| 4: ACCOUNTING SYSTEM After studying this chapter, the learners will be able to understand: Definition of Accounting - Definition as an Information System vv Users of Financial Accounting Information and their Information Needs ¥ Qualitative Characteristics of Financial Statements Functions of Accounting Advantages of Accounting Limitations of Accounting vvvy Branches of Accounting > Basis of Accounting > An overview of Artificial Intelligence and Data Analytics in Accounting Every organisation enters into a number of transactions during its course of business to achieve its objectives. These transactions affect its assets and liabilities, For example, purchase of fixed assets for long-term use of the organisation, purchase and sale of goods in a business entity, payment of salaries to the employees of the organisation etc. affect the assets and liabilities of the organisation and thus its financial position. As these transactions are generally very large in number, it is not possible for a person or a group of persons to remember all these transactions. Therefore, it is necessary to record and classify these transactions in a systematic manner. At the end of the period, these transactions should be summarised to know the results of its activities. The summarised financial records or financial statements are interpreted and communicated to the users of accounting information to aid in their decision making, DEFINITION OF ACCOUNTING The traditional definition of accounting has been provided by the American Institute of Certified Public Accountants (AICPA) which is as follows : 11 YAXMANN®] 1.2 ACCOUNTING SYSTEM “Accounting is the art of recording, classifying and summarising in a significan, manner, and in terms of money, transactions and events which are in part at least, of a financial character, and interpreting the results thereof.” As per this definition accounting is an art. Art means “thing in which skill may be exercised”, “skill as the result of knowledge and practice”. It means that accounting requires skill and persons learn to do it by knowledge and practice, The aforesaid definition gives four steps and first three steps namely recording, classifying and summarising are for generation of accounting information. The fourth step is analysis and interpretation of the results of the transactions and events. ‘Accounting process consists of recording, classifying, summarising and interpreting the transactions of the enterprise which are of financial nature. Recording is the process of entering the transactions and events in the books of original entry in chronological manner, i-e., date-wise, Classifying is the process of posting of entries in the ledgers so that the transactions of similar type are accumulated at one place and Summarising is concerned with the preparation of financial statements such as Income Statement, Balance Sheet and Cash Flow Statement. Interpreting is the next stage of the accounting process. The accountants should interpret the financial statements in. sucha way that they are useful to the users of the accounting information. The accounting information system should be designed in such a way that the right information is communicated to the right person at the right time. The process of recording of business transactions in a systematic manner and classifying them into ledgers is termed as Book-keeping. In 1966, the American Accounting Association (AAA) defined accounting as given below : “Accounting is the process of identifying, measuring and communicating economic information to permit informed judgment and decisions by users of information.” ‘This definition emphasises the need of communicating economic information so that the users of information can take informed judgment and decisions. ‘Smith and Ashbarn define accounting as follows : “Accounting is the science of recording and classifying business transactions and events, primarily of a financial character and the art of making significant summa- ries, analysis and interpretation of these transactions and events and communicating results to persons who must make decision and form judgment.” This definition says accountings bothscience and art. Science means “systematic and formulated knowledge”; “organised body of the knowledge that has been accumulated ona subject”; “branch of knowledge (esp. one that can be conducted onscientific principles)” Accounting can also be called science, it is an organised TAXMANN®ACCOUNTING SYSTEM 1.3 wledge based on accounting principles which have been formulated after a kno : ; Hrof experience. Accounting as an art has already been explained. jn 1970 the Accounting Principles Board of American Institute of Certified public Accountants gave the following definition : “Accounting ia service activity Is fction isto provide quantitative information, primarily financial in nature, about economic activities that is useful in making Feonomic decisions in making reasoned choice among alternative course of actions.” qhis definition also emphasises on providing useful financial information to the users to aid their decision making. qtmay be noted that book-keeping is concerned with the recording of business transactions in a systematic manner and classifying them in the ledger. It is mechanical and repetitive in nature. Itis the first part of accounting, Accounting jsused in a wider sense, Accounting includes the design of accounting system, preparation of financial statements, interpretation of financial statements and Pommunication of accounting information to its users, besides recording and classifying. Accounting deals with transactions which are primarily of financial character. ‘according to Kohler—A Dictionary for Accountants, transaction is “an event or condition the recognition of which gives rise to an entry in accounting records.” ‘according to Financial Accounting Standards Board (FASB) of the USA an event means “a happening of consequence to an entity”, Transaction may be internal orexternal. A transaction arising as a result of relation with an outside person crentity or due to its environment is an external transaction such as purchase gr sale of goods, or occurrence of flood or earthquake. A transaction which does not involve any outside person or entity or its environment is an internal transaction such as payment of money by the main cashier to his subordinate for meeting petty expenses. According to money measurement concept the transactions are expressed and recorded in terms of money as money is the common denominator for ail transactions. Therefore, if an event, such as death of the Chief Executive Officer of the company, cannot be measured in terms of money, it will not be recorded in accounting. After recording, classifying and summarising the transactions the next step is to analyse and interpret these summarized reports for taking decisions, i.e. preparation of profit and loss account, balance sheet etc. calculation ofaccounting ratios, use of graphs and charts tohighlight the various financial trends and relationships and explaining them. The general purpose of financial statements (i.e. profit and loss account, balance sheet, cash flow statement and notes to these statements and other statements This involves, interalia, eee eee eee KANN eee ence14 ACCOUNTING SYSTEM which may be required by law for the time being in force) are communicated to the users. - ‘Thus accounting is a principal means of communicating financial informatio, to investors, lenders, supplier of goods, managers, employees, government, regulatory authorities, and others who are interested in the enterprise. The Balance Sheet provides information about financial position, ie, about the assets, liabilities and equity of the enterprise, Profit and Loss Account provides the information about the performance, i.e., about the profit earned or loss incurred by the enterprise during the accounting period and information about the movement of cash is provided by the cash flow statement. Assets are the resources controlled by the enterprise asa result of past events from which future economic benefits are expected to flow to the enterprise. Liabilities are present obligations of the enterprise arising from past events, the settlement of which is expected to result in a outflow from the enterprise of resources embodying economic benefits so that claims of other parties can be satisfied. Equity is the residuary interest in the assets after deducting the liabilities. Financial Accounting Standards Board in 1978 stated that accounting provides “information that is useful in making business and economic decisions—for making reasoned choices among alternative uses of scarce resources in the conduct of business and economic activities.” ACCOUNTING AS AN INFORMATION SYSTEM Accountingis often called the language of business. Language means “the medium inwhich thoughts and ideas are transmitted from one to another’ ; “a vocabulary and way of using it...”; “a method of expression’. Thus language facilitates communication among people in society. Similarly, accounting facilitates communication in the world of industry, trade and commerce. Accounting is the common language used to communicate financial information to the users, both internal and external, so that they can take informed judgment and decisions. ‘Thus it is a service activity. The individuals who aspire to become professional accountant should have expert knowledge of accounting. Good knowledge of accounting is necessary for non-accountants also such as managers, investors, tax authorities, regulatory authorities, etc. as information given in a language can be understood by those who can understand that language. System means “complex whole”; “set of connected things or parts”; “organised body of material or immaterial things”. Thus a system is collection of various parts that work together to achieve a specific goal. For example, there is (2) Solar System—a group of associated bodies moving under mutual gravitation; (b) digestive, or muscular, or nervous, or reproductive system—a set of organs or parts in human and animal body with common structure or function. A ‘TAXMANN®ACCOUNTING SYSTEM 15 system converts Input into outputs. Accounting is also a system. It processes transactions to provide information to the users. Donal E Kieso and Jerry J-- ine accounting system as follows : The learned authors further state as follows : Accounting information system varies from one business to another, Factors that shape these systems are the nature of business, and the transactions in which it engages, the size of the firm, the volume of datato be handled and the informational demands that the management and others place on the system.” Thus the design of the accounting information system depend on the following factors : (a) Nature of business (6) Transactions in which the entity engages (c) The size of the firm (@) The volume of the data (e) Informational demands of the users. Asstated earlier a person cannot remember all the transactions and events which takes place in an organisation. Therefore, the owner/manager of a business organisation has to depend on the accounting process. Further accounting records are also required particularly in case of business entities, for complying with the legal requirements such as Income-tax Act, Companies Act, etc. Accounting is the system of identifying transactions and events which are to be recorded and then recording them in the journal or subsidiary books, classifying the recorded transactions in the ledgers and periodically summarising the transactions by preparing Profit and Loss Account, Balance Sheet and other statements. These statements are communicated to the users of accounting information for analysis and interpretation. Thus transactions and events which are ofa financial character serve as an input for the accounting system. These transactions are converted into output, i.e. Profit and Loss Account, Balance Sheet, Cash Flow Statement and some other statements and reports. The output, i.e. the financial statements and reports are communicated to the users for their informed judgment and decisions. The accounting information system is shown below : TAXMANN®1.6 ACCOUNTING SYSTEM z PROCESSING | >[ourPur |} + uae Business Recording, Profit and Loss Owners, transactions of classification, Account, Balance Investors, financial character summarising Sheet, Cash Lenders, (eg. purchase and the business Flow Statement, Mangers, sale of goods) transactions Explanatory Suppliers, based on Notes. Tax Customers, accounting Returns and Employees, principles, Other Regulatory Government standards, Filings. Regulatory management Other Special Authorities, estimates, actin Public, Companies Act, Eittments, Security Income-tax Act Intemal Reports Analysts and other Acts and Equity and Regulations Researchers (Now-a-days, Software packages like Tally are commonly used. for processing and output generation.) FIG. 1.1, ACCOUNTING INFORMATION SYSTEM Accounting information system must be such that the financial statements and reports can be prepared not only at the end of the accounting year but also on quarterlyand monthly basisas the information shouldbe timely communicated. It should be designed to meet the requirements of both internal and external users. Internal users include owner of sole proprietorship concern, partners of a partnership firm, directors ofa company and managers of the organisation. They need accounting information for taking various types of decisions so that they can manage the organisation effectively and in the interest of the stakeholders, External users include investors, lenders, suppliers of goods, customers, employees, prospective owner and investors, researcher, Government regulatory authorities and the public authorities. Government, regulatory authorities and tax authorities can demand some specific information from an organisation. Other external users can get only general purpose financial statements and these are published in case of corporate entities. The branch of accounting meant to serve these external users is called Financial Accounting, Therefore, accounting has been defined, as stated earlier, by the American Accounting Association as “the process of identifying, measuring and TAXMANN®.ACCOUNTING SYSTEM bed communicating information to permit Se judgment and decisions by users of accounting information is useful in making a number of decisions. For example, assessing the stewardship of management; ascertaining the ability of the entity to pay certain benefits to the employees apart from salaries andl wages; determination of distributable profits and dividends; decision regardinj investment in shares of the entity, assessing the safety of loan given or to be given toan entity, desirabi ity of sale of goods on credit to an entity to regulate the activities of an entity, etc, USERS OF FINANCIAL ACCOUNTING INFORMATION AND THEIR INFORMATION NEEDS In this book we are concerned with financial accounting. It is concerned with the recording, classifying and summarising transactions by preparing general purpose financial statements which are generally published so that it is also available to the external users, apart from the internal users for decision making. Usersneed accounting information to know the liquidity, solvency and profitability of the enterprise. As stated earlier there are two types of users—internal and external. Internal users of accounting information are persons from the management group suchas ownerand mangers in case of sole proprietorship concern, partners and manager in case of partnership firm and directors, managerial personnel and other officers in case of company or other corporate body. Thus internal users are directors, partners, managers and officers. Internal users have access not only to general purpose financial statements but also to special purpose statements and reports. Their information needs are satisfied through general and special purpose statements. Further they have access to various internal reports which are prepared for internal use and are not published. These reports are prepared so that they can plan, control and effectively manage the organisation toachieve the goals of the organisation. The branch of accounting dealing with these internal reports exclusively meant for internal use for managerial purposes is known as management accounting. External usersare those who are outside the management group suchas investors, lenders, suppliers, customers, government and regulatory authorities and the public. They use the information communicated to them by the management of the enterprise. They are mainly communicated general purpose financial statements, as they are prepared keeping in mind the general needs of the users. The branch of accounting which deals with preparation and communication of these statements is known as financial accounting. TAXMANN®18 ACCOUNTING SYSTEM mnoffinan 1s must be regarded a External usersare not involved in preparat is essential that these financial statement external users. ing are the users of Bnancial accounting Information and their may be ty firms. As provider rents and the associated pri ide loans to the enterprise. They are banks, fons and debenture holders. Long-term short- development finan: endersare interested mainly term lenders are primar enterprise. Therefore, they are interested in the informal nable them to know whether the borrowing company w« ind Rating Agencies Ltd.) to know the also known as creditors, are primar the company: Liquidity analysis means ability of the enterprise to meet its shor course of business. They are satisfied i ‘dues on time. They are also interested in the long-term cont enterprise, if their survival is dependent on the enterprise as in case of information to be used by others and use them in decisions. Theyneed information for financial statement analysis purpose TAXMANN® like the supplier to cut the prices of the pro the services. 7. Government and Regulatory Authorities. Cei Government and local authority are concerned sted companies for various in various ways. They they may purchase some TANMANNS.ACCOUNTING SYSTEM ry ACCOUNTING SYSTEM 1a should not be excluded merely on the ground Security Analysts, Credit Rating M analysis need accountinginfor 5s. They: CHARACTERISTICS OF FINANCIAL STATEMENTS QUALITATIVE! ents should be useful to the users. Theref yy. Accounting information should be reliable. Of the information gives trust and confidence that the the enterprise. Accounti material error and personal bias. reliable are : faithful representati prudence, completeness, ‘and verifiability. These are explained eae Tete [Comparbiy ] ionmustfaithullyepresentthe kt represen, information mustbebased on actual Newt : f Satyam Computers the company Timelines ne had shown large bank balance and fixed deposits in Sbetanéeovrorm the balance sheet in some years but actually that was not tue and Completeness <> eaahay therefore there was no faithful representation ofthe accounting information. the accounting information. The users should also devote some time to better understand the significance of accounting information. The users shouldalsohave working knowledge ofbusiness activities and accounting terminology. However, information about complex matters that has to be included in the Financial statements due to their relevance for decision talment, as the hire purchaser pay all the Similarly, a company purchases ‘and makes full payment but the building has not been transferred yet in the name of the company, the company can show ‘TAXMANN® anneACCOUNTING SYSTEM - based on ths attribute of substance over gas an asset bas the building form. ne counting information ted by the persona A on Factores Prepaid interest of one set of user over mind meres personassori ‘be prepared \stomake estimates in respect of certain ) Prudence Mara and doubt debts, or economic *Saun Prudene mest estima es th reasonable element of caution. {the assets and income would not be abilities and expenses would not be understated. and expenses shou mation would not be neutral ‘contained in financial statements () Completeness. The: ‘must be complet o be misleading or false. shouldbe provided othe users 's capacity to influence their decision, the similar information of the other enterpris thesame industry fora particular year. Absolute information is not much of use. Ifthe information is comparable both over the years for the same enterprise and amongst the enterprises for the same year then the use~ fulness ofthe information is enhanced for decision making. To achieve ‘comparability an enterprise should follow the same accounting policies ‘ver the years and the enterprises in the same industry should also follow the same accounting policies for the concerned year. Therefore, toachieve ‘ Dis > Capital Receipts and Revenue Receipts > Distinction between Capital Receipts and Revenue Receipts The main functions of accounting include the ascertainment of profit/loss for an accounting period and financial position as at the end of that period. The distinction between capital and revenue items is important both from the “Income Statement (Profit and Loss Account) as well as Position Statement (Balance Sheet) point of view. For example, if a depreciable asset is purchased, the depreciation on that asset is charged to Profit and Loss Account and written down value of the asset (or original cost of the asset less accumulated depreci- ation) is shown in the Balance Sheet. If purchase of a depreciable asset, which is a capital expenditure, is treated as revenue expenditure it will understate the profit of the current year and overstate the profits of the subsequent years. Similarly, the Balance Sheet will not give a true and fair view of the assets and equity of the enterprise till the useful life of the asset is over assuming that the asset is not sold earlier. Capital and revenue item are divided into (a) capital and revenue expenditure; (b) capital and revenue receipts. These are discussed below : CAPITAL EXPENDITURE AND REVENUE EXPENDITURE According to Guidance Note on terms used in financial statements issued by ICAI, “Expenditure is incurring a liability, disbursement of cash or transfer of property for the purpose of obtaining assets, goods or services”. Thus expenditure may or may not involve outflow of cash. It includes purchase of capital or long-lived 21 ‘TAXMANN®fee 2.2 CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS asset, goods for the purpose of sale or for getting services. Expenditures are divided into three categories : (1) capital expenditure (2) revenue expenditure and (3) deferred revenue expenditure. Capital Expenditure Expenditure which acquires a capital asset is capital expenditure. Further when an expenditure is made with a view to bring into existence an asset or advantage for the enduring benefit of an enterprise is a capital expenditure. If it acquires stock-in-trade, then it is revenue expenditure. Capital asset is one which is used in or for the purposes of the business and not meant for sale in the ordinary course of business of the enterprise. Purchase of stock-in-trade is not capital expenditure as it is sold in the ordinary course of business. Expenditure on purchase and installation of machinery is a capital expenditure. Asset or advantage of enduring nature means that it must not be fully consumed or used up in the accounting period in which it is incurred. Capital expenditure increases the earning capacity or reduces the operating expenses of a business. According to Kohler the term capital expenditure is “generally restricted to expenditures that add fixed asset units or that have the effect of increasing the capacity, efficiency, life span, or economy of operation of an existing fixed asset.” The following are the examples of capital expenditure : (1) Expenditure incurred for acquisition of fixed tangible assets such as land, building, machinery, furniture, motor vehicle etc. (2) Expenditure incurred for improvement or extension of fixed assets such as increasing the seating capacity of a theatre. (3) Expenditure incurred to bring the fixed assets to the place of their use and expenditure incurred on their installation or erection such as freight on fixed assets, wages paid for installation. (4) Expenditure incurred for purchase of intangible assets such as goodwill, patent rights and trade marks, copyright etc. (5) Expenditure incurred for reconditioning of old fixed assets such as expen- diture incurred on repairing or overhauling of second hand machinery. (6) Major repairs and replacement of plant which increase the efficiency of plant. (7) Cost of shifting a plant to another place isa capital expenditure [Sultanpur Sugar Works Ltd. v. CIT (1963) 49 ITR 160 (SC)] Treatment of Capital Expenditure. Capital expenditure is capitalised. It is written off over the estimated useful life of the asset. For example, when machinery i§ purchased, Machinery Account is debited at the price paid for it and later show" ‘TAXMANN® |CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS 2.3 inthe Balance Sheetas anasset after deducti 5 ing depreciation. Similarly id for installation of machinery is capitalised Pascnee eMac by debiting the Machinery Account. Rules for Determining Capital Expenditure. The following are the rules for determining capital expenditure : (1) An expenditure is capital expenditure, if it is incurred for acquiring a long-term asset (having a useful life of more than one year) for use in the business to earn revenue and not meant for sale. (2) An expenditure is capital expenditure, if it is incurred to put an asset into working condition. For example, the transportation and installation charges are added to the cost of machine. Similarly, the legal charges like registration and stamp duty is added to the cost of land and build- ing. Again, architect fee paid for supervising construction of building is capitalised, (3) An expenditure incurred for putting an old asset into working condition is treated as capital expenditure and added to the cost of the asset. (4) An expenditure incurred to increase the earning capacity of a business is treated as capital expenditure. For example, expenditure incurred for shifting the factory to convenient site is a capital expenditure. (5) 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 should be capitalised as part of the cost of that asset till the asset is ready for its intended use or sale as per AS-16 : Borrowing costs. Revenue Expenditure Ifan expenditure is made not for the purpose of bringing into existence any capital asset or advantage of enduring nature but for running the business or working it with a view to produce the profits is revenue expenditure. Such expenditure benefits the current period only. It is incurred to maintain the existing earning capacity of the business. For example, the amount spent on purchase of stock-in- trade is of revenue nature. Administrative expenses and selling and distribution expenses are other examples of revenue expenditure. Rules for Determining Revenue Expenditure. The following are the rules for determining revenue expenditure : (1) An expenditure incurred for the purpose of acquiring goods purchased for resale, consumable items, etc. is a revenue expenditure. For example, purchase of raw material in the case of manufacturing unit and purchase of merchandise meant for the purpose of resale. At the end of the year, closing stock and opening stock of these items are adjusted to match cost with revenue for calculating profit. ‘TAXMANN®24 (2) 3) (4) (5) (6) @ (8) 9) Pe CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS curred on other direct expenses, .e., expenses on produc. Expenditures i “ Pe! power, freight etc. are revenue tion and purchase of goods such as wages, expenditure. red for maintaining fixed assets in working order ig Expenditure incu on repairs and renewals revenue expenditure. For example, amount spen is revenue expenditure. Depreciation on fixed assets is revenue expenditure. Expenditures incurred on office and administrative and selling and distri- bution departments (not covered above) in the normal course of business are revenue expenditures. These include salaries, rent, telephone expenses, electricity, postage, advertisement, travelling expenses, commission to salesmen. Expenditures incurred on non-operating expenses and losses are revenue expenditures. For example, interest on loan taken after commencement of commercial production, loss on sale of a long-term asset, loss by theft, loss by fire are revenue expenditures. Expenditure incurred by an enterprise to discharge itself from recurring liability is of revenue nature. For example, a lump sum amount paid to a pensioner by the employer is revenue expenditure. Expenditure incurred for protecting the business isa revenue expenditure. For example, the amount spent on propaganda campaign to oppose the threatened nationalisation of industry is of revenue nature. Expenditure incurred to maintain the existing efficiency or the earning capacity is of revenue type. DISTINCTION BETWEEN CAPITAL EXPENDITURE AND REVE- NUE EXPENDITURE Distinction between Capital Expenditure and Revenue Expenditure 1. Nature of Asset _ | Expenditure which acquires a | Expenditure which acquires Acquired capital asset, eg., land, build-| stock-in-trade is a revenue ing, plant, machinery, vehicles, | expenditure furniture, goodwill, etc, is capital expenditure 2. Enduring Benefit | Capital expenditure is meant | Its benefit extends to one ac- for enduring benefit, ic., for | counting period only more than one accounting - period, TAXMANN®CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS 2.5 z fect on Net Aportion of thecostoftheasset | Itis ‘expired cost and therefore, Profit in case of depreciable asset is | it is transferred to income charged as depreciation over | statement for the year ending the useful life of the asset. Net | in which it is incurred. Profitisaffected by theamount of depreciation only. Unexpired Portion of capital expenditure in such a case is shown as an asset in the balance sheet. 4. Matching of cost | Itisnotmatchedagainstcapital It is matched against revenue with Revenues receipts receipts for determination of net profit. 5. Periodicity of It is of usually non-recurring | It is of recurring nature. Occurrence nature 6, Earning Capacity | It helps in increasing the earn- | It is incurred to maintain ing capacity of the business or | the earning capacity of the to reduce the operating cost. | business. 7. Commencement | It may be incurred even before | It is incurred alter the com- of Business the commencement of the | mencement of business. business, 8. Recording Itis debited to the related asset | Itis debited to related expense account. For example, if furni- | account. For example, if sala- ture is purchased, it is debited | ries are paid, it is debited to to Furniture Account salaries account. DEFERRED REVENUE EXPENDITURE Deferred revenue expenditure is a revenue expenditure by nature but it is not treated as revenue expenditure on the ground that its benefit is not fully exhausted in the accounting period in which it is incurred. The Guidance Note on ‘Terms used in Financial Statement’, issued by the Institute of Chartered Accountant of India, states that “Deferred revenue expenditure is that expenditure for which payment has been made or a liability incurred but which is carried forward on the presumption that it will benefit over a subsequent period or periods.” Deferred revenue expenditure is, for the time being, deferred from being charged against revenue. The unwritten off portion of the deferred revenue expenditure is shown on the asset side of the Balance Sheet. A portion of the total deferred revenue expenditure is charged as revenue expenditure. Deferred revenue ex- penditure should be written off over a certain number of years. AS-26 “Intangible Assets” has diluted the concept of deferred revenue expenditure. According to it, if expenditure is incurred to provide future economic benefits to an enterprise, but no intangible asset or other asset is acquired that can be recognised, then expenditure should be recognised when it is incurred. For example, preliminary expenses in establishing a ‘TAXMANN®2.6 CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS legal entity, expenditure on training sctlie and cra on relo. i anising an enterprise, expenditure on launching of new tects expen F romotional activities should be oducts, expenditure on. advertising: and p' h Pecognised as expenses in the year in ‘which these are incurred. However, share issue expenses an‘ issue of shares/debentures can be \d discount on ! (written off over a certain number of years: Deferred revenue expenditure should be distinguished from prepaid expenses, Tn case of deferred revenue expenditure the benefits available cannot be pre- f prepaid expenses, like payment of insurance in cisely estimated but in case o! i Sdvance, benefits available can be precisely estimated. In case of prepaid in. surance, insurance protection will be available for a definite period after close of the financial year. ILLUSTRATION 1. Classify the following into capital or revenue expenditure : ual expenses of € 10,000 spent on second hand machinery purchased. (a) Overhai (b) Carriage of ® 1,000 spent on machinery purchased. (0) Legal fees of & 5,000 paid to acquire property. (a) © 1,500 paid for servicing the company’s car inch nut part of a machine. luding & 500 paid for change of ol. (e) © 1,000 paid for replacement of a worn o of temporary huts, which were necessary for con- () % 18,000 spent for construction nd were demolished when the cinema house was struction of the cinema house a! ready. SOLUTION (a) Overhaul expenses spent on second hand machinery purchased isa capital expendi- ture. (b) Carriage paid on machinery is a capital exp (c) Legal fees paid to acquire property is a capital expenditure. (d) Amount spent on servicing entity's car is a revenue expenditure. lent of worn part of a machine is a revenue expenditure. jenditure. (e) Amount spent on replacem (Amount spent on construction of temporary huts is a capital expenditure. ILLUSTRATION 2. Classify the following into capital or revenue expenditure : (a) & 5,000 spent as lawyer's fee to defend a suit claiming that the firm's factory belonged to the plaintiff’ land. (b) : pred on the repairs and white-washing for the first time on purchase of (c) % 15,000 spent in connection with obtaining a licence for starting a factory. site TAXMANN®c APITAL AND REVENUE EXPENDITURES AND RECEIPTS 2.7 % 6,000 paid @ Paid as compensation to two employees who were retrenched. % 8,000 custom duty pai @ duction. 'Y paid on import of machinery for modemisation of factory pro- SOLUTION (a) Lawyer's fee to defend the impugned suit is a revenue expenditure () Amount spent on repairs and whit B ite-washing for th building is a capital expenditure. e .¢ first time on purchase of old (c) Amountspentin connection with obi: t faining licence for startinga factory is. capital expenditure. . nee (a) Amount paid as compensation to the employees is a revenue expenditure. (e) Custom duty paid on import of machinery for modernisation of factory is a capital expenditure. ILLUSTRATION 3. State with reasons whether the following are capital or revenue expenditure : (a) Freight and cartage on the new machine % 150, and erection charges % 500. (b) Fixtures of the book value of 2,500 sold off at® 1,600 and new fixtures of the value of & 4,000 were acquired, cartage on purchase ® 5. (c) A sum of & 400 was spent on painting the factory. (d) © 8,200 spent on repairs before using a second hand car purchased recently, to put it in usable condition. SOLUTION (a) Freight and cartage on the new machine and erection charges 500 are capitalised because they will benefit the business for more than one accounting period. (®) Loss on sale of fixtures € 900 (& 2,500 — 1,600) is a revenue expenditure although it is of non-operating nature. Amount spent on new fixtures & 4,000 and on cartage %5 are capital expenditures as they will benefit future periods also. (c) % 400 spent on painting the factory is a revenue expenditure as it was incurred to maintain the factory building. (@) Overhaul expenses (or repairs) 8,200 incurred to puta second hand car in working condition is a capital expenditure. It will benefit in future also. ILLUSTRATION 4. Classify the following into capital or revenue or deferred revenue expenditure : (a) Heavy advertising cost of € 10,00,000 spent on the launching of a company’s new product. (b) Advertisement expense & 50,000 incurred during peak festive season on regular basis. (c) % 2,000 paid for hiring of computer time for the preparation of the accounts of the business. ‘TAXMANN®.SS 2.8 CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS (4) Interest paid & 40,000 on loan taken for construction of building and purchasg plant and machinery before the asset is ready for intended use. * SOLUTION (a) Heavy advertising cost of & 10,00,000 spent on the launching of a company’s new product is a revenue expenditure as per AS-26. According to AS-26 (Para 56) “Intangible Assets”, expenditure incurred on “launching new products or Process" and “expenditure on advertising and promotional activities” are recognised as ey. penses when thes cd, Earlier, it used to be treated as deferred reve expenditure. (0) Advertisement expense % 50,000 incurred during peak festive season on regular basis is a revenue expenditure. (c) © 2,000 paid for hiring of computer time for the preparation of the accounts of the business is a revenue expenditure. (4) Interest paid % 40,000 on loan taken for construction of building and purchase of plant and machinery before the asset is ready for intended use is a capital expen. diture, DISTINCTION BETWEEN EXPENSES AND EXPENDITURE Expenditure : According to the Guidance Note on Terms used in financial statements issued by ICAI, expenditure is incurring a liability, disbursement of cash or transfer of property for the purpose of obtaining assets, goods or services. Itdoes not necessarily involve actual delivery or parting with money or property. Incurringa liability is also expenditure, Expenditure may be capital expenditure, revenue expenditure or deferred revenue expenditure. Expense : According to the Guidance Note on Terms used in financial state- ments issued by ICAI, expense is a cost relating to the operations of an accounting period or to the revenue earned during the period or the benefits of which do not extend beyond that period. Expense is expired cost. It decreases owners equity, other than those relating to distribution of dividend to shareholders in case of a company or withdrawal etc. made by the owner(s) in case of non-corporate entities. Expenses give benefit during the accounting period only in which they are incurred. An expense is incurred’ when goods or services are used in the process of earning revenue. CAPITAL RECEIPTS AND REVENUE RECEIPTS The distinction between capital receipt and revenue receipt is important because capital receipt is taken to the Balance Sheet and revenue receipt is taken to the Trading and Profit and Loss Account. Capital receipts are the receipts which are not obtained in course of normal business activities of the enterprise. The examples of capital receipts are : () capital contributed by the owner(s), (ii) secured or unsecured loans taken, (iti) TAXMANN®CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS. 2.9 receipts from sale of fixed assets and non-current investments. In case of not for profit organisation, legacy and life membership are capital receipts. Revenue receipts are the receipts which are obtained in course of normal business activities. They include proceeds from sale of goods, fee received from the services rendered in the ordinary course of business, receipts. ‘The nature of receipt is decided from the point of view of the person receiving it. The following broad principles may be laid down as guide for determining whether a particular receipt is of capital nature or of revenue nature : 1, Areceipt on account of fixed assets is a capital receipt whereas a receipt ‘on account of current assets or circulating capital is a revenue receipt. For example, sale proceeds from sale of fixed assets is a capital receipt while proceeds from sale of stock-in-trade is a revenue receipt. Capital profit from sale of fixed asset is to be shown in Profit and Loss Accounts. 2. Areceipt in substitution of source of income is a capital receipt whereas a receipt in substitution of income alone is a revenue receipt. For exam- ple, compensation for loss of employment or agency is a capital receipt (though taxable) whereas damages for breach of business contract is a revenue receipt. 3. An amount received for surrender of certain right under an agreement is a capital receipt whereas amount received by way of compensation of loss of future profits is a revenue receipt. For example, pension is a revenue receipt whereas lump sum received in commutation of pension is a capital receipt (though taxable). 4. The nature of a receipt is determined exclusively by its character in the hands of the receiver. 5. Where an asset is held as an investment, the sale proceeds of such asset is a capital receipt. But where an asset is held as stock-in-trade, the sale proceeds of such asset is a revenue receipt. For example, profit on sale of shares to a dealer in shares is a revenue receipt. DISTINCTION BETWEEN CAPITAL RECEIPTS AND REVENUE RECEIPTS 1. Capital receiptsare: not obtained in the course of normal business activities of the enterprise whereas revenue receipts are obtained in the course of normal business activities. 2. Capital receipts are usually obtained in case of a company from issue of shares, debentures, borrowings and sale of fixed assets or investments. Revenue receipts are usually obtained from sale of goods, rendering of a TAXMANNS2.10 - Capital receipts are usually of non-recurrin; i... | CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS, Services or use of enterprise resources yielding interest, Toyalties anu dividend. ig nature and revenue Teceips, are usually of recurring nature. Capital receipts from financing activities such as issue of shares, deben, tures and borrowings are shown on the liabilities side of the balance sheet as these receipts create liabilities payable at a future date where, interest on borrowings is shown asa charge in the Profitand Loss Account and dividends to shareholders are shown as appropriation of Profit in, the appropriation section of Profit and Loss Account. Interest accrued) Sutstanding will also be shown as a liability. ILLUSTRATION 5, State with reasons whether the (a) () (c) (d) (e) i) SOLUTION @ (b) ©) (d) e) oy) following are capital or revenue receipts : Introduction of capital by the owner ® 10,00,000. Amount realised from sale of old machinery & 50,000 (book value % 48,000). Sale of goods for cash ® 10,000, Cash received from debtors & 20,000. Sale of investments for ® 40,000 (book value ® 44,000), Interest received on investments & 3,000. Introduction of capital by the own claim on the business to repay it, Amount realised from sale of old machin Profit on sale of € 2,000 is to be s normal business activities of the enterpri Sale proceeds from investme; % 4,000 is to charged in the P; Interest on investments & 3,000 is a Fevenue receipt as use of enterprise Tesources Yielding interest is revenue, ise. MISCELLANEOUS ILLUSTRATIONS ILLUSTRATION 6, State with reasons wh (a) _— ‘ther the following Statements are true or false + incurred in an acti Legal expenses on for infringement of its trademark is capital expenditure. BCom. (4), Dethi—2006] TAXMANN® —_CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS 211 (b) Any expenditure which is reasonably large is capital expenditure. [B.Com. (H), Dethi—2007] (c) Expenses incurred to keep the machine in working conditions is capital expenditure. [B.Com. (H), Dethi—2009] (d) Heavy expenditure incurred on advertisement at the time of introducing anew product is capital expenditure. [B.Com. (H), Delhi—Nov., 2011 Modified] SOLUTION (a) False. Legal expenses incurred in an action for infringement of its trademark is revenue expenditure as it is incurred for maintaining an intangible fixed asset. (b) False. Any expenditure which is reasonably large is capital expenditure is false as the amount of expenditure is usually not the criterion for deciding whether the expenditure is of capital nature or revenue nature. The decision depends on the nature of the expenditure. (©) False. Expenses incurred to keep the machine in working condition is revenue expenditure. (@) False. Heavy expenditure incurred on advertisement at the time of introducing a new product is revenue expenditure as per AS-26, “Intangible Assets.” Earlier, it used to be treated as deferred revenue expenditure. ILLUSTRATION 7. State with reasons whether the following statements are true or false : (a) Deferred revenue expenditure is current year's revenue expenditure to be paid in later years. [B.Com. (H), Dethi—2010] (b) % 2,000 spent to remove a worn out part and replace it with a new one is revenue expenditure. (c) Insurance claim of € 10,000 received from the insurance company for loss of stock- in-trade by fire of & 15,000 is capital expenditure. (d). Rupees fifty lakhs received from issue of right shares is @ capital receipt. SOLUTION (a) False, Deferred revenue expenditure is incurred/paid in the current year and itis written-off over a certain number of years in future. (b) True. F 2,000 spent to remove a worn out part and replace it with a new one is revenue expenditure as itis in the nature of repairs and maintenance. (c) False. Insurance claim for loss of stock-in-trade is a revenue expenditure. (@) True, Amount received from issue of shares is capital receipt as it is not obtained in the course of normal business activities. TAXMANN®2 Write short notes on the following : (@) Capital expenditure: (6) Revenue expenditure and ©) Carriage paid for (© Amount paid for (d) Pi (€) Amountspent ono expenditure, “O Heavy expenditure incurred on the launch of a new Product is a revenue expenditure. “According to Para 56 of (FIFO) method of ditions, BCom. (1), Det Ans. [False— (i), (ji), Gi), (iv), (Wy) ee TAXMANN® inflationary con,CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS 2.13 State with reasons whether the following statements are true or false : (Expenses incurred to keep the machines in working conditions is a capital expenditure. (ii) Accrual concept implies accounting on cash basis, (iii) Depreciation cannot be provided in case of loss in a financial year (iv) Prudence is a concept to recognise unrealised profits and losses. (v) Thereceipts and payments account records receipts and payments of revenue nature only. [B.Com (H), Delhi—2009] Ans. (False— (i), (i), (i), (iv), (»)] 4, State with reasons whether the following statements are true or false : (A business entity can keep its accounts on accrual basis of accounting, (ii) Legal fees paid to acquire a property is capital expenditure. (iii) Higher depreciation will not affect cash profit of the business. (iv) Receipts and Payments Account highlights total income and expenditure. (v) Deferred revenue expenditure is current year's revenue expenditure to be paid in later years. [B.Com (H), Dethi—2010] Ans. [True— (i), (ii), (iii); False—(@), (v)] 5. State with reasons whether the following statements are true or fal (@ Depreciation is decrease in the market value of a fixed asset. (ii) Revenue and income are one and the same thing. (ii) According to accrual concept, revenues are recognised only when cash is actually received. (iv) Assets represent expired cost while expenses are unexpired costs. (v) Outstanding rent account is a personal account. [B.Com (H), Delhi—May, 2011] Ans. [True— (v); False— (i), (i), (ii), @)1 6. State with reasons whether the following statements are true or false : (i) Heavy expenditure incurred on advertisement at the time of introducing a new product is Capital expenditure. (ii) Expenses incurred to keep the machine in working conditions is capital expenditure. (iii) Depreciation cannot be provided in case of loss, in financial year (iv) Legal fees paid to acquire a property is Capital Expenditure. (v) Cash Account may have credit balance also. (vi) Interest is calculated on the hire-purchase price at the given rate of interest. (vii) Periodic inventory gives a continuous balance of stock in hand. [B.Com. (H), Delhi—Nov., 2011, Modified] ‘Ans, [True— (iv); False— (i), (ii, (ii), (), (vi), (i) ‘TAXMANN®2.14 CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS 7. State which of the following items will be charged to capital and which to Tevenue (a) © 4,800 were spent on repairing a second hand machine. (©) A-sum of € 10,000 were spent on painting the new factory. (©) % 800 were paid in connection with carriage on goods purchased, (4) Legal expenses & 12,000 were paid for purchasing a land, (e) © 35,000 custom duty paid on import of machinery for modernisation Of the factory production. ® 10,000 custom duty paid on import of raw materials. () Repairs for € 2,500 necessitated by negligence. (h) Sum of & 15,000 was retrenched Ans [Capital Expenditure— (a), (b),(d),(¢); Revenue Expenditure— (0), 0.@, @)) Paid as compensation to the employees who were (a) &5,000 spent towards additions to the macl hinery. (®) Repairs 1,000 necessitated by negligence (©) 8500 spent to remove a worn out part and replace it with a new one: (4) © 100 wages paid in connection with the erecti (€) Oldmachinery of book value® 7, and scrap realised for @ 100. (f) Second hand motor car immediately. ion of a new machinery, 500 worn out, dismantled ata. cost of % 1,000 Purchased for ® 10,000 and spent 1,000 for: repairs () Employees state insurance premium ® 600 paid, () Insurance claim of & 5,000 received from the insurance company for loss of g00ds by fire of & 6,000. Ans. [Capital Expenditure : (a), (d), (); Capital Receipt (e)% 100; Re diture (b), (c), (e)—% 8,400 (7,500 - 100 + 1,000), (g) % 600, (h) & 1, 9. ‘State with reasons whether the following statements (a) asis. (6) Prudence is a concept to recognise unrealised Profits and losses, (c) Any expenditure which is unreasonal (@) Heavy advertising expenditure to introduce a new product is a revenue expenditure, venue Expen- 000] are true or false ; Accrual concept implies accounting on cash b; (©) Allassetsand liabilities not taken over by the vend d esr asamst heparan Ucn a ae rant Ans. [True (d); False : (a), (6), (©), )] aN eeCHAPTER aL EVENTS OCCURRING 3 AFTER THE BALANCE SHEET DATE After studying this chapter, the learners will be able to understand: > Meaning of Events occurring after the Balance Sheet Date > Types of Events > Ind AS 10, Events after the Reporting Period > Comparison of AS 4 with Ind AS 10 Accounting Standard (AS) 4, “Contingencies and Events occurring after the Balance Sheet Date”, was originally issued in November, 1982. The standard has been revised by the Ministry of Corporate Affairs on 30th March, 2016. The standard is to be followed by the companies preparing their financial statements following Accounting Standards Rules, 2006. Such companies should follow the revised standard for preparation of accounts for accounting periods commencing onorafter the date of the notification. The standard has been revised for entities other than companies in 2016 by the Council of the ICAI and is mandatory for accounting periods commencing on or after April, 2017. EVENTS OCCURRING AFTER BALANCE SHEET DATE Meaning of events occurring after the Balance Sheet Date As per para 3.2 of AS 4, “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 case of a company, and, by the corresponding approving authority in the case of any other entity.” Thus, events occurring after the balance sheet date are as under: @ Events occurring after the balance sheet date and the date on which financial statements are approved by the competent authority; and (i) These events are significant events and they may be favourable and unfavourable. For example, for the year ending on 31st March, 2022, financial statements are approved by the Board of Directors of the company in its meeting held on June 3A ‘TAXMANN®a EVENTS OCCURRING AFTER THE BALANCE SHEET DATE 20, 2022. In this case, the events taking place between Ist April, 2022 to June, 2022 are known as events occurring after the balance sheet TYPES OF EVENTS For the Purpose of accounting treatment, events occur date may be divided into following categories: (1) Adjusting events 3.2 pi date, Mh after the balance shox @) Non-adjusting events (a) Adjusting events Adjusting events are those that provide additional evidence to assist the estimation of amounts relating to conditions existing at the balance sheet date, Insolvency of a customer after the balan additional evidence on the conditions existing on the balance sheet date. For example, a debtor (i.e. trade receivable) against whom a provision for doubtful debts was created, has become insolvent after the financial statements and estate of the debtor will ce sheet date, usually provider concern. ILLUSTRATION 1 (Adjusting Event) company entered intoan agreement tose its Janes (Able Property to another company for 75 lakhs. The property was shown in the balance sheet at 17 lakhs, The agreement pyseil as concluded on 25th February, 2022 ant the sale deed was registered on 30th April, 2022. The financial statements fer th approved by the board on 22nd May, 2022. You are required to st statements for the yeai SOLUTION In the given question, an agreement to sell the smmovable property was entered into on 25th February, 2022, i.e, before the balance sheet date of 31st March, 2022, The sale deed was executed on 30th April, 2022, Registration of sale deed on 30th April, 2022 ee TAXMANN® 'e year 2021-2022 were fate, how this transaction would be dealt with in the financial ended 31st March, 2022.ILLUSTRATION 2 (Adjusting Event) While preparing its final accounts made a provision for bad debts @ 4% for the year ended 31st March, 2022 a company a ee (as per trend followed from the larch, , a del r heavy loss due an earthquake; the loss was not Soieal pee Bee ee In apa 2022, the debtor becomes bankrupt. Can the company provide for the full loss arising out of insolvency of the debtor in the final account for the year ended 31st March, 2022? SOLUTION previous year). In the first week of A debtor for ® 8,00,000 suffered heavy loss due to earthquake in the first week of March, 2010 (i.e., before the balance sheet date), The debtor became bankrupt in April, 2022 (i.e., after the balance sheet date). The loss was not covered by any insurance policy. Therefore, the company should provide for full loss arising out of insolvency of the debtor in the final accounts for the year ended on 31st March, 2022 as per AS-4, ILLUSTRATION 3 (Adjusting Event) Cashier of the Star Limited embezzled cash amounting to® 3,00,000 during March, 2022. However, this fact of embezzlement comes to, the notice of the company management during April, 2012 only. Financial statements of the company are not yet approved by the Board of Directors of the company. In the context of AS-4, “Contingencies and Events occurring after the Balance Sheet Date” decide whether the embezzlement of cash should be adjusted in the books of account for the year ended 31st March, 2022? SOLUTION Cashier embezzled cash amounting to € 3,00,000 during March, 2022 (ie., before the balance sheet date) and the company management came to know about it in April, 2022 (ie., after the balance sheet date). Though the embezzlement of cash was detected in April, 2022, it is an additional evidence which materially affected the determination relations to conditions existing on the balance sheet date. Therefore, it is necessary to make adjustments in the books of account regarding embezzlement of cash by the cashier as per AS-4. Cash balance should be reduced by ® 3,00,000 as at 31st March, 2022 and the amount of %3,00,000 should be shown as a loss in the income statement, if nothing is recoverable from the cashier. (b) Non-Adjusting Events Decline in market value of investments: 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 the market value of investments between the balance sheet date and the date on which financial statements are ‘TAXMANN®Ro 3.4 EVENTS OCCURRING AFTER THE BALANCE SHEET DATE approved. Ordinary fluctuations in market value do not normally Telate co the condition of the investments at the balance sheet date, but Teflect circumstances which have occurred in the following period. (Para 83.4 AS-4). Proposed Dividend : If an enterprise declares dividends to shareholder after the balance sheet date, the enterprise should not recognise thy dividends as a liability at the balance sheet date unless a statue requires otherwise. Such dividends should be disclosed in the notes. (Para 14 o AS-4), ILLUSTRATION 4 (Proposed Dividend) The Board of Directors of M/s 2017, considered and approved for the financial year ended 31: equity share (on 2 crore fully p: March, 2017 if approved by th the company on 18th June, 20 New Graphics Ltd. in its meeting held on 18th Apri the audited financial results along with Auditor's report st March, 2017 and recommended a dividend of = 2 Per aid-up equity shares of & 10 each) for the year ended 31s, e member at the forthcoming annual general meeting of 17, the same will be paid to all the eligible shareholders, piscuss the accounting treatment and presentation of the said proposed dividend in the annual accounts of the company for the year ended 31st March, 2017 as per the applicable accounting standard and other statutory requirements, UPCC, May 2017] Solution Dividends proposed/declared: after the balance sheet date but before. ‘approval of financial Statements are not recognised as a liability at the balance sheet obligation existsat that time. Hence, such i Sth April, 2018 a fire occ a urred in the factory ari office Premises. The loss by fire is of such Magnitude that it was not possible to expect enterprise Dee Limited to stant operation again, a State with reasons, eo ie loss Cue to fire is an adjusting or non-adjusting event 'sclosed by the company in the coments provision (IPCC, Nov. 2018) and how the fact of of As-4 (Revised)EVENT: ‘S OCCURRING AFTER THE BALANCE SHEET DATE 35 Solution pany to start its operations again. Thus, the going concem assumption is not valid. In such a case, the company should prepare the financial statements on liquidation basis Events occurring after approval of accounts Bes occurring after the balance sheet date and also after the approval of accounts by the compet rity are non-adjusting events, Such ev i sed s ts, if material, are disc Riis resort ee percarangt oa vents, if material, are disclosed MISCELLANEOUS ILLUSTRATIONS ILLUSTRATION 6 Surya Limited follows the financial year from April to March. It has provided the following information: (i) Asuit against the company’s advertisement was filed by a party on 5th April, 2021, claiming damages of 7 5 lakhs. (i) Company sends a proposal to sell an immovable property for 45 lakhs in March, 2021. The book value of the property is € 30 lakhs as on year end date. However, the Deed was registered on 15th April, 2021. (iii) The terms and conditions for acquisition of business of another company have been decided by the end of March, 2021, but the financial resources were arranged in April, 2021. The amount invested & 50 lakhs. (iv) Theft of cash amounting to ¥ 4 lakhs was done by the cashier in the month of March, 2021 but was detected on the next day after the financial statements have been approved by the Directors. Keeping in view the provision of AS-4, you are required to state with reasons whether the above events are to be treated as contingencies, Adjusting events or Non-Adjusting events after the balance sheet date. (IPCC, July 2021) Solution (@ Suit against the company’s advertisement was filed by a party on Sth April, 2021, claiming damages of & 5 lakhs. Suit against the company is a contingent liability but it was not existing on the balance sheet date because the suit was filed on 5th April, 2021, i., after the balance sheet date. It is a non -Adjusting event because condition or situation was not existing at the balance sheet date. (i) Proposal to sell an immovable property was sent in March, 2021. However, there ‘was no contract to sell the property in March, 2021, Therefore, itis a non-adjusting event. (iii) In this case, terms and conditions for acquisition of business were finalised in the month of March, 2021, ie., before the balance sheet date. However, the resources amounting to 50 lakhs were arranged in April, 2021, é., after the balance sheet ‘TAXMANN®3.8 EVENTS OCCURRING AFTER THE BALANCE SHEET DATE inventories after the reporting period may give evidence about their ne realisable value at the end of the reporting period. (c) The determination after the balance sheet date of the cost of assets py, chased, or the proceeds from assets sold, before the end of the reporting period. (d) The discovery of fraud or errors that show that financial statements arg incorrect. 2. Non-adjusting events after the reporting period : An entity shall not adjust the amounts recognised in its financial statements to reflect non-adjusting events after the reporting period. (Para 10 of Ind AS-10). An example of non-adjusting event after the reporting period is a decline in fair value of investments between the end of the reporting period and the date when the financial statements are approved for issue. (Para 11 of Ind AS-10) Dividends Ifanentity declares dividends to holders of equity instruments after the reporting period, the entity shall not recognise those dividends as a liability at the end of the reporting period. (Para 12 of Ind AS-10). Going Concern An entity shall not prepare it financial statements on a going concern basis if management determines after the reporting period either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but to do so. (Para 14 of Ind AS-10). Disclosure (® Date of approval for issue : An entity shall disclose the date when the fi nancial statements were approved for issue and who gave that approval. (Para 17 of Ind AS-10) (ii) Updating disclosure about conditions at the end of the reporting period :1t an entity receiver information after the reporting period about condition that existed at the end of the reporting period, it shall update disclosures that relate to those conditions, in the light of the new information. (Para 19 of Ind AS-10). Gii) Non-adjusting events after the reporting period : If non-adjusting events after the reporting period are material, non-disclosure could influence the economic decisions that users make on the basis of financial statements. Accordingly, an entity shall disclose the following for each material cat- egory of non-adjusting event after the reporting period : (a) The nature of the event; and (b) An estimate of its financial effect, or a statement that such a0 estimate cannot the made. (Para 21 of Ind AS-10). OO AXMANN® oeEVENTS OCCURRING AFTER THE BALANCE SHEET DATE 39 For example, the destruction of a major production plant by fire after the fire is anexample ofnon-adjusting event after the reporting period that would generally result in disclosure. Other such non-adjusting events are : (a) a major business combination after the reporting period; (b) announcing a plant to discontinue an operation; (c) major purchases and sale of assets; (d) announcing a major restructuring plan; (e) issuing significant guarantees; (f) commencing major litigation arising solely out of events that occurred after the reporting period; (g) abnormally large change after the reporting period in asset prices in foreign exchange rates; and (/2) changes in tax rates on tax laws enacted or announced after the reporting period that have a significant effect on current and deferred tax assets and liabilities. Comparison of AS4 with Ind AS10 Basis ASA [ind as-10 1, Contingencies AS-4 deals with contingencies | It does not deal with regarding impairment of | contingencies debtors. 2. Material Non- As per AS-4 disclosure should | An entity shall disclose the adjusting events be made in the report of | following for each material approving authority of those | category of non-adjusting events occurring after the| event after the reporting balance sheet date that period : represent material changes and commitments affecting the financial position of the enterprise. () An estimate of its financial effect, or statement that such anestimatecannot be made. . Going concern AS-4 requires assets and| An entity shall not prepare liabilities to be adjusted for | its financial statements on events occurring after the|a going concern basis if, balance sheet date which | management determines indicate that the enterprise | after the reporting period ceases to be going concern, | either that it intends to e.g., destruction of major | liquidate the entity or to production plant by fire. cease trading, or that it has no realistic alternative but to do so. (a) The nature of the event; and 4. Date of approval and | No such provision. ‘An entity shall disclose the authority who gave date of approval offinancial approval statements; and who gave that approval. ‘TAXMANN®ee 3.10 EVENTS OCCURRING AFT) ER THE BALANCE SHEET DATE THEORETICAL QUESTIONS 1, What is meant by “events occurrins accounting treatment of adjusting an 2. Write notes on the following as per AS-4 (a) Adjusting events J after the balance sheet date”. Explain th, \d non-adjusting events as per AS-4. (b) Non-adjusting events 3. Explain and illustrate accounting treatment of the following as per AS-4; (a) Event affecting going concern (b) Event occurring after meeting of competent authority (c) Proposed dividend 4, Write note on “Events Occurring after Balance Reporting Period” as per Ind AS-10, 5. Give three points of difference between AS 4 and Ind AS 10. OBJECTIVE QUESTION 1. State whether each of following statements are true or false (a) Proposed dividend is to be disclosed in notes to Accounts. (b) Adjusting events are the events related to circumstances existing on the balance sheet date. (c) Incase of adjusting events, loss should be adjusted in the accounts; and assets and liabilities are to be adjusted on the balance sheet date, @) Non-adjusting events are entirely new events after the balance sheet date. (e) Incase of non-adjusting events, adjustments are made in accounts. Ans. [True : (a), (b), (c), (d); False : (e)]cs. —— 2 | EXTRAORDINARY ITEMS, __ PRIOR PERIOD ITEMS, | ACCOUNTING ESTIMATE, | ACCOUNTING POLICIES AND FAIR VALUE > Objective and Scope of AS 5 > > > > > > > > > > Definition of Ordinary Activities Net profit or Loss for the period Components of Net Profit or Loss Extraordinary Items Prior Period Items Accounting Estimate Accounting Policies Ind AS -8 Comparison of AS 5 with Ind AS 8 Fair value Accounting Standard (AS) 5, “Net Profit or Loss for the Period, Prior Pe- riod Items and Changes in Accounting Policies”, deals with disclosure of certain items of net profit or loss for the period such as extraordinary items, prior period items, changes in accounting policies and accounting estimates. This accounting standard was, originally issued in 1982 and revised in 1997 and 2001. OBJECTIVE AND SCOPE OF AS 5 Objective The objective of AS-5, “Net Pro! Changes in Accounting Policies r Loss for the Period, Prior Period Items and is to prescribe the classification and disclo- 41 TAXMANN® -42 EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FATR VALUE sure of certain items in the statement of profit and loss so that all enterprises prepare and present such a statement on uniform basis. This enhances the comparability of financial statements of an enterprise over time and with the financial statements of other enterprises. Scope of AS 5 This standard should be applied by an enterprisein presenting profit or loss from ordinary activities, extraordinary items and prior period items in the statemen of profit and loss, in accounting for changes in accounting estimates, and in disclosure of changes in accounting policies. (Para 1 of AS-5). DEFINITION OF ORDINARY ACTIVITIES 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. (Para 4.1 of AS-5), NET PROFIT OR LOSS FOR THE PERIOD All items of income and expense which are recognised in a period should be in- cluded in determination of net profit or loss for the period unless an accounting standard requires or permits otherwise. (Para 5 of AS-5) ‘This includes extraordinary items and the effect of changes in accounting es- timates. (Para 6 of AS-5) COMPONENTS OF NET PROFIT OR LOSS 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: (1) Profit or loss from ordinary activities; and (2) Extraordinary items. (1) Profit or loss from ordinary activities : As stated earlier, ordinary activities are income or expenses which are undertaken by an enterprise as part of its business and such related activities in which the enterprise engages in further ance of, incidental to, or arising from, these activities. When items of income and expense within profit or loss from ordinary activities are of such size, nature or incidence their disclosure is relevant to explain the performance of the enterprise for the period, the nature of such items should be disclosed separately. (Para 12 of AS-5). Circumstances which may give rise to the separate disclosure of item of incom? and expense in accordance with paragraph 12 include the following. TAXMANN®EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE 43 (a) The write-down of inventories to net realisable value as well as reversal of, such write-downs. (b) Disposal of items of fixed assets (i. ‘i il » property plant and equipment and intangible assets); EE ay oa eae ©) Restructuring of the activities of an enterprise and reversal of any pro- vision for the cost of restructuring; (d) Disposal of long-term investment ; (e) Legislative changes having retrospective application ; () Li (g) Other reversal of provisions, ration settlements; and (2) Extraordinary Items : The expression extraordinary item has been discussed below under separate main heading. EXTRAORDINARY ITEMS Extraordinary items are income or expenses that arise from events or transac- tions that are clearly distinct from the ordinary activities of the enterprise and, therefore, are not expected to recur frequently or regularly. (Para 4.2 of AS-5) 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 amount of each extraordinary item should be separately disclosed in the statement of profit or loss in a manner that its impact on current profit or loss can be perceived. (Para 8 of AS-5). Extraordinary items include (i) loss due to attachment of property of the en- terprise, loss due to an earthquake (except in case of an insurance company), government grants becoming refundable and government grants receivable as compensation for expenses or losses incurred in previous accounting period. ‘An event or transaction may be extraordinary for one enterprise but not so for another enterprise because of the differences between their respective ordinary activities. For example, losses sustained as a result ofan earthquake may qualify a8 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 insurer against such risks. (Para 10 of AS-5) PRIOR PERIOD ITEMS Meaning : Prior period items are income or expenses which arise in the current period as a result of error or omission in the preparation of the financial statements of one or more prior periods. (Para 4.3 of AS-5) TAXMANN®44 EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE, The term ‘prior period items’ does not include other adjustments necessitated circumstances, which though related to prior periods, are determined in the cu rent period, e.g., arrear payable to workers as a result of revision of wages with retrospective effect of during the current period. (Para 16 of AS-5) The of wages cannot be taken as error or omission in the Preparation of financiay statements, and, therefore this expense cannot be taken as prior period item, This expense does not qualify as an extraordinary item. However, if the size ae such item is large, this item should be disclosed separately. Errors in 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 math. ematical mistakes, mistakes in applying accounting policies, misinterpretation of facts, or oversight, Prior period items are generally infrequent in nature. Prior period items can distinguished from changes in accounting estimates. Accounting estimates by their nature are approximations that may need revision as additional infor. mation 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. (Para 18 of AS-5) ILLUSTRATION 1 (Prior Period Item) 4 company finds that the stock sheets on 31-3-2022 did not include two Pages containing details of inventory worth & 50 lakhs. State, how will you deal with this matter in the ac- counts of BG Lid. for the year ended 31st March, 2022 with references to AS-5. SOLUTION In the given case, two pages of stock sheet were missing in financial statements of 2021 Due to this the. closing stock as on 31st March, 2021 was shown less by 50 lakhs. Further the opening stock for the year ending 31st March, 2022 was understated which resulting in overvaluation of profit for the year ending 31st March, 2021. In the current year ending 31st March, 2022, the Prior period item will appear as a” Tee @mounting to % 50 lakhs as per AS-5. Thus the profit will be reduced by 50 lakths for the year ending 31st March, 2022 5 ILLUSTRATION 2 (Prior Period Items)| a EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE 45 received a payment of® 16,00,000 against the claim. Explain the treatment of such receipts jm final accounts for the year ended 31st March, 2023. SOLUTION In the given question, it is a case of error in preparation of financial statements for the financial statements for the year 2021-22. Therefore, the claim received in March, 2023 is a prior item as per AS-5 and should be separately disclosed in the income statement for the year ended 31st March, 2023. ILLUSTRATION 3 (Prior Period Item) ‘Acompany signed an agreement with the employees’ union on Ist November, 2020 for re- vision of wages with retrospective effect from April 1, 2019. This would cost the company ‘an additional liability of € 25 lakhs per annum, Is a disclosure necessary for the amount paid in 2020-21. SOLUTION Inthe given case, agreement for revision of wages was signed with the employees’ union on Ist November, 2020 with retrospective effect from April 1, 2009. The arrear of wages for the period from April 1, 2009 to March 31, 2010 is not an error or omission in the preparation of financial statements. Therefore, this expense cannot be taken as prior period item. Additional wages of ® 25 lakhs should be included in the current year’s wages (ie., wages for the year 2020-21). Additional wages is an expense from ordinary activities. In other words it is not an extraordinary item, However, necessary disclosure should be made regarding additional wages liability of & 25 lakhs in the financial statements. ACCOUNTING ESTIMATE Meaning of Accounting Estimate An accounting estimate is an approximation of the amount of a business transaction which cannot be precisely measured. ‘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. For example, estimates may be required 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. (Para 20 of AS-5). Change in Accounting Estimate Anestimate may have to be revised if changes occur regarding the circumstanc- es on which the estimate was based, or as a result of new information, more experience or subsequent developments. The revision of estimate, by its nature does not being the adjustment within the definitions of an extraordinary item or prior period item. (Para 21 of AS-5). ‘TAXMANN®ay 4.6 EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE The examples of change in accounting estimates are (i) change in residual uc of a depreciable asset; (ii) change in useful life of a depreciable asset, change in the estimation of amount of bad debts. I val. sand Classification of Effect of Change in Accounting Estimate If an accounting estimate which was previously included in profit or loss from ordinary activities, then change in the accounting estimate should also be classified as ordinary activities. Similarly, if an accounting estimate which wag Previously included in profit or loss as extraordinary item should be reported as an extraordinary item, Effect of change in Accounting Estimate in one or more periods Achange 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 The effect of a change in an accounting estimate should be included in the determination of net Profit or loss in: (@) The period of the chan (b) The period of the chi (Para 23 of AS-5), ge, ifthe change affects the period only; or ‘ange and future periods, if the change affects both, ILLUSTRATION 4 (Change in Accounting Estimate) A company ,mwow ssEXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE 47 ILLUSTRATION 5 (Change in Accounting Estimate) ‘A.company created a provision for bad and do the financial statement for the year 2021-29, § allowed and financial capacity ofthe custome vision 10 7.5% on debtors as on 31st March 20> Board till the date of the decision. While apply this revision be considered as an extraordinary ubtful debts @ 3% on debtors in preparing iubsequently, on a review of the credit period the company decided to increase the pro- item or prior period item? SOLUTION [As per Para 21 of AS-5 revision of an estim: 0 ate does not bring the adj thi se Peraoos of prior period Rett ae see ing the adjustment within the traordinary item. In the given case, a limited company created 3% provi provision for bad and doubtful debts for the year 2021 22-Subsequenty the company revised the estimate based on changed circumstances and decided to create 7.5% provision. As per AS-5, this is neither an ex- traordinary item nor a prior period item. As per Para 27 of AS-5, the nature and amount of change in an accounting estimate which has a material effect should be disclosed. ACCOUNTING POLICIES Meaning of Accounting Policies As per Para ll of the Accounting Standard 1, Disclosure of Accounting Policies, “Accounting Policies refers to the specific accounting principles and the method of applying those principles adopted by the enterprise in the preparation and presentation of financial statements. Areas where different Accounting Policies are followed There is no single set of accounting policies which are applicable to all circum- stances. The differing circumstances in which enterprise operate in a situation of diverse and complex economic activity make alternative accounting principles and method of applying those principles acceptable. The choice of the appro- priate accounting principles and the methods of applying those principles in the specific circumstances of each enterprise call for considerable judgment by the management of the enterprise. (Para 12 of AS-1). Different accounting policies are followed by the enterprises while charging de- preciation, valuing inventories, treatment of goodwill, treatment of expenditure during construction, valuation of investments, valuation of property, plant and equipment and intangible assets, translation of foreign currency items, nition of profit on long-term contracts and treatments of contingent liabi Considerations in the selection of Accounting Policies The following are the considerations in the selection of accounting policies as per AS-1; 1. Primary Consideration : Primary consideration in the selection of accounting policies is that the financial statements should be prepared on the basis of such TAXMANN®7 48 EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE accounting policies which show a true and fair view of the financial POSitig, (ie., Balance Sheet) and financial performance (i.e., Income Statement) Of the enterprise, 2. Secondary considerations : Secondary considerations for the selection of accounting policies are as follows; (a) Prudence : Prudence means making provision for all expected liabilities and losses but anticipated profits are not recognised until realised, (6) Materiality : All material items which affect the decisions of the users should be disclosed in the financial statements, (c) Substance over form ; It means that transactions should be recorded on the basis of their economic reality and not on the basis of their legal form, For example, if an asset is purchased on hire purchase, it is shown as an asset in the books of the hire-purchase, even though he will become the owner of the asset after paying all the instalments. Disclosure of Accounting Policies The following are the disclosure requirements regarding accounting policies as per AS-1 © All significant accounting policies adopted by an enterprise adopted by the enterprise in preparation and presentation should be disclosed as part of the financial statements and at one place. (ii) Any change in the accounting policies which has a material effect in the current or future period should also be disclosed. The amount by which an item in the financial statements is affected by such change should also be disclosed. Where such amount is not ascertainable, the fact should be disclosed. Disclosure of Fundamental Accounting Assumptions The following are the fundamental accounting assumptions as per AS-1; (a) Going concen : The enterprise is normally viewed asa going concern, that is, 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 operation. (b) Consistency : It is assumed that accounting policies are consistent from one period to another. (©) Accrual : Revenues and costs are accrued, that is recognised as they are carned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate. Ifthe fundamental accounting assumptions, namely going concern, consistencY and accrual are followed in financial statements, specific disclosure is not T°" TAXMANN® 1EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE red. Ifa fundamental accounti ‘an elgiselosed. (Para 27 of AS-1). e SS4™Ption snot followed, the fact should Change in Accounting Policies ‘nds in its financial position, performance ‘ame accounting policies are y for similar events or transactions in each Betiod inte Achange in accounting policy should be made in the following conditions: @) Ifthe adoption of a different accounting policy is required by statute or (i) Ifthe adoption of a different accountin, 1 olicy is requir i with an accounting standard utinsPolicy is required for compliance (iii) If it is considered that the change would result in a more appropriate presentation of the financial statements of the enterprise. Disclosure of Change in Accounting Policy : Any change in an accounting policy which has a material effect should be disclosed. The impact of, and the adjust- ments 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, that fact should be indicated. (Para 32 of AS-5). Ifa change is made in 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 appro- priately disclosed in the period in which the change is adopted. (Para 32 of AS-5). The following are not change in accounting policies : 1, Introduction of formal gratuity or pension scheme in place of ad loc ex-gratia payments to employees on retirement. 2. Change in the useful life of property, plant and equipment is a change in accounting estimate and not a change in accounting policy. 3. Increase in the rate of provision of doubtful debts is a change in account- ing estimate and not a change in accounting policy. ILLUSTRATION 6 (Miscellaneous) State whether the following items are an example of change in. accounting policy/ change in accounting estimate/extraordinary item/prior item/ordinary activity ; (® Change in useful life of property, plant and equipment (in short PPE). (ii) Actual bad debts turning out to be more than provision for doubtful debts. (iii) Change from cost model to revaluation model for measurement of car- rying amount of property, plant and equipment. i TAXMANN®4.10 EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE (é) Legislative changes having long-term retrospective application, (©) Government grant receivable as compensation for expenses incurred in Previous accounting period. (vi) Government grant becoming refundable (vii) Treating operating lease as finance lease. (viii) Change in the method of depreciation from straight line to written down value method. (ix) Change in cost formula in measuring the cost of inventories. Classification of given items is as follows : (Change in useful life of PPE Itis a change in accounting estimate. (ii) Actual bad debts turning out to be more than provision for doubtful debts, It is a case of change in accounting estimate. (iii) Change from cost model to revaluation model amount of property, plant and equipment. Itis a case of change in accounting policy. for measurement of carrying (iv) Legislative changes having long-term retrospective application. It is a case of ordinary activity. (©) Government grant receivable as compensation for expenses incurred in the previous accounting period: It is an extraordinary item. (vi) Government grant becoming refundable, It is an extraordinary item. (vii) Treating operating lease as finance lease. Itis a prior period item. (viti) Change in the method of depreciation from straight line to written down value. It is a change in accounting estimate. (ix) Change in cost formula for measuring the cost of inventories, It is a change in accounting policy. IND AS 8, ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS Objective of Ind AS-8 : The objective of I ind AS-8, “Accounting Policies, Changes in Accounting Estimates and Errors’, is to prescribe the criteria for selecting TAXMANN®EXT! RAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIRVALUE 4.11 and changing accounting politicies, together wi disclosure of changes in accounting policies, and corrections of errors. : ‘ith the accounting treatment and changes in accounting estimates Meaning of Accounting Policies : As per Ind AS-8, accounting policies are the specific principles, bases, conventions rules and practices adopted by an entity in preparing and presenting financial statements”. Consistency of Accounting Policies : An e ing policies consistently for similar tra unless an Ind AS specifically requires or permits categorisation of items for which different policies may be appropriate. If an Ind AS requires or permits such categorization, an appropriate accounting policy shall be selected and applied consistently to each category. (Para 13 of Ind AS-8) Changes in Accounting only if the change : ‘tity shall select and apply its account- nsactions, other events and conditions, Policies : An entity shall change an accountancy policy (a) Is required by an Ind AS ; or (b) Results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity's financial position, financial performance or cash flows. Change in Accounting Estimate Accounting estimate means the items recognised in financial statements which cannot be measured precisely or accurately. In such cases the entity has to make an estimate of the value of these items. AsperInd AS-8, “A change in accountingestimateis an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of anasset, that results from the assessment of the present status, of, and expected future benefits and obligations associated with, assets and liabilities changes in accounting estimates result from new information or new developments and, accordingly, are not correction of errors.” Examples of change in accounting estimate include (i) change in useful life of property, plant and equipment; and (ii) change in expected credit losses on accounts receivables. Prior Period Errors Prior period errors are errors committed in earlier years but discovered in current year. As per AS - 8, “Prior period errors are omissions from, and misstatements in, the entity's financial statements for one or more prior periods arising from a failure to use a misuse of, reliable information that: ‘TAXMANN®4.12 (a) Was available when financial statements for those periods were appre EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE for issue; and (©) Could reasonably be expected to have been obtained and taken into count in the preparation and presentation of those financial statements As per Ind AS-8, such errors include the following : (@_ Mathematical mistakes; (i) Mistake in applying accounting policies; (iii) Oversights; (iv) Misrepresentation of facts; and (v) Fraud Comparison of AS 5 with Ind AS 8 Basis ASS 2 Ind AS 8 = 1. Objective The objective of this standard is toprescribe the classificationand 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. The objective of this standard is to prescribe the criteria for selecting and changing account. ing policies, together with the accounting treatment and dis- closure of changesin accounting policies, changing in accounting estimates and correction of errors. 2. Definition of accounting policies AS - 5 restricts the definition of accounting policies to include specific accounting principles and the methods of applying those principles adopted by an enterprise in the preparation and presentation of financial statements. Ind AS-8 broadens the definition of accounting policies to include specific principles, bases, con- ventions, rules and practices applied by an entity in prepar. ing and presenting financial statements, 3. Change in accounting policies It allows change in accounting policy where it is required by the statute, It does not mention such a situ ation for change in accounting policy because it does not con- sider the provision of country specific statute, 4. Consistency of accounting policies AS-5 does not specifically re- quires accounting policies to be consistent for similar transac- tions, events and conditions It specifically states that a0 entity shall select and apply its accounting policies: consistently for similar transactions, oth! events and transactions unless an Ind AS specifically requires TAXMANN®EXTRAORDINARY RY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE 4.13 Basis ASS Ind AS 8 permits categorisation of items for which differently policis may be appropriate 5, Accounting Any change in an accounting | It requires that changes in for change in | Policy whichhasamaterialeffect | accounting policies should be accounting should be disclosed. However, | accounted forwith retrospective policies it does not specify how change 19(a) or 19(b) in accounting policy should be | subject to limited exceptions as accounting for mentioned in para 23. 6. Prior period | As per AS-5, prior period items | Ituses the term errors and states items/errors | are income or expenses which | that priorperioderrorsareomis- arise in the current period as a | sions from, and misstatements result of errors.or omission in| in, the entity's financial state- the preparation of the financial | ments for one or more periods statements of any one or more | arising from failure to use, or Periods. misuse of, reliable information that wasavailable when financial statements for those periods were approved for issue. 7. Effect of It does not mention that prior | It specifically states that errors fraud period items include fraud. _| include fraud. 8, Rectification | It requires rectification of prior | It requires rectification of prior of prior period | period items with prospective | period errors with retrospective itemslerrors _| effect. effect subject to limited excep- tions 9.Disclosure | It requires less disclosure as] It requires more disclosure as compared to that of Ind AS-8 _ | compared to ASS FAIR VALUE Meaning of Fair Value As per International Financial Reporting standards (IFRS 13), “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” As per Dolphy D’ Souza, fair market value is “The price that would be agreed to in an open and unrestricted market between knowledgeable and will- ing parties dealing at arm's length who are fully informed and not under any compulsion to transact. Arm's length is a term applied to any transaction on the assumption that the parties to the transaction would act without being influenced by each other or by any other person.” ‘TAXMANN®4.14 EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE, Thus fair value is the rational and unbiased estimate of ms Sete AN asset is likely to be bought or sold when both the buyer and the seller reel agree ony price and there is no compulsion to enter into the transaction from any Person Use of fair value Fair value is used for assets whose carrying amount is based on revaluation model as stated in AS-10 and Ind AS-16. For assets carried at historical cog fair value is not recognised. In cost of cost model, asset is shown at its carryin, amount which is determined by deducting accumulated of the asset as well impairment losses, from the cost of the asset. If an entity applies the revaluation model, then as per AS-10, “Property, plan, and equipment”, it will measure and report the asset at the fair value less any subsequent accumulated depreciation and subsequent impairment losses in the balance sheet revaluation should be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date. Fair value may be different from market value. For example, fair value of a share of a company whose shares are listed on a recognised stock exchange may be different from the market value of the share on a particular date. Advantages of Fair Value Accounting 1. Accuracy of valuation : When fair value accounting is used, valuations are more accurate. 2. True measure of income : Fair value accounting reflects the actual income of the entity. 3. Helps business survive : Business is full of uncertainties, There are business cycles. Fair value accounting helps in difficult times b ecause it will report the assets at fair value and not higher carrying amount. 4. Adaptable to different types of assets: Fair value can be calculated for all types assets. In case of some assets it is easy to calculate fair value; and in some cases itis relatively difficult to do so. Determining fair value Determining of fair value for an item traded on an active market such as © a recognised stock exchange is simple. Therefore, determining fair value of @ listed security, listed industrial or agricultural commodity, gold, silver, ete. 8 relatively simple. DOH RB Determining fair value for an iter 'm initially sold on a market but not traded subsequently such as a machine, Computer, etc. is more difficult. - OO Taxa ee ————————=——————— — ejEXTRAORDIN, ‘ARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE 4.15 petermining fair value of an item which is nei a nor traded subsequently is much more ci fons sold on a market initially 2 S _ QUESTIONS g THEORETICAL QUESTIONS 1, What is meant by prior period items as . ee : Ieplain their accounting pet tems #8 er AS-S?. Explain and illustrate, Also 2, What is meant by extraordinary items? Explain their accounting treatment. 3. What is meant by accounting estimate as e er AS-5? Explai in accounting estimate. : ee 4, What is meant by accounting policies as per AS-5? Explain the considerations in the selection of accounting policies. 5. What are the disclosure requirements regarding accounting policies as per AS-5? In which conditions a change in accounting policies should be made as per AS-5 and Ind AS-8 ? 6. Compare AS-5 with Ind AS-8 regarding accounting policies. 7. Write short notes on the following. (a) Accounting Estimate (b) Account Policies (c) Extraordinary Items (d) Prior Period Items (©) Fair Value OBJECTIVE QUESTIONS Whether the following statements are true or false? (a) Introduction of formal gratuity scheme in place of ad hoc ex-gratia payments to employees on retirement is a change in accounting policy. (®) Change in the useful life of machinery is a change in accounting estimate. (©) Increase in the rate of provision for doubtful debts is a change in accounting estimate. (@ Change in cost formula in measuring the cost of inventories is a change in accounting policy. (©) Change in the method of depreciation from straight line method to written down value method is a change in accounting policy. (f) Government grant receivableis compensation for expenses incurred in the previous accounting year is prior period item TAXMANN® —4.16 EXTRAORDINARY ITEMS, ACCOUNTING POLICIES AND FAIR VALUE »ment of carrying amount ge in accounting estimate. (e) Change from cost model to revaluation model for measure of plant and machinery is a chan; Ans. [True : (b), (c), d; False : (a), (e), (A, @)]PROVISIONS, | CONTINGENT LIABILITIES ‘AND CONTINGENT ASSETS CHAPTER After studying this chapter, the learners will be able to understand : > Objectives and Scope of AS 29 14 ooh Provisions Contingent Liabilities Contingent Assets Ind AS - 37, Provisions, Contingent Liabilities and Contingent Assets Comparison of AS 29 with Ind AS 37 vvvvy Accounting Standard (AS) 29, “Provisions, Contingent Liabilities and Con- tingent Asset”, was originally issued in 2003. This standard has been revised by the Ministry of Corporate Affairs vide notificated dated 30th March, 2016 for companies, following companies (Accounting Standards) Rules, 2006. It should be used by these companies for preparation of accounts for accounting periods commencing on or after the date of the notification. The standard has been revised for entities other than companies in 2016 by the Council of ICAI and is mandatory for accounting periods on or after April, 2017. OBJECTIVES AND SCOPE OF AS 29 Objectives (i) To ensure that appropriate recognition criteria and measurement bases are applied to provisions and contingent liabilities and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount; and (ii) To lay down appropriate accounting for contingent assets. Scope This standard should be applied in accounting for provisions and contingent liabilities and in dealing with contingent assets, except : 5. ‘TAXMANN®_ Bn _., INGENT ASSE: 5.2 PROVISIONS, CONTINGENT LIABILITIES AND CONTI ASSETS are carried at fairy, (a) Those resulting from financial instruments that are * ied at fair Valu (6) Those resulting from executory contracts, except where the Contact ig onerous. a ises vith policy, (c) Those arising in insurance enterprises from contracts w Policy. holders, and (d) Those covered by another Accounting Standard + ‘ial i hat are not carri Thus, this standard applies to financial instruments that “arried at faip values. This standard does not apply to executory contracts unless they are onerous Executory,contracts are those contracts which neither party has Performed am of ts obligations or both parties have Partially performed then obligations to, equal extent. A onerous contract is a contract in which the unavoidable cost, of meeting the obligations under the contract exceed the economic benefit, expected to be received under it. Provision for onerous contracts are Tequired in accounts. Certain types of provisions are addressed in other Accounting Standards, Foy cxample, Accounting Standards on (i) construction contracte (AS 7), (it) Taxes on income (AS 22), Leases (AS 19), and Retirements benefits (AS 15), This Standard defines provisions as liabilities which can be measured only by using a substantial degree of estimation, PROVISIONS Meaning of Provision From the definition of provision itis Clear that provision is liability. Therefore, itis necessary to know what is liability, tion if, based on the ey idence available, its exis- is considered Probable, i, i.e, more likely than not. ee TAXMANN® eePROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS, 5.3 Characteristics of Provision The following are the characteristics of provision: (i) Provision is a liability. ii) A provision is a present obligation and not future obligations, ie, its existence on the balance sheet date is considered probable. (iii) arises from past events. (iv) Settlement of liability results in an outflow from enterprise of resources. (v) Liability is the result of obligating event. An obligating event is an event that creates an obligation that results in an enterprise having no realistic alternative to setting that obligation. Provision for warranties is required under AS 29, if by experience it is proba- ble (more likely than not) that there will be some claims under the warranties. Provision for onerous contract is required under AS 29. For example, if an enterprise takes a factory on rent for five years. After two years, the enterprise relocates its operations to a new factory. The lease on the old factory continues for the next three years. As per the rent agreement, the lease cannot be cancelled and the factory cannot be relet to another user. In this case, the operating lease contract has become onerous because the economic benefits during the three years will be nil. Provision on account of lease rent payable in the next three years should be made in the accounts in the year the factory is relocated. Recognition of Provision Provision should be recognised in the books when the following conditions are satisfied: ( Entity has a present obligation as a result of past events. (ii) Present obligation must exist on the balance sheet date. (iii) Present obligation must be probable (ie., more likely than not) (iv) Settlement of the present obligation results in outflow of resources embodying economic benefits. (v) Reliable estimate of the amount of the obligation can be made. Therefore, if the amount of the obligation cannot be made reliably, provision cannot be recognised. (vi) When obligation arises due to changes in law, provision should be rec- ognised only when itis virtually certain that the new law will be enacted. Note : Provision should not be recognised for future operating losses because they do not meet the definition of a liability and general recognition criteria. TAXMANN®a: +t LIABILITIES AND CONTINGENT ASSET GEN’ 5.4 PROVISIONS, CONTIN ision Measurement of amount of the Prov! vhile making estimate of th mM nts should be considered while making amy Following points of the provision. (@) The amount recognised as 8 expenditure required to set date. isi he best esti wision should be t a fe the present obligation at the balanes shen i 1d not be discounted t0 its present , pera ot pn restoration and similar liabilities the eel mised s cost of Property, Plant and Equipment. The qj ny vase (Gr tates should be a pre-tax rate (or rates) that reflect(s) cure wor necas ments of the time value of money and the risk Specifig The Habis The discount rat(s) should not reflect risks for which fi aa ean te have been adjusted. Periodic unwinding of cash flow eal Of discoun, should be recognised in the statement of profit and loss as finance cya ILLUSTRATION 1. (Measurement of amount of Provision) ity established a plant on April 1, 2020 and has to pay decommissionin, peep nr eee of ® 100 lakhs after 10 years. An appropriate discount rate is 9%. What will be amount of provision to be made in the first Year of establishment of plant and how the unwinding of discount is treated in the books and pass the entries for the year 2020-21 and 2021-22? Accounts are closed on 31st March each year. Assume that the present value of 100,00,000 is discounted at the rate of 9% per annum is € 42,20,000, % 46,00,000 and 8 50,2, 000 as on Ist April, 2020, 31st March, 2021 and 31st March, 2022 respectively SOLUTION Date Present value of Provision | Increase in provision due to : : fe eal ofp (debited r E Leas 01-04-2020 | 100,00,000/(1.09)'° = 42,20,000 - 31-03-2021 100,00,000/(1.09)° 3,80,000 31-03-2022 _ | 100,00,000/(1.09) 4,20,000 Journal Entries 1-4-2020 @ %) Amount Plant A/c Amount (%) ; Dr. 42,20,000 To Provision for Decommissioning and Dismantling Charges Alc 42,20,000 a ARMANN® 4PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS 5.5 3-3-2021 Dr. 3,80,000 Interest Expense A/c To Provision for Decommissioning and Dismantling Charges A/c 3,80,000 31-3-2022 Internet Expense A/c Dr. 4,20,000 To Provision for Decommissioning and Dismantling Charges A/c 4,20,000 Note : Every year interest @ 9% p.a. will be provided and interest will be trans- ferred to the statement of profit and loss as finance cost. At the end of the 10th year, the provision will become @ 100 lakhs. (@ The risks and uncertainties that inevitably surround many events and circumstances should be taken into account in reaching the best estimate of a provision. (ii) Future events that may affect the amount required to settle an obligation should be reflected in the amount of a provision where there is sufficient objective evidence that may occur. (iii) Gain from the expected disposal of assets should not be taken into account in measuring a provision. Reimbursement of expenditure (Provisions) Sometimes, an enterprise is able to look to another party to pay part or all the expenditure required to settle a provision (e.g.; through insurance contacts, in- demnity clauses or suppliers warranties). The other party may either reimburse amounts paid by the enterprise or pay the amounts directly. Where some or all the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement should be recognised when, and only when, it is virtually certain that reimbursement will be received if the enterprise settles the liability. The reimbursement should be treated as a separate asset. The amount recognised for the reimbursement should not exceed the amount of the provision. In the statement of profit and loss, the expense relating to a provision may be presented net of the amount recognised for a reimbursement. Change in Provision Provisions should be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resourc- TAXMANN®ss 5.6 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS, es embodying economic benefits will be required to settle the Obligation, the Provision should be reversed. Use of Provisions A provision should be used only for the expenditures for which the ProVsog was originally recognised. Disclosure of Provision As per para 66 of AS 29, for each class of provision, an enterprise ShOUId disclose (@) The carrying amount at the beginning and end of the period; (b) Additional provision made in the period, includin; provision; & INCTEASES to existing (c) Amountused (i.e. incurred and charged against the provision) during the Period; and (4) Unused amounts reversed during the period. Besides these the following other disclosuies are required as per para 67 of AS 29, for each class of provision: (a) Abrief description of the nature of the obligation and the ex pected timing of any resulting outflows of economic benefits: () Major assumptions concerning future events while measuring the provision; (c) The amount of any expected reimbursement recognised as an asset. However, a Small and Medium-sized Company (SMC) and Medium-sized en- terprises (Level II and Level III non-corporate entities, may not comply with aforesaid paras 66 and 67. CONTINGENT LIABILITY Meaning of Contingent Liability As Per para 10.4 of AS 29, “A contingent liability is : (a) a possible obligation that arises () a present obligation that arises from Past events but is not recognised because: @ itisnot probable t that an outflow of re: benefits will be sources embodying economi required to settle t] the obligation; or Se TARMANN®