchase, when any one or more the conditions specified in paragraph 29 is not
satisfied.
31. When an amalgamation is considered to be an amalgamation in the nature of
merger, it should be accounted for under the pooling of interests method described in
paragraphs 33-35.
32. When an amalgamation is considered to be an amalgamation in the nature of
purchase, it should be accounted for under the purchase method described in
paragraphs 36-39.
The Pooling of Interests Method
33. In preparing the transferee company’s financial statements, the assets, liabilities
and reserves (whether capital or revenue or arising on revaluation) of the transferor
company should be recorded at their existing carrying amounts and in the same form as
at the date of the amalgamation. The balance of the Profit and Loss Account of the
transferor company should be aggregated with the corresponding balance of the
transferee company or transferred to the General Reserve, if any.
34. If, at the time of the amalgamation, the transferor and the transferee companies
have conflicting accounting policies, a uniform set of accounting polices should be
adopted following the amalgamation. The effects on the financial statements of any
changes in accounting policies should be reported in accordance with Accounting
Standard (AS) 5, ‘Prior Period and Extraordinary Items and Changes in Accounting
Policies’2.
35. The difference between the amount recorded as share capital issued (plus any
additional consideration in the form of cash or other assets) and the amount of share
capital of the transferor company should be adjusted in reserves.
The Purchase Method
36. In preparing the transferee company’s financial statements, the assets and
liabilities of the transferor company should be incorporated at their existing carrying
amounts or, alternatively, the consideration should be allocated to individual identi-

2
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’.
I.116 Financial Reporting

fiable assets and liabilities on the basis of their fair values at the date of amalgamation.
The reserves (whether capital or revenue or arising on revaluation) of the transferor
company, other than the statutory reserves, should not be included in the financial
statements of the transferee company except as stated in paragraph 39.
37. Any excess of the amount of the consideration over the value of the net assets of
the transferor company acquired by the transferee company should be recognised in
the transferee company’s financial statements as goodwill arising on amalgamation. If
the amount of the consideration is lower than the value of the net assets acquired, the
difference should be treated as Capital Reserve.
38. The goodwill arising amalgamation should be amortised to income on a systematic
basis over its useful life. The amortisation period should not exceed five years unless a
somewhat longer period can be justified.
39. Where the requirements of the relevant statute for recording the statutory reserves
in the books of the transferee company are complied with, statutory reserves of the
transferor company should be recorded in the financial statements of the transferee
company. The corresponding debit should be given to a suitable account head (e.g.,
‘Amalgamation Adjustment Account’) which should be disclosed as a part of
“miscellaneous expenditure” or other similar category in the balance sheet. When the
identity of the statutory reserves is no longer required to be maintained, both the
reserves and the aforesaid account should be reversed.
Common Procedures
40. The consideration for the amalgamation should include any non-cash element at
fair value. In case of issue of securities, the value fixed by the statutory authorities may
be taken to be the fair value. In case of other assets, the fair value may be determined
by reference to the market value of the assets given up. Where the market value of the
assets given up cannot be reliably assessed, such assets may be valued at their
respective net book values.
41. Where the scheme of amalgamation provides for an adjustment to the
consideration contingent on one or more future events, the amount of the additional
payment should be included in the consideration if payment is probable and a
reasonable estimate of the amount can be made. In all other cases, the adjustment
should be recognised as soon as the amount is determinable [See Accounting Standard
(AS) 4, Contingencies and Events Occurring after the Balance Sheet Date].
Treatment of Reserves Specified in a Scheme of Amalgamation
42. Where the scheme of amalgamation sanctioned under a statute prescribes the
treatment to be given to the reserves of the transferor company after amalgamation, the
same should be followed. Where the scheme of amalgamation sanctioned under a
Appendix I : Accounting Standards I.117

statute prescribes a different treatment to be given to the reserves of the transferor


company after amalgamation as compared to the requirements of this Statement that
would have been followed had no treatment been prescribed by the scheme, the
following disclosures should be made in the first financial statements following the
amalgamation:
(a) A description of the accounting treatment given to the reserves and the reasons
for following the treatment different from that prescribed in this Statement.
(b) Deviations in the accounting treatment given to the reserves as prescribed by the
scheme of amalgamation sanctioned under the statute as compared to the requirements
of this Statement that would have been followed had no treatment been prescribed by
the scheme.
(c) The financial effect, if any, arising due to such deviation.” €
Disclosure
43. For all amalgamations, the following disclosures should be made in the first
financial statements following the amalgamation :
(a) names and general nature of business of the amalgamating companies;
(b) effective date of amalgamation for accounting purposes;
(c) the method of accounting used to reflect the amalgamation; and
(d) particulars of the scheme sanctioned under a statute.
44. For amalgamations accounted for under the pooling of interests method, the
following additional disclosures should be made in the first financial statements
following the amalgamation :
(a) description and number of shares issued, together with the percentage of each
company’s equity shares exchanged to effect the amalgamation; and
(b) the amount of any difference between the consideration and the value of net
identifiable assets acquired, and the treatment thereof.
45. For amalgamations accounted for under the purchase method, the following
additional disclosures should be made in the first financial statements following the


As a limited revision to AS 14, the council of the Institute decided to rvise this
paragraph in 2004. the erstwhile para was as under:
Where the scheme of amalgamation sanctioned under a statute prescribes the treatment
to be given to the reserves of the transferor company after amalgamation, the same
should be followed.
I.118 Financial Reporting

amalgamations :
(a) consideration for the amalgamation and a description of the consideration paid or
contingently payable; and
(b) the amount of any difference between the consideration and the value of net
identifiable assets acquired, and the treatment thereof including the period of
amortisation of any goodwill arising on amalgamation.
Amalgamation after the Balance Sheet Date
46. When an amalgamation is effected after the balance sheet date but before the
issuance of the financial statements of either party to the amalgamation, disclosure
should be made in accordance with AS-4, ‘Contingencies and Events Occurring after
the Balance Sheet Date’, but the amalgamation should not be incorporated in the
financial statements. In certain circumstances, the amalgamation may also provide
additional information affecting the financial statements themselves, for instance by
allowing the going concern assumption to be maintained.

AS 15 (REVISED 2005)* : EMPLOYEE BENEFITS

(This Accounting Standard includes paragraphs set in bold italic type and plain type, which
have equal authority. Paragraphs in bold italic type indicate the main principles. This
Accounting Standard should be read in the context of its objective and the Preface to the
Statements of Accounting Standards.)
Accounting Standard (AS) 15, Employee Benefits (revised 2005), issued by the Council of the
Institute of Chartered Accountants of India, comes into effect in respect of accounting periods
commencing on or after April 1, 2006 and is mandatory in nature from that date:

*
Originally issued in 1995 and titled as ‘Accounting for Retirement Benefits in the
Financial Statements of Employers’. AS 15 (revised 2005) was originally published in the
March 2005 issue of the Institute’s Journal. Subsequently, the Institute of Chartered
Accountants of India (ICAI), in January 2006, made Limited Revision to AS 15 (revised
2005) primarily with a view to bring the disclosure requirements of the standard relating to
the defined benefit plans in line with the corresponding International Accounting Standard
(IAS) 19, Employee Benefits; to clarify the application of the transitional provisions; and to
provide relaxation/ exemptions to the Small and Medium-sized Enterprises (SMEs). This
Limited Revision has been duly incorporated in AS 15 (revised 2005).
Appendix I : Accounting Standards I.119

(a) in its entirety, for the enterprises which fall in any one or more of the following
categories, at any time during the accounting period:

(i) Enterprises whose equity or debt securities are listed whether in India or outside
India.

(ii) Enterprises which are in the process of listing their equity or debt securities as
evidenced by the board of directors’ resolution in this regard.

(iii) Banks including co-operative banks.

(iv) Financial institutions.

(v) Enterprises carrying on insurance business.

(vi) All commercial, industrial and business reporting enterprises, whose turnover for the
immediately preceding accounting period on the basis of audited financial statements
exceeds Rs. 50 crore. Turnover does not include ‘other income’.

(vii) All commercial, industrial and business reporting enterprises having borrowings,
including public deposits, in excess of Rs. 10 crore at any time during the accounting
period.

(viii) Holding and subsidiary enterprises of any one of the above at any time during the
accounting period.
(b) in its entirety, except the following, for enterprises which do not fall in any of the
categories in (a) above and whose average number of persons employed during the
year is 50 or more.

(i) paragraphs 11 to 16 of the standard to the extent they deal with recognition and
measurement of short-term accumulating compensated absences which are non-vesting
(i.e., short-term accumulating compensated absences in respect of which employees are
not entitled to cash payment for unused entitlement on leaving);

(ii) paragraphs 46 and 139 of the Standard which deal with discounting of amounts that
fall due more than 12 months after the balance sheet date; and
I.120 Financial Reporting

(iii) recognition and measurement principles laid down in paragraphs 50 to 116 and
presentation and disclosure requirements laid down in paragraphs 117 to 123 of the
Standard in respect of accounting for defined benefit plans. However, such enterprises
should actuarially determine and provide for the accrued liability in respect of defined
benefit plans as follows:

● The method used for actuarial valuation should be the Projected Unit Credit Method.

● The discount rate used should be determined by reference to market yields at the
balance sheet date on government bonds as per paragraph 78 of the Standard.

Such enterprises should disclose actuarial assumptions as per paragraph 120(l) of the
Standard.

(iv) recognition and measurement principles laid down in paragraphs 129 to 131 of the
Standard in respect of accounting for other long-term employee benefits. However, such
enterprises should actuarially determine and provide for the accrued liability in respect of
other long-term employee benefits as follows:

● The method used for actuarial valuation should be the Projected Unit Credit Method.

● The discount rate used should be determined by reference to market yields at the
balance sheet date on government bonds as per paragraph 78 of the Standard.
(c) in its entirety, except the following, for enterprises which do not fall in any of the
categories in (a) above and whose average number of persons employed during the
year is less than 50.

(i) paragraphs 11 to 16 of the standard to the extent they deal with recognition and
measurement of short-term accumulating compensated absences which are non-vesting
(i.e., short-term accumulating compensated absences in respect of which employees are
not entitled to cash payment for unused entitlement on leaving);

(ii) paragraphs 46 and 139 of the Standard which deal with discounting of amounts that
fall due more than 12 months after the balance sheet date;

(iii) recognition and measurement principles laid down in paragraphs 50 to 116 and
presentation and disclosure requirements laid down in paragraphs 117 to 123 of the
Standard in respect of accounting for defined benefit plans. Such enterprises may
calculate and account for the accrued liability under the defined benefit plans by
Appendix I : Accounting Standards I.121

reference to some other rational method, e.g., a method based on the assumption that
such benefits are payable to all employees at the end of the accounting year; and

(iv) recognition and measurement principles laid down in paragraphs 129 to 131 of the
Standard in respect of accounting for other long-term employee benefits. Such
enterprises may calculate and account for the accrued liability under the other long-term
employee benefits by reference to some other rational method, e.g., a method based on
the assumption that such benefits are payable to all employees at the end of the
accounting year.
Where an enterprise has been covered in any one or more of the categories in (a) above and
subsequently, ceases to be so covered, the enterprise will not qualify for exemptions specified
in (b) above, until the enterprise ceases to be covered in any of the categories in (a) above for
two consecutive years.
Where an enterprise did not qualify for the exemptions specified in (c) above and
subsequently, qualifies, the enterprise will not qualify for exemptions as per (c) above, until it
continues to be so qualified for two consecutive years.
Where an enterprise has previously qualified for exemptions in (b) or (c) above, as the case
may be, but no longer qualifies for exemptions in (b) or (c) above, as the cases may be, in the
current accounting period, this Standard becomes applicable, in its entirety or, in its entirety
except exemptions in (b) above, as the case may be, from the current period. However, the
corresponding previous period figures in respect of the relevant disclosures need not be
provided.
An enterprise, which, pursuant to the above provisions, avails exemptions specified in (b) or
(c) above, as the cases may be, should disclose the fact. An enterprise which avails
exemptions specified in (c) above should also disclose the method used to calculate and
provide for the accrued liability.
The following is the text of the revised Accounting Standard.

Objective
The objective of this Statement is to prescribe the accounting and disclosure for employee
benefits. The Statement requires an enterprise to recognise:

(a) a liability when an employee has provided service in exchange for employee benefits to
be paid in the future; and

(b) an expense when the enterprise consumes the economic benefit arising from service
provided by an employee in exchange for employee benefits.
I.122 Financial Reporting

Scope
1. This Statement should be applied by an employer in accounting for all employee benefits,
except employee share-based payments7.
2. This Statement does not deal with accounting and reporting by employee benefit plans.
3. The employee benefits to which this Statement applies include those provided:

(a) under formal plans or other formal agreements between an enterprise and individual
employees, groups of employees or their representatives;

(b) under legislative requirements, or through industry arrangements, whereby


enterprises are required to contribute to state, industry or other multi-employer plans; or

(c) by those informal practices that give rise to an obligation. Informal practices give
rise to an obligation where the enterprise has no realistic alternative but to pay employee
benefits. An example of such an obligation is where a change in the enterprise’s informal
practices would cause unacceptable damage to its relationship with employees.
4. Employee benefits include:

(a) short-term employee benefits, such as wages, salaries and social security
contributions (e.g., contribution to an insurance company by an employer to pay for
medical care of its employees), paid annual leave, profit-sharing and bonuses (if payable
within twelve months of the end of the period) and non-monetary benefits (such as
medical care, housing, cars and free or subsidised goods or services) for current
employees;

(b) post-employment benefits such as gratuity, pension, other retirement benefits, post-
employment life insurance and post-employment medical care;

(c) other long-term employee benefits, including long-service leave or sabbatical leave,
jubilee or other long-service benefits, long-term disability benefits and, if they are not
payable wholly within twelve months after the end of the period, profit-sharing, bonuses
and deferred compensation; and

7
The accounting for such benefits is dealt with in the Guidance Note on Accounting for
Employee Share-based Payments issued by the Institute of Chartered Accountants of
India.
Appendix I : Accounting Standards I.123

(d) termination benefits.


Because each category identified in (a) to (d) above has different characteristics, this
Statement establishes separate requirements for each category.
5. Employee benefits include benefits provided to either employees or their spouses,
children or other dependants and may be settled by payments (or the provision of goods or
services) made either:

(a) directly to the employees, to their spouses, children or other dependants, or to their legal
heirs or nominees; or

(b) to others, such as trusts, insurance companies.


6. An employee may provide services to an enterprise on a full-time, part-time, permanent,
casual or temporary basis. For the purpose of this Statement, employees include whole-time
directors and other management personnel.

Definitions
7. The following terms are used in this Statement with the meanings specified:
Employee benefits are all forms of consideration given by an enterprise in exchange for
service rendered by employees.
Short-term employee benefits are employee benefits (other than termination benefits)
which fall due wholly within twelve months after the end of the period in which the
employees render the related service.
Post-employment benefits are employee benefits (other than termination benefits)
which are payable after the completion of employment.
Post-employment benefit plans are formal or informal arrangements under which an
enterprise provides post-employment benefits for one or more employees.
Defined contribution plans are post-employment benefit plans under which an
enterprise pays fixed contributions into a separate entity (a fund) and will have no
obligation to pay further contributions if the fund does not hold sufficient assets to pay
all employee benefits relating to employee service in the current and prior periods.
Defined benefit plans are post-employment benefit plans other than defined
contribution plans.
Multi-employer plans are defined contribution plans (other than state plans) or defined
benefit plans (other than state plans) that:

(a) pool the assets contributed by various enterprises that are not under common
I.124 Financial Reporting

control; and

(b) use those assets to provide benefits to employees of more than one enterprise, on
the basis that contribution and benefit levels are determined without regard to the
identity of the enterprise that employs the employees concerned.
Other long-term employee benefits are employee benefits (other than post-employment
benefits and termination benefits) which do not fall due wholly within twelve months
after the end of the period in which the employees render the related service.
Termination benefits are employee benefits payable as a result of either:

(a) an enterprise’s decision to terminate an employee’s employment before the normal


retirement date; or

(b) an employee’s decision to accept voluntary redundancy in exchange for those


benefits (voluntary retirement).
Vested employee benefits are employee benefits that are not conditional on future
employment.
The present value of a defined benefit obligation is the present value, without deducting
any plan assets, of expected future payments required to settle the obligation resulting
from employee service in the current and prior periods.
Current service cost is the increase in the present value of the defined benefit
obligation resulting from employee service in the current period.
Interest cost is the increase during a period in the present value of a defined benefit
obligation which arises because the benefits are one period closer to settlement.
Plan assets comprise:

(a) assets held by a long-term employee benefit fund; and

(b) qualifying insurance policies.


Assets held by a long-term employee benefit fund are assets (other than non-
transferable financial instruments issued by the reporting enterprise) that:

(a) are held by an entity (a fund) that is legally separate from the reporting enterprise
and exists solely to pay or fund employee benefits; and

(b) are available to be used only to pay or fund employee benefits, are not available to
the reporting enterprise’s own creditors (even in bankruptcy), and cannot be returned to
Appendix I : Accounting Standards I.125

the reporting enterprise, unless either:

(i) the remaining assets of the fund are sufficient to meet all the related
employee benefit obligations of the plan or the reporting enterprise; or

(ii) the assets are returned to the reporting enterprise to reimburse it for
employee benefits already paid.
A qualifying insurance policy is an insurance policy issued by an insurer that is not a
related party (as defined in AS 18 Related Party Disclosures) of the reporting enterprise,
if the proceeds of the policy:

(a) can be used only to pay or fund employee benefits under a defined benefit
plan; and

(b) are not available to the reporting enterprise’s own creditors (even in
bankruptcy) and cannot be paid to the reporting enterprise, unless either:

(i) the proceeds represent surplus assets that are not needed for the policy
to meet all the related employee benefit obligations; or

(ii) the proceeds are returned to the reporting enterprise to reimburse it for
employee benefits already paid.
Fair value is the amount for which an asset could be exchanged or a liability settled
between knowledgeable, willing parties in an arm’s length transaction.
The return on plan assets is interest, dividends and other revenue derived from the plan
assets, together with realised and unrealised gains or losses on the plan assets, less
any costs of administering the plan and less any tax payable by the plan itself.
Actuarial gains and losses comprise:

(a) experience adjustments (the effects of differences between the previous


actuarial assumptions and what has actually occurred); and

(b) the effects of changes in actuarial assumptions.


Past service cost is the change in the present value of the defined benefit obligation for
employee service in prior periods, resulting in the current period from the introduction
of, or changes to, post-employment benefits or other long-term employee benefits. Past
service cost may be either positive (where benefits are introduced or improved) or
negative (where existing benefits are reduced).
I.126 Financial Reporting

Short-term Employee Benefits


8. Short-term employee benefits include items such as:

(a) wages, salaries and social security contributions;

(b) short-term compensated absences (such as paid annual leave) where the absences
are expected to occur within twelve months after the end of the period in which the
employees render the related employee service;

(c) profit-sharing and bonuses payable within twelve months after the end of the period
in which the employees render the related service; and

(d) non-monetary benefits (such as medical care, housing, cars and free or subsidised
goods or services) for current employees.
9. Accounting for short-term employee benefits is generally straightforward because no
actuarial assumptions are required to measure the obligation or the cost and there is no
possibility of any actuarial gain or loss. Moreover, short-term employee benefit obligations are
measured on an undiscounted basis.

Recognition and Measurement

All Short-term Employee Benefits

10. When an employee has rendered service to an enterprise during an accounting


period, the enterprise should recognise the undiscounted amount of short-term
employee benefits expected to be paid in exchange for that service:

(a) as a liability (accrued expense), after deducting any amount already paid. If
the amount already paid exceeds the undiscounted amount of the benefits, an
enterprise should recognise that excess as an asset (prepaid expense) to the
extent that the prepayment will lead to, for example, a reduction in future payments
or a cash refund; and

(b) as an expense, unless another Accounting Standard requires or permits the


inclusion of the benefits in the cost of an asset (see, for example, AS 10
Accounting for Fixed Assets).
Paragraphs 11, 14 and 17 explain how an enterprise should apply this requirement to
Appendix I : Accounting Standards I.127

short-term employee benefits in the form of compensated absences and profit-sharing


and bonus plans.

Short-term Compensated Absences


11. An enterprise should recognise the expected cost of short-term employee benefits
in the form of compensated absences under paragraph 10 as follows:

(a) in the case of accumulating compensated absences, when the employees


render service that increases their entitlement to future compensated absences;
and

(b) in the case of non-accumulating compensated absences, when the absences


occur.
12. An enterprise may compensate employees for absence for various reasons including
vacation, sickness and short-term disability, and maternity or paternity. Entitlement to
compensated absences falls into two categories:

(a) accumulating; and

(b) non-accumulating.
13. Accumulating compensated absences are those that are carried forward and can be used
in future periods if the current period’s entitlement is not used in full. Accumulating
compensated absences may be either vesting (in other words, employees are entitled to a
cash payment for unused entitlement on leaving the enterprise) or non-vesting (when
employees are not entitled to a cash payment for unused entitlement on leaving). An
obligation arises as employees render service that increases their entitlement to future
compensated absences. The obligation exists, and is recognised, even if the compensated
absences are non-vesting, although the possibility that employees may leave before they use
an accumulated non-vesting entitlement affects the measurement of that obligation.
14. An enterprise should measure the expected cost of accumulating compensated
absences as the additional amount that the enterprise expects to pay as a result of the
unused entitlement that has accumulated at the balance sheet date.
15. The method specified in the previous paragraph measures the obligation at the amount
of the additional payments that are expected to arise solely from the fact that the benefit
accumulates. In many cases, an enterprise may not need to make detailed computations to
estimate that there is no material obligation for unused compensated absences. For example,
a leave obligation is likely to be material only if there is a formal or informal understanding that
unused leave may be taken as paid vacation.
I.128 Financial Reporting

Example Illustrating Paragraphs 14 and 15

An enterprise has 100 employees, who are each entitled to five working days of leave for each
year. Unused leave may be carried forward for one calendar year. The leave is taken first out
of the current year’s entitlement and then out of any balance brought forward from the
previous year (a LIFO basis). At 31 December 20X4, the average unused entitlement is two
days per employee. The enterprise expects, based on past experience which is expected to
continue, that 92 employees will take no more than five days of leave in 20X5 and that the
remaining eight employees will take an average of six and a half days each.

The enterprise expects that it will pay an additional 12 days of pay as a result of the unused
entitlement that has accumulated at 31 December 20X4 (one and a half days each, for eight
employees). Therefore, the enterprise recognises a liability, as at 31 December 20X4, equal to
12 days of pay.

16. Non-accumulating compensated absences do not carry forward: they lapse if the current
period’s entitlement is not used in full and do not entitle employees to a cash payment for
unused entitlement on leaving the enterprise. This is commonly the case for maternity or
paternity leave. An enterprise recognises no liability or expense until the time of the absence,
because employee service does not increase the amount of the benefit.

Profit-sharing and Bonus Plans


17. An enterprise should recognise the expected cost of profit-sharing and bonus
payments under paragraph 10 when, and only when:

(a) the enterprise has a present obligation to make such payments as a result of
past events; and

(b) a reliable estimate of the obligation can be made.


A present obligation exists when, and only when, the enterprise has no realistic
alternative but to make the payments.
18. Under some profit-sharing plans, employees receive a share of the profit only if they
remain with the enterprise for a specified period. Such plans create an obligation as
employees render service that increases the amount to be paid if they remain in service until
the end of the specified period. The measurement of such obligations reflects the possibility
that some employees may leave without receiving profit-sharing payments.
Appendix I : Accounting Standards I.129

Example Illustrating Paragraph 18

A profit-sharing plan requires an enterprise to pay a specified proportion of its net profit for the
year to employees who serve throughout the year. If no employees leave during the year, the total
profit-sharing payments for the year will be 3% of net profit. The enterprise estimates that staff
turnover will reduce the payments to 2.5% of net profit.

The enterprise recognises a liability and an expense of 2.5% of net profit.


19. An enterprise may have no legal obligation to pay a bonus. Nevertheless, in some cases,
an enterprise has a practice of paying bonuses. In such cases also, the enterprise has an
obligation because the enterprise has no realistic alternative but to pay the bonus. The
measurement of the obligation reflects the possibility that some employees may leave without
receiving a bonus.
20. An enterprise can make a reliable estimate of its obligation under a profit-sharing or
bonus plan when, and only when:
(a) the formal terms of the plan contain a formula for determining the amount of the benefit;
or
(b) the enterprise determines the amounts to be paid before the financial statements are
approved; or
(c) past practice gives clear evidence of the amount of the enterprise’s obligation.
21. An obligation under profit-sharing and bonus plans results from employee service and not
from a transaction with the enterprise’s owners. Therefore, an enterprise recognises the cost
of profit-sharing and bonus plans not as a distribution of net profit but as an expense.
22. If profit-sharing and bonus payments are not due wholly within twelve months after the
end of the period in which the employees render the related service, those payments are other
long-term employee benefits (see paragraphs 127-132).

Disclosure
23. Although this Statement does not require specific disclosures about short-term employee
benefits, other Accounting Standards may require disclosures. For example, where required
by AS 18 Related Party Disclosures an enterprise discloses information about employee
benefits for key management personnel.

Post-employment Benefits: Defined Contribution Plans and Defined Benefit Plans


24. Post-employment benefits include:
(a) retirement benefits, e.g., gratuity and pension; and
I.130 Financial Reporting

(b) other benefits, e.g., post-employment life insurance and post-employment medical
care.
Arrangements whereby an enterprise provides post-employment benefits are post-employment
benefit plans. An enterprise applies this Statement to all such arrangements whether or not
they involve the establishment of a separate entity to receive contributions and to pay
benefits.
25. Post-employment benefit plans are classified as either defined contribution plans or
defined benefit plans, depending on the economic substance of the plan as derived from its
principal terms and conditions. Under defined contribution plans:
(a) the enterprise’s obligation is limited to the amount that it agrees to contribute to the fund.
Thus, the amount of the post-employment benefits received by the employee is determined by
the amount of contributions paid by an enterprise (and also by the employee) to a post-
employment benefit plan or to an insurance company, together with investment returns arising
from the contributions; and
(b) in consequence, actuarial risk (that benefits will be less than expected) and investment
risk (that assets invested will be insufficient to meet expected benefits) fall on the employee.

26. Examples of cases where an enterprise’s obligation is not limited to the amount that it
agrees to contribute to the fund are when the enterprise has an obligation through:
(a) a plan benefit formula that is not linked solely to the amount of contributions; or
(b) a guarantee, either indirectly through a plan or directly, of a specified return on
contributions; or
(c) informal practices that give rise to an obligation, for example, an obligation may arise
where an enterprise has a history of increasing benefits for former employees to keep pace
with inflation even where there is no legal obligation to do so.
27. Under defined benefit plans:

(a) the enterprise’s obligation is to provide the agreed benefits to current and former
employees; and

(b) actuarial risk (that benefits will cost more than expected) and investment risk fall, in
substance, on the enterprise. If actuarial or investment experience are worse than
expected, the enterprise’s obligation may be increased.
28. Paragraphs 29 to 43 below deal with defined contribution plans and defined benefit plans
in the context of multi-employer plans, state plans and insured benefits.
Appendix I : Accounting Standards I.131

Multi-employer Plans
29. An enterprise should classify a multi-employer plan as a defined contribution plan
or a defined benefit plan under the terms of the plan (including any obligation that goes
beyond the formal terms). Where a multi-employer plan is a defined benefit plan, an
enterprise should:
(a) account for its proportionate share of the defined benefit obligation, plan
assets and cost associated with the plan in the same way as for any other defined
benefit plan; and
(b) disclose the information required by paragraph 120.
30. When sufficient information is not available to use defined benefit accounting for a
multi-employer plan that is a defined benefit plan, an enterprise should:
(a) account for the plan under paragraphs 45-47 as if it were a defined
contribution plan;
(b) disclose:
(i) the fact that the plan is a defined benefit plan; and
(ii) the reason why sufficient information is not available to enable the
enterprise to account for the plan as a defined benefit plan; and

(c) to the extent that a surplus or deficit in the plan may affect the amount of
future contributions, disclose in addition:
(i) any available information about that surplus or deficit;
(ii) the basis used to determine that surplus or deficit; and
(iii) the implications, if any, for the enterprise.
31. One example of a defined benefit multi-employer plan is one where:
(a) the plan is financed in a manner such that contributions are set at a level that is
expected to be sufficient to pay the benefits falling due in the same period; and future
benefits earned during the current period will be paid out of future contributions; and
(b) employees’ benefits are determined by the length of their service and the
participating enterprises have no realistic means of withdrawing from the plan without
paying a contribution for the benefits earned by employees up to the date of withdrawal.
Such a plan creates actuarial risk for the enterprise; if the ultimate cost of benefits
already earned at the balance sheet date is more than expected, the enterprise will have
to either increase its contributions or persuade employees to accept a reduction in
I.132 Financial Reporting

benefits. Therefore, such a plan is a defined benefit plan.


32. Where sufficient information is available about a multi-employer plan which is a defined
benefit plan, an enterprise accounts for its proportionate share of the defined benefit
obligation, plan assets and post-employment benefit cost associated with the plan in the same
way as for any other defined benefit plan. However, in some cases, an enterprise may not be
able to identify its share of the underlying financial position and performance of the plan with
sufficient reliability for accounting purposes. This may occur if:
(a) the enterprise does not have access to information about the plan that satisfies the
requirements of this Statement; or
(b) the plan exposes the participating enterprises to actuarial risks associated with the
current and former employees of other enterprises, with the result that there is no consistent
and reliable basis for allocating the obligation, plan assets and cost to individual enterprises
participating in the plan.
In those cases, an enterprise accounts for the plan as if it were a defined contribution plan and
discloses the additional information required by paragraph 30.
33. Multi-employer plans are distinct from group administration plans. A group administration
plan is merely an aggregation of single employer plans combined to allow participating
employers to pool their assets for investment purposes and reduce investment management
and administration costs, but the claims of different employers are segregated for the sole
benefit of their own employees. Group administration plans pose no particular accounting
problems because information is readily available to treat them in the same way as any other
single employer plan and because such plans do not expose the participating enterprises to
actuarial risks associated with the current and former employees of other enterprises. The
definitions in this Statement require an enterprise to classify a group administration plan as a
defined contribution plan or a defined benefit plan in accordance with the terms of the plan
(including any obligation that goes beyond the formal terms).
34. Defined benefit plans that share risks between various enterprises under common
control, for example, a parent and its subsidiaries, are not multi-employer plans.
35. In respect of such a plan, if there is a contractual agreement or stated policy for charging
the net defined benefit cost for the plan as a whole to individual group enterprises, the
enterprise recognises, in its separate financial statements, the net defined benefit cost so
charged. If there is no such agreement or policy, the net defined benefit cost is recognised in
the separate financial statements of the group enterprise that is legally the sponsoring
employer for the plan. The other group enterprises recognise, in their separate financial
statements, a cost equal to their contribution payable for the period.
36. AS 29 Provisions, Contingent Liabilities and Contingent Assets requires an enterprise to
recognise, or disclose information about, certain contingent liabilities. In the context of a multi-
Appendix I : Accounting Standards I.133

employer plan, a contingent liability may arise from, for example:

(a) actuarial losses relating to other participating enterprises because each enterprise that
participates in a multi-employer plan shares in the actuarial risks of every other participating
enterprise; or

(b) any responsibility under the terms of a plan to finance any shortfall in the plan if other
enterprises cease to participate.

State Plans
37. An enterprise should account for a state plan in the same way as for a multi-
employer plan (see paragraphs 29 and 30).
38. State plans are established by legislation to cover all enterprises (or all enterprises in a
particular category, for example, a specific industry) and are operated by national or local
government or by another body (for example, an autonomous agency created specifically for
this purpose) which is not subject to control or influence by the reporting enterprise. Some
plans established by an enterprise provide both compulsory benefits which substitute for
benefits that would otherwise be covered under a state plan and additional voluntary benefits.
Such plans are not state plans.
39. State plans are characterised as defined benefit or defined contribution in nature based
on the enterprise’s obligation under the plan. Many state plans are funded in a manner such
that contributions are set at a level that is expected to be sufficient to pay the required benefits
falling due in the same period; future benefits earned during the current period will be paid out
of future contributions. Nevertheless, in most state plans, the enterprise has no obligation to
pay those future benefits: its only obligation is to pay the contributions as they fall due and if
the enterprise ceases to employ members of the state plan, it will have no obligation to pay
the benefits earned by such employees in previous years. For this reason, state plans are
normally defined contribution plans. However, in the rare cases when a state plan is a defined
benefit plan, an enterprise applies the treatment prescribed in paragraphs 29 and 30.

Insured Benefits
40. An enterprise may pay insurance premiums to fund a post-employment benefit
plan. The enterprise should treat such a plan as a defined contribution plan unless the
enterprise will have (either directly, or indirectly through the plan) an obligation to
either:
(a) pay the employee benefits directly when they fall due; or
(b) pay further amounts if the insurer does not pay all future employee benefits
relating to employee service in the current and prior periods.
I.134 Financial Reporting

If the enterprise retains such an obligation, the enterprise should treat the plan as a
defined benefit plan.
41. The benefits insured by an insurance contract need not have a direct or automatic
relationship with the enterprise’s obligation for employee benefits. Post-employment benefit
plans involving insurance contracts are subject to the same distinction between accounting
and funding as other funded plans.
42. Where an enterprise funds a post-employment benefit obligation by contributing to an
insurance policy under which the enterprise (either directly, indirectly through the plan,
through the mechanism for setting future premiums or through a related party relationship with
the insurer) retains an obligation, the payment of the premiums does not amount to a defined
contribution arrangement. It follows that the enterprise:

(a) accounts for a qualifying insurance policy as a plan asset (see paragraph 7); and

(b) recognises other insurance policies as reimbursement rights (if the policies satisfy the
criteria in paragraph 103).
43. Where an insurance policy is in the name of a specified plan participant or a group of
plan participants and the enterprise does not have any obligation to cover any loss on the
policy, the enterprise has no obligation to pay benefits to the employees and the insurer has
sole responsibility for paying the benefits. The payment of fixed premiums under such
contracts is, in substance, the settlement of the employee benefit obligation, rather than an
investment to meet the obligation. Consequently, the enterprise no longer has an asset or a
liability. Therefore, an enterprise treats such payments as contributions to a defined
contribution plan.

Post-employment Benefits: Defined Contribution Plans


44. Accounting for defined contribution plans is straightforward because the reporting
enterprise’s obligation for each period is determined by the amounts to be contributed for that
period. Consequently, no actuarial assumptions are required to measure the obligation or the
expense and there is no possibility of any actuarial gain or loss. Moreover, the obligations are
measured on an undiscounted basis, except where they do not fall due wholly within twelve
months after the end of the period in which the employees render the related service.

Recognition and Measurement


45. When an employee has rendered service to an enterprise during a period, the
enterprise should recognise the contribution payable to a defined contribution plan in
exchange for that service:
(a) as a liability (accrued expense), after deducting any contribution already paid.
Appendix I : Accounting Standards I.135

If the contribution already paid exceeds the contribution due for service before the
balance sheet date, an enterprise should recognise that excess as an asset
(prepaid expense) to the extent that the prepayment will lead to, for example, a
reduction in future payments or a cash refund; and
(b) as an expense, unless another Accounting Standard requires or permits the
inclusion of the contribution in the cost of an asset (see, for example, AS 10,
Accounting for Fixed Assets).
46. Where contributions to a defined contribution plan do not fall due wholly within
twelve months after the end of the period in which the employees render the related
service, they should be discounted using the discount rate specified in paragraph 78.

Disclosure
47. An enterprise should disclose the amount recognised as an expense for defined
contribution plans.
48. Where required by AS 18 Related Party Disclosures an enterprise discloses information
about contributions to defined contribution plans for key management personnel.

Post-employment Benefits: Defined Benefit Plans


49. Accounting for defined benefit plans is complex because actuarial assumptions are
required to measure the obligation and the expense and there is a possibility of actuarial gains
and losses. Moreover, the obligations are measured on a discounted basis because they may
be settled many years after the employees render the related service. While the Statement
requires that it is the responsibility of the reporting enterprise to measure the obligations under
the defined benefit plans, it is recognised that for doing so the enterprise would normally use
the services of a qualified actuary.

Recognition and Measurement


50. Defined benefit plans may be unfunded, or they may be wholly or partly funded by
contributions by an enterprise, and sometimes its employees, into an entity, or fund, that is
legally separate from the reporting enterprise and from which the employee benefits are paid.
The payment of funded benefits when they fall due depends not only on the financial position
and the investment performance of the fund but also on an enterprise’s ability to make good
any shortfall in the fund’s assets. Therefore, the enterprise is, in substance, underwriting the
actuarial and investment risks associated with the plan. Consequently, the expense
recognised for a defined benefit plan is not necessarily the amount of the contribution due for
the period.
I.136 Financial Reporting

51. Accounting by an enterprise for defined benefit plans involves the following steps:
(a) using actuarial techniques to make a reliable estimate of the amount of benefit that
employees have earned in return for their service in the current and prior periods. This
requires an enterprise to determine how much benefit is attributable to the current and
prior periods (see paragraphs 68-72) and to make estimates (actuarial assumptions)
about demographic variables (such as employee turnover and mortality) and financial
variables (such as future increases in salaries and medical costs) that will influence the
cost of the benefit (see paragraphs 73-91);
(b) discounting that benefit using the Projected Unit Credit Method in order to
determine the present value of the defined benefit obligation and the current service cost
(see paragraphs 65-67);
(c) determining the fair value of any plan assets (see paragraphs 100-102);
(d) determining the total amount of actuarial gains and losses (see paragraphs 92-93);
(e) where a plan has been introduced or changed, determining the resulting past
service cost (see paragraphs 94-99); and
(f) where a plan has been curtailed or settled, determining the resulting gain or loss
(see paragraphs 110-116).
Where an enterprise has more than one defined benefit plan, the enterprise applies these
procedures for each material plan separately.
52. For measuring the amounts under paragraph 51, in some cases, estimates, averages
and simplified computations may provide a reliable approximation of the detailed
computations.
Accounting for the Obligation under a Defined Benefit Plan
53. An enterprise should account not only for its legal obligation under the formal
terms of a defined benefit plan, but also for any other obligation that arises from the
enterprise’s informal practices. Informal practices give rise to an obligation where the
enterprise has no realistic alternative but to pay employee benefits. An example of such
an obligation is where a change in the enterprise’s informal practices would cause
unacceptable damage to its relationship with employees.
54. The formal terms of a defined benefit plan may permit an enterprise to terminate its
obligation under the plan. Nevertheless, it is usually difficult for an enterprise to cancel a plan
if employees are to be retained. Therefore, in the absence of evidence to the contrary,
accounting for post-employment benefits assumes that an enterprise which is currently
promising such benefits will continue to do so over the remaining working lives of employees.
Appendix I : Accounting Standards I.137

Balance Sheet
55. The amount recognised as a defined benefit liability should be the net total of the
following amounts:
(a) the present value of the defined benefit obligation at the balance sheet date
(see paragraph 65);
(b) minus any past service cost not yet recognised (see paragraph 94);
(c) minus the fair value at the balance sheet date of plan assets (if any) out of
which the obligations are to be settled directly (see paragraphs 100-102).
56. The present value of the defined benefit obligation is the gross obligation, before
deducting the fair value of any plan assets.
57. An enterprise should determine the present value of defined benefit obligations
and the fair value of any plan assets with sufficient regularity that the amounts
recognised in the financial statements do not differ materially from the amounts that
would be determined at the balance sheet date.
58. The detailed actuarial valuation of the present value of defined benefit obligations may be
made at intervals not exceeding three years. However, with a view that the amounts
recognised in the financial statements do not differ materially from the amounts that would be
determined at the balance sheet date, the most recent valuation is reviewed at the balance
sheet date and updated to reflect any material transactions and other material changes in
circumstances (including changes in interest rates) between the date of valuation and the
balance sheet date. The fair value of any plan assets is determined at each balance sheet
date.
59. The amount determined under paragraph 55 may be negative (an asset). An
enterprise should measure the resulting asset at the lower of:
(a) the amount determined under paragraph 55; and
(b) the present value of any economic benefits available in the form of refunds
from the plan or reductions in future contributions to the plan. The present value of
these economic benefits should be determined using the discount rate specified in
paragraph 78.
60. An asset may arise where a defined benefit plan has been overfunded or in certain cases
where actuarial gains are recognised. An enterprise recognises an asset in such cases
because:
(a) the enterprise controls a resource, which is the ability to use the surplus to generate
future benefits;
(b) that control is a result of past events (contributions paid by the enterprise and service
I.138 Financial Reporting

rendered by the employee); and


(c) future economic benefits are available to the enterprise in the form of a reduction in
future contributions or a cash refund, either directly to the enterprise or indirectly to another
plan in deficit.
Example Illustrating Paragraph 59
(Amount in Rs.)
A defined benefit plan has the following characteristics:
Present value of the obligation 1,100
Fair value of plan assets