2

Generally Accepted Accounting Principles and Accounting Standards

2.1 NATURE OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

Accounting principles or GAAP are general rules guiding recording of accounting transactions. As accounting is not an exact science, accounting practices may differ significantly from one firm to another. Accounting principles are nothing but good accounting practices evolved over a period of time. As accounting information is used by a number of users, it is important that the accounting information is relevant for making economic decisions and is objective. Often the users have conflicting objectives; accounting information must be fair to all of them without any bias. GAAP lends objectivity and relevance to accounting information. It must however be noted that GAAP do not deal with specific accounting events. To decide how a particular transaction will be recorded, the management still has a lot of latitude.

Some of the key accounting principles used in preparation of accounting information have been discussed below:

2.1.1 Separate Entity

To begin with, the accountant has to clearly define the business unit for which accounting is being done. The concept states that accounts are kept for the business entity which is distinct from the owner. The accounts must reflect the effect of a transaction on the accounting entity and not on the persons who own the entity. Therefore, the personal affairs of the owners must not be mixed with business activities. Payment of rent by a proprietorship firm for the personal residence of its proprietor will not be recorded as business expense to ascertain profit or loss of the firm, rather will be recorded as a reduction of capital.

 

Secondly, it must be recognized that any transaction between the accounting entity, on the one hand, and any other entity on the other, is the subject matter of accounting. This helps the users in understanding the scope of financial statements clearly. Accordingly, a cash transfer from one branch of a bank to another branch must be recorded as an accounting transaction when branch accounts are being prepared. However, while preparing the financial statements of the bank as an accounting entity, such inter-branch transactions are ignored.

■ Illustration 2.1

Star International UK set up a captive BPO unit in India called StarTrek India. It invested £50 million as capital in the Indian subsidiary. Should it be recorded as an accounting transaction?

Yes, Star International UK (owner) and StarTrek India are two different entities. It will appear as an investment in the books of former and as capital in the books of later.

Suppose StarTrek India provided some back office services to Star International UK. Should this be recorded as an accounting transaction in the books of StarTrek India?

Yes, the monetary value of services provided by Indian entity to UK entity is an accounting transaction.

■ Illustration 2.2

Ram Manohar & Sons is a proprietorship firm owned by Mr. Ram Manohar. During the year 2017, the firm bought goods worth ₹ 1,000,000. Goods costing ₹ 100,000 were consumed by Mr. Ram Manohar for personal purposes. The remaining goods were sold for ₹ 9,60,000. What is the profit or loss for the year?

Though the total purchases are for ₹ 1,000,000, goods costing ₹ 100,000 have been consumed by the proprietor. As such goods costing ₹ 900,000 ( ₹ 1,000,000 – ₹ 100,000) have been sold for ₹ 960,000 resulting in profit of ₹ 60,000 ( ₹ 960,000 – ₹ 900,000) for the year.

2.1.2 Accounting Period

Stakeholders want accounting information on a regular basis, therefore, financial statements are prepared periodically. The period covered by such financial statements is called the accounting period. As a matter of convention, the accounting period is a period of twelve months. In absence of a uniform accounting period, comparing results of different entities will not be possible. A period of 12 months covers all the seasonal variations. In India, financial year, i.e., from 1st April to 31st March is more popular accounting period, whereas internationally, calendar year is the preferred choice as accounting period. In certain circumstances, it may be possible to have an accounting period which is longer or shorter than 12 months. For example, the first accounting period after the commencement of business may be shorter than 12 months.

 

The Companies Act, 2013 makes it mandatory for all companies to keep their accounts on financial year basis. Those companies that were keeping their accounts on any other basis were given a period of two years from the commencement of the Act to switch over to financial year.

In addition to annual results, the users may need more frequent information. This requirement is met through interim reporting. The listed companies in India are required to report quarterly results as well, to meet the informational needs of investors.

■ Illustration 2.3

Hindustan Boiler Limited, an India subsidiary of a US company, prepares its accounts using financial year as the accounting period. The US parent company prepares its accounts on calendar year basis. What kind of problem the US Company would face to present consolidated results?

As the holding and subsidiary company are following different accounting periods, it may not be possible to directly consolidate the accounts by the holding company. The Indian subsidiary will have to prepare two set of accounts—on financial year basis for local reporting and calendar year basis for reporting to the holding company.

■ Illustration 2.4

ABC Limited was keeping its books of accounts on a calendar year basis. After preparing its accounts for the year 2014, it decided to change its accounting period to financial year basis. How would the switch over happen in terms of accounting period?

The accounts for the year 2015–16 will be for fifteen months i.e. from 1st January 2015 to 31st March 2016. Thereafter, regular financial year will be followed.

2.1.3 Money Measurement

Money is a common unit of measurement. Only those events and transactions which can be converted or expressed in money terms are subject matter of accounting. If a business unit buys 5,000 kg of raw material @ ₹ 100 per kg, only the monetary value, i.e., ₹500,000 will be entered in the books of accounts and not the quantity purchased. The necessity of this concept is obvious. For example, Progress Technologies Limited owns 20 computers ₹ 5 million in cash, a piece of land with an office building thereon and few more assets. How do we state the total assets of the company as on date unless we are able to express each of these assets into a common denominator? Fortunately, money provides the common denomination.

 

This concept has other implications too. What if a business unit earns its revenue in multiple currencies? How would the total revenue of the business be ascertained? The financial statements are prepared using a uniform currency called the reporting currency. All companies in India use Indian rupee as the reporting currency. Any revenue earned or expenses incurred in any other currency is converted into the reporting currency by using the then prevailing exchange rate.

This concept, though essential, has its limitations too. Firstly, we assume that money has a constant value. Change in the purchasing power of money is therefore not incorporated in the account books. A piece of land bought in the year 1990 at ₹ 10 million will continue to appear in the books of accounts at the same value though the value of rupee might have declined substantially in the last 20 years. This may have significant implications on the financials of the business especially in countries with high inflation rate. Secondly, events that cannot be expressed in terms of money, howsoever important, are not reflected in accounts. A major labour unrest, leading to strike in the factory or change in government regulation having adverse impact on the business, are major events but are not subject matter of accounting

■ Illustration 2.5

Progressive InfoTech Limited earned revenue of $1.5 million from exports and also ₹ 320 million in the domestic market during the month of July. Assuming the exchange rate of 1 $ equals to ₹ 65, what is the total revenue for the month of July?

To ascertain the total revenue, the export income must be converted into the reporting currency by using appropriate exchange rate. The revenue from export will be recorded at ₹ 97.5 million ($1.5 million multiplied by ₹ 65) resulting in total revenue of ₹ 417.5 million.

■ Illustration 2.6

After the death of the promoter of E-Sport Limited, there is fierce battle between his two sons for succession. How will this be reflected in the books of accounts of the company?

The above event, though very important, cannot be expressed in money terms. As such, it will not be reflected in the book of accounts of E-Sports Limited.

2.1.4 Going Concern

For the purposes of accounting, it is assumed that the business is a going concern and would continue to operate indefinitely. There is neither the need nor the intent to discontinue operations. This concept has strong implication on the valuation of assets of the business. Assets should be valued on the basis of their intrinsic value to the entity as an ongoing business rather that at their realizable value. Accounting policies and estimates must reflect the financials of the business as a going concern rather being influenced by short-term considerations.

 

However, the basis of valuation will change if the going concern assumption is violated. If there is evidence that the accounting entity or a part thereof is likely to be liquidated shortly, the assets value would reflect the liquidation value.

■ Illustration 2.7

Healthcare Pharmaceutical Limited has 3 plants located at Delhi, Mumbai and Pune. The company has decided to shut down the Pune plant and sell its assets either as a running unit or in a piecemeal manner. What is the implication of such a decision in the books of accounts of the company?

In respect of Pune plant, the going concern assumption has been violated as such the assets should be shown at their liquidation value. For the other two plants, going concern continues to hold good.

2.1.5 Cost Concept

Cost concepts states that the long-term assets are shown in the financial statements at their historical cost irrespective of the current realizable or liquidation value. This concept is an extension of going concern principle as discussed above. A temporary decline in the market value of an asset should be ignored as the business will continue to view the asset at its intrinsic value as a going concern. Due to the same reason, any appreciation in the liquidation value will also be ignored. However, if the going concern assumption is violated, e.g., in case of discontinuation of operations, cost principle will also not apply. Likewise, if decline in value of the asset is non-temporary, the asset would be shown at its liquidation value.

 

The main advantage of cost concept is objectivity. The historical cost can be objectively measured, whereas determining the current realizable value suffers from subjectivity. It will also require lot of efforts in keeping a track of change in the liquidation value of the asset.

It, however, must be noted that the cost of a long-term asset is systematically apportioned over its useful life. Such an apportionment of cost of a permanent asset over its useful life is called depreciation.

■ Illustration 2.8

Industrial Lab Limited bought a piece of land for ₹ 5 million in the year 1970. The company has used the land to set up an industrial unit. The current market price of the land is ₹ 20 million. At what value this asset should be shown in the financial statements of the company?

The land will continue to appear at its historical cost, i.e., ₹ 5 million irrespective of its current market price following cost concept.

2.1.6 Conservatism or Prudence

The conservatism or prudence principle states that it is better to understate the financial position of the business rather that overstate. In more specific terms, gains should be recognized when they are reasonably certain, however, losses should be recognized even if they are reasonably probable. Prudence is an important guiding principle while choosing accounting policies. When in doubt, choose an accounting policy that understate the profits rather than overstate it.

 

■ Illustration 2.9

Reliable Limited sells goods on credit basis. At the end of the year, it has a total outstanding of ₹ 120 million from its customers. The past experience shows that about 5% of the customers invariably default. How do we account for this anticipated loss?

As based upon past experience 5% loss is reasonably probable, the company will make a provision for anticipated losses at ₹ 6 million. This will appear in the statement of profit and loss for the year as an expense. In the balance sheet, receivables will be shown at ₹ 114 million, i.e., net of the provisions.

■ Illustration 2.10

Pee Ltd. bought 1,000 shares of RIL at ₹ 1,200 per share during the year for trading. The market price per share at the end of the year is ₹ 1,100. At what value will the short-term investment appear in the Balance Sheet of Pee Ltd? How do we treat ₹ 100 fall in value per share? What would be your answer if the market price per share at the end of the year is ₹ 1,500?

As the current market price ( ₹ 1,100) is lower than the cost price ( ₹ 1,200); there is a reasonable probability of loss of ₹ 100 per share. The short-term investment will appear at ₹ 1,100, i.e., lower of the two. At the same time, the anticipated loss of ₹ 100 per share will appear in the statement of profit and loss for the year. If the current market price is ₹ 1,500, the appreciation will be ignored as it is not certain. The short-term investment will appear at the cost price being lower of the two.

2.1.7 Materiality or Relevance

The materiality principle guides the level of details required to be disclosed in financial statements. In general, any information that is relevant to the user of financial statements should be disclosed. At the same time, unnecessary details should be avoided. If all details are provided in financial statements, they will become too long and cumbersome to understand. On the other hand, if lot of information is clubbed together, some vital information may be lost. In case of doubt, it is better to over-disclose rather than under-disclose.

 

■ Illustration 2.11

In the statement of profit and loss of Tee Ltd. about 60% of the expenses have been clubbed under the heading ‘miscellaneous expenses’, whereas Cee Ltd. has reported all heads of expenses separately including about 100 different types of expenses which together constitute only 10% of the total expenses in rupee terms. What are your views?

In case of Tee Ltd. vital details are being lost as 60% of the expenses are being clubbed as ‘miscellaneous expenses’. The company should analyze its expenses under relevant heads and disclose accordingly. Cee Ltd., on the other hand, is over disclosing. It can club a number of expense heads as miscellaneous and make financial statements simpler.

2.1.8 Consistency

The consistency principle requires that accounting policies once chosen must be applied consistently period after period. When a user is trying to establish a trend by comparing financial statements of an entity over a period of time, say, last 10 years, it is important that these statements have been prepared using the same accounting policies.

 

Consistency does not, however, mean that accounting policies cannot be changed. If there is a strong reason to change, accounting policies may be altered. For example, a change in government regulation may necessitate change in accounting policies. However in such an event, the change in accounting policy must be disclosed and the impact of the change in accounting policy must be quantified and reported separately.

■ Illustration 2.12

Red Swan Auto Limited is proposing to change its accounting policy for the valuation of inventories as the management feels that it would lead to better estimation of cost of inventories. Can they do so?

Yes, Red Swan Auto can change its accounting policy for better estimation of cost. However, the company needs to disclose the change in accounting policy. The impact of change also must be quantified and disclosed.

2.1.9 Matching

The matching principle requires that the expenses incurred must be matched against the revenue earned to ascertain the profit or loss for the business. If the expenses are incurred in one period, whereas revenues are earned in the next period, the expenses need to be carried forward to the next period to ascertain the profit. To apply matching principle, first the revenues are identified to a particular period. Once revenue has been recognized, expenses incurred to earn that revenue is matched to ascertain profit or loss.

 

■ Illustration 2.13

During the year, Smart Trading Limited bought goods worth ₹ 1,350,000. It also had goods worth ₹ 200,000 in stock which were bought during the previous year. At the end of the year, goods costing ₹ 450,000 are still unsold. Remaining goods have been sold during the year for ₹ 1,400,000. Ascertain the cost of goods sold during the year and profit or loss for the year.

The total cost of goods available for sale is made up of the goods from the previous year (opening stock) amounting to ₹ 200,000 and goods bought during the year amounting to ₹ 1,350,000. Out of this, goods costing ₹ 450,000 are still unsold (closing stock). The cost of goods sold can be calculated as:

 

The company has earned ₹ 1,400,000 from sales of goods. By matching the cost of goods sold against this income, the profit for the year comes to ₹ 300,000.

2.1.10 Accrual Basis of Accounting

There are two different methods of recording accounting transactions—cash and accrual. In cash basis of accounting, transactions are recognized only when cash is paid or received. The timing of recognizing an accounting event and the quantum depends upon exchange of cash. For example, Delhi Auto Limited made a sale of ₹ 500,000 on 28th February 2018 allowing three months to its customer to make the payment. The payment was finally received on due date, i.e., 31st May 2018. Assuming further that the company maintains its accounts on financial year basis, the transaction will be entered in account books only on 31st May 2018 when the cash is actually received. On 28th February, i.e., date of sale no accounting transaction was recorded. Cash basis of accounting is very simple and objective as recording of accounting transaction coincide with receipt or payment of cash.

 

On the other hand, in accrual basis of accounting transactions are recorded when a legally binding obligation to pay or receipt is created. Revenue is recorded in financial statements when goods have been sold or a service has been performed, resulting in creation of a right to receive payment. Likewise, expenses are recorded when goods or services have been purchased and a legally binding payment obligation has been created. In the above example, the sale has been completed on 28th February 2018 creating a right to receive payment for Delhi Auto Limited. Accordingly, sales was recorded on 28th February 2018 notwithstanding the fact that the payment is actually received later.

■ Illustration 2.14

ABC Diagnostic Limited has the practice of paying the monthly salary on the 7th of next month. Accordingly, salary for the month of March 2018 was paid on 7th April 2018. If the company follows cash basis of accounting, when would the expenses be recognized? What if the company follows accrual basis of accounting?

In cash basis of accounting, expenses are recorded upon payment only. Accordingly, the salary paid will be recorded as an expense on 7th April 2018 and will appear as an expense for the year 2018–19.

If ABC Diagnostic Limited follows accrual basis of accounting, expenses will be recorded when incurred, i.e., when a legally binding obligation to pay has occurred. As the company has used the services of its employees, it has an obligation to pay. As such, salary for the month of March has already accrued by 31st March 2018. Accordingly, it will be recorded as an expense for the year 2017–18, though paid in 2018–19.

2.1.11 Dual Aspect

The modern day accounting is based upon what is called double entry book keeping system. It states that the basic accounting equation, i.e., Assets = Owners’ Capital + Liabilities, will always be true. Each accounting transaction affects at least two accounts in such a way that the accounting equation will always be in balance. In fact, because of double entry book keeping system assets and liabilities side of balance sheet will always tally.

The equation, Assets = Capital + Liabilities, is the foundation of modern days accounting. In this equation, assets signify what a business own, e.g., land, building, plant, machinery, cash, inventories, accounts receivables, etc. Capital means business’s obligations towards the owners. It includes not only the original contribution of the owner but also retained earnings, i.e., profit made but not with-drawn by the owners. Revenue earned results in an increase of capital, whereas expenses results in decrease in capital. Liabilities mean what the business owes to non-owners, e.g., bank loans, accounts payables, creditors for goods and services, etc. At any point of time, the equation will always be true.

 

■ Illustration 2.15

Mr. Ramesh Jha started a new business on 1st April 2017 contributing ₹ 1,000,000 in cash as capital. The firm bought some furniture for ₹ 200,000 in cash and bought machinery from XYZ Limited for ₹ 700,000 on credit. How would these transactions affect the accounting equation?

When Mr. Ramesh Jha introduced ₹ 1,000,000 as capital, it has a dual effect on the business. The business has acquired an asset (Cash) and also an obligation towards Mr. Jha. At this stage:

Assets		=	Capital	+	Liabilities
Cash	₹ 1,000,000	=	₹ 1,000,000		0

When furniture is bought for ₹ 200,000 and paid for in cash, one type of asset (cash) is replaced by another (furniture). The accounting equation now is:

Assets		=	Capital	+	Liabilities
Cash	₹ 800,000	=	₹ 1,000,000		0
Furniture	₹ 200,000

When the firm bought machinery on credit, it results in increase in assets (machinery) and at the same time it has incurred a liability towards XYZ Limited.

Assets		=	Capital	+	Liabilities
Cash	₹ 800,000	=	₹ 1,000,000		XYZ Limited    ₹ 700,000
Furniture	₹ 200,000
Machinery	₹ 700,000

All accounting transactions and procedure are based upon the above fundamental accounting equation.

2.1.12 Substance Over Form

Accountants often face situations where the real intent of a transaction is totally different from the form in which the transaction is entered into. Should the accountant merely be guided by the legal form in which the transaction has been entered into or go by the substance of the transaction? As a principle, the substance of the transaction takes precedence over its legal form. The real intent behind the transaction should be explored and given effect to in accounting.

■ Illustration 2.16

On 1st May 2017, Moneywise Bank sold some securities to KM Bank for ₹ 100 million with an agreement to buy them back at ₹ 101 million after a month. The securities were delivered to KM Bank on 1st May 2017. On 1st June, Moneywise Bank paid ₹ 101 million and bought back the securities. How should the transactions be recorded in the books of Moneywise Bank?

Prima facie the transaction appears as a sale and purchase of securities. In substance, however, Moneywise Bank has borrowed ₹ 100 million from KM Bank against collateral of securities in question. The loan has been repaid on 1st June 2017 with interest of ₹ 1 million. Looking at the substance of the transaction, it will be recorded as a borrowing and ₹ 1 million will be recorded as an interest expense in the books of Moneywise Bank.

Ind AS 8 (Accounting policies, change in accounting estimates and errors), issued by the Institute of Chartered Accountants of India (ICAI) states that accounting policies are specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. Any transaction or event or condition that is specifically covered by an Ind AS, accounting policy shall be determined by applying the relevant Ind AS. If there is no specific Ind AS covering a particular transaction or event or condition, the management shall use its judgement in developing an accounting policy. Selection of accounting policy shall be governed by principles of relevance and reliability. The information must be relevant to the economic decision making needs of the users.

The accounting policies are considered to be reliable if the financial statements:

1. represent the financial position, financial performance and cash flows of the entity in a faithful manner;
2. reflect the economic substance of transactions, other events and conditions and not merely the legal form;
3. are neutral, i.e., free from bias;
4. are prudent;
5. are complete in all material respects.

An entity shall select and apply its accounting policies consistently for similar transactions, other events and conditions, unless an Ind AS specifically requires or permits categorization of items for which different policies may be appropriate.

Accounting policies once chosen shall be applied consistently periodically. However, an entity may change its accounting policy if the change is required by an Ind AS; or the change results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows.

In case of a change in accounting policy, the entity shall disclose the nature of change in it and how the new accounting policy provid will reliable and more relevant information. The impact of the change in accounting policy for the current period and each prior period presented shall also be quantified and presented.

2.2 NEED FOR ACCOUNTING STANDARDS

As discussed earlier, accounting principles have evolved over a period of time as general rules for recording accounting transactions. They do not cover specific situations. Accounting standards, on the other hands, are prescribed by a designated authority and often have backing of law. They cover specific type of accounting events and transactions. To illustrate, conservatism principle states that probable losses should be provided for, but probable gains should be ignored. Ind AS 2 applies this principle to inventory valuation by laying down specific rule that inventories should be valued at ‘lower of cost or net realizable value’. Accounting standards thus converts general accounting principles to specific rules. To that extent, they reduce management’s discretion in choosing accounting policies. Further, they also lay down disclosure requirements for better understanding of financial statements. As they have backing of law, they acquire a mandatory status.

 

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.¹

However, it must be noted that accounting standards do not completely eliminate management’s latitude in choosing accounting policies. To the extent permitted by accounting standards, management has some discretion in choosing accounting policies. For example, Ind AS 2 permits business enterprises to either use First-In-First-Out (FIFO) or weighted average method to ascertain cost of inventories. Please note that firstly, the choice of management is restricted but not eliminated as there are many more methods for inventory valuation like NIFO, HIFO, and simple average, etc. Secondly, Ind AS 2 requires disclosure to be made about the method used by the management.

2.3 ACCOUNTING STANDARDS IN INDIA²

The Institute of Chartered Accountants of India (ICAI) was set up as a statutory body in the year 1949 by an act of parliament, chartered accountants Act, 1949, with the objective of the regulation of the profession of Chartered Accountants in India. The ICAI set up the Accounting Standards Board (ASB) in 1977 and entrusted it with the role of preparation of accounting standards. The objectives of the ASB are:

 

• To conceive and suggest areas in which accounting standards need to be developed.
• To formulate accounting standards with a view of assisting the Council of the ICAI in evolving and establishing accounting standards in India.
• To examine how far the relevant international accounting standards can be adapted while formulating the accounting standards, and adapt the same.
• To review, at regular intervals, the accounting standards from the point of view of acceptance or changed conditions and if necessary revise the same.
• To provide from time to time, interpretation and guidance on accounting standards.

To ensure a wider participation by various interest groups, the ASB has a broad-based structure. It has representations form government (Ministry of Corporate Affairs, Comptroller and Auditors General of India), regulators (RBI, SEBI, IRDA, PFRDA), industry bodies (ASSOCHAM, FICCI, CII), tax authorities (CBDT, CBEC), other professional bodies (ICWAI, ICSI), academicians and member of the ICAI.

2.3.1 Process

The process adopted for laying down a new accounting standard is set out below:

• Identification of the broad areas by the ASB for formulating the accounting standards.
• Constitution of the study groups by the ASB for preparing the preliminary drafts of the proposed Accounting Standards.
• Consideration of the preliminary draft prepared by the study group by the ASB and revision, if any, of the draft on the basis of deliberations at the ASB.
• Circulation of the draft, so revised, among the Council members of the ICAI and specified outside bodies such as Standing Conference of Public Enterprises (SCOPE), Indian Banks Association, Confederation of Indian Industry (CII), Securities and Exchange Board of India (SEBI), Comptroller and Auditor General of India (C & AG), and Department of Company Affairs, for comments.
• Meeting with the representatives of specified outside bodies to ascertain their views on the draft of the proposed accounting standard.
• 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.
• Issuance of the exposure draft inviting public comments.
• 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.
• Consideration of the draft accounting standard by the Council of the Institute, and if found necessary, modification of the draft in consultation with the ASB.
• The accounting standard, so finalized, is issued under the authority of the Council.

The new accounting standards are recommendatory in nature for an initial period. The ICAI has issued 32 accounting standards. The list of accounting standards issued by ICAI is given in Table 2.1.

 

2.4 GLOBALIZATION OF ACCOUNTING STANDARDS

With the increased globalization of business, cross-border flow of capital has become increasingly common. A number of Indian companies have raised capital abroad by issuing instruments like american depository receipts (ADR), global depository receipts (GDR) and foreign currency convertible bonds. Indian companies have set up and acquired businesses overseas and foreign companies have their presence in India through subsidiaries or joint ventures. In a globalized environment, it is imperative that the Indian accounting standards are harmonized with international accounting standards.

The Ministry of Corporate Affairs (MCA) decided to converge Indian accounting standards with iternational financial reporting standards (IFRS) issued by the International Accounting Standard Board (IASB). Such a move is necessary ‘to enable accessibility of financial information to global investors since the need for restatement of accounts would be obviated for Indian companies seeking to tap international financial market’³. It is expected that IFRS convergence will result in improved disclosure by Indian companies in line with global best practices. The financial reports will enjoy better credibility enabling Indian companies to raise capital in overseas markets with ease.

 

Instead of adopting the IFRS, whereby Indian accounting standards would have ceased to exist, India has opted for convergence route for transition. In this route, a new set of accounting standards are issued, which are substantially in line with IFRS. However, the IFRS are modified in light of usage and business environment prevailing in the country. The MCA issued a new series of 40 Indian accounting standards (Ind AS) which are substantially in line with IFRS. 'While finalizing the Ind AS, the Indian standard setters have examined individual IFRS and modified the requirements wherever necessary, to suit Indian conditions. These modifications are routinely termed as ‘carve outs’.⁴ The list of 40 Ind AS is given in Table 2.2.

 

The Ministry of Corporate Affairs has notified a phased roadmap for transition to Ind AS commencing from 1st April, 2016. It was made compulsory for the listed companies and certain other class of companies to follows Ind AS with effect from 1st April, 2016, whereas other companies would be required to transit to Ind AS for the accounting periods beginning on or after 1st April, 2017.⁵

In the first phase, it was mandatory for the companies specified below to follow Ind AS for the accounting periods beginning on or after 1 April, 2016, with comparatives for the periods ending 31 March, 2016.

1. Companies whose equity and/or debt securities are listed or are in the process of listing on any stock exchange in India or outside India and having net worth of ₹ 500 crore or more.
2. Companies other than those covered above, having net worth of ₹ 500 crore or more.
3. Holding, subsidiary, joint venture or associate companies of companies covered above.

In the second phase, Ind AS is mandatory for specified companies for the accounting periods beginning on or after 1 April, 2017, with comparatives for the periods ending 31 March, 2017 or thereafter. The companies specified for the second phase are:

1. Companies whose equity and/or debt securities are listed or are in the process of being listed on any stock exchange in India or outside India and having net worth of less than ₹ 500 crore.
2. Unlisted companies having net worth of ₹ 250 crore or more but less than ₹ 500 crore.
3. Holding, subsidiary, joint venture or associate companies of companies covered above.

Once a company starts follow Ind AS, voluntarily or mandatorily, it shall be required to follow the same for all the subsequent financial statements. Companies listed or getting listed on the Small and Medium Enterprises (SME) exchanges are exempted from adoption of Ind AS. Companies not covered by the revised road map could continue to apply the existing accounting standards. In respect of insurance companies, banking companies and NBFCs, the transition to Ind AS is proposed to begin for the accounting period beginning from 1 April, 2018.

As the transition to Ind AS has already begun, the subsequent discussion in this book is based upon Ind AS issued by the MCA.

Assignment Questions

1. Explain the following accounting principles with suitable examples:
   1. Accounting period
   2. Separate entity
   3. Money measurement
   4. Substance over form
   5. Historical cost
   6. Dual aspect
2. ‘Gains are recorded if reasonably certain, whereas losses are recorded even if reasonably probable’. Explain the statement and identity the accounting principle.
3. As per consistency principle, accounting policies once chosen cannot be changed. Do you agree?
4. What is the need for accounting standards?
5. Describe the process followed by the Accounting Standard Board for laying down new accounting standards.
6. Briefly discuss the requirements of Ind AS 8 relating to accounting policies.
7. What is the rationale of convergence of Indian accounting standards with IFRS?

Problems

1. Identifying relevant accounting principle: Curewell Pharmaceutical Limited is facing a law suit wherein it may be liable to pay a fine of ₹ 10 million. The lawyer of the company has advised that there is a high probability of the company losing the law suit. How should the company record this transaction in the books of accounts? What accounting principle is involved?
2. Identifying relevant accounting principle: Shivam Limited borrowed a sum of ₹ 50 million from the State Bank of India on 1st August 2016 for a period of one year. The loan matured on 30th July 2017 and was duly repaid on due date with interest amounting to ₹ 5 million. The company maintains its books on financial year basis. In which accounting year the interest expenses should be recorded? Why?
3. Money measurement: Which of the following transactions are subject matter of accounting:
   1. Purchase of 200 kg of goods by the firm on credit for ₹ 100,000.
   2. Resignation of one of the key salesman of the firm.
   3. A pharmaceutical company has filed application for patent of a new drug.
   4. A construction company has won a major contract from the government.
   5. A telecom company has paid ₹ 200 million as a security deposit to the government.
4. Identifying relevant accounting principle: Free Flow Oil Limited, an Indian company set up an office in Sri Lanka for executing a specific contract. Due to some reasons, the Sri Lankan government put a ban on the company to operate in the country. How will it impact the valuation of assets of the Sri Lankan operations of the company?

Solutions to Problems

1. Curewell Pharmaceutical is advised to make appropriate provision for the loss as there is a reasonable probability of company losing the case. It is based upon the principle of conservatism.
2. The interest of ₹ 5 million is for a period of 12 months from 1st August 2016 to 30th July 2017. Interest accrues on a day to day basis. Interest from 1st August 2016 to 31st March 2017 should be accounted for in the year 2016–17, whereas interest for the period 1st April 2017 to 30th July 2017 will be treated as an expense for the year 2017–18. Accordingly, interest of ₹ 5 million will be split 2/3rd: 1/3rd between the two accounting years.
3. 1. Yes: ₹ 100,000 will be recorded as purchase but not the quantity
   2. No: Cannot be expressed in money terms
   3. No: Filing an application cannot be expressed in terms of money
   4. No: Winning a contract cannot be expressed in monetary terms
   5. Yes: Amount of security deposit is an accounting transaction
4. As there is evidence to believe that Sri Lankan operation of the company are no longer viable, these operations can no longer be viewed as going concern. Accordingly, valuation of assets of Sri Lankan operations should reflect their realizable value.

Try It Yourself

1. Cash basis vs. accrual basis of accounting: A business enterprise recorded cash sales of ₹ 15.5 million and credit sales of ₹ 7.8 million during the year 2016–17. The cash purchases during the year were ₹ 13 million whereas credit purchases amounted to ₹ 4 million. The enterprise also paid ₹ 3 million towards various expenses including an advance payment ₹ 1 million to one of the vendors. Ascertain the profit for the year using :
   1. Cash basis of accounting
   2. Accrual basis of accounting.
2. Identify the accounting principle: Alto Limited bought a building for ₹ 30 million in the year 2014–15 which is being used for office purposes. Due to fall in the real estate prices in the area, the company ascertains that the current market price of the same has fallen to ₹ 23 million. At what value the building should be shown in the books of accounts of the company? Also state the accounting principle involved.
3. Dual aspect: Complete the table:

    

   
4. Identify the accounting principle: P T Jewelers bought 1 kg of gold during the year at the rate of ₹ 18,000 per ten grams. At the end of the year, half of the gold is still unsold. The current market price of the gold is ₹ 21,000 per ten grams. At what value the gold inventory should be shown in the financial statements of P T Jewelers? What will be your answer if the current market price of gold is ₹ 17,000 per ten grams? State the principle involved.
5. Application of accounting principles: Straight Bank of India invests in debt securities issues by the Government of India. Some of these investments are long-term in nature and are expected to be ‘held till maturity’ whereas some of the investments are short-term in nature and are ‘held for trading’. The details of the investments as on 31st March 2018 are given below:

    

   
   1. At what value the investments should be shown in the Balance Sheet as on 31st March 2018?
   2. What will be the impact on the Profit & Loss Statement for the year ended 31st March 2018?
   3. What are the accounting principles involved?
6. Application of accounting principle: Pee Tee Limited so far has been following the Last-in-First-Out (LIFO) method for valuation of inventory. The management would like to change the method of valuation of inventory and adopt First-In-First-Out (FIFO) as this better represent the flow of inventory. Is it possible to change the method of valuation of inventory? If yes what are the requirements?
7. Change of accounting period: Sit-Sat Limited followed the calendar year as the accounting period till December 2015 and changed to financial year thereafter. During the switch over period, it prepared the accounts for fifteen months from 1st January 2016 to 31st March 2017 and thereafter on financial year basis. It reported a profit after tax of ₹ 350 million for the financial year ended 31st March 2018 compared to ₹ 370 million for the period ended on 31st March 2017. The management is concerned about the decline in profit. How do you respond to the concern of the management?

Cases

Case 2.1: Exotica Trading Company

Mr. Smart Lal commenced his trading business in the name of Exotica Trading Company on 1st April 2017 with a capital of ₹ 1,000,000 and a loan from the State Bank of India amounting to ₹ 500,000. At the end of the first year, the summary of his business transactions recorded on cash basis are set out below:

		(Amount in ₹)
Loan from State Bank at 10%	—	500,000
Deposit with the land lord for the shop taken on rent	—	200,000
Furniture purchased	—	500,000
Rent paid for the shop	—	90,000
Salary paid to salesman	—	225,000
Cash paid to the supplier for goods purchased	—	2,250,000
Other expenses paid	—	100,000
Cash Sales	—	2,500,000

At the end of the year, he prepared the profit and loss statement and a balance sheet as given as follows:

 

 

Smart Lal is very upset about the results as in the first year of operations itself, the business has incurred a loss of ₹ 865,000. He is concerned about the prospects of this business going forward. While reviewing the accounts, he also come across some more information kept by his accountant:

• Rent for a quarter is still to be paid at ₹ 10,000 per month.
• Salary paid includes an advance given to the salesman amounting to ₹ 45,000.
• Interest on bank loan for the whole year is yet to be paid.
• Suppliers of goods are yet to be paid for the supplies made ₹ 150,000.
• Goods purchased for ₹ 50,000 were consumed at the household of Smart Lal.
• Goods costing ₹ 215,000 are still unsold and lying in the stock.
• Sales amounting to ₹ 325,000 are yet to be collected from the customers. One of the customer from whom ₹ 45,000 is due is feared to be insolvent.
• It is expected that furniture would have a useful life of five years. The current market value of similar furniture is ₹ 600,000.

Mr. Smart Lal is not too sure as to how to incorporate the above information in the financial results. Please help him by preparing the revised statement of profit and loss and balance sheet highlighting the accounting principle involved.

Case 2.2 Change of Accounting Period of Hindustan Unilever Limited⁶

Hindustan Unilever Limited (HUL), incorporated in 1933, is a part of the Unilever Group. The company is present in various segments including home and personal care, food and beverages, and water. The Company used to prepare and present its financial statements on a calendar year (January–December) basis. After presenting its accounts for the calendar year 2007, the company decided to change its accounting period to financial year (April–March). The change in accounting year was done ‘to avoid duplication in preparation and audit of accounts under the companies and Income Tax Acts. This change simplifies the process, thereby saving cost and time.’ As a result, the first annual accounts of the company after the change of accounting period were presented for a period of 15 months, from 1st January 2008 to 31st March 2009. The summarized profit and loss account for the two accounting period is given below:

 

Questions for Discussion

1. How do you justify the change in accounting period by HUL?
2. The company has an exceptional year with total income increasing by 48% and PAT (before exceptional items) increasing by 43% over the previous year. Do you agree?
3. How would you make the results of current accounting year comparable with the previous accounting year?

Case 2.3: Change of accounting year for ACC Limited

ACC Limited has prepared its financial statements using the calendar year as its accounting period. The last financial statements were prepared for the year ended 31st December 2013. The Companies Act 2013, has now made it mandatory for the Indian companies to keep their accounts using financial year (i.e., 1st April to 31st March) as the accounting period. Companies are allowed a period of two years to switch over to the financial year. To meet the requirement of the law, ACC Limited would need to adopt the financial year for its accounts.

Questions for Discussion

1. The change in accounting period is a violation of consistency principle. Comment.
2. What should ACC Limited do to change the accounting period?
3. What accounting periods would you suggest during the transition period?

Endnotes

1. ICAI—Indian Accounting Standards: A perspective.
2. Discussion in this portion is based upon ICAI publication—Indian Accounting Standards: A Perspective.
3. Ministry of Corporate Affairs: Vision on Convergence.
4. ‘Final step towards IFRS convergence—CII IFRS Summit 2011’, KPMG,
5. Companies (Indian Accounting Standards) Rules, 2015.