Contemporary Accounting

)
'
,(
Edited by:
Dr. Dilfraz Singh
CONTEMPORARY ACCOUNTING
Edited By
Dr. Dilfraz Singh
Printed by
EXCEL BOOKS PRIVATE LIMITED
A-45, Naraina, Phase-I,
New Delhi-110028
for
Lovely Professional University
Phagwara
SYLLABUS
Contemporary Accounting
Objectives: The course will enable the students to identify and analyze the developments of contemporary and emerging
accounting issues. The students will be able to adapt and apply strategic tools developed from the discipline of accounting in
different decision-making environments. They will be able to analyze the implications of applying recent accounting and
business techniques and approaches in a variety of management decision settings.
Sr. No. Description

1. Accounting Standards: meaning, nature and rationale.
2. Price-level accounting; meaning and scope, major drawbacks of historical cost system, utility and
applications.
3. Environmental Accounting: methodology, objectives and observations.
4. Economic Value Added (EVA): concept, approaches to computation, applications and shortcomings.
5. Social Reporting: meaning, nature, need and models of social disclosure.
6. Human Resource Accounting: meaning, nature and scope and approaches.
7. Corporate Reporting: concept of disclosure in relation to publish accounts, issues and recent trends in
corporate reporting, IFRS and its relevance.
8. The financial reporting framework: the contribution and limitations of financial statements in meeting the
needs of users’ and capital markets; the applications, strengths and weaknesses of an accounting framework;
critical evaluation of principles and practices; Forensic Accounting.
CONTENT
Unit 1: Accounting Standards 1

Gopika Juneja, Lovely Professional University
Unit 2: Price Level Accounting 20

Dilfraz Singh, Lovely Professional University
Unit 3: Environmental Accounting 45

Unit 4: Economic Value Added (EVA) 53

Unit 5: Social Reporting 63

Unit 6: Human Resource Accounting 71

Amit Kumar Sharma, Lovely Professional University
Unit 7: Approaches of HRA 78

Unit 8; Corporate Reporting 93

Unit 9: Issues and Recent Trends in Corporate Reporting 113

Neha Tikoo, Lovely Professional University
Unit 10: IFRS and its Relevance 121

Unit 11: Introduction to Financial Reporting Framework 131

Pooja, Lovely Professional University
Unit 12: Analysis of Financial Reporting Framework 143

Pooja, Lovely Professional University
Unit 13: Critical Evaluation of Principles and Practices 150

Unit 14: Forensic Accounting 162

Gopika Juneja, Lovely Professional University Unit 1: Accounting Standards
Unit 1: Accounting Standards Notes
CONTENTS
Objectives
Introduction
1.1 Meaning of Accounting Standards
1.2 Nature and Rationale of Accounting Standards
1.2.1 Accounting Standards and Companies Act
1.2.2 Accounting Standards and Income Tax Act, 1961
1.2.3 Accounting Standards and Non-commercial Organisations
1.3 Accounting Standards Setting in India
1.3.1 Accounting Standards Setting Process
1.3.2 Accounting Standards in India
1.4 Summary
1.5 Keywords
1.6 Review Questions
1.7 Further Readings
Objectives
After studying this unit, you will be able to:
Describe the meaning of accounting standards
Discuss the nature and rationale of accounting standards
Understand the process of accounting standards setting
Introduction
Financial statements summarise the end-result business activities of an enterprise during an

accounting period in monetary term. Business activities are varied. It is strenuous task to present
the facts intelligibly, in a summarised form, and yet with minimum loss of information. In
order that the methods and principles adopted by various reporting enterprises are coherent,
not misleading – and to the extent possible are uniform and comparable – standards are evolved.
Did u know? What are standards?
The term standards denote a discipline, which provides both guidelines and yardsticks for
evaluations. As guidelines, they provide uniform practices and common techniques. As
yardsticks, standards are used in comparative analysis involving more than one subject matter.
1.1 Meaning of Accounting Standards
Accounting standard is an authoritative pronouncement of code of practice of the regulatory

accountancy body to be observed and applied in the preparation and presentation of financial
LOVELY PROFESSIONAL UNIVERSITY 1

Notes statements. World over, professional bodies of accountants have the authority and the obligation
to prescribe “Accounting Standards”. International Accounting Standards (IASs) are pronounced
by the International Accounting Standards Committee (IASC). The IASC was set up in 1973, with
headquarters in London (UK).
In India, the Institute of Chartered Accountants of India (ICAI) had established in 1977 the
Accounting Standards Board (ASB). The composition of ASB includes (i) elected (ii) ex-officio
and (iii) co-opted members of the Institute, nominees of RBI, FICCI, Assocham, ICSI, ICWAI and
special invitees from UGC, ICWAI, and SEBI, IDBI and IIM.
ASB is entrusted with the responsibility of formulating standards on significant accounting

matters, keeping in view (a) international developments as also (b) legal requirements in India.
According to the preface to the Statement on Accounting Standards issued by the ICAI, Accounting
Standards will be issued by the ASB constituted for the purpose of harmonising the different and
diverse accounting policies and practices in use in India and propagating the Accounting Standards
and persuading the concerned enterprise to adopt them in the preparation and presentation of
financial statement.
Self Assessment
Fill in the blanks:
1. Accounting standard is an authoritative pronouncement of code of practice of the regulatory

accountancy body to be observed and applied in the preparation and presentation of
………………..
2. The IASC was set up in ………….., with headquarters in London (UK).
3. In India, the Institute of Chartered Accountants of India (ICAI) had established in ………….
the Accounting Standards Board (ASB).
4. ASB is entrusted with the responsibility of formulating standards on significant accounting

matters, keeping in view (a) international developments as also (b) …………….in India.
5. The term …………….. denote a discipline, which provides both guidelines and yardsticks
for evaluations.
1.2 Nature and Rationale of Accounting Standards
Accounting Standards are formulated with a view to harmonise different accounting policies
and practices in use in a country. The objective of Accounting Standards is, therefore, to reduce
the accounting alternatives in the preparation of financial statements within the bounds of
rationality, thereby ensuring comparability of financial statements of different enterprises with
a view to provide meaningful information to various users of financial statements to enable
them to make informed economic decisions.
The following points discuss the nature of accounting standards for the perspective of key acts
and organisations:
1.2.1 Accounting Standards and Companies Act
The specific provisions of the Companies Act include,
1. Section 211 (form and contents of Balance Sheet and Profit & Loss Account)
(3A): Every profit and loss account, balance sheet of the company shall comply with
the accounting standards.
2 LOVELY PROFESSIONAL UNIVERSITY

Unit 1: Accounting Standards
(3B): Where the profit and loss account and the balance sheet of the company do not Notes
comply with the accounting standards, such companies shall disclose in its profit
and loss account and balance sheet, the following, namely:
(i) the deviation from the accounting standards
(ii) the reasons for such deviation, and
(iii) the financial effect, if any, arising due to such deviation
(3c): For the purpose of this section, the “expression, accounting standards”, means
the standards of accounting recommended by the Institute of Chartered Accountants
of India, constituted under the Chartered Accountants Act, 1949 (38 of 1949), as may
be prescribed by the Central Government in consultation with the National Advisory
Committee on Accounting Standards established under Sub-section (1) of Section
210 A:
Provided that the standards of accounting specified by the Institute of Chartered Accountants
of India shall be deemed to be the Accounting Standards as are prescribed by the Central
Government under this sub-section.
2. Section 217 (2AA) (i): Compliance with Accounting Standards
The Board’s report shall also include a Director’s Responsibility Statement, indicating
therein that in the preparation of the annual accounts, the applicable accounting standards
had been followed along with proper explanation relating to material departures.
According to the sec 217(2AA) the statement should indicate:
(i) that in the preparation of the annual accounts, the applicable accounting standards
had been followed along with proper explanation relating to material departures;
(ii) that the directors had selected such accounting policies and applied them consistently
and made judgments and estimates that are reasonable and prudent so as to give a
true and fair view of the state of affairs of the company at the end of the financial
year and of the profit or loss of the company for that period;
(iii) that the directors had taken proper and sufficient care for the maintenance of adequate
accounting records in accordance with the provisions of this Act for safeguarding
the assets of the company and for preventing and detecting fraud and other
irregularities;
(iv) that the directors had prepared the annual accounts on a going concern basis.
3. Section 227 (3) (d): Powers and Duties of Auditors
The auditor’s report shall also state –
Whether, in his opinion, the profit and loss account and balance sheet complied with the
accounting standards referred to in Subsection (3c) of Section 211.
The members discharging attest functions are bound by regulations and should examine
whether the standards complied with in the presentation of financial statements covered
by audit. In the event of deviation, adequate disclosures are to be made. For those occupying
managerial positions, exercising control functions in the area of finance and accounts,
compliance with standards is a legal requirement as well.
1.2.2 Accounting Standards and Income Tax Act, 1961

There appears to be no link and harmony between the Accounting Standards issued by the ICAI
and the tax laws and procedure for calculation of taxable income of corporate assesses. The

Notes Accounting Standards are applicable to the preparation of general-purpose financial statements
where the taxable income is calculated on the basis of tax treatment of different items. The tax
treatment is primarily guided by the fiscal considerations and other principles of taxations.
There are several areas where tax treatment of an item and the relevant accounting standards are
significantly different and therefore there is marked difference in the reported profit and taxable
income. Some of the areas where significant differences can be noted are: revenue recognition
principle, computation of depreciation, accounting for construction contracts, treatment of research
and development expenses and other intangibles, treatment of borrowing costs, leases, etc.
For example, in case of Finance Lease, the asset is to be shown in the balance sheet of the lessee
and he can charge depreciation on this asset. However, under the Income Tax Act, 1961, the assets
under finance lease are to be shown in the balance sheet of the lessor (being the real owner) and
the depreciation deduction is available to the lessor.
There is a need for harmonising the accounting treatment and tax treatment of several items. In
doing so, the principle of accounting as well as the principles of taxation, both required to be
taken care of it.
!
Caution The Finance Act, 1995 has conferred powers on the Central Government to prescribe
accounting standards for tax purposes. These Tax Accounting Standards (may be called
TAS) are to be followed by any class of assesses or in respect of any class of income. So far,
the Central Government has notified two TAS. These are:
1. TAS – 1: relating to Disclosure of Accounting Policies
2. TAS – 2: relating to Disclosure of Prior period and Extraordinary items and Changes
in Accounting Policies.
These TAS are to be followed by the assesses using mercantile systems of accounting both
corporates in as well as non-corporates.
1.2.3 Accounting Standards and Non-commercial Organisations
The Preface to Accounting Standards provides that the Accounting Standards shall apply to
commercial, industrial and business enterprises in preparation of general-purpose financial
statements issued to the public by such enterprises. So, these Accounting Standards are not
applicable to charitable organisations and co-operative societies. However, if the charitable
organisations and co-operative societies are engaged in any type of commercial activity, then
the Accounting Standards shall apply to their financial statements. The ICAI has clarified that
even if a part of the activities of these enterprises are commercial in nature, then the Accounting
Standards shall apply to all the activities of the enterprise.
Self Assessment
State true or false:
6. Accounting Standards are formulated with a view to harmonise different accounting policies
and practices in use in a country.
7. The Finance Act, 1999 has conferred powers on the Central Government to prescribe
accounting standards for tax purposes.
8. TAS – 1 is related to Disclosure of Accounting Policies.

9. The tax treatment is primarily guided by the fiscal considerations and other principles of Notes
taxations.
10. The ICAI has clarified that even if a part of the activities of charitable organisations and co-
operation societies enterprises are commercial in nature, then the Accounting Standards
shall apply to all the activities of the enterprise.
1.3 Accounting Standards Setting in India
The Institute of Chartered Accountants of India (ICAI) being a member body of the IASC,
constituted the Accounting Standards Board (ASB) on 21st April, 1977, with a view to harmonise
the diverse accounting policies and practices in use in India. After allowing the adoption of
liberalisation and globalisation as the corner stones of Indian economic policies in early ‘90s,
and the growing concern about the need of effective corporate governance in case 90s, the
Accounting Standards have increasingly assumed importance. While formulating accounting
standards, the ASB takes into consideration the applicable laws, customs, usages and business
environment prevailing in the country. The ASB also gives due consideration to International
Financial Reporting Standards (IFRSs)/International Accounting Standards (IASs) issued by
IASB and tries to integrate them, to the extent possible, in the light of conditions and practices
prevailing in India.
1.3.1 Accounting Standards Setting Process
The accounting standard setting, by its very nature, involves reaching an optimal balance of the
requirements of financial information for various interest-groups having a stake in financial
reporting. With a view to reach consensus, to the extent possible, as to the requirements of the
relevant interest-groups and thereby bringing about general acceptance of the Accounting
Standards among such groups, considerable research, consultations and discussions with the
representatives of the relevant interest-groups at different stages of standard formulation become
necessary. The standard-setting procedure of the ASB, as briefly outlined below, is designed in
such a way so as to ensure such consultation and discussions:
1. Identification of the broad areas by the ASB for formulating the Accounting Standards.
2. Constitution of the study groups by the ASB for preparing the preliminary drafts of the
proposed Accounting Standards.
3. Consideration of the preliminary draft prepared by the study group by the ASB and
revision, if any, of the draft on the basis of deliberations at the ASB.
4. Circulation of the draft, so revised, among the Council members of the ICAI and 12 other
specified. Outside bodies such as Standing Conference of Public Enterprises (SCOPE),
Indian Banks’ Association, Confederation of Indian Industry (CII), Securities and Exchange
Board of India (SEBI), Comptroller and Auditor General of India (C& AG), and Department
of Company Affairs, for comments.
5. Meeting with the representatives of specified outside bodies to ascertain their views on
the draft of the proposed Accounting Standard.
6. Finalization of the Exposure Draft of the proposed Accounting Standard on the basis of
comments received and discussion with the representatives of specified outside bodies.
7. Issuance of the Exposure Draft inviting public comments.
8. Consideration of the comments received on the Exposure Draft and finalization of the
draft Accounting Standard by the ASB for submission to the Council of the ICAI for its
consideration and approval for issuance.

Notes 9. Consideration of the draft Accounting Standard by the Council of the Institute, and if
found necessary, modification of the draft in consultation with the ASB.
10. The Accounting Standard is issued under the authority of the Council.
1.3.2 Accounting Standards in India
The Institute of Chartered Accountants of India has issued the following accounting standards:
Accounting Standards (AS) Title of the Accounting Standards

AS – 1 Disclosure of Accounting Policies
AS – 2 (Revised) Valuation of Inventories
AS – 3 (Revised) Cash Flow Statements
AS – 4 (Revised) Contingencies and Events Occurring after the Balance Sheet
Date
AS – 5 (Revised) Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies
AS – 6 (Revised) Depreciation Accounting
AS – 7 (Revised) Accounting for Construction Contracts
AS – 9 Revenue Recognition
AS – 10 Accounting for Fixed Assets
AS – 11 (Revised 2003) The Effects of Changes in Foreign Exchange Rates
AS – 12 Accounting for Government Grants
AS – 13 Accounting for Investments
AS – 14 Accounting for Amalgamations
AS – 15 Accounting for Retirement Benefits in the Financial
Statements of Employers
AS – 16 Borrowing Costs
AS – 17 Segment Reporting
AS – 18 Related Patty Disclosures
AS – 19 Leases
AS – 20 Earnings Per Share
AS – 21 Consolidated Financial Statements
AS – 22 Accounting for Taxes on Income
AS – 23 Accounting for Investment in Associates in Consolidated
Financial Statements
AS – 24 Discontinuing Operations
AS – 25 Interim Financial Reporting
AS – 26 Intangible Assets
AS- 27 Financial Reporting of Interest in Joint Ventures
AS – 28 Impairment of Assets
AS – 29 Provisions, Contingent Liabilities & Contingent Assets
AS 30 Financial Instruments: Recognition and Measurement and
Limited Revisions to AS 2, AS 11 (revised 2003), AS 21, AS 23,
AS 26, AS 27, AS 28 and AS 29
AS 31 Financial Instruments: Presentation
AS 32 Financial Instruments: Disclosures, and limited revision to
Accounting Standard (AS) 19, Leases
The given below is the brief expiation of accounting standards in India:
1. AS-1 – Disclosure of Accounting policies: Within the overall allowed framework of different
accounting standards and provisions of different statutes, a company is free to formulate

its own accounting policies. Accounting policies refer to the specific accounting principles Notes
and the methods of applying those principles adopted by the enterprise in the preparation
and presentation of financial statements.
AS-1 lays down the following requirements:
(a) All significant accounting policies adopted in the preparation and presentation of
financial statements should be disclosed in one place as a part of financial statements.
(b) Any change in the accounting policies which has a material impact in the current
period or which is expected to have a material effect in later periods should be
disclosed and the amount by which any item in the financial statements is affected
by such change should also be quantified and disclosed to the extent ascertainable.
When such amount is not ascertainable, the fact should be mentioned.
(c) If any of the fundamental accounting assumptions (viz., going concern, consistency
and accrual) is not followed, the fact should be disclosed.
2. AS-2 – Valuation of Inventories: Inventories include:
(a) Raw materials and components
(b) Work-in-process
(c) Finished goods
(d) Stores and spares
Inventories should be valued at lower of historical cost and net realisable value. For the
purpose of comparing historical cost with net realisable value, each item in the inventory
should be dealt with separately or similar items may be dealt with as a group.
However, the above principle of inventory valuation is not applicable in cases of:
(a) Consumable stores and supplies: Should be ordinarily valued at cost.
(b) By-products: Where cost of by-product cannot be separately determined, it should be
valued at net realisable value.
(c) Reusable waste: Should be valued at raw material cost less processing cost.
(d) Non-reusable waste: Should be valued at net realisable value.
3. AS-3 – Cash Flow Statement: The Companies Act, 1956 does not require corporate entities
to prepare and present cash flow statement as part of financial statements. However,
listing agreement of different stock exchanges require corporate entities to submit cash
flow statement to the respective stock exchanges. Thus, listed companies are bound to
prepare cash flow statement.
The cash flow statement should clearly show cash flows from three distinct activities:
(a) cash flows from operating activities
(b) cash flows from investing activities
(c) cash flows from financing activities
4. AS-4 – Contingencies and events occurring after the balance Sheet date: Contingencies are
conditions or situations, the ultimate outcome of which, gain or loss, will be known or
determined only on the occurrence or non-occurrence, of one or more uncertain future
events. Estimates are required for determining the amount to be stated in financial
statements for many items, e.g., depreciation, provision for doubtful debts, provision for
taxation, etc. However, the fact that the items have been estimated does not make the
items contingencies.

Notes Contingencies are of two types – contingent loss and contingent gain. The amount of a
contingent loss should be provided for by way of a change in the statement of profit and
loss if:
(a) it is probable that future events will confirm that, after taking into account any
related probable recovery, an asset has been impaired or a liability has been incurred
as at the balance sheet date, and
(b) a reasonable estimate of the amount of the resulting loss can be made. [Para 10 of AS-4.]
5. AS-5 – Net profit or loss for the periods, prior period items and changes in accounting
policies: The net profit or loss for a given accounting period comprises essentially of two
items – (a) profit or loss from Ordinary activities and (b) extraordinary items. Ordinary
activities are undertaken by a business entity as part of its business and include such
related activities in which the entity engages. Extraordinary items are income or expenses
that arise from events or transactions that are clearly distinct from the ordinary activities
of the enterprise and, therefore, are not expected to recur frequently or regularly.
Both profit or loss from ordinary activities and extraordinary items are to be disclosed on
the face of profit and loss statement. It may be noted here that virtually all items of income
and expenses included in the determination of net profit or loss arise in the course of
ordinary activities of the enterprise. Therefore, occurrence of extraordinary items is a
rarity. In most of the cases, only losses arising out of natural calamity can be considered as
an extraordinary item.
Prior Period Items
(a) The nature and amount of prior period items should be separately disclosed in the
statement of profit and loss in a manner that their impact on the current profit or
loss can be perceived.
(b) The term ‘prior period items’, as defined in this Statement, refers only to income or
expenses which arise in the current period as a result of errors or omissions in the
preparation of the financial statements of one or more prior periods.
Changes in Accounting Policies
On the other hand, a change in an accounting policy should be made only if the adoption
of the new policy is required by statute or for compliance with an accounting standard or
if it is considered that the change would result in a more appropriate presentation of
financial statements of the enterprise.
6. AS-6 – Statements of accounting standards revised – depreciation accounting: The
following is the text of the revised Accounting Standard (AS) 6, ‘Depreciation Accounting’,
issued by the Council of the Institute of Chartered Accountants of India.
(a) This statement deals with depreciation accounting and applies to all depreciable
assets, except the following items to which special considerations apply:
(i) forests, plantations and similar regenerative natural resources;
(ii) wasting assets including expenditure on the exploration for and extraction of
minerals, oils, natural gas and similar non-regenerative resources;
(iii) expenditure on research and development;
(iv) goodwill;
(v) live stock.
This statement also does not apply to land unless it has a limited useful life for the
enterprise.

(b) Different accounting policies for depreciation are adopted by different enterprises. Notes
Disclosure of accounting policies for depreciation followed by an enterprise is
necessary to appreciate the view presented in the financial statements of the
enterprise.
7. AS-7 – Accounting for construction contracts: Construction Contracts (Revised proved
reserves contracts) are basically of two types:
(a) Fixed price contracts: the contractor gets a fixed price or rate.
(b) Cost plus contracts: the contractor is reimbursed for allowable costs plus a fee is paid
to the contractor.
Para 2 of AS-7 defines construction contract as a “contract specifically negotiated for the
construction of an asset or a combination of assets that are closely interrelated or
independent in terms of their design, technology and function or their ultimate purpose
or use”. Construction contracts also include services rendered by project managers and
architects which are directly related to the construction of asset.
8. AS-8 – Accounting for research and development: Research is an original and planned
investigation to gain new scientific or technical knowledge, whereas development is the
utilisation of research results to produce new or substantially improved materials, devices,
products, processes, etc., prior to the commencement of commercial production.
Thus, the sequence can be shown as below:
Step Step Step

1 2 3
Research Development Commercial

Production
If, after step 1, no viable outcome is found, steps 2 and 3 are not undertaken. Similarly, if
step 2 does not result in any positive outcome, step 3 is not initiated. Thus, the use of each
step depends on the result of the preceding step. However, in India, we do not distinguish
between costs incurred for research and development. We use the phrase ‘costs of research
and development.’
9. AS-9 – revenue recognition: Para 4.1 of AS-9 states “Revenue is the gross inflow of cash,
receivable or other consideration arising in the course of ordinary activities of an enterprise
from the sale of goods, from the rendering of services, and from the use by others of
enterprise resources yielding interest, royalties and dividends.” Thus, revenue from
ordinary activities may arise under three situations:
(a) by sale of goods;
(b) by rendering of services; and
(c) by allowing others to use enterprise resources yielding interest, royalties and
dividends.
Revenue recognition is concerned with the timing of recognition of revenue in the profit
and loss statement.
10. AS-10 – Accounting for fixed assets: The following is the text of the Accounting Standard
10 (AS 10) issued by the Institute of Chartered Accountants of India on ‘Accounting for
Fixed Assets’.
In the initial years, this accounting standard will be recommendatory in character. During
this, this standard is recommended for use by companies listed on a recognised stock

Notes exchange and other large commercial, industrial and business enterprises in the public
and private sectors.
(a) Financial statements disclose certain information relating to fixed assets. In many
enterprises these assets are grouped into various categories, such as land, buildings,
plant and machinery, vehicles, furniture and fittings, goodwill, patents, trademarks
and designs. This statement deals with accounting for such fixed assets except as
described in paragraphs 2 to 5 below.
(b) This statement does not deal with the specialised aspects of accounting for fixed
assets that arise under a comprehensive system reflecting the effects of changing
prices but applies to financial statements prepared on historical cost basis.
(c) This statement does not deal with accounting for the following items to which
special considerations apply:
(i) forests, plantations and similar regenerative natural resources;
(ii) wasting assets including mineral rights, expenditure on the exploration for
and extraction of minerals, oil, natural gas and similar non-regenerative
resources;
(iii) expenditure on real estate development; and
(iv) livestock.
Expenditure on individual items of fixed assets used to develop or maintain the

activities covered in (i) to (iv) above, but separable from those activities, are to be
accounted for in accordance with this statement.
(d) This statement does not cover the allocation of the depreciable amount of fixed
assets to future periods since this subject is dealt with in Accounting Standard 6 on
‘Depreciation Accounting’.
(e) This statement does not deal with the treatment of government grants and subsidies,
and assets under leasing rights. It makes only a brief reference to the capitalization
of borrowing costs and to assets acquired in an amalgamation or merger. These
subjects require more extensive consideration than can be given within this Statement.
11. AS-11 – The effects of changes in foreign exchange rates: This standard was revised in 2003
and is made mandatory with effect from 1st April 2004. Originally, this accounting standard
was titled “Accounting for the effects of changes in foreign exchange rates”. AS-11 discusses
how to recognize the financial effect of changes in foreign exchange rates in the financial
statements of the reporting entity. Two currencies are involved in determining an exchange
rate–foreign currency and reporting currency. The reporting currency for business entities
in India is INR (Indian Rupee) and hence the foreign currency is any currency other than
INR. AS-11 is applicable in accounting for foreign currency transactions and in translating
the financial statements of foreign operations. Thus, accounting for transaction exposure
and translation exposure in foreign currency is dealt with in AS-11.
12. AS-12 – Accounting for government grants: Government grants are assistance by
government in cash or kind to an enterprise for past or future compliance with certain
conditions.
Para 13 of AS-12 states that “Government grants should not be recognised until there is
reasonable assurance that (i) the enterprise will comply with the conditions attached to
them, and (ii) the grants will be received.”

Government grants can essentially be of four types: Notes
(a) Grants related to specific fixed assets.
(b) Grants related to revenue items.
(c) Grants in the nature of promoters’ contribution.
(d) Grants as compensation for expense or losses incurred in a previous accounting

period.
13. AS-13 – Accounting for investments: There are two types of investment—current and
long-term. These two follow different valuation principles. Current investments are valued
at lower of cost and fair value, whereas long-term investments are valued mainly at cost.
Reclassification of current investments into long-term investments and vice versa is allowed.
Where long-term investments are reclassified as current investments, transfers are made
at the lower of cost and carrying amount at the date of transfer. Where current investments
are reclassified as long-term investments, transfers are made at the lower of cost and fair
value at the date of transfer.
14. AS-14 – Accounting for amalgamations: Para 43 of AS-14 states “For all amalgamation,
the following disclosures should be made in the first financial statements following the
amalgamation:
(a) names and general nature of business of the amalgamating companies;
(b) effective date of amalgamation for accounting purposes;
(c) the method of accounting used to reflect the amalgamation; and
(d) Particulars of the scheme sanctioned under a statute.”
15. AS-15 – Accounting for retirement benefits in the financial statements of employers:
Retirement benefits usually consist of:
(a) Provident fund
(b) Superannuation (pension)
(c) Gratuity
(d) Leave encashment benefit on retirement
(e) Post-retirement health and welfare schemes
(f) other benefits.
Accounting for retirement benefits depends on the nature of the benefit schemes.
Retirement benefit schemes are classified into two broad categories: (a) defined contribution
schemes; and (b) defined benefit schemes. In case of the former, only the contribution of
the employer (as well as that of employee, if any) is certain and the ultimate benefits,
which would accrue to the employees, would depend on the prevailing interest rates and
other market factors. The benefits under the defined contribution schemes are in no way
related to the factors like, employees salary at the time of retirement, number of years of
service rendered, etc. The obligation of the employer in these schemes is limited to periodic
and timely contribution to the funds/trust managing the schemes. Whereas, in case of
defined benefit schemes, the benefits are linked to certain defined criteria and are
determinable usually by reference to employee’s earnings and/or years of service. The
employer, in these schemes, has to ensure that retiring employees get these defined benefits
as per entitlements. Provident fund is an example of a benefit under defined contribution
scheme. Pension and gratuity benefits are examples of defined benefit schemes.

Notes 16. AS-16 – Borrowing costs: Borrowing costs are interest and other costs incurred by an
enterprise in connection with the borrowing of funds. Examples of borrowing costs include:
interest and commitment charges on borrowings; amortisation of discounts or premiums
relating to borrowings; finance charges under finance lease; exchange differences arising
from foreign currency borrowings to the extent they are regarded as an adjustment to
interest costs.
Borrowing costs incurred in connection with acquisition, construction or production of a

fixed asset should be capitalised till the date the asset is ready for commercial use. All
other borrowing costs are to be expensed in the year in which they are incurred. Borrowing
costs incurred to buy inventories (which are held for a short period of time) are not to be
added to the cost of inventories. But borrowing costs incurred to acquire long-term strategic
investments can be capitalised with the cost of acquisition.
17. AS-17 – Segment reporting: This standard suggests that a business entity should provide
important financial information on each reportable segment separately. A reportable
segment is a business segment or a geographical segment. Para 5 of AS-17 defines a
business segment as “a distinguishable component of an enterprise that is engaged in
providing an individual product or service or a group of related products or services and
that is subject to risks and returns that are different from those of other business segments.”
The same paragraph also defines a geographical segment as “a distinguishable component
of an enterprise that is engaged in providing products or services within a particular
economic environment and that is subject to risks and returns that are different from those
of components operating in other economic environments.”
A business segment or geographical segment should be identified as a reportable segment

if one or more of the following conditions are satisfied (Para 27 of AS-17):
(a) its revenue from sales to external customers and from transactions with other
segments is equal to or more than 10% of total revenue of the firm; or
(b) its segment result (profit or loss) is equal to or more than 10% of combined result of
all segments in profit or combined results of all segments in loss, whichever is
greater in absolute amount; or
(c) its segment assets are 10% or more of the total assets of all segments.
Thus, there are three criteria to select a reportable segment – sales basis, profits/loss basis
and asset basis.
18. AS-18 – Related party disclosures: This accounting standard requires that a company
reports all transactions entered into with the related parties. Paragraph 10 of AS-18 defines
related parties as “parties are considered to be related if at any time during the reporting
period one party has the ability to control the other party or exercise significant influence
over the other party in making financial and/or operating decisions.” Sometimes it may
so happen that related parties enter into certain transactions with such terms and conditions
as are not available to unrelated parties. Such favourable terms to related parties might
affect the profitability of the firm.
Related parties disclosures include the following (Para 23 of AS-18):
(a) the name of the transacting related party;
(b) a description of the relationship between the parties and of the nature of transactions;
(c) volume of the transactions either as an amount or as an appropriate proportion;
(d) the amount or appropriate proportions of outstanding items relating to related

parties at the balance sheet date;

(e) amounts written off or written back in the period in respect of debts due from or to Notes
related parties; and
(f) any other matter.
19. AS-19 – Leases: There are broadly two types of lease transactions- finance lease and operating
lease. In case of finance lease, the lessee should recognise the lease as an asset and a
liability in the Balance sheet. Hence, lessee claims depreciation too. The lessor has to
recognise assets given under finance lease in its balance sheet as receivables. In case of
operating lease, the lessor shows the asset given on lease as its asset in the balance sheet
and claims depreciation. However, Income Tax laws in India still allows tax benefit on
depreciation to the lessor for assets under finance lease. Hence, there is a contradiction
between the accounting treatment of finance lease suggested in AS-19 and the provisions
of Income Tax Act.
20. AS-20 – Earning per share: The traditional method of calculating has been done away
with. AS-20 prescribes that the profit available for equity shareholders should be divided
by weighted average number of shares instead of closing number of shares.
For the purpose of calculating basic earnings per share, the net profit or loss for the period
attributable to equity shareholders should be the net profit or loss for the period after
deducting preference dividends and any attributable tax thereto for the period. All items
of income and expense which are recognised in a period, including tax expense and
extraordinary items are included in the determination of the net profit or loss for the
period unless an Accounting Standard requires or permits otherwise. The amount of
preference dividends and any attributable tax thereto for the period is deducted from the
net profit for the period (or added to the net loss for the period) in order to calculate the net
profit or loss for the period attributable to equity shareholders.
For the purpose of calculating basic earnings per share, the number of equity shares
should be the weighted average number of equity shares outstanding during the period.
The weighted average number of equity shares outstanding during the period reflects the
fact that the amount of shareholders' capital may have varied during the period as a result
of a larger or lesser number of shares outstanding at any time. It is the number of equity
shares outstanding at the beginning of the period, adjusted by the number of equity shares
bought back or issued during the period multiplied by the time-weighting factor. The
time-weighting factor is the number of days for which the specific shares are outstanding
as a proportion of the total number of days in the period; a reasonable approximation of
the weighted average is adequate in many circumstances.
21. AS-21 – Consolidated financial statements: A holding company is now required (although
not legally mandatory) to prepare consolidated financial statements, under certain
circumstances, portraying the financial performance of the group in addition to its
individual and separate financial statements.
Consolidated financial statements normally include consolidated balance sheet,
consolidated statement of profit and loss, and notes, other statements and explanatory
material that form an integral part thereof. Consolidated cash flow statement is presented
in case a parent presents its own cash flow statement. The consolidated financial statements
are presented, to the extent possible, in the same format as that adopted by the parent for
its separate financial statements.
Users of the financial statements of a parent are usually concerned with, and need to be
informed about, the financial position and results of operations of not only the enterprise
itself but also of the group as a whole. This need is served by providing the users:
(a) separate financial statements of the parent; and
(b) consolidated financial statements, which present financial information about the
group as that of a single enterprise without regard to the legal boundaries of the
separate legal entities

Notes In preparing consolidated financial statements, the financial statements of the parent and
its subsidiaries should be combined on a line by line basis by adding together like items
of assets, liabilities, income and expenses.
22. AS-22 – Accounting for taxes on income: The accounting for taxes on income, before the
introduction of AS-22, in India was a rudimentary one where the provision for tax was
estimated only on the basis of current tax liability, thereby completely ignoring the
deferred tax liability. This treatment was quite contrary to the practices followed globally.
AS-22 attempted to reduce this gap. AS-22 demands that taxes on income should be accounted
for following the matching principle. Matching of such taxes against revenue for a period
poses problem because tax is levied on taxable income and taxable income can be
significantly different from accounting income. Such differences arise because taxable
income is based on tax laws and accounting income is determined using provisions in the
Companies Act, 1956 and in certain cases as laid down in the listing requirements of stock
exchanges.
23. AS-23 – Accounting for investment in associates in consolidated financial statements:
This standard comes into force only when a holding company prepares consolidated
financial statements. An unlisted holding company is not required to prepare consolidated
financial statements. In that case, AS-23 is not applicable for such an unlisted company
even if it has an associate. Also, it may be noted that even where a listed holding company
prepares and presents consolidated financial statements, AS-23 is not applicable for separate
financial statements of the same holding company. Where AS-23 is not applicable, the
company should follow AS-13 in presenting its investment in associates in the separate
Balance sheet.
An associate is an enterprise in which the investor has significant influence (generally
evidenced by holding of equity interest between 20%-50%) and which is neither a subsidiary
nor a joint venture of the investor. AS-23 provides that the investment in associates should
be accounted for in consolidated financial statements using the equity method.
24. AS-24 – Discontinuing operations: This standard is mandatory with effect from 1st April
2004 for all listed companies and business entities having annual turnover in excess of Rs
50 crores. For all other enterprises, AS-24 will become mandatory with effect from 1st
April 2005. This standard requires separate reporting of discontinuing operations from
continuing operations so that users of financial statements may make proper forecast of
the entity’s future cash flows/earnings from continuing operations. Para 3 of AS-24 defines
a discontinuing operation as a component of an enterprise:
(a) that the enterprise, pursuant to a single plan, is:
(i) disposing of substantially in its entirety, such as by selling the component in
a single transaction or by demerger or spin-off of ownership of the component
to the enterprise’s shareholders; or
(ii) disposing of piecemeal, such as by selling off the component’s assets and
settling its liabilities individually; or
(iii) terminating through abandonment; and
(b) that represents a separate major line of business or geographical area of operations;
and
(c) that can be distinguished operationally and for financial reporting purposes.
Thus, a discontinuing operation must be a separate line of business which is under a plan
of disposal or abandonment.

25. AS-25 – Interim financial reporting: This standard is applicable only when a business Notes
entity is required to present interim financial reports. For example, SEBI requires listed
companies to prepare and publish quarterly financial results. In such cases, AS-25 should
be followed in deciding the form and content of interim financial reporting.
Para 9 of AS-25 states that “an interim financial report should include, at a minimum, the
following components:
(a) condensed balance sheet;
(b) condensed statement of profit and loss;
(c) condensed cash flow statement; and
(d) selected explanatory notes”
An enterprise should apply the same accounting policies in its interim financial statements
as are applied in its annual financial statements. Thus, inventory valuation and depreciation
policies followed for interim financial statements should be same as those followed for
annual financial statements.
26. AS-26 – Intangible assets: An intangible asset is an “identifiable non-monetary asset,

without physical substance, held for use in the production or supply of goods or services,
for rental to others, or for administrative purposes” (Para 6 of AS-26). Common examples
of intangible assets include patents, copyright, computer software, customer list, franchises,
brands, etc. Goodwill is a special type of intangible asset in the sense that it is not separable.
The definition of an intangible asset as mentioned in Para 6 of AS-26 requires that the asset
must be separately identifiable. In that sense, Goodwill is not an intangible asset as it
cannot be bought or sold separately.
An intangible asset can be recognised in the balance sheet as an asset only if two conditions
are satisfied:
(a) it is probable that future economic benefits out of use of the asset will flow to the
enterprise; and
(b) the cost of the asset can be reliably estimated.
If both the above conditions are not satisfied, the amount incurred should be fully written
off. Goodwill can be recognised as an asset only when money or money’s worth is paid for
its acquisition. Internally generated Goodwill cannot be recognised as an asset. Similarly,
internally generated brands, customer list, publishing titles cannot be recognised as
intangible assets.
27. AS-27 – Financial reporting of interests in joint ventures: A joint venture is a business run
by two or more parties. It can take the shape of a partnership or it can also be an incorporated
venture. The criterion that one applies to determine whether a business is a joint venture
is to look for a contractual agreement (known as Joint venture agreement). Joint ventures
can be of three types:
(a) Jointly controlled operations;

(b) Jointly controlled assets; and
(c) Jointly controlled entities.
28. AS-28 – Impairment of assets: Impairment denotes loss in value. An asset is deemed
impaired when its carrying amount (i.e., depreciated value) exceeds its recoverable amount.
The difference is called impairment loss. The impairment loss should be recognised as an
expense in the statement of profit and loss immediately. This standard attempts to present

Notes the assets in the balance sheet in their recoverable amount, where it is lower than the
carrying amount. Hence, the standard follows a conservative approach in the sense that it
does not suggest carrying an asset at its recoverable amount when it is higher than the
carrying amount. Thus, AS-28 attempts to take some care of the criticism of historical cost
accounting.
29. AS-29 – Provisions, contingent liabilities and contingent assets: This is a mandatory
accounting standard effective from 1st April, 2004. The standard seeks to make a distinction
between provisions and contingencies and suggest recognition and disclosure requirements
for these items. At the outset, it should be made clear that provisions (e.g., provision for
tax) are different from outstanding liabilities (e.g., salary payable). In the case of the
former, the amount is based on estimation, whereas in case of the latter, the liability is
certain and hence no estimation is involved. Para 10 of AS-29 defines the term ‘provision’
as below:
“A provision is a liability which can be measured only by using a substantial degree of

estimation”.
Task Academy Ltd. purchased a computer for ` 1,50,000 to be paid in 2 installments of

` 1,00,000 and ` 50,000 payable on 1-12-2003 and 31-01-2004 respectively. The acquisition of
asset at ` 1,50,000 was duly recorded and the supplier was shown as a creditor for ` 50,000
in the balance sheet as on 31-12-2003. The account of the creditor, however, was settled by
paying ` 49,000 only on 31-01-04. The rebate of ` 1,000 has been considered as income of
the year 2004. Comment.
Hint: See AS-9 for Revenue Recognition
Self Assessment
Multiple Choice Questions:
11. Revenue reorganization is recorded under which Accounting Standard:
(a) AS 2 (b) AS 5
(c) AS 9 (d) AS 6
12. Earning per Share is recorded under which Accounting Standard:
(a) AS 2 (b) AS 20
(c) AS 6 (d) AS 9
13. Going concern is the part of which accounting principle under GAAP:
(a) Basic assumptions (b) Basic principles
(c) Modifying principles (d) None of the above
14. AS-20 prescribes that the profit available for equity shareholders should be divided
by……………number of shares.
(a) Weighted (b) Closing
(c) Total (d) Opening

15. The Institute of Chartered Accountants of India (ICAI) being a member body of the IASC, Notes
constituted the Accounting Standards Board (ASB) on 21st April,…………..
(a) 1999 (b) 1977
(c) 1956 (d) 1966
1.4 Summary
The term standards denote a discipline, which provides both guidelines and yardsticks for
evaluations.
Accounting standard is an authoritative pronouncement of code of practice of the regulatory

accountancy body to be observed and applied in the preparation and presentation of
financial statements.
In India, the Institute of Chartered Accountants of India (ICAI) had established in 1977 the
Accounting Standards Board (ASB).
Accounting Standards will be issued by the ASB constituted for the purpose of harmonising
the different and diverse accounting policies and practices in use in India and propagating
the Accounting Standards and persuading the concerned enterprise to adopt them in the
preparation and presentation of financial statement.
Accounting Standards are formulated with a view to harmonise different accounting policies
and practices in use in a country.
The Accounting Standards are applicable to the preparation of general-purpose financial

statements where the taxable income is calculated on the basis of tax treatment of different
items.
The Preface to Accounting Standards provides that the Accounting Standards shall apply
to commercial, industrial and business enterprises in preparation of general-purpose
financial statements issued to the public by such enterprises.
The accounting standard setting, by its very nature, involves reaching an optimal balance
of the requirements of financial information for various interest-groups having a stake in
financial reporting.
1.5 Keywords
Accounting Standards: These are norms and guidelines to prepare the financial statements. In
India these are framed by ICAI.
Disclosure of accounting policies: Giving the information of methods to prepare the accounts.
Inventories: It includes work-in-progress, materials and finished goods.
1. PQR Ltd. shows its inventory at cost in the financial statements. In the current year, the
realizable value of a portion of inventory has gone down below the cost of goods.
Comment.
2. H Ltd. manufactures furniture items as per specific order of the customer. Raw material is
purchased as per the order specification. Which method of valuation of stock of raw
materials or finished goods be adopted by the company and why?

Notes 3. Accounting Standards are formulated with a view to harmonise different accounting policies
and practices in use in a country. Discuss.
4. An enterprise has in its stock, 10,000 bags of cement purchased at a cost of ` 180 per bag.
The terms of trade are that the cement is delivered at the buyer’s door, and the cost of
delivery of ` 10 per bag is paid by the seller. The selling price of cement is `187 per bag.
Find out the value of closing stock.
5. In respect of a particular type of asset, the rate of depreciation as per WDV method under
the Income Tax Act, 1961 is higher than the rate prescribed in Schedule XIV to the Companies
Act, 1956. At what rate the depreciation be charged?
6. XYZ Ltd. purchased an asset costing `10,00,000 a few years ago. It provided depreciation
on WDV method and at present the carrying cost of the asset is `3,50,000. It is now felt that
the depreciation should have been provided as per SL method, amounting to total `7,00,000.
The remaining useful life of the asset is estimated at the 3 years. Explain the treatment in
the light of AS-6 given that the above figures do no include depreciation for the current
year.
7. PQR Ltd. charges depreciation on its plant and machinery @ 20% WDV. In the current year,
a new machine has been acquired, which will work as a part of the existing plant. However,
the life of this machine is expected to be only 4 years. So, the company wants to charge
depreciation as per 4 year SL method on this machine. Is it allowed as per AS 6?
8. The carrying amount of a machine in the balance sheet is ` 1,50,000 (original cost ` 2,30,000).
It has been revalued for ` 1,80,000, the accounting treatment of gain of ` 30,000 is:
(a) Taken to Profit and Loss A/c or
(b) Taken to Revaluation Reserve A/c or
(c) Adjusted against the depreciation for the asset of the current year
9. PQR Ltd. purchased a machine for ` 1,50,000 a few years ago. It was revalued two years ago
by adding ` 75,000 to the carrying cost and the revaluation reserve. The present carrying
amount of the asset is ` 95,000. It has been sold for ` 1,05,000 now. Find out the amount of
profit on sale to be recognised in the Profit & Loss A/c.
10. The net written down value of an asset is ` 8,50,000 as on 1-1-04. During the year 2004, the
asset has been discarded as it has been found to be of no use to the firm. The annual
depreciation charge of this asset for the year 2004 is ` 1,30,000. However, on 31.12.2004, the
net realisable value of the discarded asset has been estimated to be ` 3,50,000 only. Show
the presentation of this asset in the financial statements for the year 2004.
Answers: Self Assessment
1. Financial statements
2. 1973
3. 1977
4. Legal requirements
5. Standards
6. True
7. False
8. True

9. True Notes
10. True
11. (c)
12. (b)
13. (a)
14. (a)
15. (b)
Books Chandra, P., Financial Management - Theory and Practice, New Delhi, Tata McGraw
Hill Publishing Company Ltd., 2002, p. 3.
Sudhindra Bhat, Financial Management, New Delhi, Excel Books, 2008.
Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management,
New Delhi, Prentice Hall of India Pvt. Ltd., 1996, p. 2.
Online links www.globusz.com

www.scribd.com

Contemporary Accounting Dilfraz Singh, Lovely Professional University
Notes Unit 2: Price Level Accounting
CONTENTS
Objectives
Introduction
2.1 Meaning and Scope
2.2 Inflation Accounting
2.3 Major Drawbacks of Historical Cost System
2.4 Methods of Accounting for Changing Prices
2.4.1 Current Purchasing Power (CPP) Method
2.4.2 Current Cost Accounting Method (CCA) Method
2.4.3 Hybrid Method
2.5 Utility and Applications
2.6 Summary
2.7 Keywords
Objectives
Define price level accounting
Describe the scope of price level accounting
Identify the major drawbacks of historical cost system
Describe the utility and applications of inflation accounting
Introduction
The basic objective of accounting is the preparation of financial statements in a way that the
income statement should disclose the true profit or loss made by the business during a particular
period while the balance sheet must show a true and fair view of the financial position of the
business on a particular date. Financial statements are prepared in monetary units, i.e., rupees,
in our country. They can serve very well the basic objective if the value of such monetary units
remains stable. This is possible only when there is stability in the price levels. However, it has
been our experience that over a period of time, the prices have not remained stable. There have
been inflationary as well as deflationary tendencies. The inflationary tendencies have been
more frequent and since 1931 they have been dominating economies of all the countries of the
world. It is increasingly being accepted that in spite of all fiscal, monetary and fiscal measures,
these tendencies are likely to stay and it seems unlikely that we will return to an era of stable
prices in the near future.
2.1 Meaning and Scope
In view of the above, it has been increasingly felt that the accountant will be failing in his duties
if he continues to remain contented with the time honoured and traditional system of accounting

Unit 2: Price Level Accounting
by historical cost. He should move with the time and evolve a suitable system of accounting to Notes
deal with the changing price levels.
Price level accounting may, therefore, be defined as that technique of accounting by which the
financial statements are restated to reflect changes in the general price level. Such changes, as
stated earlier, may be either inflationary or deflationary. Of course, inflation has come to stay
and, therefore, price level accounting is more concerned with inflationary tendencies.
Did u know? What is historical accounting system?
Under historical accounting system, accounts are prepared without regard to changes in
the price levels.
2.2 Inflation Accounting
Inflation accounting is a term describing a range of accounting systems designed to correct

problems arising from historical cost accounting in the presence of inflation. Inflation accounting
is used in countries experiencing high inflation or hyperinflation. For example, in countries
experiencing hyperinflation the International Accounting Standards Board requires corporate
financial statements to be adjusted for changes in purchasing power using a price index.
“Inflation accounting is a system for accounting that purports to record as a built in mechanism
of all economic events in terms of current cost”.
According to author “Inflation accounting is an accounting technique that aims to record business
transactions at current values and to neutralise the impact of changes in the price on the business
transaction”.
“Inflation accounting is a system of accounting just like historical accounting. The difference lies
in the process of matching cost against revenue. In historical accounting cost represents ‘historical
cost’ whereas in inflation accounting cost represents the cost prevailing at the date of sale or at
the reporting time”.
The distinctive features of inflation accounting are as follows:
The recording procedure is automatic
The unit of measurement is not assumed to be stable
It considers all elements of the financial statements and is not concerned only with fixed
assets or closing stock
Realisation principles are not followed rigidly, particularly, when recording long-term
loans and fixed assets at the current value
Self Assessment
1. Price level accounting may be defined as that technique of accounting by which the financial
statements are restated to reflect changes in the general price level.
2. Under historical accounting system, accounts are prepared without regard to changes in
the price levels.
3. Conventional accounting is a system for accounting that purports to record as a built in

mechanism of all economic events in terms of current cost.

Notes 4. In historical accounting cost represents ‘historical cost’ whereas in inflation accounting
cost represents the cost prevailing at the date of sale or at the reporting time”.
5. Historical accounting is used in countries experiencing high inflation or hyperinflation.
2.3 Major Drawbacks of Historical Cost System
Under a historical cost-based system of accounting, inflation leads to two basic problems. First,
many of the historical numbers appearing on financial statements are not economically relevant
because prices have changed since they were incurred.
Second, since the numbers on financial statements represent dollars expended at different points
of time and, in turn, embody different amounts of purchasing power, they are simply not
additive.
Financial statements that are prepared according to the conventional or historical cost accounting
system, therefore, do not reflect current economic realities, in case of historical accounting
system; accounts are prepared without regard to changes in the price levels. The assets are
shown at the values they were purchased less any depreciation on such values. As a matter of fact
their values might have gone up on account of the inflationary tendencies. Similarly, the sales
are recorded at the current market prices while the inventories are recorded at the prices at
which they were purchased. It may be possible that goods sold may comprise those items that
might have been purchased in earlier years when the prices were lower than the current year.
Thus, neither the balance sheet nor the income statement shows the correct operating and
financial position of the business.
“In most countries, primary financial statements are prepared on the historical cost basis of
accounting without regard either to changes in the general level of prices or to increases in
specific prices of assets held, except to the extent that property, plant and equipment and
investments may be revalued.”
Ignoring general price level changes in financial reporting creates distortions in financial
statements such as
reported profits may exceed the earnings that could be distributed to shareholders without
impairing the company’s ongoing operations
the asset values for inventory, equipment and plant do not reflect their economic value to
the business
future earnings are not easily projected from historical earnings
the impact of price changes on monetary assets and liabilities is not clear
future capital needs are difficult to forecast and may lead to increased leverage, which
increases the business’s risk
when real economic performance is distorted, these distortions lead to social and political
consequences that damage businesses (examples: poor tax policies and public
misconceptions regarding corporate behaviour).
Thus assumption of a stable monetary unit does not hold good in the present times as a result the
practical utility of financial statements gets diminished. Inflation accounting is the technique of
such accounting methods as are designed to mirror the impact of rising prices on economic
magnitudes through the adoption of inflation adjusted accounts.

Notes
Notes Limitations of historical cost-based accounting
1. Historical cost based accounting no doubt works very well under the conditions of
stable prices. However, under the conditions of inflation or deflation, it suffers from
a major limitation.
2. It is well known that the purchasing power of rupee has been persistently shrinking
since later fifties, and more alarmingly since early seventies.
3. On the contrary, historical cost-based accounting fails to recognize the impact of this
shrinkage. It records transactions represented by rupees of varying purchasing power.
4. Historical cost-based accounting overstates the profit by undercharging depreciation

and materials cost Depreciation is undercharged since it is based on the historical
cost of fixed assets instead of their current cost.
5. Historical cost-based accounting reflects assets at their historical cost instead of

current cost. It results in understatement of the net worth of an enterprise.
6. Historical cost-based accounting thus fails to serve the primary purpose of the
financial statements. It presents a distorted view of the profitability by overstating
it and of intrinsic worth by understating it.
7. Fixed asset values shown in balance sheets are unrealistic, as fixed assets are recorded
at the cost of acquisition. Whereas replacement cost in periods of rising prices goes
up.
8. Depreciation based on historical cost is inadequate as a measure of the value of the

asset used.
Thus there is a need to take into account the changes in the purchasing power of money
while preparing the financial statements.
Self Assessment
Fill in the blanks:
6. Depreciation based on ………….is inadequate as a measure of the value of the asset used.
7. Historical cost-based accounting reflects assets at their historical cost instead of ……………...
8. Under historical accounting system the sales are recorded at the …………. prices.
2.4 Methods of Accounting for Changing Prices
The following are the key methods of accounting for price level changes:
1. Current Purchasing Power method
2. Current Cost Accounting method
3. Hybrid method
2.4.1 Current Purchasing Power (CPP) Method
Under this method, all items in the financial statements are to be restated for changes in the
general price level.

Notes CIMA Terminology defines current purchasing power accounting as follows:
“Inflation accounting is a method of accounting for inflation in which the values of the non-
monetary items in the historical cost accounts are adjusted using a general price index to show
the change in the general purchasing power of money. The current purchasing power balance
sheet shows the effect of financial capital maintenance”.
The following steps are followed in order to convert the historical cost based financial statements
into the financial statements based on current costs using the current purchasing power method.
Calculation of Conversion Factor and Mid-Point Conversion Factor
Calculation of the Gain or Loss on Monetary Items
Calculation of Cost of Sales and Inventory at Current Prices
Calculation of Profits
Construction of Balance Sheet.
Calculation of Conversion Factor and Mid-Point Conversion Factor:
1. Conversion Factor: As the financial statements prepared on historical cost accounting

basis are to be restated considering the current prices, the value of assets in historical cost
accounts are multiplied by the conversion factor.
!
Caution Conversion factor is calculated as under:
Conversion Factor = Price index at the date of conversion / Price index at the date the item
arose.
Example: Layman Brothers purchased machinery on 1.1.2008 for a sum of `6,60,000. The
retail price index on that date stood at 150. You are required to restate the value of the machinery
according to CPP method on 31st December, 2008 when the price index stood at 200.
Solution:
Conversion Factor = Price index at the date of conversion/Price index at the date of item
arose.
= 200/150 = 4/3
Value of machinery on 31st December, 2008 after conversion.
= Existing value × Conversion factor
= 6,60,000 × 4/3
= ` 8,80,000
Mid-point Conversion Factor: For translating the transactions to current prices occurring
throughout the period, conversion factor cannot be used. In such cases, the mid-point
conversion factor is used. Normally the mid-point conversion factor is given. In case the
same is not given, it can be calculated by taking the average of the index that is at the
beginning of the year and at the end of the year. Thus, it is the average index of the period.
Transactions such as purchases, sales and payment of expenses are converted using the
mid-point conversion factor.

Calculation of Gain or Loss of Monetary Items Notes
Once the conversion factor and mid-point conversion factor are known, the next step is to
calculate gain or loss on monetary items.
Did u know? What are the monetary and non-monetary items?
Monetary items are those items that are fixed by contract or otherwise remain fixed
irrespective of any change in the general price level. Monetary items can either be monetary
assets or monetary liabilities. Examples of monetary items are cash, debtors, creditors,
outstanding expenses, and loan.
Value of non-monetary assets cannot be stated in fixed monetary amounts as they change
with the changes in the price level. The examples of non-monetary items include land,
building, plant, machinery, inventory of fixed goods and equity shares.
Example: Compute the net monetary result of Mohan Company Ltd. as at 31st December
2008 from the following particulars:
1.1.2008 31.12.2008
` `
Cash 500 1,000
Book Debts 2,000 2,500
Creditors 1,500 2,000
Loan 2,000 2,000
Retail Price Index Numbers are as follows:
January 1, 2008 200
December 31, 2008 300
Average for the year 240
Solution:
Calculation of conversion factors:

Conversion factor for items as on 1.1.2008: 300/200 = 1.5
Mid-term conversion factor for items arising during 2008: 300/240 = 1.25
Calculation of the increase or decrease in monetary assets/liabilities during 2008
as on 1.1.2008 as on 31.12.2008 Increase during 2008

(a) Monetary assets 2,500 3,500 1,000
(b) Monetary liabilities 3,500 4,000 500
Statement showing the net monetary result on account of price level changes
(i) Monetary liabilities as on 1.1.2008 should

have gone up with increase in price indices
(` 3,500x1.5) 5,250
(ii) Increase in monetary liabilities during 2008
which should have gone up with increase in
price indices (500 x 1.25) 625
Monetary liabilities on 31.12.2008 should
have stood at: 5,875
Contd...

Notes However, the liabilities on 31.12.2008 stood at 4.000

Gain on holding of monetary liabilities 1,875
(iii) Monetary assets as on 1.1.2008 should have
gone up with increase in price indices
(` 2,500x1.5) 3,750
(iv) Increase in monetary assets during 2008
should have gone up with increase in
price indices (` 1,000 x 1.25) 1,250
Monetary assets on 31.12.2008 should have stood at 5,000
However, the monetary assets on 31.12.2008 stood at 3.500
Loss on holding monetary assets ( - ) 1.500
Net gain on monetary items 375
Cost of Sales and Inventories
The cost of sales and value of inventories depend upon the cost flow assumptions, i.e., first in,
first out (FIFO) or ‘last in, first out’ (LIFO). According to the ‘first in, first out’ method, inventories
first purchased are taken to be first issued to production or sold to customers; while according to
“last in, first out” method inventories purchased in the last are taken to have been first issued to
production or sold to customers. While restating the figures under CPP Method, it would be
appropriate to keep in mind the cost flow assumptions, since they affect both the cost of sales
and closing inventory as shown below:
1. First in First out (FIFO) Method: If this method is followed the composition of cost of
sales and inventory will be as under:
Cost of sales: Cost of sales will comprise of the total opening stock and current
purchases less closing stock.
Closing inventory: The composition of closing stock will normally include current
purchases only. However in cases where total sales are even less than the opening
stock a part of the opening stock may also be the part of closing stock.
2. Last in First out (LIFO) Method: If this method is followed the composition of cost of sales
and inventory will be as detailed below:
Cost of Sales: Under LIFO method the cost of sales will normally comprise of current
purchases only. However, if the purchases of the current year are less than the cost
of sales, then a part of opening stock may also become a part of cost of sales.
Closing stock: Closing stock in this case shall comprise of the purchases made in the
previous year or even of earlier years.
Indices to be used for conversion under Current Purchasing Method
In order to convert the historical cost based financial statements to the financial statements
prepared considering the current purchasing power method the indices are used:
Current purchases Average index of the year

Opening stock Index at the beginning of the year
Purchases of previous year(s) Relevant index

Notes
Example: From the following details ascertain (a) Cost of Sales and (b) Closing Inventory
as per CPP Method when the firm is following FIFO Method:
Historical Price
` Index
Opening stock on 1-1-2008 4,000 80
Purchases during 2008 20,000 125
Closing stock (out of purchases made in the last quarter) 3,000 120
Index No on 31st December, 2008 140
Solution:
Cost of Sales and Closing Inventory (FIFO)
Converted
Historical Conversion
Particulars amount
cost basis factor
under CPP
Opening inventory 4,000 140/80 7,000
Add: Purchases 20,000 140/125 22,400
Total 24,000 29,400
Less: Closing inventory (b) 3,000 140/120 3,500
Cost of goods sold (a) 21,000 25,900
Determination of Profits and Preparing Balance Sheet
For determining the profits under the current purchasing power method, any of the following
two methods can be used:
1. Net Change Method: Under this method, profit is the change in equity over the period.
Thus, both the opening balance sheet and the closing balance sheet are converted to reflect
the changes in price level and any increase in equity is taken as profit and any reduction in
equity is taken as loss. It may be worthwhile to mention here that while converting the
figures of the opening balance sheet both monetary and non-monetary items except equity
are to be converted and while converting the closing balance sheet, only non-monetary
items are converted as they already are reported at current values. Monetary items are not
to be converted. Thus, this method is based on the normal accounting principal that profit
is the change in the equity during the accounting period.
2. Conversion or Restatement of Income Statement Method: Under the second method, all
items of profit or loss account are converted. Sales and operating expenses are converted
using the average index. The index to be used for conversion of cost of sales and inventory
will depend upon the method used for valuation of inventory, i.e., LIFO or FIFO as discussed
above. Fixed assets are converted on the basis of the indices prevailing on the dates they
were purchased. The same principle applies for charging depreciation on them. Taxes and
dividend paid are to be converted using the indices of the date on which they were paid.
Gain on account of monetary items should be calculated and stated separately in the
restated income statement.

Notes
Example: Following is the comparative balance sheet of ABC Ltd. as on 31st December
2007 and 2008:
Comparative Balance Sheet
2007 2008
(`) (`)
Assets
Cash and receivables 2,00,000 2,60,000
Inventories (FIFO method) 1,50,000 1,30,000
Land 40,000 40,000
Equipment 2,10,000 2,70,000
Less: Accumulated depreciation (Nil) (24,000)
6,00,000 6,76,000
Liabilities and Capital
Current liabilities 80,000 90,000
Long-term liabilities 1,00,000 1,16,000
Equity share capital (` 10) 1,40,000 1,40,000
Share premium 2,80,000 2,80,000
Reserves and surplus (Nil) 50,000
Total 6,00,000 6,76,000
The income statement of the company for the year 2008 disclosed the following information:
Income Statement
For the year ending 31st Dec. 2008
Particulars (`) (`)

Net Sales 8,00,000
Less: Cost of goods sold:
Opening Inventories (FIFO) 1,50,000
Purchases (Net) 5,00,000
Cost of goods available for sale 6,50,000
Less: Closing inventory (FIFO) 1,30,000 5,20,000
Gross Profit 2,80,000
Less: Operating expenses (excluding depreciation) 96000

Depreciation 24000 120000
Profit before tax 1,60,000
Less: Income Tax 70,000
Profit after tax 90,000
Less: Dividend paid 40,000
Retained earnings 50,000
Equipment costing `60,000 was acquired on July 1, 2008 when the general price index was 157.5.
The amount of depreciation has been calculated as follows:
`
10% on ` 2,10,000 21,000
5% on ` 60,000 (Rate being 10% p.a.) 3,000
24,000

Sales, purchases, operating expenses (excluding depreciation) took place evenly throughout the Notes
year. Inventories are priced according to first in, first out method. Goods in closing inventories
were acquired evenly throughout the year. The dividend of `40,000 was declared and paid at the
end of 2008. Income tax accrued throughout the year.
You are required to recast the above statement taking into account the price level adjustments
under CPP Method. The general price indices are as follows:
At the end of year 2007 (and beginning of the year 2008) 150
Average for the year 2008 157.5
At the end of the year 2008 163.8
Solution:
It will be necessary to compute conversion factor for restating the figures under CPP Method.
Conversion factors
For items to which Price Index at the 163.8/150 = 1.092
beginning of 2008 is applicable,
For items to which Average Index is applicable 163.8/157.5 =1040
For Items to which Price Index at the end of 2008 is applicable = 163.8/163.8 = 1
ABC Limited
Income Statement
For the year ending 31st Dec, 2008
As per Conversion factor Restated

historical cost under CPP
basis Method
(`) (`)
Sales (1) 8,00,000 1.040 8,32,000
Cost of goods sold:
Opening inventory 1,50,000 1.092 1,63,800
Add: Purchases 5,00,000 1.040 5,20,000
Cost of goods available for sale 6,50,000 6,83,800
Less: Closing inventory
(Out of current purchases) 1,30,000 1.040 1,35,200
Cost of goods sold (2) 5,20,000 5,48,600
Gross profit (l)-(2)= 3 2,80,000 2,83,400
Operating expenses 96,000 1.040 99,840
(excluding depreciation)
Depreciation 24,000 21,000 × 1.092 26,052
= 22,932
3,000 × 1.040
= 3,120
Total operating expenses (4) 1,20,000 1,25,892
Net profit before "general price level gain
or
Contd...

Notes loss"(3)-(4) 1,60,000 1,57,508

General price-level loss
(see statement below) 4,800
Net profit after general price
level loss 1,52,708
Less: Income tax 70,000 1.040 72,800
Net Profit 90,000 79,908
Less: Dividend paid 40,000 1.000 40,000
Retained earnings at the end of 2008 50,000 39,908
Computation of General Price-Level Gain or Loss

For the year ending 31st Dec., 2008
(`) (`) (`)

Net monetary items as on 1-1-2008
Cash and Receivables 2,00,000
Less: Current Liabilities 80,000
Long-term Liabilities 1,00,000 1,80,000
20,000 1.092 21,840
Add: Source of Net monetary
items during 2008:
Sales 8,00,000 1.040 8,32,000
Total Sources (1) 8,20,000 8,53,840
Uses of net monetary items during 2008
Purchases 5,00,000 1.040 5,20,000
Operating expenses 96,000 1.040 99,840
(excluding depreciation)
Income tax 70,000 1.040 72,800
Dividends paid 40,000 1.000 40,000
Purchases of equipments 60,000 1.040 62,400
Total Uses (2) 7,66,000 7,95,040
Net monetary items as should
have been if there were no general
Price level gain or loss (l)-(2) 58,800
Net monetary items actually
existing as on 31st Dec., 2008
Cash and Receivables 2,60,000
Less: Current Liabilities 90,000
Long-term Liabilities 1,16,000 2,06,000 54,000
General price-level loss
during 2008
(58,800-54,000) 4,800

Working Notes: Notes

1. Monetary items at the end of 2008 have not been adjusted since they are already standing
at current values at the end of that year.
2. The amount of retained earnings has been taken from the Income Statement as adjusted
according to CPP Method.
3. In the preceding pages, the net profit of the business has been determined by restating all
items in CPP terms. In case it is desired to determine the net profit after tax for the year
2008 according to ‘net change method’, this can be done with the help of comparative
balance sheet restated in CPP terms as shown on page 3.175. Net profit for 2008 will be the
excess of Reserves in 2008 over that in 2007 as stated in CPP terms, as shown below:
`
Assets in CPP terms as on 31-12-2008 7,04,548
Add: Dividends paid on 31-12-91 40,000
7,44,548
Less: Liabilities in CPP terms as on 31-12-2008 6,64,640
Reserves as on 31-12-2008 79,908
Less: Reserves as on 1-12-2008 (Nil)
Net profit for 2008 (after tax but before dividends) 79,908
ABC Limited
Comparative Balance Sheet
As on 31st Dec. 2007 As on 31st Dec. 2008

Historical Conversion CPP Historical Conversion CPP
Cost factor Method Cost factor Method
basis rolled basis
forward
to end of
2008
Assets
Cash and 2,00,000 1.092 2,18,400 2,60,000 Note 1 2,60,000
Receivables
Inventories 1,50,000 1.092 1,63,800 1,30,000 1.040 1,35,200
Land 40,000 1.092 43,680 40,000 1.092 43,680
Equipment 2,10,000 1.092 2,29,320 2,70,000 1.092 2,91,720
Less: Nil Nil (24,000) (21,000x1.092) (26,052)
Accumulated
depreciation
(3,000x1.040)
6,00,000 6,55,200 6,76,000 7,04,548
Liabilities &
Share Capital
Current 80,000 1.092 87,360 90,000 Note 1 90,000
Liabilities
Long-term 1,00,000 1.092 1,09,200 1,16,000 Note 1 1,16,000
Liabilities
Equity Share 1,40,000 1.092 1,52,20080 1,40,000 1.092 1,52,20080
Capital (` 10
shares)
Share Premium 2,80,000 1.092 3,05,760 2,80,000 1.092 3,05,760
Retained Nil Nil 50,000 Note 2 39,908
Earnings
6,00,000 6,55,200 6,76,000 7,04,548

Notes 2.4.2 Current Cost Accounting Method (CCA) Method
This method attempts to measure the effect of individual rates of price changes on all assets and
liabilities, i.e., stocks, plant and machinery, investments, loan, creditors and so on. It recognises
that there may be great differences in the rates of inflation of various items and by using specific
indices for items or groups of items the method attempts to match the current cost of assets used
against current income generated by them in more meaningful manner. The chief objective of
this method is to ensure that operating capital is maintained at the current price level. Assets are
valued at current cost, considering specific price index of the relevant asset and not general price
index as is used in the Current Purchasing Power Method. Profits under this approach are
computed on the basis of what the cost would have been on the date of sale rather than actual
cost.
Notes Features of CCA method
The main features of the CCA method are as follows:
Meaning: The method requires each item of financial statements to be restated in

terms of the current value of the item. No cognisance is taken of changes in the
general purchasing power of money. Assets are shown in terms of what such assets
would currently cost.
Objectives: The method seeks to ensure that adequate provision/adjustments are

made for the maintenance and replacement of the operating assets of the company,
at least at the minimum physical levels at which the enterprise can operate efficiently,
not only for the year under the review but also for the future.
Adjustments/provisions: In order to achieve the objectives stated above, the

following adjustments/provisions are usually made.
Revaluation Adjustment: The fixed assets are shown at their “value to the business”
and not at their depreciated original cost. “Value to the business” means the amount
that the company would lose, if it were deprived of the assets.
Net current replacement value: This refers to the money now required to buy a new
asset of the same type as an existing one less an amount of depreciation that recognises
the fact that the true replacement of the asset would not be a new asset, but an asset
that has the same remaining useful life as the existing asset.
The following is the process of converting the historical cost based financial statements into the
financial statements prepared taking into account inflation factor using the current cost
accounting method:
(a) Valuation of Fixed Assets
(b) Depreciation Adjustment
(c) Cost of Sales Adjustment
(d) Monetary Working Capital Adjustment
(e) Gearing Adjustment.

Valuation of Fixed Assets Notes
The fixed assets in the balance sheet are valued at their value to the business, which is defined as
the amount the company will lose if it were deprived of these assets. The value of an asset to the
business could be either of the following:
(a) Replacement Cost Value
(b) Net Realisable Value
(c) Economic Value.
1. Replacement Cost: It refers to the money now required to buy a new asset of the type
similar to the existing asset. The amount of depreciation has also got to be deducted from
the same considering the fact that the true replacement of the asset would not be a new,
asset but an asset that has the same remaining useful life as the existing asset.
Example: Suppose a machine was purchased five years ago with an estimated total
useful life of 10 years for ` 60,000. The value of the machine in the books would stand at ` 30,000,
assuming no scrap value. We further assume the same machine today costs ` 1,00,000 in the
market. The value of this machine now will be shown in the books as ` 50,000 (` 1,00,000 less
depreciation for five years assuming no scrap value).
2. Net realisable value: This is the value which is represented by the net cash proceeds if the
existing asset is sold now.
3. Economic value: It refers to the discounted (present) value of the net income that will be
earned from using the existing assets during the remaining life of the asset. Thus, it is the
net present value of the future anticipated net income that the asset is likely to generate. A
close examination of the asset values discussed above indicates that the replacement cost
value is the purchasing value, net realisable value is the sale value and the economic value
is the holding value.
Example: TATA firm purchased machinery for a sum of `10 lakhs, on January 1, 2005. It
had an expected life of 10 years without any scrap value. The price indices for the asset were as
follows:
January 1, 2005 100

January 1, 2008 160
December 31, 2008 175
You are required to value the machinery on January 1, 2008 and December 31, 2008, both according
to Historical Cost Accounting System and Current Cost Accounting System, charging depreciation
on ‘straight line basis.
Solution:
Statement Showing the Value of Machinery
Particulars January 1, 2008 December 31, 2008

Historical Current Historical Current
Cost (`) Cost (`) Cost (`) Cost (`)
Cost 10,00,000 16,00,000 10,00,000 17,50,000
Depreciation (3 Yrs/4 Yrs) 3,00,000 4,80,000 4,00,000 7,00,000
7,00,000 11,20,000 6,00,000 10,50,000

Notes The balance sheet as on 31st December 2008 as prepared under CCA would show the machinery
at ` 10,50,000 as compared to ` 6 lakhs under HCA. The excess of ` 4,50,000 will be put to
“Current Cost Accounting Reserve”.
In case the company desires to show the machinery at current costs as on 31st December 2008, in
place of the historical cost, the increase of ` 7,50,000 in the value of machinery would be debited
to Machinery Account and credited to Current Cost Accounting Reserve. The increase in
depreciation amount of ` 4,00,000 will be charged to Current Cost Accounting Reserve and
credited to the Machinery Account. Thus, the net increase in the value of machinery would be
` 3,50,000 and Current Cost Accounting Reserve would also stand at ` 3,50,000.
Depreciation Adjustment
The charge to the profit and loss account for depreciation should be equal to the value of the
fixed assets consumed during the period. When the fixed assets are valued on the basis of their
net current replacement cost the charge should be based on such cost. A suitable “depreciation
adjustment” is, therefore, required in historical cost profit to determine the current cost profit.
Depreciation Adjustment may be ascertained according to any of the following two bases:
(i) On the basis of total replacement cost of the asset: According to this method “Depreciation
Adjustment” may be computed as follows:
Required Depreciation Provision for the accounting period as per CCA

Less: Depreciation charged for the accounting period as per HCA
Example: On the basis of figures of previous example, the amount of depreciation

adjustment to be made in the accounts of 2008 will be ascertained as follows:
Depreciation at 10% on Current Cost of ` 17,50,000 1,75,000

Less: Depreciation charged for 2008 as per HCA 1,00,000
Depreciation Adjustment 75,000
(ii) On the basis of Average Current Cost of Assets: The depreciation adjustment in the above
illustration has been made by reference to the current cost of the asset on the balance sheet
date. However, strictly speaking, this should be done on the basis of the average current
cost of the asset during the year. The average current cost may be ascertained as follows:
(Current Cost of the asset in the beginning of the year) + (Current Cost of the asset at
the end of the year) / 2
Alternatively, depreciation for the current year may be ascertained as follows:
Depreciation for the full period (say, a year) on current cost of the asset in
the beginning of the accounting period
Add: Depreciation for half the period (say, six months) on increase in the
current costs during the year presuming that such increase was gradual
Less: Depreciation charged as per HCA
The following entry will be passed for depreciation adjustment
Profit & Loss Account Dr.

To Current Cost Accounting Reserve

Notes
Example: KSBS Ltd. had the following fixed assets on 31-12-2008:
Assets Cost (`) Depreciation (`) Net (`)

Land 30,000 30,000
Building 80,000 24,000 56,000
Plant 2,60,000 96,000 1,64,000
3,70,000 1,20,000 2,50,000
Plant includes `60,000 installed on 1-1-2008, depreciation was charged at 5% on building, 10% on
plant according to straight line method. The replacement cost indices are as follows:
Assets On the date of Acquisition As on 1-1-2008 As on 31-12-2008

Land 100 250 300
Building 100 200 220
Plant 100 180 225
You are required to show how the balance sheet items will be affected by the changes according
to CCA method.
Solution:
Two items of the balance sheet, which will be affected under the CCA System are Fixed Assets
and Current Cost Accounting Reserve.
(i) Fixed Assets:
Assets Current Cost (`) Depreciation on Current Cost (`) Net (`)
Land 90,000 — 90,000
Building 1,76,000 52,800 1,23,200
Plant & Machinery 5,25,000 2,10,000 3,15,000
7,91,000 2,62,000 5,28,200
(ii) Current Cost Accounting Reserve:
Particulars `
Increase in the cost fixed assets (7,91,000-3,70,000) 4,21,000
Less: Increase in depreciation (2,62,800-1,20,000) 1,42,800
2,78,200
Add: Depreciation Adjustment [Working Note] 25,650
3,03,850
Working Notes:
(a) Computation of Current Costs:

Land: 30,000 × 300/100 90,000
Building: 80,000 × 220/100 1,76,000
Plant: as on 1-1-2008: 2,00,000 × 225/100 4,50,000
Addition during the year. 60,000 × 225/180 75,000 5,25,000
7,91,000
Contd...

Notes (b) Computation of Depreciation, till date:

Building: 24,000 × 220/100 52,800
Plant: as on 1-1-2008: 90,000* × 225/100 2,02,500
Addition during the year: 60,000 × 225/180 7,500 2,10,000
2,62,800
(c) Depreciation Adjustment:
(i) Building: Current cost on 1-1-2008 1,60,000*
Increase during year 16,000
Depreciation @5% on
1,60,000 for full year 8,000
on 16,000 for half year 400
or 5% on (1,60,000 + 1,76,000) / 2 8,400
Already charged in account-5% on 80,000 4,000
Adjustment required 4,400
(ii) Plant & Machinery: Current Cost on 1-1-2008 3,60,000
Increase in 192008 90,000
Addition (on 1-1-2008) 60,000
Particulars `
Increase in value of the addition 15,000
Depreciation @ 10% on ` 3,60,000 for full year 36,000
` 90,000 for half year 4,500
` 60,000 for half year 6,000
`15,000 for half year 750
Or 10% on (420000 + 525000)/2 47,250
Already charged in accounts 26,000
Adjustment required 21^250
Total Depreciation adjustment required: (i) + (ii) 25,650
*Depreciation on the additional plant purchased during the year would be `6,000. On the balance it would be `90,000.
Cost of Sales Adjustment
The Current Cost Accounting method is based on the important principle that current cost must
be matched against current revenue for determining the true operating profit or loss. The
amount of sales requires no adjustment as it is already at current rate.
Items that enter into the computation of cost of sales have to be taken at the present value that is
required to replace them, if consumed or sold. The difference in values is termed as cost of sales
adjustment that is debited (in case of inflation) before deriving operating profit. As the value of
closing stock will also show a higher value the same will be credited to the Current Cost
Accounting Reserve.
Example: From the following information calculate the Cost of Sales under Historical
and Current Cost Accounting Systems.

Opening Stock of raw materials on 1.1.2008 Notes

(100 tonnes @ ` 20 per tonne) ` 2,000
Purchases during 2008 Nil
Materials consumed during 2008 80 tones
Price of raw materials on Jan. 1, 2008 ` 25 per tonne
Average price during 2008 ` 30 per tonne
Price of raw materials on Dec. 31, 2008 ` 35 per tonne
Solution:
Historical Cost Accounting System (`)

Cost of sales (80 tonnes x ` 20) 1,600
Closing stock (20 tonnes x ` 20) 400
Current cost accounting system
Cost of sales (80 tonnes x ` 30) 2,400
Closing stock (20 tonnes x ` 35) 700
The increase in stock of `300 in CCA method over historical cost basis will be credited to
Current Cost Accounting Reserve. The closing stock in the balance sheet will be shown at `700.
The cost of Sales Adjustment amounting to `800 (i.e. `2,400 – `1,600) will be charged to Profit and
Loss Account and credited to Current Cost Accounting Reserve.
Monetary Working Capital Adjustment
The cost of sales adjustment only takes into account the impact of inflation on stock consumption.
Apart from it, an organisation requires additional resources to meet working capital requirements
due to the increase in prices. This extra amount of required working capital is known as additional
monetary working capital.
The additional net monetary working capital required is purely on account of increase in price levels
and not on account of increase in scale of operations. Monetary working capital normally means
aggregate of trade receivables, pre-payments and trade bills receivables less trade creditors, and
trade bills payables and accruals. An adjustment has to be made in respect of monetary working
capital while determining current cost operating profit. This adjustment should present the amount
of additional (reduced in case of deflation) finance needed for monetary working capital as a result
of changes in the input prices of goods and services used and financed by the business.
Example: From the following information, as per historical cost accounting method,
compute the monetary working capital adjustment under current cost accounting method:
Jan. 1, 2008 Dec. 31, 2008

Accounts receivable 2,000 3,600
Accounts payable 1,100 1,840
Monetary working capital 900 1,760
Price Index for materials 200 230
Price index for finished goods 150 180
Solution:
In order to determine Monetary Working Capital Adjustment, it will be necessary first to find
out the amount of increase in monetary working capital on account of increase in volume of

Notes business. This should be done by eliminating the effects of change in price levels in the amounts
of receivables and payables. The amounts of receivables and payables have been compared for
this purpose by adjusting their figures on the basis of average price indices as shown below:
Jan. 1, 2008 Dec. 31, 2008

` `
(a) Accounts receivable
2,000 × 165/150 2,200 3,600 × 165/180 3,300
(b) Accounts payable
1,100 × 215/200 1,183 1,840 × 215/230 1,720
(c) Monetary Working
Capital [(a) - (b)] 1,580
The increase in monetary working capital on account of increase in volume of business is `563
(i.e., `1,580 – `1,017). However, the actual increase in monetary working capital as shown
by Historical Cost Accounting method comes to ` 860 (i.e. `1,760 – `900). The excess of ` 297
(i.e. ` 860 – `563) representing excess working capital required is Monetary Working Capital
Adjustment. The amount would be charged to Profit and Loss Account and credited to Current
Cost Accounting Reserve.
Gearing Adjustment
The profits as calculated after taking into account the foregoing adjustments, i.e., depreciation
adjustment, cost of sales adjustment and monetary working capital adjustment reflect the true
amount of profits from operations known as current cost operating profit. This operating profit
belongs to those who bring in the operating capital for the business. It is also known that almost
all organisations obtain part of their operating capital by loans or other monetary obligations.
These loans and monetary obligations are unaffected by changes in price levels. Therefore a part
of the adjustments in respect of depreciation adjustment, cost of sales adjustment and monetary
working capital adjustment is ascribable to the loan funds or borrowings.
Thus the net adjustment of the above three factors may be reduced by the proportion to the
borrowings in the capital structure. This adjustment is known as gearing adjustment. If there are
no borrowed funds then this adjustment is not required.
To sum up, gearing adjustment is necessary because a part of the net operating assets are financed
by borrowings, which are to be repaid in the same monetary amount irrespective of changes in
prices. Equity, debts and preference shareholders provide funds. For debt, a fixed amount has to
be paid and thus the gearing adjustment is required.
Gearing Adjustment = (Opening adjustment x Average Borrowings) / (Average Borrowings +
Average Equity)
The gearing adjustment in fact reduces the impact of depreciation, cost of sales and monetary
working capital adjustments.
Example: From the data below, calculate the gearing adjustment required under Current
Cost Accounting Method:
Opening Closing
(`) (`)
Convertible Debentures 100 120
Contd...

Bank Overdraft 60 80 Notes

Cash 10 30
Paid-up Share Capital 150 200
Reserves 50 80
Cost of Sales Adjustment 20
Monetary Working Capital Adjustment 15
Depreciation Adjustment 5
Total of Adjustment 40 -
Solution:
Calculation of Net Borrowings: (`)
Opening Closing
Convertible Debentures 100 120
Bank Overdraft 60 80
Total Borrowings 160 200
Less: Cash (as this does not enter into MWCA) 10 30
Net Borrowings T50 170
Calculation of Shareholders' Funds:
Paid-up Share Capital 150 200
Reserves 50 80
Shareholders' Funds 200 280
Average Net borrowing = 15 + 170 / 2
or B = ` 160
Average Shareholders Interest = 200 + 280 / 2
S = ` 240
Gearing Adjustment = B / B+S
= 160/160 +240
As total of all the Adjustments = 40 (given)
= 160/400 x 40
= `16
Task A firm purchased machinery for a sum of `1 lakh on January 1, 2002. It has an
expected life of 10 years without any scrap value. The price indices for the asset were as
follows:
January 1, 2002 100
January 1, 2008 160
December 31, 2008 175
Contd...

Notes You are required to value the machinery on January 1, 2008 and December 31, 2008, both
according to historical cost accounting system and current cost accounting system, charging
depreciation on straight-line basis. Also, find the amount that needs to be adjusted for
depreciation in year 2008.
Hint: (1) WDV on 1.1.2008 (2) WDV on 31.12.2008
Historical Cost - 70000 Historical Cost - 60000
Current Cost - 112000 Current Cost - 105000
2.4.3 Hybrid Method
This method is a compromise between the Current Purchasing Power and Current Cost
Accounting methods. Under this method, fixed assets and inventories are valued at specific
indices—Current Cost Accounting. In addition to this, purchasing power gains and losses in
respect of monetary items are also considered, which otherwise are ignored in Current Cost
Accounting. Those who advocate this method argue that by combining the two methods, the
advantages of both the methods can be obtained. But the critics of this method state that its
acceptance may prove difficult because of theoretical objections. In addition, the method may be
a victim of the disadvantages of both the methods.
Self Assessment
Fill in the blanks:

9. …………..= Price index at the date of conversion / Price index at the date the item arose.
10. …………items are those items that are fixed by contract or otherwise remain fixed
irrespective of any change in the general price level.
11. According to the………….method, inventories first purchased are taken to be first issued
to production or sold to customers.
12. Under ………….method, fixed assets and inventories are valued at specific indices.
2.5 Utility and Applications
The effects of inflation upon a business can briefly be described as distorting its profit performance
and valuations of its capital. This, in turn, affects the judgements and decisions of its management,
shareholders, investors and the government.
The immediate operating effect of inflation is upon the cash flow of the business entity. That is
the ability of the inflowing cash to acquire the depreciated fixed asset in real terms. Assets
recorded at historical cost will have a lower real value as the purchasing power of money falls
with inflation. On the other hand, liabilities such as loans are recorded in the financial statements
at historical cost and that is the amount to be repaid despite the fact that the rupees we repay will
have a lower real value than the rupees that were borrowed.
Inflation will also affect the profits of the business. Revenues will be at current prices as they are
the price paid today. Costs will be based on historical costs. In real terms, there is no comparison
between the both, and the net effect will be overstatement of profits. Depreciation will be based
on the historical cost, possibly years ago, and will be understated.
To examine the issue in greater details an attempt is now made to study the distortions that
inflation causes in the financial statements based on historical costs and how such distortions
affect the quality of information that is available to the users.

1. The assets that are stated in the balance sheet are reported at values that are much lower Notes
than their current replacement values. Due to the understatement of the values, the business
is more vulnerable to takeover bids and the shareholders may not realise a fair value for
their shares at the time of such takeover.
2. Since the fixed assets are understated in value, the depreciation charged in the Income
Statement remains at a low figure. This would distort the current cost data compiled for
operational decisions such as pricing, make-or-buy, etc.
3. Another distortion caused is that which arises when the cost of raw materials and
components or goods purchased for resale is steadily rising. As the cost concept requires
that only the cost of purchase should be charged off to the income statement, the difference
between the historical cost and the replacement cost of such items is included in the profits
earned. In this way the operating profit also includes a part of holding profits.
4. Assets such as cash and other near-cash assets receivables in periods of inflation lose their
real value in terms of purchasing power. Similarly, the real values of monetary liabilities
such as creditors and loans outstanding gain their real value in terms of purchasing power
but the same does not get reflected in the statements in periods of inflation. The reverse is
true in the periods of deflation.
5. The profits and return on investment under historical cost accounting are overstated, as
revenue is recorded at increasing price levels and expenses such as depreciation and cost
of sales are charged off at the historical cost.
6. The financial statements also reflect a very high growth in sales value, profits, capital
additions, etc. The real growth rates of the items can be known only when adjustments are
done for the changes in the money value.
From the above, it is clear that accounts that have not been adjusted for the impact of inflation
can mislead both internal and external users in respect of decisions that may be taken on the
basis of financial statements prepared ignoring the inflation factor.
Applications of Inflation Accounting
In the past few years, the entire world has been experiencing high inflation. Companies have
reported very high profits on the one hand but on the other, they have faced real financial
difficulties. This is so because in reality, dividends and taxes have been paid out of capital due to
overstated figures of profits arrived at by adopting the historical cost concept. Thus, a shift from
historical cost concept to inflation accounting is recommended. The major advantages of inflation
accounting are as follows:
1. It enables the company to present a more realistic view of its profitability because current
revenues are matched with current costs.
2. Depreciation charged on current values of assets in inflation accounting further enables a
firm to show accounting profits more nearer to economic profits and replacement of these
assets when required become easy.
3. It enables a company to maintain its real capital by avoiding payment of dividends and
taxes out of its capital due to inflated profits in historical accounting.
4. The balance sheet reveals a more realistic and true and fair view of the financial position
of a concern because the assets are shown at current values and not on distorted values as
in historical accounting.
5. When financial statements are presented, adjusted to the price level changes, it makes
possible to compare the profitability of two concerns set up at different times.

Notes 6. Investors, employees and the public at large are not misled by inflated book profits
because inflation accounting shows more realistic profits. Higher paper profits without
adjustment for price level changes cause resentment among workers and they demand
higher wages. Also, excessive profits attract new entrepreneurs to enter the business.
Inflation accounting helps in avoiding further competition from prospective entrepreneurs.
7. The financial statements prepared by a company adjusted to the price level changes also
improve its social image.
8. Inflation accounting also affects the investment market as it helps to establish a realistic
price for the shares of a company.
Notes Disadvantages of Inflation Accounting

Some people are of the opinion that inflation accounting may create more problems than
provide solution to them, because of the following inherent disadvantages of the accounting
system considering price level changes:
1. Adjusting accounts to price level changes is a never-ending process. It involves
constant changes and alterations in the financial statements.
2. Price level accounting involves many calculations and makes financial statements
so complicated and confusing, that it becomes very difficult for a individual of
ordinary prudence to understand, analyse and interpret them.
3. The concept of price level accounting appears to have more theoretical importance
than practical relevance, because adjusting the accounts to the changes in the price
levels may lead to window dressing the accounts due to the element of subjectivity
in it. People may adjust the accounts according to the values most suited to them,
thereby, making the financial statements inaccurate.
4. Depreciation charged on current values of fixed assets is not acceptable under the
Income-tax Act, 1961, and hence adjusting it to price level changes does not serve
any practical purposes.
5. During deflation, when the prices are falling, adjustments of accounts to price level
changes will mean charging lesser depreciation and overstatement of profits
indicating that dividends could be paid from even the capital.
Self Assessment
Fill in the blanks:
13. The immediate operating effect of inflation is upon the …………of the business entity.
14. Assets recorded at historical cost will have a lower real value as the purchasing power of
money falls with …………….
15. Depreciation charged on current values of fixed assets is not acceptable under the ………….
2.6 Summary
Price level accounting may be defined as that technique of accounting by which the financial
statements are restated to reflect changes in the general price level.
Inflation accounting is a term describing a range of accounting systems designed to correct

problems arising from historical cost accounting in the presence of inflation.

Financial statements that are prepared according to the conventional or historical cost Notes
accounting system, therefore, do not reflect current economic realities, in case of historical
accounting system, accounts are prepared without regard to changes in the price levels.
The following are the key methods of accounting for price level changes:
i. Current Purchasing Power method
ii. Current Cost Accounting method
iii. Hybrid method
Under CPP method, all items in the financial statements are to be restated for changes in
the general price level.
The Current Cost Accounting (CCA) Method attempts to measure the effect of individual
rates of price changes on all assets and liabilities, i.e., stocks, plant and machinery,
investments, loan, creditors and so on.
Hybrid method is a compromise between the Current Purchasing Power and Current
Cost Accounting methods.
The FAS 33 requires companies to compute inflationary effect on profits in two different
ways: (i) constant dollar method, and (ii) current cost accounting method.
2.7 Keywords
Economic Value: It refers to the discounted (present) value of the net income that will be earned
from using the existing assets during the remaining life of the asset.
Historical Accounting: Under historical accounting system, accounts are prepared without regard
to changes in the price levels.
Inflation Accounting: Inflation accounting is a term describing a range of accounting systems

designed to correct problems arising from historical cost accounting in the presence of inflation.
Net Realisable Value: This is the value which is represented by the net cash proceeds if the
existing asset is sold now.
Price Level Accounting: Price level accounting may be defined as that technique of accounting by
which the financial statements are restated to reflect changes in the general price level.
Replacement Cost: It refers to the money now required to buy a new asset of the type similar to
the existing asset
1. Why is it necessary these days to account for price-level changes?
2. Explain the concept of Current Cost Accounting.
3. Explain and illustrate monetary and non-monetary items while accounting for price-level
changes?
4. What approaches have generally been recommended for dealing with the problem of
changes in the purchasing power of money? Which one is the best? Why? Give reasons in
brief.
5. Explain and distinguish between holding gains and operating gains. Give examples.

Notes 6. Explain:
(a) Monetary Liabilities and Non-monetary Liabilities.
(b) Cost of Sales Adjustment and Gearing Adjustment.
7. What do you mean by inflation accounting? Enumerate its advantages and disadvantages.
8. “Historical accounting shows unreal profits resulting in distribution of profits out of

capital”. Offer your observations on the above statement.
9. What is the impact of price level changes on financial statements? What suggestions do
you make to disclose the effect of price level changes on the financial statements?
10. Explain with suitable examples the problems of interpretation of financial statements in
times of inflation when accounts are scrutinized under the conventional accounting system.
1. True 2. True
3. False 4. True
5. False 6. historical cost
7. current cost 8. current market
9. Conversion Factor 10. Monetary
11. FIFO 12. hybrid
13. cash flow 14. inflation
15. Income-tax Act, 1961

www.scribd.com

Dilfraz Singh, Lovely Professional University Unit 3: Environmental Accounting
Unit 3: Environmental Accounting Notes
CONTENTS
Objectives
Introduction
3.1 Methodology of Environmental Accounting
3.2 Objectives of Environmental Accounting
3.3 Observations
3.4 Summary
3.5 Keywords
Objectives
Describe the methodology of environmental accounting
State the objectives of environmental accounting
Identify the key observations of environmental accounting
Introduction
The increasing importance of considering environmental aspects within a company’s decisions

demands a broader scope in management accounting. Eco-management accounting should enable
management to integrate environmental issues into the decision-making process.
—Thomas Orbach and Chrisa Liedtke (1998)
Environmental accounting is defined as the accountants’ contribution towards environmental

sensitivity in organizations. It gained prominence in the 1990s. The emphasis on the social
responsibilities of the accountancy profession is not new, having been led to prominence by the
social accounting debate of the 1970s. The social consciousness of the accountancy profession
was started to receive its attention. It focused on extending accountability to numerous
stakeholders by necessitating disclosure of social information in corporate annual reports.
!
Caution The accountability function of accounting was believed to be fulfilled by reporting
(financial and social) information that stakeholders would find useful in their decision
making process.
3.1 Methodology of Environmental Accounting
The preparation of environmental accounting is affected by a number of factors such as the

magnitude of the investment required, the objectivity of the data, the ability to compare different
kinds of environmental impacts, and the kinds of policy purposes to which they may be applied.

Notes The following are the key methods used for environmental accounting:
1. Natural Resource Accounts: The natural resource accounts include data on stocks of natural
resources and changes in them caused by either natural processes or human use. Such
accounts typically cover agricultural land, fisheries, forests, minerals and petroleum, and
water. In some countries, the accounts also include monetary data on the value of such
resources. But attempts at valuation raise significant technical difficulties. It is fairly easy
to track the value of resource flows when the goods are sold in markets, as in the case of
timber and fish. Valuing changes in the stocks, however, is more difficult because they
could be the result either of a physical change in the resource or of a fluctuation in market
price.
2. Emissions accounting: The concept of emission accounting was developed by the Dutch.
The National Accounting Matrix including Environmental Accounts (NAMEA) structures
the accounts in a matrix, which identifies pollutant emissions by economic sector. Eurostat,
the statistical arm of the European Union, is helping EU members apply this approach as
part of its environmental accounting program. The physical data in the NAMEA system
are used to assess the impact of different growth strategies on environmental quality.
Data can also be separated by type of pollutant emission to understand the impact on
domestic, trans-border, or global environments.
!
Caution If emissions are valued in monetary terms, these values can be used to determine
the economic cost of avoiding environmental degradation in the first place, as well as to
compare costs and benefits of environmental protection.
3. Disaggregation of conventional national accounts: Sometimes data in the conventional
accounts are taken apart to identify expenditures specifically related to the environment,
such as those incurred to prevent or mitigate harm, to buy and install protection equipment,
or to pay for charges and subsidies. Over time, revelation of these data makes it possible
to observe links between changes in environmental policy and costs of environmental
protection, as well as to track the evolution of the environmental protection industry.
4. Green GDP: Developing a gross domestic product that includes the environment is also a
matter of controversy. Most people actively involved in building environmental accounts
minimize its importance. Because environmental accounting methods are not standardized,
a green GDP can have a different meaning in each project that calculates it, so values are
not comparable across countries. Moreover, while a green GDP can draw attention to
policy problems it is not useful for figuring out how to resolve them. Nevertheless, most
accounting projects that include monetary values do calculate this indicator. Great interest
in it exists despite its limitations
Notes Forms of Environmental Accounting
1. Environmental Management Accounting (EMA): Management accounting with

particular focus on material and energy flow information and environmental cost
information. This type of accounting can be further classified in the following
subsystems:
Segment Environmental Accounting: This is an internal environmental

accounting tool to select an investment activity, or a project, related to
environmental conservation from among all processes of operations, and to
evaluate environmental effects for a certain period.
Contd...

Unit 3: Environmental Accounting
Eco Balance Environmental Accounting: This is an internal environmental Notes

accounting tool to support PDCA for sustainable environmental management
activities.
Corporate Environmental Accounting: This is a tool to inform the public of

relevant information compiled in accordance with the Environmental
Accounting. It should be called as Corporate Environmental Reporting. For
this purpose the cost and effect (in quantity and monetary value) of its
environmental conservation activities are used.
2. Environmental Financial Accounting (EFA): Financial accounting with a particular

focus on reporting environmental liability costs and other significant environmental
costs.
3. Environmental National Accounting (ENA): National Level Accounting with a

particular focus on natural resources stocks & flows, environmental costs and
externality costs etc.
4. Need of Environmental Accounting at Corporate Level: It helps to know whether

corporation has been discharging its responsibilities towards environment or not.
Basically, a company has to fulfill following environmental responsibilities.
Meeting regulatory requirements or exceeding that expectation.
Cleaning up pollution that already exists and properly disposing of the

hazardous material.
Disclosing to the investors both potential and current, the amount and nature
of the preventative measures taken by the management (disclosure required
if the estimated liability is greater than a certain percent say 10 per cent of the
companies net worth).
Operating in a way that those environmental damages do not occur.
Promoting a company having wide environmental attitude.
Control over operational and material efficiency gains driven by the

competitive global market.
Control over increases in costs for raw materials, waste management and
potential liability.
Self Assessment
Fill in the blanks:
1. ………..is defined as the accountants’ contribution towards environmental sensitivity in

organizations.
2. The …………accounts include data on stocks of natural resources and changes in them
caused by either natural processes or human use.
3. ……………….is a tool to inform the public of relevant information compiled in accordance

with the Environmental Accounting.
4. The concept of ………… accounting was developed by the Dutch.
5. The National Accounting Matrix including Environmental Accounts (NAMEA) structures

the accounts in a matrix, which identifies ………….emissions by economic sector.

Notes 3.2 Objectives of Environmental Accounting

Practical developments of environmental accounting saw tremendous growth in research, with
various initiatives and proposals being put forward by accountancy bodies and related
international organizations. In essence, environmental accounting now plays a vital role in
daily commercial undertakings, attempting to ensure that development is not at odds with
environmental protection. The potential for accountants to make a significant contribution
towards environmental consciousness in organizations has been envisaged through their
managerial, auditing and reporting skills. Increasingly, the emphasis has shifted from social
accounting in general to a more specific environmental accounting. These days, social accounting
has become synonymous with the term Social and Environmental Accounting (SEA), a linkage
that places due emphasis on the importance of environmental issues.
Did u know? What is social reporting?

Social accountability is about being answerable to the people affected by your actions.
The Environmental Accounting was first considered a new field in accounting in during 1998 by
the intergovernmental work group ISAR (United Nations Inter governmental Working Group
of Experts on International Standards of Accounting and Reporting). Jointly with this work,
ISAR has been coordinating efforts with IAPC (International Auditing Practices Committee) to
formalize a group of audit standards for verification of the environmental performance reported
on accounting statements. This work group basically emphasised the need for environmental
accounting to cover the following basic objectives:
assistance of professionals in other fields of knowledge
give the status of the information system of the analyzed company, as regards the
preparation of its internal controls to provide its financial accounting with relevant
information on environmental aspects
effective contribution of various external intervenors, as the consulting specialists,
certification companies and independent auditors, to grant an independent opinion on
specific aspects of the report
Task Discuss the regulatory framework of environmental accounting in India.
Self Assessment
Fill in the blanks:
6. The Environmental Accounting was first considered a new field in accounting in during
…………by the intergovernmental work group ISAR.
7. …………. accountability is about being answerable to the people affected by your actions.
3.3 Observations
The following are the key observations for practice of environmental accounting:
There are, in addition, four main observations regarding how useful environmental accounts
are for policy:
1. Although some countries are using the environmental accounts quite actively, the accounts
are still underutilized, especially in developing countries

2. No country has truly comprehensive environmental accounts. Notes
3. International comparisons are important, but not yet possible because of differences in
methodology, coverage, environmental standards, and other factors.
4. For a country to fully assess its environmental impact, it must have.
Accounts for the trans-boundary movement into and out of the country of pollutants
via air and water
Accounts for its major trading partners to calculate the pollution and material content
of products that it imports.
Practices of Environmental in India
1. Very few corporations give adequate information regarding environmental issue. If as

per requirement of applicable law they have to prepare and submit any information
relevant to environment they do so. The Environment Ministry has issued instruction in
this regard to prepare environment statement. It can be observed through their accounts
that mainly the following types of information are given:
What type of devices installed for pollution control.
Steps taken for energy conservation.
Steps taken for raw material conservation.
Step taken for waste water and production process waste.
Step taken for improvement of quality of product and services, process of production,
etc.
2. A study was conducted among 80 executives of different industries by Dr. B.B. Padhan and
Dr. R.K. Bal which revealed that corporate world is fully aware of the requirements of
environmental reporting. They are also aware of the environmental issue. The corporate
executives have also expressed their views in favour of environment reporting by the
industries.
Despite their awareness and consent over environmental reporting by industries is

it very poor.
It is so inadequate that very little information is found in the annual report.
3. In the words of Jong Seo Choi, research studies have examined the extent to which companies
produce social information, of which environmental information would be part. A number
of general themes that emerge from this include the following:
The proportion of companies disclosing and extent of that disclosure are small and
the quantity is low.
There is some variety in disclosure over time, between countries and between
industries. Social disclosure in general and environmental disclosure in particulars
reflects the changing business climate and social, economic and political environment
in which they occur.
However, the total amount of voluntary disclosure stays fairly constant over time
and what changes is the subject addresses in the disclosure.
There is a very definite size effects in those larger companies are more likely to
disclose than smaller companies.

Notes Very little disclosure would qualify as information under any normal criteria and
very little of it indeed will contain numbers, financial or otherwise.
4. Environmental reports as contained in the Directors Report of three Indian Companies

are as under:
(i) Asian Paints (India) Ltd., (1993-94): “Ecology and Safety: Samples of treated effluents are
periodically checked for Compliance with standards”
(ii) Goodlass Nerolac Paints Limited (1993-94): “Pollution: The company regularly monitors
measures in force in accordance with the Pollution Control Act for the protection of
environment and for ensuring industrial safety. The company carries out
improvements regularly to ensure full compliance with the statutory requirements.”
(iii) Maruti Udyog Limited (1993-94): “Environment: Modification of the existing effluent
treatment plant was undertaken to take care of additional effluents generated due to
capacity expansion. Data on non–methane hydrocarbons in Paint Shop and Engine
Testing shop, ambient air quality, stack emissions and effluents are being regularly
monitored and the parameters are maintained well within prescribed limits.
Development of green belt around gas turbine and R&D areas was further augmented
by plantation of 3000 additional saplings.
5. It was also revealed that most of the companies disclose the environment information in
descriptive manner rather than to financial type i.e. no account is made for the degradation
of natural capital when calculating corporate profits.
Notes Limitations of Environmental Accounting

EA suffers from various serious limitations as follows:
1. There is no standard accounting method.
2. Comparison between two firms or countries is not possible if method of accounting
is different which is quite obvious
3. Input for EA is not easily available because costs and benefits relevant to the
environment are not easily measurable.
4. Many business and the Government organizations even large and well managed
ones don’t adequately track the use of energy and material or the cost of inefficient
materials use, waste management and related issue. Many organisations, therefore,
significantly underestimate the cost of poor environment performance to their
organization.
5. It mainly considers the cost internal to the company and excludes cost to society.
6. EA is a long-term process. Therefore, to draw a conclusion with help of it is not easy.
7. EA cannot work independently. It should be integrated with the financial accounting,
which is not easy.
Self Assessment

8. Most of the countries have truly comprehensive environmental accounts.
9. It was also revealed that most of the companies disclose the environment information in
descriptive manner rather than to financial type.
10. Very few corporations give adequate information regarding environmental issue.

3.4 Summary Notes
Environmental accounting is defined as the accountants’ contribution towards

environmental sensitivity in organizations.
The preparation of environmental accounting is affected by a number of factors such as the

magnitude of the investment required, the objectivity of the data, the ability to compare
different kinds of environmental impacts, and the kinds of policy purposes to which they
may be applied.
The natural resource accounts include data on stocks of natural resources and changes in
them caused by either natural processes or human use.
The concept of emission accounting was developed by the Dutch.
The National Accounting Matrix including Environmental Accounts (NAMEA) structures

the accounts in a matrix, which identifies pollutant emissions by economic sector.
Sometimes data in the conventional accounts are taken apart to identify expenditures
specifically related to the environment, such as those incurred to prevent or mitigate
harm, to buy and install protection equipment, or to pay for charges and subsidies.
Environmental management accounting focuses on material and energy flow information

and environmental cost information.
Environment financial accounting focuses on reporting environmental liability costs and

other significant environmental costs.
National Level Accounting focus on natural resources stocks & flows, environmental costs
and externality costs etc.
Although some countries are using the environmental accounts quite actively, the accounts
are still underutilized, especially in developing countries.
No country has truly comprehensive environmental accounts.
International comparisons are important, but not yet possible because of differences in
methodology, coverage, environmental standards, and other factors.
3.5 Keywords
Environmental Accounting: Environmental accounting is defined as the accountants’ contribution

towards environmental sensitivity in organizations.
Environmental Financial Accounting (EFA): Financial accounting with a particular focus on

reporting environmental liability costs and other significant environmental costs.
Environmental Management Accounting (EMA): Management accounting with particular focus

on material and energy flow information and environmental cost information.
Environmental National Accounting (ENA): National Level Accounting with a particular focus
on natural resources stocks & flows, environmental costs and externality costs etc.
1. Identify the meaning and scope of environmental accounting.
2. What are the key methods used for environmental accounting?

Notes 3. How environmental management accounting is different from environmental financial

accounting?
4. Is environmental accounting PR exercise? How do you perform environmental accounting

and auditing of Fertiliser Company?
5. Identify the key observation of environmental accounting.
6. What are the key drawbacks of environmental accounting?
1. Environmental accounting
2. Natural resource
3. Corporate Environmental Accounting
4. Emission
5. Pollutant
6. 1998
7. Social
8. False
9. True
10. True

www.scribd.com

Dilfraz Singh, Lovely Professional University Unit 4: Economic Value Added (EVA)
Unit 4: Economic Value Added (EVA) Notes
CONTENTS
Objectives
Introduction
4.1 Concept of EVA
4.2 Approaches to Computation of EVA
4.2.1 Adjustments to ‘Net Operating Profit after Tax’
4.2.2 Adjustment to ‘Capital Employed’
4.2.3 Adjustment to ‘Cost of Capital’
4.3 Applications of EVA
4.4 Superiority of EVA
4.5 Shortcomings of EVA
4.6 Summary
4.7 Keywords
Objectives
Define EVA
Illustrate the approaches to compute EVA
Describe the applications and shortcomings of EVA
Introduction
Economic profit is wealth created above the capital cost of the investment. EVA prevents
managers from thinking that the cost of capital is free. In other words, a measure of a company’s
financial performance based on the residual wealth calculated by deducting cost of capital from
its operating profit (adjusted for taxes on a cash basis). The formula for calculating EVA is as
follows:
= Net Operating Profit after Taxes (NOPAT) – (Capital * Cost of Capital)
EVA focuses managers on the question, “For any given investment, will the company generate
returns above the cost of capital?” Companies that embrace EVA have bonus compensation
schemes that reward or punish managers for adding value to or subtracting value from the
company. As with any metric, it’s hard to link precise EVA returns to a specific technology
investment. EVA is ideally suited to publicly traded companies, not private companies, because
it deals with the cost of equity for shareholders, as opposed to debt capital.
If a company invests in manufacturing equipment or a warehouse, how much additional profit

will be required to pay for it? Managers are intuitively aware of the importance of value
creation to their businesses.

Notes
!
Caution EVA is a management philosophy and performance metric that elevates those
goals from intuition to rigorous analysis and ensures that no investment escapes scrutiny.
4.1 Concept of EVA
The New York-based financial advisory Stern Stewart and Co. postulated a concept of economic
income in 1990 in the name of ‘Economic Value Added’ (EVA). EVA is a modified version of
residual income concept. EVA has provided financial discipline in many US companies,
encouraged managers to act like owners and has boosted shareholders returns and the value of
their companies. The company creates shareholder value only if it generates returns in excess of
its cost of capital. The excess of returns over cost of capital is simply termed as Economic Value
Added (EVA).
Did u know? What is the role of EVA?
EVA measures whether the operating profit is sufficient enough to cover cost of capital.
Shareholders must earn sufficient returns for the risk they have taken in investing their money
in company’s capital. The returns generated by the company for shareholders have to be more
than the cost of capital to justify risk taken by the shareholders. If a company’s EVA is negative,
the firm is destroying shareholders wealth even though it may be reporting positive and growing
EPS or return on capital employed EVA is just a way of measuring an operation’s real profitability.
EVA holds a company accountable for the cost of capital it uses to expand and operate its
business and attempt to show whether a company is creating a real value for its shareholders.
EVA is a better system than ROI, to encourage growth in new products, new equipment and new
manufacturing facilities. EVA measurement also requires a company to be more careful about
resource mobilization, resource allocation and investment decisions. It effectively measures the
productivity of all factors of production. EVA can be calculated as follows:
EVA = NOPAT (TCE x WACC)
Where,
NOPAT = Net operating profit after tax
TCE = Total capital employed
WACC = Weighted average cost of capital
The fundamental proposition of EVA is that capital isn’t free and its cost must be factored into
every benefit analysis or return-on-investment model when an investment in a plant, equipment
or a new customer relationship management system is contemplated. Putting a finer point on
this concept, EVA targets equity capital as opposed to debt capital. Managers often treat equity
capital as free when it’s not—shareholders could have invested elsewhere.
Notes Steps in Implementing EVA
The implementation of EVA is a 4-step process that includes: (a) Measurement,

(b) Management System, (c) Motivation and (d) Mindset.
Contd...

Unit 4: Economic Value Added (EVA)
1. Measurement: Any company that wishes to implement EVA should institutionalise Notes
the process of measuring the metric regularly. This measurement should be carried
out after carrying out the prescribed accounting adjustments.
2. Management system: The company should be willing to align its management system
to the EVA process. The EVA-based management system is the basis on which the
company should take decisions related the choice of strategy, capital allocation,
merger and acquisitions divesting business and goal setting.
3. Motivation: Companies should decide to implement EVA only if they are prepared
to implement the incentive plan that goes with it. An EVA-based incentive system,
however, encourages managers to operate in such a way as to maximize the EVA
not just of the operations they oversee, but of the company as whole.
4. Mindset: The effective implementation of EVA necessitates a change in the culture

and mindset of the company. All constituents of the organisation need to be taught
to focus on the objective of maximising EVA. This singular focus leaves no room for
ambiguity and it is also not difficult for employees to know just what actions of
theirs will create EVA, and which will destroy it.
Self Assessment
1. EVA is ideally suited to private companies.
2. If a company’s EVA is positive, the firm is destroying shareholders wealth.
3. The excess of returns over cost of capital is simply termed as Economic Value Added
(EVA).
4. EVA measurement also requires a company to be more careful about resource mobilization,
resource allocation and investment decisions.
5. EVA measures whether the operating profit is sufficient enough to cover cost of capital.
4.2 Approaches to Computation of EVA
The pure EVA calculation for the company as a whole is:
Net Operating Profit After Taxes (NOPAT) — Capital Charge (Capital Investment × Cost of
Capital)
But purely speaking, there is no net operating profit after taxes (NOPAT) arising out of an IT
investment, so the net financial benefits of the IT investment are used as a replacement for
NOPAT.
Example: Consider, for instance, a case where the cost-benefit analysis reveals that a
` 50,000 IT investment will return `8,000 in net quantifiable benefits. The ROI is 16% (` 8,000
divided by ` 50,000). The cost of capital in the company is 12%. Using the formula above, the EVA
in this case is ` 2,000.
` 8,000 net benefits - (` 50,000 capital investment × 12% cost of capital) = ` 2,000 EVA
Another way to calculate EVA in this example is to simply deduct the 12% cost of capital from
the 16% ROI, then multiply by the investment:
4% × `50,000 = ` 2,000 EVA

Notes
!
Caution EVA is always expressed as a rupee amount.
While calculating of NOPAT, the non-operating items like dividend/interest on securities invested
outside the business, non-operating expenses, etc., will not be considered. The total capital
employed is the sum of shareholders funds as well as loan funds. But this does not include
investments outside the business. In determining WACC, cost of debt is taken as cost after tax
and the cost of equity is measured on the basis of Capital Asset Pricing Method (CAPM). CAPM
is traditionally used by the founders of EVA. Under CAPM, Cost of Equity (Ke) is given by the
following:
Ke = Rf + bi (Rm - Rf)
Where,
Rf = Risk free return
Rm = Expected market rate of return
b i = Risk coefficient of particular investment
EVA is expressed in terms of rupee figure and not as a percentage i.e., EVA measures the
absolute rupee value of wealth created. EVA calculation removes the distinction between the
providers of capital because the total capital employed in the business is taken, whether provided
by shareholders or creditors. The EVA figure measures the value added after the claims or
expectations of each of the group of capital providers have been met.
EVA calculation involves calculating the three figures NOPAT, TCE and WACC; EVA requires
some of the following adjustments for the accounting figures:
4.2.1 Adjustments to ‘Net Operating Profit after Tax’
The adjustments suggested for Net Operating Profit after Tax (NOPAT) are as follows:
The depreciation charge, if excessive, needs adjustments.
Certain marketing expenses like advertising or sales promotion for a new brand launch
are capitalized and amortised over the period during which benefits will be reaped.
Goodwill of an acquired business, if written off, is capitalized and adjusted in NOPAT and
equity.
Expenses incurred on employee training will provide benefits over a period, so these
expenses are to be capitalized.
Accounting principles allow companies to write-off research and development expenses,

but these expenses may not be truly revenue in nature. For successful R&D projects, EVA
calculations writes back the R&D expenses and amortises them over a period during
which benefits of the successful R&D projects will be reaped. The NOPAT figure calculated
from Profit and Loss account is adjusted by adding back the R&D expenses and capitalizing
them in the balance sheet. Only these R&D expenses that have no future value are charged
to the Income statement.
During periods of rising prices companies save taxes by adopting the LIFO system of
inventory valuation. Under the LIFO method, costs of the recently acquired raw material
are charged to the production while the costs of earlier purchases are accumulated in
inventory thereby understanding the inventory and the profits. For calculating EVA the
LIFO system of valuation is changed to FIFO basis, which is a better basis for estimating

current replacement costs. NOPAT and Equity are adjusted for this change from LIFO to Notes
FIFO by adding the difference between the LIFO and FIFO inventory (or LIFO and FIFO
cost of goods sold) to the equity and NOPAT. This way the tax benefits of LIFO are
retained.
Deferred taxes arise due to the difference in timing of recognition of revenues and expenses
for financial reporting versus reporting for tax purposes. It is basically the accumulation
of the difference between accounting provision of taxes and the tax amount actually paid
under the head ‘Reserve for deferred taxes’. NOPAT is adjusted for the tax actually paid,
instead of the accounting provisions. The reserves for deferred taxes are added to the
equity.
Operating leases are to be capitalized. The net present value of the lease payments is
capitalised.
Restructuring expenses and such other expenses, which will benefit the firm in the long
run, are capitalised and written-off over a period.
Other adjustments like adding back the provision for warranty claims, provisions for bad
and doubtful debts are also made. They are accounted for on cash basis. Similarly, other
non-cash bookkeeping entries are adjusted and accounted for on cash basis.
Provision for gratuity and pension should be recognised and provided for properly.
4.2.2 Adjustment to ‘Capital Employed’
For calculation of correct EVA, the following adjustments are required to be made for capital
employed:
The capital employed can be calculated through the assets side of the balance sheet or the
liability side. From the asset side, capital employed is the current assets less the non-
interest bearing current liabilities, i.e., the net working capital plus and net fixed assets.
From the liabilities side, it is the sum of interest bearing debt (short-term as well as long-
term) and net worth less and non-operating assets.
Use the beginning of the year capital employed for calculating EVA as this was the capital
available to the management to earn the returns and it helps in evaluating capital budgeting
decisions.
It is prudent to use the book value figure in the EVA calculations, as this is the amount that
has been entrusted to the management to employ in the business. The market value of a
firm is the investor’s capital and it is not the same as the firm’s capital. The capital employed
that earns operating profits is the book value of net assets and not the market value of a
firm’s stock.
4.2.3 Adjustment to ‘Cost of Capital’
The third element in EVA calculation is the cost of capital, which is the weighted average of the
cost of debt, cost of equity capital and cost of preference capital, if any.
While the cost of debt is the average interest rate paid by the company on its debt, the cost of
equity can be found out using the Capital Asset Pricing Model (CAPM) and the cost of preference
shares can be taken as the fixed rate of dividend.

Notes
Example: Calculate EVA from the following data for the year ended 31st March 2005:
(` crores)
Average debt 50
Average equity 2760
Profit after tax, before exceptional item 15.4
Interest after taxes 5
Cost of debt (post tax) 7.724
Cost of equity 16.7
Weighted average cost of capital 16.54
Source Amount (` Crores) Proportion Cost of capital (%) Weighted cost of capital
Equity 2,766 0.982 16.70 16.40
Debt 50 0.018 7.72 0.14
Total 2,816 1.000 WACC = 16.54
Cost of Capital Employed (COCE) = 2,816 x 16.54/100 = ` 465.77 crores.
(` crores)
Profit after tax, before exceptional items 1,540
Add: Interest, after taxes 5
Net operating profit after tax (NOPAT) 1,540
EVA = NOPAT - COCE = 1,546 - 465.77 = ` 1,080.23 crores.
Self Assessment
Fill in the blanks:
6. EVA is always expressed as a ……… amount.
7. …………. is traditionally used by the founders of EVA.
8. The EVA figure measures the ……………after the claims or expectations of each of the
group of capital providers have been met.
9. EVA calculation involves calculating the three figures NOPAT, TCE and ……………...
4.3 Applications of EVA
Firms compete with each other for acquiring scarce capital from shareholders. To be able to get
the capital, a firm must perform better than those of its competitors. It must earn more than
earned by similar risk-seekers. If it can achieve this objective, it has created value for the
shareholders and its stock price will command a higher premium in the market. In using the
EVA system, employees’ focus is on how the capital is being used on the cash flows generated to
it. EVA makes managers care about managing assets as well as income, and helps them properly
assess the trade-off between the two. EVA forces managers to focus on value creating activities
rather than wasting time and energy on playing with the accounting principles. The EVA based
bonus system is based on performance of employees and managers. They are rewarded for
increasing EVA relative to target, and are penalized for falling short. There is no upper limit of
bonus. The incentives of employees and managers increase as they keep on increasing EVA

relative to target. The EVA target is set for every year on the basis of a standardized acceptable Notes
formula. At the beginning of each year, the list of participating employees for the EVA bonus
plan is disclosed along with the formula for calculating bonus on the basis of EVA. The formula
is so transparent that each eligible employee can calculate his or her bonus without waiting for
the authority to announce the same. The success of EVA lies only in its linking with the
compensation plan. EVA would be effective only when the corporate decision-makers and even
the rank and file officers get bonus linked to improvement in EVA.
4.4 Superiority of EVA

EVA is a superior measure of corporate performance and reflects all the dimensions by which
management can increase value. It helps in creation of wealth in the following ways:
EVA is most directly linked to the creation of shareholder’s wealth over time. The term
‘maximising value’ in the EVA context, means maximising long-term yield on shareholders
investment and not just the absolute amount of earnings/profits.
The mechanism of EVA forces management to expressly recognize is cost of equity in all
its decisions from the boardroom to the shop floor. The inclusion of this element in
overall cost of capital results into the goal congruence of the managers and owners.
An EVA financial management system removes all the inconsistencies resulting from the
use of different financial measures for different corporate functions under the typical
traditional financial management system, as it ties all the functions; for instance:
Reviewing a capital budgeting process,
Valuing an acquisition,
Considering strategic plan alternatives,
Assessing performance,
Communicating,
Rewarding management.
To one single measure - the effect on shareholder value and thus provides a meaningful
target to pursue for both internal and external-oriented decisions.
EVA compensation system ties management’s interest with those of shareholders.
EVA captures the performance status of corporate system over a broader canvas i.e., to
arrive at true profits, cost of borrowed capital as well as cost of equity capital should be
deducted from net operating profits. Further, to maximize earnings is not sufficient, at the
same time consumption of capital should be minimum optimum under an EVA-based
system.
EVA framework provides a clear perception of underlying economics of a business and
enables managers to make better decisions.
A regular monitoring of EVA emphasises on problem areas of a company and helps
managers to take corrective actions.
It is used to assess the likely impact of competing strategies on shareholder’s wealth and
thus helps the management to select the one that will best serve shareholders.
It also fits well with the concept of corporate governance. EVA bonus systems do this by
giving employees an ownership stake in improvements in the EVA of their divisions or
operations. This causes employees to behave like owners and reduces or eliminates the
need for outside interference in decision-making.

Notes EVA also helps in brand valuation. The brand equity or value created by a particular
business unit for its brand could be equated with the value of wealth that the brand has
generated over a period of time.
Task Make a discussion on some other approaches of value addition.
Self Assessment
Fill in the blanks:
10. The success of EVA lies only in its linking with the …………… plan.
11. EVA makes managers care about managing assets as well as income, and helps them
properly assess the …………between the two.
12. The mechanism of EVA forces management to expressly recognize is …………in all its
decisions from the boardroom to the shop floor.
4.5 Shortcomings of EVA
The EVA concept is criticised for the following reasons:
EVA ignores inflation and it is biased against new assets. Whenever a new investment is
made, capital charge is on the full cost initially, so EVA figure is low. But as the depreciation
is written off, the capital charge decreases and hence EVA goes up. This problem existed
with measures like ROI.
Since EVA is measured in rupee terms, it is biased in favour of large, low return business,
Large business that have returns only slightly above the cost of capital can have higher
EVA than smaller business that earn returns much higher than the costs. This makes EVA
a poor metric for comparing businesses.
In the short run, EVA can be improved by reducing assets faster than the earnings and if
this is pursued for long it can lead to problems in the longer run when new improvements
to the asset base are mode. This new investment can have a high negative effect of EVA
because the asset base would have been reduced to a large extent and improvements will
involve will huge investments.
Notes Suggestions to Improve EVA
EVA is just a refinement of residual income. Residual income is defined as the difference
between profit and the cost of capital. It differs from EVA in the fact that profits and capital
employed are book figures i.e., the same appearing in the financial statements. No
adjustment to profit and capital employed figures as reported in profit and loss account
and balance sheet are made unlike EVA. It can be improved in any of the following ways:
Increasing NOPAT with the same amount of capital.
Reducing the capital employed without affecting the earnings i.e., discarding the
unproductive assets.
Investing in those projects that earn a return greater than the cost of capital.
Contd...

By reducing the cost of capital, which means employing more debt, as debt is cheaper Notes
than equity or preference capital.
The EVA concept is very closely related to the NPV concept. The present value of an
investment annual EVA stream is the same as its NPV. NPV analysis is a one-time measure
of the value added by an investment. EVA is a continuous annual value added measure.
Self Assessment
Fill in the blanks:
13. EVA ignores ……….. and it is biased against new assets.
14. EVA is just a refinement of …………….
15. …………..is defined as the difference between profit and the cost of capital.
4.6 Summary
Economic value added (EVA) is an important form of value addition.

EVA is ascertained as excess of return over cost of capital.
EVA measures whether operating profit is sufficient enough to cover cost of capital and
how much of EVA is generated to justify risk taken by the shareholders.
EVA can be improved by increasing returns, by reducing asset base, by reducing cost of
capital etc.
Participation of employees and managers in EVA is a modern concept of compensation

system for improving the corporate efficiency and results.
EVA forces managers to focus on value creating activities rather than wasting time and
energy on playing with the accounting principles.
The EVA based bonus system is based on performance of employees and managers.
EVA ignores inflation and it is biased against new assets. Whenever a new investment is
made, capital charge is on the full cost initially, so EVA figure is low.
4.7 Keywords
Economic Value Added (EVA): EVA is a management philosophy and performance metric that
elevates those goals from intuition to rigorous analysis and ensures that no investment escapes
scrutiny.
Return on Investment: It is the earning capability of the unit/company on the capital investment.
Total capital employed: The total capital employed is the sum of shareholders funds as well as
loan funds.
1. EVA holds a company accountable for the cost of capital it uses to expand and operate its
business and attempt to show whether a company is creating a real value for its
shareholders. Discuss.
2. What is Economic Value Added (EVA)? What does EVA show? When will EVA increase?

Notes 3. Illustrate the approaches to compute EVA.
4. EVA calculation involves calculating the three figures NOPAT, TCE and WACC. Discuss.
5. Discuss various aspects of computation of Economic Value Added and its application in
business planning and valuation.
6. “EVA is a superior measure of corporate performance and reflects all the dimensions by
which management can increase value”. Elucidate.
7. What are the key steps of calculating EVA?
8. Make some suggestions to improve EVA.
9. What are the shortcomings of EVA?
10. CAPM is traditionally used by the founders of EVA. Discuss.
1. false 2. false
3. true 4. true
5. true 6. rupee
7. CAPM 8. value added
9. WACC 10. compensation
11. trade-off 12. cost of equity
13. inflation 14. residual income
15. Residual income

www.scribd.com

Dilfraz Singh, Lovely Professional University Unit 5: Social Reporting
Unit 5: Social Reporting Notes
CONTENTS
Objectives
Introduction
5.1 Meaning and Nature of Social Reporting
5.2 Need of Social Reporting
5.3 Scope of Social Reporting
5.4 Models of Social Disclosure
5.5 Summary
5.6 Keywords
Objectives
Explain the meaning and nature of social reporting
Identify the need of social reporting
Describe the models of social disclosure
Introduction
Social reporting is reporting on those activities of an organisation that have an impact on

society at large and are not necessarily represented by its traditional financial report.
Aspects included in social reporting include such information disclosed in the annual reports
viz., Statement on Human Resource Accounting, Statement of Value Added Report on Foreign
Currency Transactions (revealing the balance of payments position) and Accounting for Various
Social Objectives. Social and ethical accounting, auditing and reporting is still relatively new in
many developing or third world nations, but is gaining acceptance internationally as the primary
demonstration of social accountability.
Did u know? What do you mean by social report?
A social report is the result of a thorough evaluative process focused on the social impact
of a business on its various stakeholders.
5.1 Meaning and Nature of Social Reporting

As discussed above, social reporting measures and reports the social costs and benefits on
account of operating activities of a business enterprise. The concept of social reporting is gaining
popularity on account of the following factors:
Increasing awareness of society regarding the contributions the corporate units are making.
Providing meaningful means of identifying and rewarding business for social contribution.

Notes Identifying adverse effects on the environment of the business houses.
Social reporting improves credibility and reputation of business.
Transferring cost of social activities to other segments of society.
Social reporting is a rational assessment of and reporting on some meaningful, definable domain
of a business enterprises activities that have social impact. This reporting aims at measuring
(either in monetary or non-monetary units) adverse and beneficial effects of such activities both
on the firms and/or those affected by the firm. Being concerned with the social, human and
environmental constraints on organizational behaviour, it measures social costs and benefits.
The social reporting information is communicated to social groups both within and outside the
firm. Thus social reporting implies the measurement and reporting, internal or external, of
information concerning the impact of a business enterprise and its activities on society.
The concept of social responsibility extends beyond the provisions embodied in current law.
Essentially, it represents an emerging debate having its roots in political and social theory.
While designing the contents to be included in social reporting, due care should be taken to see
that it does not conflict with the shareholders’ interest. Social reporting presently is being either
included in the Annual Reports or finds some reference in the Chairman’s Address or the
Director’s Report. Social reporting format tends to vary from one company to another company
as till date no format has been described by any Act in India.
Social Corporate Reporting in India
In India, the Companies Act 1956 deals with the preparation of balance sheet and profit and loss
account. The Act requires the auditor to make report under Section 227 to members (shareholders)
and express an opinion whether the company’s balance sheet ad profit and loss account exhibit
true and fair view of the company’s state of affairs.
Although, this Act has been amended from time to time, no specific provision has been made
requiring companies to provide social responsibility disclosures to their annual reports. The
Government of India appointed a Committee under the chairmanship of Justice Rajinder Sachar
to consider and report on the changes that are necessary in the form and structure of the Act. The
Committee (1978) recommended the inclusion of the following, inter alias, in the directors
report:
“Steps taken by the company in various spheres with a view to discharging its social
responsibilities towards different segments of the society, quantifying where possible and in
monetary terms. The Board should also reports on the future plans of the company towards the
discharge of its social responsibilities and duties.”
Some Indian companies have made attempts to provide information on their responsibility
activities in published annual reports and/or through separate means of disclosure. Some
companies prepare social income statements and social balance sheets and report them in their
published annual reports.
Notes List of Social Indicators
Quality of Management
Human Rights
Environmental Performance
Contd...

Unit 5: Social Reporting
Health and Safety Notes
Stakeholder Relationships
Corporate Social Investment
Employment Equity
Products and Services
Self Assessment
Fill in the blanks:
1. ……………is reporting on those activities of an organisation that have an impact on

2. The concept of ………….extends beyond the provisions embodied in current law.
3. Social reporting presently is being either included in the Annual Reports or finds some
reference in the Chairman’s Address or the …………..Report.
4. Social reporting ………….. tends to vary from one company to another company as till
date no format has been described by any Act in India.
5. A social report is the result of a thorough evaluative process focused on the social impact
of a business on all its various …………….
5.2 Need of Social Reporting
It has now become important for companies to identify society’s changing needs. Only a project
that yields economic return while satisfying social priorities should be accepted. Thus, the
priorities of the society in today’s environment need to be looked at. In addition to this, there
has been an increase in the number of ethical investors who believe that they should avoid
investing in those companies that are believed to be causing social injury or environmental
damage of one type or the other. So social reporting is equally important for both the management
and the society.
The following are the key objectives of social reporting:
To identity, measure and report the net social contribution of an individual firm towards
society, this includes not only the costs and benefits of a firm internally but also those
arising from external factors affecting the different segments of the society.
To determine whether the individual firm’s strategies and practices are consistent with
widely shared social principles of the society.
Example: Discrimination on the basis of caste, creed or sex will not be considered a good
practice by the society.
To make available relevant information about the firm’s goals, policies, programmes,
performances, use of and contribution to scarce resources etc. Relevant information is that
which provides for public accountability and also facilitates public decision-making
regarding capital choices and social resources allocation.
Example: Indian companies have to disclose their use and earnings of foreign exchange.

Notes
Notes Suggestions for Better Social Reporting
With the changing social and economic realities there is a need for reorienting the
accounting system to serve the public interest in the widest context and meaning. In order
to witness better social reporting by the business houses the following suggestions are
offered:
1. Reorienting the Accounting System: The accounting system should be designed in a

way that incorporates some aspects of social reporting.
2. Statutory Provision in the Companies Act, 1956: It is suggested that Company Law
may be amended in a way to make such disclosures mandatory for the company. It
is also suggested that the Sachar Committee Report should be implemented. In
addition to it the memorandum of association should contain a clause that states
about the social obligations of the company.
3. Proper Format for Social Reporting: It is suggested that the social reporting format
may be devised on the lines of Final Accounts format. This will not only bring about
uniformity in reporting, but will also make the reports better understood by the
readers. In order to make social reporting more effective and useful, attempts should
be made by accountants, accounting bodies, social scientists and accounting
researchers to develop a useful and feasible social reporting framework.
4. Social Reporting Disclosures be developed: It is suggested that like other accounting

disclosures, a social reporting disclosure may be developed.
5. Social Audit: There should be a mandatory requirement on the part of the auditor to
make a specific mention in his report about the manner in which social aspects are
reported.
6. Proper Publication: There should be regular publication of the social accounts. This
will help to study the comparative social performance of the company. Further,
after a certain fixed amount of turnover, the company should be subjected to
compulsory annual/periodical social audit.
Self Assessment
Fill in the blanks:
6. Social reporting is equally important for both the ………… and the society.
7. There should be regular …………. of the social accounts.
8. Relevant information is that which provides for public accountability and also facilitates
public decision-making regarding capital choices and ……………..allocation.
5.3 Scope of Social Reporting

The following are the major aspects that are covered in social reporting:
Community Development: This includes activities benefiting the general public e.g., food
programme, community improvement and financing of health services, etc.
Human Resources: This area includes social performance directed towards the well being
of employees. For example, training programmes, promotion policies and provision for
job enrichment, etc.

Environmental Contribution: Activities directed towards alleviating or preventing Notes

environmental deterioration (pollution), i.e., air, water, noise pollution. In addition, efforts
made by the organisation in conservation of scarce resources and disposal of waste, etc.,
are included.
Product or Service Contribution: This includes product quality, product safety, etc.
Notes Limitations of Social Reporting
Though the importance of social reporting is being recognised by many companies in

India, yet its progress is hindered due to the following reasons:
Lack of Clear-cut Definition of Social Reporting: Every enterprise adopts different

methods for measuring, reporting and evaluation social responsibility, as there is
no clear-cut definition and procedure for social reporting even.
Not Mandatory: Disclosure of social responsibility information is not presently

mandatory.
No Standard Format: There are no well-established concepts, conventions, postulate

and axioms to guide the social accountant in drafting his accounts and reporting.
Auditing Social Cost and Benefit is an Intricate Function: It is highly doubtful if

only accountancy scholars would be able to identify, document and audit the many
sided social effects of business behaviour and auditing social costs and benefits.
No Cadre of Social Auditors: As there is no separate cadre of social auditors, it is not

clear how and who will conduct such audit. This has also contributed to its slow
progress.
Social Reporting vs. Value Added Statements: Some business organisations mix
social reporting with value added statements, which to a large extent forfeits the
very purpose of social reporting.
Self Assessment
9. Disclosure of social responsibility information is mandatory for all organisations.
10. There are well-established concepts, conventions, postulate and axioms to guide the social
accountant in drafting accounts and reporting.
11. Some business organisations mix social reporting with value added statements.
12. Community development includes activities benefiting the general public e.g., food
programme, community improvement and financing of health services, etc.
5.4 Models Approaches of Social Disclosure
Social accounting measures and reports the social costs and benefits on account of operating
activities of a business enterprise. The following are the key models and approaches used for
reporting the social cost benefits:
1. Social statement approach: According to this approach, two statements are prepared
(i) Social Income Statement and (ii) Social Balance Sheet. The Social Income Statement

Notes provides information according to social benefits and costs to employees, local community
and the general public. Social balance sheet portrays social investment of capital nature
(i.e. social assets) viz. township, roads, buildings, hospitals, schools, clubs, etc. on the
assets side and the organisations equity and social equity on the liabilities side.
2. Operating statement approach: According to this approach, a firm presents only the
positive and negative aspects of social activities as a result of business operations. The
positive aspects are broadly termed as social benefits. While negative aspects are termed
as social costs.
!
Caution The difference between social benefits and social costs represent the net social
contribution by the firm.
3. Narrative approach: This is simplest and easiest method for reporting social costs and
social benefits information. In case of this approach, disclosure regarding social costs and
social benefits is made in a narrative and not in a quantitative form. The firm generally
highlights the positive aspects of its social activities.
Notes Important types of Social Accounts

1. A report on performance against the stated objectives.
2. An assessment of the impact on the community.
3. The views of stakeholders on our Objectives and Values.
4. A report on environmental performance.
5. A report on how we implement equal opportunities.
6. A report on our compliance with statutory and voluntary quality and procedural
standards.
Self Assessment
Fill in the blanks:
13. The …………….provides information according to social benefits and costs to employees,
local community and the general public.
14. ……………..portrays social investment of capital nature (i.e. social assets) viz. township,
roads, buildings, hospitals, schools, clubs, etc. on the assets side and the organisations
equity and social equity on the liabilities side.
15. In case of narrative approach, disclosure regarding social costs and social benefits is made
in a narrative and not in a ………….. form.
Task Identify the key Indian companies involved in social reporting.
5.5 Summary


Social reporting presently is being either included in the Annual Reports or finds some Notes
reference in the Chairman’s Address or the Director’s Report.
Social reporting format tends to vary from one company to another company as till date
no format has been described by any Act in India.
Social reporting is equally important for both the management and the society.
Social accounting measures and reports the social costs and benefits on account of operating
activities of a business enterprise.
According to social statement approach, two statements are prepared (i) Social Income
Statement and (ii) Social Balance Sheet.
According to operating statement approach, a firm presents only the positive and negative
aspects of social activities as a result of business operations.
5.6 Keywords
Social Balance Sheet: Social balance sheet portrays social investment of capital nature (i.e. social
assets) viz. township, roads, buildings, hospitals, schools, clubs, etc. on the assets side and the
organisations equity and social equity on the liabilities side.
Social Income Statement: The Social Income Statement provides information according to social
benefits and costs to employees, local community and the general public.
Social Reporting: Social reporting measures and reports the social costs and benefits on account
of operating activities of a business enterprise.
1. A social report is the result of a thorough evaluative process focused on the social impact
of a business on all its various stakeholders. Give some suggestions to support the
statement.
2. The concept of social responsibility extends beyond the provisions embodied in current
law. Discuss.
3. Social reporting is equally important for both the management and the society. How?
4. What are the key suggestions for better social reporting?
5. Discuss the scope of social reporting.
6. What are the key accounts prepared under social statement approach?
7. What are the key models of social disclosure?
1. Social reporting
2. social responsibility
3. Director’s
4. format
5. stakeholders

Notes 6. management
7. publication
8. social resources
9. false
10. false
11. true
12. true
13. Social Income Statement
14. Social balance sheet
15. quantitative

www.scribd.com

Amit Kumar Sharma, Lovely Professional University Unit 6: Human Resource Accounting
Unit 6: Human Resource Accounting Notes
CONTENTS
Objectives
Introduction
6.1 Meaning of HRA
6.2 Nature of HRA
6.3 Scope of HRA
6.4 HRA in India
6.5 Summary
6.6 Keywords
Objectives
Explain the meaning of HRA
Describe the nature of HRA
Identify the scope of HRA
Introduction
The past few decades have witnessed a global transition from manufacturing to service-based
economies. The fundamental difference between the two lies in the very nature of their assets. In
the former, physical assets like plant, machinery, material, etc., are of utmost importance. In
contrast, in the latter, knowledge and attitudes of the employees assume greater significance.
For instance, in the case of an IT firm, the value of its physical assets is negligible when compared
with the value of the knowledge and skills of its personnel. Similarly, in hospitals, academic
institutions, consulting firms, etc., the total worth of the organisation depends mainly on the
skills of its employees and the services they render. Therefore, the success of these organizations
is contingent on the quality of their human resource – their knowledge, skills, competence,
motivation and understanding of the organisational culture.
In knowledge-driven economies therefore, it is imperative that the humans be recognised as an

integral part of the total worth of an organisation. However, in order to estimate and project the
worth of human capital, it is necessary that some method of quantifying the worth of the
knowledge, motivation, skills, and contribution of the human element as well as that of the
organisational processes, like recruitment, selection, training, etc., which are used to build and
support these human aspects, is developed.
!
Caution Human Resource Accounting (HRA) denotes the process of quantification/
measurement of human resources.

Notes 6.1 Meaning of HRA
In simple words, human resource accounting is the art of, valuing, recording and presenting
systematically the worth of human resources in the books of account of an organisation. This
definition brings out three important aspects of human resource accounting:
(i) Valuation of human resources.
(ii) Recording the valuation in the books of accounts.
(iii) Disclosure of the information in the financial statements of the business.
The American Accounting Society Committee on human resource accounting defines it as follows:
“Human resource accounting is the process of identifying and measuring data about human
resources and communicating this information to interested parties.”
Mr. Woodruff Jr. Vice President of R.G. Barry Corporation defines human resources accounting
as: “Human resource accounting is an attempt to identify and report investments made in the
human resources of an organisation that are presently not accounted for in conventional
accounting practice. Basically, it is an information system that tells the management what changes
over time are occurring to the human resources of the business.”
The American Accounting Association’s Committee on Human Resource Accounting (1973) has
defined Human Resource Accounting as “the process of identifying and measuring data about
human resources and communicating this information to interested parties”. HRA, thus, not
only involves measurement of all the costs/investments associated with the recruitment,
placement, training and development of employees, but also the quantification of the economic
value of the people in an organisation.
Flamholtz (1971), too has offered a similar definition for HRA. He defines HRA as “the
measurement and reporting of the cost and value of people in organizational resources”.
As far as statutory requirements go, the Companies Act, 1956 does not demand furnishing of
HRA related information in the financial statements of the companies. The Institute of Chartered
Accountants of India too, has not been able to bring any definitive standard or measurement in
the reporting of human resources costs. While the chairmen in their AGMs often make qualitative
pronouncements regarding the importance of human resources, quantitative information about
their contribution is rarely recorded or communicated. There are a few organizations, however,
that do recognize the value of their human resources, and furnish the related information in
their annual reports.
Example: In India, some of these companies are: Infosys, Bharat Heavy Electricals Ltd
(BHEL); Steel Authority of India Ltd. (SAIL), Minerals and Metals Trading Corporation of India
Ltd. (MMTC), Southern Petrochemicals Industries Corporation of India (SPIC), Associated Cement
Companies Ltd, Madras Refineries Ltd., Hindustan Zinc Ltd., Engineers India Ltd, Oil and Natural
Gas Commission (ONGC), Oil India Ltd., Cement Corporation of India Ltd., etc.
Objectives of HRA
The following are the key objectives of HRA:
To furnish the information for making the decisions at the investors’ and managers’ level
To evaluate the return on human investment through the results
To report the worth of human resources to the organization and society

Unit 6: Human Resource Accounting
Self Assessment Notes
Fill in the blanks:

1. Human Resource Accounting (HRA) denotes the ………….. of quantification/measurement
of human resources.
2. Human resource accounting is the art of, valuing, recording and …………… systematically
the worth of human resources in the books of account of an organisation.
3. The ………….does not demand furnishing of HRA related information in the financial
statements of the companies.
6.2 Nature of HRA
Like any accounting exercise, HRA too depends heavily on the availability of relevant and
accurate information. HRA is essentially a tool to facilitate better planning and decision-making
based on the information regarding actual HR costs and organisational returns. The kind of data
that needs to be managed systematically depends upon the purpose for which HRA is being
used by an organisation.
Example: If the purpose is to control the personnel costs, a system of standard costs for
personnel recruitment, selection and training has to be developed. It helps in analysing projected
and actual costs of manpower and thereby, in taking remedial action, wherever necessary.
Did u know? What is the role of information on turnover cost?

Information on turnover costs generates awareness regarding the actual cost of turnover
and highlights the need for efforts by the management towards retention of manpower.
Accountability in the management process is often enhanced when information involving an
evaluation of managerial effectiveness is generated. Finally, information on the intangibles
like intellectual capital/human capital becomes necessary to measure the true worth of the
organisation. This information, though unaudited, needs to be communicated to the board and
the stockholders.
Notes Significance of Human Resources Accounting

Human Resources Accounting provides useful information to the management, financial
analysts and employees, as shown below:
1. Human Resources Accounting helps the management in the decision-making process
relating to the following matters:
Employment, locating and utilisation of human resources.
Transfers, promotions, training and retrenchment of human resources.
Planning of physical assets vis-à-vis human resources.
Evaluating the expenditure incurred for imparting further education and
training to employees in terms of the benefits derived by the firm.
Identifying the causes of high labour turnover at various levels and taking
preventive measures to contain it.
Contd...

Notes Locating the real cause of low return on investment, that is whether it is due
to improper or under-utilisation of physical assets or human resource of
both.
2. A financial analyst is interested in understanding and assessing the inner strength of

the firm. Such inner strength does not merely depend on the physical assets owned
and possessed by the firm. In case the human resources, specially the managerial
resources at the disposal of the firm are impartially and systematically valued and
disclosed in the financial statements, it will be a valuable information for persons
interested in making long-term investment in the firm.
3. The Human Resource Accounting helps individual employees in improving their

performance and bargaining power. It makes each of them conscious of the
contribution that he is making towards the betterment of the firm vis-à-vis the
expenditure incurred by the firm on him.
Self Assessment
Fill in the blanks:
4. HRA is essentially a tool to facilitate better planning and ……………….based on the

information regarding actual HR costs and organisational returns.
5. The kind of …………. that needs to be managed systematically depends upon the purpose
for which HRA is being used by an organisation.
6. Information on ……………generates awareness regarding the actual cost of turnover and

highlights the need for efforts by the management towards retention of manpower.
7. The Human Resource Accounting helps individual employees in improving their

performance and ………………...
6.3 Need and Scope of HRA
According to Likert (1971), HRA serves the following purposes in an organisation:
1. It furnishes cost/value information for making management decisions about acquiring,

allocating, developing, and maintaining human resources in order to attain cost-
effectiveness.
2. It allows management personnel to effectively monitor the use of human resources.
3. It provides a sound and effective basis of human asset control, that is, whether the asset is
appreciated, depleted or conserved.
4. It helps in the development of management principles by classifying the financial

consequences of various practices.
Basically, HRA is a management tool that is designed to assist senior management in

understanding the long-term cost and benefit implications of their HR decisions so that better
business decisions can be taken. If such accounting is not done, then the management runs the
risk of taking decisions that may improve profits in the short run but may also have severe
repercussions in future. For example, very often organisations hire young people from outside
on very high salaries because of an immediate business requirement. Later on, however, they
find that the de-motivating impact of this move on the existing experienced staff has caused
immense long-term harm by reducing their productivity and by creating salary distortions
across the organisational structure.

HRA also provides the HR professionals and management with information for managing the Notes
human resources efficiently and effectively. Such information is conserving, utilizing, evaluating
and rewarding in a proper way. These functions are the key transformational processes that
convert human resources from ‘raw’ inputs (in the form of individuals, groups and the total
human organization) to outputs in the form of goods and services. HRA indicates whether these
processes are adding value or enhancing unnecessary costs. In addition to facilitating internal
decision-making processes, HRA also enables critical external decision-makers, especially the
investors in making realistic investment decisions. Investors make investment decisions based
on the total worth of the organisation. HRA provides the investors with a more complete and
accurate account of the organisations’ total worth, and therefore, enables better investment
decisions. For example, conventional financial statements treat HR investments as “expenditures.
Consequently, their income statement projects expenditures to acquire, place and train human
resources as expenses during the current year rather than capitalizing and amortising them over
their expected service life. The balance sheet, thus, becomes distorted as it inaccurately presents
the “total assets” as well as the “net income” and, thereby, the “rate of return” which is the ratio
of net income to the total assets. HRA helps in removing this distortion.
Furthermore, in a business environment where corporate social responsibility is rapidly gaining

ground, HRA reflects the extent to which organisations contribute to society’s human capital by
investing in its development. Finally, in an era where performance is closely linked to rewards,
the performance of all groups/departments/functions needs to be quantified to the extent
possible. HRA helps in measuring the performance of the HR function as such.
Notes Objections or limitations against Human Resources Accounting

The following are some of the common objection against Human Resource Accounting:
1. Human beings cannot be owned like other physical assets. They, therefore, cannot
command any value.
2. Tax laws do not recognise human beings as assets. Hence, human resource accounting
remains merely as a theoretical concept.
3. There is no generally accepted model for valuation of human resources. The mode
of presentation has also not yet been codified.
4. The valuation of human resources depends on a large number of abstract factors not
measurable in precise monetary terms. Hence, the valuation lacks objectivity and
preciseness.
Self Assessment
8. HRA helps in the development of management principles by classifying the financial

consequences of various practices.
9. Tax laws recognise human beings as assets.
10. HRA does not help in measuring the performance of the HR function.
Task Identify the difference between HRA and historical accounting.

Notes 6.4 HRA in India
In India, the financial statements of companies have to be prepared as per the provisions of the
Companies Act, 1956. The Act does not provide for disclosure of any significant information
about human resources employed in a company except that the companies have to give by way
of a note to the Profit & Loss Account, particulars of employees getting remuneration of
` 6,00,000 per annum or more. However, there is nothing in the Act which prevents a company
from giving details about its human resources byway of supplementary information attached
with its financial statements.
In view of the growing importance of human resource accounting, many corporate enterprises
in India are voluntarily giving information about their human resources. They number about 15
in all and include many important public sector enterprise viz. Bharat Heavy Electricals Ltd.
(BHEL), Steel Authority of India Ltd. (SAIL), Minerals and Metal Trading Corporation of India
(MMTC), National Thermal Power Corporation (NTPC), Oil and Natural Gas Commission
(ONGC) and Engineers India Ltd. (EIL), Among all these enterprises BHEL is the pioneer in the
field of human resource accounting since mid-1 970.
Most of the Indian companies and corporations have followed basically Lev and Schwartz
Model for valuation of human resources. This is one of the popular methods in India, which
discounts the future earnings of human resource into present value till the retirement age.
It
Vy = (1 + R ) t − y
Vy = Human capital value of a person up to y years old
It = the personal annual earnings up to retirement
R = discount rate specific to the person
6.5 Summary
Human resource accounting is the art of, valuing, recording and presenting systematically
the worth of human resources in the books of account of an organisation.
The American Accounting Association’s Committee on Human Resource Accounting (1973)

has defined Human Resource Accounting as “the process of identifying and measuring
data about human resources and communicating this information to interested parties”.
Like any accounting exercise, HRA too depends heavily on the availability of relevant and
accurate information.
HRA is essentially a tool to facilitate better planning and decision-making based on the
information regarding actual HR costs and organisational returns.
Human Resources Accounting provides useful information to the management, financial

analysts and employees.
HRA is a management tool that is designed to assist senior management in understanding

the long-term cost and benefit implications of their HR decisions so that better business
decisions can be taken.
HRA also provides the HR professionals and management with information for managing
the human resources efficiently and effectively.

6.6 Keywords Notes
Historical Accounting: Under historical accounting system, accounts are prepared without regard
to changes in the price levels.
Human Resource Accounting: Human resource accounting is the art of, valuing, recording and
presenting systematically the worth of human resources in the books of account of an organisation.
1. What is HRA? Why HRA?
2. How HRA is different form conventional accounting? Discuss with suitable example.
3. Like any accounting exercise, HRA too depends heavily on the availability of relevant and
accurate information. How?
4. Human Resources Accounting provides useful information to the management, financial

analysts and employees. Identify the key informations.
5. Identify the scope of HRA.
6. What are the key objections against HRA?
1. Process
2. Presenting
3. Companies act 1956
4. Decision making
5. Data
6. Turnover cost
7. Bargaining power
8. True
9. False
10. False

www.scribd.com

Contemporary Accounting Amit Kumar Sharma, Lovely Professional University
Notes Unit 7: Approaches of HRA
CONTENTS
Objectives
Introduction
7.1 Cost Approach
7.1.1 Historical Cost Approach
7.1.2 Replacement Cost Approach
7.1.3 Opportunity Cost Approach
7.1.4 Standard Cost Approach
7.1.5 Present Value Approach
7.2 The Economic Value Approach
7.2.1 Monetary Measures for Assessing Individual Value
7.2.2 Non-monetary Methods for Determining Value
7.3 Measurement of Group Values
7.3.1 Managerial and Peer Leadership
7.3.2 Organisational Climate
7.3.3 Group Process
7.3.4 Satisfaction
7.4 Recording and Disclosure in Financial Statement
7.5 Summary
7.6 Keywords
Objectives
Describe the cost and economic approach of HRA
Measure group values
Illustrate the recording and disclosure in financial statements
Introduction
The biggest challenge in HRA is that of assigning monetary values to different dimensions of
HR costs, investments and the worth of employees. The two main approaches usually employed
for this are:
1. The cost approach, which involves methods based on the costs incurred by the company,
with regard to an employee.
2. The economic value approach, which includes methods based on the economic value of
the human resources and their contribution to the company’s gains. This approach looks

Unit 7: Approaches of HRA
at human resources as assets and tries to identify the stream of benefits flowing from the Notes
asset.
7.1 Cost Approach
The cost approaches includes the following approaches:
7.1.1 Historical Cost Approach
According to this approach, the actual cost incurred on recruiting, selecting, hiring, training and
developing the human resources of the organisation are capitalised and written off over the
expected useful life of the human resources. The historical cost of human resources in case of this
method is thus treated in the same manner as the cost of any other physical asset. Any expenditure
incurred for training or development of the human resources increases the value of human
assets like any other physical asset and is therefore capitalised in a similar manner. Amortization
of the human assets is also done in a similar manner. In case the human asset expires before the
end of the expected service life period, the whole of the amount not written off is charged
against the revenue of the year in which such an event takes place.
!
Caution In case the useful life is recognised to be longer than the original expected,
amortization is appropriately rescheduled.
Merits of Historical Cost Approach
The method has the following merits:
The method is simple to understand and easy to work out.
The method follows the traditional accounting concept of matching cost with revenue.
The method can provide a basis for valuing a firm’s returns on its investment on human
resources.
Limitations of Historical Cost Approach
The method suffers from the following limitations:

The method takes into account only a part of acquisition cost of employee. It does not
consider the aggregate value of their potential services.
It is difficult to estimate the period over which the human resource will provide service to
the organisation. It thus creates problems in determining the amount to be amortized
over the year.
The value of human assets according to this method goes on decreasing every year due to
amortization. However, in reality, the value of human assets increases over time on
account of people gaining experience.
7.1.2 Replacement Cost Approach
This approach was developed by Rensis Likert and Eric G. Flamholtz. This approach values the
human resources at their present replacement cost. In other words, human resources of an
organisation are to be valued on the basis of the assumption of what it would cost the firm if the
existing human resources need to be replaced with others of equivalent talents and experience.

Notes
Did u know? What is replacement cost?
Replacement cost occurs only at the moment of replacing the resources which is mainly
based on the current value approach.
The approach is similar to the historical cost approach mentioned above except that it allows for
changes in the cost for acquiring, training and developing the employees in place of taking their
historical cost for capitalisation.
Merits of Replacement Cost Approach
The method has the following merits:
The approach incorporates the current value of the firm’s human resources. Thus, the
financial statements prepared according to this approach are more realistic as compared
to those prepared under historical cost approach.
The method is more representative and logical.
Limitations of Replacement Cost Approach
The method has the following limitations:
The method is at variance with conventional accounting practice of valuing assets at

historical costs.
It is almost impossible to ascertain correct replacement cost of existing human resources

since there can be no complete replacement for them.
There is no objective way for determination of replacement cost. Personal prejudices do

work. Moreover, there is no foolproof method for verification of replacement cost.
7.1.3 Opportunity Cost Approach
This approach has been suggested by Hekimian and Jones. According to this approach, the value
of an employee is determined according to his alternative use. In case an employee has no
alternative use, no value will be placed on him. This approach specifically excludes those types
of employees who can be hired readily from outside. The approach suggests competitive bidding
process for the scarce employees in an organisation. It means that the opportunity cost is linked
with scarcity. The opportunity cost of an employee or a group of employees in one department
is calculated on the basis of the offers (bids) by other departments for those employees. This will
be clear from the following example.
Example: A company has two departments X and Y. The amount of capital employed (in
physical assets) in department X and Y is `10 lakhs and ` 5 lakh respectively. The required rate
of return on total capital employed (physical as well as human) is 15%. It is projected that with
the employment of a specific group of technocrats, department X can make a profit of ` 3 lakhs
while department Y can make a profit of ` 2.5 lakhs.
The capitalised value of profit with the technocrats at the rate of 15% comes to ` 20 lakhs in case
of department X and `16.67 lakhs for department Y. In case the value of physical assets is
deducted from these figures, the value of human resources comes to ` 10 lakhs in case of
department X and `11.67 lakhs in case of department Y. Hence, department Y can offer a higher
bid for the technocrats as compared to department WIPRO.

In terms of salary, department X can offer a salary of ` 1.50 lakhs (` 10 lakhs × 15%) while Notes
department Y up to `1.75 lakhs (` 11.67 × 15%). Department Y, thus, also offer a high salary.
Department Y will have the technocrats on account of a higher bid and it will include ` 11.67
lakhs as its investment in human resources.
Merits of Opportunity Cost Approach
According to the authors of this approach, a bidding process, such as this, is a promising approach
towards (a) more optimal allocation of personnel and (b) a quantitative base for planning,
evaluating and developing human assets of the firm.
Limitations of Opportunity Cost Approach
This approach has several limitations:
It has narrowed down the concept of opportunity cost by restricting it to the best use of the
employee within the same organisation.
It has specifically precluded from its purview those employees who are not scarce or, are
not being bid by other department. This is likely to result in lowering of morale and
productivity of the employees, who are not covered by the competitive bidding process.
The total valuation of human resources based on this method may be misleading and
inaccurate. This is because a person may be an expert in a particular area and therefore
may be useful for one department, but useless for another department Thus, he may be a
valuable person for the department he is working and command a high value. However,
he may have a lower price in the bid by the other department where his services are not at
all required.
7.1.4 Standard Cost Approach
David Watson has suggested this approach. According to this approach, standard costs of
recruiting, hiring, training and developing per grade of employees are determined year after
year. The standard cost so arrived at for all human beings employed in the organisation is the
value of human resources for accounting purposes.
The approach is easy to explain and can work as a suitable basis for control purposes through the
technique of variance analysis. However, determination of the standard cost for each grade of
employee is a ticklish process.
7.1.5 Present Value Approach
According to this approach, the value of human resources of an organisation is determined

according to their present value to the organisation. For determination of the present value, a
number of valuation models have been developed. Some of the important models are as follows:
1. Present Value of Future Earnings Model: This model has been developed by Lev and
Schwartz (1971). According to this model, the value of human resources is ascertained as
follows:
(a) All employees are classified in specific groups according to their age and skill.
(b) Average annual earnings are determined for various ranges of age.
(c) The total earnings that each group will receive up to retirement age are calculated.

Notes (d) The total earnings calculated as above are discounted at the rate of cost of capital.
(e) The value thus arrived at will be the value of human resources/assets.
(f) The following formula has been suggested for calculating the value of an employee
according to this model.
1(t)
∑
T
Vr =
t − r (1 + R)t − r
where
Vr = the value of an individual r years old.
I (t) - the individual’s annual earnings up to the retirement
t = retirement age
r = present age of the employee
R = discount rate
Limitations: The method suffers from several limitations:
(a) A person’s value to an organisation is not entirely determined by the salary paid to
him. A person may like to work at a salary that is less than what he actually deserves.
Moreover, salary does not remain constant over a period of time.
(b) The model ignores the possibility that an individual may leave the organisation for
reasons other than death or retirement. Thus, it overstates an employee’s prospected
service life and his future earnings.
(c) The model does not take into account the changes that people make during their
career, from one role to another, at one or more times within the organisation itself.
(d) The model also ignores other considerations such as seniority, bargaining capacity,
etc.
2. Reward Valuation Model: This model has been suggested by Flamholtz (1971). This is an
improvement on ‘present value of future earnings model’ since it takes into consideration
the possibility or probability or an employee’s movement from one role to another in his
career and also of his leaving the firm earlier than his death or retirement.
!
Caution The realisable value is estimated on the basis of the present worth of the set of
future services he is projected to provide during the period he is likely to remain with the
organisation.
The model suggests a five-step approach for this purpose.
(a) Identification of ‘service states’ (i.e. roles or posts) that the employee might occupy
during his service career including the possibility of his quitting the organisation.
(b) Estimation of the probable period for which a person will occupy each possible
‘service state’ (posts or roles) in future in the organisation.
3. Net Benefit Model: This approach has been suggested by Morse (1973). According to this
approach, the value of human resources is equivalent to the present value of net benefits
derived by the organisation from the service of its employees. The method involves the
following steps:

(a) The gross value of services to be rendered in future by the employees in their Notes
individual as well as their collective capacity is determined.
(b) The value of future payments (both direct and indirect) to the employees is
determined.
(c) The progress of the value of future human resources (as per 1 above) over the value
of future payments (as per 2 above) is ascertained. This, as a matter of fact, represents
the net benefit to the organisation on account of human resources.
(d) The present value of the net benefit is determined by applying a predetermined
discount rate (generally the cost of capital). This amount represents the value of
human resources to the organisation.
4. Certainty Equivalent Net Benefit Model: This approach has been suggested by Pekin Ogan
(1976). This, as a matter of fact, is an extension of “net benefit approach” as suggested by
Morse. According to this approach, the certainty with which the net benefits in future will
accrue should also be taken into account while determining the value of human resources.
The approach requires determination of the following:
(a) Certainty factor at which the benefits will be available.
(b) The net benefits from all employees multiplied by their certainty factor will give
certainty-equivalent net benefits. This will be the value of human resources of the
organisation.
5. Aggregate Payment Approach: This approach has been suggested by Prof. S.K. Chakraborty
(1976). As a matter of fact, he is the first Indian to suggest a model for valuation of human
resources of an organisation. According to his model, the human resources are to be
valued as a group and not on individual basis.
Professor Chakraborty’s model for valuation of human resources involves the following
steps:
(a) All the employees of an organisation are divided in two groups, managerial and
non-managerial.
(b) The average tenure of the employment of the employees in the group is estimated
on the basis of past experience.
(c) The average salary of the group is determined on the basis of the salary wage
structure prevalent in the organisation.
(d) The value of human resources is now determined by multiplying the average salary
of the group with the average tenure of the employees in that group.
6. Total Cost Concept: This approach has been suggested by Prof. N. Dasgupta (1978).
According to him the various approaches suggested in the previous pages take into account
only those persons, who are employed and ignore those who are unemployed. In case the
value of human resources of the nation is to be determined, it should be done in a manner
that brings in its purview both employed and unemployed persons. The system should be
such that it fits in preparation of a balance sheet showing the human resources not only of
a firm but also of the whole nation.
Example: From the following details, compute the value of human resources of an
employee group with an average age of 58 years.

Notes (i) Annual Average Earning of an employee till the retirement age ` 20,000
(ii) Age of retirement 60 years
(iii) Cost of capital 10%
(iv) Number of employees in the group 10
Solution:
1(t)
∑
T
Vr = t − r (1 + R)t − r
= 20,000/(1 + 0.10)(60 - 58) + (20,000)/(0.1 + 0.10)(60 - 59)
= 20,000/(1 + 0.10)2 + (20,000)/(0.1 + 0.10)1
= 16,528.93 + 18,181.82
= ` 34,710.75
Alternatively, the value of an employee can be computed with the help of Annuity Table. The
present value of on annuity of ` 1 for two years at 10% is 1.736. Hence, the present value of
` 20,000 for two years comes to 20,000 Wipro 1.736 = 34,720. This is almost the same as calculated
above.
Since the total number of employees in the group are 10, hence the total value of human resources
of this group comes to 34,710 Wipro 10 = ` 3,47,100.
Self Assessment
Fill in the blanks:
1. ……………occurs only at the moment of replacing the resources which is mainly based on
the current value approach.
2. According to opportunity cost approach, the value of an employee is determined according

to his ………..use.
3. According to ……………, the value of human resources of an organisation is determined

according to their present value to the organisation.
4. The present value of the net benefit is determined by applying a predetermined

…………..(generally the cost of capital).
5. The opportunity cost of an employee or a group of employees in one department is

calculated on the basis of the …………..by other departments for those employees.
6. The opportunity cost is linked with …………...
7.2 The Economic Value Approach
The value of an object, in economic terms, is the present value of the services that it is expected
to render in future. Similarly, the economic value of human resources is the present worth of the
services that they are likely to render in future. This may be the value of individuals, groups or
the total human organisation. The methods for calculating the economic value of individuals
may be classified into monetary and non-monetary methods.

7.2.1 Monetary Measures for Assessing Individual Value Notes
The following are the key models of monetary measures for assessing individual models:
1. Flamholtz’s Model of Determinants of Individual Value to Formal Organisations:
According to Flamholtz, the value of an individual is the present worth of the services that
he is likely to render to the organisation in future. As an individual moves from one
position to another, at the same level or at different levels, the profile of the services
provided by him is likely to change. The present cumulative value of all the possible
services that may be rendered by him during his/her association with the organisation, is
the value of the individual. Typically, this value is uncertain and has two dimensions. The
first is the expected conditional value of the individual. This is the amount that the
organisation could potentially realize from the services of an individual during his/her
productive service life in the organization. It is composed of three factors:
(a) Productivity or performance (set of services that an individual is expected to provide
in his/her present position);
(b) Transferability (set of services that he/she is expected to provide if and when he/
she is in different positions at the same level);
(c) Promotability (set of services that are expected when the individual is in higher
level positions).
These three factors depend, to a great extent, on individual determinants like activation
level of the individual (his motivation and energy level) and organizational determinants
like opportunity to use these skills or roles and the reward system.
The second dimension of an individual value is the expected realizable value, which is a
function of the expected conditional value, and the probability that the individual will
remain in the organisation for the duration of his/her productive service life. Since
individuals are not owned by the organisation and are free to leave, ascertaining the
probability of their turnover becomes important.
!
Caution The interaction between the individual and organizational determinants
mentioned above, leads to job satisfaction. The higher is the level of job satisfaction, the
lower is the probability of employee turnover. Therefore, higher is the expected realizable
value.
2. Flamholtz’s Stochastic Rewards Valuation Model: The movement or progress of people
through organizational ‘states’ or roles is called a stochastic process. The Stochastic Rewards
Model is a direct way of measuring a person’s expected conditional value and expected
realizable value. It is based on the assumption that an individual generates value as he
occupies and moves along organizational roles, and renders service to the organisation. It
presupposes that a person will move from one state in the organisation, to another,
during a specified period of time. In this model, exit is also considered to be a state. Use of
this model necessitates the following information:
(a) The set of mutually exclusive states that an individual may occupy in the system
during his/her career;
(b) The value of each state, to the organisation;
(c) Estimates of a person’s expected tenure in the organisation;
(d) The probability that in future, the person will occupy each state for the specified
time;
(e) The discount rate to be applied to the future cash flows.

Notes 7.2.2 Non-monetary Methods for Determining Value
The non-monetary methods for assessing the economic value of human resources also measure
human resources, but not in dollar or money terms. Rather, they rely on various indices or
ratings and rankings. These methods may be used as surrogates of monetary methods and also
have a predictive value. The non-monetary methods may refer to a simple inventory of skills
and capabilities of people within an organization or to the application of some behavioural
measurement technique to assess the benefits gained from the human resource of an organisation.
1. The skills or capability inventory is a simple listing of the education, knowledge, experience
and skills of the firm’s human resources.
2. Performance evaluation measures used in HRA include ratings, and rankings. Ratings
reflect a person’s performance in relation to a set of scales. They are scores assigned to
characteristics possessed by the individual. These characteristics include skills, judgment,
knowledge, interpersonal skills, intelligence, etc. Ranking is an ordinal form of rating in
which the superiors rank their subordinates on one or more dimensions, mentioned
above.
3. Assessment of potential determines a person’s capacity for promotion and development.

It usually employs a trait approach in which the traits essential for a position are identified.
The extent to which the person possesses these traits is then assessed.
4. Attitude measurements are used to assess employees’ attitudes towards their job, pay,
working conditions, etc., in order to determine their job satisfaction and dissatisfaction.
Self Assessment
Fill in the blanks:
7. The methods for calculating the …………of individuals may be classified into monetary
and non-monetary methods.
8. The …………methods may refer to a simple inventory of skills and capabilities of people
within an organization or to the application of some behavioural measurement technique
to assess the benefits gained from the human resource of an organisation.
9. The ………………is a simple listing of the education, knowledge, experience and skills of
the firm’s human resources.
10. Assessment of …………… determines a person’s capacity for promotion and development.
7.3 Measurement of Group Values
Likert and Bowers propose causal, intervening, and end-result variables, which determine the
group’s value to an organization. Causal variables are those that can be controlled by the
organization. These variables include managerial behaviour and organisational structure.
Intervening variables reflect organizational capabilities and involve group processes, peer
leadership, organization climate, and the subordinates’ satisfaction. Both the causal and the
intervening variables determine the end result variables of the causal and intervening variables.
The end-result dependent variables reflect the achievements of the organization or the total
productive efficiency in terms of sales, costs, earnings, market performance, etc. They are dependent
on the causal and the intervening variables.

7.3.1 Managerial and Peer Leadership Notes
Support-friendly—pays attention to what you are saying; Team-building—listens to subordinates’

problems; encourages subordinates to work as a team, encourages exchange of opinions and
ideas; Goal Emphasis—encourages best efforts; maintains high standards; Help with work—
shows ways to do a better job; helps subordinates plan, organize and schedule; offers new ideas,
and solutions.
7.3.2 Organisational Climate
Communication flow: Communication flow is amicable.
Decision-making: Subordinates know what is going on; superiors are practices receptive.
Concern for persons: Subordinates are involved in setting goals; decisions are made at
levels of accurate information; persons affected by decisions are asked for their ideas;
know-how of people of all levels is used.
Influence on department: The organization is interested in individual’s welfare; tries to

improve working conditions; organizes work activities sensibly.
Technological adequacy: From lower level supervisors to employees who have no

subordinates.
Motivation: Improved methods are quickly adopted; equipment and resources are well
managed. Differences and disagreements are accepted and worked through; people in
organization work hard for money, promotions, job satisfaction and to meet high money,
promotion, job satisfaction and to meet high expectations from others and are encouraged
to do so by policies, working conditions, and people.
7.3.3 Group Process
(i) Planning together, coordinating efforts.

(ii) Making good decision’s solving problems.
(iii) Knowing jobs and how to do them well.
(iv) Sharing information.
(v) Wanting to meet objectives.
(vi) Having confidence and trust in other members.
(vii) Ability to meet unusual work demands.
7.3.4 Satisfaction
With fellow workers; superiors; jobs; this organization compared with others; pay; progress in
the organization up to now; opportunities for getting ahead in the future.
1. Brummet, Flamholtz, and Pyle’s Economic Value Model: The Brummet, Flamholtz, and
Pyle model follows the principle that a resource’s value is equal to the present worth of
the future services it can be expected to provide, and therefore, it can provide a basis of
measuring the value of a group of people. According to this method, groups of human
resources should be valued by estimating their contribution to the total economic value of
the firm. Thus a firm’s forecasted future earnings are discounted to determine the firm’s
present value, and a portion of these earnings is allocated to human resources according to
their contribution.

Notes 2. Hermanson’s Unpurchased Goodwill Model: According to Hermanson, the unpurchased

goodwill notion is based on the premise that ‘the best available evidence of the present
existence of unowned resources is the fact that a given firm earned a higher than normal
rate of income for the most recent year. Here Hermanson is proposing that supernormal
earnings are an indication of resources not shown on the balance sheet, such as human
assets. Even though his method of valuing human resources is explicitly intended for use
in a company’s published financial statements rather than for internal consumption, this
would necessarily involve forecasting future earnings and allocating any excess above
normal expected earnings to human resources of the organization. However, the
assumptions would be subject to the uncertainties involved in any forecast of future
events.
!
Caution This method suffers from several limitations: Firstly, since the methods limits
recognition of human resources to the amount of earnings in excess of normal, the human
resource base that is required to carry out normal operations is totally ignored. As a
result, the value of human assets will be an underestimation. Secondly, the method only
uses the actual earnings of the most recent year as the basis for calculating human assets,
thereby, ignoring the forecasts of future earnings that are equally relevant for managerial
decision-making.
3. Human Organizational Dimensions Method: Based on the Likert-Bowers model of group’s

value to an organization, discussed earlier, this method is based on the relationship among
causal, intervening and end-result variables. The causal variables influence the intervening
variables, which, in turn, determine the organization’s end result variables. Hence changes
in the key dimensions of organisation can be used as dependable indicators for forecasting
future changes in productivity and financial performance.
Notes Monetary estimations of changes in human value of organisations

For computing a monetary estimate of the expected change in the value of human
organization, the following steps are suggested:
1. Measure the key dimensions of human organization, using a Likert scale at specified
time periods. These are in non-monetary measurements.
2. The scaled responses to questionnaire items called ‘scores’ are then standardized by
statistical methods to take into account the degree of variability of the set of responses.
This is done for responses in each time period.
3. The difference between two standardized scores from one period to the next is then
calculated. This difference (called delta) represents the change in an index of specified
dimensions of the human organization.
4. From present changes in dimensions of the human organization, the expected future
change in end result variables is estimated. Specifically, for a given variable the
delta is multiplied by coefficient or correlation between that variable and the end
result variable. This provides an estimate in standard scores of the anticipated change
in the end result variable attributable to a change in the human organisational
dimension believed to cause that change.
5. Lastly, the standard scores are converted into the measuring monetary units for the
end result variables. Likert points out that changes in the productive capability of a
Contd...

firm’s human organization cannot be assessed correctly unless periodic measurements Notes
of causal and intervening dimensions of that organization are taken regularly.
Current profit and loss reports often encourage us to believe that changes are
occurring. When profits increase, it is often assumed that the human organization
has become more productive, but steps taken to maintain earnings or prevent losses
may actually result in a decrease in the productive capability of the human
organization. There is some controversy about the validity and reliability of this
method. According to Flamholtz, future research on this method is necessary because
its validity and feasibility have not yet been established. Likert, however, maintains
that the method is feasible where reliable and valid measurements of the coefficients
are available.
Self Assessment
11. Intervening variables are those that can be controlled by the organization.
12. Causal variables include managerial behaviour and organisational structure.
13. The intervening variables reflect the achievements of the organization or the total
productive efficiency in terms of sales, costs, earnings, market performance, etc.
14. The causal variables influence the intervening variables, which, in turn, determine the
organization’s end result variables.
7.4 Recording and Disclosure in Financial Statement
In the preceding pages, we have explained the various models dealing with the mode of valuation
of human resources as an asset. The “present value of future earnings” model, as suggested by
Lev and Schwartz, has been found to be most popular model on account of convenience and
objectivity. The exponents of human resource valuation models in most cases have not dealt
with the mode of recording and disclosure of the accounting information relating to human
resources in the books of accounts or financial statements of the organisation. This has been left
to the discretion of the accounting bodies, who have yet to develop a generally accepted basis
for valuation, recording and disclosure of human resource accounting information in the financial
statements of an organisation. In most cases, the human resource accounting information is
given in the form of supplementary information attached to the financial statements.
Prof. N. Dasgupta has suggested in his total cost approach (explained earlier) the following
mode for disclosure of human resources in the balance sheet of an organisation.
Human resources valued as per his model should be shown both on the ‘assets’ as well as
‘liabilities’ sides of the balance sheet. On the assets side, it should be shown after the fixed assets
as human assets classified into two parts, (i) value of individual, (ii) value of firm’s investment.
On the liabilities side, it should be shown after the capital as human assets capital by that
amount at which it has been shown on the asset side against ‘value of individuals.’ He has given
the following example to clarify his point.
Example: A firm has started its business with a capital of ` 1,00,000. It has purchased fixed
assets worth ` 50,000 in cash. It has kept ` 26,000 as working capital and incurred ` 24,000 on
recruitment training and developing the engineers and a few workers. The value of engineers
and workers is assessed at ` 80,000.

Notes The items will be shown in the balance sheet as follows:

Balance Sheet
(Including Human Resources)
Amount Amount
Liabilities Assets
(`) (`)
Capital 1,00,000 Fixed Assets 50,000
Human Assets 80,000 Human Assets:
(i) Individuals' value 80,000
(ii) Value of firm's investment 24,000
Current Assets 26,000
1,80,000 1,80,000
Task From the following details, compute the value of human resources of an employee
group with an average age of 58 years.
(i) Annual Average Earning of an employee till the retirement age ` 10,000
(ii) Age of retirement 55 years
(iii) Cost of capital 10%
(iv) Number of employees in the group 20
Self Assessment
Fill in the blanks:
15. In most cases, the human resource accounting information is given in the form of
……………..attached to the financial statements.
16. The “present value of future earnings” model is suggested by ……………….
7.5 Summary
The biggest challenge in HRA is that of assigning monetary values to different dimensions
of HR costs, investments and the worth of employees.
According to historical cost approach, the actual cost incurred on recruiting, selecting,
hiring, training and developing the human resources of the organisation are capitalised
and written off over the expected useful life of the human resources.
The replacement cost approach values the human resources at their present replacement
cost.
According to opportunity cost approach, the value of an employee is determined according

to his alternative use.
According to standard cost approach, standard costs of recruiting, hiring, training and
developing per grade of employees are determined year after year.
According to present value approach, the value of human resources of an organisation is

determined according to their present value to the organisation.

The value of an object, in economic terms, is the present value of the services that it is Notes
expected to render in future. Similarly, the economic value of human resources is the
present worth of the services that they are likely to render in future.
The non-monetary methods for assessing the economic value of human resources also
measure human resources, but not in dollar or money terms.
Likert and Bowers propose causal, intervening, and end-result variables, which determine
the group’s value to an organization.
7.6 Keywords
Attitude Measurements: Attitude measurements are used to assess employees’ attitudes towards
their job, pay, working conditions, etc., in order to determine their job satisfaction and
dissatisfaction.
Causal Variables: Causal variables are those that can be controlled by the organization.
Intervening Variables: Intervening variables reflect organizational capabilities and involve

group processes, peer leadership, organization climate, and the subordinates’ satisfaction.
Performance Evaluation: Performance evaluation measures used in HRA include ratings, and
rankings. Ratings reflect a person’s performance in relation to a set of scales.
The End-result Dependent Variables: The end-result dependent variables reflect the achievements
of the organization or the total productive efficiency in terms of sales, costs, earnings, market
performance, etc.
1. What are the two measurements in HRA (Two Approaches)?
2. Explain the Cost Approach, the Economic Value Approach: Monetary Value Based
Approaches and the Non-Monetary Value Based Approaches.
3. Explain the concept of human resource accounting. State its importance.

4. Differentiate between the following approaches suggested for valuation of human
resources: Historical Cost Approach and Replacement Cost Approach.
5. Write a note on Human Resource Accounting in India.
6. Illustrate the recording of human assets as per the “present value of future earnings”
model.
7. For determination of the present value, a number of valuation models have been developed.
What are those models?
8. Illustrate the total cost concept with a suitable example.
9. Critically evaluate the opportunity cost approach.
10. The movement or progress of people through organizational ‘states’ or roles is called a
stochastic process. Discuss.
1. Replacement cost
2. alternative

Notes 3. present value approach
4. discount rate
5. offers (bids)
6. scarcity
7. economic value
8. non-monetary
9. skills or capability inventory
10. potential
11. false
12. true
13. false
14. true
15. supplementary information
16. Lev and Schwartz

www.scribd.com

Amit Kumar Sharma, Lovely Professional University Unit 8: Corporate Reporting
Unit 8: Corporate Reporting Notes
CONTENTS
Objectives
Introduction
8.1 Qualitative Characteristics of Financial Reporting Informations
8.2 Users Group and Financial Reporting
8.3 Objectives of Corporate Reporting/Objectives of Financial Information
8.4 Concept of Disclosure in Relation to Publish Accounts
8.5 Disclosure Requirements of Balance Sheet
8.5.1 Statutory Contents of Liabilities side of Balance Sheet
8.5.2 Statutory Contents of Assets Side of Balance Sheet
8.6 Disclosure Requirements Concerning Profit & Loss Accounts
8.7 Report of the Auditors to the Shareholders
8.8 Summary
8.9 Keywords
Objectives
Identify the disclosure requirements of publish accounts;
Illustrate the preparation of corporate financial statements as per VI Part I of the Indian
Companies Act;
Describe the contents of auditors report.
Introduction
The form of presentation of financial reports of non-corporate business organisations suffers

from non-conformity. Rigid rules and regulations, as to the manner of presenting financial
reports, do not bind the individual businessman in a sole trading or the partners in a firm. They
enjoy a higher degree of individuality, which is reflected in the myriad of forms in which
financial reports are prepared. In fact, there is no legal compulsion for these organisations to
present the financial reports at all. The reports are prepared for the own use of the businessman
and are made available only to select groups, such as lenders of resources and to tax authorities.
Corporates, which are governed by their respective acts, have not been given this latitude. The
reasons are obvious—in corporate ownership is divorced from management. With a view to
ensure that the funds made available by the shareholders (a majority of whom will not have a
say in the day to day management of the business) are properly utilised by the managers, law
has prescribed specific forms in which the financial reports are to be prepared and presented.
8.1 Qualitative Characteristics of Financial Reporting Informations
The qualitative characteristics will provide assistance when choices have to be made between
reporting policies—whether by preparers, auditors, those participating in the standard-setting

Notes process, regulators or others - and be indicative of the qualities that users can expect of the
financial information provided to them.
The financial reporting informations should contain the following qualitative characteristics:
1. Comparability: It is not sufficient that financial information is relevant and reliable at a

particular time, in a particular circumstance or for a particular reporting entity. The users
of general-purpose financial reports need to be able to compare aspects of an entity at one
time and over time, and between entities at one time and over time. This implies that the
measurement and display of transactions and events need to be carried out in a consistent
manner throughout an entity, and over time for that entity, and that there is consistency
between entities in these regards. An important implication of this concept of comparability
is that users need to be informed of the policies employed in the preparation of the
general-purpose financial reports, changes in those policies and the effects of those changes.
2. Materiality Test: Once it has decided that financial information is, in general terms, capable
of being classified as relevant and reliable, it is necessary to consider the information in
the context of the individual circumstances of the reporting entity in question. For example,
information may be relevant and reliable in general nature, but be immaterial in the
circumstances of the reporting entity. The inclusion of immaterial information in financial
reports may well impair their understandability.
The materiality test is concerned with assessing whether omission, misstatement or non-
disclosure of an item of relevant and reliable information could affect decision-making
about the allocation of scarce resources by the users of a general-purpose financial report
of an entity. For example, it may be argued that information about secured non-current
liabilities could be expected to be relevant to the decisions of potential lenders and be
capable of being reliably determined. However, in a particular entity it could be that total
debt is so small in comparison to available collateral that dissection of existing debt
between the secured and unsecured portions would be immaterial. Therefore, in this
Statement materiality is employed as a threshold test of which relevant and reliable
financial information should be excluded from a general purpose financial report of an
entity.
3. Relevance: For financial information to be relevant it must have value in terms of assisting
users in making and evaluating decisions about the allocation of scarce resources and in
assessing the rendering of accountability by preparers. If information is to assist users in
making decisions about the allocation of scarce resources, it must assist them in making
predictions about future situations and in forming expectations, and/or it must play a
confirmatory role in respect of their past evaluations. The predictive and confirmatory
roles of financial information are interrelated. For example, financial information about
the current level and structure of asset holdings will have value to users when they
endeavor to assess an entity’s ability to take advantage of opportunities in the market
place. That same information will play a confirmatory role in respect of past predictions
about the way in which the entity would be structured and about the outcome of planned
operations. Analysis of the relationship between predictions and outcomes will assist
users to identify the range of variables they ought to be considering when making
predictions.
4. Reliability: The reliability of financial information will be determined by the degree of

correspondence between what that information conveys to users and the underlying
transactions and events that have occurred and been measured and displayed. Reliable
information will, without bias or undue error, faithfully represent those transactions and
events. It is important that financial information be reliable. Information may be of a type
which bears upon users’ decision-making, that is, be relevant, but be so unreliable in

Unit 8: Corporate Reporting
nature or representation as to be useless or potentially misleading. For example, if an Notes

entity takes legal action against another entity for damages, and the validity and amount
of the claim involved are seriously disputed, it would normally be inappropriate for the
plaintiff to recognize prior to judgment an asset for the face value of the claim.
5. Understandability: The ability of users to understand financial information will depend

in part on their own capabilities and in part on the way in which the information has
displayed. General purpose financial reports ought to be constructed having regard to the
interests of users who are prepared to exercise diligence in reviewing those reports and
who possess the proficiency necessary to comprehend the significance of contemporary
accounting practices.
Self Assessment
1. Materiality test means that quality of financial information which exists when users of
that information are able to comprehend its meaning.
2. Reliability means that quality of financial information which exists when that information
can be depended upon to represent faithfully, and without bias or undue error, the
transactions or events that either it purports to represent or could reasonably be expected
to represent.
8.2 Users Group and Financial Reporting
Each business is required to maintain a set of financial statements for its operations. The benefits
may not seem to be many from an individual perspective; from the standpoint of a potential
investor, such statements may deliver what may be called an opportunity to enhance funding.
Some believe that accounting, also called bookkeeping, is non-essential and tend to concentrate
on generating sales and getting the best bargain from suppliers. Making journal entries and
maintaining ledgers and books of accounts are not the only functions of an accountant or
bookkeeper. It includes proper management of all relevant documents, such as invoices, purchases
and sales orders, agreements, and tax returns etc., which assist in developing an impressive set
of financial statements.
Investors
Investors fall into two categories, existing and potential. Some seek a takeover, leading to majority
control and shareholding. This usually occurs when a company is losing public confidence resulting
in low market value. Often considered as hostile takeovers, the investors tend to restructure the
business and control it completely, issue shares or sell it off in the open market.
The other category consists of short and long-term investors, both interested in increasing their
wealth with the minimal effort. This may be through either earning dividends or trading shares
in the Stock Exchange.
Lenders
These may supply funds to the organization on short and/or long-term basis. There are several
financial institutions and individuals willing to lend to progressive companies but few to support
those with lower earnings levels. The loan carries a charge of interest payable annually or as
agreed, on the principle or compounded principle, over the period that the loan has been issued.

Notes The financial institutions mentioned above include banks, discount houses and factors. Banks
usually provide overdraft and other flexible fund management facilities to companies, provided
they have a strong financial performance backing. Discount houses provide invoice discounting
facilities but require a proper debtor management system running in the company that ensures
that debtors are not let loose or have a habit of defaulting. Factoring companies help in recovering
the amount due by debtors but ask for a service charge, which varies with each situation and
company status.
Suppliers
Suppliers of products and services to the company would like their investments—sales made on
credit terms—received with surety. A creditor would be reluctant to trade any further if s/he is
not guaranteed a timely payment against the issued invoice.
Employees
Many would consider employees the least affected of all when it comes to analyzing the company’s
accounts. The employees will be first to feel the change in circumstances as they may be promoted,
demoted or fired. They would be very much interested in finding out if the company exhibits
any points in their favor, mainly job security and facilities.
Government Bodies
As a rule, Companies House requires each company, private or public, to submit their financial
statements and accounts annually. The list of registered companies and their most recent accounts
are published in the Companies House official publication, which informs the public of their
performance for the year or period ended. In addition, the government has the responsibility to
ensure that the information is not delusive and the rights of the public are protected. Furthermore,
it bears the responsibility of prosecuting any offender of the law, including corporate and
consumer law. For example, a director of a PLC can be prosecuted for a criminal offence if the
accounts have not been delivered to the Companies House.
Competitors
It may seem odd, but existing competitors and new entrants have to consider the likelihood of
their success or failure in trying to conquer the market. Their primary interest lies in the business
ratios of efficiency/productivity and cash, debtor and credit management. For the industry, it
acts as a comparative for better performance of firms and companies of varying sizes. They also
help in establishing a trend of the industry that is normally a guide to new entrants to study,
analyze and perform.
Self Assessment
Fill in the blanks:
3. …………… fall into two categories, existing and potential.
4. A ………… would be reluctant to trade any further if s/he is not guaranteed a timely
payment against the issued invoice.

8.3 Objectives of Corporate Reporting/Objectives of Financial Notes

Information
Basically, there are three objectives of financial reporting.
1. To give information useful for making investment and credit decisions. Financial reporting
should offer information that can help present and potential investors and creditors to
make rational investment and credit decisions. The information should be in the form that
is easy and understandable to those who have some understanding of business and are
willing to study the information carefully.
2. To provide information useful in assessing cash flow prospects. Financial reporting should
supply information to help present and potential investors and creditors appraise the
amounts, timing and possible risk of expected cash receipts from dividends or interest and
the proceeds from the sale, redemption or maturity of stocks or loans.
3. To provide information about business resources claims to those resources and changes in
them. Financial information should give information about the company’s assets, liabilities
and shareholders equity.
Financial statements are the most important way of periodically presenting to parties outside
the business the information that has been gathered and processed in the accounting system.
These financial statements are “general purpose” because most of the users are outside the
business. Because of potential conflict of interest between managers, who must prepare the
statements and the investors or creditors, who invest in or lend money to the business, these
statements are often audited by outside accountants (known as auditors) to increase creditability
and reliability.
Objective of General Purpose Financial Reporting identifies the objective of general purpose
financial reporting as the disclosure of information useful to users for making and evaluating
decisions about the allocation of scarce resources. When general purpose financial reports meet
this objective they will also be the means by which preparers of such reports discharge their
accountability to those users. The purpose of this Statement is to identify those attributes
(hereinafter “qualitative characteristics”) that financial information should possess if it is to
serve the specified objective.
Self Assessment
Fill in the blanks:
5. ……………..should give information about the company’s assets, liabilities and

shareholders equity.
6. Financial reporting should offer information that can help present and potential investors
and creditors to make rational investment and ………….decisions.
8.4 Concept of Disclosure in Relation to Publish Accounts
Section 210 of the Companies Act, 1956 stipulates that the board of directors of every company
should submit, before the annual general meeting of the company, a duly audited profit and loss
account and balance sheet. These documents should be placed before the meeting within six
months of the expiry of the financial year. Three copies of the annual reports as approved by the
shareholder are to be filed with the Registrar of Companies within thirty days of the meeting in
which they were approved. The next section, Section 211 lays down that every balance sheet of
a company shall be in the form set out in Part I of Schedule VI attached to the companies act and

Notes that every profit and loss account shall comply with the requirements of Part II of the schedule.
All the companies in India are, by force, made to adopt the format. Any deviation from the form
prescribed shall be made only with the specific approval of Central Government. Corporates
should, therefore, exercise utmost care in the preparation and presentation of the financial
statements. It may be mentioned that the message conveyed by these statements are similar to
that of non-corporate reports, except for the greater degree of disclosure, which are on the lines
of the generally accepted accounting principles.
Self Assessment
Fill in the blanks:
7. …………of the Companies Act, 1956 stipulates that the board of directors of every company
should submit, before the annual general meeting of the company, a duly audited profit
and loss account and balance sheet.
8. Three copies of the annual reports as approved by the shareholder are to be filed with the
…………within thirty days of the meeting in which they were approved.
9. The Institute of Chartered Accountants of India has issued standard on …………..AS17.
10. Companies with multiple ……………..and those with area of operation extending beyond
the boundaries of the country would have to present separate financial report for each of
the activities and for each territory.
8.5 Disclosure Requirements of Balance Sheet
The balance sheet of a company must be in accordance with the proforma given in Schedule VI
Part I of the Indian Companies Act. This is as per section 211 of the Indian Companies Act, 1956.
Sub-section 3A, 3B and 3C of section 211 have made it compulsory that Profit and Loss account
and Balance Sheet of a Company are prepared in accordance with Accounting Standards prescribed
by the Central Government in consolation with National Advisory Committee on Accounting
standards (NACAS).
The Act has laid down two forms of Balance Sheet. The two forms are generally known as:
1. Horizontal Form
2. Vertical Form
!
Caution The Balance Sheet must give a true and fair view of the company activities. This
form may be in any other form with the consent of the Central Government.
8.5.1 Statutory Contents of Liabilities side of Balance Sheet
There are two types of items shown on the liabilities side of the Balance sheet.
1. The items relating to owners equity and
2. The items relating to borrowers’ capital
The main items relating to owner’s capital: The main item are as follows:
1. Share capital
2. Reserves and surplus

1. Share Capital: It means the share of the owner’s in the company. There are different types Notes
of capital.
(a) Authorized Share Capital: This is the amount of capital which the company is authorized
to raise from the public. Generally authorized capital is given in the memorandum
of association, popularly known as M/A at the time of incorporation of the company.
There are two types of share capital – (i) Equity share capital, and (ii) Preference
share capital. It is given by way of information in the balance sheet. It is not added
to the liabilities of the company, unless the entire share capital is issued, subscribed,
called up and received in full.
(b) Issued Share Capital: It is that part of issued share capital, which is offered for the
public to subscribe till the date of Balance Sheet. Various types of share capital along
with classes and face value etc. are given.
(c) Subscribed Capital:
(i) It is that part of issued share capital which is actually, subscribed by the public
along with share value called up.
(ii) Shares, which are issued other than cash for different consideration and issued,
as bonus shares must also be given.
(iii) Shares on which calls are in arrear must also be shown by way of deduction
from called up capital.
(iv) Shares which are forfeited on account of non-payment must be shown
separately.
(v) If forfeited shares are reissued in full or in part, in case of profit must be
transferred to capital reserve account only.
Example: The following are the key informations of Amazon Artifice Ltd.:
`
1. Authorised share capital:
Equity share capital (400000 equity shares of ` 10 each) 4000000
Preference share capital (10000 15% preference share capital @ ` 100 each) 1000000
2. Issued and Subscribed share capital: 3000000
Equity share capital (300000 equity shares of ` 10 each) 500000
Preference share capital (5000 15% preference share capital @ ` 100 each) 1700000
3. Paid up capital (equity 12 lakhs and preference 5 lakhs) 2600000
4. Called up capital on allotment (14 lakhs + 12 lakhs) 12000
5. Unpaid equity shareholders on allotment (3000 equity shares@ ` 4) 6000
6. Unpaid equity shareholders on calls (2000 equity shares@ ` 3)
The share capital will be collected as under
Equity shares Preference shares

(`) (`)
with application 3 100
On allotment 4 —
On calls 3 —
10 100
The public has subscribed, in full, to both equity and preference shares of the company. Shows
the treatment of capital in company’s balance sheet.

Notes Solution:
Working note:
On allotment the 3,000 equity shareholders have not paid the allotment money so the paid up
capital would, then, be (` 26 lakh – ` 12000) 25,88.000.
On the company calling up the balance 3 per share 2000 shareholders have not honoured the call.
The paid up capital will, thus, be 34,73,000, i.e., subscribed equity capital 30 lakhs, less calls in
arrears of 27,000 plus preference shares of 5 lakhs. The entire sequence will have to be shown as
under in the balance sheet.
Amazon Artifice Ltd.
Balance sheet as on 31 March
Liabilities
Capital
Authorised
4,00,000 equity shares of ` 10 each 40,00,000
10,000. 15% Preference Shares of ` 100 each 10,00,000 50,00,000
Issued and Subscribed
3,00,000 Equity Shares of ` 10 each 30,00,000
5000 15% Pref. shares of ` 100 each 5,00,000 35,00,000
Less: Calls in arrears 27,000
Paid up capital 34,73,000
2. Reserves and Surplus: As per Companies Act, 1956 the following are the Reserves and
Surplus:
(a) Capital Reserves
(b) Capital Redemption Reserve Account
(c) Securities Premium Account
(d) Other Reserves such as – General Reserve, Reserve for depreciation etc.
(e) Surplus – The net-profit, as per profit and loss account, is to be given.
(f) Proposed Addition to Reserves
(g) Sinking Fund
Borrowers Capital Fund: There are the following types of loan capital.
1. Secured loans: If any security is given by way of a mortgage or charge on all or any of its
property, the loan is termed as secured loan and shown in the following order:
(i) Debentures: Types of debentures, redeemable and non-redeemable.
(ii) Loans and Advances from Banks
(iii) Loans and Advances from subsidiary company
(iv) Other Loans and Advances if any
2. Unsecured loans: If a company borrows loans without giving any security, then such loans
are termed as unsecured loans. Following are:
(i) Fixed deposits
(ii) Loans and Advances from Subsidiaries
(iii) Loans and Advances from the banks
(iv) Loans and Advances from others
3. Current Liabilities and Provisions:
(a) Current Liabilities: Which are payable within one year are shown in this such as
Acceptances
Sundry creditors

Investor Education and Protection Fund Notes

Advance payments
Unclaimed dividends
Interest Accrued but not due
Tax payable
Tax deducted at source (TDS).
(b) Provisions: are shown separately such as
Provision for taxation
Proposed dividend
Provision for contingencies
Provision for provident fund
Other provisions
Did u know? What are the contingent liabilities?

Contingent liabilities are such liabilities which may exist or may not exist subject to
happening or not happening the event. It is given as a foot note in the Balance Sheet.
Amount of such liabilities is not included in the total liabilities.
The following are the examples of contingent liabilities:
1. Claims against company, which are still not accepted by the company.
2. Liability for amount uncalled on partly paid shares.
3. Arrears of fixed cumulative dividends.
4. Estimated amount of incomplete contracts.
5. Other contingent liability.
Investor education and protection fund
According to section 205 A of the Companies Amendment Act, 1999, any amount transferred to
unpaid dividend account of company which will remain unpaid or unclaimed in the said accounts
for a period of seven years from the date of such transfer is required to be transferred by the
company to Investor Education and Protection Fund. Such payment are:
1. Unpaid dividends
2. Matured deposit with companies for seven year
3. Matured debentures
4. Interest accrued on the above
5. Donations or Grants from Government
8.5.2 Statutory Contents of Assets side of Balance Sheet
1. Fixed Assets: Fixed assets are those assets, which are used for long-term in the business.
Different assets are shown separately at their original cost and addition to and deductions
for depreciation provided for. Fixed Assets include
(a) Goodwill
(b) Land and Building
(c) Lease hold
(d) Railway sidings

Notes (e) Plant & Machinery
(f) Furniture & Fixture
(g) Patents, Trade Marks and Designs
(h) Development of property
(i) Copyrights
(j) Live stock
(k) Vehicles
2. Investments: Investments are shown after fixed assets. It is necessary to disclose nature
and mode of its valuation of every investment. Market price or cost price, at which
investments are valued, must be disclosed. All investments must be shown separately
such as Govt., shares, debentures, etc.
3. Current Assets loans and advances:
(a) Current assets are such assets which are likely to be converted into cash within one
year from one balance sheet. Such assets are. (1) Loose tools (2) Stock in trade
(3) Work in progress (4) Sundry debtors (5) Cash and Bank balance
(b) Loans and advances – it includes loans and advances against purchase of goods and
various expenses.
4. Miscellaneous Expenditure: Expenses not written off– (1) Preliminary Expenses (2) Discount
on issue of shares and debentures (3) Expenses including commission or brokerage on
underwriting (4) Interest paid out of capital (5) Other sums.
5. Profit and Loss Account: If there is any debit balance in profit and loss account, it will be
shown on the assets side of the balance sheet.
The given below is the proforma of Balance Sheet as per schedule VI and part I.
Form of Balance Sheet
(Horizontal Form)
Balance sheet of …………… as at …………
(Form of Balance Sheet as Per Schedule VI and Part I)
Figures Liabilities Figures Figures for Assets Figures

for the for the the for the
previous Current previous current
year (`) year (`) year (`) year (`)
1. Share Capital 1. Fixed Assets
Authorized (1) Goodwill
…………shares of (2) Land
`…………each
(3) Buildings
Issued……………….sh (4) Leaseholds
are of `…………each
(5) Railway Sidings
Subscribed and paid
up……… shares of (6) Plant &
`……………each Machinery
Less: Called unpaid (7) Furniture and
Fittings
Add: Forfeited shares
(8) Development of
Property
Contd...

(9) Patents, Trade Notes

Marks and
Designs
(10) Live Stock
(11) Vehicles etc.
2. Reserves and Surplus 2. Investments
(1) Capital Reserve (1) Investments in
(2) Capital Govt. or Trust
Redemption securities
Reserve (2) Investments in
(3) Securities Premium Shares,
Account Debentures and
Bonds
(4) Other Reserves
(3) Immovable
Less: Debit Balance
Properties
of P&L Account
(4) Investment in the
(5) Surplus, i.e.,
Capital of
Balance of P&L
Partnership
Account
Firms
(6) Proposed additions
to Reserves
(7) Sinking Funds
3. Secured Loans 3. Current Assets,
(1) Debentures Loans and Advances
(2) Loans and A. Current Assets
Advances (1) Interest accrued
from Banks on Investments
(3) Loans and (2) Stores and spare
advances parts
from Subsidiaries (3) Loose Tools
(4) Other Loans & (4) Stock in Trade
Advances (5) Work in Progress
(6) Sundry Debtors
(a) Debt outstanding
for a period
exceeding six
months.
(b) Other Debts
Less: Provision
(7) Cash and Bank
Balances
4. Unsecured Loans B. Loans & Advances:
(1) Fixed Deposit (1) Acceptances &
(2) Loans and Loans to
advances from Subsidiaries
subsidiaries (2) Exchange
(3) Short-term Loans (3) Advances
& Advances recoverable for
(a) From Banks value to be
(b) From Others received by
Rates, Taxes,
Insurance etc.
(4) Balance with
Customs, poet
Trust etc.
Contd...

Notes 5. Current Liabilities & 4. Miscellaneous

Provisions Expenditure
A. Current Liabilities (1) Preliminary
(1) Acceptance Expenditure
(2) Sundry Creditors (2) Expenses
(3) Advances including
payments & un- commission and
brokerage of
expired discounts
shares and
for the portion for
which value has debentures
still to be given (3) Discount allowed
on issue of shares
(4) Unclaimed
and debentures
Dividend
(5) Other liabilities (4) Interest paid out
but not due on of capital during
Loans construction (also
state the rate of
(6) Interest Accrued interest)
B. Provisions (5) Development
(1) Provisions for Expenditure not
taxation adjusted.
(2) Proposed (6) Other Items
Dividends, (specifying
(3) For Contingencies nature)
(4) For Provident 5. Profit and Loss A/c
Fund scheme (1) Claims against
(5) Fire Insurance, the company not
Pension and acknowledged as
similar staff debts.
benefits scheme (2) Uncalled
(6) Other Provisions liabilities on
[A footnote to the shares partly
balance sheet may paid up
be added to show (3) Arrears of fixed
separately] cumulative
dividends.
(4) Estimated
amount of
contracts
remaining to be
executed on
capital account
and not provided
for
(5) Other money for
which company
is contingently
liable.

Form of Balance Sheet Notes

(Vertical Form)
Balance Sheet of …………….Company
(As on…………………..)
Particulars Schedule Figures as at Figures as at

No. the end of the the end of the
Current Year Previous Year
1 2 3 4
1. Sources of Funds
(1) Share holders funds
(a) Capital
(b) Reserves and Surplus
(2) Loan Funds
(a) Secured Loans
(b) Unsecured Loans
Total
2. Application of Funds
(1) Fixed Assets.
(a) Gross Block
(b) Less Depreciation
(c) Net Block
(d) Capital work in progress
(2) Investments
(3) Current Assets, Loans and Advances
(a) Inventories
(b) Sundry Debtors
(c) Cash and Bank Balance
(d) Other current Assets
(e) Loans and Advances
Less: current liabilities provisions
(a) Liabilities
(b) Provisions
Net Current Assets
(4) (a) Miscellaneous Expenditure to the
extent not written off or adjusted.
(b) Profit and Loss Account
Total
Self Assessment
Fill in the blanks:
11. The balance sheet of a company must be in accordance with the proforma given in
……….Part I of the Indian Companies Act.
12. Generally …………is given in the memorandum of association, popularly known as M/A
at the time of incorporation of the company.
13. ………….are such liabilities which may exist or may not exist subject to happening or not
happening the event.
14. …………..are those assets, which are used for long-term in the business.

Notes 15. If any security is given by way of a mortgage or charge on all or any of its property, the
loan is termed as …………..
16. If a company borrows loans without giving any security, then such loans are termed as
………………..
8.6 Disclosure Requirements Concerning Profit & Loss Accounts
A company shall disclose the following notes to their accounts :

1. Revenues from operations: Revenue from operations shall be classified as:
(a) Sale of products;
(b) Sale of Services;
(c) Other operating revenues (specify nature);
Less:
(d) Discounts, allowances, and returns;
(e) Excise duty/service tax.
These shall include sales or service charges to customers for the goods and/or services
provided during the period. This section shall include information about duties, taxes,
discounts, allowances and returns in order to determine net sales or net revenues.
2. Cost of sales/services: These are costs directly associated with generating revenues and
shall include (to be disclosed separately):
(a) Change in inventories – Opening (less closing) inventories of finished goods and
work-in-process;
(b) Cost of direct materials consumed arrived at by adding net purchases (purchases
less discounts, returns and allowances plus freight-in) to beginning inventory to
obtain direct materials available. From the cost of direct materials available, the
ending inventory is deducted;
(c) Other external charges (such as the hire of plant and machinery or the cost of casual
labour used in the productive process);
(d) Direct labour (ESOP and ESPP expenses to be disclosed separately);
(e) All direct production overheads;
(f) Depreciation and amortization that can reasonably be allocated to the production
function;
(g) Indirect overheads that can reasonably be allocated to the production function;
(h) Product development expenditure not qualifying for recognition as an intangible
asset and amortization of development expenditure recognized as an intangible
asset;
(i) Inventory write downs/reversals;
(j) All direct overheads in providing services;
(k) All allocable indirect overheads in providing services;
(l) Cost of goods traded-in arrived at by adding net purchases (purchases less discounts,
returns, and allowances plus freight-in) to beginning inventory to obtain the cost of
goods available for sale. From the cost of goods available for sale amount, the
ending inventory is deducted;
(m) Other cost of sales.

3. Operating expenses: Operating expenses are those that are incurred in order to generate Notes
sales. Operating expenses shall be classified as:
(a) Selling and marketing expenses;
(b) Administrative expenses;
(c) Depreciation and amortization of assets;
(d) Foreign currency exchange gains/(losses), net.
(a) Selling and marketing expenses are those expenses that are directly related to the
company’s efforts to generate sales. These items shall include (to be disclosed
separately):
(i) Payroll costs of sales, marketing and distribution functions (ESOP and ESPP
expenses to be disclosed separately);
(ii) Advertising;
(iii) Sales persons’ travel and entertaining;
(iv) Warehouse costs for finished goods;
(v) Transport costs arising on the distribution of finished goods;
(vi) All costs of maintaining sales outlets;
(vii) Agents commission payable;
(viii) Other selling and marketing expenses.
(b) Administrative expenses are expenses related to the general administration of the
company’s operations. These items shall include (to be disclosed separately):
(i) Payroll costs of office and administrative staff (ESOP and ESPP expenses to be
disclosed separately);
(ii) All costs of maintaining the administration buildings;
(iii) Bad debts;
(iv) Professional costs;
(v) Amount paid to the auditor, whether as fees, expenses or otherwise for services
(vi) Directors remuneration;
(vii) Insurance expense;
(viii) Utilities expense;
(ix) Other administrative expenses.
(c) Depreciation and amortization of assets other than used in the production process and
included in cost of sales.
4. Other income: This shall include (to be disclosed separately):
(a) Interest income;
(b) Dividend income;
(c) Rental on investment properties;
(d) Increase (decrease) in carrying amounts of investments;

Notes (e) Gains and losses on trading derivatives;
(f) Amounts withdrawn, as no longer required, from provisions created previously for
meeting specific liabilities;
(g) Other miscellaneous income.
5. Other expenses: These shall be classified as:
(a) Finance costs.
(b) Others.
(a) Finance costs shall include (to be disclosed separately):
(i) Interest expense.
(ii) Dividends on preference shares classified as debt.
(b) Others shall include costs related to ‘other income’.
6. Tax Expense – Others: Others shall be specified separately.
Any item for which the expense exceeds one percent of the revenues from operations of
the Company or `1,00,000 whichever is higher, shall be shown as a separate and distinct
item under the appropriate head of expense in the notes to accounts and shall not be
combined with any other item.
Results from discontinued operations included in the statement of profit and loss i.e.
income (loss) from activities and gain (loss) from disposal of assets/settlement of liabilities
shall be disclosed separately in the notes to accounts.
The given below is the proforma of profit & loss account:
Profit & Loss account of ...Ltd., for the year ended...
` `
Opening Stock Sales

Purchases Less: Sales returns
Less: Purchases Returns Closing stock
Carriage/Carriage Inwards/
Carriage on Purchases
Freight, Duty & Clearing Charges
Wages/manufacturing wages,
productive wages
Packing Materials (Primary)
Fuel and Power
Coal, Gas and Water
Motive Power
Salaries / Salaries and wages By Gross Profit b/d

Rent Rates and Taxes Interest Received
Lighting Discount Received
Contd...

Notes
Printing and Stationary Commission Received
Postage and Telegrams Rent Received
Telephone Charges Miscellaneous Receipt
Legal Expenses Dividend from
Audit Fees subsidiaries
General Expenses Net Loss

Advertisement
Salesmen salaries and commission
Packing Expenses (Secondary)
Bad Debts
Provision for Doubtful Debts
Provision for Discount
Depreciation provisions
Other Provisions
Repairs and renewals
Discount allowed
Carriage Outwards
Interest on Loan
Interest on Capital
Loss by fire or theft
Charity
Issue Expenses
Commissions
Managing Agents Commission
Managerial Remuneration
Provision for taxation
Provision for Dividend
Net Profit/Loss
Self Assessment
17. Cost of direct materials consumed arrived at by adding net purchases to beginning inventory
to obtain direct materials available.
18. Administration expenses are those that are incurred in order to generate sales.
19. Operating expenses are those expenses that are directly related to the company’s efforts to
generate sales.

Notes 8.7 Report of the Auditors to the Shareholders
The independent auditors report deals with the creditability of the financial statements.
Management through its internal accounting system is logically responsible for record-keeping
because it needs similar information for its own use in operating the business. The Certified
Public Accountants (Chartered Accountant) acting independently, add the necessary creditability
to management’s figures for interested third parties. They report to the Board of Directors and
the shareholders.
In form and language, most auditors’ reports are like the one shown below. The report is
divided into four parts:
The first paragraph identifies the financial statements subject to the auditors report. The
paragraph also identifies responsibilities of company management towards financial
statements and the auditor is responsible for expressing an opinion on the financial
statements based on the audit.
Second paragraph contains the scope that states that the examination was made in
accordance with generally accepted auditing standards (accepted in India). These standards
call for an acceptable level of quality in special areas established by the Institute of Chartered
Accountants of India. This paragraph also contains a brief description of the objectives and
nature of audit.
The third paragraph contains some information on specific areas as provided by the
Companies (Auditors Report) Order 2003.
The fourth paragraph, or opinion section, states the results of the auditor’s examination.
The use of the word opinion is very important because the auditor does not certify or
guarantee that the statements are absolutely correct. Instead, the auditors simply give an
opinion about whether, overall, the financial statements give true and fair view of the
financial position, results of operations and cash flows. This means that the statements are
prepared in accordance with generally accepted accounting principles (generally accepted
in India). If in the auditor’s opinion, the statements do not meet accepted standards, the
auditors must give full disclosure and explanation.
Self Assessment
Fill in the blanks:
20. The independent ………… report deals with the creditability of the financial statements.
21. The first paragraph of auditor’s report identifies the …………….subject to the auditors
report.
Task Work out capital structure of Dawson and Ross Manufacturing Company Ltd. as it
would appear in the balance sheet as on 31 December.
The company issued a prospectus offering 50,00,000 Equity Shares of ` 100 as face value
and 10,00,000. 13.5% 2007 Redeemable Preference Shares of ` 250 each on 1 September. The
issue was open for a week. The company’s merchant bankers reported subscription of
48,50,000 Equity shares and the entire preference issue. The prospectus had stipulated ` 30
of the equity shares as application money, ` 40 to be paid on allotment and the balance at
the call. The entire face value of the preference share is to be paid along with application.
Contd...

The company allotted all shares. However it was found that 17,500 equity subscribers had Notes
not paid the allotment money and another 12,750 subscribers, who had paid allotment,
defaulted in meeting the call. The company, after due notice forfeited the shares on which
allotment money was not paid. These shares were later reissued at ` 80.
8.8 Summary
Financial reporting in corporate organisations is regulated by the laws under which the
organizations are registered.
As such, these reports are more transparent compared to non-corporate financial reports.
The Companies Act, 1956 has prescribed a format in which corporates are to present their
balance sheet.
For profit and loss account, the act has laid down parameters to be followed.
A corporate can present its financial reporting in a horizontal ‘T’ form or in a vertical
statement form.
Details on each of the items of balance sheet and profit and loss account are required to be
furnished as schedules or notes.
The prescribed corporate balance sheet follows the permanency method for marshalling
assets and liabilities.
The liability side of balance sheet has five segments—for share capital, reserves and
surpluses, secured and unsecured loans, current liabilities and provisions.
In the assets side, fixed assets, investments, current assets and miscellaneous expenses are
the groups.
The profit and loss account of a corporate can be prepared as per the pattern chosen by the
directors.
The financial statements are also to be accompanied by auditors’ report and directors’
report. The statements have to be audited and placed before the shareholders at the annual
general meeting, within six months of the expiry of the financial year.
Three copies of the report are to be furnished to the registrar of companies within thirty
days of laying the report in annual general meeting.
The reports should be signed by the managing director and at least one more director.
8.9 Keywords
Contingent Liabilities: Contingent liabilities are such liabilities which may exist or may not
exist subject to happening or not happening the event.
Secured Loans: If any security is given by way of a mortgage or charge on all or any of its
property, the loan is termed as secured loan.
Share Capital: It means the share of the owner’s in the company.
Unsecured Loans: If a company borrows loans without giving any security, then such loans are
termed as unsecured loans.
1. What on the Key qualitative characteristics of financial reporting informations?
2. Are non-corporate business organizations legally obliged to prepare financial statements?

Notes 3. Why should law prescribe format for financial reporting to corporates?
4. What does schedule VI of companies Act 1956 stipulate?
5. How are assets and liabilities of corporate organisations marshalled?
6. Describe the asset side of corporate balance sheet.
7. What are the groupings in liabilities of corporate balance sheet?
8. What, according to you, are the major differences between a corporate and non-corporate
balance sheet?
9. What are the specific features of corporate income statement compared to that of non-
corporates?
10. How are debtors presented in corporate balance sheet?
11. How do corporates income statements differ from that of non-corporate organisations?
12. State the provisions of the Companies Act, 1956, relating to the preparation and presentation
of final accounts.
13. In what aspects do company final accounts differ from final accounts of a sole trader/
partner?
1. false 2. true
3. Investors 4. creditor
5. Financial information 6. credit
7. Section 210 8. Registrar of Companies
9. segmental reporting 10. products or services
11. Schedule VI 12. authorized capital
13. Contingent liabilities 14. Fixed assets
15. secured loan 16. unsecured loans
17. true 18. false
19. false 20. auditors
21. financial statements

www.scribd.com

Neha Tikoo, Lovely Professional University Unit 9: Issues and Recent Trends in Corporate Reporting
Unit 9: Issues and Recent Trends in Corporate Reporting Notes
CONTENTS
Objectives
Introduction
9.1 Segment Reporting
9.2 Social Reporting
9.3 Transfer Pricing
9.4 Corporate Governance
9.5 Human Resource Accounting
9.6 Summary
9.7 Keywords
Objectives
Explain the concept of segment and social reporting
Define transfer pricing
Describe the emerging concepts like corporate governance and human resource accounting
Introduction
Corporate reporting is now at the centre stage of reforms in view of the shareholders’ education
by the companies. Recent developments in corporate financial reporting indicate a greater
emphasis on better voluntary disclosures by the companies regarding their performance and
state of affairs. This makes their balance sheet more transparent than ever before.
9.1 Segment Reporting
In recent years, many business enterprises have broadened the scope of their activities to
encompass different industries, foreign countries and markets. Due to the growth of diversified
business and expansion of firms into foreign markets, consolidated information becomes non-
homogeneous information. Consolidated statements enable the management to hide information
from external reporting. Some segments may be running at a loss, but the consolidated statements
will merely show the average profit figure (and other information) of all the segments taken
together. It is, therefore, necessary that along with consolidated information segment information
is also provided to the users.
With increasing tempo of globalisation, the trend in Indian corporates is to adopt international
standards in financial reporting. The Institute of Chartered Accountants of India has issued
standard on segmental reporting AS17. Indian corporates, listed or proposed to be listed on the
stock exchanges has to adopt segmental reporting. Companies with multiple products or services
and those with area of operation extending beyond the boundaries of the country would have to
present separate financial report for each of the activities and for each territory. Each segmental

Notes report will contain information as to the sales, costs, assets and liabilities pertaining to that
segment. The important aspect is that segmental transfers are to be priced fairly and disclosed.
There is also another accounting standard (AS21) which makes its compulsory to present
consolidated financial data of holding company and its subsidiaries. It is expected that the
disclosures, under the accounting standard would help the users of the data to have a holistic
assessment of the risk and return of an enterprise, with multi-product line and multinational
operations.
Business and Geographical Segments
Business and geographical segments of an enterprise for external reporting purposes should be
those organisational units for which information is reported to the board of directors and to the
chief executive officer for the purpose of evaluating the unit’s performance and for making
decisions about future allocations of resources.
A business segment or geographical segment should be identified as a reportable segment if:
1. Its revenues from sales to external customers and from transactions with other segments
is 10 per cent or more of the total revenue, external and internal, of all segments; or
2. Its segment result, whether profit or loss, is 10 per cent or more of -
the combined result of all segments in profit, or
the combined result of all segments in loss,
whichever is greater in absolute amount; or
3. Its segment assets are 10 per cent or more of the total assets of all segments.
Segment information should be prepared in conformity with the accounting policies adopted
for preparing and presenting the financial statements of the enterprise as a whole. There is a
presumption that the accounting policies that the directors and management of an enterprise
have chosen to use in preparing the financial statements of the enterprise as a whole are those
that the directors and management believe are the most appropriate for external reporting
purposes. Since the purpose of segment information is to help users of financial statements
better understand and make more informed judgements about the enterprise as a whole, this
Standard requires the use, in preparing segment information, of the accounting policies adopted
for preparing and presenting the financial statements of the enterprise as a whole. That does not
mean, however, that the enterprise accounting policies are to be applied to reportable segments
as if the segments were separate stand-alone reporting entities. A detailed calculation done in
applying a particular accounting policy at the enterprise-wide level may be allocated to segments
if there is a reasonable basis for doing so. Pension calculations, for example, often are done for
an enterprise as a whole, but the enterprise-wide figures may be allocated to segments based on
salary and demographic data for the segments.
Notes Bases of Segmenting
The following are, generally, the bases of segmenting:

Product lines: If a company has diversified its production activities, and is
manufacturing different and distinct types of products, financial information can be
provided on the basis of product lines.
Contd...

Unit 9: Issues and Recent Trends in Corporate Reporting
For example, Delhi Cloth and General Mills Ltd., which manufacturers cloth, Notes
computers, automobiles, PVC, and other engineering products, and would thus
need this kind of segment reporting.
Geographical divisions: If a company has operations extended in foreign markets,

geographical division-wise segmentation will be relevant. This will be more relevant
in the case of multinational corporations and other big companies with extensive
overseas operations. Even within a country (if it is big); there can be region-wise
segmentation for better management and reporting purposes.
Customer-type: Classification may be relevant in case of those who look for

comparability among firms. In this case a uniform standard industrial classification
is necessary. Comparability can be among firms of the same (absolute) size and type
of operations. For investors, however, that classification which permits the greatest
degree of predictability will be the most relevant.
Self Assessment
Fill in the blanks:
1. …………….statements enable the management to hide information from external

reporting.
2. The Institute of Chartered Accountants of India has issued standard on segmental reporting
…………….
3. Each segmental report will contain information as to the sales, ………….., assets and
liabilities pertaining to that segment.
4. If a company has diversified its production activities, and is manufacturing different and
distinct types of products, financial information can be provided on the basis of …………..
5. If a company has operations extended in foreign markets, …………….division-wise

segmentation will be relevant.
9.2 Social Reporting

Aspects included in social reporting include such information disclosed in the annual reports
viz., Statement on Human Resource Accounting, Statement of Value Added Report on Foreign
Currency Transactions (revealing the balance of payments position) and Accounting for Various
Social Objectives.
The concept of social reporting is gaining popularity on account of the following factors:
Increasing awareness of society regarding the contributions the corporate units are making.
Providing meaningful means of identifying and rewarding business for social contribution.
Identifying adverse effects on the environment of the business houses.
Social reporting improves credibility and reputation of business.
Transferring cost of social activities to other segments of society.
The concept of social responsibility extends beyond the provisions embodied in current law.
Essentially, it represents an emerging debate having its roots in political and social theory.

Notes While designing the contents to be included in social reporting, due care should be taken to see
that it does not conflict with the shareholders’ interest.
!
Caution Social reporting presently is being either included in the Annual Reports or finds
some reference in the Chairman’s Address or the Director’s Report. Social reporting format
tends to vary from one company to another company as till date no format has been
described by any Act in India.
Self Assessment
Fill in the blanks:
6. ……………..is reporting on those activities of an organisation that have an impact on

7. Social reporting presently is being either included in the …………….or finds some reference
in the Chairman’s Address or the Director’s Report.
9.3 Transfer Pricing

Large business units are usually organised into different divisions for better control. In such a
situation, if one division supplies its finished output as input to other division, there arises a
very important issue. The issue being at which price should be transferring unit transfer its
product or service. Such price is known as transfer price.
Transfer prices are the amounts charged by one segment of an organization for a product or
service that it supplies to another segment of the same organization.
Transfer price in simple words is the price that one sub-unit (segment, department, division and
so on) of an organization charges for a product or service supplied to another subunit of the
same organization. It is different from the normal price in that both divisions are a part of the
same organisation and therefore it is only an internal transfer and not sale. The pricing of these
flows is likely to have an impact on the performance evaluation of the divisions. Setting of
transfer pricing policies within the company is of great significance. The important issue now is
at what price should such transfers be made.
Did u know? Why do transfer-pricing systems exist?

To communicate data that will lead to goal-congruent decisions.
To evaluate segment performance and thus motivate managers toward goal-
congruent decisions.
Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and
tariffs. Ideally, the chosen transfer-pricing method should lead each subunit manager to make
optimal decisions for the organization as a whole. The three specific criteria that can help in
choosing a transfer-pricing method are:
Promotion of Goal Congruence: Goal congruence exists when each divisional or sub-unit
manager acting in his or her own best interest takes actions that automatically result in
achieving the organisation goals established by top management.
Promotion of a Sustained High Level of Management Effort: Effort is defined as exertion
towards a goal, for example, sellers are motivated to hold down costs of supplying product
or service, and buyers are motivated to acquire and use inputs efficiently. The environment

in the organisation should be such that a sustained high level of management effort is Notes
promised.
Promotion of a High Level of Subunit Autonomy in Decision-making: Autonomy is the
degree of freedom a division manager can exercise in decisions making. If top management
favours a high degree of decentralization, this criterion is of particular importance.
Self Assessment
Fill in the blanks:
8. ……………….are the amounts charged by one segment of an organization for a product or

service that it supplies to another segment of the same organization.
9. ………………companies use transfer pricing to minimize their worldwide taxes, duties,

and tariffs.
10. …………….is the degree of freedom a division manager can exercise in decisions making.
9.4 Corporate Governance

Corporate governance denotes of voluntary ethical code of business and management of
companies. It aims to maximize the effectiveness and accountability of the brand of directors.
Corporate Governance deals with terms, procedure, practices and implicit rules that determine
a company’s ability to take managerial decisions to maximize long term shareholders value and
also to take care of all other shareholders in the enterprise. Cadbury Committee England and
CII in India has framed certain rules for desirable corporate governance. The Companies in
India now have started attempt to voluntary disclose the compliance of such codes.
Good corporate governance relates to systems of supervision and monitoring that maximise
long term shareholder value of a company, and also addresses the interests of all other stakeholders
in the enterprise. Although corporate governance varies across countries, there is a growing
consensus about the need for four key elements. These are:
Transparency: Transparency means a commitment that the business is managed along
transparent lines.
Fairness: Fairness to all stakeholders in the company, but especially to minority
shareholders.
Disclosure: Disclosure of all relevant financial and non-financial information in an easily
understood manner.
Supervision: Supervision of the company’s activities by a professionally competent and
independent board of directors.
Good corporate governance deals with building trust with customers, suppliers, creditors and
diverse investors-trust that the company will be manage properly, will successfully perpetuate
its businesses, will protect and enhance the capital of its investors, and will increase corporate
value for its shareholders.
Bajaj Auto has believed in these principles since its inception and has always discharged its
fiduciary obligations towards its shareholders. During the last two years, we have gone further
by steadily increasing the levels of disclosure in our annual reports-disclosures that go beyond
the statutes.
We have accelerated the trend this year. For instance, we have checked our corporate governance
performance against the code prepared by the Confederation of Indian Industry (CII, Desirable
Corporate Governance: A code, April 1988).

Notes Self Assessment
Fill in the blanks:
11. …………….denotes of voluntary ethical code of business and management of companies.
12. Corporate Governance deals with terms, procedure, practices and implicit rules that
determine a company’s ability to take …………to maximize long term shareholders value
and also to take care of all other shareholders in the enterprise.
9.5 Human Resource Accounting
The past few decades have witnessed a global transition from manufacturing to service-based
economies. The fundamental difference between the two lies in the very nature of their assets. In
the former, physical assets like plant, machinery, material, etc., are of utmost importance. In
contrast, in the latter, knowledge and attitudes of the employees assume greater significance.
For instance, in the case of an IT firm, the value of its physical assets is negligible when compared
with the value of the knowledge and skills of its personnel. Similarly, in hospitals, academic
institutions, consulting firms etc., the total worth of the organisation depends mainly on the
skills of its employees and the services they render. Therefore, the success of these organizations
is contingent on the quality of their human resource – their knowledge, skills, competence,
motivation and understanding of the organisational culture.
In knowledge-driven economies therefore, it is imperative that the humans be recognised as an

integral part of the total worth of an organisation. However, in order to estimate and project the
worth of human capital, it is necessary that some method of quantifying the worth of the
knowledge, motivation, skills, and contribution of the human element as well as that of the
organisational processes, like recruitment, selection, training, etc., which are used to build and
support these human aspects, is developed. Human Resource Accounting (HRA) denotes just
this process of quantification/measurement of human resources.
Task Identify the key differences between human resource accounting and cost
accounting.
Self Assessment
Fill in the blanks:
13. The past few decades have witnessed a global transition from manufacturing to
…………………economies.
14. ………………….denotes just this process of quantification/measurement of human

resources.
15. In ……………..economies it is imperative that the humans be recognised as an integral

part of the total worth of an organisation.
9.6 Summary
Recent developments in corporate financial reporting indicate a greater emphasis on

better voluntary disclosures by the companies regarding their performance and state of
affairs.

Companies with multiple products or services and those with area of operation extending Notes
beyond the boundaries of the country would have to present separate financial report for
each of the activities and for each territory.
Each segmental report will contain information as to the sales, costs, assets and liabilities
pertaining to that segment.

Transfer prices are the amounts charged by one segment of an organization for a product
or service that it supplies to another segment of the same organization.
Corporate governance denotes of voluntary ethical code of business and management of

companies. It aims to maximize the effectiveness and accountability of the brand of directors.
Human Resource Accounting (HRA) denotes just this process of quantification/

measurement of human resources.
9.7 Keywords
Corporate Governance: Corporate governance denotes of voluntary ethical code of business

and management of companies. It aims to maximize the effectiveness and accountability of the
brand of directors.
Human Resource Accounting (HRA): Human Resource Accounting (HRA) denotes just this process
of quantification/measurement of human resources.
Social Reporting: Social reporting is reporting on those activities of an organisation that have an
impact on society at large and are not necessarily represented by its traditional financial report.
Transfer Prices: Transfer prices are the amounts charged by one segment of an organization for
a product or service that it supplies to another segment of the same organization.
1. Indian corporates, listed or proposed to be listed on the stock exchanges has to adopt
segmental reporting. Discuss.
2. Identify the key basis of segmentation.
3. Why social accounting is getting popularity in recent years?
4. Why do transfer-pricing systems exist?
5. What do you mean by corporate governance?
6. In knowledge-driven economies it is imperative that the humans be recognised as an

integral part of the total worth of an organisation. Why?
1. Consolidated
2. AS17
3. costs
4. product lines

Notes 5. geographical
6. Social reporting
7. Annual Reports
8. Transfer prices
9. Multinational
10. Autonomy
11. Corporate governance
12. managerial decisions
13. service-based
14. Human Resource Accounting (HRA)
15. knowledge-driven

www.scribd.com

Neha Tikoo, Lovely Professional University Unit 10: IFRS and its Relevance
Unit 10: IFRS and its Relevance Notes
CONTENTS
Objectives
Introduction
10.1 International Accounting Standard Board
10.2 Types of IFRS and their Relevance
10.3 Qualitative Characteristics of IFRS Financial Statements
10.4 Challenges in Implementation of IFRS in India
10.5 Major Difference between Indian Accounting Standards and IFRS
10.6 Summary
10.7 Keywords
Objectives
Identify the scope of IFRS
Describe the types of IFRS and their relevance
Understand conceptual framework of IASB and IASC
Describe the qualitative characteristics of IFRS
Introduction
The term International Financial Reporting Standards (IFRSs) has both a narrow and a broad
meaning. Narrowly, IFRSs refers to the new numbered series of pronouncements that The
International Accounting Standards Board (IASB) is issuing, as distinct from the International
Accounting Standards (IASs) series issued by its predecessor. More broadly, IFRSs refers to the
entire body of IASB pronouncements, including standards and interpretations approved by the
IASB and IASs interpretations approved by the predecessor International Accounting Standards
Committee.
Did u know? What is the meaning of accounting standards?
It is a set of certain generally accepted rules, principles, concepts and conventions issued
by the Institute of chartered Accountants of India in consultation with other International
Accounting bodies. The purpose of making uniform rules and principles is to make the
preparation and presentation of financial statement easy, relevant, reliable, understandable
and finally comparable. In other words, Accounting standards are the basis of accounting
policies and practices to facilitate the recording of transactions and events in such a way
which can change them into financial statements, to be used by the persons interested in
getting the correct and reliable information with a view to take future decisions.

Notes 10.1 International Accounting Standard Board
The International Accounting Standards Board (IASB) founded on April 1, 2001 is the successor of
the IASC. It is responsible for developing International Financial Reporting Standards – a new
name for International Accounting Standards – and promoting and application of the standards.
The standards issued by IASB were named as International Financial Reporting Standards (IFRS).
The International Accounting Standards Board is an independent privately-funded accounting
standard board. Since its renaming, IFRS has issued 8 standards and had adopted many of the
earlier standards issued by IASC with and without modifications. IFRS is finding favor with
most of the advanced economies of the world.
The IASB has 15 Board members, each with one vote. They are selected as a group of experts with
a mix of experience of standard-setting, preparing and using accounts, and academic work. At
their January 2009 meeting the Trustees of the Foundation concluded the first part of the second
Constitution Review, announcing the creation of a Monitoring Board and the expansion of the
IASB to 16 members and giving more consideration to the geographical composition of the
IASB.
The IFRS Interpretations of Committee has 14 members. Its brief is to provide timely guidance
on issues that arise in practice. A unanimous vote is not necessary in order for the publication of
a Standard, exposure draft, or final “IFRIC” Interpretation. The Board’s 2008 Due Process manual
stated that approval by nine of the members is required.
Notes Need for Accounting Standards
Different business enterprises were having different modes of recording the transactions
and events and lack of uniform set of rules created a lot of problems, such as comparison
was not truly possible but difficult also this was because of the nature of business, diversified
and complex economic situations. This also made accounting information incomparable
and less meaningful. Therefore a need was felt to have certain minimum standards which
are universally applicable, so that the financial statements thus made, can be more reliable,
comparable, relevant and understandable. Keeping this in view, International Accounting
Standard Committee (IASC) was set up in 1973. The objectives of this Committee were:
To formulate and publish, in the public interest, accounting standards to be observed

in the presentation of financial statements and also its world wide acceptance, and
To work for improvement and harmonization of regulation of accounting standards

and procedure relating to the presentation of financial transactions.
Self Assessment
1. The International Accounting Standards Board (IASB) founded on April 1, 2001.
2. The IASB has 14 Board members, each with one vote.
3. The IFRS Interpretations OF Committee has 15 members.
4. The International Accounting Standards Board is an independent privately-funded

accounting standard board.

Unit 10: IFRS and its Relevance
10.2 Types of IFRS and their Relevance Notes
The following are the key IFRS issued by International Accounting Standard Board (IASB):
IFRS 1: First-time Adoption: IFRS 1 requires an entity to do the following in the opening
IFRS statement of financial position that it prepares as a starting point for its accounting
under IFRSs: (a) Recognize all assets and liabilities whose recognition is required by
IFRSs; (b) Not recognize items as assets or liabilities if IFRSs do not permit such recognition;
(c) Reclassify items that it recognized under previous GAAP as one type of asset, liability
or component of equity, but are a different type of asset, liability or component of equity
under IFRSs; and (d) Apply IFRSs in measuring all recognized assets and liabilities.
IFRS 2: Share-based Payment: The objective of this IFRS is to specify the financial reporting
by an entity when it undertakes a share-based payment transaction. In particular, it requires
an entity to reflect in its profit or loss and financial position the effects of share-based
payment transactions, including expenses associated with transactions in which share
options are granted to employees.
IFRS 3: Business Combinations: The objective of the IFRS is to enhance the relevance,
reliability and comparability of the information that an entity provides in its financial
statements about a business combination and its effects. It does that by establishing
principles and requirements for how an acquirer (a) recognizes and measures in its financial
statements the identifiable assets acquired, the liabilities assumed and any non-controlling
interest in the acquiree; (b) recognizes and measures the goodwill acquired in the business
combination or a gain from a bargain purchase; and (c) determines what information to
disclose to enable users of the financial statements to evaluate the nature and financial
effects of the business combination.
IFRS 4: Insurance Contracts: The objective of this IFRS is to specify the financial reporting
for insurance contracts by any entity that issues such contracts (described in this IFRS as an
insurer) until the Board completes the second phase of its project on insurance contracts. In
particular, this IFRS requires (a) limited improvements to accounting by insurers for
insurance contracts; (b) disclosure that identifies and explains the amounts in an insurer’s
financial statements arising from insurance contracts and helps users of those financial
statements understand the amount, timing and uncertainty of future cash flows from
insurance contracts.
IFRS 5: Non-current Assets Held for Sale and Discontinued Operations: The objective of
this IFRS is to specify the accounting for assets held for sale, and the presentation and
disclosure of discontinued operations. In particular, the IFRS requires (a) assets that meet
the criteria to be classified as held for sale to be measured at the lower of carrying amount
and fair value less costs to sell, and depreciation on such assets to cease; and (b) assets that
meet the criteria to be classified as held for sale to be presented separately in the statement
of financial position and the results of discontinued.
IFRS 6: Exploration for and evaluation of Mineral Resources: The IFRS (a) permits an
entity to develop an accounting policy for exploration and evaluation assets without
specifically considering the requirements of paragraphs 11 and 12 of IAS 8. Thus, an entity
adopting IFRS 6 may continue to use the accounting policies applied immediately before
adopting the IFRS. This includes continuing to use recognition and measurement practices
that are part of those accounting policies; (b) requires entities recognising exploration and
evaluation assets to perform an impairment test on those assets, when facts and
circumstances suggest that the carrying amount of the assets may exceed their recoverable
amount; and (c) varies the recognition of impairment from that in IAS 36 but measures the
impairment in accordance with that Standard once the impairment is identified.

Notes IFRS 7: Financial Instruments: Disclosures: The IFRS applies to all entities, including
entities that have few financial instruments (for example: a manufacturer whose only
financial instruments are accounts receivable and accounts payable) and those that have
many financial instruments (for example: a financial institution most of whose assets and
liabilities are financial instruments).
The objective of this IFRS is to require entities to provide disclosures in their financial
statements that enable users to evaluate (a) the significance of financial instruments for
the entity’s financial position and performance; and (b) the nature and extent of risks
arising from financial instruments to which the entity is exposed during the period and at
the end of the reporting period, and how the entity manages those risks. The qualitative
disclosures describe management’s objectives, policies and processes for managing those
risks. The quantitative disclosures provide information about the extent to which the
entity is exposed to risk, based on information provided internally to the entity’s key
management personnel. Together, these disclosures provide an overview of the entity’s
use of financial instruments and the exposures to risks they create.
IFRS 8: Operating Segments: This IFRS shall apply to (a) the separate or individual financial
statements of an entity: whose debt or equity instruments are traded in a public market
(a domestic or foreign stock exchange or an over-the-counter market, including local and
regional markets), or (ii) that files, or is in the process of filing, its financial statements
with a securities commission or other regulatory organisation for the purpose of issuing
any class of instruments in a public market; and (b) the consolidated financial statements
of a group with a parent: (i) whose debt or equity instruments are traded in a public
market (a domestic or foreign stock exchange or an over-the-counter market, including
local and regional markets), or (ii) that files, or is in the process of filing, the consolidated
financial statements with a securities commission or other regulatory organisation for the
purpose of issuing any class of instruments in a public market.
!
Caution GAAP provides a general framework for financial accounting—objectives,
standards, concepts, assumptions, methods and rules. It is not comparable to the physical
laws, where causes lead to definite results.
Self Assessment
Fill in the blanks:
5. The objective of …………. is to specify the financial reporting by an entity when it

undertakes a share-based payment transaction.
6. The objective of IFRS 5 is to specify the accounting for assets held for sale, and the
presentation and disclosure of ……………operations.
7. ……………….provides a general framework for financial accounting—objectives,

standards, concepts, assumptions, methods and rules.
8. The ………….. applies to all entities, including entities that have few financial instruments
and those that have many financial instruments.
10.3 Qualitative Characteristics of IFRS Financial Statements
The qualitative characteristics will provide assistance when choices have to be made between
reporting policies – whether by preparers, auditors, those participating in the standard-setting

process, regulators or others – and be indicative of the qualities that users can expect of the Notes
financial information provided to them.
For the purposes of this Statement:
Comparability: Comparability means that quality of financial information which exists

when users of that information are able to discern and evaluate similarities in, and
differences between, the nature and effects of transactions and events, at one time and over
time, either when assessing aspects of a single reporting entity or of a number of reporting
entities;
Materiality Test: Materiality test means that test which is used to assess the extent to
which relevant and reliable information may be omitted, misstated or not disclosed
separately without having the potential to adversely affect the decisions about the
allocation of scarce resources made by users of a general purpose financial report or the
rendering of accountability by preparers;
Relevance: Relevance means that quality of financial information which exists when that
information influences decisions by users about the allocation of scarce resources by:
helping them form predictions about the outcomes of past, present or future events;
and/or
confirming or correcting their past evaluations; and which enables users to assess
the rendering of accountability by preparers;
Reliability: Reliability means that quality of financial information which exists when that
information can be depended upon to represent faithfully, and without bias or undue
error, the transactions or events that either it purports to represent or could reasonably be
expected to represent; and
Understandability: Understandability means that quality of financial information which
exists when users of that information are able to comprehend its meaning.
General purpose financial reporting involves making decisions about the selection of financial
information to be included in general purpose financial reports, the measurement of that
information and its presentation. These decisions should be consistent with the objective of
general purpose financial reporting and should yield information which possesses the qualitative
characteristics set out in this Statement.
Notes Benefits of IFRS

The following points explain the benefits of using IFRS:
It would benefit the economy by increasing growth of international business
It would encourage international investing and thereby lead to more foreign capital
inflows into the country.
Investors want the information that is more relevant, reliable, timely and comparable
across the jurisdictions.
IFRS would enhance the comparability between financial statements of various
companies across the globe.
Better understanding of financial statements would benefit investors who wish to
invest outside their own country.
Contd...

Notes The industry would be able to raise capital from foreign markets at lower cost if it
can create confidence in the minds of foreign investors that their financial statements
comply with globally accepted accounting standards.
It would reduce different accounting requirements prevailing in various countries
there by enabling enterprises to reduce cost of compliances.
It would provide professional opportunities to serve international clients.
It would increase their mobility to work in different parts of the world either in
industry or practice.
Self Assessment
Fill in the blanks:
9. ………….. means that quality of financial information which exists when that information
influences decisions by users about the allocation of scarce resources.
10. ………….means that quality of financial information which exists when users of that
information are able to comprehend its meaning.
11. IFRS would enhance the …………between financial statements of various companies across
the globe.
Task Discuss the applicability of IFRS in India.
10.4 Challenges in Implementation of IFRS in India
The following are the key recommendations suggested by the task force set up by ICAI in 2006:
1. Lack of Awareness: Adoption of IFRS means a complete set of different reporting standards
have to bring in. The awareness of these reporting standards is still not there among the
stakeholders like firms, banks, stock exchanges, commodity exchanges etc.
2. Training: Professional accountants are looked upon to ensure successful implementation

of IFRS. The biggest hurdle for the professionals in implementing IFRS is the lack of
training facilities and academic courses on IFRS in India. The solution to this problem is
that all stakeholders in the organisation should be trained and IFRS should be introduced
as a full time subject in the universities.
3. Amendments to the Existing Laws: It is observed that implementation of IFRS may result
in a number of inconsistencies with the existing laws which include the Companies Act
1956, SEBI regulations, banking laws and regulations and the insurance laws and
regulations. Currently, the reporting requirements are governed by various regulators in
India and their provisions override other laws. IFRS does not recognise such overriding
laws. Although steps to amend these laws have been initiated, the authorities need to
ensure that the laws are amended well in time.
4. Taxation: IFRS adoption will affect most of the items in the Financial Statements and
consequently, the tax liabilities would also undergo a change. Currently, Indian Tax Laws
do not recognize the Accounting Standards. A complete overhaul of Tax laws is the major
challenge faced by the Indian Law Makers immediately. Enough changes are to be made
in Tax laws to ensure that tax authorities recognize IFRS-Compliant financial statements
otherwise it will duplicate the administrative work for the Firms.

5. Fair Value: IFRS uses fair value as a measurement base for valuing most of the items of Notes
financial statements. The use of fair value accounting can bring a lot of volatility and
subjectivity to the financial statements. It also involves a lot of hard work in arriving at
the fair value and valuation experts have to be used. Moreover, adjustments to fair value
result in gains or losses which are reflected in the income statements. Whether this can be
included in computing distributable profit is also debated.
6. Reporting Systems: The disclosure and reporting requirements under IFRS are completely
different from the Indian reporting requirements. Companies would have to ensure that
the existing business reporting model is amended to suit the reporting requirements of
IFRS. The information systems should be designed to capture new requirements related to
fixed assets, segment disclosures, related party transactions, etc. Existence of proper internal
control and minimising the risk of business disruption should be taken care of while
modifying or changing the information systems.
10.5 Major Difference between Indian accounting standards and IFRS
The following are the key differences between Indian accounting standards and IFRS:
Contd...

Notes
Self Assessment
Fill in the blanks:

12. IFRS uses ……………..as a measurement base for valuing most of the items of financial
statements.
13. The ………… and reporting requirements under IFRS are completely different from the
Indian reporting requirements.
10.6 Summary
Accounting standards are the basis of accounting policies and practices to facilitate the
recording of transactions and events in such a way which can change them into financial
statements, to be used by the persons interested in getting the correct and reliable
information with a view to take future decisions.
The International Accounting Standards Board (IASB) founded on April 1, 2001 is the
successor of the IASC.
The International Accounting Standards Board is an independent privately-funded

accounting standard board.
IFRS has issued 8 standards and had adopted many of the earlier standards issued by IASC
with and without modifications.
GAAP provides a general framework for financial accounting— objectives, standards,

concepts, assumptions, methods and rules. It is not comparable to the physical laws,
where causes lead to definite results.
The qualitative characteristics will provide assistance when choices have to be made
between reporting policies - whether by preparers, auditors, those participating in the

standard-setting process, regulators or others - and be indicative of the qualities that users Notes
can expect of the financial information provided to them.
General purpose financial reporting involves making decisions about the selection of
financial information to be included in general purpose financial reports, the measurement
of that information and its presentation.
10.7 Keywords
Accounting Standards: Accounting standards are the basis of accounting policies and practices
to facilitate the recording of transactions and events in such a way which can change them into
financial statements, to be used by the persons interested in getting the correct and reliable
information with a view to take future decisions.
Financial Statements: Financial statements are the most important way of periodically presenting
to parties outside the business the information that has been gathered and processed in the
accounting system.
IASB: International Accounting Standards Board

IFRS: International Financial Reporting Standards
1. The term International Financial Reporting Standards (IFRSs) has both a narrow and a
broad meaning. Discuss.
2. Write a note on organisation structure of IASB.
3. Why accounting standards are important in preparing the financial statements?

4. The standards issued by IASB were named as International Financial Reporting Standards
(IFRS). What are the key standards issued by IASB?
5. What are the key benefits of using IFRS?
6. Identify the key characteristics of IFRS financial statements.
7. Discuss the meaning and scope of IFRS 7.
8. What are the key challenges in implementation of IFRS in India?
1. true 2. false
3. false 4. true
5. IFRS 2 6. discontinued
7. GAAP 8. IFRS 7
9. Relevance 10. Understandability
11. comparability 12. For value
13. Disclosure

Notes 10.9 Further Readings

www.scribd.com

Pooja, Lovely Professional University Unit 11: Introduction to Financial Reporting Framework
Unit 11: Introduction to Financial Reporting Framework Notes
CONTENTS
Objectives
Introduction
11.1 Objectives of Financial Statements
11.2 Contribution of Financial Statements in Meeting the Needs of Users
11.2.1 External Users of Accounting Information
11.2.2 Internal Users of Accounting Information
11.3 Capital Market Requirements for Preparing Financial Statements
11.4 Limitations or Drawbacks of Financial Statements
11.5 Summary
11.6 Keywords
Objectives
Identify the contribution of financial statements in meeting the needs of users and capital
market
State the limitations of financial statements
Understand the objectives of financial statements
Introduction
Accounting is thousands of years old; the earliest accounting records, which date back more than
7 million years, were found in Mesopotamia (Assyrians). The people of that time relied on
primitive accounting methods to record the growth of crops and herds. Accounting evolved,
improving over the years and advancing as business advanced.
Accounting is the language of business throughout the world. Every business organization
keeps its financial records so that the parties interested, can have an analysis through it.
Accounting means recording each transaction that takes place and further, summarizing the
records for financial communications. Accounting is the process by which the data generated in
bookkeeping are processed, analyzed and interpreted, to be used as guidelines by the management
in framing future policies of the business.
A financial statement is summarised data, collected and organised according to logical and
consistent accounting procedure. Its purpose is to convey an understanding of some financial
aspects of a business firm the term financial statement generally refer to two statements (i) the
position statement or the balance sheet and (ii) the income statement/profit & loss account.
These statements are used to convey to management and interested parties about the profitability
and financial position of a firm.
These financial statements serve a “general purpose” as most of the users are outside the business.

Notes
Figure 11.1: Components of financial statement
11.1 Objectives of Financial Statements
Basically, there are three objectives of financial reporting:
To give information useful for making investment and credit decisions. Financial reporting
should offer information that can help present and potential investors and creditors to
make rational investment and credit decisions. The information should be in the form that
is easy and understandable to those who have some understanding of business and are
willing to study the information carefully.
To provide information useful in assessing cash flow prospects. Financial reporting should
supply information to help present and potential investors and creditors appraise the
amounts, timing and possible risk of expected cash receipts from dividends or interest and
the proceeds from the sale, redemption or maturity of stocks or loans.
To provide information about business resources claims to those resources and changes in
them. Financial information should give information about the company’s assets, liabilities
and shareholders equity.
These financial statements are “general purpose” because most of the users are outside the
business. Because of potential conflict of interest between managers, who must prepare the
statements and the investors or creditors, who invest in or lend money to the business, these
statements are often audited by outside accountants (known as auditors) to increase creditability
and reliability.
Self Assessment
Fill in the blanks:
1. ……………. means recording each transaction that takes place and further, summarizing
the records for financial communications.
2. A …………..is summarised data, collected and organised according to logical and consistent
accounting procedure.
3. Financial statements are the most important way of periodically presenting to parties
outside the business the information that has been gathered and processed in the …………...

Unit 11: Introduction to Financial Reporting Framework
11.2 Contribution of Financial Statements in Meeting the Needs of Notes

Users
The accounting system generates accounting information in the form of financial reports. There
are two major categories of these reports: External and Internal.
Individuals and organisations that have an economic interest in the business but are not a part
of the management use external financial reports, included in the company’s annual report.
Information is provided to these external users in the form of general-purpose financial
statements. Special reports are sometimes required by the government agencies, which the
company has to provide. Internal users, which include managers and executives working for the
company, have access to specialised management accounting information that is not available
to outsiders.
11.2.1 External Users of Accounting Information
External users have limited access to an organisation’s valuable information. The success of
their decisions depends upon the use of external reports that are reliable, relevant and comparable.
Typically, governmental and regulatory agencies have the power to get reports in specific
forms. The rest of the external users rely on general-purpose financial statements like Balance
Sheet, Income Statement and Cash Flow Statement. The term general purpose refers to the broad
range of purposes for which external users rely on these statements.
Each external user has special information needs depending on the kind of decisions he has to
take. These decisions involve getting answers to key questions, which are often available in
accounting reports. Let us now discuss several external users and the questions that confront
them.
Investors
Ravi owns a music cassettes store at Dehradun. He got an excellent job with a music company in
Delhi so he moved here. He hired Raman to manage his store, who sends Ravi a cheque every
month representing the profits from the business. How can Ravi know whether Raman is doing
a good job of managing his store? Are the amount of profits is all that he can reasonably expect?
Should he consider selling his business and invest his money elsewhere to earn more profit?
As investors, the current owners of a firm are obviously interested in knowing how the business
is doing. If Ravi considers selling his business, he needs to know how much the business is
worth. The buyer will also be interested in a fair valuation of the firm’s assets.
Investors in a company are the shareholders (owners) of the company and in many cases they are
not a part of management. They are exposed to the greatest return and risk from the company. Risk
is high because there is no promise of either repayment of their investment or a return on their
investment. Therefore, they want information that helps them estimate how much returns they
can expect in the future if they invest in a business now. Financial statements coupled with knowledge
of business plans, market forecast and the character of management helps investors in assessing
these future cash flows. External reports aim to help answer shareholder questions such as:
What is the income for current and previous years?
Are assets adequate to meet future business plans? If the company requires raising more
funds to meet its requirements, what are the sources that the company is planning to tap?
Is the company competitive enough in its industry and how does it stand compared to
other companies in the same industry?

Notes Companies normally have a board of directors. These directors are elected representatives of
the shareholders or the lenders, and are there to oversee that the company looks after the
interests of shareholders and lenders.
Lenders
Lenders loan money (or other resources) to the organisation. They are interested in only one
thing— being repaid with interest. Lenders include banks, financial institutions, finance companies
and public. Lenders look for information to help them assess whether an organisation is likely
to repay or not. External reports help them answer questions about the organisation such as:
How promptly has the company paid its past loans?
What are the risks that it currently faces?
Can it repay its current obligations and current liabilities?
How relevant are its cash flow projections with which it will repay its obligations?
Often, reports from the credit rating agencies are used to know the credit standing of the company.
There are several international and Indian credit rating agencies. Among Indian agencies, the
major ones are CRISIL (Credit Rating and Information Services of India Ltd.), CARE (Credit
Appraisal and Rating Agency Ltd.) and ICRA (Information and Credit Rating Agency Ltd). All of
them have one or the other financial institution as their promoter. Financial institutions floated
these agencies because of their own credit appraisal and information requirements, but these
agencies perform credit ratings on an independent basis, free of the influences of their promoters.

Caselet Case: S&P Ups ICICI Rating
I
nternational credit rating agency Standard and Poor’s (S&P) some time back revised
its rating outlook on ICICI Ltd to ‘stable’ from ‘negative’, even as it reaffirmed the
financial institution’s long-term rating of ‘BB’ and short-term foreign currency rating
of ‘B’.
With the upward revision in outlook, ICICI’s rating is on par with India’s sovereign rating
and a notch higher than the long-term outlook of other financial rivals like IDBI and BoB
at ‘negative’. The other major player SBI does not have a long-term rating.
In a release, S&P had stated the change in outlook was ‘supported by continuing progress
in the strengthening of ICICI’s balance sheet and a lesser probability that asset quality
will deteriorate significantly from current levels.’
S&P had said ICICI’s steps towards universal banking have helped it diversify its risks
better than its peers, which will give it a competitive advantage. However S&P said it
would still take some time for ICICI’s universal banking strategy to manifest itself fully
in its balance sheet and earnings profile.
S&P has noted that by virtue of its expertise in innovative project and infrastructure
financing, ICICI had taken a leadership position that should enable it to withstand increased
competition from the commercial banks, which are now entering this market.
Contd...

But even while it revised its outlook upwards, S&P said that key concerns continued to be Notes
reflected in ICICI’s ratings. This include a relatively higher risk business as it was
predominantly project financing, although this had been reduced significantly in recent
years; a high level of assets seen as impaired by global standards; wholesale funding
concentrations and the risks associated with the Indian operating environment.
S&P’s also commented on the company’s improved accounting systems as the company
passed provisions for non-performing assets through the profit and loss account, rather
than the capital account. ICICI has already audited its balance sheet according to US GAAP
accounting principles.
Regulators
The basic requirement of the regulators is to ensure that the company is working in accordance
with the law and is not cheating the general public which is dependent on the company for
various reasons. Regulators often have legal authority or significant influence over the activities
of organisations. As the government exercises control over regulators, they can ask for special
formats of reports that the company has to provide. The income tax authorities require
organisations to use various reports for computing taxes. Registrar of Companies (RoC) requires
list of top shareholders along with the annual report. Securities & Exchange Board of India (SEBI)
and the Stock Exchanges (like National Stock Exchange and the Bombay Stock Exchange) require
that the listed companies (companies which have wide public holding and whose shares are
traded on the stock exchange) make adequate financial disclosures in order to make sure that
investor gets sufficient information to make informed investment decisions.
Suppliers and Customers
In many cases, suppliers and customers are interested in the long-term staying power of the
company. If you were going to put up a project that supplies its product to only one customer,
you would be interested in knowing whether that customer can last for a long time. Similarly,
if you were the customer you would be interested in the long-term viability of the supplier.
!
Caution Financial statements help you in understanding the other party’s financial position.
Employees
Employees have a special interest in the company. They are interested in judging whether the
salaries/wages paid to them are fair and also in assessing their future job prospects. They are
also interested to know that if the company is doing well so that they can bargain for better
wages or working conditions. External reports of other companies can also be used to look at the
salaries paid by other competing organisations to look for better job prospects.
11.2.2 Internal Users of Accounting Information
Internal users are the individuals who are directly involved in managing and operating the
organisation. Therefore, the internal role of accounting is to provide information to help improve
the efficiency and effectiveness of their organisation in delivering products or services.
Management accounting provides internal reports to help internal users improve an organisation’s
activities. Internal reports are not subject to the same rules as external reports because internal
users are not constrained in the use of accounting information. They have access to a lot of

Notes private and valuable information that is kept secret from the external users because of competitive
concerns. Internal reports help answer questions like:
What are the manufacturing costs of a product?
What is the most profitable mix of products or services?
At what level the product should be priced at for different levels of sales?
What level of sales is necessary to break even?
What are the costs that the organisation has to bear whether the company produces or not
produces?
Is it better to manufacture or do the activity in-house or the activity should be outsourced?
Information that help answers these questions is very critical for the success of the organisation.
There are around seven functions that are common to most of the organisations as seen below.
Some of these functions may be irrelevant for a particular type of organisation (like production
function for banks). Bigger businesses usually have these operating functions as separate
departments but smaller units usually have one department involved in more than one of these
roles. For example, production department may also look after servicing in a small air-
conditioning assembling organisation. Very small organisations tend to have no departmental
break-ups at all.
Table 11.1: Seven Common Functions in Most Organisations
Function Information requirement

Research and Research & Development is aimed at creating or improving a company's
Development products or services. Managers need information about current and projected
costs and potential sales.
Purchasing Purchasing involves buying and managing materials needed for operations.
Managers need to know what, when and how much to purchase.
Production Production is the function concerning use of raw material and other activities
to produce products and services. Good production methods depend on
information for effectively planning their operations, to monitor cost and to
ensure quality.
Human Resources Human resources aim to locate, screen, hire, train, compensate, promote and
counsel employees. Managers require information about current and potential
employees, their backgrounds, payroll costs, employee benefits related and
other performance and compensation data.
Marketing Marketing is required to promote and advertise company's products or
services. Marketing people use accounting inputs about sales and costs to
effectively target consumers and set prices. Marketing also uses accounting to
monitor consumer needs, credit and price concerns.
Distribution Involves timely and accurate delivery of products or services. Relevant
information about how to minimise the costs of distribution is often key to
quality distribution.
Servicing Servicing customers after selling products is a key to success in today's
competitive world. Information is needed on both the cost and benefits of
servicing.
Both internal and external users rely on internal controls to monitor the company’s operations.
Internal controls procedures, set-up to protect assets and show reliable accounting reports,
promote efficiency and encourage adherence to company’s policies.

Self Assessment Notes
Fill in the blanks:
4. The accounting system generates accounting information in the form of ……………..
5. ………… users are the individuals who are directly involved in managing and operating
the organisation.
6. The internal role of accounting is to provide information to help improve the efficiency
and ……………. of their organisation in delivering products or services.
7. …….. is the function concerning use of raw material and other activities to produce products
and services.
8. ………………is aimed at creating or improving a company’s products or services.
11.3 Capital Market Requirements for Preparing Financial Statements
Financial statements provide information of value to company officials as well as to various

outsiders, such as investors and lenders of funds. Publicly owned companies are required to
periodically publish general-purpose financial statements that include a balance sheet, an income
statement, and a statement of cash flows. Some companies also issue a statement of stockholders’
equity and a statement of comprehensive income, which provide additional detail on changes in
the equity section of the balance sheet.
!
Caution Financial statements issued for external distribution are prepared according to
Generally Accepted Accounting Principles (GAAP), which are the guidelines for the content
and format of the statements.
In the United States, the Securities and Exchange Commission (SEC) has the legal responsibility
for establishing the content of financial statements, but it generally defers to an independent
body, the Financial Accounting Standards Board (FASB), to determine and promote accepted
principles.
These statements provide an overview of organizations’ financial condition in both short and
long-term. Through financial statements all the relevant financial information of a business
enterprise are presented in a structured manner and in a form easy to understand. There are four
basic financial statements:
1. Balance sheet: Statement of financial position or condition. The balance sheet consists of
three major sections: assets, the resources of the firm; liabilities, the debts of the firm; and
stockholders’ equity, the owners’ interest in the firm. At any point in time, the total assets
amount must equal the total amount of the contributions of the creditors and owners. This
is expressed in the accounting equation:
Assets = Liabilities + Stockholders’ Equity
2. Income statement or Profit and Loss statement: These statements include reports on a
company’s income, expenses, and profits over a period of time. These include sale, the
various types of operating and non-operating expenses and income, incurred during the
processing state. It summarizes the results of operations for a particular period of time.
Net income is included in retained earnings in the stockholders’ equity section of the
balance sheet.

Notes 3. Statement of retained earnings: This statement explains the changes in a company’s retained
earnings over the reporting period. Retained earnings links the balance sheet to the income
statement. Retained earnings are increased by net income and decreased by net losses and
dividends paid to stockholders. There are some other possible increases or decreases to
retained earnings besides income (losses) and dividends. The income statement separately
itemizes revenues and expenses, which result from the company’s ongoing major or
central operations, and the gains and losses arising from incidental or peripheral
transactions. Certain irregular items (such as discontinued operations, extraordinary items,
effects of accounting changes) are presented separately, net of tax effect, at the end of the
statement. When revenues and gains exceed expenses and losses, net income is realized.
Net income for the period increases equity. The results of the firm’s operating activities
for the period as presented in the income statement provide information that can be used
to predict the amount, timing, and uncertainty of future cash flows. This statement is
useful to investors, creditors, and other users in determining the profit ability of operations.
The income statement must also show earnings per share (EPS), where the net income is
divided by the weighted average number of shares of common stock outstanding. Since
EPS scales income by the magnitude of the investment, it allows investors to compare
diverse companies of different sizes; hence, investors commonly use it as a summary
measurement of firm performance.
4. Statement of cash flows: These statements provide reports on a company’s cash flow
activities; particularly it’s operating, investing and financing activities. The statement of
cash flows consists of three sections: cash flows from operating activities, cash flows from
investing activities, and cash flows from financing activities. Information about key
investing and financing activities not resulting in cash receipts or payments in the period
must be provided separately. The statement of cash flow is prepared in accordance to
guidelines issued by Accounting Standard -3 (AS -3). According to that sum of net cash
flow from operating activity, net cash flow from investing activity and net cash flow from
financing activity is equal to net change in cash. The cash from operating activities reported
on the statement of cash flows must be reconciled to net income for the period. Because
GAAP requires accrual accounting methods in preparing financial statements, there may
be a significant difference between net income and cash generated by operations.
Did u know? What is the purpose of preparing cash flow statement?
The cash flow statement is used by creditors and investors to determine whether cash will
be available to meet debt and dividend payments.
5. Footnotes (Notes): Footnotes (notes) accompany these financial statements. To evaluate

the financial condition, the profitability, and cash flows of an entity, the user needs to
understand the statements and related notes. The footnotes to the financial statements are
used to present additional information about items included in the financial statements
and to present additional financial information. Footnotes are an integral part of financial
statements.
The financial statements of publicly owned companies also include an auditor’s report, indicating
that the statements have been audited by independent auditors. The auditor’s opinion is related
to fair presentation in conformity with GAAP.
The external financial statements required for not-for-profit organizations are similar to those
for business enterprises, except that there is no ownership component (equity) and no income.
Not-for-profit organizations present a statement of financial position, a statement of activities,
and a statement of cash flows. The financial statements must classify the organization’s net

assets and its revenues, expenses, gains, and losses based on the existence or absence of donor- Notes
imposed restrictions. Each of three classes of net assets — permanently restricted, temporarily
restricted, and unrestricted—must be displayed in the statement of financial position, and the
amounts of change in each of those classes of net assets must be displayed in the statement of
activities. Governmental bodies, which are guided by the Governmental Accounting Standards
Board (GASB), present general-purpose external financial statements that are similar to those of
other not-for-profit organizations, but they classify their financial statements according to fund
entities.
The rules for the recording, measurement and presentation of government financial statements
may be different from those required for business and even for non-profit organizations. They
may use either of two accounting methods: accrual accounting, or cash accounting, or a
combination of the two (OCBOA). A complete set of chart of accounts is also used that is
substantially different from the chart of a profit-oriented business.
Although laws differ from country to country, an audit of the financial statements of a public
company is usually required for investment, financing, and tax purposes. These are usually
performed by independent accountants or auditing firms. Results of the audit are summarized
in an audit report that either provides an unqualified opinion on the financial statements or
qualifications as to its fairness and accuracy. The audit opinion on the financial statements is
usually included in the annual report.
There has been much legal debate over who an auditor is liable to. Since audit reports tend to be
addressed to the current shareholders, it is commonly thought that they owe a legal duty of care
to them. But this may not be the case as determined by common law precedent. In Canada,
auditors are liable only to investors using a prospectus to buy shares in the primary market. In
the United Kingdom, they have been held liable to potential investors when the auditor was
aware of the potential investor and how they would use the information in the financial statements.
Nowadays auditors tend to include in their report liability restricting language, discouraging
anyone other than the addressees of their report from relying on it. Liability is an important
issue: in the UK, for example, auditors have unlimited liability.
Self Assessment
Fill in the blanks:

9. …………….provide information of value to company officials as well as to various
outsiders, such as investors and lenders of funds.
10. The ………….. to the financial statements are used to present additional information
about items included in the financial statements and to present additional financial
information.
11. The statement of cash flows consists of three sections: cash flows from operating activities,
cash flows from …………., and cash flows from financing activities.
12. The statement of cash flow is prepared in accordance to guidelines issued by ……………...
11.4 Limitations or Drawbacks of Financial Statements
The financial statements are based on certain accounting concepts and conventions which can
not be said to be foolproof.
The following are the limitations of the financial statements:
1. Financial statements are essentially interim reports and therefore, cannot be final because
the final gain or loss can be computed only at the termination of the business.

Notes 2. Financial statements take into consideration only the financial factors. They fail to bring
out the significance of non-financial factors which may have considerable bearing on the
operating results and financial conditions of an enterprise. For example, public image of
the enterprise, the calibre of its management, efficiency and loyalty of its workers, etc.
3. It is not always possible to discover false figures in financial statements. Unscrupulous

managements generally resort to ‘window dressing’ in the preparation of such statements.
4. Financial statements only reflect the progress and position of the business at frequent
intervals during its life. The decision regarding the period of these statements is a matter
of personal judgement and it gives rise to the problem of allocating expenditures over
various periods.
5. Financial statements though expressed in exact monetary terms, are not absolutely final
and accurate. As the balance sheet is prepared on the basis of a going concern asset valuation
represents neither the realisable value nor replacement costs. They depend on the judgement
of the management in respect of various accounting policies.
6. Financial statements are prepared primarily for shareholders. Other interested parties
have to generally make many adjustments before they use them profitably.
7. Quite often, financial statements do not disclose current worth of the business. Only
historical facts are presented and the true current worth is not reflected.
Task Prepare the proforma of key financial statements.
Self Assessment
Fill in the blanks:
13. The financial statements are based on certain accounting …………………..
14. Financial statements are prepared primarily for …………...
15. Financial statements only reflect the progress and position of the business at frequent
…………… during its life.
11.5 Summary
Accounting is the language of business throughout the world. Every business organization
keeps its financial records so that the parties interested, can have an analysis through it.
A financial statement is summarised data, collected and organised according to logical

and consistent accounting procedure.
Financial statements are the most important way of periodically presenting to parties
outside the business the information that has been gathered and processed in the accounting
system.
The accounting system generates accounting information in the form of financial reports.
There are two major categories of these reports: External and Internal.
External users have limited access to an organisation’s valuable information. The success
of their decisions depends upon the use of external reports that are reliable, relevant and
comparable.

Internal users are the individuals who are directly involved in managing and operating Notes
the organisation.
Both internal and external users rely on internal controls to monitor the company’s
operations.
Publicly owned companies are required to periodically publish general-purpose financial

statements that include a balance sheet, an income statement, and a statement of cash
flows.
Financial statements are essentially interim reports and therefore, cannot be final because
the final gain or loss can be computed only at the termination of the business
11.6 Keywords
Accounting: Accounting means recording each transaction that takes place and further,
summarizing the records for financial communications.
Financial Statement: A financial statement is summarised data, collected and organised according
to logical and consistent accounting procedure.
Internal Users: Internal users are the individuals who are directly involved in managing and
operating the organisation.
Statement of Cash Flows: These statements provide reports on a company’s cash flow activities;
particularly it’s operating, investing and financing activities.
1. Accounting is the language of business throughout the world. Discuss.
2. What do owners expect from the business records?
3. What do lenders expect from the business records?
4. Each external user has special information needs depending on the kind of decisions he
has to take. What are the key informations required by different external users?
5. Discuss the limitations of financial statements and point out how these limitations can be
removed through management accounting.
1. Accounting
2. Financial statement
3. Accounting system
4. Financial reports
5. Internal
6. Effectiveness
7. Production
8. Research & Development
9. Financial statements

Notes 10. Footnotes
11. Investing activities
12. Accounting standard -3 (AS -3)
13. Concepts and conventions
14. Shareholders
15. Intervals

www.scribd.com

Pooja, Lovely Professional University Unit 12: Analysis of Financial Reporting Framework
Unit 12 : Analysis of Financial Reporting Framework Notes
CONTENTS
Objectives
Introduction
12.1 Applications of Financial Reporting Framework
12.1.1 Top Management Reports
12.1.2 Middle Level Management Reports
12.1.3 Lower Level Management Reports
12.2 Strengths and Weakness of Accounting Framework
12.2.1 Strengths of Accounting Framework
12.2.2 Weakness of Accounting Framework
12.3 Summary
12.4 Keywords
Objectives
Describe the application of financial reporting framework
Identify the strengths and weakness of accounting framework
Introduction
The purpose of reporting is to provide the information needed by the concerned party. The
value of information is determined by how the information meets the needs of the users. This
information creates an atmosphere for internal decision makers. The communication of the
information between two or more parties through reports is known as reporting. Report is the
essence of the management information system.
Did u know? What are accounting reports?
Report is a statement containing facts and if they contain accounting information and data
they are called accounting reports.
So, report may be known as process of providing accounting information to those who needs to
make decisions. Report may be for the past, present and for the future developments.
12.1 Applications of Financial Reporting Framework
Accounting reports consist of financial statistics. Management cannot analyse all significant
facts regarding its business especially in case of large scale production where the business
operations are more complex in nature. Accounting reports helps to get full information about
the entire operative activity of the firm.

Notes Need of reporting differs at different management levels. This also differs to the user community
also. There are three levels of management and the reports can be classified according to the
needs as follows:
Top-Level Management Reports
Middle Level Management Reports
Lower Level Management Reports
12.1.1 Top Management Reports
At this level reports are concerned with the following matters:
For determining the aims of the enterprise
For formulation of policies and plans
For delegation of responsibility in successful manner to executives for the best utlisation
of resources
For formulating special significant plans
It can be assumed that top brass of the business only needs reports for cost and operational
control. The report submitted to the level should be brief or we can call it a summarized
statement, which provides an overall view on the subject. Previously these reports used to be
submitted within the time framework. The time framework may be monthly, quarterly or
yearly. With the use of information technology and the real time accounting, the whole time
framework has been changed and now these can be made available online.
Reports to top level management consist of the following:
1. Reports to the Board of Directors
2. Reports to the Chief Finance Officer
3. Reports to the Chief Production officer
4. Reports to the Chief Executive Marketing and Sales
Task Identify the key records prepared by the Board of Directors and CEO.
12.1.2 Middle Level Management Reports
The middle level management consists of the heads of various departments. The reports at this
level should show the efficiency and cost data relating to different departments. At this level
execution of plans formulated by the top management is worked out and all the managers in
each department are concerned with this. It is also the function of middle level management to
coordinate different activities of different departments.
12.1.3 Lower Level Management Reports
At this level foremen and supervisors are concerned at the floor and they prepare their reports
physically without any expert opinion. They are concerned with the daily work and they infuse
a certain amount of competitive spirit among the workers by comparing the output per man per
hour in a similar job. These reports include the following factors:

Unit 12: Analysis of Financial Reporting Framework
Workers efficiency report, Notes
Daily production report,
Workers utilization report and
Scrap report
Overtime report
Material spoilage report
Accident report etc.
Self Assessment
Fill in the blanks:
1. ……….. is the essence of the management information system.
2. Report is a statement containing facts and if they contain accounting information and data
they are called ………….
3. At lower level foremen and supervisors are concerned at the floor and they prepare their
reports ………… without any expert opinion.
4. The communication of the information between two or more parties through reports is
known as ………….
5. It can be assumed that top level of the business only needs reports for …………….control.
6. The reports at ………….. level should show the efficiency and cost data relating to different
departments.
12.2 Strengths and Weakness of Accounting Framework
operations are more complex in nature. Accounting reports helps to get full information about
the entire operative activity of the firm.
The key strengths and weakness of accounting framework can be describes as follows:
12.2.1 Strengths of Accounting Framework
The following are the key strengths of a accounting framework:
1. Providing accounting information: Accounting reports consist of financial statistics.

Management may not analyse all significant facts regarding its business operations
especially in case of large scale production where the business operations are more complex
in nature. Accounting reports help to get full information about its entire operative activity
of the firm. Thus important objective of the reporting is to provide accounting information
to operating and top level management in accurate form in understandable brief manner.
2. To take right decision: To help the management in taking the right decisions with suitable
statements provided by the management accountant.
3. Acceptability of the decision by all: Reporting leads to motivate people, increases efficiency
and boosting the morale of the people engaged in the various aspects of the work of the
enterprise.

Notes 4. Maximizing the profits: To achieve this ultimate goal of any business reporting at the
right time, at right place to the right person in right manner becomes an essential feature.
5. For better control: Abnormal events can be checked in time by obtaining the necessary
information in respect of each operating activity. Control through reports become effective
as compared to personal investigations.
12.2.2 Weakness of Accounting Framework
Financial reports are incapable of providing all relevant information. There are a number of
reasons including those related to the nature of the financial accounting processes, and those
related to cost and benefit considerations. Financial reporting is not an adequate source of
information needed by users of the reports. They also need to consider pertinent information
from other sources. The users of accounting informations should aware about the weaknesses of
accounting framework.
The following are some weakness of accounting framework:
1. Financial accounting is concerned mainly with measuring the financial effect of transactions
and other events on the entity’s financial position, results of operations and cash flows.
Accordingly, financial accounting is not usually able to produce information to assist in

the evaluation of the entity’s ability to achieve objectives that are not capable of financial
measurement in an objective manner.
2. Financial accounting does not differentiate, through its processes, between the entity’s
performance and that of its management. Although, management’s ability is one of the
important factors that affect the entity’s performance, there are other factors beyond
management control which affect the entity’s performance such as natural disasters and
external political and economic changes. Accordingly, it is not possible for financial
accounting to provide information which can assist in evaluating management’s
performance aside from the entity’s performance.
3. The information currently provided by financial accounting is predominantly historical

in nature which may or may not be indicative of the future. Yet, decisions made by those
who need this information are usually concerned with the future impact of alternative
courses of action.
4. To a significant extent, financial reporting information is based on estimates, judgments

and models of the financial effects in an entity of transactions and other events and
circumstances that have happened or that exists rather than on exact depictions of those
effects. The framework establishes the concepts that underlie those estimates, judgments
and models and other aspects of financial reporting.
Self Assessment
Fill in the blanks:
7. Accounting reports helps to get full information about the entire ……………. activity of
the firm.
8. Accounting reports consist of …………..statistics.
9. Financial accounting is concerned mainly with measuring the …………effect of transactions.
10. Financial accounting is not usually able to produce information to assist in the evaluation
of the entity’s ability to achieve objectives that are not capable of ………………..in an
objective manner.


Notes
Caselet Case: Tata group in Global Financial Reporting Panel
T
he Tata Group has joined the select group of international companies such as Nestle,
EDF, HSBC and others to launch an initiative, the International Integrated Reporting
Committee (IIRC), aimed at overhauling international company reporting in the
wake of the recent financial crisis.
Mr Ishat Hussain, Group Finance Director, Tata Sons, has been inducted into the steering
committee of London-based IIRC. When contacted, a spokesman for the Tata Group
confirmed it. No other Indian company has representation in the committee.
The move to form IIRC was initiated in December 2009 when The Prince of Wales convened
a high-level meeting of investors, standard setters, companies, accounting bodies and UN
representatives.
It was agreed at the meeting that the Prince’s Accounting for Sustainability and the Global
Reporting Initiative should work together with other organisations to establish and
international body to oversee the creation of a generally accepted integrated reporting
framework that would connect financial and sustainability reporting.
It was recommended that a working group and a steering committee be formed to establish
the IIRC. While the responsibilities of the working group would include drafting proposals
for the governance arrangements and developing proposal relating to the scope and
content of integrated reporting, the steering committee would provide expert and informed
guidance to the working group and consider and adopt, as appropriate, the proposals
drawn up the working group.
The steering committee will be chaired by Sir Michael Peat, Principal Private Secretary to
The Prince of Wales and the Duchess of Cornwall. The working Committee has co-chairmen,
Mr. Paul Druckman, as Executive Board Chairman and Mr. Ian Ball, Chief Executive Officer,
International Federation of Accountants.
The big four auditors such as PwC, Deloitte, Ernst & Young, and KPMG, international
business schools including Harvard Business School and influential non-profit groups are
also involved.
The steering committee, it is learnt, plans to publish later this year a framework for a
global integrated reporting model that would make annual reports comparable across
borders.
It would be presented to G20 in 2011. The G20 already supports creation of a single set of
reporting standards.
Source: http://www.thehindubusinessline.com
12.3 Summary
Report is a statement containing facts and if they contain accounting information and data
they are called accounting reports.
operations are more complex in nature.

Notes Accounting reports helps to get full information about the entire operative activity of the
firm.
The report submitted to the top level should be brief or we can call it a summarized
statement, which provides an overall view on the subject.
The reports at the middle level should show the efficiency and cost data relating to different
departments.
At the lower level foremen and supervisors are concerned at the floor and they prepare
their reports physically without any expert opinion.
Accounting reports helps to get full information about the entire operative activity of the
firm.
Financial reports are incapable of providing all relevant information that might be required
by those who use them.
12.4 Keywords
Report: Report is a statement containing facts and if they contain accounting information and
data they are called accounting reports.
Reporting: The communication of the information between two or more parties through reports
is known as reporting.
1. Accounting reports helps to get full information about the entire operative activity of the
firm. How you will frame a good accounting report?
2. Identify the scope of financial reporting at all the levels of management.
3. List the key reports prepared at middle and lower level.

4. What are the key strengths and weakness of accounting framework?
5. What are the key reports prepared at top level management?
1. Report
2. accounting reports
3. physically
4. reporting
5. cost and operational
6. middle
7. operative
8. financial
9. financial
10. financial measurement

12.6 Further Readings Notes

www.scribd.com

Contemporary Accounting Neha Tikoo, Lovely Professional University
Notes Unit 13 : Critical Evaluation of Principles and Practices
CONTENTS
Objectives
Introduction
13.1 Meaning and Concept of Accounting Principles
13.2 Analysis of Accounting Principles and Practices
13.2.1 The Money Measurement Concept
13.2.2 Entity Concept
13.2.3 The Going Concern Concept
13.2.4 The Cost Concept
13.2.5 The Dual Aspect Concept
13.2.6 The Accounting Period Concept
13.2.7 The Conservatism Concept
13.2.8 The Realisation Concept
13.2.9 The Matching Concept
13.2.10 The Consistency Concept
13.2.11 The Materiality Concept
13.2.12 The Objectivity Concept
13.3 Summary
13.4 Keywords
Objectives
Explain the concept of accounting principles
Evaluate the accounting principles and practices
Introduction
Externally communicated accounting information must be prepared in accordance with

accounting standards that are understood by both the senders and the users of that information.
These standards are known as Generally Accepted Accounting Principles (GAAP) and provide
the general framework for determining what information is included in financial statements
and how this information is to be presented. Since accounting is a service activity, these principles
reflect the society needs and not those of accountants or any other single constituency. These are
the guidelines for measurement and presentation of accounting information and are used by
professional accountants in preparing accounting information and reports.

Unit 13: Critical Evaluation of Principles and Practices
13.1 Meaning and Concept of Accounting Principles Notes
Accounting principles were historically developed through common acceptance and usage. A
principle was acceptable, if most professionals permitted it. These general principles became
the basic assumptions, concepts and guidelines for preparing financial statements. Specific
principles, based on these general principles, were then developed as detailed rules for reporting
business transactions and events. General principles, therefore, stem from long-used accounting
practices and specific principles arise more often from the ruling of authoritative groups.
Therefore, these specific rules differ may from country to country.
Significant differences in the specific rules create a lot of problems for multinational businesses
when they are trying to consolidate accounting information. Therefore, a need was felt to have
an international organisation that specifies the accounting standards that can be used throughout
the world. International Accounting Standards Committee (IASC) was born as a result of this
need. It issues International Accounting Standards (IAS) that identifies preferred accounting
practices worldwide and encourages their worldwide acceptance. More and more countries are
modifying their practices to confirm to these standards. As expected, India is far behind.
We need an understanding of both general and specific principles to effectively use accounting
information. Because general principles are especially crucial in using accounting information,
we will discuss them right now. Specific rules are described wherever required and connected
with the broad principles so as to help understand their applications in the practical situations.
Notes There are 12 general accounting principles that you should be aware of:
1. Money Measurement
2. Entity
3. Going Concern
4. Cost
5. Dual aspect
6. Accounting period
7. Conservatism
8. Realisation
9. Matching
10. Consistency
11. Materiality
12. Objectivity
Self Assessment
Fill in the blanks:
1. ……………were historically developed through common acceptance and usage.
2. Externally communicated accounting information must be prepared in accordance with

accounting ………….that are understood by both the senders and the users of that
information.

Notes 13.2 Analysis of Accounting Principles and Practices
The following are the key accounting principles and their application in financial reporting:
13.2.1 The Money Measurement Concept
Records should be made only of that information that can be expressed in monetary terms.
Although the business may own seven buildings, five boilers, fifty cars, thirty trucks, you
cannot add them together simply and get to know what the business is worth. Expressing these
items in monetary terms by saying that you have buildings worth ` 15 crores, boilers worth ` 50
lacs, cars worth ` 1 crore and trucks worth ` 2 crores would make it easier for you to add up these
items by adding their monetary values. You cannot add apples and oranges directly but they can
be added easily by expressing them in monetary terms.
Thus, money provides a common denominator by which the resources and other factors about
the business entity can be expressed and valued. Expressing in monetary terms also helps in
understanding the changes their impact on value of the resources.
Example: If R has invested ` 200,000 in the “R Enterprise” then it can be recorded in the
books of “R Enterprise” but on the other hand if R has put a lot of efforts for the welfare of the
company then the efforts can not be measure in terms of money.
As you can see, this concept imposes a severe limitation on the scope of accounting. It is impossible
for the accounting to record or report the dearth of the key people of the organisation, or that a
plant is not working, that labourers are going on strike, or that key people are leaving the
organisation and other important factors that may have a direct bearing on the future of the
organisation.
13.2.2 Entity Concept
Accounts can only be kept for entities, which are different from the persons who are associated
with these entities.
The business entity principle means that business is accounted for separately from its owner(s).
It also means that we account separately for each business that is controlled by the same owner.
The reason behind this principle is that different users for decision-making need separate
information about each business.
Example: If ‘R’ has invested cash of `2,00,000 in ‘R Enterprise’ then from the point of ‘R
Enterprise’ on one hand the enterprise has a cash property of `2,00,000 and on the other hand, the
it has a responsibility to return it to ‘R’ finally. In accounting terms the property is called asset
and the responsibility is called liability.
Thus the ‘separate entity’ concept helps to identify asset and liability of the business. It also helps
to look at two sides of the same transaction. Here, on one side the business ‘R Enterprise’ is able
to consider ` 2,00,000 cash as asset and on the other the same is a liability towards the owner ‘R’.
In a similar way suppose ‘K’ has agreed to lend ` 3,00,000 to ‘R Enterprise’ for some reason. Now
the property side increases by ` 3,00,000 cash while there is an additional liability towards ‘K’ let
us write these in a format. (Show the above in a T form)

Notes
R Enterprise
Property or asset (`) Responsibility or liability (`)

Cash from R 2,00,000 Towards R 2,00,000
Cash loan from K 3,00,000 Towards K 3,00,000
As a matter of practice and conventionally we could show the above as follows
R Enterprise
Liabilities Assets
R 2,00,000 Cash 5,00,000
K 3,00,000
The second one is acceptable globally. We thus introduced here how ‘one’ transaction can have
two faces just as a coin has two faces. This has its own conveniences too. It is easy to verify or
cross check in case one of them is recorded wrongly. You would notice that it helps to keep the
two sides balanced i.e. the total of each side is equal (` 5,00,000)
!
Caution In sole proprietorships and partnerships, it is difficult to separate the entity from
the owners, as there is no distinction as per the law between the financial affairs of the
partnership and the partners or the proprietorship concern and the proprietor. The
difficulties in separating the expenses of the partners or the proprietor from the concern
make it easier for them to pass on their personal expenses to the concern. This is precisely
the reason why a lot of proprietorships and partnership concerns hardly pay any income
tax.
For a company, this distinction is easier to make because company maintains separate
legal identity and its accounts correspond exactly to the scope of its activities.
13.2.3 The Going Concern Concept
Accounting records, events and transactions on the assumption that the entity will continue to
operate for an indefinitely long period of time.
Unless there is strong evidence to the contrary, accounting assumes that an entity is a going
concern. The significance of this assumption can be seen by contrasting it with another possible
alternative, i.e., that the concern would be liquidated. Under the latter assumption, accounting
should attempt to measure what the entity’s resources are currently worth to potential buyers.
The going concern concept assumes that the resources currently available to the entity will be
used in its future operations.
This helps in distributing the effects of big expenses over several periods because their benefits
also accrue over several periods.
13.2.4 The Cost Concept
Assets are always shown at their cost and not at their current market value. One of the most
fundamental concepts of accounting, the cost concept says that the asset is ordinarily entered
into the accounting records at the actual cost incurred to acquire it. Cost is measured on a cash or
equal-to-cash basis. This means if cash is given for an asset or service, its cost is measured as the

Notes amount of cash paid. If something besides cash is exchanged (such as a car traded for a truck), cost
is measured as the cash equivalent of what is given up or received. We know that the real worth
of asset may change over a period of time so the value in the accounting records may not reflect
the real value of the assets owned by the concern. Land purchased in 1975 for ` 5 lacs and a car
purchased for ` 5 lacs in 1999 would both be recorded at these respective values in the books of
accounts. Irrespective of the fact that the land could be worth ` 5 crores today and the car would
be worth ` 3 lacs now. Accountants are fully aware of this fact but do not attempt to reflect such
changes in the accounts, as there could be significant differences in values estimated by different
entities.
The cost concept does not mean that all assets will remain in the accounting records at their
original purchase price. The cost of the asset that has a long, but limited, life is systematically
reduced over that life by the process of depreciation. The purpose of the depreciation process is
to systematically remove the cost of the asset from the account and show it as the cost of
operations. Still, depreciation has no necessary relationship to changes in market value or to the
real worth of the asset.
To emphasise the distinction between the accounting concept and value, as we understand it, the
term book value is used for the historical cost amounts as shown in the accounting records and
the term market value for the actual value of the asset in the market.
The cost concept provides an excellent illustration of the objectives of the accounting principles;
relevance, objectivity and feasibility. These three criteria can often conflict with each other. For
example, if a company develops a new product, it can have a significant effect on the real value
of the company. This information of the new product is very relevant to the creditors and the
investors as also the internal users but the value of this product would normally be estimated by
the management and is highly subjective. Therefore, accounting does not attempt to record such
values thereby sacrificing relevance in the interest of objectivity. Therefore, the cost concept
fulfils the criteria of objectivity and feasibility but does not fulfil the criteria of relevance. It is
not purely objective also but is relatively more objective than estimating market values and
reporting them.
13.2.5 The Dual Aspect Concept
The value of the assets owned by the concern is equal to the claims on these assets. The
fundamental accounting equation is the formal expression of the dual aspect concept. All
accounting procedures that we will discuss later are derived from this equation. The equation is
written as:
Assets = Liabilities + Owner’s Equity
Economic events, which are recorded in the accounting system, are called transactions.
Did u know? What is double entry system of accounting?
Every transaction that an organisation undertakes has a dual impact on the accounting
records, i.e., it will have an impact on two (or more) accounts simultaneously. This is why
accounting is also called a double-entry system.
Example: Suppose that Ms. Sharda starts a dry-cleaning business and her first act is to
buy an industrial washing machine for ` 1 lac with her own money. The dual aspect of this
transaction would be that a proprietorship business now has an asset, an industrial washing
machine, of ` 1 lac and Ms. Sharda, the owner, has a claim of ` 1 lac against this asset. Putting this
in the above equation, we get

Assets (Industrial Washing Machine), ` 1 lac = Liabilities + Owner’s Equity, ` 1 lac Notes
Ms. Sharda borrows another ` 3 lacs from the bank for buying a shop. This will change her
accounting records in two ways:
1. It would show ` 3 lacs increase in cash on the asset side, and
2. On the right hand side, it would show a liability of ` 3 lacs, which is the bank’s claim
against the asset.
Cash = ` 3 lacs Owner's equity = ` 1 lac

Machinery = ` 1 lac Bank loan = ` 3 lacs
Total Assets = ` 4 lacs Total liabilities = ` 4 lacs + Owner's Equity
There is no conceivable way that a transaction can result in only a single change in the accounts.
There is another system where only a single entry is maintained for every transaction but
companies cannot use this system in India, as the Companies Act does not allow it.
13.2.6 The Accounting Period Concept
Accounting measures activity for a specified interval of time, usually a year. Net income is easy
to measure if you are only dealing once but the company deals constantly and we expect the
company to continue forever (remember going concern principle). Therefore, it becomes difficult
to find out whether the business is earning anything or not. Both the managers and external
users are unwilling to wait for the closure of the business to know how the business has fared.
They need to know how things are going in the business at frequent intervals. This leads to the
accounting period concept. The first author of a known accounting text, Pacioli, wrote in 1494;
“Books should be closed each year, especially in a partnership, because frequent accounting
makes for long friendship.” Therefore, the books of the organisation are closed at regular
intervals (usually a year) and the financial statements prepared for reporting purposes. The
Companies Act also requires that a report should be prepared annually for reporting purposes
and income tax reporting is also on an annual basis.
In India, the majority of the businesses follow ‘April 1—March 31’ (April of this year and March
of next year) as the accounting year (also known as fiscal year) but many businesses also use
calendar year as the accounting year, especially the multinational companies. This is because its
makes it easier for them to club the result of their activities with the parent companies overseas
which normally use calendar year as the accounting year. Still, they have to prepare and report
to income tax authorities following the ‘April 1– March 31’ accounting year. The accounting
period for shareholder reporting purposes could be more or less than one year but for taxation
purposes it remains the same.
For internal reporting, there is no time period specified anywhere. Companies can use any
period that they want to as computerisation have made it easier for them to take out accounting
reports as and when required. Still, many of the companies, which are not dependent on the
computers, commonly use a month as the reporting period. SEBI requires that the companies
that are listed on the stock exchanges should issue quarterly income statements for the benefit of
the external users.
13.2.7 The Conservatism Concept
Anticipate no profits but provide for all possible losses. Like most humans, managers have a
tendency to give a favourable report of the working of the entity that is under them. Accounting
safeguards are designed to offset this natural tendency of optimism. The idea behind this principle
is that the recognition of increase in entity’s earnings requires better evidence then does the

Notes expenses. For example, if customer signs an MoU for buying ` 10 lacs worth of products you
would not recognise this revenue in your accounting system because the products have not
changed hands and no transaction has taken place. You will only recognise the revenue once the
sale is made and the product is delivered to the customer so that you have a legal right to claim
payment. Now you can say that only the product has been delivered but the money has not come
in so you should not recognise the sale till the time the money is paid. A cash system of
accounting does exactly that. But the point this product has been given to him, he is under a legal
obligation to pay you the amount that is due to you. Therefore, under the accrual system of
accounting, you would recognise that this sale as revenue and the customer owns you money till
the time he pays up. Now this debt could also become a bad debt (money owned to you but
never paid) and therefore, you would provide for some losses that can happen due to bad debt
even before they happen depending upon the past experiences with your debtors.
The conservatism principle therefore, has two aspects:
1. Recognise revenues only when they are reasonably certain
2. Recognise expenses as soon as they are reasonably possible
These guiding principles are used while deciding the period in which the expenses and the
revenues fall in. Obviously, it leaves certain gaps in deciding what is meant by reasonably
certain and reasonably possible in various situations. Accounting standards do provide certain
guidelines for many specific problem areas but their abuse is quite common in India.
Therefore, you have to provide for losses that you reasonably expect but not the revenues that
you may expect in the future to make the accounting figures reflects a conservative approach.
13.2.8 The Realisation Concept
The sale is considered to have taken place only when either the cash is received or some third
party becomes legally liable to pay the amount.
We have just learned from the conservatism principle when the revenue should be recognised.
Realisation concept indicates the amount and revenue that should be recognised from a given
sale. The concepts states that the amount recognised is the amount that is reasonably certain to
be realised. Note the words ‘reasonably certain’. Differences of opinion are there when
interpreting what is ‘reasonably certain.’
The concept allows for the amount of the revenues recognised to be less than the selling price of
the goods or services sold. If the products are sold at a discount, then the revenue is recorded at
the lower amount and not at the normal price (also called the list price). When the goods are sold
on credit, you can never be sure of the amount that would be realised, so, you provide for bad
debts also.
13.2.9 The Matching Concept

When an event affects the revenues and expenses, the affect on each should be recognised in the
same accounting period.
As you already know, the sale of the products has two aspects:
1. Revenue aspect
2. Expense aspect
Revenues earned because the sale is going to fetch you some money and expenses incurred for
producing that product or providing that service. Correct measurement of the net effect of the
sale and expenses in any accounting period can only be made when you match the relevant
expenses to its related sales. Otherwise, it will allow a lot of freedom for not showing the true

profitability of the business. If you want to increase the profits, you can show the sales but not Notes
the expenses and vice versa if you want to reduce the profits for any given period. Therefore, the
matching principle is applied by first determining the items that constitute revenues for the
period and their amount in accordance with the conservatism concepts and then matching items
of cost to these revenues. The only problem is to determine which costs match with these
revenues and hence, are expenses for the period.
13.2.10 The Consistency Concept
The accounting policies and methods followed by the company should be the same every year.
The consistency concept states that once an entity has decided on one method, it should use the
same method for all subsequent events of the same character unless it has a sound reason to
change the method. This is done because frequent changes in the manner of handling same type
of events, would make it very difficult for the external users to compare financial statements
over different periods. The term consistency as used here refers to consistency over a period of
time and not the logical consistency. The external auditors have to specify in their reports if the
company is changing any of its policies or methods and the effect of these changes on the
reported figures.
13.2.11 The Materiality Concept
Insignificant events would not be recorded if the benefit of recording them does not justify the
cost.
In law, there is something called ‘de minimis non curat lex’, which means that the court will not
consider trivial matters. Similarly, the accounting does not attempt to record events so insignificant
that the work of recording them is not justified by the usefulness of the results. For example, when
the pencils are issued to the employees they are written off as expenses even though when they
may be used over a period of time and are assets of the organisation. This is done because keeping
a track of the use of the pencil would require more expenses and does not serve any real purpose,
as the value of the item is too small. In other words, insignificant events will be clubbed together
and recorded because the organisation has to account for every single paisa.
The line separating material events from immaterial events is so thin that the decision depends
only on judgement and common sense. The guiding force is to look at the expense in the light of
the total expense and see whether any real benefit could be served by going into the details of
that item. The concept is very useful when estimating the costs associated in any particular
accounting period and revenues. Because many of them would not be very close estimates and
it may not be worthwhile to attempt to refine these estimates and make these more exact.
But you should remember that there is no definitive rule that separates material information
from immaterial information. So, the materiality concept may be taken to mean that although
insignificant events may be disregarded but there must be full disclosure of all-important
information.
13.2.12 The Objectivity Concept
An evidence of the happening of the transaction should support every transaction. The objectivity
principle means that financial information is supported by independent and unbiased evidence.
It involves more than one person’s opinion. Information is not reliable if it is based only on
preparer’s perception. A preparer can be too optimistic or pessimistic. An unethical preparer
might even try to mislead users by intentionally misrepresenting the truth. The objectivity
principle is intended to make financial statements useful by ensuring that they report reliable
and verifiable information.


Notes
Caselet Case: Rule versus Principle
S
tudents of accounting would be well aware of the long discussed differences between
rule-based accounting and principle-based accounting. Both have their protagonists.
While the US GAAP is rule-based, the International Accounting Standards (IAS),
both as IAS and IFRS, are principle-based.
The debate on which is better will be put to rest when the US GAAP converges with IFRS
eventually and becomes principle-based. Being principle-based means that broad principles
are laid out by the standard-fixing body and the interpretation is left to the users of these
standards.
The problem (and also the benefit) with principle-based accounting is that most of the
times, in a situation which requires a finding, one would have to exercise a great deal of
judgment based on substance as opposed to a readymade solution being available for a
particular issue prescribed in the rule-based accounting.
While the US accounting is considered to be rule-based, one can find echoes of principle-
based accounting also in it. In the widely publicised 1969 case of Continental Vending
where the auditors were questioned for lack of professional standards, the court gave a
direction to the jury to look at the facts and the substance of the case rather than rules of
accountancy and mere adherence to GAAP.
The court held that in the audit report the statement “fairly presented … in accordance
with generally accepted accounting principles” is two statements rather than one, i.e.,
“fairly presented” is principle-based and the other “in accordance with generally accepted
accounting principles” is rule-based.
Problems for Auditors
The preparation of financial statements in accordance with the GAAP in a rule-based
environment, however, presents problems to the auditors. If an auditor were to confront
the management over a certain treatment of a transaction, the management is likely to ask
the auditor “show me where it says I can’t do that”.
In other words, in a rule-based environment, the onus is on the auditor to demonstrate
clearly that the particular treatment is not permitted and hence closes the avenues for the
auditor to develop further arguments that would be available in a principle-based
accounting environment (Principles-based Accounting, by Ronald M. Mano, Matthew
Mouritsen and Ryan Pace, published in the CPA Journal, February 2006).
Since accounting standards followed in India have their origin in the IAS, the Indian
accounting standards are principle-based. However, there are exceptions to the rule. One
prime example is the Income Recognition and Asset Classification (IRAC) norms prescribed
by the Reserve Bank of India for provisioning for non-performing assets applicable to
banks.
Thus, if any asset is non-performing, based on certain prescribed criteria, a provision is
created for the potential loan loss irrespective of the security available with the bank.
Subjectivity Issue
Principle-based accounting has its own issues too. Ian Wright, Director of Corporate
Reporting at the Financial Reporting Council of UK, writing in accountancy magazine
(October 2008), talks about the subjectivity that is present in the IFRS.
Contd...

The IFRS is full of words and phrases that are open to interpretation. The accompanying Notes
table has a selection of the probabilities in IFRS literature that a user is expected to interpret
in the context of understanding what an accounting standard requires.
Ian Wright also identifies other issues that are potentially problematic.
The IFRS literature contains an increasing range of technical terms which don’t translate
well into languages other than English. Also, the standards were written in different eras
and sometimes by individual national standard-setters due to which the usage of the
English language differs resulting in them being structured in disparate ways.
One can therefore see the potential hazards in interpreting a principle-based accounting
standard that contains highly subjective phraseology.
In this context, one can expect problems of interpretation in India also. For instance, the
word “shall” (a key word in accounting standards) is used in a manner that is completely
different from its usage in countries where English is the mother tongue. Any user of IFRS
would therefore need to be alive to these issues when interpreting IFRS.
Source: www.thehindubusinessline.com
Self Assessment
Fill in the blanks:
3. Records should be made only of that information that can be expressed in ……………
terms.
4. The business entity principle means that business is accounted for …………. from its
owner(s).
5. Assets are always shown at their cost and not at their current …………….
6. Assets = ………. + Owner’s Equity
7. Accounting records, events and transactions on the assumption that the entity will continue
to operate for an ………… long period of time.
8. Cost is measured on a cash or ………….basis.

9. The ………… is considered to have taken place only when either the cash is received or
some third party becomes legally liable to pay the amount.
10. The ………… principle means that financial information is supported by independent and
unbiased evidence.
Task Compare the Indian accounting principle with the accounting principles used in
US.
13.3 Summary
Externally communicated accounting information must be prepared in accordance with

accounting standards that are understood by both the senders and the users of that
information.
Accounting principles were historically developed through common acceptance and usage.

Notes A principle was acceptable, if most professionals permitted it.
There are 12 general accounting principles.
Records should be made only of that information that can be expressed in monetary
terms.
Accounts can only be kept for entities, which are different from the persons who are
associated with these entities.
Accounting records, events and transactions on the assumption that the entity will continue
to operate for an indefinitely long period of time.
Assets are always shown at their cost and not at their current market value.
The value of the assets owned by the concern is equal to the claims on these assets.
Accounting measures activity for a specified interval of time, usually a year.
Anticipate no profits but provide for all possible losses.
The sale is considered to have taken place only when either the cash is received or some
third party becomes legally liable to pay the amount.
When an event affects the revenues and expenses, the affect on each should be recognised
in the same accounting period.
The consistency concept states that once an entity has decided on one method, it should use
the same method for all subsequent events of the same character unless it has a sound
reason to change the method.
Insignificant events would not be recorded if the benefit of recording them does not
justify the cost.
The objectivity principle means that financial information is supported by independent

and unbiased evidence.
13.4 Keywords
Accounting Conventions: Customs and traditions which guide the accountants to record the
financial transactions.
Accounting Process: It includes the recording of financial transactions, ledger posting, preparation
of financial statements and analyzing and interpretation of them.
Cost Accounting: Accounting relating to the ascertainment of cost of the product.
Management Accounting: Presenting of accounting information in such a way as to assist the

management in taking the important decisions and making the policies.
1. Why accounting principles are important for preparing the financial reports?
2. Identify the key accounting principles of financial reporting.
3. Records should be made only of that information that can be expressed in monetary
terms. Discuss.
4. The business entity principle states that business is accounted for separately from its
owner. Illustrate with a suitable example.

5. Illustrate the concept of dual aspect. Notes
6. When an event affects the revenues and expenses, the affect on each should be recognised
in the same accounting period. Why?
7. Anticipate no profits but provide for all possible losses. Discuss the statement with suitable
examples.
8. According to cost concept assets should be shown at their cost and not at their current
market value. Why?
1. Accounting principles
2. standards
3. monetary
4. separately
5. market value
6. Liabilities
7. indefinitely
8. equal-to-cash
9. sale
10. objectivity

www.scribd.com

Contemporary Accounting Neha Tikoo, Lovely Professional University
Notes Unit 14: Forensic Accounting
CONTENTS
Objectives
Introduction
14.1 Meaning and Concept of Forensic Accounting
14.2 Characteristics of Forensic Accounting
14.3 Forensic Accounting Engagement
14.4 Skill Requirement of Forensic Accountant
14.5 Scope of Forensic Accounting
14.6 Difference between Forensic Accountant and Auditors
14.7 Forensic Accounting Process
14.8 Financial Statements Frauds
14.9 Summary
14.10 Keywords
Objectives
Define forensic accounting;
Explain the characteristics of forensic accounting;
Identify the scope of forensic accounting;
Describe the financial statements frauds.
Introduction
The concept of forensic accounting is a rapidly growing area of accounting. The term forensic
accounting is concerned with the detection and prevention of business fraud and related white-
collar crimes. Forensic accounting is different from financial auditing. Financial auditing is
performed by certified charted accountants to check the regulations of financial statements of an
organisation. On the other hand forensic accounting is performed by an expert in the field to
verify information or to investigate frauds.
!
Caution Forensic accounting requires the expertise to identify that someone is lying or not
telling the whole truth.
14.1 Meaning and Concept of Forensic Accounting
Forensic accounting is the specialized practice area of accounting. The term ‘Forensic’ means
“suitable for use in Court,” and it is to that standard and potential outcome that forensic

Unit 14: Forensic Accounting
accountants generally have to work. The forensic engagement is distinguished by engagement Notes
objective, emphasis on gathering evidence, and the application of a variety of techniques often
custom-developed to the requirements of the specific engagement.
The definition of forensic accounting is changing in response to the growing needs of corporations.
“Forensic Accounting is the application of accounting principles, theories and discipline to facts
or hypothesis at issues in a legal dispute and encompasses every branch of accounting knowledge”
AICPA.
“Forensic Accounting is a science that deals with the relation and application of finance,
accounting, tax and auditing knowledge to analyse, investigate, inquire, test and examine the
mater in civil law, criminal law in an attempt to obtain the truth from which to render an expert
opinion” Horty.
Simply we can say that forensic accounting includes the use of accounting, auditing, and
investigative skills to deal with the legal matters. It consists of two major components: litigation
services that recognise the role of an accountant as an expert consultant, and investigative
services that use a forensic accountant’s skills and may require possible courtroom testimony.
Self Assessment
Fill in the blanks:
1. Forensic accounting is the …………..practice area of accounting.
2. Financial auditing is performed by …………….to check the regulations of financial
statements of an organisation.
3. Forensic accounting includes the use of accounting, auditing, and investigative skills to
deal with the ………….matters.
4. Forensic accounting consists of two major components: litigation services and ……………..
services
14.2 Characteristics of Forensic Accounting
The following are the key characteristics of forensic accounting:

Forensic Accounting involves the use of accounting/ auditing, investigative skills and
data mining as an audit tool
It emphasizes a forensic approach in place of a risk management approach to the analysis
of corporate governance
The objective of forensic accounting is to check up for cyber frauds, prevention and
detection.
The key industries requiring the forensic accounting are insurance companies, banks,
police, and government agencies considering the growing incidence of cyber crimes or
frauds and corporate failures
Chartered Accountants, with their sound grounding in accounting/auditing/business
requirements/legal requirements, are the most appropriate professionals to offer Forensic
Accounting and Fraud Detection service.
Did u know? What is the meaning of cyber crime?
Cyber crimes may be defined as unlawful acts wherein the computer is either a tool or a
target or both.

Notes Self Assessment
Fill in the blanks:
5. Forensic accounting emphasizes a forensic approach in place of a …………….approach to

the analysis of corporate governance.
6. Forensic Accounting involves the use of accounting/ auditing, investigative skills and
data mining as an …………….tool.
14.3 Forensic Accounting Engagement
A forensic accountant has to analyse, interpret, summarise and present complex financial and
business-related issues for investigation.
Coenen (2005) identify the following as areas of specialty in forensic accounting:
Investigating corporate fraud
Litigation services
Business valuation
Computer forensic
However, Zysman (2001) in a more elaborate form captured the assignment performed by
forensic accountant as including:
Criminal investigation, which are usually on behalf of the police with the aim of presenting
evidence in a professional and concise manner.
Shareholders and partnership dispute that involve analysis of numerous year financial
record for valuation and qualification of the issue in dispute;
Personal injury claim, where for example economic losses from motor accident or wrongful
dismissal may need to be quantified.
Business interruption and other type of insurance claim. These assignments involve a
detailed review of the policy to investigate coverage issues and the appropriate methods
of calculating the loss.
Business/employee fraud investigations which can involve fraud tracing, asset
identification and recovery, forensic intelligence gathering and due diligence review.
Business economic losses, where contract disputed, construction claims, expropriation,
product liability claim and trade mark are the issues.
Professional negligence, to ascertain the breach and quantify the loss involved, and
Mediation and arbitration, as a form of alternative dispute resolution.
14.4 Skill Requirement of Forensic Accountant
A Forensic Accountant should have the following characteristics:
curiosity
persistence
creativity
discretion
organization

confidence Notes
sound professional judgement
A Forensic Accountant must be open to consider all alternatives, scrutinize the fine details and
at the same time see the big picture. In addition, a Forensic Accountant must be able to listen
effectively and communicate clearly and concisely.
14.5 Scope of Forensic Accounting
Forensic accounting encompasses both litigation support and investigative accounting.
Litigation support provides assistance of all nature in a matter involving existing or pending
litigation. It deals primarily with issues related with the quantification of economic damages,
while investigative accounting is associated to the investigation of criminal matters (Zysman,
2001). Under litigation support, forensic accountant assist in:
Obtaining document necessary to support or refute a claim
Reviewing of the relevant documentation to form an initial assessment of the case in an

identified area of loss
Examination for discovering, including the formulation of the act regarding the financial
residence
Attendance at the examination for discovery to review the testimony, assist with
understanding the financial issues and to formulate additional questions to be asked
Investigative accountant on the other hand;
reviews factual situation and provides suggestions regarding possible courses of action
assist with the protection and recovery of assets
Co-ordinate other experts (Zysman, 2001).
Self Assessment
Fill in the blanks:
7. Forensic accounting encompasses both ………..and investigative accounting.
8. ………….provides assistance of all nature in a matter involving existing or pending

litigation.
9. Investigative accounting is associated to the investigation of ………….matters.
14.6 Difference between Forensic Accountant and Auditors
The following table explains the key differences between a forensic accountant and auditor:
Forensic Accountant Auditor

1. Forensic accountants are public accountants 1. Auditors work to ensure their organization is
that have completed specialized training in running efficiently and that mismanagement
the investigation of crimes such as of funds, waste of resources, or fraudulent
bankruptcies, fraud, contract disputes and activities are not occurring.
other criminal financial actions.
Contd...

Notes 2. Forensic accountants use their expertise in 2. Auditors also manage financial records and
accounting to determine when illegal internal information to verify accuracy of
transactions and activity have taken place. employees and technology-based practices.
3. Forensic accountants, however, will look at 3. Auditors try to look at a representative
nearly every transaction in their area of sample of transactions, working under the
inquiry, checking to whom money was sent assumption that if a few transactions follow
and whether there was adequate generally accepted accounting principles,
documentation for a transaction or series of then all similar transactions likely follow
transactions. They are also much more those principles.
proactive and skeptical in their confirmation
of financial transactions.
14.7 Forensic Accounting Process
Zysman (2005) outlined the following steps in executing Forensic Accounting engagement;
1. Meet with the client to obtain an understanding of the important facts, players and issues
at hand.
2. Perform a conflict check as soon as the relevant parties are established.
3. Perform an initial investigation to allow subsequent planning to be based upon a more
complete understanding of the issues.
4. Develop an action plan that take into account the knowledge gained by meeting with the
client and carrying out the initial investigation and which will set out the objectives to be
achieved and the methodology to be utilized to accomplish them.
5. Obtain the relevant evidence: This may involve locating documents, economic information,
asset, a person or company, another expert or proof of the occurrence of an event.
6. Perform the analysis: This may involve:
calculating economic damages
summarizing a large number of transactions
performing a tracing of assets
performing present value calculations utilizing appropriate discount rates
performing a regression or sensitivity analysis
utilizing a computerized application such as spread sheet, data base or computer
model
utilizing charts and graphics to explain the analysis
7. Prepare the report. Often a report will be prepared which may include sections on the
nature of the assignment, scope of the investigation, approach utilized, limitation of scope
and findings and/or opinions. The report will include schedules and graphics necessary to
properly support explain. Joshi, (2003) stated that the job demands reporting, where the
accountability of the fraud is established and the report is considered as evidence in the
court of law or in the administrative proceeding.
Self Assessment
Fill in the blanks:
10. …………. work to ensure their organization is running efficiently and that mismanagement
of funds, waste of resources, or fraudulent activities are not occurring.

11. ……………..use their expertise in accounting to determine when illegal transactions and Notes
activity have taken place.

Caselet Case: Forensic Accounting to Prevent White-collar
Frauds: ICAI
W
ith corporate accounting frauds on the rise, the Institute of Chartered
Accountants of India (ICAI) has decided to promote forensic accounting to
equip chartered accountants with adequate tools to detect white-collar crimes
and identify malpractices like money laundering and routing terrorist funds.
Pointing out that it is difficult to detect sophisticated frauds through traditional accounting
methods, ICAI President Ved Jain said, “Forensic accounting will help professionals to
deal with this new problem in the corporate world.”
The emphasis of the ICAI on forensic accounting comes in the backdrop of the US financial
meltdown, caused due to misreading risks involved in complex derivative instruments
by credit rating agencies and other investors.
Similar, the $50 billion fraud by Wall Street trader Bernard Madoff reinforces the need for
a stronger accounting system. Madoff siphoned off billions of dollars through fake bogus
investment schemes.
Forensic accounts, Jain said, “will encompass the use of accounting and auditing skills and
will use computers as an audit tool. Chartered accountants will be trained in forensic
accounting”. Forensic accounting, which includes data mining and fraud detection, will
provide India Inc., private equities and other stakeholders an effective tool to verify the
accounts of companies and present a clear and transparent picture of the financial health of
the entity concerned, Jain said.
Under the current dispensation a chartered accountant is trained to verify and check books
of accounts, he said, adding with the development of new business practices and evolution
of complex company structures, new skill sets are needed to identify accounting frauds.
Welcoming the decision of the ICAI to promote forensic accounting, KPMG Executive
Director Neville M Dumasia said investors are becoming cautious with the rising number
of frauds and PE investors, wanting to invest in companies, are opting for this mode of
auditing to have a true picture of the books of accounts.
Improvement in accounting practices, he added, is the best way to curb white-collar frauds,
like in the case of France-based Societe Generale, and check money laundering, in addition
to keeping a tab on terrorist money flowing into the country.
Grant Thornton’s India head Vinod Chandiok said companies are increasingly looking at
newer methods to scrutinise the books of accounts, a practice that still is in initial stages in
India.
Forensic account, he said, can also help in resolving disputes pertaining to failed joint
venture agreements, ascertaining economic damages and fixing monetary liabilities.
Banks and financial institutions can also adopt forensic accounting to detect internal frauds
and those committed by customers and outsiders, he added.
Source: http://www.business-standard.com

Notes 14.8 Financial Statements Frauds
In recent years financial statement fraud is a major problem for most of the companies. It is
observed that people in positions of power within organizations sometimes intentionally
mislead investors and creditors with deliberately inaccurate financial statements. The financial
statements frauds include the following:
The falsification, alteration or manipulation of material financial records
Material, intentional omissions or misrepresentations of events, transactions, accounts, or

other vital information used in preparation of financial statements
Deliberate misapplication of accounting principles, policies, and procedures used to

measure, recognise, report, and disclose economic events and business transactions
Intentional omissions of disclosures or presentation of inadequate disclosures regarding

accounting principles and policies and related financial amount
Did u know? What are the key activities performed by forensic accountants to detect frauds?
Activities usually carried out by forensic accountants involve:

Investigating and analysing financial evidence
Developing computerised applications to assist in the analysis and presentation of

financial evidence
Communicating their findings in the form of reports, exhibits and collections of

documents
Assisting in legal proceedings, including testifying in courts, as an expert witness

and preparing visual aids to support trial evidence
Self Assessment
Fill in the blanks:

12. A …………….has to analyse, interpret, summarise and present complex financial and
business-related issues for investigation.
13. It is observed that people in positions of power within organizations sometimes

intentionally mislead investors and creditors with …………inaccurate financial statements.
Task Give some examples of cyber crime in India.
14.9 Summary
The term forensic accounting is concerned with the detection and prevention of business
fraud and related white-collar crimes.
Forensic accounting is the specialized practice area of accounting.
The term ‘Forensic’ means “suitable for use in Court,” and it is to that standard and
potential outcome that forensic accountants generally have to work.

Forensic accounting includes the use of accounting, auditing, and investigative skills to Notes
deal with the legal matters.
It consists of two major components: litigation services that recognise the role of an
accountant as an expert consultant, and investigative services that use a forensic accountant’s
skills and may require possible courtroom testimony.
Forensic Accounting involves the use of accounting/ auditing, investigative skills and
data mining as an audit tool
A forensic accountant has to analyse, interpret, summarise and present complex financial
and business-related issues for investigation.
It is observed that people in positions of power within organizations sometimes

intentionally mislead investors and creditors with deliberately inaccurate financial
statements.
14.10 Keywords
Financial Auditing: Financial auditing is performed by certified charted accountants to check

the regulations of financial statements of an organisation.
Forensic Accounting: Forensic accounting includes the use of accounting, auditing, and
investigative skills to deal with the legal matters.
1. How forensic accounting is different form financial auditing?
2. A forensic accountant has to analyse, interpret, summarise and present complex financial
and business-related issues for investigation. Discuss.
3. According to Zysman (2001), what are the key assignments performed by a forensic
accountant.
4. How you will identify the financial statements frauds?
5. Identify the scope of forensic accounting.
6. What are the key skills required for forensic accounting?
7. State the difference between forensic accountant and auditor.
1. Specialized
2. Certified charted accountants
3. Legal
4. Investigative
5. Risk management
6. Audit
7. Litigation support
8. Litigation support

LOVELY PROFESSIONAL UNIVERSITY
Jalandhar-Delhi G.T. Road (NH-1)
Phagwara, Punjab (India)-144411
For Enquiry: +91-1824-521360
Fax.: +91-1824-506111
Email: [email protected]
Notes 9. Criminal
10. Auditors
11. Forensic accountants
12. Forensic accountant
13. Deliberately

www.scribd.com

Contemporary Accounting

Uploaded by

Copyright:

Available Formats

Contemporary Accounting

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Contemporary Accounting

Uploaded by

Copyright:

Available Formats

  )

Sr. No. Description

Unit 1: Accounting Standards 1

Unit 2: Price Level Accounting 20

Unit 3: Environmental Accounting 45

Unit 4: Economic Value Added (EVA) 53

Unit 5: Social Reporting 63

Unit 6: Human Resource Accounting 71

Unit 7: Approaches of HRA 78

Unit 8; Corporate Reporting 93

Unit 9: Issues and Recent Trends in Corporate Reporting 113

Unit 10: IFRS and its Relevance 121

Unit 11: Introduction to Financial Reporting Framework 131

Unit 12: Analysis of Financial Reporting Framework 143

Unit 13: Critical Evaluation of Principles and Practices 150

Unit 14: Forensic Accounting 162

Unit 1: Accounting Standards Notes

Financial statements summarise the end-result business activities of an enterprise during an

Did u know? What are standards?

1.1 Meaning of Accounting Standards

Accounting standard is an authoritative pronouncement of code of practice of the regulatory

LOVELY PROFESSIONAL UNIVERSITY 1

ASB is entrusted with the responsibility of formulating standards on significant accounting

Fill in the blanks:

1. Accounting standard is an authoritative pronouncement of code of practice of the regulatory

2. The IASC was set up in ………….., with headquarters in London (UK).

4. ASB is entrusted with the responsibility of formulating standards on significant accounting

1.2 Nature and Rationale of Accounting Standards

1.2.1 Accounting Standards and Companies Act

The specific provisions of the Companies Act include,

2 LOVELY PROFESSIONAL UNIVERSITY

1.2.2 Accounting Standards and Income Tax Act, 1961

LOVELY PROFESSIONAL UNIVERSITY 3

1. TAS – 1: relating to Disclosure of Accounting Policies

1.2.3 Accounting Standards and Non-commercial Organisations

State true or false:

8. TAS – 1 is related to Disclosure of Accounting Policies.

4 LOVELY PROFESSIONAL UNIVERSITY

1.3 Accounting Standards Setting in India

1.3.1 Accounting Standards Setting Process

LOVELY PROFESSIONAL UNIVERSITY 5

1.3.2 Accounting Standards in India

Accounting Standards (AS) Title of the Accounting Standards

The given below is the brief expiation of accounting standards in India:

6 LOVELY PROFESSIONAL UNIVERSITY

LOVELY PROFESSIONAL UNIVERSITY 7

8 LOVELY PROFESSIONAL UNIVERSITY

Thus, the sequence can be shown as below:

Step Step Step

Research Development Commercial

(a) by sale of goods;

(b) by rendering of services; and

LOVELY PROFESSIONAL UNIVERSITY 9

(i) forests, plantations and similar regenerative natural resources;

(iii) expenditure on real estate development; and

Expenditure on individual items of fixed assets used to develop or maintain the

10 LOVELY PROFESSIONAL UNIVERSITY

Government grants can essentially be of four types: Notes

)