Financial Reporting Vol. 2

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

1.1 Introduction .................................................................................................. 8.1
1.2 Organisation of Mutual funds ........................................................................ 8.1
1.3 Mutual Fund Schemes ................................................................................... 8.3
1.4 Evaluation of Mutual Funds ............................................................................ 8.3
1.5 Valuation of Portfolio ..................................................................................... 8.5
1.6 Annual Reporting........................................................................................... 8.5
1.7 Accounting Policies ....................................................................................... 8.6
1.8 Contents of Balance Sheet and Revenue Account ........................................... 8.9
1.9 Making investments to market ...................................................................... 8.12
1.10 Disposal of investments ............................................................................... 8.13
1.11 Recognition of dividend income .................................................................... 8.15
1.12 Cost of Investments ..................................................................................... 8.14
1.13 Date of recording of transactions.................................................................. 8.15
1.14 Dividend Equalisation .................................................................................. 8.16
Unit 2: Non-Banking Finance Company
2.1 Introduction ................................................................................................. 8.19
2.2 Definition of NBFC....................................................................................... 8.19
2.3 Registration and Regulation of NBFC ........................................................... 8.19
2.4 Minimum Net owned fund ............................................................................. 8.20
2.5 Types of NBFC regulated by RBI .................................................................. 8.20
2.6 Public Deposits ........................................................................................... 8.22
2.7 Liquid Asset Requirements .......................................................................... 8.23
2.8 Prudential Accounting Norms ....................................................................... 8.23
i
2.9 Income Recognition ..................................................................................... 8.24
2.10 Accounting for Investments .......................................................................... 8.24
2.11 Asset Classification ..................................................................................... 8.25
2.12 Non-Performing Asset.................................................................................. 8.26
2.13 Provisioning Requirements .......................................................................... 8.26
2.14 Disclosures in the Balance-Sheet ................................................................. 8.28
2.15 Requirements as to Capital Adequacy .......................................................... 8.28
2.16 Asset Liability Management ......................................................................... 8.29
2.17 NBFC Prudential Norms (RBI) Direction, 1998 .............................................. 8.30
Unit 3: Merchant Bankers
3.1 Introduction ................................................................................................. 8.41
3.2 Capital Adequacy Requirement .................................................................... 8.41
3.3 Maintenance of Books of Account, Records .................................................. 8.42
Unit 4: Stock and Commodity Market Intermediaries
4.1 Introduction ................................................................................................. 8.45
4.2 Stock Brokers.............................................................................................. 8.46
4.3 Maintenance of Proper Books of Account, Records ....................................... 8.47
4.4 Presentation of Books of Account and Records ............................................. 8.49
4.5 Board’s Right to Inspect............................................................................... 8.50
4.6 Procedure for Inspection .............................................................................. 8.50
4.7 Obligations of Stock Broker on Inspection by the Board................................. 8.50
4.8 Submission of Report to the Board ............................................................... 8.51
4.9 Action on Inspection or Investigation Report ................................................. 8.51
4.10 Appointment of Auditor ................................................................................ 8.51
4.11 Regulation of Transactions between Clients and Brokers............................... 8.51
4.12 Member Broker to keep Accounts ................................................................. 8.51
4.13 Obligation to pay Money into Clients Accounts .............................................. 8.51
4.14 Accounts for Client’s Securities .................................................................... 8.52
4.15 Payment and Delivery of Securities .............................................................. 8.53
4.16 Margin ........................................................................................................ 8.53
4.17 Closing Out ................................................................................................. 8.53
ii
CHAPTER 9 – VALUATION
Unit 1: Concept of Valuation

1.1 Introduction .................................................................................................. 9.1
1.2 Concept of Valuation ..................................................................................... 9.2
1.3 Need for Valuation......................................................................................... 9.2
1.4 Bases of Valuation......................................................................................... 9.3
1.5 Types of Value .............................................................................................. 9.4
1.6 Approaches of Valuation ................................................................................ 9.6
Unit 2: Valuation of Tangible Fixed Assets
2.1 Introduction ................................................................................................... 9.7
2.2 Meaning of Original Cost ............................................................................... 9.7
2.3 Change in Original Cost ................................................................................. 9.9
2.4 Change of Original Cost -Improvements, Revaluation, Impairment ................... 9.9
2.5 Valuation Approaches .................................................................................. 9.10
2.6 Net Valuation .............................................................................................. 9.10
2.7 Disposal and Retirement .............................................................................. 9.10
2.8 Depreciation................................................................................................ 9.11
Unit 3: Valuation of Intangibles
3.1 Definition of Intangibles ............................................................................... 9.17
3.2 Recognition ................................................................................................. 9.17
3.3 Definition of goodwill ................................................................................... 9.18
3.4 Nature and Types of Goodwill ...................................................................... 9.19
3.5 Factors Contributing to Goodwill................................................................... 9.20
3.6 Relevant Provisions of the Accounting Standards.......................................... 9.21
3.7 Valuation of Goodwill ................................................................................... 9.22
3.8 Determination of Capital Employed............................................................... 9.24
3.9 Future Maintainable profit ............................................................................ 9.28
3.10 Normal Rate of Return ................................................................................. 9.32
3.11 Brand Valuation........................................................................................... 9.35
3.12 Identification of brands as an Asset .............................................................. 9.36
3.13 Objectives of Corporate Branding ................................................................. 9.37
iii
3.14 Corporate Brand Accounting ........................................................................ 9.37
3.15 Objectives of Brand Accounting.................................................................... 9.38
3.16 Difficulties in Brand Accounting .................................................................... 9.39
3.17 Valuation of Brands ..................................................................................... 9.40
3.18 Human Resources as a Brand ...................................................................... 9.45
3.19 Corporate Brand Strength ............................................................................ 9.47
Unit 4: Valuation of Liabilities......................................................................................
4.1 Introduction ................................................................................................. 9.49
4.2 Base of Valuation ........................................................................................ 9.49
4.3 Carrying Value ............................................................................................ 9.49
4.4 Leases ........................................................................................................ 9.49
4.5 Provisions ................................................................................................... 9.50
Unit 5: Valuation of Shares ..........................................................................................
5.1 Introduction ................................................................................................. 9.51
5.2 Purposes of Valuation.................................................................................. 9.51
5.3 Relevance of Valuation ................................................................................ 9.51
5.4 Limitation of Stock Exchange Price as a Basis for Valuation .......................... 9.52
5.5 Methods ...................................................................................................... 9.53
5.6 Statutory Valuation ...................................................................................... 9.60
5.7 Valuation of Preference Shares .................................................................... 9.67
5.8 Miscellaneous Problems for Practice ............................................................ 9.67
Unit 6: Valuation of Business.......................................................................................
6.1 Introduction ................................................................................................. 9.76
6.2 Need for Valuation of Business .................................................................... 9.76
6.3 Valuation Approaches .................................................................................. 9.76
6.4 Valuation Methods ....................................................................................... 9.76
6.5 Book Value ................................................................................................. 9.78
6.6 Fair Value ................................................................................................... 9.79
6.7 Earning Based Valuation of Business ........................................................... 9.80
6.8 Market Value Model ..................................................................................... 9.80
6.9 Valuation of Investments.............................................................................. 9.80
6.10 Valuation of Current Assets, Loans and Advances ........................................ 9.81
6.11 Value of Control of the Business .................................................................. 9.87
iv
CHAPTER 10 - DEVELOPMENTS IN FINANCIAL REPORTING
Unit 1: Value Added Statement

1.1 Historical Background .................................................................................. 10.1
1.2 Definitions................................................................................................... 10.1
1.3 Reporting Value Added ................................................................................ 10.3
1.4 Necessity of preparing VA Statements .......................................................... 10.3
1.5 Value Added Statement ............................................................................... 10.5
1.6 Limitations of VA ......................................................................................... 10.7
1.7 Interpretation of VA ....................................................................................10.12
Unit 2: Economic Value Added
2.1 Introduction ................................................................................................10.15
2.2 Cost of Capital ...........................................................................................10.15
2.3 Capital Asset Pricing Model ........................................................................10.16
2.4 Beta...........................................................................................................10.16
2.5 Equity Risk Premium ..................................................................................10.17
Unit 3: Market Value Added
3.1 Introduction ................................................................................................10.21
3.2 Relationship between EVA and Market Value Added ....................................10.21
3.3 Benefits of Market Value Added ..................................................................10.22
3.4 Limitations of Market Value Added ..............................................................10.24
Unit 4: Shareholders’ Value Added ..............................................................................
4.1 Introduction ................................................................................................10.25
4.2 Implications................................................................................................10.25
Unit 5: Human Resource Reporting
5.1 Introduction ................................................................................................10.26
5.2 Models of HRA ...........................................................................................10.26
5.3 Implications of Human Capital Reporting .....................................................10.30
5.4 HRA in India...............................................................................................10.31
Unit 6: Inflation Accounting
6.1 Introduction ................................................................................................10.35
6.2 Primary Purpose of Financial Statements ....................................................10.35
v
6.3 Limitations of Historical Cost based Accounts ..............................................10.36
6.4 Need for Inflation Accounting ......................................................................10.36
6.5 Current Purchasing Power Method ..............................................................10.36
6.6 Current Cost Accounting .............................................................................10.39
6.7 Evaluation of CCA ......................................................................................10.46
6.8 Miscellaneous Illustrations ..........................................................................10.46
APPENDICES
APPENDIX I .................................................................................................... I.1 – I.412
APPENDIX II ...................................................................................................II.1 – II.53
APPENDIX III .............................................................................................. III.1 – III.204
vi
8
FINANCIAL REPORTING FOR FINANCIAL INSTITUTIONS
UNIT 1
MUTUAL FUNDS
1.1 INTRODUCTION
Mutual funds are trusts, which pool resources from large number of investors through issue of
units under specified schemes. The funds raised are invested in capital market instruments
such as shares, debentures and bonds and money-market instruments, such as commercial
papers, certificates of deposits and treasury bonds. The fund earns income from these
investments by way of dividends, interests and capital gains. The income from investments,
less specified expenses for managing the funds, are distributed among unit holders in
proportion of number of units held. The investments are made under expert guidance to allow
unit holders to earn highest possible return for lowest possible risk. Risk reduction is achieved
through planned diversification of investment portfolio and also by judicious use of various
hedging techniques. The selection investments for a scheme should be within the investment
objectives and other parameters set for the scheme.
1.2 ORGANISATION OF MUTUAL FUNDS

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

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

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

Mutual funds sell their shares to public and redeem them at current net Assets Value (NAV)
which is calculated as under –
Total market value of all MF holdings - All MF liabilities
Unit size
The net asset value of a mutual fund scheme is basically the per unit market value of all the
assets of the scheme. To illustrate this better, a simple example will help.
Scheme name : XYZ
Scheme size : Rs. 50,00,00,000 (Rupees Fifty crores)
Face value of units : Rs. 10
No. of units : 5,00,00,000
Scheme size
Face value of units
Investments : In shares
Market value of shares Rs. 75,00,00,000 (Rupees seventy five crores)

Market value of investments
=
No. of units
Rs. 75,00,00,000
=
5,00,00,000
= Rs. 15
Thus, each unit of Rs. 10 is worth Rs. 15.
Simply stated, NAV is the value of the assets of each unit of the scheme, or even simpler
value of one unit of the scheme. Thus, if the NAV is more than the face value (Rs. 10), it
means your money has appreciated and vice versa.
NAV also includes dividends, interest accruals and reduction of liabilities and expenses,
besides market value of investments.The Net Asset Value (NAV) is the value of net assets
under a mutual fund scheme. The NAV per unit is NAV of the scheme divided by number of
units outstanding. NAV of a scheme keep on changing with change in market value of portfolio
under the scheme. The day of valuation of NAV is called the valuation day.
Illustration 1
A mutual fund raised Rs. 100 lakh on April 1, 2006 by issue of 10 lakh units at Rs. 10 per unit.
The fund invested in several capital market instruments to build a portfolio of Rs. 90 lakh. The
initial expenses amounted to Rs. 7 lakh. During April 2006, the fund sold certain securities of
cost 38 lakh for Rs. 40 lakh and purchased certain other securities for Rs. 28.2 lakh. The fund
management expenses for the month amounted to Rs. 4.5 lakh of which Rs. 25,000 was in
arrears. The dividend earned was Rs. 1.2 lakh. 75% of the realised earnings were distributed.
The market value of the portfolio on 30/04/06 was Rs. 101.90 lakh.
Determine NAV per unit.
Solution
Rs. lakh Rs. Lakh Rs. lakh

Opening bank (100 – 90 – 7) 3.00
Add: Proceeds from sale of securities 40.00
Add: Dividend received 1.20 44.20
Deduct:
Cost of securities purchased 28.20
Fund management expenses paid (4.50 – 0.25) 4.25

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

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

Every mutual fund or the asset management company is required to prepare in respect of
each financial year an annual report and annual statement of accounts of the schemes and
the fund as specified in Eleventh Schedule.
As per Regulation 51 the financial year for all the schemes shall end as of March 31st of each
year.
The schemewise Annual Report of a mutual fund or an abridged summary thereof shall be
published through an advertisement [and an abridged schemewise annual report shall be
mailed to all unitholders] as soon as may be but not later than six months from the date of
closure of the relevant accounts year.
According to Eleventh Schedule, the annual report shall contain –
(i) Report of the board of Trustees on the operations of the various schemes of the fund and
the fund as a whole during the year and the future outlook of the fund;
(ii) Balance Sheet and Revenue Account in accordance with paras 2, 3 and 4, respectively
of this Schedule;
(iii) Auditor’s Report in accordance with paragraph 5 of this Schedule;
(iv) Brief statement of the Board of Trustees on the following aspects, namely:-
(a) Liabilities and responsibilities of the Trustees and the Settlor;
(b) Investment objective of each scheme;
(c) Basis and policy of investment underlying the scheme;
(d) If the scheme permits investment partly or wholly in shares, bonds, debentures and
other Scrips or securities whose value can fluctuate, a statement on the following
lines :
“The price and redemption value of the units, and income from them, can go up as
well as down with the fluctuations in the market value of its underlying investments;”
(e) Comments of the Trustees on the performance of the scheme, with full justification.
(v) Statement giving relevant perspective historical ‘per unit’ statistics in accordance with
paragraph 6 of this Schedule;
(vi) Statement on the following lines :
“On written request, present and prospective unitholder/investors can obtain copy of the
trust deed, the annual report [at a price] and the text of the relevant scheme.”
1.7 ACCOUNTING POLICIES

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

Where the financial statement are prepared on a marked to market basis, there need not
be a separate provision for depreciation. Since unrealised gain arising out of the
appreciation on investments cannot be distributed, provision has to be made for its
exclusion and for calculating distributable income.
(ii) Non-traded investments shall be valued in good faith in accordance with the norms
specified in Seventh Schedule.
(iii) For quoted shares, the dividend income earned by the scheme shall be recognised, not
on the date the dividend is declared, but on the date the share is quoted on an ex-
dividend basis. For investments in shares which are not quoted on the stock exchanges,
the dividend income must be recognised on the date of declaration.
(iv) In respect of all interest-bearing investments, income shall be accrued on a day to day
basis as it is earned. Therefore when such investments are purchased, interest paid for
the period from the last interest due date upto the date of purchase, shall not be treated
as a cost of purchase, but shall be treated to Interest Recoverable Account. Similarly,
interest received at the time of sale for the period from the last interest due date upto the
date of sale must not be treated as an addition to sale value but shall be credited to
Interest Recoverable Account.
(v) In determining the holding cost of investments and the gains or loss on sale of
investments, the “average cost” method shall be followed.
(vi) Transactions for purchase or sale of investments shall be recognised as of the trade date
and not as of the settlement date, so that the effect of all investments traded during a
financial year are recorded and reflected in the financial statements for that year. Where
investment transactions take place outside the stock market, for example, acquisitions
through private placement or purchases or sales through private treaty, the transaction
shall be recorded, in the event of a purchase, as of the date on which the scheme obtains
in enforceable obligation to pay the price or, in the event of a sale, when the scheme
obtains an enforceable right to collect the proceeds of sale or an enforceable obligation
to deliver the instruments sold.
(vii) Bonus shares to which the scheme becomes entitled shall be recognised only when the
original shares on which the bonus entitlement accrues are traded on the stock exchange
on an ex-bonus basis. Similarly, rights entitlements shall be recognised only when the
original shares on which the right entitlement accrues are traded on the stock exchange
on an ex-rights basis.
(viii) Where income receivable on investments has been accrued and has not been received
for a period of 12 months beyond the due date, provision shall be made by debit to the
revenue account for the income so accrued and no further accrual of income should be
made in respect of such investment.
(ix) When the units of an open-ended scheme* are sold, the difference between the sale
price and the face value of the unit, if positive, shall be credited to Reserves and if
negative is debited to reserve, the face value being credited to Capital Account.
Similarly, when units of an open-ended scheme are repurchased, the difference between
the purchase price and face value of the unit, if positive should be debited to reserves
and, if negative, should be credited to reserves, the face value being debited to the
capital account.
(x) (a) In the case of an open-ended scheme, when units are sold an appropriate part of
the sale proceeds shall be credited to an Equalisation Account and when units are
repurchased an appropriate amount shall be debited to Equalisation Account. The
net balance on this Account should be credited or debited to the revenue account.
The balance on equalisation account debited or credited to the Revenue Account
shall not decrease or increase the net income of the fund but is only an adjustment
to the distributable surplus. It shall, therefore, be reflected in the Revenue Account
only after the net income of the fund is determined.
(b) The Trustees of the Board of the Trustee Company may, if necessary, transfer a
portion of the distributable profits to a dividend equalisation reserve. Such a transfer
would be independent of the requirement to operate an Equalisation Account as
provided in (x)(a).
(xi) In a close-ended scheme** which provide to the unitholders the option for an early
redemption or repurchase their own units, the par value of the unit shall be 1[debited] to
Capital Account and the difference between the purchase price and the par value, if
positive, should be debited to reserves and, if negative, should be credited to reserves. A
proportionate part of the unamortized initial issue expenses shall also be transferred to
the reserves so that the balance carried forward on that account is proportional to the
number of units remaining outstanding.
(xii) The cost of investments acquired or purchased shall [inter alia] include brokerage, stamp
charges and any charge customarily included in the broker’s bought note. In respect of
privately placed debt instruments any front-end discount offered shall be reduced from
the cost of the investment.
(xiii) Underwriting commission shall be recognised as revenue only when there is no
development on the scheme. Where there is development on the scheme, the full
underwriting commission received and not merely the portion applicable to the
devolvement shall be reduced from the cost of the investment.
1.8 CONTENTS OF BALANCE SHEET AND REVENUE ACCOUNT

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

(d) a full list of investments of the scheme shall be made available for inspection with
the Asset Management Company;
(e) the basis on which management fees have been paid to the Asset Management
Company and the computation thereof;
(f) if brokerage, custodial fees or any other payment for services are paid to or payable
to any entity in which the Asset Management Company or its major shareholders
have a substantial interest (being not less than 10% of the equity capital), the
amounts debited to the revenue account or amounts treated as cost of investments
in respect of such services shall be separately disclosed together with details of the
interest of the Asset Management Company or its major shareholders;
(g) aggregate value of purchases and sales of investments during the year and
expressed as a percentage of average weekly net asset value;
(h) where the non-traded investments which have been valued “in good faith” exceed
5% of the NAV at the end of the year, the aggregate value of such investments; and
(i) movement in unit capital should be stated.
An example of the manner in which the movement in unit capital may be disclosed
is given below :
No. of units (Rs. in lakhs)
Balance as on 1st April, 1994 1250,00,000 12,500.00
Units sold during the year 127,50,000 1,275.00
Units repurchased during the year (15,40,000) (154.00)
1362,10,000 13,621.00
(j) the name of the company including the amount of investment made in each
company of the group by each scheme and the aggregate investments made by all
schemes in the group companies of the sponsor;
(k) if the investments are marked to market, the total income of the scheme shall
include unrealised depreciation or appreciation on investment. There should be
disclosure and unrealised appreciation deducted before arriving at the distributable
income in the following manner, e.g.
Rs. in lakh Rs. in lakh
Net income as per Revenue Account 100
Add:Balance of undistributed income
as at 1st April, 1994 brought forward 20 120
Less:Unrealised appreciation on investments
As on 31st March, 1995 30
As on 1st April, 1994 15 (15) 105

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

For the purposes of the financial statements, mutual funds shall mark all investments to
market and carry investments in the balance sheet at market value. However, since the
unrealized gain arising out of appreciation on investments cannot be distributed, provision has
to be made for exclusion of this item when arriving at distributable income.
Clause 2(i) of Eleventh Schedule of the regulations provides that in carrying investments at
market values, the asset management companies should follow the Guidance Note issued by
the Institute of Chartered Accountants of India.
As per paragraph 10 of the Guidance Note on Accounting for Investments in the Financial
Statements of Mutual Funds, issued by the Institute of Chartered Accountants of India, while
marking investments to market on balance sheet date, the excess of cost of acquisition over
market value of securities on valuation day is treated as depreciation (unrealized loss).
Likewise, the excess of market value of securities on valuation day over cost of acquisition is
treated as appreciation, which is unrealized gain.
The provision for depreciation in the value of investments is created in the books by debiting
the Revenue Account. The provision so created is shown as a deduction from the value of
investments in the balance sheet. However, unrealised appreciations are directly transferred
to the Unrealised Appreciation Reserve, (i.e., without routing it through the Revenue Account)
with the corresponding debit to the Investments Account. The Guidance Note recommends
reversal of the Unrealised Appreciation Reserve at the beginning of the next accounting year.
Paragraph 11 of the Guidance Note recommends that the gross value of depreciation on
investments should be reflected in the Revenue Account rather than the same being netted off
with the appreciation in the value of other investments. In other words,
depreciation/appreciation on investments should be worked out on an individual investment
basis or by category of investment basis, but not on an overall (or global) basis for the entire
investment portfolio.
Illustration 2
The investment portfolio for a mutual fund scheme includes 10,000 shares of A Ltd. and 8,000
shares of B Ltd. acquired on 30/10/2005. The cost of A Ltd. shares is Rs. 20 while that of B
Ltd. shares is Rs. 30. The market values of these shares at the end of 2005-06 were Rs. 19
and Rs. 32 respectively. Show important accounting entries in books of the fund in the
accounting year 2005-06.
Solution
Rs. 000 Rs. 000
Investment in A Ltd. shares 200
Investment in B Ltd. shares 240
To Bank 440
Revenue A/c 10
To Provision for Depreciation 10
Investment in B Ltd. shares 16

To Unrealised Appreciation Reserve 16
1.10 DISPOSAL OF INVESTMENTS

The profit/loss arising on the disposal of investment is the difference between the selling price
and the cost. The profit arising on disposal of investment is recognised fully in the Revenue
Account.
The loss on disposal of investment is recognised fully in the revenue account, if the
investments are sold in the same year in which they are purchased. However, if an investment
is sold in any year subsequent to year of purchase, loss on disposal is charged first against
provision for depreciation to the extent of balance available, and the balance of loss, if any,
should be charged directly to the Revenue Account.
Illustration 3
In the previous example, suppose that shares of both of the companies were disposed off on
31/05/06 realizing Rs. 18.50 per A Ltd. shares and Rs. 33.50 per B Ltd. shares. Show
important accounting entries in books of the fund in the accounting year 2006-07
Solution
Rs. 000 Rs. 000

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

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

The cost of investments acquired or purchased should include brokerage, stamp charges and
any charge customarily included in the broker’s bought note. In respect of privately placed
debt instruments any front – end discount offered should be deducted from the cost of the
investment.
In respect of all interest – bearing investments, income must be accrued on a day-to-day basis
as it is earned. Therefore, when such investments are purchased, interest paid for the period
from the last interest due date upto the date of purchase must not be treated as a cost of
purchase but must be debited to Interest Recoverable Account. Similarly interest received at
the time of sale for the period from the last interest due date upto the date of sale must not be
treated as an addition to sale value but must be credited to Interest Recoverable Account.
In determining the holding cost of investments and the gains or loss on sale of investments,
the “average cost” method must be followed.
Illustration 2
A fund purchased 10,000 debentures of a company on June 1, 2006 for 10.7 lakh and further
5,000 debentures on November 1, 2006 for Rs. 5.45 lakh. The debentures carry fixed annual
coupon of 12%, payable on Every 31 March and 30 September. On February 28, 2007 the
fund sold 6,000 of these debentures for Rs. 6.78 lakh. Nominal value per debenture is Rs.
100.
Show Investment in Debentures A/c in books of the fund.
Solution
Investment in Debentures A/c
Rs. Rs.
Lakh Lakh
June 1, To Bank 10.70 June 1, By Interest Recoverable 0.20
2006 2006 (Note 1)
Nov. 1, To Bank 5.45 Nov. 1, By Interest Recoverable 0.05
2006 2006 (Note 2)
Feb. 28, To Interest Recoverable 0.30 Feb. 28, By Bank 6.78
2007 (Note 3) 2007
Feb. 28, To Profit on disposal 0.12 March 31, By Balance c/d 9.54
2007 (Note 4) 2007
16.57 16.57
1.13 DATE OF RECOGNITION OF TRANSACTIONS

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

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

New investors are not entitled to any share of the income of a mutual fund scheme which
arose before they bought their units. However, at the end of each distribution period the fund
management allocates the same amount from the income of the fund to each unit. To
compensate for this an equalisation payment is added to the cost of new units. This is the
amount of income that has arisen up to the date of purchase of the unit. Because these
payments are included in the amount available for distribution they are effectively repaid to the
purchaser. The purchaser's dividend voucher at the end of the first distribution period should
show the amount of the returned equalisation payment.
Illustration 2
On April 1, 2006 a mutual fund scheme had 9 lakh units of face value Rs. 10 outstanding. The
scheme earned Rs. Rs. 81 lakh in 2006-07, out of which Rs. 45 lakh was earned in first half-
year. 1 lakh units were sold on 30/09/06 at NAV Rs. 60. Show important accounting entries for
sale of units and distribution of dividend at the end of 2006-07.
Solution
Allocation of earnings
Old unit New unit
holders holders Total
earning
(9 lakh units) (1 lakh units)
Rs. Lakh Rs. lakh Rs. Lakh
First half-year (Rs. 5.00/ unit ) 45.0 Nil 45
Second half-year (Rs. 3.60 / unit) 32.4 3.6 36
77.4 3.6 81.0

Add: Equalisation payment recovered 5.0
Total available for distribution 86.0
Note: Equalisation payment = Rs. 45 lakh / 9 lakh = Rs.5 per unit.

Distribution of earning per unit
Old unit holders New unit holders

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

30/09/06 Bank 65 1 lakh x Rs. 65
To Unit Capital 10 1 lakh x Rs. 10
To Reserves 50 1 lakh x Rs. 50
To Dividend Equalisation 5 1 lakh x Rs. 5
31/03/07 Dividend Equalisation 5

To Revenue A/c 5
31/03/07 Revenue A/c 86

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

4. The following particulars are available for a scheme of a mutual fund. Calculate current
asset value (NAV) of each unit of the scheme.
Scheme size Rs. 10,00,000
In shares Rs. 10
Investments In shares
Market value of shares Rs. 25,00,000
5. Prudential XYZ Mutual Funds have introduced a scheme ‘ABC Premier’. Its major details
are as follows:
Scheme Name : ABC Premier
Scheme Size : Rs.1,00,00,00,000 (Rupees One hundred crores)
Face value of units : Rs.20
Investments : in shares
Market value of Shares : Rs.1,50,00,00,000 (Rupees One hundred and fifty crores)
Computed the net assets value per unit of ABC Premier. Is there an appreciation of the
value invested in units of ABC Premier.
UNIT 2
NON-BANKING FINANCE COMPANY
2.1 INTRODUCTION
A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act,
1956, engaged in the business of providing loans and advances, acquisition of shares,
debentures and other securities, leasing, hire-purchase, insurance business and chit business.
The term NBFC does not include any institution whose principal business is that of agriculture
activity, industrial activity or sale/purchase/construction of immovable property.
Non Banking Financial Companies (NBFC) play a crucial role in broadening access to financial
services, enhancing competition and diversification of the financial sector. They are
increasingly being recognised as complementary to the banking system, capable of absorbing
shocks and spreading risks at times of financial distress. Simplified sanction procedures,
orientation towards customers, attractive rates of return on deposits and flexibility and
timeliness in meeting the credit needs of specified sectors (like equipment leasing and hire
purchase), are some of the factors that enhanced the attractiveness of NBFCs.
2.2 DEFINITION OF NBFC

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

Under Section 45–IA of the Reserve Bank of India (Amendment) Act, 1997, no non-banking
financial company is allowed to commence or carry on the business of a non-banking financial
institution without obtaining a certificate of registration issued by the Reserve Bank of India.
A company incorporated under the Companies Act, 1956 and desirous of commencing
business of non-banking financial institution as defined under Section 45–IA of the RBI Act,
1934 can apply to Reserve Bank of India in prescribed form along with necessary documents
for registration. The RBI issues Certificate of Registration after satisfying itself that the
conditions as enumerated in Section 45-IA of the RBI Act, 1934 are satisfied.
Functions of Non-Banking Financial Companies are similar to banks. However there are a few
differences:
(a) A NBFC cannot accept demand deposits;
(b) Non-Banking Financial Companies do not take part in the payment and settlement
system and hence cannot issue cheques to its customers; and
(c) Deposit Insurance and Credit Guarantee Corporation (DICGC) does not insure the NBFC
deposits.
The Reserve Bank of India has issued directions to non-banking financial companies on
acceptance of public deposits, prudential norms like capital adequacy, income recognition,
asset classification, provision for bad and doubtful debts, risk exposure norms and other
measures to monitor the financial solvency and reporting by NBFCs. Directions were also
issued to auditors to report non-compliance with the RBI Act and regulations to the Reserve
Bank, Board of Directors and shareholders.
2.4 MINIMUM NET OWNED FUND

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

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

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

(a) No mutual benefit financial company mutual benefit company can accept or renew any
public deposit except from its shareholders. Such deposits shall not be in the nature of
current account
(b) All NBFCs are not entitled to accept public deposits. Only those NBFCs holding a valid
Certificate of Registration with authorization to accept Public Deposits can accept/hold
public deposits. The NBFCs accepting public deposits should have minimum stipulated
Net Owned Fund and comply with the Directions issued by the Reserve Bank.
(c) The ability of a NBFC to raise public deposits depends on its credit rating, Capital to Risk
Asset Ratio (CRAR). A NBFC with credit rating lower than investment grade is not
allowed to accept public deposits. A NBFC with credit rating of investment grade and
above, can accept public deposits subject to specified maximum ceiling. The ceiling
depends on the rating, CRAR and the nature of business. (Minimum credit rating for
investment grade is adequate safety, such as A for CRISIL).
The norms are as below:
♦ Equipment Leasing and Hire Purchase Companies maintaining Capital to Risk Asset
Ratio (CRAR) of 15% without credit rating can raise public deposits to the extent of
1.5 times of net owned fund or Rs. 10 crores, whichever is less.
♦ Equipment Leasing and Hire Purchase Companies maintaining Capital to Risk Asset
Ratio (CRAR) of 12% with minimum investment grade credit rating can raise public
deposits to the extent of 4 times of net owned fund.
♦ Loan companies and Investment Companies maintaining Capital to Risk Asset Ratio
(CRAR) of 15% with minimum investment grade credit rating can raise public
deposits to the extent of 1.5 times of net owned fund.
♦ There is no ceiling on maximum deposits that residuary non-banking company can
raise. However, such companies have to ensure that the amounts deposited and
investments made by the company are not less than the aggregate amount of
liabilities to the depositors. To secure the interests of depositor, residuary non-
banking companies are required to invest in a portfolio comprising of highly liquid
and secured instruments viz. Central/State Government securities, fixed
deposit/certificates of deposits of scheduled commercial banks, units of Mutual
Funds, etc.
♦ If rating of a NBFC is downgraded to below minimum investment grade rating, it
must stop accepting further public deposit and report the position within 15 working
days to the RBI. The amount of public deposit already accepted must also be
reduced within three years from the date of such downgrading of credit rating, nil or
to the permissible level.
♦ The maximum interest that a NBFC can pay on its deposits is restricted to 14% per
annum. The maximum frequency of compounding is month.
♦ The rate of brokerage that a NBFC can pay for collecting deposits is 2%. The
maximum re-imbursement of actual expenses allowed is 0.5% of deposits collected.
♦ The NBFCs are allowed to accept/renew public deposits for a minimum period of 12
months and maximum period of 60 months. They cannot accept deposits repayable
on demand.
♦ NBFCs cannot offer gifts/incentives or any other additional benefit to the depositors.
♦ Public deposits are unsecured. The deposits with NBFCs are neither insured nor the
RBI guarantees their repayments.
♦ The non-banking financial companies accepting public deposits are required to file
annual returns and financial statements with the Reserve Bank of India.
2.7 LIQUID ASSET REQUIREMENTS

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

In order to ensure that NBFCs function on sound and healthy lines, the Reserve Bank issued
its Non-banking Financial Companies Prudential Norms Directions in January 1998. All
NBFCs, accepting public deposits and residuary non-banking companies are required to
comply the norms. They are also to comply with the Accounting Standards and Guidance
Notes issued by the Institute of Chartered Accountants of India, so far as these are not
inconsistent with the prudential norms directions of the Reserve Bank of India.
The provisions of the prudential norm directions regarding capital adequacy and credit
concentration does not apply to (i) a loan company; (ii) an investment company; (iii) a hire
purchase finance company; and (iv) an equipment leasing company, unless they accept/hold
public deposit.
An investment company not accepting public deposits need not comply with the prudential
norms, provided it holds investments in the securities of its group/holding/subsidiary
companies and book value of such holding is not less than 90% of its total assets and if it
does not trade in such securities.
Prudential norms directions prescribe principles of income recognition, asset classification,
provisioning, capital adequacy and disclosures.
2.9 INCOME RECOGNITION

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

(a) Investments in securities shall be classified into current investments and long-term
investments. Current investment means an investment, which is by its nature readily
realisable and is intended to be held for not more than one year from the date on which
such investment is made. An investment, other than current investment is long-term
investment.
(b) Current investments shall be valued at cost or market value whichever is lower. Each
category of such investments shall be valued scrip-wise and depreciation or appreciation
be aggregated under each category. Net depreciation, if any, for each category of
investments shall be provided for or charged to profit and loss account. Net appreciation,
if any, shall be ignored. The depreciation in one category of investments shall not be set
off against appreciation in another category.
(c) A long term quoted investment shall be valued in accordance with the accounting
standards issued by ICAI.
(d) Unquoted equity shares shall be valued at cost or break up value, whichever is lower.
However, NBFCs can substitute fair value for the break-up value of the shares if
considered necessary. In case of non-availability of balance sheet for two years, such
shares shall be valued at one rupee only.
(e) Unquoted preference shares are to be valued at lower of cost and or face value.
Investments in unquoted Government securities or Government guaranteed bonds shall be
valued at carrying cost.
Investments in units of mutual funds shall be valued at market rates, or if such market rate is
not available, at the net asset value declared by the mutual fund in respect of each particular
scheme.
Commercial papers and treasury bills shall be valued at carrying cost.
2.11 ASSET CLASSIFICATION

Every NBFC shall, after taking into account the degree of well defined credit weaknesses and
extent of dependence on collateral security for realisation, classify its lease/hire purchase
assets, loans and advances and any other forms of credit into the following classes namely, -
(a) Standard assets;
(b) Sub-standard assets;
(c) Doubtful assets; and
(d) Loss assets.
Standard asset means an asset in respect of which, no default in repayment of principal or
payment of interest is perceived and which does not disclose any problem nor carry more than
normal risk attached to the business.
Sub-standard asset means (i) an asset, which has been classified as non-performing asset for
a period of not exceeding two years (ii) an asset, where the terms of the agreement regarding
interest and/or principal have been renegotiated or rescheduled after commencement of
operations, until the expiry of one year of satisfactory performance under the renegotiated or
rescheduled terms.
Doubtful asset means (i) a term loan or (ii) a lease asset or (iii) a hire purchase asset or (iv)
any other asset, which remains a substandard asset for a period exceeding two years.
Loss asset means (i) an asset which has been identified as loss asset by the NBFC or its
internal or external auditor or by the Reserve Bank during the inspection of the NBFC, to the
extent it is not written off by the NBFC; and (ii) an asset which is adversely affected by a
potential threat of non-recoverability due to either erosion in the value of security or non
availability of security or due to any fraudulent act or omission on the part of the borrower.
The class of assets referred to above shall not be upgraded merely as a result of
rescheduling, unless it satisfies the conditions required for the upgrdation.
2.12 NON-PERFORMING ASSET (NPA)

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

Every NBFC shall, after taking into account the time lag between an account becoming
doubtful of recovery, its recognition as such, the realisation of the security and the erosion
over time in the value of security charged, make provision against sub-standard assets,
doubtful assets and loss assets as provided hereunder :-
Loans, advances and other credit facilities including bills purchased and discounted
The provisioning requirement in respect of loans, advances and other credit facilities including
bills purchased and discounted shall be as under :
Loss Assets
The entire asset shall be written off. If the assets are permitted to remain in the books for any
reason, 100% of the outstanding should be provided for.
Doubtful Assets
(a) 100% provision to the extent to which the advance is not covered by the realisable value
of the security to which the NBFC has a valid recourse shall be made. The realisable
value is to be estimated on a realistic basis.
(b) In addition to item (a) above, depending upon the period for which the asset has
remained doubtful, provision to the provision to the extent of 20% to 50% of the secured
portion (i.e. estimated realisable value of the outstanding) shall be made on the following
basis : -
Period for which the asset has been considered as doubtful % of provision
Upto one year 20
One to three years 30
More than three years 50
Sub-standard asset
A general provision of 10% of total outstanding shall be made.
Lease and hire purchase assets
The provisioning requirements in respect of the lease and hire purchase assets shall be as
under:-
Where any amount of lease rental or
hire charges are overdue upto 12 Nil
months
a) Entire amount of overdue taken to the credit of
Where any amount is overdue for profit and loss account in earlier year shall be
more than 12 months but upto 24 provided for; and
months b) in addition, provision shall be made at not less than
10% of the net book value.
Where any amount is overdue for (a) entire amount of overdue taken to the credit of
more than 24 months but upto 36 profit and loss account earlier shall be provided for,
months and
(b) in addition, provision shall be made at not less

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

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

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

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

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

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

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

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

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

including hire purchase and lease finance made to and deposits with subsidiaries
and companies in the same group exceeding, in aggregate, ten per cent of the
owned fund;
(xx) “Tier-II capital” includes the following :
(a) preference shares other than those which are compulsorily convertible into
equity;
(b) revaluation reserves at discounted rate of fifty-five per cent;
(c) general provisions and loss reserves to the extent these are not attributable to
actual diminution in value or identifiable potential loss in any specific asset and
are available to meet unexpected losses, to the extent of one and non-fourth
per cent of risk weighted assets;
(d) hybrid debt capital instruments; and
(e) subordinated debt,
to the extent the aggregate does not exceed Tier-I capital.
(2) Other words or expressions used but not defined herein and defined in the Reserve
Bank of India Act, 1934 (2 of 1934), or the Non-Banking Financial Companies
Acceptance of Public Deposits (Reserve Bank) Directions, 1998, or the Residuary
Non-Banking Companies (Reserve Bank) Directions, 1987, shall have the same
meaning as assigned to them in that Act or those Directions. Any other words or
expressions not defined in that Act or those Directions, shall have the same
meaning assigned to them in the Companies Act,1956 (1 of 1956).
Income recognition
3. (1) The income recognition shall be based on recognised accounting principles.
(2) Income including interest/discount or any other charges on NPA shall be recognised
only when it is actually realised. Any such income recognised before the asset
became non-performing and remaining unrealised shall be reversed.
(3) In respect of hire purchase assets, where instalments are overdue for more than 12
months, income shall be recognised only when hire charges are actually received.
Any such income taken to the credit of profit and loss account before the asset
became non-performing and remaining unrealised, shall be reversed.
(4) In respect of lease assets, where lease rentals are overdue for more than 12
months, the income shall be recognised only when lease rentals are actually
received. The net lease rentals taken to the credit of profit and loss account before
the asset became non-performing and remaining unrealised shall be reversed.
Explanation: For the purpose of this paragraph, ‘net lease rentals’ mean gross lease rentals as
adjusted by the lease adjustment account debited/credited to the profit and loss account and
as reduced by depreciation at the rate applicable under Schedule XIV of the Companies Act,
1956 (1 of 1956).*
Income from investments
4. [1] Income from dividend on shares of corporate bodies and units of mutual funds shall
be taken into account on cash basis:
Provided that the income from dividend on shares of corporate bodies may be
taken into account on accrual basis when such dividend has been declared by the
corporate body in its annual general meeting and the NBFC’s right to receive
payment is established.
[2] Income from bonds and debentures of corporate bodies and from Government
securities/bonds may be taken into account on accrual basis:
Provided that the interest rate on these instruments is pre-determined and interest i
s serviced regularly and is not in arrears.
[3] Income on securities of corporate bodies or public sector undertakings, the payment
of interest and repayment of principal of which have been guaranteed by the Central
Government or a State Government may be taken into account on accrual basis.
Accounting standards
5. Accounting Standards and Guidance Notes issued by the Institute of Chartered
Accountants of India (referred to in these directions as “ICAI”) shall be followed insofar
as they are not inconsistent with any of these directions.
Accounting for investments
6. [1] Investments in securities shall be classified as current and long-term investments
[2] Quoted current investments shall, for the purposes of valuation, be grouped into the
following categories, viz.,
(a) equity shares,
(b) preferences shares,
(c) debentures and bonds,
(d) Government securities including treasury bills,
(e) units of mutual fund, and
(f) others.
Quoted current investments for each category shall be valued at cost or market
value, whichever is lower. For this purpose, the investments in each category shall
be considered scrip-wise and the cost and market value aggregated for all
investments in each category. If the aggregate market value for the category is less
than the aggregate cost for that category, the net depreciation shall be provided for
or charged to the profit and loss account. If the aggregate market value for the
category exceeds the aggregate cost for the category, the net appreciation shall be
ignored. Depreciation in one category of investments shall not be set off against
appreciation in another category.
[3] Unquoted equity shares in the nature of current investments shall be valued at cost
or break-up value, whichever is lower. However, NBFCs may substitute fair value
for the break-up value of the shares, if considered necessary. Where the balance
sheet of the investee company is not available for two years, such shares shall be
valued at one rupee only.
[4] Unquoted preference shares in the nature of current investments shall be valued at
cost or face value, whichever is lower.
[5] Investments in unquoted Government securities or Government guaranteed bonds
shall be valued at carrying cost.
[6] Unquoted investments in the units of mutual funds in the nature of current
investments shall be valued at the net asset value declared by the mutual fund in
respect of each particular scheme.
[7] Commercial papers shall be valued at carrying cost.
[8] A long-term investment shall be valued in accordance with the Accounting Standard
issued by ICAI.
Note : Unquoted debentures shall be treated as term loans or other type of credit
facilities depending upon the tenure of such debentures for the purpose of income
recognition and asset classification.
Asset classification
7. [1 Every NBFC shall, after taking into account the degree of well defined credit
weaknesses and extent of dependence on collateral security for realisation, classify
its lease/hire purchase assets, loans and advances and any other forms of credit
into the following classes, namely :
(i) Standard assets;
(ii) Sub-standard assets;
(iii) Doubtful assets; and
(iv) Loss assets.
[2] The class of assets referred to above shall not be upgraded merely as a result of
rescheduling, unless it satisfies the conditions required for the upgradation.
Provisioning requirements
8. Every NBFC shall, after taking into account the time lag between an account becoming
non-performing, its recognition as such, the realisation of the security and the erosion
over time in the value of security charged, make provision against sub-standard assets,
doubtful assets and loss assets as provided hereunder :
Loans, advances and other credit facilities including bills purchased and discounted
[1] The provisioning requirement in respect of loans, advances and other credit
facilities including bills purchased and discounted shall be as under :
(i) Loss Assets The entire asset shall be written off. If the assets
are permitted to remain in the books for any
reason, 100% of the outstanding should be
provided for;
(ii) Doubtful Assets (a) 100% provision to the extent to which the
advance is not covered by the realisable value
of the security to which the NBFC has a valid
recourse shall be made. The realisable value
is to be estimated on a realistic basis;
(b) in addition to item (a) above, depending upon
the period for which the asset has remained
doubtful, provision to the extent of 20% to 50%
of the secured portion (i.e., estimated
realisable value of the outstandings) shall be
made on the following basis :
Period for which the asset % of provision
has been considered as
doubtful :
Up to one year 20
One to three years 30
More than three years 50
(iii) sub-standard assets A general provision of 10% of total outstandings
shall be made.
Lease and hire purchase assets
[2] The provisioning requirements in respect of hire purchase and leased assets shall
be as under:–
HIRE PURCHASE ASSETS
[i] In respect of hire purchase assets, the total dues (overdue and future
instalments taken together) as reduced by
(a) the finance charges not credited to the profit and loss account and carried
forward as unmatured finance charges; and
(b) the depreciated value of the underlying asset, shall be provided for.
Explanation:– For the purpose of this paragraph,
(1) the depreciated value of the asset shall be notionally computed as
the original cost of the asset to be reduced by depreciation at the
rate of twenty per cent per annum on a straight line method; and
(2) in the case of second hand asset, the original cost shall be the
actual cost incurred for acquisition of such second hand asset.
ADDITIONAL PROVISION FOR THE HIRE PURCHASE AND LEASED ASSETS
[ii] In respect of hire purchase and leased assets, additional provision shall be
made as under :
(a) where any amounts of hire charges or lease Nil
rentals are overdue upto 12 months
SUB-STANDARD ASSETS :
(b) where any amount of hire charges or lease 10 per cent of the net book
rentals are overdue for more than 24 months value
but upto 24 months
DOUBTFUL ASSETS :
(c) where any amounts of hire charges or lease 40 per cent of the net book
but upto 36 months
(d) where any amounts of hire charges or lease 70 per cent of the net
overdue for more than 36 months book rentals are but
upto 48 months value
LOSS ASSETS:
(e) where any amounts of hire charges or lease 100 per cent of the
net book
[iii] On expiry of a period of 12 months after the due date of the last instalment of
hire purchase/leased asset, the entire net book value shall be fully provided
for.
Notes :
[1] The amount of caution money/margin money or security deposits kept by the borrower
with the NBFC in pursuance of the hire purchase agreement may be deducted against
the provisions stipulated under clause (i) above, if not already taken into account while
arriving at the equated monthly instalments under the agreement. The value of any other
security available in pursuance to the hire purchase agreement may be deducted only
against the provisions stipulated under clause (ii) above.
[2] The amount of security deposits kept by the borrower with the NBFC in pursuance to the
lease agreement together with the value of any other security available in pursuance to
the lease agreement may be deducted only against the provisions stipulated under
clause (ii) above.
[3] It is clarified that income recognition on and provisioning against NPAs are two different
aspects of prudential norms and provisions as per the norms are required to be made on
NPAs on total outstanding balances including the depreciated book value of the leased
asset under reference after adjusting the balance if any, in the lease adjustment account.
The fact that income on an NPA has not been recognised cannot be taken as reason for
not making provision.
[4] An asset which has been renegotiated or rescheduled as referred to in paragraph (2)
(xvi) (b) of these directions shall be a sub-standard asset or continue to remain in the
same category in which it was prior to its renegotiation or reschedulement as a doubtful
asset or a loss asset as the case may be. Necessary provision is required to be made as
applicable to such asset till it is upgraded.
[5] The balance sheet for the year 1999-2000 to be prepared by the NBFC may be in
accordance with the provisions contained in sub-paragraph (2) of paragraph 8.
Disclosure in the balance sheet
9. [1] Every NBFC shall, separately disclose in its balance sheet the provisions made as
per paragraph 8 above without netting them from the income or against the value of
assets.
[2] The provisions shall be distinctly indicated under separate heads of accounts as
under :–
(i) provisions for bad and doubtful debts; and
(ii) provisions for depreciation in investments.
[3] Such provisions shall not be appropriated from the general provisions and loss
reserves held, if any, by the NBFC.
[4] Such provisions for each year shall be debited to the profit and loss account. The
excess of provisions, if any, held under the heads general provisions and loss
reserves may be written back without making adjustment against them.
Constitution of Audit Committee by NBFCs
9A. An NBFC having the assets of Rs. 50 crores and above as per its last audited balance
sheet shall constitute an Audit Committee, consisting of not less than three members of its
Board of Directors.
Accounting year
9B. Every NBFC shall prepare its balance sheet and profit and loss account as on March 31
every year with effect from its accounting year ending with 31st March, 2001:
Provided that if the accounting year of any NBFC ends on any date other than 31st March,
2001 such NBFC shall prepare its balance sheet and profit and loss account for any fraction of
the year ending on 31st March, 2001.
Self- examination Questions
1. Define the following terms;
(a) Break up value.
(b) Subordinated debt.
2. What is meant by non-performing assets as per NBFC prudential norms.
3. What disclosures are required to be made in the balance sheet of ABC Co., being a non-
banking finance company?
4. On what basis income from investments is recognized by NBFC?
5. While closing its books of account on 31st March, 2005 a non banking finance company
has it’s advances classified as follows:
Rs. In lakhs
Standard assets 8,400
Sub-standard assets 910
Secured portions of doubtful debts:
-up to one year 160
-one year to three years 70
- More than three years 20
Unsecured portion of doubtful debts 87
Loss Assets 24
Calculate the amount of provision which must be made against the advances.
UNIT 3
MERCHANT BANKERS
3.1 INTRODUCTION
Dictionary meaning of 'merchant bank' refers to an organisation that underwrites corporate
securities and advises clients on issues like corporate mergers, etc. involved in the ownership
of commercial ventures. The organisation may be a bank, corporate body, firm or proprietary
concern.
In Indian context, this definition suits well. Merchant banking in India started with management
of public issues and loan syndication and has been gradually covering activities like project
counselling, portfolio management, investment counselling and mergers and amalgamation of
the corporate firms. A 'merchant banker' has been defined under the Securities & Exchange
Board of India (Merchant Banker) Rules, 1992 as "any person who is engaged in the business
of issue management either by making arrangements regarding selling, buying or subscribing
to securities as manager, consultant, advisor or rendering corporate advisory service in
relation to such issue management." Merchant bankers are the specialised agency which
manage the capital issues. They are also called the managers to the issue.
A merchant banker is an organisation that acts as an intermediary between the issuers and
the ultimate purchasers of securities in the primary security market. In addition to managing an
issue for a client, the services offered by a merchant banker includes underwriting and
providing advice on complex financings arrangements, mergers and acquisitions, and at times
direct equity investments in corporations. In exercise of the powers conferred vide Section 30
of the Securities and Exchange Board of India Act, 1992 (15 of 1992), the Board, with the
previous approval of the Central Government made the SEBI (Merchant Bankers) Regulations,
1992 which specify various requirements. These regulations specify the norms which SEBI
takes into account for considering the grant of a certificate of registration and its renewal. The
code of conduct has been given in schedule III. For General obligations and responsibilities
have been specified under chapter III of these regulations for keeping a control on the
activities of merchant bankers.
3.2 CAPITAL ADEQUACY REQUIREMENT

The capital adequacy requirement specified in regulation 7 shall not be less than the net worth
of the person making the application for grant of registration.
For the purpose, the net worth shall be as follows :

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

Every merchant banker shall keep and maintain the following books of account, records and
documents as per regulation 14 :
(a) a copy of balance sheet as at the end of the each accounting period;
(b) a copy of profit and loss account for that period;
(c) a copy of the auditor's report on the accounts for that period;
(d) a statement of financial position.
Every merchant banker shall intimate to the SEBI the place where the books of account,
records and documents are maintained. Every merchant banker shall, after the end of each
accounting period furnish to the Board copies of the balance sheet, profit and loss account
and such other documents for any other preceding five accounting years when required by the
SEBI. The merchant banker shall preserve the books of account and other records and
documents maintained under regulation 14 for a minimum period of five years.
As per Regulation 28 of the SEBI (Merchant Banker) Regulations 1992, a merchant banker
shall disclose to the Board, as and when required, the following information, namely :–
(i) his responsibilities with regard to the management of the issue;
(ii) any change in the information or particulars previously furnished, which have a bearing
on the certificate granted to it.
(iii) the names of the body corporate whose issue he has managed or has been associated
with;
(iv) the particulars relating to the breach of the capital adequacy requirements as specified in
regulation 7;
(v) relating to the activities as manager, underwriter, consultant or advisor to an issue, as
the case may be.
SEBI has the right to appoint one or more persons as inspecting authority to undertake
inspection of the books of account, records and documents of the merchant banker for any of
the following purposes :
(i) to ensure that the books of account are being maintained in the required manner;
(ii) that the provisions of the Act, rules, regulations are complied with;
(iii) to investigate into the complaints received from investors, other merchant bankers or any
other person on any matter having a bearing on the activities of the merchant banker;
and
(iv) to investigate suo motu in the interest of securities business or investors' interest into the
affairs of the merchant banker.
As per regulation 31, it shall be the duty of the merchant banker to allow the inspecting
authority to have reasonable access to the premises occupied by such merchant banker or by
any other person on his behalf and also extend reasonable facility for examining any books,
records, documents and computer data in the possession of the merchant banker or any such
other person and also provide copies of documents or other materials which, in the opinion of
the inspecting authority, are relevant for the purposes of the inspection.
The SEBI may also appoint a qualified auditor to investigate into the books of account or the
affairs of the merchant bankers.
SEBI Disclosure & Investor Protection Guidelines, 1999 has specified a format for half yearly
report to be submitted by merchant bankers.
Self-examination Questions
1. What is meant by merchant bankers? What books of accounts are required to be
maintained by a merchant banker?
2. Under what circumstances SEBI has the right to order inspection of records of a
merchant banker?
3. What capital adequacy norms are specified for merchant bankers.
UNIT 4
STOCK AND COMMODITY MARKET INTERMEDIARIES
4.1 INTRODUCTION
With the removal of the ban on forward trading in all commodities, the Indian commodities
futures market has been totally liberalised. Participants in the securities and other financial
markets can now think of exploring the opportunities offered by the emerging commodities
market. There are, however, some basic issues relating to the securities and commodity
derivative markets and the likely impact of any moves for unifying the two on participant
institutions, players and regulatory bodies. Neither convergence nor divergence may
necessarily mean a win-win situation for the existing stock and commodity exchanges in the
present situation. However, it must be conceded that any action taken must bring optimum
benefits with minimum discomfort to the various intermediaries in the markets. On the
commodities side, the task force has found that a key element in strengthening the agricultural
produce markets is to have an efficient derivatives market for the various commodities. This
will help in more efficient price-risk management. The futures market introduced in select
commodities recently will play a vital role in shaping the decisions of the market
intermediaries.
Even though there are differences between commodity and financial derivatives markets, they
also have some close link in so far as trading practices and mechanisms are concerned. The
reforms in the securities market over the past two decades were carried out both in the
primary and secondary markets. The Securities and Exchange Board of India has introduced
in the past decade a number of measures to streamline the capital market, professionalise
trading and protect the interests of the small investor. There is complete automation of trading
in the securities market. Proper risk management, governance principles and regulatory
measures are in place. In the commodities markets too the situation is changing. Some
commodity exchanges are specialising in specific areas with varying degrees of success. The
task force has stressed the need to have at least a third of each exchange board manned by
independent directors. Licences have been given for a multiple commodities exchange and
single commodity exchanges and for conducting trading on-line. Even a single commodity
exchange can trade in multiple commodities after obtaining permission from the Forward
Markets Commission (FMC).
Commodity exchanges are promoted by institutions and associations. With convergence, there
will be an opportunity to speed up the development of the commodity markets. Because of the
economies of scale in operations there will be scope for further improvement However, there
are certain differences. Financial futures generally draw their strength from actively traded
cash markets. The exchanges oversee the operations. While organised trading in commodities
may closely resemble financials (as in bullion), one area of concern in the former case is the
impact of price volatility on the market; also, commodities markets require specialised
knowledge that is different from securities trading. More agricultural reforms to ensure free
marketing and minimal price volatility will be needed to ensure orderly growth of the
commodities markets. The task force has identified many legal and regulatory hurdles in the
way of convergence of securities and commodities markets. The securities market is governed
by the Securities Contracts Regulation Act, 1956 whereas the forward market is regulated by
the Forward Contracts Regulation Act 1952. Another basic consideration is that stock
exchanges and futures markets for financials are Central subjects whereas agriculture is
under the jurisdiction of States and futures trading in commodities is with the Union
Government. In reality, policies for the securities market and development of the commodities
market are of different nature. Even though the volume of trading in commodities is much
higher than in securities, it is better to keep them apart in the initial stages. Clearing members
of a stock exchange would like to trade in a commodity exchange as it provides them another
avenue for making money. The Securities Contracts Regulation Act has therefore been
amended whereby members of a stock exchange can be members of a commodity exchange
by forming a separate company. This is essential because at present there are two regulators
and each one will exercise his supervisory powers as provided under the rules in the
respective market. The net worth for becoming a clearing member can be fixed separately for
the two exchanges and this will play an important role in risk management. Even if there is a
risk in one market, no cascading effect will be felt in the other. There is also the fact that net
worth from one market cannot be moved to another. This will provide the necessary firewall
between the two markets and will benefit all the participants.
4.2 STOCK BROKERS

In this unit of the chapter, we will concentrate on stock brokers which are considered as part of
stock and commodity market intermediaries. A stock broker is a member of a recognised stock
exchange(s) and is engaged in buying, selling and dealing in securities. A stock broker can
deal in securities only after getting registration with SEBI. A stock broker can function as a
proprietorship firm, partnership firm or a corporate. Brokers are subject to capital adequacy
requirements comprising of a basic minimum capital and additional volume related capital.
Stock brokers are also eligible to act as underwriters without obtaining a separate registration
as an underwriter. He may or may not appoint sub-brokers. A sub-broker is subordinate to
main stock broker and acts on behalf of a stock broker as an agent or otherwise, for assisting
the investors in buying, selling or dealing in securities through such stock brokers. The stock
broker as a principal, is responsible to the investor for his sub-brokers' conduct and acts.
In exercise of the powers conferred by section 30 of the Securities and Exchange Board of
India Act ,1992 the SEBI Board made the SEBI (Stock-Brokers and Sub-Brokers) Regulations,
1992 to exercise the control on the activities of stock brokers and their sub-brokers. In a
contract for buying and selling securities, stock brokers act as agents for investors. In return
for this service they charge commission or brokerage at a specified percentage on contract
value. In addition to acting as agents for others, a stockbroker may also trade directly by
buying and selling securities as principals. If a stockbroker enters into a contract to buy or sale
securities as principal with any person other than another stockbroker, he must secure the
consent or authorization from the other party and must disclose in the agreement for buying or
selling of securities that he is acting as a principal.
A sub-broker is any person not being a member of a recognised stock exchange who acts on
behalf of a stock-broker as an agent or otherwise for assisting the investors in buying, selling
or dealing in securities through such stockbroker.
The Securities and Exchange Board of India (Stockbrokers and sub-brokers) Rules, 1992
provides that no stockbroker or sub-broker can buy, sell or deal in securities, unless he holds
a certificate of registration granted by the Securities and Exchange Board of India (SEBI). The
certification of registration is granted by SEBI on an application made to it in prescribed form,
subject to fulfillment of conditions specified in the Securities and Exchange Board of India
(Stockbrokers and sub-brokers) Rules, 1992.
The Securities and Exchange Board of India (Stockbrokers and sub-brokers)
Regulations, 1992 provides inter-alia, for the obligations and responsibilities of stock brokers
regarding maintenance of proper books of accounts, records and documents and other allied
matters. In the regulations, board means, the Securities and Exchange Board of India (SEBI).
4.3 MAINTENANCE OF PROPER BOOKS OF ACCOUNT, RECORDS ETC. (REGULATION 17)

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

(j) Written consent of clients in respect of contracts entered into as principals;
(k) Margin deposit book;
(l) Register of accounts of sub-brokers;
(m) An agreement with a sub-broker specifying the scope of authority and responsibilities of
the stock-broker and such sub-brokers.
In addition to the above statutory requirements, they are also required to maintain the
following records/documents :
(a) Scripwise clientwise list in respect of scrips of specified group, i.e., 'A' Group (inclusive of
brought forward positions);
(b) Client upla statement (i.e. carry forward position of all clients);
(c) Duplicate copies of self-certificates submitted on monthly basis (i.e., that the daily and
badla break-up have been reported correctly without netting positions of two different
clients in the same scrip);
(d) Copies of all margin statements downloaded by the Stock Exchange;
(e) Copies of Valan Balance Sheet (Form 31) along with all relevant assets;
(f) Details of spot delivery transactions entered into (including securities delivered and
payments made to the members);
(g) Client database and broker client agreement;
(h) Copy of registration certificate of each sub-broker issued by SEBI;
(i) Copy of approval for each remisier given by the exchange;
(j) Copy of the power of attorney/board resolution authoritizing directors, employees to sign
the contract note;
(k) Copies of pool account statements.
Every stock broker shall intimate to the SEBI the place where the books of account, records
and documents are maintained. Every stock broker shall, after the close of each accounting
period furnish to the SEBI if so required as soon as possible but not later than six months from
the close of the said period a copy of the audited balance sheet and profit and loss account as
at the end of the said accounting period; provided that if, it is not possible to furnish the above
documents within the time specified, the stock broker shal keep the SEBI informed of the
same together with the reasons for delay and the period of time by which such documents
would be furnished. Every stock broker is required to preserve the books of account and other
records maintained under regulation 17 for a minimum period of five years.
SEBI may appoint one or more persons as inspecting authority to undertake inspection of the
books of account, other records and documents of the stock brokers for any of the following
purposes :
(a) to ensure that the books of the account and other books are being maintained in the
manner required;
(b) that the provisions of the Act, rules, regulations and the provisions of the Securities
Contract (Regulation) Act, and the rules made thereunder are being complied with;
(c) to investigate into the complaints received from investors, other stock brokers, sub-
brokers or any other person on any matter having a bearing on the activities of the stock
brokers; and
(d) to investigate suo motu, in the interest of securities business or investors' interest into
the affaris of the stock-brokers.
The SEBI may appoint a qualified auditor to investigate into the books of account or the affairs
of the stock-broker.
A stock broker who fails to comply with any of the conditions subject to which registration has
been granted; contravenes any of the provisions of the Act, rules or regulations; or the
contravenes the provisions of the Securities Contracts (Regulation) Act, or the rules made
thereunder or contravenes the rules, regulations or bye-laws of the stock exchange shall be
liable to any of the following penalities as per regulation 25 :
(a) suspension of registration, after the inquiry, for a specified period; or
(b) cancellation of registration.
Without prejudice to the requirements above, every stockbroker must, after the close of each
accounting period furnish to the Board if so required as soon as possible but not later than six
months from the close of the said period a copy of the audited balance sheet and profit and
loss account, as at the end of the said accounting period:
If it is not possible to furnish the above documents within the time specified, the stock-broker
shall keep the Board informed of the same together with the reasons for the delay and the
period of time by which such documents would be furnished.
Every stockbroker has a duty to intimate the Board of the place where the books of accounts,
records and documents are maintained.
4.4 PRESERVATION OF BOOKS OF ACCOUNTS AND RECORDS (REGULATION 18)

Every stockbroker shall preserve the books of account and other records maintained under
regulation 17 for a minimum period of five years.
4.5 BOARD'S RIGHT TO INSPECT (REGULATION 19)

Where it appears to the Board so to do, it may appoint one or more persons as inspecting
authority to undertake inspection of the books of accounts, other records and documents of
the stockbrokers for any of the following purposes.
(a) To ensure that the books of accounts and other books are being maintained in the
manner required;
(b) That the provisions of the Act, rules, regulations and the provisions of the Securities
Contracts (Regulation) Act and the rules made there under are being complied with;
(c) To investigate into the complaints received from investors, other stock brokers, sub-
brokers or any other person on any matter having a bearing on the activities of the stock-
brokers; and
(d) To investigate suo-moto, in the interest of securities business or investors' interest, into
the affairs of the stockbroker.
4.6 PROCEDURE FOR INSPECTION (REGULATION 20)

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

(REGULATION 21)
It shall be the duty of broker on inspection by the Board every director, proprietor, partner,
officer and employee of the stock-broker, who is being inspected, to produce to the inspecting
authority such books, accounts and other documents in his custody or control and furnish him
with the statements and information relating to the transactions in securities market within
such time as the said officer may require.
The stock-broker shall allow the inspecting authority to have reasonable access to the
premises occupied by such stockbroker or by any other person on his behalf and also extend
reasonable facility for examining any books, records, documents and computer data in the
possession of the stockbroker or any other person and also provide copies of documents or
other materials which, in the opinion of the inspecting authority are relevant.
The inspecting authority, in the course of inspection, shall be entitled to examine or record
statements of any member, director, partner, proprietor and employee of the stockbroker.
It shall be the duty of every director proprietor, partner, officer and employee of the stock
broker to give to the inspecting authority all assistance in connection with the inspection,
which the stock broker may be reasonably expected to give.
4.8 SUBMISSION OF REPORT TO THE BOARD (REGULATION 22)

The inspecting authority shall, as soon as may be possible submit an inspection report to the
Board.
4.9 ACTION ON INSPECTION OR INVESTIGATION REPORT (REGULATION 23)

The Board or the Chairman shall after consideration of inspection or investigation report take
such action as the Board or Chairman may deem fit and appropriate including action under the
Securities and Exchange Board of India (Procedure for Holding Enquiry by Enquiry Officer and
Imposing Penalty) Regulations, 2002.
4.10 APPOINTMENT OF AUDITOR (REGULATION 24)

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

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

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

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

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

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

Member Brokers shall make payment to their clients or deliver the securities purchased within
two working days of payout unless the client has requested otherwise. Stock Exchange shall
issue a Press Release immediately after the payout.
Member brokers shall issue the contract note for purchase/sale of securities to a client within
24 hours of the execution of the contract.
4.16 MARGIN
Member Brokers shall buy securities on behalf of client only on receipt of margin of minimum
20% on the price of the securities proposed to be purchased, unless the client already has an
equivalent credit with the broker. Member may not, if they so desire, collect such a margin
from Financial Institutions, Mutual Funds and FII’s.
Member brokers shall sell securities on behalf of client only on receipt of a minimum margin of
20% on the price of securities proposed to be sold, unless the member has received the
securities to be sold with valid transfer documents to his satisfaction prior to such sale.
Member may not, if they so desire, collect such a margin from Financial Institutions, Mutual
Funds and FII’s.
4.17 CLOSING OUT

In case of purchases on behalf of clients, Member brokers shall be a liberty to close out the
transactions by selling the securities, in case the client fails to make the full payment to the
Member Broker for the execution of the contract within two days of contract note having been
delivered for cash shares and seven days for specified shares or before pay-in day (as fixed
by Stock Exchange for the concerned settlement period), whichever is earlier; unless the client
already has an equivalent credit with the Member. The loss incurred in this regard, if any, will
be met from the margin money of that client.
In case of sales on behalf of clients, Member broker shall be at liberty to close out the contract
by effecting purchases if the client fails to deliver the securities sold with valid transfer
documents within 48 hours of the contract note having been delivered or before delivery day
(as fixed by Stock Exchange authorities for the concerned settlement period), whichever is
earlier. Loss on the transaction, if any, will be deductible from the margin money of that client.
1. What is meant by stock broker?
2. What books of accounts are required to be maintained by a stock broker?
3. For what purposes inspection of records and documents of merchant banker is ordered
by SEBI?
9
VALUATION
UNIT 1
CONCEPT OF VALUATION
1.1 INTRODUCTION
Valuation is the process that links risk and return to estimate the worth i.e. value of an asset or
a firm. Valuation of a company at a given point in time should be understood as the expected
payout value of that enterprise when a liquidity event presents itself at that moment. There is a
common misconception that the valuation calculation for enterprises is usually performed at
points of capital inflow or outflow. Valuation can be used as a very effective business tool by
management for better decision making throughout the life of the enterprise. A discussion on
valuation can be made philosophical in nature by arguing the assumptions. Companies are
governed and valuations are influenced by the market supply-demand lifecycles along with
product and technology supply-demand lifecycles. Correspondingly, the value of an enterprise
over the course of its life peaks with the market and product/ technology factors. Both financial
investors such as venture capitalists and entrepreneurs involved in a venture would ideally like
to exit the venture in some form near the peak to maximize their return on investment. Thus,
valuation helps determine the exit value of an enterprise at that peak. This exit value typically
includes the tangible and intangible value of the company’s assets. Tangible value would
typically include balance sheet items recorded as the book value of the enterprise. Intangibles
would typically include intellectual property, human capital, brand and customers, among
others. In more traditional companies considering the private equity markets, the value of
intangibles is much higher than the value of the tangible assets. Therefore, an effective
enterprise valuation methodology needs to be developed.
One can also define valuation as Measurement of value in monetary terms. Measurement of
income and valuation of wealth are two interdependent core aspects of financial accounting
and reporting. Wealth comprises of assets and liabilities. Valuation of assets and liabilities are
made to portray the wealth position of a firm through a balance sheet and to supply logistics to
the measure of the periodical income of the firm through a profit and loss account. Again
valuation of business and valuation of share are made through financial statement analysis for
management appraisal and investment decisions. Valuation is pivotal in strategic, long term or
short term decision making process in cases like reorganization of company, merger and
acquisition, extension or diversification, or for launching new schemes or projects. As the
application area of valuation moves from financial accounting to financial management, the
role of accountant also undergoes a transition. That order of transition in the concept and use
of valuation process is followed in the subsequent units of this chapter.
1.2 CONCEPT OF VALUATION

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

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

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

A number of different measurement bases are employed to different degrees and in varying
combinations in valuation of different assets in different areas of application. They include the
following:
(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the
fair value of the other consideration given to acquire them at the time of their acquisition.
(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have
to be paid if the same or an equivalent asset were acquired currently.
(c) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents
that could currently be obtained by selling the asset in an orderly disposal.
(d) Present value. Assets are carried at the present value of the future net cash inflows that
the item is expected to generate in the normal course of business.
Other valuation bases:
Net Realisable Value (NRV): This is same as the Realisable ( settlement) value. This is the
value (net of expenses) that can be realized by disposing off the assets in an orderly manner.
Net selling price or exit values also convey the same meaning.
Economic value: This is same as the present value. The other name of it is value to business.
Replacement (cost) value: This is also same as the current cost.
Recoverable (amount) value: This is the higher of the net selling price and value in use.
Deprival value: This is the lower of the replacement value and recoverable (amount) value.
Liquidation value: this is the value (net of expenses), that a business can expect to realize by
disposing of the assets in the event of liquidation. Such a value is usually lower than the NRV
or exit value. This is also called break up value.
Fair value: This is not based on a particular method of valuation. It is the acceptable value
based on appropriate method of valuation in context of the situation of valuation. Thus fair
value may represent current cost, NRV or present value as the case may be.
In financial accounting ‘An asset is recognised in the balance sheet when it is probable that
the future economic benefits associated with it will flow to the enterprise and the asset has a
cost or value that can be measured reliably.’ ‘The measurement basis most commonly
adopted by enterprises in preparing their financial statements is historical cost. This is usually
combined with other measurement bases. For example, inventories are usually carried at the
lower of cost and net realisable value and pension liabilities are carried at their present value.
Furthermore, the current cost basis may be used as a response to the inability of the historical
cost accounting model to deal with the effects of hanging prices of non-monetary assets.’
(Framework, Issued 2000, Para 100)
The requirements of regulations and accounting standards as to recognition of assets,
reliability of measurement and disclosure in financial reports have set certain limitations to the
freedom of valuation so far as financial accounting is concerned.
1.5 TYPES OF VALUE

The following are six types of value:
♦ Going-concern value is the value of a firm as an operating business.
♦ Liquidation value is the projected price that a firm would receive by selling its assets if it
were going out of business.
♦ Book value is the value of an asset as carried on a balance sheet. In other words, it
means i) the cost of an asset minus accumulated depreciation ii) the net asset value of a
company, calculated by total assets minus intangible assets (patents, goodwill) and
liabilities iii) the initial outlay for an investment. This number may be net or gross of
expenses such as trading costs, sales taxes, service charges and so on. It is the total
value of the company’s assets that shareholders would theoretically receive if a company
were liquidated. By being compared to the company’s market value, the book value can
indicate whether a stock is under- or overpriced. In personal finance, the book value of
an investment is the price paid for a security or debt investment. When a stock is sold,
the selling price less the book value is the capital gain (or loss) from the investment.
♦ Market value is the price at which buyers and sellers trade similar items in an open
market place. The current quoted price at which investors buy or sell a share of common
stock or a bond at a given time. The market capitalization plus the market value of debt.
Sometimes referred to as “total market value”. In the context of securities, market value
is often different from book value because the market takes into account future growth
potential. Most investors who use fundamental analysis to picks stocks look at a
company’s market value and then determine whether or not the market value is adequate
or if it’s undervalued in comparison to its book value, net assets or some other measure.
♦ Fair market Value is the price that a given property or asset would fetch in the
marketplace, subject to the following conditions: i) Prospective buyers and sellers are
reasonably knowledgeable about the asset; they are behaving in their own best
interests and are free of undue pressure to trade. ii). A reasonable time period is given
for the transaction to be completed. Given these conditions, an asset’s fair market value
Valuation 9.5
should represent an accurate valuation or assessment of its worth. Fair market values
are widely used across many areas of commerce. For example, municipal property taxes
are often assessed based on the fair market value of the owner’s property. Depending
upon how many years the owner has owned the home, the difference between the
purchase price and the residence’s fair market value can be substantial. Fair market
values are often used in the insurance industry as well. For example, when an insurance
claim is made as a result of a car accident, the insurance company covering the damage
to the owner’s vehicle will usually cover damages up to the fair market value of the
automobile.
♦ Intrinsic value∗ is the value at which an asset should sell based on applying data inputs
to a valuation theory or model. The actual value of a company or an asset based on an
underlying perception of its true value including all aspects of the business, in terms of
both tangible and intangible factors. This value may or may not be the same as the
current market value. Value investors use a variety of analytical techniques in order to
estimate the intrinsic value of securities in hopes of finding investments where the true
value of the investment exceeds its current market value. For call options, this is the
difference between the underlying stock’s price and the strike price. For put options, it is
the difference between the strike price and the underlying stock’s price. In the case of
both puts and calls, if the respective difference value is negative, the intrinsic value is
given as zero. For example, value investors that follow fundamental analysis look at both
qualitative (business model, governance, target market factors etc.) and quantitative
(ratios, financial statement analysis, etc.) aspects of a business to see if the business is
currently out of favour with the market and is really worth much more than its current
valuation.
These types of values can differ from one another. For example, a firm’s going-concern value
is likely to be higher than its liquidation value. The excess of going-concern value over
liquidation value represents the value of the operating firm as distinct from the value of its
assets. Book value can differ substantially from market value. For example, a piece of
equipment appears on a firm’s books at cost when purchased but decreases each year due to
depreciation charges. The price that someone is willing to pay for the asset in the market may
have little relationship with its book value. Market value reflects what someone is willing to pay
for an asset whereas intrinsic value shows what the person should be willing to pay for the
same asset.
∗
* Extrinsic value is another variety. It is the difference between an option’s price and the intrinsic
value. For example, an option that has a premium price of Rs.10 and an intrinsic value of Rs.5
would have an extrinsic value of Rs.5. Denoting the amount that the option’s price is greater than
the intrinsic value, the extrinsic or time value of the option declines as the expiration date of an
option draws closer.
1.6 APPROACHES OF VALUATION

Three General Approaches to Valuation are as follows:
1) Cost Approach: e.g. Adjusted Book Value
2) Market Approach: e.g. Comparables
3) Income Approach: e.g. Discounted Cash Flow
Each approach has advantages and disadvantages. Generally there is no “right” answer to a
valuation problem. Valuation is very much an art as much as a science!
Adjusted Book Value or Cost of Assets
This technique involves restating the value of individual assets to reflect their fair market
values. It is useful for valuing holding companies where assets are easy to value (for example,
securities) and less useful for valuing operating businesses. The value of an operating
company is generally greater than that of its assets. The difference between that value of the
expected cash flows and that of its assets is called the “going concern value”. It is a useful
approach when the purpose of the valuation is that the business will be liquidated and
creditors must be satisfied.
While doing this valuation following adjustments to book value can be made:
♦ Inventory undervaluation
♦ Bad debt reserves
♦ Market value of plant and equipment
♦ Patents and franchises
♦ Investments in affiliates
♦ Tax-loss carried forward
Valuation 9.7
UNIT 2
VALUATION OF TANGIBLE FIXED ASSETS
2.1 INTRODUCTION
Tangible Fixed Assets are valued for presenting them in the balance sheet with due reference
to the relevant portions of the “Framework for the Preparation and Presentation of Financial
Statements”, Schedule VI, Part I to the Companies Act, AS 10, AS 11, AS 12, AS 14, AS 16,
AS 26 and AS 28 we shall discuss the different approaches to and procedural aspects of
valuation of tangible fixed assets.
Schedule VI, Part I to the Companies Act requires the following classification of fixed assets:
(a) goodwill (b) land (c) building (d) leasehold (e) railway slidings (f) plant and machinery (g)
furniture and fittings (h) development of property (i) patents, trademarks and designs (j)
livestock and (k) vehicles etc. Of these, goodwill, patents, trademarks and designs are special
type of fixed assets called intangibles, the valuation whereof would be discussed in the next
unit.
The said Part I of the Schedule VI also requires that:
Gross Block i.e., the original cost for each head and the additions thereto and deductions
there from during the year, the accumulated depreciation i.e., the total depreciation written
off or provided for up to the end of the year and net block i.e., gross block less accumulated
depreciation are to be stated.
The value at which these assets stood in company’s book at the commencement of the Act
are to be shown in case the original cost is not available.
Adjustment in original cost is necessary for change in foreign exchange rate resulting in
increase or decrease in liability if the fixed assets are acquired from any country outside India.
Revaluation of the original cost is permissible.
As per the requirements of the said Part I of the Schedule VI of the Companies Act, under
each head the original cost and the additions thereto and deductions therefrom during the
year, and the total depreciation written off or provided for upto the end of the year are to be
stated.
2.2 MEANING OF ORIGINAL COST

The Para 9 of the AS10 has stated the components of cost as below (a to e):
(a) The cost of an item of fixed asset comprises its purchase price, including import duties and
other non-refundable taxes or levies, any trade discounts and rebates are deducted in arriving
at the purchase price.
(b) Any directly attributable cost of bringing the asset to its working condition for its intended
use; Examples of directly attributable costs are:
(i) Site preparation;
(ii) Initial delivery and handling costs;
(iii) Installation cost, such as special foundations for plant; and
(iv) Professional fees, for example fees of architects and engineers.
(c) Administration and other general overhead expenses are usually excluded from the cost of
fixed assets because they do not relate to a specific fixed asset. However, in some
circumstances, such expenses as are specifically attributable to construction of a project or to
the acquisition of a fixed asset or bringing it to its working condition, may be included as part
of the cost of the construction project or as a part of the cost of the fixed asset.
(d) The expenditure incurred on start-up and commissioning of the project, including the
expenditure incurred on test runs and experimental production, is usually capitalised as an
indirect element of the construction cost. However, the expenditure incurred after the plant has
begun commercial production, i.e., production intended for sale or captive consumption, is not
capitalized and is treated as revenue expenditure even though the contract may stipulate that
the plant will not be finally taken over until after the satisfactory completion of the guarantee
period.
(e) If the interval between the date a project is ready to commence commercial production and
the date at which commercial production actually begins is prolonged, all expenses incurred
during this period are charged to the profit and loss statement. However, the expenditure
incurred during this period is also sometimes treated as deferred revenue expenditure to be
amortised over a period not exceeding 3 to 5 years after the commencement of commercial
production.
(f) The AS 16 stated on capitalization of borrowing costs (i.e., interest and other costs incurred
by an enterprise in connection with the borrowing of funds) that are directly attributable to the
acquisition, construction or production of a qualifying asset.
(g) Self constructed fixed assets: The same principles that apply to value purchased fixed
assets at original cost will apply to self constructed assets also.(AS10, Para 10)
It may be remembered that administration and general overhead expenses are usually
excluded from the cost of fixed assets unless they are specifically attributable to financing cost
incurred on deferred credit or borrowed fund in relation to acquisition of fixed assets, and they
do not form part of original cost after such fixed assets are ready for use. Similarly,
expenditure incurred on start-up and commissioning of the project after the plant has begun
commercial production is not considered as a part of the original cost.
Valuation 9.9
2.3 CHANGE IN ORIGINAL COST

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

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

From the discussion in the above paragraphs we clearly observe that:
(a) In most of the cases the basis of valuation is historical cost.
(b) In case of revaluation the current cost basis (3.1 b) is applied.
(c) In case of impairment of assets we get another value called ‘recoverable amount’.
Recoverable amount is the higher of an asset’s net selling price and its value in use. Value in
use is the present value of estimated future cash flows expected to arise from the continuing
use of an asset and from its disposal at the end of its useful life. Net selling price is the
amount obtainable from the sale of an asset in an arm’s length transaction between
knowledgeable, willing parties, less the costs of disposal. (AS 28)
(d) When a fixed asset is acquired in exchange for another asset, its cost is usually
determined by reference to the fair market value of the consideration given. It may be
appropriate to consider also the fair market value of the asset acquired if this is more clearly
evident. An alternative accounting treatment that is sometimes used for an exchange of
assets, particularly when the assets exchanged are similar, is to record the asset acquired at
the net book value of the asset given up; When a fixed asset is acquired in exchange for
shares or other securities in the enterprise, it is usually recorded at its fair market value, or the
fair market value of the securities issued, whichever is more clearly evident. (AS 10,Para 11)
(Note: We find different terms in different references viz., Realisable (settlement) value, Net
selling price and fair market value connoting the same meaning. Again, Present value and
Value in use are also carrying the same meaning.)
2.6 NET VALUATION

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

An item of fixed assets is eliminated from financial statements on disposal. If any fixed asset is
retired from active use and held for disposal, it should be valued at the lower of the net book
value and net realisable value. This means expected loss arising out of retirement of the fixed
assets is immediately accounted for. Such loss should be charged to Profit and Loss Account.
Similarly, gain or loss arising out of disposal of fixed assets is generally charged to Profit and
Loss Account.
If any fixed asset was revalued earlier and the revaluation reserve remains unutilised partly or
fully any loss arising out of sale of such fixed assets can be adjusted with the unutilised
balance of revaluation reserve.
Valuation 9.11
2.8 DEPRECIATION
Assessment of depreciation and the amount to be charged is based on three factors;
(i) Value of fixed assets (already discussed);
(ii) Useful life of fixed assets; and
(iii) Estimated residual value.
There are several methods for charging depreciation of which straight line method and written
down value method are used.
Regarding depreciation, AS 6 suggests adoption of the following principle:
(i) Consistency in application of the depreciation method.
(ii) If there is change in method, unamortised amount of the fixed assets should be charged
to revenue following the new method from the date of the asset coming into use.
(iii) If useful life is revised, the unamortised value of the fixed assets should be charged to
revenue over the revised remaining period of useful life.
(iv) If the value of the fixed asset is revised, the depreciation should be charged to write off
the unamortised value of the fixed assets including revaluation profit/loss over the
remaining useful life. In case the revaluation has a material effect on the amount of
depreciation, the same should be disclosed separately in the year in which revaluation is
carried out.
Illustration 1
Fixed Assets of XYZ Ltd:
Purchased as on 1.4.2001 Rs. 7,50,000
Revaluation + 20% on 1.4.2003.
Expected life 15 years.
The company charged straight line depreciation.
The fixed asset was sold on 1.4.2006for Rs. 5,60,000
The company also charged the excess depreciation to revaluation reserve.
Show Fixed Assets A/c, Depreciation A/c, Revaluation Reserve A/c in the book of XYZ Ltd.
Solution Fixed Assets A/c
Rs. Rs.
1.4.01 To Bank 7,50,000 31.3.02 By Depreciation 50,000
By Balance c/d 7,00,000
7,50,000 7,50,000
1.4.02 To Balance b/d 7,00,000 31.3.03 By Depreciation 50,000

7,00,000 7,00,000
To Revaluation Reserve 1,30,000 By Balance c/d 7,20,000
7,80,000 7,80,000
7,20,000 7,20,000
6,60,000 6,60,000
1.4.06 To Balance b/d 6,00,000 1.4.06 By Bank 5,60,000
By Revaluation
Reserve A/c 40,000
6,00,000 6,00,000
Depreciation A/c
Rs. Rs.
31.3.02 To Fixed Assets A/c 50,000 31.3.02 By P & L A/c 50,000
Revaluation Reserve A/c
31.3.04 To P & L A/c -transfer 10,000 1.4.03 By Fixed Assets A/c 1,30,000
To Balance c/d 1,20,000
1,30,000 1,30,000
31.3.05 To P & L A/c -transfer 10,000 1.4.04 By Balance b/d 1,20,000
1,20,000 1,20,000
31.3.06 To P & L A/c -transfer 10,000 1.4.05 By Balance b/d 1,10,000
1,10,000 1,10,000
1.4.06 To Fixed Assets A/c 40,000 1.4.06 By Balance b/d 1,00,000
- Loss on disposal
To General Reserve 60,000
1,00,000 1,00,000
Valuation 9.13
Note: The company should in the first place, charge full depreciation to profit and loss
account. Thereafter, amount representing relevant portion of the depreciation resulting from
the revaluation may be transferred from the revaluation reserve. The balance on revaluation
reserve after adjustment of the loss on disposal should be transferred to general reserve.
Illustration 2
Vidarva Chemical Ltd. purchased a machinery from Madras Machine Manufacturing Ltd.
(MMM Ltd.) on 30.9.2006. Quoted price was Rs.162 lakhs. MMM Ltd. offers 1% trade
discount. Sales tax on quoted price is 5%. Vidarva Chemical Ltd. spent Rs. 42,000 for
transportation and Rs.30,000 for architect’s fees. They borrowed money from ICICI Rs.
150 lakhs for acquisition of the assets @ 20% p.a. Also they spent Rs. 18,000 for material in
relation to trial run. Wages and overheads incurred during trial run were Rs l2,000 and
Rs.8,000 respectively. The machinery was ready for use on 15.11.2006. It was put to use on
15.4.2007. Find out the original cost. Also suggest the accounting treatment for the cost
incurred in the interval between the date the machine was ready for commercial production
and the date at which commercial production actually begins.
Solution
(1) Determination of the original cost of the machine
Rs. in lakhs Rs. in lakhs
Quoted price 162.00
Less: 1% Trade discount 1.62
160.38
Add: Sales tax 8.10 168.48
Transportation 0.42
Architect’s fees 0.30
Financing cost 3.75
@ 20% on Rs. 150 lakhs for
30.9.06— 15.11.06
Expenditure for start-up:
Material 0.18
Wages 0.12
Overhead 0.08 0.38
173.33
(2) Cost incurred in the interval

Financing cost @ 20% on Rs. 150 lakhs for 15.11.06 – 15.4.2007 12.50
This may either be charged to P & L A/c or deferred for amortisation within 3 to 5 years.
Illustration 3
The original cost of the machine shown in the books of PK Ltd. as on lst Jan.,2005 is Rs. 180
lakhs which they revalued upward by 20% during 2005. In the year 2007, it appears that a 5%
downward revaluation should be made to arrive at the true value of the asset in the changed
economic and industry conditions. They charged 15% depreciation on W.D.V. of the asset.
Show the value of the asset at which it should appear in the Balance Sheet dated 31st Dec.
2007and show the Revaluation Reserve Account.
Solution
(1) Determination of Cost Rs. in lakhs
W.D.V as on 1.1.2005 180.00
Add: Revaluation profit 36.00
216.00
Less: Depreciation for 2005 32.40
W.D.V as on 1.1.2006 183.60
W.D.V as on 1.1.2007 156.06
Less : Revaluation loss 7.80
148.26
W.D.V as on 31.12.2007 126.02
(2) Revaluation Reserve Account
Dr. Cr.
31.12.05 To Balance c/d 36.00 31.12.05 By Machinery A/c 36.00
31.12.06 To Balance c/d 36.00 01.01.06 By Balance b/d 36.00
31.12.07 To Machinery A/c 7.80 01.01.07 By Balance b/d 36.00
To Balance c/d 28.20
36.00 36.00
Illustration 4
X Ltd. purchased fixed assets for Rs. 10 lakhs for which it got grants from an international
agency (which comes within the definition of government as mentioned in AS–12) Rs. 8 lakhs.
Valuation 9.15
X Ltd. decides to treat the grant as deferred income. Suggest appropriate basis for taking
credit of the grant to Profit and Loss A/c. Take life of the assets 10 years. The company
followed W.D.V method. Scrap value Rs. 2.5 lakhs.
Solution
Deferred income on account of grant should be taken credit at the proportion by which
depreciation is charged.
Calculation of Depreciation and taking Credit of Deferred Grant (Depreciation Rate 12.95
Original Cost /W. D. V Depreciation Recovery of Grant
(Rs. in Lakhs) (Rs. in Lakhs) (Rs. in Lakhs)
t0 10.000 – –
t1 10.000 1.295 1.381
t2 8.705 1.127 1.202
t3 7.578 0.981 1.046
t4 6.597 0.854 0.912
t5 5.743 0.744 0.794
t6 4.999 0.647 0.690
t7 4.352 0.564 0.602
t8 3.788 0.491 0.524
t9 3.297 0.427 0.455
t10 2.870 0.370 0.394
1
⎡ 2.5 ⎤ 10
Notes: (i) Rate of Depreciation = 1 – ⎢ ⎥ = 12.95%
⎣ 10 ⎦
Depreciation for the year
(ii) Recovery of grant = Amount of grant ×
Total depreciation
For t01, Rs. 8 lakhs × 1.295 / 7.5 = 1.381 lakhs.
1. Define tangible fixed assets. State the circumstances under which the need for valuation
of such assets arises.
2 A company purchased on 01.04.2005 a special purpose machinery for Rs. 25 lakhs. It
received a Central Government Grant for 20% of the price. The machine has an effective
life of 10 years.. You are required to advise the company on the following items from
the viewpoint of finalisation of accounts, taking note of the mandatory accounting
standards.
3. J Ltd. purchased machinery from K Ltd. on 30.09.2005. The price was Rs. 370.44 lakhs
after charging 8% Sales-tax and giving a trade discount of 2% on the quoted price.
Transport charges were 0.25% on the quoted price and installation charges come to 1%
on the quoted price.
A loan of Rs. 300 lakhs was taken from the bank on which interest at 15% per annum
was to be paid.
Expenditure incurred on the trial run was Materials Rs. 35,000, Wages Rs. 25,000 and
Overheads Rs. 15,000.
Machinery was ready for use on 1.12.2005. However, it was actually put to use only on
1.5.2006. Find out the cost of the machine and suggest the accounting treatment for the
expenses incurred in the interval between the dates 1.12.2005 to 1.5.2006. The entire
loan amount remained unpaid on 1.5.2006.
Valuation 9.17
UNIT 3
VALUATION OF INTANGIBLES
3.1 DEFINITION OF INTANGIBLES

An intangible asset is an identifiable non-monetary asset, without physical substance, held for
use in the production or supply of goods or services , for rental to others, or for administrative
purposes. Enterprises frequently expend resources, or incur liabilities, on the acquisition,
development, maintenance or enhancement of intangible resources such as scientific or
technical knowledge, design and implementation of new processes or systems, licences,
intellectual property, market knowledge and trademarks (including branch names and
publishing titles). Common examples of items encompassed by these broad headings are
computer software, patents, copyrights, motion picture films, customer lists, mortgate servicing
rights, finishing licences, import quotas, franchises, customer or supplier relationships,
customer loyalty, market share and marketing rights. Goodwill is another example of an item
of intangible nature which either arises on acquisition or is internally generated. Intangible
fixed assets can be classified as identifiable intangibles and not identifiable intangibles. The
identifiable intangibles include patents, trademarks and designs and brands whereas the not
identifiable intangibles are clubbed together as goodwill. To be identifiable, it is necessary that
the intangible asset is clearly distinguished from goodwill. An intangible asset can be clearly
distinguished from goodwill if the asset is separable.
3.2 RECOGNITION
An intangible asset should be recognised if, and only if:
(a) It is probable that the future economic benefits that are attributable to the asset will flow to
the enterprise; and
(b) The cost of the asset can be measured reliably.
If an intangible asset is acquired separately, the cost of the intangible asset can usually be
measured reliably and such intangible asset is recognized and valued at cost in the same
manner as in case if the tangible fixed assets.
If the intangible asset is internally generated:
Para 50 of the AS 26 clearly stated that ‘Internally generated brands, mastheads, publishing
titles, customer lists and items similar in substance should not be recognized as intangible
assets’.
For other types of intangible assets Para 41(AS26) stated that ‘No intangible asset arising
from research (or from the research phase of an internal project) should be recognised’ and
Para 44 requires that ‘An intangible asset arising from development (or from the development
phase of an internal project) should be recognised if, and only if, all of the conditions specified
therein are satisfied’.
When not recognized the expenditure on intangible item would be treated as expense and
when reconised the expenditure on the intangible item would be capitalized.
Subsequent expenditure on an intangible asset after its purchase or its completion should be
added to the cost of the intangible asset if:
(a) It is probable that the expenditure will enable the asset to generate future economic
benefits in excess of its originally assessed standard of performance; and (b) the expenditure
can be measured and attributed to the asset reliably.
No valuation shall be made for internally generated brand. When the brand is acquired
separately the valuation would be made at initial cost of acquisition (with subsequent addition
to cost, if any).
All identifiable intangible assets including Patents, Copyrights, Know-how and Designs which
are acquired separately valuation would be made at initial cost of acquisition(with subsequent
addition to cost, if any). If they are generated internally and are not recognized as per 5.5 no
valuation shall be made. However for internally generated recognized intangibles valuation
would be made at cost (with subsequent addition to cost, if any).
The depreciable amount of an intangible asset should be allocated on a systematic basis over
the best estimate of its useful life. There is a rebuttable presumption that the useful life of an
intangible asset will not exceed ten years from the date when the asset is available for use.
Amortisation should commence when the asset is available for use.
3.3 DEFINITION OF GOODWILL

The following are some judicial definitions of goodwill:
(1) “The goodwill of a business is the advantage, whatever it may be, which a person gets by
continuing to carry on, and being entitled to represent to the outside world that he is carrying
on a business which has been carried on for some time previously” - Warrington. In J. Hill v.
Fearis (1905).
(2) “Goodwill is a thing very easy to describe, very difficult to define. It is the benefit and
advantage of the good name, reputation and connection of a business. It is the attractive
force which brings in custom. It is one thing which distinguishes an old established business
from a new business at its first start... Goodwill is composed of a variety of elements. It differs
in its composition in different trades and in different businesses in the same trade. One
element may preponderate here and another there.” - Lord Macnaughton In IRC Vs. Muller
(1901).
From the accountant’s point of view, goodwill, in the sense of attracting custom, has little
Valuation 9.19
significance unless it has a saleable value. To the accountant, therefore, goodwill is said to be
that element arising from reputation, connection or other advantages possessed by a business
which enables it to earn greater profits than the return normally to be expected on the capital
represented by net tangible assets employed in the business. In considering the return
normally to be expected, regard must be had to the nature of the business, the risk involved,
fair management remuneration and other relevant circumstances.
SSAP-22, UK Accounting Standard on Accounting for goodwill defines the term goodwill as
follows:
“Goodwill is the difference between the value of a business as a whole and the aggregate of
the fair values of its separable net assets.” Separable net assets are those assets which can
be identified and sold (or discharged) separate without necessarily disposing off the business
as a whole. They include the identifiable intangibles. Fair value is the amount for which an
asset (or liability) could be exchanged in an arm’s length transaction.
3.4 NATURE AND TYPES OF GOODWILL

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

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

Goodwill, in general, is recorded in the books only when some consideration in money or
money’s worth has been paid for it. Whenever a business is acquired for a price (payable
either in cash or in shares or otherwise) which is in excess of the value of the net assets of the
business taken over, the excess is termed as ‘goodwill’. Goodwill arises from business
connections, trade name or reputation of an enterprise or from other intangible benefits
enjoyed by an enterprise.
As a matter of financial prudence, goodwill is written off over a period. However, many
enterprises do not write off goodwill and retain it as an asset. (AS 10)
In case of amalgamation under purchase method any excess of the amount of the
consideration over the value of the net assets of the transferor company acquired by the
transferee company should be recognised in the transferee company’s financial statements as
goodwill arising on amalgamation. (AS 14)
If Expenditure on an intangible item acquired in an amalgamation in the nature of purchase
cannot be recognised as an intangible asset, this expenditure (included in the cost of
acquisition) should form part of the amount attributed to goodwill at the date of acquisition.
(Para 55, AS 26)
Again in case of consolidation of balance sheet in the books of the parent company any
excess of the cost to the parent of its investment in a subsidiary over the parent’s portion of
equity of the subsidiary, at the date on which investment in the subsidiary is made, should be
described as goodwill to be recognised as an asset in the consolidated financial
statements;(AS 21)
Internally generated goodwill should not be recognised as an asset (AS 26). Thus in corporate
financial accounting the scope for valuation of goodwill is limited to the measurements stated
in the above circumstances. In case of amalgamation in the nature of merger, there does not
arise any goodwill. In case of amalgamation in the nature of purchase, the excess of purchase
consideration over the net asset value is computed as goodwill. In case of consolidation of
final accounts, the excess of cost of investment in subsidiary over the parent’s share in
subsidiary’s equity at the date of acquisition is computed as goodwill. Thus for determining the
value of goodwill to be shown in the financial statements, one has to find the amount of
purchase consideration, net asset value, cost to the parent of its investment in subsidiary and
parent’s share in subsidiary’s equity.
If we assume that the purchase consideration or the cost of investment in subsidiary is
inclusive of the price for goodwill, if any, then question may arise whether the valuation
process is a circular one as stated below. The purchase consideration/ cost of investment in
subsidiary are determined on the basis of valuation of business or valuation of share of
transferor/subsidiary. The purchase consideration/cost of investment determines value of
goodwill in amalgamation in the nature of purchase or in consolidation of financial statements.
Thus in the above mentioned situations value of goodwill is the resultant figure derived from
purchase consideration or cost of acquisition. Then this purchase consideration/cost of
acquisition cannot again be derived from the valuation of goodwill. This inconsistency can be
removed if we recognize that goodwill has no identity separable from the business and there
need be no separate valuation of goodwill. The valuation of business as a whole would
automatically include the value of goodwill. The fact that purchase consideration in excess of
net asset value of business taken over is recorded as goodwill also suggests that goodwill
value should not be a part of net asset value of business.
However, for the purpose of management information brand valuation and goodwill valuation
may be done by applying any of the alternative methods available although that may not be in
line with the requirements of Accounting Standards.
3.7 VALUATION OF GOODWILL

There are basically two accounting methods for goodwill valuation. These are - (i)
Capitalisation Method and (ii) Super Profit Method. A third method called annuity method is a
refinement of the super profit method of goodwill valuation.
3.7.1 Capitalisation method: Under this method future maintainable profit is capitalised
applying normal rate of return to arrive at the normal capital employed. Goodwill is taken as
the excess of normal capital employed over the actual capital employed.
Future ma int ainable profit
Normal Capital employed =
Normal rate of return
Goodwill = Normal Capital Employed – Actual Closing Capital Employed
Factors considered in this method are:
(i) Future maintainable profit;
(ii) Actual capital employed in the business enterprise for which goodwill is to be computed;
(iii) Normal rate of return in the industry to which the business enterprise belongs.
For example, Capital employed in X Ltd. is Rs. 17,00,000, future maintainable profit is
Rs. 3,00,000 and normal rate of return is 15%.
Rs.3,00,000
So goodwill = – Rs. 17,00,000 = Rs. 3,00,000
0.15
Naturally, if normal capital employed becomes less than actual capital employed there arises
negative goodwill.
It is to be noted that under Capitalisation method the actual capital employed is to be taken at
(closing) balance sheet date.
3.7.2 Super profit method: Excess of future maintainable profit over normally expected profit
Valuation 9.23
is called super profit. Under this method goodwill is taken as the aggregate super profit of the
future years for which such super profit is expected to be maintained.
Factors considered in this method are:
(i) Future maintainable profit;
(ii) Actual capital employed;
(iii) Normal rate of return;
(iv) Period for which super profit is projected.
Super profit = Future maintainable profit minus (Actual Capital employed ×
Normal rate of return)
Goodwill = Super profit × No. of years for which Super Profit can be maintained.
Example
Capital employed by X Ltd. Rs. 17,00,000, Future maintainable profit Rs.3,50,000, Normal rate
of return 15%, Super profit can be maintained for 5 years.
Future maintainable profit Rs. 3,50,000
⎡ 15 ⎤
Less: Normal Profit ⎢Rs.17,00,000 × Rs. 2,55,000
⎣ 100 ⎥⎦
Super Profit Rs. 95,000
Goodwill = Super profit × No. of years for which the super profit can be maintained.
= Rs. 95,000 × 5 = Rs. 4,75,000
3.7.3 Annuity method: It is a refinement of the super profit method. Since super profit is
expected to arise at different future time periods, it is not logical to simply multiply super profit
into number of years for which that super profit is expected to be maintained. Further future
values of super profits should be discounted using appropriate discount factor. The annuity
method got the nomenclature because of suitability to use annuity table in the discounting
process of the uniform super profit. In other words, when uniform annual super profit is
expected, annuity factor can be used for discounting the future values for converting into the
present value. Here in addition to the factors considered in super profit method, appropriate
discount rate is to be chosen for discounting the cash flows.
Example
Super Profit of X Ltd. Rs. 95,000 p.a. can be maintained for 5 years. Discount rate is 15%.
Goodwill = Rs. 95,000 × 3.352 = Rs. 3,18,440
There are atleast two frequently used approaches for arriving at the Capital employed: (i)
based on a particular Balance Sheet and (ii) average of Capital employed at different balance
sheet dates.
Capital employed is determined using historical cost values available at the balance sheet
date. However if revalued figures are given that should be considered.
3.8 DETERMINATION OF CAPITAL EMPLOYED

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

If long term fund approach is followed value of goodwill as per Capitalisation method is i.e.,
Rs.38.4 lakhs
− Rs.220 lakhs
0.18
Rs. 213.33 lakhs – Rs. 220 lakhs
i.e., (-) Rs. 6.67 lakhs, negative goodwill.
If shareholders’ fund approach is followed, value of goodwill as per capitalisation method is,
Rs.22.8 lakhs
- Rs.100 lakhs
0.20
Rs. 114 lakhs – Rs.100 lakhs
i.e., Rs. 14 lakhs, positive goodwill.
In this example, when long term capital employed was considered there was negative
goodwill, but it became positive when shareholders’ fund was considered. In the second
approach leverage advantage has been taken into consideration. Thus in goodwill valuation
generally shareholders’ fund approach is preferred.
Non-trading assets are ignored while computing capital employed. This is because surplus
fund invested outside does not influence the future maintainable profit. Particularly, Non-trade
investments are not counted while computing capital employed, but trade investments should
be taken into consideration.
Another important aspect is often discussed regarding valuation of capital employed. What
value should the accountant put for fixed assets and stock. Since historical cost is not true
indicator of the value of these assets, then it is suggested to take current cost of such assets.
Current cost represents the cost for which asset can be replaced at its present state.
However, if the asset cannot be replaced at its present state because of obsolescence, then
cost at which its best substitute is available may be taken as current cost.
Capital employed may be determined using the value given by the latest balance sheet or
taking simple average of the capitals employed at the beginning of the accounting period as
well as at the end.
Illustration 1
Balance Sheets of X Ltd.
As on 31st March 20X5 and 31st March 20X6
Liabilities 31.3.X5 31.3.X6 Assets 31.3.X5 31.3.X6
Share Capital 18,00 18,00 Sundry fixed Assets 24,00 26,00
General Reserve 6,00 6,00 Investments 1,00 2,00
Profit & Loss A/c 7,50 9,50 Stock 6,00 5,50

12% Debentures 2,00 2,00 Sundry Debtors 3,00 3,50
18% Term Loan 3,00 3,20 Cash and Bank 4,00 3,40
Cash Credit 1,20 80 Preliminary Expenses 70 10
Sundry Creditors 70 60
Tax Provision 30 40
38,70 40.50 38,70 40.50
Non-trade investments were 75% of the total investments. Find capital employed as on
31.3.X5 and as on 31.3.X6 and average capital employed.
Solution
Computation of capital employed
(Rs. in Lakhs)
31.3.X5 31.3.X6
Total Assets as per
Balance Sheet 38,70 40,50
Less: Preliminary Expenses 70 10
Non-trade Investments 75 1,50
145 160
37,25 38,90
Less: Outside Liabilities:
12% Debentures 2,00 2,00
18% Term Loan 3,00 3,20
Cash Credit 1,20 80
Sundry Creditors 70 60
Tax Provision 30 40
7,20 7,00
Capital employed 30,05 31,90
Rs.30.05 lakhs + 31.90 lakhs

Average capital employed =
2
= Rs. 30,97.50 Lakhs

Valuation 9.27
Illustration 2
Balance Sheet of AP Ltd. as on 31st March, 2006
Liabilities Rs. in Assets Rs. in
Lakhs Lakhs
Share Capital Land & Building 51,20
Equity Shares of Rs.10 each 90,00 Plant & Machinery 108,70
8½% Pref. Shares 20,00 Furniture 27,00
General Reserve 10,50 Vehicles 2,00
Profit & Loss A/c 30,00 Stock 7,00
18% Term Loan 45,00 Debtors 4,50
Cash Credit 5,80 Cash & Bank 23,40
Sundry Creditors 2,00 Preliminary Expenses 20
Provision for Taxation
(net of advance tax) 1,00
Proposed Dividend:
Equity 18,00
Preference 1,70 _____
224,00 224,00
Other information
(i) Balance as on 1.4.05
Profit and Loss A/c Rs. 4,80 Lakhs
Reserve Rs. 4,50 Lakhs
Find out average capital employed of AP Ltd.
Solution
Computation of Average Capital Employed
Rs.in Lakhs Rs.in Lakhs
Total of Assets as per Balance Sheet as on 31.3.2006 224,00
Less: Preliminary Expenses 20
223,80
Less: Outside Liabilities:
18% Term Loan 45,00
Cash Credit 5,80
Sundry Creditors 2,00
Provision for Taxation 1,00 53,80
Capital employed as on 31.3.06 170,00
Less: 1/2 of profit earned:

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

We have seen earlier while discussing various methods of goodwill valuation that estimation of
average maintainable profit is another important step in goodwill valuation. Future
maintainable profit is ascertained taking either simple or weighted average of the past profits
or by fitting trend line. Generally, profit of past three to five years are considered.
(i) Simple Average of Past Profits: If the past profits do not have any definite trend, average
is taken to arrive at the future maintainable profit.
Example
Profits of the past five years of XX Ltd. are given below:
Year ’000 Rs.
2006 71,20
2007 87,20
2008 75,70
2009 82,70
2010 78,90
In this case no trend of past profit is available. So simple average is best suitable method to
arrive at a figure which may be taken as future maintainable profit.
7,120 + 87,20 + 75,70 + 82,70 + 78,90
Future maintainable profit (Rs. in ’000) = = 79,14
5
(ii) Trend Equation: If the past profits show increasing or decreasing trend, linear trend
equation gives better estimation of the future maintainable profit.
Example
B K Ltd. gives the following profit figures for the last five years:
Year Profits
’000 Rs.
2006 37,20
2007 42,00
2008 47,50
2009 53,50
2010 57,20
Valuation 9.29
Since past profits show increasing trend, time series trend may be used to determine future
maintainable profit. Applying Linear trend equation three to five years profit may be predicted
and average of such future profits may be taken as future maintainable profit.
2
Year X Y XY X
2006 –2 37,20 –74,40 4
2007 –1 42,00 –42,00 1
2008 0 47,50 0 0
2009 1 53,50 53,50 1
2010 2 57,20 114,40 4
0 237,40 51,50 10
A=
∑Y = 237,40
=47,48
n 5
b=
∑ XY =
51,50
= 51,5
∑ XY 2
10
Trend Equation is given by:

Y = 4748 + 515 X
(iii) Weighted average of past profits: If the past profits show increasing or decreasing
trend, then more weights are given to the profit figures of the immediate past years and less
weight to the profit figures of the furthest past.
Example
Profits of the past five years of BB Ltd. are given below:
Year Profits
(’000 Rs.)
2006 71,20
2007 82,50
2008 87,00
2009 92,00
2010 95,00
In this example past profits showed an increasing trend. Weighted average of past profits may
be used in such cases to arrive at future maintainable profit.
Derivation of weighted average of the past profits:

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

∑ PW = 22,52,70
∑W 25
i.e. Rs. 9010.80 thousand.

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

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

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

Apart from capital employed and future maintainable profit, the third important step in
valuation of goodwill is determination of normal rate of return. It comprises of:
(i) the risk-free rate, i.e., the pure interest rate prevailing in the concerned economy; (the
rate of return on long term government securities or fixed deposit in bank may be taken
as risk-free rate)
(ii) the premium for business risks appropriate for the industry to which the firm/company
belongs.
Valuation 9.33
If the industry is well established and yielding profits steadily the rate of return that will satisfy
entrepreneurs will be rather low though higher than the risk- free rate. Higher the business
risk, higher will be the normal rate of return.
For practical purposes industry average return is taken as normal rate of return.
Illustration 4
On the basis of the following information, calculate the value of goodwill of Gee Ltd. at three
years’ purchase of super profits, if any, earned by the company in the previous four completed
accounting years.
Balance Sheet of Gee Ltd. as at 31st March, 2004

Liabilities Rs. in lakhs Assets Rs. in lakhs
Share Capital: Goodwill 310
Authorised 7,500 Land and Buildings 1,850
Issued and Subscribed Machinery 3,760
5 crore equity shares of Rs. Furniture and Fixtures 1,015
10 each, fully paid up 5,000 Patents and Trade Marks 32
Capital Reserve 260 9% Non-trading Investments 600
General Reserve 2,543 Stock 873
Surplus i.e. credit balance of Profit Debtors 614
and Loss (appropriation) A/c 477 Cash in hand and at Bank 546
Trade Creditors 568 Preliminary Expenses 20
Provision for Taxation (net) 22
Proposed Dividend for 2002-2003 750 _____
9,620 9,620
The profits before tax of the four years have been as follows:
Year ended 31st March Profit before tax in lakhs of Rupees
2000 3,190
2001 2,500
2002 3,108
2003 2,900
The rate of income tax for the accounting year 1999-2000 was 40%. Thereafter it has been
38% for all the years so far. But for the accounting year 2003-2004 it will be 35%.
In the accounting year 1999-2000, the company earned an extraordinary income of Rs. 1 crore
due to a special foreign contract. In August, 2000 there was an earthquake due to which the
company lost property worth Rs. 50 lakhs and the insurance policy did not cover the loss due
to earthquake or riots.
9% Non-trading investments appearing in the above mentioned Balance Sheet were
purchased at par by the company on 1st April, 2001.
The normal rate of return for the industry in which the company is engaged is 20%. Also note
that the company’s shareholders, in their general meeting have passed a resolution
sanctioning the directors an additional remuneration of Rs. 50 lakhs every year beginning from
the accounting year 2003-2004.
Solution
(1) Capital employed as on 31st March, 2004
(Refer to ‘Note’)
Rs. in lakhs
Land and Buildings 1,850
Machinery 3,760
Furniture and Fixtures 1,015
Patents and Trade Marks 32
Stock 873
Debtors 614
Cash in hand and at Bank 546
8,690
Less: Trade creditors 568
Provision for taxation (net) 22 590
8,100
(2) Future maintainable profit
(Amounts in lakhs of rupees)
1999-2000 2000-2001 2001-2002 2002-2003
Rs. Rs. Rs. Rs.
Profit before tax 3,190 2,500 3,108 2,900
Less: Extra-ordinary income due to
foreign contract 100
Add: Loss due to earthquake 50
Less: Income from non-trading
investments 54 54
3,090 2,550 3,054 2,846
Valuation 9.35
As there is no trend, simple average profits will be considered for calculation of goodwill.
Total adjusted trading profits for the last four years = Rs. (3,090 + 2,550 + 3,054 + 2,846)
= Rs. 11,540 lakhs
Rs. in lakhs
⎛ Rs. 11,540 lakhs ⎞
Average trading profit before tax = ⎜ ⎟ 2,885
⎝ 4 ⎠
Less: Additional remuneration to directors 50
2,835
Less: Income tax @ 35%(approx.) 992 (Approx)
1,843
(3) Valuation of Goodwill on Super Profits Basis
Future maintainable profits 1,843
Less: normal profits (20% of rs. 8,100 lakhs) 1,620
Super profits 223
Goodwill at 3 years’ purchase of super profits = 3 x Rs. 223 lakhs = Rs. 669 lakhs
Note: In the above solution, goodwill has been calculated on the basis of closing capital
employed (i.e. on 31st March, 2004). Goodwill should be calculated on the basis of ‘average
capital employed’ and not ‘actual capital employed’ as no trend is being observed in the
previous years’ profits. The average capital employed cannot be calculated in the absence of
details about profits for the year ended 31st March, 2004. Since the current year’s profit has
not been given in the question, goodwill has been calculated on the basis of capital employed
as on 31st March, 2004.
3.11 BRAND VALUATION

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

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

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

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

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

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

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

Intangibles are not easily measurable and it poses severe challenges in valuation of brands
also. Some of the difficulties faced by the accountants in brand valuation are as follows:
1. Distinctiveness:
Brands need to be valued distinctively as different from other intangibles such as
Goodwill etc. For instance, any attempt to commonly treat brand as a part of Goodwill as
is done at present may create serious distortions in accounting position. Besides, this
would create handicaps in brand accounting. This is because, a brand cannot be treated
like any other item such as patents and copyrights. In fact, a brand needs to be
separately disclosed in the Balance sheet, because of its significant contribution to
corporate image and identity.
2. Disclosure:
There is always a problem of making disclosure of brand values in financial statements.
This is because, there is no standard accounting practice requiring statement and
disclosure of brand values in a particular way.
3. Uncertainty:
The problem that is associated with the brand, as an item of intangibles, is that its
possible returns are uncertain, immeasurable and non-current in nature. Any expected on
such intangibles are usually either written off or treated as Deferred Revenue
Expenditure.
4. The Dilemma:
Another area of challenge posing brand accounting is whether to amortise or capitalise
the value of brand. There is no question of amortising brand values as either the
economic life of the brand cannot be determined in advance or its value depreciates over
time. In fact, it is “to be noted that a brand can be purchased or generated and
maintained, thus enhancing the corporate future income earnings capacity. The
challenge could, however, be overcome by categorising the brand expenditure into
Maintenance and Investment. Whereas the maintenance expenditure could be charged to
Profit and Loss Account and the Capital Expenditures be shown in the Balance Sheet
and where the brand value is shown separately and explicitly in the Balance Sheet, the
leverage position of the company can be shown enhanced.
5. No Market:
The prevailing practice is that the intangibles are not required to be revalued according to
some accounting standards on account of the non-existence of an active secondary
market for them. In fact, the need for brand accounting arises mainly on account of
conditions warranted by acquisition and merger.
6. New Brands:
A related problem, in accounting for such intangibles as brands is that it is often difficult
to determine whether a new one is being gradually substituted for an existing brand. This
raises the issue as to how to account for it in subsequent years. In such case, the
relevant question is: Should the original cost of brand be written-down as it erodes? It
may be difficult to determine whether a brand remains the same asset overtime as it is
subtly reshaped to meet new market opportunities.
7. Joint Costs:
The contribution to the value of a brand is made not simply by investing a desirable
product with a customer seductive name, but by building market share by the skilful
exploitation of the product in a whole host of ways of general efficiency with which a
business is conducted by expending money on a joint cost basis. It is very difficult to
segregate and account for joint costs that are incurred and the cost of brand developed
as a result of general operations of the business.
3.17 VALUATION OF BRANDS

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

A purchased brand is one, which is acquired from other existing concerns. The acquiring
company may acquire only the brand name(s). The value of acquired brands is given below:
Brand value = Price paid for acquisition
On the other hand, a company may acquire an existing business concern along with its
brands. These are the cases of business mergers and amalgamations. The sum involved in
these transactions provides an indication of the financial value of the brands. At the maximum
this value is equal to the difference between the price and the value of the net assets
indicated on the acquired company’s balance sheet.
Brand value = Purchase consideration - Net assets taken over
However, it is questionable to say that the excess price paid always represents the brand
value. The excess is only an amount of purchased goodwill and the acquiring company may
have paid the excess price for varied factors also, location of the factory, long term contracts
with suppliers, better employee morale, better manufacturing technology etc. besides for
brands.
It would be difficult to say what part of the excess price paid is attributable to brands. Besides,
the price r payable is always decided by forces of demand and supply conditions of mergers
and amalgamations I market. Competitive force may make the acquirer to increase the bid
price thereby increasing the amount I Of purchased goodwill. This inseparability of brand from
other intangible assets makes it difficult to value the brands.
Valuation of Self-generated Brands
Several approaches have been evolved over a period of time for determining the brand
values. The important methods in valuation of self-generated brands are discussed below:
Historical Cost Model –
According to this approach, the valuation of a brand is determined by taking into account the
actual expenses incurred in the creation, maintenance and growth of corporate brands. The
value of the brand computed as follows:
Brand value = Brand Development Cost + Brand Marketing and Distribution Cost + Brand
Promotion Costs including advertising and other costs.
The historical cost method is specifically applicable to home-grown brands for which various
costs like development costs, marketing costs, advertising and general communication costs
etc. are incurred. The sum total of all these costs would represent the value of brands.
However, the entire advertisement costs cannot be regarded as incurred for brand. Further,
several heavily advertised brands today show hardly any value or presence.
The chief advantage of this model is that the various types of costs that are actually incurred
are considered. This facilitates easy computation of brand values. However, it does not
explain the impact of brand value on the profitability of a firm.
Replacement Cost Model-
Under this model, the brands are valued at the costs, which would be required to recreate the
existing brands. The method is based on the assumption that the existing brands can be
recreated exactly by new brands. It is the opportunity cost of investments made for the
replacement of the brand.
Brand value = Replacement Brand Cost
The main disadvantage with this model is that this model gives an estimation of brand value
but it is near impossible to replace the existing brands by new brands. Further, such values
are only subjective ones.
Market Price Model-
The probable value that a company would get for sale of its brands is taken as the value of the
brands under this model. Therefore, the brand value is given by:
Brand value = Net Realisable Value
However, this value is only an assumed value because there exist no ready-made market for
many brands. Further, brands are created or bought by corporate not for sale or resale. Value
payable by the purchaser depends upon the benefits expected from the purchase of brand.
But the method determines the value from the seller’s point of view.
Current Cost Model-
According to this approach, the current corporate brands are valued at the current value
(current costs) to the Group, which is reviewed annually and is not subject to amortisation.
This basis of valuation ignores any possible alternative use of brand, any possible extension
to the range of products currently marketed under a brand, any element of hope value and any
possible increase in value of a brand due to either a special investment or a financial
transaction (e.g. licensing) which would leave the Group with different interest from the one
being valued.
Potential Earning Model –
The Potential Earnings (PE) model is based on the estimated potential earnings that would be
generated by a brand and their capitalisation by using appropriate discount rate, the volume of
revenues raised by a brand in the market, determines its value. Accordingly, the value of a
brand at any one point of time is given by:
Total Market value of brand = Net Brand Revenue/Capitalisation Rate,
Valuation 9.43
Where
Net Brand Revenues = (Brand units × Unit brand price) - (Brand units × Unit brand
cost) (Marketing cost + R & D cost + Tax costs).
Though the model sounds objective, problem lies in ascertaining the actual marketing cost
incurred for I particular brand of a product. Moreover, it is difficult to select an appropriate
capitalisation rate.
Present Value Model –
According to present value model, the value of a brand is the sum total of present value of
future estimated flow of brand revenues for the entire economic life of the brand plus the
residual value attached to the brand. This model is also called Discounted Cash Flow model
which has been wisely used by considering the year wise revenue attributable to the brand
over a period of 5, 8 or l0 years. The discounting rate is the weighted average capital cost, this
being increased where necessary to account the risks arising out of a week brand. The
residual value is estimated on the basis of a perpetual income, assuming that such revenue is
constant or increased at a constant rate.
Rt Re sidual value
Brand value = +
(1 + r ) t
(1 + r )N
Where,
R1 = Anticipated revenue in year t, attributable to the brand.
t = Discounting rate
Residual value beyond year N
Brands supported by strong customer loyalty, may be visualised as a kind of an ‘annuity’,
since, mathematically, an annuity is a series of equal payments made at equal intervals of
time. Brands backed Body the loyalty of hard-core customers offer strong probability of having
steady long-term incomes. Great care must be taken to estimate as much correctly as
possible, the future cash flow likely to emanate from a strongly positioned specific brand. A
realistic present value of a particular brand having strong loyalty of customers can thus be
obtained from summation of discounted values of the expected future incomes from it.
The DCF model for evaluating brand values has got three sources of failure: (i) Anticipation of
cash flow, (ii) Choice of period, and (iii) Discounting rate.
Sensitivity Model –
According to this approach, the brand revenues are determined as a functional inflow of such
market factors as level of awareness of brand (AB), level of customer influence P) and level of
brand autonomy (BA) in the market, all these factors in the first place predominating the sales
revenues and then the brand revenues or the brand value. In other words, sensitivity of each
of the above forces determines the brand value.

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

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

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

The brand valuation models lay emphasis on methods of ascertaining the ‘Brand Strength’
product or service of a corporate entity, which is defined as the sum total of all benefits flowing
from different dimensions of a brand such as quality of market leadership (ML) of the brand,
relative stability* of market (SM) enjoyed by the brand, the extent of market share (MS) of the
brand, the levels oi’ international acceptance (IA) of the brand, ability of the brand to meet the
changing modern marketing trends (MT), the extent of strategic support (SS) provided by the
brand to the corporate’s survival and growth, competitive strength (CS) offered by the brand
and above all the legal and social brand protection (BP). The composition of corporate brand
strength is shown in the following figure
Thus, the brand value/strength can be stated as follows:
Brand value = (ML + MS + SM + IA + MT + SS + CS + BP)
1. Define goodwill. Distinguish between purchased goodwill and inherent goodwill.
2. Discuss briefly the contributing factor of goodwill.
3. Discuss with examples various methods of goodwill valuation.
4. How do you find out capital employed for goodwill valuation? Would you prefer ‘long
term fund’ approach to ‘shareholders’ fund’ approach?
5. Given below the assets and liabilities of X Pro Y Pro Ltd. as on 31st March
2004 2005 2006
Assets: (Rs. in lacs)
Sundry Fixed Assets:
Gross Value 15,29 17,22 19,21
Less: Accumulated depreciation 4,25 5,10 6,10
11,04 12,12 13,11
Investments:
Trade 1,12 1,27 1,40
Non-trade 85 1,12 1,40
Current Assets 7,15 10,15 11,12
Misc. Expenditure 25 20 15
20,41 24,86 27,18
Liabilities:
Share Capital and Reserves 9,46 10,41 9,91
12% Debentures 5,50 7,50 9,50
18% Term loan 2,50 3,00 3,50
Cash credit 1,00 80 60
Sundry creditors 75 1,85 2,12
Provision for taxation (net of advance tax) 40 50 55
Proposed dividend 80 80 1,00
20,41 24,86 27,18
Find out average capital employed.
6. Current cost of capital employed Rs. 10,40,000
Profit earned after current cost adjustments Rs. 1,72,000
20% Long term loan Rs. 4,50,000
Normal rate of return:
Equity capital employed 22%
Long term capital employed 25%
Find out leverage effect on the value of goodwill.
7. Given future maintainable profit Rs. 15 lacs
Capital employed Rs. 60 lacs
Normal rate of return 22%
Find out value of goodwill. Super profit can be maintained for 5 years.
8. Define Brands. What is the need for their valuation.
9. Discuss some of the important methods of brand valuation.
Valuation 9.49
UNIT 4
VALUATION OF LIABILITIES
4.1 INTRODUCTION
Proper valuation of all assets and liabilities is required to ensure true and fair financial position
of the business entity. In other words, all matters which affect the financial position of the
business has to be disclosed. Under- or over-valuation of liabilities may not only affect the
operating results and financial position of the current period but will also affect theses for the
next accounting period The present unit deals with different principles involved in the valuation
of different types of liabilities.
4.2 BASE OF VALUATION

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

The liability items of the balance sheet are generally carried at the settlement values. However
for shares and debentures if the book value is measured including the premium or loss on
issue, that comprehensive book value should match with the historical cost value. For certain
items like income received in advance, liability for tax the historical cost basis is generally
applicable. In such cases the historical cost and settlement value should be similar. Liabilities
may be carried at the present value in case of finance lease.
4.4 LEASES
In case of a finance lease, the lessee should recognize a liability equal to the fair value of the
leased asset at the inception of the lease.
If the fair value of the leased asset exceeds the present value of the minimum lease payments
from the standpoint of the lessee, the amount recorded as an asset and a liability should be
the present value of the minimum lease payments from the standpoint of the lessee. In
calculating the present value of the minimum lease payments the discount rate is the interest
rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental
borrowing rate should be used. (AS 19 Para 11)
4.5 PROVISIONS
In regard provision, the valuation is based on settlement value and not on present value. AS
29 stated in Para 35 that the amount recognised as a provision should be the best estimate of
the expenditure required to settle the present obligation at the balance sheet date. The
amount of a provision should not be discounted to its present value.
Valuation 9.51
UNIT 5
VALUATION OF SHARES
5.1 INTRODUCTION
The considerations governing share valuation are varied, intricate and numerous of which
some are accounting and others non-accounting; some are objective, others are subjective.
As a result, very often accountants fail to come to agreement on the valuation to be placed on
shares. Valuation calls for judicious assessment of the rights, advantages, interests,
expectations, hazards and difficulties of the parties involved in it, having conflicting interests.
If the purpose of valuation is known, the valuer should arrive at the same value whether he is
appointed by the seller or the buyer. However, the valuer’s approach to the question is
influenced by the purpose for which the valuation is requested. For example, though the
underlying principles are the same, a valuer may apply them in a liberal way in cases of
valuation for compensation purposes, while a more conservative test may be applied in
valuation for tax-purposes.
5.2 PURPOSES OF VALUATION

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

Valuation by an expert is generally called for when parties involved in the
transaction/deal/scheme, etc. fail to arrive at a mutually acceptable value or agreement or
when the Articles of Association etc. provide for valuation by experts. For transactions
concerning relatively small blocks of shares which are quoted on the stock exchange,
generally the ruling stock exchange price (average price) provides the basis. But valuation, by
a valuer becomes necessary when:
(i) shares are not quoted;
(ii) shares relate to private limited companies;
(iii) the court so directs;
(iv) Articles of Association or relevant agreements so provide;
(v) a large block of shares is under transfer; and
(vi) statutes so require (like Wealth Tax, Gift Tax Acts).
5.4 LIMITATION OF STOCK EXCHANGE PRICE AS A BASIS FOR VALUATION

A rough classification of buyers at the stock exchange may be made as: (a) informed or
analytical investors; (b) informed speculators; and (c) the un-informed. Similarly, a rough
classification of sellers is: (a) informed; and (b) those with an urgent need to sell. It is
sufficient to say that in a stock exchange numerous people collect-some to deal, some to
watch and some to rig. Consequently, depending on the motivation they react and the result of
such reactions come out as the market price, which is partly an outcome of reasoned
investments or sales policy, partly embodying the effect of speculative motives. Thus it is not
reasonable to use stock exchange price as share value - one should consider other factors
too. The Council of the London Stock Exchange has opined: “We desire to state
authoritatively that stock exchange quotations are not related directly to the value of a
company’s assets, or to the amount of its profits and consequently these quotations, no matter
what date may be chosen for reference, cannot form a fair and equitable, or rational basis for
compensation. The stock exchange, does not determine the prices of which the official list is
the record. The stock exchange may be likened to a scientific recording instrument which
registers, not its own actions and opinions, but the actions and opinions of private and
institutional investors all over the country and, indeed the world. These actions and opinions
are the results of hope, fear, guesswork, intelligent or otherwise, good or bad investment
policy and many other considerations. The quotations that result definitely do not represent a
valuation of a company by reference to its assets and its earning potential”.
On a summarisation, it may be stated that stock exchange price is mostly determined by bull
and bear effects rather than fundamental factors like net assets, earnings, yield, etc. Stock
exchange price is basically determined on the inter-action of demand and supply and may not
reflect a true value of shares.
Factors: Two factors stand out to be basically important: assets employed and the profit
earned; mostly both are considered. The following has general acceptance:
(i) For a company destined to be liquidated, assets will constitute the basis for valuing the
shares of the company.
Valuation 9.53
(ii) Where assets play a relatively unimportant role, for example in the case of professional
practice of architects and engineering consultants, valuation may depend wholly on the
earning capacity.
(iii) Earning power and assets both may be considered in valuation of the shares of a going
concern, earning power playing a major role while assets are considered only to indicate
safety margin i.e. asset backing.
5.5 METHODS
Principally two basic methods are used for share valuation; one on the basis of net assets and
the other on the basis of earning capacity or yield (which, nevertheless, must take into
consideration net assets used).
5.5.1 Net Asset Basis: According to this method, value of equity share is determined as
follows:
Net assets available to equity shareholders
Number of equity shares
The following important aspects are to be considered while arriving at the net assets available
to the equity shareholders:
(i) Value of tangible fixed assets: Tangible fixed assets like plant, machinery, building, land,
furniture, etc. should be taken at their current cost. Current cost implies current entry
price, i.e., the price to be paid by the enterprise if it wants to acquire such assets at their
present locations and conditions.
(ii) Value of intangibles: Intangibles like goodwill, patents and know-how should also be
taken at their current cost. Inherent goodwill is not shown in the books of accounts. For
asset based valuation of share, valuation of goodwill is essential and valuation should be
made following any of the methods (depending upon the circumstances) discussed in
Unit 3. If purchased goodwill appears in the books of account it should be eliminated and
new valuation should be taken into consideration.
(iii) Investments: Shares and securities which are quoted in the stock exchange and traded
on a regular basis, market price of them should be used as current value of investments.
For other investments book value may be taken after adjustments for known loss or gain.
(iv) Inventories : The stock of finished goods may be taken at the market price. But other
stocks like raw material, stores and work-in-progress should be taken at cost following
conservative approach. Due allowance should be made for any obsolete, unusable or
unmarketable stocks held by the company.
(v) Sundry Debtors: Appropriate allowance should be made for bad and doubtful debts.
(vi) Development expenses: These arise (i) in the case of a new company, when it is in the
process of executing its project and (ii) in the case of an old company, when either there
is an expansion of the existing production lines or diversifications with a view to entering
new lines.
Such expenses generally appear in the balance sheet as Capital Work-in-Progress. It

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

(iii) Finding out the capitalisation factor or the multiplier;
(iv) Multiplying the future maintainable profit, by the multiplier; and
(v) Dividing the results obtained in (iv) by the number of shares.
Determination of the normal rate of return and capitalisation factor: This obviously has
tremendous bearing on the ultimate result but, unfortunately, it is subjective and therefore,
valuers differ more widely in this area than in any other in the whole valuation process. As a
general rule, the nature of investment would decide the rate of return. Companies, investment
in which is more risky, would call for a higher rate of return and consequently they will have
lower capitalisation factor and lower valuation than companies with assured profits. For
investment in government securities, the risk is least and consequently, the investor would be
content with a very low rate of return. In a logical order, we find that mortgage debentures,
being riskier than government paper, require slightly higher rate of return. Preference shares
are less risky than equity shares but more risky than mortgage debentures; preference shares
rank in between debentures and equity shares in the matter of rate of return. Equity shares
are exposed to the highest risk and, consequently, the normal rate of return is highest in the
case of equity shares, though, in the case of equity shares of progressive and efficiently
managed companies, such a risk is rather low. In fact, shares of such companies provide a
safeguard against inflation - equity share prices are likely to rise sufficiently high to counteract
the effect of a rise in prices.
The above also applies to companies and industries–the normal rate of return will always
depend on the attendant risk. In this respect, net tangible asset backing is also relevant. The
higher the net tangible asset backing for each share, the greater would be the confidence of
the investor. Normally 1.5 to 2 times backing is considered satisfactory. This ratio should be
reviewed carefully to ascertain whether shares are adequately covered or too much covered
which may indicate over-capitalisation in the form of idle funds or inadequate use of productive
resources. Symptoms suggesting idle assets would be holding of large cash and bank
balances, high current ratio, unutilised land and machinery, etc. The normal rate of return
should be increased suitably in either case.
Adjustment necessary for the determination of future maintainable profit : Determination of
future maintainable profits, based on past record, is a delicate and complicated task as it
involves not only objective consideration of the available financial information but also
subjective evaluation of many other factors, such as capabilities of the company’s
management, general economic conditions, future government policies, etc. Guiding principles
can be laid down only in respect of the former and the valuer will have to give due
consideration to the other matters according to his reading of the situation in each individual
case. The steps necessary to arrive at the future maintainable profits of a company are: (a)
calculation of past average taxed earnings, (b) projection of the future maintainable taxed
profits, and (c) adjustment of preferred rights.
Calculation of past average earnings: In order to calculate the past average earnings, it is
necessary to decide upon the number of years whose results should be taken for averaging:
select the years and adjust their profits to make them acceptable for averaging.
The number of years to be selected must be large enough so as to cover generally the length
of a business cycle, as an average for a shorter period might not be suitable. But it should not
go too far back: results in the early 80’s may have bearing on the results expected in the 90’s.
In inflationary conditions, that are present today, it is considered that a relatively short period
may be more representative since it reveals more recent results. Similarly, for companies
having steady growth, average of a rather short period, is more useful. In some unusual
circumstances, average of a still shorter period, even only one year’s profit may be more
significant in estimating future earning, such as where a change in the business or a change in
trading conditions forces the valuer to discard all earlier years and to rely upon the current
year only or to select certain normal years and exclude others. In all these matters, a sound
reasoning would alone aid the valuer. Whether a 3-yearly, 5- yearly or longer average would
reflect the correct future earnings of a company depend upon the nature of concerned
industry.
The following are some items which generally require adjustment in arriving at the average of
the past earnings:
(i) Elimination of material non-recurring items such as loss of exceptional nature through
strikes, fires, floods and theft, etc., profit and loss of any isolated transaction not being
part of the business of the company, Lump-sum compensation or retiring allowances and
cost in legal actions, abnormal repair charges in a particular year, etc.
(ii) Elimination of income and profits and losses from non-trading assets.
(iii) Elimination of any capital profit or loss or receipt or expense included in the profit and
loss account.
(iv) Adjustment for any interest, remuneration, commission, etc., foregone or overcharged by
directors and any other managerial personnel.
(v) Adjustment for any matters suggested by notes, appended to the accounts, or by
qualification in the auditor’s report such as provisions for taxation and gratuities, bad
debts, under or over provision for depreciation, inconsistency in the valuation of stocks,
etc.
(vi) Taxation: The tax rates may be such as were ruling for the respective years or the latest
ruling rate may be deducted from the average profit. However, the consensus of opinion
is for adjusting tax payable rather than tax paid because so many short- term reliefs and
tax holidays might have temporarily reduced the effective tax burden.
(vii) Depreciation: It is a significant item that calls for careful review. The valuer may adopt
book depreciation provided he is satisfied that the rate was realistic and the method was
suitable for the nature of the company and they were consistently applied from year to
year. But imbalances do arise in cases where consistently written down value method
Valuation 9.57
was in use and heavy expenditure in the recent past has been made in rehabilitating or
expanding fixed assets, since the depreciation charges would be unfairly heavy and
would prejudice the seller. Under such circumstances, it would be desirable to readjust
depreciation on a straight line basis to bring a more equitable charge on the profits meant
for averaging.
In averaging past earnings, another important factor comes up for consideration and that is
the trend of profits earned. It is indeed imperative that estimation of maintainable profits be
based on the only available record, i.e., the record of past earnings. But indiscreet use of past
results may lead to an entirely fallacious and unrealistic result. In this regard, three situations
may have to be faced. Where the past profits of a company are widely fluctuating from year to
year, the average fails to aid future projection. In such cases, a study of the whole history of
the company and of earnings of a fairly long period may be necessary. If the profits of a
company do not show a regular trend upward or downward, the average of the cycle can
usefully be employed for projection of future earnings. In some companies, profits may record
a distinct rising or falling trend, from year to year; in these circumstances, a simple average
fails to consider the significant factor, namely trend in earning. The share of a company which
records a clear upward trend of past profits would certainly be more valuable than that of a
company whose trend of past earnings indicate a static or down-trend. In such cases, a
weighted average, giving more weight to the recent years than to the past, is appropriate. A
simple way of weighting is to multiply the profits by the respective number of the years
arranged chronologically so that the largest weight is associated with the most recent past
year and the least for the remotest (If net worth is under consideration, the respective years’
average net worth may be weighted in a similar way). However, if the profits have been
consistently coming down, even weighted average may be misleading-fitting a trend line may
be more appropriate.
Projection of future maintainable taxed profits: Projection is more a matter of intelligent guess
work since it is essentially an estimation of what will happen in the risky and uncertain future.
The average profit earned by a company in the past could be normally taken as the average
profit that would be maintainable by it in the future, if the future is considered basically as a
continuation of the past. If future performance of the company is viewed as departing
significantly from the past, then appropriate adjustment will be called for before accepting the
past average profit as the future maintainable profit of the company. The factors requiring
consideration may be as stated below:
(i) Discontinuance of a part of the business;
(ii) Under-utilisation of installed capacity;
(iii) Expansion programmes;
(iv) Major change in the policy of the company; and
(v) Adjustment for rehabilitation and replacement.
In arriving at the average profits and their future projection all charges including interest
on debentures and other borrowings are deducted. But the dividend on preference
shares depends upon the availability of divisible profits and, therefore, should be
considered after the estimate of future profits has been arrived at. Dividends payable to
preference shareholders, according to the terms of their issue, should be deducted from
the maintainable profit.
5.5.3 Factors having a bearing on valuation: In addition to what has already been stated,
consideration of the following factors is also necessary in a valuation:
(a) Nature of industry, its history and risks to which it is subject;
(b) Prospects of the industry in the future;
(c) The company’s history-its past performance and its record of past dividends;
(d) The basis of valuation of assets of the company and their value;
(e) The ratio of liabilities to capital;
(f) The nature of management and chance for its continuation;
(g) Capital structure or gearing;
(h) Size, location and reputation of the company’s products;
(i) Incidence of taxation;
(j) The number of shareholders;
(k) Yield on shares of companies engaged in the same industry, which are listed on the
stock exchanges;
(1) Composition of purchasers of the products of the company; and
(m) Size of the block of shares offered for sale since, for large blocks, very few buyers would
be available and that has a depressing effect on the valuation. Question of control,
however, may become important when large blocks are involved.
Special Factors: Valuation of equity shares must take note of special features in the company
or in the particular task. These are briefly stated below:
(a) Importance of the size of the block of shares: Valuation of the identical shares of a
company may vary quite significantly at the same point of time on a consideration of the
size of the block of shares under negotiation. It is common knowledge that the holder of
75% of the voting power in a company can always alter the provisions of the articles of
association to suit himself; a holder of voting power exceeding 50% and less than 75%
can substantially influence the operations of the company even to alter the articles of
association or comfortably pass a special resolution.
Even persons holding much less than 50% of the total voting strength in a public limited
company may control the affairs of the company, if the shares carrying the rest of the
voting power are widely scattered; such shareholders rarely combine to defeat a
determined block. Usually a person holding 50% of the total voting power is in a position
Valuation 9.59
to have his way in the company, even to change the provision of the articles of
association or pass any special resolution. A controlling interest, according to most
authorities, carries a separate substantial value.
(b) Restricted transferability: Along with principal consideration of yield and safety of capital,
another important factor is easy exchangeability or liquidity. Shares of reputed
companies generally enjoy the advantage of easy marketability which is of great
significance to the holder. At the time of need, he may get cash in exchange of shares
without being required to hunt out a willing buyer or without being required to go through
a process of protracted negotiation and valuation. Generally, quoted shares of good
companies are preferred for the purpose. On the other hand, holders of shares of
unquoted public companies or of private companies do not enjoy this advantage;
therefore, such shares, however good, are discounted for lack of liquidity at rates which
may be determined on the basis of circumstances of each case. The discount may be
either in the form of a reduction in the value otherwise determined or an increase in the
normal rate of return. Generally, the articles of private companies contain provision for
offering shares to one who is already a member of the company and this necessarily
restricts the ready market for the shares. These are discounted for limited transferability.
But exceptions are also there; by acquisition of a small block, if one can extend his
holding in the company to such an extent as to effectively control the company, the share
values may not be discounted in that case.
(c) Dividends and Valuation: Generally, companies paying dividends at steady rates enjoy
greater popularity and the prices of their shares are high while shares of companies with
unstable dividends do not enjoy confidence of the investing public as to returns they
expect to get and, consequently, they suffer in valuation. For companies paying
dividends at unsteady rates, the question of risk also becomes great and it depresses the
price. The question of risk may be looked upon from another angle. A company which
pays only a small proportion of its profits as dividend and thus builds up reserves is less
risky than the one which has a high pay out ratio. The dividend rate is also likely to
fluctuate in the latter case. Investors, however, do not like a company whose pay-out
ratio is too small.
Shares are generally quoted high immediately before the declaration of dividend if the
dividend prospect is good; or immediately after the declaration of dividend to take care of
the dividend money that the prospective holder would get.
(d) Bonus and Right Issue: Shares values have been noticed to go up when bonus or right
issues are announced, since they indicate an immediate prospect of gain to the holder
although in the ultimate analysis, it is doubtful whether really these can alter the
valuation. Bonus issues are made out of the accumulated reserves in the employment of
the business. Such shares in no way contribute to the increased earning capacity of the
business and ultimately depress the dividend rate since the same quantum of profit
would be distributed over a large number of shares which in turn also would depress the
market value of the shares. A progressive company may sometimes pick up the old rate
of dividend after a short while but this is in no way a result of the bonus issue; it is the
contribution of natural growth potential of the company. Good companies, however, try to
maintain the rate of dividend even after the bonus issue. In such a case, the total
holdings of shareholders will increase in value.
In the case of right issues, existing holders are offered shares forming part of a new issue;
more funds flow into the company for improving the earning capacity. Share value will
naturally depend on the effectiveness with which new funds will be used.
5.5.4 Mean between asset and yield based valuation: This is, in fact, no valuation, but a
compromise formula for bringing the parties to an agreement. This presents averaging two
results obtained on quite different basis. It is argued that average of book value and yield
based value incorporates the advantages of both the methods. That is why such average is
called the fair value of share.
5.6 STATUTORY VALUATION

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

Share Capital -
1,50,000 Equity Shares of Rs.10 each 15,00 Sundry Fixed Assets 22,00
2,00,000 Equity Shares of Rs. 10 Investments 4,00
Valuation 9.61
each Rs. 6 paid up 12,00 Stock 8,00

9% Cum Pref. Shares 6,00 Debtors 4,00
18% Term Loan 14,00 Cash & Bank 4,00
Sundry Creditors 8,00 P & L A/c 13,00
55,00 55,00
Other Information:
(1) Current Cost of Sundry Fixed Assets Rs. 37,00 thousand and stock Rs.10,00 thousand,
(2) Investments could fetch only Rs. 100 thousand,
(3) 50% debtors are doubtful,
(4) Preference dividend was in arrear for the last five years.
Find out the intrinsic value per share of John Engg. Ltd.
Solution
(i) Net assets available to the equity shareholders
Amount in Rs.’000
Sundry fixed assets 37,00
Investments 1,00
Stock 10,00
Debtors 2,00
Cash & Bank 4,00
54,00
Less: Outside liabilities & 9% cumulative pref shares:
18% Term Loan 14,00
9% Cumulative Pref. Shares 6,00
Arrear Pref. Dividend 2,70 30,70
Net Assets 23,30
(ii) Valuation of Equity Shares
Net assets as per (i) above 23,30
Add: Notional call on 2,00,000 partly paid up equity shares @ Rs. 4 each 8,00
31,30
Number of equity shares 350 thousand
Value per fully paid up equity share = Rs. 31,30thousand / 3,50thousand = Rs.8.94
Value per partly paid up equity share = Rs. 8.94 – Rs. 4 = Rs. 4.94
Illustration 2
Balance Sheet of Mcneil Ltd.
as on 31.12.06
(Figure in ‘000 Rs.)
Share Capital Sundry fixed assets 280,20
5,00,000 Equity Shares Investments in subsidiaries 60,40
of Rs. 10 each fully paid up 50,00 Other non-trade investments 50,00
8,00,000 Equity Shares Stock 80,60
of Rs. 10 each Rs. 8 paid up 64,00 Debtors 80,40
10,00,000 Equity Shares Advances 50,60
of Rs. 5 each fully paid up 50,00 Cash & Bank 16,60
Share suspense A/c 20,00 Preliminary expenses 40
General reserve 102,00
P & L A/c 84,00
13% Debentures 60,00
(50% Convertible at the
beginning of next year)
18% Term Loan 40,00
Sundry creditors 20,00
Tax Provision 80,00
Proposed dividend 49,20 _____
619,20 619,20
Other Information:
(1) Profit before tax (and before deducting interest on convertible debentures) of Mcneil Ltd.
for the last five years were as follows (’000 Rs.): 2002 – 132,00, 2003 – 244,00, 2004 –
274,00, 2005 – 315,00, 2006 – 332,00.
(2) Non-trade investments earned @ 20% on an average.
(3) Expected increase in expenditure without commensurate increase in selling price Rs.
60,000.
(4) Annual R & D expenses in future Rs. 1,00,000.
(5) Expected foreign currency loss in future (annualised) Rs.120,000.
(6) Expected tax rate 45%. Tax rate in 2006: 52%
(7) Normal return 15% (on the basis of closing capital employed)
Required:
(1) Find out intrinsic value for different categories of equity shares. For this purpose goodwill
may be taken as 3 years’ purchase of super profit.
Valuation 9.63
(2) Value of share as per dividend yield. Normal dividend in the industry is 18%.
(3) Value of share as per EPS. Average EPS is Rs. 3 for Rs. 10 share.
Solution
Calculation of intrinsic value of equity shares of Mcneil Ltd.
1. Calculation of Goodwill:
Rs. in ’000 Rs. in ’000
(i) Capital Employed:
Total of asset side of the Balance-Sheet 6,19,20
Less: Preliminary expenses 40
Non-trade investment 50,00 50,40
5,68,80
Less: Outside liabilities:
Sundry creditors 20,00
18% Term loan 40,00
Tax provision 80,00
13% Debenture – net of conversion 30,00 1,70,00
Capital employed 3,98,80
(ii) Future Maintainable Profit:
Year Profit Before Tax Weight Product
(in ’000 Rs.) (in ’000 Rs.)
2002 1,32,00 1 1,32,00
2003 2,44,00 2 4,88,00
2004 2,74,00 3 8,22,00
2005 3,15,00 4 12,60,00
2006 3,32,00 5 16,60,00
15 43,62,00
Rs. in ’000 Rs. in ’000
Weighted average profit before tax = 43,62,00 /15 2,90,80
Less : Income from non-trade investments 10,00
Expected increase in expenditure 60
Annual R & D expenses 1,00
Expected increase in
Foreign currency liability 1,20 12,80
2,78,00
Less : Tax @ 45% 1,25,10
Expected Profit After Tax 1,52,90
(iii) Normal Return:

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

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

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

7.68
Rs. X Rs. 10 = Rs. 25.6
3
Value per share of Rs. 5 fully paid up

4.8
Rs. X Rs. 10 = Rs. 16
3
Illustration 3
From the following figures calculate the value of the share of Rs.100 on (i) yield on
capital employed basis, and (ii) dividend basis, the market expectation being 12%.
Year Capital employed (Rs.) Profit (Rs.) Dividend %
2007 5,50,000 88,000 12
2008 8,00,000 1,60,000 15
2009 10,00,000 2,20,000 18
2010 15,00,000 3,75,000 20
Solution
The dividend rate on the simple average is 65/4 or 16¼%. But since the dividend
has been rising it would be better to take the weighted average which comes to
17.6%:
Year Rate Weight Product
2007 12 1 12
2008 15 2 30
2009 18 3 54
2010 20 4 80
10 176
The value of the share on the basis of dividend (weighted average) should be 17.6/12 ×
Rs.100 or Rs. 146.67
The yield on capital employed for each year and its weighted average is as follows:
Year Yield or capital employed (%) Weight Product
2007 16 1 16
2008 20 2 40
2009 22 3 66
2010 25 4 100
10 222
Weighted average is 22.2%: on this basis the value should be 22.2/12 × Rs.100 or Rs.185.
Valuation 9.67
5.7 VALUATION OF PREFERENCE SHARES

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

Illustration 4
Capital structure of Lot Ltd. as at 31.3.2007as under:
(Rs. in lakhs)
Equity share capital 10
10% preference share capital 5
15% debentures 8
Reserves 4
Lot Ltd. earns a profits of Rs. 5 lakhs annually on an average before deduction of interest on
debentures and income tax which works out to 40%.
Normal return on equity shares of companies similarly placed is 12% provided:
(a) Profit after tax covers fixed interest and fixed dividends at least 3 times.
(b) Capital gearing ratio is .75.
(c) Yield on share is calculated at 50% of profits distributed and at 5% on undistributed
profits.
Lot Ltd. has been regularly paying equity dividend of 10%.
Solution
(i) Profit for calculation of interest and fixed dividend coverage: Rs.
Average profit of the Company (before interest and taxation) 5,00,000
Less: Debenture interest (15% on Rs. 8,00,000) 1,20,000
3,80,000
Less: Tax @ 40% 1,52,000
Profit after interest and taxation 2,28,000
Add back: Debenture interest 1,20,000
Profit before interest but after tax 3,48,000
(ii) Calculation of interest and fixed dividend coverage: Rs.

Fixed interest and fixed dividend:
Debenture interest 1,20,000
Preference dividend 50,000
1,70,000
3,48,000
Fixed interest and fixed dividend coverage = = 2.05 times
1,70,000
Interest and fixed dividend coverage 2.05 times is less than the prescribed three times.
(iii) Capital gearing ratio:
Equity share capital + reserves = Rs. 10,00,000 + Rs. 4,00,000
= Rs. 14,00,000
Preference share capital + debentures = Rs. 5,00,000 + Rs. 8,00,000
= Rs. 13,00,000
13,00,000
Capital Gearing Ratio = = 0.93 (approximately)
14,00,000
Ratio 0.93 is more than the prescribed ratio of 0.75.
(iv) Yield on equity shares: Rs.
Average profit after interest and tax 2,28,000
Less: Preference Dividend 50,000
Equity Dividend (10% on Rs. 10,00,000) 1,00,000 1,50,000
Undistributed profit 78,000
Valuation 9.69
50% of distributed profit (50% of Rs. 1,00,000) 50,000

5% of undistributed profit (5% of Rs. 78,000) 3,900
53,900
53,900
Yield on equity shares = × 100 = 5.39%
10,00,000
(v) Expected yield of equity shares:
%
Normal return 12.00
Add: For low coverage of fixed interest and fixed dividends (2.05 < 3) 0.50*
Add: For high capital gearing ratio (0.93 > 0.75) 0.50**
13.00
(vi) Value per equity share:

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

(b) If you are buying controlling interest shares.
(ii) If you plan to invest only in preference shares which company’s preference shares would
you prefer ?
(iii) Would your rates be different for buying small lot, if the company ‘A’ retains 30% and
company ‘B’ 10% of the profits?
Solution
(i) (a) Buying a small lot of equity shares: If the purpose of valuation is to provide data base
to aid a decision of buying a small (non-controlling) position of the equity of the
companies, dividend capitalisation method is most appropriate. Under this method,
value of equity share is given by:
Dividend per share
× 100
Market capitalisation rate
240
Company A : Rs. × 100 = Rs. 13.33
18
208
Company B : Rs. × 100 = Rs. 11.56
18
(b) Buying controlling interest equity shares
If the purpose of valuation is to provide data base to aid a decision of buying controlling
interest in the company, EPS capitalisation method is most appropriate. Under this
method, value of equity is given by:
Earning per share (EPS)
× 100
Market capitalisation rate
3
Company A : Rs. × 100 = Rs. 16.67
18
2. 6
Company B : Rs. × 100 = Rs. 14.44
18
(ii) Preference Dividend coverage ratios of both companies are to be compared to make
such decision.
Preference dividend coverage ratio is given by:
Profit after tax
Preference Dividend
Rs. 3,00,000
Company A : = 5 times
Rs. 60,000
Valuation 9.71
Rs. 3,00,000
Company B : = 7.5 times
Rs. 40,000
If we are planning to invest only in preference shares, we would prefer shares of B

Company as there is more coverage for preference dividend.
(iii) Yes, the rates will be different for buying a small lot of equity shares, if the company ‘A’
retains 30% and company ‘B’ 10% of profits.
The new rates will be calculated as follows:
2.1
Company A : Rs. × 100 = Rs. 11.67
18
2.34
Company B : Rs. × 100 = Rs. 13.00
18
Working Notes:
1. Computation of earning per share and dividend per share (companies distribute 80% of
profits)
Company A Company B
Profit before tax 3,00,000 3,00,000
Less: Preference dividend 60,000 40,000
Earnings available to equity shareholders (A) 2,40,000 2,60,000
Number of Equity Shares (B) 80,000 1,00,000
Earning per share (A/B) 3.0 2.60
Retained earnings 20% 48,000 52,000
Dividend declared 80% (C) 1,92,000 2,08,000
Dividend per share (C/B) 2.40 2.08
2. Computation of dividend per share (Company A retains 30% and Company B 10% of
profits)
Earnings available for Equity Shareholders 2,40,000 2,60,000
Number of Equity Shares 80,000 1,00,000
Retained Earnings 72,000 26,000
Dividend Distribution 1,68,000 2,34,000
Dividend per share 2.10 2.34
Illustration 6
The Capital Structure of M/s XYZ Ltd., on 31st March, 2006 was as follows:
Rs.
Equity Capital 18,000 Shares of Rs. 100 each 18,00,000
12% Preference Capital 5,000 Shares of Rs. 100 each 5,00,000
12% Secured Debentures 5,00,000
Reserves 5,00,000
Profit earned before Interest and Taxes during the year 7,20,000
Tax Rate 40%
Generally the return on equity shares of this type of Industry is 15%.
Subject to:
(a) The profit after tax covers Fixed Interest and Fixed Dividends at least 4 times.
(b) The Debt Equity ratio is at least 2;
(c) Yield on shares is calculated at 60% of distributed profits and 10% of undistributed
profits;
The Company has been paying regularly an Equity dividend of 15%.
The risk premium for Dividends is generally assumed at 1%.
Find out the value of Equity shares of the Company.
Solution
Calculation of profit after tax (PAT) Rs.

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

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

Yield on equity shares is calculated at 60% of distributed profits and 10% of undistributed
profits:
60% of distributed profits (60% of Rs. 2,70,000) 1,62,000

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

Normal return expected 15%
Add: Risk premium for low interest and fixed dividend 1%*
coverage (3.8 < 4)
Risk for debt equity ratio not required Nil**
16%
Value of an Equity Share
Actual yield
= × Paid up value of a share
Expected yield
9.37
= × 100 = Rs. 58.56
16
* When interest and fixed dividend coverage is lower than the prescribed norm, the
riskiness of equity investors is high. They should claim additional risk premium over and
above the normal rate of return. Hence, the additional risk premium of 1% has been
added.
** The debt equity ratio is lower than the prescribed ratio, that means outside funds (Debts)
are lower as compared to shareholders’ funds. Therefore, the risk is less for equity
shareholders. Therefore, no risk premium.
1. Write short note on capital market information- P/E ratio and Yield ratio and market / book
value of shares.
2. Judge, on the basis of following information, the capitalisation rate for companies A and
B when for the industry as a whole it is 9%.
Company A Company B
Dividend for past five years 40%, 5%, 25%, 10%, 13%, 16%, 17½%.
20% 17½’%. 17½%
Intrinsic value of share Rs. 175 Rs. 300.
Future plans None Expanding capacity by 50%,
partly by using reserves and
partly by using borrowing.
Evaluate the shares of the companies.
3. Ascertain the value of a 6% Participating Preference Share of Rs. 100 with a normal
market yield of 8%. The Preference share holders are entitled to 1/4th of the dividend in
Valuation 9.75
excess of 10% paid on equity shares. In the year the equity shareholders were paid 30%
(this rate was likely to be maintained).
4. Compute values of equity shares of the companies A and B on the basis of dividend and
that of yield on capital employed. The following information is provided:
Company A Company B
Rs. Rs.
Profit per year 1,00,000 1,00,000
7½% Preference Capital 2,00,000 6,00,000
Equity capital (Rs. 200 each) 8,00,000 4,00,000
Assume that all the profits were distributed. Market expectation is 10%.
5. Compute the values of a preference share and an equity share of each of the companies
A and B on the basis of following information:
Company A Company B
Rs. Rs.
Profit after tax 10,00,000 10,00,000
12% Preference share capital (shares of Rs.100 each) 10,00,000 20,00,000
Equity share capital (shares of Rs.10 each) 50,00,000 40,00,000
Assume that market expectation is 15% and that 80% of profits are distributed
UNIT 6
VALUATION OF BUSINESS
6.1 INTRODUCTION
The business is a composite asset. So valuation technique applied for any single asset can
not be applied for valuation of business. A business is comprised of fixed assets, investments
and current assets, loans and advances. A popular misconception is that the gross value of
business is the aggregate of the value of various assets. In fact, value of business is different
from that of the aggregate value of assets. Moreover, it is dependent on the circumstances for
which such valuation is necessary.
In this section we shall discuss the need for the valuation of business and different,
approaches and methods thereto.
6.2 NEED FOR VALUATION OF BUSINESS

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

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

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

For piecemeal sale of the business, only ‘net realisable value’ basis is appropriate.
¨ Historical cost valuation: It is also called book value method. All assets are taken at their
respective historical cost. Value of goodwill is ascertained and added to such historical cost of
assets.
Historical cost value of business = Historical cost of all assets + Value of goodwill.
¨ Current cost valuation: Current cost of assets are taken for this purpose instead of
historical cost. Current cost of various assets can be ascertained as follows:
♦ Tangible fixed Assets: Price to be paid to replace such assets at their present
condition. If replacement price of the same type of tangible assets is not available, then
replacement price of the next best substitute may be taken.
♦ Investments: Quoted investments are valued at current market price. Unquoted
investments are taken at cost unless the available information is sufficient to determine
their current market value.
♦ Stock :Current market value of the stock-in-hand is taken up.
♦ Debtors : At their net collection amount.
♦ Intangibles: Trade marks , Patents, Copyright, etc. are valued at current acquisition price
less the proportionate value already expired.
¨ Economic valuation: Under this method value of the business is given by the sum of
discounted value of future earnings or cash flows.
(i) Capitalisation of Future Maintainable Profit: Value of business as a going concern is
dependent on its future earnings. By earning we may mean ‘earnings before interest but
after tax’.
Future Maintainable Profit
Value of Business =
Capitalisation rate
In case of listed company inverse of the price-earning ratio may be used for determining
capitalisation rate. For example, if P/E ratio is 12, Capitalisation rate becomes 8.33%,
i.e. 100/12
(ii) Present value of future earnings : Under this approach,
∞
Et
Vo = ∑ (1 + k )
t =1
t
Where Vo = Value of business at the present time or zero time, E is
t
the Earnings at time t, k = appropriate discount factor, t = 1, 2, .... ∞
E1 E2 E
Thus Vo = + + ....... n n + .......
(1+ k) (1+ k)
1 2
(1+ k)
(iii) Present value of future cash flows: Frequently in valuation model cash flows from
operations are used instead of earnings. Under this approach value of business is given
by
C1 C2 Cn
+ + ..... + .....
(1 + k ) (1 + k )
1 2
(1 + k ) n
Where Vo = Value of business.
Cl, C2, Cn etc. are cash flows from operations at different point of time.
k = Discount rate.
6.5 BOOK VALUE

NAV (book value)/break up value of business share are computed as below:
When the calculation starts from the liability side:
Paid up value of equity and preference shares ******

Add Reserves(excluding reserves not created out of ******
Revenue profit or not realized in cash)
Less Miscellaneous expenditure not written off ******
,, Accumulated losses ******
,, Arrears of depreciation ******
,, Contingent liabilities ****** ******
Net Asset Value of the business (A) ******
When the calculation starts from the asset side the balance sheet values are considered:
Tangible fixed assets ******

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

Net Asset Value of the business (A) ******
NAV of equity is NAV of business less preference share capital.
6.6 FAIR VALUE

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

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

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

Part I, Schedule VI to the Companies Act requires classification of investments into:
(a) investments in government or trust securities,
(b) Investments in shares, debentures or bonds,
(c) Investments in immovable properties,
(d) Investments in the capital of partnership firms, and
(e) *balance of unutilised monies raised by issue
Under each category, valuation may be at cost or market value. To arrive at the cost, the
price paid to acquire the assets, brokerage and commission paid and other related expenses
are taken into consideration. Sometimes, ‘bonus’ and ‘right’ are received with respect to a
share or unit. Cost of such shares and units are determined with reference to the investment
in such shares or units as a whole and not isolately. For quoted investments, stock exchange
quotation provides market value information.
* All unutilised monies out of the issue must be separately disclosed in the Balance Sheet of
the company indicating the form in which such unutilised funds have been invested,
Disclosure requirement of Schedule VI: It is necessary to disclose aggregate amount of
Valuation 9.81
company’s quoted investment and value thereof and also the unquoted investments.
A statement of investments is to be annexed to the balance sheet showing:
(i) trade investments and non-trade investments of the company separately;
(ii) names of the bodies corporate (including separately the names of bodies corporate
under the same management) in whose shares and debentures investments have been
made.
All investments are to be included in the statement which have been acquired after the
previous balance sheet date whether these are existing or not at the date of current balance
sheet. However, for an investment company it is sufficient to give details of the existing
shares or debentures at the balance sheet date. In case of investment in the partnership firm it
is necessary to give names of all the partners, their share in the partnership and total capital
of the partnership.
It may be noted that ICAI has issued AS 13 on Accounting for Investment. AS 13 contains
explanation relating to classification of investments, determination of cost of investments,
carrying amount of investments, disposal of investments and disclosure requirements.
6.10 VALUATION OF CURRENT ASSETS, LOANS AND ADVANCES

The conservatism principle is applied in valuation of current assets, loans and advances. By
this principle, lower of the cost or market value is preferred. This means if the realisable value
of these assets is lower than cost, such value is preferred. In other words, all possible losses
are accounted for but no estimated profit is taken until it is realised. So in case of current
assets like sundry debtors, loans and advances, adequate provision is necessary for doubtful
debts. Here cost means current dues from sundry debtors or amount of loans and advances
given.
Inventory is an important component of current assets which needs elaboration. ICAI has
recently issued a revised AS-2 on Valuation of Inventories. This Standard comes into effect in
respect of accounting periods commencing on or after April 1, 2009 and is mandatory in
nature. This revised standard supersedes Accounting Standard on Valuation of Inventories,
issued in June, 1981.
The basic principle of inventory valuation is valuation at lower of the cost and net realisable
value. Students are advised to refer AS 2 (Revised). As per pre-revised Standard, either direct
costing or absorbtion costing technique could be followed.
In direct costing method, cost of inventory includes only appropriate proportion of variable
costs but fixed costs are being charged against revenue in the period to which they relate
while in abosrption costing method, cost of inventories is determined so as to include the
appropriate share of both variable costs and fixed costs. However as per revised AS 2, both
fixed and variable overheads that are incurred in converting materials into finished goods are
to be allocated.
Rational for using historical cost: Inventories are held for deriving revenue directly or
indirectly from their sale or use.
In historical cost accounting system ‘cost’ means acquisition cost. Although the value of
inventories is more than acquisition cost, by following conservative path, no profit is taken until
it is realised.
Techniques of determining historical cost: Several formulae used to arrive at inventory
costs are :
(a) First in first out (FIFO), (b) Average cost, (c) Last in first out (LIFO), (d) Base stock, (e)
Specific identification, (f) Standard cost, (g) Adjusted selling price and (h) Latest
purchase price.
(b) Of these FIFO, LIFO, Base stock and specific identification formulae are based on costs
which have been incurred by the enterprise at one time or another.
(c) However, as per AS 2 (Revised) the cost of inventories should be assigned by using only
first-in-first-out or weighted average cost formula where the specific identification of cost
of inventories is not possible.
Valuation of inventories at net realisable value : If the cost of inventories is higher than net
realisable value, the inventories should be valued at lower than cost. Such circumstances may
occur due to decline in selling price or obsolescence of the inventory items. Moreover, in some
cases inventory piling up may be of high is not possible to be sold within the normal turnover
period. That apart there may be risk of physical deterioration of inventory items.
Sometimes by-product cost cannot be determined separately. In such circumstances by-
products are valued at their net realisable value.
Inclusion of overheads in Inventory Cost: Production overheads are part of the inventory cost.
Since as per AS 2 (Revised) absorption costing method is followed, fixed as well as variable
production overheads become part of inventory cost. Fixed production overheads are
absorbed on the basis of normal capacity of the production facilities.
General administration overheads, selling and distribution overheads, and interest are not
usually treated as expenses related to putting the inventories to their present location and
condition. So these are excluded while computing inventory cost. The abnormal amounts of
wasted materials, labour, or other production costs and storage costs, unless these costs are
necessary in the production process prior to a further production stage, are also excluded.
But overheads other than production overheads should be included as part of the inventory
cost only to the extent they are clearly related to put the inventories to their present location
and condition.
Comparison of cost and net realisable value: Comparison of historical cost and net
realisable value should be made for each item or a group of items separately. Comparison of
aggregate values of dissimilar items may lead to setting off loss against unrealised profit.
Valuation 9.83
Example
Given cost and net realisable value of five groups of inventory items:
Group Cost (Rs.) Net realisable Valuation
Value (Rs.) (Rs.)
A 15,000 5,000 5,000
B 27,000 52,000 27,000
C 54,000 74,000 54,000
D 1,10,000 85,000 85,000
E 68,000 62,000 62,000
2,74,000 2,78,000 2,33,000
If aggregate values are taken, inventories should be valued at Rs. 2,74,000 instead of Rs.
2,33,000 which would overvalue the inventories. Prudence suggests elimination of all sorts of
overvaluation.
Illustration 1
MICO Ltd. gives the following cash flows estimate:
2003 Rs. 20,00 lakhs
2004 to 2006 Compound Growth Rate 6.5%
2007 to 2010 Compound growth rate 9.5%
Apply 20% discount rate and determine the value of business.
Solution
Year Cash Flows Discount Discounted
Rs. in lakhs factor cash flows (Rs.)
2003 20,00.00 0.8333 16,66.60
2004 21,30.00 0.6944 14,79.07
2005 22,68.45 0.5787 13,12.75
2006 24,15.90 0.4823 11,65.19
2007 26,45.41 0.4019 10,63.19
2008 28,96.72 0.3349 9,70.11
2009 31,71.91 0.2791 8,85.28
2010 34,73.24 0.2326 8,07.88
93,50.07
Value of Business Rs. 93,50.07 lakhs based on discounted value of eight years’ cash flows.
The deficiencies of economic valuation are
(i) difficulties involved in estimating future cash flows;
(ii) subjectivity involved in choice of the future period for which cash flows to be estimated;
(iii) subjectivity involved in the selection of discount rate.
Asset valuation method: It may be argued that if a business is acquiring or retaining an
asset, the value of that asset to the business must, in the case of acquisition of the asset, be
greater than the cost of that asset and, in the case of retention of the asset, be greater than
the net realisable value of the asset. If, therefore, all the assets of the business are valued at
their net realisable value, the aggregate will be clearly less than value of the business as a
whole. It gives the lower bound to the range of values based on the asset valuation approach.
The upper bound of the range of assets will be the sum of the current costs of the company’s
assets so long as it is recognised that the assets include intangibles such as goodwill.
Thus under asset valuation approach, one can get lower bound of the business value using
net realisable value of the assets and the upper bound by the current costs of the assets
including goodwill.
Valuation of business for amalgamation with another: The valuation of business which is
to be amalgamated with the another business is a more complex process because it cannot be
made in isolation. From the point of view of the potential purchaser, the maximum price that
he will be prepared to pay is the difference between the value of the combined business and
the value of his existing business.
If the amalgamation gives rise to positive synergy, the value of the amalgamated business will
be greater than the sum of the values of the individual business taken in isolation. The
purchaser will usually not only have to consider the tangible assets, which can be valued with
relative ease, but also the intangible assets which may be particularly influenced by the
synergical effect of the amalgamation.
In many amalgamations, all the assets of the acquired business are not retained in the new
business. So, the first step in valuing business for acquisition will be to determine the asset
structure of the business and to identify the assets which will not be required in the future.
Such assets must be valued at their net realisable value at the time at which they are
expected to be sold and these figures discounted to the present time to ascertain the present
value of the superfluous assets. In many cases, the sale of the superfluous assets will take
place immediately and therefore, no discounting becomes necessary and the value of these
may be considered to be a deduction from the purchase price of the business.
In practice, the valuation figure is the net realisable value of the surplus assets which are to be
sold plus the present value of the additional earnings which will accrue to the acquirer of the
business as a result of the acquisition. It is of course, apparent that a major problem arises in
determining the rate of interest at which the earnings of the business should be discounted as
well as the period for which such earning of estimation should be considered. Also it is
possible to take cash flows instead of earnings as discussed earlier.
Valuation 9.85
Illustration 2
Shyam Garments Ltd. is a company which produces and sells to retailers a certain range of
fashion clothings. They have made the following estimates of potential cash flows for the next
10 years.
Year 1 2 3 4 5 6 7 8 9 10
Cash flows
(Rs. in lacs) 15,00 17,00 20,00 25,00 30,00 34,00 38,00 45,00 50,00 60,00
Kiddies Wear Ltd. is a company which owns a series of boutiques in a certain locality. The
boutiques buy clothes from various suppliers and retail them. Each boutique has a manager
and an assistant but all purchasing and policy decisions are taken centrally. Independent cash
flow estimates of Kiddies Wear Ltd. was as follows:
Year 1 2 3 4 5 6 7 8 9 10
Cash flows
(Rs. in lacs) 1,20 1,60 2,00 2,80 3,40 4,60 5,20 6,00 6,60 8,00
Shyam Garments Ltd. is interested in acquiring Kiddies Wear Ltd. in order to get some
additional retail outlets. They make the following cost-benefit calculations:
(i) Net value of assets of Kiddies Wear Ltd.
Rs in lacs
Sundry Fixed Assets 800
Investments 200
Stock 400
1400
Less: Sundry Creditors 400
Net Assets 1000
(ii) Sundry Fixed Assets amounting to Rs. 50 lacs cannot be used and their net realisable
value is Rs. 45 lacs.
(iii) Stock can be realised immediately at Rs. 470 lacs.
(iv) Investments can be disposed off for Rs. 212 lacs.
(v) Some workers of Kiddies Wear Ltd. are to be retrenched for which estimated
compensation is Rs. 1,30 lacs.
(vi) Sundry creditors are to be discharged immediately.
(vii) Liabilities on account of retirement benefits not accounted for in the Balance Sheet by
Kiddies Wear Ltd. is Rs. 48 lacs.
(viii) Expected cash flows of the combined business will be as follows:
Year 1 2 3 4 5 6 7 8 9 10
Cash flow
(Rs. in lacs)18,00 19,00 23,00 29,50 35,00 40,00 45,00 53,00 58,00 69,00
Find out the maximum value of Kiddies Wear Ltd. which Shyam Garments Ltd. can quote. Also
show the difference in valuation had there been no merger. Use 20% as discount factor.
Solution
(1) Calculation of operational synergy expected to arise out of merger
Year 1 2 3 4 5 6 7 8 9 10
(Rs. in lacs)
Projected cash
flows of Shyam
Garments after
merger with
Kiddies Wear
Limited 18,00 19,00 23,00 29,50 35,00 40,00 45,00 53,00 58,00 69,00
Less: Projected
cash flows of
Shyam Gar-
ments Ltd.
without merger 15,00 17,00 20,00 25,00 30,00 34,00 38,00 45,00 50,00 60,00
3,00 2,00 3,00 4,50 5,00 6,00 7,00 8,00 8,00 9,00
(2) Valuation of Kiddies Wear Ltd. ignoring merger
Year Cash Flows Discount Factor Discounted Cash Flow
(Rs. in lacs) (Rs. in lacs)
1 120 0.8333 99.996
2 160 0.6944 111.104
3 200 0.5787 115.740
4 280 0.4823 135.044
5 340 0.4019 136.646
6 460 0.3349 154.054
7 520 0.2791 145.132
8 600 0.2326 139.560
9 660 0.1938 127.908
10 800 0.1615 129.200
1294.384
Valuation 9.87
(3) Valuation of Kiddies Wear Ltd. in case of merger

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

The main difference between the value of a business compared with a minority holding of
shares is the value of voting control. The value of control is the present value of the change in
cash flows which will be realised from exercising control. The main obvious reason for this
higher valuation is that the controlling interest enables the owner of that interest to arrange the
affairs of the business in a way that best suits his own circumstances. If a company is
efficiently managed at present, the value of control may be very low. If however, it is thought
that the company is inefficiently managed, then, obtaining control may enable operations and
financing to be changed thereby substantially increasing the present value of cash flows
generated by a firm.
Illustration 3
The Balance Sheets of R Ltd. for the years ended on 31.3.2004, 31.3.2005 and 31.3.2006 are
as follows:
31.3.2004 31.3.2005 31.3.2006
Liabilities Rs. Rs. Rs.
3,20,000 Equity Shares of Rs. 10
each fully paid 32,00,000 32,00,000 32,00,000
General Reserve 24,00,000 28,00,000 32,00,000
Profit and Loss Account 2,80,000 3,20,000 4,80,000
Creditors 12,00,000 16,00,000 20,00,000
70,80,000 79,20,000 88,80,000
31.3.2004 31.3.2005 31.3.2006

Assets Rs. Rs. Rs.
Goodwill 20,00,000 16,00,000 12,00,000
Building and Machinery
(Less: Depreciation) 28,00,000 32,00,000 32,00,000
Stock 20,00,000 24,00,000 28,00,000
Debtors 40,000 3,20,000 8,80,000
Bank Balance 2,40,000 4,00,000 8,00,000
70,80,000 79,20,000 88,80,000
Actual valuation were as under:
31.3.2004 31.3.2005 31.3.2006
Rs. Rs. Rs.
Building and Machinery 36,00,000 40,00,000 44,00,000
Stock 24,00,000 28,00,000 32,00,000
Net Profit (including opening balance)
after writing off depreciation and goodwill,
tax provision and transfer to General
Reserve 8,40,000 12,40,000 16,40,000
Capital employed in the business at market values at the beginning of 2003-2004 was Rs.
73,20,000, which included the cost of goodwill. The normal annual return on Average Capital
Valuation 9.89
employed in the line of business engaged by R Ltd. is 12½%.

The balance in the General Reserve account on 1st April, 2004 was Rs. 20 lakhs.
The goodwill shown on 31.3.2004 was purchased on 1.4.2004 for Rs. 20,00,000 on which date
the balance in the Profit and Loss Account was Rs. 2,40,000. Find out the average capital
employed each year.
Goodwill is to be valued at 5 years purchase of super profits (Simple average method). Also
find out the total value of the business as on 31.3.2006.
Solution
Note:
1. Since goodwill has been paid for, it is taken as part of capital employed. Capital
employed at the end of each year is shown below.
2. Assumed that the building and machinery figure as revalued is after considering
depreciation.
31.3.2004 31.3.2005 31.3.2006
Rs. Rs. Rs.
Goodwill 20,00,000 16,00,000 12,00,000
Building and Machinery (revalued) 36,00,000 40,00,000 44,00,000
Stock (revalued) 24,00,000 28,00,000 32,00,000
Debtors 40,000 3,20,000 8,80,000
Bank Balance 2,40,000 4,00,000 8,00,000
Total Assets 82,80,000 91,20,000 1,04,80,000
Less: Creditors 12,00,000 16,00,000 20,00,000
Closing Capital 70,80,000 75,20,000 84,80,000
Opening Capital 73,20,000 70,80,000 75,20,000
1,44,00,000 1,46,00,000 1,60,00,000
Average Capital 72,00,000 73,00,000 80,00,000
Maintainable profit has to be found out after making adjustments as given below:
31.3.2004 31.3.2005 31.3.2006
Rs. Rs. Rs.
Net Profit as given 8,40,000 12,40,000 16,40,000
Less: Opening Balance 2,40,000 2,80,000 3,20,000
6,00,000 9,60,000 13,20,000

Add: Under valuation of closing stock 4,00,000 4,00,000 4,00,000
10,00,000 13,60,000 17,20,000
Less: Adjustment for valuation in opening stock ________ 4,00,000 4,00,000
10,00,000 9,60,000 13,20,000
Add: Goodwill written-off ________ 4,00,000 4,00,000
10,00,000 13,60,000 17,20,000
Add: Transfer to Reserves 4,00,000 4,00,000 4,00,000
14,00,000 17,60,000 21,20,000
Less: 12½% Normal Return 9,00,000 9,12,500 10,00,000
Super Profit 5,00,000 8,47,500 11,20,000
Average super profits = (Rs.5,00,000 + Rs.8,47,500 + Rs.11,20,000) / 3

= 24,67,500 / 3 = Rs 8,22,500
Goodwill = 5 years purchase = Rs. 8,22,500 × 5 = Rs. 41,12,500.
Rs.
Total Net Assets (31/3/2006) 84,80,000
Less: Goodwill 12,00,000
72,80,000
Add: Goodwill 41,12,500
Value of Business 1,13,92,500
1. What valuation base should you adopt while valuing a business as going concern?
Explain briefly the relative advantages and disadvantages of valuation of business
following
(i) Capitalisation of future maintainable profit method (ii) Present value of future earnings
and (iii) Present value of future cash flows method.
2 Why does valuation of business differ if done in isolation as compared to that when done
in combination of another business? What is meant by value of control?
3. A Ltd. gives the following information:
Current profit Rs. 210 lakhs
Compound growth rate of profit 7.5% p.a.
Valuation 9.91
Current Cash Flows from operations Rs. 270 lakhs

Compound growth rate of Cash flows 6.5% p.a.
Current price-earning ratio 12
Discount factor 20%
Find out the value of A Ltd. taking 10 years projected profit or cash flows. You may use
(i) future maintainable profit method, (ii) present value of future earnings method and (iii)
present value of future cash flow method.
4. XX Ltd. plans to take over YY Ltd. Independent Cash Flow forecasts of the companies
are as follows:
Year 1 2 3 4 5
XX Ltd. (Rs. in lakhs) 2,00 2,25 2,50 2,70 2,85
YY Ltd. (Rs. in lakhs) 50 65 80 95 110
Year 6 7 8 9 10
XX Ltd. (Rs. in lakhs) 3,10 3,50 6,00 6,10 6,50
YY Ltd. (Rs. in lakhs) 1,20 1,30 1,50 1,70 1,80
Following further information is available from the latest Balance Sheet of YY Ltd.
Assets: Rs. in lacs Rs. in lacs
Fixed Assets 5,00
Stock 1,15
Debtors 50
6,65
Less: Liabilities:
Long term Loan 2,00 3,65
Net Assets 3,00
XX Ltd. finds that fixed assets of book value Rs. 75 lakhs will not be used which will fetch
Rs. 50 lakhs on immediate disposal. Moreover, stock will fetch Rs. 140 lakhs and
debtors Rs. 48 lakhs immediately. But XX Ltd. has to pay off the liabilities immediately.
Also it has to pay Rs. 110 lakhs to workers of YY Ltd. whose service cannot be used. It
appears that after merger the XX Ltd. has to invest Rs. 210 lakhs for renovation of the
plant and machinery at the end of lst year and Rs.50 lakhs for modernisation at the end
of 2nd year after merger. Forecast Cash Flows of XX Ltd. after merger:
Year 1 2 3 4 5
Cash Flows (Rs. in lakhs) 2,40 2,80 3,50 4,00 4,10
Year 6 7 8 9 10
Cash Flows (Rs. in lakhs) 4,80 5,50 8,00 8,80 9,50
Determine the maximum value of YY Ltd. which its management should ask from XX Ltd.,
you may use 20% discount rate.
10
DEVELOPMENTS IN FINANCIAL REPORTING
UNIT 1
VALUE ADDED STATEMENT
1.1 HISTORICAL BACKGROUND

The concept of value added is considerably old. It originated in the U.S. Treasury in the 18th
Century and periodically accountants have deliberated upon whether the concept should be
incorporated in financial accounting practice. But actually, the value added statement has
come to be seen with greater frequency in Europe and more particularly in Britain. The
discussion paper ‘Corporate Report’ published in 1975 by the then Accounting Standard
Steering Committee (now known as Accounting Standards Board) of the U.K. advocated the
publication of value added statement along with the conventional annual corporate report. In
1977, the Department of Trade, U.K. published ‘The Future of Company Reports’ which stated
that all substantially large British companies should include a value added (V.A.) statement in
their annual reports. Also, a few companies in the Netherlands include V.A. information in their
annual reports, but the disclosures often fall short of being a full V.A. statement and also the
method of arriving at V.A. is grossly non-standardised. In India, Britannia Industries Limited
and some others prepare value added statement as supplementary financial statement in its
annual report.
1.2 DEFINITIONS
1.2.1 Value Added (VA): VA is the wealth a reporting entity has been able to create through
the collective effort of capital, management and employees. In economic terms, value added is
the market price of the output of an enterprise less the price of the goods and services
acquired by transfer from other firms. VA can provide a useful measure in gauging
performance and activity of the reporting entity.
1.2.2 Gross Value Added (GVA): GVA is arrived at by deducting from sales revenue the cost
of all materials and services which were brought in from outside suppliers. We know that the
retained profit of a company for a given accounting year is derived as below:
R = S – B – Dep – W – I – T – Div ... (1)
Where R = Retained profit, S = Sales revenue, B = Bought in cost of materials and services,
Dep = annual depreciation charge, W = Annual wage cost, I = Interest payable for the year, T
= Annual corporate tax and Div = Total dividend payable for the year. Rearranging the
equation (1) we get GVA as below:
S – B = R + Dep + W + I + T + Div .. (2)
Each side of equation (2) represents GVA. However this is a very simple definition of GVA. In
practice GVA includes many other things.
Besides sales revenue, any direct income, investment income and extraordinary incomes or
expenses are also included in calculation of GVA. Including these items in the above equation
No. 2, we get
(S + Di) – B + Inv + EI = R + Dep + W + T + I + Div. ... (3)
Where Di = Direct incomes, Inv = Investment incomes, EI = Extraordinary items.
The above equation can be shown by way of the following statement.
Gross value added of a manufacturing company
Sales X
Add: Royalties and other direct income X
Less: Materials and Services used X
Value added by trading activities X
Add : Investment Income X
Add/Less: Extraordinary items X X
Gross Value Added X
Applied as follows:
To employees as salaries, wages, etc. X
To government as taxes, duties, etc. X
To financiers as interest on borrowings X
To shareholders as dividends X
To retained earnings including depreciation X
1.2.3 Net Value Added (NVA) : NVA can be defined as GVA less depreciation. Rearranging
the equation (1) we can get NVA as below :
S – B – Dep = R + W + I + T + Div.
Developments in Financial Reporting 10.3
1.3 REPORTING VALUE ADDED

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

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

The VA statement shows the value added for a business for a particular period and how it is
arrived at and apportioned to the following stakeholders:
The workforce – for wages, salaries and related expenses;
The financiers – for interest on loans and for dividends on share capital.
The government – for corporation tax.
The business – for retained profits.
A statement of VA represents the profit and loss account in different and possibly more useful
manner.
The conventional VA statement is divided into two parts – the first part shows how VA is
arrived at and the second part shows the application of such VA.
Illustration 1
Given below is the Profit and Loss Account of Creamco Ltd.:
Profit and Loss Account
for the year ended 31st March, 2006
Notes Amount
(Rs. ’000)
Income
Sales 1 28,525
Other Income 756
29,281
Expenditure
Operating cost 2 25,658
Excise duty 1,718
Interest on Bank overdraft 3 93
Interest on 10% Debentures 1,157
28,626
Profit before Depreciation 655
Less: Depreciation 255
Profit before tax 400
Provision for tax 4 275

Profit after tax 125
Less: Transfer to Fixed Asset Replacement Reserve 25
100
Less: Dividend paid and payable 45
Retained profit 55
Notes:
1. This represents the invoice value of goods supplied after deducting discounts, returns and
sales tax.
2. Operating cost includes Rs. (’000) 10,247 as wages, salaries and other benefits to
employees.
3. The bank overdraft is treated as a temporary source of finance.
4. The charge for taxation includes a transfer of Rs. (’000) 45 to the credit of deferred tax
account.
You are required to:
(a) Prepare a value added statement for the year ended 31st March, 2006.
(b) Reconcile total value added with profit before taxation.
Solution
(a)
CREAMCO LTD.
for the year ended March 31, 2006
Rs. (’000) Rs. (’000) %
Sales 28,525
Less: Cost of bought in material and services:
Operating cost 15,411
Excise duty 1,718
Interest on bank overdraft 93 17,222
Value added by manufacturing and trading activities 11,303
Add: Other income 756
Total value added 12,059
Application of value added:

To pay employees:
Wages, salaries and other benefits 10,247 84.97
To pay government:
Corporation tax 230 1.90
To pay providers of capital:
Dividends 45 1,202 9.98
To provide for the maintenance and
expansion of the company:
Depreciation 255
Fixed Assets Replacement Reserve 25
Deferred Tax Account 45
Retained profit 55 380 3.15
12,059 100.0
(b) Reconciliation between Total Value Added and Profit Before Taxation
Rs. (’000) Rs. (’000)
Add back:
Depreciation 255
Wages, salaries and other benefits 10,247
Debenture interest 1,157 11,659
Total Value added 12,059
Notes :
(1) Deferred tax could alternatively be shown as a part of ‘To pay government’.
(2) Bank overdraft, being a temporary source of finance, has been considered as the provision
of a banking service rather than of capital. Therefore, interest on bank overdraft has been
shown by way of deduction from sales and as a part of ‘cost of bought in material and
services’.
1.6 LIMITATION OF VA
It is argued that although the VA statement shows the application of VA to several interest
groups (like employees, government, shareholders, etc.), the risk associated with the
company is only borne by the shareholders. In other words, employees, government and
outside financiers are only interested in getting their share on VA but when the company is in
trouble, the entire risk associated therein is borne only by the shareholders. Therefore, the
concept of showing value added as applied to several interested groups is being questioned
by many academics. They advocated that since the shareholders are the ultimate risk takers,
the residual profit remaining after meeting the obligations of outside interest groups should
only be shown as value added accruing to the shareholders. However, academics have also
admitted that from overall point of view value added statement may be shown as
supplementary statement of financial information. But in no case can the VA statement
substitute the traditional income statement (i.e. Profit & Loss Account).
Another contemporary criticism of VA statement is that such statements are non-standardised.
One area of non-standardisation is the inclusion or exclusion of depreciation in the calculation
of value added. Another major area of non-standardisation in current VA practice is taxation.
Some companies report only tax levied on profits under the heading of “VA applied to
governments”. Other companies prefer to report on extensive range of taxes and duties under
the same heading. In the case of Britannia Industries Limited, it has shown taxes and duties
paid under the heading “VA applied to Government”. In the illustration given in para 1.5 excise
duty has been shown as a part of bought-in cost and deducted while calculating value added.
Some academics argued that such excise duty should be shown as an application of VA.
However, this practice of non-standardisation can be effectively eliminated by bringing out an
accounting standard on value added. Therefore, this criticism is a temporary phenomenon.
We have stated in para 1.3, the reasons for preferring NVA to GVA. We prepare the NVA
statement on the basis of the information given in Illustration in para 1.5. It can be mentioned
here that in preparing VA statement on NVA basis excise duty has been shown as an
application of VA.
(a) CREAMCO LTD.
for the year ended March 31, 2006
Rs. (’000) Rs. (’000) %
Sales 28,525
Less: Cost of bought in material and services:
Operating cost 15,411
Interest on bank overdraft 93 15,504
Gross Value Added 13,021
Net Value Added 12,766
Add: Other income 756
Available for application 13,522
Applied as follows:
To pay employees:
Wages, salaries and other benefits 10,247 75.78

To pay government:
Corporation tax & excise duty 1948 14.41
To pay providers of capital:
Dividends 45 1,202 8.89
To provide for the maintenance
and expansion of the company:
Fixed Assets Replacement Reserve 25
Deferred Tax Account 45
Retained profit 55 125 0.92
13,522 100.00
(b) Reconciliation between Total Value Added and Profit Before Taxation
Rs. (’000) Rs. (’000)
Add back:
Excise duty 1,718
Wages, salaries and other benefits 10,247
Debenture interest 1,157 13,122
Total Value Added 13,522
We can see that VA based ratios have changed significantly particularly with respect to
payments to employees and government (i.e., Payroll/VA and taxation /VA). Taxation/VA ratio
has increased from a meagre 1.9% to a significant 14.41%, whereas payroll/VA ratio has
come down from 84.97% to 75.78%. It suggests that although the employees are enjoying the
major share of VA, government’s share has also increased significantly. As a result the
retained profit of the company has significantly come down.
Illustration 2
Prepare a Gross Value Added Statement from the following Profit and Loss Account of Strong
Ltd. Show also the reconciliation between Gross Value Added and Profit before Taxation:
Profit & Loss Account for the year ended 31st March, 2006
Income Notes Amount
(Rs. in lakhs) (Rs. in lakhs)
Sales 610
Other Income 25
635
Expenditure
Production & Operational Expenses 1 465
Administration Expenses 2 19
Interest and Other Charges 3 27
Depreciation 14 525
Profit before Taxes 110
Provision for Taxes 16
94
Balance as per Last Balance Sheet 7
101
Transferred to:
General Reserve 60
Proposed Dividend 11 71
Surplus Carried to Balance Sheet 30
101
Notes :
1. Production & Operational Expenses (Rs. in lakhs)
Increase in Stock 112
Consumption of Raw Materials 185
Consumption of Stores 22
Salaries, Wages, Bonus & Other Benefits 41
Cess and Local Taxes 11
Other Manufacturing Expenses 94
465
2. Administration expenses include inter-alia audit fees of Rs.4.80 lakhs, salaries &
commission to directors Rs.5 lakhs and provision for doubtful debts Rs.5.20 lakhs.
3. Interest and Other Charges: (Rs. in lakhs)
On Working Capital Loans from Bank 8
On Fixed Loans from IDBI 12
Debentures 7
27
Solution
Strong Limited
Value Added Statement
Rs. in lakhs Rs. in lakhs %
Sales 610
Less: Cost of bought-in material and services:
Production and operational expenses 413
Administration expenses 14
Interest on working capital loans 8
435
Value added by manufacturing and
trading activities 175
Add : Other income 25
Total Value Added 200
Application of Value Added:

To Pay Employees :
Salaries, Wages, Bonus and
Other Benefits 41 20.50
To Pay Directors :
Salaries and Commission 5 2.50
To Pay Government :
Income Tax 16
27 13.50
To Pay Providers of Capital:
Interest on Debentures 7
Interest on Fixed Loans 12
Dividend 11
30 15.00
To Provide for Maintenance and
Expansion of the Company :
Depreciation 14
General Reserve 60
Retained Profit (30–7) 23
97 48.50
200 100.00
Reconciliation Between Total Value Added And Profit Before Taxation:
Profit before Tax 110
Add back :
Depreciation 14
Salaries, Wages, Bonus and
other Benefits 41
Directors’ Remuneration 5
Interest on Debentures 7
Interest on Fixed Loans 12
Total Value Added 90
200
1.7 INTERPRETATION OF VA
While the absolute value of net VA and its proportion to gross output are very important, the
factor components of value addition reveal more information. It is generally found that value
addition is highest for service companies and lowest for a trading business. Consider a
hypothetical situation. There are three companies A, B and C. Each sells the finished product
for Rs. 1,000. Company A buys a lump of metal in the market for Rs. 500, performs four
operations on it – annealing, forging, trimming and polishing - and sells the finished product
for Rs. 1,000. Company B buys the semi-finished product in the market for Rs. 800, performs
certain operations and sells the finished product at the said price of Rs. 1,000. Company C
buys the finished product from another company for Rs. 950 and sells it for Rs. 1,000.
Thus, even though all the three companies have the same turnover, company A has added
highest net value to its product and Company C the least. As a percentage of the gross
output, company A’s value addition is 50%, company B’s 20% and company C’s a meagre 5%.
At this point it appears that company A, having highest value addition, will give highest returns
to shareholders. But if it so happens that out of total value addition of Rs. 500 by company A,
almost 90% goes out for meeting wage bill, the position is entirely different. Therefore,
considering the ratio of net value added to gross output does not yield a complete picture. If
much of a company’s net value added comes from an unproductive labour force, there will be
little left over for future investments or for addition to reserves. Hence, besides considering
the ratio of net value addition to gross output, one must consider the contribution of various
factor costs to the net value added.
1. What is a Value Added Statement? Why such statement is needed?
2. State the advantage of Net Value Added over Gross Value Added.
3. What information can we gather from value added statements?
4. From the following information in respect of Pretext Ltd. prepare a value added statement
on the basis of :
(i) Gross Value Added
(ii) Net Value Added
(Rs. ’000) Notes Amount
(Rs. ’000)
Sales 8,540
Trading Profit 1 766
Interest 56 2 (177)
Add: Rent from let-
out properties 33
Provision for tax 3 275
Profit after tax 347
Less: Extraordinary items 4 7
340
Less: Dividend paid and payable 136
Retained profit 204
Notes:
1. Trading profit is arrived at after charging the following:
(Rs. ’000)
Salaries, wages etc. to employees 1,475
Directors’ remuneration 145
Audit fees 90
Hire of equipment 115
2. Interest figure is ascertained as below:
Interest paid on bank loans and overdrafts 65
Interest received (9)
(56)
3. Provision for tax includes a transfer of Rs. (’000) 57 to the credit of deferred tax account.
4. Extraordinary items:
Surplus on sale and lease back of properties 8
Loss of cash by theft (15)
(7)
UNIT 2
ECONOMIC VALUE ADDED
2.1 INTRODUCTION
Economic Value Added, EVA for short, is primarily a benchmark to measure earnings
efficiency. Though the term “Economic Profit” was very much there since the inception of
“Economics”, Stern Stewart & Co., of USA has got a registered Trade Mark for this by the
name “EVA”, an acronym for Economic Value Added.
EVA as a residual income measure of financial performance, is simply the operating profit
after tax less a charge for the capital, equity as well as debt, used in the business.
Because EVA includes both profit and loss as well as balance sheet efficiency as well as the
opportunity cost of investor capital – it is better linked to changes in shareholder wealth and is
superior to traditional financial metrics such as PAT or percentage rate of return measures
such as ROCE, or ROE.
In addition, EVA is a management tool to focus managers on the impact of their decisions in
increasing shareholder wealth. These include both strategic decisions such as what
investments to make, which businesses to exit, what financing structure is optimal; as well as
operational decisions involving trade-offs between profit and asset efficiency such as whether
to make in house or outsource, repair or replace a piece of equipment, whether to make short
or long production runs etc.
Most importantly the real key to increasing shareholder wealth is to integrate the EVA
framework in four key areas: to measure business performance; to guide managerial decision
making; to align managerial incentives with shareholders’ interests; and to improve the
financial and business literacy throughout the organisation.
To better align managers interests with Shareholders – the EVA framework needs to be
holistically applied in an integrated approach – simply measuring EVAs is not enough it must
also become the basis of key management decisions as well as be linked to senior
management’s variable compensation.
2.2 COST OF CAPITAL

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

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

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

Cost of Debt Capital and cost of Preference Share Capital are easy to calculate as they
depend on actual after tax cash outflows on account of interest payment but calculation of cost
of Equity Capital is little tough as it depends on market expected rate of return. There are
many theories to calculate cost of Equity Capital. Out of all those theories Capital Asset
Pricing Model (CAPM) is the most widely used method of calculating the Cost of Equity
Capital. Under CAPM cost of Equity Capital is expressed as
Risk Free Rate + Specific Risk Premium = Risk Free Rate + Beta X Equity Risk Premium
= Risk Free Rate + Beta X (Market Rate - Risk Free Rate)
The risk free rate represents the most secure return that can be achieved. There is no
consensus among the practitioners regarding risk free rate.
Specific Risk Premium is a multiple of Beta and Equity Risk Premium. Equity Risk Premium is
almost same for all the listed companies in the stock market. Unless the volatility of share
prices and share market indices of two companies are same, their Beta will be different.
2.4 BETA
Beta is a relative measure of volatility that is determined by comparing the return on a share to
the return on the stock market. In simple terms, the greater the volatility, the more risky the
share and the higher the Beta. If a company is affected by the macroeconomic factors in the
same way as the market is, then the company will have a Beta of one and will be expected to
have returns equal to the market. A company having a Beta of 1.2 implies that it stock market
increases by 10% the company’s share price will increase by 12% (i.e., 10% × 1.2) and if the
stock market decreases by 10% the company’s share price will decrease by 12%. Beta is a
statistical measure of volatility and is calculated as the Covariance of daily return on stock
market indices and the return on daily share prices of a particular company divided by the
Variance of the return on daily Stock Market indices. While considering market index a broad
based index like S & P 500 should be considered.
For the companies, which are not listed in stock exchanges, beta of the similar industry may
be considered after transforming it to un-geared beta and then re-gearing it according to the
debt equity ratio of the company. The formula for un-gearing and gearing beta is shown
below.
Ungeared Beta = Industry Beta / [1 + (1–Tax Rate) (Industry Debt Equity Ratio)]
Geared Beta = Ungeared Beta/[1 = (1 – tax rate) (Debt Equity Ratio)]
2.5 EQUITY RISK PREMIUM

Equity Risk Premium is the excess return above the risk free rate that investors demand for
holding risky securities. It is calculated as “Market rate of Return (MRR) minus Risk Free
Rate”. Market rate may be calculated from the movement of share market indices over a
period of an economic cycle basing on moving average to smooth out abnormalities.
Practitioners do not have a consensus on the methodology of calculation of MRR. Many of
them do not calculate the MRR but on an ad-hoc basis they assume 8% to 12% as the equity
risk premium.
Example :
An hypothetical example of computing cost of capital of a company with a 12.5% Debt Capital
of Rs.2,000 crores (redeemable in 10 years), Equity Capital of Rs. 500 crores, Reserves &
Surplus of Rs. 7,500 crores, and without taking Preference Share Capital is shown below.
Assuming the return on Tax-free Government Bonds at 11%, a Beta of 1.06, market rate at
18% and corporate tax rate at 30%, the cost of capital of the company works out as shown
below:
Capital employed (Rs. 10,000 crores) = Debt Capital (Rs. 2,000 crores) + Equity Capital
(Rs. 500 crores + Rs. 7,500 crores)
Equity to Capital Employed = 8,000 / 10,000 = 0.80
Debt to Capital Employed = 2,000 / 10,000 = 0.20
Weighted Average Cost of Capital (WACC)
(0.80 × 18.42% + 0.20 × 8.75% = 16.49%)
Equity to Capital Employed = 0.80 Debt to Capital Employed = 0.20
Cost of Equity Capital (11% + 7.42% = 18.42%)

Risk Free Specific Risk Premium (1.06 × 7% = 7.42%)Cost of Debt Capital
Rate Beta Equity Risk Premium 18% − 11% = 7%
(11%) 1.06 Market Rate of Return Risk Free Rate (8.75%)*
(18%) (11%)
*Payment of interest (after tax) is Rs. 175 crores (Rs. 250 crores – Rs. 75 crores). So, upto
9th year net cash outflow is Rs. 175 crores per year and on 10th year with repayment of
principal cash outflow stands at Rs. 2175 crores.
In the above hypothetical example total cost of capital comes to Rs. 1649 crores i.e., 16.49%
× Rs. 10,000 crores. Maintenance of shareholders’ value will require the company to earn a
NOPAT over Rs. 1649 crores i.e., over its cost of capital. In other words, to maintain
shareholders’ value the % of NOPAT to capital Employed should be greater or at least be
equal to the % of WACC. For the sake of simplicity, if we presume NOPAT is equal to
Accounting Profit then, to maintain shareholder’s value, Return on Capital employed (ROCE)
has to be more than or equal to WACC. In case of a banking and financial company, return on
Tier I and Tier II capital has to be more than WACC to generate a positive EVA.
Extracts from Annual Report of NIIT Limited :
NIIT Limited – Economic Value Added Statement
Year ending 30th September (Rs. Million)* 1997 1998 1999
Average Capital Employed 2793 3503 3859
Average Debt/Total Capital (%) 40% 35% 13%
Beta Variant 1.14 1.17 1.18
Risk free Rate (%) 12.5% 12.5% 12.5%
Market Risk Premium (%) 10.0% 10.0% 8.0%
Cost of Equity (%) 23.9% 24.2% 21.9%
Cost of Debt (post tax) (%) 12% 10% 10%
Weighted Average Cost of Capital (WACC) (%) 19% 19% 20%
Economic Value Added
Opening Profit 857 1,253 1,618
Less: Economic Taxes 87 74 124
NOPAT 770 1,179 1,494
Less: Capital Charge (Av. Capital Employed × WACC) 531 666 772
Economic Value Added 239 513 723

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

1. What is a Economic Value Added Statement? Why such statement is needed?
2. Explain the concept of ‘Economic value added’ (EVA for short) and its uses.
3. What is economic value added and how is it calculated? Discuss.
4. The following information is available of a concern; calculate E.V.A:

Debt capital 12% Rs. 2,000 crores
Equity capital Rs. 500 crores
Reserve and surplus Rs. 7,500 crores
Capital employed Rs. 10,000 crores
Risk-free rate 9%
Beta factor 1.05
Market rate of return 19%
Equity (market) risk premium 10%
Operating profit after tax Rs.2,100 crores
Tax rate 30%
UNIT 3
MARKET VALUE ADDED
3.1 INTRODUCTION
Market Value Added (MVA) is the difference between the current market value of a firm and
the capital contributed by investors. If MVA is positive, the firm has added value. If it is
negative the firm has destroyed value.
To find out whether management has created or destroyed value since its inception, the firm's
MVA can be used:
MVA = Market Value of Capital - Capital employed
This calculation shows the difference between the market value of a company and the capital
contributed by investors (both bondholders and shareholders). In other words, it is the sum of
all capital claims held against the company plus the market value of debt and equity.
Calculated as:
The higher the MVA, the better. A high MVA indicates the company has created substantial
wealth for the shareholders. A negative MVA means that the value of the actions and
investments of management is less than the value of the capital contributed to the company by
the capital markets, meaning wealth or value has been destroyed.
The aim of the company should be to maximize MVA. The aim should not be to maximize the
value of the firm, since this can be easily accomplished by investing ever-increasing amounts
of capital.
3.2 RELATIONSHIP BETWEEN EVA AND MARKET VALUE ADDED

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

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

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

1. MVA does not into account the opportunity costs of the invested capital.
2. MVA does not consider the interim cash returns to the shareholders.
3. MVA can not be calculated at divisional or business unit levels.
1. What is a Market Value Added?
2. Explain the concept of ‘Market value added’ (MVA for short) and its uses.
3. What is Market value added and how is it calculated? Discuss.
UNIT 4
SHAREHOLDERS’ VALUE ADDED
4.1 INTRODUCTION
Shareholders’ Value Added is a value-based performance measure of a company's worth to
shareholders. The basic calculation is net operating profit after tax (NOPAT) minus the cost of
capital from the issuance of debt and equity, based on the company's weighted average cost
of capital (WACC).
4.2 IMPLICATIONS
Shareholder value is a term used in many ways:
• To refer to the market capitalization of a company (rarely used)
• To refer to the concept that the primary goal for a company is to enrich its shareholders
(owners) by paying dividends and/or causing the stock price to increase
• To refer to the more specific concept that planned actions by management and the
returns to shareholders should outperform certain bench-marks such as the cost of
capital concept. In essence, the idea that shareholders money should be used to earn a
higher return then they could earn themselves by investing in risk free bonds for
example.
For a publicly traded company, SV is the part of its capitalization that is equity as opposed to
long-term debt. In the case of only one type of stock, this would roughly be the number of
outstanding shares times current shareprice. Things like dividends augment shareholder value
while issuing of shares (stock options) lower it. This Shareholder value added should be
compared to average/required increase in value, ie. cost of capital.
For a privately held company,the value of the firm after debt must be estimated using one of
several valuation methods, such as. discounted cash flow or others.
This management principle, also known under value based management, states that
management should first and foremost consider the interests of shareholders in its business
decisions. Although this is built into the legal premise of a publicly traded company, this
concept is usually highlighted in opposition to alleged examples of CEO's and other
management actions which enrich themselves at the expense of shareholders. Examples of
this include acquisitions which are dilutive to shareholders, that is, they may cause the
combined company to have twice the profits for example but these might have to be split
amongst three times the shareholders
Self- examination Questions

1. Define the concept of shareholder value added in brief?
2. Differentiate shareholder value added with market value added.
3. Discuss the comparison of economic value added with shareholder value added.
UNIT 5
HUMAN RESOURCE REPORTING
5.1 INTRODUCTION
Human beings are considered central to achievement of productivity, well above equipment,
technology and money. Human Resource Reporting is an attempt to identify, quantify and
report investments made in human resources of an organisation that are not presently
accounted for under conventional accounting practice. The committee on HRA of the
American Accounting Association defined HRA as “the process of identifying and measuring
data about human resources and communicating this information to interested parties”.
However “Human Resources” are not yet recognised as ‘assets’ in the Balance Sheet. The
measures of net income which are provided in the conventional financial statement do not
accurately reflect the level of business performance. Expenses relating to the human
organisation are charged to current revenue instead of being treated as investments to be
amortised over the economic service life, with the result that the magnitude of net income is
significantly distorted.
The necessity of Human resource reporting arose primarily as a result of the growing concern
for human relations management in industry since the sixties of this century. Behavioural
scientists (like R Likert, 1960), concerned with the management of organisations, pointed out
that the failure of accountants to value human resources was a serious handicap for effective
management.
Many people pointed out that it is very difficult to value human resources. Some others have
cautioned that people are sensitive to the value others place on them. A machine never reacts
to an over or under-valuation of its capacity, but an employee will certainly react to such
distortion. Conventionally human resources are treated just as any other services purchased
from outside the business unit. As a result conventional balance sheets fail to reflect the value
of human assets and hence distort the value of the business. The treatment of human
resources as assets is desirable with a view to ensuring comparability and completeness of
financial statements and more efficient allocation of funds as well as providing more useful
information to management for decision-making purposes.
5.2 MODELS OF HRA

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

(1) Capitalisation of historical costs: R. Likert and his associates at R.G. Barry
Corporation in Ohio, Columbia (USA) developed this model in 1967. It was first adopted for
managers in 1968 and then extended to other employees of R.G. Barry Corporation. The
method involves capitalising all costs related with making an employee ready for providing
service – recruitment training, development etc. The sum of such costs for all the employees
of the enterprise is taken to represent the total value of human resources. The value is
amortised annually over the expected length of service of individual employees. The
unamortised cost is shown as investment in human assets. If an employee leaves the firm
(i.e. human assets expire) before the expected service life period, the net asset value to that
extent is charged to current revenue.
This model is simple and easy to understand and satisfies the basic principle of matching cost
and revenues. But historical costs are sunk costs and are irrelevant for decision- making. This
model was severely criticised because it failed to provide a reasonable value to human assets.
It capitalises only training and development costs incurred on employees and ignores the
future expected cost to be incurred for their maintenance. This model distorts the value of
highly skilled human resources. Skilled employees require less training and therefore,
according to this model, will be valued at a lesser cost. For all these reasons, this model has
now been totally rejected.
(2) Replacement Cost: The Flamholtz Model (1973): Replacement cost indicates the value
of sacrifice that an enterprise has to make to replace its human resource by an identical one.
Flamholtz has referred to two different concepts of replacement cost viz. ‘individual
replacement cost’ and ‘positional replacement cost’. The ‘individual replacement cost’ refers to
the cost that would have to be incurred to replace an individual by a substitute who can
provide the same set of services as that of the individual being replaced. The ‘positional
replacement cost’, on the other hand, refers to the cost of replacing the set of services
required of any incumbent in a defined position. Thus the positional replacement cost takes
into account the position in the organisation currently held by an employee and also future
positions expected to be held by him.
However, determination of replacement cost of an employee is highly subjective and often
impossible. Particularly at the management cadre, finding out an exact replacement is very
difficult. The exit of a top management person may substantially change the human asset
value.
(B) Economic Value Models

(1) Opportunity Cost: The Hekimian and Jones Model (1967): This model uses the
opportunity cost, that is the value of an employee in his alternative use, as a basis for
estimating the value of human resources. The opportunity cost value may be established by
competitive bidding within the firm, so that in effect, managers must bid for any scarce
employee. A human asset, therefore, will have a value only if it is a scarce resource, that is,
when its employment in one division denies it to another division.
One of the serious drawbacks of this method is that it excludes employees of the type which
can be ‘hired’ readily from outside the firm, so that the approach seems to be concerned with
only one section of a firm’s human resources, having special skills within the firm or in the
labour market. Secondly, circumstances in which managers may like to bid for an employee
would be rare, in any case, not very numerous.
(2) Discounted wages and salaries: The Lev and Schwartz Model (1971): This model
involves determining the value of human resources as the present value of estimated future
earnings of employees (in the form of wages, salaries etc.) discounted by the rate of return on
investment (cost of capital). According to Lev and Schwartz, the value of human capital
embodied in a person of age τ is the present value of his remaining future earnings from
employment. Their valuation model for a discrete income stream is given by the following:
T I( t )
Vτ = ∑
t =τ (1 + r ) r − τ
Where,
Vτ = the human capital value of a person τ years old.
I(t) = the person’s annual earnings upto retirement.
r = a discount rate specific to the person.
T = retirement age.
However, the above expression is an ex-post computation of human capital value at any age
of the person, since only after retirement can the series I(t) be known. Lev and Schwartz,
therefore, converted their ex-post valuation model to an ex-ante model by replacing the
observed (historical) values of I(t) with estimates of future annual earnings denoted by I*(t).
Accordingly, the estimated value of human capital of a person years old is given by:
T I * (t )
V τ* = ∑
t =τ (1 + r ) t − τ
Lev and Schwartz again pointed out the limitation of the above formulation in the sense that
the above model ignored the possibility of death occurring prior to retirement age. They
suggested that the death factor can be incorporated into the above model with some
modification and accordingly they recommended the following expression for calculating the
expected value of a person’s human capital:
T
Ii *
∑ P (t + 1)
T
E(Vτ* ) = τ ∑
t =τ
t =τ (1 + r ) t − τ
where P (t) is the probability of a person dying at age ‘t’.

Lev and Schwartz have shown in the form of a hypothetical example the method of computing
the firm’s value of human capital. Employees of the hypothetical firm have been decomposed
by age groups and degress of skill and the average annual earnings for each age and skill
group have been ascertained. Finally the present values of future earnings for each group of
employees have been calculated on the basis of a capitalisation rate. The sum of all such
present value of future earnings was taken as the firm’s value of human capital.
In this model, wages and salaries are taken as surrogate for the value of human assets and
therefore it provides a measure of ‘future estimated cost’. Although according to economic
theory, the value of an asset to a firm lies in the rate of return to be derived by the firm from its
employment, Lev and Schwartz model surrogated wages and salaries of the employees for the
income to be derived from their employment. They felt that income generated by the workforce
is very difficult to measure because income is the result of group effort of all factors of
production.
However, this model is subject to the following criticisms:
(a) A person’s value to an organisation is determined not only by the characteristics of the
person himself (as suggested by Lev and Schwartz) but also by the organisational role in
which the individual is utilised. An individual’s knowledge and skill is valuable only if these
are expected to serve as a means to given organisational ends.
(b) The model ignores the possibility and probability that the individual may leave an
organisation for reasons other than death or retirement. The model’s expected value of
human capital is actually a measure of the expected ‘conditional value’ of a person’s
human capital – the implicit condition is that the person will remain in an organisation until
death or retirement. This assumption is not practically social.
(c) It ignores the probability that people may make role changes during their careers. For
example, an Assistant Engineer will not remain in the same position throughout his
expected service life in an organisation.
In spite of the above limitations, this model is the most popular measure of human capital both
in India and abroad.
(3) Stochastic process with service rewards: Flamholtz (1971) Model: Flamholtz (1971)
advocated that an individual’s value to an organisation is determined by the services he is
expected to render. An individual moves through a set of mutually exclusive organisational
roles or service states during a time interval. Such movement can be estimated
probabilistically. The expected service to be derived from an individual is given by:
n
E (S) = ∑
i =1
Si P (Si)
Where Si represent the quantity of services expected to be derived in each state and P(Si) is
the probability that they will be obtained.
However, economic valuation requires that the services of the individuals are to be presented
in terms of a monetary equivalent. This monetary representation can be derived in one of the
two ways:
(a) by determining the product of their quantity and price, and
(b) by calculating the income expected to be derived from their use.
The present worth of human capital may be derived by discounting the monetary equivalent of
expected future services at a specified rate (e.g. interest rate).
The major drawback of this model is that it is difficult to estimate the probabilities of likely
service states of each employee. Determining monetary equivalent of service states is also
very difficult and costly affair. Another limitation of this model arises from the narrow view
taken of an organisation. Since the analysis is restricted to individuals, it ignores the added
value element of individuals operating as groups.
(4) Valuation on group basis: Jaggi and Lau Model: Jaggi and Lau realised that proper
valuation of human resources is not possible unless the contributions of individuals as a group
are taken into consideration. A group refers to homogeneous employees whether working in
the same department or division of the organisation or not. An individual’s expected service
tenure in the organisation is difficult to predict but on a group basis it is relatively easy to
estimate the percentage of people in a group likely to leave the organisation in future. This
model attempted to calculate the present value of all existing employees in each rank. Such
present value is measured with the help of the following steps:
(i) Ascertain the number of employees in each rank.
(ii) Estimate the probability that an employee will be in his rank within the organisation or
terminated/promoted in the next period. This probability will be estimated for a specified
time period.
(iii) Ascertain the economic value of an employee in a specified rank during each time period.
(iv) The present value of existing employees in each rank is obtained by multiplying the above
three factors and applying an appropriate discount rate.
Jaggi and Lau tried to simplify the process of measuring the value of human resources by
considering a group of employees as valuation base. But in the process they ignored the
exceptional qualities of certain skilled employees. The performance of a group may be
seriously affected in the event of exit of a single individual.
5.3 IMPLICATIONS OF HUMAN CAPITAL REPORTING

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

HRA is a recent phenomena in India. Leading public sector units like OIL, BHEL, NTPC,
MMTC, SAIL etc. have started reporting ‘Human Resources’ in their Annual Reports as
additional information from late seventies or early eighties. The Indian companies basically
adopted the model of human resource valuation advocated by Lev and Schwartz (1971). This
is because the Indian companies focussed their attention on the present value of employee
earnings as a measure of their human capital. However, the Indian companies have suitably
modified the Lev and Schwartz model to suit their individual circumstances. For example
BHEL applied Lev and Schwartz model with the following assumptions:
(i) Present pattern of employee compensation including direct and indirect benefits;
(ii) Normal career growth as per the present policies, with vacancies filled from the levels
immediately below;
(iii) Weightage for changes in efficiency due to age, experience and skills;
(iv) Application of a discount factor of 12% per annum on the future earnings to arrive at the
present value.
However, the application of Lev and Schwartz model by the public sector companies has in
many cases, led to over ambitious and arbitrary value of the human assets without giving any
scope for interpreting along with the financial results of the corporation. In the Indian context,
more particularly in the Public Sector, the payments made to the employees are not directly
linked to productivity. The fluctuations in the value of employees’ contributions to the
organisation are seldom proportional to the changes in the payments to employees. All
qualitative factors like the attitude and morale of the employees are out of the purview of Lev
and Schwartz model of human resource valuation.
Illustration 1
From the following information in respect of Exe Ltd., calculate the total value of human capital
by following Lev and Schwartz model:
Distribution of employees of Exe Ltd.
Age Unskilled Semi-skilled Skilled
No . Av. Annual No. Av. Annual No. Av. annual
earnings earnings earnings
(Rs. ’000 ) (Rs. ’000) (Rs.’000)
30-39 70 3 50 3.5 30 5
40-49 20 4 15 5 15 6
50-54 10 5 10 6 5 7
Apply 15% discount factor.
Solution
The present value of earnings of each category of employees is ascertained as below:
(A) Unskilled employees:
Age group 30-39. Assume that all 70 employees are just 30 years old:
Present value
Rs.
Rs. 3,000 p.a. for next 10 years 15,057
Rs. 4,000 p.a. for years 11 to 20 4,960
Rs. 5,000 p.a. for years 21 to 25 1,025
21,042
Age group 40-49. Assume that all 20 employees are just 40 years old:
Rs. 5,000 p.a. for years 11 to 15 4,140
24,216
Age group 50-54: Assume that all 10 employees are just 50 years old:
Similarly, present value of each employee under other categories will be calculated.
(B) Semi-skilled employees:
Present value
Rs.
Age group 30-39.
3,500 p.a. for next 10 years 17,567
Rs. 5,000 p.a. for years 11 to 20 6,200
Rs. 6,000 p.a. for years 21 to 25 1,230
24,997
Age group 40-49.
Rs. 6,000 p.a. for years 11 to 15 4,968
30,063
Age group 50-54.

(C) Skilled employees: Present value
Rs.
Age group 30-39.
Rs. 6,000 p.a. for years 11 to 20 7,440
Rs. 7,000 p.a. for years 21 to 25 1,435
33,970
Age group 40-49.
Rs. 7,000 p.a. for years 11 to 15 5,796
35,910
Age group 50-54.
Total value of Human Capital

Age Unskilled Semi-skilled Skilled Total
No. Av. annual No. Av.annual No. Av.annual No. Av.annual

earnings. earnings earnings earnings
(Rs. ‘000) (Rs. ‘000) (Rs. ‘000) (Rs. ‘000)
30-39 70 14,72,940 50 12,49,850 30 10,19,100 150 37,41,890
40-49 20 4,94,320 15 4,50,945 15 5,38,650 50 14,73,915
50-54 10 1,67,600 10 2,01,120 5 1,17,320 25 4,86,040
100 21,24,860 75 19,01,915 50 16,75,070 57,01,845
The central problem in HRA is not what kind of resources should be treated, but rather when
the resources should be recognised. This timing issue is particularly important because human
resources are not owned by the firm, while many physical resources are. However, the firm
also uses many services from physical resources which it does not own. The accounting
treatment for such services should, therefore, be the same as the treatment used for human
resources. Traditional accounting involves treatment of human capital and non-human capital
differently. While non-human capital is represented by the recorded value of assets, the only
reference to be found in financial statement about human resources are entries in the income
statement in respect of wages and salaries, directors’ fees etc. But it should be kept in mind
that measuring and reporting the value of human assets in financial statements would prevent
management from liquidating human resources or overlooking profitable investments in human
resources in a period of profit squeeze. But while valuing human assets one should not lose
sight of the fact that human beings are highly sensitive to external forces and human skills in
an organisation do not remain static. Skill formation, skill obsolescence or utilisation may take
a continuous process. Besides, employee attitude, loyalty, commitment, job satisfaction etc.
may also influence the way in which human resource skills are utilised. Therefore human
resources should be valued in such a way so as to cover the qualitative aspects of human
beings. As human beings are highly susceptible to certain behavioural factors (unlike physical
assets), any human resource valuation model without behavioural features can hardly present
the value of human assets in an objective manner. However while attaching respective
weightage to behavioural factors, care should be taken to avoid excessive subjectiveness.
1. Is Human Resource Accounting essential?
2. Why R. Likert’s model of human resource valuation is now totally rejected?
3. Comment upon the Lev and Schwartz model.
4. From the following information in respect of Pathetic Ltd., Calculate the total value of
human capital by following Lev and Schwartz model:
Distribution of employees:
Unskilled Semi-skilled Skilled
Age No. Average No. Average No. Average
Annual Annual
Annual
earnings earning earnings
(Rs. ’000) (Rs. ’000) (Rs. ’000)
25–34 150 2.5 100 4 56 5
35–44 110 3.5 75 5.5 42 7
45–54 50 5 40 7 25 9
55–58 20 7 15 8.5 10 12
Apply 20% discount factor.
5. Discuss critically two Flamholtz’s model on human resource valuation. Which model is
better?
UNIT 6
INFLATION ACCOUNTING
6.1 INTRODUCTION
Inflation accounting is an accounting system that adjusts values for changes in purchasing
power. The system of inflation accounting should be such that, with minor modifications, it will
yield the necessary information to moderate proper management. As all of us are already
aware from the fact that Money Measurement Concept is a fundamental accounting
assumption of Accounting. According to this assumption, only those business transactions
which are capable of being expressed in terms of money are recorded by the accounting
system. It is also assumed that monetary unit, recording the business transactions, is stable
in nature. This is, however, not true in practical situations as all the countries-developing as
well as developed have been experiencing/have experienced inflation of a very high
magnitude during different time spans. Inflation brings downward changes in the purchasing
power of the monetary unit and thus makes its stability a myth. It is obvious that financial
statements prepared without any regard to the current purchasing power of the monetary unit
lose much of their significance and can not be properly appreciated by their various users,
such as investors, lenders, Government, Employees and Management, who are interested in
them, in a meaningful manner. They, therefore, lose their utilty. However, their utility can be
restored by making adjustments for the changes in the purchasing power of the monetary unit.
In India, though the post-independence era has seen high rate of inflation, not much
awareness seems to have developed about this problem. The present chapter on inflation
accounting concentrates on accounting for current purchasing power of rupee (i.e., the
monetary unit prevalent in India) and seeks to suggest an acceptable solution to the problem
in the Indian context.
6.2 PARIMARY PURPOSE OF THE FINANCIAL STATEMENTS

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

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

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

Under this method any established and approved general price index is used to convert the
values of various items in the balance-sheet and the profit and loss account. The main
argument is that a change in the price level reflects change in the value of the rupee. This
change is denoted by a general price index. In India, we may take a general price index like
the Wholesale Price Index of the Reserve Bank of India which would show the changes in the
value of the rupee in the past years. Thus, if we want to add up the values of certain assets
purchased in 1992, to those of some other assets purchased in 2000, we can do so only after
we have converted the rupee values of 2000 in terms of rupees of 1992.
The CPP Method accounts for changes in the value of money. It does not account for
changes in the value of the individual assets. Thus, a particular machine may have become
cheaper over the last few years, whereas the general price level may have risen; the value of
the machine will also be raised in accordance with the general price index. This is because
we are not trying to work out the current values of the various assets in the possession of the
business. What we are trying to achieve is that the financial statements should be stated in
terms of rupees of uniform value.
The basic aspects of the CPP Method can be explained as follows:
1. Inflation, which is the decline in the purchasing power of money as the general price of
goods and services rises, affects most aspects of economic life, including investment
decisions wage negotiations, pricing policies, international trade and government taxation
policy.
2. It is important that managements and other users of financial accounts should be in a
position to appreciate the effects of inflation on the business entities with which they are
concerned – for example, the effects on costs, profits distribution policies, dividend cover, the
exercise of borrowing powers, returns on funds and future cash needs etc. The purpose of
this statement is the limited one of establishing a standard practice for disclosing the effect of
changes in the purchasing power of money on accounts prepared on the basis of existing
conventions. It does not suggest the abandonment of the historical cost convention, but
simply that historical costs should be converted from an aggregation of historical rupees of
many different purchasing powers into approximate figure of current purchasing power and
that this information should be given in a supplement to the basic accounts prepared on the
historical cost basis.
Monetary and Non-Monetary Items:

In converting the figures in the basic historical cost accounts into those in the supplementary
current purchasing power statement a distinction is drawn between:
(a) monetary items; and
(b) non-monetary items.
Monetary items are those whose amounts are fixed by contract or otherwise in terms of
specified rupees, regardless of changes in general price level. Examples of monetary items
are cash, debtors, creditors and loan capital. Holders of monetary assets lose general
purchasing power during a period of inflation to the extent that any income from the assets
does not adequately compensate for the loss; the reverse applies to those having monetary
liabilities. A company with a material excess on average over the year of long, and short-term
debts (e.g., debentures and creditors) over debtors and cash will show, in its supplementary
current purchasing power statement, a gain in purchasing power during the year.
It has been argued that the gain on long-term borrowing should not be shown as profit in the
supplementary statement because it might not bepossible to distribute it without raising
additional finance. This argument, however, confuses the measurement of profitability, with
the measurement of liquidity. Even in the absence of inflation, the whole of a company’s profit
may not be distributable without raising additional finance for example because it has been
invested in, or earmarked for, investment in non-liquid assets.
Moreover, it is inconsistent to exclude such gain when profit has been debited with the cost of
borrowing (which must be assumed to reflect anticipation of inflation by the lender during the
currency of the loan) and with depreciation on the converted value of fixed assets.
Non-monetary items include such assets as stock, plant and buildings. The retention of the
historical cost concept requires that holders of non-monetary assets are assumed neither to
gain nor to lose purchasing power of the rupee.
The owners of a company’s equity capital have the residual claim on its net monetary and
non-monetary assets. The equity interest is therefore neither a monetary nor a non-monetary
item.
CONVERSION PROCESS
20. In converting from basic historical cost accounts to supplementary current purchasing
power statements for any particular period.
(a) monetary items in the balance sheet at the end of the period remain the same;
(b) non-monetary items are increased in proportion to the inflation that has occurred since their
acquisition or revaluation (and conversely, reduced in times of deflation)
In the conversion process, after increasing non-monetary items by the amount of inflation, it is
necessary to apply the test of lower of cost (expressed in rupees of current purchasing power)
and net realizable value to relevant current assets, e.g., stocks, and further to adjust the
figures if necessary. Similarly, after restating fixed assets in terms of pounds of current
purchasing power, the question of the value of the business needs to be reviewed in that
context and provision made if necessary.
In applying these tests, and during the whole process of conversion, it is important to balance
the effort involved against the materiality of the figures concerned. The supplementary current
purchasing power statement can be no more than an approximation, and it is pointless to
strive for over-elaborate precision.
Example 1. A company bought investments at a cost of Rs.6,00,000 on July 1, 2005 when
the price index stood at 300. On 31st March, 2006 the index had moved to 320 and the market
value of the investments was Rs.6,10,000. On CPP basis, what is the loss or profit on the
investment?
Solution
Rs.
The “Cost” on CPP basis on 31st March, 2006, Rs.6,00,000 x 320/300 6,40,000
Market Value 6,10,000
Loss 30,000
Example 2 Ess Ltd. made a sale of Rs.67,50,000 during the year ended 31st March, 2006.
The price indices were 250 in the beginning of the year, 270 in the middle of year and 300 at
the end. Using year-end price adjustment basis, what is the sale under the CPP Method?
Answer. Sale for CPP purpose: Rs.67,50,000 x 300/270 or Rs.75,00,000.
6.6 CURRENT COST ACCOUNTING

This system takes into account price changes relevant to the particular firm or industry rather
than the economy as a whole. It seeks to arrive at a profit which can be safely distributed as
dividend without ipairing the operational capability of the firm. In addition to adjustments for
depreciation and cost of sales, it deals with the working capital and also loans raised. The
ambit is operation profit and operating capital employed.
Current cost accounting has the following important features:
(a) Fixed assets are to be shown in the balance sheet at their value to the business and not at
the lower of their original cost and realizable value.
(b) Stocks are to be shown in the balance sheet at their value to the business and not at the
lower of their original cost and realizable value.
(c) Depreciation for the year is to be calculated on the current value of the relevant fixed
assets.
(d) The cost of stock consumed during the year is to be calculated on the value to the business
of the stock at the date of consumption and not at the date of purchase.
(e) The effects of the loss orgain from loans will be computed and set off against interest.
The increased replacement cost of fixed assets and of stocks, the increased requirements for
monetary working capital and the under provision of depreciation in the past years may be
adjusted through a revaluation reserve.
Fixed assets in the balance sheet should be shown at their ‘value of the business’, which is
defined as the amount which the company would lose if it were deprived of the assets. The
value to the business can be defined in one of the following three ways:
(a) Net Replacement Value: This refers to the money now required to buy a new asset of
the same type as the existing one less an amount of depreciation that recognizes the fact
that the true replacement of the asset would not be a new asset but an asset which has
the same remaining useful life as the existing asset. Suppose, a machine whose total life
is 10 years can now be procured for Rs.80,000. Suppose further that the machine is 5
years old. Assuming that the machine has no scrap value, the net replacement cost of
the machine would be Rs.80,000 minus depreciation for 5 years, i.e., Rs.40,000.
(b) Net Realisable Value: This is the value which is represented by the net cash proceeds
which would be received if the existing asset is sold now.
(c) Economic Value: This refers to the present value of the net income that will be earned
from using the existing asset during the rest of its life. Suppose, the net cash inflow (gross
income minus expenditure of the machine in our example) is Rs.8,000 per annum. This
means that in the 5 years of its remaining life it will yield Rs.40,000 in all. Since the sum
(Rs.40,000) will be accruing over the next 5 years and not immediately, it should be
discounted and the present value of the future net cash inflows worked out.
The three values discussed above represent the purchase, sale and the holding value of the
asset. The net replacement cost is usually the best indicator of the value to the business of
an asset.
The value to the business of the self-occupied land and buildings will normally be the open
market value for their existing use plus estimated attributable acquisition costs. The
depreciated replacement cost of the buildings and the open market value of land, including the
estimated acquisition costs for the existing use, should be taken as their value to the
business. Such as valuation should be made by a professionally qualified valuer at intervals
of not more than 5 years.
Plant and machinery should be valued at their net current replacement costs. For this
purpose, the gross current replacement cost of plant and machinery should be worked out.
This is the cost that would have to be incurred to obtain and install at the date of the
valuation, a substantially identical replacement assets in new condition. Since the plant and
machinery is not new, the gross replacement cost arrived at as above should be written down
with reference to the number of years that the existing plant and machinery has already
served. In other words, depreciation should be charged on the gross current replacement cost
on the basis of the expired service potential of the asset in question.
Investments held by the company, not as current assets, should be valued at their value to
business. This implies that the quoted investments should be based on the stock market mid
prices and the unquoted investments should be based on the directors’ valuation of, on the
basis of the current cost, net asset value of the company in which the investments have been
made or on the basis of the present value of the likely future income from the unquoted
investments.
In case investments are held as current assets, their treatment should be the same as that of
stock and work in progress.

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

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

1. Fixed Assets are shown in the balance sheet at their current values and not at their
depreciated original costs.
2. Stocks are shown in the balance sheet at their value to the business, i.e., at the value
prevailing on the date of the balance sheet. These are not shown at cost or market price
whichever is lower as is done in case of historical accounting.
3. To find out profit for the year, depreciation is calculated on the current values of the
relevant fixed assets.
4. The difference between the current values and the depreciated original costs of fixed
assets is transferred to Revaluation Reserve Account and is written on the liabilities side of
the balance sheet. The revaluation reserve is not available f or distribution as dividend but
is utilised for increased replacement cost of fixed assets and under provision of
depreciation in the past years.
5. The cost of stock consumed during the year is taken at curr4ent value of the stock at the
date of consumption and not the purchase price of the stock consumed.
6. Monetary assets and liabilities a re not adjusted under this method because they a re
always recorded at their value to the business. The values of these items do not change
with changes in price level because we are not going to receive more or pay less on
account of these items.
7. Under current cost accounting approach of inflation accounting, accounting profit is divided
into three parts: (i) current operating profit, (ii) realised holding gain, and (iii) unrealised
holding gain. The above classification is made to show separately the effect of holding
non-monetary assets (i.e., holding activities) during inflation. It will also help to assess
properly the result of operating activities. Now, we may give below the meaning of these
types of profits.
Realised holding Gain. It is the excess of the replacement cost of a non-monetary asset on
the closing date over its historical cost. Such a gain is shown separately in the balance sheet
as revaluation reserve and is not available for distribution as dividend but is utilised for
increased replacement cost of the non-monetary asset.
Current Operating Profit. It is the excess of the sale proceeds of goods and services sold
during a particular accounting period over the replacement cost of the goods or services sold
on the dates the sales were effect.
For calculating current operating profit, following adjustments are to be made in the current
cost accounting method:
(a) Depreciation adjustment
(b) Cost of sales adjustment (COSA)
(c) Monetary working capital adjustment (MWCA)
(d) Gearing adjustment.
(a) Depreciation adjustment: Profit and Loss Account should be debited for depreciation
calculated on the basis of current value of the fixed asset to the business. Depreciation
should not be calculated on the basis of historical cost of the fixed asset; rather it should be
calculated on the replacement cost of the asset (i.e., current value of the asset to the
business). The current depreciation charge under CCA method is obtained by apportioning
the average net replacement cost over the expected remaining useful life of the fixed asset at
the beginning of the period. When fixed assets are revalued every year, there will be a
shortfall of depreciation known as backlog depreciation representing the effect of price rise
during the period. Backlog depreciation can be taken as the additional amount required to
increase the total of the accummulated depreciation at the beginning of any accounting year
and the charge for depreciation for that year to the amount required to equal the difference
between the gross and net replacement cost of an asset at the end of the year.
For example, a concern uses a fixed asset which has a historical gross value of Rs.50,000
and the accumulated depreciation of Rs.20,000 including Rs.5,000 depreciation for the current
year. The gross repalceme3nt cost of the machine is Rs.1,00,000 and it is estimated that its
remaining useful life will not change. In this case, depreciation and backlog depreciation
under CCA method will be calculated as given below:
Historical Cost Current Cost
Accounting Accounting
Rs. Rs.
Value of the asset 50,000 1,00,000
Current depreciation 5,000 10,000
Previous accumulated depreciation 15,000 30,000
Total accumulated depreciation 20,000 40,000
Balance sheet value 30,000 60,000
Backlog depreciation = Gross replacement cost – net replacement cost
- (previous accumulated depreciation+depreciation for the
current year)
= 1,00,000- 60,000 – (15,000 + 10,000)
= 40,000 – 25,000 = Rs.15,000
The amount of backlog depreciation should be charged to current cost reserve or it should be
adjusted against revaluation surplus on the fixed assets.
In the above example, the current cost depreciation is Rs.10,000 against the historic cost
depreciation of Rs.5,000. Therefore, depreciation adjustment required is Rs.5,000 (i.e.,

Rs.10,000 – Rs.5,000)
(c) Cost of Sales Adjustment (COSA): This adjustment is made for determining current cost
operating profit and represents the difference between value to the business and the historical
cost of stock consumed in the period. It is determined as given below:
⎛C O⎞
COSA = (C – O) - I a ⎜⎜ − ⎟⎟
⎝ Ic Io ⎠
Where
O = Historical cost of opening stock
C = Historical cost of closing stock
Ia = Average index number for the period
Io = Index number appropriate to opening MWC.
Ic = Index number of appropriate to closing MWC.
(d) Gearing Adjustment. Gearing is the ratio of borrowed capital and shareholders’ funds.
Fixed assets and working capital are partly financed by borrowed capital and partly by
shareholders’ funds. But the amount of borrowed capital to be repaid will not change on
account of changing prices because it is fixed by agreement. During inflation the value to the
business of assets exceeds the amount of borrowings that has financed them. Thus,
shareholders enjoy an advantage in the period of rising prices because the benefit of increase
in prices is fully given to shareholders. Reverse effect is experienced when prices decline. As
a result the profit attributable to shareholders would be understated/overstated if the whole of
additional depreciation, cost of sales adjustment and monetary working capital adjustment
were charged in the profit and loss account. The total of these adjustments is abated by
another adjustment known as gearing adjustment. After gearing adjustment, current cost
operating profit will be abated and this abated profit will be attributable to shareholders would
be understated/overstated if the whole of additional depreciation, cost of sales adjustment and
monetary working capital adjustment were charged in the profit and loss account. The total of
these adjustments is abated by another adjustment known as gearing adjustment. After
gearing adjustment, current cost operating profit will be abated and this abated profit will be
attributable to shareholders which will reflect the result of adjustment to the historical cost
trading profit. Gearing adjustment is calculated by applying the following formula:
L
Gearing Adjustment = ×A
L+S
Where L = Average net borrowing

S = Average shareholders’ funds

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

The following points of criticism against the CCA can still, however, be made:-
(a) The system ignores, in reality, the question of backlog deprecation; even if from the very
beginning inflation is kept in view, the accumulated depreciation will not be equal to the
funds ultimately required for replacement. Properly, the backlog depreciation should be
charged against revenue reserves available for dividend – only then will management be
restrained from disposing of profits required really for replacement of funds.
(b) Even if the depreciation funds are adequate for replacement, they will be adequate for
replacement for similar assets; they may not suffice for moving into another industry. It is
surely the duty of management to do constant and serious thinking about its business
policies and take stock of its resources, including financial resources, and husband them
properly.
6.8 MISCELLANEOUS ILLUSTRATIONS
Illustration 1
On 31st March, 1996, when the general price index was say 100, Forward Ltd. purchased fixed
assets of Rs. one crore. It had also permanent working capital of Rs.40 lakh. The entire
amount required for purchase and permanent working capital was financed by 10%
redeemable preference share capital. Forward Ltd. wants to maintain its physical capital
On 31st March, 2006, the company had reserves of Rs.1.75 crore. The general price index on
this day was 200. The written down value of fixed assets was Rs.10 lakh and they were sold
for Rs.1.5 crore. The proceeds were utilized for redemption of preference shares.
On the same day (31st March, 2006) the company purchased a new factory for Rs.10 crore.
The ratio of permanent working capital to cost of assets is to be maintained at 0.4:1.
The company raised the additional funds required by issue of equity share.
Based on the above information (a) Quantify the amount of equity capital raised and (b) Show
the Balance Sheet as on 1.4.2006.
Solution
(Rs. in crores)
(i) Preference share capital on 31st March, 2006:
Fixed assets 1.0
Working capital 0.4
10% Redeemable preference share capital 1.4
=====
To maintain physical capital, the company needs to evaluate the financial capital on 31st
March, 2006 which is required to maintain the existing operating capability of the physical
assets. On the basis of price index data available, it has been worked out as follows:
200
Rs. 1.4 crore × = Rs. 2.8 crore
100
The actual amount has been moré than this minimum capital required to be maintained as can
be seen below:
(ii) Working capital on 31st March, 2006:

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

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

Equity Share Capital 10.85 Fixed Assets 10.00
Reserves and Surplus 3.15 Working Capital 4.00
14.00 14.00
====== =====
Illustration 2
Zero Limited commenced its business on 1st April, 2006, 2,00,000 equity shares of Rs.10 each
at par and 12.5% debentures of the aggregate value of Rs.2,00,000 were issued and fully
taken up. The proceeds were utilized as under:
Rs.
Fixtures and Equipments 16,00,000
(Estimated life 10 years, no scrap value)
Goods purchased for resale at Rs.200 per unit 6,00,000
The goods were entirely sold by 31st January, 2006 at a profit of 40% on selling price.
Collections from debtors outstanding on 31st March, 2006 amounted to Rs.60,000, goods sold
were replaced at a cost of Rs.7,20,000, the number of units purchased being the same as
before. A payment of Rs.40,000 to a supplier was outstanding as on 31st March, 2006.
The replaced goods remained entirely in stock on 31st March, 2006.
Replacement cost as at 31st March, 2006 was considered to be Rs.280 per unit.
Replacement cost of fixtures and equipments (depreciation on straight line basis) was
Rs.20,00,000 as at 31st March, 2006.
Draft the Profit and Loss Account and the Balance Sheet on replacement cost (entry value)
basis and on historical cost basis.
Solution
Profit and Loss Account for the year ended 31st March, 2006
Historical Cost Replacement
Basis Cost Basis
Rs. Rs.
Sales 10,00,000 10,00,000
Less: Cost of Sales 6,00,000 7,20,000
Gross Profit 4,00,000 2,80,000
Less: Depreciation 1,60,000 1,80,000
Profit before interest 2,40,000 1,00,000
Less: Debenture Interest 25,000 25,000
Net Profit 2,15,000 75,000
Balance Sheet of Zero Limited as at 31st March, 2006
Historical Cost Replacement Cost
Basis Basis
Rs. Rs.
Liabilities
Equity Share Capital 20,00,000 20,00,000
Profit and Loss Account 2,15,000 75,000
Replacement Reserve ---- 6,20,000
12.5% Debentures 2,00,000 2,00,000
Creditors 40,000 40,000
24,55,000 29,35,000
Rs. Rs.
Assets
Fixtures and Equipment 14,40,000 18,00,000
Stock 7,20,000 8,40,000
Debtors 60,000 60,000
Cash and Bank 2,35,000 2,35,000
Working Notes:
(i) Replacement cost of sales on the basis of replacement cost on the date of sale = Rs. 240 x
3,000 = Rs.7,20,000.
(ii) Under replacement cost basis, depreciation, calculated on the average basis = 10% of
Rs.16,00,000 + Rs.20,000
= Rs.1,80,000
2
(iii) Fixtures and equipments at net current replacement cost.
Rs.
Gross replacement cost 20,00,000
Less: Depreciation, 10% of Rs.20,00,000 2,00,000
18,00,000
(iv) Replacement Reserve = Realised holding gains + Unrealised holding gains
Realised Unrealised
holding gains holding gains
Rs. Rs.
Stocks:
Sold [replacement cost at the date of
sale – historical cost]
Rs.[7,20,000 – 6,00,000) 1,20,000
Unsold [closing stock x (closing rate – rate at the
date of purchase)]
= 3,000 x Rs.280 – 240)] 1,20,000
Fixtures and Equipments:
Depreciation Rs. (1,80,000 – 1,60,000) 20,000
Net book value at year end,
Rs.(18,00,000 – 14,40,000) 3,60,000
1,40,000 4,80,000
======= ========
Replacement + Reserve = Rs.1,40,000 + Rs.4,80,000 = Rs.6,20,000.
Illustration 3
The following data relate to Bearing Ltd:
On 1.4.2005 On 31.3.2006
(Rs.’000) (Rs.’000)
(a) Net long-term borrowing 25,000 28,000
Creditors 15,000 5,000
Bank overdraft 6,000 10,600
Taxation 2,000 2,000
Cash (9,000) (14,800)
39,000 30,800
====== =====
(b) Share capital and reserves from current cost 74,000 94,000
balance sheet
Proposed dividend 1,160 1,312
75,160 95,312
===== =====
(c) Current cost adjustment depreciation 3,400
Fixed assets disposal 3,600
Cost of sales adjustments 3,240
Monetary working capital adjustment 2,240
12,480
Compute:
(i) Gearing adjustment ratio; and
(ii) Current cost adjustment after abating gearing adjustment.
Solution
On1.4.2005 On 31.3.2006
(Rs. ‘ 000) (Rs.’000)
Average Net Borrowing 39,000 30,800
Total Shareholders Interest (Average 75,160 95,312
Total 1,14,160 1,26,112
======= =======
(39,000 + 30,800)/2 x 100 = 29.05%

Gearing Adjustment Ratio –
(1,14,160 + 1,26,112)/2
Total Current Cost Adjustment 12,480

Less: Gearing (29.05% of 12,480) 3,625
Current Cost Adjustment after abating 8,855
Gearing Adjustment
Illustration 4
A company had the following monetary items on January 1:
Rs.
Debtors 41,000
Bills Receivable 10,000
Cash 20,000
71,000
Less: Bills Payable 10,000
Creditors 25,000 35,000
Net Monetary Assets 36,000
The transactions affecting, monetary items during the year were:
(a) Sales of Rs.1,40,000 made evenly throughout the year.
(b) Purchases of goods of Rs.1,05,000 made evenly during the year.
(c) Operating expenses of Rs.35,000 were incurred evenly throughout the year.
(d) One machine was sold for Rs.18,000 on July 1.

(e) One machine was purchased for Rs.25,000 on December 31.
The general price index was as follows:
On January 1 300
Average for the year 350
On July 1 360
On December 31 400
You are required to compute the general purchasing power, gain or loss, for the year stated in
terms of the current year end rupee.
Solution
STATEMENT OF GENERAL PURCHASING POWER GAIN OR LOSS

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

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

beginning of 2006:
Cash at Bank 15,000 125/100 18,750

⎛ 125 ⎞
⎜15,000 × ⎟
⎝ 100 ⎠
Accounts Receivable 45,000 125/100 56,250
⎛ 125 ⎞
⎜ 45,000 × ⎟
⎝ 100 ⎠
Add: Increase in
monetary assets during
the year
Cash at Bank 6,000 125/120 6,250
(21,000- ⎛ 125 ⎞
15,000) ⎜ 6,000 × ⎟
⎝ 120 ⎠
Accounts Receivable 9,000 125/120 9,375
(54,000 – ⎛ 125 ⎞
45,000) ⎜ 9,000 × ⎟
⎝ 120 ⎠
Total 75,000 90,625
Purchasing Power Loss
(90,625 – 75,000) 15,625
Monetary liabilities a t the

beginning of 2006:
Accounts Payable 75,000 125/100 93,750
⎛ 125 ⎞
⎜ 75,000 × ⎟
⎝ 100 ⎠
Less: Decrease in 25,000 125/120 26,042

Accounts Payable
⎛ 125 ⎞
⎜ 25,000 × ⎟
⎝ 120 ⎠
50,000 67,708
Purchasing Power Gain
(67,708 – 50,000) 17,708
Net Purchasing Power 2,083

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

Rs.
Inventory on 31-12-2005 40,000 200
Purchases during 2006 3,10,000 220 (Average for 1996)
Inventory on 31.12.2006 50,000 230
Solution
Cost of Sales is: Rs.
Opening inventory 40,000
Add: Purchases 3,10,000
3,50,000
Less: Closing inventory 50,000
Cost of sales 3,00,000
1. What is meant by inflation accounting?
2. What are the limitations of historical accounting in a period of inflation?
3. Explain Current Cost Accounting.
4. The fixed assets of a company were stated as follows in the balance sheet:
31.3.2005 31.3.2006
Rs. Rs.
Land at cost 5,00,000 5,00,000
Building at cost 20,00,000 20,00,000
Plant and Machinery 1,00,00,000 1,25,00,000
1,25,00,000 1,50,00,000
The depreciation provision was:
Buildings 2,50,000 3,00,000
Plant and Machinery 50,00,000 62,50,000
The depreciation was provided on straight line basis @ 2½% p.a. on building and 10% p.a.
on plant and machinery ignoring scrap value.
The following price indices can be confidently applied to the assets of the company to
arrive at present day prices, the base year being 2005-2006.
31.3.2005 31.3.2006
Land 200 250
Buildings 150 180
Plant and Machinery 200 225
Show the adjustments to be made under the CCA resulting from the information given
above.
5. The balance sheet of Wye Ltd revealed the following among other things:
31.3.2005 31.3.2006
Rs. Rs.
Inventories 5,50,000 6,10,000
Book debts 4,50,000 5,50,000
Cash at Bank 60,000 80,000
Advances for supply of materials 1,00,000 1,26,500
Due to suppliers 2,50,000 3,22,000
During 2005-2006 material prices rose by 15% and those of finished goods by 10%.
Calculate the Monetary Working Capital Adjustment to be made under the Current Cost
Accounting system.
APPENDIX I
AS 1 : DISCLOSURE OF ACCOUNTING POLICIES∗
The following is the text of the Accounting Standard 1(AS-1) issued by the Accounting Standards
Board, the Institute of Chartered Accountants of India on “Disclosure of Accounting Policies”. The
Standard deals with the disclosure of significant accounting policies followed in preparing and
presenting financial statements.
In the initial years, this accounting standard will be recommendatory in character. During this
period, this standard is recommended for use by companies listed on a recognised stock
exchange and other large commercial, industrial and business enterprises in the public and
private sectors.
INTRODUCTION
1. This statement deals with the disclosure of significant accounting policies followed in
preparing presenting financial statements.
2. The view presented in the financial statements of an enterprise of its state of affairs and
of the profit or loss can be significantly affected by the accounting policies followed in the
preparation and presentation of the financial statements. The accounting policies followed
vary from enterprise to enterprise. Disclosure of significant accounting policies followed is
necessary if the view presented is to be properly appreciated.
3. The disclosure of some of accounting policies followed in the preparation and
presentation of the financial statements is required by law in some cases.
4. The Institute of Chartered Accountants of India has, in Statements issued by it,
recommended the disclosure of certain accounting policies, e.g., translation policies in respect
of foreign currency items.
5. In recent years, a few enterprises in India have adopted the practice of including in their
annual reports to shareholders a separate statement of accounting policies followed in
preparing and presenting the financial statements.
6. In general, however, accounting policies are not at present regularly and fully disclosed
in all financial statements. Many enterprises include in the Notes on the Accounts,
∗
Issued in November, 1979
I.2 Financial Reporting
descriptions of some of the significant accounting policies. But the nature and degree of
disclosure vary considerably between the corporate and the non-corporate sectors and
between units in the same sector.
7. Even among the few enterprises that presently include in their annual reports a separate
statement of accounting policies, considerable variation exists. The statement of accounting
policies form part of accounts in some cases while in others it is given as supplementary
information.
8. The purpose of this statement is to promote better understanding of financial statements
by establishing through an accounting standard the disclosure of significant accounting
policies and the manner in which accounting policies are disclosed in the financial statements.
Such disclosure would also facilitate a more meaningful comparison between financial
statements of different enterprises.
Explanation
Fundamental Accounting Assumptions

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

11. The accounting policies refer to the specific accounting principles and the methods of
applying those principles adopted by the enterprise in the preparation and presentation of
financial statements.
Appendix I : Accounting Standards I.3
12. There is no single list of accounting policies which are applicable to all circumstances.
The differing circumstances in which enterprises operate in a situation of diverse and complex
economic activity make alternative accounting principles and methods of applying those
principles acceptable. The choice of the appropriate accounting principles and the methods of
applying those principles in the specific circumstances of each enterprise calls for
considerable judgment by the management of the enterprise.
13. The various statements of the Institute of Chartered Accountants of India combined with
the efforts of government and other regulatory agencies and progressive managements have
reduced in recent years the number of acceptable alternatives particularly in the case of
corporate enterprises. While continuing efforts in this regard in future are likely to reduce the
number still further, the availability of alternative accounting principles and methods of
applying those principles is not likely to be eliminated altogether in view of the differing
circumstances faced by the enterprises.
Areas in Which Differing Accounting Policies are Encountered

14. The following are examples of the areas in which different accounting policies may be
adopted by different enterprises.
♦ Methods of depreciation, depletion and amortisation
♦ Treatment of expenditure during construction
♦ Conversion or translation of foreign currency items
♦ Valuation of inventories
♦ Treatment of goodwill
♦ Valuation of investments
♦ Treatment of retirement benefits
♦ Recognition of profit on long-term contracts
♦ Valuation of fixed assets
♦ Treatment of contingent liabilities
15. The above list of examples is not intended to be exhaustive.
Considerations in the Selection of Accounting Policies

16. The primary consideration in the selection of Accounting Policies by an enterprise is that
the financial statements prepared and presented on the basis of such accounting policies
should represent a true and fair view of the state of affairs of the enterprise as at the Balance
Sheet date and of the profit or loss for the period ended on that date.
17. For this purpose, the major considerations governing the selection and application of
accounting policies are :—

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

18. To ensure proper understanding of financial statements, it is necessary that all significant
accounting policies adopted in the preparation and presentation of financial statements should
be disclosed.
19. Such disclosure should form part of the financial statements.
20. It would be helpful to the reader of financial statements if they are all disclosed as such in
one place instead of being scattered over several statements, schedules and notes.
21. Examples of matters in respect of which disclosure of accounting policies adopted will be
required are contained in paragraph 14. This list of examples is not, however, intended to be
exhaustive.
22. Any change in an accounting policy which has a material effect should be disclosed. The
amount by which any item in the financial statements is affected by such change should also
be disclosed to the extent ascertainable. Where such amount is not ascertainable, wholly or in
part, the fact should be indicated. If a change is made in the accounting policies which has no
material effect on the financial statements for the current period but which is reasonably
expected to have a material effect in later periods, the fact of such change should be
appropriately disclosed in the period in which the change is adopted.
23. Disclosure of accounting policies or of changes therein cannot remedy a wrong or
inappropriate treatment of the item in the accounts.
Accounting Standard
(The Accounting Standard comprises paragraphs 24-27 of this Statement. The Standard
should be read in the context of paragraphs 1-23 of this Statement and of the Preface to the
Statements of Accounting Standards.)

24. All significant accounting policies adopted in the preparation and presentation of
financial statements should be disclosed.
25. The disclosure of the significant accounting policies as such should form part of
the financial statements and the significant accounting policies should normally be
disclosed in one place.
26. Any change in the accounting policies which has a material effect in the current
period or which is reasonably expected to have a material effect in later periods should
be disclosed. In the case of a change in accounting policies which has a material effect
in the current period, the amount by which any item in the financial statements is
affected by such change should also be disclosed to the extent ascertainable. Where
such amount is not ascertainable, wholly or in part, the fact should be indicated.
27. If the fundamental accounting assumptions, viz. Going concern, Consistency and
Accrual are followed in financial statements, specific disclosure is not required. If a
fundamental accounting assumption is not followed, the fact should be disclosed.
AS 2 (REVISED) : VALUATION OF INVENTORIES
The following is the text of the revised Accounting Standard (AS) 2, ‘Valuation of Inventories’,
issued by the Council of the Institute of Chartered Accountants of India. This revised Standard
supersedes Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued in June, 1981. The
revised standard comes into effect in respect of accounting periods commencing on or after
1.4.1999 and is mandatory in nature.
Objective
A primary issue in accounting for inventories is the determination of the value at which
inventories are carried in the financial statements until the related revenues are recognised.
This Statement deals with the determination of such value, including the ascertainment of cost
of inventories and any write-down thereof to net realisable value.
Scope
1. This Statement should be applied in accounting for inventories other than:
(a) work in progress arising under construction contracts, including directly related
service contracts (see Accounting Standard (AS) 7, Accounting for Construction 1

Contracts);
(b) work in progress arising in the ordinary course of business of service providers;
(c) shares, debentures and other financial instruments held as stock-in-trade; and
(d) producers’ inventories of livestock, agricultural and forest products, and mineral
oils, ores and gases to the extent that they are measured at net realisable value in
accordance with well established practices in those industries.
2. The inventories referred to in paragraph 1 (d) are measured at net realisable value at
certain stages of production. This occurs, for example, when agricultural crops have been
harvested or mineral oils, ores and gases have been extracted and sale is assured under a
forward contract or a government guarantee, or when a homogenous market exists and there
is a negligible risk of failure to sell. These inventories are excluded from the scope of this
Statement.
Definitions
3. The following terms are used in this Statement with the meanings specified:
Inventories are assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or
in the rendering of services.
Net realisable value is the estimated selling price in the ordinary course of business
less the estimated costs of completion and the estimated costs necessary to make the
sale.
4. Inventories encompass goods purchased and held for resale, for example, merchandise
purchased by a retailer and held for resale, computer software held for resale, or land and
other property held for resale. Inventories also encompass finished goods produced, or work
in progress being produced, by the enterprise and include materials, maintenance supplies,
consumables and loose tools awaiting use in the production process. Inventories do not
include machinery spares which can be used only in connection with an item of fixed asset
and whose use is expected to be irregular; such machinery spares are accounted for in
accordance with Accounting Standard (AS) 10, Accounting for Fixed Assets.2
1
This standard has been revised and titled as ‘Construction Contracts.’
2
Refer to Accounting Standards interpretation (ASI)2.
Measurement of Inventories
5. Inventories should be valued at the lower of cost and net realisable value.
Cost of Inventories
6. The cost of inventories should comprise all costs of purchase, costs of conversion
and other costs incurred in bringing the inventories to their present location and
condition.
Costs of Purchase
7. The costs of purchase consist of the purchase price including duties and taxes (other
than those subsequently recoverable by the enterprise from the taxing authorities), freight
inwards and other expenditure directly attributable to the acquisition. Trade discounts,
rebates, duty drawbacks and other similar items are deducted in determining the costs of
purchase.
Costs of Conversion
8. The costs of conversion of inventories include costs directly related to the units of
production, such as direct labour. They also include a systematic allocation of fixed and
variable production overheads that are incurred in converting materials into finished goods.
Fixed production overheads are those indirect costs of production that remain relatively
constant regardless of the volume of production, such as depreciation and maintenance of
factory buildings and the cost of factory management and administration. Variable production
overheads are those indirect costs of production that vary directly, or nearly directly, with the
volume of production, such as indirect materials and indirect labour.
9. The allocation of fixed production overheads for the purpose of their inclusion in the
costs of conversion is based on the normal capacity of the production facilities. Normal
capacity is the production expected to be achieved on an average over a number of periods or
seasons under normal circumstances, taking into account the loss of capacity resulting from
planned maintenance. The actual level of production may be used if it approximates normal
capacity. The amount of fixed production overheads allocated to each unit of production is not
increased as a consequence of low production or idle plant. Unallocated overheads are
recognised as an expense in the period in which they are incurred. In periods of abnormally
high production, the amount of fixed production overheads allocated to each unit of production
is decreased so that inventories are not measured above cost. Variable production overheads
are assigned to each unit of production on the basis of the actual use of the production
facilities.
10. A production process may result in more than one product being produced
simultaneously. This is the case, for example, when joint products are produced or when there
is a main product and a by-product. When the costs of conversion of each product are not
separately identifiable, they are allocated between the products on a rational and consistent
basis. The allocation may be based, for example, on the relative sales value of each product
either at the stage in the production process when the products become separately
identifiable, or at the completion of production. Most by-products as well as scrap or waste
materials, by their nature, are immaterial. When this is the case, they are often measured at
net realisable value and this value is deducted from the cost of the main product. As a result,
the carrying amount of the main product is not materially different from its cost.
Other Costs
11. Other costs are included in the cost of inventories only to the extent that they are
incurred in bringing the inventories to their present location and condition. For example, it may
be appropriate to include overheads other than production overheads or the costs of designing
products for specific customers in the cost of inventories.
12. Interest and other borrowing costs are usually considered as not relating to bringing the
inventories to their present location and condition and are, therefore, usually not included in
the cost of inventories.
Exclusions from the Cost of Inventories

13. In determining the cost of inventories in accordance with paragraph 6, it is appropriate to
exclude certain costs and recognise them as expenses in the period in which they are
incurred. Examples of such costs are:
(a) abnormal amounts of wasted materials, labour, or other production costs;
(b) storage costs, unless those costs are necessary in the production process prior to a
further production stage;
(c) administrative overheads that do not contribute to bringing the inventories to their
present location and condition; and
(d) selling and distribution costs.
Cost Formulas
14. The cost of inventories of items that are not ordinarily interchangeable and goods
or services produced and segregated for specific projects should be assigned by
specific identification of their individual costs.
15. Specific identification of cost means that specific costs are attributed to identified items of
inventory. This is an appropriate treatment for items that are segregated for a specific project,
regardless of whether they have been purchased or produced. However, when there are large
numbers of items of inventory which are ordinarily interchangeable, specific identification of
costs is inappropriate since, in such circumstances, an enterprise could obtain predetermined
effects on the net profit or loss for the period by selecting a particular method of ascertaining
the items that remain in inventories.
16. The cost of inventories, other than those dealt with in paragraph 14, should be
assigned by using the first-in, first-out (FIFO), or weighted average cost formula. The
formula used should reflect the fairest possible approximation to the cost incurred in
bringing the items of inventory to their present location and condition.
17. A variety of cost formulas is used to determine the cost of inventories other than those
for which specific identification of individual costs is appropriate. The formula used in
determining the cost of an item of inventory needs to be selected with a view to providing the
fairest possible approximation to the cost incurred in bringing the item to its present location
and condition. The FIFO formula assumes that the items of inventory which were purchased or
produced first are consumed or sold first, and consequently the items remaining in inventory at
the end of the period are those most recently purchased or produced. Under the weighted
average cost formula, the cost of each item is determined from the weighted average of the
cost of similar items at the beginning of a period and the cost of similar items purchased or
produced during the period. The average may be calculated on a periodic basis, or as each
additional shipment is received, depending upon the circumstances of the enterprise.
Techniques for the Measurement of Cost

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

20. The cost of inventories may not be recoverable if those inventories are damaged, if they
have become wholly or partially obsolete, or if their selling prices have declined. The cost of
inventories may also not be recoverable if the estimated costs of completion or the estimated
costs necessary to make the sale have increased. The practice of writing down inventories
below cost to net realisable value is consistent with the view that assets should not be carried
in excess of amounts expected to be realised from their sale or use.
21. Inventories are usually written down to net realisable value on an item-by-item basis. In
some circumstances, however, it may be appropriate to group similar or related items. This
may be the case with items of inventory relating to the same product line that have similar
purposes or end uses and are produced and marketed in the same geographical area and
cannot be practicably evaluated separately from other items in that product line. It is not
appropriate to write down inventories based on a classification of inventory, for example,
finished goods, or all the inventories in a particular business segment.
22. Estimates of net realisable value are based on the most reliable evidence available at the
time the estimates are made as to the amount the inventories are expected to realise. These
estimates take into consideration fluctuations of price or cost directly relating to events
occurring after the balance sheet date to the extent that such events confirm the conditions
existing at the balance sheet date.
23. Estimates of net realisable value also take into consideration the purpose for which the
inventory is held. For example, the net realisable value of the quantity of inventory held to
satisfy firm sales or service contracts is based on the contract price. If the sales contracts are
for less than the inventory quantities held, the net realisable value of the excess inventory is
based on general selling prices. Contingent losses on firm sales contracts in excess of
inventory quantities held and contingent losses on firm purchase contracts are dealt with in
accordance with the principles enunciated in Accounting Standard (AS) 4, Contingencies and
Events Occurring After the Balance Sheet Date∗.
24. Materials and other supplies held for use in the production of inventories are not written
down below cost if the finished products in which they will be incorporated are expected to be
sold at or above cost. However, when there has been a decline in the price of materials and it
is estimated that the cost of the finished products will exceed net realisable value, the
materials are written down to net realisable value. In such circumstances, the replacement
cost of the materials may be the best available measure of their net realisable value.
25. An assessment is made of net realisable value as at each balance sheet date.
Disclosure
26. The financial statements should disclose:
(a) the accounting policies adopted in measuring inventories, including the cost
formula used; and
∗
Pursuant to AS 29, Provisions, Contingent Liabilities and Contingent Assets, becoming
mandatory in respect of accounting periods commencing on or after 1.4.2004, all
paragraphs of AS 4 that deal with contingencies stand withdrawn except to the extent
they deal with impairment of assets not covered by other Indian Accounting Standards
(b) the total carrying amount of inventories and its classification appropriate to the
enterprise.
27. Information about the carrying amounts held in different classifications of inventories and
the extent of the changes in these assets is useful to financial statement users. Common
classifications of inventories are raw materials and components, work in progress, finished
goods, stores and spares, and loose tools.
AS-3 (REVISED 1997) CASH FLOW STATEMENTS
The following is the text of the revised Accounting Standard (AS 3), Cash Flow Statements,
issued by the Council of the Institute of Chartered Accountants of India. This Standard
supersedes Accounting Standard (AS 3), Changes In Financial Position, issued in June,
1981.This standard is mandatory in nature in respect of accounting periods commencing on or
after 1-4-2004 for the enterprises which fall in any one or more of the following categories, at
any time during the accounting period:
(i) Enterprises whose equity or debt securities are listed whether in India or outside India.
(ii) Enterprises which are in the process of listing their equity or debt securities as evidence by
the board of directors’ resolution in this regard.
(iii) Banks including co-operative banks.
(iv) Financial institutions.
(v) Enterprises carrying on insurance business.
(vi) All commercial, industrial and business reporting enterprises, whose turnover for the
immediately preceding accounting period on the basis of audited financial statements
exceeds Rs.50 crore. Turnover does not include ‘other income’.
(vii) All commercial, industrial and business reporting enterprises having borrowings, including
public deposits, in excess of Rs.10 crore at any time during the accounting period.
(viii) Holding and subsidiary enterprises of any one of the above at any time during the accounting
period.
The enterprises which do not fall in any of the above categories are encouraged, but are not
required, to apply this Standard.
Where an enterprise has been covered in any one or more of the above categories and
subsequently, ceases to be so covered, the enterprise will not qualify for exemption from
application of this Standard, until the enterprise ceases to be covered in any of the above
categories for two consecutive years.

Where an enterprise has previously qualified for exemption from application of this Standard
(being not covered by any of the above categories) but no longer qualifies for exemption in the
current accounting period, this Standard becomes applicable from the current period.
However, the corresponding previous period figures need not be disclosed.
An enterprise, which, pursuant to the above provisions, does not present a cash flow
statement, should disclose the fact.
The following is the text of the Accounting Standard.
Objective
Information about the cash flows of an enterprise is useful in providing users of financial
statements with a basis to assess the ability of the enterprise to generate cash and cash
equivalents and the needs of the enterprise to utilise those cash flows. The economic
decisions that are taken by users require an evaluation of the ability of an enterprise to
generate cash and cash equivalents and the timing and certainty of their generation.
The Statement deals with the provision of information about the historical changes in cash and
cash equivalents of an enterprise by means of a cash flow statement which classifies cash
flows during the period from operating, investing and financing activities.
Scope
1. An enterprise should prepare a cash flow statement and should present it for each
period for which financial statements are presented.
2. Users of an enterprise’s financial statements are interested in how the enterprise
generates and uses cash and cash equivalents. This is the case regardless of the nature of
the enterprise’s activities and irrespective of whether cash can be viewed as the product of the
enterprise, as may be the case with financial enterprise. Enterprises need cash for essentially
the same reasons, however different their principal revenue-producing activities might be.
They need cash to conduct their operations, to pay their obligations, and to provide returns to
their investors.
Benefits of Cash Flow Information

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

using different accounting treatments for the same transactions and events.
4. Historical cash flow information is often used as an indicator of the amount, timing and
certainty of future cash flows. It is also useful in checking the accuracy of past assessments of
future cash flows and in examining the relationship between profitability and net cash flow and
the impact of changing prices.
Definitions
5. The following terms are used in this Statement with the meanings specified :
Cash comprises cash on hand and demand deposits with banks.
Cash equivalents are short-term, highly liquid investments that are readily convertible
into known amounts of cash and which are subject to an insignificant risk of changes in
value.
Cash flows are inflows and outflows of cash and cash equivalents.
Operating activities are the principal revenue-producing activities of the enterprise and
other activities that are not investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
Financing activities are activities that result in changes in the size and composition of
the owners’ capital (including preference share capital in the case of a company) and
borrowings of the enterprise.)
Cash and Cash Equivalents

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

8. The cash flow statement should report cash flows during the period classified by
operating, investing and financing activities.
9. An enterprise presents its cash flows from operating, investing and financing activities in
a manner which is most appropriate to its business. Classification by activity provides informa-
tion that allows users to assess the impact of those activities on the financial position of the
enterprise and the amount of its cash and cash equivalents. This information may also be
used to evaluate the relationships among those activities.
10. A single transaction may include cash flows that are classified differently. For example,
when the instalment paid in respect of a fixed asset acquired on deferred payment basis
includes both interest and loan, the interest element is classified under financing activities and
the loan element is classified under investing activities.
Operating Activities
11. The amount of cash flows arising from operating activities is a key indicator of the extent
to which the operations of the enterprise have generated sufficient cash flows to maintain the
operating capability of the enterprise, pay dividends, repay loans, and make new investments
without recourse to external sources of financing. Information about the specific components
of historical operating cash flows is useful, in conjunction with other information, in forecasting
future operating cash flows.
12. Cash flows from operating activities are primarily derived from the principal revenue-
producing activities of the enterprise. Therefore, they generally result from the transactions
and other events that enter into the determination of net profit or loss. Examples of cash flows
from operating activities are :
(a) cash receipts from the sale of goods and the rendering of services;
(b) cash receipts from royalties, fees, commissions, and other revenue;
(c) cash payments to suppliers for goods and services;
(d) cash payments to and on behalf of employees;
(e) cash receipts and cash payments of an insurance enterprise for premiums and claims,
annuities and other policy benefits;
(f) cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities; and
(g) cash receipts and payments relating to futures contracts, forward contracts, option
contracts, and swap contracts when the contracts are held for dealing or trading purposes.
13. Some transactions, such as the sale of an item of plant, may give rise to a gain or loss
which is included in the determination of net profit or loss. However, the cash flows relating to
such transactions are cash flows from investing activities.
14. An enterprise may hold securities and loans for dealing or trading purposes, in which
case they are similar to inventory acquired specifically for resale. Therefore, cash flows arising
from the purchase and sale of dealing or trading securities are classified as operating
activities. Similarly, cash advances and loans made by financial enterprises are usually
classified as operating activities since they relate to the main revenue-producing activity of
that enterprise.
Investing Activities
15. The separate disclosure of cash flows arising from investing activities is important
because the cash flows represent the extent to which expenditures have been made for
resources intended to generate future income and cash flows. Examples of cash flows arising
from investing activities are :
(a) cash payments to acquire fixed assets (including intangibles). These payments include
those relating to capitalised research and development costs and self-constructed fixed
assets;
(b) cash receipts from disposal of fixed assets (including intangibles);
(c) cash payments to acquire shares, warrants, or debt instruments of other enterprises and
interests in joint ventures (other than payments for those instruments considered to be cash
equivalents and those held for dealing or trading purposes);
(d) cash receipts from disposal of shares, warrants, or debt instruments of other enterprises
and interests in joint ventures (other than receipts from those instruments considered to be
cash equivalents and those held for dealing or trading purposes);
(e) cash advances and loans made to third parties (other than advances and loans made by
a financial enterprise);
(f) cash receipts from the repayment of advances and loans made to third parties (other
than advances and loans of a financial enterprise);
(g) cash payments for futures contracts, forward contracts, option contracts, and swap
contracts except when the contracts are held for dealing or trading purposes, or the payments
are classified as financing activities; and
(h) cash receipts from futures contracts, forward contracts, option contracts, and swap
contracts except when the contracts are held for dealing or trading purposes, or the receipts
are classified as financing activities.
16. When a contract is accounted for as a hedge of an identifiable position, the cash flows of
the contract are classified in the same manner as the cash flows of the position being hedged.
Financing Activities
17. The separate disclosure of cash flows arising from financing activities is important
because it is useful in predicting claims on future cash flows by providers of funds (both
capital and borrowings) to the enterprise. Examples of cash flows arising from financing
activities are :
(a) cash proceeds from issuing shares or other similar instruments;
(b) cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-
term borrowings; and
(c) cash repayments of amounts borrowed.
Reporting Cash Flows from Operating Activities

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

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

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

25. Cash flows arising from transactions in a foreign currency should be recorded in
an enterprise’s reporting currency by applying to the foreign currency amount the
exchange rate between the reporting currency and the foreign currency at the date of
the cash flow. A rate that approximates the actual rate may be used if the result is
substantially the same as would arise if the rates at the dates of the cash flows were
used. The effect of changes in exchange rates on cash and cash equivalents held in a
foreign currency should be reported as a separate part of the reconciliation of the
changes in cash and cash equivalents during the period.
26. Cash flows denominated in foreign currency are reported in a manner consistent with
Accounting Standard (AS) 11, Accounting for the Effects of Changes in Foreign Exchange
Rates∗. This permits the use of an exchange rate that approximates the actual rate. For
example, a weighted average exchange rate for a period may be used for recording foreign
currency transactions.
27. Unrealised gains and losses arising from changes in foreign exchange rates are not cash
flows. However, the effect of exchange rate changes on cash and cash equivalents held or
due in foreign currency is reported in the cash flow statement in order to reconcile cash and
cash equivalents at the beginning and the end of the period. This amount is presented
separately from cash flows from operating, investing and financing activities and includes the
differences, if any, had those cash flows been reported at the end-of-period exchange rates.
Extraordinary Items
28. The cash flows associated with extraordinary items should be classified as arising
from operating, investing or financing activities as appropriate and separately
disclosed.
29. The cash flows associated with extraordinary items are disclosed separately as arising
from operating, investing or financing activities in the cash flow statement, to enable users to
understand their nature and effect on the present and future cash flows of the enterprise.
These disclosures are in addition to the separate disclosures of the nature and amount of
extraordinary items required by Accounting Standard (AS) 5, Net Profit or loss for the Period,
Prior Period Items, and Changes in Accounting Policies.
∗
This standard has been revised in 2003, and titled as ‘The Effects of Changes in
Foreign Exchange Rates’.
Interest and Dividends

30. Cash flows from interest and dividends received and paid should each be
disclosed separately. Cash flows arising from interest paid and interest and dividends
received in the case of a financial enterprise should be classified as cash flows arising
from operating activities. In the case of other enterprises, cash flows arising from
interest paid should be classified as cash flows from financing activities while interest
and dividends received should be classified as cash flows from investing activities.
Dividends paid should be classified as cash flows from financing activities.
31. The total amount of interest paid during the period is disclosed in the cash flow statement
whether it has been recognised as an expense in the statement of profit and loss or
capitalised in accordance with Accounting Standard (AS) 10, Accounting for Fixed Assets.∗
32. Interest paid and interest and dividends received are usually classified as operating cash
flows for a financial enterprise. However, there is no consensus on the classification of these
cash flows for other enterprises. Some argue that interest paid and interest and dividends
received may be classified as operating cash flows because they enter into the determination
of net profit or loss. However, it is more appropriate that interest paid and interest and
dividends received are classified as financing cash flows and investing cash flows
respectively, because they are cost of obtaining financial resources or returns on investments.
33. Some argue that dividends paid may be classified as a component of cash flows from
operating activities in order to assist users to determine the ability of an enterprise to pay
dividends out of operating cash flows. However, it is considered more appropriate that
dividends paid should be classified as cash flows from financing activities because they are
cost of obtaining financial resources.
Taxes on Income
34. Cash flows arising from taxes on income should be separately disclosed and
should be classified as cash flows from operating activities unless they can be
specifically identified with financing and investing activities.
35. Taxes on income arise on transactions that give rise to cash flows that are classified as
operating, investing or financing activities in a cash flow statement. While tax expense may be
readily identifiable with investing or financing activities, the related tax cash flows are often
impracticable to identify and may arise in a different period from the cash flows of the under-
lying transactions. Therefore, taxes paid are usually classified as cash flows from operating
activities. However, when it is practicable to identify the tax cash flow with an individual
∗
Pursuant to the issuance of AS 16, Borrowing Costs, which came into effect in respect
of accounting periods commencing on or after 1.4.2004, accounting for borrowing costs is
governed by As 16 from that date.
transaction that gives rise to cash flows that are classified as investing or financing activities,
the tax cash flow is classified as an investing or financing activity as appropriate. When tax
cash flows are allocated over more than one class of activity, the total amount of taxes paid is
disclosed.
Investments in Subsidiaries, Associates, and Joint Ventures

36. When accounting for an investment in an associate or a subsidiary or a joint
venture, an investor restricts its reporting in the cash flow statement to the cash flows
between itself and the investee/joint venture, for example, cash flows relating to
dividends and advances.
Acquisitions and Disposals of Subsidiaries and Other Business Units
37. The aggregate cash flows arising from acquisitions and from disposals of
subsidiaries or other business units should be presented separately and classified as
investing activities.
38. An enterprise should disclose, in aggregate, in respect of both acquisition and
disposal of subsidiaries or other business units during the period each of the
following :
(a) the total purchase or disposal consideration; and
(b) the portion of the purchase or disposal consideration discharged by means of cash
and cash equivalents.
39. The separate presentation of the cash flow effects of acquisitions and disposals of
subsidiaries and other business units as single line items helps to distinguish those cash flows
from other cash flows. The cash flow effects of disposals are not deducted from those of
acquisitions.
Non-Cash Transactions
40. Investing and financing transactions that do not require the use of cash or cash
equivalents should be excluded from a cash flow statement. Such transactions should
be disclosed elsewhere in the financial statements in a way that provides all the rele-
vant information about these investing and financing activities.
41. Many investing and financing activities do not have a direct impact on current cash flows
although they do affect the capital and asset structure of an enterprise. The exclusion of non-
cash transactions from the cash flow statement is consistent with the objective of a cash flow
statement as these items do not involve cash flows in the current period. Examples of non-
cash transactions are :
(a) the acquisition of assets by assuming directly related liabilities;
(b) the acquisition of an enterprise by means of issue of shares; and

(c) the conversion of debt to equity.
Components of Cash and Cash Equivalents

42. An enterprise should disclose the components of cash and cash equivalents and
should present a reconciliation of the amounts in its cash flow statement with the
equivalent items reported in the balance sheet.
43. In view of the variety of cash management practices, an enterprise discloses the policy
which it adopts in determining the composition of cash and cash equivalents.
44. The effect of any change in the policy for determining components of cash and cash
equivalents is reported in accordance with Accounting Standard (AS) 5, Net Profit or Loss for
the Period, Prior Period Items, and Changes in Accounting Policies.
Other Disclosures
45. An enterprise should disclose, together with a commentary management, the
amount of significant cash and cash equivalent balances held by the enterprise that are
not available for use by it.
46. There are various circumstances in which cash and cash equivalent balances held by an
enterprise are not available for use by it. Examples include cash and cash equivalent balances
held by a branch of the enterprise that operates in a country where exchange controls or other
legal restrictions apply as a result of which the balances are not available for use by the
enterprise.
47. Additional information may be relevant to users in understanding the financial position
and liquidity of an enterprise. Disclosure of this information, together with a commentary by
management, is encouraged and may include :
(a) the amount of undrawn borrowing facilities that may be available for future operating
activities and to settle capital commitments, indicating any restrictions on the use of these
facilities; and
(b) the aggregate amount of cash flows that represent increases in operating capacity
separately from those cash flows that are required to maintain operating capacity.
48. The separate disclosure of cash flows that represent increases in operating capacity and
cash flows that are required to maintain operating capacity is useful in enabling the user to
determine whether the enterprise is investing adequately in the maintenance of its operating
capacity. An enterprise that does not invest adequately in the maintenance of its operating
capacity may be prejudicing future profitability for the sake of current liquidity and distributions
to owners.
Appendix I
Cash flow statement for an enterprise other than a financial enterprise

The appendix is illustrative only and does not form part of the accounting standard. The
purpose of this appendix is to illustrate the application of the accounting standard.
1. The example shows only current period amounts.
2. Information from the statement of profit and loss and balance sheet is provided to show
how the statements of cash flows under the direct method and the indirect method have been
derived. Neither the statement of profit and loss nor the balance sheet is presented in
conformity with the disclosure and presentation requirements of applicable laws and
accounting standards. The working notes given towards the end of this appendix are intended
to assist in understanding the manner in which the various figures appearing in the cash flow
statement have been derived. These working notes do not form part of the cash flow
statement and, accordingly, need not be published.
3. The following additional information is also relevant for the preparation of the statement
of cash flows (figures are in Rs. ’000).
(a) An amount of 250 was raised from the issue of share capital and a further 250 was raised
from long-term borrowings.
(b) Interest expense was 400 of which 170 was paid during the period. 100 relating to
interest expense of the prior period was also paid during the period.
(c) Dividends paid were 1,200.
(d) Tax deducted at source on dividends received (included in the tax expense of 300 for the
year) amounted to 40.
(e) During the period, the enterprise acquired fixed assets for 350. The payment was made
in cash.
(f) Plant with original cost of 80 and accumulated depreciation of 60 was sold for 20.
(g) Foreign exchange loss of 40 represents the reduction in the carrying amount of a short-
term investment in foreign currency designated bonds arising out of a change in exchange
rate between the date of acquisition of the investment and the balance sheet date.
(h) Sundry debtors and sundry creditors include amounts relating to credit sales and credit
purchases only.
Balance Sheet as at 31-12-1996
(Rs. ’000)
1996 1995
Assets
Cash on hand and balances with banks 200 25
Short-term investments 670 135
Sundry debtors 1,700 1,200
Interest receivable 100 -
Inventories 900 1,950
Long-term investments 2,500 2,500
Fixed assets at cost 2,180 1,910
Accumulated depreciation (1,450) (1,060)
Fixed assets (net) 730 850
Total Assets 6,800 6,660
Liabilities
Sundry creditors 150 1,890
Interest payable 230 100
Income taxes payable 400 1,000
Long-term debt 1,110 1,040
Total liabilities 1,890 4,030
Shareholders’ Funds
Share capital 1,500 1,250
Reserves 3,410 1,380
Total shareholders funds 4,910 2,630
Total liabilities and Shareholders’ funds 6,800 6,660
Statement of Profit and Loss for the period ended 31-12-1996
(Rs. ’000)
Sales 30,650
Cost of sales (26,000)
Gross profit 4,650
Depreciation (450)
Administrative and selling expenses (910)
Interest expense (400)
Interest income 300
Dividend income 200
Foreign exchange loss (40)
Net profit before taxation and extraordinary item 3,350
Extraordinary item - Insurance proceeds from earthquake
disaster settlement 180
Net profit after extraordinary item 3,530
Income tax (300)
Net Profit 3,230
Direct Method Cash Flow Statement [Paragraph 18(a)]
(Rs. ’000)
1996
Cash flows from operating activities
Cash receipts from customers 30,150
Cash paid to suppliers and employees (27,600)
Cash generated from operations 2,550
Income taxes paid (860)
Cash flow before extraordinary item 1,690
Proceeds from earthquake disaster settlement 180
Net cash from operating activities 1,870
Cash flows from investing activities
Purchase of fixed assets (350)
Proceeds from sale of equipment 20
Interest received 200
Dividend received 160 30
Net cash from investing activities
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long-term borrowings 250
Repayments of long-term borrowings (180)

Interest paid (270)
Dividend paid (1,200)
Net cash used in financing activities (1,150)
Net increase in cash and cash equivalents 750
Cash and cash equivalents at beginning of period (See Note 1) 160
Cash and cash equivalents at end of the period (see Note 1) 910
Indirect Method Cash Flow Statement [Paragraph 18 (b)]

(Rs. ’000)
1996
Net profit before taxation, and extraordinary item 3,350
Adjustments for :
Depreciation 450
Foreign exchange loss 40
Interest income (300)
Dividend income (200)
Interest expense 400
Operating profit before working capital changes 3,740
Increase in sundry debtors (500)
Decrease in inventories 1,050
Decrease in sundry creditors (1,740)
Cash generated from operations 2,550
Cash flow before extraordinary item 1,690
Proceeds from earthquake disaster settlement 180
Proceeds from sale of equipment 20
Dividends received 160

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

(direct method and indirect method)
1. Cash and Cash Equivalents
Cash and cash equivalents consist of cash on hand and balances with banks, and investments
in money-market instruments. Cash and cash equivalents included in the cash flow statement
comprise the following balance sheet amounts.
1996 1995
Cash on hand and balances with banks 200 25
Short-term investments 670 135
Cash and cash equivalents 870 160
Effect of exchange rate changes 40 -
Cash and cash equivalents as restated 910 160
Cash and cash equivalents at the end of the period include deposits with banks of 100 held by
a branch which are not freely remissible to the company because of currency exchange
restrictions.
The company has undrawn borrowing facilities of 2,000 of which 700 may be used only for
future expansion.
2. Total tax paid during the year (including tax deducted at source on dividends received)
amounted to 900.
Alternative Presentation (indirect method)

As an alternative, in an indirect method cash flow statement, operating profit before working
capital changes is sometimes presented as follows :
Revenues excluding investment income 30,650

Operating expense excluding depreciation (26, 910)
Operating profit before working capital changes 3,740
Working Notes
The working notes given below do not form part of the cash flow statement and, accordingly
need not be published. The purpose of these working notes is merely to assist in
understanding the manner in which various figures in the cash flow statement have been
derived.
(Figures are in Rs. ’000)

1. Cash receipts from customers
Sales 30,650
Add : Sundry debtors at the beginning of the year 1,200
31,850
Less : Sundry debtors at the end of the year 1,700
30,150
2. Cash paid to suppliers and employees
Cost of sales 26,000
Administrative and selling expenses 910
26,910
Add : Sundry creditors at the beginning of the year 1,890
Inventories at the end of the year 900 2,790
29,700
Less : Sundry creditors at the end of the year 150
Inventories at the beginning of the year 1,950 2,100
27,600
3. Income taxes paid (including tax deducted at source from dividends received)
Income tax expense for the year (including tax
deducted at source from dividends received) 300
Add : Income tax liability at the beginning of the year 1,000
1,300
Less : Income tax liability at the end of the year 400
900
Out of 900, tax deducted at source on dividends received (amounting to 40) is included in cash
flows from investing activities and the balance of 860 is included in cash flows from operating
activities (See Paragraph 34).
4. Repayment of long-term borrowings
Long-term debt at the beginning of the year 1,040
Add : Long-term borrowings made during the year 250
1,290
Less : Long-term borrowings at the end of the year 1,110
180
5. Interest paid
Interest expense for the year 400
Add : Interest payable at the beginning of the year 100
500
Less : Interest payable at the end of the year 230
270
Appendix II
Cash Flow Statement for a Financial Enterprise
1. The example shows only current period amounts.
2. The example is presented using the direct method.
(Rs. ’000)
1996
Interest and commission receipts 28,447
Interest payments (23,463)
Recoveries on loans previously written off 237
Cash payments to employees and suppliers (997)
Operating profit before changes in operating assets 4,224
(Increase) decrease in operating assets :
Short-term funds (650)
Deposits held for regulatory or monetary control purposes234
Funds advanced to customers (288)
Net increase in credit card receivables (360)
Other short-term securities (120)
Increase (decrease) in operating liabilities :
Deposits from customers 600
Certificates of deposit (200)
Net cash from operating activities before income tax 3,440
Dividends received 250
Proceeds from sales of permanent investments 1,200
Purchase of permanent investments (600)

Net cash from investing activities 650
Issue of shares 1,800
Repayment of long-term borrowings (200)
Net decrease in other borrowings (1,000)
Dividends paid (400)
Net cash from financing activities 200
Net increase in cash and cash equivalents 4,190
Cash and cash equivalents at beginning of period 4,650
Cash and cash equivalents at end of the period 8,840
AS 4 (REVISED) : CONTINGENCIES AND EVENTS OCCURRING AFTER THE BALANCE

SHEET DATE
The following is the text of the revised Accounting Standard (AS) 4, ‘Contingencies and Events
Occurring after the Balance Sheet Date’ issued by the Council of the Institute of Chartered Ac-
countants of India.
This revised standard comes into effect in respect of accounting periods commencing on or
after 1-4-1995 and is mandatory in nature.1 It is clarified that in respect of accounting periods
commencing on a date prior to 1-4-1995, Accounting Standard 4 as originally issued in
November, 1982 (and subsequently made mandatory) applies.
INTRODUCTION
1. This Statement deals with the treatment in financial statements of
(a) contingencies, and
(b) events occurring after the balance sheet date.
1
2. The following subjects, which may result in contingencies, are excluded from the scope
of this Statement in view of special considerations applicable to them :
(a) liabilities of life assurance and general insurance enterprises arising from policies issued;
(b) obligations under retirement benefit plans; and
(c) commitments arising from long-term lease contracts.
Definitions
3.1 A contingency2 is a condition or situation, the ultimate outcome of which, gain or loss, will
be known or determined only on the occurrence, or non-occurrence, of one or more uncertain
future events.
3.2 Events occurring after the balance sheet date are those significant events, both
favourable and unfavourable, that occur between the balance sheet date and the date on
which the financial statements are approved by the Board of Directors in the case of a
company, and, by the corresponding approving authority in the case of any other entity.
Two types of events can be identified :
(a) those which provide further evidence of conditions that existed at the balance sheet date;
and
(b) those which are indicative of conditions that arose subsequent to the balance sheet date.
Explanation
4. CONTINGENCIES
4.1 The term “contingencies” used in this Statement is restricted to conditions or situations at
the balance sheet date, the financial effect of which is to be determined by future events which
may or may not occur.
4.2 Estimates are required for determining the amount to be stated in the financial
statements for many ongoing and recurring activities of an enterprise. One must, however,
distinguish between an event which is certain and one which is uncertain. The fact that an
estimate is involved does not, of itself, create the type of uncertainty which characterises a
contingency. For example, the fact that estimates of useful life are used to determine
depreciation, does not make depreciation a contingency; the eventual expiry of the useful life
of the asset is not uncertain. Also, amounts owed for services received are not contingencies
2
See footnote 1.
as defined in paragraph 3.1, even though the amounts may have been estimated, as there is
nothing uncertain about the fact that these obligations have been incurred.
4.3 The uncertainty relating to future events can be expressed by a range of outcomes. This
range may be presented as quantified probabilities, but in most circumstances, this suggests a
level of precision that is not supported by the available information. The possible outcomes
can, therefore, usually be generally described except where reasonable quantification is
practicable.
4.4 The estimates of the outcome and of the financial effect of contingencies are determined
by the judgment of the management of the enterprise. This judgment is based on
consideration of information available up to the date on which the financial statements are
approved and will include a review of events occurring after the balance sheet date,
supplemented by experience of similar transactions and, in some cases, reports from
independent experts.
5. ACCOUNTING TREATMENT OF CONTINGENT LOSSES

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

Contingent gains are not recognised in financial statements since their recognition may result
in the recognition of revenue which may never be realised. However, when the realisation of a
gain is virtually certain, then such gain is not a contingency and accounting for the gain is
appropriate.
7. DETERMINATION OF THE AMOUNTS AT WHICH CONTINGENCIES ARE INCLUDED

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

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

8.3 Adjustments to assets and liabilities are not appropriate for events occurring after the
balance sheet date, if such events do not relate to conditions existing at the balance sheet
date. An example is the decline in market value of investments between the balance sheet
date and the date on which the financial statements are approved. Ordinary fluctuations in
market values do not normally relate to the condition of the investments at the balance sheet
date, but reflect circumstances which have occurred in the following period.
8.4 Events occurring after the balance sheet date which do not affect the figures stated in the
financial statements would not normally require disclosure in the financial statements although
they may be of such significance that they may require a disclosure in the report of the
approving authority to enable users of financial statements to make proper evaluations and
decisions.
8.5 There are events which, although they take place after the balance sheet date, are
sometimes reflected in the financial statements because of statutory requirements or because
of their special nature. Such items include the amount of dividend proposed or declared by the
enterprise after the balance sheet date in respect of the period covered by the financial
statements.
8.6 Events occurring after the balance sheet date may indicate that the enterprise ceases to
be a going concern. A deterioration in operating results and financial position, or unusual
changes affecting the existence or substratum of the enterprise after the balance sheet date
(e.g., destruction of a major production plant by a fire after the balance sheet date) may
indicate a need to consider whether it is proper to use the fundamental accounting assumption
of going concern in the preparation of the financial statements.
9. DISCLOSURE
9.1 The disclosure requirements herein referred to apply only in respect of those
contingencies or events which affect the financial position to a material extent.
9.2 If a contingent loss is not provided for, its nature and an estimate of its financial effect
are generally disclosed by way of note unless the possibility of a loss is remote (other than the
circumstances mentioned in paragraph 5.5). If a reliable estimate of the financial effect cannot
be made, this fact is disclosed.
9.3 When the events occurring after the balance sheet date are disclosed in the report of the
approving authority, the information given comprises the nature of the events and an estimate
of their financial effects or a statement that such an estimate cannot be made.
Accounting Standard
should be read in the context of paragraphs 1-9 of this Statement and of the ‘Preface to the
Statements of Accounting Standards’.)
Contingencies
10. The amount of a contingent loss should be provided for by a charge in the
statement of profit and loss if :
(a) it is probable that future events will confirm that, after taking into account any
related probable recovery, an asset has been impaired or a liability has been incurred
as at the balance sheet date, and
(b) a reasonable estimate of the amount of the resulting loss can be made.
11. The existence of a contingent loss should be disclosed in the financial statements
if either of the conditions in paragraph 10 is not met, unless the possibility of a loss is
remote.
12. Contingent gains should not be recognised in the financial statements.
Events Occurring after the Balance Sheet Date
13. Assets and liabilities should be adjusted for events occurring after the balance
sheet date that provide additional evidence to assist the estimation of amounts relating
to conditions existing at the balance sheet date or that indicate that the fundamental
accounting assumption of going concern (i.e., the continuance of existence or
substratum of the enterprise) is not appropriate.
14. Dividends stated to be in respect of the period covered by the financial
statements, which are proposed or declared by the enterprise after the balance sheet
date but before approval of the financial statements, should be adjusted.
15. Disclosure should be made in the report of the approving authority of those events
occurring after the balance sheet date that represent material changes and
commitments affecting the financial position of the enterprise.
Disclosure
16. If disclosure of contingencies is required by paragraph 11 of this Statement, the
following information should be provided :
(a) the nature of the contingency;
(b) the uncertainties which may affect the future outcome;
(c) an estimate of the financial effect, or a statement that such an estimate cannot be
made.
17. If disclosure of events occurring after the balance sheet date in the report of the
approving authority is required by paragraph 15 of this Statement, the following
information should be provided :
(a) the nature of the event;
(b) an estimate of the financial effect, or a statement that such an estimate cannot be
made.
AS 5 (REVISED) NET PROFIT OR LOSS FOR THE PERIOD,

PRIOR PERIOD ITEMS AND CHANGES IN
ACCOUNTING POLICIES*
The following is the text of the revised Accounting Standard (AS) 5, Net Profit or Loss for the
Period, Prior Period Items and Changes in Accounting Policies, issued by the Council of the
Institute of Chartered Accountants of India.
This revised standard comes into effect in respect of accounting periods commencing on or
after 1-4-1996, and is mandatory in nature. It is clarified that in respect of accounting periods
commencing on a date prior to 1-4-1996, Accounting Standard (AS) 5 as originally issued in
November, 1982 (and subsequently made mandatory), will apply.
Objective
The objective of this Statement is to prescribe the classification and disclosure of certain items
in the statement of profit and loss so that all enterprises prepare and present such a statement
on a uniform basis. This enhances the comparability of the financial statements of an
enterprise over time and with the financial statements of other enterprises. Accordingly, this
Statement requires the classification and disclosure of extraordinary and prior period items,
and the disclosure of certain items, within profit or loss from ordinary activities. It also
specifies the accounting treatment for changes in accounting estimates and the disclosures to
be made in the financial statements regarding changes in accounting policies.
Scope
1. This Statement should be applied by an enterprise in presenting profit or loss from
ordinary activities, extraordinary items and prior period items in the statement of profit
and loss, in accounting for changes in accounting estimates, and in disclosure of
changes in accounting policies.
2. This Statement deals with, among other matters, the disclosure of certain items of net
profit or loss for the period. These disclosures are made in addition to any other disclosures
required by other Accounting Standards.
3. This Statement does not deal with the tax implications of extraordinary items, prior period
items, changes in accounting estimates, and changes in accounting policies for which
appropriate adjustments will have to be made depending on the circumstances.
Definitions
Ordinary activities are any activities which are undertaken by an enterprise as part of its
business and such related activities in which the enterprise engages in furtherance of,
incidental to, or arising from, these activities.
Extraordinary items are income or expenses that arise from events or transactions that
are clearly distinct from the ordinary activities of the enterprise and, therefore, are not
expected to recur frequently or regularly.
Prior period items are income or expenses which arise in the current period as a result
of errors or omissions in the preparation of the financial statements of one or more
prior periods.
Accounting policies are the specific accounting principles and the methods of applying
those principles adopted by an enterprise in the preparation and presentation of
Net Profit or Loss for the Period

5. All items of income and expenses which are recognised in a period should be
included in the determination of net profit or loss for the period unless an Accounting
Standard requires or permits otherwise.
6. Normally, all items of income and expense which are recognised in a period are included
in the determination of the net profit or loss for the period. This includes extraordinary items
and the effects of changes in accounting estimates.
7. The net profit or loss for the period comprises the following components, each of
which should be disclosed on the face of the statement of profit and loss :
(a) Profit or loss from ordinary activities; and
(b) Extraordinary items.
Extraordinary Items
8. Extraordinary items should be disclosed in the statement of profit and loss as a
part of net profit or loss for the period. The nature and the amount of each extraordinary
item should be separately disclosed in the statement of profit and loss in a manner that
its impact on current profit or loss can be perceived.
9. Virtually all items of income and expense included in the determination of net profit or
loss for the period arise in the course of the ordinary activities of the enterprise. Therefore,
only on rare occasions does an event or transaction give rise to an extraordinary item.
10. Whether an event or transaction is clearly distinct from the ordinary activities of the
enterprise is determined by the nature of the event or transaction in relation to the business
ordinarily carried on by the enterprise rather than by the frequency with which such events are
expected to occur. Therefore, an event or transaction may be extraordinary for one enterprise
but not for another enterprise because of the differences between their respective ordinary
activities. For example, losses sustained as a result of an earthquake may qualify as an
extraordinary item for many enterprises. However, claims from policy-holders arising from an
earthquake do not qualify as an extraordinary item for an insurance enterprise that insures
against such risks.
11. Examples of events or transactions that generally give rise to extraordinary items for
most enterprises are :—
- attachment of property of the enterprise; or
- an earthquake.
Profit or Loss from Ordinary Activities

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

(g) other reversals of provisions.
Prior Period Items

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

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

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

28. Users need to be able to compare the financial statements of an enterprise over a period
of time in order not identify trends in its financial position, performance, and cash flows. There-
fore, the same accounting policies are normally adopted for similar events or transactions in
each period.
29. A change in an accounting policy should be made only if the adoption of a different
accounting policy is required by statute or for compliance with an accounting standard
or if it is considered that the change would result in a more appropriate presentation of
the financial statements of the enterprise.
30. A more appropriate presentation of events or transactions in the financial statements
occurs when the new accounting policy results in more relevant or reliable information about
the financial position, performance, or cash flows of the enterprise.
31. The following are not changes in accounting policies :
(a) the adoption of an accounting policy for events or transactions that differ in substance
from previously occurring events or transactions e.g., introduction of a formal retirement
gratuity scheme by an employer in place of ad hoc ex-gratia payments to employees on
retirement; and
(b) the adoption of a new accounting policy for events or transactions which did not occur
previously or that were immaterial.
32. Any change in an accounting policy which has a material effect should be
disclosed. The impact of, and the adjustments resulting from, such change, if material,
should be shown in the financial statements of the period in which such change is
made, to reflect the effect of such change. Where the effect of such change is not
ascertainable, wholly or in part, the fact should be indicated. If a change is made in the
accounting policies which has no material effect on the financial statements for the
current period but which is reasonably expected to have a material effect in later
periods, the fact of such change should be appropriately disclosed in the period in
which the change is adopted.
“33. A change in accounting policy consequent upon the adoption of an Accounting
Standard should be accounted for in accordance with the specific transitional
provisions, if any, contained in that Accounting Standard. However, disclosures
required by paragraph 32 of this Statement should be made unless the transitional
provisions of any other Accounting Standard require alternative disclosures in this
regard. ”∗
AS 6 (REVISED) : DEPRECIATION ACCOUNTING
Accounting Standard (AS) 6, ‘Depreciation Accounting’, was issued by the Institute in 1985.
Subsequently, in the context of insertion of Schedule XIV in the Companies Act in 1988, the
Institute brought out a Guidance Note on Accounting for Depreciation in Companies. The
Guidance Note differed from AS-6 in respect of accounting treatment of (a) change in the
∗
The Council of the Institute of Chartered Accountants of India decided to add this
paragraph after paragraph 32 of AS 5.
The above revision comes into effect in respect of accounting periods commencing on or
after 1.4.2001.
method of depreciation, and (b) change in the rates of depreciation.

Based on the recommendations of the Accounting Standards Board, the Council of the
Institute at its 168th meeting held on May 26-29, 1994, decided to bring AS-6 in line with the
Guidance Note in respect of the aforementioned matters. Accordingly, it was decided to
modify paragraphs 11, 15, 22 and 24 and delete paragraph 19 of AS-6. Also, in the context of
delinking of rates of depreciation under the Companies Act from those under the Income-tax
Act/Rules by the Companies (Amendment) Act, 1988, the Council decided to suitably modify
paragraph 13 of AS 6. From the date of AS26 ‘Intangible Assets’ becoming mandatory for the
concerned enterprises, the standard stands withdrawn in so far as it relates to the
amortization(depreciation of intangible assets).
The complete text of the revised AS-6, which incorporates the above changes, is given below.
Introduction
1. This Statement deals with depreciation accounting and applies to all depreciable assets,
except the following items to which special considerations apply :
(i) forests, plantations and similar regenerative natural resources;
(ii) wasting assets including expenditure on the exploration for and extraction of minerals,
oils, natural gas and similar non-regenerative resources;
(iii) expenditure on research and development;
(iv) goodwill;
(v) live stock.
This statement also does not apply to land unless it has a limited useful life for the enterprise.
2. Different accounting policies for depreciation are adopted by different enterprises.
Disclosure of accounting policies for depreciation followed by an enterprise is necessary to
appreciate the view presented in the financial statements of the enterprise.
Definitions
3. The following terms are used in this statement with the meanings specified :
3.1 ‘Depreciation’ is a measure of the wearing out, consumption or other loss of value of a
depreciable asset arising from use, effluxion of time or obsolescence through technology and
market changes. Depreciation is allocated so as to charge a fair proportion of the depreciable
amount in each accounting period during the expected useful life of the asset. Depreciation
includes amortisation of assets whose useful life is predetermined.
3.2 ‘Depreciable assets’ are assets which :
(i) are expected to be used during more than one accounting period;
(ii) have a limited useful life; and

(iii) are held by an enterprise for use in the production or supply of goods and services, for
rental to others, or for administrative purposes and not for the purpose of sale in the ordinary
course of business.
3.3 ‘Useful life’ is either (i) the period over which a depreciable asset is expected to be used
by the enterprise; or (ii) the number of production or similar units expected to be obtained from
the use of the asset by the enterprise.
3.4 ‘Depreciable amount’ of a depreciable asset is its historical cost, or other amount
substituted for historical cost∗ in the financial statements, less the estimated residual value.
Explanation
4. Depreciation has a significant effect in determining and presenting the financial position
and results of operations of an enterprise. Depreciation is charged in each accounting period
by reference to the extent of the depreciable amount, irrespective of an increase in the market
value of the assets.
5. Assessment of depreciation and the amount to be charged in respect thereof in an
accounting period are usually based on the following three factors:
(i) historical cost or other amount substituted for the historical cost of the depreciable asset
when the asset had been revalued;
(ii) expected useful life of the depreciable asset; and
(iii) estimated residual value of the depreciable asset.
6. Historical cost of a depreciable asset represents its money outlay or its equivalent in
connection with its acquisition, installation and commissioning as well as for additions to or
improvement thereof. The historical cost of a depreciable asset may undergo subsequent
changes arising as a result of increase or decrease in long-term liability on account of
exchange fluctuations, price adjustments, changes in duties or similar factors.
7. The useful life of a depreciable asset is shorter than its physical life and is :
(i) pre-determined by legal or contractual limits, such as the expiry dates of related leases;
(ii) directly governed by extraction or consumption;
(iii) dependent on the extent of use and physical deterioration on account of wear and tear
∗
This statement does not deal with the treatment of the revaluation difference which
may arise when historical costs are substituted by revaluations.
which again depends on operational factors, such as, the number of shifts for which the asset
is to be used, repair and maintenance policy of the enterprise etc.; and
(iv) reduced by obsolescence arising from such factors as :
(a) technological changes;
(b) improvement in production methods;
(c) change in market demand for the product or service output of the asset; or
(d) legal or other restrictions.
8. Determination of the useful life of a depreciable asset is a matter of estimation and is
normally based on various factors including experience with similar types of assets. Such
estimation is more difficult for an asset using new technology or used in the production of a
new product or in the provision of a new service but is nevertheless required on some
reasonable basis.
9. Any addition or extension to an existing asset which is of a capital nature and which
becomes an integral part of the existing asset is depreciated over the remaining useful life of
that asset. As a practical measure, however, depreciation is sometimes provided on such
addition or extension at the rate which is applied to an existing asset. Any addition or
extension which retains a separate identity and is capable of being used after the existing
asset is disposed of, is depreciated independently on the basis of an estimate of its own useful
life.
10. Determination of residual value of an asset is normally a difficult matter. If such value is
considered as insignificant, it is normally regarded as nil. On the contrary, if the residual value
is likely to be significant, it is estimated at the time of acquisition/installation, or at the time of
subsequent revaluation of the asset. One of the bases for determining the residual value
would be the realisable value of similar assets which have reached the end of their useful lives
and have operated under conditions similar to those in which the asset will be used.
11. The quantum of depreciation to be provided in an accounting period involves the exercise
of judgment by management in the light of technical, commercial, accounting and legal
requirements and accordingly may need periodical review. If it is considered that the original
estimate of useful life of an asset requires any revision, the unamortised depreciable amount
of the asset is charged to revenue over the revised remaining useful life.
12. There are several methods of allocating depreciation over the useful life of the assets.
Those most commonly employed in industrial and commercial enterprises are the straightline
method and the reducing balance method. The management of a business selects the most
appropriate method(s) based on various important factors, e.g. (i) type of asset, (ii) the nature
of the use of such asset, and (iii) circumstances prevailing in the business. A combination of
more than one method is sometimes used. In respect of depreciable assets which do not have
material value depreciation is often allocated fully in the accounting period in which they are
acquired.
13. The statute governing an enterprise may provide the basis for computation of the
depreciation. For example, the Companies Act, 1956 lays down the rates of depreciation in
respect of various assets. Where the managements’ estimate of the useful life of an asset of
the enterprise is shorter than that envisaged under the provisions of the relevant statute, the
depreciation provision is appropriately computed by applying a higher rate. If the manage-
ment’s estimate of the useful life of the asset is longer than that envisaged under the statute,
depreciation rate lower than that envisaged by the statute can be applied only in accordance
with requirements of the statute.
14. Where depreciable assets are disposed of, discarded, demolished or destroyed, the net
surplus or deficiency, if material, is disclosed separately.
15. The method of depreciation is applied consistently to provide comparability of the results
of the operations of the enterprise from period to period. A change from one method of
providing depreciation to another is made only if the adoption of the new method is required
by statute or for compliance with an accounting standard or if it is considered that the change
would result in a more appropriate preparation or presentation of the financial statements of
the enterprise. When such a change in the method of depreciation is made, depreciation is
recalculated in accordance with the new method from the date of the asset coming into use.
The deficiency or surplus arising from retrospective recomputation of depreciation in
accordance with the new method is adjusted in the accounts in the year in which the method
of depreciation is changed. In case the change in the method results in deficiency in
depreciation in respect of past years, the deficiency is charged in the statement of profit and
loss. In case the change in the method results in surplus, the surplus is credited to the
statement of profit and loss. Such a change is treated as a change in accounting policy and its
effect is quantified and disclosed.
16. Where the historical cost of an asset has undergone a change due to circumstances
specified in para 6 above, the depreciation on the revised unamortised depreciable amount is
provided prospectively over the residual useful life of the asset.
Disclosure
17. The depreciation methods used, the total depreciation for the period for each class of
assets, the gross amount of each class of depreciable assets and the related accumulated
depreciation are disclosed in the financial statements along with the disclosure of other
accounting policies. The depreciation rates or the useful lives of the assets are disclosed only
if they are different from the principal rates specified in the statute governing the enterprise.
18. In case the depreciable assets are revalued, the provision for depreciation is based on
the revalued amount on the estimate of the remaining useful life of such assets. In case the
revaluation has a material effect on the amount of depreciation, the same is disclosed
separately in the year in which revaluation is carried out.
19. A change in the method of depreciation is treated as a change in an accounting policy
and is disclosed accordingly.∗
Accounting Standard
20. The depreciable amount of a depreciable asset should be allocated on a
systematic basis to each accounting period during the useful life of the asset.
21. The depreciation method selected should be applied consistently from period to
period. A change from one method of providing depreciation to another should be made
only if the adoption of the new method is required by statute or for compliance with an
accounting standard or if it is considered that the change would result in a more
appropriate preparation or presentation of the financial statements of the enterprise.
When such a change in the method of depreciation is made, depreciation should be
recalculated in accordance with the new method from the date of the asset coming into
use. The deficiency or surplus arising from retrospective recomputation of depreciation
in accordance with the new method should be adjusted in the accounts in the year in
which the method of depreciation is changed. In case the change in the method results
in deficiency in depreciation in respect of past years, the deficiency should be charged
in the statement of profit and loss. In case the change in the method results in surplus,
the surplus should be credited to the statement of profit and loss. Such a change
should be treated as a change in accounting policy and its effect should be quantified
and disclosed.
22. The useful life of a depreciable asset should be estimated after considering the
following factors:
(i) expected physical wear and tear;
(ii) obsolescence;
(iii) legal or other limits on the use of the asset.
23. The useful lives of major depreciable assets or classes of depreciable assets may
be reviewed periodically. Where there is a revision of the estimated useful life of an
asset, the unamortised depreciable amount should be charged over the revised
remaining useful life.
∗
Refer to AS 5
24. Any addition or extension which becomes an integral part of the existing asset
should be depreciated over the remaining useful life of that asset. The depreciation on
such addition or extension may also be provided at the rate applied to the existing
asset. Where an addition or extension retains a separate identity and is capable of
being used after the existing asset is disposed of, depreciation should be provided
independently on the basis of an estimate of its own useful life.
∗
25. Where the historical cost of a depreciable asset has undergone a change due to
increase or decrease in long-term liability on account of exchange fluctuations, price
adjustments, changes in duties or similar factors, the depreciation on the revised
unamortised depreciable amount should be provided prospectively over the residual
useful life of the asset.
26. Where the depreciable assets are revalued, the provision for depreciation should
be based on the revalued amount and on the estimate of the remaining useful lives of
such assets. In case the revaluation has a material effect on the amount of depreciation,
the same should be disclosed separately in the year in which revaluation is carried out.
27. If any depreciable asset is disposed of, discarded, demolished or destroyed, the
net surplus or deficiency, if material, should be disclosed separately.
28. The following information should be disclosed in the financial statements :
(i) the historical cost or other amount substituted for historical cost of each class of
depreciable assets;
(ii) total depreciation for the period for each class of assets; and
(iii) the related accumulated depreciation.
29. The following information should also be disclosed in the financial statements
along with the disclosure of other accounting policies :
(i) depreciation methods used; and
(ii) depreciation rates or the useful lives of the assets, if they are different from the
principal rates specified in the statute governing the enterprise.
∗
Refer to AS 11 (Revised 2003), “The Effects of Changes in Foreign Exchange Rates”.
AS 7 (REVISED)3 : CONSTRUCTION CONTRACTS
Construction Contracts
Accounting Standard (AS) 7, Construction Contracts (revised), issued by the Council of the
Institute of Chartered Accountants of India, comes into effect in respect of all contracts
entered into during accounting periods commencing on or after 1-4-2003 and is mandatory in
nature from that date. Accordingly, Accounting Standard (AS) 7, ‘Accounting for Construction
Contracts’, issued by the Institute in December 1983, is not applicable in respect of such
contracts. Early application of this Standard is, however, encouraged.
The following is the text of the revised Accounting Standard.
Objective
The objective of this Statement is to prescribe the accounting treatment of revenue and costs
associated with construction contracts. Because of the nature of the activity undertaken in
construction contracts, the date at which the contract activity is entered into and the date
when the activity is completed usually fall into different accounting periods. Therefore, the
primary issue in accounting for construction contracts is the allocation of contract revenue and
contract costs to the accounting periods in which construction work is performed. This
Statement uses the recognition criteria established in the Framework for the Preparation and
Presentation of Financial Statements to determine when contract revenue and contract costs
should be recognised as revenue and expenses in the statement of profit and loss. It also
provides practical guidance on the application of these criteria.
Scope
1. This Statement should be applied in accounting for construction contracts in the
financial statements of contractors.
Definitions
A construction contract is a contract specifically negotiated for the construction of an
asset or a combination of assets that are closely interrelated or interdependent in terms
of their design, technology and function or their ultimate purpose or use.
A fixed price contract is a construction contract in which the contractor agrees to a
fixed contract price, or a fixed rate per unit of output, which in some cases is subject to
3
Revised in 2002
cost escalation clauses.

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

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

(b) the contracts are so closely interrelated that they are, in effect, part of a single
project with an overall profit margin; and
(c) the contracts are performed concurrently or in a continuous sequence.
9. A contract may provide for the construction of an additional asset at the option of
the customer or may be amended to include the construction of an additional asset. The
construction of the additional asset should be treated as a separate construction
contract when:
(a) the asset differs significantly in design, technology or function from the asset or
assets covered by the original contract; or
(b) the price of the asset is negotiated without regard to the original contract price.
Contract Revenue
10. Contract revenue∗ should comprise:
(a) the initial amount of revenue agreed in the contract; and
(b) variations in contract work, claims and incentive payments:
(i) to the extent that it is probable that they will result in revenue; and
(ii) they are capable of being reliably measured
11. Contract revenue is measured at the consideration received or receivable. The
measurement of contract revenue is affected by a variety of uncertainties that depend on the
outcome of future events. The estimates often need to be revised as events occur and
uncertainties are resolved. Therefore, the amount of contract revenue may increase or
decrease from one period to the next. For example:
(a) a contractor and a customer may agree to variations or claims that increase or decrease
contract revenue in a period subsequent to that in which the contract was initially agreed;
(b) the amount of revenue agreed in a fixed price contract may increase as a result of cost
escalation clauses;
(c) the amount of contract revenue may decrease as a result of penalties arising from delays
caused by the contractor in the completion of the contract; or
(d) when a fixed price contract involves a fixed price per unit of output, contract revenue
increases as the number of units is increased.
12. A variation is an instruction by the customer for a change in the scope of the work to be
∗
See also ASI 29.
performed under the contract. A variation may lead to an increase or a decrease in contract
revenue. Examples of variations are changes in the specifications or design of the asset and
changes in the duration of the contract. A variation is included in contract revenue when:
(a) it is probable that the customer will approve the variation and the amount of revenue
arising from the variation; and
(b) the amount of revenue can be reliably measured.
13. A claim is an amount that the contractor seeks to collect from the customer or another
party as reimbursement for costs not included in the contract price. A claim may arise from, for
example, customer caused delays, errors in specifications or design, and disputed variations
in contract work. The measurement of the amounts of revenue arising from claims is subject to
a high level of uncertainty and often depends on the outcome of negotiations. Therefore,
claims are only included in contract revenue when:
(a) negotiations have reached an advanced stage such that it is probable that the customer
will accept the claim; and
(b) the amount that it is probable will be accepted by the customer can be measured reliably.
14. Incentive payments are additional amounts payable to the contractor if specified
performance standards are met or exceeded. For example, a contract may allow for an
incentive payment to the contractor for early completion of the contract. Incentive payments
are included in contract revenue when:
(a) the contract is sufficiently advanced that it is probable that the specified performance
standards will be met or exceeded; and
(b) the amount of the incentive payment can be measured reliably.
Contract Costs
15. Contract costs should comprise:
(a) costs that relate directly to the specific contract;
(b) costs that are attributable to contract activity in general and can be allocated to
the contract; and
(c) such other costs as are specifically chargeable to the customer under the terms of
the contract.
16. Costs that relate directly to a specific contract include:
(a) site labour costs, including site supervision;
(b) costs of materials used in construction;
(c) depreciation of plant and equipment used on the contract;
(d) costs of moving plant, equipment and materials to and from the contract site;
(e) costs of hiring plant and equipment;
(f) costs of design and technical assistance that is directly related to the contract;
(g) the estimated costs of rectification and guarantee work, including expected warranty
costs; and
(h) claims from third parties.
These costs may be reduced by any incidental income that is not included in contract revenue,
for example income from the sale of surplus materials and the disposal of plant and equipment
at the end of the contract.
17. Costs that may be attributable to contract activity in general and can be allocated to
specific contracts include:
(a) insurance;
(b) costs of design and technical assistance that is not directly related to a specific contract;
and
(c) construction overheads.
Such costs are allocated using methods that are systematic and rational and are applied
consistently to all costs having similar characteristics. The allocation is based on the normal
level of construction activity. Construction overheads include costs such as the preparation
and processing of construction personnel payroll. Costs that may be attributable to contract
activity in general and can be allocated to specific contracts also include borrowing costs as
per Accounting Standard (AS) 16, Borrowing Costs.
18. Costs that are specifically chargeable to the customer under the terms of the contract
may include some general administration costs and development costs for which
reimbursement is specified in the terms of the contract.
19. Costs that cannot be attributed to contract activity or cannot be allocated to a contract
are excluded from the costs of a construction contract. Such costs include:
(a) general administration costs for which reimbursement is not specified in the contract;
(b) selling costs;
(c) research and development costs for which reimbursement is not specified in the contract;
and
(d) depreciation of idle plant and equipment that is not used on a particular contract.
20. Contract costs include the costs attributable to a contract for the period from the date of
securing the contract to the final completion of the contract. However, costs that relate directly
to a contract and which are incurred in securing the contract are also included as part of the
contract costs if they can be separately identified and measured reliably and it is probable that
the contract will be obtained. When costs incurred in securing a contract are recognised as an
expense in the period in which they are incurred, they are not included in contract costs when
the contract is obtained in a subsequent period.
Recognition of Contract Revenue and Expenses

21. When the outcome of a construction contract can be estimated reliably, contract
revenue and contract costs associated with the construction contract should be
recognised as revenue and expenses respectively by reference to the stage of
completion of the contract activity at the reporting date. An expected loss on the
construction contract should be recognised as an expense immediately in accordance
with paragraph 35.
22. In the case of a fixed price contract, the outcome of a construction contract can be
estimated reliably when all the following conditions are satisfied:
(a) total contract revenue can be measured reliably;
(b) it is probable that the economic benefits associated with the contract will flow to
the enterprise;
(c) both the contract costs to complete the contract and the stage of contract
completion at the reporting date can be measured reliably; and
(d) the contract costs attributable to the contract can be clearly identified and
measured reliably so that actual contract costs incurred can be compared with prior
estimates.
23. In the case of a cost plus contract, the outcome of a construction contract can be
estimated reliably when all the following conditions are satisfied:
(a) it is probable that the economic benefits associated with the contract will flow to
the enterprise; and
(b) the contract costs attributable to the contract, whether or not specifically
reimbursable, can be clearly identified and measured reliably.
24. The recognition of revenue and expenses by reference to the stage of completion of a
contract is often referred to as the percentage of completion method. Under this method,
contract revenue is matched with the contract costs incurred in reaching the stage of
completion, resulting in the reporting of revenue, expenses and profit which can be attributed
to the proportion of work completed. This method provides useful information on the extent of
contract activity and performance during a period.
25. Under the percentage of completion method, contract revenue is recognised as revenue
in the statement of profit and loss in the accounting periods in which the work is performed.
Contract costs are usually recognised as an expense in the statement of profit and loss in the
accounting periods in which the work to which they relate is performed. However, any
expected excess of total contract costs over total contract revenue for the contract is
recognised as an expense immediately in accordance with paragraph 35.
26. A contractor may have incurred contract costs that relate to future activity on the
contract. Such contract costs are recognised as an asset provided it is probable that they will
be recovered. Such costs represent an amount due from the customer and are often classified
as contract work in progress.
27. When an uncertainty arises about the collectability of an amount already included in
contract revenue, and already recognised in the statement of profit and loss, the uncollectable
amount or the amount in respect of which recovery has ceased to be probable is recognised
as an expense rather than as an adjustment of the amount of contract revenue.
28. An enterprise is generally able to make reliable estimates after it has agreed to a
contract which establishes:
(a) each party’s enforceable rights regarding the asset to be constructed;
(b) the consideration to be exchanged; and
(c) the manner and terms of settlement.
It is also usually necessary for the enterprise to have an effective internal financial budgeting
and reporting system. The enterprise reviews and, when necessary, revises the estimates of
contract revenue and contract costs as the contract progresses. The need for such revisions
does not necessarily indicate that the outcome of the contract cannot be estimated reliably.
29. The stage of completion of a contract may be determined in a variety of ways. The
enterprise uses the method that measures reliably the work performed. Depending on the
nature of the contract, the methods may include:
(a) the proportion that contract costs incurred for work performed upto the reporting date
bear to the estimated total contract costs; or
(b) surveys of work performed; or
(c) completion of a physical proportion of the contract work.
Progress payments and advances received from customers may not necessarily reflect the
work performed.
30. When the stage of completion is determined by reference to the contract costs incurred
upto the reporting date, only those contract costs that reflect work performed are included in
costs incurred upto the reporting date. Examples of contract costs which are excluded are:
(a) contract costs that relate to future activity on the contract, such as costs of materials that
have been delivered to a contract site or set aside for use in a contract but not yet installed,
used or applied during contract performance, unless the materials have been made specially
for the contract; and
(b) payments made to subcontractors in advance of work performed under the subcontract.
31. When the outcome of a construction contract cannot be estimated reliably:
(a) revenue should be recognised only to the extent of contract costs incurred of
which recovery is probable; and
(b) contract costs should be recognised as an expense in the period in which they are
incurred.
An expected loss on the construction contract should be recognised as an expense
immediately in accordance with paragraph 35.
32. During the early stages of a contract it is often the case that the outcome of the contract
cannot be estimated reliably. Nevertheless, it may be probable that the enterprise will recover
the contract costs incurred. Therefore, contract revenue is recognised only to the extent of
costs incurred that are expected to be recovered. As the outcome of the contract cannot be
estimated reliably,no profit is recognised. However, even though the outcome of the contract
cannot be estimated reliably, it may be probable that total contract costs will exceed total
contract revenue. In such cases, any expected excess of total contract costs over total
contract revenue for the contract is recognised as an expense immediately in accordance with
paragraph 35.
33. Contract costs recovery of which is not probable are recognised as an expense
immediately. Examples of circumstances in which the recoverability of contract costs incurred
may not be probable and in which contract costs may, therefore, need to be recognised as an
expense immediately include contracts:
(a) which are not fully enforceable, that is, their validity is seriously in question;
(b) the completion of which is subject to the outcome of pending litigation or legislation;
(c) relating to properties that are likely to be condemned or expropriated;
(d) where the customer is unable to meet its obligations; or
(e) where the contractor is unable to complete the contract or otherwise meet its obligations
under the contract.
34. When the uncertainties that prevented the outcome of the contract being estimated
reliably no longer exist, revenue and expenses associated with the construction
contract should be recognised in accordance with paragraph 21 rather than in
accordance with paragraph 31.
Recognition of Expected Losses

35. When it is probable that total contract costs will exceed total contract revenue, the
expected loss should be recognised as an expense immediately.
36. The amount of such a loss is determined irrespective of:
(a) whether or not work has commenced on the contract;
(b) the stage of completion of contract activity; or
(c) the amount of profits expected to arise on other contracts which are not treated as a
single construction contract in accordance with paragraph 8.
Changes in Estimates
37. The percentage of completion method is applied on a cumulative basis in each
accounting period to the current estimates of contract revenue and contract costs. Therefore,
the effect of a change in the estimate of contract revenue or contract costs, or the effect of a
change in the estimate of the outcome of a contract, is accounted for as a change in
accounting estimate (see Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior
Period Items and Changes in Accounting Policies). The changed estimates are used in
determination of the amount of revenue and expenses recognised in the statement of profit
and loss in the period in which the change is made and in subsequent periods.
Disclosure
38. An enterprise should disclose:
(a) the amount of contract revenue recognised as revenue in the period;
(b) the methods used to determine the contract revenue recognised in the period; and
(c) the methods used to determine the stage of completion of contracts in progress.
39. An enterprise should disclose the following for contracts in progress at the
reporting date:
(a) the aggregate amount of costs incurred and recognised profits (less recognised
losses) upto the reporting date;
(b) the amount of advances received; and
(c) the amount of retentions.
40. Retentions are amounts of progress billings which are not paid until the satisfaction of
conditions specified in the contract for the payment of such amounts or until defects have
been rectified. Progress billings are amounts billed for work performed on a contract whether
or not they have been paid by the customer. Advances are amounts received by the contractor
before the related work is performed.
41. An enterprise should present:

(a) the gross amount due from customers for contract work as an asset; and
(b) the gross amount due to customers for contract work as a liability.
42. The gross amount due from customers for contract work is the net amount of:
(a) costs incurred plus recognised profits; less
(b) the sum of recognised losses and progress billings
for all contracts in progress for which costs incurred plus recognised profits (less recognised
losses) exceeds progress billings.
43. The gross amount due to customers for contract work is the net amount of:
(a) the sum of recognised losses and progress billings; less
(b) costs incurred plus recognised profits for all contracts in progress for which progress
billings exceed costs incurred plus recognised profits (less recognised losses).
44. An enterprise discloses any contingencies in accordance with Accounting Standard (AS)
4, Contingencies and Events Occurring After the Balance Sheet Date. Contingencies may
arise from such items as warranty costs, penalties or possible losses.∗
APPENDIX
The appendix is illustrative only and does not form part of the Accounting Standard. The
purpose of the appendix is to illustrate the application of the Accounting Standard to assist in
clarifying its meaning.
Disclosure of Accounting Policies

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

The following example illustrates one method of determining the stage of completion of a
contract and the timing of the recognition of contract revenue and expenses (see paragraphs
21 to 34 of the Standard). (Amounts shown herein below are in Rs. lakhs)
A construction contractor has a fixed price contract for Rs. 9,000 to build a bridge. The initial
amount of revenue agreed in the contract is Rs. 9,000. The contractor’s initial estimate of
contract costs is Rs. 8,000. It will take 3 years to build the bridge.
By the end of year 1, the contractor’s estimate of contract costs has increased to Rs. 8,050.
In year 2, the customer approves a variation resulting in an increase in contract revenue of Rs.
200 and estimated additional contract costs of Rs. 150. At the end of year 2, costs incurred
include Rs. 100 for standard materials stored at the site to be used in year 3 to complete the
project.
The contractor determines the stage of completion of the contract by calculating the proportion
that contract costs incurred for work performed upto the reporting date bear to the latest
estimated total contract costs. A summary of the financial data during the construction period
is as follows:
(amount in Rs. lakhs)
Year 1 Year 2 Year 3
Initial amount of revenue agreed in contract 9,000 9,000 9,000

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

Reporting Date Prior years current year
Year 1
Revenue (9,000x .26) 2,340 2,340

Expenses (8,050x .26) 2,093 2,093
Profit 247 247
Year 2
Revenue (9,200x .74) 6,808 2,340 4,468

Expenses (8,200x .74) 6,068 2,093 3,975
Profit 740 247 493
Year 3
Revenue (9,200x 1.00) 9,200 6,808 2,392

Expense 8,200 6,068 2,132
Profit 1,000 740 260
Contract Disclosures
A contractor has reached the end of its first year of operations. All its contract costs incurred
have been paid for in cash and all its progress billings and advances have been received in
cash. Contract costs incurred for contracts B, C and E include the cost of materials that have
been purchased for the contract but which have not been used in contract performance upto
the reporting date. For contracts B, C and E, the customers have made advances to the
contractor for work not yet performed.
The status of its five contracts in progress at the end of year 1 is as follows:
Contract
A B C D E Total
Contract Revenue recognised in 145 520 380 200 55 1,300

accordance with paragraph 21
Contract Expenses recognised in 110 450 350 250 55 1,215
Expected Losses recognised in — — — 40 30 70

Recognised profits less recognised 35 70 30 (90) (30) 15
losses
Contract Costs incurred in the period 110 510 450 250 100 1,420
Contract Costs incurred recognised
as contract expenses in the period
in accordance with paragraph 21 110 450 350 250 55 1,215
Contract Costs that relate to future

activity recognised as an asset in
accordance with paragraph 26 — 60 100 — 45 205
Contract Revenue (see above) 145 520 380 200 55 1,300
Progress Billings (paragraph 40) 100 520 380 180 55 1,235
Unbilled Contract Revenue 45 — — 20 — 65
Advances (paragraph 40) — 80 20 — 25 125
The amounts to be disclosed in accordance with the Standard are as follows:
Contract revenue recognised as revenue in the period (paragraph 38(a)) 1,300

Contract costs incurred and recognised profits (less recognised losses)
upto the reporting date (paragraph 39(a)) 1,435
Advances received (paragraph 39(b)) 125
Gross amount due from customers for contract work—
presented as an asset in accordance with paragraph 41(a) 220
Gross amount due to customers for contract work—
presented as a liability in accordance with paragraph 41(b) (20)
The amounts to be disclosed in accordance with paragraphs 39(a), 41(a) and 41(b) are
calculated as follows:
A B C D E TOTAL
Contract Costs incurred 110 510 450 250 100 1,420

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

recognised losses
145 580 480 160 70 1,435
Progress billings 100 520 380 180 55 1,235
Due from customers 45 60 100 — 15 220
Due to customers — — — (20) — (20)
The amount disclosed in accordance with paragraph 39(a) is the same as the amount for the
current period because the disclosures relate to the first year of operation.
AS 9 : REVENUE RECOGNITION
The following is the ‘text of the Accounting Standard 9 (AS 9) issued by the Institute of
Chartered Accountants of India on “Revenue Recognition1 ”.
private sectors.
INTRODUCTION
1. This Statement deals with the bases for recognition of revenue in the statement of profit
and loss of an enterprise. The Statement is concerned with the recognition of revenue arising
in the course of the ordinary activities of the enterprise from
— the sale of goods∗
— the rendering of services, and
— the use by others of enterprise resources yielding interest, royalties and dividends.
2. This Statement does not deal with the following aspects of revenue recognition to which
special considerations apply :
1
It is reiterated that this AS (as in the case of other AS) assumes that the three
fundamental accounting assumptions i.e. going concern, consistency and accrual
have been followed in the preparation and presentation of financial statements.
∗
Refer to ASI 14.
(i) Revenue arising from construction contracts;

(ii) Revenue arising from hire-purchase, lease agreements;
(iii) Revenue arising from government grants and other similar subsidies;
(iv) Revenue of insurance companies arising from insurance contracts.
3. Examples of items not included within the definition of “revenue” for the purpose of this
Statement are :
(i) Realised gains resulting from the disposal of, and unrealised gains resulting from the
holding of non-current assets e.g. appreciation in the value of fixed assets;
(ii) Unrealised holding gains resulting from the change in value of current assets, and the
natural increases in herds and agricultural and forest products;
(iii) Realised or unrealised gains resulting from changes in foreign exchange rates and
adjustments arising on the translation of foreign currency financial statements;
(iv) Realised gains resulting from the discharge of an obligation at less than its carrying
amount;
(v) Unrealised gains resulting from the restatement of the carrying amount of an obligation.
Definitions
4.1 Revenue is the gross inflow of cash, receivables or other consideration arising in the
course of the ordinary activities of an enterprise€ from the sale of goods, from the rendering of
services, and from the use by others of enterprise resources yielding interest, royalties and
dividends. Revenue is measured by the charges made to customers or clients for goods
supplied and services rendered to them and by the charges and rewards arising from the use
of resources by them. In an agency relationship, the revenue is the amount of commission and
not the gross inflow of cash, receivables or other consideration.
4.2 Completed Service contract method is a method of accounting which recognises revenue
in the statement of profit and loss only when the rendering of services under a contract is
completed or substantially completed.
4.3 Proportionate completion method is a method of accounting which recognises revenue in the
statement of profit and loss proportionately with the degree of completion of services under a
contract.
€
the Institute has issued an announcement in 2005 titled ‘Treatment of Inter-divisional
Transfers’. As per this announcement, the recognition of inter divisional transfers as sales
is an inappropriate treatment and is inconsistent with AS 9.
Explanation
5. Revenue recognition is mainly concerned with the timing of recognition of revenue in the
statement of profit and loss of an enterprise. The amount of revenue arising on a transaction is
usually determined by agreement between the parties involved in the transaction. When
uncertainties exist regarding the determination of the amount, or its associated costs, these
uncertainties may influence the timing of revenue recognition.
6. SALE OF GOODS
6.1 A key criterion for determining when to recognise revenue from a transaction involving
the sale of goods is that the seller has transferred the property in the goods to the buyer for a
consideration. The transfer of property in goods, in most cases, results in or coincides with the
transfer of significant risks and rewards of ownership to the buyer. However, there may be
situations where transfer of property in goods, does not coincide with the transfer of significant
risks and rewards of ownership. Revenue in such situations is recognised at the time of
transfer of significant risks and rewards of ownership to the buyer. Such cases may arise
where delivery has been delayed through the fault of either the buyer or the seller and the
goods are at the risk of the party at fault as regards any loss which might not have occurred
but for such fault. Further, sometimes the parties may agree that the risk will pass at a time
different from the time when ownership passes.
6.2 At certain stages in specific industries, such as when agricultural crops have been
harvested or mineral ores have been extracted, performance may be substantially complete
prior to the execution of the transaction generating revenue. In such cases when sale is
assured under a forward contract or a government guarantee or where market exists and there
is a negligible risk of failure to sell, the goods involved are often valued at net realisable value.
Such amounts, while not revenue as defined in this Statement, are sometimes recognised in
the statement of profit and loss and appropriately described.
7. RENDERING OF SERVICES
7.1 Revenue from service transactions is usually recognised as the service is performed,
either by the proportionate completion method or by the completed service contract method.
(i) Proportionate completion method : Performance consists of the execution of more than
one act. Revenue is recognised proportionately by reference to the performance of each act.
The revenue recognised under this method would be determined on the basis of contract
value, associated costs, number of acts or other suitable basis. For practical purposes, when
services are provided by an indeterminate number of acts over a specific period of time,
revenue is recognised on a straight line basis over the specific period unless there is evidence
that some other method better represents the pattern of performance.
(ii) Completed service contract method : Performance consists of the execution of a single
act. Alternatively, services are performed in more than a single act, and the services yet to be
performed are so significant in relation to the transaction taken as a whole that performance
cannot be deemed to have been completed until the execution of those acts. The completed
service contract method is relevant to these patterns of performance and accordingly revenue
is recognised when the sole or final act takes place and the service becomes chargeable.
8. THE USE BY OTHERS OF ENTERPRISE RESOURCES YIELDING INTEREST,

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

9.1 Recognition of revenue requires that revenue is measurable and that at the time of sale
of goods or the rendering of the service it would not be unreasonable to expect ultimate collec-
tion.
9.2 Where the ability to assess the ultimate collection with reasonable certainty is lacking at
the time of raising any claim, e.g., for escalation of price, export incentives, interest etc.,
revenue recognition is postponed to the extent of uncertainty involved. In such cases, it may
be appropriate to recognise revenue only when it is reasonably certain that the ultimate
collection will be made. Where there is no uncertainty as to ultimate collection, revenue is
recognised at the time of sale or rendering of service even though payments are made by
instalments.
9.3 When the uncertainty relating to collectability arises subsequent to the time of sale or the
rendering of the service, it is more appropriate to make a separate provision to reflect the
uncertainty rather than to adjust the amount of revenue originally recorded.
9.4 An essential criterion for the recognition of revenue is that the consideration receivable
for the sale of goods,the rendering of services or from the use by others of enterprise
resources is reasonably determinable. When such consideration is not determinable within
reasonable limits, the recognition of revenue is postponed.
9.5 When recognition of revenue is postponed due to the effect of uncertainties, it is
considered as revenue of the period in which it is properly recognised.
Accounting Standard
(Accounting Standard comprises paragraphs 10-14 of this Statement. ‘The Standard should
be read in the context of paragraphs 1-9 of this Statement and of the Preface to the
10. Revenue from sales or service transactions should be recognised when the
requirements as to performance set out in paragraphs 11 and 12 are satisfied, provided
that at the time of performance it is not unreasonable to expect ultimate collection. If at
the time of raising of any claim it is unreasonable to expect ultimate collection, revenue
recognition should be postponed.
11. In a transaction involving the sale of goods, performance should be regarded as
being achieved when the following conditions have been fulfilled :
(i) the seller of goods has transferred to the buyer the property in the goods for a
price or all significant risks and rewards of ownership have been transferred to the
buyer and the seller retains no effective control of the goods transferred to a degree
usually associated with ownership; and
(ii) no significant uncertainty exists regarding the amount of the consideration that
will be derived from the sale of the goods.
12. In a transaction involving the rendering of services, performance should be
measured either under the completed service contract method or under the
proportionate completion method, whichever relates revenue to the work accomplished.
Such performance should be regarded as being achieved when no significant
uncertainty exists regarding the amount of the consideration that will be derived from
rendering the service.
13. Revenue arising from the use by others of enterprise resources yielding interest,
royalties and dividends should only be recognised when no significant uncertainty as to
measurability or collectability exists. These revenues are recognised on the following
bases :
(i) Interest : on a time proportion basis taking into account the

amount outstanding and the rate applicable;
(ii) Royalties : on an accrual basis in accordance with the terms
of the relevant agreement; and
(iii) Dividends from : when the owner’s right to receive payment is
Investments in shares established.
Disclosure
14. In addition to the disclosures required by Accounting Standard 1 on Disclosure of
Accounting Policies (AS 1), an enterprise should also disclose the circumstances in
which revenue recognition has been postponed pending the resolution of significant
uncertainties.
APPENDIX
This appendix is illustrative only and does not form part of the accounting standard set forth in
this Statement. The purpose of the appendix is to illustrate the application of the Standard to a
number of commercial situations in an endeavour to assist in clarifying application of the
Standard.
A. Sale of goods
1 Delivery is delayed at buyer’s request and buyer takes title and accepts billing
Revenue should be recognised not withstanding that physical delivery has not been
completed so long as there is every expectation that delivery will be made. However, the
item must be on hand, identified and ready for delivery to the buyer at the time the sale is
recognised rather than there being simply an intention to acquire or manufacture the
goods in time for delivery.
2 Delivered subject to conditions
(a) installation and inspection i.e., goods are sold subject to installation, inspection etc.
Revenue should normally not be recognised until the customer accepts delivery and
installation and inspection are complete. In some cases, however, the installation
process may be so simple in nature that it may be appropriate to recognise the sale
notwithstanding that installation is not yet completed (e.g. installation of a factory
tested television receiver normally only requires unpacking and connecting of power
of antennae).
(b) on approval
Revenue should not be recognised until the goods have been formally accepted by
the buyer or the buyer has done an act adopting the transaction or the time period
for rejection has elapsed or where no time has been fixed, a reasonable time has
elapsed.
(c) guaranteed sales i.e., delivery is made giving the buyer an unlimited right of return
Recognition of revenue in such circumstances will depend on the substance of the
agreement. In the case of retail sales offering a guarantee of “money back if not
completely satisfied” it may be appropriate to recognise the sale but to make a
suitable provision for returns based on previous experience. In other cases, the
substance of the agreement may amount to a sale on consignment, in which case it
should be treated as indicated below.
(d) consignment sales i.e., a delivery is made whereby the recipient undertakes to sell
the goods on behalf of the consignor
Revenue should not be recognised until the goods are sold to a third party.
(e) cash on delivery sales
Revenue should not be recognised until cash is received by the seller or his agent.
3. Sales where the purchaser makes a series of instalment payments to the seller and the
seller delivers the goods only when the final payment is received
Revenue from such sales should not be recognised until goods are delivered. However,
when experience indicates that most such sales have been consummated, revenue may
be recognised when a significant deposit is received.
4. Special orders and shipments, i.e. where payment (or partial payment) is received for
goods not presently held in stock, e.g. the stock is still to be manufactured or is to be
delivered directly to the customer from a third party.
Revenue from such sales should not be recognised until goods are manufactured, identified
and ready for delivery to the buyer by the third party.
5. Sale - repurchase agreements, i.e. where seller concurrently agrees to repurchase the
same goods at a later date
For such transactions that are in substance a financing agreement, the resulting cash
inflow is not revenue as defined and should not be recognised as revenue.
6. Sales to intermediate parties, i.e. where goods are sold to distributors, dealers or others
for resale
Revenue from such sales can generally be recognised if significant risks of ownership
have passed; however, in some situations the buyer may in substance be an agent and
in such cases the sale should be treated as a consignment sale.
7. Subscriptions for publications
Revenue received or billed should be differed and recognised either on a straight line
basis over time or, where the items delivered vary in value from period of period, revenue
should be based on the sales value of the item delivered in relation to the total sales
value of all items covered by the subscription.
8. Instalment sales
When the consideration is receivable in instalments, revenue attributable to the sales
price exclusive of interest should be recognised at the date of sale. The interest element
should be recognised as revenue, proportionately to the unpaid balance due to the seller.
9. Trade discounts and volume rebates
Trade discounts and volume rebates received are not encompassed within the definition
of revenue, since they represent a reduction of cost. Trade discounts and volume rebates
given should be deducted in determining revenue.
B. Rendering of services
1. Installation fees
In cases where installation fees are other than incidental to the sale of a product, they
should be recognised as revenue only when the equipment is installed and accepted by
the customer.
2. Advertising and insurance agency commissions
Revenue should be recognised when the service is completed. For advertising agencies,
media commissions will normally be recognised when the related advertisement or
commercial appears before the public and the necessary intimation is received by the
agency, as opposed to production commission, which will be recognised when the project
is completed. Insurance agency commissions should be recognised on the effective
commencement or renewal dates of the related policies.
3. Financial service commissions
A financial service may be rendered as a single act or may be provided over a period of
time. Similarly, charges for such services may be made as a single amount or in stages
over the period of the service or the life of the transaction to which it relates. Such
charges may be settled in full when made, or added to a loan or other account and
settled in stages. The recognition of such revenue should therefore have regard to :
(a) whether the service has been provided “once and for all” or is on a “continuing”
basis;
(b) the incidence of the costs relating to the service; and
(c) when the payment for the service will be received. In general, commissions charged
for arranging or granting loan or other facilities should be recognised when a
binding obligation has been entered into. Commitment, facility or loan management
fees which relate to continuing obligations or services should normally be

recognised over the life of the loan or facility having regard to the amount of the
obligation outstanding, the nature of the services provided and the timing of the
costs relating thereto.
4. Admission fees
Revenue from artistic performances, banquets and other special events should be
recognised when the event takes place. When a subscription to a number of events is
sold, the fee should be allocated to each event on a systematic and rational basis.
5. Tuition fees
Revenue should be recognised over the period of instruction.
6. Entrance and membership fees
Revenue recognition from these sources will depend on the nature of the services being
provided. Entrance free received is generally capitalised. If the membership fee permits
only membership and all other services or products are paid for separately, or if there is
a separate annual subscription, the fee should be recognised when received. If the
membership fee entitles the member to services or publications to be provided during the
year, it should be recognised on a systematic and rational basis having regard to the
timing and nature of all services provided.
AS 10 : ACCOUNTING FOR FIXED ASSETS
The following is the text of the Accounting Standard 10 (AS 10) issued by the Institute of
Chartered Accountants of India on “Accounting for fixed assets”.
private sectors.
INTRODUCTION
1. Financial statements disclose certain information relating to fixed assets. In many
enterprises these assets are grouped into various categories, such as land and buildings,
plant and machinery, vehicles, furniture and fittings, goodwill, patents, trademarks and
designs. This Statement deals with accounting for such fixed assets except as described in
paragraphs 2 to 5 below. ∗
2. This statement does not deal with the specialised aspects of accounting for fixed assets
that arise under a comprehensive system reflecting the effects of changing prices but applies
to financial statements prepared on historical cost basis.
3. This statement does not deal with accounting for the following items to which special
considerations apply :
(i) forests, plantations and similar regenerative natural resources ;
(ii) wasting assets including mineral rights, expenditure on the exploration for and extraction
of minerals, oil, natural gas and similar non-regenerative resources ;
(iii) expenditure on real estate development ; and
(iv) livestock.
Expenditure on individual items of fixed assets used to develop or maintain the activities
covered in (i) to (iv) above, but separable from those activities, are to be accounted for in
accordance with this statement.
4. This statement does not cover the allocation of the depreciable amount of fixed assets to
future periods since this subject is dealt with in Accounting Standard 6 on “Depreciation
Accounting”.
5. This statement does not deal with the treatment of Government grants and subsidies,
and assets under leasing rights. It makes only a brief reference to the capitalisation of
borrowing costs£ and assets acquired in an amalgamation or merger. These subjects require
more extensive consideration than can be given within the statement.
Definitions
6. The following terms are used in this Statement with their meanings specified :
6.1 Fixed asset is an asset held with the intention of being used for the purpose of producing
or providing goods or services and is not held for sale in the normal course of business.
6.2 Fair market value is the price that would be agreed to in an open and unrestricted
market between knowledgeable and willing parties dealing at arm’s length who are fully
∗
From the date of AS 26, becoming mandatory for the concerned enterprises, the
relevant paragraphs of the standard that deal with patents and know-how, stand
withdrawn and therefore, the same are omitted from this standard.
£
The relevant requirements in this regard are omitted from this standard pursuant to As
16, Borrowing Costs, becoming mandatory in respect of accounting periods commencing
on or after 1.4.2004.
informed and are not under any compulsion to transact.

6.3 Gross book value of a fixed asset is its historical cost or other amount substituted for
historical cost in the books of account or financial statements. When this amount is shown net
of accumulated depreciation, it is termed as net book value.
Explanation
7. Fixed assets often comprise a significant portion of the total assets of an enterprise and
therefore, are important in the presentation of financial position. Furthermore, the
determination of whether an expenditure represents an asset or an expense can have a
material effect on an enterprise’s reported results of operations.
8. IDENTIFICATION OF FIXED ASSETS

8.1 The definition in paragraph 6.1 gives criteria for determining whether items are to be
classified as fixed assets. Judgment is required in applying the criteria to specific
circumstances or specific types of enterprises. It may be appropriate to aggregate individually
insignificant items, and to apply the criteria to the aggregate value. An enterprise may decide
to expense an item which could otherwise have been included as fixed assets, because the
amount of the expenditure is not material.
8.2 Stand-by equipment and servicing equipment are normally capitalised. Machinery spares
are usually charged to the profit and loss statement as and when consumed. However, if such
spares can be used only in connection with an item of fixed assets and their use is expected
to be irregular, it may be appropriate to allocate the total cost on a systematic basis over a
period not exceeding the useful life of the principal item.€
8.3 In certain circumstances, the accounting for an item of fixed asset may be improved if the
total expenditure thereon is allocated to its component parts, provided they are in practice
separable, and estimates are made of the useful lives of these components. For example,
rather than treat an aircraft and its engines as one unit, it may be better to treat the engines as
a separate unit if it is likely that their useful life is shorter than that of the aircraft as a whole.
9. COMPONENTS OF COST
9.1 The cost of an item of fixed assets comprises its purchase price, including import duties
and other non-refundable taxes or levies and any directly attributable cost of bringing the
asset to its working condition for its intended use ; any trade discounts and rebates are
deducted in arriving at the purchase price. Examples of directly attributable costs are :
(i) site preparation ;
€
See also ASI 2
(ii) initial delivery and handling costs ;

(iii) installation cost, such as special foundations for plant ; and
(iv) professional fees, for example fees of architects and engineers.
The cost of a fixed asset may undergo changes subsequent to its acquisition or construction
on account of exchange fluctuations, price adjustments, changes in duties or similar factors.
9.21 Financing costs relating to deferred credits or to borrowed funds attributable to
construction or acquisition of fixed assets for the period up to the completion of construction or
acquisition of fixed assets are also sometimes included in the gross book value of the asset to
which they relate. However, financing costs (including interest) on fixed assets purchased on a
deferred credit basis or on monies borrowed for construction or acquisition of fixed assets are
not capitalised to the extent that such costs relate to periods after such assets are ready to be
put to use.
9.3 Administration and other general overhead expenses are usually excluded from the cost
of fixed assets because they do not relate to a specific fixed asset. However, in some circum-
stances, such expenses as are specifically attributable to construction of a project or to the
acquisition of a fixed asset or bringing it to its working condition, may be included as part of
the cost of the construction project or as a part of the cost of the fixed asset.
9.4 The expenditure incurred on start-up and commissioning of the project, including the
expenditure incurred on test runs and experimental production, is usually capitalised as an
indirect element of the construction cost. However, the expenditure incurred after the plant has
begun commercial production i.e., production intended for sale or captive consumption, is not
capitalised and is treated as revenue expenditure even though the contract may stipulate that
the plant will not be finally taken over until after the satisfactory completion of the guarantee
period.
9.5 If the interval between the date a project is ready to commence commercial production
and the date at which commercial production actually begins is prolonged, all expenses
incurred during this period are charged to the profit and loss statement. However, the
expenditure incurred during this period is also sometimes treated as deferred revenue
expenditure to be amortised over a period not exceeding 3 to 5 years after the commencement
of commercial production2.
1
Pursuant to the issuance of AS 16, Borrowing costs, which comes into effect in respect of
accounting periods commencing on or after 1.4.2000, this paragraph stands withdrawn from
the aforesaid date.
2
It may be noted that this paragraph relates to "all expenses" incurred during the period. This
expenditure would also include borrowing costs incurred during the said period. Since AS 16,
Borrowing Costs, specifically deals with the treatment of borrowing costs, the treatment provided
by AS 16 would prevail over the provisions in this respect contained in this paragraph as these
provisions are general in nature and apply to "all expenses". Accordingly, this paragraph stands
withdrawn in so far as borrowing costs are concerned.
10. SELF-CONSTRUCTED FIXED ASSETS

10.1 In arriving at the gross book value of self-constructed fixed assets, the same principles
apply as those described in paragraphs 9.1 to 9.5. Included in the gross book value are costs
of construction that relate directly to the specific asset and costs that are attributable to the
construction activity in general and can be allocated to the specific asset. Any internal profits
are eliminated in arriving at such costs.
11. NON-MONETARY CONSIDERATION

11.1 When a fixed asset is acquired in exchange for another asset, its cost is usually
determined by reference to the fair market value of the consideration given. It may be
appropriate to consider also the fair market value of the asset acquired if this is more clearly
evident. An alternative accounting treatment that is sometimes used for an exchange of
assets, particularly when the assets exchanged are similar, is to record the asset acquired at
the net book value of asset given up. In each case an adjustment is made for any balancing
receipt or payment of cash or other consideration.
11.2 When a fixed asset is acquired in exchange for shares or other securities in the
enterprise, it is usually recorded at its fair market value, or the fair market value of the
securities issued, whichever is more clearly evident.
12. IMPROVEMENTS AND REPAIRS

12.1 Frequently, it is difficult to determine whether subsequent expenditure related to fixed
assets represents improvements that ought to be added to the gross book value or repairs that
ought to be charged to the profit and loss statement. Only expenditure that increases the
future benefits from the existing asset beyond its previously assessed standard of
performance is included in the gross book value, e.g. an increase in capacity.
12.2 The cost of an addition or extension to an existing asset which is of a capital nature and
which becomes an integral part of the existing asset is usually added to its gross book value.
Any addition or extension which has a separate identity and is capable of being used after the
existing asset is disposed of, is accounted for separately.
13. AMOUNT SUBSTITUTED FOR HISTORICAL COST

13.1 Sometimes financial statements that are otherwise prepared on a historical cost basis
include part or all of fixed assets at a valuation in substitution for historical costs and
depreciation is calculated accordingly. Such financial statements are to be distinguished from

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

14.1 An item of fixed asset is eliminated from the financial statements on disposal.
14.2 Items of fixed assets that have been retired from active use and are held for disposal are
stated at the lower of their net book value and net realisable value and are shown separately
in the financial statements. Any expected loss is recognised immediately in the profit and loss
statement.
14.3 In historical cost financial statements, gains or losses arising on disposal are generally
recognised in the profit and loss statement.
14.4 On disposal of a previously revalued item of fixed asset, the difference between net
disposal proceeds and the net book value is normally charged or credited to the profit and loss
statement except that to the extent such a loss is related to an increase which was previously
recorded as a credit to revaluation reserve and which has not been subsequently reversed or
utilised, it is charged directly to that account. The amount standing in revaluation reserve
following the retirement or disposal of an asset which relates to that asset may be transferred
to general reserve.
15. VALUATION OF FIXED ASSETS IN SPECIAL CASES

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

16.1 Goodwill in general, is recorded in the books only when some consideration in money or
money’s worth has been paid for it. Whenever a business is acquired for a price (payable
either in cash or in shares or otherwise) which is in excess of the value of the net assets of the
business taken over, the excess is termed as goodwill. Goodwill arises from business
connections, trade name or reputation of an enterprise or from other intangible benefits
3
AS 19, Leases has come into effect in respect of assets leased during accounting
periods commencing on or after 1.4.2001. AS 19 also applies to assets acquired on
hire purchase during accounting periods commencing on or after 1.4.2001.
Accordingly, this paragraph is not applicable in respect of assets acquired on hire
purchase during accounting periods commencing on or after 1.4.2001.
enjoyed by an enterprise.
16.2 As a matter of financial prudence, goodwill is written off over a period. However, many
enterprises do not write off goodwill and retain it as an asset.
4
17. DISCLOSURE
17.1 Certain specific disclosures on accounting for fixed assets are already required by
Accounting Standard 1 on “Disclosure of Accounting Policies” and Accounting Standard-6 on
“Depreciation Accounting”.
17.2 Further disclosures that are sometimes made in financial statements include :
(i) gross and net book values of fixed assets at the beginning and end of an accounting
period showing additions, disposals, acquisitions and other movements ;
(ii) expenditure incurred on account of fixed assets in the course of construction or
acquisition ; and
(iii) revalued amounts substituted for historical costs of fixed assets, the method adopted to
compute the revalued amounts, the nature of any indices used, the year of any appraisal
made, and whether an external valuer was involved, in case where fixed assets are
stated at revalued amounts.
Accounting Standard
(The Accounting Standard comprises paragraphs 18 to 39 of this Statement. The Standard
should be read in the context of paragraphs 1 to 17 of this Statement and of the ‘Preface to
the Statements of Accounting Standards’.)
18. The items determined in accordance with the definition in paragraph 6.1 of this
statement should be included under fixed assets in financial statements.
19. The gross book value of a fixed asset should be either historical cost or a
revaluation computed in accordance with this Standard. The method of accounting for
fixed assets included at historical cost is set out in paragraphs 20 to 26 ; the method of
accounting for revalued assets is set out in paragraphs 27 to 32.
20. The cost of a fixed asset should comprise its purchase price and any attributable
costs of bringing the asset to its working condition for its intended use. [Financing
costs relating to deferred credits or to borrowed funds attributable to construction or
acquisition of fixed assets for the period up to the completion of construction or
4
From the date of AS 26 becoming mandatory for the concerned enterprises, paragraphs
16.3 to 16.7 stand withdrawn and hence not given here.
acquisition of fixed assets should also be included in the gross book value of the asset
to which they relate. However, the financing costs (including interest) on fixed assets
purchased on a deffered credit basis or on monies borrowed for construction or
acquisition of fixed assets should not be capitalised to the extent that such costs relate
to periods after such assets are ready to be put to use.]∗
21. The cost of a self-constructed fixed asset should comprise those costs that relate
directly to the specific asset and those that are attributable to the construction activity
in general and can be allocated to the specific asset.
22. When a fixed asset is acquired in exchange or in part exchange for another asset,
the cost of the asset acquired should be recorded either at fair market value or at the
net book value of the asset given up, adjusted for any balancing payment or receipt of
cash or other consideration. For these purposes fair market value may be determined
by reference either to the asset given up or to the asset acquired, whichever is more
clearly evident. Fixed asset acquired in exchange for shares or other securities in the
enterprise should be recorded at its fair market value, or the fair market value of the
securities issued, whichever is more clearly evident.
23. Subsequent expenditures related to an item of fixed asset should be added to its
book value only if they increase the future benefits from the existing asset beyond its
previously assessed standard of performance.
24. Material items retired from active use and held for disposal should be stated at the
lower of their net book value and net realisable value and shown separately in the
25. Fixed asset should be eliminated from the financial statements on disposal or
when no further benefit is expected from its use and disposal.
26. Losses arising from the retirement or gains or losses arising from disposal of fixed
asset which is carried at cost should be recognised in the profit and loss statement.
27. When a fixed asset is revalued in financial statements, an entire class of assets
should be revalued, or the selection of assets for revaluation should be made on a
systematic basis. This basis should be disclosed.
28. The revaluation in financial statements of a class of assets should not result in the
net book value of that class being greater than the recoverable amount of assets of that
class.
29. When a fixed asset is revalued upwards, any accumulated depreciation existing at
∗
The marked portion of this paragraph has been withdrawn after issuance of AS16,
‘Borrowing Costs’.
the date of the revaluation should not be credited to the profit and loss statement.
30. An increase in net book value arising on revaluation of fixed assets should be
credited directly to owner’s interests under the head of revaluation reserve, except that,
to the extent that such increase is related to and not greater than a decrease arising on
revaluation previously recorded as a charge to the profit and loss statement, it may be
credited to the profit and loss statement. A decrease in net book value arising on
revaluation of fixed asset should be charged directly to the profit and loss statement
except that to the extent that such a decrease is related to an increase which was
previously recorded as a credit to revaluation reserve and which has not been
subsequently reversed or utilised, it may be charged directly to that account.
31. The provisions of paragraphs 23,24 and 25 are also applicable to fixed assets
included in financial statements at a revaluation.
32. On disposal of a previously revalued item of fixed asset, the difference between net
disposal proceeds and the net book value should be charged or credited to the profit
and loss statement except that to the extent that such a loss is related to an increase
which was previously recorded as a credit to revaluation reserve and which has not
been subsequently reversed or utilised, it may be charged directly to that account.
33. Fixed assets acquired on hire purchase terms should be recorded at their cash
value, which, if not readily available, should be calculated by assuming an appropriate
rate of interest. They should be shown in the balance sheet with an appropriate
narration to indicate that the enterprise does not have full ownership thereof6.
34. In the case of fixed assets owned by the enterprise jointly with others, the extent of
the enterprise’s shares in such assets, and the proportion of the original cost,
accumulated depreciation and written down value should be stated in the balance
sheet. Alternatively, the pro rata cost of such jointly owned assets may be grouped
together with similar fully owned assets with an appropriate disclosure thereof.
35. Where several fixed assets are purchased for a consolidated price, the
consideration should be apportioned to the various assets on a fair basis as determined
by competent valuers.
36. Goodwill should be recorded in the books only when some consideration in money
or money’s worth has been paid for it. Whenever a business is acquired for a price
(payable in cash or in shares or otherwise) which is in excess of the value of the net
assets of the business taken over, the excess should be termed as “goodwill”.
6
Refer footnote 3.
37. {}∗
38. { } ∗
Disclosure
(i) gross and net book values of fixed assets at the beginning and end of an
accounting period showing additions, disposals, acquisitions and other movements ;
(ii) expenditure incurred on account of fixed assets in the course of construction or
acquisition ; and
(iii) revalued amount substituted for historical costs of fixed assets, the method
adopted to compute the revalued amounts, the nature of indices used, the year of any
appraisal made, and whether an external valuer was involved, in case where fixed
assets are stated at revalued amounts.
AS 11 (Revised 2003): THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
(In this Accounting Standard, the standard portions have been set in bold italic type. These
should be read in the context of the background material which has been set in normal type,
and in the context of the ‘Preface to the Statements of Accounting Standards1'.)
Accounting Standard (AS) 11, The Effects of Changes in Foreign Exchange Rates (revised
2003), issued by the Council of the Institute of Chartered Accountants of India, comes into
effect in respect of accounting periods commencing on or after 1-4-2004 and is mandatory in
nature2 from that date. The revised Standard supersedes Accounting Standard (AS) 11,
∗
From the date of AS 26 becoming mandatory for the concerned enterprises, paragraphs
37 and 38 stand withdrawn and hence not given here.
1
Attention is specifically drawn to paragraph 4.3 of the Preface, according to which
accounting standards are intended to apply only to material items.
2
This implies that, while discharging their attest function, it will be the duty of the
members of the Institute to examine whether this Accounting Standard is complied with in
the presentation of financial statements covered by their audit. In the event of any
deviation from this Accounting Standard, it will be their duty to make adequate
disclosures in their audit reports so that the users of financial statements may be aware
of such deviations.
Accounting for the Effects of Changes in Foreign Exchange Rates (1994), except that in
respect of accounting for transactions in foreign currencies entered into by the reporting
enterprise itself or through its branches before the date this Standard comes into effect, AS 11
(1994) will continue to be applicable.
Objective
An enterprise may carry on activities involving foreign exchange in two ways. It may have
transactions in foreign currencies or it may have foreign operations. In order to include foreign
currency transactions and foreign operations in the financial statements of an enterprise,
transactions must be expressed in the enterprise's reporting currency and the financial
statements of foreign operations must be translated into the enterprise's reporting currency.
The principal issues in accounting for foreign currency transactions and foreign operations are
to decide which exchange rate to use and how to recognise in the financial statements the
financial effect of changes in exchange rates.
Scope
1. This Statement should be applied:
(a) in accounting for transactions in foreign currencies; and
(b) in translating the financial statements of foreign operations.
2. This Statement also deals with accounting for foreign currency transactions in the nature
of forward exchange contracts.∗
3. This Statement does not specify the currency in which an enterprise presents its financial
statements. However, an enterprise normally uses the currency of the country in which it
is domiciled. If it uses a different currency, this Statement requires disclosure of the
reason for using that currency. This Statement also requires disclosure of the reason for
∗
It may be noted that on the basis of a decision of the Council at its meeting held on
June 24-26, 2004, an Announcement title “Applicability of Accounting Standard (AS) 11
(revised 2003), The Effects of Changes in Foreign Exchange Rates, in respect of
exchange differences arising on a forward exchange contract entered into to hedge the
foreign currency risk of a firm commitment or a highly probable forecast transaction’ has
been issued. The Announcement clarifies that AS 11 (revised 2003) does not deal with
the accounting of exchange difference arising on a forward exchange contract entered
into to hedge the foreign currency risk of a firm commitment or a highly probable forecast
transaction. It has also been separately clarified that AS 11 (revised 2003) continues to
be applicable to exchange differences on all other forward exchange contracts.
any change in the reporting currency.

4. This Statement does not deal with the restatement of an enterprise's financial statements
from its reporting currency into another currency for the convenience of users
accustomed to that currency or for similar purposes.
5. This Statement does not deal with the presentation in a cash flow statement of cash
flows arising from transactions in a foreign currency and the translation of cash flows of a
foreign operation (see AS 3, Cash Flow Statements).
6. This Statement does not deal with exchange differences arising from foreign currency
borrowings to the extent that they are regarded as an adjustment to interest costs (see
paragraph 4(e) of AS 16, Borrowing Costs).
Definitions
Average rate is the mean of the exchange rates in force during a period.
Closing rate is the exchange rate at the balance sheet date.
Exchange difference is the difference resulting from reporting the same number of
units of a foreign currency in the reporting currency at different exchange rates.
Exchange rate is the ratio for exchange of two currencies.
Fair value is the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arm's length transaction.
Foreign currency is a currency other than the reporting currency of an enterprise.
Foreign operation is a subsidiary3, associate4, joint venture5 or branch of the
reporting enterprise, the activities of which are based or conducted in a country
other than the country of the reporting enterprise.
Forward exchange contract means an agreement to exchange different currencies
at a forward rate.
Forward rate is the specified exchange rate for exchange of two currencies at a
specified future date.
3
As defined in AS 21, Consolidated Financial Statements.
4
As defined in AS 23, Accounting for Investments in Associates in Consolidated
Financial Statements.
5
As defined in AS 27, Financial Reporting of Interests in Joint Ventures.
Integral foreign operation is a foreign operation, the activities of which are an

integral part of those of the reporting enterprise.
Monetary items are money held and assets and liabilities to be received or paid in
fixed or determinable amounts of money.
Net investment in a non-integral foreign operation is the reporting enterprise’s
share in the net assets of that operation.
Non-integral foreign operation is a foreign operation that is not an integral foreign
operation.
Non-monetary items are assets and liabilities other than monetary items.
Reporting currency is the currency used in presenting the financial statements.
Foreign Currency Transactions
Initial Recognition
8. A foreign currency transaction is a transaction which is denominated in or requires
settlement in a foreign currency, including transactions arising when an enterprise either:
(a) buys or sells goods or services whose price is denominated in a foreign currency;
(b) borrows or lends funds when the amounts payable or receivable are denominated in
a foreign currency;
(c) becomes a party to an unperformed forward exchange contract; or
(d) otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated
in a foreign currency.
9. A foreign currency transaction should be recorded, on initial recognition in the

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

11. At each balance sheet date:
(a) foreign currency monetary items should be reported using the closing rate.
However, in certain circumstances, the closing rate may not reflect with
reasonable accuracy the amount in reporting currency that is likely to be

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

13. Exchange differences arising on the settlement of monetary items or on reporting
an enterprise's monetary items at rates different from those at which they were
initially recorded during the period, or reported in previous financial statements,
£
It may be noted that the Institute has issued in 2003 an Announcement titled ‘Treatment
of exchange differences under Accounting Standard (AS) 11 (revised 2003), The Effects
of Changes in Foreign Exchange Rates vis-à-vis Schedule VI to the Companies Act,
1956’. As per the Announcement, the requirement with regard to treatment of exchange
differences contained in AS 11 (revised 2003), is different from Schedule VI to the
Companies Act, 1956, since AS 11 (revised 2003) does not require the adjustment of
exchange differences in the carrying amount of the fixed assets, in the situations
envisaged in Schedule VI. It has been clarified that pending the amendment, if any, to
Schedule VI to the Companies Act, 1956, in respect of the matter, a company adopting
the treatment described in Schedule VI will still be considered to be complying with AS
11(revised 2003) for the purpose of section 211 of the act.
should be recognised as income or as expenses in the period in which they arise,

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

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

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

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

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

24. In translating the financial statements of a non-integral foreign operation for
incorporation in its financial statements, the reporting enterprise should use the
following procedures:
(a) the assets and liabilities, both monetary and non-monetary, of the non-integral
foreign operation should be translated at the closing rate;
(b) income and expense items of the non-integral foreign operation should be
translated at exchange rates at the dates of the transactions; and
(c) all resulting exchange differences should be accumulated in a foreign
currency translation reserve until the disposal of the net investment.
25. For practical reasons, a rate that approximates the actual exchange rates, for example
an average rate for the period, is often used to translate income and expense items of a
foreign operation.
26. The translation of the financial statements of a non-integral foreign operation results in
the recognition of exchange differences arising from:
(a) translating income and expense items at the exchange rates at the dates of
transactions and assets and liabilities at the closing rate;
(b) translating the opening net investment in the non-integral foreign operation at an
exchange rate different from that at which it was previously reported; and
(c) other changes to equity in the non-integral foreign operation.
These exchange differences are not recognised as income or expenses for the period
because the changes in the exchange rates have little or no direct effect on the present
and future cash flows from operations of either the non-integral foreign operation or the
reporting enterprise. When a non-integral foreign operation is consolidated but is not
wholly owned, accumulated exchange differences arising from translation and
attributable to minority interests are allocated to, and reported as part of, the minority
interest in the consolidated balance sheet.
27. Any goodwill or capital reserve arising on the acquisition of a non-integral foreign
operation is translated at the closing rate in accordance with paragraph 24.
28. A contingent liability disclosed in the financial statements of a non-integral foreign
operation is translated at the closing rate for its disclosure in the financial statements of
the reporting enterprise.
29. The incorporation of the financial statements of a non-integral foreign operation in those
of the reporting enterprise follows normal consolidation procedures, such as the
elimination of intra-group balances and intra-group transactions of a subsidiary (see AS
21, Consolidated Financial Statements, and AS 27, Financial Reporting of Interests in
Joint Ventures). However, an exchange difference arising on an intra-group monetary
item, whether short-term or long-term, cannot be eliminated against a corresponding
amount arising on other intra-group balances because the monetary item represents a
commitment to convert one currency into another and exposes the reporting enterprise to
a gain or loss through currency fluctuations. Accordingly, in the consolidated financial
statements of the reporting enterprise, such an exchange difference continues to be
recognised as income or an expense or, if it arises from the circumstances described in
paragraph 15, it is accumulated in a foreign currency translation reserve until the
disposal of the net investment.
30. When the financial statements of a non-integral foreign operation are drawn up to a
different reporting date from that of the reporting enterprise, the non-integral foreign
operation often prepares, for purposes of incorporation in the financial statements of the
reporting enterprise, statements as at the same date as the reporting enterprise. When it
is impracticable to do this, AS 21, Consolidated Financial Statements, allows the use of
financial statements drawn up to a different reporting date provided that the difference is
no greater than six months and adjustments are made for the effects of any significant
transactions or other events that occur between the different reporting dates. In such a
case, the assets and liabilities of the non-integral foreign operation are translated at the
exchange rate at the balance sheet date of the non-integral foreign operation and
adjustments are made when appropriate for significant movements in exchange rates up
to the balance sheet date of the reporting enterprises in accordance with AS 21. The
same approach is used in applying the equity method to associates and in applying
proportionate consolidation to joint ventures in accordance with AS 23, Accounting for
Investments in Associates in Consolidated Financial Statements and AS 27, Financial
Reporting of Interests in Joint Ventures.
Disposal of a Non-integral Foreign Operation

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

33. When there is a change in the classification of a foreign operation, the translation
procedures applicable to the revised classification should be applied from the date of
the change in the classification.
34. The consistency principle requires that foreign operation once classified as integral or
non-integral is continued to be so classified. However, a change in the way in which a
foreign operation is financed and operates in relation to the reporting enterprise may lead
to a change in the classification of that foreign operation. When a foreign operation that
is integral to the operations of the reporting enterprise is reclassified as a non-integral
foreign operation, exchange differences arising on the translation of non-monetary assets
at the date of the reclassification are accumulated in a foreign currency translation
reserve. When a non-integral foreign operation is reclassified as an integral foreign
operation, the translated amounts for non-monetary items at the date of the change are
treated as the historical cost for those items in the period of change and subsequent
periods. Exchange differences which have been deferred are not recognised as income
or expenses until the disposal of the operation.
All Changes in Foreign Exchange Rates
Tax Effects of Exchange Differences

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

36. An enterprise may enter into a forward exchange contract or another financial
instrument that is in substance a forward exchange contract, which is not intended
for trading or speculation purposes, to establish the amount of the reporting
currency required or available at the settlement date of a transaction. The premium
or discount arising at the inception of such a forward exchange contract should be
amortised as expense or income over the life of the contract. Exchange differences
on such a contract should be recognised in the statement of profit and loss in the
reporting period in which the exchange rates change. Any profit or loss arising on
cancellation or renewal of such a forward exchange contract should be recognised
as income or as expense for the period.
37. The risks associated with changes in exchange rates may be mitigated by entering into
forward exchange contracts. Any premium or discount arising at the inception of a
forward exchange contract is accounted for separately from the exchange differences on
the forward exchange contract. The premium or discount that arises on entering into the
contract is measured by the difference between the exchange rate at the date of the
inception of the forward exchange contract and the forward rate specified in the contract.
Exchange difference on a forward exchange contract is the difference between (a) the
foreign currency amount of the contract translated at the exchange rate at the reporting
date, or the settlement date where the transaction is settled during the reporting period,
and (b) the same foreign currency amount translated at the latter of the date of inception
of the forward exchange contract and the last reporting date.
38. A gain or loss on a forward exchange contract to which paragraph 36 does not
apply should be computed by multiplying the foreign currency amount of the
forward exchange contract by the difference between the forward rate available at
the reporting date for the remaining maturity of the contract and the contracted
forward rate (or the forward rate last used to measure a gain or loss on that
contract for an earlier period). The gain or loss so computed should be recognised
in the statement of profit and loss for the period. The premium or discount on the
forward exchange contract is not recognised separately.
39. In recording a forward exchange contract intended for trading or speculation purposes,
the premium or discount on the contract is ignored and at each balance sheet date, the
value of the contract is marked to its current market value and the gain or loss on the
contract is recognised.
Disclosure
40. An enterprise should disclose:
(a) the amount of exchange differences included in the net profit or loss for the
period; and
(b) net exchange differences accumulated in foreign currency translation reserve
as a separate component of shareholders’ funds, and a reconciliation of the
amount of such exchange differences at the beginning and end of the period.
41. When the reporting currency is different from the currency of the country in which
the enterprise is domiciled, the reason for using a different currency should be
disclosed. The reason for any change in the reporting currency should also be
disclosed.
42. When there is a change in the classification of a significant foreign operation, an
enterprise should disclose:
(a) the nature of the change in classification;
(b) the reason for the change;
(c) the impact of the change in classification on shareholders' funds; and
(d) the impact on net profit or loss for each prior period presented had the change in
classification occurred at the beginning of the earliest period presented.
43. The effect on foreign currency monetary items or on the financial statements of a foreign
operation of a change in exchange rates occurring after the balance sheet date is
disclosed in accordance with AS 4, Contingencies and Events Occurring After the
Balance Sheet Date.
44. Disclosure is also encouraged of an enterprise's foreign currency risk management
policy.
Transitional Provisions
45. On the first time application of this Statement, if a foreign branch is classified as a
non-integral foreign operation in accordance with the requirements of this
Statement, the accounting treatment prescribed in paragraphs 33 and 34 of the
Statement in respect of change in the classification of a foreign operation should be

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

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

IAS 21, as a benchmark treatment, requires, in general, that exchange differences on
transactions be recognised as income or as expenses in the period in which they arise. IAS
21, however, also permits as an allowed alternative treatment, that exchange differences that
arise from a severe devaluation or depreciation of a currency be included in the carrying
amount of an asset, if certain conditions are satisfied. In line with the preference of the Council
of the Institute of Chartered Accountants of India, to eliminate alternatives, where possible,
revised AS 11 (2003) adopts the benchmark treatment as the only acceptable treatment.
3. Terminology
Foreign operation
The revised AS 11 (2003) uses the terms, integral foreign operation and non-integral foreign
operation respectively for the expressions “foreign operations that are integral to the
operations of the reporting enterprise” and “foreign entity” used in IAS 21. The intention is to
communicate the meaning of these terms concisely. This change has no effect on the
requirements in revised AS 11 (2003). Revised AS 11 (2003) provides additional
implementation guidance by including two more indicators for the classification of a foreign
operation as a non-integral foreign operation.
AS 12 : ACCOUNTING FOR GOVERNMENT GRANTS
The following is the text of the Accounting Standard (AS) 12 issued by the Council of the
Institute of Chartered Accountants of India on ‘Accounting for Government Grants’.
The Standard comes into effect in respect of accounting periods commencing on or after 1-4-
1992 and will be recommendatory in nature for an initial period of two years. Accordingly, the
Guidance Note on ‘Accounting for Capital Based Grants’ issued by the Institute in 1981 shall
stand withdrawn from this date. This Standard will become mandatory in respect of accounts
for periods commencing on or after 1-4-1994.1
Introduction
1. This Statement deals with accounting for government grants. Government grants are
sometimes called by other names such as subsidies, cash incentives, duty drawbacks, etc.
2. This Statement does not deal with :
(i) The special problems arising in accounting for government grants in financial statements
reflecting the effects of changing prices or in supplementary information of a similar nature;
(ii) Government assistance other than in the form of government grants ; and
(iii) Government participation in the ownership of the enterprise.
Definitions
3.1 Government refers to government, government agencies and similar bodies whether
local, national or international.
3.2 Government grants are assistance by government in cash or kind to an enterprise for
past or future compliance with certain conditions. They exclude those forms of government
assistance which cannot reasonably have a value placed upon them and transactions with
government which cannot be distinguished from the normal trading transactions of the
enterprise.
Explanation
4. The receipt of government grants by an enterprise is significant for preparation of the
financial statements for two reasons. Firstly, if a government grant has been received, an
appropriate method of accounting therefore is necessary. Secondly, it is desirable to give an
indication of the extent to which the enterprise has benefited from such grant during the
reporting period.
This facilitates comparison of an enterprise’s financial statements with those of prior periods
and with those of other enterprises.
Accounting Treatment of Government Grants

5. Capital Approach versus Income Approach
5.1 Two broad approaches may be followed for the accounting treatment of government
grants : the ‘capital approach’, under which a grant is treated as part of shareholder’s funds,
and the ‘income approach’ under which a grant is taken to income over one or more periods.
5.2 Those in support of the ‘capital approach’ argue as follows :
(i) Many government grants are in the nature of promoters’ contribution, i.e., they are given
with reference to the total investment in an undertaking or by way of contribution towards its
total capital outlay and no repayment is ordinarily expected in the case of such grants. These
should, therefore, be credited directly to shareholders’ funds.
(ii) It is inappropriate to recognise government grants in the profit and loss statement, since
they are not earned but represent an incentive provided by government without related costs.
5.3 Arguments in support of the ‘income approach’ are as follows :
(i) Government grants are rarely gratuitous. The enterprise earns them through compliance
with their conditions and meeting the envisaged obligation. They should therefore be taken to
income and matched with the associated costs which the grant is intended to compensate.
(ii) As income tax and other taxes are charges against income it is logical to deal also with
government grants, which are an extension of fiscal policies, in the profit and loss statement.
(iii) In case grants are credited to shareholders’ funds, no correlation is done between the
accounting treatment of the grant and the accounting treatment of the expenditure to which the
grant relates.
5.4 It is generally considered appropriate that accounting for government grant should be
based on the nature of the relevant grant. Grants which have the characteristics similar to
those of promoters’ contribution should be treated as part of shareholders’ funds. Income
approach may be more appropriate in the case of other grants.

5.5 It is fundamental to the ‘income approach’ that government grants be recognised in the
profit and loss statement on a systematic and rational basis over the periods necessary to
match them with the related costs. Income recognition of government grants on a receipts
basis is not in accordance with the accrual accounting assumption [see Accounting Standard
(AS) 1, Disclosure of Accounting policies).
5.6 In most cases, the periods over which an enterprise recognises the costs or expenses
related to a government grant are readily ascertainable and thus grants in recognition of
specific expenses are taken to income in the same period as the relevant expenses.
6. RECOGNITION OF GOVERNMENT GRANTS

6.1 Government grants available to the enterprise are considered for inclusion in
accounts :
(i) where there is reasonable assurance that the enterprise will comply with the conditions
attached to them ; and
(ii) where such benefits have been earned by the enterprise and it is reasonably certain that
the ultimate collection will be made.
Mere receipt of a grant is not necessarily a conclusive evidence that conditions attaching to
the grant have been or will be fulfilled.
6.2 An appropriate amount in respect of such earned benefits, estimated on a prudent basis,
is credited to income for the year even though the actual amount of such benefits may be
finally settled and received after the end of the relevant accounting period.
6.3 A contingency related to a government grant, arising after the grant has been recognised,
is treated in accordance with Accounting Standard (AS) 4, Contingencies and Events
Occurring After the Balance Sheet Date.5
6.4 In certain circumstances, a government grant is awarded for the purpose of giving
immediate financial support to an enterprise rather than as an incentive to undertake specific
expenditure. Such grants may be confined to an individual enterprise and may not be available
to a whole class of enterprises. These circumstances may warrant taking the grant to income
in the period in which the enterprise qualifies to receive it, as an extraordinary item if
appropriate [see Accounting Standard (AS) 5, Prior Period and Extraordinary Items and
5
Pursuant to AS 29, becoming mandatory in respect of accounting periods commencing
on or afer 1.4.2004, all paragraphs of As 4 that deal with contingencies stand withdrawn
except to the extent they deal with impairment of assets not covered by other Indian
Accounting Standard.
Changes in Accounting Policies]6.

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

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

8.1 Grants related to specific fixed assets are government grants whose primary condition is
that an enterprise qualifying for them should purchase, construct or otherwise acquire such
assets. Other conditions may also be attached restricting the type or location of the assets or
the periods during which they are to be acquired or held.
8.2 Two methods of presentation in financial statements of grants (or the appropriate
portions of grants) related to specific fixed assets are regarded as acceptable alternatives.
8.3 Under one method, the grant is shown as a deduction from the gross value of the asset
concerned in arriving at its book value. The grant is thus recognised in the profit and loss
statement over the useful life of a depreciable asset by way of a reduced depreciation charge.
Where the grant equals the whole, or virtually the whole, of the cost of the asset, the asset is
shown in the balance sheet at a nominal value.
8.4 Under the other method, grants related to depreciable assets are treated as deferred
income which is recognised in the profit and loss statement on a systematic and rational basis
over the useful life of the asset. Such allocation to income is usually made over the periods
and in the proportions in which depreciation on related assets is charged. Grants related to
non-depreciable assets are credited to capital reserve under this method, as there is usually
no charge to income in respect of such assets. However, if a grant related to a non-
depreciable asset requires the fulfilment of certain obligations, the grant is credited to income
over the same period over which the cost of meeting such obligations is charged to income.
The deferred income is suitably disclosed in the balance sheet pending its apportionment to
6
AS 5 has been revised in February, 1997. The title of revised AS 5 is ‘Net Profit or Loss
for the Period, Prior Period Items and Changes in Accounting Policies’.
profit and loss account. For example, in the case of a company, it is shown after ‘Reserves
and Surplus’ but before ‘Secured Loans’ with a suitable description, e.g., ‘Deferred
government grants’.
8.5 The purchase of assets and the receipt of related grants can cause major movements in
the cash flow of an enterprise. For this reason and in order to show the gross investment in
assets, such movements are often disclosed as separate items in the statement of changes in
financial position regardless of whether or not the grant is deducted from the related asset for
the purpose of balance sheet presentation.
9. PRESENTATION OF GRANTS RELATED TO REVENUE

9.1 Grants related to revenue are sometimes presented as a credit in the profit and loss
statement, either separately or under a general heading such as ‘Other Income’. Alternatively,
they are deducted in reporting the related expense.
9.2 Supporters of the first method claim that it is inappropriate to net income and expense
items and that separation of the grant from the expense facilitates comparison with other
expenses not affected by a grant. For the second method, it is argued that the expense might
well not have been incurred by the enterprise if the grant had not been available and
presentation of the expense without offsetting the grant may therefore be misleading.
10. PRESENTATION OF GRANTS OF THE NATURE OF PROMOTERS’ CONTRIBUTION

10.1 Where the government grants are of the nature of promoters’ contribution, i.e., they are
given with reference to the total investment in an undertaking or by way of contribution
towards its total capital outlay (for example, Central Investment Subsidy Scheme) and no
repayment is ordinarily expected in respect thereof, the grants are treated as capital reserve
which can be neither distributed as dividend nor considered as deferred income.
11. REFUND OF GOVERNMENT GRANTS

11.1 Government grants sometimes become refundable because certain conditions are not
fulfilled. A government grant that becomes refundable is treated as an extraordinary item [see
Accounting Standard (AS) 5, Prior Period Extraordinary Items and Changes in Accounting
Policies]1.
11.2 The amount refundable in respect of a government grant related to revenue is applied
first against any unamortised deferred credit remaining in respect of the grant. To the extent
that the amount refundable exceeds any such deferred credit, or where no deferred credit
1
AS 5 has been revised in February, 1997. The title of revised AS 5 is ‘Net Profit or
Loss for the Period, Prior Period Items and Changes in Accounting Policies’.
exists, the amount is charged immediately to profit and loss statement.

11.3 The amount refundable in respect of a government grant related to a specific fixed asset
is recorded by increasing the book value of the asset or by reducing the capital reserve or the
deferred income balance, as appropriate, by the amount refundable. In the first alternative,
i.e., where the book value of the asset is increased, depreciation on the revised book value is
provided prospectively over the residual useful life of the asset.
11.4 Where a grant which is in the nature of promoters’ contribution becomes refundable, in
part or in full, to the government on non-fulfilment of some specified conditions, the relevant
amount recoverable by the government is reduced from the capital reserve.
12. DISCLOSURE
12.1 The following disclosures are appropriate :
(i) the accounting policy adopted for government grants, including the methods of
presentation in the financial statement;
(ii) the nature and extent of government grants recognised in the financial statements,
including grants of non-monetary assets given at a concessional rate or free of cost.
Accounting Standard
(The Accounting Standard comprises paragraphs 13 to 23 of this Statement. The Standard should
be read in the context of paragraphs 1 to 12 of this Statement and of the ‘Preface to the State-
ments of Accounting Standards’.)
13. Government grants should not be recognised until there is reasonable assurance
that (i) the enterprise will comply with the conditions attached to them, and (ii) the
grants will be received.
14. Government grants related to specific fixed assets should be presented in the
balance sheet by showing the grant as a deduction from the gross value of the assets
concerned in arriving at their book value. Where the grant related to a specific fixed
asset equals the whole, or virtually the whole, of the cost of the asset, the asset should
be shown in the balance sheet at a nominal value. Alternatively, government grants
related to depreciable fixed assets may be treated as deferred income which should be
recognised in the profit and loss statement on a systematic and rational basis over the
useful life of the asset, i.e., such grants should be allocated to income over the periods
and in the proportions in which depreciation on those assets is charged. Grants related
to non-depreciable assets should be credited to capital reserve under this method.
However, if a grant related to a non-depreciable asset requires the fulfilment of certain
obligations, the grant should be credited to income over the same period over which the
cost of meeting such obligations is charged to income. The deferred income balance
should be separately disclosed in the financial statements.
15. Government grants related to revenue should be recognised on a systematic basis

in the profit and loss statement over the periods necessary to match them with related
costs which they are intended to compensate. Such grants should either be shown
separately under ‘other income’ or deducted in reporting the related expense.
16. Government grants of the nature of promoters’ contribution should be credited to
capital reserve and treated as a part of shareholders’ funds.
17. Government grants in the form of non-monetary assets, given at a concessional
rate, should be accounted for on the basis of their acquisition cost. In case a non-
monetary asset is given free of cost, it should be recorded at a nominal value.
18. Government grants that are receivable as compensation for expenses or losses
incurred in a previous accounting period or for the purpose of giving immediate
financial support to the enterprise with no further related cost, should be recognised
and disclosed in the profit and loss statement of the period in which they are
receivable, as an extraordinary item if appropriate [see Accounting Standard (AS) 5,
Prior Period and Extraordinary Items and Changes in Accounting Policies]2.
19. A contingency related to a government grant, arising after the grant has been
recognised, should be treated in accordance with Accounting Standard (AS) 4,
Contingencies and Events Occurring After the Balance Sheet Date.
20. Government grants that become refundable should be accounted for as an
extraordinary item [see Accounting Standard (AS) 5, Prior Period and Extraordinary
Items and Changes in Accounting Policies]3.
21. The amount refundable in respect of a grant related to revenue should be applied
first against any unamortised deferred credit remaining in respect of the grant. To the
extent that the amount refundable exceeds any such deferred credit, or where no
deferred credit exists, the amount should be charged to profit and loss statement. The
amount refundable in respect of a grant related to a specific fixed asset should be
recorded by increasing the book value of the asset or by reducing the capital reserve or
the deferred income balance, as appropriate, by the amount refundable. In the first
alternative, i.e., where the book value of the asset is increased, depreciation on the
revised book value should be provided prospectively over the residual useful life of the
asset.
22. Government grants in the nature of promoters’ contribution that become
2
3
refundable should be reduced from the capital reserve.
Disclosure
23. The following should be disclosed :
(i) the accounting policy adopted for government grants, including the methods of
presentation in the financial statements;
(ii) the nature and extent of government grants recognised in the financial statements,
including grants of non-monetary assets given at a concessional rate or free of cost.
AS 13∗ : ACCOUNTING FOR INVESTMENTS
Introduction
1. This statement deals with accounting for investments in the financial statements of
enterprises and related diclosure requirements.1
2. This statement does not deal with :
(a) the bases for recognition of interest, dividends and rentals earned on investments which
are covered by Accounting Standard 9 on Revenue Recognition;
(b) operating or finance leases;
(c) investments of retirement benefit plans and life insurance enterprises; and
∗
A limited revision to this standard has been made in 2003, pursuant to which paragraph
2(d) of this standard has been revised (See footnote 2 to this standard)
1
Shares, debentures and other securities held as stock-in-trade (i.e. for sale in the
ordinary course of business) are not ‘investments’ as defined in this statement. However,
the manner in which they are accounted for and disclosed in the financial statements is
quite similar to that applicable in respect of current investments. Accordingly, the
provisions of this statement, to the extent that they relate to current investments, are also
applicable to shares, debentures and other securities held as stock-in-trade, with suitable
modifications as specified in this statement.
(d) mutual funds and venture capital funds2 and/or the related asset management
companies, banks and public financial institutions formed under a Central or State
Government Act or so declared under the Companies Act, 1956.
Definitions
3. The following terms are used in this Statement with the meanings assigned :
Investments are assets held by an enterprise for earning income by way of dividends, interest,
and rentals, for capital appreciation, or for other benefits to the investing enterprise. Assets
held as stock-in-trade are not ‘investments’.
A current investment is an investment that is by its nature readily realisable and is intended to
be held for not more than one year from the date on which such investment is made.
A long-term investment is an investment other than a current investment.
An investment property is an investment in land or buildings that are not intended to be
occupied substantially for use by, or in the operations of, the investing enterprise.
Fair value is the amount for which an asset could be exchanged between a knowledgeable,
willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Under
appropriate circumstances, market value or net realisable value provides an evidence of fair
value.
Market value is the amount obtainable from the sale of an investment in an open market, net
of expenses necessarily to be incurred on or before disposal.
Explanation
Forms of Investments
4. Enterprises hold investments for diverse reasons. For some enterprises, investment
activity is a significant element of operations, and assessment of the performance of the
enterprise may largely, or solely, depend on the reported results of this activity.
5. Some investments have no physical existence and are represented merely by certificates
or similar documents (e.g., shares) while others exist in a physical form (e.g., buildings). The
nature of an investment may be that of a debt, other than a short or long- term loan or a trade
debt, representing a monetary amount owing to the holder and usually bearing interest,
alternatively, it may be a stake in the results and net assets of an enterprise such as an equity
2
The Council of the Institute decided to make the limited revision to AS 13 in 2003
pursuant to which the words ‘and venture capital funds’ have been added in paragraph
2(d) of AS 13. This revision comes into effect in respect of accounting periods
commencing on or after 1.4.2002.
share. Most investments represent financial rights, but some are tangible, such as certain
investments in land or buildings.
6. For some investments, an active market exists from which a market value can be
established. For such investments, market value generally provides the best evidence of fair
value. For other investments, an active market does not exist and other means are used to
determine fair value.
Classification of Investments
7. Enterprises present financial statements that classify fixed assets, investments and
current assets into separate categories. Investments are classified as Long Term Investments
and Current Investments. Current investments are in the nature of current assets, although the
common practice may be to include them in investments.3
8. Investments other than current investments are classified as long-term investments, even
though may be readily marketable.
Cost of Investments
9. The cost of an investment includes acquisition charges such as brokerage, fees and
duties.
10. If an investment is acquired, or partly acquired, by the issue of shares or other securities,
the acquisition cost is the fair value of the securities issued (which, in appropriate cases, may
be indicated by the issue price as determined by statutory authorities). The fair value may not
necessarily be equal to the nominal or par value of the securities issued.
11. If an investment is acquired in exchange, or part exchange, for another asset, the
acquisition cost of the investment is determined by reference to the fair value of the asset
given up. It may be appropriate to consider the fair value of the investment acquired if it is
more clearly evident.
12. Interest, dividends and rentals receivables in connection with an investment are generally
regarded as income, being the return on the investment. However, in some circumstances,
such inflows represent a recovery of cost and do not form part of income. For example, when
unpaid interest has accrued before the acquisition of an interest-bearing investment and is
therefore included in the price paid for the investment, the subsequent receipt of interest is
allocated between pre-acquisition and post-acquisition periods; the pre-acquisition portion is
deducted from cost. When dividends on equity are declared from pre-acquisition profits, a
similar treatment may apply. If it is difficult to make such an allocation except on an arbitrary
basis, the cost of investment is normally reduced by dividends receivable only if they clearly
represent a recovery of a part of the cost.
13. When rights shares offered are subscribed for, the cost of the rights shares is added to
the carrying amount of the original holding. If rights are not subscribed for but are sold in the
market, the sale proceeds are taken to the profit and loss statement. However, where the
investments are acquired on cum-right basis and the market value of investments immediately
after their becoming ex-right is lower than the cost for which they were acquired, it may be
3
Shares, debentures and other securities held for sale in the ordinary course of
business are disclosed as ‘stock-in-trade’ under the head ‘current assets’.
appropriate to apply the sale proceeds of rights to reduce the carrying amount of such
investments to the market value.
Carrying Amount of Investments

Current Investments
14. The carrying amount for current investments is the lower of cost and fair value. In respect
of investments for which an active market exists, market value generally provides the best
evidence of fair value. The valuation of current investments at lower of cost and fair value
provides a prudent method of determining the carrying amount to be stated in the balance
sheet.
15. Valuation of current investments on overall (or global) basis is not considered
appropriate. Sometimes, the concern of an enterprise may be with the value of a category of
related current investments and not with each individual investment, and accordingly the
investments may be carried at the lower of cost and fair value computed categorywise (i.e.
equity shares, preference shares, convertible debentures, etc.). However, the more prudent
and appropriate method is to carry investments individually at the lower of cost and fair value.
16. For current investments, any reduction to fair value and any reversals of such reductions
are included in the profit and loss statement.
Long-Term Investments
17. Long-term investments are usually carried at cost. However, when there is a decline,
other than temporary, in the value of a long-term investment, the carrying amount is reduced
to recognise the decline. Indicators of the value of an investment are obtained by reference to
its market value, the investee’s assets and results and the expected cash flows from the
investment. The type and extent of the investor’s stake in the investee are also taken into
account. Restrictions on distributions by the investee or on disposal by the investor may affect
the value attributed to the investment.
18. Long-term investments are usually of individual importance to the investing enterprise.
The carrying amount of long-term investments is therefore determined on an individual
investment basis.
19. Where there is a decline, other than temporary, in the carrying amounts of long-term
investments, the resultant reduction in the carrying amount is charged to the profit and loss
statement. The reduction in carrying amount is reversed when there is a rise in the value of
the investment, or if the reasons for the reduction no longer exist.
Investment Properties
20. The cost of any shares in co-operative society or a company, the holding of which is
directly related to the right to hold the investment property, is added to the carrying amount of the
investment property.
Disposal of Investments
21. On disposal of an investment, the difference between the carrying amount and the
disposal proceeds, net of expenses, is recognised in the profit and loss statement.
22. When disposing of a part of the holding of an individual investment, the carrying amount
to be allocated to that part is to be determined on the basis of the average carrying amount of
the total holding of the investment4.
Reclassification of Investments
23. Where, long-term investments are reclassified as current investments, transfers are
made at the lower of cost and carrying amount at the date of transfer.
24. Where investments are reclassified from current to long-term, transfers are made at the
lower of cost and fair value at the date of transfer.
Disclosure
25. The following disclosures in financial statements in relation to investments are
appropriate :
(a) the accounting policies for the determination of carrying amount of investments;
(b) the amounts included in profit and loss statement for :
(i) interest, dividends (showing separately dividends from subsidiary companies), and
rentals on investments showing separately such income from long-term and current
investments, Gross income should be stated, the amount of income tax deducted at
source being included under Advance Taxes Paid;
(ii) profits and losses on disposal of current investments and changes in carrying
amount of such investments;
(iii) profits and losses on disposal of long-term investments and changes in the carrying
amount of such investments;
(c) significant restrictions on the right of ownership, realisability of investments or the
remittance of income and proceeds of disposal;
4
In respect of shares, debentures and other securities held as stock-in-trade. The
cost of stocks disposed of is determined by applying an appropriate cost formula (e.g.
first-in, first-out, average cost, etc.). These cost formulae are the same as those
specified in AS 2 in respect of Valuation of Inventories.
(d) the aggregate amount of quoted and unquoted investments, giving the aggregate market
value of quoted investments;
(e) other disclosures as specifically required by the relevant statute governing the enterprise.
Accounting Standard
Classification of Investments
26. An enterprise should disclose current investments and long-term investments
distinctly in its financial statements.
27. Further classification of current and long-term investments should be as specified
in the statute governing the enterprise. In the absence of a statutory requirement, such
further classification should disclose, where applicable, investments in :
(a) Government or Trust securities;
(b) Shares, debentures or bonds;
(c) Investment properties; and
(d) Others - specifying nature.
Cost of Investments
28. The cost of an investment should include acquisition charges such as brokerage,
fees and duties.
29. If an investment is acquired, or partly acquired, by the issue of shares or other
securities the acquisition cost should be the fair value of the securities issued (which in
appropriate cases may be indicated by the issue price as determined by statutory
authorities). The fair value may not necessarily be equal to the nominal or par value of
the securities issued. If an investment is acquired in exchange for another asset, the
acquisition cost of the investment should be determined by reference to the fair value
of the asset given up. Alternatively, the acquisition cost of the investment may be
determined with reference to the fair value of the investment acquired if it is more
clearly evident.
Investment Properties
30. An enterprise holding investment properties should account for them as long-term
investments.
Carrying Amount of Investments
31. Investments classified as current investments should be carried in the financial

statements at the lower of cost and fair value determined either on an individual
investment basis or by category of investment, but not on an overall (or global) basis.
32. Investments classified as long-term investments should be carried in the financial
statements at cost. However, provision for diminution shall be made to recognise a
decline, other than temporary, in the value of the investments, such reduction being
determined and made for each investment individually.
Changes in Carrying Amounts of Investments
33. Any reduction in the carrying amount and any reversals of such reductions should
be charged or credited to the profit and loss statement.
Disposal of Investments
34. On disposal of an investment, the difference between the carrying amount and net
disposal proceeds should be charged or credited to the profit and loss statement.
Disclosure
(a) the accounting policies for determination of carrying amount of investments;
(b) classification of investments as specified in paragraphs 26 and 27 above;
(c) the amounts included in profit and loss statement for:
(i) interest, dividends (showing separately dividends from subsidiary
companies), and rentals on investments showing separately such income
from long-term and current investments. Gross income should be stated, the
amount of income tax deducted at source being included under Advance
Taxes Paid;
(ii) profits and losses on disposal of current investments and changes in the
carrying amount of such investments; and
(iii) profits and losses on disposal of long term investments and changes in the
carrying amount of such investments;
(d) significant restrictions on the right of ownership, realisability of investments or the
remittance of income and proceeds of disposal;
(e) the aggregate amount of quoted and unquoted investments, giving the aggregate
market value of quoted investments;
(f) other disclosures as specifically required by the relevant statute governing the
enterprise.
Effective Date
36. This Accounting Standard comes into effect for financial statements covering
periods commencing on or after April 1, 1995.
AS 14 : ACCOUNTING FOR AMALGAMATIONS∗
The following is the text of Accounting Standard (AS) 14, ‘Accounting for Amalgamations’,
issued by the council of the Institute of Chartered Accountants of India.
This standard will come into effect in respect of accounting periods commencing on or after 1-
4-1995 and will be mandatory in nature. The Guidance Note on Accounting Treatment of
Reserves in Amalgations issued by the Institute in, 1983 will stand withdrawn from the
aforesaid date.
INTRODUCTION
1. This statement deals with accounting for amalgamations and the treatment of any
resultant goodwill or reserves. This statement is directed principally to companies although
some of its requirements also apply to financial statements of other enterprises.
2. This statement does not deal with cases of acquisitions which arise when there is a
purchase by one company (referred to as the acquiring company) of the whole or part of the
shares, or the whole or part of the assets, of another company (referred to as the acquired
company) in consideration for payment in cash or by issue of shares or other securities in the
acquiring company or partly in one form and partly in the other. The distinguishing feature of
an acquisition is that the acquired company is not dissolved and its separate entity continues
to exist.
Definitions
3. The following terms are used in this statement with the meanings specified :
(a) Amalgamation means an amalgamation pursuant to the provisions of the
Companies Act, 1956, or any other statute which may be applicable to companies.
(b) Transferor company means the company which is amalgamated into another
company.
(c) Transferee company means the company into which a transferor company is
amalgamated.
∗
A limited revision to the standard has been mad I 2004, pursuant to ehich paragraphs
23 and 42 of the standard have been revised.
(d) Reserve means the portion of earnings, receipts or other surplus of an enterprise
(whether capital or revenue) appropriated by the management for a general or a
specific purpose other than a provision for depreciation or diminution in the value of
assets or for a known liability.
(e) Amalgamation in the nature of merger is an amalgamation which satisfies all the
following conditions :
(i) All the assets and liabilities of the transferor company become, after
amalgamation, the assets and liabilities of the transferee company.
(ii) Shareholders holding not less than 90% of the face value of the equity shares
of the transferor company (other than the equity shares already held therein,
immediately before the amalgamation, by the transferee company or its
subsidiaries or their nominees) become equity shareholders of the transferee
company by virtue of the amalgamation.
(iii) The consideration for the amalgamation receivable by those equity
shareholders of the transferor company who agree to become equity
shareholders of the transferee company is discharged by the transferee
company wholly by the issue of equity shares in the transferee company,
except that cash may be paid in respect of any fractional shares.
(iv) The business of the transferor company is intended to be carried on, after the
amalgamation, by the transferee company.
(v) No adjustment is intended to be made to the book values of the assets and
liabilities of the transferor company when they are incorporated in the financial
statements of the transferee company except to ensure uniformity of
accounting policies.
(f) Amalgamation in the nature of purchase is an amalgamation which does not satisfy
any one or more of the conditions specified in sub-paragraph (e) above.
(g) Consideration for the amalgamation means the aggregate of the shares and other
securities issued and the payment made in the form of cash or other assets by the
transferee company to the shareholders of the transferor company.
(h) Fair value is the amount for which an asset could be exchanged between a
knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length
transaction.
(i) Polling of interests is a method of accounting for amalgamations the object of which
is to account for the amalgamations as if the separate businesses of the
amalgamating companies were intended to be continued by the transferee
company. Accordingly, only minimal changes are made in aggregating the individual
financial statements of the amalgamating companies.
Explanation
Types of Amalgamations
4. Generally speaking, amalgamations fall into two broad categories. In the first category
are those amalgamations where there is a genuine pooling not merely of the assets and
liabilities of the amalgamating companies but also of the shareholders’ interests and of the
businesses of these companies. Such amalgamations are amalgamations which are in the
nature of ‘merger’ and the accounting treatment of such amalgamations should ensure that the
resultant figures of assets, liabilities, capital and reserves more or less represent the sum of
the relevant figures of the amalgamating companies. In the second category are those
amalgamations which are in effect a mode by which one company acquires another company
and, as a consequence, the shareholders of the company which is acquired normally do not
continue to have a proportionate share in the equity of the combined company or the business
of the company which is acquired is not intended to be continued. Such amalgamations are
amalgamations in the nature of ‘purchase’.
5. An amalgamation is classified as an ‘amalgamation in the nature of merger’ when all the
conditions listed in paragraph 3(e) are satisfied. There are, however, differing views regarding
the nature of any further conditions that may apply. Some believe that, in addition to an
exchange of equity shares, it is necessary that the shareholders of the transferor company
obtain a substantial share in the transferee company even to the extent that it should not be
possible to identify any one party as dominant therein. This belief is based in part on the view
that the exchange of control of one company for an insignificant share in a larger company
does not amount to a mutual sharing or risks and benefits.
6. Others believe that the substance of an amalgamation in the nature of merger is
evidenced by meeting certain criteria regarding the relationship of the parties, such as the
former independence of the amalgamating companies, the manner of their amalgamation, the
absence of planned transactions that would undermine the effect of the amalgamation, and
the continuing participation by the management of the transferor company in the management
of the transferee company after the amalgamation.
Methods of Accounting for Amalgamations

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

10. Under the pooling of interests method, the assets, liabilities and reserves of the
transferor company are recorded by the transferee company at their existing carrying amounts
(after making the adjustments required in paragraph 11).
11. If, at the time of the amalgamation, the transferor and the transferee companies have
conflicting accounting policies, a uniform set of accounting policies is adopted following the
amalgamation. The effects on the financial statements of any changes in accounting policies
are reported in accordance with Accounting Standard (AS) 5, ‘Prior Period and Extraordinary
Items and Changes in Accounting Policies’1.
The Purchase Method
12. Under the purchase method, the transferee company accounts for the amalgamation
either by incorporating the assets and liabilities at their existing carrying amounts or by
allocating the consideration to individual identifiable assets and liabilities of the transferor
company on the basis of their fair values at the date of amalgamation. The identifiable assets
and liabilities may include assets and liabilities not recorded in the financial statements of the
transferor company.
13. Where assets and liabilities are restated on the basis of their fair values, the
determination of fair values may be influenced by the intentions of the transferee company.
For example, the transferee company may have a specialised use for an asset, which is not
available to other potential buyers. The transferee company may intend to effect changes in
the activities of the transferor company which necessitate the creation of specific provisions
for the expected costs, e.g. planned employee termination and plant relocation costs.
Consideration
14. The consideration for the amalgamation may consist of securities, cash or other assets.
In determining the value of the consideration, an assessment is made of the fair value of its
elements. A variety of techniques is applied in arriving at fair value. For example, when the
consideration includes securities, the value fixed by the statutory authorities may be taken to
be the fair value. In case of other assets, the fair value may be determined by reference to the
market value of the assets given up. Where the market value of the assets given up cannot be
reliably assessed, such assets may be valued at their respective net book values.
15. Many amalgamations recognise that adjustments may have to be made to the
1
consideration in the light of one or more future events. When the additional payment is
probable and can reasonably be estimated at the date of amalgamation, it is included in the
calculation of the consideration. In all other cases, the adjustment is recognised as soon as
the amount is determinable [see Accounting Standard (AS) 4, Contingencies and Events
Occurring after the Balance Sheet Date].
Treatment of Reserves on Amalgamation

16. If the amalgamation is an ‘amalgamation in the nature of merger’, the identity of the
reserves is preserved and they appear in the financial statements of the transferee company
in the same form in which they appeared in the financial statements of the transferor company.
Thus, for example, the General Reserve of the transferor company becomes the General
Reserve of the transferee company, the Capital Reserve of the transferor company becomes
the Capital Reserve of the transferee company and the Revaluation Reserve of the transferor
company becomes the Revaluation Reserve of the transferee company. As a result of preserv-
ing the identity, reserves which are available for distribution as dividend before the
amalgamation would also be available for distribution as dividend after the amalgamation. The
difference between the amount recorded as share capital issued (plus any additional
consideration in the form of cash or other assets) and the amount of share capital of the
transferor company is adjusted in reserves in the financial statements of the transferee
company.
17. If the amalgamation is an ‘amalgamation in the nature of purchase’,the identity of the
reserves, other than the statutory reserves dealt with in paragraph 18, is not preserved. The
amount of the consideration is deducted from the value of the net assets of the transferor
company acquired by the transferee company. If the result of the computation is negative, the
difference is debited to goodwill arising on amalgamation and dealt with in the manner stated
in paragraphs 19-20. If the result of the computation is positive, the difference is credited to
Capital Reserve.
18. Certain reserves may have been created by the transferor company pursuant to the
requirements of, or to avail of the benefits under the Income-tax Act, 1961; for example,
Development Allowance Reserve, or Investment Allowance Reserve. The Act requires that the
identity of the reserves should be preserved for a specified period. Likewise, certain other
reserves may have been created in the financial statements of the transferor company in
terms of the requirements of other statutes. Though, normally, in an amalgamation in the
nature of purchase, the identity of reserves is not preserved, an exception is made in respect
of reserves of the aforesaid nature (referred to hereinafter as ‘statutory reserves’) and such
reserves retain their identity in the financial statements of the transferee company in the same
form in which they appeared in the financial statements of the transferor company, so long as
their identity is required to be maintained to comply with the relevant statute. This exception is
made only in those amalgamations where the requirements of the relevant statute for
recording the statutory reserves in the books of the transferee company are complied with. In
such cases, the statutory reserves are recorded in the financial statements of the transferee
company by a corresponding debit to a suitable account head (e.g. ‘Amalgamation Adjustment
Account’) which is disclosed as a part of “miscellaneous expenditure” or other similar category
in the balance sheet. When the identity of the statutory reserves is no longer required to be
maintained, both the reserves and the aforesaid account are reversed.
Treatment of Goodwill arising on Amalgamation

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

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

23. The scheme of amalgamation sanctioned under the provisions of the Companies Act,
1956 or any other statute may prescribe the treatment to be given to the reserves of the
transferor company after its amalgamation. Where the treatment is so prescribed, the same is
followed. In some cases, the scheme of amalgamation sanctioned under a statute may
prescribe a different treatment to be given to the reserves of the transferor company after
amalgamation as compared to the requirements of this Statement that would have been
followed had no treatment been prescribed by the scheme. In such cases, the following
disclosures are made in the first financial statements following the amalgamation:
(a) A description of the accounting treatment given to the reserves and the reasons for
following the treatment different from that prescribed in this Statement.
(b) Deviations in the accounting treatment given to the reserves as prescribed by the
scheme of amalgamation sanctioned under the statute as compared to the requirements of
this Statement that would have been followed had no treatment been prescribed by the
scheme.
(c) The financial effect, if any, arising due to such deviation.”€
Disclosure
24. For all amalgamations, the following disclosures are considered appropriate in the first
financial statements following the amalgamation :
(a) names and general nature of business of amalgamating companies;
(b) effective date of amalgamation for accounting purposes;
(c) the method of accounting used to reflect the amalgamation; and
(d) particulars of the scheme sanctioned under a statute.
25. For amalgamations accounted for under the pooling of interests method, the following
additional disclosures are considered appropriate in the first financial statements following the
amalgamation :
(a) description and number of shares issued, together with the percentage of each
company’s equity shares exchanged to effect the amalgamation;
(b) the amount of any difference between the consideration and the value of net identifiable
assets acquired, and the treatment thereof.
26. For amalgamations accounted for under the purchase method, the following additional
disclosures are considered appropriate in the first financial statements following the
amalgamation :
€
As a limited revision to AS 14, the council of the Institute decided to rvise this paragraph
in 2004. the erstwhile para was as under:
The scheme of amalgamation sanctioned under the provisions of the Companies Act,
1956 or any other statute may prescribe the treatment to be given to the reserves of the
transferor company after its amalgamation. Where the treatment is so prescribed, the
same is followed.
(a) consideration for the amalgamation and a description of the consideration paid or
contingently payable; and
(b) the amount of any difference between the consideration and the value of net identifiable
assets acquired, and the treatment thereof including the period of amortisation of any good-
will arising on amalgamation.
Amalgamation after the Balance Sheet Date

27. When an amalgamation is effected after the balance sheet date but before the issuance
of the financial statements of either party to the amalgamation, disclosure is made in
accordance with AS 4, ‘Contingencies and Events Occurring after the Balance Sheet Date’,
but the amalgamation is not incorporated in the financial statements. In certain circumstances,
the amalgamation may also provide additional information affecting the financial statements
themselves, for instance, by allowing the going concern assumption to be maintained.
Accounting Standard
(The Accounting Standard comprises paragraphs 28 to 46 of this statement. The ‘Standard
should be read in the context of paragraphs 1 to 27 of this Statement and of the Preface to
the Statements of Accounting Standards’.)
28. An amalgamation may be either :
(a) an amalgamation in the nature of merger, or
(b) an amalgamation in the nature of purchase.
29. An amalgamation should be considered to be an amalgamation in the nature of
merger when all the following conditions are satisfied :
(i) All the assets and liabilities of the transferor company become, after
amalgamation, the assets and liabilities of the transferee company.
(ii) Shareholders holding not less than 90% of the face value of the equity shares of
the transferor company (other than the equity shares already held therein, immediately
before the amalgamation, by the transferee company or its subsidiaries or their
nominees) become equity shareholders of the transferee company by virtue of the
amalgamation.
(iii) The consideration for the amalgamation receivable by those equity shareholders of
the transferor company who agree to become equity shareholders of the transferee
company is discharged by the transferee company wholly by the issue of equity shares
in the transferee company, except that cash may be paid in respect of any fractional
shares.
(iv) The business of the transferor company is intended to be carried on, after the
amalgamation, by the transferee company.
(v) No adjustment is intended to be made to the book values of the assets and
liabilities of the transferor company when they are incorporated in the financial
statements of the transferee company except to ensure uniformity of accounting
policies.
30. An Amalgamation should be considered to be an amalgamation in the nature of
purchase, when any one or more the conditions specified in paragraph 29 is not
satisfied.
31. When an amalgamation is considered to be an amalgamation in the nature of
merger, it should be accounted for under the pooling of interests method described in
paragraphs 33-35.
32. When an amalgamation is considered to be an amalgamation in the nature of
purchase, it should be accounted for under the purchase method described in
paragraphs 36-39.
The Pooling of Interests Method
33. In preparing the transferee company’s financial statements, the assets, liabilities
and reserves (whether capital or revenue or arising on revaluation) of the transferor
company should be recorded at their existing carrying amounts and in the same form as
at the date of the amalgamation. The balance of the Profit and Loss Account of the
transferor company should be aggregated with the corresponding balance of the
transferee company or transferred to the General Reserve, if any.
34. If, at the time of the amalgamation, the transferor and the transferee companies
have conflicting accounting policies, a uniform set of accounting polices should be
adopted following the amalgamation. The effects on the financial statements of any
changes in accounting policies should be reported in accordance with Accounting
Standard (AS) 5, ‘Prior Period and Extraordinary Items and Changes in Accounting
Policies’2.
35. The difference between the amount recorded as share capital issued (plus any
additional consideration in the form of cash or other assets) and the amount of share
capital of the transferor company should be adjusted in reserves.
The Purchase Method
36. In preparing the transferee company’s financial statements, the assets and
liabilities of the transferor company should be incorporated at their existing carrying
amounts or, alternatively, the consideration should be allocated to individual identi-
2
fiable assets and liabilities on the basis of their fair values at the date of amalgamation.
The reserves (whether capital or revenue or arising on revaluation) of the transferor
company, other than the statutory reserves, should not be included in the financial
statements of the transferee company except as stated in paragraph 39.
37. Any excess of the amount of the consideration over the value of the net assets of
the transferor company acquired by the transferee company should be recognised in
the transferee company’s financial statements as goodwill arising on amalgamation. If
the amount of the consideration is lower than the value of the net assets acquired, the
difference should be treated as Capital Reserve.
38. The goodwill arising amalgamation should be amortised to income on a systematic
basis over its useful life. The amortisation period should not exceed five years unless a
somewhat longer period can be justified.
39. Where the requirements of the relevant statute for recording the statutory reserves
in the books of the transferee company are complied with, statutory reserves of the
transferor company should be recorded in the financial statements of the transferee
company. The corresponding debit should be given to a suitable account head (e.g.,
‘Amalgamation Adjustment Account’) which should be disclosed as a part of
“miscellaneous expenditure” or other similar category in the balance sheet. When the
identity of the statutory reserves is no longer required to be maintained, both the
reserves and the aforesaid account should be reversed.
Common Procedures
40. The consideration for the amalgamation should include any non-cash element at
fair value. In case of issue of securities, the value fixed by the statutory authorities may
be taken to be the fair value. In case of other assets, the fair value may be determined
by reference to the market value of the assets given up. Where the market value of the
assets given up cannot be reliably assessed, such assets may be valued at their
respective net book values.
41. Where the scheme of amalgamation provides for an adjustment to the
consideration contingent on one or more future events, the amount of the additional
payment should be included in the consideration if payment is probable and a
reasonable estimate of the amount can be made. In all other cases, the adjustment
should be recognised as soon as the amount is determinable [See Accounting Standard
(AS) 4, Contingencies and Events Occurring after the Balance Sheet Date].
Treatment of Reserves Specified in a Scheme of Amalgamation
42. Where the scheme of amalgamation sanctioned under a statute prescribes the
treatment to be given to the reserves of the transferor company after amalgamation, the
same should be followed. Where the scheme of amalgamation sanctioned under a
statute prescribes a different treatment to be given to the reserves of the transferor

company after amalgamation as compared to the requirements of this Statement that
would have been followed had no treatment been prescribed by the scheme, the
following disclosures should be made in the first financial statements following the
amalgamation:
(a) A description of the accounting treatment given to the reserves and the reasons
for following the treatment different from that prescribed in this Statement.
(b) Deviations in the accounting treatment given to the reserves as prescribed by the
scheme of amalgamation sanctioned under the statute as compared to the requirements
of this Statement that would have been followed had no treatment been prescribed by
the scheme.
(c) The financial effect, if any, arising due to such deviation.” €
Disclosure
43. For all amalgamations, the following disclosures should be made in the first
financial statements following the amalgamation :
(a) names and general nature of business of the amalgamating companies;
(b) effective date of amalgamation for accounting purposes;
(c) the method of accounting used to reflect the amalgamation; and
(d) particulars of the scheme sanctioned under a statute.
44. For amalgamations accounted for under the pooling of interests method, the
following additional disclosures should be made in the first financial statements
following the amalgamation :
(a) description and number of shares issued, together with the percentage of each
company’s equity shares exchanged to effect the amalgamation; and
(b) the amount of any difference between the consideration and the value of net
identifiable assets acquired, and the treatment thereof.
45. For amalgamations accounted for under the purchase method, the following
additional disclosures should be made in the first financial statements following the
€
As a limited revision to AS 14, the council of the Institute decided to rvise this
paragraph in 2004. the erstwhile para was as under:
Where the scheme of amalgamation sanctioned under a statute prescribes the treatment
to be given to the reserves of the transferor company after amalgamation, the same
should be followed.
amalgamations :
(a) consideration for the amalgamation and a description of the consideration paid or
contingently payable; and
(b) the amount of any difference between the consideration and the value of net
identifiable assets acquired, and the treatment thereof including the period of
amortisation of any goodwill arising on amalgamation.
Amalgamation after the Balance Sheet Date
46. When an amalgamation is effected after the balance sheet date but before the
issuance of the financial statements of either party to the amalgamation, disclosure
should be made in accordance with AS-4, ‘Contingencies and Events Occurring after
the Balance Sheet Date’, but the amalgamation should not be incorporated in the
financial statements. In certain circumstances, the amalgamation may also provide
additional information affecting the financial statements themselves, for instance by
allowing the going concern assumption to be maintained.
AS 15 (REVISED 2005)* : EMPLOYEE BENEFITS
(This Accounting Standard includes paragraphs set in bold italic type and plain type, which
have equal authority. Paragraphs in bold italic type indicate the main principles. This
Accounting Standard should be read in the context of its objective and the Preface to the
Statements of Accounting Standards.)
Accounting Standard (AS) 15, Employee Benefits (revised 2005), issued by the Council of the
Institute of Chartered Accountants of India, comes into effect in respect of accounting periods
commencing on or after April 1, 2006 and is mandatory in nature from that date:
*
Originally issued in 1995 and titled as ‘Accounting for Retirement Benefits in the
Financial Statements of Employers’. AS 15 (revised 2005) was originally published in the
March 2005 issue of the Institute’s Journal. Subsequently, the Institute of Chartered
Accountants of India (ICAI), in January 2006, made Limited Revision to AS 15 (revised
2005) primarily with a view to bring the disclosure requirements of the standard relating to
the defined benefit plans in line with the corresponding International Accounting Standard
(IAS) 19, Employee Benefits; to clarify the application of the transitional provisions; and to
provide relaxation/ exemptions to the Small and Medium-sized Enterprises (SMEs). This
Limited Revision has been duly incorporated in AS 15 (revised 2005).
(a) in its entirety, for the enterprises which fall in any one or more of the following
categories, at any time during the accounting period:
(i) Enterprises whose equity or debt securities are listed whether in India or outside
India.
(ii) Enterprises which are in the process of listing their equity or debt securities as
evidenced by the board of directors’ resolution in this regard.
exceeds Rs. 50 crore. Turnover does not include ‘other income’.
(vii) All commercial, industrial and business reporting enterprises having borrowings,
including public deposits, in excess of Rs. 10 crore at any time during the accounting
period.
(viii) Holding and subsidiary enterprises of any one of the above at any time during the
accounting period.
(b) in its entirety, except the following, for enterprises which do not fall in any of the
categories in (a) above and whose average number of persons employed during the
year is 50 or more.
(i) paragraphs 11 to 16 of the standard to the extent they deal with recognition and
measurement of short-term accumulating compensated absences which are non-vesting
(i.e., short-term accumulating compensated absences in respect of which employees are
not entitled to cash payment for unused entitlement on leaving);
(ii) paragraphs 46 and 139 of the Standard which deal with discounting of amounts that
fall due more than 12 months after the balance sheet date; and
(iii) recognition and measurement principles laid down in paragraphs 50 to 116 and
presentation and disclosure requirements laid down in paragraphs 117 to 123 of the
Standard in respect of accounting for defined benefit plans. However, such enterprises
should actuarially determine and provide for the accrued liability in respect of defined
benefit plans as follows:
● The method used for actuarial valuation should be the Projected Unit Credit Method.
● The discount rate used should be determined by reference to market yields at the
balance sheet date on government bonds as per paragraph 78 of the Standard.
Such enterprises should disclose actuarial assumptions as per paragraph 120(l) of the
Standard.
(iv) recognition and measurement principles laid down in paragraphs 129 to 131 of the
Standard in respect of accounting for other long-term employee benefits. However, such
enterprises should actuarially determine and provide for the accrued liability in respect of
other long-term employee benefits as follows:
● The method used for actuarial valuation should be the Projected Unit Credit Method.
● The discount rate used should be determined by reference to market yields at the
balance sheet date on government bonds as per paragraph 78 of the Standard.
(c) in its entirety, except the following, for enterprises which do not fall in any of the
categories in (a) above and whose average number of persons employed during the
year is less than 50.
(i) paragraphs 11 to 16 of the standard to the extent they deal with recognition and
measurement of short-term accumulating compensated absences which are non-vesting
(i.e., short-term accumulating compensated absences in respect of which employees are
not entitled to cash payment for unused entitlement on leaving);
(ii) paragraphs 46 and 139 of the Standard which deal with discounting of amounts that
fall due more than 12 months after the balance sheet date;
(iii) recognition and measurement principles laid down in paragraphs 50 to 116 and
presentation and disclosure requirements laid down in paragraphs 117 to 123 of the
Standard in respect of accounting for defined benefit plans. Such enterprises may
calculate and account for the accrued liability under the defined benefit plans by
reference to some other rational method, e.g., a method based on the assumption that
such benefits are payable to all employees at the end of the accounting year; and
(iv) recognition and measurement principles laid down in paragraphs 129 to 131 of the
Standard in respect of accounting for other long-term employee benefits. Such
enterprises may calculate and account for the accrued liability under the other long-term
employee benefits by reference to some other rational method, e.g., a method based on
the assumption that such benefits are payable to all employees at the end of the
accounting year.
Where an enterprise has been covered in any one or more of the categories in (a) above and
subsequently, ceases to be so covered, the enterprise will not qualify for exemptions specified
in (b) above, until the enterprise ceases to be covered in any of the categories in (a) above for
two consecutive years.
Where an enterprise did not qualify for the exemptions specified in (c) above and
subsequently, qualifies, the enterprise will not qualify for exemptions as per (c) above, until it
continues to be so qualified for two consecutive years.
Where an enterprise has previously qualified for exemptions in (b) or (c) above, as the case
may be, but no longer qualifies for exemptions in (b) or (c) above, as the cases may be, in the
current accounting period, this Standard becomes applicable, in its entirety or, in its entirety
except exemptions in (b) above, as the case may be, from the current period. However, the
corresponding previous period figures in respect of the relevant disclosures need not be
provided.
An enterprise, which, pursuant to the above provisions, avails exemptions specified in (b) or
(c) above, as the cases may be, should disclose the fact. An enterprise which avails
exemptions specified in (c) above should also disclose the method used to calculate and
provide for the accrued liability.
Objective
The objective of this Statement is to prescribe the accounting and disclosure for employee
benefits. The Statement requires an enterprise to recognise:
(a) a liability when an employee has provided service in exchange for employee benefits to
be paid in the future; and
(b) an expense when the enterprise consumes the economic benefit arising from service
provided by an employee in exchange for employee benefits.
Scope
1. This Statement should be applied by an employer in accounting for all employee benefits,
except employee share-based payments7.
2. This Statement does not deal with accounting and reporting by employee benefit plans.
3. The employee benefits to which this Statement applies include those provided:
(a) under formal plans or other formal agreements between an enterprise and individual
employees, groups of employees or their representatives;
(b) under legislative requirements, or through industry arrangements, whereby

enterprises are required to contribute to state, industry or other multi-employer plans; or
(c) by those informal practices that give rise to an obligation. Informal practices give
rise to an obligation where the enterprise has no realistic alternative but to pay employee
benefits. An example of such an obligation is where a change in the enterprise’s informal
practices would cause unacceptable damage to its relationship with employees.
4. Employee benefits include:
(a) short-term employee benefits, such as wages, salaries and social security
contributions (e.g., contribution to an insurance company by an employer to pay for
medical care of its employees), paid annual leave, profit-sharing and bonuses (if payable
within twelve months of the end of the period) and non-monetary benefits (such as
medical care, housing, cars and free or subsidised goods or services) for current
employees;
(b) post-employment benefits such as gratuity, pension, other retirement benefits, post-
employment life insurance and post-employment medical care;
(c) other long-term employee benefits, including long-service leave or sabbatical leave,
jubilee or other long-service benefits, long-term disability benefits and, if they are not
payable wholly within twelve months after the end of the period, profit-sharing, bonuses
and deferred compensation; and
7
The accounting for such benefits is dealt with in the Guidance Note on Accounting for
Employee Share-based Payments issued by the Institute of Chartered Accountants of
India.
(d) termination benefits.

Because each category identified in (a) to (d) above has different characteristics, this
Statement establishes separate requirements for each category.
5. Employee benefits include benefits provided to either employees or their spouses,
children or other dependants and may be settled by payments (or the provision of goods or
services) made either:
(a) directly to the employees, to their spouses, children or other dependants, or to their legal
heirs or nominees; or
(b) to others, such as trusts, insurance companies.

6. An employee may provide services to an enterprise on a full-time, part-time, permanent,
casual or temporary basis. For the purpose of this Statement, employees include whole-time
directors and other management personnel.
Definitions
Employee benefits are all forms of consideration given by an enterprise in exchange for
service rendered by employees.
Short-term employee benefits are employee benefits (other than termination benefits)
which fall due wholly within twelve months after the end of the period in which the
employees render the related service.
Post-employment benefits are employee benefits (other than termination benefits)
which are payable after the completion of employment.
Post-employment benefit plans are formal or informal arrangements under which an
enterprise provides post-employment benefits for one or more employees.
Defined contribution plans are post-employment benefit plans under which an
enterprise pays fixed contributions into a separate entity (a fund) and will have no
obligation to pay further contributions if the fund does not hold sufficient assets to pay
all employee benefits relating to employee service in the current and prior periods.
Defined benefit plans are post-employment benefit plans other than defined
contribution plans.
Multi-employer plans are defined contribution plans (other than state plans) or defined
benefit plans (other than state plans) that:
(a) pool the assets contributed by various enterprises that are not under common
control; and
(b) use those assets to provide benefits to employees of more than one enterprise, on
the basis that contribution and benefit levels are determined without regard to the
identity of the enterprise that employs the employees concerned.
Other long-term employee benefits are employee benefits (other than post-employment
benefits and termination benefits) which do not fall due wholly within twelve months
after the end of the period in which the employees render the related service.
Termination benefits are employee benefits payable as a result of either:
(a) an enterprise’s decision to terminate an employee’s employment before the normal

retirement date; or
(b) an employee’s decision to accept voluntary redundancy in exchange for those

benefits (voluntary retirement).
Vested employee benefits are employee benefits that are not conditional on future
employment.
The present value of a defined benefit obligation is the present value, without deducting
any plan assets, of expected future payments required to settle the obligation resulting
from employee service in the current and prior periods.
Current service cost is the increase in the present value of the defined benefit
obligation resulting from employee service in the current period.
Interest cost is the increase during a period in the present value of a defined benefit
obligation which arises because the benefits are one period closer to settlement.
Plan assets comprise:
(a) assets held by a long-term employee benefit fund; and
(b) qualifying insurance policies.

Assets held by a long-term employee benefit fund are assets (other than non-
transferable financial instruments issued by the reporting enterprise) that:
(a) are held by an entity (a fund) that is legally separate from the reporting enterprise
and exists solely to pay or fund employee benefits; and
(b) are available to be used only to pay or fund employee benefits, are not available to
the reporting enterprise’s own creditors (even in bankruptcy), and cannot be returned to
the reporting enterprise, unless either:
(i) the remaining assets of the fund are sufficient to meet all the related
employee benefit obligations of the plan or the reporting enterprise; or
(ii) the assets are returned to the reporting enterprise to reimburse it for
employee benefits already paid.
A qualifying insurance policy is an insurance policy issued by an insurer that is not a
related party (as defined in AS 18 Related Party Disclosures) of the reporting enterprise,
if the proceeds of the policy:
(a) can be used only to pay or fund employee benefits under a defined benefit
plan; and
(b) are not available to the reporting enterprise’s own creditors (even in
bankruptcy) and cannot be paid to the reporting enterprise, unless either:
(i) the proceeds represent surplus assets that are not needed for the policy
to meet all the related employee benefit obligations; or
(ii) the proceeds are returned to the reporting enterprise to reimburse it for
employee benefits already paid.
Fair value is the amount for which an asset could be exchanged or a liability settled
between knowledgeable, willing parties in an arm’s length transaction.
The return on plan assets is interest, dividends and other revenue derived from the plan
assets, together with realised and unrealised gains or losses on the plan assets, less
any costs of administering the plan and less any tax payable by the plan itself.
Actuarial gains and losses comprise:
(a) experience adjustments (the effects of differences between the previous

actuarial assumptions and what has actually occurred); and
(b) the effects of changes in actuarial assumptions.

Past service cost is the change in the present value of the defined benefit obligation for
employee service in prior periods, resulting in the current period from the introduction
of, or changes to, post-employment benefits or other long-term employee benefits. Past
service cost may be either positive (where benefits are introduced or improved) or
negative (where existing benefits are reduced).
Short-term Employee Benefits

8. Short-term employee benefits include items such as:
(a) wages, salaries and social security contributions;
(b) short-term compensated absences (such as paid annual leave) where the absences
are expected to occur within twelve months after the end of the period in which the
employees render the related employee service;
(c) profit-sharing and bonuses payable within twelve months after the end of the period
in which the employees render the related service; and
(d) non-monetary benefits (such as medical care, housing, cars and free or subsidised
goods or services) for current employees.
9. Accounting for short-term employee benefits is generally straightforward because no
actuarial assumptions are required to measure the obligation or the cost and there is no
possibility of any actuarial gain or loss. Moreover, short-term employee benefit obligations are
measured on an undiscounted basis.
Recognition and Measurement
All Short-term Employee Benefits
10. When an employee has rendered service to an enterprise during an accounting

period, the enterprise should recognise the undiscounted amount of short-term
employee benefits expected to be paid in exchange for that service:
(a) as a liability (accrued expense), after deducting any amount already paid. If
the amount already paid exceeds the undiscounted amount of the benefits, an
enterprise should recognise that excess as an asset (prepaid expense) to the
extent that the prepayment will lead to, for example, a reduction in future payments
or a cash refund; and
(b) as an expense, unless another Accounting Standard requires or permits the

inclusion of the benefits in the cost of an asset (see, for example, AS 10
Accounting for Fixed Assets).
Paragraphs 11, 14 and 17 explain how an enterprise should apply this requirement to
short-term employee benefits in the form of compensated absences and profit-sharing

and bonus plans.
Short-term Compensated Absences

11. An enterprise should recognise the expected cost of short-term employee benefits
in the form of compensated absences under paragraph 10 as follows:
(a) in the case of accumulating compensated absences, when the employees

render service that increases their entitlement to future compensated absences;
and
(b) in the case of non-accumulating compensated absences, when the absences

occur.
12. An enterprise may compensate employees for absence for various reasons including
vacation, sickness and short-term disability, and maternity or paternity. Entitlement to
compensated absences falls into two categories:
(a) accumulating; and
(b) non-accumulating.
13. Accumulating compensated absences are those that are carried forward and can be used
in future periods if the current period’s entitlement is not used in full. Accumulating
compensated absences may be either vesting (in other words, employees are entitled to a
cash payment for unused entitlement on leaving the enterprise) or non-vesting (when
employees are not entitled to a cash payment for unused entitlement on leaving). An
obligation arises as employees render service that increases their entitlement to future
compensated absences. The obligation exists, and is recognised, even if the compensated
absences are non-vesting, although the possibility that employees may leave before they use
an accumulated non-vesting entitlement affects the measurement of that obligation.
14. An enterprise should measure the expected cost of accumulating compensated
absences as the additional amount that the enterprise expects to pay as a result of the
unused entitlement that has accumulated at the balance sheet date.
15. The method specified in the previous paragraph measures the obligation at the amount
of the additional payments that are expected to arise solely from the fact that the benefit
accumulates. In many cases, an enterprise may not need to make detailed computations to
estimate that there is no material obligation for unused compensated absences. For example,
a leave obligation is likely to be material only if there is a formal or informal understanding that
unused leave may be taken as paid vacation.
Example Illustrating Paragraphs 14 and 15
An enterprise has 100 employees, who are each entitled to five working days of leave for each
year. Unused leave may be carried forward for one calendar year. The leave is taken first out
of the current year’s entitlement and then out of any balance brought forward from the
previous year (a LIFO basis). At 31 December 20X4, the average unused entitlement is two
days per employee. The enterprise expects, based on past experience which is expected to
continue, that 92 employees will take no more than five days of leave in 20X5 and that the
remaining eight employees will take an average of six and a half days each.
The enterprise expects that it will pay an additional 12 days of pay as a result of the unused
entitlement that has accumulated at 31 December 20X4 (one and a half days each, for eight
employees). Therefore, the enterprise recognises a liability, as at 31 December 20X4, equal to
12 days of pay.
16. Non-accumulating compensated absences do not carry forward: they lapse if the current
period’s entitlement is not used in full and do not entitle employees to a cash payment for
unused entitlement on leaving the enterprise. This is commonly the case for maternity or
paternity leave. An enterprise recognises no liability or expense until the time of the absence,
because employee service does not increase the amount of the benefit.
Profit-sharing and Bonus Plans

17. An enterprise should recognise the expected cost of profit-sharing and bonus
payments under paragraph 10 when, and only when:
(a) the enterprise has a present obligation to make such payments as a result of
past events; and
(b) a reliable estimate of the obligation can be made.

A present obligation exists when, and only when, the enterprise has no realistic
alternative but to make the payments.
18. Under some profit-sharing plans, employees receive a share of the profit only if they
remain with the enterprise for a specified period. Such plans create an obligation as
employees render service that increases the amount to be paid if they remain in service until
the end of the specified period. The measurement of such obligations reflects the possibility
that some employees may leave without receiving profit-sharing payments.
Example Illustrating Paragraph 18
A profit-sharing plan requires an enterprise to pay a specified proportion of its net profit for the
year to employees who serve throughout the year. If no employees leave during the year, the total
profit-sharing payments for the year will be 3% of net profit. The enterprise estimates that staff
turnover will reduce the payments to 2.5% of net profit.
The enterprise recognises a liability and an expense of 2.5% of net profit.

19. An enterprise may have no legal obligation to pay a bonus. Nevertheless, in some cases,
an enterprise has a practice of paying bonuses. In such cases also, the enterprise has an
obligation because the enterprise has no realistic alternative but to pay the bonus. The
measurement of the obligation reflects the possibility that some employees may leave without
receiving a bonus.
20. An enterprise can make a reliable estimate of its obligation under a profit-sharing or
bonus plan when, and only when:
(a) the formal terms of the plan contain a formula for determining the amount of the benefit;
or
(b) the enterprise determines the amounts to be paid before the financial statements are
approved; or
(c) past practice gives clear evidence of the amount of the enterprise’s obligation.
21. An obligation under profit-sharing and bonus plans results from employee service and not
from a transaction with the enterprise’s owners. Therefore, an enterprise recognises the cost
of profit-sharing and bonus plans not as a distribution of net profit but as an expense.
22. If profit-sharing and bonus payments are not due wholly within twelve months after the
end of the period in which the employees render the related service, those payments are other
long-term employee benefits (see paragraphs 127-132).
Disclosure
23. Although this Statement does not require specific disclosures about short-term employee
benefits, other Accounting Standards may require disclosures. For example, where required
by AS 18 Related Party Disclosures an enterprise discloses information about employee
benefits for key management personnel.
Post-employment Benefits: Defined Contribution Plans and Defined Benefit Plans

24. Post-employment benefits include:
(a) retirement benefits, e.g., gratuity and pension; and
(b) other benefits, e.g., post-employment life insurance and post-employment medical
care.
Arrangements whereby an enterprise provides post-employment benefits are post-employment
benefit plans. An enterprise applies this Statement to all such arrangements whether or not
they involve the establishment of a separate entity to receive contributions and to pay
benefits.
25. Post-employment benefit plans are classified as either defined contribution plans or
defined benefit plans, depending on the economic substance of the plan as derived from its
principal terms and conditions. Under defined contribution plans:
(a) the enterprise’s obligation is limited to the amount that it agrees to contribute to the fund.
Thus, the amount of the post-employment benefits received by the employee is determined by
the amount of contributions paid by an enterprise (and also by the employee) to a post-
employment benefit plan or to an insurance company, together with investment returns arising
from the contributions; and
(b) in consequence, actuarial risk (that benefits will be less than expected) and investment
risk (that assets invested will be insufficient to meet expected benefits) fall on the employee.
26. Examples of cases where an enterprise’s obligation is not limited to the amount that it
agrees to contribute to the fund are when the enterprise has an obligation through:
(a) a plan benefit formula that is not linked solely to the amount of contributions; or
(b) a guarantee, either indirectly through a plan or directly, of a specified return on
contributions; or
(c) informal practices that give rise to an obligation, for example, an obligation may arise
where an enterprise has a history of increasing benefits for former employees to keep pace
with inflation even where there is no legal obligation to do so.
27. Under defined benefit plans:
(a) the enterprise’s obligation is to provide the agreed benefits to current and former
employees; and
(b) actuarial risk (that benefits will cost more than expected) and investment risk fall, in
substance, on the enterprise. If actuarial or investment experience are worse than
expected, the enterprise’s obligation may be increased.
28. Paragraphs 29 to 43 below deal with defined contribution plans and defined benefit plans
in the context of multi-employer plans, state plans and insured benefits.
Multi-employer Plans
29. An enterprise should classify a multi-employer plan as a defined contribution plan
or a defined benefit plan under the terms of the plan (including any obligation that goes
beyond the formal terms). Where a multi-employer plan is a defined benefit plan, an
enterprise should:
(a) account for its proportionate share of the defined benefit obligation, plan
assets and cost associated with the plan in the same way as for any other defined
benefit plan; and
(b) disclose the information required by paragraph 120.
30. When sufficient information is not available to use defined benefit accounting for a
multi-employer plan that is a defined benefit plan, an enterprise should:
(a) account for the plan under paragraphs 45-47 as if it were a defined
contribution plan;
(b) disclose:
(i) the fact that the plan is a defined benefit plan; and
(ii) the reason why sufficient information is not available to enable the
enterprise to account for the plan as a defined benefit plan; and
(c) to the extent that a surplus or deficit in the plan may affect the amount of
future contributions, disclose in addition:
(i) any available information about that surplus or deficit;
(ii) the basis used to determine that surplus or deficit; and
(iii) the implications, if any, for the enterprise.
31. One example of a defined benefit multi-employer plan is one where:
(a) the plan is financed in a manner such that contributions are set at a level that is
expected to be sufficient to pay the benefits falling due in the same period; and future
benefits earned during the current period will be paid out of future contributions; and
(b) employees’ benefits are determined by the length of their service and the
participating enterprises have no realistic means of withdrawing from the plan without
paying a contribution for the benefits earned by employees up to the date of withdrawal.
Such a plan creates actuarial risk for the enterprise; if the ultimate cost of benefits
already earned at the balance sheet date is more than expected, the enterprise will have
to either increase its contributions or persuade employees to accept a reduction in
benefits. Therefore, such a plan is a defined benefit plan.

32. Where sufficient information is available about a multi-employer plan which is a defined
benefit plan, an enterprise accounts for its proportionate share of the defined benefit
obligation, plan assets and post-employment benefit cost associated with the plan in the same
way as for any other defined benefit plan. However, in some cases, an enterprise may not be
able to identify its share of the underlying financial position and performance of the plan with
sufficient reliability for accounting purposes. This may occur if:
(a) the enterprise does not have access to information about the plan that satisfies the
requirements of this Statement; or
(b) the plan exposes the participating enterprises to actuarial risks associated with the
current and former employees of other enterprises, with the result that there is no consistent
and reliable basis for allocating the obligation, plan assets and cost to individual enterprises
participating in the plan.
In those cases, an enterprise accounts for the plan as if it were a defined contribution plan and
discloses the additional information required by paragraph 30.
33. Multi-employer plans are distinct from group administration plans. A group administration
plan is merely an aggregation of single employer plans combined to allow participating
employers to pool their assets for investment purposes and reduce investment management
and administration costs, but the claims of different employers are segregated for the sole
benefit of their own employees. Group administration plans pose no particular accounting
problems because information is readily available to treat them in the same way as any other
single employer plan and because such plans do not expose the participating enterprises to
actuarial risks associated with the current and former employees of other enterprises. The
definitions in this Statement require an enterprise to classify a group administration plan as a
defined contribution plan or a defined benefit plan in accordance with the terms of the plan
(including any obligation that goes beyond the formal terms).
34. Defined benefit plans that share risks between various enterprises under common
control, for example, a parent and its subsidiaries, are not multi-employer plans.
35. In respect of such a plan, if there is a contractual agreement or stated policy for charging
the net defined benefit cost for the plan as a whole to individual group enterprises, the
enterprise recognises, in its separate financial statements, the net defined benefit cost so
charged. If there is no such agreement or policy, the net defined benefit cost is recognised in
the separate financial statements of the group enterprise that is legally the sponsoring
employer for the plan. The other group enterprises recognise, in their separate financial
statements, a cost equal to their contribution payable for the period.
36. AS 29 Provisions, Contingent Liabilities and Contingent Assets requires an enterprise to
recognise, or disclose information about, certain contingent liabilities. In the context of a multi-
employer plan, a contingent liability may arise from, for example:
(a) actuarial losses relating to other participating enterprises because each enterprise that
participates in a multi-employer plan shares in the actuarial risks of every other participating
enterprise; or
(b) any responsibility under the terms of a plan to finance any shortfall in the plan if other
enterprises cease to participate.
State Plans
37. An enterprise should account for a state plan in the same way as for a multi-
employer plan (see paragraphs 29 and 30).
38. State plans are established by legislation to cover all enterprises (or all enterprises in a
particular category, for example, a specific industry) and are operated by national or local
government or by another body (for example, an autonomous agency created specifically for
this purpose) which is not subject to control or influence by the reporting enterprise. Some
plans established by an enterprise provide both compulsory benefits which substitute for
benefits that would otherwise be covered under a state plan and additional voluntary benefits.
Such plans are not state plans.
39. State plans are characterised as defined benefit or defined contribution in nature based
on the enterprise’s obligation under the plan. Many state plans are funded in a manner such
that contributions are set at a level that is expected to be sufficient to pay the required benefits
falling due in the same period; future benefits earned during the current period will be paid out
of future contributions. Nevertheless, in most state plans, the enterprise has no obligation to
pay those future benefits: its only obligation is to pay the contributions as they fall due and if
the enterprise ceases to employ members of the state plan, it will have no obligation to pay
the benefits earned by such employees in previous years. For this reason, state plans are
normally defined contribution plans. However, in the rare cases when a state plan is a defined
benefit plan, an enterprise applies the treatment prescribed in paragraphs 29 and 30.
Insured Benefits
40. An enterprise may pay insurance premiums to fund a post-employment benefit
plan. The enterprise should treat such a plan as a defined contribution plan unless the
enterprise will have (either directly, or indirectly through the plan) an obligation to
either:
(a) pay the employee benefits directly when they fall due; or
(b) pay further amounts if the insurer does not pay all future employee benefits
relating to employee service in the current and prior periods.
If the enterprise retains such an obligation, the enterprise should treat the plan as a
defined benefit plan.
41. The benefits insured by an insurance contract need not have a direct or automatic
relationship with the enterprise’s obligation for employee benefits. Post-employment benefit
plans involving insurance contracts are subject to the same distinction between accounting
and funding as other funded plans.
42. Where an enterprise funds a post-employment benefit obligation by contributing to an
insurance policy under which the enterprise (either directly, indirectly through the plan,
through the mechanism for setting future premiums or through a related party relationship with
the insurer) retains an obligation, the payment of the premiums does not amount to a defined
contribution arrangement. It follows that the enterprise:
(a) accounts for a qualifying insurance policy as a plan asset (see paragraph 7); and
(b) recognises other insurance policies as reimbursement rights (if the policies satisfy the
criteria in paragraph 103).
43. Where an insurance policy is in the name of a specified plan participant or a group of
plan participants and the enterprise does not have any obligation to cover any loss on the
policy, the enterprise has no obligation to pay benefits to the employees and the insurer has
sole responsibility for paying the benefits. The payment of fixed premiums under such
contracts is, in substance, the settlement of the employee benefit obligation, rather than an
investment to meet the obligation. Consequently, the enterprise no longer has an asset or a
liability. Therefore, an enterprise treats such payments as contributions to a defined
contribution plan.
Post-employment Benefits: Defined Contribution Plans

44. Accounting for defined contribution plans is straightforward because the reporting
enterprise’s obligation for each period is determined by the amounts to be contributed for that
period. Consequently, no actuarial assumptions are required to measure the obligation or the
expense and there is no possibility of any actuarial gain or loss. Moreover, the obligations are
measured on an undiscounted basis, except where they do not fall due wholly within twelve
months after the end of the period in which the employees render the related service.

45. When an employee has rendered service to an enterprise during a period, the
enterprise should recognise the contribution payable to a defined contribution plan in
exchange for that service:
(a) as a liability (accrued expense), after deducting any contribution already paid.
If the contribution already paid exceeds the contribution due for service before the
balance sheet date, an enterprise should recognise that excess as an asset
(prepaid expense) to the extent that the prepayment will lead to, for example, a
reduction in future payments or a cash refund; and
(b) as an expense, unless another Accounting Standard requires or permits the
inclusion of the contribution in the cost of an asset (see, for example, AS 10,
Accounting for Fixed Assets).
46. Where contributions to a defined contribution plan do not fall due wholly within
twelve months after the end of the period in which the employees render the related
service, they should be discounted using the discount rate specified in paragraph 78.
Disclosure
47. An enterprise should disclose the amount recognised as an expense for defined
contribution plans.
48. Where required by AS 18 Related Party Disclosures an enterprise discloses information
about contributions to defined contribution plans for key management personnel.
Post-employment Benefits: Defined Benefit Plans

49. Accounting for defined benefit plans is complex because actuarial assumptions are
required to measure the obligation and the expense and there is a possibility of actuarial gains
and losses. Moreover, the obligations are measured on a discounted basis because they may
be settled many years after the employees render the related service. While the Statement
requires that it is the responsibility of the reporting enterprise to measure the obligations under
the defined benefit plans, it is recognised that for doing so the enterprise would normally use
the services of a qualified actuary.

50. Defined benefit plans may be unfunded, or they may be wholly or partly funded by
contributions by an enterprise, and sometimes its employees, into an entity, or fund, that is
legally separate from the reporting enterprise and from which the employee benefits are paid.
The payment of funded benefits when they fall due depends not only on the financial position
and the investment performance of the fund but also on an enterprise’s ability to make good
any shortfall in the fund’s assets. Therefore, the enterprise is, in substance, underwriting the
actuarial and investment risks associated with the plan. Consequently, the expense
recognised for a defined benefit plan is not necessarily the amount of the contribution due for
the period.
51. Accounting by an enterprise for defined benefit plans involves the following steps:
(a) using actuarial techniques to make a reliable estimate of the amount of benefit that
employees have earned in return for their service in the current and prior periods. This
requires an enterprise to determine how much benefit is attributable to the current and
prior periods (see paragraphs 68-72) and to make estimates (actuarial assumptions)
about demographic variables (such as employee turnover and mortality) and financial
variables (such as future increases in salaries and medical costs) that will influence the
cost of the benefit (see paragraphs 73-91);
(b) discounting that benefit using the Projected Unit Credit Method in order to
determine the present value of the defined benefit obligation and the current service cost
(see paragraphs 65-67);
(c) determining the fair value of any plan assets (see paragraphs 100-102);
(d) determining the total amount of actuarial gains and losses (see paragraphs 92-93);
(e) where a plan has been introduced or changed, determining the resulting past
service cost (see paragraphs 94-99); and
(f) where a plan has been curtailed or settled, determining the resulting gain or loss
(see paragraphs 110-116).
Where an enterprise has more than one defined benefit plan, the enterprise applies these
procedures for each material plan separately.
52. For measuring the amounts under paragraph 51, in some cases, estimates, averages
and simplified computations may provide a reliable approximation of the detailed
computations.
Accounting for the Obligation under a Defined Benefit Plan
53. An enterprise should account not only for its legal obligation under the formal
terms of a defined benefit plan, but also for any other obligation that arises from the
enterprise’s informal practices. Informal practices give rise to an obligation where the
enterprise has no realistic alternative but to pay employee benefits. An example of such
an obligation is where a change in the enterprise’s informal practices would cause
unacceptable damage to its relationship with employees.
54. The formal terms of a defined benefit plan may permit an enterprise to terminate its
obligation under the plan. Nevertheless, it is usually difficult for an enterprise to cancel a plan
if employees are to be retained. Therefore, in the absence of evidence to the contrary,
accounting for post-employment benefits assumes that an enterprise which is currently
promising such benefits will continue to do so over the remaining working lives of employees.
Balance Sheet
55. The amount recognised as a defined benefit liability should be the net total of the
following amounts:
(a) the present value of the defined benefit obligation at the balance sheet date
(see paragraph 65);
(b) minus any past service cost not yet recognised (see paragraph 94);
(c) minus the fair value at the balance sheet date of plan assets (if any) out of
which the obligations are to be settled directly (see paragraphs 100-102).
56. The present value of the defined benefit obligation is the gross obligation, before
deducting the fair value of any plan assets.
57. An enterprise should determine the present value of defined benefit obligations
and the fair value of any plan assets with sufficient regularity that the amounts
recognised in the financial statements do not differ materially from the amounts that
would be determined at the balance sheet date.
58. The detailed actuarial valuation of the present value of defined benefit obligations may be
made at intervals not exceeding three years. However, with a view that the amounts
recognised in the financial statements do not differ materially from the amounts that would be
determined at the balance sheet date, the most recent valuation is reviewed at the balance
sheet date and updated to reflect any material transactions and other material changes in
circumstances (including changes in interest rates) between the date of valuation and the
balance sheet date. The fair value of any plan assets is determined at each balance sheet
date.
59. The amount determined under paragraph 55 may be negative (an asset). An
enterprise should measure the resulting asset at the lower of:
(a) the amount determined under paragraph 55; and
(b) the present value of any economic benefits available in the form of refunds
from the plan or reductions in future contributions to the plan. The present value of
these economic benefits should be determined using the discount rate specified in
paragraph 78.
60. An asset may arise where a defined benefit plan has been overfunded or in certain cases
where actuarial gains are recognised. An enterprise recognises an asset in such cases
because:
(a) the enterprise controls a resource, which is the ability to use the surplus to generate
future benefits;
(b) that control is a result of past events (contributions paid by the enterprise and service
rendered by the employee); and

(c) future economic benefits are available to the enterprise in the form of a reduction in
future contributions or a cash refund, either directly to the enterprise or indirectly to another
plan in deficit.
(Amount in Rs.)
A defined benefit plan has the following characteristics:
Present value of the obligation 1,100
Fair value of plan assets (1,190)
(90)
Unrecognised past service cost (70)
Negative amount determined under paragraph 55 (160)
Present value of available future refunds and reductions in future contributions
Limit under paragraph 59 (b) 90
Rs. 90 is less than Rs. 160. Therefore, the enterprise recognises an asset of Rs. 90 and
discloses that the limit reduced the carrying amount of the asset by Rs. 70 (see
paragraph 120(f)(ii)).
Statement of Profit and Loss

61. An enterprise should recognise the net total of the following amounts in the
statement of profit and loss, except to the extent that another Accounting Standard
requires or permits their inclusion in the cost of an asset:
(a) current service cost (see paragraphs 64-91);
(b) interest cost (see paragraph 82);
(c) the expected return on any plan assets (see paragraphs 107-109) and on any
reimbursement rights (see paragraph 103);
(d) actuarial gains and losses (see paragraphs 92-93);
(e) past service cost to the extent that paragraph 94 requires an enterprise to
recognise it;
(f) the effect of any curtailments or settlements (see paragraphs 110 and 111);
and
(g) the effect of the limit in paragraph 59 (b), i.e., the extent to which the amount
determined under paragraph 55 (if negative) exceeds the amount determined under
paragraph 59 (b).
62. Other Accounting Standards require the inclusion of certain employee benefit costs within
the cost of assets such as tangible fixed assets (see AS 10 Accounting for Fixed Assets). Any
post-employment benefit costs included in the cost of such assets include the appropriate
proportion of the components listed in paragraph 61.
Illustrative Example
63. Appendix A contains an example describing the components of the amounts recognised
in the balance sheet and statement of profit and loss in respect of defined benefit plans.
Recognition and Measurement: Present Value of Defined Benefit Obligations and

Current Service Cost
64. The ultimate cost of a defined benefit plan may be influenced by many variables, such as
final salaries, employee turnover and mortality, medical cost trends and, for a funded plan, the
investment earnings on the plan assets. The ultimate cost of the plan is uncertain and this
uncertainty is likely to persist over a long period of time. In order to measure the present value
of the post-employment benefit obligations and the related current service cost, it is necessary
to:
(a) apply an actuarial valuation method (see paragraphs 65-67);
(b) attribute benefit to periods of service (see paragraphs 68-72); and
(c) make actuarial assumptions (see paragraphs 73-91).
Actuarial Valuation Method
65. An enterprise should use the Projected Unit Credit Method to determine the present
value of its defined benefit obligations and the related current service cost and, where
applicable, past service cost.
66. The Projected Unit Credit Method (sometimes known as the accrued benefit method pro-
rated on service or as the benefit/years of service method) considers each period of service as
giving rise to an additional unit of benefit entitlement (see paragraphs 68-72) and measures
each unit separately to build up the final obligation (see paragraphs 73-91).
67. An enterprise discounts the whole of a post-employment benefit obligation, even if part of
the obligation falls due within twelve months of the balance sheet date.
A lump sum benefit, equal to 1% of final salary for each year of service, is payable on
termination of service. The salary in year 1 is Rs. 10,000 and is assumed to increase at 7%
(compound) each year resulting in Rs. 13,100 at the end of year 5. The discount rate used is
10% per annum. The following table shows how the obligation builds up for an employee who
is expected to leave at the end of year 5, assuming that there are no changes in actuarial
assumptions. For simplicity, this example ignores the additional adjustment needed to reflect
the probability that the employee may leave the enterprise at an earlier or later date.
(Amount in Rs.)
Year 1 2 3 4 5
Benefit attributed to:
- prior years 0 131 262 393 524
- current year (1% of final salary) 131 131 131 131 131
- current and prior years 131 262 393 524 655
Opening Obligation (see note 1) - 89 196 324 476
Interest at 10% - 9 20 33 48
Current Service Cost (see note 2) 89 98 108 119 131
Closing Obligation (see note 3) 89 196 324 476 655
Notes:
¾ 1. The Opening Obligation is the present value of benefit attributed to prior years.
¾ 2. The Current Service Cost is the present value of benefit attributed to the current
year.
¾ 3. The Closing Obligation is the present value of benefit attributed to current and prior
years.
Attributing Benefit to Periods of Service

68. In determining the present value of its defined benefit obligations and the related
current service cost and, where applicable, past service cost, an enterprise should
attribute benefit to periods of service under the plan’s benefit formula. However, if an
employee’s service in later years will lead to a materially higher level of benefit than in
earlier years, an enterprise should attribute benefit on a straight-line basis from:
(a) the date when service by the employee first leads to benefits under the plan
(whether or not the benefits are conditional on further service); until
(b) the date when further service by the employee will lead to no material amount
of further benefits under the plan, other than from further salary increases.
69. The Projected Unit Credit Method requires an enterprise to attribute benefit to the current
period (in order to determine current service cost) and the current and prior periods (in order
to determine the present value of defined benefit obligations). An enterprise attributes benefit
to periods in which the obligation to provide post-employment benefits arises. That obligation
arises as employees render services in return for post-employment benefits which an
enterprise expects to pay in future reporting periods. Actuarial techniques allow an enterprise
to measure that obligation with sufficient reliability to justify recognition of a liability.
Examples Illustrating Paragraph 69

1. A defined benefit plan provides a lump-sum benefit of Rs. 100 payable on retirement for
each year of service.
A benefit of Rs. 100 is attributed to each year. The current service cost is the present value of
Rs. 100. The present value of the defined benefit obligation is the present value of Rs. 100,
multiplied by the number of years of service up to the balance sheet date.
If the benefit is payable immediately when the employee leaves the enterprise, the current
service cost and the present value of the defined benefit obligation reflect the date at which the
employee is expected to leave. Thus, because of the effect of discounting, they are less than
the amounts that would be determined if the employee left at the balance sheet date.
2. A plan provides a monthly pension of 0.2% of final salary for each year of service. The
pension is payable from the age of 60.
Benefit equal to the present value, at the expected retirement date, of a monthly pension of
0.2% of the estimated final salary payable from the expected retirement date until the expected
date of death is attributed to each year of service. The current service cost is the present value
of that benefit. The present value of the defined benefit obligation is the present value of
monthly pension payments of 0.2% of final salary, multiplied by the number of years of service
up to the balance sheet date. The current service cost and the present value of the defined
benefit obligation are discounted because pension payments begin at the age of 60.
70. Employee service gives rise to an obligation under a defined benefit plan even if the
benefits are conditional on future employment (in other words they are not vested). Employee
service before the vesting date gives rise to an obligation because, at each successive
balance sheet date, the amount of future service that an employee will have to render before
becoming entitled to the benefit is reduced. In measuring its defined benefit obligation, an
enterprise considers the probability that some employees may not satisfy any vesting
requirements. Similarly, although certain post-employment benefits, for example, post-
employment medical benefits, become payable only if a specified event occurs when an
employee is no longer employed, an obligation is created when the employee renders service
that will provide entitlement to the benefit if the specified event occurs. The probability that the
specified event will occur affects the measurement of the obligation, but does not determine
whether the obligation exists.

1. A plan pays a benefit of Rs. 100 for each year of service. The benefits vest after ten years
of service.
A benefit of Rs. 100 is attributed to each year. In each of the first ten years, the current service
cost and the present value of the obligation reflect the probability that the employee may not
complete ten years of service.
2. A plan pays a benefit of Rs. 100 for each year of service, excluding service before the age
of 25. The benefits vest immediately.
No benefit is attributed to service before the age of 25 because service before that date does
not lead to benefits (conditional or unconditional). A benefit of Rs. 100 is attributed to each
subsequent year.
71. The obligation increases until the date when further service by the employee will lead to
no material amount of further benefits. Therefore, all benefit is attributed to periods ending on
or before that date. Benefit is attributed to individual accounting periods under the plan’s
benefit formula. However, if an employee’s service in later years will lead to a materially
higher level of benefit than in earlier years, an enterprise attributes benefit on a straight-line
basis until the date when further service by the employee will lead to no material amount of
further benefits. That is because the employee’s service throughout the entire period will
ultimately lead to benefit at that higher level.
1. A plan pays a lump-sum benefit of Rs. 1,000 that vests after ten years of service. The plan
provides no further benefit for subsequent service.
A benefit of Rs. 100 (Rs. 1,000 divided by ten) is attributed to each of the first ten years. The
current service cost in each of the first ten years reflects the probability that the employee may not
complete ten years of service. No benefit is attributed to subsequent years.
2. A plan pays a lump-sum retirement benefit of Rs. 2,000 to all employees who are still
employed at the age of 50 after twenty years of service, or who are still employed at the age
of 60, regardless of their length of service.
For employees who join before the age of 30, service first leads to benefits under the plan at the
age of 30 (an employee could leave at the age of 25 and return at the age of 28, with no effect on
the amount or timing of benefits). Those benefits are conditional on further service. Also, service
beyond the age of 50 will lead to no material amount of further benefits. For these employees, the
enterprise attributes benefit of Rs. 100 (Rs. 2,000 divided by 20) to each year from the age of 30
to the age of 50.
For employees who join between the ages of 30 and 40, service beyond twenty years will lead to
no material amount of further benefits. For these employees, the enterprise attributes benefit of
Rs. 100 (Rs. 2,000 divided by 20) to each of the first twenty years.
For an employee who joins at the age of 50, service beyond ten years will lead to no material
amount of further benefits. For this employee, the enterprise attributes benefit of Rs. 200 (Rs.
2,000 divided by 10) to each of the first ten years.
For all employees, the current service cost and the present value of the obligation reflect the
probability that the employee may not complete the necessary period of service.
3. A post-employment medical plan reimburses 40% of an employee’s post-employment
medical costs if the employee leaves after more than ten and less than twenty years of
service and 50% of those costs if the employee leaves after twenty or more years of service.
Under the plan’s benefit formula, the enterprise attributes 4% of the present value of the expected
medical costs (40% divided by ten) to each of the first ten years and 1% (10% divided by ten) to
each of the second ten years. The current service cost in each year reflects the probability that
the employee may not complete the necessary period of service to earn part or all of the benefits.
For employees expected to leave within ten years, no benefit is attributed.
4. A post-employment medical plan reimburses 10% of an employee’s post-employment
medical costs if the employee leaves after more than ten and less than twenty years of
service and 50% of those costs if the employee leaves after twenty or more years of service.
Service in later years will lead to a materially higher level of benefit than in earlier years.
Therefore, for employees expected to leave after twenty or more years, the enterprise attributes
benefit on a straight-line basis under paragraph 69. Service beyond twenty years will lead to no
material amount of further benefits. Therefore, the benefit attributed to each of the first twenty
years is 2.5% of the present value of the expected medical costs (50% divided by twenty).
For employees expected to leave between ten and twenty years, the benefit attributed to each of
the first ten years is 1% of the present value of the expected medical costs. For these employees,
no benefit is attributed to service between the end of the tenth year and the estimated date of
leaving.
For employees expected to leave within ten years, no benefit is attributed.
72. Where the amount of a benefit is a constant proportion of final salary for each year of
service, future salary increases will affect the amount required to settle the obligation that
exists for service before the balance sheet date, but do not create an additional obligation.
Therefore:
(a) for the purpose of paragraph 68(b), salary increases do not lead to further benefits, even
though the amount of the benefits is dependent on final salary; and
(b) the amount of benefit attributed to each period is a constant proportion of the salary to
which the benefit is linked.
Employees are entitled to a benefit of 3% of final salary for each year of service before the
age of 55.
Benefit of 3% of estimated final salary is attributed to each year up to the age of 55. This is
the date when further service by the employee will lead to no material amount of further
benefits under the plan. No benefit is attributed to service after that age.
Actuarial Assumptions
73. Actuarial assumptions comprising demographic assumptions and financial
assumptions should be unbiased and mutually compatible. Financial assumptions
should be based on market expectations, at the balance sheet date, for the period over
which the obligations are to be settled.
74. Actuarial assumptions are an enterprise’s best estimates of the variables that will
determine the ultimate cost of providing post-employment benefits. Actuarial assumptions
comprise:
(a) demographic assumptions about the future characteristics of current and former
employees (and their dependants) who are eligible for benefits. Demographic
assumptions deal with matters such as:
(i) mortality, both during and after employment;
(ii) rates of employee turnover, disability and early retirement;
(iii) the proportion of plan members with dependants who will be eligible for
benefits; and
(iv) claim rates under medical plans; and
(b) financial assumptions, dealing with items such as:
(i) the discount rate (see paragraphs 78-82);
(ii) future salary and benefit levels (see paragraphs 83-87);
(iii) in the case of medical benefits, future medical costs, including, where material,
the cost of administering claims and benefit payments (see paragraphs 88-91); and
(iv) the expected rate of return on plan assets (see paragraphs 107-109).
75. Actuarial assumptions are unbiased if they are neither imprudent nor excessively
conservative.
76. Actuarial assumptions are mutually compatible if they reflect the economic relationships
between factors such as inflation, rates of salary increase, the return on plan assets and
discount rates. For example, all assumptions which depend on a particular inflation level (such
as assumptions about interest rates and salary and benefit increases) in any given future
period assume the same inflation level in that period.
77. An enterprise determines the discount rate and other financial assumptions in nominal
(stated) terms, unless estimates in real (inflation-adjusted) terms are more reliable, for
example, where the benefit is index-linked and there is a deep market in index-linked bonds of
the same currency and term.
Actuarial Assumptions: Discount Rate

78. The rate used to discount post-employment benefit obligations (both funded and
unfunded) should be determined by reference to market yields at the balance sheet date
on government bonds. The currency and term of the government bonds should be
consistent with the currency and estimated term of the post-employment benefit
obligations.
79. One actuarial assumption which has a material effect is the discount rate. The discount
rate reflects the time value of money but not the actuarial or investment risk. Furthermore, the
discount rate does not reflect the enterprise-specific credit risk borne by the enterprise’s
creditors, nor does it reflect the risk that future experience may differ from actuarial
assumptions.
80. The discount rate reflects the estimated timing of benefit payments. In practice, an
enterprise often achieves this by applying a single weighted average discount rate that reflects
the estimated timing and amount of benefit payments and the currency in which the benefits
are to be paid.
81. In some cases, there may be no government bonds with a sufficiently long maturity to
match the estimated maturity of all the benefit payments. In such cases, an enterprise uses
current market rates of the appropriate term to discount shorter term payments, and estimates
the discount rate for longer maturities by extrapolating current market rates along the yield
curve. The total present value of a defined benefit obligation is unlikely to be particularly
sensitive to the discount rate applied to the portion of benefits that is payable beyond the final
maturity of the available government bonds.
82. Interest cost is computed by multiplying the discount rate as determined at the start of
the period by the present value of the defined benefit obligation throughout that period, taking
account of any material changes in the obligation. The present value of the obligation will
differ from the liability recognised in the balance sheet because the liability is recognised after
deducting the fair value of any plan assets and because some past service cost are not
recognised immediately. [Appendix A illustrates the computation of interest cost, among other
things]
Actuarial Assumptions: Salaries, Benefits and Medical Costs

83. Post-employment benefit obligations should be measured on a basis that reflects:
(a) estimated future salary increases;
(b) the benefits set out in the terms of the plan (or resulting from any obligation
that goes beyond those terms) at the balance sheet date; and
(c) estimated future changes in the level of any state benefits that affect the
benefits payable under a defined benefit plan, if, and only if, either:
(i) those changes were enacted before the balance sheet date; or
(ii) past history, or other reliable evidence, indicates that those state
benefits will change in some predictable manner, for example, in line with
future changes in general price levels or general salary levels.
84. Estimates of future salary increases take account of inflation, seniority, promotion and
other relevant factors, such as supply and demand in the employment market.
85. If the formal terms of a plan (or an obligation that goes beyond those terms) require an
enterprise to change benefits in future periods, the measurement of the obligation reflects
those changes. This is the case when, for example:
(a) the enterprise has a past history of increasing benefits, for example, to mitigate the
effects of inflation, and there is no indication that this practice will change in the future; or
(b) actuarial gains have already been recognised in the financial statements and the
enterprise is obliged, by either the formal terms of a plan (or an obligation that goes beyond
those terms) or legislation, to use any surplus in the plan for the benefit of plan participants
(see paragraph 96(c)).
86. Actuarial assumptions do not reflect future benefit changes that are not set out in the
formal terms of the plan (or an obligation that goes beyond those terms) at the balance sheet
date. Such changes will result in:
(a) past service cost, to the extent that they change benefits for service before the change;
and
(b) current service cost for periods after the change, to the extent that they change benefits
for service after the change.
87. Some post-employment benefits are linked to variables such as the level of state
retirement benefits or state medical care. The measurement of such benefits reflects expected
changes in such variables, based on past history and other reliable evidence.
88. Assumptions about medical costs should take account of estimated future
changes in the cost of medical services, resulting from both inflation and specific
changes in medical costs.
89. Measurement of post-employment medical benefits requires assumptions about the level
and frequency of future claims and the cost of meeting those claims. An enterprise estimates
future medical costs on the basis of historical data about the enterprise’s own experience,
supplemented where necessary by historical data from other enterprises, insurance
companies, medical providers or other sources. Estimates of future medical costs consider the
effect of technological advances, changes in health care utilisation or delivery patterns and
changes in the health status of plan participants.
90. The level and frequency of claims is particularly sensitive to the age, health status and
sex of employees (and their dependants) and may be sensitive to other factors such as
geographical location. Therefore, historical data is adjusted to the extent that the demographic
mix of the population differs from that of the population used as a basis for the historical data.
It is also adjusted where there is reliable evidence that historical trends will not continue.
91. Some post-employment health care plans require employees to contribute to the medical
costs covered by the plan. Estimates of future medical costs take account of any such
contributions, based on the terms of the plan at the balance sheet date (or based on any obligation
that goes beyond those terms). Changes in those employee contributions result in past service
cost or, where applicable, curtailments. The cost of meeting claims may be reduced by benefits
from state or other medical providers (see paragraphs 83(c) and 87).
Actuarial Gains and Losses
92. Actuarial gains and losses should be recognised immediately in the statement of
profit and loss as income or expense (see paragraph 61).
93. Actuarial gains and losses may result from increases or decreases in either the present
value of a defined benefit obligation or the fair value of any related plan assets. Causes of
actuarial gains and losses include, for example:
(a) unexpectedly high or low rates of employee turnover, early retirement or mortality or of
increases in salaries, benefits (if the terms of a plan provide for inflationary benefit increases)
or medical costs;
(b) the effect of changes in estimates of future employee turnover, early retirement or
mortality or of increases in salaries, benefits (if the terms of a plan provide for inflationary
benefit increases) or medical costs;
(c) the effect of changes in the discount rate; and
(d) differences between the actual return on plan assets and the expected return on plan
assets (see paragraphs 107-109).
Past Service Cost

94. In measuring its defined benefit liability under paragraph 55, an enterprise should
recognise past service cost as an expense on a straight-line basis over the average
period until the benefits become vested. To the extent that the benefits are already
vested immediately following the introduction of, or changes to, a defined benefit plan,
an enterprise should recognise past service cost immediately.
95. Past service cost arises when an enterprise introduces a defined benefit plan or changes
the benefits payable under an existing defined benefit plan. Such changes are in return for
employee service over the period until the benefits concerned are vested. Therefore, past
service cost is recognised over that period, regardless of the fact that the cost refers to
employee service in previous periods. Past service cost is measured as the change in the
liability resulting from the amendment (see paragraph 65).
An enterprise operates a pension plan that provides a pension of 2% of final salary for each year
of service. The benefits become vested after five years of service. On 1 January 20X5 the
enterprise improves the pension to 2.5% of final salary for each year of service starting from 1
January 20X1. At the date of the improvement, the present value of the additional benefits for
service from 1 January 20X1 to 1 January 20X5 is as follows:
Employees with more than five years’ service at 1/1/X5 Rs. 150
Employees with less than five years’ service at 1/1/X5
(average period until vesting: three years) Rs. 120
Rs. 270
The enterprise recognises Rs. 150 immediately because those benefits are already vested. The
enterprise recognises Rs. 120 on a straight-line basis over three years from 1 January 20X5.
96. Past service cost excludes:

(a) the effect of differences between actual and previously assumed salary increases
on the obligation to pay benefits for service in prior years (there is no past service cost
because actuarial assumptions allow for projected salaries);
(b) under and over estimates of discretionary pension increases where an enterprise
has an obligation to grant such increases (there is no past service cost because actuarial
assumptions allow for such increases);
(c) estimates of benefit improvements that result from actuarial gains that have already
been recognised in the financial statements if the enterprise is obliged, by either the
formal terms of a plan (or an obligation that goes beyond those terms) or legislation, to
use any surplus in the plan for the benefit of plan participants, even if the benefit
increase has not yet been formally awarded (the resulting increase in the obligation is an
actuarial loss and not past service cost, see paragraph 85(b));
(d) the increase in vested benefits (not on account of new or improved benefits) when
employees complete vesting requirements (there is no past service cost because the
estimated cost of benefits was recognised as current service cost as the service was
rendered); and
(e) the effect of plan amendments that reduce benefits for future service (a curtailment).
97. An enterprise establishes the amortisation schedule for past service cost when the
benefits are introduced or changed. It would be impracticable to maintain the detailed records
needed to identify and implement subsequent changes in that amortisation schedule.

Moreover, the effect is likely to be material only where there is a curtailment or settlement.
Therefore, an enterprise amends the amortisation schedule for past service cost only if there
is a curtailment or settlement.
98. Where an enterprise reduces benefits payable under an existing defined benefit plan, the
resulting reduction in the defined benefit liability is recognised as (negative) past service cost
over the average period until the reduced portion of the benefits becomes vested.
99. Where an enterprise reduces certain benefits payable under an existing defined benefit
plan and, at the same time, increases other benefits payable under the plan for the same
employees, the enterprise treats the change as a single net change.
Recognition and Measurement: Plan Assets
Fair Value of Plan Assets

100. The fair value of any plan assets is deducted in determining the amount recognised in the
balance sheet under paragraph 55. When no market price is available, the fair value of plan
assets is estimated; for example, by discounting expected future cash flows using a discount
rate that reflects both the risk associated with the plan assets and the maturity or expected
disposal date of those assets (or, if they have no maturity, the expected period until the
settlement of the related obligation).
101. Plan assets exclude unpaid contributions due from the reporting enterprise to the fund,
as well as any non-transferable financial instruments issued by the enterprise and held by the
fund. Plan assets are reduced by any liabilities of the fund that do not relate to employee
benefits, for example, trade and other payables and liabilities resulting from derivative
financial instruments.
102. Where plan assets include qualifying insurance policies that exactly match the amount
and timing of some or all of the benefits payable under the plan, the fair value of those
insurance policies is deemed to be the present value of the related obligations, as described in
paragraph 55 (subject to any reduction required if the amounts receivable under the insurance
policies are not recoverable in full).
Reimbursements
103. When, and only when, it is virtually certain that another party will reimburse some
or all of the expenditure required to settle a defined benefit obligation, an enterprise
should recognise its right to reimbursement as a separate asset. The enterprise should
measure the asset at fair value. In all other respects, an enterprise should treat that
asset in the same way as plan assets. In the statement of profit and loss, the expense
relating to a defined benefit plan may be presented net of the amount recognised for a
reimbursement.
104. Sometimes, an enterprise is able to look to another party, such as an insurer, to pay part
or all of the expenditure required to settle a defined benefit obligation. Qualifying insurance
policies, as defined in paragraph 7, are plan assets. An enterprise accounts for qualifying
insurance policies in the same way as for all other plan assets and paragraph 103 does not
apply (see paragraphs 40-43 and 102).
105. When an insurance policy is not a qualifying insurance policy, that insurance policy is not
a plan asset. Paragraph 103 deals with such cases: the enterprise recognises its right to
reimbursement under the insurance policy as a separate asset, rather than as a deduction in
determining the defined benefit liability recognised under paragraph 55; in all other respects,
including for determination of the fair value, the enterprise treats that asset in the same way
as plan assets. Paragraph 120(f)(iii) requires the enterprise to disclose a brief description of
the link between the reimbursement right and the related obligation.
Example Illustrating Paragraphs 103-105

(Amount in Rs.)
Liability recognised in balance sheet being the
present value of obligation 1,258
Rights under insurance policies that exactly match the amount
and timing of some of the benefits payable under the plan.
Those benefits have a present value of Rs. 1,092 1,092
106. If the right to reimbursement arises under an insurance policy that exactly matches the
amount and timing of some or all of the benefits payable under a defined benefit plan, the fair
value of the reimbursement right is deemed to be the present value of the related obligation,
as described in paragraph 55 (subject to any reduction required if the reimbursement is not
recoverable in full).
Return on Plan Assets

107. The expected return on plan assets is a component of the expense recognised in
the statement of profit and loss. The difference between the expected return on plan
assets and the actual return on plan assets is an actuarial gain or loss.
108. The expected return on plan assets is based on market expectations, at the beginning of
the period, for returns over the entire life of the related obligation. The expected return on plan
assets reflects changes in the fair value of plan assets held during the period as a result of
actual contributions paid into the fund and actual benefits paid out of the fund.
109. In determining the expected and actual return on plan assets, an enterprise deducts
expected administration costs, other than those included in the actuarial assumptions used to
measure the obligation.
At 1 January 20X1, the fair value of plan assets was Rs. 10,000. On 30 June 20X1, the plan paid
benefits of Rs. 1,900 and received contributions of Rs. 4,900. At 31 December 20X1, the fair
value of plan assets was Rs. 15,000 and the present value of the defined benefit obligation was
Rs. 14,792. Actuarial losses on the obligation for 20X1 were Rs. 60.
At 1 January 20X1, the reporting enterprise made the following estimates, based on market prices
at that date:
%
Interest and dividend income, after tax payable by the fund 9.25
Realised and unrealised gains on plan assets (after tax) 2.00
Administration costs (1.00)
Expected rate of return 10.25
For 20X1, the expected and actual return on plan assets are as follows:
(Amount in Rs.)
Return on Rs. 10,000 held for 12 months at 10.25% 1,025
Return on Rs. 3,000 held for six months at 5% (equivalent to
10.25% annually, compounded every six months) 150
Expected return on plan assets for 20X1 1,175
Fair value of plan assets at 31 December 20X1 15,000
Less fair value of plan assets at 1 January 20X1 (10,000)
Less contributions received (4,900)
Add benefits paid 1,900
Actual return on plan assets 2,000
The difference between the expected return on plan assets (Rs. 1,175) and the actual return on
plan assets (Rs. 2,000) is an actuarial gain of Rs. 825. Therefore, the net actuarial gain of Rs. 765
(Rs. 825 – Rs. 60 (actuarial loss on the obligation)) would be recognised in the statement of profit
and loss.
The expected return on plan assets for 20X2 will be based on market expectations at 1/1/X2 for
returns over the entire life of the obligation.
Curtailments and Settlements

110. An enterprise should recognise gains or losses on the curtailment or settlement of
a defined benefit plan when the curtailment or settlement occurs. The gain or loss on a
curtailment or settlement should comprise:
(a) any resulting change in the present value of the defined benefit obligation;
(b) any resulting change in the fair value of the plan assets;
(c) any related past service cost that, under paragraph 94, had not previously
been recognised.
111. Before determining the effect of a curtailment or settlement, an enterprise should
remeasure the obligation (and the related plan assets, if any) using current actuarial
assumptions (including current market interest rates and other current market prices).
112. A curtailment occurs when an enterprise either:
(a) has a present obligation, arising from the requirement of a statute/regulator or
otherwise, to make a material reduction in the number of employees covered by a plan;
or
(b) amends the terms of a defined benefit plan such that a material element of future
service by current employees will no longer qualify for benefits, or will qualify only for
reduced benefits.
A curtailment may arise from an isolated event, such as the closing of a plant, discontinuance
of an operation or termination or suspension of a plan. An event is material enough to qualify
as a curtailment if the recognition of a curtailment gain or loss would have a material effect on
the financial statements. Curtailments are often linked with a restructuring. Therefore, an
enterprise accounts for a curtailment at the same time as for a related restructuring.
113. A settlement occurs when an enterprise enters into a transaction that eliminates all
further obligations for part or all of the benefits provided under a defined benefit plan, for
example, when a lump-sum cash payment is made to, or on behalf of, plan participants in
exchange for their rights to receive specified post-employment benefits.
114. In some cases, an enterprise acquires an insurance policy to fund some or all of the
employee benefits relating to employee service in the current and prior periods. The
acquisition of such a policy is not a settlement if the enterprise retains an obligation (see
paragraph 40) to pay further amounts if the insurer does not pay the employee benefits
specified in the insurance policy. Paragraphs 103-106 deal with the recognition and
measurement of reimbursement rights under insurance policies that are not plan assets.
115. A settlement occurs together with a curtailment if a plan is terminated such that the
obligation is settled and the plan ceases to exist. However, the termination of a plan is not a
curtailment or settlement if the plan is replaced by a new plan that offers benefits that are, in
substance, identical.
116. Where a curtailment relates to only some of the employees covered by a plan, or where
only part of an obligation is settled, the gain or loss includes a proportionate share of the
previously unrecognised past service cost. The proportionate share is determined on the basis
of the present value of the obligations before and after the curtailment or settlement, unless
another basis is more rational in the circumstances.
An enterprise discontinues a business segment and employees of the discontinued segment will
earn no further benefits. This is a curtailment without a settlement. Using current actuarial
assumptions (including current market interest rates and other current market prices) immediately
before the curtailment, the enterprise has a defined benefit obligation with a net present value of
Rs. 1,000 and plan assets with a fair value of Rs. 820 and unrecognised past service cost of Rs.
50. The curtailment reduces the net present value of the obligation by Rs. 100 to Rs. 900.
Of the previously unrecognised past service cost, 10% (Rs. 100/Rs. 1000) relates to the part of
the obligation that was eliminated through the curtailment. Therefore, the effect of the curtailment
is as follows:
(Amount in Rs.)
Before Curtailment After
Curtailment gain curtailment
Net present value of obligation 1,000 (100) 900
Fair value of plan assets (820) - (820)
180 (100) 80
Unrecognised past service cost (50) 5 (45)
Net liability recognised in balance sheet 130 (95) 35
Presentation
Offset
117. An enterprise should offset an asset relating to one plan against a liability relating
to another plan when, and only when, the enterprise:
(a) has a legally enforceable right to use a surplus in one plan to settle
obligations under the other plan; and
(b) intends either to settle the obligations on a net basis, or to realise the surplus
in one plan and settle its obligation under the other plan simultaneously.
Financial Components of Post-employment Benefit Costs

118. This Statement does not specify whether an enterprise should present current service
cost, interest cost and the expected return on plan assets as components of a single item of
income or expense on the face of the statement of profit and loss.
Disclosure
119. An enterprise should disclose information that enables users of financial
statements to evaluate the nature of its defined benefit plans and the financial effects of
changes in those plans during the period.
120. An enterprise should disclose the following information about defined benefit
plans:
(a) the enterprise’s accounting policy for recognising actuarial gains and losses.
(b) a general description of the type of plan.
(c) a reconciliation of opening and closing balances of the present value of the
defined benefit obligation showing separately, if applicable, the effects during the
period attributable to each of the following:
(i) current service cost,
(ii) interest cost,
(iii) contributions by plan participants,
(iv) actuarial gains and losses,
(v) foreign currency exchange rate changes on plans measured in a currency
different from the enterprise’s reporting currency,
(vi) benefits paid,
(vii) past service cost,
(viii) amalgamations,
(ix) curtailments, and
(x) settlements.
(d) an analysis of the defined benefit obligation into amounts arising from plans
that are wholly unfunded and amounts arising from plans that are wholly or partly
funded.
(e) a reconciliation of the opening and closing balances of the fair value of plan
assets and of the opening and closing balances of any reimbursement right
recognised as an asset in accordance with paragraph 103 showing separately, if
applicable, the effects during the period attributable to each of the following:
(i) expected return on plan assets,
(ii) actuarial gains and losses,
(iii) foreign currency exchange rate changes on plans measured in a currency
different from the enterprise’s reporting currency,
(iv) contributions by the employer,
(v) contributions by plan participants,
(vi) benefits paid,
(vii) amalgamations, and
(viii) settlements.
(f) a reconciliation of the present value of the defined benefit obligation in (c) and
the fair value of the plan assets in (e) to the assets and liabilities recognised in the
balance sheet, showing at least:
(i) the past service cost not yet recognised in the balance sheet (see
paragraph 94);
(ii) any amount not recognised as an asset, because of the limit in paragraph
59(b);
(iii) the fair value at the balance sheet date of any reimbursement right
recognised as an asset in accordance with paragraph 103 (with a brief
description of the link between the reimbursement right and the related
obligation); and
(iv) the other amounts recognised in the balance sheet.
(g) the total expense recognised in the statement of profit and loss for each of the
following, and the line item(s) of the statement of profit and loss in which they are
included:
(i) current service cost;
(ii) interest cost;
(iii) expected return on plan assets;
(iv) expected return on any reimbursement right recognised as an asset in
accordance with paragraph 103;
(v) actuarial gains and losses;
(vi) past service cost;
(vii) the effect of any curtailment or settlement; and

(viii) the effect of the limit in paragraph 59 (b), i.e., the extent to which the
amount determined in accordance with paragraph 55 (if negative) exceeds the
amount determined in accordance with paragraph 59 (b).
(h) for each major category of plan assets, which should include, but is not
limited to, equity instruments, debt instruments, property, and all other assets, the
percentage or amount that each major category constitutes of the fair value of the
total plan assets.
(i) the amounts included in the fair value of plan assets for:
(i) each category of the enterprise’s own financial instruments; and
(ii) any property occupied by, or other assets used by, the enterprise.
(j) a narrative description of the basis used to determine the overall expected
rate of return on assets, including the effect of the major categories of plan assets.
(k) the actual return on plan assets, as well as the actual return on any
reimbursement right recognised as an asset in accordance with paragraph 103.
(l) the principal actuarial assumptions used as at the balance sheet date,
including, where applicable:
(i) the discount rates;
(ii) the expected rates of return on any plan assets for the periods presented
in the financial statements;
(iii) the expected rates of return for the periods presented in the financial
statements on any reimbursement right recognised as an asset in accordance
with paragraph 103;
(iv) medical cost trend rates; and
(v) any other material actuarial assumptions used.
An enterprise should disclose each actuarial assumption in absolute terms (for
example, as an absolute percentage) and not just as a margin between different
percentages or other variables.
Apart from the above actuarial assumptions, an enterprise should include an assertion
under the actuarial assumptions to the effect that estimates of future salary increases,
considered in actuarial valuation, take account of inflation, seniority, promotion and
other relevant factors, such as supply and demand in the employment market.
(m) the effect of an increase of one percentage point and the effect of a decrease
of one percentage point in the assumed medical cost trend rates on:
(i) the aggregate of the current service cost and interest cost components of
net periodic post-employment medical costs; and
(ii) the accumulated post-employment benefit obligation for medical costs.
For the purposes of this disclosure, all other assumptions should be held constant. For
plans operating in a high inflation environment, the disclosure should be the effect of a
percentage increase or decrease in the assumed medical cost trend rate of a
significance similar to one percentage point in a low inflation environment.
(n) the amounts for the current annual period and previous four annual periods
of:
(i) the present value of the defined benefit obligation, the fair value of the
plan assets and the surplus or deficit in the plan; and
(ii) the experience adjustments arising on:
(A) the plan liabilities expressed either as (1) an amount or (2) a
percentage of the plan liabilities at the balance sheet date, and
(B) the plan assets expressed either as (1) an amount or (2) a
percentage of the plan assets at the balance sheet date.
(o) the employer’s best estimate, as soon as it can reasonably be determined, of
contributions expected to be paid to the plan during the annual period beginning
after the balance sheet date.
121. Paragraph 120(b) requires a general description of the type of plan. Such a description
distinguishes, for example, flat salary pension plans from final salary pension plans and from
post-employment medical plans. The description of the plan should include informal practices
that give rise to other obligations included in the measurement of the defined benefit obligation
in accordance with paragraph 53. Further detail is not required.
122. When an enterprise has more than one defined benefit plan, disclosures may be made in
total, separately for each plan, or in such groupings as are considered to be the most useful. It
may be useful to distinguish groupings by criteria such as the following:
(a) the geographical location of the plans, for example, by distinguishing domestic plans
from foreign plans; or
(b) whether plans are subject to materially different risks, for example, by distinguishing flat
salary pension plans from final salary pension plans and from post-employment medical plans.
When an enterprise provides disclosures in total for a grouping of plans, such disclosures are
provided in the form of weighted averages or of relatively narrow ranges.
123. Paragraph 30 requires additional disclosures about multi-employer defined benefit plans
that are treated as if they were defined contribution plans.
124. Where required by AS 18 Related Party Disclosures an enterprise discloses information

about:
(a) related party transactions with post-employment benefit plans; and
(b) post-employment benefits for key management personnel.
125. Where required by AS 29 Provisions, Contingent Liabilities and Contingent Assets an
enterprise discloses information about contingent liabilities arising from post-employment
benefit obligations.
Illustrative Disclosures
126. Appendix B contains illustrative disclosures.
Other Long-term Employee Benefits

127. Other long-term employee benefits include, for example:
(a) long-term compensated absences such as long-service or sabbatical leave;
(b) jubilee or other long-service benefits;
(c) long-term disability benefits;
(d) profit-sharing and bonuses payable twelve months or more after the end of the
period in which the employees render the related service; and
(e) deferred compensation paid twelve months or more after the end of the period in
which it is earned.
128. In case of other long-term employee benefits, the introduction of, or changes to, other
long-term employee benefits rarely causes a material amount of past service cost. For this
reason, this Statement requires a simplified method of accounting for other long-term
employee benefits. This method differs from the accounting required for post-employment
benefits insofar as that all past service cost is recognised immediately.

129. The amount recognised as a liability for other long-term employee benefits should
be the net total of the following amounts:
(a) the present value of the defined benefit obligation at the balance sheet date
(see paragraph 65);
(b) minus the fair value at the balance sheet date of plan assets (if any) out of
which the obligations are to be settled directly (see paragraphs 100-102).
In measuring the liability, an enterprise should apply paragraphs 49-91, excluding
paragraphs 55 and 61. An enterprise should apply paragraph 103 in recognising and
measuring any reimbursement right.

130. For other long-term employee benefits, an enterprise should recognise the net total
of the following amounts as expense or (subject to paragraph 59) income, except to the
extent that another Accounting Standard requires or permits their inclusion in the cost
of an asset:
(a) current service cost (see paragraphs 64-91);
(b) interest cost (see paragraph 82);
(c) the expected return on any plan assets (see paragraphs 107-109) and on
any reimbursement right recognised as an asset (see paragraph 103);
(d) actuarial gains and losses, which should all be recognised immediately;
(e) past service cost, which should all be recognised immediately; and
(f) the effect of any curtailments or settlements (see paragraphs 110 and
111).
131. One form of other long-term employee benefit is long-term disability benefit. If the level of
benefit depends on the length of service, an obligation arises when the service is rendered.
Measurement of that obligation reflects the probability that payment will be required and the
length of time for which payment is expected to be made. If the level of benefit is the same for
any disabled employee regardless of years of service, the expected cost of those benefits is
recognised when an event occurs that causes a long-term disability.
Disclosure
132. Although this Statement does not require specific disclosures about other long-term
employee benefits, other Accounting Standards may require disclosures, for example, where
the expense resulting from such benefits is of such size, nature or incidence that its disclosure
is relevant to explain the performance of the enterprise for the period (see AS 5 Net Profit or
Loss for the Period, Prior Period Items and Changes in Accounting Policies). Where required
by AS 18 Related Party Disclosures an enterprise discloses information about other long-term
employee benefits for key management personnel.
Termination Benefits
133. This Statement deals with termination benefits separately from other employee benefits
because the event which gives rise to an obligation is the termination rather than employee
service.
Recognition
134. An enterprise should recognise termination benefits as a liability and an expense
when, and only when:

(a) the enterprise has a present obligation as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will
be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.
135. An enterprise may be committed, by legislation, by contractual or other agreements with
employees or their representatives or by an obligation based on business practice, custom or
a desire to act equitably, to make payments (or provide other benefits) to employees when it
terminates their employment. Such payments are termination benefits. Termination benefits
are typically lump-sum payments, but sometimes also include:
(a) enhancement of retirement benefits or of other post-employment benefits, either
indirectly through an employee benefit plan or directly; and
(b) salary until the end of a specified notice period if the employee renders no further service
that provides economic benefits to the enterprise.
136. Some employee benefits are payable regardless of the reason for the employee’s
departure. The payment of such benefits is certain (subject to any vesting or minimum service
requirements) but the timing of their payment is uncertain. Although such benefits may be
described as termination indemnities, or termination gratuities, they are post-employment
benefits, rather than termination benefits and an enterprise accounts for them as post-
employment benefits. Some enterprises provide a lower level of benefit for voluntary
termination at the request of the employee (in substance, a post-employment benefit) than for
involuntary termination at the request of the enterprise. The additional benefit payable on
involuntary termination is a termination benefit.
137. Termination benefits are recognised as an expense immediately.
138. Where an enterprise recognises termination benefits, the enterprise may also have to
account for a curtailment of retirement benefits or other employee benefits (see paragraph
110).
Measurement
139. Where termination benefits fall due more than 12 months after the balance sheet
date, they should be discounted using the discount rate specified in paragraph 78.
Disclosure
140. Where there is uncertainty about the number of employees who will accept an offer of
termination benefits, a contingent liability exists. As required by AS 29, Provisions, Contingent
Liabilities and Contingent Assets an enterprise discloses information about the contingent
liability unless the possibility of an outflow in settlement is remote.

141. As required by AS 5, Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies an enterprise discloses the nature and amount of an expense if it is of
such size, nature or incidence that its disclosure is relevant to explain the performance of the
enterprise for the period. Termination benefits may result in an expense needing disclosure in
order to comply with this requirement.
142. Where required by AS 18, Related Party Disclosures an enterprise discloses information
about termination benefits for key management personnel.
Employee Benefits other than Defined Benefit Plans and Termination Benefits
143. Where an enterprise first adopts this Statement for employee benefits, the
difference (as adjusted by any related tax expense) between the liability in respect of
employee benefits other than defined benefit plans and termination benefits, as per this
Statement, existing on the date of adopting this Statement and the liability that would
have been recognised at the same date, as per the pre-revised AS 15, should be
adjusted against opening balance of revenue reserves and surplus.
Defined Benefit Plans

144. On first adopting this Statement, an enterprise should determine its transitional
liability for defined benefit plans at that date as:
(a) the present value of the obligation (see paragraph 65) at the date of adoption;
(b) minus the fair value, at the date of adoption, of plan assets (if any) out of
which the obligations are to be settled directly (see paragraphs 100-102);
(c) minus any past service cost that, under paragraph 94, should be recognised in
later periods.
145. The difference (as adjusted by any related tax expense) between the transitional
liability and the liability that would have been recognised at the same date, as per the
pre-revised AS 15, should be adjusted immediately, against opening balance of revenue
reserves and surplus.
Example Illustrating Paragraphs 144 and 145

At 31 March 20X6, an enterprise’s balance sheet includes a pension liability of Rs. 100,
recognised as per the pre-revised AS 15. The enterprise adopts the Statement as of 1
April 20X6, when the present value of the obligation under the Statement is Rs. 1,300
and the fair value of plan assets is Rs. 1,000. On 1 April 20X0, the enterprise had
improved pensions (cost for non-vested benefits: Rs. 160; and average remaining period
at that date until vesting: 10 years).

(Amount in Rs.)
The transitional effect is as follows:
Present value of the obligation 1,300
Fair value of plan assets (1,000)
Less: past service cost to be recognised in later periods
(160 x 4/10) (64)
Transitional liability 236
Liability already recognised 100
Increase in liability 136
This increase in liability (as adjusted by any related deferred tax) should be adjusted
against the opening balance of revenue reserves and surplus as on 1 April 20X6.
Termination Benefits
146. This Statement requires immediate expensing of expenditure on termination benefits
(including expenditure incurred on voluntary retirement scheme (VRS)). However, where an
enterprise incurs expenditure on termination benefits on or before 31st March, 2009, the
enterprise may choose to follow the accounting policy of deferring such expenditure over its
pay-back period. However, the expenditure so deferred cannot be carried forward to
accounting periods commencing on or after 1st April, 2010.
Appendix A
Illustrative Example
The appendix is illustrative only and does not form part of the Statement. The purpose of the
appendix is to illustrate the application of the Statement to assist in clarifying its meaning.
Extracts from statements of profit and loss and balance sheets are provided to show the
effects of the transactions described below. These extracts do not necessarily conform with all
the disclosure and presentation requirements of other Accounting Standards.
Background Information
The following information is given about a funded defined benefit plan. To keep interest
computations simple, all transactions are assumed to occur at the year end. The present value
of the obligation and the fair value of the plan assets were both Rs. 1,000 at 1 April, 20X4.
(Amount in Rs.)
20X4-X5 20X5-X6 20X6-X7
Discount rate at start of year 10.0% 9.0% 8.0%

Expected rate of return on plan assets at start of year
12.0% 11.1% 10.3%
Current service cost 130 140 150
Benefits paid 150 180 190
Contributions paid 90 100 110
Present value of obligation at 31 March 1,141 1,197 1,295
Fair value of plan assets at 31 March 1,092 1,109 1,093
Expected average remaining working lives of 10 10 10
employees (years)
In 20X5-X6, the plan was amended to provide additional benefits with effect from 1 April 20X5.
The present value as at 1 April 20X5 of additional benefits for employee service before 1 April
20X5 was Rs. 50 for vested benefits and Rs. 30 for non-vested benefits. As at 1 April 20X5,
the enterprise estimated that the average period until the non-vested benefits would become
vested was three years; the past service cost arising from additional non-vested benefits is
therefore recognised on a straight-line basis over three years. The past service cost arising
from additional vested benefits is recognised immediately (paragraph 94 of the Statement).
Changes in the Present Value of the Obligation and in the Fair Value of the Plan Assets
The first step is to summarise the changes in the present value of the obligation and in the fair
value of the plan assets and use this to determine the amount of the actuarial gains or losses
for the period. These are as follows:
(Amount in Rs.)
20X4-X5 20X5-X6 20X6-X7
Present value of obligation, 1 April 1,000 1,141 1,197

Interest cost 100 103 96
Past service cost – (non vested benefits) - 30 -
Past service cost – (vested benefits) - 50 -
Benefits paid (150) (180) (190)
Actuarial (gain) loss on obligation (balancing figure) 61 (87) 42
Present value of obligation, 31 March 1,141 1,197 1,295

Fair value of plan assets, 1 April 1,000 1,092 1,109
Expected return on plan assets 120 121 114
Contributions 90 100 110
Benefits paid (150) (180) (190)
Actuarial gain (loss) on plan assets (balancing figure) 32 (24) (50)
Fair value of plan assets, 31 March 1,092 1,109 1,093
Total actuarial gain (loss) to be recognised immediately as per
the Statement (29) 63 (92)
Amounts Recognised in the Balance Sheet and Statements of Profit and Loss, and
Related Analyses
The final step is to determine the amounts to be recognised in the balance sheet and
statement of profit and loss, and the related analyses to be disclosed in accordance with
paragraphs 120 (f), (g) and (j) of the Statement (the analyses required to be disclosed in
accordance with paragraph 120(c) and (e) are given in the section of this Appendix ‘Changes
in the Present Value of the Obligation and in the Fair Value of the Plan Assets’). These are as
follows:
(Amount in Rs.)
20X4-X5 20X5-X6 20X6-X7
Present value of the obligation 1,141 1,197 1,295

Fair value of plan assets (1,092) (1,109) (1,093)
49 88 202
Unrecognised past service cost – non vested benefits - (20) (10)
Liability recognised in balance sheet 49 68 192

Interest cost 100 103 96
Expected return on plan assets (120) (121) (114)
Net actuarial (gain) loss recognised in year 29 (63) 92
Past service cost - non-vested benefits - 10 10
Past service cost - vested benefits - 50 -
Expense recognised in the statement of profit and loss 139 119 234
Actual return on plan assets:

Expected return on plan assets 120 121 114
Actuarial gain (loss) on plan assets 32 (24) (50)
Actual return on plan assets 152 97 64
Note: see example illustrating paragraphs 103-105 for presentation of reimbursements.
Appendix B
This appendix is illustrative only and does not form part of the Statement. The purpose of the
appendix is to illustrate the application of the Statement to assist in clarifying its meaning.
Extracts from notes to the financial statements show how the required disclosures may be
aggregated in the case of a large multi-national group that provides a variety of employee
benefits. These extracts do not necessarily provide all the information required under the
disclosure and presentation requirements of AS 15 (2005) and other Accounting Standards. In
particular, they do not illustrate the disclosure of:
(a) accounting policies for employee benefits (see AS 1 Disclosure of Accounting Policies).
Paragraph 120(a) of the Statement requires this disclosure to include the enterprise’s
accounting policy for recognising actuarial gains and losses.
(b) a general description of the type of plan (paragraph 120(b)).
(c) a narrative description of the basis used to determine the overall expected rate of return
on assets (paragraph 120(j)).
(d) employee benefits granted to directors and key management personnel (see AS 18
Related Party Disclosures).
Employee Benefit Obligations

The amounts (in Rs.) recognised in the balance sheet are as follows:
Defined benefit Post-employment
pension plans medical benefits
20X5-X6 20X4-X5 20X5-X6 20X4-X5
Present value of funded obligations 20,300 17,400 - -
Fair value of plan assets 18,420 17,280 - -
1,880 120 - -
Present value of unfunded obligations 2000 1000 7,337 6,405
Unrecognised past service cost (450) (650) - -
Net liability 3,430 470 7,337 6,405

Amounts in the balance sheet:
Liabilities 3,430 560 7,337 6,405
Assets - (90) - -
Net liability 3,430 470 7,337 6,405
The pension plan assets include equity shares issued by [name of reporting enterprise] with a fair
value of Rs. 317 (20X4-X5: Rs. 281). Plan assets also include property occupied by [name of
reporting enterprise] with a fair value of Rs. 200 (20X4-X5: Rs. 185).
The amounts (in Rs.) recognised in the statement of profit and loss are as follows:
Defined benefit pension Post-employment
plans medical benefits
20X5-X6 20X4-X5 20X5-X6 20X4-X5
Current service cost 850 750 479 411
Interest on obligation 950 1,000 803 705
Expected return on plan assets (900) (650)
Net actuarial losses (gains) recognised in year 2650 (650) 250 400
Past service cost 200 200 - -
Losses (gains) on curtailments and settlements 175 (390) - -
Total, included in ‘employee benefit expense’ 3,925 260 1,532 1,516
Actual return on plan assets 600 2,250 - -
Changes in the present value of the defined benefit obligation representing reconciliation of
opening and closing balances thereof are as follows:
Defined benefit pension Post-employment
plans medical benefits
20X5-X6 20X4-X5 20X5-X6 20X4-X5
Opening defined benefit obligation 18,400 11,600 6,405 5,439
Service cost 850 750 479 411
Interest cost 950 1,000 803 705
Actuarial losses (gains) 2,350 950 250 400
Losses (gains) on curtailments (500) -
Liabilities extinguished on settlements - (350)
Liabilities assumed in an amalgamation in
the nature of purchase - 5,000
Exchange differences on foreign plans 900 (150)

Benefits paid (650) (400) (600) (550)
Closing defined benefit obligation 22,300 18,400 7,337 6,405
Changes in the fair value of plan assets representing reconciliation of the opening and closing
balances thereof are as follows:
Defined benefit
pension plans
20X5-X6 20X4-X5
Opening fair value of plan assets 17,280 9,200
Expected return 900 650
Actuarial gains and (losses) (300) 1,600
Assets distributed on settlements (400) -
Contributions by employer 700 350
Assets acquired in an amalgamation in the
nature of purchase - 6,000
Exchange differences on foreign plans 890 (120)
Benefits paid (650) (400)
18,420 17,280
The Group expects to contribute Rs. 900 to its defined benefit pension plans in 20X6-X7.
The major categories of plan assets as a percentage of total plan assets are as follows:
Defined benefit Post-employment medical
pension plans benefits
20X5-X6 20X4-X5 20X5-X6 20X4-X5
Government of India Securities 80% 82% 78% 81%
High quality corporate bonds 11% 10% 12% 12%
Equity shares of listed companies 4% 3% 10% 7%
Property 5% 5% - -
Principal actuarial assumptions at the balance sheet date (expressed as weighted averages):
20X5-X6 20X4-X5
Discount rate at 31 March 5.0% 6.5%
Expected return on plan assets at 31 March 5.4% 7.0%
Proportion of employees opting for early retirement 30% 30%

Annual increase in healthcare costs 8% 8%
Future changes in maximum state health care benefits 3% 2%
The estimates of future salary increases, considered in actuarial valuation, take account of
inflation, seniority, promotion and other relevant factors, such as supply and demand in the
employment market.
Assumed healthcare cost trend rates have a significant effect on the amounts recognised in
the statement of profit and loss. At present, healthcare costs, as indicated in the principal
actuarial assumption given above, are expected to increase at 8% p.a. A one percentage
point change in assumed healthcare cost trend rates would have the following effects on the
aggregate of the service cost and interest cost and defined benefit obligation:
One percentage One percentage
point increase point decrease
Effect on the aggregate of the service cost
and interest cost 190 (150)
Effect on defined benefit obligation 1,000 (900)
Amounts for the current and previous four periods are as follows:
Defined benefit pension plans
20X5-X6 20X4-X5 20X3-X4 20X2-X3 20X1-X2
Defined benefit obligation (22,300) (18,400) (11,600) (10,582) (9,144)
Plan assets 18,420 17,280 9,200 8,502 10,000
Surplus/(deficit) (3,880) (1,120) (2,400) (2,080) 856
Experience adjustments on plan
liabilities (1,111) (768) (69) 543 (642)
assets (300) 1,600 (1,078) (2,890) 2,777
Post-employment medical benefits

20X5-X6 20X4-X5 20X3-X4 20X2-X3 20X1-X2
Defined benefit obligation 7,337 6,405 5,439 4,923 4,221
liabilities (232) 829 490 (174) (103)
The group also participates in an industry-wide defined benefit plan which provides pensions
linked to final salaries and is funded in a manner such that contributions are set at a level that
is expected to be sufficient to pay the benefits falling due in the same period. It is not
practicable to determine the present value of the group’s obligation or the related current
service cost as the plan computes its obligations on a basis that differs materially from the
basis used in [name of reporting enterprise]’s financial statements. [describe basis] On that
basis, the plan’s financial statements to 30 September 20X3 show an unfunded liability of Rs.
27,525. The unfunded liability will result in future payments by participating employers. The
plan has approximately 75,000 members, of whom approximately 5,000 are current or former
employees of [name of reporting enterprise] or their dependants. The expense recognised in
the statement of profit and loss, which is equal to contributions due for the year, and is not
included in the above amounts, was Rs. 230 (20X4-X5: Rs. 215). The group’s future
contributions may be increased substantially if other enterprises withdraw from the plan.
Appendix C
Note:This Appendix is not a part of the Accounting Standard. The purpose of this appendix is
only to bring out the major differences between Accounting Standard 15 (revised 2005) and
corresponding International Accounting Standard (IAS) 19, Employee Benefits (as amended in
December 2004).
Comparison with IAS 19, Employee Benefits (as amended in December 2004)
Revised AS 15 (2005) differs from International Accounting Standard (IAS) 19, Employees
Benefits, in the following major respects:
1. Recognition of Actuarial Gains and Losses
IAS 19 provides options to recognise actuarial gains and losses as follows:
(i) by following a ‘Corridor Approach’, which results in deferred recognition of the actuarial
gains and losses, or
(ii) immediately in the statement of profit and loss, or
(iii) immediately outside the profit or loss in a statement of changes in equity titled ‘statement
of recognised income and expense’.
The revised AS 15 (2005) does not admit options and requires that actuarial gains and losses
should be recognised immediately in the statement of profit and loss. The following are the
reasons of requiring immediate recognition in the statement of profit and loss:
(a) Deferred recognition and ‘corridor’ approaches are complex, artificial and difficult to
understand. They add to cost by requiring enterprises to keep complex records. They also
require complex provisions to deal with curtailments, settlements and transitional matters.
Also, as such approaches are not used for other uncertain assets and liabilities, it is not
appropriate to use the same for post-employment benefits.
(b) Immediate recognition of actuarial gains and losses represents faithfully the enterprise’s
financial position. An enterprise will report an asset only when a plan is in surplus and a
liability only when a plan has a deficit. Paragraph 94 of the Framework for the Preparation and
Presentation of Financial Statements notes that the application of the matching concept does
not allow the recognition of items in the balance sheet which do not meet the definition of
assets or liabilities. Deferred actuarial losses do not represent future benefits and hence do
not meet the Framework’s definition of an asset, even if offset against a related liability.
Similarly, deferred actuarial gains do not meet the Framework’s definition of a liability.
(c) Immediate recognition of actuarial gains and losses generates income and expense
items that are not arbitrary and that have information content.
(d) The primary argument for the ‘corridor approach’ is that in the long term, actuarial gains
and losses may offset one another. However, it is not reasonable to assume that all actuarial
gains or losses will be offset in future years; on the contrary, if the original actuarial
assumptions are still valid, future fluctuations will, on average, offset each other and thus will
not offset past fluctuations.
(e) Deferred recognition by using the ‘corridor approach’ attempts to avoid volatility.
However, a financial measure should be volatile if it purports to represent faithfully
transactions and other events that are themselves volatile.
(f) Immediate recognition is consistent with AS 5, Net Profit or Loss for the Period, Prior
Period Items and Changes in Accounting Policies. Under AS 5, the effect of changes in
accounting estimates should be included in net profit or loss for the period if the change
affects the current period only but not future periods. Actuarial gains and losses are not an
estimate of future events, but result from events before the balance sheet date that resolve a
past estimate (experience adjustments) or from changes in the estimated cost of employee
service before the balance sheet date (changes in actuarial assumptions).
(g) Any amortisation period (or the width of a ‘corridor’) is arbitrary.
(h) Actuarial gains and losses are items of income and expense. Recognition of such items
outside the statement of profit and loss, as per the option (iii) above is not appropriate.
(i) Immediate recognition requires less disclosure because all actuarial gains and losses are
recognised.
(j) Immediate recognition is also permitted under IAS 19. Providing only one treatment is in
line with the ICAI’s endeavour to eliminate alternatives, to the extent possible.
(k) The existing AS 15 (1995) also requires immediate recognition of actuarial gains and
losses.
2. Recognition of Defined Benefit Asset
Both IAS 19 and revised AS 15 (2005) specify an ‘asset ceiling’ in case of a situation of
defined benefit asset. AS 15 (2005) provides that the asset should be recognised only to the
extent of the present value of any economic benefits available in the form of refunds from the
plan or reductions in future contributions to the plan. IAS 19, on the other hand, provides that
the asset should be recognised to the extent of the total of (i) any cumulative unrecognised net
actuarial losses and past service cost; and (ii) the present value of any economic benefits
available in the form of refunds from the plan or reductions in future contributions to the plan.
IAS 19, however, also provides that the application of this should not result in a gain being
recognised solely as a result of an actuarial loss or past service cost in the current period or in
a loss being recognised solely as a result of an actuarial gain in the current period.
The aspect with regard to unrecognised net actuarial losses is not relevant in the context of
revised AS 15 (2005) since it does not permit the adoption of ‘corridor approach’. In respect
of past service cost, it is felt that in a situation of defined benefit asset, the asset, to the extent
of unrecognised past service cost, should not be required to be recognised in view of the
prudence consideration for preparation of financial statements.
3. Termination Benefits – Recognition of Liability
IAS 19 provides that an enterprise should recognise termination benefits as a liability and an
expense when, and only when, the enterprise is demonstrably committed to either (a)
terminate the employment of an employee or group of employees before the normal retirement
date; or (b) provide termination benefits as a result of an offer made in order to encourage
voluntary redundancy. It further provides that an enterprise is demonstrably committed to a
termination when, and only when, the enterprise has a detailed formal plan for the termination
and is without realistic possibility of withdrawal. It is felt that merely on the basis of a detailed
formal plan, it would not be appropriate to recognise a provision since a liability cannot be
considered to be crystalised at this stage. Accordingly, the revised AS 15 (2005) provides
criteria for recognition of liability in respect of termination benefits on the lines of AS 29,
Provisions, Contingent Liabilities and Contingent Assets.
4. Transitional Provisions
In respect of transitional liability for defined benefit plans, IAS 19 provides that if the
transitional liability is more than the liability that would have been recognised at the same date
under the enterprise’s previous accounting policy, the enterprise should make an irrevocable
choice to recognise that increase as part of its defined benefit liability (a) immediately, under
IAS 8 Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting
Policies; or (b) as an expense on a straight-line basis over up to five years from the date of
adoption subject to certain conditions. IAS 19 also requires that if the transitional liability is
less than the liability that would have been recognised at the same date under the enterprise’s
previous accounting policy, the enterprise should recognise that decrease immediately under
IAS 8.
The revised AS 15 (2005), on the other hand, provides no choice in this regard, and requires
that the difference between the transitional liability as per this Statement and the liability that
would have been recognised as per the pre-revised AS 15, should be adjusted against the
opening balance of revenue reserves and surplus. This treatment is in line with the
transitional provisions provided in other Indian Accounting Standards.
In respect of termination benefits, the revised AS 15 (2005), considering that the industry in
India at present is passing through a restructuring phase, specifically contains a transitional
provision providing that where an enterprise incurs expenditure on termination benefits on or
before 31st March, 2009, the enterprise may choose to follow the accounting policy of
deferring such expenditure over its pay-back period. However, the expenditure so deferred
cannot be carried forward to accounting periods commencing on or after 1st April, 2010. IAS
19 does not provide such a transitional provision.
AS 16 : BORROWING COSTS
and in the context of the ‘Preface to the Statements of Accounting Standards’).
The following is the text of Accounting Standard (AS) 16, ‘Borrowing Costs’, issued by the
Council of the Institute of Chartered Accountants of India. This Standard comes into effect in
respect of accounting periods commencing on or after 1-4-2000 and is mandatory in nature.
Paragraph 9.2 and paragraph 20 (except the first sentence) of Accounting Standard (AS) 10,
‘Accounting for Fixed Assets’, stand withdrawn from this date.
Objective
The objective of this Statement is to prescribe the accounting treatment for borrowing costs.
Scope
1. This statement should be applied in accounting for borrowing costs.
2. This Statement does not deal with the actual or imputed cost of owners’ equity, including
preference share capital not classified as a liability.
Definitions
Borrowing costs are interest and other costs incurred by an enterprise in connection
with the borrowing of funds.
A qualifying asset is an asset that necessarily takes a substantial period of time1 to get
ready for its intended use or sale.
1
See also Accounting Standards Interpretation (ASI)1.
4. Borrowing costs may include:

(a) interest and commitment charges on bank borrowings and other short-term and
long-term borrowings;
(b) amortisation of discounts or premiums relating to borrowings;
(c) amortisation of ancillary costs incurred in connection with the arrangement of
borrowings;
(d) finance charges in respect of assets acquired under finance leases or under other
similar arrangements; and
(e) exchange differences arising from foreign currency borrowings to the extent that they are
regarded as an adjustment to interest costs.∗
5. Examples of qualifying assets are manufacturing plants, power generation facilities,
inventories that require a substantial period of time to bring them to a saleable condition, and
investment properties. Other investments, and those inventories that are routinely
manufactured or otherwise produced in large quantities on a repetitive basis over a short
period of time, are not qualifying assets. Assets that are ready for their intended use or sale
when acquired also are not qualifying assets.
Recognition
6. Borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset should be capitalised as part of the cost of that asset.
The amount of borrowing costs eligible for capitalisation should be determined in
accordance with this Statement. Other borrowing costs should be recognised as an
expense in the period in which they are incurred.
7. Borrowing costs are capitalised as part of the cost of a qualifying asset when it is
probable that they will result in future economic benefits to the enterprise and the costs can be
measured reliably. Other borrowing costs are recognised as an expense in the period in which
they are incurred.
Borrowing Costs Eligible for Capitalisation

8. The borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset are those borrowing costs that would have been avoided if the
expenditure on the qualifying asset had not been made. when an enterprise borrows funds
specifically for the purpose of obtaining a particular qualifying asset, the borrowing costs that
∗
See also Accounting Standards Interpretation (ASI)1.
directly relate to that qualifying asset can be readily identified.

9. It may be difficult to identify a direct relationship between particular borrowings and a
qualifying asset and to determine the borrowings that could otherwise have been avoided.
Such a difficulty occurs, for example, when the financing activity of an enterprise is
coordinated centrally or when a range of debt instruments are used to borrow funds at varying
rates of interest and such borrowings are not readily identifiable with a specific qualifying
asset. As a result, the determination of the amount of borrowing costs that are directly
attributable to the acquisition, construction or production of a qualifying asset is often difficult
and the exercise of judgement is required.
10. To the extent that funds are borrowed specifically for the purpose of obtaining a
qualifying asset, the amount of borrowing costs eligible for capitalisation on that asset
should be determined as the actual borrowing costs incurred on that borrowing during
the period less any income on the temporary investment of those borrowings.
11. The financing arrangements for a qualifying asset may result in an enterprise obtaining
borrowed funds and incurring associated borrowing costs before some or all of the funds are
used for expenditure on the qualifying asset. In such circumstances, the funds are often
temporarily invested pending their expenditure on the qualifying asset. In determining the
amount of borrowing costs eligible for capitalisation during a period, any income earned on the
temporary investment of those borrowings is deducted from the borrowing costs incurred.
12. To the extent that funds are borrowed generally and used for the purpose of
obtaining a qualifying asset, the amount of borrowing costs eligible for capitalisation
should be determined by applying a capitalisation rate to the expenditure on that asset.
The capitalisation rate should be the weighted average of the borrowing costs
applicable to the borrowings of the enterprise that are outstanding during the period,
other than borrowings made specifically for the purpose of obtaining a qualifying asset.
The amount of borrowing costs capitalised during a period should not exceed the
amount of borrowing costs incurred during that period.
EXCESS OF THE CARRYING AMOUNT OF THE QUALIFYING ASSET OVER

RECOVERABLE AMOUNT
13. When the carrying amount or the expected ultimate cost of the qualifying asset exceeds
its recoverable amount or net realisable value, the carrying amount is written down or written
off in accordance with the requirements of other Accounting Standards. In certain
circumstances, the amount of the write-down or write-off is written back in accordance with
those other Accounting Standards.
COMMENCEMENT OF CAPITALISATION
14. The capitalisation of borrowing costs as part of the cost of a qualifying asset
should commence when all the following conditions are satisfied:
(a) expenditure for the acquisition, construction or production of a qualifying asset is
being incurred;
(b) borrowing costs are being incurred; and
(c) activities that are necessary to prepare the asset for its intended use or sale are in
progress.
15. Expenditure on a qualifying asset includes only such expenditure that has resulted in
payments of cash, transfers of other assets or the assumption of interest-bearing liabilities.
Expenditure is reduced by any progress payments received and grants received in connection
with the asset (see Accounting Standard 12, Accounting for Government Grants). The
average carrying amount of the asset during a period, including borrowing costs previously
capitalised, is normally a reasonable approximation of the expenditure to which the
capitalisation rate is applied in that period.
16. The activities necessary to prepare the asset for its intended use or sale encompass
more than the physical construction of the asset. They include technical and administrative
work prior to the commencement of physical construction, such as the activities associated
with obtaining permits prior to the commencement of the physical construction. However, such
activities exclude the holding of an asset when no production or development that changes the
asset’s condition is taking place. For example, borrowing costs incurred while land is under
development are capitalised during the period in which activities related to the development
are being undertaken. However, borrowing costs incurred while land acquired for building
purposes is held without any associated development activity do not qualify for capitalisation.
SUSPENSION OF CAPITALISATION
17. Capitalisation of borrowing costs should be suspended during extended periods in
which active development is interrupted.
18. Borrowing costs may be incurred during an extended period in which the activities
necessary to prepare an asset for its intended use or sale are interrupted. Such costs are
costs of holding partially completed assets and do not qualify for capitalisation. However,
capitalisation of borrowing costs is not normally suspended during a period when substantial
technical and administrative work is being carried out. Capitalisation of borrowing costs is
also not suspended when a temporary delay is a necessary part of the process of getting an
asset ready for its intended use or sale. For example, capitalisation continues during the
extended period needed for inventories to mature or the extended period during which high
water levels delay construction of a bridge, if such high water levels are common during the
construction period in the geographic region involved.
CESSATION OF CAPITALISATION
19. Capitalisation of borrowing costs should cease when substantially all the
activities necessary to prepare the qualifying asset for its intended use or sale are
complete.
20. An asset is normally ready for its intended use or sale when its physical construction or
production is complete even though routine administrative work might still continue. If minor
modifications, such as the decoration of a property to the user’s specification, are all that are
outstanding, this indicates that substantially all the activities are complete.
21. When the construction of a qualifying asset is completed in parts and a completed
part is capable of being used while construction continues for the other parts,
capitalisation of borrowing costs in relation to a part should cease when substantially
all the activities necessary to prepare that part for its intended use or sale are complete.
22. A business park comprising several buildings, each of which can be used individually, is
an example of a qualifying asset for which each part is capable of being used while
construction continues for the other parts. An example of a qualifying asset that needs to be
complete before any part can be used is an industrial plant involving several processes which
are carried out in sequence at different parts of the plant within the same site, such as a steel
mill.
DISCLOSURE
23. The financial statements should disclose:
(a) the accounting policy adopted for borrowing costs; and
(b) the amount of borrowing costs capitalised during the period.
AS 17 : SEGMENT REPORTING
The following is the text of Accounting Standard 17, ‘Segment Reporting’, issued by the
Council of the Institute of Chartered Accountants of India. This Standard comes into effect in
respect of accounting periods commencing on or after 1.4.2001.
The standard is mandatory in nature in respect of accounting periods commencing on or after
1-4-2003∗ for the enterprises fall in any one or more of the following categories, at any time
during during the accounting period:
(ii) Enterprises which are in the process of listing their equity or debtsecurities as evidenced
by the Board’s resolution in this regard.
OBJECTIVE
The objective of this Statement is to establish principles for reporting financial information,
about the different types of products and services an enterprise produces and the different
geographical areas in which it operates. Such information helps users of financial statements :
(a) better understand the performance of the enterprise;
(b) better assess the risks and returns of the enterprise; and
(c) make more informed judgements about the enterprise as a whole.
Many enterprises provide groups of products and services or operate in geographical areas
that are subject to differing rates of profitability, opportunities for growth, future prospects, and
risks. Information about different types of products and services of an enterprise and its
operations in different geographical areas - often called segment information - is relevant to
assessing the risks and returns of a diversified or multi-locational enterprise but may not be
determinable from the aggregated data. Therefore, reporting of segment information is widely
regarded as necessary for meeting the needs of users of financial statements.
SCOPE
1. This Statement should be applied in presenting general purpose financial
statements.
2. The requirements of this Statement are also applicable in case of consolidated financial
statements.
∗
AS 17 was originally made mandatory in respect of accounting periods commencing on or after 1-4-2001for the
following enterprises:
(i) Enterprises whose equity or debt securities are listed on a recognised stock exchange in India, and enterprises
that are in the process of issuing equity or debt securities that will be listed on a recognised stock exchange in
India as evidenced by the board of directors’ resolution in this regard.
(ii) All other commercial, industrial and business reporting enterprises, whose turnover for the accounting period
exceeds Rs. 50 crores.
3. An enterprise should comply with the requirements of this Statement fully and not
selectively.
4. If a single financial report contains both consolidated financial statements and the
separate financial statements of the parent, segment information need be presented
only on the basis of the consolidated financial statements. In the context of reporting of
segment information in consolidated financial statements, the references in this
Statement to any financial statement items should construed to be the relevant item as
appearing in the consolidated financial statements.
DEFINITIONS
A business segment is 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. Factors that should be considered in determining whether products or
services are related include:
(a) the nature of the products or services;
(b) the nature of the production processes;
(c) the type or class of customers for the products or services;
(d) the methods used to distribute the products or provide the services; and
(e) if applicable, the nature of the regulatory environment, for example, banking,
insurance, or public utilities.
A geographical segment is 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. Factors that should be considered in
identifying geographical segments include:
(a) similarity of economic and political conditions;
(b) relationships between operations in different geographical areas;
(c) proximity of operations;
(d) special risks associated with operations in a particular area;
(e) exchange control regulations; and
(f) the underlying currency risks.
A reportable segment is a business segment or a geographical segment identified on
the basis of foregoing definitions for which segment information is required to be

disclosed by this Statement.
Enterprise revenue is revenue from sales to external customers as reported in the
statement of profit and loss.
Segment revenue is the aggregate of
(i) the portion of enterprise revenue that is directly attributable to a segment,
(ii) the relevant portion of enterprise revenue that can be allocated on a reasonable
basis to a segment, and
(iii) revenue from transactions with other segments of the enterprise.
Segment revenue does not include:
(a) extraordinary items as defined in AS 5, Net Profit or Loss for the Period, Prior
Period Items and Changes in Accounting Policies;
(b) interest or dividend income, including interest earned on advances or loans to
other segments, unless the operations of the segment are primarily of a financial
nature; and
(c) gains on sales of investments or on extinguishment of debt unless the operations
of the segment are primarily of a financial nature.
Segment expense is the aggregate of
(i) the expense resulting from the operating activities of a segment that is directly
attributable to the segment, and
(ii) the relevant portion of enterprise expense that can be allocated on a reasonable
basis to the segment.
including expense relating to transactions with other segments of the enterprise.
Segment expense does not include:
(a) extraordinary items are defined in AS 5, Net Profit or Loss for the Period, Prior
Period Items and Changes in Accounting Policies.
(b) interest expense, including interest incurred on advances or loans from other
segments, unless the operations of the segment are primarily of a financial nature;
(c) losses on sales of investments or losses on extinguishment of debt unless the
operations of the segment are primarily of a financial nature;
(d) income tax expense; and
(e) general administrative expenses, head-office expenses, and other expenses that
arise at the enterprise level and relate to the enterprise as a whole. However, costs
are sometimes incurred at the enterprise level on behalf of a segment. Such costs
are part of segment expense if they relate to the operating activities of the segment
and if they can be directly attributed or allocated to the segment on a reasonable
basis
Segment result is segment revenue less segment expense.
Segment assets are those operating assets that are employed by a segment in its
operating activities and that either are directly attributable to the segment or can be
allocated to the segment on a reasonable basis.
If the segment result of a segment includes interest or dividend income, its segment
assets include the related receivables, loans, investments, or other interest or dividend
generating assets.
Segment assets do not include income tax assets.
Segment assets are determined after deducting related allowances/provisions that are
reported as direct offsets in the balance sheet of the enterprise.
Segment liabilities are those operating liabilities that result from the operating activities
of a segment and that either are directly attributable to the segment or can be allocated
to the segment on a reasonable basis.
If the segment result of a segment includes interest expense, its segment liabilities
include the related interest-bearing liabilities.
Segment liabilities do not include income tax liabilities.
Segment accounting policies are the accounting policies adopted for preparing and
presenting the financial statements of the enterprise as well as those accounting
policies that relate specifically to segment reporting.
6. The factors in paragraph 5 for identifying business segments and geographical segments
are not listed in any particular order.
7. A single business segment does not include products and services with significantly
differing risks and returns. While there may be dissimilarities with respect to one or several of
the factors listed in the definition of business segment, the products and services included in a
single business segment are expected to be similar with respect to a majority of the factors.
8. Similarly, a single geographical segment does not include operations in economic
environments with significantly differing risks and returns. A geographical segment may be a
single country, a group of two or more countries, or a region within a country.
9. The risks and returns of an enterprise are influenced both by the geographical location of
its operations (where its products are produced or where its service rendering activities are
based) and also by the location of its customers (where its products are sold or services are
rendered). The definition allows geographical segments to be based on either:

(a) the location of production or service facilities and other assets of an enterprise; or
(b) the location of its customers.
10. The organisational and internal reporting structure of an enterprise will normally provide
evidence of whether its dominant source of geographical risks results from the location of its
assets (the origin of its sales) or the location of its customers (the destination of its sales).
Accordingly, an enterprise looks to this structure to determine whether its geographical
segments should be based on the location of its assets or on the location of its customers.
11. Determining the composition of a business or geographical segment involves a certain
amount of judgement. In making that judgement, enterprise management takes into account
the objective of reporting financial information by segment as set forth in this Statement and
the qualitative characteristics of financial statements as identified in the Framework for the
Preparation and Presentation of Financial Statements issued by the Institute of Chartered
Accountants of India. The qualitative characteristics include the relevance, reliability, and
comparability over time of financial information that is reported about the different groups of
products and services of an enterprise and about its operations in particular geographical
areas, and the usefulness of that information for assessing the risks and returns of the
enterprise as a whole.
12. The predominant sources of risks affect how most enterprises are organised and
managed. Therefore, the organisational structure of an enterprise and its internal financial
reporting system are normally the basis for identifying its segments.
13. The definitions of segment revenue segment expense, segment assets and segment
liabilities include amounts of such items that are directly attributable to a segment and
amounts of such items that can be allocated to a segment on a reasonable basis. An
enterprise looks to its internal financial reporting system as the starting point for identifying
those items that can be directly attributed, or reasonably allocated, to segments. There is thus
a presumption that amounts that have been identified with segments for internal financial
reporting purposes are directly attributable or reasonably allocable to segments for the
purpose of measuring the segment revenue, segment expense, segment assets, and segment
liabilities of reportable segments.
14. In some cases, however, a revenue, expense, asset or liability may have been allocated
to segments for internal financial reporting purposes on a basis that is understood by
enterprise management but that could be deemed arbitrary in the perception of external users
of financial statements. Such an allocation would not constitute a reasonable basis under the
definitions of segment revenue, segment expense, segment assets, and segment liabilities in
this Statement. Conversely, an enterprise may choose not to allocate some item of revenue,
expense, asset or liability for internal financial reporting purposes, even though a reasonable
basis for doing so exists. Such an item is allocated pursuant to the definitions of segment
revenue, segment expense, segment assets, and segment liabilities in this Statement.
15. Examples of segment assets include current assets that are used in the operating
activities of the segment and tangible and intangible fixed assets. If a particular item of
depreciation or amortisation is included in segment expense, the related asset is also included
in segment assets. Segment assets do not include assets used for general enterprise or head-
office purposes. Segment assets include operating assets shared by two or more segments if
a reasonable basis for allocation exists. Segment assets include goodwill that is directly
attributable to a segment or that can be allocated to a segment on a reasonable basis, and
segment expense includes related amortisation of goodwill. If segment assets have been
revalued subsequent to acquisition, then the measurement of segment assets reflects those
revaluations.
16. Examples of segment liabilities include trade and other payables, accrued liabilities,
customer advances, product warranty provisions, and other claims relating to the provision of
goods and services. Segment liabilities do not include borrowings and other liabilities that are
incurred for financing rather than operating purposes. The liabilities of segments whose
operations are not primarily of a financial nature do not include borrowings and similar
liabilities because segment result represents an operating, rather than a net-of-financing, profit
or loss. Further, because debt is often issued at the head-office level on an enterprise-wide
basis, it is often not possible to directly attribute, or reasonably allocate, the interest-bearing
liabilities to segments.
17. Segment revenue, segment expense, segment assets and segment liabilities are
determined before intra-enterprise balances and intra-enterprise transactions are eliminated
as part of the process of preparation of enterprise financial statements, except to the extent
that such intra-enterprise balances and transactions are within a single segment.
18. While the accounting policies used in preparing and presenting the financial statements
of the enterprise as a whole are also the fundamental segment accounting policies, segment
accounting policies include, in addition, policies that relate specifically to segment reporting,
such as identification of segments, method of pricing inter-segment transfers, and basis for
allocating revenues and expenses to segments.
IDENTIFYING REPORTABLE SEGMENTS
Primary and Secondary Segment Reporting Formats

19. The dominant source and nature of risks and returns of an enterprise should
govern whether its primary segment reporting format will be business segments or
geographical segments. If the risks and returns of an enterprise are affected
predominantly by differences in the products and services it produces, its primary
format for reporting segment information should be business segments, with secondary
information reported geographically. Similarly, if the risks and returns of the enterprise
are affected predominantly by the fact that it operates in different countries or other
geographical areas, its primary format for reporting segment information should be
geographical segments, with secondary information reported for groups of related
products and services.
20. Internal organisation and management structure of an enterprise and its system of
internal financial reporting to the board of directors and the chief executive officer
should normally be the basis for identifying the predominant source and nature of risks
and differing rates of return facing the enterprise and, therefore, for determining which
reporting format is primary and which is secondary, except as provided in sub-
paragraphs (a) and (b) below:
(a) if risks and returns of an enterprise are strongly affected both by differences in the
products and services it produces and by differences in the geographical areas in
which it operates, as evidenced by a “matrix approach” to managing the company
and to reporting internally to the board of directors and the chief executive officer,
then the enterprise should use business segments as its primary segment
reporting format and geographical segments as its secondary reporting format;
and
(b) if internal organisational and management structure of an enterprise and its
system of internal financial reporting to the board of directors and the chief
executive officer are based neither on individual products or services or groups of
related products/services nor on geographical areas, the directors and
management of the enterprise should determine whether the risks and returns of
the enterprise are related more to the products and services it produces or to the
geographical areas in which it operates and should, accordingly, choose business
segments or geographical segments as the primary segment reporting
format of the enterprise, with the other as its secondary reporting
format.
21. For most enterprises, the predominant source of risks and returns determines how the
enterprise is organised and managed. Organisational and management structure of an
enterprise and its internal financial reporting system normally provide the best evidence of the
predominant source of risks and returns of the enterprise for the purpose of its segment
reporting. Therefore, except in rare circumstances, an enterprise will report segment
information in its financial statements on the same basis as it reports internally to top
management. Its predominant source of risks and returns becomes its primary segment
reporting format. Its secondary source of risks and returns becomes its secondary segment
reporting format.
22. A ‘matrix presentation’ - both business segments and geographical segments as primary
segment reporting formats with full segment disclosures on each basis - will often provide
useful information if risks and returns of an enterprise are strongly affected both by differences
in the products and services it produces and by differences in the geographical areas in which
it operates. This Statement does not require, but does not prohibit, a ‘matrix presentation’.
23. In some cases, organisation and internal reporting of an enterprise may have developed
along lines unrelated to both the types of products and services it produces, and the
geographical areas in which it operates. In such cases, the internally reported segment data
will not meet the objective of this Statement. Accordingly, paragraph 20(b) requires the
directors and management of the enterprise to determine whether the risks and returns of the
enterprise are more product/service driven or geographically driven and to accordingly choose
business segments or geographical segments as the primary basis of segment reporting. The
objective is to achieve a reasonable degree of comparability with other enterprises, enhance
understandability of the resulting information, and meet the needs of investors, creditors, and
others for information about product/service-related and geographically-related risks and
returns.
Business and Geographical Segments

24. 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,
except as provided in paragraph 25.
25. If internal organisational and management structure of an enterprise and its
system of internal financial reporting to the board of directors and the chief executive
officer are based neither on individual products or services or groups of related
products/services nor on geographical areas, paragraph 20(b) requires that the
directors and management of the enterprise should choose either business segments
or geographical segments as the primary segment reporting format of the enterprise
based on their assessment of which reflects the primary source of the risks and returns
of the enterprise, with the other as its secondary reporting format. In that case, the
directors and management of the enterprise should determine its business segments
and geographical segments for external reporting purposes based on the factors in the
definitions in paragraph 5 of this Statement, rather than on the basis of its system of
internal financial reporting to the board of directors and chief executive officer,
consistent with the following:
(a) if one or more of the segments reported internally to the directors and
management is a business segment or a geographical segment based on the
factors in the definitions in paragraph 5 but others are not, sub-paragraph (b)
below should be applied only to those internal segments that do not meet the
definitions in paragraph 5 (that is, an internally reported segment that meets the
definition should not be further segmented);
(b) for those segments reported internally to the directors and management that do
not satisfy the definitions in paragraph 5, management of the enterprise should
look to the next lower level of internal segmentation that reports information along
product and service lines or geographical lines, as appropriate under the
definitions in paragraph 5; and
(c) if such an internally reported lower-level segment meets the definition of business
segment or geographical segment based on the factors in paragraph 5, the criteria
in paragraph 27 for identifying reportable segments should be applied to that
segment.
26. Under this Statement, most enterprises will identify their business and geographical
segments as the organisational units for which information is reported to the board of the
directors (particularly the non-executive directors, if any) and to the chief executive officer (the
senior operating decision maker, which in some cases may be a group of several people) for
the purpose of evaluating each unit’s performance and for making decisions about future
allocations of resources. Even if an enterprise must apply paragraph 25 because its internal
segments are not along product/service or geographical lines, it will consider the next lower
level of internal segmentation that reports information along product and service lines or
geographical lines rather than construct segments solely for external reporting purposes. This
approach of looking to organisational and management structure of an enterprise and its
internal financial reporting system to identify the business and geographical segments of the
enterprise for external reporting purposes is sometimes called the ‘management approach’,
and the organisational components for which information is reported internally are sometimes
called ‘operating segments’.
Reportable Segments
27. A business segment or geographical segment should be identified as a reportable
segment if:
(a) its revenue 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
(b) its segment result, whether profit or loss, is 10 per cent or more of -
(i) the combined result of all segments in profit, or
(ii) the combined result of all segments in loss,
whichever is greater in absolute amount; or
(c) its segment assets are 10 per cent or more of the total assets of all segments.
28. A business segment or a geographical segment which is not a reportable segment
as per paragraph 27, may be designated as a reportable segment despite its size at the
discretion of the management of the enterprise. If that segment is not designated as a

reportable segment, it should be included as an unallocated reconciling item.
29. If total external revenue attributable to reportable segments constitutes less than
75 per cent of the total enterprise revenue, additional segments should be identified as
reportable segments, even if they do not meet the 10 per cent thresholds in paragraph
27, until at least 75 per cent of total enterprise revenue is included in reportable
segments.
30. The 10 per cent thresholds in this Statement are not intended to be a guide for
determining materiality for any aspect of financial reporting other than identifying reportable
business and geographical segments.
Appendix II to this Statement presents an illustration of the determination of reportable
segments as per paragraphs 27-29.
31. A segment identified as a reportable segment in the immediately preceding period
because it satisfied the relevant 10 per cent thresholds should continue to be a
reportable segment for the current period notwithstanding that its revenue, result, and
assets all no longer meet the 10 per cent thresholds.
32 If a segment is identified as a reportable segment in the current period because it
satisfies the relevant 10 per cent thresholds, preceding-period segment data that is
presented for comparative purposes should, unless it is impracticable to do so, be
restated to reflect the newly reportable segment as a separate segment, even if that
segment did not satisfy the 10 per cent thresholds in the preceding period.
SEGMENT ACCOUNTING POLICIES

33. 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.
34. 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 Statement 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.
35. This Statement does not prohibit the disclosure of additional segment information that is
prepared on a basis other than the accounting policies adopted for the enterprise financial
statements provided that (a) the information is reported internally to the board of directors and
the chief executive officer for purposes of making decisions about allocating resources to the
segment and assessing its performance and (b) the basis of measurement for this additional
information is clearly described.
36. Assets and liabilities that relate jointly to two or more segments should be
allocated to segments if, and only if, their related revenues and expenses also are
allocated to those segments.
37. The way in which asset, liability, revenue, and expense items are allocated to segments
depends on such factors as the nature of those items, the activities conducted by the
segment, and the relative autonomy of that segment. It is not possible or appropriate to
specify a single basis of allocation that should be adopted by all enterprises; nor is it
appropriate to force allocation of enterprise asset, liability, revenue, and expense items that
relate jointly to two or more segments, if the only basis for making those allocations is
arbitrary. At the same time, the definitions of segment revenue, segment expense, segment
assets, and segment liabilities are interrelated, and the resulting allocations should be
consistent. Therefore, jointly used assets and liabilities are allocated to segments if, and only
if, their related revenues and expenses also are allocated to those segments. For example, an
asset is included in segment assets if, and only if, the related depreciation or amortisation is
included in segment expense.
DISCLOSURE
38. Paragraphs 39-46 specify the disclosures required for reportable segments for primary
segment reporting format of an enterprise. Paragraphs 47-51 identify the disclosures required
for secondary reporting format of an enterprise. Enterprises are encouraged to make all of the
primary-segment disclosures identified in paragraphs 39-46 for each reportable secondary
segment although paragraphs 47-51 require considerably less disclosure on the secondary
basis. Paragraphs 53-59 address several other segment disclosure matters. Appendix III to
this Statement illustrates the application of these disclosure standards.
PRIMARY REPORTING FORMAT

39. The disclosure requirements in paragraphs 40-46 should be applied to each
reportable segment based on primary reporting format of an enterprise.
40. An enterprise should disclose the following for each reportable segment:
(a) segment revenue, classified into segment revenue from sales to external
customers and segment revenue from transactions with other segments;

(b) segment result;
(c) total carrying amount of segment assets;
(d) total amount of segment liabilities;
(e) total cost incurred during the period to acquire segment assets that are
expected to be used during more than one period (tangible and intangible
fixed assets);
(f) total amount of expense included in the segment result for depreciation and
amortisation in respect of segment assets for the period; and
(g) total amount of significant non-cash expenses, other than depreciation and
amortisation in respect of segment assets, that were included in segment
expense and, therefore, deducted in measuring segment result.
41. Paragraph 40 (b) requires an enterprise to report segment result. If an enterprise can
compute segment net profit or loss or some other measure of segment profitability other than
segment result, without arbitrary allocations, reporting of such amount(s) in addition to
segment result is encouraged. If that measure is prepared on a basis other than the
accounting policies adopted for the financial statements of the enterprise, the enterprise will
include in its financial statements a clear description of the basis of measurement.
42. An example of a measure of segment performance above segment result in the
statement of profit and loss is gross margin on sales. Examples of measures of segment
performance below segment result in the statement of profit and loss are profit or loss from
ordinary activities (either before or after income taxes) and net profit or loss.
43. Accounting Standard 5, ‘Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies’ requires that “when items of income and expense within profit
or loss from ordinary activities are of such size, nature or incidence that their disclosure is
relevant to explain the performance of the enterprise for the period, the nature and amount of
such items should be disclosed separately”. Examples of such items include write-downs of
inventories, provisions for restructuring, disposals of fixed assets and long-term investments,
legislative changes having retrospective application, litigation settlements, and reversal of
provisions. An enterprise is encouraged, but not required, to disclose the nature and amount
of any items of segment revenue and segment expense that are of such size, nature, or
incidence that their disclosure is relevant to explain the performance of the segment for the
period. Such disclosure is not intended to change the classification of any such items of
revenue or expense from ordinary to extraordinary or to change the measurement of such
items. The disclosure, however, does change the level at which the significance of such items
is evaluated for disclosure purposes from the enterprise level to the segment level.
44. An enterprise that reports the amount of cash flows arising from operating,
investing and financing activities of a segment need not disclose depreciation and
amortisation expense and non-cash expenses of such segment pursuant to sub-
paragraphs (f) and (g) of paragraph 40.
45. AS 3, Cash Flow Statements, recommends that an enterprise present a cash flow
statement that separately reports cash flows from operating, investing and financing activities.
Disclosure of information regarding operating, investing and financing cash flows of each
reportable segment is relevant to understanding the enterprise’s overall financial position,
liquidity, and cash flows. Disclosure of segment cash flow is, therefore, encouraged, though
not required. An enterprise that provides segment cash flow disclosures need not disclose
depreciation and amortisation expense and non-cash expenses pursuant to sub-paragraphs (f)
and (g) of paragraph 40.
46. An enterprise should present a reconciliation between the information disclosed
for reportable segments and the aggregated information in the enterprise financial
statements. In presenting the reconciliation, segment revenue should be reconciled to
enterprise revenue; segment result should be reconciled to enterprise net profit or loss;
segment assets should be reconciled to enterprise assets; and segment liabilities
should be reconciled to enterprise liabilities.
SECONDARY SEGMENT INFORMATION

47. Paragraphs 39-46 identify the disclosure requirements to be applied to each reportable
segment based on primary reporting format of an enterprise. Paragraphs 48-51 identify the
disclosure requirements to be applied to each reportable segment based on secondary
reporting format of an enterprise, as follows:
(a) if primary format of an enterprise is business segments, the required secondary-format
disclosures are identified in paragraph 48;
(b) if primary format of an enterprise is geographical segments based on location of assets
(where the products of the enterprise are produced or where its service rendering operations
are based), the required secondary-format disclosures are identified in paragraphs 49 and 50;
(c) if primary format of an enterprise is geographical segments based on the location of its
customers (where its products are sold or services are rendered), the required secondary-
format disclosures are identified in paragraphs 49 and 51.
48. If primary format of an enterprise for reporting segment information is business
segments, it should also report the following information:
(a) segment revenue from external customers by geographical area based on the
geographical location of its customers, for each geographical segment whose
revenue from sales to external customers is 10 per cent or more of enterprise
revenue;
(b) the total carrying amount of segment assets by geographical location of assets, for
each geographical segment whose segment assets are 10 per cent or more of the
total assets of all geographical segments; and
(c) the total cost incurred during the period to acquire segment assets that are
expected to be used during more than one period (tangible and intangible fixed
assets) by geographical location of assets, for each geographical segment whose
segment assets are 10 per cent or more of the total assets of all geographical
segments.
49. If primary format of an enterprise for reporting segment information is
geographical segments (whether based on location of assets or location of customers),
it should also report the following segment information for each business segment
whose revenue from sales to external customers is 10 per cent or more of enterprise
revenue or whose segment assets are 10 per cent or more of the total assets of all
business segments:
(a) segment revenue from external customers;
(b) the total carrying amount of segment assets; and
(c) the total cost incurred during the period to acquire segment assets that are
assets).
geographical segments that are based on location of assets, and if the location of its
customers is different from the location of its assets, then the enterprise should also
report revenue from sales to external customers for each customer-based geographical
segment whose revenue from sales to external customers is 10 per cent or more of
enterprise revenue.
geographical segments that are based on location of customers, and if the assets of the
enterprise are located in different geographical areas from its customers, then the
enterprise should also report the following segment information for each asset-based
geographical segment whose revenue from sales to external customers or segment
assets are 10 per cent or more of total enterprise amounts:
(a) the total carrying amount of segment assets by geographical location of the
assets; and
(b) the total cost incurred during the period to acquire segment assets that are
assets) by location of the assets.
ILLUSTRATIVE SEGMENT DISCLOSURES

52. Appendix III to this Statement presents an illustration of the disclosures for primary and
secondary formats that are required by this Statement.
OTHER DISCLOSURES
53. In measuring and reporting segment revenue from transactions with other
segments, inter-segment transfers should be measured on the basis that the enterprise
actually used to price those transfers. The basis of pricing inter-segment transfers and
any change therein should be disclosed in the financial statements.
54. Changes in accounting policies adopted for segment reporting that have a material
effect on segment information should be disclosed. Such disclosure should include a
description of the nature of the change, and the financial effect of the change if it is
reasonably determinable.
55. AS 5 requires that changes in accounting policies adopted by the enterprise should be
made only if 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 events or
transactions in the financial statements of the enterprise.
56. Changes in accounting policies adopted at the enterprise level that affect segment
information are dealt with in accordance with AS 5. AS 5 requires that any change in an
accounting policy which has a material effect should be disclosed. The impact of, and the
adjustments resulting from, such change, if material, should be shown in the financial
statements of the period in which such change is made, to reflect the effect of such change.
Where the effect of such change is not ascertainable, wholly or in part, the fact should be
indicated. If a change is made in the accounting policies which has no material effect on the
financial statements for the current period but which is reasonably expected to have a material
effect in later periods, the fact of such change should be appropriately disclosed in the period
in which the change is adopted.
57. Some changes in accounting policies relate specifically to segment reporting. Examples
include changes in identification of segments and changes in the basis for allocating revenues
and expenses to segments. Such changes can have a significant impact on the segment
information reported but will not change aggregate financial information reported for the
enterprise. To enable users to understand the imspact of such changes, this Statement
requires the disclosure of the nature of the change and the financial effect of the change, if
reasonably determinable.
58. An enterprise should indicate the types of products and services included in each
reported business segment and indicate the composition of each reported geographical
segment, both primary and secondary, if not otherwise disclosed in the financial
statements.
59. To assess the impact of such matters as shifts in demand, changes in the prices of inputs
or other factors of production, and the development of alternative products and processes on a
business segment, it is necessary to know the activities encompassed by that segment.
Similarly, to assess the impact of changes in the economic and political environment on the
risks and returns of a geographical segment, it is important to know the composition of that
geographical segment.
Appendix I
Segment Definition Decision Tree
The purpose of this appendix is to illustrate the application of paragraphs 24-32 of the Accounting
Standard
Do the segments reflected in the management reporting system meet the requisite
definitions of business or geographical segments in para 5 (para 24)
Yes No
Use the segments reported to the board of Do some management reporting segments
directors and CEO as business segments meet the definitions in para 5 (para 20)
of geographical segment (para 20)
No Yes
For those segments that do not meet the definitions, go to the next Those segments
lower level of internal segmentation that reports information along may be reportable
product/service lines or geographical lines (para 25) segments
Does the segment exceed the quantitative thresholds (para 27)
Yes
No This segment is a reportable segment
a. This segment may be separately reported desp ite its size.

b. If no t separately rep orted, it is unallocate d reco nciling item (para 28 )
Does total segment external revenue exce ed No Identify additional segmen ts un til 75%
75% of total enterprise revenue (para 29) threshold is reached (para 29)
APPENDIX II
Illustration on Determination of Reportable Segments [Paragraphs 27-29]
This appendix is illustrative only and does not form part of the Accounting Standard. The
purpose of this appendix is to illustrate the application of paragraphs 27-29 of the Accounting
Standard.
An enterprise operates through eight segments, namely, A, B, C, D, E, F, G and H. The

relevant information about these segments is given in the following table (amounts in Rs.’000):
A B C D E F G H Total Total
(Segments) (Enterprise)
1. SEGMENT REVENUE
(a) External Sales - 255 15 10 15 50 20 35 400
(b) Inter-segment Sales 100 60 30 5 - - 5 - 200
(c) Total Revenue 100 315 45 15 15 50 25 35 600 400
2. Total Revenue of each 16.7 52.5 7.5 2.5 2.5 8.3 4.2 5.8
segment as a percentage
of total revenue of all
segments
3.SEGMENT RESULT 5 (90) 15 (5) 8 (5) 5 7
[Profit/(Loss)]
4. Combined Result of 5 15 8 5 7 40
all Segments in profits
5. Combined Result of (90) (5) (5) (100)
all Segments in loss
6. Segment Result as a 5 90 15 5 8 5 5 7
percentage of the greater
of the totals arrived at
4 and 5 above in abso-
lute amount (i.e., 100)
7.SEGMENT ASSETS 15 47 5 11 3 5 5 9 100
8. Segment assets as a 15 47 5 11 3 5 5 9
per centage of total assets
of all segments
The reportable segments of the enterprise will be identified as below:

(a) In accordance with paragraph 27(a), segments whose total revenue from external sales
and inter-segment sales is 10% or more of the total revenue of all segments, external
and internal, should be identified as reportable segments. Therefore, Segments A and B
are reportable segments.

(b) As per the requirements of paragraph 27(b), it is to be first identified whether the
combined result of all segments in profit or the combined result of all segments in loss is
greater in absolute amount. From the table, it is evident that combined result in loss (i.e.,
Rs.100,000) is greater. Therefore, the individual segment result as a percentage of
Rs.100,000 needs to be examined. In accordance with paragraph 27(b), Segments B and
C are reportable segments as their segment result is more than the threshold limit of
10%.
(c) Segments A, B and D are reportable segments as per paragraph 27(c), as their segment
assets are more than 10% of the total segment assets.
Thus, Segments A, B, C and D are reportable segments in terms of the criteria laid down in
paragraph 27.
Paragraph 28 of the Statement gives an option to the management of the enterprise to
designate any segment as a reportable segment. In the given case, it is presumed that the
management decides to designate Segment E as a reportable segment.
Paragraph 29 requires that if total external revenue attributable to reportable segments
identified as aforesaid constitutes less than 75% of the total enterprise revenue, additional
segments should be identified as reportable segments even if they do not meet the 10%
thresholds in paragraph 27, until at least 75% of total enterprise revenue is included in
reportable segments.
The total external revenue of Segments A, B, C, D and E, identified above as reportable
segments, is Rs.295,000. This is less than 75% of total enterprise revenue of Rs.400,000. The
management of the enterprise is required to designate any one or more of the remaining
segments as reportable segment(s) so that the external revenue of reportable segments is at
least 75% of the total enterprise revenue. Suppose, the management designates Segment H
for this purpose. Now the external revenue of reportable segments is more than 75% of the
total enterprise revenue.
Segments A, B, C, D, E and H are reportable segments. Segments F and G will be shown as
reconciling items.
APPENDIX III
Illustrative Segment Disclosures

purpose of this appendix is to illustrate the application of paragraphs 38-59 of the Accounting
Standard
This Appendix illustrates the segment disclosures that this Statement would require for a
diversified multi-locational business enterprise. This example is intentionally complex to

Information About Business segments (Note xx)
(All amounts in Rs. Lakhs)
Paper Products Office Products Publishing Other Operations Eliminations Consolidated Total
Current Previous Current Previous Current Previous Current Previous Current Previous Current Previous
Year Year Year Year Year Year Year Year Year Year Year Year
REVENUE
External sales 55 50 20 17 19 16 7 7
Inter-segment 15 10 10 14 2 4 2 2 (29) (30)
sales
Total Revenue 70 60 30 31 21 20 9 9 (29) (30) 101 90
RESULT
Segment result 20 17 9 7 2 1 0 0 (1) (1) 30 24
Unallocated (7) (9)
corporate expenses
Operating profit 23 15
Interest expense (4) (4)
Interest income 2 3
Income taxes (7) (4)
Profit from ordinary 14 10
activities
Extraordinary loss: (3) (3)
uninsured earthquake
damage to factory
Net profit 14 7
OTHER
INFORMATION
Segment assets 54 50 34 30 10 10 10 9 108 99
Unallocated 35 30
Corporate assets
Total assets 143 129
Segment 25 15 8 11 8 8 1 1 42 35
liabilities
Unallocated 40 55
liabilities
Total liabilities 82 90
Capital 12 10 3 5 5 4 3
expenditure
Depreciation 9 7 9 7 5 3 3 4
Non-cash 8 2 7 3 2 2 2 1
expenses other
than
Note xx-Business and Geograpical Segments (amounts in Rs. lakhs)

Business segments : For management purposes, the Company is organised on a worldwide
basis into three major operating divisions-paper products, office products and publishing —
each headed by a senior vice president. The divisions are the basis on which the company
reports its primary segment information. The paper products segment produces a broad range
of writing and publishing papers and newsprint. The office products segment manufactures
labels, binders, pens, and markers and also distributes office products made by others. The
publishing segment develops and sells books in the fields of taxation, law and accounting.
Other operations include development of computer software for standard and specialised
business applications. Financial information about business segments is presented in above
table.
Geographical segments : Although the Company’s major operating divisions are managed on
a worldwide basis, they operate in four principal geographical areas of the world. In India, its
home country, the Company produces and sells a broad range of papers and office products.
Additionally, all of the Company’s publishing and computer software development operations
are conducted in India. In the European Union, the Company operates paper and office
products manufacturing facilities and sales offices in the following countries: France, Belgium,
Germany and the U.K. Operations in Canada and the United States are essentially similar and
consist of manufacturing papers and newsprint that are sold entirely within those two
countries. Operations in Indonesia include the production of paper pulp and the manufacture
of writing and publishing papers and office products, almost all of which is sold outside
Indonesia, both to other segments of the company and to external customers.
Sales by market : The following table shows the distribution of the Company’s consolidated
sales by geographical market, regardless of where the goods were produced:
Sales Revenue by
Geographical Market
Current Year Previous Year
India 19 22
European Union 30 31
Canada and the United States 28 21
Mexico and South America 6 2
Southeast Asia (principally Japan and Taiwan) 18 14
101 90
Assets and additions to tangible and intangible fixed assets by geographical area : The
following table shows the carrying amount of segment assets and additions to tangible and
intangible fixed assets by geographical area in which the assets are located:
Carrying Amount Additions to Fixed
of Segment Assets Assets and
Intangible Assets
Current Previous Current Previous
Year Year Year Year
India 72 78 8 5
European Union 47 37 5 4
Canada and the United States 34 20 4 3
Indonesia 22 20 7 6
175 155 24 18
Segment revenue and expense : In India, paper and office products are manufactured in
combined facilities and are sold by a combined sales force. Joint revenues and expenses are
allocated to the two business segments on a reasonable basis. All other segment revenue and
expense are directly attributable to the segments.
Segment assets and liabilities : Segment assets include all operating assets used by a
segment and consist principally of operating cash, debtors, inventories and fixed assets, net of
allowances and provisions which are reported as direct offsets in the balance sheet. While
most such assets can be directly attributed to individual segments, the carrying amount of
certain assets used jointly by two or more segments is allocated to the segments on a
reasonable basis. Segment liabilities include all operating liabilities and consist principally of
creditors and accrued liabilities. Segment assets and liabilities do not include deferred income
taxes.
Inter-segment transfers : Segment revenue, segment expenses and segment result include
transfers between business segments and between geographical segments. Such transfers
are accounted for at competitive market prices charged to unaffiliated customers for similar
goods. Those transfers are eliminated in consolidation.
Unusual item : Sales of office products to external customers in the current year were
adversely affected by a lengthy strike of transportation workers in India, which interrupted
product shipments for approximately four months. The Company estimates that sales of office
products during the four-month period were approximately half of what they would otherwise
have been.
Extraordinary loss : As more fully discussed in Note x, the Company incurred an uninsured
loss of Rs.300,000 caused by earthquake damage to a paper mill in India during the previous
year.
APPENDIX IV
Summary of Required Disclosure

The appendix is illustrative only and does not form part of the Accounting Standard. Its
purpose is to summarise the disclosures required by paragraphs 38-59 for each of the three
possible primary segment reporting formats.
Figures in parentheses refer to paragraph numbers of the relevant paragraphs in the
text.
PRIMARY FORMAT IS PRIMARY FORMAT IS PRIMARY FORMAT IS
BUSINESS SEGMENTS GEOGRAPHICAL SEGMENTS GEOGRAPHICAL
BY LOCATION OF ASSETS SEGMENTS BY
LOCATION OF
CUSTOMERS
Required Primary Required Primary Disclosures Required Primary
Disclosures Disclosures
Revenue from external Revenue from external Revenue from external
customers by business customers by location of assets customers by location
segment [40(a)] [40(a)] of customers [40(a)]
Revenue from transactions with Revenue from transactions with Revenue from
other segments by business other segments by location of transactions with other
segment [40(a)] assets [40(a)] segments by location of
customers [40(a)]
Segment result by business Segment result by location of Segment result by
segment [40(b)] assets [40(b)] location of customers
[40(b)]
Carrying amount of segment Carrying amount of segment Carrying amount of
assets by business segment assets by location of assets segment assets by
[40(c)] [40(c)] location of customers
[40(c)]
Segment liabilities by business Segment liabilities by location of Segment liabilities by
segment [40(d)] assets [40(d)] location of customers
[40(d)]
Cost to acquire tangible and Cost to acquire tangible and Cost to acquire tangible
intangible fixed assets by intangible fixed assets by and intangible fixed
business segment [40(e)] location of assets [40(e)] assets by location of
customers [40(e)]
Required Secondary Required Secondary Required Secondary

Disclosures Disclosures Disclosures
Depreciation and amortisation Depreciation and amortisation Depreciation and
expense by business segment expense by location of assets amortisation expense
[40(f)] [40(f)] by location of
customers [40(f)]
Non-cash expenses other than Non-cash expenses other than Non-cash expenses
depreciation and amortisation depreciation and amortisation by other than depreciation
by business segment [40(g)] location of assets [40(g)] and amortisation by
location of customers
[40(g)]
Reconciliation of revenue, Reconciliation of revenue, result, Reconciliation of
result, assets and liabilities by assets and liabilities [46] revenue, result, assets
business segment [46] and liabilities [46]
Revenue from external Revenue from external Revenue from external

customers by location of customers by business segment customers by business
customers [48] [49] segment [49]
Carrying amount of segment Carrying amount of segment Carrying amount of
assets by location of assets assets by business segment [49] segment assets by
[48] business segment [49]
Cost to acquire tangible and Cost to acquire tangible and Cost to acquire tangible
intangible fixed assets by intangible fixed assets by and intangible fixed
location of assets [48] business assets by business
segment [49] segment [49]
Revenue from external
customers by geographical
customers if different from
location of assets [50]
PRIMARY FORMAT IS PRIMARY FORMAT IS PRIMARY FORMAT IS

BUSINESS SEGMENTS GEOGRAPHICAL SEGMENTS GEOGRAPHICAL
BY LOCATION OF ASSETS SEGMENTS BY
LOCATION OF
CUSTOMERS
Carrying amount of
segment assets by
location of assets if
different from location
of customers [51]
Cost to acquire tangible
and intangible fixed
assets by location of
assets if different from
location of customers
[51]
Other Required Disclosures Other Required Disclosures Other Required
Disclosures
Basis of pricing inter- Basis of pricing inter- Basis of pricing inter-
segment transfers and segment transfers and segment transfers and
any change therein [53] any change therein [53] any change therein [53]
Changes in segment Changes in segment Changes in segment
accounting policies [54] accounting policies [54] accounting policies [54]
Types of products and services Types of products and services in Types of products and
in each business segment [58] each business segment [58] services in each
business segment [58]
Composition of each Composition of each geographical Composition of each

geographical segment [58] segment [58] geographical segment
[58]
Announcement
Disclosure of corresponding previous year figures in the first year of application of

Accounting Standard (AS) 17, Segment Reporting
The Institute has issued Accounting Standard (AS) 17, Segment Reporting (published in the
October, 2000, issue of the Institute’s Journal ‘The Chartered Accountant’). AS 17 has come
into effect in respect of accounting periods commencing on or after 1-4-2001 and is mandatory
in nature, from that date, in respect of the following:
Enterprises whose equity or debt securities are listed on a recognised stock exchange in
India, and enterprises that are in the process of issuing equity or debt securities that will be
listed on a recognised stock exchange in India as evidenced by the board of directors’
resolution in this regard.
All other commercial, industrial and business reporting enterprises, whose turnover for the
accounting period exceeds Rs. 50 crores.
The Council, at its 224th meeting, held on March 8-10, 2002, considered the matter relating to
disclosure of corresponding previous year figures in respect of segment reporting in the first
year of application of AS 17. The Council decided that in the first year of application of AS 17,
corresponding previous year figures in respect of segment reporting need not be disclosed.
AS 18 : RELATED PARTY DISCLOSURES∗
and in the context of the ‘Preface to the Statements of Accounting Standards’.)
The following is the text of Accounting Standard (AS) 18, ‘Related Party Disclosures’, issued
by the Council of the Institute of Chartered Accountants of India. This Standard comes into
effect in respect of accounting periods commencing on or after 1-4-2001. This standard is
mandatory in nature in respect of accounting periods commencing on or after 1.4.2003£ for the
∗
A limited revision to this standard has been made in 2003 , pursuant to which paragraph
26 of this standard has been revised and paragraph 27 has been added to the standard.
£
AS 18 was earlier made mandatory in respect of accounting periods on or after 1-4-
2001 only for the following enterprises:
(i) Enterprises whose equity or debt securities are listed on a recognised stock exchange in
India, and enterprises that are in the process of issuing equity or debt securities that will
be listed on a recognised stock exchange in India as evidenced by the board of directors’
(ii) All other commercial, industrial and business reporting enterprises, whose turnover for
the accounting period exceeds Rs. 50 crores.
enterprises which fall in any one or more of the following categories, at any time during the
accounting period:
(ii) Enterprises which are in the process of listing their equity or debt securities as evidenced
by the board of directors; resolution in this regard.
(iii) Banks including cooperative banks.
exceeds Rs.50 crore. Turnover does not include “other income”.
including public deposits, in excess of Rs.10 crore at any time during the accounting
period.
accounting period.
The enterprises which do not fall in any of the above categories are not required to apply this
Standard.
An enterprise, which, pursuant to the above provisions, does not make related party
disclosures, should disclose the fact.
Objective
The objective of this Statement is to establish requirements for disclosure of:
(a) related party relationships; and
(b) transactions between a reporting enterprise and its related parties.
Scope
1. This Statement should be applied in reporting related party relationships and
transactions between a reporting enterprise and its related parties. The
requirements of this Statement apply to the financial statements of each reporting
enterprise as also to consolidated financial statements presented by a holding
company.
2. This Statement applies only to related party relationships described in paragraph
3.
3. This Statement deals only with related party relationships described in (a) to (e) below:
(a) enterprises that directly, or indirectly through one or more intermediaries, control, or
are controlled by, or are under common control with, the reporting enterprise (this
includes holding companies, subsidiaries and fellow subsidiaries);
(b) associates and joint ventures of the reporting enterprise and the investing party or
venturer in respect of which the reporting enterprise is an associate or a joint
venture;
(c) individuals owning, directly or indirectly, an interest in the voting power of the
reporting enterprise that gives them control or significant influence over the
enterprise, and relatives of any such individual;
(d) key management personnel and relatives of such personnel; and
(e) enterprises over which any person described in (c) or (d) is able to exercise
significant influence. This includes enterprises owned by directors or major
shareholders of the reporting enterprise and enterprises that have a member of key
management in common with the reporting enterprise.
4. In the context of this Statement, the following are deemed not to be related parties:
(a) two companies simply because they have a director in common, notwithstanding
paragraph 3(d) or (e) above (unless the director is able to affect the policies of both
companies in their mutual dealings);
(b) a single customer, supplier, franchiser, distributor, or general agent with whom an
enterprise transacts a significant volume of business merely by virtue of the
resulting economic dependence; and
(c) the parties listed below, in the course of their normal dealings with an enterprise by
virtue only of those dealings (although they may circumscribe the freedom of action
of the enterprise or participate in its decision-making process):
(i) providers of finance;
(ii) trade unions;
(iii) public utilities;
(iv) government departments and government agencies including government

sponsored bodies.
5. Related party disclosure requirements as laid down in this Statement do not apply
in circumstances where providing such disclosures would conflict with the
reporting enterprise’s duties of confidentiality as specifically required in terms of a
statute or by any regulator or similar competent authority.
6. In case a statute or a regulator or a similar competent authority governing an enterprise
prohibit the enterprise to disclose certain information which is required to be disclosed as
per this Statement, disclosure of such information is not warranted. For example, banks
are obliged by law to maintain confidentiality in respect of their customers’ transactions
and this Statement would not override the obligation to preserve the confidentiality of
customers’ dealings.
7. No disclosure is required in consolidated financial statements in respect of intra-
group transactions.
8. Disclosure of transactions between members of a group is unnecessary in consolidated
financial statements because consolidated financial statements present information about
the holding and its subsidiaries as a single reporting enterprise.
9. No disclosure is required in the financial statements of state-controlled enterprises
as regards related party relationships with other state-controlled enterprises and
transactions with such enterprises.
DEFINITIONS
10. For the purpose of this Statement, the following terms are used with the meanings
specified:
Related party - 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.
Related Party Transactions - a transfer of resources or obligations between related
parties regardless of whether or not a price is charged.
Control – (a) ownership, directly or indirectly, of more than one half of the voting power
of an enterprise, or
(b) control of the composition of the board of directors in the case of a company or of
the composition of the corresponding governing body in case of any other enterprise,
or
(c) a substantial interest in voting power and the power to direct, by statute or
agreement, the financial and/or operating policies of the enterprise.
Significant influence - participation in the financial and/or operating policy decisions of

an enterprise, but not control of those policies.
An Associate - an enterprise in which an investing reporting party has significant
influence and which is neither a subsidiary nor a joint venture of that party.
A Joint venture - a contractual arrangement whereby two or more parties undertake an
economic activity which is subject to joint control.
Joint control - the contractually agreed sharing of power to govern the financial and
operating policies of an economic activity so as to obtain benefits from it.
Key management personnel - those persons who have the authority and responsibility
for planning, directing and controlling the activities of the reporting enterprise.
Relative – in relation to an individual, means the spouse, son, daughter, brother, sister,
father and mother who may be expected to influence, or be influenced by, that
individual in his/her dealings with the reporting enterprise.
Holding company - a company having one or more subsidiaries.
Subsidiary - a company:
(a) in which another company (the holding company) holds, either by itself and/or
through one or more subsidiaries, more than one-half in nominal value of its equity
share capital; or
(b) of which another company (the holding company) controls, either by itself and/or
through one or more subsidiaries, the composition of its board of directors.
Fellow subsidiary - a company is considered to be a fellow subsidiary of another
company if both are subsidiaries of the same holding company.
State-controlled enterprise - an enterprise which is under the control of the Central
Government and/or any State Government(s).
11. For the purpose of this Statement, an enterprise is considered to control the composition
of
(i) the board of directors of a company, if it has the power, without the consent or
concurrence of any other person, to appoint or remove all or a majority of directors
of that company. An enterprise is deemed to have the power to appoint a director if
any of the following conditions is satisfied:
(a) a person cannot be appointed as director without the exercise in his favour by
that enterprise of such a power as aforesaid; .or
(b) a person’s appointment as director follows necessarily from his appointment to
a position held by him in that enterprise; or
(c) the director is nominated by that enterprise; in case that enterprise is a

company, the director is nominated by that company/subsidiary thereof.
(ii) the governing body of an enterprise that is not a company, if it has the power,
without the consent or the concurrence of any other person, to appoint or remove all
or a majority of members of the governing body of that other enterprise. An
enterprise is deemed to have the power to appoint a member if any of the following
conditions is satisfied:
(a) a person cannot be appointed as member of the governing body without the
exercise in his favour by that other enterprise of such a power as aforesaid; or
(b) a person’s appointment as member of the governing body follows necessarily
from his appointment to a position held by him in that other enterprise; or
(c) the member of the governing body is nominated by that other enterprise.
12. An enterprise is considered to have a substantial interest in another enterprise if that
enterprise owns, directly or indirectly, 20 per cent or more interest in the voting power of
the other enterprise. Similarly, an individual is considered to have a substantial interest in
an enterprise, if that individual owns, directly or indirectly, 20 per cent or more interest in
the voting power of the enterprise.
13. Significant influence may be exercised in several ways, for example, by representation
on the board of directors, participation in the policy making process, material inter-
company transactions, interchange of managerial personnel, or dependence on technical
information. Significant influence may be gained by share ownership, statute or
agreement. As regards share ownership, if an investing party holds, directly or indirectly
through intermediaries, 20 per cent or more of the voting power of the enterprise, it is
presumed that the investing party does have significant influence, unless it can be clearly
demonstrated that this is not the case. Conversely, if the investing party holds, directly or
indirectly through intermediaries , less than 20 per cent of the voting power of the
enterprise, it is presumed that the investing party does not have significant influence,
unless such influence can be clearly demonstrated. A substantial or majority ownership
by another investing party does not necessarily preclude an investing party from having
significant influence.
14. Key management personnel are those persons who have the authority and responsibility
for planning, directing and controlling the activities of the reporting enterprise. For
example, in the case of a company, the managing director(s), whole time director(s),
manager and any person in accordance with whose directions or instructions the board of
directors of the company is accustomed to act, are usually considered key management
personnel.
The Related Party Issue

15. Related party relationships are a normal feature of commerce and business. For
example, enterprises frequently carry on separate parts of their activities through
subsidiaries or associates and acquire interests in other enterprises - for investment
purposes or for trading reasons - that are of sufficient proportions for the investing
enterprise to be able to control or exercise significant influence on the financial and/or
operating decisions of its investee.
16. Without related party disclosures, there is a general presumption that transactions
reflected in financial statements are consummated on an arm’s-length basis between
independent parties. However, that presumption may not be valid when related party
relationships exist because related parties may enter into transactions which unrelated
parties would not enter into. Also, transactions between related parties may not be
effected at the same terms and conditions as between unrelated parties. Sometimes, no
price is charged in related party transactions, for example, free provision of management
services and the extension of free credit on a debt. In view of the aforesaid, the resulting
accounting measures may not represent what they usually would be expected to
represent. Thus, a related party relationship could have an effect on the financial position
and operating results of the reporting enterprise.
17. The operating results and financial position of an enterprise may be affected by a related
party relationship even if related party transactions do not occur. The mere existence of
the relationship may be sufficient to affect the transactions of the reporting enterprise
with other parties. For example, a subsidiary may terminate relations with a trading
partner on acquisition by the holding company of a fellow subsidiary engaged in the
same trade as the former partner. Alternatively, one party may refrain from acting
because of the control or significant influence of another - for example, a subsidiary may
be instructed by its holding company not to engage in research and development.
18. Because there is an inherent difficulty for management to determine the effect of
influences which do not lead to transactions, disclosure of such effects is not required by
this Statement.
19. Sometimes, transactions would not have taken place if the related party relationship had
not existed. For example, a company that sold a large proportion of its production to its
holding company at cost might not have found an alternative customer if the holding
company had not purchased the goods.
Disclosure
20. The statutes governing an enterprise often require disclosure in financial statements of
transactions with certain categories of related parties. In particular, attention is focussed
on transactions with the directors or similar key management personnel of an enterprise,
especially their remuneration and borrowings, because of the fiduciary nature of their
relationship with the enterprise.
21. Name of the related party and nature of the related party relationship where control
exists should be disclosed irrespective of whether or not there have been
transactions between the related parties.
22. Where the reporting enterprise controls, or is controlled by, another party, this
information is relevant to the users of financial statements irrespective of whether or not
transactions have taken place with that party. This is because the existence of control
relationship may prevent the reporting enterprise from being independent in making its
financial and/or operating decisions. The disclosure of the name of the related party and
the nature of the related party relationship where control exists may sometimes be at
least as relevant in appraising an enterprise’s prospects as are the operating results and
the financial position presented in its financial statements. Such a related party may
establish the enterprise’s credit standing, determine the source and price of its raw
materials, and determine to whom and at what price the product is sold.
23 If there have been transactions between related parties, during the existence of a
related party relationship, the reporting enterprise should disclose the following:
(i) the name of the transacting related party;
(ii) a description of the relationship between the parties;
(iii) a description of the nature of transactions;
(iv) volume of the transactions either as an amount or as an appropriate
proportion;
(v) any other elements of the related party transactions necessary for an
understanding of the financial statements;
(vi) the amounts or appropriate proportions of outstanding items pertaining to
related parties at the balance sheet date and provisions for doubtful debts due
from such parties at that date; and
(vii) amounts written off or written back in the period in respect of debts due from
or to related parties.
24. The following are examples of the related party transactions in respect of which
disclosures may be made by a reporting enterprise:
purchases or sales of goods (finished or unfinished);
♦ purchases or sales of fixed assets;
♦ rendering or receiving of services;
♦ agency arrangements;
♦ leasing or hire purchase arrangements;
♦ transfer of research and development;
♦ licenses agreements;
♦ finance (including loans and equity contributions in cash or in kind);
♦ guarantees and collaterals; and
♦ management contracts including for deputation of employees.
25. Paragraph 23 (v) requires disclosure of ‘any other elements of the related party
transactions necessary for an understanding of the financial statements’. An example of
such a disclosure would be an indication that the transfer of a major asset had taken
place at an amount materially different from that obtainable on normal commercial terms.
26. Items of a similar nature may be disclosed in aggregate by type of related party
except when separate disclosure is necessary for an understanding of the effects
of a related party transactions on the financial statements of reporting enterprise∗.
27. Disclosure of details of particular transactions with individual related parties would
frequently be too voluminous to be easily understood. Accordingly, items of a similar
nature may be disclosed in aggregate by type of related party. However, this is not done
in such a way as to obscure the importance of significant transactions. Hence, purchases
or sales of goods are not aggregated with purchases or sales of fixed assets. Nor a
material related party transaction with an individual party is clubbed in an aggregated
disclosure.
∗
The Council of the Institute decided to make the limited revision to AS 18 in 2003
pursuant to which paragraph 26 has been revised and a explanatory paragraph 27
has been added (See ‘The Chartered Accountant’, March 2003, pp. 963). The
revisions have come into effect in respect of accounting periods commencing on or
after 1.4.2003. The erstwhile paragraph 26 was as under;
"26. Items of similar nature may be disclosed in aggregate by type of related party."
AS 19 : LEASES
AS 19, ‘Leases’, issued by the Council of the Institute of Chartered Accountants of India. This
Standard comes into effect in respect of all assets leased during accounting periods
commencing on or after 1.4.2001 and is mandatory in nature from that date. Accordingly, the
‘Guidance Note on Accounting for Leases’ issued by the Institute in 1995, is not applicable in
respect of such assets. Earlier application of this Standard is, however, encouraged.
In respect of accounting periods commencing on or after 1-4-2004, an enterprise which does
not fall in any of the following categories need not disclose the information required by
paragraphs 22(c), (e) and (f); 25(a), (b) and (e); 37(a), (f) and (g); and 46(b), (d) and (e), of
this Standard:
by the board of directors’ resolution in this regard.
exceeds Rs.50 crore. Turnover does not include ‘other income’.
period.
accounting period.
In respect of an enterprise which falls in any one or more of the above categories, at any time
during the accounting period, the Standard is applicable in its entirety.
paragraphs 22(c), (e) and (f); 25(a), (b) and (e); 37(a), (f) and (g); and 46(b), (d) and (e), of
this Standard, until the enterprise ceases to be covered in any of the above categories for two
consecutive years.
Where an enterprise has previously qualified for exemption from paragraphs 22(c), (e) and (f);
25(a), (b) and (e); 37(a), (f) and (g); and 46(b), (d) and (e), of this Standard (being not covered
by any of the above categories) but no longer qualifies for exemption in the current accounting
period, this Standard becomes applicable, in its entirety, from the current period. However,
the corresponding previous period figures in respect of above paragraphs need not be
disclosed.
An enterprise, which, pursuant to the above provisions, does not disclose the information
required by paragraphs 22(c), (e) and (f); 25(a), (b) and (e); 37(a), (f) and (g); and 46(b), (d)
and (e) should disclose the fact.
The following is the text of the Accounting Standard. 8
Objective
The objective of this Statement is to prescribe, for lessees and lessors, the appropriate
accounting policies and disclosures in relation to finance leases and operating leases.
Scope
1. This Statement should be applied in accounting for all leases other than:
(a) lease agreements to explore for or use natural resources, such as oil, gas,
timber, metals and other mineral rights; and
(b) licensing agreements for items such as motion picture films, video
recordings, plays, manuscripts, patents and copyrights; and
(c) lease agreements to use lands.
2. This Statement applies to agreements that transfer the right to use assets even though
substantial services by the lessor may be called for in connection with the operation or
maintenance of such assets. On the other hand, this Statement does not apply to
agreements that are contracts for services that do not transfer the right to use assets
from one contracting party to the other.
Definitions
A lease is an agreement whereby the lessor conveys to the lessee in return for a
payment or series of payments the right to use an asset for an agreed period of time.
8
AS 19 was originally made mandatory in its entirety, for all enterprises in respect of all
assets leased during accounting periods commencing on or after 1.4.2001.
A finance lease is a lease that transfers substantially all the risks and rewards incident
to ownership of an asset.
An operating lease is a lease other than a finance lease.
A non-cancellable lease is a lease that is cancellable only:
(a) upon the occurrence of some remote contingency; or
(b) with the permission of the lessor; or
(c) if the lessee enters into a new lease for the same or an equivalent asset with the
same lessor; or
(d) upon payment by the lessee of an additional amount such that, at inception,
continuation of the lease is reasonably certain.
The inception of the lease is the earlier of the date of the lease agreement and the date
of a commitment by the parties to the principal provisions of the lease.
The lease term is the non-cancellable period for which the lessee has agreed to take on
lease the asset together with any further periods for which the lessee has the option to
continue the lease of the asset, with or without further payment, which option at the
inception of the lease it is reasonably certain that the lessee will exercise.
Minimum lease payments are the payments over the lease term that the lessee is, or can
be required, to make excluding contingent rent, costs for services and taxes to be paid
by and reimbursed to the lessor, together with:
(a) in the case of the lessee, any residual value guaranteed by or on behalf of the
lessee; or
(b) in the case of the lessor, any residual value guaranteed to the lessor:
(i) by or on behalf of the lessee; or
(ii) by an independent third party financially capable of meeting this guarantee.
However, if the lessee has an option to purchase the asset at a price which is expected
to be sufficiently lower than the fair value at the date the option becomes exercisable
that, at the inception of the lease, is reasonably certain to be exercised, the minimum
lease payments comprise minimum payments payable over the lease term and the
payment required to exercise this purchase option.
Fair value is the amount for which an asset could be exchanged or a liability settled
Economic life is either:
(a) the period over which an asset is expected to be economically usable by one or
more users; or
(b) the number of production or similar units expected to be obtained from the asset
by one or more users.
Useful life of a leased asset is either:
(a) the period over which the leased asset is expected to be used by the lessee; or
(b) the number of production or similar units expected to be obtained from the use of
the asset by the lessee.
Residual value of a leased asset is the estimated fair value of the asset at the end of the
lease term.
Guaranteed residual value is :
(a) in the case of the lessee, that part of the residual value which is guaranteed by the
lessee or by a party on behalf of the lessee (the amount of the guarantee being the
maximum amount that could, in any event, become payable); and
(b) in the case of the lessor, that part of the residual value which is guaranteed by or
on behalf of the lessee, or by an independent third party who is financially capable
of discharging the obligations under the guarantee.
Unguaranteed residual value of a leased asset is the amount by which the residual
value of the asset exceeds its guaranteed residual value.
Gross investment in the lease is the aggregate of the minimum lease payments under a
finance lease from the standpoint of the lessor and any unguaranteed residual value
accruing to the lessor.
Unearned finance income is the difference between:
(a) the gross investment in the lease; and
(b) the present value of
(i) the minimum lease payments under a finance lease from the standpoint of the
lessor; and
(ii) any unguaranteed residual value accruing to the lessor, at the interest rate
implicit in the lease.
Net investment in the lease is the gross investment in the lease less unearned finance
income.
The interest rate implicit in the lease is the discount rate that, at the inception of the
lease, causes the aggregate present value of
(a) the minimum lease payments under a finance lease from the standpoint of the
lessor; and
(b) any unguaranteed residual value accruing to the lessor, to be equal to the fair
value of the leased asset.
The lessee’s incremental borrowing rate of interest is the rate of interest the lessee
would have to pay on a similar lease or, if that is not determinable, the rate that, at the
inception of the lease, the lessee would incur to borrow over a similar term, and with a
similar security, the funds necessary to purchase the asset.
Contingent rent is that portion of the lease payments that is not fixed in amount but is
based on a factor other than just the passage of time (e.g., percentage of sales, amount
of usage, price indices, market rates of interest).
4. The definition of a lease includes agreements for the hire of an asset which contain a
provision giving the hirer an option to acquire title to the asset upon the fulfillment of
agreed conditions. These agreements are commonly known as hire purchase
agreements. Hire purchase agreements include agreements under which the property in
the asset is to pass to the hirer on the payment of the last instalment and the hirer has a
right to terminate the agreement at any time before the property so passes.
CLASSIFICATION OF LEASES
5. The classification of leases adopted in this Statement is based on the extent to which
risks and rewards incident to ownership of a leased asset lie with the lessor or the
lessee. Risks include the possibilities of losses from idle capacity or technological
obsolescence and of variations in return due to changing economic conditions. Rewards
may be represented by the expectation of profitable operation over the economic life of
the asset and of gain from appreciation in value or realisation of residual value.
6. A lease is classified as a finance lease if it transfers substantially all the risks and
rewards incident to ownership. Title may or may not eventually be transferred. A lease is
classified as an operating lease if it does not transfer substantially all the risks and
rewards incident to ownership.
7. Since the transaction between a lessor and a lessee is based on a lease agreement
common to both parties, it is appropriate to use consistent definitions. The application of
these definitions to the differing circumstances of the two parties may sometimes result in
the same lease being classified differently by the lessor and the lessee.
8. Whether a lease is a finance lease or an operating lease depends on the substance of
the transaction rather than its form. Examples of situations which would normally lead to
a lease being classified as a finance lease are:
(a) the lease transfers ownership of the asset to the lessee by the end of the lease
term;
(b) the lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable
such that, at the inception of the lease, it is reasonably certain that the option will be
exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is
not transferred;
(d) at the inception of the lease the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset; and
(e) the leased asset is of a specialised nature such that only the lessee can use it
without major modifications being made.
9. Indicators of situations which individually or in combination could also lead to a lease
being classified as a finance lease are:
(a) if the lessee can cancel the lease, the lessor’s losses associated with the
cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual fall to the lessee
(for example, in the form of a rent rebate equalling most of the sales proceeds at the
end of the lease); and
(c) the lessee can continue the lease for a secondary period at a rent which is
substantially lower than market rent.
10. Lease classification is made at the inception of the lease. If at any time the lessee and
the lessor agree to change the provisions of the lease, other than by renewing the lease,
in a manner that would have resulted in a different classification of the lease under the
criteria in paragraphs 5 to 9 had the changed terms been in effect at the inception of the
lease, the revised agreement is considered as a new agreement over its revised term.
Changes in estimates (for example, changes in estimates of the economic life or of the
residual value of the leased asset) or changes in circumstances (for example, default by
the lessee), however, do not give rise to a new classification of a lease for accounting
purposes.
LEASES IN THE FINANCIAL STATEMENTS OF LESSEES
Finance Leases
11. At the inception of a finance lease, the lessee should recognise the lease as an
asset and a liability. Such recognition should be at an amount equal to the fair
value of the leased asset at the inception of the lease. However, if the fair value of
the leased asset exceeds the present value of the minimum lease payments from
the standpoint of the lessee, the amount recorded as an asset and a liability should
be the present value of the minimum lease payments from the standpoint of the
lessee. In calculating the present value of the minimum lease payments the
discount rate is the interest rate implicit in the lease, if this is practicable to
determine; if not, the lessee’s incremental borrowing rate should be used.
Example
(a) An enterprise (the lessee) acquires a machinery on lease from a leasing company
(the lessor) on January 1, 20X0. The lease term covers the entire economic life of
the machinery, i.e. 3 years. The fair value of the machinery on January 1, 20X0 is
Rs.2,35,500. The lease agreement requires the lessee to pay an amount of
Rs.1,00,000 per year beginning December 31, 20X0. The lessee has guaranteed a
residual value of Rs.17,000 on December 31, 20X2 to the lessor. The lessor,
however, estimates that the machinery would have a salvage value of only Rs.3,500
on December 31, 20X2. The interest rate implicit in the lease is 16 per cent
(approx.). This is calculated using the following formula:
ALR + ALR + ALR + RV
Fair value = ............
(1 + r ) (1 + r )
1 2
(1 + r ) (1 + r )n
n
where ALR is annual lease rental,

RV is residual value (both guaranteed and unguaranteed),
n is the lease term,
r is interest rate implicit in the lease.
The present value of minimum lease payments from the stand point of the lessee is
Rs.2,35,500.
The lessee would record the machinery as an asset at Rs.2,35,500 with a
corresponding liability representing the present value of lease payments over the
lease term (including the guaranteed residual value).
(b) In the above example, suppose the lessor estimates that the machinery would have
a salvage value of Rs.17,000 on December 31, 20X2. The lessee, however,
guarantees a residual value of Rs.5,000 only.
The interest rate implicit in the lease in this case would remain unchanged at 16%
(approx.). The present value of the minimum lease payments from the standpoint of
the lessee, using this interest rate implicit in the lease, would be Rs.2,27,805. As
this amount is lower than the fair value of the leased asset (Rs. 2,35,500), the
lessee would recognise the asset and the liability arising from the lease at
Rs.2,27,805.
In case the interest rate implicit in the lease is not known to the lessee, the present
value of the minimum lease payments from the standpoint of the lessee would be
computed using the lessee’s incremental borrowing rate.
12. Transactions and other events are accounted for and presented in accordance with their
substance and financial reality and not merely with their legal form. While the legal form
of a lease agreement is that the lessee may acquire no legal title to the leased asset, in
the case of finance leases the substance and financial reality are that the lessee acquires
the economic benefits of the use of the leased asset for the major part of its economic
life in return for entering into an obligation to pay for that right an amount approximating
to the fair value of the asset and the related finance charge.
13. If such lease transactions are not reflected in the lessee’s balance sheet, the economic
resources and the level of obligations of an enterprise are understated thereby distorting
financial ratios. It is therefore appropriate that a finance lease be recognised in the
lessee’s balance sheet both as an asset and as an obligation to pay future lease
payments. At the inception of the lease, the asset and the liability for the future lease
payments are recognised in the balance sheet at the same amounts.
14. It is not appropriate to present the liability for a leased asset as a deduction from the
leased asset in the financial statements. The liability for a leased asset should be
presented separately in the balance sheet as a current liability or a long-term liability as
the case may be.
15. Initial direct costs are often incurred in connection with specific leasing activities, as in
negotiating and securing leasing arrangements. The costs identified as directly
attributable to activities performed by the lessee for a finance lease are included as part
of the amount recognised as an asset under the lease.
16. Lease payments should be apportioned between the finance charge and the
reduction of the outstanding liability. The finance charge should be allocated to
periods during the lease term so as to produce a constant periodic rate of interest
on the remaining balance of the liability for each period.
Example
In the example (a) illustrating paragraph 11, the lease payments would be apportioned by the
lessee between the finance charge and the reduction of the outstanding liability as follows.
Year Finance Payment Reduction Outstanding
charge (Rs.) in liability
(Rs.) outstanding (Rs.)
liability
(Rs.)
Year 1 (January 1) 2,35,500
(December 31) 37,680 1,00,000 62,320 1,73,180
Year 2 (December 31) 27,709 1,00,000 72,291 1,00,889
Year 3 (December 31) 16,142 1,00,000 83,858 17,031∗
∗
The difference between this figure and guaranteed residual value (Rs. 17,000) is
due to approximation in computing the interest rate implicit in the lease.
17. n practice, in allocating the finance charge to periods during the lease term, some form of
approximation may be used to simplify the calculation.
18. A finance lease gives rise to a depreciation expense for the asset as well as a
finance expense for each accounting period. The depreciation policy for a leased
asset should be consistent with that for depreciable assets which are owned, and
the depreciation recognised should be calculated on the basis set out in
Accounting Standard (AS) 6, Depreciation Accounting. If there is no reasonable
certainty that the lessee will obtain ownership by the end of the lease term, the
asset should be fully depreciated over the lease term or its useful life, whichever is
shorter.
19. The depreciable amount of a leased asset is allocated to each accounting period during
the period of expected use on a systematic basis consistent with the depreciation policy
the lessee adopts for depreciable assets that are owned. If there is reasonable certainty
that the lessee will obtain ownership by the end of the lease term, the period of expected
use is the useful life of the asset; otherwise the asset is depreciated over the lease term
or its useful life, whichever is shorter.
20. The sum of the depreciation expense for the asset and the finance expense for the
period is rarely the same as the lease payments payable for the period, and it is,
therefore, inappropriate simply to recognise the lease payments payable as an expense
in the statement of profit and loss. Accordingly, the asset and the related liability are
unlikely to be equal in amount after the inception of the lease.
21. To determine whether a leased asset has become impaired, an enterprise applies the
Accounting Standard dealing with impairment of assets1, that sets out the requirements
as to how an enterprise should perform the review of the carrying amount of an asset,
how it should determine the recoverable amount of an asset and when it should
recognise, or reverse, an impairment loss.
22. The lessee should, in addition to the requirements of AS 10, Accounting for Fixed
Assets, AS 6, Depreciation Accounting, and the governing statute, make the
following disclosures for finance leases:
(a) assets acquired under finance lease as segregated from the assets owned;
(b) for each class of assets, the net carrying amount at the balance sheet date;
(c) a reconciliation between the total of minimum lease payments at the balance
sheet date and their present value. In addition, an enterprise should disclose
the total of minimum lease payments at the balance sheet date, and their
1
AS 28, ‘impairment of Assets’, specifies the requirements relating to impairment of
assets.
present value, for each of the following periods:

(i) not later than one year;
(ii) later than one year and not later than five years;
(iii) later than five years;
(d) contingent rents recognised as income in the statement of profit and loss for
the period;
(e) the total of future minimum sublease payments expected to be received under
non-cancellable subleases at the balance sheet date; and
(f) a general description of the lessee’s significant leasing arrangements
including, but not limited to, the following:
(i) the basis on which contingent rent payments are determined;
(ii) the existence and terms of renewal or purchase options and escalation
clauses; and
(iii) restrictions imposed by lease arrangements, such as those concerning
dividends, additional debt, and further leasing.
OPERATING LEASES
23. Lease payments under an operating lease should be recognised as an expense in
the statement of profit and loss on a straight line basis over the lease term unless
another systematic basis is more representative of the time pattern of the user’s
benefit.
24. For operating leases, lease payments (excluding costs for services such as insurance
and maintenance) are recognised as an expense in the statement of profit and loss on a
straight line basis unless another systematic basis is more representative of the time
pattern of the user’s benefit, even if the payments are not on that basis.
25. The lessee should make the following disclosures for operating leases:
(a) the total of future minimum lease payments under non-cancellable operating
leases for each of the following periods:
(b) the total of future minimum sublease payments expected to be received under
non-cancellable subleases at the balance sheet date;
(c) lease payments recognised in the statement of profit and loss for the period,
with separate amounts for minimum lease payments and contingent rents;
(d) sub-lease payments received (or receivable) recognised in the statement of

profit and loss for the period;
(e) a general description of the lessee’s significant leasing arrangements
including, but not limited to, the following:
(i) the basis on which contingent rent payments are determined;
(ii) the existence and terms of renewal or purchase options and escalation
clauses; and
(iii) restrictions imposed by lease arrangements, such as those concerning
dividends, additional debt, and further leasing.
LEASES IN THE FINANCIAL STATEMENTS OF LESSORS
Finance Leases
26. The lessor should recognise assets given under a finance lease in its balance
sheet as a receivable at an amount equal to the net investment in the lease.
27. Under a finance lease substantially all the risks and rewards incident to legal ownership
are transferred by the lessor, and thus the lease payment receivable is treated by the
lessor as repayment of principal, i.e., net investment in the lease, and finance income to
reimburse and reward the lessor for its investment and services.
28. The recognition of finance income should be based on a pattern reflecting a
constant periodic rate of return on the net investment of the lessor outstanding in
respect of the finance lease.
29. A lessor aims to allocate finance income over the lease term on a systematic and rational
basis. This income allocation is based on a pattern reflecting a constant periodic return
on the net investment of the lessor outstanding in respect of the finance lease. Lease
payments relating to the accounting period, excluding costs for services, are reduced
from both the principal and the unearned finance income.
30. Estimated unguaranteed residual values used in computing the lessor’s gross investment
in a lease are reviewed regularly. If there has been a reduction in the estimated
unguaranteed residual value, the income allocation over the remaining lease term is
revised and any reduction in respect of amounts already accrued is recognised
immediately. An upward adjustment of the estimated residual value is not made.
31. Initial direct costs, such as commissions and legal fees, are often incurred by lessors in
negotiating and arranging a lease. For finance leases, these initial direct costs are
incurred to produce finance income and are either recognised immediately in the
statement of profit and loss or allocated against the finance income over the lease term.
32. The manufacturer or dealer lessor should recognise the transaction of sale in the
statement of profit and loss for the period, in accordance with the policy followed
by the enterprise for outright sales. If artificially low rates of interest are quoted,
profit on sale should be restricted to that which would apply if a commercial rate of
interest were charged. Initial direct costs should be recognised as an expense in
the statement of profit and loss at the inception of the lease.
33. Manufacturers or dealers may offer to customers the choice of either buying or leasing an
asset. A finance lease of an asset by a manufacturer or dealer lessor gives rise to two
types of income:
(a) the profit or loss equivalent to the profit or loss resulting from an outright sale of the
asset being leased, at normal selling prices, reflecting any applicable volume or
trade discounts; and
(b) the finance income over the lease term.
34. The sales revenue recorded at the commencement of a finance lease term by a
manufacturer or dealer lessor is the fair value of the asset. However, if the present value
of the minimum lease payments accruing to the lessor computed at a commercial rate of
interest is lower than the fair value, the amount recorded as sales revenue is the present
value so computed. The cost of sale recognised at the commencement of the lease term
is the cost, or carrying amount if different, of the leased asset less the present value of
the unguaranteed residual value. The difference between the sales revenue and the cost
of sale is the selling profit, which is recognised in accordance with the policy followed by
the enterprise for sales.
35. Manufacturer or dealer lessors sometimes quote artificially low rates of interest in order
to attract customers. The use of such a rate would result in an excessive portion of the
total income from the transaction being recognised at the time of sale. If artificially low
rates of interest are quoted, selling profit would be restricted to that which would apply if
a commercial rate of interest were charged.
36. Initial direct costs are recognised as an expense at the commencement of the lease term
because they are mainly related to earning the manufacturer’s or dealer’s selling profit.
37. The lessor should make the following disclosures for finance leases:
(a) a reconciliation between the total gross investment in the lease at the balance
sheet date, and the present value of minimum lease payments receivable at
the balance sheet date. In addition, an enterprise should disclose the total
gross investment in the lease and the present value of minimum lease
payments receivable at the balance sheet date, for each of the following
periods:
(b) unearned finance income;
(c) the unguaranteed residual values accruing to the benefit of the lessor;
(d) the accumulated provision for uncollectible minimum lease payments
receivable;
(e) contingent rents recognised in the statement of profit and loss for the period;
(f) a general description of the significant leasing arrangements of the lessor;
and
(g) accounting policy adopted in respect of initial direct costs.
38. As an indicator of growth it is often useful to also disclose the gross investment less
unearned income in new business added during the accounting period, after deducting
the relevant amounts for cancelled leases.
Operating Leases
39. The lessor should present an asset given under operating lease in its balance
sheet under fixed assets.
40. Lease income from operating leases should be recognised in the statement of
profit and loss on a straight line basis over the lease term, unless another
systematic basis is more representative of the time pattern in which benefit derived
from the use of the leased asset is diminished.
41. Costs, including depreciation, incurred in earning the lease income are recognised as an
expense. Lease income (excluding receipts for services provided such as insurance and
maintenance) is recognised in the statement of profit and loss on a straight line basis
over the lease term even if the receipts are not on such a basis, unless another
systematic basis is more representative of the time pattern in which benefit derived from
the use of the leased asset is diminished.
42. Initial direct costs incurred specifically to earn revenues from an operating lease are
either deferred and allocated to income over the lease term in proportion to the
recognition of rent income, or are recognised as an expense in the statement of profit
and loss in the period in which they are incurred.
43. The depreciation of leased assets should be on a basis consistent with the normal
depreciation policy of the lessor for similar assets, and the depreciation charge
should be calculated on the basis set out in AS 6, Depreciation Accounting.
44. To determine whether a leased asset has become impaired, an enterprise applies the
Accounting Standard dealing with impairment of assets2 that sets out the requirements
for how an enterprise should perform the review of the carrying amount of an asset, how
it should determine the recoverable amount of an asset and when it should recognise, or
reverse, an impairment loss.
45. A manufacturer or dealer lessor does not recognise any selling profit on entering into an
operating lease because it is not the equivalent of a sale.
46. The lessor should, in addition to the requirements of AS 6, Depreciation
Accounting and AS 10, Accounting for Fixed Assets, and the governing statute,
make the following disclosures for operating leases:
(a) for each class of assets, the gross carrying amount, the accumulated
depreciation and accumulated impairment losses at the balance sheet date;
and
(i) the depreciation recognised in the statement of profit and loss for the
period;
(ii) impairment losses recognised in the statement of profit and loss for the
period;
(iii) impairment losses reversed in the statement of profit and loss for the
period;
(b) the future minimum lease payments under non-cancellable operating leases in
the aggregate and for each of the following periods:
(c) total contingent rents recognised as income in the statement of profit and loss
for the period;
(d) a general description of the lessor’s significant leasing arrangements; and
(e) accounting policy adopted in respect of initial direct costs.
SALE AND LEASEBACK TRANSACTIONS

47. A sale and leaseback transaction involves the sale of an asset by the vendor and the
leasing of the same asset back to the vendor. The lease payments and the sale price are
2
AS 28, ‘impairment of Assets’, specifies the requirements relating to impairment of
assets.
usually interdependent as they are negotiated as a package. The accounting treatment of

a sale and leaseback transaction depends upon the type of lease involved.
48. If a sale and leaseback transaction results in a finance lease, any excess or
deficiency of sales proceeds over the carrying amount should not be immediately
recognised as income or loss in the financial statements of a seller-lessee. Instead,
it should be deferred and amortised over the lease term in proportion to the
depreciation of the leased asset.
49. If the leaseback is a finance lease, it is not appropriate to regard an excess of sales
proceeds over the carrying amount as income. Such excess is deferred and amortised
over the lease term in proportion to the depreciation of the leased asset. Similarly, it is
not appropriate to regard a deficiency as loss. Such deficiency is deferred and amortised
over the lease term.
50. If a sale and leaseback transaction results in an operating lease, and it is clear that
the transaction is established at fair value, any profit or loss should be recognised
immediately. If the sale price is below fair value, any profit or loss should be
recognised immediately except that, if the loss is compensated by future lease
payments at below market price, it should be deferred and amortised in proportion
to the lease payments over the period for which the asset is expected to be used. If
the sale price is above fair value, the excess over fair value should be deferred and
amortised over the period for which the asset is expected to be used.
51. If the leaseback is an operating lease, and the lease payments and the sale price are
established at fair value, there has in effect been a normal sale transaction and any profit
or loss is recognised immediately.
52. For operating leases, if the fair value at the time of a sale and leaseback
transaction is less than the carrying amount of the asset, a loss equal to the
amount of the difference between the carrying amount and fair value should be
recognised immediately.
53. For finance leases, no such adjustment is necessary unless there has been an
impairment in value, in which case the carrying amount is reduced to recoverable amount
in accordance with the Accounting Standard dealing with impairment of assets.
54. Disclosure requirements for lessees and lessors apply equally to sale and leaseback
transactions. The required description of the significant leasing arrangements leads to
disclosure of unique or unusual provisions of the agreement or terms of the sale and
leaseback transactions.
55. Sale and leaseback transactions may meet the separate disclosure criteria set out in
paragraph 12 of Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior
Period Items and Changes in Accounting Policies.
APPENDIX
Sale and Leaseback Transactions that Result in Operating Leases

A sale and leaseback transaction that results in an operating lease may give rise to profit or a
loss, the determination and treatment of which depends on the leased asset’s carrying
amount, fair value and selling price. The following table shows the requirements of the
accounting standard in various circumstances.
Sale price Carrying amount Carrying amount less than Carrying
established at fair equal tofair value fair value amount
value (paragraph above fair
50) value
Profit No profit Recognise profit Not
immediately applicable
Loss No loss Not applicable Recognise
loss
immediately
Sale price below fair
value (paragraph 50)
Profit No profit Recognise profit No profit

immediately (note 1)
Loss not Recognise loss Recognise loss immediately (note 1)
compensated by immediately
future lease
payments at below
market price
Loss compensated Defer and amortise Defer and amortise loss (note 1)
by future lease loss
payments at below
market price
Sale price above

fair value
(paragraph 50)
Profit Defer and amortise Defer and amortise profitDefer and

profit amortise profit
(note 2)
Loss No loss No loss (note 1)
Note 1. These parts of the table represent circumstances that would have been dealt with
under paragraph 52 of the Standard. Paragraph 52 requires the carrying amount of an asset to
be written down to fair value where it is subject to a sale and leaseback.
Note 2. The profit would be the difference between fair value and sale price as the carrying
amount would have been written down to fair value in accordance with paragraph 52.
AS 20 : EARNINGS PER SHARE∗
Accounting Standard (AS) 20, ‘Earnings Per Share’, issued by the Council of the Institute
of Chartered Accountants of India, comes into effect in respect of accounting periods
commencing on or after 1-4-2001 and is mandatory in nature, from that date, in respect
of enterprises whose equity shares or potential equity shares are listed on a recognised
stock exchange in India.
An enterprise which has neither equity shares nor potential equity shares which are so
listed but which discloses earnings per share, should calculate and disclose earnings per
share in accordance with this Standard from the aforesaid date. However, in respect of
accounting periods commencing on or after 1-4-20041, if any such enterprise does not
∗
A limited revision this standard has been made in 2004, pursuant to which paragraphs
48 and 51 of this standard have been revised.
1
Originally, no exemption was available to an enterprise, which had neither equity shares
nor potential equity shares which were listed on a recognised stock exchange in India,
but which disclosed earnings per share. It is clarified that no exemption is available even
in respect of accounting periods commencing on or after 1-4-2004 to enterprises whose
equity shares or potential equity shares are listed on a recognised stock exchange in
India. It is also clarified that this Standard is not applicable to an enterprise which has
fall in any of the following categories, it need not disclose diluted earnings per share
(both including and excluding extraordinary items) and information required by paragraph
48 (ii) of this Standard:
(i) Enterprises whose equity securities or potential equity securities are listed outside
India and enterprises whose debt securities (other than potential equity securities)
are listed whether in India or outside India.
immediately preceding accounting period on the basis of audited financial
statements exceeds Rs. 50 crore. Turnover does not include ‘other income’.
including public deposits, in excess of Rs. 10 crore at any time during the
accounting period.
accounting period.
Where an enterprise (which has neither equity shares nor potential equity shares which
are listed on a recognised stock exchange in India but which discloses earnings per
share) has been covered in any one or more of the above categories and subsequently,
ceases to be so covered, the enterprise will not qualify for exemption from the disclosure
of diluted earnings per share (both including and excluding extraordinary items) and
paragraph 48 (ii) of this Standard, until the enterprise ceases to be covered in any of the
above categories for two consecutive years.
Where an enterprise (which has neither equity shares nor potential equity shares which
are listed on a recognised stock exchange in India but which discloses earnings per
share) has previously qualified for exemption from the disclosure of diluted earnings per
share (both including and excluding extraordinary items) and paragraph 48 (ii) of this
Standard (being not covered by any of the above categories) but no longer qualifies for
exemption in the current accounting period, this Standard becomes applicable, in its
entirety, from the current period. However, the relevant corresponding previous period
figures need not be disclosed.
neither equity shares nor potential equity shares which are listed on a recognised stock
exchange in India and which also does not disclose earnings per share.
If an enterprise (which has neither equity shares nor potential equity shares which are
listed on a recognised stock exchange in India but which discloses earnings per share),
pursuant to the above provisions, does not disclose the diluted earnings per share (both
including and excluding earnings per share) and information required by paragraph 48
(ii), it should disclose the fact.
Objective
The objective of this Statement is to prescribe principles for the determination and
presentation of earnings per share which will improve comparison of performance among
different enterprises for the same period and among different accounting periods for the same
enterprise. The focus of this Statement is on the denominator of the earnings per share
calculation. Even though earnings per share data has limitations because of different
accounting policies used for determining ‘earnings’, a consistently determined denominator
enhances the quality of financial reporting.
Scope
1. This Statement should be applied by enterprises whose equity shares or potential
equity shares are listed on a recognised stock exchange in India. An enterprise which
has neither equity shares nor potential equity shares which are so listed but which
discloses earnings per share should calculate and disclose earnings per share in
accordance with this Statement. ∗
2. In consolidated financial statements, the information required by this Statement
should be presented on the basis of consolidated information1.
3. This Statement applies to enterprises whose equity or potential equity shares are listed
on a recognised stock exchange in India. An enterprise which has neither equity shares nor
potential equity shares which are so listed is not required to disclose earnings per share.
However, comparability in financial reporting among enterprises is enhanced if such an
enterprise that is required to disclose by any statute or chooses to disclose earnings per share
calculates earnings per share in accordance with the principles laid down in this Statement. In
the case of a parent (holding enterprise), users of financial statements are usually concerned
with, and need to be informed about, the results of operations of both the enterprise itself as
∗
See also ASI 12
1
AS – 21, ‘Consolidated Financial Statements’, specifies the requirements relating to
consolidated financial statements.
well as of the group as a whole. Accordingly, in the case of such enterprises, this Statement
requires the presentation of earnings per share information on the basis of consolidated
financial statements as well as individual financial statements of the parent. In consolidated
financial statements, such information is presented on the basis of consolidated information.
Definitions
specified:
An equity share is a share other than a preference share.
A preference share is a share carrying preferential rights to dividends and repayment of
capital.
A financial instrument is any contract that gives rise to both a financial asset of one
enterprise and a financial liability or equity shares of another enterprise.
A potential equity share is a financial instrument or other contract that entitles, or may
entitle, its holder to equity shares.
Share warrants or options are financial instruments that give the holder the right to
acquire equity shares.
Fair value is the amount for which an asset could be exchanged, or a liability settled,
5. Equity shares participate in the net profit for the period only after preference shares. An
enterprise may have more than one class of equity shares. Equity shares of the same class
have the same rights to receive dividends.
6. A financial instrument is any contract that gives rise to both a financial asset of one
enterprise and a financial liability or equity shares of another enterprise. For this purpose, a
financial asset is any asset that is
(a) cash;
(b) a contractual right to receive cash or another financial asset from another enterprise;
(c) a contractual right to exchange financial instruments with another enterprise under
conditions that are potentially favourable; or
(d) an equity share of another enterprise.
A financial liability is any liability that is a contractual obligation to deliver cash or another
financial asset to another enterprise or to exchange financial instruments with another
enterprise under conditions that are potentially unfavourable.
7. Examples of potential equity shares are:

(a) debt instruments or preference shares, that are convertible into equity shares.
(b) share warrants;
(c) options including employee stock option plans under which employees of an enterprise
are entitled to receive equity shares as part of their remuneration and other similar plans;
and
(d) shares which would be issued upon the satisfaction of certain conditions resulting from
contractual arrangements (contingently issuable shares), such as the acquisition of a
business or other assets, or shares issuable under a loan contract upon default of
payment of principal or interest, if the contract so provides.
Presentation
8. An enterprise should present basic and diluted earnings per share on the face of
the statement of profit and loss for each class of equity shares that has a different right
to share in the net profit for the period. An enterprise should present basic and diluted
earnings per share with equal prominence for all periods presented.
9. This Statement requires an enterprise to present basic and diluted earnings per
share, even if the amounts disclosed are negative (a loss per share).
MEASUREMENT
Basic Earnings Per Share

10. Basic earnings per share should be calculated by dividing the net profit or loss for
the period attributable to equity shareholders by the weighted average number of equity
shares outstanding during the period.
EARNINGS - BASIC
11. 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.
12. 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 (see Accounting Standard
(AS) 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting
Policies). 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.
13. The amount of preference dividends for the period that is deducted from the net profit for
the period is:
(a) the amount of any preference dividends on non-cumulative preference shares provided
for in respect of the period; and
(b) the full amount of the required preference dividends for cumulative preference shares for
the period, whether or not the dividends have been provided for. The amount of
preference dividends for the period does not include the amount of any preference
dividends for cumulative preference shares paid or declared during the current period in
respect of previous periods.
14. If an enterprise has more than one class of equity shares, net profit or loss for the period
is apportioned over the different classes of shares in accordance with their dividend rights.
Per Share - Basic

15. 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.
16. 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.
Appendix I illustrates the computation of weighted average number of shares.
17. In most cases, shares are included in the weighted average number of shares from the
date the consideration is receivable , for example:
(a) equity shares issued in exchange for cash are included when cash is receivable;
(b) equity shares issued as a result of the conversion of a debt instrument to equity shares
are included as of the date of conversion;
(c) equity shares issued in lieu of interest or principal on other financial instruments are
included as of the date interest ceases to accrue;
(d) equity shares issued in exchange for the settlement of a liability of the enterprise are
included as of the date the settlement becomes effective;
(e) equity shares issued as consideration for the acquisition of an asset other than cash are
included as of the date on which the acquisition is recognised; and
(f) equity shares issued for the rendering of services to the enterprise are included as the
services are rendered.
In these and other cases, the timing of the inclusion of equity shares is determined by the
specific terms and conditions attaching to their issue. Due consideration should be given to
the substance of any contract associated with the issue.
18. Equity shares issued as part of the consideration in an amalgamation in nature of
purchase are included in the weighted average number of shares as of the date of the
acquisition because the transferee incorporates the results of the operations of the transferor
into its statement of profit and loss as from the date of acquisition. Equity shares issued during
the reporting period as part of the consideration in an amalgamation in the nature of merger
are included in the calculation of the weighted average number of shares from the beginning
of the reporting period because the financial statements of the combined enterprise for the
reporting period are prepared as if the combined entity had existed from the beginning of the
reporting period. Therefore, the number of equity shares used for the calculation of basic
earnings per share in an amalgamation in the nature of merger is the aggregate of the
weighted average number of shares of the combined enterprises, adjusted to equivalent
shares of the enterprise whose shares are outstanding after the amalgamation.
19. Partly paid equity shares are treated as a fraction of an equity share to the extent that
they were entitled to participate in dividends relative to a fully paid equity share during the
reporting period.
Appendix II illustrates the computations in respect of partly paid equity shares.
20. Where an enterprise has equity shares of different nominal values but with the same
dividend rights, the number of equity shares are calculated by converting all such equity
shares into equivalent number of shares of the same nominal value.
21. Equity shares which are issuable upon the satisfaction of certain conditions resulting
from contractual arrangements (contingently issuable shares) are considered outstanding, and
included in the computation of basic earnings per share from the date when all necessary
conditions under the contract have been satisfied.
22. The weighted average number of equity shares outstanding during the period and
for all periods presented should be adjusted for events, other than the conversion of
potential equity shares, that have changed the number of equity shares outstanding,
without a corresponding change in resources.
23. Equity shares may be issued, or the number of shares outstanding may be reduced,
without a corresponding change in resources. Examples include:
(a) a bonus issue;

(b) a bonus element in any other issue, for example a bonus element in a rights issue to
existing shareholders;
(c) a share split; and
(d) a reverse share split (consolidation of shares).
24. In case of a bonus issue or a share split, equity shares are issued to existing
shareholders for no additional consideration. Therefore, the number of equity shares
outstanding is increased without an increase in resources. The number of equity shares
outstanding before the event is adjusted for the proportionate change in the number of equity
shares outstanding as if the event had occurred at the beginning of the earliest period
reported. For example, upon a two-for-one bonus issue, the number of shares outstanding
prior to the issue is multiplied by a factor of three to obtain the new total number of shares, or
by a factor of two to obtain the number of additional shares.
Appendix III illustrates the computation of weighted average number of equity shares in case
of a bonus issue during the period.
25. The issue of equity shares at the time of exercise or conversion of potential equity shares
will not usually give rise to a bonus element, since the potential equity shares will usually have
been issued for full value, resulting in a proportionate change in the resources available to the
enterprise. In a rights issue, on the other hand, the exercise price is often less than the fair
value of the shares. Therefore, a rights issue usually includes a bonus element. The number
of equity shares to be used in calculating basic earnings per share for all periods prior to the
rights issue is the number of equity shares outstanding prior to the issue, multiplied by the
following factor:
Fair value per share immediately prior to the exercise of rights
Theoretical ex - rights fair value per share
The theoretical ex-rights fair value per share is calculated by adding the aggregate fair value
of the shares immediately prior to the exercise of the rights to the proceeds from the exercise
of the rights, and dividing by the number of shares outstanding after the exercise of the rights.
Where the rights themselves are to be publicly traded separately from the shares prior to the
exercise date, fair value for the purposes of this calculation is established at the close of the
last day on which the shares are traded together with the rights.
Appendix IV illustrates the computation of weighted average number of equity shares in case
of a rights issue during the period.
DILUTED EARNINGS PER SHARE

26. For the purpose of calculating diluted earnings per share, the net profit or loss for
the period attributable to equity shareholders and the weighted average number of
shares outstanding during the period should be adjusted for the effects of all dilutive
potential equity shares.
27. In calculating diluted earnings per share, effect is given to all dilutive potential equity
shares that were outstanding during the period, that is:
(a) the net profit for the period attributable to equity shares is:
(i) increased by the amount of dividends recognised in the period in respect of the
dilutive potential equity shares as adjusted for any attributable change in tax
expense for the period;
(ii) increased by the amount of interest recognised in the period in respect of the
dilutive potential equity shares as adjusted for any attributable change in tax
expense for the period; and
(iii) adjusted for the after-tax amount of any other changes in expenses or income that
would result from the conversion of the dilutive potential equity shares.
(b) the weighted average number of equity shares outstanding during the period is increased
by the weighted average number of additional equity shares which would have been
outstanding assuming the conversion of all dilutive potential equity shares.
28. For the purpose of this Statement, share application money pending allotment or any
advance share application money as at the balance sheet, which is not statutorily required to
be kept separately and is being utilised in the business of the enterprise, is treated in the
same manner as dilutive potential equity shares for the purpose of calculation of diluted
earnings per share.
EARNINGS - DILUTED
29. For the purpose of calculating diluted earnings per share, the amount of net profit
or loss for the period attributable to equity shareholders, as calculated in accordance
with paragraph 11, should be adjusted by the following, after taking into account any
attributable change in tax expense for the period:
(a) any dividends on dilutive potential equity shares which have been deducted in
arriving at the net profit attributable to equity shareholders as calculated in
accordance with paragraph 11;
(b) interest recognised in the period for the dilutive potential equity shares; and
(c) any other changes in expenses or income that would result from the conversion of
the dilutive potential equity shares.
30. After the potential equity shares are converted into equity shares, the dividends, interest
and other expenses or income associated with those potential equity shares will no longer be
incurred (or earned). Instead, the new equity shares will be entitled to participate in the net
profit attributable to equity shareholders. Therefore, the net profit for the period attributable to
equity shareholders calculated in accordance with paragraph 11 is increased by the amount of
dividends, interest and other expenses that will be saved, and reduced by the amount of
income that will cease to accrue, on the conversion of the dilutive potential equity shares into
equity shares. The amounts of dividends, interest and other expenses or income are adjusted
for any attributable taxes.
Appendix V illustrates the computation of diluted earnings in case of convertible debentures.
31. The conversion of some potential equity shares may lead to consequential changes in
other items of income or expense. For example, the reduction of interest expense related to
potential equity shares and the resulting increase in net profit for the period may lead to an
increase in the expense relating to a non-discretionary employee profit sharing plan. For the
purpose of calculating diluted earnings per share, the net profit or loss for the period is
adjusted for any such consequential changes in income or expenses.
PER SHARE - DILUTED

32. For the purpose of calculating diluted earnings per share, the number of equity
shares should be the aggregate of the weighted average number of equity shares
calculated in accordance with paragraphs 15 and 22, and the weighted average number
of equity shares which would be issued on the conversion of all the dilutive potential
equity shares into equity shares. Dilutive potential equity shares should be deemed to
have been converted into equity shares at the beginning of the period or, if issued later,
the date of the issue of the potential equity shares.
33. The number of equity shares which would be issued on the conversion of dilutive
potential equity shares is determined from the terms of the potential equity shares. The
computation assumes the most advantageous conversion rate or exercise price from the
standpoint of the holder of the potential equity shares.
34. Equity shares which are issuable upon the satisfaction of certain conditions resulting
from contractual arrangements (contingently issuable shares) are considered outstanding and
included in the computation of both the basic earnings per share and diluted earnings per
share from the date when the conditions under a contract are met. If the conditions have not
been met, for computing the diluted earnings per share, contingently issuable shares are
included as of the beginning of the period (or as of the date of the contingent share
agreement, if later). The number of contingently issuable shares included in this case in
computing the diluted earnings per share is based on the number of shares that would be
issuable if the end of the reporting period was the end of the contingency period. Restatement
is not permitted if the conditions are not met when the contingency period actually expires
subsequent to the end of the reporting period. The provisions of this paragraph apply equally
to potential equity shares that are issuable upon the satisfaction of certain conditions
(contingently issuable potential equity shares).
35. For the purpose of calculating diluted earnings per share, an enterprise should
assume the exercise of dilutive options and other dilutive potential equity shares of the
enterprise. The assumed proceeds from these issues should be considered to have
been received from the issue of shares at fair value. The difference between the number
of shares issuable and the number of shares that would have been issued at fair value
should be treated as an issue of equity shares for no consideration.
36. Fair value for this purpose is the average price of the equity shares during the period.
Theoretically, every market transaction for an enterprise’s equity shares could be included in
determining the average price. As a practical matter, however, a simple average of last six
months weekly closing prices are usually adequate for use in computing the average price.
37. Options and other share purchase arrangements are dilutive when they would result in
the issue of equity shares for less than fair value. The amount of the dilution is fair value less
the issue price. Therefore, in order to calculate diluted earnings per share, each such
arrangement is treated as consisting of:
(a) a contract to issue a certain number of equity shares at their average fair value during
the period. The shares to be so issued are fairly priced and are assumed to be neither
dilutive nor anti-dilutive. They are ignored in the computation of diluted earnings per
share; and
(b) a contract to issue the remaining equity shares for no consideration. Such equity shares
generate no proceeds and have no effect on the net profit attributable to equity shares
outstanding. Therefore, such shares are dilutive and are added to the number of equity
shares outstanding in the computation of diluted earnings per share.
Appendix VI illustrates the effects of share options on diluted earnings per share.
38. To the extent that partly paid shares are not entitled to participate in dividends during the
reporting period they are considered the equivalent of warrants or options.
DILUTIVE POTENTIAL EQUITY SHARES

39. Potential equity shares should be treated as dilutive when, and only when, their
conversion to equity shares would decrease net profit per share from continuing
ordinary operations.
40. An enterprise uses net profit from continuing ordinary activities as “the control figure” that
is used to establish whether potential equity shares are dilutive or anti-dilutive. The net profit
from continuing ordinary activities is the net profit from ordinary activities (as defined in AS 5)
after deducting preference dividends and any attributable tax thereto and after excluding items
relating to discontinued operations2.
41. Potential equity shares are anti-dilutive when their conversion to equity shares would
increase earnings per share from continuing ordinary activities or decrease loss per share
from continuing ordinary activities. The effects of anti-dilutive potential equity shares are
ignored in calculating diluted earnings per share.
42. In considering whether potential equity shares are dilutive or anti-dilutive, each issue or
series of potential equity shares is considered separately rather than in aggregate. The
sequence in which potential equity shares are considered may affect whether or not they are
dilutive. Therefore, in order to maximise the dilution of basic earnings per share, each issue or
series of potential equity shares is considered in sequence from the most dilutive to the least
dilutive. For the purpose of determining the sequence from most dilutive to least dilutive
potential equity shares, the earnings per incremental potential equity share is calculated.
Where the earnings per incremental share is the least, the potential equity share is considered
most dilutive and vice-versa.
Appendix VII illustrates the manner of determining the order in which dilutive securities should
be included in the computation of weighted average number of shares.
43. Potential equity shares are weighted for the period they were outstanding. Potential
equity shares that were cancelled or allowed to lapse during the reporting period are included
in the computation of diluted earnings per share only for the portion of the period during which
they were outstanding. Potential equity shares that have been converted into equity shares
during the reporting period are included in the calculation of diluted earnings per share from
the beginning of the period to the date of conversion; from the date of conversion, the
resulting equity shares are included in computing both basic and diluted earnings per share.
RESTATEMENT
44. If the number of equity or potential equity shares outstanding increases as a result
of a bonus issue or share split or decreases as a result of a reverse share split
(consolidation of shares), the calculation of basic and diluted earnings per share should
be adjusted for all the periods presented. If these changes occur after the balance sheet
date but before the date on which the financial statements are approved by the board of
directors, the per share calculations for those financial statements and any prior period
financial statements presented should be based on the new number of shares. When
per share calculations reflect such changes in the number of shares, that fact should be
disclosed.
2
AS 24, ‘Discontinuing Operations’, specifies the requirements in respect of discontinued
operations.
45. An enterprise does not restate diluted earnings per share of any prior period presented
for changes in the assumptions used or for the conversion of potential equity shares into
equity shares outstanding.
46. An enterprise is encouraged to provide a description of equity share transactions or
potential equity share transactions, other than bonus issues, share splits and reverse share
splits (consolidation of shares) which occur after the balance sheet date when they are of such
importance that non-disclosure would affect the ability of the users of the financial statements
to make proper evaluations and decisions. Examples of such transactions include:
(a) the issue of shares for cash;
(b) the issue of shares when the proceeds are used to repay debt or preference shares
outstanding at the balance sheet date;
(c) the cancellation of equity shares outstanding at the balance sheet date;
(d) the conversion or exercise of potential equity shares, outstanding at the balance sheet
date, into equity shares;
(e) the issue of warrants, options or convertible securities; and
(f) the satisfaction of conditions that would result in the issue of contingently issuable
shares.
47. Earnings per share amounts are not adjusted for such transactions occurring after the
balance sheet date because such transactions do not affect the amount of capital used to
produce the net profit or loss for the period.
DISCLOSURE
48. In addition to disclosures as required by paragraphs 8, 9 and 44 of this Statement,
an enterprise should disclose the following:
(i) where the statement of profit and loss includes extraordinary items (within the
meaning of AS 5, Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies), the enterprise should disclose basic and diluted earnings per
share computed on the basis of earnings excluding extraordinary items (net of tax
expense); and
(ii) (a) the amounts used as the numerators in calculating basic and diluted earnings
per share, and a reconciliation of those amounts to the net profit or loss for
the period;
(b) the weighted average number of equity shares used as the denominator in
calculating basic and diluted earnings per share, and a reconciliation of these
denominators to each other; and
(c) the nominal value of shares along with the earnings per share figures£
49. Contracts generating potential equity shares may incorporate terms and conditions which
affect the measurement of basic and diluted earnings per share. These terms and conditions
may determine whether or not any potential equity shares are dilutive and, if so, the effect on
the weighted average number of shares outstanding and any consequent adjustments to the
net profit attributable to equity shareholders. Disclosure of the terms and conditions of such
contracts is encouraged by this Statement.
50. If an enterprise discloses, in addition to basic and diluted earnings per share, per
share amounts using a reported component of net profit other than net profit or loss for
the period attributable to equity shareholders, such amounts should be calculated
using the weighted average number of equity shares determined in accordance with this
Statement. If a component of net profit is used which is not reported as a line item in
the statement of profit and loss, a reconciliation should be provided between the
component used and a line item which is reported in the statement of profit and loss.
Basic and diluted per share amounts should be disclosed with equal prominence.
51. An enterprise may wish to disclose more information than this Statement requires. Such
information may help the users to evaluate the performance of the enterprise and may take
the form of per share amounts for various components of net profit,. Such disclosures are
encouraged. However, when such amounts are disclosed, the denominators need to be
calculated in accordance with this Statement in order to ensure the comparability of the per
share amounts disclosed. £
APPENDICES
Note : These appendices are illustrative only and do not form part of the Accounting Standard.
The purpose of the appendices is to illustrate the application of the Accounting Standard.
Appendix I
Example - Weighted Average Number of Shares
(Accounting year 01-01-20X1 to 31-12-20X1)
No. of No. of No. of
Shares Shares Shares
Issued Bought Outstanding
Back
1st Balance at beginning 1,800 - 1,800
£
A limited revision to AS 20 hs been made in 2004 thereby revising this paragraph.This
paragraph
January, of year
20X1
31st Issue of share for 600 - 2,400
May, cash
20X1
1st Nov., Buy Back of shares - 300 2,100
20X1
31st Balance at end of 2,400 300 2,100
Dec., year
20X1
Computation of Weighted Average:
(1,800 x 5/12) + (2,400 x 5/12) + (2,100 x 2/12) = 2,100 shares.
The weighted average number of shares can alternatively be computed as follows:
(1,800 x12/12) + (600 x 7/12) - (300 x 2/12) = 2,100 shares
Appendix II
Example – Partly paid shares
(Accounting year 01-01-20X1 to 31-12-20X1)
No. of Shares Nominal Amount paid
issued value of
shares
1st January, Balance at beginning 1,800 Rs. 10 Rs. 10

20X1 of the year
31st Issue of 600 Rs. 10 Rs. 5

October, Shares
20X1
Assuming that partly paid shares are entitled to participate in the dividend to the extent of
amount paid, number of partly paid equity shares would be taken as 300 for the purpose of
calculation of earnings per share.
Computation of weighted average would be as follows:
(1800x12/12) + (300x2/12) = 1850 shares.

Appendix III
Example – Bonus Issue
(Accounting year 01-01-20XX to 31-12-20XX)
Net profit for the year 20X0 Rs. 18,00,000
No. of equity shares outstanding 20,00,000
until 30th September 20X1
Bonus issue 1st October 20X1 2 equity shares for each equity share
outstanding at 30th September, 20X1
20,00,000 × 2 = 40,00,000
Rs.60,00,000
Earnings per share for the year 20X1 = Re. 1.00
(20,00,000 + 40,00,000)
Rs.18,00,000
Adjusted earnings per share for the year 20X0 = Re. 0.30
(20,00,000 + 40,00,000)
Since the bonus issue is an issue without consideration, the issue is treated as if it had
occurred prior to the beginning of the year 20X0, the earliest period reported.
Appendix IV
Example – Rights Issue
Net profit Year 20X0 : Rs. 11,00,000
Year 20X1 : Rs. 15,00,000
No. of shares outstanding 5,00,000 shares
prior to rights issue
Rights issue One new share for each five outstanding
(i.e. 1,00,000 new shares)
Rights issue price : Rs. 15.00
Last date to exercise rights: 1st March 20X1
Fair value of one equity Rs. 21.00
share immediately prior to exercise
of rights on 1st March 20X1
Computation of theoretical ex-rights fair value per share

Fair value of all outstanding shares immediately prior to exercise of rights + total amount received from exercise
Number of shares outstanding prior to exercise + number of shares issued in the exercise
(Rs.21.00 × 5,00,000 shares) + (Rs.15.00 × 1,00,000 shares)

5,00,000 shares + 1,00,000 shares
Theoretical ex-rights fair value per share = Rs. 20.00
Computation of adjustment factor

Fair value per share prior to exercise of rights Rs.(21.00 )
= = 1.05
Theoretica l ex - rights value per share Rs.(20.00 )
Computation of earnings per share

Year 20X0 Year 20X1
EPS for the year 20X0 as originally Rs. 2.20

reported: Rs.11,00,000/5,00,000 shares
EPS for the year 20X0 restated for rights
issue: Rs.11,00,000/(5,00,000 shares x 1.05) Rs. 2.10
EPS for the year 20X1 including effects of
rights issue
Rs.15,00,000
Rs. 2.55
(5,00,000 × 1.05 × 2 / 12) + (6,00,000 × 10 / 12)
Appendix V
Example - Convertible Debentures
Net profit for the current year Rs. 1,00,00,000
No. of equity shares outstanding 50,00,000
Basic earnings per share Rs. 2.00
No. of 12% convertible debentures of Rs. 100 each 1,00,000
Each debenture is convertible into 10 equity shares
Interest expense for the current year Rs. 12,00,000
Tax relating to interest expense (30%) Rs. 3,60,000
Adjusted net profit for the current year Rs. (1,00,00,000 + 12,00,000 –
3,60,000) = Rs. 1,08,40,000
No. of equity shares resulting from 10,00,000
conversion of debentures
No. of equity shares used to compute 50,00,000 + 10,00,000 =
diluted earnings per share 60,00,000
Diluted earnings per share 1,08,40,000 / 60,00,000 = Rs. 1.81
Appendix VI
Example - Effects of Share Options on Diluted Earnings Per Share
Weighted average number of equity shares 5,00,000 shares
outstanding during the year 20X1
Average fair value of one equity share during the year 20X1 Rs. 20.00
Weighted average number of shares under 1,00,000 shares
option during the year 20X1
Exercise price for shares under option during the year 20X1 Rs. 15.00
Computation of earnings per share
Earnings Shares Earnings per share
(Rs.)
Net profit for the year 20X1 Rs.12,00,000
Weighted average number of shares 5,00,000
outstanding during year 20X1
Basic earnings per share Rs. 2.40
Number of shares under option 1,00,000
Number of shares that * (75,000)
would have been issued at fair value:
(100,000 x 15.00)/20.00
Diluted earnings per share Rs.12,00,000 5,25,000 Rs. 2.29
*The earnings have not been increased as the total number of shares has been increased only
by the number of shares (25,000) deemed for the purpose of the computation to have been
issued for no consideration {see para 37(b)}
AS 21 : CONSOLIDATED FINANCIAL STATEMENTS
Accounting Standard (AS) 21, ‘Consolidated Financial Statements’, issued by the Council of
the Institute of Chartered Accountants of India, comes into effect in respect of accounting
periods commencing on or after 1-4-2001. An enterprise that presents consolidated financial
statements should prepare and present these statements in accordance with this Standard.
The following is the text of the Accounting Standard1.
Objective
The objective of this Statement is to lay down principles and procedures for preparation and
presentation of consolidated financial statements. Consolidated financial statements are
presented by a parent (also known as holding enterprise) to provide financial information
about the economic activities of its group. These statements are intended to present financial
information about a parent and its subsidiary(ies) as a single economic entity to show the
economic resources controlled by the group, the obligations of the group and results the group
achieves with its resources.
Scope
1. This Statement should be applied in the preparation and presentation of
consolidated financial statements for a group of enterprises under the control of a
parent.
2. This Statement should also be applied in accounting for investments in
subsidiaries in the separate financial statements of a parent.
3. In the preparation of consolidated financial statements, other Accounting Standards also
apply in the same manner as they apply to the separate financial statements.
4. This Statement does not deal with:
1
It is clarified that AS 21 is mandatory if an enterprise presents consolidated financial
statements. In other words, the accounting standard does not mandate an enterprise
to present consolidated financial statements but, if the enterprise presents
consolidated financial statements for complying with the requirements of any statute
or otherwise, it should prepare and present consolidated financial statements in
accordance with AS – 21.
(a) methods of accounting for amalgamations and their effects on consolidation,

including goodwill arising on amalgamation (see AS 14, Accounting for
Amalgamations);
(b) accounting for investments in associates (at present governed by AS 13,
Accounting for Investments)2; and
(c) accounting for investments in joint ventures (at present governed by AS 13,
Accounting for Investments)3.
Definitions
specified:
Control:
(a) the ownership, directly or indirectly through subsidiary(ies), of more than one-half
of the voting power of an enterprise; or
the composition of the corresponding governing body in case of any other
enterprise so as to obtain economic benefits from its activities.
A subsidiary is an enterprise that is controlled by another enterprise (known as the
parent).
A parent is an enterprise that has one or more subsidiaries.
A group is a parent and all its subsidiaries.
Consolidated financial statements are the financial statements of a group presented as
those of a single enterprise.
Equity is the residual interest in the assets of an enterprise after deducting all its
liabilities.
Minority interest is that part of the net results of operations and of the net assets of a
subsidiary attributable to interests which are not owned, directly or indirectly through
subsidiary(ies), by the parent.
2
AS 23, ‘Accounting for Investments in Associates in Consolidated Financial
Statements’, which came into effect in respect of accounting periods commencing on
or after 1.4.2002, specifies the requirements relating to accounting for investment in
associates in Consolidated Financial Statement.
3
AS 27, ‘Financial Reporting of Interests in Joint Ventures’, which came into effect in
respect of accounting periods commencing on or after 1.4.2002 specifies the
requirements relating to accounting for investments in joint ventures.
6. 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.
PRESENTATION OF CONSOLIDATED FINANCIAL STATEMENTS

7. A parent which presents consolidated financial statements should present these
statements in addition to its separate financial statements.
8. 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.
SCOPE OF CONSOLIDATED FINANCIAL STATEMENTS

9. A parent which presents consolidated financial statements should consolidate all
subsidiaries, domestic as well as foreign, other than those referred to in paragraph 11.
10. The consolidated financial statements are prepared on the basis of financial statements
of parent and all enterprises that are controlled by the parent, other than those subsidiaries
excluded for the reasons set out in paragraph 11. Control exists when the parent owns,
directly or indirectly through subsidiary(ies), more than one-half of the voting power of an
enterprise. Control also exists when an enterprise controls the composition of the board of
directors (in the case of a company) or of the corresponding governing body (in case of an
enterprise not being a company) so as to obtain economic benefits from its activities. An
enterprise may control the composition of the governing bodies of entities such as gratuity
trust, provident fund trust etc. Since the objective of control over such entities is not to obtain
economic benefits from their activities, these are not considered for the purpose of preparation
of consolidated financial statements. For the purpose of this Statement, an enterprise is
considered to control the composition of:
(i) the board of directors of a company, if it has the power, without the consent or
concurrence of any other person, to appoint or remove all or a majority of directors of
that company. An enterprise is deemed to have the power to appoint a director, if any of
the following conditions is satisfied:
(a) a person cannot be appointed as director without the exercise in his favour by that
enterprise of such a power as aforesaid; or
(b) a person’s appointment as director follows necessarily from his appointment to a
position held by him in that enterprise; or
(c) the director is nominated by that enterprise or a subsidiary thereof.
(ii) the governing body of an enterprise that is not a company, if it has the power, without the
consent or the concurrence of any other person, to appoint or remove all or a majority of
members of the governing body of that other enterprise. An enterprise is deemed to have
the power to appoint a member, if any of the following conditions is satisfied:
(a) a person cannot be appointed as member of the governing body without the
exercise in his favour by that other enterprise of such a power as aforesaid; or
(b) a person’s appointment as member of the governing body follows necessarily from
his appointment to a position held by him in that other enterprise; or
(c) the member of the governing body is nominated by that other enterprise.
11. A subsidiary should be excluded from consolidation when:
(a) control is intended to be temporary because the subsidiary is acquired and
held exclusively with a view to its subsequent disposal in the near future; or
(b) it operates under severe long-term restrictions which significantly impair its
ability to transfer funds to the parent.
In consolidated financial statements, investments in such subsidiaries should be
accounted for in accordance with Accounting Standard (AS) 13, Accounting for
Investments. The reasons for not consolidating a subsidiary should be disclosed in the
12. Exclusion of a subsidiary from consolidation on the ground that its business activities are
dissimilar from those of the other enterprises within the group is not justified because better
information is provided by consolidating such subsidiaries and disclosing additional
information in the consolidated financial statements about the different business activities of
subsidiaries. For example, the disclosures required by Accounting Standard (AS) 17, Segment
Reporting, help to explain the significance of different business activities within the group.
CONSOLIDATION PROCEDURES
13. 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. In order that the
consolidated financial statements present financial information about the group as that
of a single enterprise, the following steps should be taken:
(a) the cost to the parent of its investment in each subsidiary and the parent’s portion
of equity of each subsidiary, at the date on which investment in each subsidiary is
made, should be eliminated;
(b) any excess of the cost to the parent of its investment in a subsidiary over the
parent’s portion of equity of the subsidiary, at the date on which investment in the
subsidiary is made, should be described as goodwill to be recognised as an asset
in the consolidated financial statements;
(c) when the cost to the parent of its investment in a subsidiary is less than the
parent’s portion of equity of the subsidiary, at the date on which investment in the
subsidiary is made, the difference should be treated as a capital reserve in the
consolidated financial statements;
(d) minority interests in the net income of consolidated subsidiaries for the reporting
period should be identified and adjusted against the income of the group in order
to arrive at the net income attributable to the owners of the parent; and
(e) minority interests in the net assets of consolidated subsidiaries should be
identified and presented in the consolidated balance sheet separately from
liabilities and the equity of the parent’s shareholders. Minority interests in the net
assets consist of
(i) the amount of equity attributable to minorities at the date on which investment
in a subsidiary is made; and
(ii) the minorities’ share of movements in equity since the date the parent-
subsidiary relationship came in existence.
Where the carrying amount of the investment in the subsidiary is different from its
cost, the carrying amount is considered for the purpose of above computations.
14. The parent’s portion of equity in a subsidiary, at the date on which investment is made, is
determined on the basis of information contained in the financial statements of the subsidiary
as on the date of investment. However, if the financial statements of a subsidiary, as on the
date of investment, are not available and if it is impracticable to draw the financial statements
of the subsidiary as on that date, financial statements of the subsidiary for the immediately
preceding period are used as a basis for consolidation. Adjustments are made to these
financial statements for the effects of significant transactions or other events that occur
between the date of such financial statements and the date of investment in the subsidiary.
15. If an enterprise makes two or more investments in another enterprise at different dates
and eventually obtains control of the other enterprise, the consolidated financial statements
are presented only from the date on which holding-subsidiary relationship comes in existence.
If two or more investments are made over a period of time, the equity of the subsidiary at the
date of investment, for the purposes of paragraph 13 above, is generally determined on a
step-by-step basis; however, if small investments are made over a period of time and then an
investment is made that results in control, the date of the latest investment, as a practicable
measure, may be considered as the date of investment.
16. Intragroup balances and intragroup transactions and resulting unrealised profits
should be eliminated in full. Unrealised losses resulting from intragroup transactions
should also be eliminated unless cost cannot be recovered.
17. Intragroup balances and intragroup transactions, including sales, expenses and
dividends, are eliminated in full. Unrealised profits resulting from intragroup transactions that
are included in the carrying amount of assets, such as inventory and fixed assets, are
eliminated in full. Unrealised losses resulting from intragroup transactions that are deducted in
arriving at the carrying amount of assets are also eliminated unless cost cannot be recovered.
18. The financial statements used in the consolidation should be drawn up to the same
reporting date. If it is not practicable to draw up the financial statements of one or more
subsidiaries to such date and, accordingly, those financial statements are drawn up to
different reporting dates, adjustments should be made for the effects of significant
transactions or other events that occur between those dates and the date of the
parent’s financial statements. In any case, the difference between reporting dates
should not be more than six months.
19. The financial statements of the parent and its subsidiaries used in the preparation of the
consolidated financial statements are usually drawn up to the same date. When the reporting
dates are different, the subsidiary often prepares, for consolidation purposes, statements as at
the same date as that of the parent. When it is impracticable to do this, financial statements
drawn up to different reporting dates may be used provided the difference in reporting dates is
not more than six months. The consistency principle requires that the length of the reporting
periods and any difference in the reporting dates should be the same from period to period
20. Consolidated financial statements should be prepared using uniform accounting
policies for like transactions and other events in similar circumstances. If it is not
practicable to use uniform accounting policies in preparing the consolidated financial
statements, that fact should be disclosed together with the proportions of the items in
the consolidated financial statements to which the different accounting policies have
been applied.
21. If a member of the group uses accounting policies other than those adopted in the
consolidated financial statements for like transactions and events in similar circumstances,
appropriate adjustments are made to its financial statements when they are used in preparing
the consolidated financial statements.
22. The results of operations of a subsidiary are included in the consolidated financial
statements as from the date on which parent-subsidiary relationship came in existence. The
results of operations of a subsidiary with which parent-subsidiary relationship ceases to exist
are included in the consolidated statement of profit and loss until the date of cessation of the
relationship. The difference between the proceeds from the disposal of investment in a
subsidiary and the carrying amount of its assets less liabilities as of the date of disposal is
recognised in the consolidated statement of profit and loss as the profit or loss on the disposal
of the investment in the subsidiary. In order to ensure the comparability of the financial
statements from one accounting period to the next, supplementary information is often
provided about the effect of the acquisition and disposal of subsidiaries on the financial
position at the reporting date and the results for the reporting period and on the corresponding
amounts for the preceding period.

23. An investment in an enterprise should be accounted for in accordance with
Accounting Standard (AS) 13, Accounting for Investments, from the date that the
enterprise ceases to be a subsidiary and does not become an associate.4
24. The carrying amount of the investment at the date that it ceases to be a subsidiary is
regarded as cost thereafter
25. Minority interests should be presented in the consolidated balance sheet
separately from liabilities and the equity of the parent’s shareholders. Minority interests
in the income of the group should also be separately presented.
26. The losses applicable to the minority in a consolidated subsidiary may exceed the
minority interest in the equity of the subsidiary. The excess, and any further losses applicable
to the minority, are adjusted against the majority interest except to the extent that the minority
has a binding obligation to, and is able to, make good the losses. If the subsidiary
subsequently reports profits, all such profits are allocated to the majority interest until the
minority’s share of losses previously absorbed by the majority has been recovered.
27. If a subsidiary has outstanding cumulative preference shares which are held outside the
group, the parent computes its share of profits or losses after adjusting for the subsidiary’s
preference dividends, whether or not dividends have been declared.
ACCOUNTING FOR INVESTMENTS IN SUBSIDIARIES IN A PARENT’S SEPARATE

FINANCIAL STATEMENTS
28. In a parent’s separate financial statements, investments in subsidiaries should be
Investments.
DISCLOSURE
29. In addition to disclosures required by paragraph 11 and 20, following disclosures
should be made:
(a) in consolidated financial statements a list of all subsidiaries including the name,
country of incorporation or residence, proportion of ownership interest and, if
different, proportion of voting power held;
4
AS 23, ‘Accounting for Investments in Associates in Consolidated Financial
Statements’, which came into effect in respect of accounting periods commencing on
or after 1.4.2002 defines the term ‘associate’ and specifies the requirements relating
to accounting for investments in associates in consolidated Financial Statements.
(b) in consolidated financial statements, where applicable:

(i) the nature of the relationship between the parent and a subsidiary, if the
parent does not own, directly or indirectly through subsidiaries, more than
one-half of the voting power of the subsidiary;
(ii) the effect of the acquisition and disposal of subsidiaries on the financial
position at the reporting date, the results for the reporting period and on the
corresponding amounts for the preceding period; and
(iii) the names of the subsidiary(ies) of which reporting date(s) is/are different
from that of the parent and the difference in reporting dates.
TRANSITIONAL PROVISIONS
30. On the first occasion that consolidated financial statements are presented,
comparative figures for the previous period need not be presented. In all subsequent
years full comparative figures for the previous period should be presented in the
AS 22 : ACCOUNTING FOR TAXES ON INCOME
and in the context of the ‘Preface to the Statements of Accounting Standards’).
Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Council of the
commencing on or after 1-4-2001. It is mandatory in nature for:
(a) All the accounting periods commencing on or after 01.04.2001, in respect of the
following:
(i) Enterprises whose equity or debt securities are listed on a recognised stock
exchange in India and enterprises that are in the process of issuing equity or debt
securities that will be listed on a recognised stock exchange in India as evidenced
by the board of directors resolution in this regard.
(ii) All the enterprises of a group, if the parent presents consolidated financial
statements and the Accounting Standard is mandatory in nature in respect of any of
the enterprises of that group in terms of (i) above.
(b) All the accounting periods commencing on or after 01.04.2002, in respect of companies
not covered by (a) above.
(c) All the accounting periods commencing on or after 01.04.2003, in respect of all other
enterprises. ∗
The Guidance Note on Accounting for Taxes on Income, issued by the Institute of Chartered
Accountants of India in 1991, stands withdrawn from 1.4.2001. The following is the text of the
Objective
The objective of this Statement is to prescribe accounting treatment for taxes on income.
Taxes on income is one of the significant items in the statement of profit and loss of an
enterprise. In accordance with the matching concept, taxes on income are accrued in the
same period as the revenue and expenses to which they relate. Matching of such taxes
against revenue for a period poses special problems arising from the fact that in a number of
cases, taxable income may be significantly different from the accounting income. This
divergence between taxable income and accounting income arises due to two main reasons.
Firstly, there are differences between items of revenue and expenses as appearing in the
statement of profit and loss and the items which are considered as revenue, expenses or
deductions for tax purposes. Secondly, there are differences between the amount in respect of
a particular item of revenue or expense as recognised in the statement of profit and loss and
the corresponding amount which is recognised for the computation of taxable income.
Scope
1. This Statement should be applied in accounting for taxes on income. This includes
the determination of the amount of the expense or saving related to taxes on income in
respect of an accounting period and the disclosure of such an amount in the financial
statements.
2. For the purposes of this Statement, taxes on income include all domestic and foreign
taxes which are based on taxable income.
3. This Statement does not specify when, or how, an enterprise should account for taxes
that are payable on distribution of dividends and other distributions made by the enterprise.
Definitions
specified:
Accounting income (loss) is the net profit or loss for a period, as reported in the
∗
The council at its meeting held on June 254-26, 2004 decide to defer the applicability of
the standard so as to make it mandatory to such enterprises in respect of accounting
periods commencing on or after 1-4-2004.
statement of profit and loss, before deducting income tax expense or adding income tax
saving.
Taxable income (tax loss) is the amount of the income (loss) for a period, determined in
accordance with the tax laws, based upon which income tax payable (recoverable) is
determined.
Tax expense (tax saving) is the aggregate of current tax and deferred tax charged or
credited to the statement of profit and loss for the period.
Current tax is the amount of income tax determined to be payable (recoverable) in
respect of the taxable income (tax loss) for a period.
Deferred tax is the tax effect of timing differences.
Timing differences are the differences between taxable income and accounting income
for a period that originate in one period and are capable of reversal in one or more
subsequent periods.
Permanent differences are the differences between taxable income and accounting
income for a period that originate in one period and do not reverse subsequently.
5. Taxable income is calculated in accordance with tax laws. In some circumstances, the
requirements of these laws to compute taxable income differ from the accounting policies
applied to determine accounting income. The effect of this difference is that the taxable
income and accounting income may not be the same.
6. The differences between taxable income and accounting income can be classified into
permanent differences and timing differences. Permanent differences are those differences
between taxable income and accounting income which originate in one period and do not
reverse subsequently. For instance, if for the purpose of computing taxable income, the tax
laws allow only a part of an item of expenditure, the disallowed amount would result in a
permanent difference.
7. Timing differences are those differences between taxable income and accounting income
for a period that originate in one period and are capable of reversal in one or more subsequent
periods. Timing differences arise because the period in which some items of revenue and
expenses are included in taxable income do not coincide with the period in which such items
of revenue and expenses are included or considered in arriving at accounting income. For
example, machinery purchased for scientific research related to business is fully allowed as
deduction in the first year for tax purposes whereas the same would be charged to the
statement of profit and loss as depreciation over its useful life. The total depreciation charged
on the machinery for accounting purposes and the amount allowed as deduction for tax
purposes will ultimately be the same, but periods over which the depreciation is charged and
the deduction is allowed will differ. Another example of timing difference is a situation where,
for the purpose of computing taxable income, tax laws allow depreciation on the basis of the
written down value method, whereas for accounting purposes, straight line method is used.
Some other examples of timing differences arising under the Indian tax laws are given in
Appendix 1.
8. Unabsorbed depreciation and carry forward of losses which can be set-off against future
taxable income are also considered as timing differences and result in deferred tax assets,
subject to consideration of prudence (see paragraphs 15-18).
Recognition
9. Tax expense for the period, comprising current tax and deferred tax, should be
included in the determination of the net profit or loss for the period.
10. Taxes on income are considered to be an expense incurred by the enterprise in earning
income and are accrued in the same period as the revenue and expenses to which they relate.
Such matching may result into timing differences. The tax effects of timing differences are
included in the tax expense in the statement of profit and loss and as deferred tax assets
(subject to the consideration of prudence as set out in paragraphs 15-18) or as deferred tax
liabilities, in the balance sheet.
11. An example of tax effect of a timing difference that results in a deferred tax asset is an
expense provided in the statement of profit and loss but not allowed as a deduction under
Section 43B of the Income-tax Act, 1961. This timing difference will reverse when the
deduction of that expense is allowed under Section 43B in subsequent year(s). An example of
tax effect of a timing difference resulting in a deferred tax liability is the higher charge of
depreciation allowable under the Income-tax Act, 1961, compared to the depreciation provided
in the statement of profit and loss. In subsequent years, the differential will reverse when
comparatively lower depreciation will be allowed for tax purposes.
12. Permanent differences do not result in deferred tax assets or deferred tax liabilities.
13. Deferred tax should be recognised for all the timing differences, subject to the
consideration of prudence in respect of deferred tax assets as set out in paragraphs 15-
18.
14. This Statement requires recognition of deferred tax for all the timing differences. This is
based on the principle that the financial statements for a period should recognise the tax
effect, whether current or deferred, of all the transactions occurring in that period.
15. Except in the situations stated in paragraph 17, deferred tax assets should be recognised
and carried forward only to the extent that there is a reasonable certainty that sufficient future
taxable income will be available against which such deferred tax assets can be realised.
16. While recognising the tax effect of timing differences, consideration of prudence cannot
be ignored. Therefore, deferred tax assets are recognised and carried forward only to the
extent that there is a reasonable certainty of their realisation. This reasonable level of
certainty would normally be achieved by examining the past record of the enterprise and by
making realistic estimates of profits for the future.
17. Where an enterprise has unabsorbed depreciation or carry forward of losses under tax
laws, deferred tax assets should be recognised only to the extent that there is virtual certainty
supported by convincing evidence that sufficient future taxable income will be available
against which such deferred tax assets can be realised.
18. The existence of unabsorbed depreciation or carry forward of losses under tax laws is
strong evidence that future taxable income may not be available. Therefore, when an
enterprise has a history of recent losses, the enterprise recognises deferred tax assets only to
the extent that it has timing differences the reversal of which will result in sufficient income or
there is other convincing evidence that sufficient taxable income will be available against
which such deferred tax assets can be realised. In such circumstances, the nature of the
evidence supporting its recognition is disclosed.
RE-ASSESSMENT OF UNRECOGNISED DEFERRED TAX ASSETS

19. At each balance sheet date, an enterprise re-assesses unrecognised deferred tax assets.
The enterprise recognises previously unrecognised deferred tax assets to the extent that it
has become reasonably certain or virtually certain, as the case may be (see paragraphs 15 to
18), that sufficient future taxable income will be available against which such deferred tax
assets can be realised. For example, an improvement in trading conditions may make it
reasonably certain that the enterprise will be able to generate sufficient taxable income in the
future.
Measurement
20. Current tax should be measured at the amount expected to be paid to (recovered
from) the taxation authorities, using the applicable tax rates and tax laws.
21. Deferred tax assets and liabilities should be measured using the tax rates and tax
laws that have been enacted or substantively enacted by the balance sheet date.
22. Deferred tax assets and liabilities are usually measured using the tax rates and tax laws
that have been enacted. However, certain announcements of tax rates and tax laws by the
government may have the substantive effect of actual enactment. In these circumstances,
deferred tax assets and liabilities are measured using such announced tax rate and tax laws.
23. When different tax rates apply to different levels of taxable income, deferred tax assets
and liabilities are measured using average rates.
24. Deferred tax assets and liabilities should not be discounted to their present value.
25. The reliable determination of deferred tax assets and liabilities on a discounted basis
requires detailed scheduling of the timing of the reversal of each timing difference. In a
number of cases such scheduling is impracticable or highly complex. Therefore, it is

inappropriate to require discounting of deferred tax assets and liabilities. To permit, but not to
require, discounting would result in deferred tax assets and liabilities which would not be
comparable between enterprises. Therefore, this Statement does not require or permit the
discounting of deferred tax assets and liabilities.
REVIEW OF DEFERRED TAX ASSETS

26. The carrying amount of deferred tax assets should be reviewed at each balance
sheet date. An enterprise should write-down the carrying amount of a deferred tax asset
to the extent that it is no longer reasonably certain or virtually certain, as the case may
be (see paragraphs 15 to 18), that sufficient future taxable income will be available
against which deferred tax asset can be realised. Any such write-down may be reversed
to the extent that it becomes reasonably certain or virtually certain, as the case may be
(see paragraphs 15 to 18), that sufficient future taxable income will be available.
PRESENTATION AND DISCLOSURE

27. An enterprise should offset assets and liabilities representing current tax if the
enterprise:
(a) has a legally enforceable right to set off the recognised amounts; and
(b) intends to settle the asset and the liability on a net basis.
28. An enterprise will normally have a legally enforceable right to set off an asset and liability
representing current tax when they relate to income taxes levied under the same governing
taxation laws and the taxation laws permit the enterprise to make or receive a single net
payment.
29. An enterprise should offset deferred tax assets and deferred tax liabilities if:
(a) the enterprise has a legally enforceable right to set off assets against liabilities
representing current tax; and
(b) the deferred tax assets and the deferred tax liabilities relate to taxes on income
levied by the same governing taxation laws.
30. Deferred tax assets and liabilities should be distinguished from assets and
liabilities representing current tax for the period. Deferred tax assets and liabilities
should be disclosed under a separate heading in the balance sheet of the enterprise,
separately from current assets and current liabilities.
31. The break-up of deferred tax assets and deferred tax liabilities into major
components of the respective balances should be disclosed in the notes to accounts.
32. The nature of the evidence supporting the recognition of deferred tax assets
should be disclosed, if an enterprise has unabsorbed depreciation or carry forward of

losses under tax laws.
33. On the first occasion that the taxes on income are accounted for in accordance
with this Statement, the enterprise should recognise, in the financial statements, the
deferred tax balance that has accumulated prior to the adoption of this Statement as
deferred tax asset/liability with a corresponding credit/charge to the revenue reserves,
subject to the consideration of prudence in case of deferred tax assets (see paragraphs
15-18). The amount so credited/charged to the revenue reserves should be the same as
that which would have resulted if this Statement had been in effect from the beginning1.
34. For the purpose of determining accumulated deferred tax in the period in which this
Statement is applied for the first time, the opening balances of assets and liabilities for
accounting purposes and for tax purposes are compared and the differences, if any, are
determined. The tax effects of these differences, if any, should be recognised as deferred tax
assets or liabilities, if these differences are timing differences. For example, in the year in
which an enterprise adopts this Statement, the opening balance of a fixed asset is Rs. 100 for
accounting purposes and Rs. 60 for tax purposes. The difference is because the enterprise
applies written down value method of depreciation for calculating taxable income whereas for
accounting purposes straight line method is used. This difference will reverse in future when
depreciation for tax purposes will be lower as compared to the depreciation for accounting
purposes. In the above case, assuming that enacted tax rate for the year is 40% and that
there are no other timing differences, deferred tax liability of Rs. 16 [(Rs. 100 - Rs. 60) x 40%]
would be recognised. Another example is an expenditure that has already been written off for
accounting purposes in the year of its incurrance but is allowable for tax purposes over a
period of time. In this case, the asset representing that expenditure would have a balance only
for tax purposes but not for accounting purposes. The difference between balance of the asset
for tax purposes and the balance (which is nil) for accounting purposes would be a timing
difference which will reverse in future when this expenditure would be allowed for tax
purposes. Therefore, a deferred tax asset would be recognised in respect of this difference
subject to the consideration of prudence (see paragraphs 15 - 18).
1
It is clarified that an enterprise, which applies AS 22 for the first time in respect of
accounting period commencing on 1st April, 2001 should determine the amount of the
opening balance of the accumulated deferred tax by using the rate of income tax
applicable as on 1st April, 2001.
APPENDIX 1
Examples of Timing Differences

Note: This appendix is illustrative only and does not form part of the Accounting Standard. The
purpose of this appendix is to assist in clarifying the meaning of the Accounting Standard. The
sections mentioned hereunder are references to sections in the Income-tax Act, 1961, as
amended by the Finance Act, 2001.
1. Expenses debited in the statement of profit and loss for accounting purposes but allowed
for tax purposes in subsequent years, e.g.
(a) Expenditure of the nature mentioned in section 43B (e.g. taxes, duty, cess, fees,
etc.) accrued in the statement of profit and loss on mercantile basis but allowed for
tax purposes in subsequent years on payment basis.
(b) Payments to non-residents accrued in the statement of profit and loss on mercantile
basis, but disallowed for tax purposes under section 40(a)(i) and allowed for tax
purposes in subsequent years when relevant tax is deducted or paid.
(c) Provisions made in the statement of profit and loss in anticipation of liabilities where
the relevant liabilities are allowed in subsequent years when they crystallize.
2. Expenses amortized in the books over a period of years but are allowed for tax purposes
wholly in the first year (e.g. substantial advertisement expenses to introduce a product,
etc. treated as deferred revenue expenditure in the books) or if amortization for tax
purposes is over a longer or shorter period (e.g. preliminary expenses under section 35D,
expenses incurred for amalgamation under section 35DD, prospecting expenses under
section 35E).
3. Where book and tax depreciation differ. This could arise due to:
(a) Differences in depreciation rates.
(b) Differences in method of depreciation e.g. SLM or WDV.
(c) Differences in method of calculation e.g. calculation of depreciation with reference
to individual assets in the books but on block basis for tax purposes and calculation
with reference to time in the books but on the basis of full or half depreciation under
the block basis for tax purposes.
(d) Differences in composition of actual cost of assets.
4. Where a deduction is allowed in one year for tax purposes on the basis of a deposit
made under a permitted deposit scheme (e.g. tea development account scheme under
section 33AB or site restoration fund scheme under section 33ABA) and expenditure out
of withdrawal from such deposit is debited in the statement of profit and loss in
subsequent years.
5. Income credited to the statement of profit and loss but taxed only in subsequent years
e.g. conversion of capital assets into stock in trade.

6. If for any reason the recognition of income is spread over a number of years in the
accounts but the income is fully taxed in the year of receipt.
APPENDIX 2
Note: This appendix is illustrative only and does not form part of the Accounting Standard. The
purpose of this appendix is to illustrate the application of the Accounting Standard. Extracts
from statement of profit and loss are provided to show the effects of the transactions
described below.
Illustration 1
A company, ABC Ltd., prepares its accounts annually on 31st March. On 1st April, 20x1, it
purchases a machine at a cost of Rs. 1,50,000. The machine has a useful life of three years
and an expected scrap value of zero. Although it is eligible for a 100% first year depreciation
allowance for tax purposes, the straight-line method is considered appropriate for accounting
purposes. ABC Ltd. has profits before depreciation and taxes of Rs. 2,00,000 each year and
the corporate tax rate is 40 per cent each year.
The purchase of machine at a cost of Rs. 1,50,000 in 20x1 gives rise to a tax saving of Rs.
60,000. If the cost of the machine is spread over three years of its life for accounting
purposes, the amount of the tax saving should also be spread over the same period as shown
below:
(for the three years ending 31st March, 20×1, 20×2, 20×3)
(Rs.in Thousands)
20×1 20×2 20×3
Profit before depreciation and taxes 200 200 200
Less: Depreciation for accounting purposes 50 50 50
Profit before taxes 150 150 150
Less: Tax expense
Current tax
0.40 (200 - 150) 20
0.40 (200) 80 80
Deferred Tax
Tax effect of timing differences originating
during the year 0.40 (150 - 50) 40
Tax effect of timing differences reversing (20) (20)
during the year 0.40 (0 - 50) __ __ __

Tax expense 60 60 60
Profit after tax 90 90 90
Net timing differences 100 50 0
Deferred tax liability 40 20 0
In 20×1, the amount of depreciation allowed for tax purposes exceeds the amount of
depreciation charged for accounting purposes by Rs. 1,00,000 and, therefore, taxable income
is lower than the accounting income. This gives rise to a deferred tax liability of Rs. 40,000. In
20×2 and 20×3, accounting income is lower than taxable income because the amount of
depreciation charged for accounting purposes exceeds the amount of depreciation allowed for
tax purposes by Rs. 50,000 each year. Accordingly, deferred tax liability is reduced by Rs.
20,000 each in both the years. As may be seen, tax expense is based on the accounting
income of each period.
In 20×1, the profit and loss account is debited and deferred tax liability account is credited with
the amount of tax on the originating timing difference of Rs. 1,00,000 while in each of the
following two years, deferred tax liability account is debited and profit and loss account is
credited with the amount of tax on the reversing timing difference of Rs. 50,000.
The following Journal entries will be passed
Year 20×1
Profit and Loss A/c Dr. 20,000
To Current tax A/c 20,000
(Being the amount of taxes payable for the year
20×1 provided for)
To Deferred tax A/c 40,000
(Being the deferred tax liability created for originating
timing difference of Rs. 1,00,000)
Year 20×2
(Being the amount of taxes payable for the
year 20x2 provided for)
Deferred tax A/c Dr. 20,000

To Profit and Loss A/c 20,000
(Being the deferred tax liability adjusted for
reversing timing difference of Rs. 50,000)
Year 20×3
(Being the amount of taxes payable for the year
20×3 provided for)
Deferred tax A/c Dr. 20,000
To Profit and Loss A/c 20,000
(Being the deferred tax liability adjusted for reversing
timing difference of Rs. 50,000)
In year 20×1, the balance of deferred tax account i.e., Rs. 40,000 would be shown separately
from the current tax payable for the year in terms of paragraph 30 of the Statement. In Year
20×2, the balance of deferred tax account would be Rs. 20,000 and be shown separately from
the current tax payable for the year as in year 20x1. In Year 20×3, the balance of deferred tax
liability account would be nil.
Illustration 2
In the above illustration, the corporate tax rate has been assumed to be same in each of the
three years. If the rate of tax changes, it would be necessary for the enterprise to adjust the
amount of deferred tax liability carried forward by applying the tax rate that has been enacted
or substantively enacted by the balance sheet date on accumulated timing differences at the
end of the accounting year (see paragraphs 21 and 22). For example, if in Illustration 1, the
substantively enacted tax rates for 20×1, 20×2 and 20×3 are 40%, 35% and 38% respectively,
the amount of deferred tax liability would be computed as follows:
The deferred tax liability carried forward each year would appear in the balance sheet as
under:
31st March, 20×1 = 0.40 (1,00,000) = Rs. 40,000
31st March, 20×2 = 0.35 (50,000) = Rs. 17,500
31st March, 20×3 = 0.38 (Zero) = Rs. Zero
Accordingly, the amount debited/(credited) to the profit and loss account (with corresponding
credit or debit to deferred tax liability) for each year would be as under:
31st March, 20×1 Debit = Rs. 40,000
31st March, 20×2 (Credit) = Rs. (22,500)
31st March, 20×3 (Credit) = Rs. (17,500)
Illustration 3
A company, ABC Ltd., prepares its accounts annually on 31st March. The company has
incurred a loss of Rs. 1,00,000 in the year 20×1 and made profits of Rs. 50,000 and 60,000 in
year 20×2 and year 20×3 respectively. It is assumed that under the tax laws, loss can be
carried forward for 8 years and tax rate is 40% and at the end of year 20×1, it was virtually
certain, supported by convincing evidence, that the company would have sufficient taxable
income in the future years against which unabsorbed depreciation and carry forward of losses
can be set-off. It is also assumed that there is no difference between taxable income and
accounting income except that set-off of loss is allowed in years 20×2 and 20×3 for tax
purposes.
(for the three years ending 31st March, 20×1, 20×2, 20×3)
(Rs in Thousands)
20×1 20×2 20×3
Profit (loss) (100) 50 60
Less: Current tax — — (4)
Deferred Tax:
Tax effect of timing differences originating
during the year 40
Tax effect of timing differences reversing
during the year – (20) (20)
Profit (loss) after tax effect (60) 30 36
CLARIFICATION ON ACCOUNTING STANDARD (AS) 22, ACCOUNTING

FOR TAXES ON INCOME
Accounting Standard (AS) 22, Accounting for Taxes on Income, which is mandatory for certain
enterprises, as specified in the standard, in respect of accounting periods commencing on or
after 1-4-2001, contains the following paragraph under Transitional Provisions :
“33. On the first occasion that the taxes on income are accounted for in accordance
with this Statement, the enterprise should recognise, in the financial statements, the
deferred tax balance that has accumulated prior to the adoption of this Statement as
deferred tax asset/liability with a corresponding credit/charge to the revenue reserves,
subject to the consideration of prudence in case of deferred tax assets (see paragraphs
15-18). The amount so credited/charged to the revenue reserves should be the same as
that which would have resulted if this Statement had been in effect from the beginning.”
An issue has been raised as to whether an enterprise, which accounts for taxes on income as
per AS 22 for the first time for accounting period commencing on 1st April, 2001, should use
the rate of income-tax applicable on 31st March, 2001 or on 1st April, 2001, for determination
of the opening balance of the accumulated deferred tax.
The amount of deferred tax assets and liabilities represents the amount recoverable/payable
in future. Accordingly, the amount of the opening balance of the accumulated deferred tax
determined by using the tax rate applicable on 1st April, 2001 will give the best estimate of the
amount expected to be recovered/paid on the settlement. In this context, it may be noted that
paragraphs 21 and 22 of AS 22 provide that where announcements of tax rates and tax laws
have the substantive effect of actual enactment, deferred tax assets and liabilities are
measured using such announced tax rates and tax laws.
Accordingly, it is clarified that an enterprise, which applies AS 22 for the first time in respect of
accounting period commencing on 1st April, 2001, should determine the amount of the
opening balance of the accumulated deferred tax by using the rate of income tax applicable as
on 1st April, 2001.
AS 23 : ACCOUNTING FOR INVESTMENTS IN ASSOCIATES IN

CONSOLIDATED FINANCIAL STATEMENTS
(In this Accounting Standard, the standard portions have been set in bold italic
type. These should be read in the context of the background material which has
been set in normal type, and in the context of the ‘Preface to the Statements of
Accounting Standards.)
Accounting Standard (AS) 23, ‘Accounting for Investments in Associates in Consolidated
Financial Statements’, issued by the Council of the Institute of Chartered Accountants of India,
comes into effect in respect of accounting periods commencing on or after 1-4-2002. An
enterprise that presents consolidated financial statements should account for investments in
associates in the consolidated financial statements in accordance with this Standard 1. The
following is the text of the Accounting Standard.
Objective
The objective of this Statement is to set out principles and procedures for recognising, in the
consolidated financial statements, the effects of the investments in associates on the financial
position and operating results of a group.
Scope
1. This Statement should be applied in accounting for investments in associates in
the preparation and presentation of consolidated financial statements by an investor.
2. The Statement does not deal with accounting for investments in associates in the
preparation and presentation of separate financial statements by an investor2.
Definitions
specified :
An associate is an enterprise in which the investor has significant influence and which
is neither a subsidiary nor a joint venture3 of the investor.
Significant influence is the power to participate in the financial and/or operating policy
decisions of the investee but not control over those policies.
Control :
(a) The ownership, directly or indirectly through subsidiary (ies), of more than one-
half of the voting power of an enterprise; or
the composition of the corresponding governing body in case of any other
1
It is clarified that AS 23 is mandatory if an enterprise presents consolidated financial
statements. In other words, if an enterprise presents consolidated financial
statements, it should account for investments in associates in the consolidated
financial statements in accordance with AS 23 from the date of its coming into effect,
i.e. 1.4.2002.
2
AS 13, ‘Accounting for Investments’, is applicable for accounting for investment in
associates in the separate financial statement of an investor
3
AS 27, ‘Financial Reporting of Interests in Joint Ventures’, defines the term ‘joint
venture’ and specifies the requirements relating to accounting for investments in joint
ventures.
enterprise so as to obtain economic benefits from its activities.

parent).
A parent is an enterprise that has one or more subsidiaries.
A group is a parent and all its subsidiaries.
Consolidated financial statements are financial statements of a group presented as
those of a single enterprise.
The equity method is a method of accounting whereby the investment is initially
recorded at cost, identifying any goodwill/capital reserve arising at the time of
acquisition. The carrying amount of the investment is adjusted thereafter for the post
acquisition change in the investor’s share of net assets of the investee. The
consolidated statement of profit and loss reflects the investor’s share of the results of
operations of the investee.
Equity is the residual interest in the assets of an enterprise after deducting all its
liabilities.
4. For the purpose of this Statement, significant influence does not extend to power to
govern the financial and/ or operating policies of an enterprise. Significant influence may be
gained by share ownership, statue or agreement. As regards share of ownership, if an investor
holds, directly or indirectly through subsidiary(ies), 20% or more of the voting power of the
investee, it is presumed that the investor has significant influence, unless it can be clearly
demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly
through subisidiary(ies), less than 20% of the voting power of the investee, it is persumed that
the investor does not have significant influence, unless such influence can be clearly
demonstrated. A substantial or majority ownership by another investor does not necessarily
preclude an investor from having significant influence.
5. The existence of significant influence by an investor is usually evidenced in one or more
of the following ways :
(a) Representation on the board of directors or corresponding governing body of the
investee;
(b) participation in policy making processes;
(c) material transactions between the investor and the investee;
(d) interchange of managerial personnel; or
(e) provision of essential technical information.
6. Under the equity method, the investment is initially recorded at cost, identifying any
goodwill/capital reserve arising at the time of acquisition and the carrying amount is increased
or decreased to recognise the investor's share of the profits and losses of the investee after
the date of acquisition. Distributions received from an investee reduce the carrying amount of
the investment. Adjustments to the carrying amount may also be necessary for alterations in
the investor's proportionate interest in the investee arising from changes in the investee's
equity that have not been included in the statement of profit and loss. Such changes include
those arising from the revaluation of fixed assets and investments, from foreign exchange
translation differences and from the adjustment of differences arising on amalgmations.
ACCOUNTING FOR INVESTMENTS-EQUITY METHOD

7. An investment in an associate should be accounted for in consolidated financial
statements under the equity method except when :
(a) the investment is acquired and held exclusively with a view to its subsequent
disposal in the near future; or
(b) the associate operates under the severe long-term restrictions that significantly
impair it ability to transfer funds to the investor.
Investments in such associates should be accounted for in accordance with Accounting
Standard (AS) 13, Accounting for Investments. The reasons for not applying the equity
method in accounting for investments in an associate should be disclosed in the
8. Recognition of income on the basis received may not be an adequate measure of the
income earned by an investor on an investment in an associate because the distributions
received may bear little relationship to the performance of the associate. As the investor has
significant influence over the associate, the investor has a measure of responsibility for the
associate's performance and, as a result, the return on its investment. The investor accounts
for this stewardship by extending the scope of its consolidated financial statements to include
its share of results of such an associate and so provides an analysis of earnings and
investment from which more useful ratios can be calculated. As a result, application of the
equity method in consolidated financial statements provides more informative reporting of the
net assets and net income of the investor.
9. An investor should discontinue the use of the equity method from the date that :
(a) it ceases to have significant influence in an associate but retains, either in whole
or in part, its investment; or
(b) the use of the equity method is no longer appropriate because the associate
operates under severe long-term restrictions that significantly impair its ability to
transfer funds to the investor.
From the date of discontinuing the use of the equity method, investments in such
associates should be accounted for in accordance with Accounting Standard (AS) 13,
Accounting for Investments. For this purpose, the carrying amount of the investment at
that date should be regarded as cost thereafter.
APPLICATION OF THE EQUITY METHOD

10. Many of the procedures appropriate for the application of the equity method are similar to
the consolidation procedures set out in Accounting Standard (AS) 21, Consolidated Financial
Statements. Furthermore, the broad concepts underlying the consolidation procedures used in
the acquisition of a subsidiary are adopted on the acquisition of an investment in an associate.
11. An investment in an associate is accounted for under the equity method from the date on
which it falls within the definition of an associate. On acquisition of the investment any
difference between the cost of acquisition and the investor's share of the equity of the
associate is described as goodwill or capital reserve, as the case may be.
12. Goodwill/capital reserve arising on the acquisition of an associate by investor
should be included in the carraying amount of investment in the associate but should
be disclosed separately.
13. In using equity method for accounting for investment in an associate, unrealised
profits and losses resulting from transactions between the investor (or its consolidated
subsidiaries) and the associate should be eliminated to the extent of the investor's
interest in the associate. Unrealised losses should not be eliminated if and to the extent
the cost of the transferred asset cannot be recovered.∗
14. The most recent available financial statements of the associate are used by the investor
in applying the equity method; they are usually drawn up to the same date as the financial
statements of the investor. When the reporting dates of the investor and the associate are
different, the associate often prepares, for the use of the investor, statements as at the same
date as the financial statements of the investor. When its is impracticable to do this, financial
statements drawn up to a different reporting date may be used. The consistency principle
requires that the length of the reporting periods, and any difference in the reporting dates, are
consistent from period to period.
15. When financial statements with a different reporting date are used, adjustments are
made for the effects of any significant events or transactions between the investor (or its
consolidated subsidiaries) and the associate that occur between the date of the associate's
∗
An announcement titled “ Elimination of unrealized profits and losses under AS 21,
AS 23 and AS27” has been issued in July, 2004. As per the announcement , while
applying the ‘equity method’, elimination of unrealized profits and losses in respect of
transactions entered into during accounting periods commencing on or before 313-2002,
is encouraged, but not required on practical grounds.
financial statements and the date of the investor's consolidated financial statements.
16. The investor usually prepares consolidated financial statements using uniform accounting
policies thas those adopted for the consolidated financial statements for the like transactions
and events in similar circumstances, appropriate adjustments are made to the associate's
financial statements when they are used by the investor in applying the equity method. If it not
practicable to do so, that fact is dislcosed along with a brief discription of the differences
between the accounting policies.
17. If an associate has oustanding cumulative preference shares held outside the group, the
investor computes its shares of profits or losses after adjusting for the preference dividends
whether or not the dividends have been declared.
18. If, under the equity method, an investor's share of losses of an associate equals or
exceeds the carrying amount of the investment, the investor ordinarily discontinues
recgonising its share of further losses and the investment is reported at nil value. Additional
losses are provided for to the extent that the investor has incurred obligations or made
payments on behalf of the associate to satisfy obligations of the associate that the investor
has guaranteed or to which the investor is otherwise committed. If the associate subsequently
reports profits, the investor resumes including its share of those profits only after its share of
the profits equals the share of net losses that have not been recognised.
19. Where an associate presents consolidated financial statements, the results and net
assets to be taken into account are those reported in that associate's consolidated financial
statements.
20. The carrying amount of investment in an associate should be reduced to recognise
a decline, other than temporary, in the value of the investment, such reduction being
determined and made for each investment individually.
CONTINGENCIES
21. In accordance with Accounting Standard (AS) 4, Contingencies and Events Occurring
After the Balance Sheet Date€, the investor discloses in the consolidated financial statements :
(a) its share of the contingencies and capital commitments of an associate for which it is also
contingently liable; and
(b) those contingencies that arise because the investor is serverally liable for the liabilities of
€
they deal with impairment of assets not covered by other Indian Accounting Standards.
the associate.
Disclosure
22. In addition to the disclosures required by paragraphs 7 and 12, an appropriate
listing and description of associates including the proportion of ownership interest and,
if different, the proportion of voting power held should be disclosed in the consolidated
23. Investments in associates accounted for using the equity method should be
classified as long-term investments and disclosed separately in the consolidated
balance sheet. The investor's share of the profits or losses of such investments should
be disclosed separately in the consolidated statement of profit and loss. The investor's
share of any extraordinary or prior period items should also be separately disclosed.
24. The name(s) of the associate(s) of which reporting date(s) is/are different from that
of the financial statements of an investor and the difference in reporting dates should
be disclosed in the consolidated financial statements.
25. In case an associate uses accounting policies other than those adopted for the
consolidated financial statements for like transactions and events in similar
circumstances and it is no practicable to make appropriate adjustments to the
associate's financial statements, the fact should be disclosed along with a brief
description of the differences in the accounting policies
Transitional provisions
26. On the first occasion when investment in an associate is accounted for in
consolidated financial statements in accordance with this Statement, the carrying
amount of investment in the associate should be brought to the amount that would have
resulted had the equity method of accounting been followed as per this Statement since
the acquisition of the associate. The corresponding adjustment in this regard should be
made in the retained earnings in the consolidated financial statements.
AS 24 : DISCONTINUING OPERATIONS*
Accounting Standard (AS) 24, ‘Discontinuing Operations’, issued by the Council of the Institute
of Chartered Accountants of India, comes into effect in respect of accounting periods
commencing on or after 1.4.2004. This standard is mandatory in nature in respect of
accounting periods commencing on or after 1-4-2004 for the enterprises which fall in any one
or more of the following categories, at any time during the accounting period:
by the board of directors; resolution in this regard.
exceeds Rs.50 crore. Turnover does not include “other income”.
period.
accounting period.
Earlier application of this standard is encouraged.
The enterprises which do not fall in any of the above categories are not required to apply this
Standard.
An enterprise, which, pursuant to the above provisions , does not present the information
relating to the discontinuing operations, should disclose the fact.
Objective
The objective of this Statement is to establish principles for reporting information about
discontinuing operations, thereby enhancing the ability of users of financial statements to
make projections of an enterprise's cash flows, earnings-generating capacity, and financial
position by segregating information about discontinuing operations from information about
continuing operations.
Scope
1. This Statement applies to all discontinuing operations of an enterprise.
2. The requirements related to cash flow statement contained in this Statement are
applicable where an enterprise prepares and presents a cash flow statement.
Definitions
Discontinuing Operation
3. A discontinuing operation is 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.
4. Under criterion (a) of the definition (paragraph 3 (a)), a discontinuing operation may be
disposed of in its entirety or piecemeal, but always pursuant to an overall plan to discontinue
the entire component.
5. If an enterprise sells a component substantially in its entirety, the result can be a net gain
or net loss. For such a discontinuance, a binding sale agreement is entered into on a specific
date, although the actual transfer of possession and control of the discontinuing operation may
occur at a later date. Also, payments to the seller may occur at the time of the agreement, at
the time of the transfer, or over an extended future period.
6. Instead of disposing of a component substantially in its entirety, an enterprise may

discontinue and dispose of the component by selling its assets and settling its liabilities
piecemeal (individually or in small groups). For piecemeal disposals, while the overall result
may be a net gain or a net loss, the sale of an individual asset or settlement of an individual
liability may have the opposite effect. Moreover, there is no specific date at which an overall
binding sale agreement is entered into. Rather, the sales of assets and settlements of
liabilities may occur over a period of months or perhaps even longer. Thus, disposal of a
component may be in progress at the end of a financial reporting period. To qualify as a
discontinuing operation, the disposal must be pursuant to a single co-ordinated plan.
7. An enterprise may terminate an operation by abandonment without substantial sales of
assets. An abandoned operation would be a discontinuing operation if it satisfies the criteria in
the definition. However, changing the scope of an operation or the manner in which it is
conducted is not an abandonment because that operation, although changed, is continuing.
8. Business enterprises frequently close facilities, abandon products or even product lines,
and change the size of their work force in response to market forces. While those kinds of
terminations generally are not, in themselves, discontinuing operations as that term is defined
in paragraph 3 of this Statement, they can occur in connection with a discontinuing operation.
9. Examples of activities that do not necessarily satisfy criterion (a) of paragraph 3, but that
might do so in combination with other circumstances, include:
(a) gradual or evolutionary phasing out of a product line or class of service;
(b) discontinuing, even if relatively abruptly, several products within an ongoing line of
business;
(c) shifting of some production or marketing activities for a particular line of business from
one location to another; and
(d) closing of a facility to achieve productivity improvements or other cost savings.
An example in relation to consolidated financial statements is selling a subsidiary whose
activities are similar to those of the parent or other subsidiaries.
10. A reportable business segment or geographical segment as defined in Accounting
Standard (AS) 17, Segment Reporting, would normally satisfy criterion (b) of the definition of a
discontinuing operation (paragraph 3), that is, it would represent a separate major line of
business or geographical area of operations. A part of such a segment may also satisfy
criterion (b) of the definition. For an enterprise that operates in a single business or
geographical segment and therefore does not report segment information, a major product or
service line may also satisfy the criteria of the definition.
11. A component can be distinguished operationally and for financial reporting purposes -
criterion (c) of the definition of a discontinuing operation (paragraph 3) - if all the following
conditions are met:

(a) the operating assets and liabilities of the component can be directly attributed to it;
(b) its revenue can be directly attributed to it;
(c) at least a majority of its operating expenses can be directly attributed to it.
12. Assets, liabilities, revenue, and expenses are directly attributable to a component if they
would be eliminated when the component is sold, abandoned or otherwise disposed of. If debt
is attributable to a component, the related interest and other financing costs are similarly
attributed to it.
13. Discontinuing operations, as defined in this Statement, are expected to occur relatively
infrequently. All infrequently occurring events do not necessarily qualify as discontinuing
operations. Infrequently occurring events that do not qualify as discontinuing operations may
result in items of income or expense that require separate disclosure pursuant to Accounting
Standard (AS) 5, Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies, because their size, nature, or incidence make them relevant to explain
the performance of the enterprise for the period.
14. The fact that a disposal of a component of an enterprise is classified as a discontinuing
operation under this Statement does not, in itself, bring into question the enterprise's ability to
continue as a going concern.
Initial Disclosure Event

15. With respect to a discontinuing operation, the initial disclosure event is the
occurrence of one of the following, whichever occurs earlier:
(a) the enterprise has entered into a binding sale agreement for substantially all of the
assets attributable to the discontinuing operation; or
(b) the enterprise’s board of directors or similar governing body has both (i) approved
a detailed, formal plan for the discontinuance and (ii) made an announcement of the
plan.
16. A detailed, formal plan for the discontinuance normally includes:
(a) identification of the major assets to be disposed of;
(b) the expected method of disposal;
(c) the period expected to be required for completion of the disposal;
(d) the principal locations affected;
(e) the location, function, and approximate number of employees who will be compensated
for terminating their services; and
(f) the estimated proceeds or salvage to be realised by disposal.

17. An enterprise’s board of directors or similar governing body is considered to have made
the announcement of a detailed, formal plan for discontinuance, if it has announced the main
features of the plan to those affected by it, such as, lenders, stock exchanges, creditors, trade
unions, etc., in a sufficiently specific manner so as to make the enterprise demonstrably
committed to the discontinuance.

18. An enterprise should apply the principles of recognition and measurement that are
set out in other Accounting Standards for the purpose of deciding as to when and how
to recognise and measure the changes in assets and liabilities and the revenue,
expenses, gains, losses and cash flows relating to a discontinuing operation.
19. This Statement does not establish any recognition and measurement principles. Rather,
it requires that an enterprise follow recognition and measurement principles established in
other Accounting Standards, e.g., Accounting Standard (AS) 4, Contingencies and Events
Occurring After the Balance Sheet Date€ and Accounting Standard on Impairment of Assets¥.
Presentation and Disclosure
Initial Disclosure
20. An enterprise should include the following information relating to a discontinuing
operation in its financial statements beginning with the financial statements for the
period in which the initial disclosure event (as defined in paragraph 15) occurs:
(a) a description of the discontinuing operation(s);
(b) the business or geographical segment(s) in which it is reported as per AS 17,
Segment Reporting;
(c) the date and nature of the initial disclosure event;
(d) the date or period in which the discontinuance is expected to be completed if
known or determinable;
€
they deal with impairment of assets not covered by other Indian Accounting Standards.
¥
Accounting Standard (AS)28 , ‘Impairment of Assets ‘, specifies the requirements
relating to impairment of assets.
(e) the carrying amounts, as of the balance sheet date, of the total assets to be
disposed of and the total liabilities to be settled;
(f) the amounts of revenue and expenses in respect of the ordinary activities
attributable to the discontinuing operation during the current financial reporting
period;
(g) the amount of pre-tax profit or loss from ordinary activities attributable to the
discontinuing operation during the current financial reporting period, and the
income tax expense€ related thereto; and
(h) the amounts of net cash flows attributable to the operating, investing, and
financing activities of the discontinuing operation during the current financial
reporting period.
21. For the purpose of presentation and disclosures required by this Statement, the items of
assets, liabilities, revenues, expenses, gains, losses, and cash flows can be attributed to a
discontinuing operation only if they will be disposed of, settled, reduced, or eliminated when
the discontinuance is completed. To the extent that such items continue after completion of
the discontinuance, they are not allocated to the discontinuing operation. For example, salary
of the continuing staff of a discontinuing operation.
22. If an initial disclosure event occurs between the balance sheet date and the date on
which the financial statements for that period are approved by the board of directors in the
case of a company or by the corresponding approving authority in the case of any other
enterprise, disclosures as required by Accounting Standard (AS) 4, Contingencies and Events
Occurring After the Balance Sheet Date, are made.
Other Disclosures
23. When an enterprise disposes of assets or settles liabilities attributable to a
discontinuing operation or enters into binding agreements for the sale of such assets
or the settlement of such liabilities, it should include, in its financial statements, the
following information when the events occur:
(a) for any gain or loss that is recognised on the disposal of assets or settlement of
liabilities attributable to the discontinuing operation, (i) the amount of the pre-tax
gain or loss and (ii) income tax expense relating to the gain or loss; and
(b) the net selling price or range of prices (which is after deducting expected disposal
costs) of those net assets for which the enterprise has entered into one or more
€
As defined in Accounting Standard (AS) 22, Accounting for Taxes on Income.
binding sale agreements, the expected timing of receipt of those cash flows and
the carrying amount of those net assets on the balance sheet date.
24. The asset disposals, liability settlements, and binding sale agreements referred to in the
preceding paragraph may occur concurrently with the initial disclosure event, or in the period
in which the initial disclosure event occurs, or in a later period.
25. If some of the assets attributable to a discontinuing operation have actually been sold or
are the subject of one or more binding sale agreements entered into between the balance
sheet date and the date on which the financial statements are approved by the board of
directors in case of a company or by the corresponding approving authority in the case of any
other enterprise, the disclosures required by Accounting Standard (AS) 4, Contingencies and
Events Occurring After the Balance Sheet Date, are made.
Updating the Disclosures

26. In addition to the disclosures in paragraphs 20 and 23, an enterprise should
include, in its financial statements, for periods subsequent to the one in which the
initial disclosure event occurs, a description of any significant changes in the amount
or timing of cash flows relating to the assets to be disposed or liabilities to be settled
and the events causing those changes.
27. Examples of events and activities that would be disclosed include the nature and terms of
binding sale agreements for the assets, a demerger or spin-off by issuing equity shares of the
new company to the enterprise's shareholders, and legal or regulatory approvals.
28. The disclosures required by paragraphs 20, 23 and 26 should continue in financial
statements for periods up to and including the period in which the discontinuance is
completed. A discontinuance is completed when the plan is substantially completed or
abandoned, though full payments from the buyer(s) may not yet have been received.
29. If an enterprise abandons or withdraws from a plan that was previously reported as
a discontinuing operation, that fact, reasons therefor and its effect should be disclosed.
30. For the purpose of applying paragraph 29, disclosure of the effect includes reversal of
any prior impairment loss∗ or provision that was recognised with respect to the discontinuing
operation.
∗
Accounting Standard (AS)28 , ‘Impairment of Assets ‘, specifies the requirements
relating to impairment of assets.
Separate Disclosure for Each Discontinuing Operation

31. Any disclosures required by this Statement should be presented separately for
each discontinuing operation.
Presentation of the Required Disclosures

32. The disclosures required by paragraphs 20, 23, 26, 28, 29 and 31 should be
presented in the notes to the financial statements except the following which should be
shown on the face of the statement of profit and loss:
(a) the amount of pre-tax profit or loss from ordinary activities attributable to the
discontinuing operation during the current financial reporting period, and the
income tax expense related thereto (paragraph 20 (g)); and
(b) the amount of the pre-tax gain or loss recognised on the disposal of assets or
settlement of liabilities attributable to the discontinuing operation (paragraph 23
(a)).
Illustrative Presentation and Disclosures

33. Appendix 1 provides examples of the presentation and disclosures required by this
Statement.
Restatement of Prior Periods

34. Comparative information for prior periods that is presented in financial statements
prepared after the initial disclosure event should be restated to segregate assets,
liabilities, revenue, expenses, and cash flows of continuing and discontinuing
operations in a manner similar to that required by paragraphs 20, 23, 26, 28, 29, 31 and
32.
35. Appendix 2 illustrates application of paragraph 34.
Disclosure in Interim Financial Reports

36. Disclosures in an interim financial report in respect of a discontinuing operation
should be made in accordance with AS 25, Interim Financial Reporting, including:
(a) any significant activities or events since the end of the most recent annual
reporting period relating to a discontinuing operation; and
(b) any significant changes in the amount or timing of cash flows relating to the assets
to be disposed or liabilities to be settled.
Appendix 1
Facts
♦ Delta Company has three segments, Food Division, Beverage Division and Clothing
Division.
♦ Clothing Division, is deemed inconsistent with the long-term strategy of the Company.
Management has decided, therefore, to dispose of the Clothing Division.
♦ On 15 November 20X1, the Board of Directors of Delta Company approved a detailed,
formal plan for disposal of Clothing Division, and an announcement was made. On that
date, the carrying amount of the Clothing Division’s net assets was Rs. 90 lakhs (assets
of Rs. 105 lakhs minus liabilities of Rs. 15 lakhs).
♦ The recoverable amount of the assets carried at Rs. 105 lakhs was estimated to be Rs.
85 lakhs and the Company had concluded that a pre-tax impairment loss of Rs. 20 lakhs
should be recognised.
♦ At 31 December 20Xl, the carrying amount of the Clothing Division’s net assets was Rs.
70 lakhs (assets of Rs. 85 lakhs minus liabilities of Rs. 15 lakhs). There was no further
impairment of assets between 15 November 20X1 and 31 December 20X1 when the
financial statements were prepared.
♦ On 30 September 20X2, the carrying amount of the net assets of the Clothing Division
continued to be Rs. 70 lakhs. On that day, Delta Company signed a legally binding
contract to sell the Clothing Division.
♦ The sale is expected to be completed by 31 January 20X3. The recoverable amount of
the net assets is Rs. 60 lakhs. Based on that amount, an additional impairment loss of
Rs. 10 lakhs is recognised.
♦ In addition, prior to 31 January 20X3, the sale contract obliges Delta Company to
terminate employment of certain employees of the Clothing Division, which would result
in termination cost of Rs 30 lakhs, to be paid by 30 June 20X3. A liability and related
expense in this regard is also recognised.
♦ The Company continued to operate the Clothing Division throughout 20X2.
♦ At 31 December 20X2, the carrying amount of the Clothing Division’s net assets is Rs. 45
lakhs, consisting of assets of Rs. 80 lakhs minus liabilities of Rs. 35 lakhs (including
provision for expected termination cost of Rs. 30 lakhs).

♦ Delta Company prepares its financial statements annually as of 31 December. It does not
prepare a cash flow statement.
♦ Other figures in the following financial statements are assumed to illustrate the
presentation and disclosures required by the Statement.
I. Financial Statements for 20X1

1.1 Statement of Profit and Loss for 20X1
The Statement of Profit and Loss of Delta Company for the year 20X1 can be presented as
follows:
(Amount in Rs. lakhs)

20X1 20X0
TURNOVER 140 150
Operating expenses (92) (105)
Impairment loss (20) (---)
Pre-tax profit from operating activities 28 45
Profit before tax 13 25
Profit from continuing operations
before tax (see Note 5) 15 12
Income tax expense (7) (6)
Profit from continuing
operations after tax 8 6
Profit (loss) from discontinuing
operations before tax (see Note 5) (2) 13
Income tax expense 1 (7)
Profit (loss) from discontinuing
operations after tax (1) 6
Profit from operating
activities after tax 7 12
1.2 Note to Financial Statements for 20X1

The following is Note 5 to Delta Company's financial statements:
On 15 November 20Xl, the Board of Directors announced a plan to dispose of Company’s
Clothing Division, which is also a separate segment as per AS 17, Segment Reporting. The
disposal is consistent with the Company's long-term strategy to focus its activities in the areas
of food and beverage manufacture and distribution, and to divest unrelated activities. The
Company is actively seeking a buyer for the Clothing Division and hopes to complete the sale
by the end of 20X2. At 31 December 20Xl, the carrying amount of the assets of the Clothing
Division was Rs. 85 lakhs (previous year Rs. 120 lakhs) and its liabilities were Rs. 15 lakhs
(previous year Rs. 20 lakhs). The following statement shows the revenue and expenses of
continuing and discontinuing operations:
Continuing Discontinuing Total

Operations (Food and Operation
Beverage Divisions) (Clothing
Division)
20X1 20X0 20X1 20X0 20X1 20X0
Turnover 90 80 50 70 140 150
Operating Expenses (65) (60) (27) (45) (92) (105)
Impairment Loss ---- ---- (20) (---) (20) (---)
Pre-tax profit from
operating activities
25 20 3 25 28 45
Interest expense (10) (8) (5) (12) (15) (20)
Profit (loss) before tax 15 12 (2) 13 13 25
Income tax expense (7) (6) 1 (7) (6) (13)
Profit (loss) from
operating activities
after tax 8 6 (1) 6 7 12
II. Financial Statements for 20X2

2.1 Statement of Profit and Loss for 20X2
The Statement of Profit and Loss of Delta Company for the year 20X2 can be presented as
follows:

20X2 20X1
TURNOVER 140 140
Operating expenses (90) (92)
Impairment loss (10) (20)
Provision for employee termination benefits (30) --
Pre-tax profit from operating activities 10 28
Profit (loss) before tax (15) 13
PROFIT FROM CONTINUING OPERATIONS
before tax (see Note 5) 20 15
Income tax expense (6) (7)
Profit from continuing
operations after tax 14 8
Loss from discontinuing
operations before tax (see Note 5) (35) (2)
Income tax expense 10 1
Loss from discontinuing
operations after tax (25) (1)
Profit (loss) from operating
activities after tax (11) 7
2.2 Note to Financial Statements for 20X2
The following is Note 5 to Delta Company's financial statements:
On 15 November 20Xl, the Board of Directors had announced a plan to dispose of Company’s
Clothing Division, which is also a separate segment as per AS 17, Segment Reporting. The
disposal is consistent with the Company’s long-term strategy to focus its activities in the areas
of food and beverage manufacture and distribution, and to divest unrelated activities. On 30
September 20X2, the Company signed a contract to sell the Clothing Division to Z Corporation
for Rs. 60 lakhs.
Clothing Division’s assets are written down by Rs. 10 lakhs (previous year Rs. 20 lakhs)
before income tax saving of Rs. 3 lakhs (previous year Rs. 6 lakhs) to their recoverable
amount.
The Company has recognised provision for termination benefits of Rs. 30 lakhs (previous year
Rs. nil) before income tax saving of Rs. 9 lakhs (previous year Rs. nil) to be paid by 30 June
20X3 to certain employees of the Clothing Division whose jobs will be terminated as a result of
the sale.
At 31 December 20X2, the carrying amount of assets of the Clothing Division was Rs. 80 lakhs
(previous year Rs. 85 lakhs) and its liabilities were Rs. 35 lakhs (previous year Rs. 15 lakhs),
including the provision for expected termination cost of Rs. 30 lakhs (previous year Rs. nil).
The process of selling the Clothing Division is likely to be completed by 31 January 20X3.
The following statement shows the revenue and expenses of continuing and discontinuing
operations:

Continuing Discontinuing Total
Operations (Food Operation
and Beverage (Clothing
Divisions) Division)
20X2 20X1 20X2 20X1 20X2 20X1
Turnover 100 90 40 50 140 140
Operating Expenses (60) (65) (30) (27) (90) (92)
Impairment Loss ---- ---- (10) (20) (10) (20)
Provision for employee
termination ---- ---- (30) ---- (30) ---
Pre-tax profit (loss) from
operating activities 40 25 (30) 3 10 28
Interest expense (20) (10) (5) (5) (25) (15)
Profit (loss) before tax 20 15 35 (2) (15) 13
Income tax expense (6) (7) 10 1 4 (6)
Profit (loss) from operating
activities after tax 14 8 (25) (1) (11) 7
III. Financial Statements for 20X3
The financial statements for 20X3, would disclose information related to discontinued
operations in a manner similar to that for 20X2 including the fact of completion of
discontinuance.
APPENDIX 2
Classification of Prior Period Operations

Facts
1. Paragraph 34 requires that comparative information for prior periods that is presented in
financial statements prepared after the initial disclosure event be restated to segregate
assets, liabilities, revenue, expenses, and cash flows of continuing and discontinuing
operations in a manner similar to that required by paragraphs 20, 23, 26, 28, 29, 31 and
32.
2. Consider following facts:
(a) Operations A, B, C, and D were all continuing in years 1 and 2;
(b) Operation D is approved and announced for disposal in year 3 but actually disposed
of in year 4;
(c) Operation B is discontinued in year 4 (approved and announced for disposal and
actually disposed of) and operation E is acquired; and
(d) Operation F is acquired in year 5.
3. The following table illustrates the classification of continuing and discontinuing operations
in years 3 to 5:
FINANCIAL STATEMENTS FOR YEAR 3
(Approved and Published early in Year 4)
Year 2 Comparatives Year 3
Continuing Discontinuing Continuing Discontinuing
A A
B B
C C
D D

A A
B B
C C
D D
E

A A
B
C C
D
E E
F
4. If, for whatever reason, five-year comparative financial statements were prepared in year
5, the classification of continuing and discontinuing operations would be as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
Comparatives Comparatives Comparatives Comparatives
Cont. Disc. Cont. Disc. Cont. Disc. Cont. Disc. Cont. Disc.
A A A A A
B B B B
C C C C C
D D D D
E E
F
AS 25 : INTERIM FINANCIAL REPORTING*
Accounting Standard (AS) 25, ‘Interim Financial Reporting’, issued by the Council of the
commencing on or after 1-4-2002. If an enterprise is required or elects to prepare and present
an interim financial report, it should comply with this Standard. The following is the text of the
Objective
The objective of this Statement is to prescribe the minimum content of an interim financial
report and to prescribe the principles for recognition and measurement in a complete or
condensed financial statements for an interim period. Timely and reliable interim financial
reporting improves the ability of investors, creditors, and others to understand an enterprise’s
capacity to generate earnings and cash flows, its financial condition and liquidity.
Scope
1. This Statement does not mandate which enterprises should be required to present
interim financial reports, how frequently, or how soon after the end of an interim
period. If an enterprise is required or elects to prepare and present an interim

financial report, it should comply with this Statement.
2. A statute governing an enterprise or a regulator may require an enterprise to prepare and
present certain information at an interim date which may be different in form and/or
content as required by this Statement. In such a case, the recognition and measurement
principles as laid down in this Statement are applied in respect of such information,
unless otherwise specified in the statute or by the regulator.
3. The requirements related to cash flow statement, complete or condensed, contained in
this Statement are applicable where an enterprise prepares and presents a cash flow
statement for the purpose of its annual financial report.
Definitions
Interim period is a financial reporting period shorter than a full financial year.
Interim financial report means a financial report containing either a complete set of
financial statements or a set of condensed financial statements (as described in this
Statement) for an interim period.
5. During the first year of operations of an enterprise, its annual financial reporting period
may be shorter than a financial year. In such a case, that shorter period is not
considered as an interim period.
Content of an Interim Financial Report
6. A complete set of financial statements normally includes:
(a) balance sheet;
(b) statement of profit and loss;
(c) cash flow statement; and
(d) notes including those relating to accounting policies and other statements and
explanatory material that are an integral part of the financial statements.
7. In the interest of timeliness and cost considerations and to avoid repetition of information
previously reported, an enterprise may be required to or may elect to present less
information at interim dates as compared with its annual financial statements. The benefit
of timeliness of presentation may be partially offset by a reduction in detail in the
information provided. Therefore, this Statement requires preparation and presentation of
an interim financial report containing, as a minimum, a set of condensed financial
statements. The interim financial report containing condensed financial statements is
intended to provide an update on the latest annual financial statements. Accordingly, it
focuses on new activities, events, and circumstances and does not duplicate information
previously reported.
8. This Statement does not prohibit or discourage an enterprise from presenting a complete
set of financial statements in its interim financial report, rather than a set of condensed
financial statements. This Statement also does not prohibit or discourage an enterprise
from including, in condensed interim financial statements, more than the minimum line
items or selected explanatory notes as set out in this Statement. The recognition and
measurement principles set out in this Statement apply also to complete financial
statements for an interim period, and such statements would include all disclosures
required by this Statement (particularly the selected disclosures in paragraph 16) as well
as those required by other Accounting Standards.
Minimum Components of an Interim Financial Report
9. 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.
Form and Content of Interim Financial Statements
10. If an enterprise prepares and presents a complete set of financial statements in its
interim financial report, the form and content of those statements should conform
to the requirements as applicable to annual complete set of financial statements.
11. If an enterprise prepares and presents a set of condensed financial statements in
its interim financial report, those condensed statements should include, at a
minimum, each of the headings and sub-headings that were included in its most
recent annual financial statements and the selected explanatory notes as required
by this Statement. Additional line items or notes should be included if their
omission would make the condensed interim financial statements misleading.
12. If an enterprise presents basic and diluted earnings per share in its annual
financial statements in accordance with Accounting Standard (AS) 20, Earnings
Per Share, basic and diluted earnings per share should be presented in accordance
with AS 20 on the face of the statement of profit and loss, complete or condensed,
for an interim period.
13. If an enterprise’s annual financial report included the consolidated financial statements in
addition to the parent’s separate financial statements, the interim financial report includes
both the consolidated financial statements and separate financial statements, complete
or condensed.
14. Appendix 1 provides illustrative formats of condensed financial statements.
Selected Explanatory Notes

15. A user of an enterprise’s interim financial report will ordinarily have access to the most
recent annual financial report of that enterprise. It is, therefore, not necessary for the
notes to an interim financial report to provide relatively insignificant updates to the
information that was already reported in the notes in the most recent annual financial
report. At an interim date, an explanation of events and transactions that are significant
to an understanding of the changes in financial position and performance of the
enterprise since the last annual reporting date is more useful.
16. An enterprise should include the following information, as a minimum, in the notes
to its interim financial statements, if material and if not disclosed elsewhere in the
interim financial report:
(a) a statement that the same accounting policies are followed in the interim
financial statements as those followed in the most recent annual financial
statements or, if those policies have been changed, a description of the nature
and effect of the change;
(b) explanatory comments about the seasonality of interim operations;
(c) the nature and amount of items affecting assets, liabilities, equity, net income,
or cash flows that are unusual because of their nature, size, or incidence (see
paragraphs 12 to 14 of Accounting Standard (AS) 5, Net Profit or Loss for the
Period, Prior Period Items and Changes in Accounting Policies);
(d) the nature and amount of changes in estimates of amounts reported in prior
interim periods of the current financial year or changes in estimates of
amounts reported in prior financial years, if those changes have a material
effect in the current interim period;
(e) issuances, buy-backs, repayments and restructuring of debt, equity and
potential equity shares;
(f) dividends, aggregate or per share (in absolute or percentage terms),
separately for equity shares and other shares;
(g) segment revenue, segment capital employed (segment assets minus segment
liabilities) and segment result for business segments or geographical
segments, whichever is the enterprise’s primary basis of segment reporting
(disclosure of segment information is required in an enterprise’s interim
financial report only if the enterprise is required, in terms of AS 17, Segment
Reporting, to disclose segment information in its annual financial statements);
(h) material events subsequent to the end of the interim period that have not been
reflected in the financial statements for the interim period.£
(i) the effect of changes in the composition of the enterprise during the
interim period, such as amalgamations, acquisition or disposal of
subsidiaries and long-term investments, restructurings, and
£
The council of the Institute decided to make a limited revision to AS 25 in 2004, pursuant to
which this sub-paragraph has been added in paragraph 16 of AS 25. The revision comes into effect
in respect of accounting periods commencing on or after 1.4.2004.
discontinuing operations; and

(i) material changes in contingent liabilities since the last annual balance
sheet date.
The above information should normally be reported on a financial year-to-date
basis. However, the enterprise should also disclose any events or transactions that
are material to an understanding of the current interim period.
17. Other Accounting Standards specify disclosures that should be made in financial
statements. In that context, financial statements mean complete set of financial
statements normally included in an annual financial report and sometimes included in
other reports. The disclosures required by those other Accounting Standards are not
required if an enterprise’s interim financial report includes only condensed financial
statements and selected explanatory notes rather than a complete set of financial
statements.
Periods for which Interim Financial Statements are required to be presented

18. Interim reports should include interim financial statements (condensed or
complete) for periods as follows:
(a) balance sheet as of the end of the current interim period and a comparative
balance sheet as of the end of the immediately preceding financial year;
(b) statements of profit and loss for the current interim period and cumulatively
for the current financial year to date, with comparative statements of profit
and loss for the comparable interim periods (current and year-to-date) of the
immediately preceding financial year;
(c) cash flow statement cumulatively for the current financial year to date, with a
comparative statement for the comparable year-to-date period of the
immediately preceding financial year.
19. For an enterprise whose business is highly seasonal, financial information for the twelve
months ending on the interim reporting date and comparative information for the prior
twelve-month period may be useful. Accordingly, enterprises whose business is highly
seasonal are encouraged to consider reporting such information in addition to the
information called for in the preceding paragraph.
20. Appendix 2 illustrates the periods required to be presented by an enterprise that reports
half-yearly and an enterprise that reports quarterly.
Materiality
21. In deciding how to recognise, measure, classify, or disclose an item for interim
financial reporting purposes, materiality should be assessed in relation to the
interim period financial data. In making assessments of materiality, it should be
recognised that interim measurements may rely on estimates to a greater extent
than measurements of annual financial data.
22. The Preface to the Statements of Accounting Standards states that “The Accounting
Standards are intended to apply only to items which are material.” The Framework for the
Preparation and Presentation of Financial Statements, issued by the Institute of
Chartered Accountants of India, states that “information is material if its misstatement
(i.e., omission or erroneous statement) could influence the economic decisions of users
taken on the basis of the financial information.”
23. Judgement is always required in assessing materiality for financial reporting purposes.
For reasons of understandability of the interim figures, materiality for making recognition
and disclosure decision is assessed in relation to the interim period financial data. Thus,
for example, unusual or extraordinary items, changes in accounting policies or estimates,
and prior period items are recognised and disclosed based on materiality in relation to
interim period data. The overriding objective is to ensure that an interim financial report
includes all information that is relevant to understanding an enterprise’s financial position
and performance during the interim period.
Disclosure in Annual Financial Statements

24. An enterprise may not prepare and present a separate financial report for the final interim
period because the annual financial statements are presented. In such a case, paragraph
25 requires certain disclosures to be made in the annual financial statements for that
financial year.
25. If an estimate of an amount reported in an interim period is changed significantly
during the final interim period of the financial year but a separate financial report is
not prepared and presented for that final interim period, the nature and amount of
that change in estimate should be disclosed in a note to the annual financial
statements for that financial year.
26. Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies, requires disclosure, in financial statements, of the
nature and (if practicable) the amount of a change in an accounting estimate which has a
material effect in the current period, or which is expected to have a material effect in
subsequent periods. Paragraph 16(d) of this Statement requires similar disclosure in an
interim financial report. Examples include changes in estimate in the final interim period
relating to inventory write-downs, restructurings, or impairment losses that were reported
in an earlier interim period of the financial year. The disclosure required by the preceding
paragraph is consistent with AS 5 requirements and is intended to be restricted in scope
so as to relate only to the change in estimates. An enterprise is not required to include
additional interim period financial information in its annual financial statements.

Same Accounting Policies as Annual
27. An enterprise should apply the same accounting policies in its interim financial
statements as are applied in its annual financial statements, except for accounting
policy changes made after the date of the most recent annual financial statements
that are to be reflected in the next annual financial statements. However, the
frequency of an enterprise’s reporting (annual, half-yearly, or quarterly) should not
affect the measurement of its annual results. To achieve that objective,
measurements for interim reporting purposes should be made on a year-to-date
basis.
28. Requiring that an enterprise apply the same accounting policies in its interim financial
statements as in its annual financial statements may seem to suggest that interim period
measurements are made as if each interim period stands alone as an independent
reporting period. However, by providing that the frequency of an enterprise’s reporting
should not affect the measurement of its annual results, paragraph 27 acknowledges that
an interim period is a part of a financial year. Year-to-date measurements may involve
changes in estimates of amounts reported in prior interim periods of the current financial
year. But the principles for recognising assets, liabilities, income, and expenses for
interim periods are the same as in annual financial statements.
29. To illustrate:
(a) the principles for recognising and measuring losses from inventory write-downs,
restructurings, or impairments in an interim period are the same as those that an
enterprise would follow if it prepared only annual financial statements. However, if
such items are recognised and measured in one interim period and the estimate
changes in a subsequent interim period of that financial year, the original estimate
is changed in the subsequent interim period either by accrual of an additional
amount of loss or by reversal of the previously recognised amount;
(b) a cost that does not meet the definition of an asset at the end of an interim period is
not deferred on the balance sheet date either to await future information as to
whether it has met the definition of an asset or to smooth earnings over interim
periods within a financial year; and
(c) income tax expense is recognised in each interim period based on the best estimate
of the weighted average annual effective income tax rate expected for the full
financial year. Amounts accrued for income tax expense in one interim period may
have to be adjusted in a subsequent interim period of that financial year if the
estimate of the annual effective income tax rate changes.
30. Under the Framework for the Preparation and Presentation of Financial Statements,
recognition is the “process of incorporating in the balance sheet or statement of profit
and loss an item that meets the definition of an element and satisfies the criteria for
recognition”. The definitions of assets, liabilities, income, and expenses are fundamental
to recognition, both at annual and interim financial reporting dates.
31. For assets, the same tests of future economic benefits apply at interim dates as they
apply at the end of an enterprise’s financial year. Costs that, by their nature, would not
qualify as assets at financial year end would not qualify at interim dates as well. Similarly,
a liability at an interim reporting date must represent an existing obligation at that date,
just as it must at an annual reporting date.
32. Income is recognised in the statement of profit and loss when an increase in future
economic benefits related to an increase in an asset or a decrease of a liability has
arisen that can be measured reliably. Expenses are recognised in the statement of profit
and loss when a decrease in future economic benefits related to a decrease in an asset
or an increase of a liability has arisen that can be measured reliably. The recognition of
items in the balance sheet which do not meet the definition of assets or liabilities is not
allowed.
33. In measuring assets, liabilities, income, expenses, and cash flows reported in its financial
statements, an enterprise that reports only annually is able to take into account
information that becomes available throughout the financial year. Its measurements are,
in effect, on a year-to-date basis.
34. An enterprise that reports half-yearly, uses information available by mid-year or shortly
thereafter in making the measurements in its financial statements for the first six-month
period and information available by year-end or shortly thereafter for the twelve-month
period. The twelve-month measurements will reflect any changes in estimates of
amounts reported for the first six-month period. The amounts reported in the interim
financial report for the first six-month period are not retrospectively adjusted. Paragraphs
16(d) and 25 require, however, that the nature and amount of any significant changes in
estimates be disclosed.
35. An enterprise that reports more frequently than half-yearly, measures income and
expenses on a year-to-date basis for each interim period using information available
when each set of financial statements is being prepared. Amounts of income and
expenses reported in the current interim period will reflect any changes in estimates of
amounts reported in prior interim periods of the financial year. The amounts reported in
prior interim periods are not retrospectively adjusted. Paragraphs 16(d) and 25 require,
however, that the nature and amount of any significant changes in estimates be
disclosed.
Revenues Received Seasonally or Occasionally

36. Revenues that are received seasonally or occasionally within a financial year
should not be anticipated or deferred as of an interim date if anticipation or
deferral would not be appropriate at the end of the enterprise’s financial year.
37. Examples include dividend revenue, royalties, and government grants. Additionally, some
enterprises consistently earn more revenues in certain interim periods of a financial year
than in other interim periods, for example, seasonal revenues of retailers. Such revenues
are recognised when they occur.
Costs Incurred Unevenly During the Financial Year

38. Costs that are incurred unevenly during an enterprise’s financial year should be
anticipated or deferred for interim reporting purposes if, and only if, it is also
appropriate to anticipate or defer that type of cost at the end of the financial year.
Applying the Recognition and Measurement principles

39. Appendix 3 provides examples of applying the general recognition and measurement
principles set out in paragraphs 27 to 38.
Use of Estimates
40. The measurement procedures to be followed in an interim financial report should
be designed to ensure that the resulting information is reliable and that all material
financial information that is relevant to an understanding of the financial position
or performance of the enterprise is appropriately disclosed. While measurements
in both annual and interim financial reports are often based on reasonable
estimates, the preparation of interim financial reports generally will require a
greater use of estimation methods than annual financial reports.
41. Appendix 4 provides examples of the use of estimates in interim periods.
RESTATEMENT OF PREVIOUSLY REPORTED INTERIM PERIODS

42. A change in accounting policy, other than one for which the transition is specified
by an Accounting Standard, should be reflected by restating the financial
statements of prior interim periods of the current financial year.
43. One objective of the preceding principle is to ensure that a single accounting policy is
applied to a particular class of transactions throughout an entire financial year. The effect
of the principle in paragraph 42 is to require that within the current financial year any
change in accounting policy be applied retrospectively to the beginning of the financial
year.
Transitional Provision
44. On the first occasion that an interim financial report is presented in accordance with this
Statement, the following need not be presented in respect of all the interim periods of the
current financial year:
(a) comparative statements of profit and loss for the comparable interim periods
(current and year-to-date) of the immediately preceding financial year; and
(b) comparative cash flow statement for the comparable year-to-date period of the
immediately preceding financial year.
APPENDIX 1
Illustrative Format of Condensed Financial Statements

This Appendix, which is illustrative and does not form part of the Accounting Standard,
provides illustrative format of condensed financial statements. The purpose of the appendix is
to illustrate the application of the Accounting Standard to assist in clarifying its meaning.
Paragraph 11 of the Accounting Standard provides that if an enterprise prepares and presents
a set of condensed financial statements in its interim financial report, those condensed
statements should include, at a minimum, each of the headings and sub-headings that were
included in its most recent annual financial statements and the selected explanatory notes as
required by the Standard. Additional line items or notes should be included if their omission
would make the condensed interim financial statements misleading.
The purpose of the following illustrative format is primarily to illustrate the requirements of
paragraph 11 of the Standard. It may be noted that these illustrative formats are subject to the
requirements laid down in the Standard including those of paragraph 11.
Illustrative Format of Condensed Financial Statements for an enterprise other than a
bank
(A) Condensed Balance Sheet
Figures at the end of the Figures at the end of
current interim period the previous
accounting year
I. Sources of Funds
1. Capital
2. Reserve and surplus
3. Minority interests (in case of
consolidated financial statements)
4. Loan funds:
(a) Secured loans
(b) Unsecured loans
Total
II. Application of funds
1. Fixed assets
(a) Tangible fixed assets
(b) Intangible fixed assets
2. Investments
3. Current assets, loans and
advances
(a) Inventories
(b) Sundry debtors
(c) Cash and bank balances
(d) Loans and advances
(e) Others
Less: Current liabilities and
provisions
(a) Liabilities
(b) Provisions
Net Current assets

4. Miscellaneous expenditure to the
extent not written off or adjusted
5. Profit and loss account
Total
(B) Condensed Statement of Profit and Loss
Three Corresponding Year-to-date Year-to-
months three months of figures for date
ended the previous current figures for
accounting year period the
previous
year
1 Turnover
2. Other Income
Total
3. Changes in inventories
of finished goods and work
in progress
4. Cost of Raw materials
and consumables used
5. Salaries, wages and
other staff costs
6. Other expenses
7. Interest
8. Depreciation and
amortisations
Total
9. Profit or loss from
ordinary activities before
tax
10. Extraordinary items
11. Profit or loss before tax
12. Tax expense
13. Profit or loss after tax
14. Minority Interests (in
case of consolidated
financial statements)
15. Net profit or loss for
the period
Earnings Per share

1. Basic Earnings Per
Share
2. Diluted Earnings Per
Share
(C) Condensed Cash Flow Statement
Year-to-date figures for the Year-to-date figures for
current period the previous year
1. Cash flows from operating
activities
2. Cash flows from investing
activities
3. Cash flows from financing
activities
4. Net increase/(decrease) in cash
and cash equivalents
5. Cash and cash equivalents at
beginning of period
6. Cash and cash equivalents at end
of period
(D) Selected Explanatory Notes
This part should contain selected explanatory notes as required by paragraph 16 of this
Statement.
Illustrative Format of Condensed Financial Statements for a Bank
(A) Condensed Balance Sheet
Figures at the end of the Figures at the end of
current interim period the previous
accounting year
I. Capital and Liabilities
1. Capital
2. Reserve and surplus
3. Minority interests (in case of
consolidated financial statements)
4. Deposits
5. Borrowings
6. Other liabilities and provisions
Total
II. Assets
1. Cash and balances with Reserve
Bank of India
2. Balances with banks and money

at call and short notice
3. Investments
4. Advances
5. Fixed assets
(a) Tangible fixed assets
(b) Intangible fixed assets
6. Other Assets
Total
(B) Condensed Statement of Profit and Loss

Three Corresponding Year-to-date Year-to-
months three months of figures for date
ended the previous current figures for
accounting year period the
previous
year
1. Interest earned
(a) Interest/discount
on advances/bills
(b) Interest on
Investments
(c) Interest on
balances with
Reserve Bank of
India and other
inter banks funds
(d) Others
2. Other Income
Total Income
1. Interest expended
2. Operating expenses
(a) Payments to and
provisions for
employees
(b) Other operating
expenses
3. Total expenses
(excluding provisions and
contingencies)
4. Operating profit (profit
before provisions and

contingencies)
5. Provisions and
contingencies
6. Profit or loss from
ordinary activities before
tax
7. Extraordinary items
8. Profit or loss before tax
9. Tax expense
10. Profit or loss after tax
11. Minority Interests (in
case of consolidated
financial statements)
12. Net profit or loss for
the period
Earnings Per share
1. Basic Earnings Per
Share
2. Diluted Earnings Per
Share
(C) Condensed Cash Flow Statement

Year-to-date figures for the Year-to-date figures for the
current period previous year
1. Cash flows from operating
activities
2. Cash flows from investing
activities
3. Cash flows from financing
activities
4. Net increase/(decrease) in
cash and cash equivalents
5. Cash and cash equivalents
at beginning of period
6. Cash and cash equivalents
at end of period
(D) Selected Explanatory Notes
This part should contain selected explanatory notes as required by paragraph 16 of this
Statement.
APPENDIX 2
Illustration of Periods Required to Be Presented
provides examples to illustrate application of the principles in paragraphs 18 and 19. The
Enterprise Preparing and Presenting Interim Financial Reports Half-Yearly
1. An enterprise whose financial year ends on 31 March, presents financial statements
(condensed or complete) for following periods in its half-yearly interim financial report as
of 30 September 2001:
Balance Sheet:
As at 30 September 2001 31 March 2001
Statement of Profit and Loss :
6 months ending 30 September 2001 30 September 2000
Cash Flow Statement1:
Enterprise Preparing and Presenting Interim Financial Reports Quarterly
2. An enterprise whose financial year ends on 31 March, presents financial statements
(condensed or complete) for following periods in its interim financial report for the second
quarter ending 30 September 2001:
Balance Sheet:
Statement of Profit and Loss:
Cash Flow Statement:
Enterprise whose business is highly seasonal Preparing and Presenting Interim
Financial Reports Quarterly
3. An enterprise whose financial year ends on 31 March, may present financial statements
1
It is assumed that the enterprise prepares a cash flow statement for the purpose of its Annual
Report.
(condensed or complete) for the following periods in its interim financial report for the
second quarter ending 30 September 2001:
Balance Sheet:
30 September 2000
Statement of Profit and Loss:
Cash Flow Statement:
APPENDIX 3
Examples of Applying the Recognition and Measurement Principles

provides examples of applying the general recognition and measurement principles set out in
paragraphs 27-38 of this Standard. The purpose of the appendix is to illustrate the application
of the Accounting Standard to assist in clarifying its meaning.
Gratuity and Other Defined Benefit Schemes

1. Provisions in respect of gratuity and other defined benefit schemes for an interim period
are calculated on a year-to-date basis by using the actuarially determined rates at the
end of the prior financial year, adjusted for significant market fluctuations since that time
and for significant curtailments, settlements, or other significant one-time events.
Major Planned Periodic Maintenance or Overhaul

2. The cost of a major planned periodic maintenance or overhaul or other seasonal
expenditure that is expected to occur late in the year is not anticipated for interim
reporting purposes unless an event has caused the enterprise to have a present
obligation. The mere intention or necessity to incur expenditure related to the future is
not sufficient to give rise to an obligation.
Provisions
3. This Statement requires that an enterprise apply the same criteria for recognising and
measuring a provision at an interim date as it would at the end of its financial year. The
existence or non-existence of an obligation to transfer economic benefits is not a function
of the length of the reporting period. It is a question of fact subsisting on the reporting
date.
Year-End Bonuses
4. The nature of year-end bonuses varies widely. Some are earned simply by continued
employment during a time period. Some bonuses are earned based on monthly,
quarterly, or annual measure of operating result. They may be purely discretionary,
contractual, or based on years of historical precedent.
5. A bonus is anticipated for interim reporting purposes if, and only if, (a) the bonus is a
legal obligation or an obligation arising from past practice for which the enterprise has no
realistic alternative but to make the payments, and (b) a reliable estimate of the
obligation can be made.
Intangible Assets
6. An enterprise will apply the definition and recognition criteria for an intangible asset in
the same way in an interim period as in an annual period. Costs incurred before the
recognition criteria for an intangible asset are met are recognised as an expense. Costs
incurred after the specific point in time at which the criteria are met are recognised as
part of the cost of an intangible asset. “Deferring” costs as assets in an interim balance
sheet in the hope that the recognition criteria will be met later in the financial year is not
justified.
Other Planned but Irregularly Occurring Costs

7. An enterprise’s budget may include certain costs expected to be incurred irregularly
during the financial year, such as employee training costs. These costs generally are
discretionary even though they are planned and tend to recur from year to year.
Recognising an obligation at an interim financial reporting date for such costs that have
not yet been incurred generally is not consistent with the definition of a liability.
Measuring Income Tax Expense for Interim Period

8. Interim period income tax expense is accrued using the tax rate that would be applicable
to expected total annual earnings, that is, the estimated average annual effective income
tax rate applied to the pre-tax income of the interim period.
9. This is consistent with the basic concept set out in paragraph 27 that the same
accounting recognition and measurement principles should be applied in an interim
financial report as are applied in annual financial statements. Income taxes are assessed
on an annual basis. Therefore, interim period income tax expense is calculated by
applying, to an interim period’s pre-tax income, the tax rate that would be applicable to
expected total annual earnings, that is, the estimated average annual effective income
tax rate. That estimated average annual effective income-tax rate would reflect the tax
rate structure expected to be applicable to the full year’s earnings including enacted or
substantively enacted changes in the income tax rates scheduled to take effect later in
the financial year. The estimated average annual effective income tax rate would be re-
estimated on a year-to-date basis, consistent with paragraph 27 of this Statement.
Paragraph 16(d) requires disclosure of a significant change in estimate.
10. To the extent practicable, a separate estimated average annual effective income tax rate is
determined for each governing taxation law and applied individually to the interim period pre-
tax income under such laws. Similarly, if different income tax rates apply to different
categories of income (such as capital gains or income earned in particular industries), to
the extent practicable a separate rate is applied to each individual category of interim
period pre-tax income. While that degree of precision is desirable, it may not be
achievable in all cases, and a weighted average of rates across such governing taxation
laws or across categories of income is used if it is a reasonable approximation of the
effect of using more specific rates.
11. As illustration, an enterprise reports quarterly, earns Rs. 150 lakhs pre-tax profit in the
first quarter but expects to incur losses of Rs 50 lakhs in each of the three remaining
quarters (thus having zero income for the year), and is governed by taxation laws
according to which its estimated average annual effective income tax rate is expected to
be 35 per cent. The following table shows the amount of income tax expense that is
reported in each quarter:
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter Annual
Tax Expense 52.5 (17.5) (17.5) (17.5) 0
Difference in Financial Reporting Year and Tax Year

12. If the financial reporting year and the income tax year differ, income tax expense for the
interim periods of that financial reporting year is measured using separate weighted
average estimated effective tax rates for each of the income tax years applied to the
portion of pre-tax income earned in each of those income tax years.
13. To illustrate, an enterprise’s financial reporting year ends 30 September and it reports
quarterly. Its year as per taxation laws ends 31 March. For the financial year that begins
1 October, Year 1 ends 30 September of Year 2, the enterprise earns Rs 100 lakhs pre-
tax each quarter. The estimated weighted average annual effective income tax rate is 30
per cent in Year 1 and 40 per cent in Year 2.
Quarter Quarter Quarter Quarter Year
Ending Ending Ending Ending Ending
31 Dec. 31 Mar. 30 June 30 Sep. 30 Sep.
Year 1 Year 1 Year 2 Year 2 Year 2
Tax Expense 30 30 40 40 140

Tax Deductions/Exemptions
14. Tax statutes may provide deductions/exemptions in computation of income for
determining tax payable. Anticipated tax benefits of this type for the full year are
generally reflected in computing the estimated annual effective income tax rate, because
these deductions/exemptions are calculated on an annual basis under the usual
provisions of tax statutes. On the other hand, tax benefits that relate to a one-time event
are recognised in computing income tax expense in that interim period, in the same way
that special tax rates applicable to particular categories of income are not blended into a
single effective annual tax rate.
Tax Loss Carry forwards

15. A deferred tax asset should be recognised in respect of carryforward tax losses to the
extent that it is virtually certain, supported by convincing evidence, that future taxable
income will be available against which the deferred tax assets can be realised. The
criteria are to be applied at the end of each interim period and, if they are met, the effect
of the tax loss carryforward is reflected in the computation of the estimated average
annual effective income tax rate.
16. To illustrate, an enterprise that reports quarterly has an operating loss carryforward of Rs
100 lakhs for income tax purposes at the start of the current financial year for which a
deferred tax asset has not been recognised. The enterprise earns Rs 100 lakhs in the
first quarter of the current year and expects to earn Rs 100 lakhs in each of the three
remaining quarters. Excluding the loss carryforward, the estimated average annual
effective income tax rate is expected to be 40 per cent. The estimated payment of the
annual tax on Rs. 400 lakhs of earnings for the current year would be Rs. 120 lakhs {(Rs.
400 lakhs – Rs. 100 lakhs) x 40%}. Considering the loss carryforward, the estimated
average annual effective income tax rate would be 30% {(Rs. 120 lakhs/Rs. 400 lakhs) x
100}. This average annual effective income tax rate would be applied to earnings of
each quarter. Accordingly, tax expense would be as follows:
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter Annual
Tax Expense 30.00 30.00 30.00 30.00 120.00
Contractual or Anticipated Purchase Price Changes

17. Volume rebates or discounts and other contractual changes in the prices of goods and
services are anticipated in interim periods, if it is probable that they will take effect. Thus,
contractual rebates and discounts are anticipated but discretionary rebates and discounts
are not anticipated because the resulting liability would not satisfy the conditions of
recognition, viz., that a liability must be a present obligation whose settlement is
expected to result in an outflow of resources.
Depreciation and Amortisation

18. Depreciation and amortisation for an interim period is based only on assets owned during
that interim period. It does not take into account asset acquisitions or disposals planned
for later in the financial year.
Inventories
19. Inventories are measured for interim financial reporting by the same principles as at
financial year end. AS 2 on Valuation of Inventories, establishes standards for
recognising and measuring inventories. Inventories pose particular problems at any
financial reporting date because of the need to determine inventory quantities, costs, and
net realisable values. Nonetheless, the same measurement principles are applied for
interim inventories. To save cost and time, enterprises often use estimates to measure
inventories at interim dates to a greater extent than at annual reporting dates. Paragraph
20 below provides an example of how to apply the net realisable value test at an interim
date.
Net Realisable Value of Inventories

20. The net realisable value of inventories is determined by reference to selling prices and
related costs to complete and sell the inventories. An enterprise will reverse a write-down
to net realisable value in a subsequent interim period as it would at the end of its
financial year.
Foreign Currency Translation Gains and Losses

21. Foreign currency translation gains and losses are measured for interim financial reporting
by the same principles as at financial year end in accordance with the principles as
stipulated in AS 11 on Accounting for the Effects of Changes in Foreign Exchange Rates.
Impairment of Assets
22. Accounting Standard on Impairment of Assets2 requires that an impairment loss be
recognised if the recoverable amount has declined below carrying amount.
23. An enterprise applies the same impairment tests, recognition, and reversal criteria at an
interim date as it would at the end of its financial year. That does not mean, however,
that an enterprise must necessarily make a detailed impairment calculation at the end of
each interim period. Rather, an enterprise will assess the indications of significant
impairment since the end of the most recent financial year to determine whether such a
calculation is needed.
2
Accounting Standard (AS)28 , ‘Impairment of Assets ‘, specifies the requirements relating to
impairment of assets..
APPENDIX 4
Examples of the Use of Estimates

provides examples to illustrate application of the principles in this Standard. The purpose of
the appendix is to illustrate the application of the Accounting Standard to assist in clarifying its
meaning.
1. Provisions: Determination of the appropriate amount of a provision (such as a provision
for warranties, restructuring costs, gratuity, etc.) may be complex and often costly and time-
consuming. Enterprises sometimes engage outside experts to assist in annual calculations.
Making similar estimates at interim dates often involves updating the provision made in the
preceding annual financial statements rather than engaging outside experts to do a new
calculation.
2. Contingencies: Measurement of contingencies may involve obtaining opinions of legal
experts or other advisers. Formal reports from independent experts are sometimes obtained
with respect to contingencies. Such opinions about litigation, claims, assessments, and other
contingencies and uncertainties may or may not be needed at interim dates.
3. Specialised industries: Because of complexity, costliness, and time involvement,
interim period measurements in specialised industries might be less precise than at financial
year end. An example is calculation of insurance reserves by insurance companies.
AS 26 : INTANGIBLE ASSETS*
Accounting Standard (AS) 26, ‘Intangible Assets’, issued by the Council of the Institute of
Chartered Accountants of India, comes into effect in respect of expenditure incurred on
intangible items during accounting periods commencing on or after 1-4-2003 and is mandatory
in nature from that date for the following:
India, and enterprises that are in the process of issuing equity or debt securities that will
be listed on a recognised stock exchange in India as evidenced by the board of directors’
the accounting period exceeds Rs.50 crores.
In respect of all other enterprises, the Accounting Standard comes into effect in respect of
expenditure incurred on intangible items during accounting periods commencing on or after 1-
4-2004 and is mandatory in nature from that date.
Earlier application of the Accounting Standard is encouraged.
In respect of intangible items appearing in the balance sheet as on the aforesaid date, i.e.,
1-4-2003 or 1-4-2004, as the case may be, the Standard has limited application as stated in
paragraph 99. From the date of this Standard becoming mandatory for the concerned
enterprises, the following stand withdrawn:
(i) Accounting Standard (AS) 8, Accounting for Research and Development;
(ii) Accounting Standard (AS) 6, Depreciation Accounting, with respect to the amortisation
(depreciation) of intangible assets; and
(iii) Accounting Standard (AS) 10, Accounting for Fixed Assets - paragraphs 16.3 to 16.7, 37
and 38.
Objective
The objective of this Statement is to prescribe the accounting treatment for intangible assets
that are not dealt with specifically in another Accounting Standard. This Statement requires
an enterprise to recognise an intangible asset if, and only if, certain criteria are met. The
Statement also specifies how to measure the carrying amount of intangible assets and
requires certain disclosures about intangible assets.
Scope
1. This Statement should be applied by all enterprises in accounting for intangible
assets, except:
(a) intangible assets that are covered by another Accounting Standard;
(b) financial assets3;
(c) mineral rights and expenditure on the exploration for, or development and
extraction of, minerals, oil, natural gas and similar non-regenerative resources;
and
(d) intangible assets arising in insurance enterprises from contracts with
policyholders.
£This statement should not be applied in respect of termination benefits ∗also.
3
A financial asset is any asset that is:
(a) cash;
(b) a contractual right to receive cash or another financial asset from another
enterprise;
(c) a contractual right to exchange financial instruments with another enterprise
under conditions that are potentially favourable; or
(d) an ownership interest in another enterprise.
£
Termination benefits are employee benefits payable as a result of either:
2. If another Accounting Standard deals with a specific type of intangible asset, an

enterprise applies that Accounting Standard instead of this Statement. For example, this
Statement does not apply to:
(a) intangible assets held by an enterprise for sale in the ordinary course of business (see
AS 2, Valuation of Inventories, and AS 7, Accounting for Construction Contracts);
(b) deferred tax assets (see AS 22, Accounting for Taxes on Income);
(c) leases that fall within the scope of AS 19, Leases; and
(d) goodwill arising on an amalgamation (see AS 14, Accounting for Amalgamations) and
goodwill arising on consolidation (see AS 21, Consolidated Financial Statements).
3. This Statement applies to, among other things, expenditure on advertising, training, start-
up, research and development activities. Research and development activities are directed to
the development of knowledge. Therefore, although these activities may result in an asset
with physical substance (for example, a prototype), the physical element of the asset is
secondary to its intangible component, that is the knowledge embodied in it. This Statement
also applies to rights under licensing agreements for items such as motion picture films, video
recordings, plays, manuscripts, patents and copyrights. These items are excluded from the
scope of AS 19.
4. In the case of a finance lease, the underlying asset may be either tangible or intangible.
After initial recognition, a lessee deals with an intangible asset held under a finance lease
under this Statement.
5. Exclusions from the scope of an Accounting Standard may occur if certain activities or
transactions are so specialised that they give rise to accounting issues that may need to be
dealt with in a different way. Such issues arise in the expenditure on the exploration for, or
development and extraction of, oil, gas and mineral deposits in extractive industries and in the
case of contracts between insurance enterprises and their policyholders. Therefore, this
Statement does not apply to expenditure on such activities. However, this Statement applies
to other intangible assets used (such as computer software), and other expenditure (such as
start-up costs), in extractive industries or by insurance enterprises. Accounting issues of
specialised nature also arise in respect of accounting for discount or premium relating to
borrowings and ancillary costs incurred in connection with the arrangement of borrowings,
share issue expenses and discount allowed on the issue of shares. Accordingly, this
Statement does not apply to such items also.
(a) an enterprise’s decision to terminate an employee’s employment before the normal

retirement date;
(b) an employee’s decision to accept voluntary redundancy in exchange for those benefits
(voluntary retirement)
∗
The council of the Institute decided to make a limited revision to As 26 in 2004, pursuant to
which the last sentence has been added to paragraph 1.
Definitions
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.
An asset is a resource:
(a) controlled by an enterprise as a result of past events; and
(b) from which future economic benefits are expected to flow to the enterprise.
Monetary assets are money held and assets to be received in fixed or determinable amounts
of money.
Non-monetary assets are assets other than monetary assets.
Research is original and planned investigation undertaken with the prospect of gaining
new scientific or technical knowledge and understanding.
Development is the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices,
products, processes, systems or services prior to the commencement of commercial
production or use.
Amortisation is the systematic allocation of the depreciable amount of an intangible
asset over its useful life.
Depreciable amount is the cost of an asset less its residual value.
Useful life is either:
(a) the period of time over which an asset is expected to be used by the enterprise; or
by the enterprise.
Residual value is the amount which an enterprise expects to obtain for an asset at the
end of its useful life after deducting the expected costs of disposal.
Fair value of an asset is the amount for which that asset could be exchanged between
knowledgeable, willing parties in an arm's length transaction.
An active market is a market where all the following conditions exist:
(a) the items traded within the market are homogeneous;
(b) willing buyers and sellers can normally be found at any time; and
(c) prices are available to the public.
An impairment loss is the amount by which the carrying amount of an asset exceeds its
recoverable amount.4
Carrying amount is the amount at which an asset is recognised in the balance sheet, net
of any accumulated amortisation and accumulated impairment losses thereon.
Intangible Assets
7. Enterprises frequently expend resources, or incur liabilities, on the acquisition,
development, maintenance or enhancement of intangible resources such as scientific or
technical knowledge, design and implementation of new processes or systems, licences,
intellectual property, market knowledge and trademarks (including brand names and
publishing titles). Common examples of items encompassed by these broad headings are
computer software, patents, copyrights, motion picture films, customer lists, mortgage
servicing rights, fishing licences, import quotas, franchises, customer or supplier relationships,
customer loyalty, market share and marketing rights. Goodwill is another example of an item
of intangible nature which either arises on acquisition or is internally generated.
8. Not all the items described in paragraph 7 will meet the definition of an intangible asset,
that is, identifiability, control over a resource and expectation of future economic benefits
flowing to the enterprise. If an item covered by this Statement does not meet the definition of
an intangible asset, expenditure to acquire it or generate it internally is recognised as an
expense when it is incurred. However, if the item is acquired in an amalgamation in the nature
of purchase, it forms part of the goodwill recognised at the date of the amalgamation (see
paragraph 55).
9. Some intangible assets may be contained in or on a physical substance such as a
compact disk (in the case of computer software), legal documentation (in the case of a licence
or patent) or film (in the case of motion pictures). The cost of the physical substance
containing the intangible assets is usually not significant. Accordingly, the physical substance
containing an intangible asset, though tangible in nature, is commonly treated as a part of the
intangible asset contained in or on it.
10. In some cases, an asset may incorporate both intangible and tangible elements
that are, in practice, inseparable. In determining whether such an asset should be
treated under AS 10, Accounting for Fixed Assets, or as an intangible asset under this
Statement, judgement is required to assess as to which element is predominant. For
example, computer software for a computer controlled machine tool that cannot operate
without that specific software is an integral part of the related hardware and it is treated
as a fixed asset. The same applies to the operating system of a computer. Where the
software is not an integral part of the related hardware, computer software is treated as
an intangible asset.
4
impairment of assets.
Identifiability
11. The definition of an intangible asset requires that an intangible asset be identifiable. To
be identifiable, it is necessary that the intangible asset is clearly distinguished from goodwill.
Goodwill arising on an amalgamation in the nature of purchase represents a payment made by
the acquirer in anticipation of future economic benefits. The future economic benefits may
result from synergy between the identifiable assets acquired or from assets which, individually,
do not qualify for recognition in the financial statements but for which the acquirer is prepared
to make a payment in the amalgamation.
12. An intangible asset can be clearly distinguished from goodwill if the asset is separable.
An asset is separable if the enterprise could rent, sell, exchange or distribute the specific
future economic benefits attributable to the asset without also disposing of future economic
benefits that flow from other assets used in the same revenue earning activity.
13. Separability is not a necessary condition for identifiability since an enterprise may be
able to identify an asset in some other way. For example, if an intangible asset is acquired
with a group of assets, the transaction may involve the transfer of legal rights that enable an
enterprise to identify the intangible asset. Similarly, if an internal project aims to create legal
rights for the enterprise, the nature of these rights may assist the enterprise in identifying an
underlying internally generated intangible asset. Also, even if an asset generates future
economic benefits only in combination with other assets, the asset is identifiable if the
enterprise can identify the future economic benefits that will flow from the asset.
Control
14. An enterprise controls an asset if the enterprise has the power to obtain the future
economic benefits flowing from the underlying resource and also can restrict the access of
others to those benefits. The capacity of an enterprise to control the future economic benefits
from an intangible asset would normally stem from legal rights that are enforceable in a court
of law. In the absence of legal rights, it is more difficult to demonstrate control. However,
legal enforceability of a right is not a necessary condition for control since an enterprise may
be able to control the future economic benefits in some other way.
15. Market and technical knowledge may give rise to future economic benefits. An enterprise
controls those benefits if, for example, the knowledge is protected by legal rights such as
copyrights, a restraint of trade agreement (where permitted) or by a legal duty on employees
to maintain confidentiality.
16. An enterprise may have a team of skilled staff and may be able to identify incremental
staff skills leading to future economic benefits from training. The enterprise may also expect
that the staff will continue to make their skills available to the enterprise. However, usually an
enterprise has insufficient control over the expected future economic benefits arising from a
team of skilled staff and from training to consider that these items meet the definition of an
intangible asset. For a similar reason, specific management or technical talent is unlikely to
meet the definition of an intangible asset, unless it is protected by legal rights to use it and to
obtain the future economic benefits expected from it, and it also meets the other parts of the
definition.
17. An enterprise may have a portfolio of customers or a market share and expect that, due
to its efforts in building customer relationships and loyalty, the customers will continue to trade
with the enterprise. However, in the absence of legal rights to protect, or other ways to
control, the relationships with customers or the loyalty of the customers to the enterprise, the
enterprise usually has insufficient control over the economic benefits from customer
relationships and loyalty to consider that such items (portfolio of customers, market shares,
customer relationships, customer loyalty) meet the definition of intangible assets.
Future Economic Benefits
18. The future economic benefits flowing from an intangible asset may include revenue from
the sale of products or services, cost savings, or other benefits resulting from the use of the
asset by the enterprise. For example, the use of intellectual property in a production process
may reduce future production costs rather than increase future revenues.
Recognition and Initial Measurement of an Intangible Asset
19. The recognition of an item as an intangible asset requires an enterprise to demonstrate
that the item meets the:
(a) definition of an intangible asset (see paragraphs 6-18); and
(b) recognition criteria set out in this Statement (see paragraphs 20-54).
20. An intangible asset should be recognised if, and only if:
(a) it is probable that the future economic benefits that are attributable to the asset
will flow to the enterprise; and
(b) the cost of the asset can be measured reliably.
21. An enterprise should assess the probability of future economic benefits using
reasonable and supportable assumptions that represent best estimate of the set of
economic conditions that will exist over the useful life of the asset.
22. An enterprise uses judgement to assess the degree of certainty attached to the flow of
future economic benefits that are attributable to the use of the asset on the basis of the
evidence available at the time of initial recognition, giving greater weight to external evidence.
23. An intangible asset should be measured initially at cost.
Separate Acquisition
24. If an intangible asset is acquired separately, the cost of the intangible asset can usually
be measured reliably. This is particularly so when the purchase consideration is in the form of
cash or other monetary assets.
25. The cost of an intangible asset comprises its purchase price, including any import duties
and other taxes (other than those subsequently recoverable by the enterprise from the taxing
authorities), and any directly attributable expenditure on making the asset ready for its
intended use. Directly attributable expenditure includes, for example, professional fees for
legal services. Any trade discounts and rebates are deducted in arriving at the cost.
26. If an intangible asset is acquired in exchange for shares or other securities of the
reporting enterprise, the asset is recorded at its fair value, or the fair value of the securities
issued, whichever is more clearly evident.
Acquisition as Part of an Amalgamation

27. An intangible asset acquired in an amalgamation in the nature of purchase is accounted
for in accordance with Accounting Standard (AS) 14, Accounting for Amalgamations. Where in
preparing the financial statements of the transferee company, the consideration is allocated to
individual identifiable assets and liabilities on the basis of their fair values at the date of
amalgamation, paragraphs 28 to 32 of this Statement need to be considered.
28. Judgement is required to determine whether the cost (i.e. fair value) of an intangible
asset acquired in an amalgamation can be measured with sufficient reliability for the purpose
of separate recognition. Quoted market prices in an active market provide the most reliable
measurement of fair value. The appropriate market price is usually the current bid price. If
current bid prices are unavailable, the price of the most recent similar transaction may provide
a basis from which to estimate fair value, provided that there has not been a significant
change in economic circumstances between the transaction date and the date at which the
asset's fair value is estimated.
29. If no active market exists for an asset, its cost reflects the amount that the enterprise
would have paid, at the date of the acquisition, for the asset in an arm's length transaction
between knowledgeable and willing parties, based on the best information available. In
determining this amount, an enterprise considers the outcome of recent transactions for
similar assets.
30. Certain enterprises that are regularly involved in the purchase and sale of unique
intangible assets have developed techniques for estimating their fair values indirectly. These
techniques may be used for initial measurement of an intangible asset acquired in an
amalgamation in the nature of purchase if their objective is to estimate fair value as defined in
this Statement and if they reflect current transactions and practices in the industry to which the
asset belongs. These techniques include, where appropriate, applying multiples reflecting
current market transactions to certain indicators driving the profitability of the asset (such as
revenue, market shares, operating profit, etc.) or discounting estimated future net cash flows
from the asset.
31. In accordance with this Statement:
(a) a transferee recognises an intangible asset that meets the recognition criteria in
paragraphs 20 and 21, even if that intangible asset had not been recognised in the
financial statements of the transferor; and
(b) if the cost (i.e. fair value) of an intangible asset acquired as part of an amalgamation
in the nature of purchase cannot be measured reliably, that asset is not recognised
as a separate intangible asset but is included in goodwill (see paragraph 55).
32. Unless there is an active market for an intangible asset acquired in an amalgamation in
the nature of purchase, the cost initially recognised for the intangible asset is restricted to an
amount that does not create or increase any capital reserve arising at the date of the
amalgamation.
Acquisition by way of a Government Grant

33. In some cases, an intangible asset may be acquired free of charge, or for nominal
consideration, by way of a government grant. This may occur when a government transfers or
allocates to an enterprise intangible assets such as airport landing rights, licences to operate
radio or television stations, import licences or quotas or rights to access other restricted
resources. AS 12, Accounting for Government Grants, requires that government grants in the
form of non-monetary assets, given at a concessional rate should be accounted for on the
basis of their acquisition cost. AS 12 also requires that in case a non-monetary asset is given
free of cost, it should be recorded at a nominal value. Accordingly, intangible asset acquired
free of charge, or for nominal consideration, by way of government grant is recognised at a
nominal value or at the acquisition cost, as appropriate; any expenditure that is directly
attributable to making the asset ready for its intended use is also included in the cost of the
asset.
Exchanges of Assets
34. An intangible asset may be acquired in exchange or part exchange for another asset. In
such a case, the cost of the asset acquired is determined in accordance with the principles
laid down in this regard in AS 10, Accounting for Fixed Assets.
Internally Generated Goodwill

35. Internally generated goodwill should not be recognised as an asset.
36. In some cases, expenditure is incurred to generate future economic benefits, but it does
not result in the creation of an intangible asset that meets the recognition criteria in this
Statement. Such expenditure is often described as contributing to internally generated
goodwill. Internally generated goodwill is not recognised as an asset because it is not an
identifiable resource controlled by the enterprise that can be measured reliably at cost.
37. Differences between the market value of an enterprise and the carrying amount of its
identifiable net assets at any point in time may be due to a range of factors that affect the
value of the enterprise. However, such differences cannot be considered to represent the cost
of intangible assets controlled by the enterprise.
Internally Generated Intangible Assets

38. It is sometimes difficult to assess whether an internally generated intangible asset
qualifies for recognition. It is often difficult to:
(a) identify whether, and the point of time when, there is an identifiable asset that will
generate probable future economic benefits; and
(b) determine the cost of the asset reliably. In some cases, the cost of generating an
intangible asset internally cannot be distinguished from the cost of maintaining or
enhancing the enterprise's internally generated goodwill or of running day-to-day

operations.
Therefore, in addition to complying with the general requirements for the recognition and initial
measurement of an intangible asset, an enterprise applies the requirements and guidance in
paragraphs 39-54 below to all internally generated intangible assets.
39. To assess whether an internally generated intangible asset meets the criteria for
recognition, an enterprise classifies the generation of the asset into:
(a) a research phase; and
(b) a development phase.
Although the terms 'research' and 'development' are defined, the terms 'research phase' and
'development phase' have a broader meaning for the purpose of this Statement.
40. If an enterprise cannot distinguish the research phase from the development phase of an
internal project to create an intangible asset, the enterprise treats the expenditure on that
project as if it were incurred in the research phase only.
Research Phase
41. No intangible asset arising from research (or from the research phase of an
internal project) should be recognised. Expenditure on research (or on the research
phase of an internal project) should be recognised as an expense when it is incurred.
42. This Statement takes the view that, in the research phase of a project, an enterprise
cannot demonstrate that an intangible asset exists from which future economic benefits are
probable. Therefore, this expenditure is recognised as an expense when it is incurred.
43. Examples of research activities are:
(a) activities aimed at obtaining new knowledge;
(b) the search for, evaluation and final selection of, applications of research findings or
other knowledge;
(c) the search for alternatives for materials, devices, products, processes, systems or
services; and
(d) the formulation, design, evaluation and final selection of possible alternatives for
new or improved materials, devices, products, processes, systems or services.
Development Phase
44. An intangible asset arising from development (or from the development phase of
an internal project) should be recognised if, and only if, an enterprise can demonstrate
all of the following:
(a) the technical feasibility of completing the intangible asset so that it will be
available for use or sale;
(b) its intention to complete the intangible asset and use or sell it;
(c) its ability to use or sell the intangible asset;
(d) how the intangible asset will generate probable future economic benefits. Among
other things, the enterprise should demonstrate the existence of a market for the
output of the intangible asset or the intangible asset itself or, if it is to be used
internally, the usefulness of the intangible asset;
(e) the availability of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset; and
(f) its ability to measure the expenditure attributable to the intangible asset during its
development reliably.
45. In the development phase of a project, an enterprise can, in some instances, identify an
intangible asset and demonstrate that future economic benefits from the asset are probable.
This is because the development phase of a project is further advanced than the research
phase.
46. Examples of development activities are:
(a) the design, construction and testing of pre-production or pre-use prototypes and
models;
(b) the design of tools, jigs, moulds and dies involving new technology;
(c) the design, construction and operation of a pilot plant that is not of a scale
economically feasible for commercial production; and
(d) the design, construction and testing of a chosen alternative for new or improved
materials, devices, products, processes, systems or services.
47. To demonstrate how an intangible asset will generate probable future economic benefits,
an enterprise assesses the future economic benefits to be received from the asset using the
principles in Accounting Standard on Impairment of Assets5. If the asset will generate
economic benefits only in combination with other assets, the enterprise applies the concept of
cash-generating units as set out in Accounting Standard on Impairment of Assets.
48. Availability of resources to complete, use and obtain the benefits from an intangible asset
can be demonstrated by, for example, a business plan showing the technical, financial and
other resources needed and the enterprise's ability to secure those resources. In certain
cases, an enterprise demonstrates the availability of external finance by obtaining a lender's
indication of its willingness to fund the plan.
49. An enterprise's costing systems can often measure reliably the cost of generating an
intangible asset internally, such as salary and other expenditure incurred in securing
copyrights or licences or developing computer software.
50. Internally generated brands, mastheads, publishing titles, customer lists and items
similar in substance should not be recognised as intangible assets.
5
51. This Statement takes the view that expenditure on internally generated brands,
mastheads, publishing titles, customer lists and items similar in substance cannot be
distinguished from the cost of developing the business as a whole. Therefore, such items are
not recognised as intangible assets.
Cost of an Internally Generated Intangible Asset

52. The cost of an internally generated intangible asset for the purpose of paragraph 23 is
the sum of expenditure incurred from the time when the intangible asset first meets the
recognition criteria in paragraphs 20-21 and 44. Paragraph 58 prohibits reinstatement of
expenditure recognised as an expense in previous annual financial statements or interim
financial reports.
53. The cost of an internally generated intangible asset comprises all expenditure that can be
directly attributed, or allocated on a reasonable and consistent basis, to creating, producing
and making the asset ready for its intended use. The cost includes, if applicable:
(a) expenditure on materials and services used or consumed in generating the intangible
asset;
(b) the salaries, wages and other employment related costs of personnel directly engaged in
generating the asset;
(c) any expenditure that is directly attributable to generating the asset, such as fees to
register a legal right and the amortisation of patents and licences that are used to
generate the asset; and
(d) overheads that are necessary to generate the asset and that can be allocated on a
reasonable and consistent basis to the asset (for example, an allocation of the
depreciation of fixed assets, insurance premium and rent). Allocations of overheads are
made on bases similar to those used in allocating overheads to inventories (see AS 2,
Valuation of Inventories). AS 16, Borrowing Costs, establishes criteria for the recognition
of interest as a component of the cost of a qualifying asset. These criteria are also
applied for the recognition of interest as a component of the cost of an internally
generated intangible asset.
54. The following are not components of the cost of an internally generated intangible asset:
(a) selling, administrative and other general overhead expenditure unless this expenditure
can be directly attributed to making the asset ready for use;
(b) clearly identified inefficiencies and initial operating losses incurred before an asset
achieves planned performance; and
(c) expenditure on training the staff to operate the asset.
An enterprise is developing a new production process. During the year 20X1, expenditure
incurred was Rs. 10 lakhs, of which Rs. 9 lakhs was incurred before 1 December 20X1 and 1
lakh was incurred between 1 December 20X1 and 31 December 20X1. The enterprise is able
to demonstrate that, at 1 December 20X1, the production process met the criteria for
recognition as an intangible asset. The recoverable amount of the know-how embodied in the
process (including future cash outflows to complete the process before it is available for use)
is estimated to be Rs. 5 lakhs.
At the end of 20X1, the production process is recognised as an intangible asset at a cost of
Rs. 1 lakh (expenditure incurred since the date when the recognition criteria were met, that is,
1 December 20X1). The Rs. 9 lakhs expenditure incurred before 1 December 20X1 is
recognised as an expense because the recognition criteria were not met until 1 December
20X1. This expenditure will never form part of the cost of the production process recognised
in the balance sheet.
During the year 20X2, expenditure incurred is Rs. 20 lakhs. At the end of 20X2, the
recoverable amount of the know-how embodied in the process (including future cash outflows
to complete the process before it is available for use) is estimated to be Rs. 19 lakhs.
At the end of the year 20X2, the cost of the production process is Rs. 21 lakhs (Rs. 1 lakh
expenditure recognised at the end of 20X1 plus Rs. 20 lakhs expenditure recognised in 20X2).
The enterprise recognises an impairment loss of Rs. 2 lakhs to adjust the carrying amount of
the process before impairment loss (Rs. 21 lakhs) to its recoverable amount (Rs. 19 lakhs).
This impairment loss will be reversed in a subsequent period if the requirements for the
reversal of an impairment loss in Accounting Standard on Impairment of Assets6, are met.
Recognition of an Expense
55. Expenditure on an intangible item should be recognised as an expense when it is
incurred unless:
(a) it forms part of the cost of an intangible asset that meets the recognition criteria
(see paragraphs 19-54); or
(b) the item is acquired in an amalgamation in the nature of purchase and cannot be
recognised as an intangible asset. If this is the case, this expenditure (included in
the cost of acquisition) should form part of the amount attributed to goodwill
(capital reserve) at the date of acquisition (see AS 14, Accounting for
Amalgamations).
56. In some cases, expenditure is incurred to provide future economic benefits to an
enterprise, but no intangible asset or other asset is acquired or created that can be
recognised. In these cases, the expenditure is recognised as an expense when it is incurred.
For example, expenditure on research is always recognised as an expense when it is incurred
(see paragraph 41). Examples of other expenditure that is recognised as an expense when it
is incurred include:
(a) expenditure on start-up activities (start-up costs), unless this expenditure is included in
6
the cost of an item of fixed asset under AS 10. Start-up costs may consist of preliminary
expenses incurred in establishing a legal entity such as legal and secretarial costs,
expenditure to open a new facility or business (pre-opening costs) or expenditures for
commencing new operations or launching new products or processes (pre-operating
costs);
(b) expenditure on training activities;
(c) expenditure on advertising and promotional activities; and
(d) expenditure on relocating or re-organising part or all of an enterprise.
57. Paragraph 55 does not apply to payments for the delivery of goods or services made in
advance of the delivery of goods or the rendering of services. Such prepayments are
recognised as assets.
Past Expenses not to be Recognised as an Asset
58. Expenditure on an intangible item that was initially recognised as an expense by a
reporting enterprise in previous annual financial statements or interim financial reports should
not be recognised as part of the cost of an intangible asset at a later date.
Subsequent Expenditure
59. Subsequent expenditure on an intangible asset after its purchase or its completion
should be recognised as an expense when it is incurred unless:
(a) it is probable that the expenditure will enable the asset to generate future
economic benefits in excess of its originally assessed standard of performance;
and
(b) the expenditure can be measured and attributed to the asset reliably.
If these conditions are met, the subsequent expenditure should be added to the cost of
the intangible asset.
60. Subsequent expenditure on a recognised intangible asset is recognised as an expense if
this expenditure is required to maintain the asset at its originally assessed standard of
performance. The nature of intangible assets is such that, in many cases, it is not possible to
determine whether subsequent expenditure is likely to enhance or maintain the economic
benefits that will flow to the enterprise from those assets. In addition, it is often difficult to
attribute such expenditure directly to a particular intangible asset rather than the business as a
whole. Therefore, only rarely will expenditure incurred after the initial recognition of a
purchased intangible asset or after completion of an internally generated intangible asset
result in additions to the cost of the intangible asset.
61. Consistent with paragraph 50, subsequent expenditure on brands, mastheads, publishing
titles, customer lists and items similar in substance (whether externally purchased or internally
generated) is always recognised as an expense to avoid the recognition of internally
generated goodwill.
Measurement Subsequent to Initial Recognition

62. After initial recognition, an intangible asset should be carried at its cost less any
accumulated amortisation and any accumulated impairment losses.
Amortisation
Amortisation Period
63. The depreciable amount of an intangible asset should be allocated on a systematic
basis over the best estimate of its useful life. There is a rebuttable presumption that the
useful life of an intangible asset will not exceed ten years from the date when the asset
is available for use. Amortisation should commence when the asset is available for
use.
64. As the future economic benefits embodied in an intangible asset are consumed over
time, the carrying amount of the asset is reduced to reflect that consumption. This is achieved
by systematic allocation of the cost of the asset, less any residual value, as an expense over
the asset's useful life. Amortisation is recognised whether or not there has been an increase
in, for example, the asset's fair value or recoverable amount. Many factors need to be
considered in determining the useful life of an intangible asset including:
(a) the expected usage of the asset by the enterprise and whether the asset could be
efficiently managed by another management team;
(b) typical product life cycles for the asset and public information on estimates of useful lives
of similar types of assets that are used in a similar way;
(c) technical, technological or other types of obsolescence;
(d) the stability of the industry in which the asset operates and changes in the market
demand for the products or services output from the asset;
(e) expected actions by competitors or potential competitors;
(f) the level of maintenance expenditure required to obtain the expected future economic
benefits from the asset and the company's ability and intent to reach such a level;
(g) the period of control over the asset and legal or similar limits on the use of the asset,
such as the expiry dates of related leases; and
(h) whether the useful life of the asset is dependent on the useful life of other assets of the
enterprise.
65. Given the history of rapid changes in technology, computer software and many other
intangible assets are susceptible to technological obsolescence. Therefore, it is likely that
their useful life will be short.
66. Estimates of the useful life of an intangible asset generally become less reliable as the
length of the useful life increases. This Statement adopts a presumption that the useful life of
intangible assets is unlikely to exceed ten years.
67. In some cases, there may be persuasive evidence that the useful life of an intangible
asset will be a specific period longer than ten years. In these cases, the presumption that the
useful life generally does not exceed ten years is rebutted and the enterprise:
(a) amortises the intangible asset over the best estimate of its useful life;
(b) estimates the recoverable amount of the intangible asset at least annually in order to
identify any impairment loss (see paragraph 83); and
(c) discloses the reasons why the presumption is rebutted and the factor(s) that played a
significant role in determining the useful life of the asset (see paragraph 94(a)).
Examples
A. An enterprise has purchased an exclusive right to generate hydro-electric power for sixty
years. The costs of generating hydro-electric power are much lower than the costs of
obtaining power from alternative sources. It is expected that the geographical area
surrounding the power station will demand a significant amount of power from the power
station for at least sixty years.
The enterprise amortises the right to generate power over sixty years, unless there is
evidence that its useful life is shorter.
B. An enterprise has purchased an exclusive right to operate a toll motorway for thirty years.
There is no plan to construct alternative routes in the area served by the motorway. It is
expected that this motorway will be in use for at least thirty years.
The enterprise amortises the right to operate the motorway over thirty years, unless there is
evidence that its useful life is shorter.
68. The useful life of an intangible asset may be very long but it is always finite. Uncertainty
justifies estimating the useful life of an intangible asset on a prudent basis, but it does not
justify choosing a life that is unrealistically short.
69. If control over the future economic benefits from an intangible asset is achieved
through legal rights that have been granted for a finite period, the useful life of the
intangible asset should not exceed the period of the legal rights unless:
(a) the legal rights are renewable; and
(b) renewal is virtually certain.
70. There may be both economic and legal factors influencing the useful life of an intangible
asset: economic factors determine the period over which future economic benefits will be
generated; legal factors may restrict the period over which the enterprise controls access to
these benefits. The useful life is the shorter of the periods determined by these factors.
71. The following factors, among others, indicate that renewal of a legal right is virtually
certain:
(a) the fair value of the intangible asset is not expected to reduce as the initial expiry date
approaches, or is not expected to reduce by more than the cost of renewing the
underlying right;
(b) there is evidence (possibly based on past experience) that the legal rights will be
renewed; and
(c) there is evidence that the conditions necessary to obtain the renewal of the legal right (if
any) will be satisfied.
Amortisation Method
72. The amortisation method used should reflect the pattern in which the asset's economic
benefits are consumed by the enterprise. If that pattern cannot be determined reliably, the
straight-line method should be used. The amortisation charge for each period should be
recognised as an expense unless another Accounting Standard permits or requires it to be
included in the carrying amount of another asset.
73. A variety of amortisation methods can be used to allocate the depreciable amount of an
asset on a systematic basis over its useful life. These methods include the straight-line
method, the diminishing balance method and the unit of production method. The method used
for an asset is selected based on the expected pattern of consumption of economic benefits
and is consistently applied from period to period, unless there is a change in the expected
pattern of consumption of economic benefits to be derived from that asset. There will rarely, if
ever, be persuasive evidence to support an amortisation method for intangible assets that
results in a lower amount of accumulated amortisation than under the straight-line method.
74. Amortisation is usually recognised as an expense. However, sometimes, the economic
benefits embodied in an asset are absorbed by the enterprise in producing other assets rather
than giving rise to an expense. In these cases, the amortisation charge forms part of the cost
of the other asset and is included in its carrying amount. For example, the amortisation of
intangible assets used in a production process is included in the carrying amount of
inventories (see AS 2, Valuation of Inventories).
Residual Value
75. The residual value of an intangible asset should be assumed to be zero unless:
(a) there is a commitment by a third party to purchase the asset at the end of its useful
life; or
(b) there is an active market for the asset and:
(i) residual value can be determined by reference to that market; and
(ii) it is probable that such a market will exist at the end of the asset's useful life.
76. A residual value other than zero implies that an enterprise expects to dispose of the
intangible asset before the end of its economic life.
77. The residual value is estimated using prices prevailing at the date of acquisition of the
asset, for the sale of a similar asset that has reached the end of its estimated useful life and
that has operated under conditions similar to those in which the asset will be used. The
residual value is not subsequently increased for changes in prices or value.
Review of Amortisation Period and Amortisation Method

78. The amortisation period and the amortisation method should be reviewed at least at each
financial year end. If the expected useful life of the asset is significantly different from
previous estimates, the amortisation period should be changed accordingly. If there has been
a significant change in the expected pattern of economic benefits from the asset, the
amortisation method should be changed to reflect the changed pattern. Such changes should
be accounted for in accordance with AS 5, Net Profit or Loss for the Period, Prior Period Items
and Changes in Accounting Policies.
79. During the life of an intangible asset, it may become apparent that the estimate of its
useful life is inappropriate. For example, the useful life may be extended by subsequent
expenditure that improves the condition of the asset beyond its originally assessed standard of
performance. Also, the recognition of an impairment loss may indicate that the amortisation
period needs to be changed.
80. Over time, the pattern of future economic benefits expected to flow to an enterprise from
an intangible asset may change. For example, it may become apparent that a diminishing
balance method of amortisation is appropriate rather than a straight-line method. Another
example is if use of the rights represented by a licence is deferred pending action on other
components of the business plan. In this case, economic benefits that flow from the asset
may not be received until later periods.
Recoverability of the Carrying Amount - Impairment Losses

81. To determine whether an intangible asset is impaired, an enterprise applies Accounting
Standard on Impairment of Assets7. That Standard explains how an enterprise reviews the
carrying amount of its assets, how it determines the recoverable amount of an asset and when
it recognises or reverses an impairment loss.
82. If an impairment loss occurs before the end of the first annual accounting period
commencing after acquisition for an intangible asset acquired in an amalgamation in the
nature of purchase, the impairment loss is recognised as an adjustment to both the amount
assigned to the intangible asset and the goodwill (capital reserve) recognised at the date of
the amalgamation. However, if the impairment loss relates to specific events or changes in
circumstances occurring after the date of acquisition, the impairment loss is recognised under
Accounting Standard on Impairment of Assets and not as an adjustment to the amount
assigned to the goodwill (capital reserve) recognised at the date of acquisition.
83. In addition to the requirements of Accounting Standard on Impairment of Assets,
an enterprise should estimate the recoverable amount of the following intangible assets
at least at each financial year end even if there is no indication that the asset is
impaired:
7
(a) an intangible asset that is not yet available for use; and
(b) an intangible asset that is amortised over a period exceeding ten years from the
date when the asset is available for use.
The recoverable amount should be determined under Accounting Standard on Impairment of
Assets and impairment losses recognised accordingly.
84. The ability of an intangible asset to generate sufficient future economic benefits to
recover its cost is usually subject to great uncertainty until the asset is available for use.
Therefore, this Statement requires an enterprise to test for impairment, at least annually, the
carrying amount of an intangible asset that is not yet available for use.
85. It is sometimes difficult to identify whether an intangible asset may be impaired because,
among other things, there is not necessarily any obvious evidence of obsolescence. This
difficulty arises particularly if the asset has a long useful life. As a consequence, this
Statement requires, as a minimum, an annual calculation of the recoverable amount of an
intangible asset if its useful life exceeds ten years from the date when it becomes available for
use.
86. The requirement for an annual impairment test of an intangible asset applies whenever
the current total estimated useful life of the asset exceeds ten years from when it became
available for use. Therefore, if the useful life of an intangible asset was estimated to be less
than ten years at initial recognition, but the useful life is extended by subsequent expenditure
to exceed ten years from when the asset became available for use, an enterprise performs the
impairment test required under paragraph 83(b) and also makes the disclosure required under
paragraph 94(a).
Retirements and Disposals

87. An intangible asset should be derecognised (eliminated from the balance sheet) on
disposal or when no future economic benefits are expected from its use and subsequent
disposal.
88. Gains or losses arising from the retirement or disposal of an intangible asset should be
determined as the difference between the net disposal proceeds and the carrying amount of
the asset and should be recognised as income or expense in the statement of profit and loss.
89. An intangible asset that is retired from active use and held for disposal is carried at its
carrying amount at the date when the asset is retired from active use. At least at each
financial year end, an enterprise tests the asset for impairment under Accounting Standard on
Impairment of Assets8, and recognises any impairment loss accordingly.
8
Disclosure
General
90. The financial statements should disclose the following for each class of intangible
assets, distinguishing between internally generated intangible assets and other
intangible assets:
(a) the useful lives or the amortisation rates used;
(b) the amortisation methods used;
(c) the gross carrying amount and the accumulated amortisation (aggregated with
accumulated impairment losses) at the beginning and end of the period;
(d) a reconciliation of the carrying amount at the beginning and end of the period showing:
(i) additions, indicating separately those from internal development and through
amalgamation;
(ii) retirements and disposals;
(iii) impairment losses recognised in the statement of profit and loss during the
period (if any);
(iv) impairment losses reversed in the statement of profit and loss during the
period (if any);
(v) amortisation recognised during the period; and
(vi) other changes in the carrying amount during the period.
91. A class of intangible assets is a grouping of assets of a similar nature and use in an
enterprise's operations. Examples of separate classes may include:
(a) brand names;
(b) mastheads and publishing titles;
(c) computer software;
(d) licences and franchises;
(e) copyrights, and patents and other industrial property rights, service and operating rights;
(f) recipes, formulae, models, designs and prototypes; and
(g) intangible assets under development.
The classes mentioned above are disaggregated (aggregated) into smaller (larger) classes if
this results in more relevant information for the users of the financial statements.
92. An enterprise discloses information on impaired intangible assets under Accounting
Standard on Impairment of Assets9 in addition to the information required by paragraph
9
90(d)(iii) and (iv).

93. An enterprise discloses the change in an accounting estimate or accounting policy such
as that arising from changes in the amortisation method, the amortisation period or estimated
residual values, in accordance with AS 5, Net Profit or Loss for the Period, Prior Period Items
and Changes in Accounting Policies.
94. The financial statements should also disclose:
(a) if an intangible asset is amortised over more than ten years, the reasons why
it is presumed that the useful life of an intangible asset will exceed ten years
from the date when the asset is available for use. In giving these reasons, the
enterprise should describe the factor(s) that played a significant role in
determining the useful life of the asset;
(b) a description, the carrying amount and remaining amortisation period of any
individual intangible asset that is material to the financial statements of the
enterprise as a whole;
(c) the existence and carrying amounts of intangible assets whose title is restricted
and the carrying amounts of intangible assets pledged as security for liabilities;
and
(d) the amount of commitments for the acquisition of intangible assets.
95. When an enterprise describes the factor(s) that played a significant role in determining
the useful life of an intangible asset that is amortised over more than ten years, the enterprise
considers the list of factors in paragraph 64.
Research and Development Expenditure
96. The financial statements should disclose the aggregate amount of research and
development expenditure recognised as an expense during the period.
97. Research and development expenditure comprises all expenditure that is directly
attributable to research or development activities or that can be allocated on a reasonable and
consistent basis to such activities (see paragraphs 53-54 for guidance on the type of
expenditure to be included for the purpose of the disclosure requirement in paragraph 96).
Other Information
98. An enterprise is encouraged, but not required, to give a description of any fully amortised
intangible asset that is still in use.
99. Where, on the date of this Statement coming into effect, an enterprise is following
an accounting policy of not amortising an intangible item or amortising an intangible
item over a period longer than the period determined under paragraph 63 of this
Statement and the period determined under paragraph 63 has expired on the date of
this Statement coming into effect, the carrying amount appearing in the balance sheet
in respect of that item should be eliminated with a corresponding adjustment to the

opening balance of revenue reserves.
In the event the period determined under paragraph 63 has not expired on the date of
this Statement coming into effect and:
(a) if the enterprise is following an accounting policy of not amortising an intangible
item, the carrying amount of the intangible item should be restated, as if the
accumulated amortisation had always been determined under this Statement, with
the corresponding adjustment to the opening balance of revenue reserves. The
restated carrying amount should be amortised over the balance of the period as
determined in paragraph 63.
(b) if the remaining period as per the accounting policy followed by the enterprise:
(i) is shorter as compared to the balance of the period determined under
paragraph 63, the carrying amount of the intangible item should be amortised
over the remaining period as per the accounting policy followed by the
enterprise,
(ii) is longer as compared to the balance of the period determined under
paragraph 63, the carrying amount of the intangible item should be restated,
as if the accumulated amortisation had always been determined under this
Statement, with the corresponding adjustment to the opening balance of
revenue reserves. The restated carrying amount should be amortised over the
balance of the period as determined in paragraph 63.
100. Appendix B illustrates the application of paragraph 99.
Appendix A
provides illustrative application of the principles laid down in the Standard to internal use
software and web-site costs. The purpose of the appendix is to illustrate the application of the
Accounting Standard to assist in clarifying its meaning.
I. Illustrative Application of the Accounting Standard to Internal Use Computer
Software
Computer software for internal use can be internally generated or acquired.
Internally Generated Computer Software
1. Internally generated computer software for internal use is developed or modified
internally by the enterprise solely to meet the needs of the enterprise and at no stage it is
planned to sell it.
2. The stages of development of internally generated software may be categorised into the
following two phases:
♦ Preliminary project stage, i.e., the research phase
♦ Development phase
Preliminary project stage

3. At the preliminary project stage the internally generated software should not be
recognised as an asset. Expenditure incurred in the preliminary project stage should be
recognised as an expense when it is incurred. The reason for such a treatment is that at this
stage of the software project an enterprise can not demonstrate that an asset exists from
which future economic benefits are probable.
4. When a computer software project is in the preliminary project stage, enterprises are
likely to:
(a) Make strategic decisions to allocate resources between alternative projects at a given
point in time. For example, should programmers develop a new payroll system or direct
their efforts toward correcting existing problems in an operating payroll system.
(b) Determine the performance requirements (that is, what it is that they need the software to
do) and systems requirements for the computer software project it has proposed to
undertake.
(c) Explore alternative means of achieving specified performance requirements. For
example, should an entity make or buy the software. Should the software run on a
mainframe or a client server system.
(d) Determine that the technology needed to achieve performance requirements exists.
(e) Select a consultant to assist in the development and/or installation of the software.
Development Stage
5. An internally generated software arising at the development stage should be recognised
as an asset if, and only if, an enterprise can demonstrate all of the following:
(a) the technical feasibility of completing the internally generated software so that it will be
available for internal use;
(b) the intention of the enterprise to complete the internally generated software and use it to
perform the functions intended. For example, the intention to complete the internally
generated software can be demonstrated if the enterprise commits to the funding of the
software project;
(c) the ability of the enterprise to use the software;
(d) how the software will generate probable future economic benefits. Among other things,
the enterprise should demonstrate the usefulness of the software;
(e) the availability of adequate technical, financial and other resources to complete the
development and to use the software; and
(f) the ability of the enterprise to measure the expenditure attributable to the software during
its development reliably.
6. Examples of development activities in respect of internally generated software include:

(a) Design including detailed program design – which is the process of detail design of
computer software that takes product function, feature, and technical requirements
to their most detailed, logical form and is ready for coding.
(b) Coding which includes generating detailed instructions in a computer language to
carry out the requirements described in the detail program design. The coding of
computer software may begin prior to, concurrent with, or subsequent to the
completion of the detail program design.
At the end of these stages of the development activity, the enterprise has a working
model, which is an operative version of the computer software capable of
performing all the major planned functions, and is ready for initial testing (“beta”
versions).
(c) Testing which is the process of performing the steps necessary to determine
whether the coded computer software product meets function, feature, and technical
performance requirements set forth in the product design.
At the end of the testing process, the enterprise has a master version of the internal
use software, which is a completed version together with the related user
documentation and the training materials.
Cost of internally generated software
7. The cost of an internally generated software is the sum of the expenditure incurred from
the time when the software first met the recognition criteria for an intangible asset as stated in
paragraphs 20 and 21 of this Statement and paragraph 5 above. An expenditure which did not
meet the recognition criteria as aforesaid and expensed in an earlier financial statements
should not be reinstated if the recognition criteria are met later.
8. The cost of an internally generated software comprises all expenditure that can be
directly attributed or allocated on a reasonable and consistent basis to create the software for
its intended use. The cost include:
(a) expenditure on materials and services used or consumed in developing the software;
(b) the salaries, wages and other employment related costs of personnel directly engaged in
developing the software;
(c) any expenditure that is directly attributable to generating software; and
(d) overheads that are necessary to generate the software and that can be allocated on a
reasonable and consistent basis to the software (For example, an allocation of the
depreciation of fixed assets, insurance premium and rent). Allocation of overheads are
made on basis similar to those used in allocating the overhead to inventories.
9. The following are not components of the cost of an internally generated software:
(a) selling, administration and other general overhead expenditure unless this
expenditure can be directly attributable to the development of the software;
(b) clearly identified inefficiencies and initial operating losses incurred before software
achieves the planned performance; and
(c) expenditure on training the staff to use the internally generated software.
Software Acquired for Internal Use
10. The cost of a software acquired for internal use should be recongised as an asset if it
meets the recognition criteria prescribed in paragraphs 20 and 21 of this Statement.
11. The cost of a software purchased for internal use comprises its purchase price, including
any import duties and other taxes (other than those subsequently recoverable by the
enterprise from the taxing authorities) and any directly attributable expenditure on making the
software ready for its use. Any trade discounts and rebates are deducted in arriving at the
cost. In the determination of cost, matters stated in paragraphs 24 to 34 of the Statement
need to be considered, as appropriate.
Subsequent expenditure
12. Enterprises may incur considerable cost in modifying existing software systems.
Subsequent expenditure on software after its purchase or its completion should be recognised
as an expense when it is incurred unless:
(a) it is probable that the expenditure will enable the software to generate future economic
benefits in excess of its originally assessed standards of performance; and
(b) the expenditure can be measured and attributed to the software reliably.
If these conditions are met, the subsequent expenditure should be added to the carrying
amount of the software. Costs incurred in order to restore or maintain the future economic
benefits that an enterprise can expect from the originally assessed standard of performance of
existing software systems is recognised as an expense when, and only when, the restoration
or maintenance work is carried out.
Amortisation period
13. The depreciable amount of a software should be allocated on a systematic basis over the
best estimate of its useful life. The amortisation should commence when the software is
available for use.
14. As per this Statement, there is a rebuttable presumption that the useful life of an
intangible asset will not exceed ten years from the date when the asset is available for use.
However, given the history of rapid changes in technology, computer software is susceptible to
technological obsolescence. Therefore, it is likely that useful life of the software will be much
shorter, say 3 to 5 years.
Amortisation method
15. The amortisation method used should reflect the pattern in which the software’s
economic benefits are consumed by the enterprise. If that pattern can not be determined
reliably, the straight-line method should be used. The amortisation charge for each period
should be recognised as an expenditure unless another Accounting Standard permits or

requires it to be included in the carrying amount of another asset. For example, the
amortisation of a software used in a production process is included in the carrying amount of
inventories.
II. Illustrative Application of the Accounting Standard to Web-Site Costs

1. An enterprise may incur internal expenditures when developing, enhancing and
maintaining its own web site. The web site may be used for various purposes such as
promoting and advertising products and services, providing electronic services, and selling
products and services.
2. The stages of a web site’s development can be described as follows:
(a) Planning – includes undertaking feasibility studies, defining objectives and
specifications, evaluating alternatives and selecting preferences;
(b) Application and Infrastructure Development – includes obtaining a domain name,
purchasing and developing hardware and operating software, installing developed
applications and stress testing; and
(c) Graphical Design and Content Development – includes designing the appearance of
web pages and creating, purchasing, preparing and uploading information, either
textual or graphical in nature, on the web site prior to the web site becoming
available for use. This information may either be stored in separate databases that
are integrated into (or accessed from) the web site or coded directly into the web
pages.
3. Once development of a web site has been completed and the web site is available for
use, the web site commences an operating stage. During this stage, an enterprise maintains
and enhances the applications, infrastructure, graphical design and content of the web site.
4. The expenditures for purchasing, developing, maintaining and enhancing hardware (e.g.,
web servers, staging servers, production servers and Internet connections) related to a web
site are not accounted for under this Statement but are accounted for under AS 10,
Accounting for Fixed Assets. Additionally, when an enterprise incurs an expenditure for
having an Internet service provider host the enterprise’s web site on it’s own servers
connected to the Internet, the expenditure is recognised as an expense.
5. An intangible asset is defined in paragraph 6 of this Statement as 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. Paragraph 7 of this Statement
provides computer software as a common example of an intangible asset. By analogy, a web
site is another example of an intangible asset. Accordingly, a web site developed by an
enterprise for its own use is an internally generated intangible asset that is subject to the
requirements of this Statement.
6. An enterprise should apply the requirements of this Statement to an internal expenditure
for developing, enhancing and maintaining its own web site. Paragraph 55 of this Statement
provides expenditure on an intangible item to be recognised as an expense when incurred
unless it forms part of the cost of an intangible asset that meets the recognition criteria in
paragraphs 19-54 of the Statement. Paragraph 56 of the Statement requires expenditure on
start-up activities to be recognised as an expense when incurred. Developing a web site by
an enterprise for its own use is not a start-up activity to the extent that an internally generated
intangible asset is created. An enterprise applies the requirements and guidance in
paragraphs 39-54 of this Statement to an expenditure incurred for developing its own web site
in addition to the general requirements for recognition and initial measurement of an intangible
asset. The cost of a web site, as described in paragraphs 52-54 of this Statement, comprises
all expenditure that can be directly attributed, or allocated on a reasonable and consistent
basis, to creating, producing and preparing the asset for its intended use.
The enterprise should evaluate the nature of each activity for which an expenditure is incurred
(e.g., training employees and maintaining the web site) and the web site’s stage of
development or post-development:
(a) Paragraph 41 of this Statement requires an expenditure on research (or on the research
phase of an internal project) to be recognised as an expense when incurred. The
examples provided in paragraph 43 of this Statement are similar to the activities
undertaken in the Planning stage of a web site’s development. Consequently,
expenditures incurred in the Planning stage of a web site’s development are recognised
as an expense when incurred.
(b) Paragraph 44 of this Statement requires an intangible asset arising from the development
phase of an internal project to be recognised if an enterprise can demonstrate fulfillment
of the six criteria specified. Application and Infrastructure Development and Graphical
Design and Content Development stages are similar in nature to the development phase.
Therefore, expenditures incurred in these stages should be recognised as an intangible
asset if, and only if, in addition to complying with the general requirements for recognition
and initial measurement of an intangible asset, an enterprise can demonstrate those
items described in paragraph 44 of this Statement. In addition,
(i) an enterprise may be able to demonstrate how its web site will generate probable
future economic benefits under paragraph 44(d) by using the principles in
Accounting Standard on Impairment of Assets10. This includes situations where the
web site is developed solely or primarily for promoting and advertising an
enterprise’s own products and services. Demonstrating how a web site will generate
probable future economic benefits under paragraph 44(d) by assessing the
economic benefits to be received from the web site and using the principles in
Accounting Standard on Impairment of Assets, may be particularly difficult for an
enterprise that develops a web site solely or primarily for advertising and promoting
its own products and services; information is unlikely to be available for reliably
estimating the amount obtainable from the sale of the web site in an arm’s length
10
transaction, or the future cash inflows and outflows to be derived from its continuing
use and ultimate disposal. In this circumstance, an enterprise determines the future
economic benefits of the cash-generating unit to which the web site belongs, if it
does not belong to one. If the web site is considered a corporate asset (one that
does not generate cash inflows independently from other assets and their carrying
amount cannot be fully attributed to a cash-generating unit), then an enterprise
applies the ‘bottom-up’ test and/or the ‘top-down’ test under Accounting Standard
on Impairment of Assets.
(ii) an enterprise may incur an expenditure to enable use of content, which had been
purchased or created for another purpose, on its web site (e.g., acquiring a license
to reproduce information) or may purchase or create content specifically for use on
its web site prior to the web site becoming available for use. In such circumstances,
an enterprise should determine whether a separate asset, is identifiable with
respect to such content (e.g., copyrights and licenses), and if a separate asset is
not identifiable, then the expenditure should be included in the cost of developing
the web site when the expenditure meets the conditions in paragraph 44 of this
Statement. As per paragraph 20 of this Statement, an intangible asset is recognised
if, and only if, it meets specified criteria, including the definition of an intangible
asset. Paragraph 52 indicates that the cost of an internally generated intangible
asset is the sum of expenditure incurred from the time when the intangible asset
first meets the specified recognition criteria. When an enterprise acquires or
creates content, it may be possible to identify an intangible asset (e.g., a license or
a copyright) separate from a web site. Consequently, an enterprise determines
whether an expenditure to enable use of content, which had been created for
another purpose, on its web site becoming available for use results in a separate
identifiable asset or the expenditure is included in the cost of developing the web
site.
(c) the operating stage commences once the web site is available for use, and therefore an
expenditure to maintain or enhance the web site after development has been completed
should be recognised as an expense when it is incurred unless it meets the criteria in
paragraph 59 of the Statement. Paragraph 60 explains that if the expenditure is required
to maintain the asset at its originally assessed standard of performance, then the
expenditure is recognised as an expense when incurred.
7. An intangible asset is measured subsequent to initial recognition by applying the
requirements in paragraph 62 of this Statement. Additionally, since paragraph 68 of the
Statement states that an intangible asset always has a finite useful life, a web site that is
recognised as an asset is amortised over the best estimate of its useful life. As indicated in
paragraph 65 of the Statement, web sites are susceptible to technological obsolescence, and
given the history of rapid changes in technology, their useful life will be short.
8. The following table illustrates examples of expenditures that occur within each of the
stages described in paragraphs 2 and 3 above and application of paragraphs 5 and 6 above. It
is not intended to be a comprehensive checklist of expenditures that might be incurred.
Nature of Expenditure Accounting treatment

Planning
• undertaking feasibility studies Expense when incurred
• defining hardware and software specifications
• evaluating alternative products and suppliers
• selecting preferences
Application and Infrastructure Development
• purchasing or developing hardware Apply the requirements of AS 10
• obtaining a domain name Expense when incurred, unless it
• developing operating software (e.g., operating meets the recognition criteria under
system and server software) paragraphs 20 and 44
• developing code for the application
• installing developed applications on the web
server
• stress testing
Graphical Design and Content Development
• designing the appearance (e.g., layout and
colour) of web pages If a separate asset is not identifiable,
• creating, purchasing, preparing (e.g., creating then expense when incurred, unless
links and identifying tags), and uploading it meets the recognition criteria under
information, either textual or graphical in nature, paragraphs 20 and 44
on the web site prior to the web site becoming
available for use. Examples of content include
information about an enterprise, products or
services offered for sale, and topics that
subscribers access
OPERATING
• updating graphics and revising content
• adding new functions, features and content Expense when incurred, unless in
• registering the web site with search engines rare circumstances it meets the
criteria in paragraph 59, in which
• backing up data
case the expenditure is included in
• reviewing security access the cost of the web site
• analysing usage of the web site
Other
• selling, administrative and other general
overhead expenditure unless it can be directly Expense when incurred
attributed to preparing the web site for use
• clearly identified inefficiencies and initial
operating losses incurred before the web site

achieves planned performance (e.g., false start
testing)
• training employees to operate the web site
Appendix B
provides illustrative application of the requirements contained in paragraph 99 of this
Accounting Standard in respect of transitional provisions.
Example 1 – Intangible Item was not amortised and the amortisation period determined
under paragraph 63 has expired.
An intangible item is appearing in the balance sheet of A Ltd. at Rs. 10 lakhs as on 1-4-2003.
The item was acquired for Rs. 10 lakhs on April 1, 1990 and was available for use from that
date. The enterprise has been following an accounting policy of not amortising the item.
Applying paragraph 63, the enterprise determines that the item would have been amortised
over a period of 10 years from the date when the item was available for use i.e., April 1, 1990.
Since the amortisation period determined by applying paragraph 63 has already expired as on
1-4-2003, the carrying amount of the intangible item of Rs. 10 lakhs would be required to be
eliminated with a corresponding adjustment to the opening balance of revenue reserves as on
1-4-2003.
Example 2 – Intangible Item is being amortised and the amortisation period determined
under paragraph 63 has expired.
date. The enterprise has been following a policy of amortising the item over a period of 20
years on straight-line basis. Applying paragraph 63, the enterprise determines that the item
would have been amortised over a period of 10 years from the date when the item was
available for use i.e., April 1, 1991.
Since the amortisation period determined by applying paragraph 63 has already expired as on
1-4-2003, the carrying amount of Rs. 8 lakhs would be required to be eliminated with a
corresponding adjustment to the opening balance of revenue reserves as on 1-4-2003.
Example 3 – Amortisation period determined under paragraph 63 has not expired and
the remaining amortisation period as per the accounting policy followed by
the enterprise is shorter.
date. The enterprise has been following a policy of amortising the intangible item over a
period of 5 years on straight line basis. Applying paragraph 63, the enterprise determines the
amortisation period to be 8 years, being the best estimate of its useful life, from the date when
the item was available for use i.e., April 1, 2000.

On 1-4-2003, the remaining period of amortisation is 2 years as per the accounting policy
followed by the enterprise which is shorter as compared to the balance of amortisation period
determined by applying paragraph 63, i.e., 5 years. Accordingly, the enterprise would be
required to amortise the intangible item over the remaining 2 years as per the accounting
policy followed by the enterprise
Example 4 – Amortisation period determined under paragraph 63 has not expired and
the remaining amortisation period as per the accounting policy followed by
the enterprise is longer.
date. The enterprise has been following a policy of amortising the intangible item over a
period of 12 years on straight-line basis. Applying paragraph 63, the enterprise determines
that the item would have been amortised over a period of 10 years on straight line basis from
the date when the item was available for use i.e., April 1, 2000.
On 1-4-2003, the remaining period of amortisation is 9 years as per the accounting policy
followed by the enterprise which is longer as compared to the balance of period stipulated in
paragraph 63, i.e., 7 years. Accordingly, the enterprise would be required to restate the
carrying amount of intangible item on 1-4-2003 at Rs. 16.8 lakhs (Rs. 24 lakhs – 3xRs. 2.4
lakhs, i.e., amortisation that would have been charged as per the Standard) and the difference
of Rs. 1.2 lakhs (Rs. 18 lakhs-Rs. 16.8 lakhs) would be required to be adjusted against the
opening balance of the revenue reserves. The carrying amount of Rs. 16.8 lakhs would be
amortised over 7 years which is the balance of the amortisation period as per paragraph 63.
Example 5 – Intangible Item is not amortised and amortisation period determined under
paragraph 63 has not expired.
date. The enterprise has been following an accounting policy of not amortising the item.
Applying paragraph 63, the enterprise determines that the item would have been amortised
over a period of 10 years on straight line basis from the date when the item was available for
use i.e., April 1, 2000.
On 1-4-2003, the enterprise would be required to restate the carrying amount of intangible
item at Rs. 14 lakhs (Rs. 20 lakhs – 3xRs. 2 lakhs, i.e., amortisation that would have been
charged as per the Standard) and the difference of Rs. 6 lakhs (Rs. 20 lakhs-Rs. 14 lakhs)
would be required to be adjusted against the opening balance of the revenue reserves. The
carrying amount of Rs. 14 lakhs would be amortised over 7 years which is the balance of the
amortisation period as per paragraph 63.
AS 27 : FINANCIAL REPORTING OF INTERESTS IN JOINT VENTURES*
Accounting Standard (AS) 27, ‘Financial Reporting of Interests in Joint Ventures’, issued by
the Council of the Institute of Chartered Accountants of India, comes into effect in respect of
accounting periods commencing on or after 01.04.2002. In respect of separate financial
statements of an enterprise, this Standard is mandatory in nature from that date. In respect of
consolidated financial statements of an enterprise, this Standard is mandatory in nature where
the enterprise prepares and presents the consolidated financial statements in respect of
accounting periods commencing on or after 01.04.2002. Earlier application of the Accounting
Standard is encouraged. The following is the text of the Accounting Standard.
Objective
The objective of this Statement is to set out principles and procedures for accounting for
interests in joint ventures and reporting of joint venture assets, liabilities, income and
expenses in the financial statements of venturers and investors.
Scope
1. This Statement should be applied in accounting for interests in joint ventures and
the reporting of joint venture assets, liabilities, income and expenses in the financial
statements of venturers and investors, regardless of the structures or forms under
which the joint venture activities take place.
2. The requirements relating to accounting for joint ventures in consolidated financial

statements, contained in this Statement, are applicable only where consolidated financial
statements are prepared and presented by the venturer.
Definitions
specified:
A joint venture is a contractual arrangement whereby two or more parties undertake an

economic activity, which is subject to joint control.
Joint control is the contractually agreed sharing of control over an economic activity.
Control is the power to govern the financial and operating policies of an economic
activity so as to obtain benefits from it.
A venturer is a party to a joint venture and has joint control over that joint venture.
An investor in a joint venture is a party to a joint venture and does not have joint
control over that joint venture.
Proportionate consolidation is a method of accounting and reporting whereby a

venturer's share of each of the assets, liabilities, income and expenses of a jointly
controlled entity is reported as separate line items in the venturer's financial
statements.
Forms of Joint Venture

4. Joint ventures take many different forms and structures. This Statement identifies three
broad types – jointly controlled operations, jointly controlled assets and jointly controlled
entities – which are commonly described as, and meet the definition of, joint ventures. The
following characteristics are common to all joint ventures:
(a) two or more venturers are bound by a contractual arrangement; and
(b) the contractual arrangement establishes joint control.
Contractual Arrangement
5. The existence of a contractual arrangement distinguishes interests which involve joint
control from investments in associates in which the investor has significant influence (see
Accounting Standard (AS) 23, Accounting for Investments in Associates in Consolidated
Financial Statements). Activities which have no contractual arrangement to establish joint
control are not joint ventures for the purposes of this Statement.
6. In some exceptional cases, an enterprise by a contractual arrangement establishes joint
control over an entity which is a subsidiary of that enterprise within the meaning of Accounting
Standard (AS) 21, Consolidated Financial Statements. In such cases, the entity is not
consolidated under AS 21, but is treated as a joint venture as per this Statement. The
consolidation of such an entity does not necessarily preclude other venturer(s) treating such
entity as a joint venture.∗
∗
As a limited revision to AS 27, the council of the institute decided to revise this paragraph in
2004. The revision comes into effect in respect of accounting periods commencing on or after
1.4.2004. The erstwhile paragraph was under:
“In some exceptional cases, an enterprise by a contractual arrangement establishes joint control
over an entity which is a subsidiary of that enterprise within the meaning of Accounting Standard
7. The contractual arrangement may be evidenced in a number of ways, for example by a

contract between the venturers or minutes of discussions between the venturers. In some
cases, the arrangement is incorporated in the articles or other by-laws of the joint venture.
Whatever its form, the contractual arrangement is normally in writing and deals with such
matters as:
(a) the activity, duration and reporting obligations of the joint venture;
(b) the appointment of the board of directors or equivalent governing body of the joint
venture and the voting rights of the venturers;
(c) capital contributions by the venturers; and
(d) the sharing by the venturers of the output, income, expenses or results of the joint
venture.
8. The contractual arrangement establishes joint control over the joint venture. Such an
arrangement ensures that no single venturer is in a position to unilaterally control the activity.
The arrangement identifies those decisions in areas essential to the goals of the joint venture
which require the consent of all the venturers and those decisions which may require the
consent of a specified majority of the venturers.
9. [€]10. The contractual arrangement may identify one venturer as the operator or
manager of the joint venture. The operator does not control the joint venture but acts within
the financial and operating policies which have been agreed to by the venturers in accordance
with the contractual arrangement and delegated to the operator.
Jointly Controlled Operations

11. The operation of some joint ventures involves the use of the assets and other resources
of the venturers rather than the establishment of a corporation, partnership or other entity, or a
(AS) 21, Consolidated Financial Statements. In such cases, the entity is not consolidated under
AS 21, but is treated as a joint venture as per this Statement.”
€
As a limited revision to AS 27, the council of the institute decided to revise this paragraph in
2004. The revision comes into effect in respect of accounting periods commencing on or after
1.4.2004. The erstwhile paragraph was under:
“The contractual arrangement will indicate whether or not an enterprise has joint control over the
venture, along with the other venturers. In evaluating whether an enterprise has joint control over
a venture, it would need to be considered whether the contractual arrangement provides protective
rights or participating rights to the enterprise. Protective rights merely allow an enterprise to
protect its interests in the venture in situations where its interests are likely to be adversely
affected. The participating rights enable the enterprise to jointly control the financial and
operating policies related to the venture's ordinary course of business. The existence of
participating rights would evidence joint control.’
financial structure that is separate from the venturers themselves. Each venturer uses its own
fixed assets and carries its own inventories. It also incurs its own expenses and liabilities and
raises its own finance, which represent its own obligations. The joint venture's activities may
be carried out by the venturer's employees alongside the venturer's similar activities. The joint
venture agreement usually provides means by which the revenue from the jointly controlled
operations and any expenses incurred in common are shared among the venturers.
12. An example of a jointly controlled operation is when two or more venturers combine their
operations, resources and expertise in order to manufacture, market and distribute, jointly, a
particular product, such as an aircraft. Different parts of the manufacturing process are
carried out by each of the venturers. Each venturer bears its own costs and takes a share of
the revenue from the sale of the aircraft, such share being determined in accordance with the
contractual arrangement.
13. In respect of its interests in jointly controlled operations, a venturer should
recognise in its separate financial statements and consequently in its consolidated
financial statements:
(a) the assets that it controls and the liabilities that it incurs; and
(b) the expenses that it incurs and its share of the income that it earns from the joint
venture.
14. Because the assets, liabilities, income and expenses are already recognised in the
separate financial statements of the venturer, and consequently in its consolidated financial
statements, no adjustments or other consolidation procedures are required in respect of these
items when the venturer presents consolidated financial statements.
15. Separate accounting records may not be required for the joint venture itself and financial
statements may not be prepared for the joint venture. However, the venturers may prepare
accounts for internal management reporting purposes so that they may assess the
performance of the joint venture.
Jointly Controlled Assets

16. Some joint ventures involve the joint control, and often the joint ownership, by the
venturers of one or more assets contributed to, or acquired for the purpose of, the joint
venture and dedicated to the purposes of the joint venture. The assets are used to obtain
economic benefits for the venturers. Each venturer may take a share of the output from the
assets and each bears an agreed share of the expenses incurred.
17. These joint ventures do not involve the establishment of a corporation, partnership or
other entity, or a financial structure that is separate from the venturers themselves. Each
venturer has control over its share of future economic benefits through its share in the jointly
controlled asset.
18. An example of a jointly controlled asset is an oil pipeline jointly controlled and operated
by a number of oil production companies. Each venturer uses the pipeline to transport its own
product in return for which it bears an agreed proportion of the expenses of operating the
pipeline. Another example of a jointly controlled asset is when two enterprises jointly control a
property, each taking a share of the rents received and bearing a share of the expenses.
19. In respect of its interest in jointly controlled assets, a venturer should recognise,
in its separate financial statements, and consequently in its consolidated financial
statements:
(a) its share of the jointly controlled assets, classified according to the nature of the
assets;
(b) any liabilities which it has incurred;
(c) its share of any liabilities incurred jointly with the other venturers in relation to the
joint venture;
(d) any income from the sale or use of its share of the output of the joint venture,
together with its share of any expenses incurred by the joint venture; and
(e) any expenses which it has incurred in respect of its interest in the joint venture.
20. In respect of its interest in jointly controlled assets, each venturer includes in its
accounting records and recognises in its separate financial statements and consequently in its
consolidated financial statements:
(a) its share of the jointly controlled assets, classified according to the nature of the assets
rather than as an investment, for example, a share of a jointly controlled oil pipeline is
classified as a fixed asset;
(b) any liabilities which it has incurred, for example, those incurred in financing its share of
the assets;
(c) its share of any liabilities incurred jointly with other venturers in relation to the joint
venture;
(d) any income from the sale or use of its share of the output of the joint venture, together
with its share of any expenses incurred by the joint venture; and
(e) any expenses which it has incurred in respect of its interest in the joint venture, for
example, those related to financing the venturer's interest in the assets and selling its
share of the output.
Because the assets, liabilities, income and expenses are already recognised in the
separate financial statements of the venturer, and consequently in its consolidated
financial statements, no adjustments or other consolidation procedures are required in
respect of these items when the venturer presents consolidated financial statements.
21. The treatment of jointly controlled assets reflects the substance and economic reality
and, usually, the legal form of the joint venture. Separate accounting records for the joint
venture itself may be limited to those expenses incurred in common by the venturers and
ultimately borne by the venturers according to their agreed shares. Financial statements may
not be prepared for the joint venture, although the venturers may prepare accounts for internal
management reporting purposes so that they may assess the performance of the joint venture.
Jointly Controlled Entities

22. A jointly controlled entity is a joint venture which involves the establishment of a
corporation, partnership or other entity in which each venturer has an interest. The entity
operates in the same way as other enterprises, except that a contractual arrangement
between the venturers establishes joint control over the economic activity of the entity.
23. A jointly controlled entity controls the assets of the joint venture, incurs liabilities and
expenses and earns income. It may enter into contracts in its own name and raise finance for
the purposes of the joint venture activity. Each venturer is entitled to a share of the results of
the jointly controlled entity, although some jointly controlled entities also involve a sharing of
the output of the joint venture.
24. An example of a jointly controlled entity is when two enterprises combine their activities
in a particular line of business by transferring the relevant assets and liabilities into a jointly
controlled entity. Another example is when an enterprise commences a business in a foreign
country in conjunction with the government or other agency in that country, by establishing a
separate entity which is jointly controlled by the enterprise and the government or agency.
25. Many jointly controlled entities are similar to those joint ventures referred to as jointly
controlled operations or jointly controlled assets. For example, the venturers may transfer a
jointly controlled asset, such as an oil pipeline, into a jointly controlled entity. Similarly, the
venturers may contribute, into a jointly controlled entity, assets which will be operated jointly.
Some jointly controlled operations also involve the establishment of a jointly controlled entity
to deal with particular aspects of the activity, for example, the design, marketing, distribution
or after-sales service of the product.
26. A jointly controlled entity maintains its own accounting records and prepares and
presents financial statements in the same way as other enterprises in conformity with the
requirements applicable to that jointly controlled entity.
Separate Financial Statements of a Venturer

27. In a venturer's separate financial statements, interest in a jointly controlled entity
should be accounted for as an investment in accordance with Accounting Standard (AS)
13, Accounting for Investments.
28. Each venturer usually contributes cash or other resources to the jointly controlled entity.
These contributions are included in the accounting records of the venturer and are recognised
in its separate financial statements as an investment in the jointly controlled entity.
Consolidated Financial Statements of a Venturer
29. In its consolidated financial statements, a venturer should report its interest in a
jointly controlled entity using proportionate consolidation except
(a) an interest in a jointly controlled entity which is acquired and held exclusively with
a view to its subsequent disposal in the near future; and
(b) an interest in a jointly controlled entity which operates under severe long-term
restrictions that significantly impair its ability to transfer funds to the venturer.
Interest in such a jointly controlled entity should be accounted for as an investment in
accordance with Accounting Standard (AS) 13, Accounting for Investments.

30. When reporting an interest in a jointly controlled entity in consolidated financial
statements, it is essential that a venturer reflects the substance and economic reality of the
arrangement, rather than the joint venture's particular structure or form. In a jointly controlled
entity, a venturer has control over its share of future economic benefits through its share of the
assets and liabilities of the venture. This substance and economic reality is reflected in the
consolidated financial statements of the venturer when the venturer reports its interests in the
assets, liabilities, income and expenses of the jointly controlled entity by using proportionate
consolidation.
31. The application of proportionate consolidation means that the consolidated balance sheet
of the venturer includes its share of the assets that it controls jointly and its share of the
liabilities for which it is jointly responsible. The consolidated statement of profit and loss of the
venturer includes its share of the income and expenses of the jointly controlled entity. Many
of the procedures appropriate for the application of proportionate consolidation are similar to
the procedures for the consolidation of investments in subsidiaries, which are set out in
Accounting Standard (AS) 21, Consolidated Financial Statements.
32. For the purpose of applying proportionate consolidation, the venturer uses the
consolidated financial statements of the jointly controlled entity.
33. Under proportionate consolidation, the venturer includes separate line items for its share
of the assets, liabilities, income and expenses of the jointly controlled entity in its consolidated
financial statements. For example, it shows its share of the inventory of the jointly controlled
entity separately as part of the inventory of the consolidated group; it shows its share of the
fixed assets of the jointly controlled entity separately as part of the same items of the
consolidated group.
34. The financial statements of the jointly controlled entity used in applying proportionate
consolidation are usually drawn up to the same date as the financial statements of the
venturer. When the reporting dates are different, the jointly controlled entity often prepares,
for applying proportionate consolidation, statements as at the same date as that of the
venturer. When it is impracticable to do this, financial statements drawn up to different
reporting dates may be used provided the difference in reporting dates is not more than six
months. In such a case, adjustments are made for the effects of significant transactions or
other events that occur between the date of financial statements of the jointly controlled entity
and the date of the venturer’s financial statements. The consistency principle requires that the
length of the reporting periods, and any difference in the reporting dates, are consistent from
period to period.
35. The venturer usually prepares consolidated financial statements using uniform
accounting policies for the like transactions and events in similar circumstances. In case a
jointly controlled entity uses accounting policies other than those adopted for the consolidated
financial statements for like transactions and events in similar circumstances, appropriate
adjustments are made to the financial statements of the jointly controlled entity when they are
used by the venturer in applying proportionate consolidation. If it is not practicable to do so,
that fact is disclosed together with the proportions of the items in the consolidated financial
statements to which the different accounting policies have been applied.

36. While giving effect to proportionate consolidation, it is inappropriate to offset any assets
or liabilities by the deduction of other liabilities or assets or any income or expenses by the
deduction of other expenses or income, unless a legal right of set-off exists and the offsetting
represents the expectation as to the realisation of the asset or the settlement of the liability.
37. Any excess of the cost to the venturer of its interest in a jointly controlled entity over its
share of net assets of the jointly controlled entity, at the date on which interest in the jointly
controlled entity is acquired, is recognised as goodwill, and separately disclosed in the
consolidated financial statements. When the cost to the venturer of its interest in a jointly
controlled entity is less than its share of the net assets of the jointly controlled entity, at the
date on which interest in the jointly controlled entity is acquired, the difference is treated as a
capital reserve in the consolidated financial statements. Where the carrying amount of the
venturer’s interest in a jointly controlled entity is different from its cost, the carrying amount is
considered for the purpose of above computations.
38. The losses pertaining to one or more investors in a jointly controlled entity may exceed
their interests in the equity£ of the jointly controlled entity. Such excess, and any further losses
applicable to such investors, are recognised by the venturers in the proportion of their shares
in the venture, except to the extent that the investors have a binding obligation to, and are
able to, make good the losses. If the jointly controlled entity subsequently reports profits, all
such profits are allocated to venturers until the investors' share of losses previously absorbed
by the venturers has been recovered.
39. A venturer should discontinue the use of proportionate consolidation from the date
that:
(a) it ceases to have joint control over a jointly controlled entity but retains, either in
whole or in part, its interest in the entity; or
(b) the use of the proportionate consolidation is no longer appropriate because the
jointly controlled entity operates under severe long-term restrictions that
significantly impair its ability to transfer funds to the venturer.
40. From the date of discontinuing the use of the proportionate consolidation, interest
in a jointly controlled entity should be accounted for:
(a) in accordance with Accounting Standard (AS) 21, Consolidated Financial
Statements, if the venturer acquires unilateral control over the entity and becomes
parent within the meaning of that Standard; and
(b) in all other cases, as an investment in accordance with Accounting Standard (AS)
13, Accounting for Investments, or in accordance with Accounting Standard (AS)
23, Accounting for Investments in Associates in Consolidated Financial
£
Equity is the residual interest in the assets of an enterprise after deducting all its liabilities.
Statements, as appropriate. For this purpose, cost of the investment should be

determined as under:
(i) the venturer’s share in the net assets of the jointly controlled entity as at the
date of discontinuance of proportionate consolidation should be ascertained,
and
(ii) the amount of net assets so ascertained should be adjusted with the carrying
amount of the relevant goodwill/capital reserve (see paragraph 37) as at the
date of discontinuance of proportionate consolidation.
Transactions between a Venturer and Joint Venture

41. When a venturer contributes or sells assets to a joint venture, recognition of any
portion of a gain or loss from the transaction should reflect the substance of the
transaction. While the assets are retained by the joint venture, and provided the
venturer has transferred the significant risks and rewards of ownership, the venturer
should recognise only that portion of the gain or loss which is attributable to the
interests of the other venturers. The venturer should recognise the full amount of any
loss when the contribution or sale provides evidence of a reduction in the net realisable
value of current assets or an impairment loss.
42. When a venturer purchases assets from a joint venture, the venturer should not
recognise its share of the profits of the joint venture from the transaction until it resells
the assets to an independent party. A venturer should recognise its share of the losses
resulting from these transactions in the same way as profits except that losses should
be recognised immediately when they represent a reduction in the net realisable value
of current assets or an impairment loss.
43. To assess whether a transaction between a venturer and a joint venture provides
evidence of impairment of an asset, the venturer determines the recoverable amount of the
asset as per Accounting Standard on Impairment of Assets¥ In determining value in use,
future cash flows from the asset are estimated based on continuing use of the asset and its
ultimate disposal by the joint venture.
44. In case of transactions between a venturer and a joint venture in the form of a
jointly controlled entity, the requirements of paragraphs 41 and 42 should be applied
only in the preparation and presentation of consolidated financial statements and not in
the preparation and presentation of separate financial statements of the venturer.
45. In the separate financial statements of the venturer, the full amount of gain or loss on the
transactions taking place between the venturer and the jointly controlled entity is recognised.
However, while preparing the consolidated financial statements, the venturer’s share of the
unrealised gain or loss is eliminated. Unrealised losses are not eliminated, if and to the extent
they represent a reduction in the net realisable value of current assets or an impairment loss.
¥
AS 28 “Impairment of Assets” specifies the requirements relating to impairment of assets.
The venturer, in effect, recognises, in consolidated financial statements, only that portion of
gain or loss which is attributable to the interests of other venturers ¡.
Reporting Interests in Joint Ventures in the Financial Statements of an Investor

46. An investor in a joint venture, which does not have joint control, should report its
interest in a joint venture in its consolidated financial statements in accordance with
Accounting Standard (AS) 13, Accounting for Investments, Accounting Standard (AS)
21, Consolidated Financial Statements or Accounting Standard (AS) 23, Accounting for
Investments in Associates in Consolidated Financial Statements, as appropriate.
47. In the separate financial statements of an investor, the interests in joint ventures
should be accounted for in accordance with Accounting Standard (AS) 13, Accounting
for Investments.
Operators of Joint Ventures

48. Operators or managers of a joint venture should account for any fees in
accordance with Accounting Standard (AS) 9, Revenue Recognition.
49. One or more venturers may act as the operator or manager of a joint venture. Operators
are usually paid a management fee for such duties. The fees are accounted for by the joint
venture as an expense.
Disclosure
50. A venturer should disclose the information required by paragraphs 51, 52 and 53 in
its separate financial statements as well as in consolidated financial statements.
51. A venturer should disclose the aggregate amount of the following contingent
liabilities, unless the probability of loss is remote, separately from the amount of other
contingent liabilities:
(a) any contingent liabilities that the venturer has incurred in relation to its interests in
joint ventures and its share in each of the contingent liabilities which have been
incurred jointly with other venturers;
(b) its share of the contingent liabilities of the joint ventures themselves for which it is
contingently liable; and
(c) those contingent liabilities that arise because the venturer is contingently liable for
the liabilities of the other venturers of a joint venture.
¡
An announcement ‘Elimination of unrealized profits and losses under AS 21, AS 23 and AS 27
has been issued in July, 2004. As per the announcement , while applying ‘proportionate
consolidation method’, elimination of unrealised profits and losses in respect of transactions
entered into during accounting periods commencing on or before 31-3-2002, is encouraged, but
not required on practical grounds.
52. A venturer should disclose the aggregate amount of the following commitments in
respect of its interests in joint ventures separately from other commitments:
(a) any capital commitments of the venturer in relation to its interests in joint ventures
and its share in the capital commitments that have been incurred jointly with other
venturers; and
(b) its share of the capital commitments of the joint ventures themselves.
53. A venturer should disclose a list of all joint ventures and description of interests in
significant joint ventures. In respect of jointly controlled entities, the venturer should
also disclose the proportion of ownership interest, name and country of incorporation
or residence.
54. A venturer should disclose, in its separate financial statements, the aggregate
amounts of each of the assets, liabilities, income and expenses related to its interests
in the jointly controlled entities.
AS- 28 :IMPAIRMENT OF ASSETS (ISSUED 2002)

Accounting Standard (AS) 28, ‘Impairment of Assets’, issued by the Council of the Institute of
Chartered Accountants of India, comes into effect in respect of accounting periods
commencing on or after 1-4-2004.
This standard is mandatory in nature∗ in respect of accounting periods commencing on or
after:
(a) 1-4-2003, for the enterprises, which fall in any one or more of the following categories, at
any time during the accounting period:
.(i) Enterprises whose equity or debt securities are listed whether in India or outside
India.
∗
It was originally decided to make As 28 mandatory in respect of accounting periods commencing
on or after 1.4.2004 for the following:
India, and enterprises that are in the process of issuing equity or debt securities that will be
listed on a recognised stock exchange in India as evidenced by the board of directors’
the accounting period exceeds Rs. 50 crores.
In respect of all other enterprises, the Accounting Standard comes into effect in respect of
accounting periods commencing on or after 1-4-2005 and is mandatory in nature from that
date.
evidenced by the board of directors; resolution in this regard.
statements exceeds Rs.50 crore. Turnover does not include “other income”.
period.
accounting period.
(b) 1-4-2006, for the enterprises which do not fall in any of the categories in (a) above but
fall in any one or more of the following categories:
(i) All commercial , industrial and business reporting enterprises, whose turnover for
the immediately preceding accounting period on the basis of audited financial
statements exceeds Rs.40 lakhs but does not exceed Rs.50 crore. Turnover does
not include ‘other income’.
(ii) All commercial, industrial and business reporting enterprises having borrowings,
including public deposits, in excess Rs.1 crore but not in excess of Rs.10 crore at
any time during the accounting period.
(iii) Holding and subsidiary enterprises of any one of the above at any time during the
accounting period.
(c) 1-4-2008, for the enterprises, which do not fall in any of the categories in (a) and (b)
above.
Earlier application of the Accounting Standard is encouraged.
Objective
The objective of this Statement is to prescribe the procedures that an enterprise applies to
ensure that its assets are carried at no more than their recoverable amount. An asset is
carried at more than its recoverable amount if its carrying amount exceeds the amount to be
recovered through use or sale of the asset. If this is the case, the asset is described as
impaired and this Statement requires the enterprise to recognise an impairment loss. This
Statement also specifies when an enterprise should reverse an impairment loss and it
prescribes certain disclosures for impaired assets.
Scope
1. This Statement should be applied in accounting for the impairment of all assets,
other than:
(a) inventories (see AS 2, Valuation of Inventories);
(b) assets arising from construction contracts€ (see AS 7, Accounting for Construction
Contracts);
(c) financial assets¥, including investments that are included in the scope of AS 13,
Accounting for Investments; and
(d) deferred tax assets (see AS 22, Accounting for Taxes on Income).
2. This Statement does not apply to inventories, assets arising from construction contracts,
deferred tax assets or investments because existing Accounting Standards applicable to these
assets already contain specific requirements for recognising and measuring the impairment
related to these assets.
3. This Statement applies to assets that are carried at cost. It also applies to assets that are
carried at revalued amounts in accordance with other applicable Accounting Standards.
However, identifying whether a revalued asset may be impaired depends on the basis used to
determine the fair value of the asset:
(a) if the fair value of the asset is its market value, the only difference between the fair value
of the asset and its net selling price is the direct incremental costs to dispose of the
asset:
(i) if the disposal costs are negligible, the recoverable amount of the revalued asset is
necessarily close to, or greater than, its revalued amount (fair value). In this case,
after the revaluation requirements have been applied, it is unlikely that the revalued
asset is impaired and recoverable amount need not be estimated; and
(ii) if the disposal costs are not negligible, net selling price of the revalued asset is
necessarily less than its fair value. Therefore, the revalued asset will be impaired if
its value in use is less than its revalued amount (fair value). In this case, after the
revaluation requirements have been applied, an enterprise applies this Statement to
determine whether the asset may be impaired; and
€
This Standard has been revised and titled as ‘Construction Contracts’.
¥
financial asset is any asset that is:
(a) cash;
(b) a contractual right to receive cash or another financial asset fro another enterprise;
(c) a contractual right to exchange financial instruments with another enterprise under
conditions that a re potentially favourable; or
(d) an ownership interest in another enterprise.
(b) if the asset’s fair value is determined on a basis other than its market value, its revalued
amount (fair value) may be greater or lower than its recoverable amount. Hence, after the
revaluation requirements have been applied, an enterprise applies this Statement to
determine whether the asset may be impaired.
Definitions
Recoverable amount is the higher of an asset’s net selling price and its value in use.
Value in use is the present value of estimated future cash flows expected to arise from
the continuing use of an asset and from its disposal at the end of its useful life.
Net selling price is the amount obtainable from the sale of an asset in an arm’s length
transaction between knowledgeable, willing parties, less the costs of disposal.
Costs of disposal are incremental costs directly attributable to the disposal of an asset,
excluding finance costs and income tax expense.
An impairment loss is the amount by which the carrying amount of an asset exceeds its
recoverable amount.
Carrying amount is the amount at which an asset is recognised in the balance sheet
after deducting any accumulated depreciation (amortisation) and accumulated
impairment losses thereon.
Depreciation (Amortisation) is a systematic allocation of the depreciable amount of an
asset over its useful life.µ
Depreciable amount is the cost of an asset, or other amount substituted for cost in the
financial statements, less its residual value.
Useful life is either:
(a) the period of time over which an asset is expected to be used by the enterprise;
or
by the enterprise.
A cash generating unit is the smallest identifiable group of assets that generates cash
inflows from continuing use that are largely independent of the cash inflows from other
assets or groups of assets.
Corporate assets are assets other than goodwill that contribute to the future cash flows
of both the cash generating unit under review and other cash generating units.
An active market is a market where all the following conditions exist :
µ
In the case of an intangible asset or goodwill, the term amortization is generally used instead of
‘depreciation’. Both terms have the same meaning.
(a) the items traded within the market are homogeneous;

(b) willing buyers and sellers can normally be found at any time; and
(c) prices are available to the public.
IDENTIFYING AN ASSET THAT MAY BE IMPAIRED

5. An asset is impaired when the carrying amount of the asset exceeds its recoverable
amount. Paragraphs 6 to 13 specify when recoverable amount should be determined. These
requirements use the term ‘an asset’ but apply equally to an individual asset or a cash-
generating unit.
6. An enterprise should assess at each balance sheet date whether there is any
indication that an asset may be impaired. If any such indication exists, the enterprise
should estimate the recoverable amount of the asset.
7. Paragraphs 8 to 10 describe some indications that an impairment loss may have
occurred: if any of those indications is present, an enterprise is required to make a formal
estimate of recoverable amount. If no indication of a potential impairment loss is present, this
Statement does not require an enterprise to make a formal estimate of recoverable amount.
8. In assessing whether there is any indication that an asset may be impaired, an
enterprise should consider, as a minimum, the following indications:
External sources of information
(a) during the period, an asset’s market value has declined significantly more than
would be expected as a result of the passage of time or normal use;
(b) significant changes with an adverse effect on the enterprise have taken place
during the period, or will take place in the near future, in the technological, market,
economic or legal environment in which the enterprise operates or in the market to
which an asset is dedicated;
(c) market interest rates or other market rates of return on investments have increased
during the period, and those increases are likely to affect the discount rate used in
calculating an asset’s value in use and decrease the asset’s recoverable amount
materially;
(d) the carrying amount of the net assets of the reporting enterprise is more than its
market capitalisation;
Internal sources of information
(e) evidence is available of obsolescence or physical damage of an asset;
(f) significant changes with an adverse effect on the enterprise have taken place
during the period, or are expected to take place in the near future, in the extent to
which, or manner in which, an asset is used or is expected to be used. These
changes include plans to discontinue or restructure the operation to which an
asset belongs or to dispose of an asset before the previously expected date; and
(g) evidence is available from internal reporting that indicates that the economic
performance of an asset is, or will be, worse than expected.
9. The list of paragraph 8 is not exhaustive. An enterprise may identify other indications that
an asset may be impaired and these would also require the enterprise to determine the asset’s
recoverable amount.
10. Evidence from internal reporting that indicates that an asset may be impaired includes
the existence of:
(a) cash flows for acquiring the asset, or subsequent cash needs for operating or maintaining
it, that are significantly higher than those originally budgeted;
(b) actual net cash flows or operating profit or loss flowing from the asset that are
significantly worse than those budgeted;
(c) a significant decline in budgeted net cash flows or operating profit, or a significant
increase in budgeted loss, flowing from the asset; or
(d) operating losses or net cash outflows for the asset, when current period figures are
aggregated with budgeted figures for the future.
11. The concept of materiality applies in identifying whether the recoverable amount of an
asset needs to be estimated. For example, if previous calculations show that an asset’s
recoverable amount is significantly greater than its carrying amount, the enterprise need not
re-estimate the asset’s recoverable amount if no events have occurred that would eliminate
that difference. Similarly, previous analysis may show that an asset’s recoverable amount is
not sensitive to one (or more) of the indications listed in paragraph 8.
12. As an illustration of paragraph 11, if market interest rates or other market rates of return
on investments have increased during the period, an enterprise is not required to make a
formal estimate of an asset’s recoverable amount in the following cases:
(a) if the discount rate used in calculating the asset’s value in use is unlikely to be affected
by the increase in these market rates. For example, increases in short-term interest rates
may not have a material effect on the discount rate used for an asset that has a long
remaining useful life; or
(b) if the discount rate used in calculating the asset’s value in use is likely to be affected by
the increase in these market rates but previous sensitivity analysis of recoverable
amount shows that:
(i) it is unlikely that there will be a material decrease in recoverable amount because
future cash flows are also likely to increase. For example, in some cases, an
enterprise may be able to demonstrate that it adjusts its revenues to compensate for
any increase in market rates; or
(ii) the decrease in recoverable amount is unlikely to result in a material impairment
loss
13. If there is an indication that an asset may be impaired, this may indicate that the
remaining useful life, the depreciation (amortisation) method or the residual value for the asset
need to be reviewed and adjusted under the Accounting Standard applicable to the asset,
such as Accounting Standard (AS) 6, Depreciation AccountingΩ, even if no impairment loss is
recognised for the asset.
Measurement of Recoverable Amount

14. This Statement defines recoverable amount as the higher of an asset’s net selling price
and value in use. Paragraphs 15 to 55 set out the requirements for measuring recoverable
amount. These requirements use the term ‘an asset’ but apply equally to an individual asset or
a cash-generating unit.
15. It is not always necessary to determine both an asset’s net selling price and its value in
use. For example, if either of these amounts exceeds the asset’s carrying amount, the asset is
not impaired and it is not necessary to estimate the other amount.
16. It may be possible to determine net selling price, even if an asset is not traded in an
active market. However, sometimes it will not be possible to determine net selling price
because there is no basis for making a reliable estimate of the amount obtainable from the
sale of the asset in an arm’s length transaction between knowledgeable and willing parties. In
this case, the recoverable amount of the asset may be taken to be its value in use.
17. If there is no reason to believe that an asset’s value in use materially exceeds its net
selling price, the asset’s recoverable amount may be taken to be its net selling price. This will
often be the case for an asset that is held for disposal. This is because the value in use of an
asset held for disposal will consist mainly of the net disposal proceeds, since the future cash
flows from continuing use of the asset until its disposal are likely to be negligible.
18. Recoverable amount is determined for an individual asset, unless the asset does not
generate cash inflows from continuing use that are largely independent of those from other
assets or groups of assets. If this is the case, recoverable amount is determined for the cash-
generating unit to which the asset belongs (see paragraphs 63 to 86), unless either:
(a) the asset’s net selling price is higher than its carrying amount; or
(b) the asset’s value in use can be estimated to be close to its net selling price and net
selling price can be determined.
19. In some cases, estimates, averages and simplified computations may provide a
reasonable approximation of the detailed computations illustrated in this Statement for
determining net selling price or value in use.
Net Selling Price

20. The best evidence of an asset’s net selling price is a price in a binding sale agreement in
an arm’s length transaction, adjusted for incremental costs that would be directly attributable
to the disposal of the asset.
Ω
From the date of AS 26 “Intangible Assets”, becoming mandatory for the concerned enterprises,
As 6 stands withdrawn insofar as it relates to the amortization (depreciation)of intangible assets.
21. If there is no binding sale agreement but an asset is traded in an active market, net
selling price is the asset’s market price less the costs of disposal.The appropriate market price
is usually the current bid price. When current bid prices are unavailable, the price of the most
recent transaction may provide a basis from which to estimate net selling price, provided that
there has not been a significant change in economic circumstances between the transaction
date and the date at which the estimate is made.
22. If there is no binding sale agreement or active market for an asset, net selling price is
based on the best information available to reflect the amount that an enterprise could obtain,
at the balance sheet date, for the disposal of the asset in an arm’s length transaction between
knowledgeable, willing parties, after deducting the costs of disposal. In determining this
amount, an enterprise considers the outcome of recent transactions for similar assets within
the same industry. Net selling price does not reflect a forced sale, unless management is
compelled to sell immediately.
23. Costs of disposal, other than those that have already been recognised as liabilities, are
deducted in determining net selling price. Examples of such costs are legal costs, costs of
removing the asset, and direct incremental costs to bring an asset into condition for its sale.
However, termination benefits and costs associated with reducing or reorganising a business
following the disposal of an asset are not direct incremental costs to dispose of the asset.
24. Sometimes, the disposal of an asset would require the buyer to take over a liability and
only a single net selling price is available for both the asset and the liability. Paragraph 76
explains how to deal with such cases.
Value in Use
25. Estimating the value in use of an asset involves the following steps:
(a) estimating the future cash inflows and outflows arising from continuing use of the asset
and from its ultimate disposal; and
(b) applying the appropriate discount rate to these future cash flows.
Basis for Estimates of Future Cash Flows
26. In measuring value in use:
(a) cash flow projections should be based on reasonable and supportable
assumptions that represent management’s best estimate of the set of economic
conditions that will exist over the remaining useful life of the asset. Greater weight
should be given to external evidence;
(b) cash flow projections should be based on the most recent financial
budgets/forecasts that have been approved by management. Projections based on
these budgets/forecasts should cover a maximum period of five years, unless a
longer period can be justified; and
(c) cash flow projections beyond the period covered by the most recent
budgets/forecasts should be estimated by extrapolating the projections based on
the budgets/forecasts using a steady or declining growth rate for subsequent
years, unless an increasing rate can be justified. This growth rate should not
exceed the long-term average growth rate for the products, industries, or country
or countries in which the enterprise operates, or for the market in which the asset
is used, unless a higher rate can be justified.
27. Detailed, explicit and reliable financial budgets/forecasts of future cash flows for periods
longer than five years are generally not available. For this reason, management’s estimates of
future cash flows are based on the most recent budgets/forecasts for a maximum of five years.
Management may use cash flow projections based on financial budgets/forecasts over a
period longer than five years if management is confident that these projections are reliable
and it can demonstrate its ability, based on past experience, to forecast cash flows accurately
over that longer period.
28. Cash flow projections until the end of an asset’s useful life are estimated by extrapolating
the cash flow projections based on the financial budgets/forecasts using a growth rate for
subsequent years. This rate is steady or declining, unless an increase in the rate matches
objective information about patterns over a product or industry lifecycle. If appropriate, the
growth rate is zero or negative.
29. Where conditions are very favourable, competitors are likely to enter the market and
restrict growth. Therefore, enterprises will have difficulty in exceeding the average historical
growth rate over the long term (say, twenty years) for the products, industries, or country or
countries in which the enterprise operates, or for the market in which the asset is used.
30. In using information from financial budgets/forecasts, an enterprise considers whether
the information reflects reasonable and supportable assumptions and represents
management’s best estimate of the set of economic conditions that will exist over the
remaining useful life of the asset.
Composition of Estimates of Future Cash Flows
31. Estimates of future cash flows should include:
(a) projections of cash inflows from the continuing use of the asset;
(b) projections of cash outflows that are necessarily incurred to generate the cash
inflows from continuing use of the asset (including cash outflows to prepare the
asset for use) and that can be directly attributed, or allocated on a reasonable and
consistent basis, to the asset; and
(c) net cash flows, if any, to be received (or paid) for the disposal of the asset at the
end of its useful life.
32. Estimates of future cash flows and the discount rate reflect consistent assumptions about
price increases due to general inflation. Therefore, if the discount rate includes the effect of
price increases due to general inflation, future cash flows are estimated in nominal terms. If
the discount rate excludes the effect of price increases due to general inflation, future cash
flows are estimated in real terms but include future specific price increases or decreases.
33. Projections of cash outflows include future overheads that can be attributed directly, or
allocated on a reasonable and consistent basis, to the use of the asset.
34. When the carrying amount of an asset does not yet include all the cash outflows to be
incurred before it is ready for use or sale, the estimate of future cash outflows includes an
estimate of any further cash outflow that is expected to be incurred before the asset is ready
for use or sale. For example, this is the case for a building under construction or for a
development project that is not yet completed.
35. To avoid double counting, estimates of future cash flows do not include:
(a) cash inflows from assets that generate cash inflows from continuing use that are largely
independent of the cash inflows from the asset under review (for example, financial
assets such as receivables); and
(b) cash outflows that relate to obligations that have already been recognised as liabilities
(for example, payables, pensions or provisions).
36. Future cash flows should be estimated for the asset in its current condition.
Estimates of future cash flows should not include estimated future cash inflows or
outflows that are expected to arise from:
(a) a future restructuring to which an enterprise is not yet committed; or
(b) future capital expenditure that will improve or enhance the asset in excess of its
originally assessed standard of performance.
37. Because future cash flows are estimated for the asset in its current condition, value in
use does not reflect:
(a) future cash outflows or related cost savings (for example, reductions in staff costs) or
benefits that are expected to arise from a future restructuring to which an enterprise is
not yet committed; or
(b) future capital expenditure that will improve or enhance the asset in excess of its originally
assessed standard of performance or the related future benefits from this future
expenditure.
38. A restructuring is a programme that is planned and controlled by management and that
materially changes either the scope of the business undertaken by an enterprise or the
manner in which the business is conducted.
39. When an enterprise becomes committed to a restructuring, some assets are likely to be
affected by this restructuring. Once the enterprise is committed to the restructuring, in
determining value in use, estimates of future cash inflows and cash outflows reflect the cost
savings and other benefits from the restructuring (based on the most recent financial
budgets/forecasts that have been approved by management).
Example 5 given in the Appendix illustrates the effect of a future restructuring on a value in
use calculation.
40. Until an enterprise incurs capital expenditure that improves or enhances an asset in
excess of its originally assessed standard of performance, estimates of future cash flows do
not include the estimated future cash inflows that are expected to arise from this expenditure
(see Example 6 given in the Appendix).
41. Estimates of future cash flows include future capital expenditure necessary to maintain or
sustain an asset at its originally assessed standard of performance.
42. Estimates of future cash flows should not include:
(a) cash inflows or outflows from financing activities; or
(b) income tax receipts or payments.
43. Estimated future cash flows reflect assumptions that are consistent with the way the
discount rate is determined. Otherwise, the effect of some assumptions will be counted twice
or ignored. Because the time value of money is considered by discounting the estimated future
cash flows, these cash flows exclude cash inflows or outflows from financing activities.
Similarly, since the discount rate is determined on a pre-tax basis, future cash flows are also
estimated on a pre-tax basis.
44. The estimate of net cash flows to be received (or paid) for the disposal of an asset
at the end of its useful life should be the amount that an enterprise expects to obtain
from the disposal of the asset in an arm’s length transaction between knowledgeable,
willing parties, after deducting the estimated costs of disposal.
45. The estimate of net cash flows to be received (or paid) for the disposal of an asset at the
end of its useful life is determined in a similar way to an asset’s net selling price, except that,
in estimating those net cash flows:
(a) an enterprise uses prices prevailing at the date of the estimate for similar assets that
have reached the end of their useful life and that have operated under conditions similar
to those in which the asset will be used; and
(b) those prices are adjusted for the effect of both future price increases due to general
inflation and specific future price increases (decreases). However, if estimates of future
cash flows from the asset’s continuing use and the discount rate exclude the effect of
general inflation, this effect is also excluded from the estimate of net cash flows on
disposal.
Foreign Currency Future Cash Flows
46. Future cash flows are estimated in the currency in which they will be generated and then
discounted using a discount rate appropriate for that currency. An enterprise translates the
present value obtained using the exchange rate at the balance sheet date (described in
Accounting Standard (AS) 11, Accounting for the Effects of Changes in Foreign Exchange
RatesФ, as the closing rate).
Ф
AS 11 has been revised in 2003, and titled as ‘The Effects of Changes in Foreign Exchange
Rates’.
Discount Rate
47. The discount rate(s) should be a pre tax rate(s) that reflect(s) current market
assessments of the time value of money and the risks specific to the asset. The
discount rate(s) should not reflect risks for which future cash flow estimates have been
adjusted.
48. A rate that reflects current market assessments of the time value of money and the risks
specific to the asset is the return that investors would require if they were to choose an
investment that would generate cash flows of amounts, timing and risk profile equivalent to
those that the enterprise expects to derive from the asset. This rate is estimated from the rate
implicit in current market transactions for similar assets or from the weighted average cost of
capital of a listed enterprise that has a single asset (or a portfolio of assets) similar in terms of
service potential and risks to the asset under review.
49. When an asset-specific rate is not directly available from the market, an enterprise uses
other bases to estimate the discount rate. The purpose is to estimate, as far as possible, a
market assessment of:
(a) the time value of money for the periods until the end of the asset’s useful life; and
(b) the risks that the future cash flows will differ in amount or timing from estimates.
50. As a starting point, the enterprise may take into account the following rates:
(a) the enterprise’s weighted average cost of capital determined using techniques such as
the Capital Asset Pricing Model;
(b) the enterprise’s incremental borrowing rate; and
(c) other market borrowing rates.
51. These rates are adjusted:
(a) to reflect the way that the market would assess the specific risks associated with the
projected cash flows; and
(b) to exclude risks that are not relevant to the projected cash flows.
Consideration is given to risks such as country risk, currency risk, price risk and cash flow risk.
52. To avoid double counting, the discount rate does not reflect risks for which future cash
flow estimates have been adjusted.
53. The discount rate is independent of the enterprise’s capital structure and the way the
enterprise financed the purchase of the asset because the future cash flows expected to arise
from an asset do not depend on the way in which the enterprise financed the purchase of the
asset.
54. When the basis for the rate is post-tax, that basis is adjusted to reflect a pre-tax rate.
55. An enterprise normally uses a single discount rate for the estimate of an asset’s value in
use. However, an enterprise uses separate discount rates for different future periods where
value in use is sensitive to a difference in risks for different periods or to the term structure of
interest rates.
RECOGNITION AND MEASUREMENT OF AN IMPAIRMENT LOSS

56. Paragraphs 57 to 62 set out the requirements for recognising and measuring impairment
losses for an individual asset. Recognition and measurement of impairment losses for a cash-
generating unit are dealt with in paragraphs 87 to 92.
57. If the recoverable amount of an asset is less than its carrying amount, the carrying
amount of the asset should be reduced to its recoverable amount. That reduction is an
impairment loss.
58. An impairment loss should be recognised as an expense in the statement of profit
and loss immediately, unless the asset is carried at revalued amount in accordance with
another Accounting Standard (see Accounting Standard (AS) 10, Accounting for Fixed
Assets), in which case any impairment loss of a revalued asset should be treated as a
revaluation decrease under that Accounting Standard.
59. An impairment loss on a revalued asset is recognised as an expense in the statement of
profit and loss. However, an impairment loss on a revalued asset is recognised directly
against any revaluation surplus for the asset to the extent that the impairment loss does not
exceed the amount held in the revaluation surplus for that same asset.
60. When the amount estimated for an impairment loss is greater than the carrying
amount of the asset to which it relates, an enterprise should recognise a liability if, and
only if, that is required by another Accounting Standard.
61. After the recognition of an impairment loss, the depreciation (amortisation) charge
for the asset should be adjusted in future periods to allocate the asset’s revised
carrying amount, less its residual value (if any), on a systematic basis over its
remaining useful life.
62. If an impairment loss is recognised, any related deferred tax assets or liabilities are
determined under Accounting Standard (AS) 22, Accounting for Taxes on Income (see
Example 3 given in the Appendix).
CASH-GENERATING UNITS
63. Paragraphs 64 to 92 set out the requirements for identifying the cash-generating unit to
which an asset belongs and determining the carrying amount of, and recognising impairment
losses for, cash-generating units.
Identification of the Cash-Generating Unit to Which an Asset Belongs

64. If there is any indication that an asset may be impaired, the recoverable amount
should be estimated for the individual asset. If it is not possible to estimate the
recoverable amount of the individual asset, an enterprise should determine the
recoverable amount of the cash-generating unit to which the asset belongs (the asset’s
cash-generating unit).
65. The recoverable amount of an individual asset cannot be determined if:

(a) the asset’s value in use cannot be estimated to be close to its net selling price (for
example, when the future cash flows from continuing use of the asset cannot be
estimated to be negligible); and
(b) the asset does not generate cash inflows from continuing use that are largely
independent of those from other assets. In such cases, value in use and, therefore,
recoverable amount, can be determined only for the asset’s cash-generating unit.
Example
A mining enterprise owns a private railway to support its mining activities. The private railway
could be sold only for scrap value and the private railway does not generate cash inflows from
continuing use that are largely independent of the cash inflows from the other assets of the
mine.
It is not possible to estimate the recoverable amount of the private railway because the value
in use of the private railway cannot be determined and it is probably different from scrap value.
Therefore, the enterprise estimates the recoverable amount of the cash-generating unit to
which the private railway belongs, that is, the mine as a whole.
66. As defined in paragraph 4, an asset’s cash-generating unit is the smallest group of
assets that includes the asset and that generates cash inflows from continuing use that are
largely independent of the cash inflows from other assets or groups of assets. Identification of
an asset’s cash-generating unit involves judgement. If recoverable amount cannot be
determined for an individual asset, an enterprise identifies the lowest aggregation of assets
that generate largely independent cash inflows from continuing use.
Example
A bus company provides services under contract with a municipality that requires minimum
service on each of five separate routes. Assets devoted to each route and the cash flows from
each route can be identified separately. One of the routes operates at a significant loss.
Because the enterprise does not have the option to curtail any one bus route, the lowest level
of identifiable cash inflows from continuing use that are largely independent of the cash
inflows from other assets or groups of assets is the cash inflows generated by the five routes
together. The cash-generating unit for each route is the bus company as a whole.
67. Cash inflows from continuing use are inflows of cash and cash equivalents received from
parties outside the reporting enterprise. In identifying whether cash inflows from an asset (or
group of assets) are largely independent of the cash inflows from other assets (or groups of
assets), an enterprise considers various factors including how management monitors the
enterprise’s operations (such as by product lines, businesses, individual locations, districts or
regional areas or in some other way) or how management makes decisions about continuing
or disposing of the enterprise’s assets and operations. Example 1 in the Appendix gives
examples of identification of a cash-generating unit.
68. If an active market exists for the output produced by an asset or a group of assets,
this asset or group of assets should be identified as a separate cash-generating unit,
even if some or all of the output is used internally. If this is the case, management’s
best estimate of future market prices for the output should be used:
(a) in determining the value in use of this cash-generating unit, when estimating the
future cash inflows that relate to the internal use of the output; and
(b) in determining the value in use of other cash-generating units of the reporting
enterprise, when estimating the future cash outflows that relate to the internal
use of the output.
69. Even if part or all of the output produced by an asset or a group of assets is used by
other units of the reporting enterprise (for example, products at an intermediate stage of a
production process), this asset or group of assets forms a separate cash-generating unit if the
enterprise could sell this output in an active market. This is because this asset or group of
assets could generate cash inflows from continuing use that would be largely independent of
the cash inflows from other assets or groups of assets. In using information based on financial
budgets/forecasts that relates to such a cash-generating unit, an enterprise adjusts this
information if internal transfer prices do not reflect management’s best estimate of future
market prices for the cash-generating unit’s output.
70. Cash-generating units should be identified consistently from period to period for
the same asset or types of assets, unless a change is justified.
71. If an enterprise determines that an asset belongs to a different cash-generating unit than
in previous periods, or that the types of assets aggregated for the asset’s cash-generating unit
have changed, paragraph 121 requires certain disclosures about the cash-generating unit, if
an impairment loss is recognised or reversed for the cash-generating unit and is material to
the financial statements of the reporting enterprise as a whole.
Recoverable Amount and Carrying Amount of a Cash-Generating Unit

72. The recoverable amount of a cash-generating unit is the higher of the cash-generating
unit’s net selling price and value in use. For the purpose of determining the recoverable
amount of a cash-generating unit, any reference in paragraphs 15 to 55 to ‘an asset’ is read
as a reference to ‘a cash-generating unit’.
73. The carrying amount of a cash-generating unit should be determined consistently
with the way the recoverable amount of the cash-generating unit is determined.
74. The carrying amount of a cash-generating unit:
(a) includes the carrying amount of only those assets that can be attributed directly, or
allocated on a reasonable and consistent basis, to the cash-generating unit and that will
generate the future cash inflows estimated in determining the cash-generating unit’s
value in use; and
(b) does not include the carrying amount of any recognised liability, unless the recoverable
amount of the cash-generating unit cannot be determined without consideration of this

liability.
This is because net selling price and value in use of a cash-generating unit are determined
excluding cash flows that relate to assets that are not part of the cash-generating unit and
liabilities that have already been recognised in the financial statements, as set out in
paragraphs 23 and 35.
75. Where assets are grouped for recoverability assessments, it is important to include in the
cash-generating unit all assets that generate the relevant stream of cash inflows from
continuing use. Otherwise, the cash-generating unit may appear to be fully recoverable when
in fact an impairment loss has occurred. In some cases, although certain assets contribute to
the estimated future cash flows of a cash-generating unit, they cannot be allocated to the
cash-generating unit on a reasonable and consistent basis. This might be the case for goodwill
or corporate assets such as head office assets. Paragraphs 78 to 86 explain how to deal with
these assets in testing a cash-generating unit for impairment.
76. It may be necessary to consider certain recognised liabilities in order to determine the
recoverable amount of a cash-generating unit. This may occur if the disposal of a cash-
generating unit would require the buyer to take over a liability. In this case, the net selling
price (or the estimated cash flow from ultimate disposal) of the cash-generating unit is the
estimated selling price for the assets of the cash-generating unit and the liability together, less
the costs of disposal. In order to perform a meaningful comparison between the carrying
amount of the cash-generating unit and its recoverable amount, the carrying amount of the
liability is deducted in determining both the cash-generating unit’s value in use and its carrying
amount.
Example
A company operates a mine in a country where legislation requires that the owner must
restore the site on completion of its mining operations. The cost of restoration includes the
replacement of the overburden, which must be removed before mining operations commence.
A provision for the costs to replace the overburden was recognised as soon as the overburden
was removed. The amount provided was recognised as part of the cost of the mine and is
being depreciated over the mine’s useful life. The carrying amount of the provision for
restoration costs is Rs. 50,00,000, which is equal to the present value of the restoration costs.
The enterprise is testing the mine for impairment. The cash-generating unit for the mine is the
mine as a whole. The enterprise has received various offers to buy the mine at a price of
around Rs. 80,00,000; this price encompasses the fact that the buyer will take over the
obligation to restore the overburden. Disposal costs for the mine are negligible. The value in
use of the mine is approximately Rs. 1,20,00,000 excluding restoration costs. The carrying
amount of the mine is Rs. 1,00,00,000.
The net selling price for the cash-generating unit is Rs. 80,00,000. This amount considers
restoration costs that have already been provided for. As a consequence, the value in use for
the cash-generating unit is determined after consideration of the restoration costs and is
estimated to be Rs. 70,00,000 (Rs. 1,20,00,000 less Rs. 50,00,000). The carrying amount of
the cash-generating unit is Rs. 50,00,000, which is the carrying amount of the mine (Rs.
1,00,00,000) less the carrying amount of the provision for restoration costs (Rs. 50,00,000).
77. For practical reasons, the recoverable amount of a cash-generating unit is sometimes
determined after consideration of assets that are not part of the cash-generating unit (for
example, receivables or other financial assets) or liabilities that have already been recognised
in the financial statements (for example, payables, pensions and other provisions). In such
cases, the carrying amount of the cash-generating unit is increased by the carrying amount of
those assets and decreased by the carrying amount of those liabilities.
Goodwill
78. In testing a cash-generating unit for impairment, an enterprise should identify
whether goodwill that relates to this cash-generating unit is recognised in the financial
statements. If this is the case, an enterprise should:
(a) perform a ‘bottom-up’ test, that is, the enterprise should:
(i) identify whether the carrying amount of goodwill can be allocated on a
reasonable and consistent basis to the cash-generating unit under review; and
(ii) then, compare the recoverable amount of the cash-generating unit under
review to its carrying amount (including the carrying amount of allocated
goodwill, if any) and recognise any impairment loss in accordance with
paragraph 87.
The enterprise should perform the step at (ii) above even if none of the carrying
amount of goodwill can be allocated on a reasonable and consistent basis to the
cash-generating unit under review; and
(b) if, in performing the ‘bottom-up’ test, the enterprise could not allocate the carrying
amount of goodwill on a reasonable and consistent basis to the cash-generating
unit under review, the enterprise should also perform a ‘top-down’ test, that is, the
enterprise should:
(i) identify the smallest cash-generating unit that includes the cash-generating
unit under review and to which the carrying amount of goodwill can be
allocated on a reasonable and consistent basis (the ‘larger’ cash-generating
unit); and
(ii) then, compare the recoverable amount of the larger cash-generating unit to its
carrying amount (including the carrying amount of allocated goodwill) and
recognise any impairment loss in accordance with paragraph 87.
79. Goodwill arising on acquisition represents a payment made by an acquirer in anticipation
of future economic benefits. The future economic benefits may result from synergy between
the identifiable assets acquired or from assets that individually do not qualify for recognition in
the financial statements. Goodwill does not generate cash flows independently from other
assets or groups of assets and, therefore, the recoverable amount of goodwill as an individual
asset cannot be determined. As a consequence, if there is an indication that goodwill may be
impaired, recoverable amount is determined for the cash-generating unit to which goodwill
belongs. This amount is then compared to the carrying amount of this cash-generating unit
and any impairment loss is recognised in accordance with paragraph 87.
80. Whenever a cash-generating unit is tested for impairment, an enterprise considers any
goodwill that is associated with the future cash flows to be generated by the cash-generating
unit. If goodwill can be allocated on a reasonable and consistent basis, an enterprise applies
the ‘bottom-up’ test only. If it is not possible to allocate goodwill on a reasonable and
consistent basis, an enterprise applies both the ‘bottom-up’ test and ‘top-down’ test (see
Example 7 given in the Appendix).
81. The ‘bottom-up’ test ensures that an enterprise recognises any impairment loss that
exists for a cash-generating unit, including for goodwill that can be allocated on a reasonable
and consistent basis. Whenever it is impracticable to allocate goodwill on a reasonable and
consistent basis in the ‘bottom-up’ test, the combination of the ‘bottom-up’ and the ‘top-down’
test ensures that an enterprise recognises:
(a) first, any impairment loss that exists for the cash-generating unit excluding any
consideration of goodwill; and
(b) then, any impairment loss that exists for goodwill. Because an enterprise applies the
‘bottom-up’ test first to all assets that may be impaired, any impairment loss identified for
the larger cash-generating unit in the ‘top-down’ test relates only to goodwill allocated to
the larger unit.
82. If the ‘top-down’ test is applied, an enterprise formally determines the recoverable
amount of the larger cash-generating unit, unless there is persuasive evidence that there is no
risk that the larger cash-generating unit is impaired.
Corporate Assets
83. Corporate assets include group or divisional assets such as the building of a
headquarters or a division of the enterprise, EDP equipment or a research centre. The
structure of an enterprise determines whether an asset meets the definition of corporate
assets (see paragraph 4) for a particular cash-generating unit. Key characteristics of corporate
assets are that they do not generate cash inflows independently from other assets or groups
of assets and their carrying amount cannot be fully attributed to the cash-generating unit under
review.
84. Because corporate assets do not generate separate cash inflows, the recoverable
amount of an individual corporate asset cannot be determined unless management has
decided to dispose of the asset. As a consequence, if there is an indication that a corporate
asset may be impaired, recoverable amount is determined for the cash-generating unit to
which the corporate asset belongs, compared to the carrying amount of this cash-generating
unit and any impairment loss is recognised in accordance with paragraph 87.
85. In testing a cash-generating unit for impairment, an enterprise should identify all
the corporate assets that relate to the cash-generating unit under review. For each
identified corporate asset, an enterprise should then apply paragraph 78, that is:
(a) if the carrying amount of the corporate asset can be allocated on a reasonable and
consistent basis to the cash-generating unit under review, an enterprise should
apply the ‘bottom-up’ test only; and
(b) if the carrying amount of the corporate asset cannot be allocated on a reasonable
and consistent basis to the cash-generating unit under review, an enterprise
should apply both the ‘bottom-up’ and ‘top-down’ tests.
86. An example of how to deal with corporate assets is given as Example 8 in the Appendix.
Impairment Loss for a Cash-Generating Unit

87. An impairment loss should be recognised for a cash-generating unit if, and only if,
its recoverable amount is less than its carrying amount. The impairment loss should be
allocated to reduce the carrying amount of the assets of the unit in the following order:
(a) first, to goodwill allocated to the cash-generating unit (if any); and
(b) then, to the other assets of the unit on a pro-rata basis based on the carrying
amount of each asset in the unit.
These reductions in carrying amounts should be treated as impairment losses on
individual assets and recognised in accordance with paragraph 58.
88. In allocating an impairment loss under paragraph 87, the carrying amount of an
asset should not be reduced below the highest of:
(a) its net selling price (if determinable);
(b) its value in use (if determinable); and
(c) zero.
The amount of the impairment loss that would otherwise have been allocated to the
asset should be allocated to the other assets of the unit on a pro-rata basis.
89. The goodwill allocated to a cash-generating unit is reduced before reducing the carrying
amount of the other assets of the unit because of its nature.
90. If there is no practical way to estimate the recoverable amount of each individual asset of
a cash-generating unit, this Statement requires the allocation of the impairment loss between
the assets of that unit other than goodwill on a pro-rata basis, because all assets of a cash-
generating unit work together.
91. If the recoverable amount of an individual asset cannot be determined (see paragraph
65):
(a) an impairment loss is recognised for the asset if its carrying amount is greater than the
higher of its net selling price and the results of the allocation procedures described in
paragraphs 87 and 88; and
(b) no impairment loss is recognised for the asset if the related cash-generating unit is not
impaired. This applies even if the asset’s net selling price is less than its carrying
amount.
Example
A machine has suffered physical damage but is still working, although not as well as it used to.
The net selling price of the machine is less than its carrying amount. The machine does not
generate independent cash inflows from continuing use. The smallest identifiable group of
assets that includes the machine and generates cash inflows from continuing use that are
largely independent of the cash inflows from other assets is the production line to which the
machine belongs. The recoverable amount of the production line shows that the production
line taken as a whole is not impaired.
Assumption 1: Budgets/forecasts approved by management reflect no commitment of
management to replace the machine.
The recoverable amount of the machine alone cannot be estimated since the machine’s value
in use:
(a) may differ from its net selling price; and
(b) can be determined only for the cash-generating unit to which the machine belongs (the
production line).
The production line is not impaired, therefore, no impairment loss is recognised for the
machine. Nevertheless, the enterprise may need to reassess the depreciation period or the
depreciation method for the machine. Perhaps, a shorter depreciation period or a faster
depreciation method is required to reflect the expected remaining useful life of the machine or
the pattern in which economic benefits are consumed by the enterprise.
Assumption 2: Budgets/forecasts approved by management reflect a commitment of
management to replace the machine and sell it in the near future. Cash flows from continuing
use of the machine until its disposal are estimated to be negligible.
The machine’s value in use can be estimated to be close to its net selling price. Therefore, the
recoverable amount of the machine can be determined and no consideration is given to the
cash-generating unit to which the machine belongs (the production line). Since the machine’s
net selling price is less than its carrying amount, an impairment loss is recognised for the
machine.
92. After the requirements in paragraphs 87 and 88 have been applied, a liability
should be recognised for any remaining amount of an impairment loss for a cash-
generating unit if that is required by another Accounting Standard.
Reversal of an Impairment Loss

93. Paragraphs 94 to 100 set out the requirements for reversing an impairment loss
recognised for an asset or a cash-generating unit in prior accounting periods. These
requirements use the term ‘an asset’ but apply equally to an individual asset or a cash-
generating unit. Additional requirements are set out for an individual asset in paragraphs 101
to 105, for a cash-generating unit in paragraphs 106 to 107 and for goodwill in paragraphs 108
to 111.
94. An enterprise should assess at each balance sheet date whether there is any
indication that an impairment loss recognised for an asset in prior accounting periods
may no longer exist or may have decreased. If any such indication exists, the enterprise
should estimate the recoverable amount of that asset.
95. In assessing whether there is any indication that an impairment loss recognised
for an asset in prior accounting periods may no longer exist or may have decreased, an
enterprise should consider, as a minimum, the following indications:
External sources of information
(a) the asset’s market value has increased significantly during the period;
(b) significant changes with a favourable effect on the enterprise have taken place
during the period, or will take place in the near future, in the technological, market,
economic or legal environment in which the enterprise operates or in the market to
which the asset is dedicated;
(c) market interest rates or other market rates of return on investments have
decreased during the period, and those decreases are likely to affect the discount
rate used in calculating the asset’s value in use and increase the asset’s
recoverable amount materially
Internal sources of information
(d) significant changes with a favourable effect on the enterprise have taken place
during the period, or are expected to take place in the near future, in the extent to
which, or manner in which, the asset is used or is expected to be used. These
changes include capital expenditure that has been incurred during the period to
improve or enhance an asset in excess of its originally assessed standard of
performance or a commitment to discontinue or restructure the operation to which
the asset belongs; and
(e) evidence is available from internal reporting that indicates that the economic
performance of the asset is, or will be, better than expected.
96. Indications of a potential decrease in an impairment loss in paragraph 95 mainly mirror
the indications of a potential impairment loss in paragraph 8. The concept of materiality
applies in identifying whether an impairment loss recognised for an asset in prior accounting
periods may need to be reversed and the recoverable amount of the asset determined.
97. If there is an indication that an impairment loss recognised for an asset may no longer
exist or may have decreased, this may indicate that the remaining useful life, the depreciation
(amortisation) method or the residual value may need to be reviewed and adjusted in
accordance with the Accounting Standard applicable to the asset, even if no impairment loss
is reversed for the asset.
98. An impairment loss recognised for an asset in prior accounting periods should be
reversed if there has been a change in the estimates of cash inflows, cash outflows or
discount rates used to determine the asset’s recoverable amount since the last
impairment loss was recognised. If this is the case, the carrying amount of the asset
should be increased to its recoverable amount. That increase is a reversal of an

impairment loss.
99. A reversal of an impairment loss reflects an increase in the estimated service potential of
an asset, either from use or sale, since the date when an enterprise last recognised an
impairment loss for that asset. An enterprise is required to identify the change in estimates
that causes the increase in estimated service potential. Examples of changes in estimates
include:
(a) a change in the basis for recoverable amount (i.e., whether recoverable amount is based
on net selling price or value in use);
(b) if recoverable amount was based on value in use: a change in the amount or timing of
estimated future cash flows or in the discount rate; or
(c) if recoverable amount was based on net selling price: a change in estimate of the
components of net selling price.
100. An asset’s value in use may become greater than the asset’s carrying amount simply
because the present value of future cash inflows increases as they become closer. However,
the service potential of the asset has not increased. Therefore, an impairment loss is not
reversed just because of the passage of time (sometimes called the ‘unwinding’ of the
discount), even if the recoverable amount of the asset becomes higher than its carrying
amount.
Reversal of an Impairment Loss for an Individual Asset

101. The increased carrying amount of an asset due to a reversal of an impairment loss
should not exceed the carrying amount that would have been determined (net of
amortisation or depreciation) had no impairment loss been recognised for the asset in
prior accounting periods.
102. Any increase in the carrying amount of an asset above the carrying amount that would
have been determined (net of amortisation or depreciation) had no impairment loss been
recognised for the asset in prior accounting periods is a revaluation. In accounting for such a
revaluation, an enterprise applies the Accounting Standard applicable to the asset.
103. A reversal of an impairment loss for an asset should be recognised as income
immediately in the statement of profit and loss, unless the asset is carried at revalued
amount in accordance with another Accounting Standard (see Accounting Standard
(AS) 10, Accounting for Fixed Assets) in which case any reversal of an impairment loss
on a revalued asset should be treated as a revaluation increase under that Accounting
Standard.
104. A reversal of an impairment loss on a revalued asset is credited directly to equity under
the heading revaluation surplus. However, to the extent that an impairment loss on the same
revalued asset was previously recognised as an expense in the statement of profit and loss, a
reversal of that impairment loss is recognised as income in the statement of profit and loss.
105. After a reversal of an impairment loss is recognised, the depreciation
(amortisation) charge for the asset should be adjusted in future periods to allocate the
asset’s revised carrying amount, less its residual value (if any), on a systematic basis
over its remaining useful life.
Reversal of an Impairment Loss for a Cash-Generating Unit

106. A reversal of an impairment loss for a cash-generating unit should be allocated to
increase the carrying amount of the assets of the unit in the following order:
(a) first, assets other than goodwill on a pro-rata basis based on the carrying amount
of each asset in the unit; and
(b) then, to goodwill allocated to the cash-generating unit (if any), if the requirements
in paragraph 108 are met.
These increases in carrying amounts should be treated as reversals of impairment
losses for individual assets and recognised in accordance with paragraph 103.
107. In allocating a reversal of an impairment loss for a cash-generating unit under
paragraph 106, the carrying amount of an asset should not be increased above the
lower of:
(a) its recoverable amount (if determinable); and
(b) the carrying amount that would have been determined (net of amortisation or
depreciation) had no impairment loss been recognised for the asset in prior
accounting periods.
The amount of the reversal of the impairment loss that would otherwise have been
allocated to the asset should be allocated to the other assets of the unit on a pro-rata
basis.
Reversal of an Impairment Loss for Goodwill

108. As an exception to the requirement in paragraph 98, an impairment loss
recognised for goodwill should not be reversed in a subsequent period unless:
(a) the impairment loss was caused by a specific external event of an exceptional
nature that is not expected to recur; and
(b) subsequent external events have occurred that reverse the effect of that event.
109. Accounting Standard (AS) 26, Intangible Assets, prohibits the recognition of internally
generated goodwill. Any subsequent increase in the recoverable amount of goodwill is likely to
be an increase in internally generated goodwill, unless the increase relates clearly to the
reversal of the effect of a specific external event of an exceptional nature.
110. This Statement does not permit an impairment loss to be reversed for goodwill because
of a change in estimates (for example, a change in the discount rate or in the amount and
timing of future cash flows of the cash-generating unit to which goodwill relates).
111. A specific external event is an event that is outside of the control of the enterprise.
Examples of external events of an exceptional nature include new regulations that significantly
curtail the operating activities, or decrease the profitability, of the business to which the
goodwill relates.
Impairment in case of Discontinuing Operations

112. The approval and announcement of a plan for discontinuance4 is an indication that the
assets attributable to the discontinuing operation may be impaired or that an impairment loss
previously recognised for those assets should be increased or reversed. Therefore, in
accordance with this Statement, an enterprise estimates the recoverable amount of each
asset of the discontinuing operation and recognises an impairment loss or reversal of a prior
impairment loss, if any.
113. In applying this Statement to a discontinuing operation, an enterprise determines whether
the recoverable amount of an asset of a discontinuing operation is assessed for the individual
asset or for the asset’s cash-generating unit. For example:
(a) if the enterprise sells the discontinuing operation substantially in its entirety, none of the
assets of the discontinuing operation generate cash inflows independently from other
assets within the discontinuing operation. Therefore, recoverable amount is determined
for the discontinuing operation as a whole and an impairment loss, if any, is allocated
among the assets of the discontinuing operation in accordance with this Statement;
(b) if the enterprise disposes of the discontinuing operation in other ways such as piecemeal
sales, the recoverable amount is determined for individual assets, unless the assets are
sold in groups; and
(c) if the enterprise abandons the discontinuing operation, the recoverable amount is
determined for individual assets as set out in this Statement.
114. After announcement of a plan, negotiations with potential purchasers of the discontinuing
operation or actual binding sale agreements may indicate that the assets of the discontinuing
operation may be further impaired or that impairment losses recognised for these assets in
prior periods may have decreased. As a consequence, when such events occur, an enterprise
re-estimates the recoverable amount of the assets of the discontinuing operation and
recognises resulting impairment losses or reversals of impairment losses in accordance with
this Statement.
115. A price in a binding sale agreement is the best evidence of an asset’s (cash-generating
unit’s) net selling price or of the estimated cash inflow from ultimate disposal in determining
the asset’s (cash-generating unit’s) value in use.
116. The carrying amount (recoverable amount) of a discontinuing operation includes the
carrying amount (recoverable amount) of any goodwill that can be allocated on a reasonable
and consistent basis to that discontinuing operation.
Disclosure
117. For each class of assets, the financial statements should disclose:
(a) the amount of impairment losses recognised in the statement of profit and loss
during the period and the line item(s) of the statement of profit and loss in which
those impairment losses are included;
(b) the amount of reversals of impairment losses recognised in the statement of profit
and loss during the period and the line item(s) of the statement of profit and loss in
which those impairment losses are reversed;
(c) the amount of impairment losses recognised directly against revaluation surplus
during the period; and
(d) the amount of reversals of impairment losses recognised directly in revaluation
surplus during the period.
118. A class of assets is a grouping of assets of similar nature and use in an enterprise’s
operations.
119. The information required in paragraph 117 may be presented with other information
disclosed for the class of assets. For example, this information may be included in a
reconciliation of the carrying amount of fixed assets, at the beginning and end of the period,
as required under AS 10, Accounting for Fixed Assets.
120. An enterprise that applies AS 17, Segment Reporting, should disclose the following
for each reportable segment based on an enterprise’s primary format (as defined in AS
17):
(a) the amount of impairment losses recognised in the statement of profit and loss and
directly against revaluation surplus during the period; and
(b) the amount of reversals of impairment losses recognised in the statement of profit
and loss and directly in revaluation surplus during the period.
121. If an impairment loss for an individual asset or a cash-generating unit is
recognised or reversed during the period and is material to the financial statements of
the reporting enterprise as a whole, an enterprise should disclose:
(a) the events and circumstances that led to the recognition or reversal of the
impairment loss;
(b) the amount of the impairment loss recognised or reversed;
(c) for an individual asset:
(i) the nature of the asset; and
(ii) the reportable segment to which the asset belongs, based on the enterprise’s
primary format (as defined in AS 17, Segment Reporting);
(d) for a cash-generating unit:
(i) a description of the cash-generating unit (such as whether it is a product line,
a plant, a business operation, a geographical area, a reportable segment as
defined in AS 17 or other);
(ii) the amount of the impairment loss recognised or reversed by class of assets
and by reportable segment based on the enterprise’s primary format (as

defined in AS 17); and
(iii) if the aggregation of assets for identifying the cash-generating unit has
changed since the previous estimate of the cash-generating unit’s recoverable
amount (if any), the enterprise should describe the current and former way of
aggregating assets and the reasons for changing the way the cash-generating
unit is identified;
(e) whether the recoverable amount of the asset (cash-generating unit) is its net
selling price or its value in use;
(f) if recoverable amount is net selling price, the basis used to determine net selling
price (such as whether selling price was determined by reference to an active
market or in some other way); and
(g) if recoverable amount is value in use, the discount rate(s) used in the current
estimate and previous estimate (if any) of value in use.
122. If impairment losses recognised (reversed) during the period are material in
aggregate to the financial statements of the reporting enterprise as a whole, an
enterprise should disclose a brief description of the following:
(a) the main classes of assets affected by impairment losses (reversals of impairment
losses) for which no information is disclosed under paragraph 121; and
(b) the main events and circumstances that led to the recognition (reversal) of these
impairment losses for which no information is disclosed under paragraph 121.
123. An enterprise is encouraged to disclose key assumptions used to determine the
recoverable amount of assets (cash-generating units) during the period.
124. On the date of this Statement becoming mandatory, an enterprise should assess
whether there is any indication that an asset may be impaired (see paragraphs 5-13). If
any such indication exists, the enterprise should determine impairment loss, if any, in
accordance with this Statement. The impairment loss, so determined, should be
adjusted against opening balance of revenue reserves being the accumulated
impairment loss relating to periods prior to this Statement becoming mandatory unless
the impairment loss is on a revalued asset. An impairment loss on a revalued asset
should be recognised directly against any revaluation surplus for the asset to the extent
that the impairment loss does not exceed the amount held in the revaluation surplus for
that same asset. If the impairment loss exceeds the amount held in the revaluation
surplus for that same asset, the excess should be adjusted against opening balance of
revenue reserves.
125. Any impairment loss arising after the date of this Statement becoming mandatory
should be recognised in accordance with this Statement (i.e., in the statement of profit
and loss unless an asset is carried at revalued amount. An impairment loss on a
revalued asset should be treated as a revaluation decrease).
APPENDIX
Illustrative Examples
EXAMPLE 1– IDENTIFICATION OF CASH-GENERATING UNITS

A– Retail Store Chain
B– Plant for an Intermediate Step in a Production Process
C– Single Product Enterprise
D– Magazine Titles
E– Building: Half Rented to Others and Half Occupied for Own Use
EXAMPLE 2– CALCULATION OF VALUE IN USE AND RECOGNITION OF AN IMPAIRMENT

LOSS
EXAMPLE 3– DEFERRED TAX EFFECTS

EXAMPLE 4– REVERSAL OF AN IMPAIRMENT LOSS
EXAMPLE 5– TREATMENT OF A FUTURE RESTRUCTURING
EXAMPLE 6– TREATMENT OF FUTURE CAPITAL EXPENDITURE
EXAMPLE 7– APPLICATION OF THE ‘BOTTOM-UP’ AND ‘TOP-DOWN’
TESTS TO GOODWILL
A – Goodwill Can Be Allocated on a Reasonable and Consistent Basis
B – Goodwill Cannot Be Allocated on a Reasonable and Consistent Basis
EXAMPLE 8– ALLOCATION OF CORPORATE ASSETS
APPENDIX
Illustrative Examples
All the examples in this appendix assume the enterprises concerned have no transactions
other than those described.
Example 1 - Identification of Cash-Generating Units

The purpose of this example is:
(a) to give an indication of how cash-generating units are identified in various situations; and
(b) to highlight certain factors that an enterprise may consider in identifying the cash-
generating unit to which an asset belongs.
A - Retail Store Chain

Background
Al. Store X belongs to a retail store chain M. X makes all its retail purchases through M’s
purchasing centre. Pricing, marketing, advertising and human resources policies (except for
hiring X’s cashiers and salesmen) are decided by M. M also owns 5 other stores in the same
city as X (although in different neighbourhoods) and 20 other stores in other cities. All stores
are managed in the same way as X. X and 4 other stores were purchased 4 years ago and
goodwill was recognised.
What is the cash-generating unit for X (X’s cash-generating unit)?
Analysis
A2. In identifying X’s cash-generating unit, an enterprise considers whether, for example:
(a) internal management reporting is organised to measure performance on a store-by-store
basis; and
(b) the business is run on a store-by-store profit basis or on region/city basis.
A3. All M’s stores are in different neighbourhoods and probably have different customer
bases. So, although X is managed at a corporate level, X generates cash inflows that are
largely independent from those of M’s other stores. Therefore, it is likely that X is a cash-
generating unit.
A4. If the carrying amount of the goodwill can be allocated on a reasonable and consistent
basis to X’s cash-generating unit, M applies the ‘bottom-up’ test described in paragraph 78 of
this Statement. If the carrying amount of the goodwill cannot be allocated on a reasonable and
consistent basis to X’s cash-generating unit, M applies the ‘bottom-up’ and ‘top-down’ tests.
B - Plant for an Intermediate Step in a Production Process

Background
A5. A significant raw material used for plant Y’s final production is an intermediate product
bought from plant X of the same enterprise. X’s products are sold to Y at a transfer price that
passes all margins to X. 80% of Y’s final production is sold to customers outside of the
reporting enterprise. 60% of X’s final production is sold to Y and the remaining 40% is sold to
customers outside of the reporting enterprise.
For each of the following cases, what are the cash-generating units for X and Y?
Case 1:X could sell the products it sells to Y in an active market. Internal transfer prices are
higher than market prices.
Case 2:There is no active market for the products X sells to Y.
Analysis
Case 1
A6. X could sell its products on an active market and, so, generate cash inflows from
continuing use that would be largely independent of the cash inflows from Y. Therefore, it is
likely that X is a separate cash-generating unit, although part of its production is used by Y
(see paragraph 68 of this Statement).
A7. It is likely that Y is also a separate cash-generating unit. Y sells 80% of its products to
customers outside of the reporting enterprise. Therefore, its cash inflows from continuing use
can be considered to be largely independent.
A8. Internal transfer prices do not reflect market prices for X’s output. Therefore, in
determining value in use of both X and Y, the enterprise adjusts financial budgets/forecasts to
reflect management’s best estimate of future market prices for those of X’s products that are
used internally (see paragraph 68 of this Statement).
Case 2
A9. It is likely that the recoverable amount of each plant cannot be assessed independently
from the recoverable amount of the other plant because:
(a) the majority of X’s production is used internally and could not be sold in an active market.
So, cash inflows of X depend on demand for Y’s products. Therefore, X cannot be
considered to generate cash inflows that are largely independent from those of Y; and
(b) the two plants are managed together.
A10. As a consequence, it is likely that X and Y together is the smallest group of assets that
generates cash inflows from continuing use that are largely independent.
C - Single Product Enterprise

Background
A11. Enterprise M produces a single product and owns plants A, B and C. Each plant is
located in a different continent. A produces a component that is assembled in either B or C.
The combined capacity of B and C is not fully utilised. M’s products are sold world-wide from
either B or C. For example, B’s production can be sold in C’s continent if the products can be
delivered faster from B than from C. Utilisation levels of B and C depend on the allocation of
sales between the two sites.
For each of the following cases, what are the cash-generating units for A, B and C?
Case 1: There is an active market for A’s products.
Case 2: There is no active market for A’s products.
Analysis
Case 1
A12. It is likely that A is a separate cash-generating unit because there is an active market for
its products (see Example B-Plant for an Intermediate Step in a Production Process, Case 1).
A13. Although there is an active market for the products assembled by B and C, cash inflows
for B and C depend on the allocation of production across the two sites. It is unlikely that the
future cash inflows for B and C can be determined individually. Therefore, it is likely that B and
C together is the smallest identifiable group of assets that generates cash inflows from
continuing use that are largely independent.
A14. In determining the value in use of A and B plus C, M adjusts financial budgets/forecasts
to reflect its best estimate of future market prices for A’s products (see paragraph 68 of this
Statement).
Case 2
A15. It is likely that the recoverable amount of each plant cannot be assessed independently
because:
(a) there is no active market for A’s products. Therefore, A’s cash inflows depend on sales of
the final product by B and C; and
(b) although there is an active market for the products assembled by B and C, cash inflows
for B and C depend on the allocation of production across the two sites. It is unlikely that
the future cash inflows for B and C can be determined individually.
A16. As a consequence, it is likely that A, B and C together (i.e., M as a whole) is the smallest
identifiable group of assets that generates cash inflows from continuing use that are largely
independent.
D - Magazine Titles
Background
A17. A publisher owns 150 magazine titles of which 70 were purchased and 80 were self-
created. The price paid for a purchased magazine title is recognised as an intangible asset.
The costs of creating magazine titles and maintaining the existing titles are recognised as an
expense when incurred. Cash inflows from direct sales and advertising are identifiable for
each magazine title. Titles are managed by customer segments. The level of advertising
income for a magazine title depends on the range of titles in the customer segment to which
the magazine title relates. Management has a policy to abandon old titles before the end of
their economic lives and replace them immediately with new titles for the same customer
segment.
What is the cash-generating unit for an individual magazine title?
Analysis
A18. It is likely that the recoverable amount of an individual magazine title can be assessed.
Even though the level of advertising income for a title is influenced, to a certain extent, by the
other titles in the customer segment, cash inflows from direct sales and advertising are
identifiable for each title. In addition, although titles are managed by customer segments,
decisions to abandon titles are made on an individual title basis.
A19. Therefore, it is likely that individual magazine titles generate cash inflows that are largely
independent one from another and that each magazine title is a separate cash-generating unit.
E - Building: Half-Rented to Others and Half-Occupied for Own Use

Background
A20. M is a manufacturing company. It owns a headquarter building that used to be fully
occupied for internal use. After down-sizing, half of the building is now used internally and half
rented to third parties. The lease agreement with the tenant is for five years.
What is the cash-generating unit of the building?
Analysis
A21. The primary purpose of the building is to serve as a corporate asset, supporting M’s
manufacturing activities. Therefore, the building as a whole cannot be considered to generate
cash inflows that are largely independent of the cash inflows from the enterprise as a whole.
So, it is likely that the cash-generating unit for the building is M as a whole.
A22. The building is not held as an investment. Therefore, it would not be appropriate to
determine the value in use of the building based on projections of future market related rents.
Example-2 - Calculation of Value in Use and Recognition of an Impairment Loss

In this example, tax effects are ignored.
Background and Calculation of Value in Use
A23. At the end of 20X0, enterprise T acquires enterprise M for Rs. 10,000 lakhs. M has
manufacturing plants in 3 countries. The anticipated useful life of the resulting merged
activities is 15 years.
Schedule 1. Data at the end of 20X0 (Amount in Rs. lakhs)
End of 20X0 Allocation of Fair value of Goodwill(1)

purchase price identifiable assets
Activities in Country A 3,000 2,000 1,000

Activities in Country B 2,000 1,500 500
Activities in Country C 5,000 3,500 1,500
Total 10,000 7,000 3,000
(1.) Activities in each country are the smallest cash-generating units to which goodwill
can be allocated on a reasonable and consistent basis (allocation based on the purchase
price of the activities in each country, as specified in the purchase agreement).
A24. T uses straight-line depreciation over a 15-year life for the Country A assets and no
residual value is anticipated. In respect of goodwill, T uses straight-line amortisation over a 5
year life.
A25. In 20X4, a new government is elected in Country A. It passes legislation significantly
restricting exports of T’s main product. As a result, and for the foreseeable future, T’s
production will be cut by 40%.
A26. The significant export restriction and the resulting production decrease require T to
estimate the recoverable amount of the goodwill and net assets of the Country A operations.
The cash-generating unit for the goodwill and the identifiable assets of the Country A
operations is the Country A operations, since no independent cash inflows can be identified
for individual assets.
A27. The net selling price of the Country A cash-generating unit is not determinable, as it is
unlikely that a ready buyer exists for all the assets of that unit.
A28. To determine the value in use for the Country A cash-generating unit (see Schedule 2),
T:
(a) prepares cash flow forecasts derived from the most recent financial budgets/forecasts for
the next five years (years 20X5-20X9) approved by management;
(b) estimates subsequent cash flows (years 20X10-20X15) based on declining growth rates.
The growth rate for 20X10 is estimated to be 3%. This rate is lower than the average
long-term growth rate for the market in Country A; and
(c) selects a 15% discount rate, which represents a pre-tax rate that reflects current market
assessments of the time value of money and the risks specific to the Country A cash-
generating unit.
Recognition and Measurement of Impairment Loss
A29. The recoverable amount of the Country A cash-generating unit is 1,360 lakhs: the higher
of the net selling price of the Country A cash-generating unit (not determinable) and its value
in use (Rs. 1,360 lakhs).
A30. T compares the recoverable amount of the Country A cash-generating unit to its carrying
amount (see Schedule 3).
A31. T recognises an impairment loss of Rs. 307 lakhs immediately in the statement of profit
and loss. The carrying amount of the goodwill that relates to the Country A operations is
eliminated before reducing the carrying amount of other identifiable assets within the Country
A cash-generating unit (see paragraph 87 of this Statement).
A32. Tax effects are accounted for separately in accordance with AS 22, Accounting for Taxes
on Income.
Schedule 2. Calculation of the value in use of the Country A cash-generating unit at the end
of 20X4 (Amount in Rs. lakhs)
Year Long-term Future cash Present value factor at Discounted future
growth rates flows 15% discount rate(3) cash flows
20X5(n=1) 230(1) 0.86957 200

20X6 253(1) 0.75614 191
20X7 273(1) 0.65752 180
20X8 290(1) 0.57175 166
20X9 304(1) 0.49718 151
20X10 3% 313(2) 0.43233 135
20X11 –2% 307(2) 0.37594 115
20X12 –6% 289(2) 0.32690 94
20X13 –15% 245(2) 0.28426 70
20X14 –25% 184(2) 0.24719 45
20X15 –67% 61(2) 0.21494 13
Value in use 1,360
(1) Based on management’s best estimate of net cash flow projections (after the 40% cut).
(2) Based on an extrapolation from preceding year cash flow using declining growth rates.
(3) The present value factor is calculated as k = 1/(1+a)n, where a = discount rate and n
= period of discount.
Schedule 3. Calculation and allocation of the impairment loss for the Country A cash-
generating unit at the end of 20X (Amount in Rs. lakhs)
End of 20X4 Goodwill Identifiable assets Total
Historical cost 1,000 2,000 3,000

Accumulated depreciation/amortisation (20X1-20X4) (800) (533) (1,333)
Carrying amount 200 1, 467 1,667
Impairment Loss (200) (107) (307)
Carrying amount after impairment loss 0 1,360 1,360
EXAMPLE 3 - DEFERRED TAX EFFECTS

A33. An enterprise has an asset with a carrying amount of Rs. 1,000 lakhs. Its recoverable
amount is Rs. 650 lakhs. The tax rate is 30% and the carrying amount of the asset for tax
purposes is Rs. 800 lakhs. Impairment losses are not allowable as deduction for tax purposes.
The effect of the impairment loss is as follows:
Amount in
Rs. lakhs
Impairment Loss recognised in the statement of profit and loss 350

Impairment Loss allowed for tax purposes ----
Timing Difference 350
Tax Effect of the above timing difference at 30% (deferred tax asset) 105
Less: Deferred tax liability due to difference in depreciation for accounting
purposes and tax purposes [(1,000 – 800) x 30%] 60
Deferred tax asset 45
A34. In accordance with AS 22, Accounting for Taxes on Income, the enterprise recognises
the deferred tax asset subject to the consideration of prudence as set out in AS 22.
EXAMPLE 4 - REVERSAL OF AN IMPAIRMENT LOSS

Use the data for enterprise T as presented in Example 2, with supplementary information as
provided in this example. In this example, tax effects are ignored.
Background
A35. In 20X6, the government is still in office in Country A, but the business situation is
improving. The effects of the export laws on T’s production are proving to be less drastic than
initially expected by management. As a result, management estimates that production will
increase by 30%. This favourable change requires T to re-estimate the recoverable amount of
the net assets of the Country A operations (see paragraphs 94-95 of this Statement). The
cash-generating unit for the net assets of the Country A operations is still the Country A
operations.
A36. Calculations similar to those in Example 2 show that the recoverable amount of the
Country A cash-generating unit is now Rs. 1,710 lakhs.
Reversal of Impairment Loss
A37. T compares the recoverable amount and the net carrying amount of the Country A cash-
generating unit.
Schedule 1. Calculation of the carrying amount of the Country A cash-generating unit at the
end of 20X6 (Amount in Rs. lakhs)
Goodwill Identifiable Total
assets
End of 20X4 (Example 2)
Historical Cost 1,000 2,000 3,000
Accumulated depriciation/ Amortisation (4 years) (800) (533) (1,333)
Impairment loss (200) (107) (307)
Carrying amount after impairment loss 0 1,360 1,360
End of 20X6 – (247) (247)
Additional depreciation 0 1,113 1,113
2years) (1) 1,710
Carrying amount 597
Recoverable amount
Excess of recoverable amount over carrying amount
(1)After
recognition of the impairment loss at the end of 20X4, T revised the depreciation
charge for the Country A identifiable assets (from Rs. 133.3 lakhs per year to Rs. 123.7 lakhs
per year), based on the revised carrying amount and remaining useful life (11 years).
A38. There has been a favourable change in the estimates used to determine the recoverable
amount of the Country A net assets since the last impairment loss was recognised. Therefore,
in accordance with paragraph 98 of this Statement, T recognises a reversal of the impairment
loss recognised in 20X4.
A39. In accordance with paragraphs 106 and 107 of this Statement, T increases the carrying
amount of the Country A identifiable assets by Rs. 87 lakhs (see Schedule 3), i.e., up to the
lower of recoverable amount (Rs. 1,710 lakhs) and the identifiable assets’ depreciated
historical cost (Rs. 1,200 lakhs) (see Schedule 2). This increase is recognised in the
statement of profit and loss immediately.
Schedule 2. Determination of the depreciated historical cost of the Country A identifiable
assets at the end of 20X6 (Amount in Rs. lakhs)
End of 20X6 Identifiable
assets
Historical cost 2,000

Accumulated depreciation (133.3 * 6 years) (800)
Depreciated historical cost 1,200
Carrying amount (Schedule 1) 1,113
Difference 87
Schedule 3. Carrying amount of the Country A assets at the end of 20X6 (Amount in Rs.
lakhs)
End of 20X6 Goodwill Identifiable assets Total
Gross carrying amount 1,000 2,000 3,000

Accumulated depreciation/ amortisation (800) (780) (1,580)
Accumulated impairment loss (200) (107) (307)
Carrying amount 0 1,113 1,113
Reversal of impairment loss 0 87 87
Carrying amount after reversal of impairment loss 0 1,200 1,200
EXAMPLE 5 - TREATMENT OF A FUTURE RESTRUCTURING

Background
A40. At the end of 20X0, enterprise K tests a plant for impairment. The plant is a cash-
generating unit. The plant’s assets are carried at depreciated historical cost. The plant has a
carrying amount of Rs. 3,000 lakhs and a remaining useful life of 10 years.
A41. The plant is so specialised that it is not possible to determine its net selling price.
Therefore, the plant’s recoverable amount is its value in use. Value in use is calculated using
a pre-tax discount rate of 14%.
A42. Management approved budgets reflect that:
(a) at the end of 20X3, the plant will be restructured at an estimated cost of Rs. 100 lakhs.
Since K is not yet committed to the restructuring, a provision has not been recognised for
the future restructuring costs; and
(b) there will be future benefits from this restructuring in the form of reduced future cash
outflows.
A43. At the end of 20X2, K becomes committed to the restructuring. The costs are still
estimated to be Rs. 100 lakhs and a provision is recognised accordingly. The plant’s estimated
future cash flows reflected in the most recent management approved budgets are given in
paragraph A47 and a current discount rate is the same as at the end of 20X0.
A44. At the end of 20X3, restructuring costs of Rs. 100 lakhs are paid. Again, the plant’s
estimated future cash flows reflected in the most recent management approved budgets and a
current discount rate are the same as those estimated at the end of 20X2.
At the End of 20X0

Schedule 1. Calculation of the plant’s value in use at the end of 20X0 (Amount in Rs. lakhs)
Year Future cash flows Discounted at 14%
20X1 300 263
20X2 280 215
20X3 420(1) 283
20X4 520(2) 308
20X5 350(2) 182
20X6 420(2) 191
20X7 480(2) 192
20X8 480(2) 168
20X9 460(2) 141
20X10 400(2) 108
Value in use 2,051
(1) Excludes estimated restructuring costs reflected in management budgets.

(2) Excludes estimated benefits expected from the restructuring reflected in management
budgets.
A45. The plant’s recoverable amount (value in use) is less than its carrying amount.
Therefore, K recognises an impairment loss for the plant.
Schedule 2. Calculation of the impairment loss at the end of 20X0 (Amount in Rs. lakhs)
Plant
Carrying amount before impairment loss 3,000
Recoverable amount (Schedule 1) 2,051
Impairment loss (949)
Carrying amount after impairment loss 2,051
At the End of 20X1
A46. No event occurs that requires the plant’s recoverable amount to be re-estimated.
Therefore, no calculation of the recoverable amount is required to be performed.
At the End of 20X2

A47. The enterprise is now committed to the restructuring. Therefore, in determining the
plant’s value in use, the benefits expected from the restructuring are considered in forecasting
cash flows. This results in an increase in the estimated future cash flows used to determine
value in use at the end of 20X0. In accordance with paragraphs 94-95 of this Statement, the
recoverable amount of the plant is re-determined at the end of 20X2.
Schedule 3. Calculation of the plant’s value in use at the end of 20X2 (Amount in Rs. Lakhs)

20X3 420(1) 368
20X4 570(2) 439
20X5 380(2) 256
20X6 450(2) 266
20X7 510(2) 265
20X8 510(2) 232
20X9 480(2) 192
20X10 410(2) 144
Value in use 2162
(1) Excludes estimated restructuring costs because a liability has already been recognised.
(2) Includes estimated benefits expected from the restructuring reflected in management
budgets.
A48. The plant’s recoverable amount (value in use) is higher than its carrying amount (see
Schedule 4). Therefore, K reverses the impairment loss recognised for the plant at the end of
20X0.
Schedule 4. Calculation of the reversal of the impairment loss at the

end of 20X2 (Amount in Rs. lakhs) Plant
Carrying amount at the end of 20X0 (Schedule 2) 2,051
End of 20X2 (410)
Depreciation charge (for 20X1 and 20X2 Schedule 5) 1,641
Carrying amount before reversal 2,162
Recoverable amount (Schedule 3) 521
Reversal of the impairment loss 2,162
Carrying amount after reversal 2,400(1)
Carrying amount: depreciated historical cost (Schedule 5)
(1) The reversal does not result in the carrying amount of the plant exceeding what its
carrying amount would have been at depreciated historical cost. Therefore, the full
reversal of the impairment loss is recognised.
At the End of 20X3
A49. There is a cash outflow of Rs. 100 lakhs when the restructuring costs are paid. Even
though a cash outflow has taken place, there is no change in the estimated future cash flows
used to determine value in use at the end of 20X2. Therefore, the plant’s recoverable amount
is not calculated at the end of 20X3
Schedule 5. Summary of the carrying amount of the plant (Amount in Rs. lakhs)
End of year Depreciated Recoverable Adjusted Impairment Carrying amount
historical cost amount depreciation loss after impairment
charge
20X0 3,000 2,051 0 (949) 2,051

20X1 2,700 n.c. (205) 0 1,846
20X2 2,400 2,162 (205) 521 2,162
20X3 2,100 n.c. (270) 0 1,892
n.c. = not calculated as there is no indication that the impairment loss may have
increased/decreased.
EXAMPLE 6 - TREATMENT OF FUTURE CAPITAL EXPENDITURE

BACKGROUND
A50. At the end of 20X0, enterprise F tests a plane for impairment. The plane is a cash-
generating unit. It is carried at depreciated historical cost and its carrying amount is Rs. 1,500
lakhs. It has an estimated remaining useful life of 10 years.
A51. For the purpose of this example, it is assumed that the plane’s net selling price is not
determinable. Therefore, the plane’s recoverable amount is its value in use. Value in use is
calculated using a pre-tax discount rate of 14%.
A52. Management approved budgets reflect that:
(a) in 20X4, capital expenditure of Rs. 250 lakhs will be incurred to renew the engine of the
plane; and
(b) this capital expenditure will improve the performance of the plane by decreasing fuel
consumption.
A53. At the end of 20X4, renewal costs are incurred. The plane’s estimated future cash flows
reflected in the most recent management approved budgets are given in paragraph A56 and a
current discount rate is the same as at the end of 20X0.
At the End of 20X0

Schedule 1. Calculation of the plane’s value in use at the end of 20X0 (Amount in Rs. lakhs)

20X1 221.65 194.43
20X2 214.50 165.05
20X3 205.50 138.71
20X4 247.25(1) 146.39
20X5 253.25(2) 131.53
20X6 248.25(2) 113.10
20X7 241.23(2) 96.40
20X8 255.33(2) 89.51
20X9 242.34(2) 74.52
20X10 228.50(2) 61.64
Value in use 1,211.28
(1) Excludes estimated renewal costs reflected in management budgets.
(2) Excludes estimated benefits expected from the renewal of the engine reflected in
management budgets
A54. The plane’s carrying amount is less than its recoverable amount (value in use).
Therefore, F recognises an impairment loss for the plane.
Schedule 2. Calculation of the impairment loss at the end of 20X0 (Amount in Rs. lakhs)
Plane
Carrying amount before impairment loss
1,500.00
Recoverable amount (Schedule 1)
1,211.28
Impairment loss
(288.72)
Carrying amount after impairment loss
1,211.28
Years 20X1-20X3
A55. No event occurs that requires the plane’s recoverable amount to be re-estimated.
Therefore, no calculation of recoverable amount is required to be performed.
At the End of 20X4
A56. The capital expenditure is incurred. Therefore, in determining the plane’s value in use,
the future benefits expected from the renewal of the engine are considered in forecasting cash
flows. This results in an increase in the estimated future cash flows used to determine value in
use at the end of 20X0. As a consequence, in accordance with paragraphs 94-95 of this
Statement, the recoverable amount of the plane is recalculated at the end of 20X4.
Schedule 3. Calculation of the plane’s value in use at the end of 20X4 (Amount in Rs. lakhs)
Year Future cash flows(1) Discounted at 14%
20X5 303.21 265.97

20X6 327.50 252.00
20X7 317.21 214.11
20X8 319.50 189.17
20X9 331.00 171.91
20X10 279.99 127.56
Value in use 1,220.72
(1) Includes estimated benefits expected from the renewal of the engine reflected in
management budgets.
A57. The plane’s recoverable amount (value in use) is higher than the plane’s carrying amount
and depreciated historical cost (see Schedule 4). Therefore, K reverses the impairment loss
recognised for the plane at the end of 20X0 so that the plane is carried at depreciated
historical cost.
Schedule 4. Calculation of the reversal of the impairment loss at the end of 20X4 (Amount in
Rs. lakhs)
Plane
Carrying amount at the end of 20X0 (Schedule 2) 1,211.28
End of 20X4
Depreciation charge (20X1 to 20X4-Schedule 5) (484.52)
Renewal expenditure 250.00
Carrying amount before reversal 976.76
Recoverable amount (Schedule 3) 1,220.72
Reversal of the impairment loss 173.24
Carrying amount after reversal 1,150.00
Carrying amount: depreciated historical cost (Schedule 5) 1,150.00(1)
(1) The value in use of the plane exceeds what its carrying amount would have been at
depreciated historical cost. Therefore, the reversal is limited to an amount that does not
result in the carrying amount of the plane exceeding depreciated historical cost.
Schedule 5. Summary of the carrying amount of the plane (Amount in Rs. lakhs)
Year Depreciated Recoverable Adjusted Impairment Carrying
historical cost amount depreciation loss amount after
charge impairment
20X0 1,500.00 1,211.28 0 (288.72) 1,211.28

20X1 1,350.00 n.c. (121.13) 0 1,090.15
20X2 1,200.00 n.c. (121.13) 0 969.02
20X3 1,050.00 n.c. (121.13) 0 847.89
20X4 900.00 (121.13)
renewal 250.00 -----
1,150.00 1,220.72 (121.13) 173.24 1,150.00
20X5 958.33 n.c. (191.67) 0 958.33
EXAMPLE 7 - APPLICATION OF THE ‘BOTTOM-UP’ AND ‘TOP-DOWN’ TESTS TO

GOODWILL

A58. At the end of 20X0, enterprise M acquired 100% of enterprise Z for Rs. 3,000 lakhs. Z has 3
cash-generating units A, B and C with net fair values of Rs. 1,200 lakhs, Rs. 800 lakhs and Rs. 400
lakhs respectively. M recognises goodwill of Rs. 600 lakhs (Rs. 3,000 lakhs less Rs. 2,400 lakhs)
that relates to Z.
A59. At the end of 20X4, A makes significant losses. Its recoverable amount is estimated to be
Rs. 1,350 lakhs. Carrying amounts are detailed below.
Schedule 1. Carrying amounts at the end of 20X4 (Amount in Rs. lakhs)
End of 20X4 A B C Goodwill Total
Net carrying amount 1,300 1,200 800 120 3,420
A - Goodwill Can be Allocated on a Reasonable and Consistent Basis

A60. At the date of acquisition of Z, the net fair values of A, B and C are considered a
reasonable basis for a pro-rata allocation of the goodwill to A, B and C.
Schedule 2. Allocation of goodwill at the end of 20X4
A B C Total
End of 20X0
Net fair values 1,200 800 400 2,400
Pro-rata 50% 33% 17% 100%
End of 20X4
Net carrying amount 1,300 1,200 800 3,300
Allocation of goodwill (using the pro-rata above) 60 40 20 120
Net carrying amount (after allocation of goodwill) 1,360 1,240 820 3,420
A61. In accordance with the ‘bottom-up’ test in paragraph 78(a) of this Statement, M compares
A’s recoverable amount to its carrying amount after the allocation of the carrying amount of
goodwill.
Schedule 3. Application of ‘bottom-up’ test (Amount in Rs. lakhs)
End of 20X4 A
Carrying amount after allocation of goodwill (Schedule 2) 1,360
Recoverable amount 1,350
Impairment loss 10
A62. M recognises an impairment loss of Rs. 10 lakhs for A. The impairment loss is fully
allocated to the goodwill in accordance with paragraph 87 of this Statement.
B-Goodwill Cannot Be Allocated on a Reasonable and Consistent Basis

A63. There is no reasonable way to allocate the goodwill that arose on the acquisition of Z to
A, B and C. At the end of 20X4, Z’s recoverable amount is estimated to be Rs. 3,400 lakhs.
A64. At the end of 20X4, M first applies the ‘bottom-up’ test in accordance with paragraph
78(a) of this Statement. It compares A’s recoverable amount to its carrying amount excluding
the goodwill.
End of 20X4 A
Carrying amount 1,300
Impairment loss 0
A65. Therefore, no impairment loss is recognised for A as a result of the ‘bottom-up’ test.
A66. Since the goodwill could not be allocated on a reasonable and consistent basis to A, M
also performs a ‘top-down’ test in accordance with paragraph 78(b) of this Statement. It
compares the carrying amount of Z as a whole to its recoverable amount (Z as a whole is the
smallest cash-generating unit that includes A and to which goodwill can be allocated on a
reasonable and consistent basis).
Schedule 5. Application of the ‘top-down’ test (Amount in Rs. lakhs)
End of 20X4 A B C Goodwill Z
Carrying amount 1,300 1,200 800 120 3,420

Impairment loss arising from the ‘bottom-up’ test
Carrying amount after the ‘bottom-up’ test 0 – – – 0
1,300 1,200 800 120 3,420
Impairment loss arising from ‘top-down’ test 20
A67. Therefore, M recognises an impairment loss of Rs. 20 lakhs that it allocates fully to
goodwill in accordance with paragraph 87 of this Statement.
EXAMPLE 8 - ALLOCATION OF CORPORATE ASSETS

Background
A68. Enterprise M has three cash-generating units: A, B and C. There are adverse changes in
the technological environment in which M operates. Therefore, M conducts impairment tests of
each of its cash-generating units. At the end of 20X0, the carrying amounts of A, B and C are
Rs. 100 lakhs, Rs. 150 lakhs and Rs. 200 lakhs respectively.
A69. The operations are conducted from a headquarter. The carrying amount of the
headquarter assets is Rs. 200 lakhs: a headquarter building of Rs. 150 lakhs and a research
centre of Rs. 50 lakhs. The relative carrying amounts of the cash-generating units are a
reasonable indication of the proportion of the head-quarter building devoted to each cash-
generating unit. The carrying amount of the research centre cannot be allocated on a
reasonable basis to the individual cash-generating units.
A70. The remaining estimated useful life of cash-generating unit A is 10 years. The remaining
useful lives of B, C and the headquarter assets are 20 years. The headquarter assets are
depreciated on a straight-line basis.
A71. There is no basis on which to calculate a net selling price for each cash-generating unit.
Therefore, the recoverable amount of each cash-generating unit is based on its value in use.
Value in use is calculated using a pre-tax discount rate of 15%.

Identification of Corporate Assets
A72. In accordance with paragraph 85 of this Statement, M first identifies all the corporate
assets that relate to the individual cash-generating units under review. The corporate assets
are the headquarter building and the research centre.
A73. M then decides how to deal with each of the corporate assets:
(a) the carrying amount of the headquarter building can be allocated on a reasonable and
consistent basis to the cash-generating units under review. Therefore, only a ‘bottom-up’
test is necessary; and
(b) the carrying amount of the research centre cannot be allocated on a reasonable and
consistent basis to the individual cash-generating units under review. Therefore, a ‘top-
down’ test will be applied in addition to the ‘bottom-up’ test.
Allocation of Corporate Assets
A74. The carrying amount of the headquarter building is allocated to the carrying amount of
each individual cash-generating unit. A weighted allocation basis is used because the
estimated remaining useful life of A’s cash-generating unit is 10 years, whereas the estimated
remaining useful lives of B and C’s cash-generating units are 20 years.
Schedule 1. Calculation of a weighted allocation of the carrying amount of the headquarter
building (Amount in Rs. lakhs)
End of 20X0 A B C Total
Carrying amount 100 150 200 450

Useful life 10 years 20 years 20 years
Weighting based on useful life 1 2 2
Carrying amount after weighting 100 300 400 800
Pro-rata allocation of the building 12.5% 37.5% 50% 100%
(100/800) (300/800) (400/800)
Allocation of the carrying amount of the building
(based on pro-rata above)
19 56 75 150
Carrying amount (after allocation of the building)
119 206 275 600
Determination of Recoverable Amount

A75. The ‘bottom-up’ test requires calculation of the recoverable amount of each individual
cash-generating unit. The ‘top-down’ test requires calculation of the recoverable amount of M
as a whole (the smallest cash-generating unit that includes the research centre).
Schedule 2. Calculation of A, B, C and M’s value in use at the end of 20X0 (Amount in Rs.
lakhs)
A B C M
Year Future Discount Future Discount Future Discount Future Discount

cash cash cash cash
at 15% at 15% at 15% at 15%
flows flows flows flows
1 18 16 9 8 10 9 39 34
2 31 23 16 12 20 15 72 54
3 37 24 24 16 34 22 105 69
4 42 24 29 17 44 25 128 73
5 47 24 32 16 51 25 143 71
6 52 22 33 14 56 24 155 67
7 55 21 34 13 60 22 162 61
8 55 18 35 11 63 21 166 54
9 53 15 35 10 65 18 167 48
10 48 12 35 9 66 16 169 42
11 36 8 66 14 132 28
12 35 7 66 12 131 25
13 35 6 66 11 131 21
14 33 5 65 9 128 18
15 30 4 62 8 122 15
16 26 3 60 6 115 12
17 22 2 57 5 108 10
18 18 1 51 4 97 8
19 14 1 43 3 85 6
20 10 1 35 2 71 4
Value in use 199 164 271 720(1)

(1) It is assumed that the research centre generates additional future cash flows for the
enterprise as a whole. Therefore, the sum of the value in use of each individual cash-
generating unit is less than the value in use of the business as a whole. The additional cash
flows are not attributable to the headquarter building.
Calculation of Impairment Losses
A76. In accordance with the ‘bottom-up’ test, M compares the carrying amount of each cash-
generating unit (after allocation of the carrying amount of the building) to its recoverable
amount.
End of 20X0 A B C
Carrying amount (after allocation of the building) (Schedule 1) 119 206 275
Recoverable amount (Schedule 2) 199 164 271
Impairment loss 0 (42) (4)
A77. The next step is to allocate the impairment losses between the assets of the cash-
generating units and the headquarter building.
Schedule 4. Allocation of the impairment losses for cash-generating units B and C (Amount in
Rs. lakhs)
Cash-generating unit B C
To headquarter building (12) (42×56/206) (1) (4×75/275)
o assets in cash-generating unit (30) (42×150/206) (3) (4×200/275)

(42) (4)
A78. In accordance with the ‘top-down’ test, since the research centre could not be allocated
on a reasonable and consistent basis to A, B and C’s cash-generating units, M compares the
carrying amount of the smallest cash-generating unit to which the carrying amount of the
research centre can be allocated (i.e., M as a whole) to its recoverable amount.
Schedule 5. Application of the ‘top-down’ test (Amount in Rs. lakhs)
End of 20X0 A B C Building Research M

centre
Carrying amount 100 150 200 150 50 650

Impairment loss arising from the ‘bottom up’ – (30) (3) (13) – (46)
test
100 120 197 137 50 604
Carrying amount after the ‘bottom-up’ test
720
Recoverable amount (Schedule 2)
0
Impairment loss arising from ‘top-down’ test
A79. Therefore, no additional impairment loss results from the application of the ‘top-down’
test. Only an impairment loss of Rs. 46 lakhs is recognised as a result of the application of the
‘bottom-up’ test.
AS – 29 : PROVISIONS, CONTINGENT LIABILITIES

AND CONTINGENT ASSETS
Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and Contingent Assets’,
issued by the Council of the Institute of Chartered Accountants of India, comes into effect in
respect of accounting periods commencing on or after 1-4-2004. This Standard is mandatory
in nature from that date:
(a) in its entirety, for the enterprises which fall in any one or more of the following categories,
at any time during the accounting period:
(i) Enterprises whose equity or debt securities are listed whether in India or outside
India.
statements exceeds Rs. 50 crore. Turnover does not include ‘other income’.
including public deposits, in excess of Rs. 10 crore at any time during the
accounting period.
accounting period.
(b) in its entirety, except paragraph 67, for the enterprises which do not fall in any of the
categories in (a) above but fall in any one or more of the following categories:
(i) All commercial, industrial and business reporting enterprises, whose turnover for the
statements exceeds Rs. 40 lakhs but does not exceed Rs. 50 crore. Turnover does
not include ‘other income’.
(ii) All commercial, industrial and business reporting enterprises having borrowings,
including public deposits, in excess of Rs. 1 crore but not in excess of Rs. 10 crore
at any time during the accounting period.
(iii) Holding and subsidiary enterprises of any one of the above at any time during the
accounting period.
(c) in its entirety, except paragraphs 66 and 67, for the enterprises, which do not fall in any
of the categories in (a) and (b) above.
Where an enterprise has been covered in any one or more of the categories in (a) above and
paragraph 67 of this Standard, until the enterprise ceases to be covered in any of the
categories in (a) above for two consecutive years.
Where an enterprise has been covered in any one or more of the categories in (a) or (b) above
and subsequently, ceases to be covered in any of the categories in (a) and (b) above, the
enterprise will not qualify for exemption from paragraphs 66 and 67 of this Standard, until the
enterprise ceases to be covered in any of the categories in (a) and (b) above for two
consecutive years.
Where an enterprise has previously qualified for exemption from paragraph 67 or paragraphs
66 and 67, as the case may be, but no longer qualifies for exemption from paragraph 67 or
paragraphs 66 and 67, as the case may be, in the current accounting period, this Standard
becomes applicable, in its entirety or, in its entirety except paragraph 67, as the case may be,
from the current period. However, the relevant corresponding previous period figures need not
be disclosed.
An enterprise, which, pursuant to the above provisions, does not disclose the information
required by paragraph 67 or paragraphs 66 and 67, as the case may be, should disclose the
fact.
From the date of this Accounting Standard becoming mandatory (in its entirety or with the
exception of paragraph 67 or paragraphs 66 and 67, as the case may be), all paragraphs of
Accounting Standard (AS) 4, Contingencies and Events Occurring After the Balance Sheet
Date, that deal with contingencies (viz., paragraphs 1 (a), 2, 3.1, 4 (4.1 to 4.4), 5 (5.1 to 5.6),
6, 7 (7.1 to 7.3), 9.1 (relevant portion), 9.2, 10, 11, 12 and 16), stand withdrawn.∗
Objective
The objective of this Statement is to ensure that appropriate recognition criteria and
measurement bases are applied to provisions and contingent liabilities and that sufficient
information is disclosed in the notes to the financial statements to enable users to understand
their nature, timing and amount. The objective of this Statement is also to lay down
appropriate accounting for contingent assets.
Scope
1. This Statement should be applied in accounting for provisions and contingent
liabilities and in dealing with contingent assets, except:
(a) those resulting from financial instruments∗∗ that are carried at fair value;
(b) those resulting from executory contracts;
(c) those arising in insurance enterprises from contracts with policy-holders; and
(d) those covered by another Accounting Standard.
2. This Statement applies to financial instruments (including guarantees) that are not
carried at fair value.
3. Executory contracts are contracts under which neither party has performed any of its
obligations or both parties have partially performed their obligations to an equal extent.
4. This Statement applies to provisions, contingent liabilities and contingent assets of
insurance enterprises other than those arising from contracts with policy-holders.
5. Where another Accounting Standard deals with a specific type of provision, contingent
liability or contingent asset, an enterprise applies that Statement instead of this
Statement. For example, certain types of provisions are also addressed in Accounting
Standards on:
(a) construction contracts (see AS 7, Construction Contracts);
(b) taxes on income (see AS 22, Accounting for Taxes on Income);
(c) leases (see AS 19, Leases); and
(d) retirement benefits (see AS 15, Accounting for Retirement Benefits in the Financial
Statements of Employers).
∗
It is clarified that paragraphs of AS 4 that deal with contingencies would remain operational to
the extent they deal with impairment of assets not covered by other Indian Accounting Standard.
∗∗
For the purpose of this Statement, the term ‘financial instruments’ shall have the same meaning
as in Accounting Standard (AS) 20, Earnings Per Share.
6. Some amounts treated as provisions may relate to the recognition of revenue, for
example where an enterprise gives guarantees in exchange for a fee. This Statement
does not address the recognition of revenue. AS 9, Revenue Recognition, identifies the
circumstances in which revenue is recognised and provides practical guidance on the
application of the recognition criteria. This Statement does not change the requirements
of AS 9.
7. This Statement defines provisions as liabilities which can be measured only by using a
substantial degree of estimation. The term 'provision' is also used in the context of items
such as depreciation, impairment of assets and doubtful debts: these are adjustments to
the carrying amounts of assets and are not addressed in this Statement.
8. Other Accounting Standards specify whether expenditures are treated as assets or as
expenses. These issues are not addressed in this Statement. Accordingly, this
Statement neither prohibits nor requires capitalisation of the costs recognised when a
provision is made.
9. This Statement applies to provisions for restructuring (including discontinuing
operations). Where a restructuring meets the definition of a discontinuing operation,
additional disclosures are required by AS 24, Discontinuing Operations.
Definitions
A provision is a liability which can be measured only by using a substantial degree
of estimation.
A liability is a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of
resources embodying economic benefits.
An obligating event is an event that creates an obligation that results in an
enterprise having no realistic alternative to settling that obligation.
A contingent liability is:
(a) a possible obligation that arises from past events and the existence of which
will be confirmed only by the occurrence or non-occurrence of one or more
uncertain future events not wholly within the control of the enterprise; or
(b) a present obligation that arises from past events but is not recognised
because:
(i) it is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation; or
(ii) a reliable estimate of the amount of the obligation cannot be made.
A contingent asset is a possible asset that arises from past events the
existence of which will be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events not wholly within the
control of the enterprise.

Present obligation - an obligation is a present obligation if, based on the
evidence available, its existence at the balance sheet date is considered
probable, i.e., more likely than not.
Possible obligation - an obligation is a possible obligation if, based on the
evidence available, its existence at the balance sheet date is considered not
probable.
A restructuring is a programme that is planned and controlled by
management, and materially changes either:
(a) the scope of a business undertaken by an enterprise; or
(b) the manner in which that business is conducted.
11. An obligation is a duty or responsibility to act or perform in a certain way. Obligations
may be legally enforceable as a consequence of a binding contract or statutory
requirement. Obligations also arise from normal business practice, custom and a desire
to maintain good business relations or act in an equitable manner.
12. Provisions can be distinguished from other liabilities such as trade payables and accruals
because in the measurement of provisions substantial degree of estimation is involved
with regard to the future expenditure required in settlement. By contrast:
(a) trade payables are liabilities to pay for goods or services that have been received or
supplied and have been invoiced or formally agreed with the supplier; and
(b) accruals are liabilities to pay for goods or services that have been received or
supplied but have not been paid, invoiced or formally agreed with the supplier,
including amounts due to employees. Although it is sometimes necessary to
estimate the amount of accruals, the degree of estimation is generally much less
than that for provisions.
13. In this Statement, the term 'contingent' is used for liabilities and assets that are not
recognised because their existence will be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events not wholly within the control of the
enterprise. In addition, the term 'contingent liability' is used for liabilities that do not meet
the recognition criteria.
RECOGNITION
Provisions
14. A provision should be recognised when:
(a) an enterprise has a present obligation as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will
be required to settle the obligation; and
If these conditions are not met, no provision should be recognised.
PRESENT OBLIGATION
15. In almost all cases it will be clear whether a past event has given rise to a present
obligation. In rare cases, for example in a lawsuit, it may be disputed either whether
certain events have occurred or whether those events result in a present obligation. In
such a case, an enterprise determines whether a present obligation exists at the balance
sheet date by taking account of all available evidence, including, for example, the opinion
of experts. The evidence considered includes any additional evidence provided by events
after the balance sheet date. On the basis of such evidence:
(a) where it is more likely than not that a present obligation exists at the balance sheet
date, the enterprise recognises a provision (if the recognition criteria are met); and
(b) where it is more likely that no present obligation exists at the balance sheet date,
the enterprise discloses a contingent liability, unless the possibility of an outflow of
resources embodying economic benefits is remote (see paragraph 68).
Past Event
16. A past event that leads to a present obligation is called an obligating event. For an event
to be an obligating event, it is necessary that the enterprise has no realistic alternative to
settling the obligation created by the event.
17. Financial statements deal with the financial position of an enterprise at the end of its
reporting period and not its possible position in the future. Therefore, no provision is
recognised for costs that need to be incurred to operate in the future. The only liabilities
recognised in an enterprise's balance sheet are those that exist at the balance sheet
date.
18. It is only those obligations arising from past events existing independently of an
enterprise's future actions (i.e. the future conduct of its business) that are recognised as
provisions. Examples of such obligations are penalties or clean-up costs for unlawful
environmental damage, both of which would lead to an outflow of resources embodying
economic benefits in settlement regardless of the future actions of the enterprise.
Similarly, an enterprise recognises a provision for the decommissioning costs of an oil
installation to the extent that the enterprise is obliged to rectify damage already caused.
In contrast, because of commercial pressures or legal requirements, an enterprise may
intend or need to carry out expenditure to operate in a particular way in the future (for
example, by fitting smoke filters in a certain type of factory). Because the enterprise can
avoid the future expenditure by its future actions, for example by changing its method of
operation, it has no present obligation for that future expenditure and no provision is
recognised.
19. An obligation always involves another party to whom the obligation is owed. It is not
necessary, however, to know the identity of the party to whom the obligation is owed --
indeed the obligation may be to the public at large.
20. An event that does not give rise to an obligation immediately may do so at a later date,
because of changes in the law. For example, when environmental damage is caused
there may be no obligation to remedy the consequences. However, the causing of the
damage will become an obligating event when a new law requires the existing damage to
be rectified.
21. Where details of a proposed new law have yet to be finalised, an obligation arises only
when the legislation is virtually certain to be enacted. Differences in circumstances
surrounding enactment usually make it impossible to specify a single event that would
make the enactment of a law virtually certain. In many cases it will be impossible to be
virtually certain of the enactment of a law until it is enacted.
Probable Outflow of Resources Embodying Economic Benefits
22. For a liability to qualify for recognition there must be not only a present obligation but
also the probability of an outflow of resources embodying economic benefits to settle that
obligation. For the purpose of this Statement∗, an outflow of resources or other event is
regarded as probable if the event is more likely than not to occur, i.e., the probability that
the event will occur is greater than the probability that it will not. Where it is not probable
that a present obligation exists, an enterprise discloses a contingent liability, unless the
possibility of an outflow of resources embodying economic benefits is remote (see
paragraph 68).
23. Where there are a number of similar obligations (e.g. product warranties or similar
contracts) the probability that an outflow will be required in settlement is determined by
considering the class of obligations as a whole. Although the likelihood of outflow for any
one item may be small, it may well be probable that some outflow of resources will be
needed to settle the class of obligations as a whole. If that is the case, a provision is
recognised (if the other recognition criteria are met).
RELIABLE ESTIMATE OF THE OBLIGATION

24. The use of estimates is an essential part of the preparation of financial statements and
does not undermine their reliability. This is especially true in the case of provisions,
which by their nature involve a greater degree of estimation than most other items.
Except in extremely rare cases, an enterprise will be able to determine a range of
possible outcomes and can therefore make an estimate of the obligation that is reliable to
use in recognising a provision.
25. In the extremely rare case where no reliable estimate can be made, a liability exists that
cannot be recognised. That liability is disclosed as a contingent liability (see paragraph
68).
∗
The interpretation of ‘probable’ in this Statement as ‘more likely than not’ does not necessarily
apply in other Accounting Standards.
CONTINGENT LIABILITIES
26. An enterprise should not recognise a contingent liability.
27. A contingent liability is disclosed, as required by paragraph 68, unless the possibility of
an outflow of resources embodying economic benefits is remote.
28. Where an enterprise is jointly and severally liable for an obligation, the part of the
obligation that is expected to be met by other parties is treated as a contingent liability.
The enterprise recognises a provision for the part of the obligation for which an outflow of
resources embodying economic benefits is probable, except in the extremely rare
circumstances where no reliable estimate can be made (see paragraph 14).
29. Contingent liabilities may develop in a way not initially expected. Therefore, they are
assessed continually to determine whether an outflow of resources embodying economic
benefits has become probable. If it becomes probable that an outflow of future economic
benefits will be required for an item previously dealt with as a contingent liability, a
provision is recognised in accordance with paragraph 14 in the financial statements of
the period in which the change in probability occurs (except in the extremely rare
circumstances where no reliable estimate can be made).
CONTINGENT ASSETS
30. An enterprise should not recognise a contingent asset.
31. Contingent assets usually arise from unplanned or other unexpected events that give rise
to the possibility of an inflow of economic benefits to the enterprise. An example is a
claim that an enterprise is pursuing through legal processes, where the outcome is
uncertain.
32. Contingent assets are not recognised in financial statements since this may result in the
recognition of income that may never be realised. However, when the realisation of
income is virtually certain, then the related asset is not a contingent asset and its
recognition is appropriate.
33. A contingent asset is not disclosed in the financial statements. It is usually disclosed in
the report of the approving authority (Board of Directors in the case of a company, and,
the corresponding approving authority in the case of any other enterprise), where an
inflow of economic benefits is probable.
34. Contingent assets are assessed continually and if it has become virtually certain that an
inflow of economic benefits will arise, the asset and the related income are recognised in
the financial statements of the period in which the change occurs.
MEASUREMENT
Best Estimate
35. The amount recognised as a provision should be the best estimate of the expenditure
required to settle the present obligation at the balance sheet date. The amount of a
provision should not be discounted to its present value.
36. The estimates of outcome and financial effect are determined by the judgment of the
management of the enterprise, supplemented by experience of similar transactions and,
in some cases, reports from independent experts. The evidence considered includes any
additional evidence provided by events after the balance sheet date.
37. The provision is measured before tax; the tax consequences of the provision, and
changes in it, are dealt with under AS 22, Accounting for Taxes on Income.
RISKS AND UNCERTAINTIES

38. The risks and uncertainties that inevitably surround many events and circumstances
should be taken into account in reaching the best estimate of a provision.
39. Risk describes variability of outcome. A risk adjustment may increase the amount at
which a liability is measured. Caution is needed in making judgments under conditions of
uncertainty, so that income or assets are not overstated and expenses or liabilities are
not understated. However, uncertainty does not justify the creation of excessive
provisions or a deliberate overstatement of liabilities. For example, if the projected costs
of a particularly adverse outcome are estimated on a prudent basis, that outcome is not
then deliberately treated as more probable than is realistically the case. Care is needed
to avoid duplicating adjustments for risk and uncertainty with consequent overstatement
of a provision.
40. Disclosure of the uncertainties surrounding the amount of the expenditure is made under
paragraph 67(b).
FUTURE EVENTS
41. Future events that may affect the amount required to settle an obligation should be
reflected in the amount of a provision where there is sufficient objective evidence that
they will occur.
42. Expected future events may be particularly important in measuring provisions. For
example, an enterprise may believe that the cost of cleaning up a site at the end of its life
will be reduced by future changes in technology. The amount recognised reflects a
reasonable expectation of technically qualified, objective observers, taking account of all
available evidence as to the technology that will be available at the time of the clean-up.
Thus, it is appropriate to include, for example, expected cost reductions associated with
increased experience in applying existing technology or the expected cost of applying
existing technology to a larger or more complex clean-up operation than has previously
been carried out. However, an enterprise does not anticipate the development of a
completely new technology for cleaning up unless it is supported by sufficient objective
evidence.
43. The effect of possible new legislation is taken into consideration in measuring an existing
obligation when sufficient objective evidence exists that the legislation is virtually certain
to be enacted. The variety of circumstances that arise in practice usually makes it

impossible to specify a single event that will provide sufficient, objective evidence in
every case. Evidence is required both of what legislation will demand and of whether it is
virtually certain to be enacted and implemented in due course. In many cases sufficient
objective evidence will not exist until the new legislation is enacted.
EXPECTED DISPOSAL OF ASSETS

44. Gains from the expected disposal of assets should not be taken into account in
measuring a provision.
45. Gains on the expected disposal of assets are not taken into account in measuring a
provision, even if the expected disposal is closely linked to the event giving rise to the
provision. Instead, an enterprise recognises gains on expected disposals of assets at the
time specified by the Accounting Standard dealing with the assets concerned.
REIMBURSEMENTS
46. Where some or all of the expenditure required to settle a provision is expected to be
reimbursed by another party, the reimbursement should be recognised when, and only
when, it is virtually certain that reimbursement will be received if the enterprise settles
the obligation. The reimbursement should be treated as a separate asset. The amount
recognised for the reimbursement should not exceed the amount of the provision.
47. In the statement of profit and loss, the expense relating to a provision may be presented
net of the amount recognised for a reimbursement.
48. Sometimes, an enterprise is able to look to another party to pay part or all of the
expenditure required to settle a provision (for example, through insurance contracts,
indemnity clauses or suppliers' warranties). The other party may either reimburse
amounts paid by the enterprise or pay the amounts directly.
49. In most cases, the enterprise will remain liable for the whole of the amount in question so
that the enterprise would have to settle the full amount if the third party failed to pay for
any reason. In this situation, a provision is recognised for the full amount of the liability,
and a separate asset for the expected reimbursement is recognised when it is virtually
certain that reimbursement will be received if the enterprise settles the liability.
50. In some cases, the enterprise will not be liable for the costs in question if the third party
fails to pay. In such a case, the enterprise has no liability for those costs and they are not
included in the provision.
51. As noted in paragraph 28, an obligation for which an enterprise is jointly and severally
liable is a contingent liability to the extent that it is expected that the obligation will be
settled by the other parties.
Changes in Provisions
52. Provisions should be reviewed at each balance sheet date and adjusted to reflect
the current best estimate. If it is no longer probable that an outflow of resources
embodying economic benefits will be required to settle the obligation, the
provision should be reversed.
Use of Provisions
53. A provision should be used only for expenditures for which the provision was originally
recognised.
54. Only expenditures that relate to the original provision are adjusted against it. Adjusting
expenditures against a provision that was originally recognised for another purpose
would conceal the impact of two different events.
APPLICATION OF THE RECOGNITION AND MEASUREMENT RULES
Future Operating Losses

55. Provisions should not be recognised for future operating losses.
56. Future operating losses do not meet the definition of a liability in paragraph 10 and the
general recognition criteria set out for provisions in paragraph 14.
57. An expectation of future operating losses is an indication that certain assets of the
operation may be impaired. An enterprise tests these assets for impairment under
Accounting Standard (AS) 28, Impairment of Assets.
Restructuring
58. The following are examples of events that may fall under the definition of restructuring:
(a) sale or termination of a line of business;
(b) the closure of business locations in a country or region or the relocation of business
activities from one country or region to another;
(c) changes in management structure, for example, eliminating a layer of management;
and
(d) fundamental re-organisations that have a material effect on the nature and focus of
the enterprise's operations.
59. A provision for restructuring costs is recognised only when the recognition criteria for
provisions set out in paragraph 14 are met.
60. No obligation arises for the sale of an operation until the enterprise is committed to the
sale, i.e., there is a binding sale agreement.
61. An enterprise cannot be committed to the sale until a purchaser has been identified and
there is a binding sale agreement. Until there is a binding sale agreement, the enterprise
will be able to change its mind and indeed will have to take another course of action if a
purchaser cannot be found on acceptable terms. When the sale of an operation is
envisaged as part of a restructuring, the assets of the operation are reviewed for
impairment under Accounting Standard (AS) 28, Impairment of Assets.
62. A restructuring provision should include only the direct expenditures arising from
the restructuring, which are those that are both:
(a) necessarily entailed by the restructuring; and
(b) not associated with the ongoing activities of the enterprise.
63. A restructuring provision does not include such costs as:
(a) retraining or relocating continuing staff;
(b) marketing; or
(c) investment in new systems and distribution networks.
These expenditures relate to the future conduct of the business and are not liabilities for
restructuring at the balance sheet date. Such expenditures are recognised on the same
basis as if they arose independently of a restructuring.
64. Identifiable future operating losses up to the date of a restructuring are not included in a
provision.
65. As required by paragraph 44, gains on the expected disposal of assets are not taken into
account in measuring a restructuring provision, even if the sale of assets is envisaged as
part of the restructuring.
DISCLOSURE
66. For each class of provision, an enterprise should disclose:
(a) the carrying amount at the beginning and end of the period;
(b) additional provisions made in the period, including increases to existing
provisions;
(c) amounts used (i.e. incurred and charged against the provision) during the
period; and
(d) unused amounts reversed during the period.
67. An enterprise should disclose the following for each class of provision:
(a) a brief description of the nature of the obligation and the expected timing of
any resulting outflows of economic benefits;
(b) an indication of the uncertainties about those outflows. Where necessary to
provide adequate information, an enterprise should disclose the major
assumptions made concerning future events, as addressed in paragraph 41;
and
(c) the amount of any expected reimbursement, stating the amount of any asset
that has been recognised for that expected reimbursement.
68. Unless the possibility of any outflow in settlement is remote, an enterprise should
disclose for each class of contingent liability at the balance sheet date a brief
description of the nature of the contingent liability and, where practicable:
(a) an estimate of its financial effect, measured under paragraphs 35-45;
(b) an indication of the uncertainties relating to any outflow; and
(c) the possibility of any reimbursement.
69. In determining which provisions or contingent liabilities may be aggregated to form a
class, it is necessary to consider whether the nature of the items is sufficiently similar for
a single statement about them to fulfill the requirements of paragraphs 67 (a) and (b) and
68 (a) and (b). Thus, it may be appropriate to treat as a single class of provision amounts
relating to warranties of different products, but it would not be appropriate to treat as a
single class amounts relating to normal warranties and amounts that are subject to legal
proceedings.
70. Where a provision and a contingent liability arise from the same set of circumstances, an
enterprise makes the disclosures required by paragraphs 66-68 in a way that shows the
link between the provision and the contingent liability.
71. Where any of the information required by paragraph 68 is not disclosed because it is not
practicable to do so, that fact should be stated.
72. In extremely rare cases, disclosure of some or all of the information required by
paragraphs 66-70 can be expected to prejudice seriously the position of the
enterprise in a dispute with other parties on the subject matter of the provision or
contingent liability. In such cases, an enterprise need not disclose the information,
but should disclose the general nature of the dispute, together with the fact that,
and reason why, the information has not been disclosed.
APPENDIX A
Tables - Provisions, Contingent Liabilities and Reimbursements

The purpose of this appendix is to summarise the main requirements of the Accounting
Standard. It does not form part of the Accounting Standard and should be read in the context
of the full text of the Accounting Standard.
PROVISIONS AND CONTINGENT LIABILITIES

Where, as a result of past events, there may be an outflow of resources embodying future
economic benefits in settlement of: (a) a present obligation the one whose existence at the
balance sheet date is considered probable; or (b) a possible obligation the existence of
which at the balance sheet date is considered not probable.
There is a present obligation There is a possible There is a possible

that probably requires an obligation or a present obligation or a present
outflow of resources and a obligation that may, but obligation where the
reliable estimate can be made probably will not, require an likelihood of an outflow of
of the amount of obligation. outflow of resources. resources is remote.
A provision is recognised No provision is recognised No provision is recognised
(paragraph 14). (paragraph 26). (paragraph 26).
Disclosures are required for the Disclosures are required for No disclosure is required
provision (paragraphs 66 and the contingent liability (paragraph 68).
67) (paragraph 68).
Reimbursements
Some or all of the expenditure required to settle a provision is expected to be reimbursed
by another party.
The enterprise has no The obligation for the The obligation for the
obligation for the part of the amount expected to be amount expected to be
expenditure to be reimbursed remains with the reimbursed remains with the
reimbursed by the other enterprise and it is virtually enterprise and the
party. certain that reimbursement reimbursement is not
will be received if the virtually certain if the
enterprise settles the enterprise settles the
provision. provision.
The enterprise has no The reimbursement is The expected reimbursement
liability for the amount to be recognised as a separate asset is not recognised as an asset
reimbursed (paragraph 50). in the balance sheet and may (paragraph 46).
be offset against the expense
in the statement of profit and
loss. The amount recognised
for the expected
reimbursement does not
exceed the liability
(paragraphs 46 and 47).
The reimbursement is
No disclosure is required. The expected reimbursement
disclosed together with the
is disclosed (paragraph 67(c)).
amount recognised for the
reimbursement (paragraph
67(c)).
APPENDIX B
Decision Tree
The purpose of the decision tree is to summarise the main recognition requirements of the
Accounting Standard for provisions and contingent liabilities. The decision tree does not form
part of the Accounting Standard and should be read in the context of the full text of the
Note: in rare cases, it is not clear whether there is a present obligation. In these cases, a past
event is deemed to give rise to a present obligation if, taking account of all available evidence,
it is more likely than not that a present obligation exists at the balance sheet date (paragraph
15 of the Standard).
APPENDIX C
Examples: Recognition
This appendix illustrates the application of the Accounting Standard to assist in clarifying its
meaning. It does not form part of the Accounting Standard.
All the enterprises in the examples have 31 March year ends. In all cases, it is assumed that a
reliable estimate can be made of any outflows expected. In some examples the circumstances
described may have resulted in impairment of the assets - this aspect is not dealt with in the
examples.
The cross references provided in the examples indicate paragraphs of the Accounting
Standard that are particularly relevant. The appendix should be read in the context of the full
text of the Accounting Standard.
EXAMPLE 1: WARRANTIES
A manufacturer gives warranties at the time of sale to purchasers of its product. Under the
terms of the contract for sale the manufacturer undertakes to make good, by repair or
replacement, manufacturing defects that become apparent within three years from the date of
sale. On past experience, it is probable (i.e. more likely than not) that there will be some
claims under the warranties.
Present obligation as a result of a past obligating event - The obligating event is the sale
of the product with a warranty, which gives rise to an obligation.
An outflow of resources embodying economic benefits in settlement - Probable for the
warranties as a whole (see paragraph 23).
Conclusion - A provision is recognised for the best estimate of the costs of making good
under the warranty products sold before the balance sheet date (see paragraphs 14 and 23).
Example 2: Contaminated Land - Legislation Virtually Certain to be Enacted

An enterprise in the oil industry causes contamination but does not clean up because there is
no legislation requiring cleaning up, and the enterprise has been contaminating land for
several years. At 31 March 2005 it is virtually certain that a law requiring a clean-up of land
already contaminated will be enacted shortly after the year end.
Present obligation as a result of a past obligating event - The obligating event is the
contamination of the land because of the virtual certainty of legislation requiring cleaning up.
An outflow of resources embodying economic benefits in settlement - Probable.
Conclusion - A provision is recognised for the best estimate of the costs of the clean-up (see
paragraphs 14 and 21).
EXAMPLE 3: OFFSHORE OILFIELD

An enterprise operates an offshore oilfield where its licensing agreement requires it to remove
the oil rig at the end of production and restore the seabed. Ninety per cent of the eventual
costs relate to the removal of the oil rig and restoration of damage caused by building it, and
ten per cent arise through the extraction of oil. At the balance sheet date, the rig has been
constructed but no oil has been extracted.
Present obligation as a result of a past obligating event - The construction of the oil rig
creates an obligation under the terms of the licence to remove the rig and restore the seabed
and is thus an obligating event. At the balance sheet date, however, there is no obligation to
rectify the damage that will be caused by extraction of the oil.
Conclusion - A provision is recognised for the best estimate of ninety per cent of the eventual
costs that relate to the removal of the oil rig and restoration of damage caused by building it
(see paragraph 14). These costs are included as part of the cost of the oil rig. The ten per cent
of costs that arise through the extraction of oil are recognised as a liability when the oil is
extracted.
EXAMPLE 4: REFUNDS POLICY

A retail store has a policy of refunding purchases by dissatisfied customers, even though it is
under no legal obligation to do so. Its policy of making refunds is generally known.
Present obligation as a result of a past obligating event - The obligating event is the sale
of the product, which gives rise to an obligation because obligations also arise from normal
business practice, custom and a desire to maintain good business relations or act in an
equitable manner.
An outflow of resources embodying economic benefits in settlement - Probable, a
proportion of goods are returned for refund (see paragraph 23).
Conclusion - A provision is recognised for the best estimate of the costs of refunds (see
paragraphs 11, 14 and 23).
EXAMPLE 5: LEGAL REQUIREMENT TO FIT SMOKE FILTERS

Under new legislation, an enterprise is required to fit smoke filters to its factories by 30
September 2005. The enterprise has not fitted the smoke filters.
(a) At the balance sheet date of 31 March 2005
Present obligation as a result of a past obligating event - There is no obligation because
there is no obligating event either for the costs of fitting smoke filters or for fines under the
legislation.
Conclusion - No provision is recognised for the cost of fitting the smoke filters (see
paragraphs 14 and 16-18).
(b) At the balance sheet date of 31 March 2006
Present obligation as a result of a past obligating event - There is still no obligation for the
costs of fitting smoke filters because no obligating event has occurred (the fitting of the filters).
However, an obligation might arise to pay fines or penalties under the legislation because the
obligating event has occurred (the non-compliant operation of the factory).
An outflow of resources embodying economic benefits in settlement - Assessment of
probability of incurring fines and penalties by non-compliant operation depends on the details
of the legislation and the stringency of the enforcement regime.
Conclusion - No provision is recognised for the costs of fitting smoke filters. However, a
provision is recognised for the best estimate of any fines and penalties that are more likely
than not to be imposed (see paragraphs 14 and 16-18).
Example 6: Staff Retraining as a Result of Changes in the Income Tax System

The government introduces a number of changes to the income tax system. As a result of
these changes, an enterprise in the financial services sector will need to retrain a large
proportion of its administrative and sales workforce in order to ensure continued compliance
with financial services regulation. At the balance sheet date, no retraining of staff has taken
place.
Present obligation as a result of a past obligating event - There is no obligation because
no obligating event (retraining) has taken place.
Conclusion - No provision is recognised (see paragraphs 14 and 16-18).
EXAMPLE 7: A SINGLE GUARANTEE

During 2004-05, Enterprise A gives a guarantee of certain borrowings of Enterprise B, whose
financial condition at that time is sound. During 2005-06, the financial condition of Enterprise B
deteriorates and at 30 September 2005 Enterprise B goes into liquidation.
(a) At 31 March 2005
Present obligation as a result of a past obligating event - The obligating event is the giving
of the guarantee, which gives rise to an obligation.
An outflow of resources embodying economic benefits in settlement - No outflow of
benefits is probable at 31 March 2005.
Conclusion - No provision is recognised (see paragraphs 14 and 22). The guarantee is
disclosed as a contingent liability unless the probability of any outflow is regarded as remote
(see paragraph 68).
(b) At 31 March 2006
Present obligation as a result of a past obligating event - The obligating event is the giving
of the guarantee, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement - At 31 March 2006,
it is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation.
Conclusion - A provision is recognised for the best estimate of the obligation (see paragraphs
14 and 22).
Note: This example deals with a single guarantee. If an enterprise has a portfolio of similar
guarantees, it will assess that portfolio as a whole in determining whether an outflow of
resources embodying economic benefit is probable (see paragraph 23). Where an enterprise
gives guarantees in exchange for a fee, revenue is recognised under AS 9, Revenue
Recognition.
EXAMPLE 8: A COURT CASE

After a wedding in 2004-05, ten people died, possibly as a result of food poisoning from
products sold by the enterprise. Legal proceedings are started seeking damages from the
enterprise but it disputes liability. Up to the date of approval of the financial statements for the
year 31 March 2005, the enterprise's lawyers advise that it is probable that the enterprise will
not be found liable. However, when the enterprise prepares the financial statements for the
year 31 March 2006, its lawyers advise that, owing to developments in the case, it is probable
that the enterprise will be found liable.
(a) At 31 March 2005
Present obligation as a result of a past obligating event - On the basis of the evidence
available when the financial statements were approved, there is no present obligation as a
result of past events.
Conclusion - No provision is recognised (see definition of ‘present obligation’ and paragraph
15). The matter is disclosed as a contingent liability unless the probability of any outflow is
regarded as remote (paragraph 68).
(b) At 31 March 2006
Present obligation as a result of a past obligating event - On the basis of the evidence
available, there is a present obligation.
Conclusion - A provision is recognised for the best estimate of the amount to settle the
obligation (paragraphs 14-15).
EXAMPLE 9A: REFURBISHMENT COSTS - NO LEGISLATIVE REQUIREMENT
A furnace has a lining that needs to be replaced every five years for technical reasons. At the
balance sheet date, the lining has been in use for three years.
Present obligation as a result of a past obligating event - There is no present obligation.
The cost of replacing the lining is not recognised because, at the balance sheet date, no
obligation to replace the lining exists independently of the company's future actions - even the
intention to incur the expenditure depends on the company deciding to continue operating the
furnace or to replace the lining.
EXAMPLE 9B: REFURBISHMENT COSTS - LEGISLATIVE REQUIREMENT
An airline is required by law to overhaul its aircraft once every three years.
Present obligation as a result of a past obligating event - There is no present obligation.
The costs of overhauling aircraft are not recognised as a provision for the same reasons as
the cost of replacing the lining is not recognised as a provision in example 9A. Even a legal
requirement to overhaul does not make the costs of overhaul a liability, because no obligation
exists to overhaul the aircraft independently of the enterprise's future actions - the enterprise
could avoid the future expenditure by its future actions, for example by selling the aircraft.
APPENDIX D
Example: Disclosures
An example of the disclosures required by paragraph 67 is provided below.
EXAMPLE 1 WARRANTIES
A manufacturer gives warranties at the time of sale to purchasers of its three product lines.
Under the terms of the warranty, the manufacturer undertakes to repair or replace items that
fail to perform satisfactorily for two years from the date of sale. At the balance sheet date, a
provision of Rs. 60,000 has been recognised. The following information is disclosed:
A provision of Rs. 60,000 has been recognised for expected warranty claims on products sold
during the last three financial years. It is expected that the majority of this expenditure will be
incurred in the next financial year, and all will be incurred within two years of the balance
sheet date.
An example is given below of the disclosures required by paragraph 72 where some of the
information required is not given because it can be expected to prejudice seriously the position
of the enterprise.
EXAMPLE 2 DISCLOSURE EXEMPTION
An enterprise is involved in a dispute with a competitor, who is alleging that the enterprise has
infringed patents and is seeking damages of Rs. 1000 lakhs. The enterprise recognises a
provision for its best estimate of the obligation, but discloses none of the information required
by paragraphs 66 and 67 of the Statement. The following information is disclosed:
Litigation is in process against the company relating to a dispute with a competitor who alleges
that the company has infringed patents and is seeking damages of Rs. 1000 lakhs. The
information usually required by AS 29, Provisions, Contingent Liabilities and Contingent
Assets is not disclosed on the grounds that it can be expected to prejudice the interests of the
company. The directors are of the opinion that the claim can be successfully resisted by the
company.
APPENDIX E
Note: This Appendix is not a part of the Accounting Standard. The purpose of this
appendix is only to bring out the major differences between Accounting Standard 29 and
corresponding International Accounting Standard (IAS) 37.
Comparison with IAS 37, Provisions, Contingent Liabilities and Contingent Assets
(1998)
The Accounting Standard differs from International Accounting Standard (IAS) 37, Provisions,
Contingent Liabilities and Contingent Assets, in the following major respects:
1. Discounting of Provisions
IAS 37 requires that where the effect of the time value of money is material, the amount of a
provision should be the present value of the expenditures expected to be required to settle the
obligation. On the other hand, the Accounting Standard requires that the amount of a provision
should not be discounted to its present value. The reason for not requiring discounting is that,
at present, in India, financial statements are prepared generally on historical cost basis and
not on present value basis.
2. Onerous Contracts
IAS 37 requires that if an enterprise has a contract that is onerous, the present obligation
under the contract should be recognised and measured as a provision. For this purpose, IAS
37 defines an onerous contract as a contract in which the unavoidable costs of meeting the
obligations under the contract exceed the economic benefits expected to be received under it.
It is decided that in respect of onerous contracts, on which IAS 37 is applicable, present
obligation should not be required to be recognised. This is because recognition of estimated
loss in case of an onerous contract amounts to recognition of loss of future periods in the
current year’s profit and loss account thereby distorting the operating results of the current
year. Further, it may not be feasible to determine, in all cases, whether a particular contract is
onerous or not because which costs are unavoidable may be a matter of subjective
judgement. Accordingly, the provisions of IAS 37 relating to onerous contracts including the
definition of ‘onerous contract’ have been omitted from the Accounting Standard.
3. Constructive obligation and Restructurings
IAS 37 deals with ‘constructive obligation’ in the context of creation of a provision. The effect
of recognising provision on the basis of constructive obligation is that, in some cases,
provision will be required to be recognised at an early stage. For example, in case of a
restructuring, a constructive obligation arises when an enterprise has a detailed formal plan for
the restructuring and the enterprise has raised a valid expectation in those affected that it will
carry out the restructuring by starting to implement that plan or announcing its main features to
those affected by it. It is felt that merely on the basis of a detailed formal plan and
announcement thereof, it would not be appropriate to recognise a provision since a liability
can not be considered to be crystalised at this stage. Further, the judgment whether the
management has raised valid expectations in those affected may be a matter of considerable
argument.
In view of the above, the Accounting Standard does not deal with ‘constructive obligation’.
Thus, in situations such as restructuring, general recognition criteria are required to be
applied.
4. Contingent Assets
Both the Accounting Standard and IAS 37 require that an enterprise should not recognise a
contingent asset. However, IAS 37 requires certain disclosures in respect of contingent
assets in the financial statements where an inflow of economic benefits is probable. In
contrast to this, as a measure of prudence, the Accounting Standard does not even require
contingent assets to be disclosed in the financial statements. The Standard recognises that
contingent asset is usually disclosed in the report of the approving authority where an inflow of
economic benefits is probable.
5. Definitions
The definitions of the terms ‘legal obligation’, ‘constructive obligation’ and ‘onerous contract’
contained in IAS 37 have been omitted from the Accounting Standard, as a consequence to
above departures from IAS 37. Further, the definitions of the terms ‘provision’ and ‘obligating
event’ contained in IAS 37 have been modified as a consequence to above departures from
IAS 37. In the Accounting Standard, the definitions of the terms ‘present obligation’ and
‘possible obligation’ have been added as compared to IAS 37 with a view to bring more clarity.
Limited Revision to Accounting Standard (AS) 29,
Provisions, Contingent Liabilities and Contingent Assets
The Council of the Institute of Chartered Accountants of India has decided to make the
following limited revisions of Accounting Standard (AS) 29, Provisions, Contingent Liabilities
and Contingent Assets.
Paragraphs 1, 3 and 5 of AS 29 have been decided to be modified as under (modifications are
shown as underlined):
Scope
1. This Statement should be applied in accounting for provisions and contingent liabilities
and in dealing with contingent assets, except:
(a) those resulting from financial instruments that are carried at flair value;
(b) those resulting from executory contracts, except where the contract is onerous;
(c) those arising in insurance enterprises from contracts with policy-holders; and
(d) those covered by another Accounting Standard.”
“3. Executory contracts are contracts under which neither party has performed any of its
obligations or both parties have partially performed their obligations to an equal extent. This
Statement does not apply to executory contracts unless they are onerous.”
“5. Where another Accounting Standard deals with a specific type of provision, contingent
liability or contingent asset, an enterprise applies that Statement instead of this Statement.
For example, certain types of provisions are also addressed in Accounting Standards on:
(a) construction contracts (see AS 7, Construction Contracts);
(b) taxes on income (see AS22, Accounting for Taxes on income);
(c) leases (see AS 19, Leases). However, as AS 19 contains no specific requirements to deal
with operating leases that have become onerous, this Statement applies to such cases; and
(d) retirement benefits (see AS 15, Accounting for Retirement Benefits in the Financial
Statements of Employers).
Pursuant to the above limited revision, paragraph 2 of Appendix E (dealing with comparison of
AS 29 with IAS 37) to AS 29 stands withdrawn. Consequently, the numbering of subsequent
paragraphs of Appendix E is also changed.
The limited revision comes into effect in respect of accounting periods commencing on or after
April 1, 2006.
As a consequence to the Limited Revision to AS 29, Accounting Standards
Interpretation (ASI) 30 has been issued.
APPENDIX – II
ACCOUNTING STANDARDS INTERPRETATIONS

The authority of the Accounting Standards Interpretations (ASI) is the same as that of the
Accounting Standard to which it relates. The contents of this ASI are intended for the limited
purpose of the Accounting Standard to which it relates. ASI is intended to apply only to material
items. The Institute of Chartered Accountants of India has, so far, issued 30 ASIs. Text of these
Interpretations have been given below:
Accounting Standards Interpretation (ASI) 1
Substantial Period of Time
Accounting Standard (AS) 16, Borrowing Costs
ISSUE
1. Accounting Standard (AS) 16, Borrowing Costs, defines the term ‘qualifying asset’ as “an
asset that necessarily takes a substantial period of time to get ready for its intended use or
sale”.
2. The issue is what is the meaning of the expression ‘substantial period of time’ for the
purpose of this definition.
CONSENSUS
3. The issue as to what constitutes a substantial period of time primarily depends on the
facts and circumstances of each case. However, ordinarily, a period of twelve months is
considered as substantial period of time unless a shorter or longer period can be justified on
the basis of facts and circumstances of the case. In estimating the period, time which an asset
takes, technologically and commercially, to get it ready for its intended use or sale should be
considered.
4. The following assets ordinarily take twelve months or more to get ready for intended use
or sale unless the contrary can be proved by the enterprise:
(i) assets that are constructed or otherwise produced for an enterprise’s own use, e.g.,
assets constructed under major capital expansions.
(ii) assets intended for sale or lease that are constructed or otherwise produced as discrete
projects (for example, ships or real estate developments).
5. In case of inventories, substantial period of time is considered to be involved where time
is the major factor in bringing about a change in the condition of inventories. For example,
liquor is often required to be kept in store for more than twelve months for maturing.
II.2 Financial Reporting
BASIS FOR CONCLUSION

6. Paragraph 6 of AS 16 provides that “Borrowing costs that are directly attributable to the
acquisition, construction or production of a qualifying asset should be capitalised as part of the
cost of that asset. The amount of borrowing costs eligible for capitalisation should be
determined in accordance with this Statement. Other borrowing costs should be recognised as
an expense in the period in which they are incurred”.
This paragraph recognises that borrowing costs should be expensed except where they are
directly attributable to acquisition, construction or production of a qualifying asset. To qualify
for capitalisation of borrowing costs, the asset should take a long period of time to get ready
for its intended use or sale.
7. Paragraph 5 of AS 16 gives examples of manufacturing plants, power generation
facilities etc. as qualifying assets. In these cases, normally a period of more than twelve
months is required for getting them ready for their intended use. Therefore, a rebuttable
presumption of a period of twelve months is considered “substantial” period of time.
8. Paragraph 5 of AS 16 provides, inter alia, that “inventories that are routinely
manufactured or otherwise produced in large quantities on a repetitive basis over a short
period of time, are not qualifying assets.” Paragraph 12 of Accounting Standard (AS) 2,
Valuation of Inventories, provides that “Interest and other borrowing costs are usually
considered as not relating to bringing the inventories to their present location and condition
and are, therefore, usually not included in the cost of inventories”. It is only in exceptional
cases, where time is a major factor in bringing about change in the condition of inventories
that borrowing costs are included in the valuation of inventories.

Accounting for Machinery Spares
Accounting Standard (AS) 2, Valuation of Inventories and
AS 10, Accounting for Fixed Assets
ISSUE
1. Which machinery spares are covered under AS 2 and AS 10 and what should be the
accounting for machinery spares under the respective standards.
CONSENSUS
2. Machinery spares which are not specific to a particular item of fixed asset but can be
used generally for various items of fixed assets should be treated as inventories for the
purpose of AS 2. Such machinery spares should be charged to the statement of profit and loss
as and when issued for consumption in the ordinary course of operations.
Appendix II : Accounting Standards Interpretations II.3
3. Whether to capitalise a machinery spare under AS 10 or not will depend on the facts and
circumstances of each case. However, the machinery spares of the following types should be
capitalised being of the nature of capital spares/insurance spares -
(i) Machinery spares which are specific to a particular item of fixed asset, i.e., they can be
used only in connection with a particular item of the fixed asset, and
(ii) their use is expected to be irregular.
4. Machinery spares of the nature of capital spares/insurance spares should be capitalised
separately at the time of their purchase whether procured at the time of purchase of the fixed
asset concerned or subsequently. The total cost of such capital spares/insurance spares
should be allocated on a systematic basis over a period not exceeding the useful life of the
principal item, i.e., the fixed asset to which they relate.
5. When the related fixed asset is either discarded or sold, the written down value less
disposal value, if any, of the capital spares/insurance spares should be written off.
6. The stand-by equipment is a separate fixed asset in its own right and should be
depreciated like any other fixed asset.
7. Paragraphs 8.2 and 25 of AS 10, ‘Accounting for Fixed Assets’, state as below:
“8.2 Stand-by equipment and servicing equipment are normally capitalised. Machinery spares
are usually charged to the profit and loss statement as and when consumed. However, if such
spares can be used only in connection with an item of fixed asset and their use is expected to
be irregular, it may be appropriate to allocate the total cost on a systematic basis over a
period not exceeding the useful life of the principal item.”
“25. Fixed asset should be eliminated from the financial statements on disposal or when
no further benefit is expected from its use and disposal.”
8. Paragraph 4 of AS 2, ‘Valuation of Inventories’, states as below:
“4. Inventories encompass goods purchased and held for resale, for example, merchandise
purchased by a retailer and held for resale, computer software held for resale, or land and
other property held for resale. Inventories also encompass finished goods produced, or work
in progress being produced, by the enterprise and include materials, maintenance supplies,
consumables and loose tools awaiting use in the production process. Inventories do not
include machinery spares which can be used only in connection with an item of fixed asset
and whose use is expected to be irregular; such machinery spares are accounted for in
accordance with Accounting Standard (AS) 10, Accounting for Fixed Assets.”
9. Machinery spares of the nature of capital spares/insurance spares are capitalised.
Capital spares/insurance spares are meant for occasional use. Since they can be used only in
relation to a specific item of fixed asset, they are to be discarded in case that specific fixed
asset is disposed of. In other words, such spares are integral parts of the fixed asset.
10. A stand-by equipment is not of the nature of a spare but is of the nature of another piece
of equipment which is being used in the manufacturing process. For example, a generator set
kept in store as a stand-by to the generator set which is being used in the manufacturing
process. Therefore, the stand-by equipment is a separate fixed asset in its own right and is
depreciated like any other fixed asset.

(Revised)
Accounting for Taxes on Income in the situations
Of Tax Holiday under Sections 80-IA and 80-IB
of the Income-tax Act, 1961
Accounting Standard (AS) 22, Accounting for Taxes on Income
ISSUE
1. Sections 80-IA and 80-IB of the Income-tax Act, 1961 (hereinafter referred to as the ‘Act’)
provide certain deductions, for certain years, in determining the taxable income of an
enterprise. These deductions are commonly described as ‘tax holiday’ and the period during
which these deductions are available is commonly described as ‘tax holiday period’.
2. The issue is how AS 22 should be applied in the situations of tax-holiday under sections
80-IA and 80-IB of the Act.
CONSENSUS
3. The deferred tax in respect of timing differences which reverse during the tax holiday
period and reverse during the tax holiday period, should not be recognised to the extent the
enterprise’s gross total income is subject to the deduction during the tax holiday period as per
the requirements of the Act.
4. Deferred tax in respect of timing differences which reverse after the tax holiday period
should be recognised in the year in which the timing differences originate. However,
recognition of deferred tax assets should be subject to the consideration of prudence as laid
down in paragraphs 15 to 18 of AS 22.
5. For the above purposes, the timing differences which originate first should be considered
to reverse first.
The Appendix to this Interpretation illustrates the application of the above requirements.

6. Section 80A (1) of the Act, provides that in computing the total income of an assessee,
there shall be allowed from his gross total income, in accordance with and subject to the
provisions of this Chapter, the deductions specified in sections 80C to 80U. Therefore, the
deductions under sections 80-IA and 80-IB are the deductions from the gross total income of
an assessee determined in accordance with the provisions of the Act. For example,
depreciation under section 32 of the Act is provided for arriving at the amount of gross total
income even if it is not claimed in view of Explanation 5 to clause (ii) of sub-section (1) of
section 32 of the Act.
7. In view of the above, the amount of the deduction under sections 80-IA and 80-IB of the
Act, is based on the gross total income which is determined in accordance with the provisions
of the Act. In respect of the situations covered under sections 80-IA and 80-IB, the difference
in the relevant accounting income and taxable income (relevant gross total income minus
deduction allowed under sections 80-IA and 80-IB) of an enterprise during a tax holiday period
is classified into permanent differences and timing differences. The amount of deduction in
respect of sections 80-IA and 80-IB is a permanent difference whereas the differences which
arise because of different treatment of items of income and expenses for determination of
relevant accounting income and relevant gross total income such as depreciation are timing
differences.
8. The Framework for the Preparation and Presentation of Financial Statements provides
that “An asset is recognised in the balance sheet when it is probable that the future economic
benefits associated with it will flow to the enterprise and the asset has a cost or value that can
be measured reliably”. The Framework also provides that “A liability is recognised in the
balance sheet when it is probable that an outflow of resources embodying economic benefits
will result from the settlement of a present obligation and the amount at which the settlement
will take place can be measured reliably”. In the situation of tax holiday under Sections 80-IA
and 80-IB of the Act, it is probable that deferred tax assets and liabilities in respect of timing
differences which reverse during the tax holiday period whether originated in the tax holiday
period or before that (refer provisions of Section 80-IA(2) of the Act), will not be realised or
settled. Accordingly, a deferred tax asset or a liability for timing differences which reverse
during the tax holiday period does not meet the above criteria for recognition of asset or
liability, as the case may be, and therefore is not recognised to the extent the gross total
income of the enterprise is subject to the deduction during the tax holiday period.
9. Deferred tax assets/liabilities for timing differences which reverse after the tax holiday
period, whether originated in the tax holiday period or before that, are recognised in the period
in which these differences originate because these can be realised/paid after the expiry of the
tax holiday period by payment of lesser or higher amount of tax after the tax holiday period
because of reversal of timing differences.
10. According to one view, during the tax holiday period, no deferred tax should be
recognised even for the timing differences which reverse after the tax holiday period, because
timing differences do not originate, for example, in the situation of a 100 percent tax holiday
period the taxable income is nil. This view was not accepted because in the aforesaid
situation, although the current tax is nil but deferred tax, on account of the timing differences
which will reverse after the tax holiday period, exists. Further, even in case of carry forward of
losses which can be set-off against future taxable income, deferred tax may be recognised, as
per AS 22, in respect of all timing differences irrespective of the fact that the taxable income of
the enterprise is nil in the period in which the timing differences originate.
11. According to another view, the timing differences which will reverse after the tax holiday
period should be recognised at the beginning of the first year after the expiry of the tax holiday
period and not in the year in which the timing differences originate. Accordingly, as per this
view, during the tax holiday period, deferred tax should not be recognised. This view was also
not accepted because as per AS 22 deferred tax should be recognised in the period in which
the relevant timing differences originate.
Appendix
Note: This appendix is illustrative only and does not form part of the Accounting Standards
Interpretation. The purpose of this appendix is to illustrate the application of the Interpretation
to assist in clarifying its meaning.
Facts:
1. The income before depreciation and tax of an enterprise for 15 years is Rs. 1000 lakhs
per year, both as per the books of account and for income-tax purposes.
2. The enterprise is subject to 100 percent tax-holiday for the first 10 years under section
80-IA. Tax rate is assumed to be 30 percent.
3. At the beginning of year 1, the enterprise has purchased one machine for Rs. 1500 lakhs.
Residual value is assumed to be nil.
4. For accounting purposes, the enterprise follows an accounting policy to provide
depreciation on the machine over 15 years on straight-line basis.
5. For tax purposes, the depreciation rate relevant to the machine is 25% on written down
value basis.
The following computations will be made, ignoring the provisions of section 115JB (MAT), in
this regard:
Table 1
Computation of depreciation on the machine for accounting purposes and tax purposes
Year Depreciation for accounting purposes Depreciation for tax purposes

1 100 375
2 100 281
3 100 211
4 100 158
5 100 119
6 100 89
7 100 67
8 100 50
9 100 38
10 100 28
11 100 21
12 100 16
13 100 12
14 100 9
15 100 7
At the end of the 15th year, the carrying amount of the machinery for accounting purposes
would be nil whereas for tax purposes, the carrying amount is Rs. 19 lakhs which is eligible to
be allowed in subsequent years.
Table 2
Computation of Timing differences

(Amounts in Rs. lakhs)
1 2 3 4 5 6 7 8 9
Year Income Accounting Gross Total Deduction Taxable Total Permanent Timing Difference
before Income after Income after under Income Difference Difference (due to different
deprecation depreciation deducting section 80- (4-5) between (deduction amounts of
and tax depreciation IA accounting pursuant to depreciation for
(both for under tax income and section 80- accounting
accounting laws) taxable IA) purposes and tax
purposes income (3- purposes) (O=
and tax 6) originating and R=
purposes) Reversing)
1 1000 900 625 625 Nil 900 625 275 (O)
2 1000 900 719 719 Nil 900 719 181 (O)
3 1000 900 789 789 Nil 900 789 111 (O)
4 1000 900 842 842 Nil 900 842 58 (O)
5 1000 900 881 881 Nil 900 881 19 (O)
6 1000 900 911 911 Nil 900 911 11 (R)
7 1000 900 933 933 Nil 900 933 33 (R)
8 1000 900 950 950 Nil 900 950 50 (R)
9 1000 900 962 962 Nil 900 962 62 (R)
10 1000 900 972 972 Nil 900 972 72 (R)
11 1000 900 979 Nil 979 -79 Nil 79 (R)
12 1000 900 984 Nil 984 -84 Nil 84 (R)
13 1000 900 988 Nil 988 -88 Nil 88 (R)
14 1000 900 991 Nil 991 -91 Nil 91 (R)
15 1000 900 993 Nil 993 -93 Nil 74 (R)

19 (O)
Notes:
1. Timing differences originating during the tax holiday period are Rs. 644 lakhs, out of
which Rs. 228 lakhs are reversing during the tax holiday period and Rs. 416 lakhs are
reversing after the tax holiday period. Timing difference of Rs. 19 lakhs is originating in the
15th year which would reverse in subsequent years when for accounting purposes
depreciation would be nil but for tax purposes the written down value of the machinery of Rs.
19 lakhs would be eligible to be allowed as depreciation.
2. As per the Interpretation, deferred tax on timing differences which originate during the tax
holiday period and reverse during the tax holiday period should not be recognised. For this
purpose, timing differences which originate first are considered to reverse first. Therefore, the
reversal of timing difference of Rs. 228 lakhs during the tax holiday period, would be
considered to be out of the timing difference which originated in year 1. The rest of the timing
difference originating in year 1 and timing differences originating in years 2 to 5 would be
considered to be reversing after the tax holiday period. Therefore, in year 1, deferred tax
would be recognised on the timing difference of Rs. 47 lakhs (Rs. 275 lakhs - Rs. 228 lakhs)
which would reverse after the tax holiday period. Similar computations would be made for the
subsequent years. The deferred tax assets/liabilities to be recognised during different years
would be computed as per the following Table.
Table 3
Computation of current tax and deferred tax
Year Current tax Deferred tax (Timing Accumulated Deferred tax Tax
(Taxable Income x difference x 30%) (L= Liability and A= Asset) expense
30%)
1 Nil 47x30%=14 (see note 2 14 (L) 14

above)
2 Nil 181x30%=54 68 (L) 54
3 Nil 111x30%=33 101 (L) 33
4 Nil 58x30%=17 118 (L) 17
5 Nil 19x30%=6 124 (L) 6

6 Nil Nil1 124 (L) Nil
11 294 -79x30%=-24 100 (L) 270
12 295 -84x30%=-25 75 (L) 270
13 296 -88x30%=-26 49 (L) 270
14 297 -91x30%=-27 22 (L) 270
15 298 -74x30%=-22 Nil 270

-19x30%=-6 6 (A) 2
1No deferred tax is recognised since in respect of timing differences reversing during the tax
holiday period, no deferred tax was recognised at their origination.
2 Deferred tax asset of Rs. 6 lakhs would be recognised at the end of year 15 subject to
consideration of prudence as per AS 22. If it is so recognised, the said deferred tax asset
would be realised in subsequent periods when for tax purposes depreciation would be allowed
but for accounting purposes no depreciation would be recognised.
Accounting Standards Interpretation (ASI)4

(Revised)
Losses under the head Capital Gains
Accounting Standard (AS) 22, Accounting for
Taxes on Income
[This revised Accounting Standards Interpretation replaces ASI 4 issuedin December 2002.]
ISSUE
1. The issue is how AS 22 should be applied in respect of ‘loss’ arising under the head
‘Capital gains’ of the Income-tax Act, 1961 (hereinafter referred to as the ‘Act’), which can be
carried forward and set-off in future years, only against the income arising under that head as
per the requirements of the Act.
CONSENSUS
2. Where an enterprise’s statement of profit and loss includes an item of ‘loss’ which can be
set-off in future for taxation purposes, only against the income arising under the head ‘Capital
gains’ as per the requirements of the Act, that item is a timing difference to the extent it is not
set-off in the current year and is allowed to be set-off against the income arising under the
head ‘Capital gains’ in subsequent years subject to the provisions of the Act. In respect of
such ‘loss’, deferred tax asset should be recognised and carried forward subject to the
consideration of prudence.Accordingly, in respect of such ‘loss’, deferred tax asset should be
recognised and carried forward only to the extent that there is a virtual certainty, supported by
convincing evidence, that sufficient future taxable income will be available under the head
‘Capital gains’ against which the loss can be set-off as per the provisions of the Act. Whether
the test of virtual certainty is fulfilled or not would depend on the facts and circumstances of
each case. The examples of situations in which the test of virtual certainty, supported by
convincing evidence, for the purposes of the recognition of deferred tax asset in respect of
loss arising under the head ‘Capital gains’ is normally fulfilled, are sale of an asset giving rise
to capital gain (eligible to set-off the capital loss as per the provisions of the Act) after the
balance sheet date but before the financial statements are approved, and binding sale
agreement which will give rise to capital gain (eligible to set-off the capital loss as per the
provisions of the Act).
3. In cases where there is a difference between the amounts of ‘loss’ recognised for
accounting purposes and tax purposes because of cost indexation under the Act in respect of
long-term capital assets, the deferred tax asset should be recognised and carried forward
(subject to the consideration of prudence) on the amount which can be carried forward and
set-off in future years as per the provisions of the Act.
Transitional Provision
4. Where an enterprise first applies this revised ASI, the deferred tax asset recognised
previously considering the reasonable level of certainty, as per the pre-revised ASI 4, and no
longer meets the recognition criteria laid down in the revised ASI, should be written-off with a
corresponding charge to the revenue reserves.
BASIS FOR CONCLUSIONS

5. Section 71 (3) of the Act provides that “Where in respect of any assessment year, the net
result of the computation under the head “Capital gains” is a loss and the assessee has
income assessable under any other head of income, the assessee shall not be entitled to have
such loss set off against income under the other head”.
6. Section 74 (1) of the Act provides that “Where in respect of any assessment year, the net
result of the computation under the head “Capital gains” is a loss to the assessee, the whole
loss shall, subject to the other provisions of this Chapter, be carried forward to the following
assessment year, and—
(a) in so far as such loss relates to a short-term capital asset, it shall be set off against
income, if any, under the head “Capital gains” assessable for that assessment year in
respect of any other capital asset;
(b) in so far as such loss relates to a long-term capital asset, it shall be set off against
income, if any, under the head “Capital gains” assessable for that assessment year in
respect of any other capital asset not being a short-term capital asset;
(c) if the loss cannot be wholly so set-off, the amount of loss not so set off shall be carried
forward to the following assessment year and so on.”
Section 74 (2) of the Act provides that “No loss shall be carried forward under this section for
more than eight assessment years immediately succeeding the assessment year for which the
loss was first computed”.
7. AS 22 defines ‘timing differences’ as “the differences between taxable income and
accounting income for a period that originate in one period and are capable of reversal in one
or more subsequent periods”.
8. Where an enterprise’s statement of profit and loss includes an item of loss, which is
considered a ‘loss’ under the head ‘Capital gains’ as per the provisions of the Act, the loss is a
timing difference, to the extent the same is not set-off in the current year, because this loss
can be allowed to be set-off against income arising under the head ‘Capital gains’ in future,
subject to the provisions of the Act, and to that extent the amount of income under that head
will not be taxable in the future year even though the said income would be included in the
determination of the accounting income of that year.
9. AS 22 provides that “Deferred tax should be recognised for all the timing
differences, subject to the consideration of prudence in respect of deferred tax assets
as set out in paragraphs 15-18”. Paragraph 15 of AS 22 provides that “Except in the
situations stated in paragraph 17, deferred tax assets should be recognised and carried
forward only to the extent that there is a reasonable certainty that sufficient future
taxable income will be available against which such deferred tax assets can be
realised.”
Paragraphs 17 and 18 of AS 22 provide as follows:
“17. Where an enterprise has unabsorbed depreciation or carry forward of losses under
tax laws, deferred tax assets should be recognised only to the extent that there is
virtual certainty supported by convincing evidence that sufficient future taxable income
will be available against which such deferred tax assets can be realised.
18. The existence of unabsorbed depreciation or carry forward of losses under tax laws is
strong evidence that future taxable income may not be available. Therefore, when an
enterprise has a history of recent losses, the enterprise recognises deferred tax assets only to
the extent that it has timing differences the reversal of which will result in sufficient income or
there is other convincing evidence that sufficient taxable income will be available against
which such deferred tax assets can be realised. In such circumstances, the nature of the
evidence supporting its recognition is disclosed.”
The income under the head ‘Capital gains’ does not arise in the course of the operating
activities of an enterprise. Thus, for the purpose of recognition of a deferred tax asset, the
degree of certainty of such an income arising in future should be higher. Accordingly, in case
of ‘loss’ under the head ‘Capital gains’, deferred tax asset should be recognised and carried
forward only to the extent that there is a virtual certainty, supported by convincing evidence,
that sufficient future taxable income will be available under the head ‘Capital gains’ against
which the loss can be set-off as per the provisions of the Act.
In this regard, virtual certainty of the availability of sufficient future taxable income against
which deferred tax assets can be realised, will be construed to mean virtual certainty of the
availability of taxable income under the head “Capital gains” in future in accordance with the
provisions of the Act.
10. In cases where there is a difference between the amounts of ‘loss’ recognised for
accounting purposes and tax purposes because of cost indexation under the Act in respect of
long-term capital assets, deferred tax asset is recognised and carried forward (subject to the
consideration of prudence) on the amount which can be carried forward and set-off in future
years as per the provisions of the Act since that is the amount which will be available for set-
off in future years as per the provisions of the Act.
11. As per the requirements of the pre-revised ASI 4, deferred tax asset in respect of a loss
arising under the head ‘Capital Gains’, in certain situations, was recognised on the
consideration of the reasonable certainty. The revised ASI 4, however, requires that in all
cases, deferred tax asset in respect of such loss is recognised only to the extent there is a
virtual certainty, supported by convincing evidence, that sufficient future taxable income will be
available under the head ‘Capital gains’ against which the loss can be set-off as per the
provisions of the Act. As a result, a deferred tax asset, recognised as per the pre-revised ASI
4, may not meet the recognition criteria laid down in the revised ASI and consequently, would
be required to be written-off. A deferred tax asset, which is required to be written-off in this
manner, is charged to the revenue reserves.

Accounting for Taxes on Income in the situations of
Tax Holiday under sections 10A and 10B
Of the Income-tax Act, 1961
ISSUE
1. Chapter III of the Income-tax Act, 1961 (hereinafter referred to as the ‘Act’) deals with
incomes which do not form part of total income. Sections 10A and 10B of the Act are covered
under Chapter III. These sections allow certain deductions, for certain years, from the total
income of an assessee. These deductions are commonly described as ‘tax holiday’ and the
period during which these deductions are available is commonly described as ‘tax holiday
period’.
2. The issue is how AS 22 should be applied in the situations of tax-holiday under sections
10A and 10B of the Act.
CONSENSUS
3. The deferred tax in respect of timing differences which originate during the tax holiday
period and reverse during the tax holiday period, should not be recognised to the extent
deduction from the total income of an enterprise is allowed during the tax holiday period as per
the provisions of sections 10A and 10B of the Act.
4. Deferred tax in respect of timing differences which originate during the tax holiday period
but reverse after the tax holiday period should be recognised in the year in which the timing
differences originate. However, recognition of deferred tax assets should be subject to the
consideration of prudence as laid down in paragraphs 15 to 18 of AS 22.
5. For the above purposes, the timing differences which originate first should be considered
to reverse first.

6. Sections 10A and 10B are covered under Chapter III of the Act. These sections allow
certain deductions, for certain years, from the total income of the assessee.
7. The Framework for the Preparation and Presentation of Financial Statements provides
that “An asset is recognised in the balance sheet when it is probable that the future economic
be measured reliably”. The Framework also provides that “A liability is recognised in the
balance sheet when it is probable that an outflow of resources embodying economic benefits
will result from the settlement of a present obligation and the amount at which the settlement
will take place can be measured reliably”. In the situation of tax holiday under sections 10A
and 10B of the Act, it is probable that deferred tax assets and liabilities in respect of timing
differences which originate and reverse during the tax holiday period will not be realised or
settled. Accordingly, a deferred tax asset or a liability for timing differences which reverse
during the tax holiday period does not meet the above criteria for recognition of asset or
liability, as the case may be, and therefore is not recognised to the extent deduction from the
total income of the enterprise is allowed during the tax holiday period as per the provisions of
sections 10A and 10B of the Act.
8. Deferred tax assets/liabilities for timing differences which reverse after the tax holiday
period are recognised in the period in which these differences originate because these can be
realised/paid after the expiry of the tax holiday period by payment of lesser or higher amount
of tax after the tax holiday period because of reversal of timing differences.
9. This Interpretation prescribes the same accounting treatment for situations of tax holiday
under sections 10A and 10B of the Act as prescribed for situations of tax holiday under
sections 80-IA and 80-IB of the Act (see ASI 3).
According to one view situation of tax holiday under sections 10A and 10B should be treated
differently as compared to situations of tax holiday under sections 80-IA and 80-IB of the Act
since sections 10A and 10B are covered under Chapter III of the Act which deals with incomes
which do not form part of total income whereas sections 80-IA and 80-IB are covered under
Chapter VI-A which deals with deductions to be made in computing total income.
This view was not accepted because irrespective of the fact that Sections 10A and 10B are
covered under Chapter III and Sections 80-IA and 80-IB are covered under Chapter VI-A, the
substance of the reliefs, in terms of economic reality is the same. Keeping in view the
‘substance over form’ principle of accounting as laid down in AS 1, Disclosure of Accounting
Policies, there should not be any difference between the treatment in respect of tax holiday
under sections 80-IA, 80-IB and 10A, 10B.
Accounting for Taxes on Income in the context of
Section 115JB of the Income-tax Act, 1961
ISSUE
1. The issue is how AS 22 is applied in a situation where a company pays tax under section
115JB (commonly referred to as Minimum Alternative Tax) of the Income-tax Act, 1961
(hereinafter referred to as the ‘Act’).
2. Another issue is how deferred tax is measured on the timing differences originating
during the current year if the enterprise expects that these differences would reverse in a
period in which it may pay tax under section 115JB of the Act.
CONSENSUS
3. The payment of tax under section 115JB of the Act is a current tax for the period.
4. In a period in which a company pays tax under section 115JB of the Act, the deferred tax
assets and liabilities in respect of timing differences arising during the period, tax effect of
which is required to be recognised under AS 22, should be measured using the regular tax
rates and not the tax rate under section 115JB of the Act.
5. In case an enterprise expects that the timing differences arising in the current period
would reverse in a period in which it may pay tax under section 115JB of the Act, the deferred
tax assets and liabilities in respect of timing differences arising during the current period, tax
effect of which is required to be recognised under AS 22, should be measured using the
regular tax rates and not the tax rate under section 115JB of the Act.

6. Sub-section (1) of Section 115JB of the Act provides that “Notwithstanding anything
contained in any other provision of this Act, where in the case of an assessee, being a
company, the income-tax, payable on the total income as computed under this Act in respect
of any previous year relevant to the assessment year commencing on or after the 1st day of
April, 2001, is less than seven and one-half per cent of its book profit, such book profit shall be
deemed to be the total income of the assessee and the tax payable by the assessee on such
total income shall be the amount of income-tax at the rate of seven and one-half per cent.”
Tax paid/payable under section 115JB is the current tax and does not, in itself, give rise to any
deferred tax since this payment of tax is pursuant to the special provision of the Act. This
section only prescribes the mode of computation of tax payable for the current year.
7. Paragraph 20 of AS 22 requires that current tax should be measured at the amount
expected to be paid to (recovered from) the taxation authorities, using the applicable tax rates
and tax laws. Paragraph 21 of AS 22 provides that deferred tax assets and liabilities should be
measured using the tax rates and tax laws that have been enacted or substantively enacted
by the balance sheet date. In a period in which an enterprise pays tax under section 115JB of
the Act, the rate of seven and one-half percent is relevant for the purpose of measurement of
current tax and not for the purpose of measurement of deferred tax.
8. There are two methods for recognition and measurement of tax effects of timing
differences, viz., the “full provision method” and “partial provision method”. Under the “full
provision method”, the deferred tax is recognised and measured in respect of all timing
differences (subject to consideration of prudence in case of deferred tax assets) without
considering assumptions regarding future profitability, future capital expenditure etc. On the
other hand, the ‘partial provision method’ excludes the tax effects of certain timing differences
which will not reverse for some considerable period ahead. Thus, this method is based on
many subjective judgements involving assumptions regarding future profitability, future capital
expenditure etc. In other words, partial provision method is based on an assessment of what
would be the position in future. Keeping in view the elements of subjectivity, the ‘partial
provision method’ under which deferred tax is recognised on the basis of assessment as to
what would be the expected position, has generally been discarded the world-over. AS 22 also
does not consider the above assumptions and, therefore, is based on ‘full provision method’.
The expectation that the timing differences arising in the current period would reverse in a
period in which the enterprise may pay tax under section 115JB of the Act, also involves
assessment of the future taxable income and accounting income and therefore, is
considerably subjective. It can not be known beforehand, with a reasonable degree of
certainty, whether in future an enterprise would pay tax under section 115JB of the Act
because that determination can only be made after the fact.
Recognition and measurement of deferred tax using the rate under section 115JB of the Act,
i.e., seven and one-half percent, on the basis of an assessment that the timing differences
would reverse in a period in which the enterprise may pay tax under section 115JB of the Act,
would be a situation analogous to the adoption of the ‘partial provision method’ which has
already been rejected.
In view of the above, this Interpretation requires that even if an enterprise expects that the
timing differences arising in the current period would reverse in a period in which it may pay
tax under section 115JB of the Act, the deferred tax assets and liabilities in respect of timing
differences arising during the current period, tax effect of which is required to be recognised
under AS 22, should be measured using the regular tax rates and not the tax rate under
section 115JB of the Act.
Disclosure of deferred tax assets and deferred taxes liabilities in
the balance sheet of a company
Section 115JB of the Income-tax Act, 1961
ISSUE
1. The issue is how should deferred tax assets and deferred tax liabilities be disclosed in
the balance sheet of a company.
CONSENSUS
2. In case of a company, deferred tax assets should be disclosed on the face of the balance
sheet separately after the head ‘Investments’ and deferred tax liabilities should be disclosed
on the face of the balance sheet separately after the head ‘Unsecured Loans’.

3. Paragraph 30 of Accounting Standard (AS) 22, Accounting for Taxes on Income,
provides as follows:
“30. Deferred tax assets and liabilities should be distinguished from assets and
liabilities representing current tax for the period. Deferred tax assets and liabilities
should be disclosed under a separate heading in the balance sheet of the enterprise,
separately from current assets and current liabilities.”
From the above, it may be noted that the deferred tax assets and deferred tax liabilities should
be disclosed separately from current assets and current liabilities.
4. Part I of Schedule VI to the Companies Act, 1956, does not contain a specific head for
disclosure of deferred tax assets/liabilities. Section 211(1) of the Companies Act, 1956,
provides that every balance sheet of a company shall be prepared in the form set out in Part I
of Schedule VI, or as near thereto as circumstances admit. It is, therefore, clear that format of
balance sheet as set out in Part I of Schedule VI to the Companies Act, 1956, has in-built
flexibility to accommodate necessary modifications. A deferred tax asset is normally more
liquid (realisable) as compared to fixed assets and investments and less liquid as compared to
current assets. Therefore, in case of a company, it is appropriate to present the amount of the
deferred tax assets after the head ‘Investments’. Similarly, keeping in view the nature of a
‘deferred tax liability’, it is appropriate that the same is presented in the balance sheet of a
company after the head ‘Unsecured Loans’.
INTERPRETATION OF THE TERM ‘NEAR FUTURE’
Accounting Standard (AS) 21, Consolidated Financial Statements, AS 23, Accounting for
Investments in Associates in Consolidated Financial
Statements and AS 27, Financial Reporting of Interests in Joint Ventures
ISSUE
1. Paragraph 11 of AS 21, paragraph 7 of AS 23 and paragraph 29 of AS 27 use the words
‘near future’ in the context of exclusions from consolidation, application of the equity method
and application of the proportionate consolidation method, respectively.
2. The issue is what period of time should be considered as ‘near future’ for the above
purposes.
CONSENSUS
3. The issue as to what period of time should be considered as near future for the purposes
of AS 21, AS 23 and AS 27 primarily depends on the facts and circumstances of each case.
However, ordinarily, the meaning of the words ‘near future’ should be considered as not more
than twelve months from acquisition of relevant investments unless a longer period can be
justified on the basis of facts and circumstances of the case. The intention with regard to
disposal of the relevant investment should be considered at the time of acquisition of the
investment. Accordingly, if the relevant investment is acquired without an intention to its
subsequent disposal in near future, and subsequently, it is decided to dispose off the
investment, such an investment is not excluded from consolidation, application of the equity
method or application of the proportionate consolidation method, as the case may be, until the
investment is actually disposed off. Conversely, if the relevant investment is acquired with an
intention to its subsequent disposal in near future, however, due to some valid reasons, it
could not be disposed off within that period, the same will continue to be excluded from
consolidation, application of the equity method or application of the proportionate
consolidation method, as the case may be, provided there is no change in the intention.
4. A period of more than twelve months would not normally signify ‘near future’.
Accordingly, it is considered appropriate that the near future should normally be considered as
a period not exceeding twelve months.
5. Paragraph 11 of AS 21, paragraph 7 of AS 23 and paragraph 29 of AS 27, also use the
words, ‘acquired and held’. Accordingly, for exclusion from consolidation, application of the
equity method or application of the proportionate consolidation, as the case may be,
consideration of the intention at the time of acquisition of the relevant investment is essential.

Virtual Certainty Supported by Convincing Evidence
ISSUE
1. Paragraph 17 of AS 22 requires that “Where an enterprise has unabsorbed
depreciation or carry forward of losses under tax laws, deferred tax assets should be
recognised only to the extent that there is virtual certainty supported by convincing
evidence that sufficient future taxable income will be available against which such
deferred tax assets can be realised”.
2. The issue is what amounts to ‘virtual certainty supported by convincing evidence’ for the
purpose of paragraph 17 of AS 22.
CONSENSUS
3. Determination of virtual certainty that sufficient future taxable income will be available is
a matter of judgement and will have to be evaluated on a case to case basis. Virtual certainty
refers to the extent of certainty, which, for all practical purposes, can be considered certain.
Virtual certainty cannot be based merely on forecasts of performance such as business plans.
4. Virtual certainty is not a matter of perception and it should be supported by convincing
evidence. Evidence is a matter of fact. To be convincing, the evidence should be available at
the reporting date in a concrete form, for example, a profitable binding export order,
cancellation of which will result in payment of heavy damages by the defaulting party. On the
other hand, a projection of the future profits made by an enterprise based on the future capital
expenditures or future restructuring etc., submitted even to an outside agency, e.g., to a credit
agency for obtaining loans and accepted by that agency cannot, in isolation, be considered as
convincing evidence.
5. In a situation where an enterprise does not have unabsorbed depreciation or carry
forward of losses, the degree of certainty required under AS 22 for recognition of deferred tax
asset is ‘reasonable certainty’. In contrast, as a measure of greater prudence, AS 22
prescribes a much higher level of certainty, i.e., virtual certainty, for recognition of deferred tax
asset in a situation where an enterprise has unabsorbed depreciation or carry forward of
losses. Therefore, the level of certainty required for recognition of deferred tax asset in a
situation where an enterprise has unabsorbed depreciation or carry forward of losses is much
more than the situation where the enterprise does not have the same.
6. Projections on the basis of future actions of an enterprise cannot be considered as
convincing evidence since the enterprise may change its plans on the basis of subsequent
developments.

Interpretation of paragraph 4(e) of AS 16
Accounting Standard (AS) 16, Borrowing Costs
ISSUE
1. Paragraph 4 (e) of AS 16, ‘Borrowing Costs’, provides that borrowing costs may include
“exchange differences arising from foreign currency borrowings to the extent that they are
regarded as an adjustment to interest costs”.
2. The issue is which exchange differences are covered under paragraph 4 (e) of AS 16.
CONSENSUS
3. Paragraph 4 (e) of AS 16 covers exchange differences on the amount of principal of the
foreign currency borrowings to the extent of difference between interest on local currency
borrowings and interest on foreign currency borrowings. For this purpose, the interest rate for
the local currency borrowings should be considered as that rate at which the enterprise would
have raised the borrowings locally had the enterprise not decided to raise the foreign currency
borrowings. If the difference between the interest on local currency borrowings and the
interest on foreign currency borrowings is equal to or more than the exchange difference on
the amount of principal of the foreign currency borrowings, the entire amount of exchange
difference is covered under paragraph 4 (e) of AS 16.

4. Enterprises often borrow in foreign currency at a lower interest rate as an alternative to
borrowing locally in rupees, at a higher rate. However, the likely currency depreciation and
resulting exchange loss often offset, fully or partly, the difference in the interest rates. In such
cases, the exchange difference on the foreign currency borrowings to the extent of the
difference between interest on local currency borrowing and interest on foreign currency
borrowing, is regarded as an adjustment to the interest costs. This exchange difference is, in
substance, a borrowing cost. In case of an enterprise, which instead of borrowing locally at a
higher interest rate, borrows in foreign currency on the basis that the interest cost on foreign
currency borrowings as adjusted by the exchange fluctuations, is expected to be less than the
interest cost of an equivalent rupee borrowing, it is not appropriate to consider only the explicit
interest cost on the foreign currency borrowing as the borrowing costs. In such a case, to the
extent the exchange differences are regarded as an adjustment to the interest costs, as
explained above, the same should also be considered as borrowing costs and accounted for
accordingly with a view to reflect economic reality. Accordingly, such an exchange difference
is covered under AS 16.
5. The explicit interest cost, including exchange difference thereon, if any, is covered under
paragraph 4 (a) of AS 16, which provides that borrowing costs may include interest and
commitment charges on bank borrowing and other short term and long term borrowings.
Accordingly, the intention of paragraph 4(e) of AS 16 is to cover exchange differences on the
amount of the principal of the foreign currency borrowings. Further, since paragraph 4 (e) uses
the words ‘to the extent that they are regarded as an adjustment to interest costs’, the entire
exchange difference on principal amount is not covered by paragraph 4 (e). Since, the
difference between interest on local currency borrowings and interest on foreign currency
borrowings, is regarded as an adjustment to the interest costs, only the exchange difference to
the extent of such difference is covered by paragraph 4 (e) of AS 16. The entire exchange
difference on the principal amount is regarded as an adjustment to the interest cost only in a
situation where the difference between interest on local currency borrowings and interest on
foreign currency borrowings is equal to or more than the exchange difference.
APPENDIX
Facts:
XYZ Ltd. has taken a loan of USD 10,000 on April 1, 20X3, for a specific project at an interest
rate of 5% p.a., payable annually. On April 1, 20X3, the exchange rate between the currencies
was Rs. 45 per USD. The exchange rate, as at March 31, 20X4, is Rs. 48 per USD. The
corresponding amount could have been borrowed by XYZ Ltd. in local currency at an interest
rate of 11 per cent per annum as on April 1, 20X3.
The following computation would be made to determine the amount of borrowing costs for the
purposes of paragraph 4(e) of AS 16:
(i) Interest for the period = USD 10,000 x 5%x Rs. 48/USD = Rs. 24,000/-
(ii) Increase in the liability towards the principal amount = USD 10,000 x (48-45) = Rs.
30,000/-
(iii) Interest that would have resulted if the loan was taken in Indian currency = USD 10000 x
45 x 11%). = Rs. 49,500
(iv) Difference between interest on local currency borrowing and foreign currency borrowing
= Rs. 49,500 - Rs. 24,000 = Rs. 25,500
Therefore, out of Rs. 30,000 increase in the liability towards principal amount, only Rs. 25,500
will be considered as the borrowing cost. Thus, total borrowing cost would be Rs. 49,500
being the aggregate of interest of Rs. 24,000 on foreign currency borrowings (covered by
paragraph 4(a) of AS 16) plus the exchange difference to the extent of difference between
interest on local currency borrowing and interest on foreign currency borrowing of Rs. 25,500.
Thus, Rs. 49,500 would be considered as the borrowing cost to be accounted for as per AS 16
and the remaining Rs. 4,500 would be considered as the exchange difference to be accounted
for as per Accounting Standard (AS) 11, The Effects of Changes in Foreign Exchange Rates.
In the above example, if the interest rate on local currency borrowings is assumed to be 13%
instead of 11%, the entire exchange difference of Rs. 30,000 would be considered as
borrowing costs, since in that case the difference between the interest on local currency
borrowings and foreign currency borrowings i.e., Rs. 34,500 (Rs. 58,500 - Rs. 24,000) is more
than the exchange difference of Rs. 30,000. Therefore, in such a case, the total borrowing
cost would be Rs. 54,000 (Rs. 24,000 + Rs. 30,000) which would be accounted for under AS
16 and there would be no exchange difference to be accounted for under AS 11.

Accounting for Taxes on Income in case of an Amalgamation
ISSUE
1. The following issues relating to accounting for taxes on income in the case of an
amalgamation are dealt with in this Interpretation:
(i) In an amalgamation in the nature of purchase, where the consideration for the
amalgamation is allocated to the individual identifiable assets/liabilities of the transferor
enterprise on the basis of their fair values at the date of amalgamation as per AS 14,
‘Accounting for Amalgamations’, and the carrying amounts thereof for tax purposes
continue to be the same as that for the transferor enterprise, whether deferred tax on the
difference between the values of the assets/liabilities arrived at for accounting purposes
on the basis of their fair values and the carrying amounts thereof for tax purposes should
be recognised.∗
(ii) If any deferred tax asset, including in respect of unabsorbed depreciation and carry
forward of losses, was not recognised by the transferor enterprise, because the
conditions relating to prudence laid down in paragraph 15 or paragraph 17, as the case
may be, of AS 22, were not satisfied, whether the transferee enterprise can recognise the
same if the conditions relating to prudence as per AS 22 are satisfied.
CONSENSUS
2. In an amalgamation in the nature of purchase, where the consideration for the
amalgamation is allocated to the individual identifiable assets/liabilities on the basis of their
fair values at the date of amalgamation as per AS 14, ‘Accounting for Amalgamations’, and the
carrying amounts thereof for tax purposes continue to be the same as that for the transferor
enterprise, deferred tax on the difference between the values of the assets/liabilities, arrived at
∗
In case of an amalgamation in the nature of merger and amalgamation in the nature of purchase
where the transferee enterprise incorporates the assets/liabilities of the transferor enterprise at their
existing carrying amounts as per AS 14 and the carrying amounts thereof for tax purposes
continue to be the same as that for the transferor enterprise, the amalgamation does not, in itself,
give rise to any difference between the carrying amounts of assets/liabilities for accounting
purposes and tax purposes and, consequently, to any deferred tax asset/liability. Accordingly, in
respect of such amalgamations, this issue does not arise.
for accounting purposes on the basis of their fair values, and the carrying amounts thereof for
tax purposes should not be recognised as this constitutes a permanent difference. The
consequent differences between the amounts of depreciation for accounting purposes and tax
purposes in respect of such assets in subsequent years would also be permanent differences.
3. In a situation where any deferred tax asset, including in respect of unabsorbed
depreciation and carry forward of losses, was not recognised by the transferor enterprise,
because the conditions relating to prudence laid down in paragraph 15 or paragraph 17, as the
case may be, of AS 22, were not satisfied, the transferee enterprise can recognise the same if
the conditions relating to prudence as per AS 22 are satisfied. In such a case, the accounting
treatment, as described below, depends on the nature of amalgamation as well as the
accounting treatment adopted for amalgamation in accordance with AS 14.
(i) Where the amalgamation is in the nature of purchase and the consideration for the
amalgamation is allocated to individual identifiable assets/liabilities on the basis of their
fair values at the date of amalgamation as permitted in AS 14, the deferred tax assets
should be recognised by the transferee enterprise at the time of amalgamation itself
considering these as identifiable assets. These deferred tax assets can be recognised at
the time of amalgamation only if the conditions relating to prudence laid down in
paragraph 15 or paragraph 17, as the case may be, of AS 22, are satisfied from the point
of view of the transferee enterprise at the time of amalgamation. The recognition of
deferred tax assets will automatically affect the amount of the goodwill/capital reserve
arising on amalgamation.
In a case where the conditions for recognition of deferred tax assets as per AS 22 are not
satisfied at the time of the amalgamation, but are satisfied by the first annual balance
sheet date following the amalgamation, the deferred tax assets are recognised in
accordance with paragraph 19 of AS 22. The corresponding adjustment should be made
to the goodwill/capital reserve arising on the amalgamation. If, however, the conditions
for recognition of deferred tax assets are not satisfied even by the first annual balance
sheet date following the amalgamation, the corresponding effect of any subsequent
recognition of the deferred tax asset on the satisfaction of the conditions should be given
in the statement of profit and loss of the year in which the conditions are satisfied and not
in the goodwill/capital reserve.
(ii) Where the amalgamation is in the nature of purchase and the transferee enterprise
incorporates the assets/liabilities of the transferor enterprise at their existing carrying
amounts as permitted in AS 14, the deferred tax assets should not be recognised at the
time of amalgamation. However, if, by the first annual balance sheet date subsequent to
amalgamation, the unrecognised deferred tax assets are recognised pursuant to the
provisions of paragraph 19 of AS 22 relating to re-assessment of unrecognised deferred
tax assets, the corresponding adjustment should be made to goodwill/capital reserve
arising on the amalgamation. In a case where the conditions for recognition of deferred
tax assets as per AS 22 are not satisfied by the first annual balance sheet date following
the amalgamation, the corresponding effect of any subsequent recognition of the
deferred tax asset on the satisfaction of the conditions should be given in the statement
of profit and loss of the year in which the conditions are satisfied and not in the
goodwill/capital reserve.
(iii) Where the amalgamation is in the nature of merger, the deferred tax assets should not
be recognised at the time of amalgamation. However, if, by the first annual balance sheet
date subsequent to the amalgamation, the unrecognised deferred tax assets are
recognised pursuant to the provisions of paragraph 19 of AS 22 relating to re-
assessment of unrecognised deferred tax assets, the corresponding adjustment should
be made to the revenue reserves. In a case where the conditions for recognition of
deferred tax assets as per AS 22 are not satisfied by the first annual balance sheet date
following the amalgamation, the corresponding effect of any subsequent recognition of
the deferred tax asset on the satisfaction of the conditions should be given in the
statement of profit and loss of the year in which the conditions are satisfied and not in the
revenue reserves.
4. AS 22 is based on the ‘income statement approach’. In an amalgamation in the nature of

purchase, recognition of individual identifiable assets/liabilities of the transferor enterprise on
the basis of their fair values at the date of amalgamation does not affect the statement of profit
and loss. In a situation where, as per the tax laws, the carrying amounts of the
assets/liabilities acquired as a result of amalgamation in the nature of purchase continue to be
the same as that for the transferor enterprise, the difference between the carrying amounts of
assets/liabilities (with reference to fair values) for accounting purposes and the carrying
amounts thereof for tax purposes will never be allowed for deduction for tax purposes.
Accordingly, the difference between the carrying amounts of assets/liabilities for accounting
purposes and that for tax purposes is a permanent difference. The consequent differences
between the amounts of depreciation for accounting purposes and tax purposes in respect of
such assets in subsequent years would also be permanent differences.
5. There may be certain deferred tax assets that were not recognised by the transferor
enterprise before the amalgamation because there was no reasonable certainty or virtual
certainty, as the case of may be, of the availability of future taxable income against which
such assets can be realised. On amalgamation, the availability of future taxable income may
become reasonably certain or virtually certain, as the case may be, against which such assets
can be realised.
In the case of amalgamation in the nature of purchase where the consideration for
amalgamation is allocated to individual identifiable assets and liabilities on the basis of their
fair values, the deferred tax assets are recognised, subject to the requirements of AS 22,
considering these as identifiable assets at the time of amalgamation itself since identifiable
assets and liabilities acquired include assets, such as deferred tax assets, and liabilities not
recorded in the financial statements of transferor enterprise. The recognition of deferred tax
assets will automatically affect the amount of the goodwill/capital reserve arising on
amalgamation.
In case of amalgamation in the nature of purchase where the transferee enterprise
incorporates the assets and liabilities of the transferor enterprise of the transferor enterprise at
their existing carrying amounts as per AS 14, the deferred tax assets are not recognised at the
time of amalgamation since, as per AS 14, assets/liabilities of the transferor enterprise are
recognised at their existing carrying amounts in the balance sheet of the transferee enterprise.
Therefore, the assets which are not appearing in the balance sheet of the transferor enterprise
at the time of amalgamation can not be recognised. However, by the first annual balance
sheet date following the amalgamation, the deferred tax assets are recognised by the
transferee enterprise subject to the provisions of paragraph 19 of AS 22. The corresponding
adjustment is made in the goodwill/capital reserve, since, normally, the benefits to be received
from deferred tax assets are in-built in the purchase consideration. Since, in such a case, the
benefits to be received from deferred tax assets get clubbed with the goodwill/capital reserve,
on a separate recognition of deferred tax assets by the first annual balance sheet date
following the amalgamation, it is appropriate to adjust the same against goodwill/capital
reserve and not in the statement of profit and loss of the transferee enterprise. In a case
where the conditions of recognition of deferred tax assets as per AS 22 are not satisfied by the
first annual balance sheet date following the amalgamation, the corresponding effect of any
subsequent recognition of the deferred tax asset on the satisfaction of the conditions is given
in the statement of profit and loss of the year in which the conditions are satisfied and not in
the goodwill/capital reserve. The reason for this is that after the first annual balance sheet
following the amalgamation, the satisfaction of conditions relating to prudence as laid down in
AS 22, is not attributed to the amalgamation but is a result of the operations of the combined
enterprises. Therefore, it is not appropriate to adjust the goodwill/capital reserves arising on
amalgamation.
In case of amalgamation in the nature of merger, since as per AS 14, assets/liabilities of the
transferor enterprise are recognised at their existing carrying amounts in the balance sheet of
the transferee enterprise, at the time of amalgamation, no deferred tax asset is recognised.
However, by the first annual balance sheet date following the amalgamation, the deferred tax
assets are recognised subject to the provisions of paragraph 19 of AS 22. The corresponding
adjustment is made to the revenue reserves, since in case of amalgamation in the nature of
merger the situation should be the same had merged entities were continuing as one entity
from the beginning. Keeping in view this objective, the corresponding effect is given to
revenue reserves since had the merged entities been continuing as one entity from the
beginning, the deferred tax assets would have been recognised earlier and would have
affected the revenue reserves and not the profit or loss for the year. In a case where the
conditions of recognition of deferred tax assets as per AS 22 are not satisfied by the first
annual balance sheet date following the amalgamation, the corresponding effect of any
subsequent recognition of the deferred tax assets on the satisfaction of the conditions is given
in the statement of profit and loss of the year in which the conditions are satisfied and not to
the revenue reserves. The reason for this is that after the first annual balance sheet following
the amalgamation, the satisfaction of conditions relating to prudence as laid down in AS 22, is
not attributed to the merger but is a result of the operations of the merged entities. Therefore,
it is not appropriate to adjust the revenue reserves.

Applicability of AS 20 Accounting Standard (AS) 20,
Earnings per Share Issue
[Pursuant to the issuance of this Accounting Standards Interpretation, General Clarification
(GC) – 1/2002, issued in March 2002 stands withdrawn.]
ISSUE
1. Whether companies which are required to give information under Part IV of Schedule VI
to the Companies Act, 1956, should calculate and disclose earnings per share in accordance
with AS 20.
CONSENSUS
2. Every company, which is required to give information under Part IV of Schedule VI to the
Companies Act, 1956, should calculate and disclose earnings per share in accordance with
AS 20, whether or not its equity shares or potential equity shares are listed on a recognised
stock exchange in India.
3. AS 20, ‘Earnings Per Share’, has come into effect in respect of accounting periods
commencing on or after 1-4-2001 and is mandatory in nature, from that date, in respect of
enterprises whose equity shares or potential equity shares are listed on a recognised stock
exchange in India. AS 20 does not mandate an enterprise, which has neither equity shares nor
potential equity shares which are so listed, to calculate and disclose earnings per share, but, if
that enterprise discloses earnings per share for complying with the requirements of any statute
or otherwise, it should calculate and disclose earnings per share in accordance with AS 20.
4. Part IV of Schedule VI to the Companies Act, 1956, requires, among other things,
disclosure of earnings per share. Accordingly, every company, which is required to give
information under Part IV of Schedule VI to the Companies Act, 1956, should calculate and
disclose earnings per share in accordance with AS 20, whether or not its equity shares or
potential equity shares are listed on a recognised stock exchange in India.

Interpretation of paragraphs 26 and 27 of AS 18
Accounting Standard (AS) 18, Related Party Disclosures
(GC) – 2/2002, issued in May 2002 stands withdrawn.]
ISSUES
1. Paragraph 23 of AS 18 requires certain disclosures in respect of transactions between
related parties. Paragraph 26 of AS 18, inter alia, provides that items of a similar nature may
be disclosed in aggregate by type of related party. The issue is as to what is the meaning of
type of related party for this purpose.
2. Paragraph 27 of AS 18 provides that “Disclosure of details of particular transactions with
individual related parties would frequently be too voluminous to be easily understood.
Accordingly, items of a similar nature may be disclosed in aggregate by type of related party.
However, this is not done in such a way as to obscure the importance of significant
transactions. Hence, purchases or sales of goods are not aggregated with purchases or sales
of fixed assets. Nor a material related party transaction with an individual partly is
clubbed in an aggregated disclosure” (emphasis added). The issue is as to how the test of
the materiality should be applied for this purpose.
CONSENSUS
3. The type of related party for the purpose of aggregation of items of a similar nature
should be construed to mean the related party relationships given in paragraph 3 of AS 18.
The manner of disclosure required by paragraph 23 of AS 18, read with paragraph 26 thereof,
in accordance with the above requirement, is illustrated in the Appendix to this Interpretation.
4. Materiality primarily depends on the facts and circumstances of each case. In deciding
whether an item or an aggregate of items is material, the nature and the size of the item(s) are
evaluated together. Depending on the circumstances, either the nature or the size of the item
could be the determining factor. As regards size, for the purpose of applying the test of
materiality as per paragraph 27 of AS 18, ordinarily a related party transaction, the amount of
which is in excess of 10% of the total related party transactions of the same type (such as
purchase of goods), is considered material, unless on the basis 1 The authority of this ASI is
the same as that of the Accounting Standard to which it relates. The contents of this ASI are
intended for the limited purpose of the Accounting Standard to which it relates. ASI is intended
to apply only to material items. A:\ASIs\ASI 13(GC2).doc - 2 - of facts and circumstances of
the case it can be concluded that even a transaction of less than 10% is material. As regards
nature, ordinarily the related party transactions which are not entered into in the normal course
of the business of the reporting enterprise are considered material subject to the facts and
circumstances of the case.

5. Paragraphs 23 and 26 of AS 18 provide as below:
“23. If there have been transactions between related parties, during the existence of a
related party relationship, the reporting enterprise should disclose the following:
(i) the name of the transacting related party;
(ii) a description of the relationship between the parties;
(iii) a description of the nature of transactions;
(iv) volume of the transactions either as an amount or as an appropriate proportion;
(v) any other elements of the related party transactions necessary for an
understanding of the financial statements;
(vi) the amounts or appropriate proportions of outstanding items pertaining to related
parties at the balance sheet date and provisions for doubtful debts due from such
parties at that date; and
(vii) amounts written off or written back in the period in respect of debts due from or to
related parties.
26. Items of a similar nature may be disclosed in aggregate by type of related party
except when separate disclosure is necessary for an understanding of the effects of
related party transactions on the financial statements of the reporting enterprise.”
6. Paragraph 3 of AS 18 provides as under:
“This Statement deals only with related party relationships described in (a) to (e) below:
(a) enterprises that directly, or indirectly through one or more intermediaries, control, or are
controlled by, or are under common control with, the reporting enterprise (this includes
holding companies, subsidiaries and fellow subsidiaries);
venturer in respect of which the reporting enterprise is an associate or a joint venture;
(c) individuals owning, directly or indirectly, an interest in the voting power of the reporting
enterprise that gives them control or significant influence over the enterprise, and
relatives of any such individual;
(e) enterprises over which any person described in (c) or (d) is able to exercise significant
influence. This includes enterprises owned by directors or major shareholders of the
reporting enterprise and enterprises that have a member of key management in common
with the reporting enterprise.”
7. In view of the above, for the purpose of providing disclosures under paragraph 23 of AS
18, the items of a similar nature may be aggregated by the type of related parties described in
paragraph 3 of AS 18, e.g., subsidiaries, joint ventures, associates etc. However, the
aggregation cannot be done when separate disclosure is necessary for an understanding of
the effects of related party transactions on the financial statements of the reporting enterprise.
8. Paragraph 30 of the Framework for the Preparation and Presentation of Financial
Statements, provides as follows:
“30. The relevance of information is affected by its materiality. Information is material if its
misstatement (i.e., omission or erroneous statement) could influence the economic decisions
of users taken on the basis of the financial information. Materiality depends on the size and
nature of the item or error, judged in the particular circumstances of its misstatement.
Materiality provides a threshold or cut-off point rather than being a primary qualitative
characteristic which the information must have if it is to be useful”.
In the context of paragraph 27 of AS 18, a rebuttable presumption of 10% is considered
appropriate for application of the test of materiality so far as size is concerned. Further, since
materiality not only depends on the size but also depends on the nature of the transaction, the
related party transactions, which are not entered into in the normal course of the business are
considered material on the basis of facts and circumstances of the case. An example of such
a transaction is purchase of an asset by an enterprise from an outside party and selling the
same to its subsidiary when the parent is not primarily engaged in the purchase and sale of
such assets. Another example could be granting a loan by a parent enterprise to its subsidiary
when the parent is not primarily engaged in the financial activities.
Appendix
The manner of disclosures required by paragraphs 23 and 26 of AS 18 is illustrated as below.
It may be noted that the format given below is merely illustrative in nature and is not
exhaustive.
Holding Subsidiaries Fellow Associates Key Relatives of Total
Company Subsidiaries Management Key
Personnel Management
Personnel
Purchases of
goods
Sale of goods
Purchases of
fixed assets
Sale of fixed
assets
Rendering of
services
Receiving of
services
Agency
arrangements
Leasing or
hire purchase
arrangements
Transfer of
research and
development
Licence
agreements
Finance
(including
loans and
equity
contribution in
cash or in
kind)
Guarantees
and collaterals
Management
contracts
including for
deputation of
employees
Note:
Names of related parties and description of relationship:
1. Holding Company A Ltd.
2. Subsidiaries B Ltd. and C (P) Ltd.
3. Fellow Subsidiaries D Ltd. and Q Ltd.
4. Associates X Ltd., Y Ltd. and Z (P) Ltd.
5. Key Management Personnel Mr. Y and Mr. Z
6. Relatives of Key Management Personnel

Mrs. Y (wife of Mr. Y), Mr. F (father of Mr. Z)

(Revised)
Disclosure of Revenue from Sales
Transactions
Accounting Standard (AS) 9, Revenue Recognition
[This revised Accounting Standards Interpretation replaces ASI 14 issued in March 2004.]
ISSUE
1. What should be the manner of disclosure of excise duty in the presentation of revenue
from sales transactions (turnover) in the statement of profit and loss.
CONSENSUS
2. The amount of turnover should be disclosed in the following manner on the face of the
statement of profit and loss:
Turnover (Gross) XX
Less: Excise Duty XX
Turnover (Net) XX
3. The amount of excise duty to be shown as deduction from turnover as per paragraph 2
above should be the total excise duty for the year except the excise duty related to the
difference between the closing stock and opening stock. The excise duty related to the
difference between the closing stock and opening stock should be recognised separately in
the statement of profit and loss, with an explanatory note in the notes to accounts to explain
the nature of the two amounts of excise duty.
4. Financial analysts and other users of financial statements, sometimes, require the
information related to turnover gross of excise duty as well as net of excise duty for
meaningful understanding of financial statements.
However, it was noted that some enterprises disclose turnover net of excise duty while others
disclose turnover at gross amount. Accordingly, this Interpretation requires disclosure of
turnover gross of excise duty as well as net of excise duty on the face of the statement of
profit and loss.
5. The excise duty related to the difference between the closing stock and opening stock is
not shown as deduction from turnover since it is not included in the turnover (gross). As per
the interpretation, the excise duty related to the difference between the closing stock and
opening stock is recognised separately in the statement of profit and loss.
6. As per the interpretation, two amounts of excise duty would be appearing in the
statement of profit and loss: one as deduction from turnover and the other as a separate item
in the statement of profit and loss. With a view to explain the nature of these two amounts of
excise duty appearing in the statement of profit and loss, this Interpretation requires an
explanatory note to be included in this regard in the notes to accounts.

Notes to the Consolidated Financial Statements
Accounting Standard (AS) 21, Consolidated Financial Statements
(GC) – 5/2002, issued in June 2002, stands withdrawn.]
ISSUE
1. Whether all the notes appearing in the separate financial statements of the parent
enterprise and its subsidiaries should be included in the notes to the consolidated financial
statements.
CONSENSUS
2. All the notes appearing in the separate financial statements of the parent enterprise and
its subsidiaries need not be included in the notes to the consolidated financial statements. For
preparing consolidated financial statements, the following principles should be observed in
respect of notes and other explanatory material that form an integral part thereof:
(a) Notes which are necessary for presenting a true and fair view of the consolidated
financial statements should be included in the consolidated financial statements as an
integral part thereof.
(b) Only the notes involving items which are material need to be disclosed. Materiality for
this purpose should be assessed in relation to the information contained in consolidated
financial statements. In view of this, it is possible that certain notes which are disclosed
in separate financial statements of a parent or a subsidiary would not be required to be
disclosed in the consolidated financial statements when the test of materiality is applied
in the context of consolidated financial statements.
(c) Additional statutory information disclosed in separate financial statements of the
subsidiary and/or a parent having no bearing on the true and fair view of the consolidated
financial statements need not be disclosed in the consolidated financial statements. For
instance, in the case of companies, the information such as the following given in the
notes to the separate financial statements of the parent and/or the subsidiary, need not
be included in the consolidated financial statements:

(i) Source from which bonus shares are issued, e.g., capitalisation of profits or
Reserves or from Share Premium Account.
(ii) Disclosure of all unutilised monies out of the issue indicating the form in which such
unutilised funds have been invested.
(iii) The name(s) of small scale industrial undertaking(s) to whom the company owe any
sum together with interest outstanding for more than thirty days.
(iv) A statement of investments (whether shown under “Investment” or under “Current
Assets” as stock-in-trade) separately classifying trade investments and other
investments, showing the names of the bodies corporate (indicating separately the
names of the bodies corporate under the same management) in whose shares or
debentures, investments have been made (including all investments, whether
existing or not, made subsequent to the date as at which the previous balance sheet
was made out) and the nature and extent of the investment so made in each such
body corporate.
(v) Quantitative information in respect of sales, raw materials consumed, opening and
closing stocks of goods produced/traded and purchases made, wherever applicable.
(vi) A statement showing the computation of net profits in accordance with section 349
of the Companies Act, 1956, with relevant details of the calculation of the
commissions payable by way of percentage of such profits to the directors
(including managing directors) or manager (if any).
(vii) In the case of manufacturing companies, quantitative information in regard to the
licensed capacity (where licence is in force); the installed capacity; and the actual
production.
(viii) Value of imports calculated on C.I.F. basis by the company during the financial year
in respect of :- (a) raw materials; (b) components and spare parts; (c) capital goods.
(ix) Expenditure in foreign currency during the financial year on account of royalty,
know-how, professional, consultation fees, interest, and other matters.
(x) Value of all imported raw materials, spare parts and components consumed during
the financial year and the value of all indigenous raw materials, spare parts and
components similarly consumed and the percentage of each to the total
consumption.
(xi) The amount remitted during the year in foreign currencies on account of dividends,
with a specific mention of the number of non-resident shareholders, the number of
shares held by them on which the dividends were due and the year to which the
dividends related.
(xii) Earnings in foreign exchange classified under the following heads, namely:-
(a) export of goods calculated on F.O.B. basis;
(b) royalty, know-how, professional and consultation fees;

(c) interest and dividend;
(d) other income, indicating the nature thereof.
3. Paragraph 6 of Accounting Standard (AS) 21, Consolidated Financial Statements, states
as below: “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.”
5. In view of the above, consolidated financial statements should be prepared considering
parent and subsidiary enterprises as one enterprise. Therefore, the test of materiality is to be
applied in the context of the consolidated financial statements.
6. As per the Framework for the Preparation and Presentation of Financial Statements, the
benefits derived from information should exceed the cost of providing it. In the separate
financial statements, certain information is disclosed as a result of the statutory requirements.
Such information may not have a bearing on the true and fair view of the consolidated
financial statements. Accordingly, with a view to maintain a balance between cost and the
benefits, such information need not be disclosed in the consolidated financial statements.
Treatment of Proposed Dividend under AS 23
Accounting Standard (AS) 23, Accounting for Investments in
Associates in Consolidated Financial Statements
[Pursuant to the issuance of this Accounting Standards Interpretation, General Clarification (GC) –
6/2002, issued in June 2002, stands withdrawn.]
ISSUE
1. In case an associate has made a provision for proposed dividend in its financial
statements, whether the investor should consider the same while computing its share of the
results of operations of the associate.
CONSENSUS
2. In case an associate has made a provision for proposed dividend in its financial
statements, the investor’s share of the results of operations of the associate should be
computed without taking into consideration the proposed dividend.
3. Pursuant to the requirements of Schedule VI to the Companies Act, 1956, the provision
for dividend is shown under the head ‘Current Liabilities and Provisions’, and in the statement
of profit of loss account, it is included after determination of the net profit or loss for the period
(below the line). Although provision for dividend is disclosed by companies which are
governed by the Companies Act, 1956, under the head ‘Current Liabilities and Provisions’,
from accounting point of view, it is strictly not a liability. In this context, the definition of the
term ‘liability’ can be noted from the ‘Framework for the Preparation and Presentation of
Financial Statements’, which is as follows:
“A liability is a present obligation of the enterprise arising from past events, the settlement of
which is expected to result in an outflow from the enterprise of resources embodying economic
benefits.”
Proposed dividend, pending the approval of the shareholders in General Meeting, does not
fulfill the above definition since it is not a present obligation at the balance sheet date.
4. AS 23 defines ‘the equity method’ as under:
“The equity method is a method of accounting whereby the investment is initially
recorded at cost, identifying any goodwill/capital reserve arising at the time of
acquisition. The carrying amount of the investment is adjusted thereafter for the post
acquisition change in the investor’s share of net assets of the investee. The
consolidated statement of profit and loss reflects the investor’s share of the results of
operations of the investee.”
Paragraph 6 of AS 23 states that:
“ …..Distributions received from an investee reduce the carrying amount of the investment…..”
In view of paragraph 3 above, it is appropriate that while applying the equity method, proposed
dividend provided by the associate in its separate financial statements is not considered by
the investor.

Adjustments to the Carrying Amount of Investment arising
from Changes in Equity not Included in the Statement
of Profit and Loss of the Associate
ISSUE
1. The issue is as to how the adjustments to the carrying amount of investment in an
associate arising from changes in the associate’s equity that have not been included in the
statement of profit and loss of the associate, should be made.
CONSENSUS
2. Adjustments to the carrying amount of investment in an associate arising from changes in
the associate’s equity that have not been included in the statement of profit and loss of the
associate should be directly made in the carrying amount of investment without routing it
through the consolidated statement of profit and loss. The corresponding debit/credit should
be made in the relevant head of the equity interest in the consolidated balance sheet. For
example, in case the adjustment arises because of revaluation of fixed assets by the
associate, apart from adjusting the carrying amount of investment to the extent of
proportionate share of the investor in the revalued amount, the corresponding amount of
revaluation reserve should be shown in the consolidated balance sheet.
3. Paragraph 6 of AS 23 states as follows:
“6. Under the equity method, the investment is initially recorded at cost, identifying any
goodwill/capital reserve arising at the time of acquisition and the carrying amount is increased
or decreased to recognise the investor’s share of the profits or losses of the investee after the
date of acquisition. Distributions received from an investee reduce the carrying amount of the
investment. Adjustments to the carrying amount may also be necessary for alterations in the 1
The authority of this ASI is the same as that of the Accounting Standard to which it relates.
The contents of this ASI are intended for the limited purpose of the Accounting Standard to
which it relates. ASI is intended to apply only to material items. A:\ investor’s proportionate
interest in the investee arising from changes in the investee’s equity that have not been
included in the statement of profit and loss. Such changes include those arising from the
revaluation of fixed assets and investments, from foreign exchange translation differences and
from the adjustment of differences arising on amalgamations.”

4. In view of the above, adjustments to the carrying amount of an investment in an
associate are made for alterations in the investor’s proportionate interest in the investee
arising from changes in the investee’s equity that have not been included in the statement of
profit and loss. In respect of the corresponding effect of such adjustments, it is not appropriate
to route the same through the consolidated statement of profit and loss since the relevant item
has not been recognised by the associate in its statement of profit and loss.
Consideration of Potential Equity Shares for Determining
whether an Investee is an Associate under AS 23
ISSUE
1. For applying the definition of an ‘associate’, whether the potential equity shares of the
investee held by the investor should be taken into account for determining the voting power of
the investor.
CONSENSUS
2. The potential equity shares of the investee held by the investor should not be taken into
account for determining the voting power of the investor.
3. AS 23 defines ‘associate’ as “an enterprise in which the investor has significant
influence and which is neither a subsidiary nor a joint venture of the investor”.
‘Significant influence’ is defined in AS 23 as “the power to participate in the financial
and/or operating policy decisions of the investee but not control over those policies”.
AS 23 further explains in paragraph 4 that as regards share ownership, if an investor holds,
directly or indirectly through subsidiary(ies), 20% or more of the voting power of the investee,
it is presumed that the investor has significant influence, unless it can be clearly demonstrated
that this is not the case. Conversely, if the investor holds, directly or indirectly through
subsidiary(ies), less than 20% of the voting power of the investee, it is presumed that the
investor does not have significant influence, unless such influence can be clearly
demonstrated.
4. For the above purpose, it is appropriate that the voting power is determined on the basis
of the current outstanding securities with voting rights since potential equity shares do not
have the voting power from the point of view of participating in the financial and/or operating
policy decisions of the investee.
Interpretation of the term ‘intermediaries’
Accounting Standard (AS) 18,
Related Party Disclosures
(GC) – 9/2002, issued in October 2002, stands withdrawn.]
ISSUE
1. The issue is how the term ‘intermediaries’ should be interpreted for the purposes of
paragraphs 3 and 13 of AS 18.
CONSENSUS
2. For the purposes of paragraphs 3 and 13 of AS 18, the term ‘intermediaries’ should be
confined to mean enterprises which are ‘subsidiaries’ as defined in AS 21, Consolidated
Financial Statements.
3. Paragraphs 3 and 13 of AS 18 state as under:
“3. This Statement deals only with related party relationships described in (a) to (e) below:
holding companies, subsidiaries and fellow subsidiaries); ……………….”
“13. Significant influence may be exercised in several ways, for example, by representation on
the board of directors, participation in the policy making process, material inter-company
transactions, interchange of managerial personnel, or dependence on technical information.
Significant influence may be gained by share ownership, statute or agreement. As regards
share ownership, if an investing party holds, directly or indirectly through intermediaries, 20
per cent or more of the voting power of the enterprise, it is presumed that the investing party
does have significant influence, unless it can be clearly demonstrated that this is not the case.
Conversely, if the investing party holds, directly or indirectly through intermediaries, less than
20 per cent of the voting power of the enterprise, it is presumed that the investing party does
not have significant influence, unless such influence can be clearly demonstrated. A
substantial or majority ownership by another investing party does not necessarily preclude an
investing party from having significant influence.”
4. In the context of ‘control’ and exercise of ‘significant influence’, the meaning of the term
‘intermediaries’ should be confined to mean only enterprises which are ‘subsidiaries’ within the
meaning of AS 21, and extending it to cover ‘associate’ etc. would not be practicable.
(Revised)
Disclosure of Segment Information
ISSUE
1. Whether an enterprise, which has neither more than one business segment nor more
than one geographical segment, is required to disclose segment information as per AS 17.
CONSENSUS
2. In case, by applying the definitions of ‘business segment’ and ‘geographical segment’,
contained in AS 17, it is concluded that there is neither more than one business segment nor
more than one geographical segment, segment information as per AS 17 is not required to be
disclosed. However, the fact that there is only one ‘business segment’ and ‘geographical
segment’ should be disclosed by way of a note only.
3. The paragraph of AS 17 dealing with ‘Objective’ provides as under:
“The objective of this Statement is to establish principles for reporting financial information,
about the different types of products and services an enterprise produces and the different
geographical areas in which it operates. Such information helps users of financial statements:
(a) better understand the performance of the enterprise;
(b) better assess the risks and returns of the enterprise; and
(c) make more informed judgements about the enterprise as a whole.
Many enterprises provide groups of products and services or operate in geographical areas
that are subject to differing rates of profitability, opportunities for growth, future prospects, and
risks. Information about different types of products and services of an enterprise and its
operations in different geographical areas - often called segment information - is relevant to
assessing the risks and returns of a diversified or multi-locational enterprise but may not be
determinable from the aggregated data. Therefore, reporting of segment information is widely
regarded as necessary for meeting the needs of users of financial statements.”
In case of an enterprise, which has neither more than one business segment nor more than
one geographical segment, the relevant information is available from the balance sheet and
statement of profit and loss itself and, therefore, keeping in view the objective of segment
reporting, such an enterprise is not required to disclose segment information as per AS 17.
The disclosure of the fact that there is only one ‘business segment’ and ‘geographical
segment’ and therefore, the segment information is not provided by the concerned enterprise
is useful for the users of the financial statements while making a comparison among various
enterprises.
Non-Executive Directors on the Board – whether related parties
ISSUES
1. The issue is as to whether a non-executive director on the Board of Directors of a
company is a key management person.
2. Another related issue is as to whether a non-executive director is covered by AS 18 in
case he participates in the financial and/or operating policy decisions of an enterprise.
CONSENSUS
3. A non-executive director of a company should not be considered as a key management
person under AS 18 by virtue of merely his being a director unless he has the authority and
responsibility for planning, directing and controlling the activities of the reporting enterprise.
4. The requirements of AS 18 should not be applied in respect of a non-executive director
even if he participates in the financial and/or operating policy decision of the enterprise, unless
he falls in any of the categories in paragraph 3 of AS 18.
5. AS 18 defines “key management personnel” as under:
“Key management personnel - those persons who have the authority and responsibility
for planning, directing and controlling the activities of the reporting enterprise.”
Paragraph 14 of AS 18 explains as under:
“14. Key management personnel are those persons who have the authority and responsibility
for planning, directing and controlling the activities of the reporting enterprise. For example, in
the case of a company, the managing director(s), whole time director(s), manager and any
person in accordance with whose directions or instructions the board of directors of the
company is accustomed to act, are usually considered key management personnel.”
AS 18 considers only such persons as key management personnel who have the authority and
Therefore, merely being a director of a company is not sufficient for becoming key
management person within the meaning of AS 18, unless that director has the authority and
6. AS 18 defines ‘related party’ and ‘significant influence’ as below:
“Related party - 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.”
“Significant influence - participation in the financial and/or operating policy decisions
of an enterprise, but not control of those policies.”
A non-executive director, who participates in the financial and/or operating policy decisions of
the enterprise, may qualify as a ‘related party’. However, paragraphs 2 and 3 of AS 18 dealing
with the scope of AS 18 provide as below:
“2. This Statement applies only to related party relationships described in paragraph 3.
3. This Statement deals only with related party relationships described in (a) to (e) below:
holding companies, subsidiaries and fellow subsidiaries);
venturer in respect of which the reporting enterprise is an associate or a joint venture;
(c) individuals owning, directly or indirectly, an interest in the voting power of the reporting
enterprise that gives them control or significant influence over the enterprise, and
relatives of any such individual;
(e) enterprises over which any person described in (c) or (d) is able to exercise significant
influence. This includes enterprises owned by directors or major shareholders of the
reporting enterprise and enterprises that have a member of key management in common
with the reporting enterprise.”
In view of the above, a non-executive director, merely by virtue of his being a director and
thereby participating in the financial and/or operating policy decisions of the enterprise, is not
covered under any one of the above. Accordingly, AS 18 is not applicable to such a non-
executive director. However, a non-executive director is covered by a related party
relationship in case other requirements of the Standard are met. For instance, he is
considered as a key management person as per paragraph 3 of this Interpretation or he is in a
position to exercise control or significant influence by virtue of owning an interest in the voting
power as per paragraph 3 (c) of AS 18.

Treatment of Interest for determining Segment Expense
ISSUES
1. Whether interest expense relating to overdrafts and other operating liabilities identified to
a particular segment should be included in the segment expense or not.
2. Another issue is that in case interest is included as a part of the cost of inventories where
it is so required as per Accounting Standard (AS) 16, Borrowing Costs, read with Accounting
Standard (AS) 2, Valuation of Inventories, and those inventories are part of segment assets of
a particular segment, whether such interest would be considered as a segment expense.
CONSENSUS
3. The interest expense relating to overdrafts and other operating liabilities identified to a
particular segment should not be included as a part of the segment expense unless the
operations of the segment are primarily of a financial nature or unless the interest is included
as a part of the cost of inventories as per paragraph 4 below.
4. In case interest is included as a part of the cost of inventories where it is so required as
per AS 16, read with AS 2, Valuation of Inventories, and those inventories are part of segment
assets of a particular segment, such interest should be considered as a segment expense.
In this case, the amount of such interest and the fact that the segment result has been arrived
at after considering such interest should be disclosed by way of a note to the segment result.
5. The definition of the term “segment expense” (paragraph 5) contained in AS 17 does not
include, inter alia, “interest expense, including interest incurred on advances or loans
from other segments, unless the operations of the segment are primarily of a financial
nature.” Accordingly, the interest expense relating to overdrafts and other operating liabilities
identified to a particular segment is not included as a part of the segment expense unless the
operations of the segment are primarily of a financial nature or unless the interest is included
as a part of the cost of inventories as per paragraph 4 above.
6. According to AS 16, read with AS 2, interest can be added to the cost of inventories only
where time is the major factor in bringing about a change in the condition of inventories.
Change in the condition of inventories is an operational activity. Accordingly, such interest is
resulting from the operating activities of the segment in respect of which such inventories
constitute the segment asset. The definition of ‘segment expense’ under AS 17 comprises,
inter alia, “the expense resulting from the operating activities of a segment that is
directly attributable to the segment.” Accordingly, interest on such inventories should be
considered as a segment expense. The clause excluding the interest expense in the definition
of ‘segment expense’ (see paragraph 5 above) does not apply to such interest.
Remuneration paid to key management personnel –
whether a related party transaction
ISSUES
1. The issue is whether remuneration paid to key management personnel is a related party
transaction. Another related issue is whether remuneration paid to non-executive directors on
the Board of Directors is a related party transaction.
CONSENSUS
2. Remuneration paid to key management personnel should be considered as a related
party transaction requiring disclosures under AS 18. In case non-executive directors on the
Board of Directors are not related parties (see Accounting Standards Interpretation 21),
remuneration paid to them should not be considered a related party transaction.
3. AS 18 defines “related party transaction” as under:
“Related party transaction - a transfer of resources or obligations between related
parties, regardless of whether or not a price is charged.”
Paragraph 24 of AS 18 provides as under:
“24. The following are examples of the related party transactions in respect of which
disclosures may be made by a reporting enterprise:
* purchases or sales of goods (finished or unfinished);
* purchases or sales of fixed assets;
* rendering or receiving of services;
* agency arrangements;
* leasing or hire purchase arrangements;
* transfer of research and development;

* licence agreements;
* finance (including loans and equity contributions in cash or in kind);
* guarantees and collaterals; and
* management contracts including for deputation of employees.”
As per the definition of the related party transaction, the transaction should be between
related parties to qualify as a related party transaction.
Since key management personnel are related parties under AS 18, remuneration paid to key
management personnel is a related party transaction requiring disclosures under AS 18.
Further, in case non-executive directors on the Board of Directors are not related parties (see
Accounting Standards Interpretation 21), remuneration paid to them is not considered a
related party transaction.
Definition of ‘Control’
ISSUE
1. In case an enterprise is controlled by two enterprises - one controls by virtue of
ownership of majority of the voting power of that enterprise and the other controls, by virtue of
an agreement or otherwise, the composition of the board of directors so as to obtain economic
benefits from its activities - whether in such a case both the controlling enterprises should
consolidate the financial statements of the first mentioned enterprise.
CONSENSUS
2. In a rare situation, when an enterprise is controlled by two enterprises as per the
definition of ‘control’ under AS 21, the first mentioned enterprise will be considered as
subsidiary of both the controlling enterprises within the meaning of AS 21 and, therefore, both
the enterprises should consolidate the financial statements of that enterprise as per the
requirements of AS 21.
3. AS 21 defines “control” and “subsidiary” as under:
“Control: (a) the ownership, directly or indirectly through subsidiary(ies), of more than
one-half of the voting power of an enterprise; or
the composition of the corresponding governing body in case of any other enterprise
so as to obtain economic benefits from its activities.
parent).”
The definition of ‘control’ lays down two independent tests as above. Consequently, it is
possible that an enterprise is controlled by two enterprises - one controls by virtue of
ownership of majority of the voting power of that enterprise and the other controls, by virtue of
an agreement or otherwise, the composition of the board of directors so as to obtain economic
benefits from its activities. This Interpretation, while recognising that the above situation will
occur rarely, requires that in such a case, the first mentioned enterprise will be considered as
subsidiary of both the controlling enterprises within the meaning of AS 21 and, therefore, both
the enterprises should consolidate the financial statements of that enterprise as per the
requirements of AS 21.
Exclusion of a subsidiary from consolidation
ISSUE
1. In case an enterprise owns majority of the voting power of another enterprise but all the
shares are held as ‘stock-in-trade’, whether this will amount to temporary control within the
meaning of paragraph 11(a) of AS 21.
CONSENSUS
2. Where an enterprise owns majority of voting power by virtue of ownership of the shares
of another enterprise and all the shares held as ‘stock-in-trade’ are acquired and held
exclusively with a view to their subsequent disposal in the near future, the control by the first
mentioned enterprise should be considered to be temporary within the meaning of paragraph
11(a).
“11. A subsidiary should be excluded from consolidation when:
(a) control is intended to be temporary because the subsidiary is acquired and held
exclusively with a view to its subsequent disposal in the near future; or
(b) it operates under severe long-term restrictions which significantly impair its ability
to transfer funds to the parent.
In consolidated financial statements, investments in such subsidiaries should be
Investments. The reasons for not consolidating a subsidiary should be disclosed in the
consolidated financial statements.”
In view of the above, merely holding all the shares as ‘stock-in-trade’, is not sufficient to be
considered as temporary control within the meaning of paragraph 11(a) above. It is only when
all the shares held as ‘stock-in-trade’ are acquired and held exclusively with a view to their
subsequent disposal in the near future, the control would be considered to be temporary within
the meaning of paragraph 11(a).
Accounting for taxes on income in the consolidated
financial statements
ISSUE
1. For preparing consolidated financial statements, whether the tax expense (comprising
current tax and deferred tax) should be recomputed in the context of consolidated information
or the tax expense appearing in the separate financial statements of the parent and its
subsidiaries should be aggregated and no further adjustments should be made for the
purposes of consolidated financial statements.
CONSENSUS
2. While preparing consolidated financial statements, the tax expense to be shown in the
consolidated financial statements should be the aggregate of the amounts of tax expense
appearing in the separate financial statements of the parent and its subsidiaries.
3. The amounts of tax expense appearing in the separate financial statements of a parent
and its subsidiaries do not require any adjustment for the purpose of consolidated financial
statements. In view of this, while preparing consolidated financial statements, the tax expense
to be shown in the consolidated financial statements is the aggregate of the amounts of tax
expense appearing in the separate financial statements of the parent and its subsidiaries.

Applicability of AS 25 to Interim Financial Results
Accounting Standard (AS) 25, Interim Financial Reporting
ISSUE
1. Whether AS 25 is applicable to interim financial results presented by an enterprise
pursuant to the requirements of a statute/regulator, for example, quarterly financial results
presented under Clause 41 of the Listing Agreement entered into between Stock Exchanges
and the listed enterprises.
CONSENSUS
2. The presentation and disclosure requirements contained in AS 25 should be applied only
if an enterprise prepares and presents an ‘interim financial report’ as defined in AS 25.
Accordingly, presentation and disclosure requirements contained in AS 25 are not required to
be applied in respect of interim financial results (which do not meet the definition of ‘interim
financial report’ as per AS 25) presented by an enterprise. For example, quarterly financial
results presented under Clause 41 of the Listing Agreement entered into between Stock
Exchanges and the listed enterprises do not meet the definition of ‘interim financial report’ as
per AS 25. However, the recognition and measurement principles laid down in AS 25 should
be applied for recognition and measurement of items contained in such interim financial
results.
3. The consensus is arrived at on the basis of the provisions of the following paragraphs of
AS 25: “Accounting Standard (AS) 25, ‘Interim Financial Reporting’, issued by the Council of
the Institute of Chartered Accountants of India, comes into effect in respect of accounting
periods commencing on or after 1-4-2002. If an enterprise is required or elects to prepare and
present an interim financial report, it should comply with this Standard.” (applicability
paragraph)
“1. This Statement does not mandate which enterprises should be required to present
interim financial reports, how frequently, or how soon after the end of an interim period.
If an enterprise is required or elects to prepare and present an interim financial report, it
should comply with this Statement.”
“2. A statute governing an enterprise or a regulator may require an enterprise to prepare and
present certain information at an interim date which may be different in form and/or content as
required by this Statement. In such a case, the recognition and measurement principles as laid
down in this Statement are applied in respect of such information, unless otherwise specified
in the statute or by the regulator.”
“4. The following terms are used in this Statement with the meanings specified:
…………...
Interim financial report means a financial report containing either a complete set of
financial statements or a set of condensed financial statements (as described in this
Statement) for an interim period.”

Disclosure of parent’s/venturer’s shares in post-acquisition
reserves of a subsidiary/jointly controlled entity
and AS 27, Financial Reporting of Interests in Joint Ventures
ISSUE
1. What should be the manner of disclosure of the parent’s/venturer’s share in the post-
acquisition reserves of a subsidiary/jointly controlled entity in the consolidated balance sheet?
CONSENSUS
2. The parent’s share in the post-acquisition reserves of a subsidiary, forming part of the
corresponding reserves in the consolidated balance sheet, is not required to be disclosed
separately in the consolidated balance sheet.
3. While applying proportionate consolidation method, the venturer’s share in the post-
acquisition reserves of the jointly controlled entity should be shown separately under the
relevant reserves in the consolidated financial statements.
4. The objective paragraph of AS 21 provides, inter alia, that the consolidated financial
statements are intended to present financial information about a parent and its subsidiary(ies)
as a single economic entity to show the economic resources controlled by the group, the
obligations of the group and the results the group achieves with its resources. Further,
paragraph 8 of AS 21 provides that 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. It further provides that this
need is served by providing the users separate financial statements of the parent and
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.
5. Paragraph 13 of AS 21, as a starting point of applying consolidation procedures,
provides, inter alia, that in preparing consolidated financial statements, the financial
statements of the parent and its subsidiaries should be combined on a line by line basis
adding together like items of assets, liabilities, income and expenses. Pursuant to this, the
reserves of the subsidiary(ies) are also added line by line with the corresponding reserves of
the parent. Other provisions of paragraph 13 and paragraphs 14 to 27 lay down other
consolidation procedures which, considering the overall scheme of the consolidation
procedures, are to be applied after addition on a line by line basis. These procedures are
applied so as to present financial information about the group as that of a single enterprise.
The effect of applying consolidation procedures as per AS 21 is that the parent’s share in the
post-acquisition reserves of the subsidiary forms part of the corresponding reserves in the
consolidated balance sheet. This is not disclosed separately keeping in view the objective of
consolidated financial statements to present financial information of the group as a whole.
6. Paragraphs 31 and 33 of AS 27 provide as below:
“31. The application of proportionate consolidation means that the consolidated balance sheet
of the venturer includes its share of the assets that it controls jointly and its share of the
liabilities for which it is jointly responsible. The consolidated statement of profit and loss of the
venturer includes its share of the income and expenses of the jointly controlled entity. Many of
the procedures appropriate for the application of proportionate A:\ consolidation are similar to
the procedures for the consolidation of investments in subsidiaries, which are set out in
Accounting Standard (AS) 21, Consolidated Financial Statements.”
“33. Under proportionate consolidation, the venturer includes separate line items for its share
of the assets, liabilities, income and expenses of the jointly controlled entity in its consolidated
financial statements. For example, it shows its share of the inventory of the jointly controlled
entity separately as part of the inventory of the consolidated group; it shows its share of the
fixed assets of the jointly controlled entity separately as part of the same items of the
consolidated group.”
In view of the above, while applying proportionate consolidation method, as in the case of
items of assets and liabilities, the venturer’s share in the postacquisition reserves of the jointly
controlled entity is shown separately under the relevant reserves in the consolidated financial
statements.

Turnover incase of Contractors
Accounting Standard (AS) 7, Construction Contracts
(Revised 2002)
ISSUE
1. As 7, Construction Contracts (revised 2002) deals, inter alia, with revenue recognition in
respect of construction contracts in the financial statements of contractors. It requires
recognition of revenue by reference to the stage of completion of a contract (referred to as
‘percentage of completion method’). This method results in reporting of revenue which can be
attributed to the proportion of work completed. Under this method, contract revenue is
recognized as revenue in the statement of profit and loss in the accounting period in which the
work is performed.
The issue is whether the revenue so recognized in the financial statements of contractors as per
the requirements of AS 7 can be considered as ‘turnover’.
CONSENSUS
2. The amount of contract revenue recognized as revenue in the statement of profit and
loss as per the requirements of AS 7 should be considered as ‘turnover’.

3. The paragraph dealing with the ‘Objective’ of AS 7 provides as follows:
“Objective
The objective of this Statement is to prescribe the accounting treatment of revenue and costs
associated with construction contracts. Because of the nature of the activity undertaken in
construction contracts, the date at which the contract activity is entered into and the date
when the activity is completed usually fall into different accounting periods. Therefore, the
primary issue in accounting for construction contracts is the allocation of contract revenue and
contract costs to the accounting period in which construction work is performed. This
Statement uses the recognition criteria established in the Frame work for the Preparation and
Presentation of financial Statements to determine when contract revenue and contract costs
should be recognized as revenue and expenses in the statement of profit and loss. It also
provides practical guidance on the application of these criteria.”
From the above, it may be noted that AS 7 deals, inter alia, with the allocation of contract
revenue to the accounting periods in which constructions work is performed.
4. Paragraphs 21 and 31 of AS 7 provide as follows:
“21. When the outcome of a construction contract can be estimated reliably, contract
revenue and contract costs associated with the construction contract should be
recognized as revenue and expenses respectively by reference to the stage of
completion of the contract activity at the reporting date. An expected loss on the
construction contract should be recognised as an expense immediately in accordance
with paragraph 35.”
“31. When the outcome of a construction contract cannot be estimated reliably:
(a) revenue should be recognized only to the extent of contract costs incurred of
which recovery is probable; and
(b) contract costs should be recognized as an expense in the period in which they are
incurred.
An expected loss on the construction contract should be recognized as an expense

immediately in accordance with paragraph 35.”
From the above, it may be noted that the recognition of revenue as per AS 7 may be inclusive of
profit (as per paragraph 21 reproduced above) or exclusive of profit (as per paragraph 31 above)
depending on whether the outcome of the construction contact can be estimated reliably or not.
When the outcome of the construction contract can be estimated reliably, the revenue is
recognized inclusive of profit and when klthe same cannot be estimated reliably, it is recognized
exclusive of profit. However , in either case it is considered as revenue as per AS 7.
5. ‘Revenue’ is a wider term. For example, within the meaning of AS 9, revenue
Recognition, the term ‘revenue’ includes revenue from sales transactions, rendering of
services and from the use by others of enterprise resources yielding interest, royalties and
dividends. The term ‘turnover’ is used in relation to the source of revenue that arises from the
principal revenue generating activity of an enterprise. In case of a contractor, the construction
activity is its principal revenue generating activity. Hence, the revenue recognized in the
statement of profit and loss of a contractor in accordance with the principles laid down in AS 7,
by whatever nomenclature described in the financial statements, is considered as ‘turnover’.

Applicability of AS 29 to Onerous Contracts
Accounting Standard (AS) 29, Provisions, Contingent Liabilities and Contingent Assets
ISSUE
1. An ‘onerous contract’ is a contract in which the unavoidable costs of meeting the
obligations under the contract exceed the economic benefits expected to be received under it.
The issue is how the recognition and measurement principles of AS 29 should be applied to
the ‘onerous contracts’ covered within its scope.
CONSENSUS
1. If an enterprise has a contract that is onerous, the present obligation under the contract
should be recognized and measured as a provision as per AS 29.
2. For a contract to qualify as an onerous contract, the unavoidable costs of meeting the
obligation under the contract should exceed the economic benefits expected to be
received under it. The unavoidable costs under a contract reflect the least net cost of
exiting from the contract, which is the lower of the cost of fulfilling it and any
compensation or penalties arising from failure to fulfill it.
3. The amount of provision in respect of an onerous contract should be measured by
applying the principles laid down in AS 29. Accordingly, the amount of the provision
should not be discounted to its present value.

1. Paragraph 14 of AS 29 provides as follows:
“14. A provision should be recognized when:
(a) an enterprise has a present obligation as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
If these conditions are not met, no provision should be recognized.”
Many contracts (for example, some routine purchase orders) can be cancelled without paying
compensation to the other party, and therefore, there is no obligation. Other contracts
established both rights and obligations for each of the contracting parties. Where events
make such a contract onerous, a liability exists, which is recognized.
In respect of such contracts the past obligating event is the signing of the contract, which
gives rise to the present obligation. Besides this, when such a contract becomes onerous, an
outflow of resources embodying economic benefits is probable.
6. Recognition of losses with regard to onerous contracts relating to items of inventory are
recognized, under AS 2, Valuation of Inventories, by virtue of the consideration of the net
realizable value. Further, the recognition of losses in case of onerous construction contracts
is dealt with in AS 7, Construction Contracts. Therefore, it is inappropriate if in case of
onerous contracts to which AS 29 is applicable, the provision is not recognized.
Appendix
An enterprise operates profitably from a factory that it has leased under an operating lease.
During December, 2005 the enterprise relocates its operations to a new factory. The lease on
the old factory continues for the next four years, it cannot be cancelled and the factory cannot
be re-let to another user.
Present obligation as a result of a past obligating event – When obligating event occurs
when the lease contract becomes binding on the enterprise, which gives rise to a legal
obligation.
An outflow of resources embodying economic benefits in settlement – When the lease
becomes onerous, an outflow of resources embodying economic benefits is probable. (Until
the lease becomes onerous, the enterprise accounts for the lease under AS 19, Leases).
Conclusion – A provision is recognized for the best estimate of the unavoidable lease
payments.
APPENDIX III
GN(A) 2 (Revised 1976)

Guarantees & Counter-Guarantees Given by Companies
1. INTRODUCTION
1.1 Companies are often required to furnish guarantees, warranties or indemnities (hereinafter
collectively called guarantees) to parties. While normally these guarantees are furnished
directly by the company, often they are furnished by other parties like banks, directors etc. on
behalf of the company. In such cases, the company issues counter-guarantees to the persons
who furnish the guarantee. As there appears to be considerable divergence of practice in the
treatment given to guarantees in published accounts of companies, this Note is issued to offer
guidance in this matter.
1.2 In a strictly legal sense, it is possible to distinguish between guarantees, warranties and
indemnities. However, for the purposes of this Note this distinction is not important.
2. PRACTICES RELATING TO DISCLOSURE PRESENTLY FOLLOWED

The treatment of guarantees and counter-guarantees in published accounts generally follows
one of the under mentioned methods:
(a) The guarantees and counter-guarantees are disclosed as a separate item on the balance
sheet under the general heading of “Contingent Liabilities”.
(b) The guarantees and counter-guarantees are disclosed by way of a footnote, on the
balance sheet but not under the general heading of “Contingent Liabilities”.
(c) The guarantees and counter-guarantees are not disclosed at all.
3. SUGGESTED METHOD OF DISCLOSURE

3.1 The method of disclosure would depend upon the nature of the guarantee. It is possible to
group guarantees into the following classes:
(a) A guarantee furnished as security or cover for an existing liability which is already recorded
in the books of account.
(b) A guarantee furnished as security or cover for a contingent liability.
(c) A guarantee furnished by way of security for the performance of certain obligations or by
way of security to ensure the non-commission of certain statutory or other defaults.
III.2 Financial Reporting
(d) A guarantee furnished in respect of a matter for which no liability, actual or contingent
existed prior to the issue of the guarantee.
(e) Other forms of guarantee.
3.2 Where a guarantee falls in category (a) of paragraph 3.1 above, it is not necessary to refer
to the guarantee by way of a note, since the principal liability is already recorded and the
guarantee does not create any further liability either actual or contingent. Where the guarantee
is given by a party other than the company, to secure the liability of the company, a note may,
if so desired, be made merely by way of information.
3.3 Where a guarantee falls in category (b) of paragraph 3.1 above, it would be more
appropriate to disclose the contingent liability itself rather than the guarantee, not only
because it is the former which requires disclosure under the provisions of the Companies Act
but also because the guarantee may have been furnished for a possible aggregate sum not
equal to or related to the estimated amount at the balance sheet date of the contingent liability
required to be disclosed.
3.4 Guarantees which fall in category (c) of paragraph 3.1 above are often issued to public
authorities who require guarantees to be furnished to them either by the Company itself or by
its bankers in order to protect such authorities from any financial loss which they may suffer as
a result of the non-performance of obligations or the commission of defaults by the Companies
concerned. For example, an importer may be required to furnish a bond or guarantee to the
Customs Authorities which would protect the latter in case the importer either fails to perform
certain statutory obligations under the Customs Act and Regulations or commits any statutory
defaults. Similarly, the Railway Authorities may require
a guarantee from Companies which wish to transport goods without prepayment of freight or
which wish to avail of any other facilities offered by the Railways. In all such cases, there is no
liability - either actual or contingent which requires to be disclosed, nor does the mere
submission of a guarantee constitute a contingent liability. Where the guarantee is furnished
as security against statutory defaults, there is no reason to believe that a Company will
commit a statutory default or that it will fail to comply with its statutory obligations. In any case,
this is a matter which is in the control of the Company itself and the commission of a statutory
default by the Company in the future of its statutory obligations cannot be said to involve the
existence of a contingent liability, even though in any such eventuality, the Company would be
financially liable for penalty or damages. It should also be recognised that all Companies face
a situation of this type and if disclosure is to be made at all, it should be made by all
Companies and not merely by those which have furnished a guarantee against the financial
liability which they may incur in the future by the commission of statutory defaults or by the
non-observance of statutory requirements. If it is accepted that a situation of this type does
not involve any actual or contingent liability, it must equally be accepted that there is no
obligation to disclose the guarantees given by the Company in respect of its possible future
obligations. The question which should be asked is whether any event had taken place at the
balance sheet date – or even at the date the balance sheet is signed which has resulted in a
liability. The mere possibility or chance of such an event taking place in the future would not
involve any question of contingent liability on the balance sheet date. It is therefore suggested
Appendix III : Guidance Notes III.3
that no disclosure need be made – either of the possible future liability or of the guarantee
which has been given in order to cover such possible future liability. It would not be
appropriate in such cases to suggest that disclosure of the guarantee may be made by way of
abundant caution or in order to provide additional information to the shareholders and others,
because such disclosure, in fact, can be positively misleading, by conveying a false
impression to the casual reader of the balance sheet as to existence of actual or contingent
liabilities related to such guarantee.
3.5 Guarantees which fall in category (d) of paragraph 3.1 above are usually in respect of the
obligations of parties other than the company. For example, a company may issue a
guarantee to a bank in respect of a loan granted by the bank to the company’s subsidiary. In
this case the issue of the guarantee creates the contingent liability and disclosure becomes
necessary. However, the amount of the contingent liability is not the full value of the guarantee
but the amount of the loan outstanding at the balance sheet date. It is therefore suggested
that the note regarding the contingent liability should disclose both the amount of the
guarantee and the amount outstanding at the balance sheet date.
3.6 Where a guarantee does not fall within any of the categories (a) to (d) mentioned in
paragraph 3.1 above, disclosure would be necessary only if the issuance of the guarantee has
created a contingent liability which did not exist prior to the issue of the guarantee.
4. COUNTER-GUARANTEE
4.1 The principles governing the method of disclosure regarding counter-guarantees should be
the same as applicable to guarantees. Counter-guarantees are furnished by a company to the
banker or other third party who furnished the principal guarantee on behalf of the company.
Obviously, if the principal guarantor is called upon to meet his guarantee obligation, he will
proceed against the company in order to recover the amount which he has paid under his
guarantee obligation. The only difference between a guarantee and a counter-guarantee in so
far as the company is concerned, is that in the former case, the company is obligated on the
guarantee to the person to whom it is furnished whereas in the latter case, it is obligated to the
banker or other third party who has furnished the original guarantee.
4.2 Where tangible security has been provided to the principal guarantor, this fact should also
be disclosed. This situation is frequently encountered in the cases of borrowings from financial
institutions, where one institution, after obtaining tangible security, guarantees, on behalf of
the borrower, the loans given by another institution. In such cases the classification of the loan
has led to much divergence in practice, some companies classifying it as an unsecured loan
(as the security is not provided to the lender), and other companies classifying it as a secured
loan (as the assets of the company are encumbered). On a strict legal view of the matter, in
such cases, the loan is unsecured, but considering the overriding requirement that the
accounts should provide a true and fair view of the financial position, the recommended
procedure is to classify it as a secured loan, (making it clear that the security is given to the
guarantor and not the lender).
4.3 An exception to the rule stated in paragraph 4.1 above would arise in a case where
persons connected with the company- e.g. managers, directors, etc. furnished guarantees in
respect of the company’s obligations and disclosure thereof is required under the provisions of
the Companies Act. If any commission is paid to such persons for the issue of the guarantee,
the requirements of the Companies Act will have to be observed both with regard to the
method of disclosure as also regarding the validity of the payment.
5. GUARANTEES GIVEN BY A COMPANY ON BEHALF OF OTHERS

The foregoing remarks apply either where a company has given a guarantee on its own behalf
or where third parties have given a guarantee on behalf of the company and the company has
given a counter-guarantee or counter-indemnity to such third parties. Where, however, a
company has itself given a guarantee on behalf of third parties, it would certainly be necessary
to disclose the same as a contingent liability. Moreover, if such guarantee has been given on
behalf of persons concerned with the management of the company – for example directors or
managing agents – a further disclosure of this fact would also be required.
6. DISCLOSURE OF GUARANTEES IN THE ACCOUNTS OF A COMPANY RECEIVING A

GUARANTEE
A question of disclosure would also arise in the case of a company which receives a
guarantee from a debtor or from person to whom a loan has been advanced or from whom
money or other obligation is owing to the company, or who is obligated to the company for the
performance of services or otherwise. In all such cases, no disclosure of the guarantee is
required unless the guarantee is supported by tangible security in which case the classification
of the debt, loan, or advance, as the case may be would be “secured” to the extent of the
value of the security.
GN(A) 3 (Issued 1982)

Guidance Note on Treatment of Reserve Created on Revaluation of Fixed Assets
1. In the preparation of the financial statements of a company, various fixed assets are stated
on the basis of their historical cost. Sometimes, in order to bring into the Balance Sheet their
replacement cost, a company revalues its fixed assets on the basis of a valuation made by
competent valuers. When the value of fixed assets in written up in the books of account of a
company on revaluation, a corresponding credit is given to the Revaluation Reserve. Such
reserve represents the difference between the estimated present market values and the book
values of the fixed assets. When such reserve is created, a question arises about its nature
and the manner in which it can be utilised. This guidance note deals with accounting treatment
of the reserve created on revaluation of fixed assets (herein referred to as “Revaluation
Reserve”).
2. Part I of Schedule VI to the Companies Act, 1956 provide that every company shall classify
its fixed assets under convenient heads and show under each head the original cost,
additions/deductions and the total depreciation provided upto the end of each accounting
period. When a company revalues its fixed assets, it is necessary for the company to show
separately the date of revaluation and, for a period of five years thereafter, the amount of
increase made.
3. When a company revalues its fixed assets, depreciation should be provided on the basis of
the revalued figures.
4. A view has been expressed in some quarters that, for measurement of profits, revenue is
deemed to have arisen when it is actually collected or when a justifiable claim to collect it
arises (e.g. credit sale) or when there is knowledge and evidence that it is capable of being
collected if a sale were to be made (i.e. prevailing market price). According to this view, this
principle will apply equally to current and fixed assets and, therefore, when fixed assets are
written up to their present value, the corresponding Revaluation Reserve cannot be
considered as an unrealised reserve. It is, therefore, argued that past accumulated losses as
well as depreciation for the year or arrears of depreciation for earlier years which are required
to be provided under Section 205 of the Companies Act can be written off or adjusted against
such Revaluation Reserve.
5. There is a contrary view that such Revaluation Reserve is created as a result of a book
adjustment only and, therefore, such a reserve is an unrealized reserve which is not available
for distribution as dividends. When accounts are prepared on the basis of historical cost,
measurement of profits can be made by comparing the cost of the assets at the beginning and
at the end of the Treatment of Reserve Created on Revaluation of Fixed Assets 11accounting
period. As such there is no justification for taking credit for unrealised gains because the
increase in market value may be due to various extraneous factors such as fall in the
purchasing power of currency or other factors not related to the operations of the company. So
far as fixed assets are concerned, these are held for the use in the business and not for sale
in the normal course of business. In the circumstance, the difference between the market
value and the book value does not represent realised gain and cannot be treated as such in
the books of account.
6. Section 205 of the Companies Act provides that a company can declare or pay dividend
only out of its profits. The profits for this purpose are to be arrived at after providing for
depreciation. If dividend is to be declared out of the profits of any earlier year or years, it is
necessary that such profits should be arrived at after providing for depreciation for the
respective years.
7. Proviso (a) to Section 205 (1) of the Companies Act reads as under:
“(a) if the company has not provided for depreciation for any previous financial year or years
which falls or fall after the commencement of the Companies (Amendment) Act, 1960, it shall
before declaring or paying dividend for any financial year provide for such depreciation out of
the profits of that financial year or out of the profits of any other previous financial year or
years.”
This proviso makes it clear that it is necessary to provide for arrears of depreciation of earlier
years, if any dividend is to be declared out of profits of any subsequent year. For this purpose
depreciation (or arrears of depreciation) is to be provided out of the profits of the company.
Indeed, a reference to Part II of Schedule VI to the Companies Act indicates that the Profit and
Loss Account is to be so made as clearly to disclose the result of working of the company
during the period covered by the account.
8. When accumulated losses and depreciation (including arrears of depreciation) are adjusted
against Revaluation Reserve it will amount to setting off actual losses against unrealised
gains. If dividend is declared out of the current profits after adjusting accumulated losses or
arrears of depreciation against the Revaluation Reserve, it will mean that dividend is declared
out of profits which should, in fact, have been utilised in setting off past losses and arrears of
depreciation. In effect, the company will be declaring dividend out of profits which are not
available for distribution. By adopting this method, the company will be declaring dividend out
of unrealised gains appearing in the accounts in the form of Revaluation Reserve. Accordingly,
accumulated losses or arrears of depreciation should not be set off against Revaluation
Reserve.
9. A question may arise, as to whether the additional depreciation provision required in
consequence of revaluation can be adjusted against “Revaluation Reserve”. As stated earlier,
depreciation is required to be provided with reference to the total value of the fixed assets as
appearing in the account after revaluation. However, for certain statutory purposes e.g.,
dividends, managerial remuneration etc., only depreciation relatable to the historical cost of
the fixed assets is to be provided out of the current profits of the company. In the
circumstance, the additional depreciation relatable to revaluation may be adjusted against
“Revaluation Reserve” by transfer to Profit and Loss Account.
In other words, as per the requirements of Part II of Schedule VI to the Companies Act, the
company will have to provide the depreciation on the total book value of the fixed assets
(including the increased amount as a result of revaluation) in the Profit and Loss Account of
the relevant period, and thereafter the company can transfer an amount equivalent to the
additional depreciation from the Revaluation Reserve. Such transfer from Revaluation
Reserve should be shown in the Profit and Loss Account separately and an appropriate note
by way of disclosure would be desirable. Such a disclosure would appear to be in consonance
with the requirement of Part I of Schedule VI to the Companies Act, prescribing disclosure of
write-up in the value of fixed asset for the first five years after revaluation.
10. If a company has transferred the difference between the revalued figure and the book
value of fixed assets to the “Revaluation Reserve” and has charged the additional depreciation
related thereto to its Profit and Loss Account, it is possible to transfer an amount equivalent to
accumulated additional depreciation from the revaluation reserve to the Profit and Loss
Account or to the General Reserve as the circumstances may permit, provided suitable
disclosure is made in the accounts as recommended in this guidance note.
11. The Revaluation Reserve is not available for payment of dividends. This view is also
supported by the Companies (Declaration of Dividend out of Reserves) Rules, 1975.
Similarly, accumulated losses or arrears of depreciation should not be set off against
Revaluation Reserve. However, the revaluation reserve can be utilised for adjustment of
the additional depreciation on the increased amount due to revaluation from year to
year or on the retirement of the relevant fixed assets (as discussed in paras 9 and 10
above respectively).
Treatment of Reserve Created on Revaluation of Fixed Assets

12. The revaluation of fixed assets is normally done in order to bring into books the
replacement cost of such assets. This is a healthy trend as it recognises the importance of
retaining sufficient funds through additional depreciation in the business for replacement of
fixed assets. As such, it will be prudent not to charge the additional depreciation against
revaluation reserve, though this may result in reduction of distributable profits. This practice
would also give a more realistic appraisal of the company’s operations in an inflationary
situation.

Guidance Note on Accounting for Changing Prices
INTRODUCTION
The following is the text of the Guidance Note “Accounting for Changing Prices” issued by the
Research Committee of the Institute of Chartered Accountants of India for the information and
guidance of members.
1. The subject of treatment of changing prices in financial statements, popularly known as
inflation accounting has assumed considerable importance in the last few decades. The
persistent inflation during this period has lent urgency to the need for preparing accounting
statements which reflect the effects of inflation upon an enterprise. Recognising the
importance of this subject the Research Committee of the Institute of Chartered Accountants
of India is bringing out this Guidance Note for the benefit of members.
2. The Research Committee wishes to acknowledge that in the preparation of this paper it has
drawn heavily on the various publications on the subject by various international professional
bodies and more particularly those by the Accounting Standards Committee in the U.K. The
Committee recognises that a great deal of research and experimentation on the subject has
already been conducted by various professional institutes, accountants and academicians and
the Committee has taken these into account in framing this Guidance Note. The main
objective of this Guidance Note is to encourage the adoption of accounting for changing
prices, and to suggest a methodology relevant in the prevailing economic environment in
India.
NEED FOR ACCOUNTING FOR CHANGING PRICES

3. The primary purpose of the financial statements of an enterprise is to present information
showing from where the funds have been raised, how they have been utilised and the extent
to which such utilisation has resulted in profits or losses during a period. A balance sheet
shows in monetary terms the capital, the reserves, loans and other liabilities of a business as
on the date at which it is prepared and how the total funds so raised have been distributed
over the several types of assets. The profit and loss account on the other hand is a statement
showing the way in which profits (losses) have been earned (incurred) during a period. It must
be recognised that the transactions appearing in both the balance sheet and the profit and
loss account are recorded in the books of account in monetary amounts which reflect their
historical costs. The historical costs basis of accounting reduces to a minimum the extent to
which the accounts may be affected by the personal judgement of those responsible for their
preparation.
Another advantage of historical cost-based accounts is that the transactions relating thereto
are capable of being easily verified by reference to the relevant documentary and other
evidence.
4. In an economic environment where prices are constantly rising, as has been the case in
our country at least in the last four decades of this century, certain inherent limitations of
historical cost-based accounting become apparent.
Firstly, the monetary unit (rupee in our country) which is used as a standard of measurement
itself shrinks in value as the prices rise. The historical cost-based accounting ignores this
shrinkage in the value of a rupee as a measuring rod and keeps adding transactions which are
represented by rupees of differing value over a period of time.
5. Another major problem with historical cost-based accounting is that in periods of inflation
it results in substantial diminution in the operating capital and therefore in the operating
capability by showing what many have termed as ‘exaggerated and illusory figures’ of profits*.
This loss of operating capital arises due to the fact that historical cost-based accounting does
not match current revenues with the current costs of operations. For example, the depreciation
charge under conventional accounting is based on historical cost of fixed assets. During an
inflationary period, the historical cost-based depreciation charge is not adequate to maintain
the operating capability of the enterprise.
6. Another factor which contributes to the loss of operating capability is that in historical cost-
based accounting, the cost of good sold charged to the profit and loss account is understated.
This is because the inventories consumed are valued at their historical costs and not at their
current prices. This results in over-statement of profits.
7. It is clear from the above that historical cost-based accounts do not take cognizance of the
fact that in an inflationary situation the charging of the historical costs of operations to the
profit and loss account may endanger the maintenance of the operating capital of an
enterprise besides giving a misleading indication of its profit or loss.
8. Another drawback of the historical cost-based accounting is that by showing assets at their
historical costs, the balance sheet does not reflect the current worth of the enterprise.
* In this Guidance Note, the entire discussion is with reference to inflation, which at present is
almost a world-wide phenomenon. In deflation, the situation is just the reverse and the
accounting may be carried on accordingly.
METHODS OF ACCOUNTING FOR CHANGING PRICES

9. Many proposals have been offered to reduce the limitations of the conventional system of
accounting and to recognise the effects of changing prices on the financial statements.
Though no consensus has yet been reached on a specific solution, the professional bodies in
various countries have issued a number of statements suggesting the use of different methods
of accounting for changing prices. Noteworthy among them are FAS 33 (FASB, USA), SSAP
16 (ASC, U.K.) and IAS 15 (International Accounting Standards Committee). It would indeed
be a major development in the building up of a coherent and logical structure of accounting if
an objective and useful method of accounting for changing prices gains universal acceptance.
10. Out of the many proposals that have been put forward for accounting for changing prices
the following three need specific consideration:
(i) Periodical revaluation of fixed assets along with the adoption of LIFO formula for inventory
valuation.
(ii) The current purchasing power accounting method (CPPA)
(iii) The current cost accounting method (CCA)
Each of these methods is discussed in the subsequent paragraphs.
Periodical Revaluation of Fixed Assets along with the Adoption of
LIFO
11. Many enterprises have in periods of inflation been able to keep their operating capability
more or less intact by revaluing their fixed assets periodically and by simultaneously adopting
the LIFO formula for stock valuation. The main objective of periodic revaluation of fixed assets
is to charge by way of depreciation to the Profit and Loss Account an amount which reflects
the current cost of replacement. Under this method, the enterprises estimate the replacement
cost of the fixed assets at regular intervals of say 3 to 5 years and charge depreciation on the
revalued amounts. The revaluation of assets is normally based on expert opinion or on certain
specific price indices indicative of the replacement cost of the relevant fixed assets.
12. Many enterprises adopt LIFO (last in-first out) formula for assigning costs between the
cost of goods sold and the closing stocks. In many countries like the USA, LIFO has been
accepted as a valid basis for assigning costs for Accounting for Changing Prices 19 the
purposes of taxation. Under this method the latest purchase costs are assigned to the cost of
goods sold and are therefore written off. The closing stocks on other hand are valued at the
earlier costs.
13. Adoption of periodical revaluation along with LIFO is one of the practical approaches to the
problem of maintenance of operating capability in a period of inflation. It seeks to maintain the
operating capability of an enterprise at least with regard to the fixed assets and the inventories
–undoubtedly the two most significant components of the operating capital of an undertaking.
However, it must be mentioned that this approach is not a complete solution to the problem.
Periodic revaluations tend to be somewhat adhoc in nature and lack the advantages incidental
to a systematic and consistent basis. Moreover with the high inflation rates in the present day
economies even regular revaluations, say every five years, may not serve the purpose of
maintaining the operating capability of an enterprise. Similarly LIFO may in some situations
result in the cost of goods sold being reflected at current costs but in many other situations the
cost assigned on the basis of LIFO may still fall substantially short of the amount which should
be charged as the current cost of goods sold to maintain the operating capability of the
enterprise as far as the inventories are concerned. In view of this, the approach has
significance only till such time that a comprehensive and widely acceptable method of
accounting for price changes is adopted.
Current Purchasing Power Accounting (CPPA)
14. This method seeks to restate the financial statements in terms of units of equal purchasing
power and thus eliminates the effects of changes in the value of money itself. It has been
stated earlier that money as a measuring rod is somewhat defective since its value (its
command over goods and services in general) keeps on changing due to inflation or deflation.
The current purchasing power accounting method overcomes this limitation of the
conventional financial statement by restating them in terms of uniform rupees of current
purchasing power. Thus the method is not strictly a proposal for a change from the historical
cost-based accounting; it merely attempts to remove the distortions in the financial statements
which arise due to changing value of rupee.
15. To convert the historical rupees into uniform rupees as at the date of the balance sheet an
index portraying the changes in the general purchasing power of the rupee is required.
Generally therefore the most broad based index of consumer goods prices or of prices in
general is used. The historical cost figures are multiplied by a conversion factor which is the
ratio of the index at the date of conversion and the index at the transaction date. Assume that
an item of furniture was purchased on January 1, 1978 for Rs. 20,000/-. Its value in terms of
rupees of current purchasing power as on December 31, 1980 can be ascertained by
multiplying its historical cost by the index number as on December 31, 1980 and dividing the
product by the index number as on January 1, 1978. If the general price index on the two
dates was 243 and 189 respectively, the cost of the furniture in terms of rupees of December
31, 1980 would be Rs. 25,714 (i.e. Rs. 20,000 x 243/ 189).
Since it is practically very difficult to convert each figure in terms of the index number of the
date of the transaction, it is assumed that all transactions take place evenly throughout the
year.
16. In converting the historical rupees into rupees of uniform value as at the date of the
balance sheet the current purchasing power accounting method makes a distinction between
the monetary items and the non-monetary items.
Monetary items are those the amounts of which are fixed by contract or otherwise remain fixed
irrespective of any change in the general level of prices.
Examples of monetary assets are cash, debtors, bills receivable, etc. Similarly, debentures,
creditors, etc. are monetary liabilities. It is obvious that in a period of inflation, the holders of
monetary liabilities gain since they repay the amounts due in rupees of lower purchasing
power as compared to that at the time when the liabilities arose. Conversely, the holders of
net monetary assets lose in a period of inflation. The current purchasing power accounting
method therefore suggests the computation of the purchasing power gain or loss made by an
enterprise on holding net monetary items.
17. A number of adjustments are required to be made to restate the conventional financial
statements on the basis of current purchasing power.
The illustration at Appendix I shows the basic methodology adopted for the purpose of such
restatement.
18. The main advantage of the current purchasing power accounting method, as already
stated, is that it removes the shortcomings of money as a measuring rod during the period of
price changes. As it uses uniform purchasing power as the measuring unit, it possesses the
qualities of objectivity and comparability. Besides, it retains the historical cost accounts as the
basic accounts and the price-level adjusted accounts are shown only on a supplementary
basis. It is simple to apply and is not very expensive. However, the current purchasing power
accounting method has lost considerable support in the recent years mainly because of the
fact that the unit of measurement proposed by the method (general purchasing power) is not
easily perceived by the users of financial statements. Everyone understands and perceives
the monetary unit, but only very few understand a purchasing power unit. Besides, unlike a
monetary unit, the purchasing power unit is not a physical object capable of being exchanged
between parties to a transaction. Moreover, the method does not solve, except indirectly and
incidentally, the problem of gradual depletion of operating capital of an enterprise in periods of
inflation.
The balance sheet too, prepared on the CPPA basis, does not reflect the current worth of an
enterprise.
Current Cost Accounting (CCA)
19. Current cost accounting or CCA, as it is popularly known, seeks to:
(a) state the assets and liabilities in the balance sheets at their current value, i.e., value as at
the date of the balance sheet;
(b) measure the profit or loss after matching current costs with current revenues; and
incidentally
(c) remove the distortions of summing up of rupees of different values.
20. CCA is based on the concept of “operating capability” which may be viewed as the amount
of goods and services which an entity is capable of providing with its existing resources during
a given period. It is argued that in order to maintain its operating capability, an entity should
continuously remain in command of resources which form the basis of its activities. To this
end, it is necessary to take into account the rising costs of assets consumed in generating the
revenues. Current cost accounting by substituting the current cost of assets consumed in
place of the corresponding historical costs, takes into account the changes in specific prices of
assets as they affect the entity.
21. This method was originally proposed by the Sandilands Committee as Current Cost
Accounting (CCA). After considerable debate, in 1980 the Accounting Standards Committee in
the U.K. issued the Standard on the subject, i.e., SSAP 16.
The main features of the method are:
(i) Money is the unit of measurement.

(ii) Assets and liabilities are shown in the balance sheet at a valuation (discussed later in
detail).
(iii) Operating profit is struck after charging the “value to the business” of assets consumed
during the period. Three adjustments – depreciation, cost of sales and monetary working
capital – are made to the historical cost profit to arrive at the current cost profit. A fourth
adjustment known as gearing adjustment is made to arrive at the current cost profit
attributable to the shareholders (discussed later in detail).
Methodology of CCA
22. Fixed Assets : The fixed assets should be shown in the balance sheet at their “value to the
business”. The value to the business of an asset is the amount which the business would lose
if it were deprived of that asset. The concepts of gross and net current replacement cost are
important in this context.
The gross current replacement cost of an existing asset is the cost that would have to be
incurred at the date of the valuation to obtain and install a substantially identical asset in new
condition. For example, if an equipment purchased on 1.1.1978 for Rs. 80,000 can be
purchased on 31.12.1980 for Rs.1,00,000 its gross current replacement cost on 31.12.1980 is
Rs. 1,00,000.
The net current replacement cost of an existing asset refers to that part of the gross current
replacement cost which represents its unexpired service potential.
For example, suppose that the equipment in the above example is estimated to have an
economic life of five years. Since it has already been used for three years, its net current
replacement cost would be Rs. 40,000 (assuming that the equipment will have a zero scrap
value at the end of its economic life).
23. Plant and Machinery: The gross current replacement costs of items of plant and machinery
and other fixed assets (except land and buildings) may be determined by applying the relevant
indices to their gross book values. In U.K., the government statistical department regularly
publishes indices for various categories of fixed assets and for different industries. In India,
however, there is no such agency which publishes specific indices for fixed assets employed
in various industries. However, the Bulletin of Wholesale Prices published every month by the
Government of India contains details about the price changes of a number of capital assets. In
case the use of specific indices is considered inappropriate or impracticable the gross current
replacement cost may be determined on the basis of the expert opinion or by comparison with
other assets or groups of assets having a similar service potential for which information may
be available.
24. Land and Buildings: The land & buildings occupied by the owner himself should be shown
in the balance sheet at their “value to the business” which will normally be the open market
value for their existing use, plus estimated acquisition costs. However, in cases where an
open market valuation of the land and buildings as whole cannot be made, the net
replacement cost of the buildings and the open market value of land for its existing use plus
the estimated acquisition costs should be taken as their value to the business. The valuation
should be made by professionally qualified valuers at periodic intervals.
25. Inventories: In the balance sheet the inventories should normally be shown at the lower of
the current replacement cost as on the date of the balance sheet and the net realisable value.
26. Current Cost Operating Profit: The current cost operating profit should be ascertained by
making the following three adjustments to the historical cost profit (before interest on net
borrowings). Those adjustments represent the allowance for the impact of price changes on
the funds required for maintaining the net operating assets.
(a) depreciation adjustment
(b) cost of sales adjustment
(c) monetary working capital adjustment
27. Depreciation Adjustment: The charge to the profit and loss account for depreciation should
be equal to the value to the business of the fixed assets consumed during the period. When
the fixed assets are valued on the basis of their net current replacement cost, which may
increase during the year, the charge may be based on the average net current replacement
cost for the period. The current depreciation charge is obtained by apportioning the average
net current replacement cost over the expected remaining useful life of the fixed assets as at
the beginning of the period. When the fixed assets are revalued every year, there will also be
a shortfall of depreciation representing the effect of price rise during the current year on the
accumulated depreciation till date. This shortfall is called backlog depreciation which is the
amount needed to uplift the accumulated depreciation to a figure needed to cover the total
depreciation provision based on replacement cost at the year-end. This backlog depreciation
arising out of increase in current costs could be charged either to the general reserves or
against the related revaluation surplus on the fixed assets. The former will ensure that the
enterprise maintains its operating capital at the time of the replacement of fixed assets. The
latter is the recommended procedure in the U.K. standard on the subject.
28. Cost of Sales Adjustment: The second adjustment is known as ‘cost of sales adjustments’
(COSA). This represents difference between the value to the business of the stock consumed
during the period and its historical cost.
The value to the business of stock will generally be its replacement cost at the date of
consumption. Theoretically, the current cost of sales should be determined on an item-by-item
basis. In a real world situation, however, it would be impragmatic to do so, and therefore,
groups of similar items may be used instead. If a company has a fairly regular sales pattern
and if prices have increased steadily during the period, the use of the average method of
calculation of current cost of sales may be appropriate.
29. Monetary Working Capital Adjustment: The third adjustment called the ‘monetary working
capital adjustment’ (MWCA) reflects the amount of additional (or reduced) 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. Monetary working capital (usually represented by the difference
between the trade debtors and trade creditors) is an integral part of the net operating assets of
the business. In times of rising prices, a business needs more funds to finance monetary
working capital. The adjustment reflects this additional need for funds.
30. Gearing Adjustment: It is argued that the profit as calculated above reflects the true
amount of profit from operation (current cost operating profit) after maintaining the net
operating capability of the entity. However, to the extent that the net operating assets are
funded through borrowings, the impact of price changes made in arriving at current cost
operation profit is not on the shareholders. This is because the repayment obligations in
respect of borrowings are not affected by changing prices. It is therefore suggested that the
current cost profit attributable to shareholders should be determined by taking into account the
method of financing the net operating assets. The current cost profit attributable to
shareholders reflects the surplus for the period after making allowance for the impact of price
changes on the funds needed to maintain the shareholders’ proportion of the net operating
assets. To take note of the existence of borrowings in the capital structure, an adjustment
known as ‘gearing adjustment’ is made.
31. A new reserve, the ‘current cost reserve’, is created to take the credits or charges relating
to the revaluation of fixed assets and stock, as also those relating to the depreciation
adjustment, the cost of sales adjustment, the monetary working capital adjustment, and the
gearing adjustment.
32. Price Indices in CCA: Accounting for changing prices involves the use of certain price
indices for the restatement of assets and for making adjustments to the historical cost profit
and loss account. In the United Kingdom, the Government Statistical Service regularly
publishes the relevant price indices. In India, database at such a large scale has not yet been
developed. However, the Bulletin of wholesale prices published every month by the
Government of India contains details about the price changes of a number of items.
33. The CCA method possesses the merit of closely approximating the impact of specific price
changes on the business enterprise because it makes use of specific indices. As such, the
method seeks to maintain the operating capability of the enterprise during inflation. The
method is however, not free from weaknesses, the most important of which seems to be the
element of subjectivity inherent in periodic valuations, specially in our country where specific
indices are not generated by an authoritative external agency.
34. From the discussion above, it is clear that during a period of rising price, historical cost-
based financial statements show inflated profits and that the taxation of such profits amounts
to a levy on capital. Thus, there is a need for reform in our tax laws and practices which
should take into account the impact of rising prices on the funds required for maintenance of
the operating capability.
35. Appendix II shows an illustrative set of current cost accounts as adapted from the
guidance notes issued by the Accounting Standards Committee in the U.K.
RECOMMENDATIONS
36. The rationale for an accounting technique to make necessary adjustments for changing
prices, as also the main solutions, have been discussed above. The Committee’s
recommendations in this regard are contained in paragraphs 37 - 43.
37. The adoption of a system of accounting for changing prices would require a considerable
amount of time, money and specialised skills. Also the various techniques are still in the
process of development. However, in view of the importance of the subject, it is recommended
that enterprises, particularly the large enterprises, may develop the necessary systems to
prepare and present this information.
38. Out of the various methods of accounting for changing prices discussed above, the
Current Cost Accounting method seems to be most appropriate in the context of the economic
environment in India. The periodic revaluations of fixed assets and the adoption of LIFO
formula for inventory valuation are partial responses to the problem of accounting for changing
prices. Current Purchasing Power Accounting, though simple to apply, does not ensure the
maintenance of the operating capability of an enterprise. Current Cost Accounting, on the
other hand, is a rational and comprehensive system of accounting for changing prices as it
considers the specific effect of changing prices on individual enterprises and thus ensures that
profits are reported only after maintaining the operating capability. However, the introduction
of a fullfledged system of Current Cost Accounting on a wide scale in India will inevitably take
some time. During this transitional phase, periodic revaluations of fixed assets along with the
adoption of LIFO formula for inventory valuation would reflect the impact of changing prices
substantially in the case of manufacturing and trading enterprises.
39. Adequate data base has presently not been developed in India for accounting for changing
prices. Therefore, every enterprise may have to select the price indices depending on its own
circumstances. The detailed price indices published in its monthly bulletin by the Government
of India can be adopted in a number of cases. There is no doubt that further steps will have to
be taken for the timely publication of statistical information required by various industries for
the implementation of accounting for changing prices.
40. Considering the importance of the information regarding the impact of changing prices it is
recommended that while the primary financial statements should continue to be prepared and
presented on the historical cost basis, supplementary information reflecting the effect of
changing prices may also be provided in the financial statements on a voluntary basis, at least
by large enterprises.
41. Since the presentation of statements adjusted for the impact of changing prices is
voluntary, the enterprise may or may not get this information audited. However, the audit of
such statements would enhance their credibility.
42. Apart from its utility in external reporting, accounting for changing prices may also provide
useful information for internal management purposes. Accounting information system is
designed primarily to provide relevant information to various levels of management with a view
to assist in managerial decision- making, control and evaluation. However, in periods of rapid
and violent fluctuations in prices, the information provided by historical cost-based accounting
system may need to be supplemented by information regarding the impact of changing prices.
The areas in which such information may be of prime importance to management include
investment decisions and allocation of resources, divisional and overall corporate performance
evaluation, pricing policy, dividend policy etc.
43. In countries like the United Kingdom, there have been some reforms in the tax structure in
the wake of introduction of accounting for changing prices. Though, the tax legislation in India
at present does not give recognition to such an accounting system, even then accounting for
changing prices would be useful for generating relevant information for internal and external
decision making.
Note: For the text of the appendices given in the Guidance Note, students are advised to refer
the compendium of Guidance Notes- Accounting (as on July, 1 2006)
GUIDANCE NOTE ON ACCRUAL BASIS OF ACCOUNTING

1. INTRODUCTION
1.1 Certain fundamental accounting assumptions underlie the preparation and presentation
of financial statements. “Accrual” is one of the fundamental accounting assumptions. Para 27
of the Accounting Standard on Disclosure of Accounting Policies (AS-1), issued by the
Institute of Chartered Accountants of India (ICAI), provides that if fundamental accounting
assumptions, viz., going concern, consistency and accrual are not followed, the fact should be
disclosed.
1.2 There are three bases of accounting in use, viz., (i) accrual (ii) cash and (iii) hybrid. The
Companies (Amendment) Act, 1988, has amended section 209 of the Companies Act, 1956,
with effect from 15th June, 1988, making it obligatory on all companies to maintain their
accounts on accrual basis and according to the double entry system of accounting. In view of
this amendment all companies will now be required to keep their accounts on accrual basis of
accounting, in respect of any accounting year closing on or after 15th June, 1988.
1.3 This guidance note is issued by the Research Committee of the ICAI providing guidance
in respect of maintenance of accounts on the accrual basis of accounting.
2. ACCRUAL BASIS OF ACCOUNTING
2.1 The term “Accrual” has been explained in the Accounting Standard on Disclosure of
Accounting Policies (AS-1), as under:
“Revenues and costs are accrued, that is, recognised as they are earned or incurred (and not
as money is received or paid) and recorded in the financial statements of the periods to which
they relate”.
2.2 The Guidance Note on Terms Used in Financial Statements, issued by the Accounting
Standards Board of the ICAI, explains ‘Accrual Basis of Accounting’ as under:
“The method of recording transactions by which revenues, costs, assets and liabilities are
reflected in the accounts in the period in which they accrue. The ‘Accrual Basis of Accounting’
includes considerations relating to deferrals, allocations, depreciation and amortisation. This
basis is also referred to as ‘Mercantile Basis of Accounting’.”
Accrual Basis of Accounting
2.3 Accrual basis of accounting, thus, attempts to record the financial effects of the
transactions, events, and circumstances of an enterprises in the period in which they occur
rather than recording them in the period(s) in which cash is received or paid by the enterprise.
It recognises that the buying, producing, selling and other economic events that affect
enterprise’s performance often do not coincide with the cash receipts and payments of the
period. The goal of accrual basis of accounting is to relate the accomplishments (measured in
the form of revenue) and the efforts (measured in terms of cost) so that reported net income
measures an enterprise’s performance during a period instead of merely listing its cash
receipts and payments. Apart from income measurement, accrual basis of accounting
recognises assets, liabilities or components of revenues and expenses for amounts received
or paid in cash in past, and amounts expected to be received or paid in cash in the future.
2.4 The major difference between accrual accounting and accounting based on cash receipts
and outlays, is in timing of recognition of revenues, expenses, gains and losses. Cash receipts
in a particular period may largely reflect the effects of activities of the enterprise in the earlier
periods, while many of the cash outlays may relate to activities and efforts expected in future
periods. Thus, an account showing cash receipts and cash outlays of an enterprise for a short
period cannot indicate how much of the cash received is return of investment and how much is
return on investment and thus cannot indicate whether or to what extent an enterprise is
successful or unsuccessful.
2.5 The following are the essential features of accrual basis of accounting:
(i) Revenue is recognised as it is earned.
(ii) Costs are matched either against revenues so recognised or against the relevant time
period to determine periodic income, and
(iii) Costs which are not charged to income are carried forward and are kept under
continuous review. Any cost that appears to have lost its utility or its power to generate
future revenue is written-off as a loss.
2.6 The above features of accrual basis of accounting are discussed in the following
paragraphs.
3. REVENUE RECOGNITION
3.1 The Accounting Standard on “Revenue Recognition” (AS-9) issued by ICAI deals with the
bases for recognition of revenue in the statement of profit and loss of an enterprise. This
standard lays down rules for recognition of revenue arising in the course of the ordinary
activities of the enterprise from (i) sale of goods, (ii) rendering of services, and (iii) use of
resources of the enterprise by others yielding interest, royalties and dividends.
3.2 Recognition of revenue requires that revenue is measurable and that at the time of sale
or the rendering of service or the use of resources of the enterprise by others it would not be
unreasonable to expect ultimate collection.
3.3 An essential criterion for the recognition of revenue is that the consideration receivable
from the sale of goods, the rendering of services or from the use by others of resources of the
enterprise is reasonably determinable. When such consideration is not determinable within
3.4 When recognition of revenue is postponed due to the effect of uncertainties, it is
considered as revenue for the period in which it is properly recognised according to the
principles discussed herein.
3.5 Where the ability to assess the ultimate collection with reasonable certainty is lacking at
the time of raising any claim, e.g., for escalation of price, export incentives, interest etc.,
revenue recognition is postponed to the extent of uncertainty involved. It is possible that the
uncertainty of collection may be either in respect of the entire transaction or a part thereof. For
that part in respect of which there is no uncertainty of collection, the revenue is immediately
recognised and for the remaining part the recognition of revenue is postponed. In such cases,
it may be appropriate to recognise revenue only when it is reasonably certain that the ultimate
collection will be made. It is necessary to disclose the circumstances in which revenue
recognition has been postponed pending the resolution of significant uncertainties. Where
there is no uncertainty as to ultimate collection, revenue is recognised at the time of sale or
rendering of service even though payments are made by installments. When the uncertainty
relating to collectability arises subsequent to the time of sale or the rendering of the service, it
is more appropriate to make a separate provision to reflect the uncertainty rather than to
adjust the amount of revenue originally recorded.
3.6 Revenue from sales or service transactions should be recognised when the requirements
as to performance set out in paragraphs 3.7 and 3.8 are satisfied, provided that at the time of
performance it is not unreasonable to expect ultimate collection.
3.7 In a transaction involving the sale of goods, performance should be regarded as being
achieved when the following conditions have been fulfilled:
(i) The seller of goods has transferred to the buyer the property in the goods for a price or
all significant risks and rewards of ownership have been transferred to the buyer and the
seller retains no effective control of the goods transferred to a degree usually associated
with ownership; and

(ii) no significant uncertainty exists regarding the amount of the consideration that will be
derived from the sale of goods. Thus, when such consideration is not determinable within
3.8 In a transaction involving the rendering of services, performance should be measured
either under the completed service contract method or under the proportionate completion
method, whichever relates the revenue to the work accomplished. Such performance should
be regarded as being achieved when no significant uncertainty exists regarding the amount of
the consideration that will be derived from rendering the service.
3.9 The use of resources of the enterprise by others yielding interest, royalties and dividends
is recognised when no significant uncertainty as to measurability or collectability exists. The
terms interest, royalties and dividends mean -
(i) Interest - charges for the use of cash resources or amounts due to the enterprise;
(ii) royalties - charges for the use of such assets as know-how, patents, trade marks and
copyrights;
(iii) dividends - rewards from the holding of investments in shares.
3.10 The revenues from the above sources are recognised on the following basis:
(i) Interest accrues, in most circumstances, on the time basis determined by the amount
outstanding and the rate applicable. Usually, discount or premium on debt securities held
is treated as though it were accruing over the period of maturity.
(ii) Royalties accrue in accordance with the terms of the relevant agreement and are usually
recognised on that basis unless, having regard to the substance of the transactions, it is
more appropriate to recognise revenue on some other systematic and rational basis.
(iii) Dividends from investments in shares accrue when the owner’s right to receive payment
is established.
Similar considerations would apply where the resources of the enterprise are used by others
and yield revenue such as rent.
3.11 When interest, royalties and dividends from foreign countries require exchange
permission and uncertainty in remittances is anticipated, revenue recognition may need to be
postponed.
3.12 The accrual basis of accounting necessitates adjustments for income received in
advance as well as for outstanding income at the end of the period of accounting since the
receipts during the period may not coincide with what is properly recognisable as income for
the period.
4. RULES FOR EXPENSE RECOGNITION
4.1 The Guidance Note on Terms Used in Financial Statements, explains the term ‘Expense’
as under:
“A cost relating to the operations of an accounting period or to the revenue earned during the
period or the benefits of which do not extend beyond that period”.
4.2 In the accrual basis of accounting, costs are matched either against revenues or against
the relevant time period to determine periodic income.
Further, costs which are not charged against income of the period are carried forward. If any
particular item of cost has lost its utility or its power to generate future revenue the same is
written off as an expense or a loss.
4.3 Under accrual basis of accounting, expenses are recognised by the following
approaches:
(i) Identification with revenue transactions

Costs directly associated with the revenue recognised during the relevant period (in respect of
which whether money has been paid or not) are considered as expenses and are charged to
income for the period.
(ii) Identification with a period of time
In many cases, although some costs may have connection with the revenue for the period, the
relationship is so indirect that it is impracticable to attempt to establish it. However, there is a
clear identification with a period of time. Such costs are regarded as ‘period costs’ and are
expensed in the relevant period, e.g., salaries, telephone, traveling, depreciation on office
building etc.
Similarly, the costs the benefits of which do not clearly extend beyond the accounting period
are also charged as expenses.
4.4 Expenses relating to a future period are accounted for as prepaid expenses even though
they are paid for in the current accounting period.
Similarly, expenses of the current year, for which payment has not yet been made
(outstanding expenses) are charged to the profit and loss account for the current accounting
period.
4.5 The amount of a contingent loss should be provided for by a charge in the statement of
profit and loss if:
(a) it is probable that at the date of the financial statements events subsequent thereto will
confirm that (after taking into account any related probable recovery) an asset has been
impaired or a liability has been incurred as at that date, and

(b) a reasonable estimate of the amount of the resulting loss can be made.
4.6 The existence of a contingent loss should be disclosed in the financial statements if
either of the conditions in paragraph 4.5 is not met, unless the possibility of a loss is remote.
5. RECOGNITION OF ASSETS AND LIABILITIES

5.1 As in the case of revenues and expenses which are recognised under the accrual basis
of accounting, as they are earned or incurred (and not as money is received or paid), the
transactions related to assets and liabilities are recognised as they occur irrespective of the
actual receipts or payments.
6. CONCEPT OF MATERIALITY
6.1 Section 209(3) of the Companies Act, 1956, requires that every company has to keep the
books of account in such a manner that they give a ‘true and fair’ view of its state of affairs
and that the books are maintained on the accrual basis of accounting.
6.2 The concept of ‘true and fair’ view also recognises that the concept of materiality must be
given due importance in the preparation and presentation of financial statements. As
explained in para 17 of Accounting Standard on ‘Disclosure of Accounting Policies’ (AS-1),
financial statements should disclose all “material” items, i.e., items the knowledge of which
might influence the decisions of the user of the financial statements.
6.3 The accrual basis of accounting does not necessarily imply that detailed calculations are
required to be made in respect of even the smallest and immaterial amounts of revenue and
expenditure and co-relate the same on the basis of the principle of accrual. For example, it
may not be improper to write off a small calculator costing Rs.100 even though it is expected
to be used for more than one year.
7. CHANGE IN THE BASIS OF ACCOUNTING

7.1 When an enterprise which was earlier following cash basis of accounting for all or any of
its transactions, changes over to the accrual basis of accounting, the effect of the change
should be ascertained with reference to the transactions of the previous accounting periods
also, to the extent such transactions have an impact on the current financial position of the
enterprise.
The fact of such change should be disclosed in the financial statements. The impact of, and
the adjustments resulting from, such change, if material, should be shown in the financial
statements of the period in which such change is made to reflect the effect of such change.
Where the effect of the change is not ascertainable, wholly or in part, the fact should be
indicated. If the change has no material effect on the financial statements for the current
period but is reasonably expected to have a material effect in later periods, the fact of such
change should be appropriately disclosed in the period in which the change is adopted.
8. AUTHORITATIVE PRONOUNCEMENTS OF THE INSTITUTE VIS-A-VIS ACCRUAL

ACCOUNTING
8.1 The Council of the ICAI and its various committees have issued various Guidance Notes,
Statements and Accounting Standards. The accounting treatments contained in these
documents are primarily based on accrual accounting. Thus, adoption of accounting
treatments recommended in these documents would ensure that a company has followed
accrual basis of accounting. The Appendix to this guidance note contains some special
circumstances of recognition of revenue and expenses as dealt with in the aforesaid
documents issued by the Institute. The Appendix also contains illustrations of situations where
due to uncertainty of collection, revenue recognition may be postponed.
9. AUDITOR’S RESPONSIBILITY
9.1 Where a company has maintained its books of account in a manner that all material
transactions are accounted for on accrual basis as discussed above, the auditor should state
in his report that, as far as this aspect is concerned, the company has maintained proper
books of account as required by law.
Where a company has not maintained its books of account in a manner that all material
transactions are accounted for on accrual basis as discussed above, the auditor will have to
qualify his report or give a negative opinion with regard to the following assertions:
(a) Whether proper books of account as required by law have been kept by the company.
(b) Whether the accounts give the information required by this Act in the manner so required
and give a true and fair view of:
(i) in the case of the balance sheet, of the state of the company’s affairs as at the end
of its financial year; and
(ii) in the case of the profit and loss account, of the profit or loss for its financial year.
APPENDIX
This Appendix is illustrative only. The purpose of the Appendix is to illustrate the application of
the Guidance Note on Accrual Basis of Accounting to some of the important commercial
situations.
REVENUE RECOGNITION
1. Sale of Goods
(i) Delivery is delayed at buyer’s request and buyer takes title and accepts billing
Revenue should be recognised notwithstanding that physical delivery has not been completed
so long as there is every expectation that delivery will be made. However, the item must be on
hand, identified and ready for delivery to the buyer at the time the sale is recognised rather
than there being simply an intention to acquire or manufacture the goods in time for delivery.
(ii) Delivered subject to conditions
(a) installation and inspection i.e. goods are sold subject to installation, inspection etc.
Revenue should normally not be recognised until the customer accepts delivery and
installation and inspection are complete. In some cases, however, the installation
process may be so simple in nature that it may be appropriate to recognise the sale
notwithstanding that installation is not yet completed (e.g. installation of a factory
tested television receiver normally only requires unpacking and connecting of power
and antenna.)
(b) on approval
Revenue should not be recognised until the goods have been formally accepted by
the buyer or the buyer has done an act adopting the transaction or the time period
for rejection has elapsed or where no time has been fixed, a reasonable time has
elapsed.
(c) guaranteed sales i.e. delivery is made giving the buyer an unlimited right of return
Recognition of revenue in such circumstances will depend on the substance of the
agreement. In the case of retail sales offering a guarantee of “money back if not
completely satisfied” it may be appropriate to recognise the sale but to make a
suitable provision for returns based on previous experience. In other cases, the
substance of the agreement may amount to a sale on consignment, in which case it
should be treated as indicated below.
(d) Consignment sales i.e. a delivery is made whereby the recipient undertakes to sell
the goods on behalf of the consignor
Revenue should not be recognised until the goods are sold to a third party.
(e) Cash on delivery sales
Revenue should not be recognised until cash is received by the seller or his agent.
(iii) Sales where the purchaser makes a series of installment payments to the seller, and the
seller delivers the goods only when the final payment is received
Revenue from such sales should not be recognised until goods are delivered. However,
when experience indicates that most such sales have been consummated, revenue may
be recognised when a significant deposit is received.
(iv) Special order and shipments i.e. where payment (or partialpayment) is received for
goods not presently held in stock e.g. the stock is still to be manufactured or is to be
delivered directly to the customer from a third party

Revenue from such sales should not be recognised until goods are manufactured,
identified and ready for delivery to the buyer by the third party.
(v) Sale/repurchase agreements i.e. where seller concurrently agrees to repurchase the
same goods at a later date
For such transactions that are in substance a financing agreement, the resulting cash
inflow is not revenue as defined and should not be recognised as revenue.
(vi) Sales to intermediate parties i.e. where goods are sold to distributors, dealers or others
for resale
Revenue from such sales can generally be recognised if significant risks of ownership
have passed, however, in some situations the buyer may in substance be an agent and
in such cases the sale should be treated as a consignment sale.
(vii) Subscriptions for publications
Revenue received or billed should be deferred and recognised either on a straight line
basis over time or, where the items delivered vary in value from period to period, revenue
should be based on the sales value of the item delivered in relation to the total sales
value of all items covered by the subscription.
(viii) Installments sales
When the consideration is receivable in installments, revenue attributable to the sales
price exclusive of interest should be recognised at the date of sale. The interest element
should be recognised as revenue, proportionately to the unpaid balance due to the seller.
2. RENDERING OF SERVICES
(i) Installation fees
In cases where installation fees are other than incidental to the sale of a product, they
should be recognised as revenue only when the equipment is installed and accepted by
the customer.
(ii) Advertising and Insurance Agency Commissions
Revenue should be recognised when the service is completed. For advertising agencies,
media commissions will normally be recognized when the related advertisement or
commercial appears before the public and the necessary intimation is received by the
agency, as opposed to production commission which will be recognised when the project
is completed. Insurance agency commissions should be recognised on the effective
commencement or renewal dates of the related policies.
(iii) Financial service commissions
A financial service may be rendered as a single act or may be provided over a period of
time. Similarly, charges for such services may be made as a single amount or in stages
over the period of the service or the life of the transaction to which it relates. Such
charges may be settled in full when made, or added to a loan or other account and
settled in stages.
The recognition of such revenue should, therefore, have regard to:
(a) Whether the service has been provided “once and for all”or is on a “continuing”
basis;
(b) the incidence of the costs relating to the service;
(c) when the payment for the service will be received. In general, commissions charged
for arranging or granting loan or other facilities should be recognised when a
binding obligation has been entered into. Commitment, facility or loan management
fees which relate to continuing obligations or services should normally be
recognised over the life of the loan or facility having regard to the amount of the
obligation outstanding, the nature of the services provided and the timing of the
costs relating thereto.
(iv) Admission fees
Revenue from artistic performances, banquets and other special events should be
recognised when the event takes place. When a subscription to a number of events is
sold, the fee should be allocated to each event on a systematic and rational basis.
(v) Entrance and membership fees
Revenue recognition from these sources will depend on the nature of the services being
provided. Entrance fee received is generally capitalized. If the membership fee permits
only membership and all other services or products are paid for separately, or is there is
a separate annual subscription, the fee should be recognised when received. If the
membership fee entitles the member to services or publications to be provided during the
year, it should be recognised on a systematic and rational basis having regard to the
timing and nature of all services provided.
3. UNCERTAINTY OF COLLECTION
In respect of the following items of revenue, if the ability to assess the ultimate collection with
reasonable certainty is lacking at the time of raising any claim, revenue recognition is
postponed to the extent of uncertainty involved :
(i) Claim for escalation of price under a contract.
(ii) Export incentives due from the Government or any statutory authority.
(iii) Drawback claims, cash subsidies, benefits of Import Licenses etc. received from the
Government or any statutory authority.

(iv) Interest due or receivable on loans or other dues when the recovery of the amount is in
dispute or is doubtful.
(v) Insurance claim in respect of loss of goods or loss of profits, when the amount receivable
is not certain or capable or being determined.
4. CONSTRUCTION CONTRACTS∗
In accounting for construction contracts in financial statements either the percentage of
completion method or the completed contract method1 may be used. When a contractor uses a
particular method of accounting for a contract, then the same method should be adopted for all
other contracts which meet similar criteria.
LIABILITY FOR EXPENDITURE

Gratuity
Under accrual basis of accounting it is necessary to provide for accruing liability in each
accounting period.
Guidance Note on Treatment of Expenditure during Construction Period

(under revision)
1. INTRODUCTION AND GENERAL NATURE OF THE PROBLEM

1.1 A recent feature of the developing economy in India is the emergence of large capital
projects which involve heavy capital investment. A characteristic of such projects is that they
usually involve a fairly prolonged period of construction and, owing to the incidence of heavy
initial costs and charges in respect of depreciation and other similar matters, the project
involves a gestation period of several years before it is able to recoup its initial losses and
initial depreciation charges and is able to earn profits commensurate with the investment in
the project.
1.2 During the prolonged period of construction, the project has necessarily to incur various
expenses which prima facie, are of a revenue nature. During the construction period, the
project also incurs various expenses of the nature of preliminary expenses, as well as
expenses which are associated with the corporate form assumed by the project, such as
∗
Accounting Standard (AS) 7, ‘Construction Contracts’ (revised) issued by the Institute of
Chartered Accountants of India, permits the use of only percentage of completion method for
accounting for construction contracts. AS 7 (revised) comes into effect in respect of all contracts
entered into during accounting periods commencing on or after 1-4-2003 and is mandatory in
nature.
expenses in connection with the issue of shares and debentures, and expenses in connection
with maintaining the secretarial department and the share transfer department. These
expenses are in addition to the preliminary project expenditure which would be incurred at a
very early stage in the existence of the project and sometimes even before the project has
been incorporated in the form of a company.
1.3 Since large capital projects are rarely financed out of shareholder’s funds alone, it is
usual to find that they incur financial expenses in the way of interest charges and commitment
fees during the period of construction, in respect of funds borrowed for the purpose of
construction.
1.4 At the same time, the project may also earn some interest and other income during its
construction phase from the temporary investment of surplus funds or from other sources.
1.5 An accounting problem is posed by the various matters referred to above. The problem is
not merely one of accounting for the income and expenditure which may arise during the
construction period. There is also the problem involved in regard to the tax treatment of such
income and expenditure during this period and in regard to the method of disclosing such
income and expenditure in the financial statements of a company, prepared in accordance
with the provisions of the Companies Act. Since there is a certain amount of confused
thinking in regard to these matters, it is felt that members would appreciate some advice from
the Council and it is possible that the issuance of a recommendation by the Council on this
matter will help to achieve a certain degree of uniformity of accounting treatment. It is also
hoped that the Government of India and authorities responsible for the Administration of the
Companies Act and the Income-tax Act will be influenced by the Council’s pronouncement in
regard to the correct accounting treatment of income and expenditure during the period of
construction.
1.6 Although large capital projects may assume any particular form of organisation, other
than the corporate form, it is considered that, in large majority of cases, such projects would
be formed as companies under the Companies Act. Consequently, this Note has been framed
with special reference to the problems of large capital projects which are organised in the
corporate form.
1.7 The expenditure other than direct capital expenditure which may be incurred by a new
project during its construction or pre-production period, may be classified under the following
different heads, each of which will be considered in later paragraphs of this Note.
(a) Preliminary expenses, formation expenses, expenses in connection with the issue of
shares and debentures, expenses in connection with public document such as the
prospectus etc.
(b) Preliminary project expenditure incurred in connection with the work of preparing the
project report, conducting feasibility studies, preliminary financial studies, land surveys,
location studies, etc., handling preliminary negotiations with foreign collaborators and
with the Government for the purpose of arranging for industrial licences, etc.
(c) Financial expenses such as interest charges and commitment fees on loans, as well as
expenditure incurred for preparing and issuing loan agreements and other documents
including debentures, trust deeds in favour of lenders, mortgage and hypothecation
deeds, etc.
(d) Indirect expenditure relating to the construction of the project comprising items of
expenditure which would normally be regarded as of revenue nature, if incurred after the
project commences commercial production.
(e) Other items of expenditure which would also normally be regarded as revenue
expenditure if incurred after the project has commenced commercial production which
are incurred during the construction stage, although they do not relate either directly or
indirectly to the construction work itself.
(f) Corporate expenses, that is, expenses incurred by a company owing to its corporate
status.
1.8 Two other problems are also considered in this Note. The first problem relates to the
determination of the point of time at which a new project can be said to have concluded the
construction stage of its activities and entered into the production stage. Usually, all expenses
up to this point of time are capitalised whereas all expenses thereafter are treated as revenue
expenses, unless they are directly of a capital nature. Consequently, the exact determination
of this point of time is very important both from an accounting point of view as well as from a
tax point of view. Another problem which is connected with this arises in a case where there
is delay in the start-up or commissioning of the plant for active production after its construction
has been physically completed. Such delay may occur due to several reasons many of which
are usually beyond the control of the management. For example, electric or water supply may
not be ready or there may be delay in the receipt of the first consignment of the raw materials
required for the plant. Quite often, such a period of delay may extend to several weeks or
even several months. During this period, various indirect expenses continue to be incurred
since it would not be practical to discharge employees who have already been engaged, nor it
would be possible to reduce the various fixed overhead expenses. The accounting and tax
treatment of the expenses incurred during this period, is therefore, also a matter for serious
consideration.
1.9 The other problem which is considered in this Note is the one which relates directly to the
accounting treatment of indirect expenses incurred by an existing project during the period
when it is engaged in a programme of substantial capital expansion. It is considered
appropriate to deal with this problem in this Note because it is analogous, in many respects, to
the problem relating to the indirect expenditure incurred by a new project during its
construction period.
2. PRELIMINARY EXPENSES
These expenses would include formation expenses, expenses in connection with issue of
shares and debentures, expenses in connection with public documents such as the
prospectus, etc. The present practice is that such expenses are carried forward on the
balance sheet and shown under the general group heading of “Miscellaneous Expenditure”
except to the extent that they are written off to profit and loss account. There is no legal
requirement to write-off these expenses to profit and loss account within any specified period
of time nor is there any rigid accounting convention in regard to this matter. However, good
corporate practice recognises the need to write-off these expenses to profit and loss account
within a period of 3 to 5 years after commencement of commercial production, and this
practice is usually followed by most well-managed companies even though, for Income tax
purposes, preliminary expenses within prescribed limits can be amortized over ten years. It is
recommended that no change is necessary in the existing practice in regard to these
expenses, and the present practice may therefore continue both from an accounting point of
view as well as from a tax point of view. However, members would be well advised to impress
upon their clients that it is good corporate and financial practice to write-off these expenses
within as short period as possible after commencement of commercial production and, in any
case, it is advisable that this period should not exceed 3 to 5 years.
3. PRELIMINARY PROJECT EXPENDITURE

3.1 Under this classification would be included the expenditure incurred in connection with
the work of preparing the project report, conducting feasibility studies, preliminary financial
studies, land surveys, location studies, etc. as well as the expenditure involved in connection
with preliminary negotiations with foreign collaborators and with the Government for the
purpose of arranging for various industrial and other licences, etc.
3.2 The suggested accounting treatment of the foregoing types of expenditure is discussed
below:
(a) The cost of preparing the project report as well as the cost of conducting feasibility
studies, land surveys, location studies, etc. is definitely related to the overall cost of the
project and can be regarded as an addition to the total construction cost of the project. It
is therefore recommended that expenditure of this type may be capitalised as part of the
total construction cost of the project. The position would be the same whether the
expenditure is directly incurred by the company itself or is paid by the company either to
its promoters or collaborators or to outside professional or other agencies. The
apportionment of this cost as an addition to the cost of various capital assets etc., is
considered in a later paragraph which deals generally with the problem of apportionment
of indirect construction costs and indirect capital expenditures against the cost of
individual assets.
(b) From a purely theoretical standpoint, it may be disputed whether it would be appropriate
to accord the same treatment to the costs and expenditures incurred in connection with
preliminary financial studies as well as in connection with preliminary negotiations with
foreign collaborators and with the Government for the purpose of obtaining the various
industrial and other licences. In practice, however, it should be recognised that these
costs and expenses are also incurred directly in connection with the project and are
definitely related to the project. Without incurring these expenses, it would not be
possible for the project to be commissioned, far less completed. Also, in actual practice,
it may be very difficult to segregate these expenses from the sum, total of the various
indirect expenses incurred during the construction stage of the project and, even if
segregated, it is unlikely that these expenses would represent a significant proportion of
the total construction cost. It is therefore recommended that these expenses should also
be capitalised as part of the total construction cost.
3.3 In a fast growing company, preparations for several projects will usually, be in hand at
the same time. Some of the projects may not reach a successful stage. The cost of project
reports, feasibility studies, preliminary financial studies, etc., relating to projects which prove
infructuous, should not be added to the cost of successful projects but should be aggregated
under a separate head and written off against revenue over a period of three to five years.
The recommendation contained in paragraph 3.2 above, applies only to costs incurred in
respect of projects which ultimately succeed.
4. FINANCIAL EXPENSES
4.1 These expenses would include interest charges and commitment fees on loans, as well
as expenditure incurred for preparing and issuing loan agreements and other documents
including debentures, trust deeds in favour of lenders, mortgage and hypothecation deeds,
etc.
4.2 For the sake of a better understanding of the problem, it may be clarified that the
expression “commitment fees” refers to the charges which are sometimes stipulated to be
payable to the lenders between the date loan agreement is finalised and the date the loan or
any part thereof is actually taken by the company. The full interest charges begin to accrue in
favour of the lender only from the date the loan is actually taken, but, in the meantime, the
lender is committed to keeping in readiness the funds which he has agreed to lend. For this
service, the lender sometimes charges a commitment fee, which is at a rate much lower than
the full interest charges and which is, quite often, based on the difference between the full
interest charges on the loan and the interest which the lender can earn during the period
before the loan is availed of by a temporary or short-term investment of funds.
4.3 There is no doubt that interest charges and commitment fees incurred after the date of
commencement of commercial production should be treated as revenue expenditure in the
normal way. However, during the period of construction, both these charges would represent
indirect construction expenditure and should be added to the total capital cost of the project.
(This view has already been accepted by the Institute vide paragraph No.3.25 of the
Statement on Auditing Practices). These remarks would apply with particular force in the case
of loans which have been taken for the purpose of capital assets or for incurring capital
expenditure. It is possible that the accounting treatment suggested in this paragraph may
appear to be slightly controversial and unorthodox from a purely theoretical standpoint but, on
practical considerations, the suggested treatment is probably fair and is also probably the
most appropriate choice out of various alternatives, each of which is bound to be subject to
some practical or theoretical objection. This view has not been accepted by the Supreme
Court of India in the case of Challapalli Sugars Ltd. V C.I. T. (1975) 98 ITR- 167 (S. C.). With
regard to interest charges and commitment fees on loans taken specially and exclusively for
the purpose of providing working capital, the treatment suggested above may not be proper
and, in this case, it will be more appropriate to transfer the interest charges and commitment
fees during the period of construction to a separate account which is carried forward in the
balance sheet under the group heading of “Miscellaneous Expenditure” until it is subsequently
written-off to profit and loss account after the commencement of commercial production, over
a period not exceeding 3 to 5 years.
4.4 It may be emphasised that the accounting treatment suggested in the foregoing
paragraph would apply only to actual interest charges and commitment fees. It would not
apply to any notional or imputed interest charges which are not actually incurred. For example,
it would not be appropriate to compute the notional interest on the share capital during the
period of construction and charge the same as an addition to the construction cost. The only
exception to this would be in a case where interest is actually paid on share capital during the
period of construction under section 208 of the Companies Act, 1956, in which case, as
mentioned in that section, such interest charges can be capitalised as part of the construction
cost or as part of the cost of the relevant plant and equipment.
4.5 Although it is stated in paragraph 4.3 that the interest charges on loans taken for the
purpose of providing working capital cannot logically be treated as capital expenditure and
added to the cost of fixed assets as an indirected charge relating thereto, these remarks would
not apply to the case of a loan which is taken partly for the purpose of providing working
capital and partly for the purpose of financing capital expenditure. In that case, the total
amount of the loan should be reasonably apportioned between working capital and fixed
capital expenditure, the interest during the construction period on the latter portion can be
treated as indirect capital expenditure and added to the cost of the relevant fixed assets, in the
same manner as is suggested in the early part of paragraph 4.3.
4.6 The costs and charges incurred for preparing and issuing loan agreements and other
documents including debentures, trust deeds in favour of lenders, mortgage and
hypothecation deeds, etc., are sometimes written off to profit and loss account, whereas in
other cases, especially if the amount involved is heavy, the total amount is carried forward on
the balance sheet as an item of “Miscellaneous Expenditure” and is written-off to revenue
over a period of years. These alternative methods of accounting apply where such costs and
charges are incurred after the commencement of commercial production. In the latter case,
that is, where the total amount of such costs and charges are treated as deferred revenue
expenditure, it is recommended that they should be written off to revenue as soon as possible
and, in any case, over a period not exceeding 3 to 5 years. Where however such charges are
incurred during the period of construction, it is suggested that they should be capitalised in the
same manner as interest charges.
5. INDIRECT EXPENDITURE INCIDENTAL AND RELATED TO CONSTRUCTION

5.1 This paragraph deals with the bulk of the indirect expenditure which should be incurred
by a project during its construction period, with the exception of the various other expenditures
which are considered in separate paragraphs of this Note. A characteristic of this type of -
expenditure is that, for a running concern it would be of a revenue nature. However, because
the expenditure is incurred during the construction period and because, during that period, the
expenditure is indirectly related to construction and is incidental thereto, it should be
capitalised as part of the construction cost.
5.2 The following list of some of the possible items of expenditure which would qualify for
inclusion under this heading is by no means exhaustive but is merely illustrative of the type of
expenditures which are discussed in this paragraph:-
(a) Expenditure on employees who are either assigned to construction work or to supervision
over construction work including salaries, provident fund and other benefits, staff welfare
expenses etc.
(b) Expenditure on technical and other consultants.
(c) General administrative and office expenditure which is indirectly related or incidental to
construction, including, as may be appropriate, stationery and printing, rent, rates and
taxes, postage and telegrams, travel and conveyance etc.
(d) Appropriate insurance charges.
(e) Appropriate expenditures on maintenance and operation of vehicles.
(f) Appropriate expenditures in connection with temporary structures and service facilities
built or acquired specially for the purpose of construction (see paragraphs 9.4 and 9.5 of
this Note).
(g) Preliminary project expenditure to the extent to which it is capitalised as part of the
construction cost (see paragraph 3 of this Note).
(h) Financial expenses including interest and other similar charges (see paragraph 4 of the
Note).
(i) Depreciation on fixed assets as well as on temporary structure and other facilities; used
during the period of construction (see paragraphs 9.4 and 9.5 of this Note).
(j) Expenses on test runs (see paragraph 11 of this Note).
(k) Expenses on land grading and levelling (see paragraph 9.6 of this Note).
5.3 In actual practice, it will be a matter for careful consideration whether a certain revenue
type expenditure is to be included under the heading of indirect expenditure related and
incidental to construction, or whether it would be more appropriate to treat it as an item of
other indirect expenditure not related to construction and therefore not qualifying for ultimate
inclusion in the total construction cost. Some indication of the principles to be applied is given
in the discussion contained in this paragraph which relates to the indirect expenditure which
can be capitalised as part of the indirect construction cost, as compared to the discussion in
the immediately succeeding paragraph (paragraph 6) which deals with indirect expenditure
which is not related to construction and which should not therefore be capitalised as part of
the indirect construction cost. In actual practice, however, the dividing line will always be very
thin.
6. OTHER INDIRECT EXPENDITURE NOT RELATED TO CONSTRUCTION

6.1 This heading refers to various items of indirect expenditure incurred by a project during
its construction period, which are not related either directly or indirectly to the work of
construction, but which are incurred mainly in preparation for the work which will be
undertaken after the project commences commercial production.
6.2 Expenditure under this head would include expenses in connection with staff training
programmes, as well as expenditure relating to the work of preparing for the production
activities which are soon to commence. For example, the concern would naturally have to
recruit and train its sales staff and its general office staff well in advance of the date of
commercial production. It may also have to send a few selected trainees overseas, especially
if there is a foreign collaborator involved in the project who has undertaken to provide such
training abroad. Expenses will also be incurred in connection with the salaries of employees
who are appointed ahead of the date of production but whose work involves no connection,
direct or indirect, with the work of construction, for example, employees of the sales
department, publicity and public relations departments, etc. The concern may also engage in
advance publicity campaigns in the press and otherwise in order to popularise itself and its
products, well in advance of the date it goes into production.
6.3 Indirect expenses of the type discussed in this paragraph cannot be regarded as part of
the incidental cost of construction because as explained above, they are not related either
directly or indirectly to the work of construction. At the same time, since these expenses are
incurred during the pre production period, they cannot be written off to revenue. The only
alternative, therefore, is to treat such expenses as deferred revenue expenditure to be carried
forward on the balance sheet under the general heading of “Miscellaneous Expenditure”.
They should, however, be written off to revenue as soon as possible after the commencement
of commercial production and, in no case, should the period of such write-off extend beyond a
reasonable period of time say three to five years, depending upon circumstances.
7. CORPORATE EXPENSES
7.1 If a new project is constituted in the corporate form, it will incur certain expenses during
its pre-production or construction period simply because it is constituted as a company.
7.2 Expenses of this type would include Directors’ fees - especially their sitting fees or
meeting fees and travelling expenses - expenditure of the secretarial department and the
share registration department, charges paid to outside professional or other agencies
entrusted with the work of handling share issues or share transfers, etc. Fees or other
remuneration paid to whole-time, managing or technical directors would not be included under
this head but would have to be considered as part of the indirect expenditure during
construction which have already been discussed in paragraph 5 above.
7.3 Expenditure of this type has no connection with construction and cannot therefore be
capitalised as an indirect cost of the construction. Since this expenditure cannot also be
written off to revenue during the pre-production period it may be treated in the same manner
as the other indirect expenditure discussed in paragraph 6 - namely, it may be treated initially
as deferred revenue expenditure to be shown in the Balance Sheet under the group heading
of “Miscellaneous Expenditure” and written off as soon as possible in the manner as is
suggested above in paragraph 6.3 relating to other indirect expenditure.
8. INCOME DURING THE CONSTRUCTION OR PRE-CONSTRUCTION PERIOD

8.1 It is possible that a new project may earn some income from miscellaneous sources
during its construction or pre-production period. Such income may be earned by way of
interest from the temporary investment of surplus funds prior to their utilisation for capital or
other expenditure or from sale of products manufactured during the period of test runs and
experimental production. Such items of income should be disclosed separately either in the
profit and loss account, where this account is prepared during construction period, or in the
account/statement prepared in lieu of the profit and loss account, i.e., Development
Account/Incidental Expenditure During Construction Period Account/Statement on Incidental
Expenditure During Construction (Refer to para 14.7). The treatment of such incomes for
arriving at the amount of expenditure to be capitalised / deferred, has been dealt with in para
15.2.
8.2 The question relating to tax liability on the income during the construction or pre-produc-
tion period needs to be considered. Necessary provision for such liability should be made in
the accounts.
9. CAPITAL EXPENDITURE DURING THE CONSTRUCTION OR PRE-PRODUCTION

PERIOD
9.1 The expenditure during the construction or pre-production period which is directly of a
capital nature can be further classified as follows:
(a) Advance payments to contractors for construction work.
(b) Construction work-in-progress
(c) Purchase or acquisition of fixed assets during the construction period.
(d) Cost of structure, facilities, etc. constructed or acquired during the construction period for
use in the construction.
(e) Land, and expenditure on land.
In addition, there may be expenditure that goes waste e.g., when a machine gets heavily
damaged and becomes useless.
Each of the foregoing classifications is considered in greater detail in the subsequent para-
graphs.
9.2 (a) Sometimes, payments are made to contractors as advances from time to time or in
accordance with the specific terms of the contract. This is particularly true in the
case of construction contracts which are executed on the basis of a so-called “turn-
key” agreement. However, in addition to ‘turn-key” contracts, advance payments
made to contractors may be a feature of other types of contracts as well. In all such
cases, until the contract is completed and the constructed project handed over by
the contractor, several payments are made to the contractor by way of advances to
enable the contractor to meet his various financial commitments. In the books of
account of the company making such payments, they should be treated as advance
payments until the contract is completed, at which time the total of the advance
payments made can be adjusted against the final contract price. Having regard to
the nature and purpose of the advance, it would be preferable for a fair presentation
to disclose it in the balance sheet as a separate item under the heading “Fixed
Capital Expenditure” rather than under “Loans and Advances”. Alternatively, if the
Company prefers to classify the advances to contractors under the heading “Loans
and Advances” this should be described clearly in such a manner so as to indicate
that the advances are of a capital nature and represent advance payments to
contractors for construction work. However, irrespective of the method which is
adopted in classifying the advances on the balance sheet, they should not be
segregated or classified against any specific “Fixed Assets” until the construction
work is completed and the title to the property constructed or delivered by the
contractor has passed to the purchaser. The same considerations would also apply
where the construction work is sub-divided among a number of contractors the
principal consideration being, to treat such payments as advances until the project
under construction is completed and the property therein passes from the contractor
to the company as the owner. In certain construction contracts, the total amount
payable to the contractor or contractors is fixed, whereas in other types of
arrangements, the total amount is determined by reference to calculations of the
contractor’s cost plus an agreed margin of profit, or other similar calculations.
Where the total contract consideration is fixed lump sum, and the contract embraces
the acquisition or construction of several units of plant and machinery, this should
be apportioned on a reasonable basis amongst the various components. Such
apportionment, however, is important and essential not only because it is necessary
to record separately the value of the different units of fixed assets, but also because
the rate of depreciation for each of those units would be different both from the tax
point of view as well as from the point of view of corporate accounting. Wherever
possible; this apportionment should be made on the basis of the data furnished by
the contractor himself, failing which the apportionment would have to be made by
the Board of Directors on any other reasonable basis which may be proper and
appropriate in the circumstances. It is suggested that in cases where the
apportionment is not made on the basis of the data furnished by the contractor
himself, or on the basis of any other objective evidence, the financial statements
should contain a note indicating briefly the manner in which the total consideration
has been apportioned over the various units of fixed assets.
9.2 (b) Advance payments to contractors should be made with due regard to the normal
considerations of internal control. When the terms of the contract are specific and
explicit, the advance payments should naturally be made on the basis of the
contract terms. Where the contract indicates that advance payments are to be
made, but does not specify the amount and frequency of such payments, it is for the
Company’s directors to establish a suitable procedure in order to ensure that
advance payments are not made recklessly, in excess of the progress of the work,
thereby making it difficult for the company to retain ultimate control over the
contractor. In most cases, a fair arrangement requires that advance payments may
be made on the basis of work completed as determined under the joint certificate of
the engineers from both sides after keeping a reasonable margin. However, this
cannot be taken as a hard and fast rule and, within the normal limitations of internal
control and contractual terms, each case should be considered on its own merits.
9.3 In complicated projects, the principal construction work relating to the plant and
machinery is usually of a highly technical nature and, as such, it is usually assigned to a
specialised contractor to whom advances are paid from time to time which are adjusted at the
end of the construction in the manner suggested in the immediately preceding paragraph. In
addition, in such cases, it is frequently found that the company itself undertakes directly the
construction of the non-technical aspects of the project with such local outside help as may be
necessary. For example, in a project involving the construction of a complicated chemical

plant, the work of constructing the plant itself may be entrusted to specialised contractors with
expert technical know-how in the subject. However, in addition to the construction of the
chemical plant which needs specialised know-how, the project would also require the
construction of employee housing, railway sidings, roads in the factory area, various utility and
service facilities, etc., which the company may either construct on its own or whose
construction may be entrusted by the company to various local contractors acting under the
supervision of the company’s own engineers. In such a case, the expenditure on the latter
items of construction work should be shown in the accounts suitably classified under the
general caption “Construction work-in-progress” or some other similar caption while the
advances paid to the principal contractor for the construction of the chemical plant would
continue to be treated in the manner as suggested in the preceding paragraph. Where local
construction work of a subsidiary nature is carried out by the company in the manner indicated
in this paragraph, it is necessary to recognise that the company may incur certain common
expenses which would have to be suitably apportioned over the various units of the local
construction work. For example, the company may engage the services of a firm of consulting
engineers to supervise the local construction work in which case the fees and expenses paid
to them may have to be apportioned suitably over the various items involved, such as
employee housing, railway sidings, roads within the factory area, utility and service facilities,
etc.
9.4 In addition to any local construction work of the nature mentioned in the preceding
paragraph, it is almost inevitable that the company will purchase various items of fixed assets
during its construction or pre-production period. The commonest example of such a purchase
would be the purchase of automobiles, transport equipment, furniture and fixtures, and office
equipment, etc. Such assets would be required from the very inception of the company even
before the company enters its productive stage. It is extremely likely that all or some of the
fixed assets purchased during the construction period may be actually or indirectly utilised in
the work of construction, in which case the appropriate depreciation charges during the period
in which they are utilised in the work of construction should be treated as part of the indirect
construction expenditure and dealt with in the manner suggested in paragraph 5 of this Note
which deals with the treatment of indirect expenditure during the construction. For example,
earth moving equipment, tractors and heavy motorised equipment purchased during the period
of construction may be utilised directly for the purpose of construction. To a lesser extent,
motor cars and office equipment may also be utilised for the purpose of the construction work,
though indirectly. If some equipment purchased during the period of construction has been
utilised only partly for purposes of construction, a part of the depreciation thereon, on the
basis of a suitable proportion, should be capitalised as an indirect expenditure incurred during
the construction period. Therefore the total cost of the equipment purchased during the
construction period less the depreciation charged during that period should be carried forward
to the production period so that the accounts of the production period would begin with the
depreciation value of such equipment, which would then be further depreciated in the normal
way.
9.5 Where the work of construction is likely to be prolonged, it is inevitable that certain
facilities would have to be acquired or constructed especially for the purpose of the
construction. In some cases, these facilities can be used with suitable adjustments after the
commencement of production, whereas in other cases, they would have to be scrapped or
dismantled after completion of construction. For example, if the construction work has to be
undertaken at a fairly remote place, it may be necessary to construct temporary housing for
the workers who will be engaged on the construction work. In most cases, the housing which
is constructed for this purpose will be of a temporary nature and would, in all probability, be
much in excess of the company’s requirements after it commences production. Similarly, it
may be necessary to provide temporary water connections and electricity supply during the
period of construction which are intended to be dismantled and disconnected after permanent
arrangements are made for the company’s water and electric power requirements. It may also
be necessary to purchase or acquire equipment especially for the purpose of construction for
example, earth-moving equipment, cranes, cement batching and mixing equipment, etc. It is
suggested, that in such cases, the proper procedure would be initially to capitalise the cost of
all such temporary facilities and equipment. Logically, depreciation should be charged on
such facilities and equipment during the period of construction, but in actual practice this may
not always be possible because of the difficulty involved in ascertaining the fair amount of
such depreciation. Therefore, a more convenient method in practice would be initially to
capitalise the full cost of such temporary facilities, services and equipment and thereafter to
credit against this cost the residual or scrap value thereof at the end of the construction
period. In those cases where the temporary facilities and equipment are sold or scrapped or
are intended to be sold or scrapped at the end of the construction period, the value to be
credited would be the actual or estimated sale value or scrap value. Where, however, the
assets are intended to be taken over by the company for use in production at the end of the
construction period, the value to be credited would have to be estimated on some reasonable
basis. Thereafter, the initial cost of the temporary facilities and equipment less the value
credited at the end of the construction period, should be treated as an element of the indirect
cost of construction and dealt with accordingly in the manner suggested in paragraph 5 of this
Note, dealing with the subject of indirect expenditure during construction. In effect, what this
means is that the depreciation in the value of the temporary facilities and equipment used
during the construction period would be charged to the cost of construction.
9.6 The expenditure on land would represent an element of cost common to all new capital
projects large or small. The matter, however, is not entirely simple and therefore some
elaboration is necessary. Obviously, any consideration paid directly for the purchase of land
would have to be capitalised and accounted for separately as the cost of land. In a large
number of cases, the land is not purchased outright but is acquired with the help of various
Government agencies under the relevant laws relating to land acquisition, which aim at
enabling essential industries to obtain land at a reasonable cost without the risk of being, in
effect “black mailed” by a few landlords who refuse to sell their property, thereby defeating the
purpose of acquiring other tracts of land adjacent to, or surrounding, that property. Where the
land is acquired in this manner, the cost of acquisition would usually represent deposits paid
to, or through, the relevant Collector or other Government agency. The amounts so paid may
be shown in the balance sheet as cost of land, provided that, in appropriate circumstances, a
suitable note is given indicating that the cost of land represents the value of deposits paid up
to date for land acquisition purposes, which would be adjusted when the final value of land is
determined and the title to land is transferred to the company. In addition to the actual cost of
land, various expenses may be incurred in connection with the land which should also be
capitalised. These expenses would include the following :
(a) Legal costs, stamp duties and fees, etc.
(b) Cost of measuring the land, investigating its title, etc.
(c) Cost of acquiring trees and other structures which stand on the land, even though they
may not be of any ultimate use to the new project and may in fact have to be demolished
in order to clear the land for construction.
(d) Expenditure on grading and levelling the land in order to make it fit for construction.
(e) Expenditure on land surveys.
As regards items (a) and (b), they would invariably have to be capitalised as part of the cost of
land. As regards item (c), if any of the structures standing on the land have been, or can be,
utilised for the purpose of the project, the estimated apportioned value of that structure should
be capitalised separately from the value of the land, otherwise the total value paid for the land
including that structure may be regarded as part of the cost of land. For example, if the total
amount paid for a piece of land is, say, Rs. 10 lakhs, and the land so purchased has a
warehouse standing on it, it would be necessary to determine whether or not the project
intends to utilise that warehouse or whether it intends to demolish it before constructing on the
land. In the latter case the total consideration of Rs. 10 lakhs would have to be treated as the
cost of land. On the other hand, in the former case, a suitable estimate would have to be
made of the value of the warehouse. Assuming such value to be Rs. 1 lakh, it would be
appropriate to capitalise Rs. 9 lakhs as the cost of the land and separately capitalise Rs 1
lakhs as the value of the warehouse to be included under the caption of “Factory Buildings”.
As regards (d), i.e., the expenditure on levelling and grading the land it is submitted that this
can be treated as an indirect cost of construction rather than as an additional cost relating to
the land itself, having regard to the primary purpose for which this expenditure is incurred.
Wherever possible, the expenditure on levelling, clearing and grading the land should be
related with, and added to, the cost of the particular buildings or other structures which stand
on each particular piece of land. Where this is not practicable, the total expenditure on
levelling, clearing and grading the land may be apportioned among the different buildings and
structures standing on the land in the ratio of the respective areas occupied by each such
building or structure, or in any other suitable ratio. What is stated above in this context is not
intended to imply that only that portion of the expenditure on levelling, clearing and grading
the land can be capitalised, as an indirect cost of construction, which relates to the area of the
land actually occupied by a building or other structure. It is recognised that, in practice, it may
not be possible to occupy the entire land area by constructing a building or other structures
thereon. If the entire land is reasonably occupied by buildings or other structures and if the
expenditure on levelling, clearing and grading the land is reasonably incurred for the purpose
of the construction, such expenditure can be treated entirely as an indirect cost of construction
and capitalised as part of the cost of the buildings or other structures. However, any part of
the expenditure on levelling, clearing and grading the land which is incurred for purposes of
landscaping or for any other purposes, not connected with the construction of the project,
should be treated as part of the cost of land. As regards (e) it is suggested that the
expenditure on land surveys should be treated as part of the preliminary project expenditure
and capitalised as an element of indirect construction cost in the manner discussed in
paragraph 3 of this Note.
9.7 Reference has been made in the earlier paragraphs of this section to expenditure
incurred on construction under agreements with contractors. There are a few specific matters
and problems which may arise in connection with construction contracts and the expenditure
incurred thereon which are considered below:
(a) It is possible that, in addition to constructing the plant or other structures, the contractors
may also agree to render other services. For example: the contractors may agree to
supply technical know-how, train the technicians of the purchasing company, and provide
credit facilities to the purchasing company by way of deferred payment terms in
connection with the purchase cost under the contract. In such cases, the value of the
additional services rendered by the contractors should be separated from the cost of the
construction and accounted for accordingly. This would present no problem if the
contract itself stipulates a separate consideration for the construction as well as for each
such specific service. However, if the contract consideration is not so specified, the lump
sum consideration would then have to be apportioned between the construction cost and
the value of each such specific service in some suitable manner which is appropriate in
the circumstances of the case. The basis of such apportionment should preferably be
indicated in a footnote to the financial statements. In the example given above, the
consideration, if any, which is paid separately for the value of the technical know-how
supplied by the contractors, would have to be accounted for, depending on the nature of
the technical know-how which is supplied. If the technical know-how which is supplied by
the contractors relates to the construction of the plant, it may be added to the value of
the plant. The only question in that case would be the apportionment of the total
consideration for such technical know-how among the different units of the plant which
are constructed by utilising the know-how. Such apportionments can be made in any
suitable manner. Wherever possible, in making the apportionment, regard should be had
to any data which may be supplied by the contractors and which may indicate a suitable
basis for apportionment. Failing any such data, the apportionment may be made on the
basis of the value or cost of the different units which are constructed or on the basis of
the approximate time spent by the contractors in designing the construction of each unit,
or on any other suitable basis. Care should be taken, however, to ensure that no part of
the value of the technical know-how relating to construction is apportioned to any unit of
construction which has not involved the utilisation of such know-how. If, on the other
hand, the technical know-how which is supplied relates to productive facilities and
processes, the value would have to be treated initially as an item of deferred revenue
expenditure to be amortised in suitable instalments after the commencement of
production, preferably over a period not exceeding 3 to 5 years after the commencement
of production. Any consideration paid separately to the contractors for training the
technicians of the purchasing company would have to be treated also as deferred
revenue expenditure in the manner suggested in paragraphs 6.2 and 6.3 of this Note.
Any expenditure by way of interest charges on the credit facilities provided by the
contractor would have to be treated in the manner suggested in paragraph 4 of this Note,
which deals in some detail with the various items of financial expenses.
(b) In several contracts for construction, there is a stipulation which requires the purchasing
company to pay separately the various reimbursable expenses of the contractor such as
customs duty, clearing and forwarding charges, ocean freight, railway freight, etc. The
payment of many of these charges would be made in composite amounts and it would be
necessary to apportion such payments among the different units of construction - either
on the basis of contract allocation wherever possible or, in the alternative, on some other
suitable basis.
(c) The purchasing company would also often need to maintain an establishment at the port
of entry in order to deal with clearing and forwarding matters and the cost of such
establishment would similarly have to be apportioned over the various units of
construction in some suitable manner.
(d) Another common charge requiring similar apportionment would be the fees payable to
the overall consulting or supervising engineers, if any.
(e) Several construction contracts contain a price escalation clause which operates under
different circumstances. If any circumstances have arisen under which this clause would
operate, the additional amount under the price escalation clause which is paid or payable
on the basis thereof, would have to be apportioned over the different units of construction
- either on the basis of direct allocation or in any other suitable manner.
(f) Also, construction contracts - especially with foreign contractors - sometimes provide for
payments to be made free of income tax or payments to be made in an amount which
after deducting income tax, would leave a net residue with the (foreign) contractor of a
stated amount. In such cases, care should be taken to ensure that the gross amount
payable under the contract is apportioned over the various units which are constructed.
9.8 During the course of construction of a big project, some losses are bound to occur. To an
extent the losses may be treated as normal and added to the cost of the project. For instance,
a wall may have to be pulled down and rebuilt. The total cost then can be capitalised.
However, to the extent the loss is avoidable and results from inefficiency, mischief or an
accident it should not be treated as part of the cost of the project. The amount of such a loss
should be segregated and written off when production commences, over a period of three to
five years.
10. CAPITAL EXPENDITURE NOT REPRESENTED BY ASSETS

Sometimes, circumstances force a project to incur capital expenditure which is not
represented by any specific or tangible assets. For example, a project may have to pay the
cost of laying pipelines in order to facilitate the supply of its products or raw materials to or
from a seaport, but the Port Trust or other similar authorities may insist that the pipelines
belong to them even though the cost thereof is paid by the company. In other cases, a project
may have to agree with a local authority to pay the cost or part of the cost of roads to be built
by that authority in the vicinity of the project for the purpose of facilitating the business of the
project. In this case also, the capital expenditure incurred by the project for this purpose
would not be represented by any actual assets, since the roads would remain the property of
the relevant State authorities even though the whole or a part of their cost may have been
defrayed by the company in order to facilitate its business. In all such cases the expenditure
so incurred would have to be treated in the books of account as a capital expenditure. There
seems to be no valid objection to disclosing the same in the balance sheet under the general
heading of “Capital Expenditure” subject to two conditions. In the first place, the description of
the specific item on the balance sheet should be such as to indicate quite clearly that the
capital expenditure is not represented by any assets owned by the company. In the second
place, the capital expenditure should be written off over the approximate period of its utility or
over a relatively brief period not exceeding five years, whichever is less. In fact, having regard
to the nature of the expenditure and the purpose for which it is incurred, it is suggested that it
would be more appropriate and realistic to classify such expenditure in the balance sheet
under the heading of “Capital Expenditure” rather than either, write-off the expenditure to
revenue or classify the expenditure under the heading of “Miscellaneous Expenditure” or
“Deferred Revenue Expenditure”.
11. EXPENDITURE ON START-UP AND COMMISSIONING OF THE PROJECT

11.1 After the plant has been constructed and the project has been completed in all respects it
is usually tested and adjusted for commercial production before it is finally commissioned.
Several items of expenditure are necessarily incurred in the process of starting the plant,
adjusting it, and experimenting with and adjusting the plant for commercial production. The
expenditure incurred during this period and in this process would include the salaries or fees
of consulting engineers, travelling expenses in connection with visits by engineers and
technicians to the plant, as well as the cost of raw materials and stores consumed in the
process of test runs.
11.2 As a general rule, it would be correct to capitalise all expenses incurred during this
period and in connection with the process of start-up and commissioning of the plant, for two
reasons. In the first place, such expenses would be incurred in order to bring the plant up to
the stage at which it can commence commercial production. In the second place, this
expenditure would normally be incurred before the plant is taken over. On both these
considerations, it would be fair and correct to capitalise the expenditure incurred on start-up
and commissioning the plant. The expenditure so incurred may be capitalised in the same way
as other indirect construction expenditure.
11.3 Sometimes, the agreement with the contractors responsible for constructing the plant
stipulates that the plant will not be finally taken over until after the guarantee period has been
satisfactorily completed. In most cases, the guarantee period would be completed several
months after the commencement of commercial production. Obviously, in such cases, it would
not be fair to continue to capitalise the expenses incurred after the commencement of
commercial production merely because the guarantee period has not been completed and
therefore the property in the plant has not been finally transferred to the purchasing company.
In such cases, the general rule should be followed which is, that all expenditure of a revenue
nature incurred after the date when the plant is ready to commence commercial production
should be written off as revenue expenditure.
11.4 During the period of test runs and experimental production it is quite possible that some
income will be earned through the sale of the merchandise produced or manufactured during
this period. The sale revenue should be set off against the indirect expenditure incurred
during the period of test runs and treated as suggested in para 15.2.
12. DATE OF COMMENCEMENT OF COMMERCIAL PRODUCTION

12.1 In any project which involves lengthy construction period, it is extremely important to be
very specific about the selection of a “cut-off date”, based on the date when the project is
officially recognised as being ready for commercial production. In theory, it may appear to be
a relatively simple matter to select this date, but in actual practice many complications may
arise owing to the fact that there is often an intervening period between the date when the
plant is finally completed and commissioned and the date when commercial production
actually begins. This intervening period is due to the time taken up in completing the various
tests and experiments which are usually necessary before commercial production can begin
as well as the time which is sometimes lost because all requisite permission from Government
Departments and all necessary service facilities such as water and electric power are not
ready and available on the date when the plant is completed and commissioned.
12.2 In several cases, guidance may be available in selecting the official date of
commencement of production by reference to the date of the inauguration ceremony as well
as by reference to the date which is publicly and officially announced by the company as the
date on which it has commenced commercial production. It should be borne in mind, in this
connection, that “commercial production” is a term of somewhat wider import than the mere
term “production”. Even during a period of test runs and experimentation, a plant may be
engaged in actual production, but until the test runs are completed and the plant is properly
adjusted on the basis thereof, it may not be said to be ready for “commercial production”. The
term “commercial production” refers to production in commercially feasible quantities and in a
commercially practicable manner.
12.3 As discussed in other paragraphs of this Note, various expenditures of a revenue nature
which are incurred during the construction period are either capitalised as part of the indirect
cost of construction, or are carried forward as deferred revenue expenditure, as may be ap-
propriate. However, from the moment the plant is completed and commissioned and is ready
for commercial production, all expenditures of revenue nature must be charged to the profit
and loss account. It is for this reason that it is so important to determine the “cut-off date”
based on the date when the plant is ready for commercial production, with a great degree of
precision.
12.4 It is important to note in this connection that what is significant for this purpose is the
date when the plant is ready for commercial production and not the date when the plant
actually commences commercial production. Therefore, if a plant had been completed and
commissioned and is ready for commercial production, but the company for some reason or
other, does not start commercial production immediately thereafter, the expenditure incurred
during this intermediate period must be treated as revenue expenditure and cannot be
capitalised. This follows from an important rule, both in accounting principle as well as in
economic theory. The rule is that only those expenses should be capitalised as part of the
cost of an asset which relate to the acquisition or construction of that asset or which add
anything to the value or utility of that asset. When a plant has once been completed and is
ready for commercial production, the expenditure incurred during the intervening period of
delay in actually commencing commercial production is neither related to the acquisition or
construction of the fixed assets nor does it add to the value or utility thereof - consequently, it
must be written off as revenue expenditure and cannot be capitalised.
12.5 As regards the general principles which would assist in the determination of the
appropriate date when a company can be said to be ready to commence business, guidance
can be obtained from several decided tax cases which are relevant because the consideration
under which a new project can be said to have been set up or established so that it is ready to
commence business are almost identical for tax purposes as well as for accounting purposes.
The following general principles emerge from a consideration of some of the decided tax
cases on this subject.
(a) The expression “set-up” as applied to a new project for tax purposes is identical with the
expression “ready to commence business.”
(b) The setting up of a new business or a new project represents a stage which is anterior to
the actual commencement of business.
(c) There is a clear distinction between commencement of business and setting up a
business; what is important is the date on which the business is set up rather than the
date on which the business is actually commenced.
(d) When an undertaking is established and is ready to commence business, it may be said
that it has been set up.
(e) There may be an interval of time between the setting up of a business and actual
commencement of business, in which case all expenses incurred during this interval of
time would be permissible deductions for tax purposes - and would also have to be
treated as revenue expenses for accounting purposes.
(f) The expression “set up” as used in the Income and Wealth Tax Acts with reference to a
new undertaking means that the undertaking is complete and ready to be commissioned
and ready to commence business. It is implied in this that the factory must have been
erected and the plant and machinery installed, before the business can be said to have
been set up, but it is not essential that the business should have been actually
commenced. It is also not essential that the factory should have actually functioned or
gone into production.
The aforesaid principles are based on the following tax decisions:
(1) Western India Vegetable Products Limited v. C.I.T. 26 ITR-151 (Bombay).
(2) C.I.F. v. Sarabhai Sons Ltd. 90 ITR-318 (Gujarat).
(3) Sarabhai Management Corporation Ltd. v. C.I.T. 102 ITR-25 (Gujarat).
(4) C.W.T. v. Ramaraju Surgical Cotton Mills Ltd. 63 ITR-478 (S.C.)
(5) Travancore Cochin Chemicals Pvt. Ltd. v. C.W.T. 65 ITR-651 (S.C.)
13. INTERVAL BETWEEN ESTABLISHING OF A BUSINESS AND THE COMMENCEMENT

OF ACTUAL PRODUCTION
13.1 As indicated in paragraph 12, a new project can be treated as having arrived at the
revenue earning stage as soon as it is ready to commence commercial production, that is as
soon as it is established and is ready for commercial production. However, there is often an
interval of time between the date a project is completed and commissioned and is ready for
production and the date when commercial production actually begins. The question which is
discussed in this paragraph relates to the treatment of the expenditure incurred during this
period.
13.2 In the normal course, the interval of time between the date a project is commissioned and
is ready for production and the date that commercial production actually begins should be very
brief. However, several factors sometimes operate to make this interval of time very
prolonged and this is especially so in India because of the multifarious list of regulations to be
complied with before commencing production as well as the acute shortage of basic materials
and services. For example, the fact that certain licences may have not been obtained in time
from a Government or local authorities may hold up commercial production. In other cases,
the plant may be commissioned and completed and may be ready in all respects to commence
production, but there may be delay in obtaining the power line or the water supply.
Sometimes, one project is linked to another in such a way that it relies on the latter for its
supply of raw materials. This is particularly the case with the chemical and process industries.
For example, a fertiliser plant may be established as part of a large petrochemical complex.
One of the essential raw materials for making fertilisers may be derived from the petro
chemical complex. In such a case, even if the fertiliser plant is complete in all respects and is
commissioned for commercial production, it cannot actually commence production until the
petro chemical complex has been completed, it will thus be appreciated that circumstances
can arise in which the interval of time between the completion of the plant and its readiness
for commercial production and the time when commercial production actually commences will
be very prolonged indeed. During such an interval of time, it is inevitable that the normal
running expenses will continue to be incurred.
13.3 Having regard to the consideration outlined in paragraph 12 which deals in some detail
with the date of commencement of commercial production, it would follow that all expenses of
a revenue nature incurred after the date when the plant is completed and commissioned and
is ready for commercial production or, to put it differently, all expenses of a revenue nature
incurred after the date when the business has been set up or established would have to be
charged to the profit and loss account and can no longer be capitalised, even though
commercial production has not actually commenced. There is no reason to depart from this
principle even in a case where there is a prolonged interval of time between the date of setting
up or establishing a business and the date on which it actually commences commercial
production.
13.4 If commercial production is considerably delayed, the problem which would arise is that
there would be no income during the period of such delay while, on the other hand, the
expenditure of a revenue nature incurred during this period would have to be charged to the
profit and loss account as mentioned above. If the period of delay in commencing commercial
production is extremely prolonged, the only possible concession which may be made is that
the expenditure incurred during this period can be treated as deferred revenue expenditure, to
be amortised over a period not exceeding 3 to 5 years after the commencement of commercial
production. This procedure is not, however, recommended as a matter of general policy or
practice, but may be resorted to only in those exceptional cases where fairly heavy revenue
expenditure is incurred during a prolonged period of delay in commencing commercial produc-
tion. In any case, it would be completely wrong to treat such expenditure as capital
expenditure since it does not add in any way to the value or cost or utility of the plant and
other manufacturing facilities which have already been constructed but which have remained
idle due to delay in commencing commercial production.
13.5 After commercial production has been commenced, it is customary to provide deprecia-
tion on fixed assets for the full annual period disregarding any short periods during the year
when particular assets have remained idle due to various reasons. This is only a rule of
practical convenience but the application of the rule also takes into consideration the fact that
an asset does depreciate to some extent even during idle periods and also, when fixing the
depreciation rate, some regard is usually given to the fact that there will inevitably be a few
idle periods when the particular plant or machinery will not remain in use. However, if there is
delay in commencing commercial production, it is suggested that it would not be necessary to
provide depreciation on fixed assets during this period. In other words, it would be necessary
to provide depreciation on fixed assets only as from the date when commercial production is
actually commenced.
14. DISCLOSURE IN FINANCIAL STATEMENTS

14.1 The method of disclosure of the expenditure incurred during the construction period, in
the financial statements prepared during that period would obviously depend on the nature of
those expenses. In certain cases, no difficulty would arise and the disclosure would be made
in accordance with generally accepted accounting principles.
14.2 As regards advances to contractors pending completion of the construction work,
reference may be made to the detailed discussion in paragraph 9.2(a) of this Note which
indicates the manner in which such advances, should be disclosed in the financial statements.
14.3 It is suggested that, in a large number of cases, it would be appropriate to indicate the
following items in the balance sheet under the general heading of “Fixed Assets”.
(a) Fixed assets actually purchased during the construction period less depreciation thereon,
which may be described in a separate Schedule annexed to the balance sheet (see
paragraph 9.4 of this Note) - this would also include land and expenses on land (see
paragraph 9.6 of this Note).
(b) Construction work-in-progress- to be described either on the balance sheet itself by
reference to relevant headings or in a separate Schedule annexed to the balance sheet
(see paragraph 9.3 of this Note).
(c) Cost of temporary structures and other facilities erected or acquired specially for the
purpose of construction (see paragraph 9.5 of this Note) - these items would continue to
appear on the balance sheet until end of the construction period when they would either
be transferred to the general fixed assets of the company if absorbed by the company for
use in its operations, or the temporary structures and other facilities would be sold or
scrapped if no longer required.

(d) Incidental and indirect expenditure relating to construction (see paragraph 5)- this would
also include preliminary project expenditure to the extent to which it is capitalised as part
of the total construction cost as well as financial expenses in the way of interest charges
etc. which are similarly capitalised (see paragraphs 3 and 4 of this note).
14.4 It would be appropriate to indicate the following items in the balance sheet under the
general heading of “Miscellaneous Expenditure” or “Deferred Revenue Expenditure” as may
be appropriate:
(a) Corporate expenses - including preliminary expenses, formation expenses in connection
with issue of shares and debentures, expenses of the share registrar’s department,
expenses in connection with the issue of public documents such as prospectus, director’s
sitting fees and travelling expenses, etc. (see paragraphs 2 and 7 of this Note).
(b) Preliminary project expenditure to the extent, it is not considered to be a part of the
indirect construction expenditure (see paragraph 3 of this Note)
(c) Financial expenses including interest and other similar charges, to the extent that they
are not capitalised as part of the indirect cost of construction (see paragraph 4 of this
Note)
(d) Indirect expenditure not related to construction (see paragraph 6 of this Note)
14.5 Income during the construction or pre production period should be shown separately in
the financial statements (see paragraph 8.1 of this Note). However, contributions made by
Government or other parties toward expenses shown under each of the headings and sub-
headings as suggested in the above paragraphs can be deducted therefrom. It is suggested
that such deductions should be shown separately in the financial statements.
14.6 As indicated elsewhere in this Note, almost all the expenditure during the period of
construction would be either capitalised or would be treated as deferred revenue expenditure,
to be amortised in suitable annual instalments extending over a period of 3 to 5 years after the
commencement of production. On the other hand, there would be little or no revenue, or
income during the construction period and such income, of a minor nature, which may be
earned during this period, can be adequately accounted for in the manner suggested in
paragraph 15.2 of this Note.
14.7 There is some doubt on the question whether or not a company is obliged to prepare a
profit and loss account during the period of construction when it is not in fact engaged in any
revenue operations. In view of the requirement of Section 210(3) of the Companies Act, every
company has to prepare its profit and loss account from the date of incorporation. However,
to prepare a profit and loss account during the period of construction might be somewhat
misleading as it may give an impression to the lay shareholder that the company was engaged
in revenue operations during this period and has incurred a substantial loss in those
operations. It is true that the requirements of Part II of Schedule VI to the Companies Act
relating to disclosure of specific items of expenditure have to be complied with. However,
these requirements can be adequately complied with if the relevant items of expenditure
requiring specific disclosure are suitably disclosed under the heading “Development Account”,
“Expenditure During Construction Account”, “Statement of Incidental Expenditure During
Construction” or by any other suitable name. This practice has also been recommended by the
Department of Company Affairs, Government of India, as per their circular No.2/17/64, dated
29th January, 1964 which is given in Appendix B.
Where the aforesaid practice is followed, it is desirable that a note be inserted in the financial
statements explaining the reason for not preparing a profit and loss account. It appears that
this would represent reasonable compliance with the legal requirements, since, the specific
disclosure requirements of Schedule VI, Part II are complied with. Whether the disclosure
should be made in the conventional profit and loss account form or through an
account/statement as per the recommendation made in the above paragraph, is a matter for
each company to decide. In this connection, it may be noted that Schedule VI, Part II of the
Act only contains disclosure requirements and does not prescribe specific form of profit and
loss account unlike Schedule VI, Part I which does so for the balance sheet.
14.8 Reference has been made in this Note to a number of cases where it may be appropriate
to treat certain expenditures incurred during the construction period as “deferred revenue
expenses”. It is necessary that the financial statements should disclose the amount and brief
details of the expenses which have been deferred indicating the extent to which they have
been written off to profit and loss account. In appropriate cases, it may also be necessary to
give a note indicating the reasons and basis for the deferral of expenses.
14.9 Normally, it should not be necessary to disclose in the Schedule of fixed assets the
extent to which the cost of the various assets is comprised of direct capital expenses and
allocated indirect expenses respectively, since the latter are also ultimately treated as capital
expenses forming part of the cost of the relevant assets. In appropriate cases, however, a
note may be given indicating the basis of allocation of indirect expenses incurred during the
period of construction - especially if the indirect expenses form a sizeable proportion of the
total capital expenditure.
14.10 Illustrative Specimen Statements are given in Appendices at the end of this book
15. ALLOCATION OF INDIRECT CAPITAL EXPENDITURE TO SPECIFIC ASSET HEADS

15.1 Mention has been made in earlier paragraphs of this Note to the various items of indirect
expenditure which may be capitalised. In particular, attention is drawn to the undernoted
paragraphs which deal with different items of indirect expenditure which may be capitalised as
part of the cost of construction.
Paragraph 3 - relating to Preliminary Project Expenditure.

Paragraph 4 - relating to Interest Charges and other Financial Expenses.
Paragraph 5 - relating to Indirect Expenditure Incidental to Construction.
Paragraph 9.5 - relating to expenditure on Temporary Structures and
Service Facilities Built or Acquired Specially for the purpose
of Construction.
Paragraph 9.4/5 - relating to Depreciation on Fixed Assets as well as on
Temporary Structures and other Facilities used during the
period of construction.
Paragraph 9.6 - relating to the Expenditure on Land Grading and Levelling.
Paragraph 11. - relating to Expenditure on Test Runs.
15.2 From the total of the aforesaid items of indirect expenditure would be deducted the
income, if any, earned during the period of construction provided it can be identified with the
project.
15.3 While the construction work is in progress, the various items of indirect capital expendi-
ture may be carried forward to be ultimately included as part of the indirect cost of
construction. It is not necessary to make any attempt to apportion the various items of indirect
capital expenditure to any specific asset or assets while the construction work is still in
progress. However, after the construction work is completed, it will be necessary to tackle the
problem of the specific allocation of the total indirect capital expenditure to the various
individual asset or assets.
15.4 The first principle to be borne in mind is to exclude from such allocation those assets
which have not benefited from the indirect capital expenditure, as well as those capital assets
to which the indirect expenditure is not at all related. For example, in most cases, capital
expenditure on land would not be affected by any of the items of indirect capital expenditure
and it would therefore be inappropriate to add to the value of the land any element
representing the indirect capital expenditure incurred during construction. Similarly, in several
cases, many of the items of indirect capital expenditure would not be related to the cost of the
buildings constructed for the project. For example, it is unlikely that the technical consultants
engaged to assist on the construction of a complex project would have devoted any portion of
their time to the construction of buildings which may therefore have been left entirely to local
contractors - in which case it would not be appropriate to add to the cost of buildings any
element of indirect capital expenditure which represents the expenditure on technical
consultants.
15.5 It follows from what is stated above that the first step in allocating the indirect
expenditure during construction would be to prepare, in as much detail as may be possible, a
statement indicating the various items of fixed assets which have not benefited from certain
specific items of indirect capital expenditure. Another statement should be prepared analysing
the indirect capital expenditure in as much detail as possible, after which an attempt should be
made to indicate against each item of indirect capital expenditure the specific assets or group
of assets to which that expenditure was related. For example, if an oil refinery is being
constructed, it is possible that one of the items of indirect expenditure would represent, say,
the expenditure on welding consultants engaged specially for the construction of storage
tanks. In that case, when analysing the total indirect capital expenditure, care should be taken
to state against the item relating to the expenditure on welding consultants the fact that this
expenditure was incurred exclusively for the construction of storage tanks. If this is done, it
would follow logically that certain items of indirect capital expenditure can be allocated
straightway to those specific assets or groups of assets to which they are related. It would
also follow from the method suggested above that inappropriate allocations of indirect capital
expenditure would be avoided. For example, in the illustration given above, the indirect
expenditure incurred on welding consultants would not be apportioned indiscriminately to all
items of fixed assets, if the method suggested above is adopted.
15.6 On the actual allocation of indirect capital expenditure, it is impossible to be dogmatic or
to make any specific pronouncements. Much would depend upon the circumstances of each
case as well as the total amount of the expenditure to be allocated. If the total of the indirect
expenditure is a relatively small amount, elaborate methods of allocation need not be adopted.
On the other hand, if the total indirect capital expenditure is relatively significant, greater care
should be taken to select a suitable basis of allocation, otherwise, the total asset values would
not be realistic. Basically, the problem should be solved in the manner suggested above -
which is to allocate, as far as possible, items of indirect capital expenditure to those specific
asset or assets to which they are related.
15.7 In a large number of cases of indirect capital expenditure, it would obviously be
impossible to link the expenditure to any specific asset or assets. In that case, it is suggested
that the indirect expenditure may be allocated having regard to various applicable
considerations, some of which are suggested below:
(a) Some items of indirect capital expenditure may be susceptible to allocation on the basis
of analysis of time spent on different items of construction by designated groups of
personnel, for example, the indirect expenditure representing the element of cost
incurred on technical consultants for different items of construction.
(b) In other cases, a more suitable method of allocation would be obtained by reference to
the cubic or tonnage measurement of different items of construction. For example, the
indirect expenditure which is incurred in connection with civil engineering work can be
allocated quite appropriately on the basis of the cubic measurement of the buildings or
other structures. On the other hand the indirect expenditure involving freight and
clearing charges can be appropriately allocated to different assets on the basis of
tonnage measurements.
(c) As already suggested earlier in paragraph 9.6 relating to the indirect expenditure on land
grading and clearing, the indirect expenditure incurred on grading and clearing the land
may be allocated to the different structures which stand on the land, in proportion to the
respective area occupied by the various structures.
15.8 The considerations suggested in the preceding paragraph are obviously illustrative rather
than exhaustive and, in each particular case, the allocation of indirect capital expenditure
would have to be made on the basis of the consideration which is most suitable bearing in
mind, however, the fact that too meticulous an attention to this problem is not called for. Any
method of allocation is bound to be somewhat arbitrary and the time and expenditure incurred
in the process of allocation should not be disproportionate.
16. EXPANSION OF EXISTING PROJECTS

16.1 The major part of this Note is devoted to a consideration of the accounting problems
relating to new capital projects while they are in the stage of construction. Somewhat similar
accounting problems are also encountered by an existing enterprise when it embarks on a
programme of capital expansion concurrently with current production.
16.2 It is suggested that the following guidelines may be regarded as the basis of determining
the correct accounting treatment in the case of a project which carries out a programme of
capital expansion concurrently with normal production:
(a) All direct expenditure must be capitalised in the normal way.
(b) The indirect expenditure which is capitalised should be restricted to the additional
expenditure, if any, incurred as a result of capital expansion and construction. In other
words, the indirect expenditure which is capitalised should be limited to the marginal
increase in such expenditure involved as a result of capital expansion. It would not be
correct or appropriate to capitalise indirect expenditure on a pro rata basis as that would
have the effect of reducing the charge to current revenue for the indirect expenditure
which would have been incurred in connection with the normal revenue operations in any
case, even in the absence of any capital expansion plans. To put it differently, indirect
expenditure should be marginally capitalised so as to ensure that current revenue does
not suffer as a result of any additional indirect expenditure incurred because of
construction. On the other hand, it is not intended that current revenue should actually
benefit by reason of the capital expansion project which is what would happen if indirect
expenditure is capitalised on a pro rata basis.
17. SUMMARY OF CONCLUSIONS AND RECOMMENDATIONS

17.1 A characteristic of large capital projects is that they usually involve a prolonged period of
construction during which the projects incur various items of direct as well as indirect
expenditure while, at the same time, it may also earn some income from miscellaneous
sources during its construction phase. An accounting problem is posed with regard to the
treatment of expenditure incurred and income earned during the construction period
(paragraph 1).
17.2 As regards the preliminary corporate expenses incurred by a new project - such as
company formation expenses, expenses in connection with the issue of shares and
debentures, etc. it is suggested that the present practice may continue. Consequently, such
expenses should be carried forward on the balance sheet and shown under the group heading
of “Miscellaneous Expenditure”, but they should be written off within a period of three to five
years after commencement of commercial production (paragraph 2).
17.3 It is recommended that the preliminary project expenditure incurred in connection with
the preparation of the project report, conducting feasibility studies, surveys, etc. should be
capitalised as part of the indirect construction cost. From a practical point of view it is also
suggested that the same treatment should be accorded to the expenditure incurred in
connection with preliminary studies and preliminary negotiations with foreign collaborators and
government authorities (paragraph 3).
17.4 It is recommended that the interest charges and commitment fees incurred during the
construction period on loans and other forms of borrowing, should be treated as part of the
indirect construction cost, if the loan or other borrowing was taken or incurred for the purpose
of financing the construction of the project (paragraph 4.3).
17.5 If the loan or other form of borrowing was taken or incurred for the purpose of providing
working capital, the interest and other charges thereon during the period of construction may
be treated as deferred revenue expenditure, to be written off to revenue over a period of three
to five years after commencement of production. In case a loan has been taken jointly for the
purpose of financing the construction and for working capital, the interest and the commitment
charge should be apportioned on a reasonable basis. The portion relating to financing of
construction should be capitalised and the other should be treated as deferred revenue
expenditure to be written off over a period of three to five years after production commences
(paragraphs 4.3 and 4.5).
17.6 The same treatment should be accorded to the various costs and charges incurred for
preparing the loan agreements and other documents as is given to the interest and
commitment fees incurred on the loan during the construction period (paragraph 4.6).
17.7 Notional or imputed interest charges, which are not actually incurred, should not be
capitalised (paragraph 4.4).
17.8 As regards the indirect expenditure incurred during the construction period, it is
recommended that it should be capitalised as part of the indirect construction cost to the
extent to which the expenditure is indirectly related to construction or is incidental thereto
(paragraph 5.1). The different kinds of expenditure which may qualify for inclusion as indirect
capital expenditure are given in paragraph 5.2 by way of examples of such expenditure.
17.9 As regards other indirect expenditure incurred during the construction period which is not
at all related to the construction activity nor is incidental ‘ thereto, it is recommended that such
expenditure should be treated as deferred revenue expenditure and written off to revenue
within a period of three to five years after commencement of production. Examples of such
expenditure are given in paragraph 6.2.
17.10 It is recommended that a similar treatment should also be accorded to various
“Corporate expenses” incurred during the construction period (paragraph 7)
17.11 During the construction period, a project may earn income from miscellaneous sources -
for example, interest income, income from hire of equipment or assets and income from sale
of products manufactured during the period of test runs and experimental production. It is
recommended that where such income can be identified with the project, it should be
deducted from the total of the indirect expenditure so that only the net amount of the
expenditure is capitalised or treated as deferred revenue expenditure, as the case may be
(paragraph 15.2). In either case, consideration may have to be given to the question of
providing for the income tax liability on such income (paragraph 8.2).
17.12 Advance payments and other similar payments to contractors during the period of
construction should not be segregated or classified against any specific “Fixed Assets” until
the contract has been completed and the property handed over by the contractor to the
purchaser so that legal title to the fixed assets has passed to the purchaser. In the meantime,
advance payments to contractors should be shown separately in the balance sheet as such,
either under the general heading of “Fixed Capital Expenditure” or as a separate item under
the general heading of “Loans and Advances” with a clear indication that the advance is of a
capital nature for pending construction work [paragraph 9.2(a)].
Reasonable control should be exercised over advance payments to contractors in order to
ensure that such payments are covered by the terms of the contract. Where the terms of the
contract are not explicit, advance payment should not ordinarily exceed the value of completed
work after retaining a reasonable margin [paragraph 9.2(b)].
17.13 In the case of a composite construction contract - especially a “turnkey’ contract - for a
fixed total amount of consideration, it will be necessary, at the end of the construction, to
apportion the total contractual value between the various units of plant and assets represented
thereby. Such apportionment should be made on the basis of data furnished by the contractor
himself, if possible; otherwise, on the basis of any other available evidence [paragraph 9.2(a)].
17.14 Capital expenditure incurred directly by the project itself on incomplete construction
work should be shown in the balance sheet as “construction work in progress” or under a
similar caption (paragraph 9.3).
17.15 Where the total construction work is spread over more than one contractor or where part
of the construction work is handled through contractors while a part thereof is undertaken
directly by the project itself, it will be necessary to apportion on a suitable basis certain
common expenses incurred in connection with the construction - for example, fees and
expenses of consulting engineers, custom duties, freight and clearance charges, expenses of
the establishment maintained at the port of entry, etc. [paragraphs 9.3 and 9.7(b),(c) and (d)]
17.16 Any complete units of fixed assets purchased or acquired during the construction period
should be shown in the accounts as “fixed assets” or “capital expenditure” - for example,
transport equipment, furniture and fixtures and office equipment (paragraph 9.4).
17.17 Similarly, it would be appropriate to capitalise the value of any facilities or equipment
which have been acquired or built specially for the purpose of construction, for example,
temporary housing for construction labour, temporary warehouses for construction stores,
temporary water and power connections, and purchase of construction equipment such as
cranes, earth moving equipment, etc. (paragraph 9.5).
17.18 It is recommended that depreciation should be charged during the construction period
on any items of fixed assets or temporary construction facilities used during the period of
construction. Such depreciation may be charged either by applying the normal depreciation
rates to the original cost of such assets, or, in the alternative, the depreciation may be
charged indirectly by capitalising the difference between the original cost of the equipment or
facilities and the sale or scrap value thereof at the end of the construction. The latter method
is particularly appropriate in the case of special construction equipment and temporary
construction facilities. In either case, the depreciation provided during the construction period
should ordinarily be treated as part of the indirect construction cost and capitalised
accordingly. If any item of fixed assets used during the construction period is retained by the
project for use after production, the residual book value of such assets should be depreciated
in the normal way after commencement of production (paragraphs 9.4 and 9.5).
17.19 In several cases, the land required for a new capital project is acquired with the help of
government authorities under the relevant land acquisition laws. In such cases, the total
amount of deposits paid for acquisition of land pending completion of the land acquisition
proceedings may be shown in the balance sheet as “cost of land” rather than “deposits” -
subject to suitable disclosure as to the absence of title as well as of the fact that the land cost
represents deposit payments which are subject to suitable adjustment after determination of
the final land value (paragraph 9.6).
17.20 Legal costs, stamp duties and fees, cost of measuring the land and investigating its title,
etc., should invariably be capitalized as part of the cost of the land (paragraph 9.6).
17.21 The value of any structures purchased together with the land may be segregated and
capitalised separately from the cost of the land, if it is intended to retain the structure for use
in the operations of the project after it commences production. If this is not intended and if the
structures purchased with the land are to be demolished for the purpose of construction, the
entire value paid for the land, including the structures purchased along with the land, should
be capitalized as the cost of the land itself [paragraph 9.6(c)].
17.22 If the operation of levelling, clearing and grading the land is undertaken principally for
the purpose of construction, the cost of such levelling, clearing and grading may be capitalised
as an indirect element of the construction cost, in which case it may be apportioned between
the different buildings and structures standing on the land in the ratio of the respective areas
occupied by such buildings and structures (paragraph 9.6).
17.23 Abnormal losses, resulting from inefficiency, mischief or accidents should not be
capitalised but should be written off over a period of 3 to 5 years against revenue when
production commences (paragraph 9.8).
17.24 Sometimes, capital expenditure is incurred which is not represented by any specific
assets. Examples of such expenditure are given in paragraph 10. It is recommended that
such expenditure may be shown in the balance sheet under the heading of “capital
expenditure” with suitable disclosure (paragraph 10).
17.25 It is recommended that the expenditure incurred on start-up and commissioning of the
project, including the expenditure incurred on test runs and experimental production, may be
capitalised as an indirect element of the construction cost. However, the expenditure incurred
over a prolonged guarantee period during which the plant is commercially operated cannot be
capitalised and must be treated as revenue expenditure even though the contract may
stipulate that the plant will not be finally taken over until after the satisfactory completion of the
guarantee period (paragraph 11).
17.26 It is extremely important to fix a specific date representing the date when the plant-has
been completed, set up and is recognised as being ready for commercial production. For this
purpose, the term “commercial production” refers to production in commercially feasible quan-
tities and in a commercially practicable manner. Consequently it is not sufficient if the plant is
ready for experimental production on a limited scale. With reference to the determination of
the specific date when the plant can be said to be ready for “commercial production”, some
guidance may be obtained from the several decided tax cases on this subject (paragraphs
12.1,12.2 and 12.5).
17.27 All expenses incurred after the date when the plant is ready for commercial production
should be charged to the profit and loss account as revenue expenses - with the exception
only of those expenses which are directly of a capital nature. This accounting treatment is also
applicable during the period when the plant is ready for commercial production even though
actual commercial production has been delayed for some reason. Sometimes, there may be
considerable delay between the date when the plant is ready for commercial production and
the date of actual commencement of production. Such prolonged delay may occur due to
several possible factors. If the period of delay in commencing production is extremely
prolonged, with the result that there is no matching of income to set-off the revenue
expenditure incurred during this period, it may be permissible to treat such expenditure initially
as “deferred revenue expenditure” to be written off within a period of three to five years after
commencement of production. In all cases of normal delay in commencing commercial
production, however, expenses of a revenue nature incurred during the period of delay should
be debited to profit and loss account. It would not be necessary, however, to provide any
depreciation on fixed assets until after the date when they are first utilised in the company’s
operations. Consequently, it would not be necessary to provide any depreciation on fixed
assets during the period of delay in commencing production, if the fixed assets have not
actually been utilised during this period (paragraphs 12.3, 12.4 and 13).
17.28 If a company’s financial statements are prepared during the period when the company is
still engaged in the construction of its project, some consideration would have to be given to
the question of appropriate disclosure in those financial statements (paragraph 14.1).
17.29 The cost of all incomplete construction work executed by the company itself should be
shown under the general heading of “Construction Work-in-progress” with suitable sub-
headings to describe the various items. Any completed units of fixed assets actually
purchased or acquired during the construction period should be shown in the normal way as
“Fixed Assets” after providing for appropriate depreciation thereon. In the case of temporary
structures and other facilities erected or acquired specially for the purpose of construction, as
well as in the case of special construction equipment, the cost thereof should be shown in the
balance sheet as part of the company’s “Fixed Assets”. It would be necessary to indicate
whether such assets as stated in the balance sheet as “at cost” or “at cost less depreciation”.
In some cases, it may be appropriate to state the value of such assets in the balance sheet as
“at cost” where the ultimate intention is to determine the depreciation of such assets at the
end of the construction period by measuring the difference between the original cost of such
assets and their saleable or scrap value at the end of the construction. In that case, the
description of such assets in the balance sheet as “at cost” should be clarified by a suitable
disclosure of this fact (paragraph 14.3).
17.30 During the period of construction, a company may incur several expenses of a revenue
nature. In some cases, such expenses would be treated as indirect or incidental expenses
relating to construction whereas in other cases, if the indirect expenses do not relate and are
incidental to construction, they may be treated as “Deferred Revenue Expenditure”. There
may also be cases of various corporate expenses, formation expenses, etc., which are treated
as “Preliminary Expenses”. The Statement of Incidental Expenditure During Construction for
the periods covered should give details of expenses as per Part II of Schedule VI of the
Companies Act (paragraphs 14.4, 14.5, 14.6 and 14.7).
17.31 It is also recommended that, in appropriate cases, the financial statements should
disclose the amount and brief details of “Deferred Revenue Expenses” indicating the reasons
and basis for the deferral of such expenses. The financial statements should also disclose, in
appropriate cases, the basis of allocation of indirect capital expenses to the various units of
plant and machinery, buildings, etc.-especially if the direct construction expenses form a
sizeable proportion of the total capital expenditure (paragraphs 14.8 and 14.9).
17.32 The allocation of indirect capital expenditure to specific asset heads would have to be
made bearing in mind a few general principles. Such allocation should be made only after the
construction work has been completed and no attempt should be made to allocate indirect
capital expenditure to specific asset heads while the construction work is still in progress.
Wherever possible, specific items of indirect expenditure should be allocated directly to related
asset heads. In those cases where such direct allocation is not possible, it will be necessary
to have recourse to indirect allocation. Even in such cases, however, care should be taken ‘to
exclude from such allocation those assets or groups of assets which have not benefited from
any particular item of indirect capital expenditure, as well as those fixed assets to which a
particular item of indirect expenditure is not at all related. Having ascertained and identified
the various items of indirect expenditure against the various asset heads or groups of assets
to which they may be related, the actual process of such indirect allocation may be
accomplished by one of several methods, taking care to select the method which is most
appropriate to a particular case. For example, in some cases the indirect allocation may be
made on the basis of time analysis whereas in other cases, a more suitable method of
allocation would be obtained by reference to the cubic, tonnage, or area measurements of the
different items of construction. Failing any such appropriate basis of allocation, the indirect
expenses may be apportioned by reference to the total direct capital costs of the different
items of fixed assets (paragraph 15).
17.33 When an existing enterprise carries out a programme of capital expansion concurrently
with normal production, all direct capital expenditure must be capitalised in the normal way.
As regards indirect expenditure, only that portion of such expenditure should be capitalised
which represents the marginal increase in such expenditure involved as a result of capital
expansion. It would not be appropriate in such a case to capitalise indirect expenditure on a
pro rata basis (paragraph 16).

Guidance Note on
Accounting for Depreciation in Companies1
INTRODUCTION
1. The Council of the Institute of Chartered Accountants of India has issued Accounting
Standard (AS) 6 on ‘Depreciation Accounting’. This Standard lays down general principles of
1
This Guidance Note also applies to various non-corporate entities to the extent it may be
relevant though it has been issued specifically for companies.
accounting for depreciation applicable to all entities. As such, the Standard is applicable to
companies also in all matters where there are no specific requirements under the Companies
Act.
AS 6 also provides that the statute governing an enterprise may provide the basis for
computation of depreciation. In such a situation, the requirements of the statute have to be
complied with. Thus, in case of companies, sections 205 and 350 of the Companies Act, 1956,
which govern provisions regarding charge of depreciation for the purpose of payment of
dividends and computation of managerial remuneration, respectively, provide the basis for
computation of depreciation. The Companies (Amendment) Act, 1988, has amended section
350, as a consequence to which rates of depreciation prescribed in Income-tax Act, 1961, and
the Rules made thereunder are no more relevant as the aforesaid section now provides that
the rates of depreciation applicable would be those prescribed in Schedule XIV, which has
been inserted in the Act. This Guidance Note on Accounting for Depreciation in Companies is
issued by the Research Committee in the context of the aforesaid sections of the Act as well
as the Accounting Standard.
2. The Council of the Institute and its various committees have issued, from time to time,
various pronouncements on the subject of accounting for depreciation, in particular reference
to the corporate sector, which are listed below:
(a) Guidance Note on Provision for Depreciation [published in Compendium of Guidance
Notes, Vol. 1 (2nd Edition)]
(b) Statement on Provision for Depreciation in Respect of Extra or Multiple Shift Allowance
[Published in Compendium of Statements and Standards on Accounting, 1st Edition]
(c) Statements on Changes in the Mode of Charging Depreciation in Accounts [Published as
an Appendix in the Guide to Company Audit]
(d) Guidance Note on Accounting for Depreciation Consequent to Changes in Rates of
Depreciation [Published in Compendium of Guidance Notes, Vol. II, 1st Edition]
This Guidance Note comes into effect in respect of accounting periods commencing on or after
1st April, 1989. Accordingly, the above Guidance Notes/Statements stand withdrawn from that
date.
METHODS OF CHARGING DEPRECIATION

3. Section 205 of the Companies Act, 1956, prescribes the methods of charging
depreciation. The relevant extracts thereof are as follows:
“(2)....depreciation shall be provided either-
(a) to the extent specified in section 350; or
(b) in respect of each item of depreciable asset, for such an amount as is arrived at by
dividing ninety-five percent of the original cost thereof to the company by the specified
period in respect of such asset; or
(c) on any other basis approved by the Central Government which has the effect of writing
off by way of depreciation ninety-five percent of the original cost to the company of each
such depreciable asset on the expiry of the specified period; or
(d) as regards any other depreciable asset for which no rate of depreciation has been laid
down by this Act or rules made thereunder, on such basis as may be approved by the
Central Government by the general order published in the Official Gazette or by any
special order in any particular case:
Provided that where depreciation is provided for in the manner laid down in clause (b) or
clause (c), then, in the event of the depreciable asset being sold, discarded, demolished or
destroyed the written down value thereof at the end of the financial year in which the asset is
sold, discarded, demolished or destroyed, shall be written off in accordance with the proviso to
section 350.
(5) ‘Specified period’ in respect of any depreciable asset shall mean the number of years at
the end of which at least ninety-five per cent of the original cost of the asset to the company
will have been provided for by way of depreciation if depreciation were to be calculated in
accordance with the provisions of section 350.”
4. Note No. 5(i) to Schedule XIV requires that depreciation method(s) used by the company
shall be disclosed. Part II of Schedule VI requires that if no provision is made for depreciation,
the fact that no provision has been made should be stated and the quantum of arrears of
depreciation computed in accordance with section 205(2) of the Act shall be disclosed by way
of a note. The Committee is of the view that the company should also disclose the method(s)
by which the arrears of depreciation have been computed.
Adoption of different methods for different types of assets
5. A company may adopt more than one method of depreciation. Thus, it is permissible to
follow different methods for different types of assets provided the same methods are
consistently adopted from year to year in accordance with Section 205(2). Also, units in
different geographical locations can follow different methods of depreciation provided the
same are consistently followed.
Change in the method of providing depreciation
6. The depreciation method selected should be applied consistently from period to period. A
change from one method of providing depreciation to another should be made only if the
adoption of the new method is required by statute or for compliance with an accounting
standard or if it is considered that the change would result in a more appropriate preparation
or presentation of the financial statements of the enterprise. When a change in the method of
depreciation is made, depreciation should be recalculated in accordance with the new method
from the date of the asset coming into use. The deficiency or surplus arising from
retrospective recomputation of depreciation in accordance with the new method would be
adjusted in the accounts in the year in which the method of depreciation is changed. In case
the change in the method results in deficiency in depreciation in respect of past years, the
deficiency should be charged to the profit and loss account. In case the change in the method
results in surplus, it is recommended that the surplus be initially transferred to the
‘Appropriations’ part of the profit and loss account and thence to General Reserve through the
same part of the profit and loss account. Such a change should be treated as a change in
accounting policy and its effects should be quantified and disclosed.
RELEVANT RATES OF DEPRECIATION FOR THE PURPOSE OF PREPARATION OF

ACCOUNTS OF A COMPANY
7. Section 205 of the Companies Act requires that no dividend shall be declared or paid by
a company except out of the profits of the company arrived at after providing for depreciation
in accordance with the provisions of sub-section 2 of that Section. This sub-section allows the
company to provide for depreciation either in the manner specified in Section 350 of the Act or
in the alternative manners specified in that sub-section itself. Part II of Schedule VI further
provides that if no provision for depreciation is made, the fact that no provision has been made
shall be stated and the quantum of arrears of depreciation computed in accordance with
Section 205(2) of the Act shall be disclosed by way of a note.
8. A question may arise as to whether it is obligatory on a company to provide for
depreciation only on the basis mentioned in Section 205(2) read with section 350 and
Schedule XIV of the Act or whether these bases can be considered as indicating the minimum
depreciation which must be provided by the company, insofar as the accounts of the company
are concerned and insofar as it is required to exhibit a true and fair view of the state of affairs
of the company as on a given date and of the profit or loss for the year.
9. The Committee is of the view that in arriving at the rates at which depreciation should be
provided the company must consider the true commercial depreciation, i.e., the rate which is
adequate to write off the asset over its normal working life. If the rate so arrived at is higher
than the rates prescribed under Schedule XIV, then the company should provide depreciation
at such higher rate but if the rate so arrived at is lower than the rate prescribed in Schedule
XIV, then the company should provide depreciation at the rates prescribed in Schedule XIV,
since these represent the minimum rates of depreciation to be provided. Since the
determination of commercial life of an asset is a technical matter, the decision of the Board of
Directors based on technological evaluation should be accepted by the auditor unless he has
reason to believe that such decision results in a charge which does not represent true
commercial depreciation. In case a company adopts the higher rates of depreciation as
recommended above, the higher depreciation rates/lower lives of the assets must be disclosed
as required in Note No. 5 of Schedule XIV to the Companies Act, 1956.
10. This view is supported by the Department of Company Affairs and it has clarified that “the
rates as contained in Schedule XIV should be viewed as the Accounting for minimum rates,
and, therefore, a company will not be permitted to charge depreciation at rates lower than
those specified in the Schedule in relation to assets purchased after the date of applicability of
the Schedule. If, however, on the basis of bona fide technological evaluation, higher rates of
depreciation are justified, they may be provided with proper disclosure by way of a note
forming part of annual accounts”2.
11. The Committee is, however, of the view that in respect of assets existing on the date of
Schedule XIV coming into force, and where the company is following the Circular of the
Department of Company Affairs bearing No. 1/86, dated 21st May, 1986, whereby
depreciation under straight line method was worked out based on depreciation rates in force
under Income-tax Act, 1961 and Rules made thereunder at the time of the acquisition of the
asset, it would be permissible to the company to follow Circular no. 1/86, dated 21st May,
1986. An appropriate note will be required to be given in this regard.
12. Schedule XIV requires that where the concern has worked extra shift, the multiple or
extra shift depreciation will have to be provided on the plant and machinery, wherever
applicable. In this regard, various units/departments/mills/factories should be taken as
separate concerns. In cases where depreciation has not been provided in respect of extra or
multiple shift allowance, it will be necessary for the auditor to qualify his report accordingly.
An example of the qualification is given below:
“Depreciation in respect of extra or multiple shift allowance amounting to rupees ........... has
not been provided which is contrary to the provisions of Schedule XIV to the Companies Act.
This has resulted in the profit being overstated by Rs ................. and plant and machinery
overstated by Rs...........”
13. It has been argued that the SLM rates (corresponding to the WDV rates as per Schedule
XIV) can be different than those prescribed under Schedule XIV, provided the company
continues to determine the rates as provided under Section 205. For instance, against the
SLM rate of 11.31 (triple shift rate for general plant and machinery) prescribed in Schedule
XIV, a company can charge depreciation at the rate of 10.56%. It may be mentioned that the
rate of 11.31% has been determined on the basis of 8 years and 6 months or so of specified
period whereas 10.56% is arrived at if 95% of the cost of the asset is divided by 9 years. It is
argued that for calculating the SLM rates complete years have to be taken into account
whereas the rates under Schedule XIV also take into account fractions of years.
14. The Committee is of the view that a company should provide SLM depreciation at the
rates prescribed under Schedule XIV instead of holding the contention that fractions of years
can be ignored. This view is supported by Department of Company Affairs, as per its Circular
2
Circular No. 2/89, dated March 7, 1989
No. 2/89, dated March 7, 1989.

Applicability of the rates prescribed in Schedule XIV to assets existing on the date on
which Schedule XIV came into force.
15. Applicability of the rates prescribed in Schedule XIV to existing assets would depend
upon whether the company has been charging depreciation on its assets as per the written
down value method or the straight line method.
16. Where a company has been following the written down value method of depreciation in
respect of its assets, the WDV rates prescribed in Schedule XIV should be applied to the
written down value as at the end of the previous financial year as per the books of the
company.
17. Where a company has been following the straight line basis of depreciation in respect of
its assets the position prevailing at present is discussed hereunder.
18. In January, 1985, the Department of Company Affairs issued a circular No. 1/85 dated
10.1.1985 (enclosed as Annexure II). In this Circular, the Government recognised the need for
recalculating the specified period consequent to changes in the income-tax rates. For
determining depreciation consequent upon changes in the income-tax rates it recommended
the following method:
(i) As far as recomputation of specified period is concerned, the specified period be
recomputed by applying to the original cost, the revised rate of depreciation as
prescribed under Income-tax Rules.
(ii) As far as charge of depreciation is concerned, depreciation be charged by allocating the
written down value as per books over the remaining part of the recomputed specified
period.
19. The Department of Company Affairs issued another Circular (No. 1/86 dated 21st May,
1986, enclosed as Annexure III) wherein it re-examined its earlier Circular of 1985. The
Department accordingly expressed its view that “once the ‘specified period’ was determined at
the time of purchase of an asset in accordance with the procedure laid down under Section
205(5) read with Section 350 of the Companies Act with reference to the rates of depreciation
under the Income-tax Act at that time and the amount of depreciation fixed under Section
205(2)(b) of the Companies Act, the same need not be changed subsequently consequent on
changes in the rates of depreciation in the Income-tax Act.” The Circular further stated that it
was therefore “open to the companies to provide for depreciation under clause (b) of Section
205(2) of the Companies Act on the basis of rates of depreciation prescribed under Income-
tax Act and in force at the time of acquisition/purchase of the asset.”
20. In its Circular No. 2/89 dated March 7, 1989, the Department has reiterated that the
companies which follow Circular No. 1/86 “may, therefore, continue to charge depreciation at
the old SLM rates in respect of the already acquired assets against which depreciation has
been provided in earlier years on SLM basis.”

21. The Committee is of the view that where a company is following the straight line method
of depreciation in respect of its assets existing on the date of Schedule XIV coming into force,
it would be permissible to apply the relevant SLM rates prescribed in the said Schedule on the
original cost of the assets from the year of the change of rates.
22. The Committee is accordingly of the view that where a company has been following
straight line method of depreciation in respect of its assets existing on the date of Schedule
XIV coming into force, the following alternative bases may be adopted for computing the
depreciation charge:
(a) Where a company follows the manner of charging depreciation recommended by the
Department of Company Affairs in its Circular No. 1/85, it has to change its depreciation
rates as follows:
(i) The specified period should be recomputed by applying to the original cost, the
revised rate as prescribed in Schedule XIV;
(ii) depreciation charge should be calculated by allocating the unamortized value as per
the books of account over the remaining part of the recomputed specified period.
(b) A company which follows the Circular No. 1/86, can continue to charge depreciation on
straight line basis at old rates in respect of assets existing on the date on which the new
provisions relating to depreciation came into force.
(c) SLM rates prescribed in Schedule XIV can be straightaway applied to the original cost of
all the assets including the existing assets from the year of change of the rates.
23. A company which changes the rates of depreciation should make an appropriate
disclosure in its accounts pertaining to the year in which the change is made.
PRO-RATA DEPRECIATION
24. Note no.4 in Schedule XIV to the Companies Act, 1956, prescribes that “where, during
any financial year, any addition has been made to any asset, or where any asset has been
sold, discarded, demolished or destroyed, the depreciation on such assets shall be calculated
on a pro rata basis from the date of such addition or, as the case may be, up to the date on
which such asset has been sold, discarded, demolished or destroyed”. The Committee is of
the view that a company may group additions and disposals in appropriate time period(s), e.g.,
15 days, a month, a quarter etc., for the purpose of charging pro rata depreciation in respect
of additions and disposals of its assets keeping in view the materiality of the amounts
involved.
25. Where the financial year of a company is more/less than 12 months, a question may
arise as to whether the rates of depreciation prescribed in Schedule XIV are to be applied
proportionately to the duration of the financial year of the company or the said rates are to be
applied as flat rates irrespective of the duration of the financial year. It may be argued that
since section 205 and 350 of the Companies Act, 1956, are in relation to the financial year, the
rates prescribed in Schedule XIV are applicable in respect of the financial year of the
company, irrespective of its duration. The Committee is, however, of the opinion that in view of
the true and fair consideration of preparation of accounts, the rates of depreciation as per
Schedule XIV should be applied proportionately taking into consideration the duration of the
financial year.
DEPRECIATION ON LOW VALUE ITEMS3

26. Prior to the enforcement of the Companies (Amendment) Act, 1988, many companies
used to follow the practice of writing off low value items in the year of acquisition, since such a
write off was permitted under the Income-tax Act. The limit for such a write off was Rs. 5,000/-.
Schedule XIV is, however, silent on this aspect. The Committee is of the view that the concept
of materiality should be kept in mind while deciding the amounts to be written off in this
regard. For instance, in small companies, the total write off on this basis may be a substantial
figure, it may not, therefore, be proper to charge 100% depreciation on low value items.
However, in large companies, where the value of assets is very high, it may be proper to
charge 100% depreciation on low value items keeping in view the concept of materiality. The
Committee recommends that the accounting policy followed by the company in this regard
should be disclosed appropriately in the accounts.
COMPUTATION OF MANAGERIAL REMUNERATION — WHETHER SLM RATES GIVEN IN

SCHEDULE CAN BE USED
27. The Department of Company Affairs, as per its circular no. 3\19\88-CL. V, dated April 13,
1989, has stated that “For the purpose of determining net profits of any financial year the
amount of depreciation required to be deducted in pursuance of clause (k) of sub-section (4)
of Section 349 read with Section 350 shall be the amount calculated as per the written down
value method at the rate specified in Schedule XIV, on the assets as shown by the books of
the Company at the end of the relevant financial year”. The Committee is of the opinion that
the language of Section 350 as it stands at present, does not permit the use of the Straight
Line Method. The aforesaid section makes reference to ‘written-down value of the assets’
indicating thereby that for the purposes of computation of managerial remuneration, only the
WDV method can be used as the SLM rates, by definition, are applicable only to the original
cost of the assets and not to the WDV of the assets.
CHARGING OF DEPRECIATION IN CASE OF REVALUATION OF ASSETS

28. A question may arise, as to whether the additional depreciation provision required in
consequence of revaluation of fixed assets can be adjusted against “Revaluation Reserve”
3
This paragraph stands superseded by the ‘Guidance Note on Some Important Issues Arising
from the Amendments to Schedule XIV to the Companies Act, 1956’, issued in August 1994.
which is created by a company by transferring the difference between the revalued figure and
the book value of the fixed assets.
Depreciation is required to be provided with reference to the total value of the fixed assets as
appearing in the accounts after revaluation. However, for certain statutory purposes e.g.,
dividends, managerial remuneration etc., only depreciation relatable to the historical cost of
the fixed assets is to be provided out of the current profits of the company. In the
circumstance, the additional depreciation relatable to revaluation may be adjusted against
“Revaluation Reserve” by transfer to Profit and Loss Account. In other words, as per the
requirements of Part II of Schedule VI to the Companies Act, the company will have to provide
the depreciation on the total book value of the fixed assets (including the increased amount as
a result of revaluation) in the Profit and Loss Account of the relevant period, and thereafter the
company can transfer an amount equivalent to the additional depreciation from the
Revaluation Reserve. Such transfer from Revaluation Reserve should be shown in the Profit
and Loss Account separately and an appropriate note by way of disclosure would be
desirable. Such a disclosure would appear to be in consonance with the requirement of Part I
of Schedule VI to the Companies Act, prescribing disclosure of write-up in the value of fixed
asset for the first five years after revaluation.
29. If a company has transferred the difference between the revalued figure and the book
value of fixed assets to the “Revaluation Reserve” and has charged the additional depreciation
related thereto to its Profit and Loss Account, it is possible to transfer an amount equivalent to
accumulated additional depreciation from the revaluation reserve to the Profit and Loss
Account or to the General Reserve provided suitable disclosure is made in the accounts as
recommended in this guidance note.
30. The Revaluation Reserve is not available for payment of dividends. This view is also
supported by the Companies (Declaration of Dividend out of Reserves) Rules, 1975. Similarly,
accumulated losses or arrears of depreciation should not be set off against Revaluation
Reserve. However, the revaluation reserve can be utilised for adjustment of the additional
depreciation on the increased amount due to revaluation from year to year or on the retirement
of the relevant fixed assets (as discussed in paragraphs 28 and 29 above respectively).
31. The revaluation of fixed assets is normally done in order to bring into books the
replacement cost of such assets. This is a healthy trend as it recognises the importance of
retaining sufficient funds through additional depreciation in the business for replacement of
fixed assets. As such, it will be prudent not to charge the additional depreciation against
revaluation reserve, though the charge of additional depreciation against revaluation reserve
is not prohibited as discussed in paragraphs 28 and 29 above. The practice of not charging
the additional depreciation against revaluation reserve would also give a more realistic
appraisal of the company’s operations in an inflationary situation.

Guidance Note on Availability of Revaluation Reserve for Issue of Bonus Shares
1. In the recent past, a few private companies and closely held public companies have
resorted to the practice of utilising the reserve created on revaluation of fixed assets for issue
of bonus shares. This Guidance Note discusses the nature of revaluation reserve and in this
context examines the question whether such reserves can be utilised for issue of bonus
shares. It supplements the Guidance Note on Treatment of Reserve Created on Revaluation
of Fixed Assets issued in 1982.
2. Revaluation of fixed assets is one of the issues dealt with in Accounting Standard (AS)
10 on ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India,
which states, inter alia, as follows:
“13.1 Sometimes financial statements that are otherwise prepared on a historical cost basis
include part or all of fixed assets at a valuation in substitution for historical costs....
13.2 A commonly accepted and preferred method of restating fixed assets is by appraisal,
normally undertaken by competent valuers. Other methods sometimes used are indexation
and reference to current prices which when applied are cross checked periodically by
appraisal method.”
3. AS 10 lays down as below:
“29. When a fixed asset is revalued upwards, any accumulated depreciation existing at the
date of the revaluation should not be credited to the profit and loss statement.
30. An increase in net book value arising on revaluation of fixed assets should be credited
directly to owners’ interests under the head of revaluation reserve, except that, to the extent
that such increase is related to and not greater than a decrease arising on revaluation
previously recorded as a charge to the profit and loss statement, it may be credited to the
profit and loss statement. A decrease in net book value arising on revaluation of fixed asset
should be charged directly to the profit and loss statement except that to the extent that such
a decrease is related to an increase which was previously recorded as, credit to revaluation
reserve and which has not been subsequently reversed or utilised, it may be charged directly
to that account.”
4. It may be noted that the excess of the revalued amount over the net book value of fixed
assets, which is credited to revaluation reserve, is created as a result of a book adjustment
only. The revaluation reserve does not result from an arm’s length transaction; it represents an
expert’s perception of value. The revaluation reserve thus does not represent a realised gain.
5. Share capital represents the amount of money or money’s worth received from the
owners and the capitalisation of earned profits or other gains arising out of an arm’s length
transaction. It has, therefore, been a cardinal principle that only such profits as are earned or
the relevant capital receipts (e.g. share premium), as are realised, can be capitalised.
6. In view of the above, in the opinion of the Institute of Chartered Accountants of India,
bonus shares cannot be issued by capitalisation of revaluation reserve. If any company
(including a private or a closely held public company) utilises revaluation reserve for issue of
bonus shares, the statutory auditor of the company should qualify his audit report. An
illustrative manner of the qualification is given below:
“The company has issued bonus shares for Rs. ___________ (_________ equity shares of
Rs._________ each) by capitalising its revaluation reserve. Accordingly, the Paid-up Equity
Share Capital of the company stands increased by Rs. ___________ and the revaluation
reserve stands reduced by that amount. The issue of bonus shares as aforesaid is contrary to
the recommendations of the Institute of Chartered Accountants of India.
Subject to the above __________”.
7. The above would also apply to situations where the revaluation reserve is utilised to
increase the amount paid-up on equity shares of a company.
8. In this context, it may also be noted that the Securities and Exchange Board of India
(SEBI) has prohibited listed companies from issuing bonus shares out of revaluation reserves.
Guidance Note on
Accounting for Corporate Dividend Tax
1. The Finance Act, 1997, has introduced Chapter XIID on “Special Provisions Relating to
Tax on Distributed Profits of Domestic Companies” [hereinafter referred to as ‘CDT’
(Corporate Dividend Tax)]. The relevant extracts of sections 115O and 115Q of the Income-tax
Act, 1961, governing CDT have been reproduced in Annexure I. This Guidance Note is being
issued to provide guidance on accounting for CDT.
2. The salient features of CDT are as below:
(i) CDT is in addition to the income-tax chargeable in respect of the total income of a
domestic company.
(ii) CDT is chargeable on any amount declared, distributed or paid by such company by
way of dividends (whether interim or otherwise) on or after the 1st day of June
1997.
(iii) The dividends chargeable to CDT may be out of the current profits or accumulated
profits.
(iv) The rate of CDT is ten per cent.
(v) CDT shall be payable even if no income-tax is payable by the domestic company on
its total income.

(vi) CDT is payable to the credit of the Central Government within 14 days of -
(a) declaration of any dividend,
(b) distribution of any dividend, or
(c) payment of any dividend,
whichever is the earliest.
(vii) CDT paid shall be treated as the final payment of tax on the dividends and no
further credit therefor shall be claimed by the company or by any person in respect
of the tax so paid.
(viii) The expression ‘dividend’ shall have the same meaning as is given to ‘dividend’ in
clause (22) of Section 2 but shall not include sub-clause (e) thereof. (The relevant
extracts of Section 2(22) of the Income-tax Act, 1961, have been reproduced in
Annexure II).
ACCOUNTING FOR CDT

3. According to generally accepted accounting principles, the provision for dividend is
recognised in the financial statements of the year to which the dividend relates. In view of this,
CDT on dividend, being directly linked to the amount of the dividend concerned, should also
be reflected in the accounts of the same financial year even though the actual tax liability in
respect thereof may arise in a different year.
DISCLOSURE AND PRESENTATION OF CDT IN FINANCIAL STATEMENTS

4. It is noted that clause 3(vi) of Part II of Schedule VI to the Companies Act, 1956, requires
the disclosure of “the amount of charge for Indian Incometax and other Indian taxation on
profits, including, where practicable, with Indian income-tax any taxation imposed elsewhere
to the extent of the relief, if any, from Indian income-tax and distinguishing, where practicable,
between income-tax and other taxation.” It is also noted that Part II of Schedule VI only lays
down the information to be disclosed in the profit and loss account. However, as a matter of
convention and to improve readability, the information in the profit and loss account is
generally shown in two parts, viz., the first part contains the information which is required to
arrive at the figure of the current year’s profit - often referred to as ‘above the line’, and the
second part which discloses, inter alia, information involving the appropriations of the current
year’s profits - often referred to as ‘below the line’.
5. Since dividends are disclosed ‘below the line’, a question arises with regard to disclosure
and presentation of CDT, as to whether the said tax should also be disclosed ‘below the line’
or should be disclosed along with the normal income-tax provision for the year ‘above the line’.
6. The liability in respect of CDT arises only if the profits are distributed as dividends
whereas the normal income-tax liability arises on the earning of the taxable profits. Since the
CDT liability relates to distribution of profits as dividends which are disclosed ‘below the line’,
it is appropriate that the liability in respect of CDT should also be disclosed ‘below the line’ as
a separate item. It is felt that such a disclosure would give a proper picture regarding
payments involved with reference to dividends.
RECOMMENDATIONS
7. CDT liability should be recognised in the accounts of the same financial year in which the
dividend concerned is recognised.
8. CDT liability should be disclosed separately in the profit and loss account, ‘below the
line’, as follows:
Dividend xxxxx
Corporate Dividend Tax thereon xxxxx xxxxx
9. Provision for Corporate Dividend Tax should be disclosed separately under the head
‘Provisions’ in the balance sheet.
Annexure I
RELEVANT EXTRACTS OF THE PROVISIONS UNDER CHAPTER XII D OF THE INCOME

TAX ACT, 1961, REGARDING SPECIAL PROVISIONS RELATING TO TAX ON
DISTRIBUTED PROFITS OF DOMESTIC COMPANIES.
115 O. Tax on Distributed Profits of Domestic Companies
(1) Notwithstanding anything contained in any other provision of this Act and subject to the
provisions of this section, in addition to the income-tax chargeable in respect of the total
income of a domestic company for any assessment year, any amount declared, distributed or
paid by such company by way of dividends (whether interim or otherwise) on or after the 1st
day of June, 1997, whether out of current or accumulated profits shall be charged to additional
income-tax (hereafter referred to as tax on distributed profits) at the rate of ten per cent.
(1A) Notwithstanding that no income-tax is payable by a domestic company on its total income
computed in accordance with the provisions of this Act, the tax on distributed profits under
subsection
(1) shall be payable by such company.
(2) The principal officer of the domestic company and the company shall be liable to pay the
tax on distributed profits to the credit of the Central Government within fourteen days
from the date of -
(a) declaration of any dividend; or
(b) distribution of any dividend; or
(c) payment of any dividend,

whichever is earliest.
(3) The tax on distributed profits so paid by the company shall be treated as the final
payment of tax in respect of the amount declared, distributed or paid as dividends and no
further credit therefore shall be claimed by the company or by any other person in
respect of the amount of tax so paid.
(4) No deduction under any other provision of this Act shall be allowed to the company or a
shareholder in respect of the amount which has been charged to tax under sub-section
(1) or the tax thereon.
115 Q
.......
Explanation —— For the purposes of this Chapter, the expression “dividend” shall have the
same meaning as is given to “dividend” in clause (22) of Section 2 but shall not include sub-
clause (e) thereof.
Annexure II
RELEVANT EXTRACTS OF THE DEFINITION OF THE TERM DIVIDEND AS PER SECTION

2(22) OF THE INCOME TAX ACT, 1961.
2(22) 1“Dividend includes -
(a) any distribution by a company of accumulated profits, whether capitalised or not, if such
distribution entails the release by the company to its shareholders of all or any part of the
assets of the company;
(b) any distribution to its shareholders by a company of debentures, debenture-stock, or
deposit certificates in any form, whether with or without interest, and any distribution to
its preference shareholders of shares by way of bonus, to the extent to which the
company possesses accumulated profits, whether capitalized or not;
(c) any distribution made to the shareholders of a company on its liquidation, to the extent to
which the distribution is attributable to the accumulated profits of the company
immediately before its liquidation, whether capitalised or not;
(d) any distribution to its shareholders by a company on the reduction of its capital, to the
extent to which the company possesses accumulated profits which arose after the end of
the previous year ending next before the 1st day of April, 1933, whether such
accumulated profits have been capitalised or not;
(e) .........but ‘dividend’ does not include -
(i) a distribution made in accordance with sub-clause (c) or sub-clause (d) in respect of
any share issued for full cash consideration, where the holder of the share is not
entitled in the event of liquidation to participate in the surplus assets;
(ii) any advance or loan made to a shareholder 4[or the said concern] by a company in
the ordinary course of its business, where the lending of money is a substantial part
of the business of the company;
(iii) any dividend paid by a company which is set off by the company against the whole
or any part of any sum previously paid by it and treated as a dividend within the
meaning of sub-clause (e), to the extent to which it is so set off.
Explanation 1. - The expression ‘accumulated profits’, wherever it occurs in this clause, shall
not include capital gains arising before the 1st day of April, 1946, or after the 31st day of
March, 1948, and before the 1st day of April,1956.
Explanation 2. - The expression ‘accumulated profits’ in sub-clauses (a), (b), (d) and (e), shall
include all profits of the company up to the date of distribution or payment referred to in those
sub-clauses and in sub-clause (c) shall include all profits of the company up to the date of
liquidation, 5[but shall not, where the liquidation is consequent on the compulsory acquisition
of its undertaking by the Government or a corporation owned or controlled by the Government
under any law for the time being in force, include any profits of the company prior to three
successive previous years immediately preceding the previous year in which such acquisition
took place].
GN(A) 12 (Revised 2000)

Guidance Note on
Accounting Treatment for Excise Duty
INTRODUCTION
1. The Institute of Chartered Accountants of India had issued a Guidance Note on
Accounting Treatment for Excise Duties in 1979. In order to bring uniformity in the accounting
treatment of excise duty and inventory valuation, the Guidance Note was revised in 1988.
Keeping in view further developments, viz., issuance of the revised Accounting Standard (AS)
2, “Valuation of Inventories” (which has come into effect in respect of accounting periods
commencing on or after 1.4.1999 and is mandatory in nature), it has been decided to revise
this Guidance Note again. This revised Guidance Note is being issued in supersession of the
earlier Guidance Note issued in 1988 and is effective in respect of accounting periods
beginning on or after April 1,1999.
2. This Guidance Note recommends accounting treatment for Excise Duty in respect of
excisable goods produced or manufactured by an enterprise. A separate Guidance Note on
Accounting Treatment for MODVAT sets out principles for accounting for MODVAT (now
renamed as ‘CENVAT’).
3. At the outset, this Guidance Note briefly deals with normally accepted accounting
principles for inventory valuation as prescribed in revised Accounting Standard (AS) 2,
“Valuation of Inventories” issued by the Institute of Chartered Accountants of India, and nature
of excise duty. For details, reference should be made to revised Accounting Standard (AS) 2
and Central Excise Act, Rules, Notifications and Circulars.
NORMALLY ACCEPTED ACCOUNTING PRINCIPLES FOR INVENTORY VALUATION

4. Normally accepted accounting principles with regard to the valuation of inventories (i.e.,
materials or supplies to be consumed in the production process or in the rendering of services,
work-in-process and finished goods), as prescribed in revised Accounting Standard (AS) 2,
“Valuation of Inventories”, are reproduced below:
“5. Inventories should be valued at the lower of cost and net realisable value.
6. The cost of inventories should comprise all costs of purchase, costs of conversion and
other costs incurred in bringing the inventories to their present location and condition.
purchase.
8. The costs of conversion of inventories include costs directly related to the units of
production, such as direct labour. They also include a systematic allocation of fixed and
variable production overheads that are incurred in converting materials into finished goods.
Fixed production overheads are those indirect costs of production that remain relatively
constant regardless of the volume of production, such as depreciation and maintenance of
factory buildings and the cost of factory management and administration. Variable production
overheads are those indirect costs of production that vary directly, or nearly directly, with the
volume of production, such as indirect materials and indirect labour.
9. The allocation of fixed production overheads for the purpose of their inclusion in the
costs of conversion is based on the normal capacity of the production facilities. Normal
capacity is the production expected to be achieved on an average over a number of periods or
seasons under normal circumstances, taking into account the loss of capacity resulting from
planned maintenance. The actual level of production may be used if it approximates normal
capacity. The amount of fixed production overheads allocated to each unit of production is not
increased as a consequence of low production or idle plant. Unallocated overheads are
recognised as an expense in the period in which they are incurred. In periods of abnormally
high production, the amount of fixed production overheads allocated to each unit of production
is decreased so that inventories are not measured above cost. Variable production overheads
are assigned to each unit of production on the basis of the actual use of the production
facilities.”
“11. Other costs are included in the cost of inventories only to the extent that they are
incurred in bringing the inventories to their present location and condition. For example, it may
be appropriate to include overheads other than production overheads or the costs of designing
products for specific customers in the cost of inventories.”
NATURE OF EXCISE DUTY

5. Excise duty is a duty on manufacture or production of excisable goods in India. Section 3
of the Central Excise Act, 1944, deals with charge of Excise Duty. This Section provides that a
duty of excise on excisable goods which are produced or manufactured in India shall be levied
and collected in such manner as may be prescribed. This prescription is contained in the
Central Excise Rules, 1944, which provide that excise duty shall be collected at the time of
removal of goods from factory premises or from approved place of storage (Rule 49). Rate of
duty and tariff valuation to be applied is the one in force on that date, i.e., the date of removal
(Rule 9A) and not the date of manufacture. This difference in the point of time between
taxable event, viz., manufacture and that of its collection has been examined and discussed in
a number of judgements. For instance, the Supreme Court in the case of Wallace Flour Mills
Co. Ltd. vs. CCE [1989 (44) ELT 598] summed up the legal position as under:
“It is well settled by the scheme of the Act as clarified by several decision sthat even though
the taxable event is the manufacture or production of an excisable article, the duty can be
levied and collected at a later stage for administrative convenience. The Scheme of the said
Act read with the relevant rules framed under the Act particularly Rule 9A of the said rules,
reveals that the taxable event is the fact of manufacture or production of an excisable article,
the payment of duty is related to the date of removal of such article from the factory.”
Supreme Court in another case, viz., CCE vs. Vazir Sultan Tobacco Co. [1996 (83) ELT 3]
held as under:
“We are of the opinion that Section 3 cannot be read as shifting the levy from the stage of
manufacture or production of goods to the stage of removal. The levy is and remains upon the
manufacture or production alone. Only the collection part of it is shifted to the stage of
removal.”
6. The levy of excise duty is not restricted only to excisable goods manufactured and
intended for sale. It is also leviable on excisable goods manufactured or produced in a factory
for internal consumption. Such intermediate products may be used in manufacture of final
products or for repairs within the factory or for use as capital goods within the factory.
Excisable goods so used for captive consumption may be eligible for exemption under specific
notifications issued from time to time. Finished excisable goods cleared from the place of
removal may also be eligible for whole or partial duty exemption in terms of notifications
issued from time to time. Such exemption, subject to specified limits, if any, may relate to a
manufacturer, e.g., a small-scale industrial unit. Exemption may be goods specific, e.g.,
handicrafts are currently wholly exempt from duty. The exemption may also be end-use
specific, e.g., goods for use by defence services. Excisable goods can be removed for export
out of India either wholly without payment of duty or under bond or on payment of duty under
claim for rebate of duty paid.
7. Excisable goods, after completion of their manufacturing process, are required to be kept
in a storeroom or other identified place of storage in a factory till the time of their clearance.
Each such storeroom or storage place is required to be declared to the Excise Authorities and
approved by them. Such storeroom or storage place is generally referred to as a Bonded
Storeroom. Dutiable goods are also allowed, subject to approval of Excise Authorities, to be
removed without payment of duty, to a Bonded Warehouse outside factory. In such cases,
excise duty is collected at the time of clearance of goods from such Bonded Warehouses.
8. Amount of excise duty forming part of the sale price of the goods is required to be
indicated separately in all documents relating to assessment of duty, e.g., excise invoice used
for clearance of excisable goods (Section 12A). It is, however, open to a manufacturer to
recover excise duty separately or not to make a separate recovery but charge a consolidated
sale price inclusive of excise duty. The incidence of excise duty is deemed to be passed on to
the buyer, unless contrary is proved by the payer of excise duty (Section 12B).
EXCISE DUTY AS AN ELEMENT OF COST

9. In considering the appropriate treatment of excise duty for the purpose of determination
of cost for inventory valuation, it is necessary to consider whether excise duty should be
considered differently from other expenses.
10. Admittedly, excise duty is an indirect tax but it cannot, for that reason alone, be treated
differently from other expenses. Excise duty arises as a consequence of manufacture of
excisable goods irrespective of the manner of use/disposal of goods thereafter, e.g., sale,
destruction and captive consumption. It does not cease to be a levy merely because the same
may be remitted by appropriate authority in case of destruction or exempted in case goods are
used for further manufacture of excisable goods in the factory. Tax (other than a tax on
income or sale) payable by a manufacturer is as much a cost of manufacture as any other
expenditure incurred by him and it does not cease to be an expenditure merely because it is
an exaction or a levy or because it is unavoidable. In fact, in a wider context, any expenditure
is an imposition which a manufacturer would like to minimise.
11. Excise duty contributes to the value of the product. A “duty paid” product has a higher
value than a product on which duty remains to be paid and no sale or further utilisation of
excisable goods can take place unless the duty is paid. It is, therefore, a necessary expense
which must be incurred if the goods are to be put in the location and condition in which they
can be sold or further used in the manufacturing process.
12. Excise duty cannot, therefore, be treated differently from other expenses for the purpose
of determination of cost for inventory valuation. To do so would be contrary to the basic
objective of carrying forward the cost related to inventories until these are sold or consumed.
13. As stated in para 6 above, liability to excise duty arises even on excisable goods
manufactured and used in further manufacturing process. In such a case, excise duty paid (if
the same is not exempted) on the intermediary product becomes a manufacturing expense.
Excise duty paid on such intermediary products must, therefore, be included in the valuation of
work-in-process or finished goods manufactured by the subsequent processing of such
products.
PROVISION FOR UNPAID EXCISE DUTY

14. Since the point of time at which duty is collected is not necessarily the point of time at
which the liability to pay the duty arises, situations will often arise when duty remains to be
collected on goods which have been manufactured.
The most common of these situations arises when the goods are stored under bond, i.e., in a
Bonded Store Room, and the duty is paid when the goods are removed from such Bonded
Store Room.
15. Divergent views exist as to whether provision should be made in the accounts for the
liability in respect of goods which are not cleared or which are lying in bond at the balance
sheet date.
16. The arguments in favour of the creation of liability are briefly summarized under:
(a) The liability for excise duty arises at the point of time at which the manufacture is
completed and it is only its collection which is deferred; and
(b) failure to provide for the liability will result in the balance sheet not showing a true
and fair view of the state of affairs of the enterprise.
17. The arguments against the creation of the liability, briefly summarised, are as under:
(a) Though the liability for excise duty arises at the point of time at which the
manufacture is completed, it gets quantified only when goods are cleared from the
factory or the bonded warehouse;
(b) the actual liability for excise duty may get modified by the time the goods are
cleared from the factory or bonded warehouse;
(c) where goods are damaged or destroyed before clearance, excise duty may be
waived by the competent authority and therefore the duty may never be paid; and
(d) failure to provide for the liability does not affect the profits or losses.
18. Since the liability for excise duty arises when the manufacture of the goods is completed,
it is necessary to create a provision for liability of unpaid excise duty on stocks lying in the
factory or bonded warehouse. It is true that the recovery of the duty is deferred till the goods
are removed from the factory or the bonded warehouse and the exact quantification will,
therefore, be at the time of removal and that estimate of duty made on balance sheet date
may change on account of subsequent events, e.g., change in the rate of duty and exports
under bond. But, this is true of many other items also, e.g., provision for gratuity and this
cannot be an argument for not making a provision for existing liability on estimated basis.
19. The estimate of such liability can be made at the rates in force on the balance sheet
date. For this purpose, other factors affecting liability should also be considered, e.g.,
exemptions being availed by the enterprise, pattern of sales –export, domestic etc. Thus, if a
small-scale undertaking is availing the benefit of exemption allowed in a particular financial
year and declares that it wishes to avail such exemption during next financial year also, excise
duty liability should be calculated after taking into consideration the availability of exemption
under the relevant notification. Similarly, if an enterprise is captively consuming all its
production of a specific product and has been availing of exemption from payment of duty on
that product, no provision for excise duty may be required in respect of non-duty paid stock of
that product lying in factory or bonded warehouse. An auditor must, however, apply
appropriate audit tests while verifying statements and declarations made by an enterprise in
this regard.
AUDITOR’S RESPONSIBILITY
20. The auditor has a responsibility to express his opinion whether the financial statements
on which he reports give a true and fair view of the operating results and state of affairs of the
entity. In the case of companies, under MAOCARO, 1988, the auditor has to express an
opinion whether the valuation of inventories is fair and proper in accordance with normally
accepted accounting principles and is on the same basis as in the earlier years. If there is any
change in the basis of valuation, the effect of such change, if material, is to be reported.
21. As explained in this Guidance Note, the liability for excise duty arises at the point of time
at which the manufacture is completed. The excise duty paid or provided on finished goods
should, therefore, be included in inventory valuation. Similarly, excise duty paid on purchases
(other than those subsequently recoverable by the enterprise from the taxing authorities) as
well as intermediary products used for manufacture should also be included in the valuation of
work-in progress or finished goods.
22. If the method of accounting for excise duty is not in accordance with the principles
explained in this Guidance Note, the auditor should qualify his report. In the case of a
company, reference to this qualification should also be made in the auditor’s report under
section 227(4A) of the Companies Act, 1956.
23. SUMMARY OF RECOMMENDATIONS

(i) Excise duty should be considered as a manufacturing expense and like other
manufacturing expenses be considered as an element of cost for inventory
valuation.
(ii) Where excise duty is paid on excisable goods and such goods are subsequently
utilised in the manufacturing process, the duty paid on such goods, if the same is
not recoverable from taxing authorities, becomes a manufacturing cost and must be
included in the valuation of work-in-progress or finished goods arising from the
subsequent processing of such goods.
(iii) Where the liability for excise duty has been incurred but its collection is deferred,
provision for the unpaid liability should be made.
(iv) Excise duty cannot be treated as a period cost.
(v) If the method of accounting for excise duty is not in accordance with the principles
explained in this Guidance Note, the auditor should qualify his report.
Guidance Note on
Accounting Treatment for
MODVAT/CENVAT
(The following is the text of the Guidance Note on Accounting Treatment for
MODVAT/CENVAT, issued by the Council of the Institute of Chartered Accountants of India.)
INTRODUCTION
1. The Guidance Note on Accounting Treatment for MODVAT was first issued in March 1988.
The Guidance Note was revised in July 1995 in view of extension of MODVAT Credit Scheme
to capital goods. The Guidance Note is revised again with the issuance of revised Accounting
Standard (AS) 2 on ‘Valuation of Inventories’, which has come into effect in respect of
accounting periods commencing on or after 1.4.1999 and is mandatory in nature. This revised
Guidance Note is issued in supersession of the earlier Guidance Note issued in July 1995,
and is effective in respect of accounting for MODVAT for accounting periods beginning on or
after April 1, 1999. With the substitution of the MODVAT Credit Scheme with CENVAT Credit
Scheme w.e.f. 1.4.2000, this revised Guidance Note also deals with accounting treatment in
respect of the latter Scheme.
OBJECTIVE
2. The objective of this Guidance Note is to provide guidance in respect of accounting for
MODVAT/CENVAT credit. Salient features of MODVAT and CENVAT credit schemes are
briefly set out hereinafter. Reference may be made to Central Excise Act, 1944, Central
Excise Rules, 1944, Notifications and Circulars issued from time to time for details of the
provisions of MODVAT/CENVAT Schemes. Guidance for accounting for excise duty is

provided in the Guidance Note on Accounting Treatment for Excise Duty, which has been
revised and issued separately.
MODVAT CREDIT SCHEME (UPTO 31.3.2000) – SALIENT
FEATURES
3. Modified Value Added Tax (MODVAT) Scheme allows instant credit of specified duties
paid on specified inputs used in or in relation to manufacture of specified final excisable goods
to be utilised for payment of 552 Compendium of Guidance Notes – Accounting excise duties in
respect of such goods. The Scheme covers imported goods as also those acquired
indigenously. Specified duty in relation to imported goods is countervailing duty and in case of
indigenous goods is excise duty, additional excise duty under Additional Duties of Excise
(Textile and Textile Articles) Act, 1978 as also additional excise duty under Additional Duties
of Excise (Goods of Special Importance) Act, 1957.
4. MODVAT Scheme was introduced in 1986, effective from 1.3.86, with a view to reduce
the cascading effect of duties. Initially, the Schemewas restrictive in its application in that
(i) it applied only to limited categories of inputs and final goods;and
(ii) use of inputs in or in relation to manufacture of final goods was essential for utilisation of
duty credit for payment of excise duties on clearance of such final goods. In other words,
correlation of inputs and final goods was essential though one to one correlation of inputs
was not essential.
5 Significant amendments have since been made to the MODVAT Scheme and the scope
of the Scheme has been expanded considerably. Salient features of the Scheme are
summarised hereinafter.
6. The Scheme applies to inputs (‘Input Duty Credit Scheme’) and capital goods (‘Capital
Goods Duty Credit Scheme’).
Input Duty Credit Scheme
7. Provisions in relation to this Scheme are contained in Rules 57A to 57J of the Central
Excise Rules, 1944. The Scheme covers inputs and final products classifiable under any of the
headings of the Chapters of the Central Excise Tariff Act, 1985. The salient features of the
Input Duty Credit Scheme are as follows:
(i) The Scheme is operative only when excise duty is payable on final goods. Thus,
MODVAT credit cannot be availed of if the final goods are exempted from duty or are
chargeable to nil rate of duty. However, the Scheme is operative in case the final goods
enjoy partial exemption from duty.
(ii) Correlation between inputs and final goods is not required, i.e., Accounting Treatment for
MODVAT/CENVAT 553 duty credit in respect of any input brought into the factory can be
utilised for payment of duty on any final product manufactured in that factory even if that
input is not used in or in relation to manufacture of that final product.
(iii) A manufacturer is required to debit RG 23A or account current with an amount equal to
10% of the value of inputs or partially processed inputs removed from his factory for
jobwork. The said amount is available as credit on return of processed/final goods to his
factory from jobworkers’ premises or on clearance of such processed/final goods from
jobworkers’ premises, if so permitted by the Commissioner, within specified time period.
The debited amount is also available for adjustment against duty payable on such inputs
or partially processed inputs not received back within specified time.
(iv) If common inputs are used in manufacture of final products which do not attract duty
liability as also those which are chargeable to duty, manufacturer (except in specified
cases) is required to pay an amount equal to 8% of the price of products not chargeable
to duty at the time of clearance of such products.
8. Supreme Court in a recent judgement in the case of CCE, Pune vs.Dai Ichi Karkaria Ltd.
[1999 (112) ELT 353; decided on 11.8.99] had occasion to summarise the Scheme. Relevant
extract from the decision is reproduced below:
“It is clear from these Rules, as we read them, that a manufacturer obtains credit for the
excise duty paid on raw material to be used by him in the production of an excisable product
immediately it makes the requisite declaration and obtains an acknowledgement thereof.
It is entitled to use the credit at any time thereafter when making payment of excise duty on
the excisable product. There is no provision in the Rules which provides for a reversal of the
credit by the excise authorities except where it has been illegally or irregularly taken, in which
event it stands cancelled or, if utilised, has to be paid for. We are here really concerned with
credit that has been validly taken, and its benefit is available to the manufacturer without any
limitation in time or otherwise unless the manufacturer itself chooses not to use the raw
material in its excisable product. The credit is, therefore,indefeasible. It should also be noted
there is no co-relation of the raw material and the final product; that is to say, it is not as if
credit can be taken only on a final product that is manufactured out of the particular raw
material to which the credit is related. The credit may be taken against the excise duty on a
final product manufactured on the very day that it becomes available.”
Capital Goods Duty Credit Scheme
9. Provisions in relation to this Scheme are contained in Rules 57Q to 57U of the Central
Excise Rules, 1944. The salient features of the Capital Goods Duty Credit Scheme are as
follows:
(i) The Scheme covers specified capital goods used in the factory of the manufacturer in
relation to the production of specified final products;
(ii) A manufacturer would not be entitled to the MODVAT credit on capital goods until the
capital goods are installed or, as the case may be, used for manufacture of excisable
goods, in the factory of the manufacturer;
(iii) A manufacturer has option to:
(a) avail MODVAT credit in respect of duty paid on capital goods as per the Rules;
or
(b) claim depreciation on duty element under Section 32 of the Income-tax Act, 1961 or
claim deduction of duty element by way of revenue expenditure under any section of
the Income-tax Act, 1961, as the case may be;
(iv) A manufacturer can claim MODVAT credit of the duty element of capital goods even if
capital goods are acquired on lease, hire-purchase or loan agreement if specified duty is
paid by manufacturer either directly to capital goods supplier or to the finance company
before payment of first lease/hire-purchase or loan installment, as the case may be.
General
10. The general salient features relevant to Input Duty Credit Scheme and Capital Goods
Duty Credit Scheme are as below:
(i) A manufacturer is required to comply with various procedural requirements, in particular,
filing of declaration, and maintenance of register of receipts, issues and balance of inputs
and capital goods in Form RG-23A Part I and RG-23C Part I, respectively.
It is also required to maintain registers related to MODVAT credit in respect of inputs and
capital goods in Form RG-23A Part II and RG-23C Part II, respectively.
(ii) There is no time limit for utilisation of MODVAT credit. Government is, however,
empowered to provide for lapsing of unutilised credit balances for specific products.
(iii) Cash refund of duty credit is not allowable except in case of export of goods if the
manufacturer is unable to utilise duty credit towards payment of excise duty on clearance
of final goods from his factory.
CENVAT SCHEME (EFFECTIVE FROM 1.4.2000) – SALIENT
FEATURES
11. Modified Value Added Tax (MODVAT) scheme has been replaced by Central Value
Added Tax (CENVAT) Scheme with effect from 1.4.2000.
The same is contained in newly inserted Rules 57AA to 57AK. CENVAT Scheme, in essence,
is the same as MODVAT Scheme except that it is simpler in that, the erstwhile separate
schemes for inputs and capital goods are merged into one under CENVAT Scheme. The
scope of the Scheme is also expanded in that all inputs (except High Speed Diesel Oil and
Petrol) and specified capital goods (except equipments or appliances used in office) are
covered in the Scheme.
12. Procedural simplifications have been introduced and requirement of filing declarations
has been dispensed with.
13. The major difference between MODVAT and CENVAT Schemes is in relation to capital
goods. The CENVAT credit in respect of capital goods received in a factory at any point of
time in a given financial year is allowed to be taken only for an amount not exceeding fifty
percent of the duty paid on such capital goods in the same financial year. The balance of
CENVAT credit can be taken in any financial year(s) subsequent to the financial year in which
the capital goods were received in the factory of the manufacturer provided capital goods are
still in the possession and use of the manufacturer of final products in such subsequent
year(s). The condition of possession and use is not applicable to components, spares and
accessories, refactories and refractory materials and goods falling under Tariff Heading 68.02
and sub-heading 6801.10 of first Schedule of the Central Excise Tariff Act, 1985, if they are
not removed without use.
14. Outstanding balances in MODVAT Credit accounts are allowed to be transferred to the
CENVAT Credit accounts and utilized as per the CENVAT Scheme.
ACCOUNTING TREATMENT IN CASE OF INPUTS USED IN OR IN RELATION TO

MANUFACTURE OF FINAL PRODUCTS
15. In the light of the basic features of ‘MODVAT/CENVAT’ discussed above, it may be
stated that MODVAT/CENVAT is a procedure whereby the manufacturer can utilise credit for
specified duty on inputs against duty payable on final products. Duty credit taken on inputs is
of the nature of setoff available against the payment of excise duty on the final products.
16. Specified duty paid on inputs may be debited to a separate account, e.g.,
MODVAT/CENVAT Credit Receivable (Inputs) Account. As and when MODVAT/CENVAT
credit is actually utilised against payment of excise duty on final products, appropriate
accounting entries will be required to adjust the excise duty paid out of MODVAT/CENVAT
Credit Receivable (Inputs) Account to the account maintained for payment/provision for excise
duty on final product. In this case, the purchase cost of the inputs would be net of the
specified duty on inputs. Therefore, the inputs consumed and the inventory of inputs would be
valued on the basis of purchase cost net of the specified duty on inputs. The debit balance in
MODVAT/CENVAT Credit Receivable (Inputs) Account should be shown on the assets side
under the head ‘advances’.
An illustration of the above method is given in Annexure ‘A’.
17. It may be appropriate to quote the following paragraphs nos. 6 and 7, dealing with ‘cost
of inventories’ and ‘costs of purchase’, of Accounting Standard (AS) 2 (Revised) on ‘Valuation

of Inventories’, issued by the Institute of Chartered Accountants of India.
“6. The cost of inventories should comprise all costs of purchases, costs of conversion and
other costs incurred in bringing the inventories to their present location and condition.
purchase.” Particular attention is invited to the paragraph related to ‘costs of purchase’,
according to which, only those duties have to be included as costs of purchase which are not
subsequently recoverable by the enterprise from the taxing authorities. Since the specified
duty on inputs is available for setoff against the excise duty on final products, it is considered
of the nature of duty recoverable from taxing authorities.
18. A question may arise as to when the ‘MODVAT/CENVAT’ credit should be taken if
documents evidencing payment of specified duty on inputs are received later than the physical
receipt of the goods. According to the accrual concept of accounting, one may account for
such credit, provided one is reasonably certain of getting the said documents at a later date.
Change in Accounting Policy
19. In cases, where enterprises were accounting for MODVAT credit on inputs in accordance
with the erstwhile inclusive method, i.e., the second alternative1 recommended in the earlier
edition (1995) of the Guidance Note on Accounting Treatment for MODVAT, they will have to
change the method of accounting in accordance with paragraph 16 of this Guidance Note.
Accordingly, such an enterprise will have to adjust the amount of opening stock in respect of
the accounting periods commencing on or after April 1, 1999, in such a way so that the
opening stock should appear at the amount which would have been arrived at had the method
suggested in paragraph 16 of this Guidance Note been followed. This could be done by
adjusting the amount of opening stock in respect of the accounting periods commencing on or
after April 1, 1999, by the amount of the balance lying in the MODVAT credit availed account.
Further, an amount equal to the balance of RG23A register, representing the MODVAT credit
receivable in respect of the inputs purchased in the earlier years should be transferred to
MODVAT Credit Receivable Account2 with a corresponding adjustment in the amount of
opening stock. After the aforesaid adjustments, the MODVAT Credit Receivable Account
should also appear at the amount which would have been arrived at had the method
suggested in paragraph 16 of this Guidance Note been followed. An example illustrating the
change in accounting policy has been given as Annexure B. Appropriate disclosures as per
Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior Period Items and Changes
in Accounting Policies, are also required to be made in the financial statements for change in
accounting policy.
Accounting Treatment – Job-work

Accounting treatment in case of inputs and/or partially processed inputs sent outside the
factory to job-worker for further processing
20. In a case where an enterprise removes inputs as such or in a partially processed form to
a place outside the factory for the purpose of testing, repairing, refining, reconditioning or
carrying out any other operations necessary for manufacture of final products, the enterprise is
required to debit MODVAT Credit Register (RG 23A) or account current with an amount equal
to 10% of the value of inputs or partially processed inputs, as the case may be. The said debit
is in the nature of deposit and is available for credit at the time of return of duly processed
goods to the factory within the prescribed time. The said deposit is also available for
adjustment against duty payment if the goods are not received back in the factory within the
prescribed time limit. If this amount is debited to MODVAT Credit Register (RG 23A), the same
should be accounted for as a deposit and should be debited to a separate account with
appropriate nomenclature say, ‘MODVAT Credit Deposit (Jobwork) Account’ and credited to
‘MODVAT Credit Receivable Account’. This deposit amount should be credited and ‘MODVAT
Credit Receivable Account’ should be debited at the time of receipt of duly processed goods in
the factory within the prescribed time limit or for adjustment of duty if the goods are not
received back in the factory within the prescribed time limit. This requirement of debit has
been dispensed with under CENVAT Scheme.
Accounting treatment in case of inputs received by enterprise for further processing on job-
work basis
21. An enterprise may receive inputs from a principal for processing and/ or converting to
final products on job work basis and may be required to avail MODVAT/CENVAT credit on
such inputs and discharge duty liability on clearance of final products on behalf of the
principal; the ownership of the inputs and final products continuing to be of the principal. In
such cases, the enterprise should, at the time of taking MOVDAT/CENVAT credit, debit an
appropriate account say, ‘MODVAT/CENVAT Credit Receivable Account’ and the account to
be credited would depend upon the terms of jobwork with the principal. If the enterprise is
required to bear excise duty burden, ‘Excise Duty Account’ should be credited. If, on the other
hand, excise duty is to be paid on the principal’s account, ‘Principal Account’ should be
credited. Similarly, in former case, excise duty paid on clearance of final products should be
debited to ‘Excise Duty Account’ and in latter case to ‘Principal Account’ and credited to
‘MODVAT/CENVAT Credit Receivable Account’.
ACCOUNTING TREATMENT FOR MODVAT CREDIT IN CASE OF CAPITAL GOODS USED

FOR MANUFACTURE OF SPECIFIED GOODS
22. In case an enterprise does not avail MODVAT credit on capital goods obviously no
accounting treatment would be necessary. The following paragraphs apply only to those
situations where an enterprise avails of MODVAT credit on capital goods.
23. Accounting Standard (AS) 10 on ‘Accounting for Fixed Assets’, issued by the Institute of
Chartered Accountants of India, states, inter-alia, in para 9.1, as follows:
“The cost of an item of fixed asset comprises its purchase price, including import duties and
other non-refundable taxes or levies and any directly attributable cost of bringing the asset to
its working condition for its intended use; any trade discounts and rebates are deducted in
arriving at the purchase price.”
MODVAT credit can be considered is of the nature of a refundable tax. Therefore, MODVAT
credit should be reduced from the purchase cost of capital goods concerned.
24. In view of the above, the specified duty on capital goods should be debited to separate
account, e.g., MODVAT Credit Receivable (Capital Goods) Account. On actual utilisation, the
account will be adjusted against excise duty on final products. Accordingly, the purchase cost
of the capital goods would be net of the specified duty on capital goods. The unadjusted
balance standing in the MODVAT Credit Receivable (Capital Goods) Account, if any, should
be shown on the assets side under the head ‘advances’.
25. MODVAT credit in respect of capital goods should be recognised in the books of account
when the following conditions are satisfied:
(i) The enterprise is entitled to the MODVAT credit as per the Rules, and
(ii) There is a reasonable certainty that the MODVAT credit would be utilised.
ACCOUNTING TREATEMNT FOR CENVAT CREDIT IN CASE OF CAPITAL GOODS
26. The nature of the CENVAT Credit in respect of capital goods is the same as that of
MODVAT Credit. However, the CENVAT Credit in respect of capital goods is allowed for an
amount not exceeding fifty percent of the duty paid on such capital goods in the financial year
in which the goods are received in factory and the balance will be allowed in the subsequent
year(s).
In case the conditions specified in para 25 above are met and the enterprise decides to take
CENVAT credit, the entire amount of CENVAT Credit should be deducted from the cost of
capital goods. The amount of CENVAT credit taken in the financial year, in which goods are
received, should be debited to an appropriate account, say, ‘CENVAT Credit Receivable
(Capital Goods)
Accounting Treatment for MODVAT/CENVAT
Account’ and balance may be debited to another appropriate account, say, ‘CENVAT Credit
Deferred Account’. In the subsequent financial year(s), when balance ‘CENVAT credit is
availed of, the appropriate adjustment for the same should be made, i.e., amount of CENVAT
credit availed of should be credited to ‘CENVAT Credit Deferred Account’ with a
corresponding debit to ‘CENVAT Credit Receivable (Capital Goods) Account’.
ACCOUNTING TREATMENT WHERE CAPITAL GOODS ARE ACQUIRED ON LEASE OR

HIRE PURCHASE
27. MODVAT/CENVAT credit is available to the lessee or hirer where the capital goods have
been acquired on lease or hire purchase. The accounting treatment in this regard is described
hereinafter.
28. In the books of the lessor, where the financing arrangement also covers the specified
duty on capital goods, the asset given on lease should be shown at purchase cost net of the
specified duty on the capital goods. The specified duty on capital goods, which would be
availed of as MODVAT/CENVAT credit by the lessee, should be recorded and disclosed
separately as the duty recoverable from the lessee. This will not form part of ‘Minimum Lease
Payments’ in view of the definition of the aforesaid term reproduced below from the Guidance
Note on Accounting for Leases, issued by the Institute of Chartered Accountants of India:
“Minimum Lease Payments: The payments over the lease term that the lessee is or can be
required to make (excluding costs for services and taxes to be paid by and be reimbursable to
the lessor) together with the residual value.”
Where the specified duty on capital goods does not form part of the financing arrangement
and the lessee pays the duty directly to the supplier, obviously the same need not be recorded
in the books of the lessor. In the books of the lessee, MODVAT/CENVAT credit receivable on
the capital assets acquired on lease should be treated in the same manner as recommended
in paras 24 and 26 above, except that the cost of the relevant leased capital asset and
depreciation is not accounted in the books of the lessee.
29. Capital asset acquired on hire purchase should be recorded and disclosed at net cash
value, i.e., cash value net of MODVAT/CENVAT credit receivable in the books of the hirer.
The other accounting treatment in relation to MODVAT/CENVAT in the books of the hirer
should be the same as if the asset has been acquired on outright purchase basis. The
aforesaid accounting treatment, in the books of the hirer, should be made whether or not the
specified duty on the capital goods forms part of the financing arrangement.
In the books of the vendor, in case the specified duty on capital goods forms part of the hire
purchase arrangement and the benefit of MODVAT/CENVAT credit is available to the hirer,
the vendor should book the sale in the normal course inclusive of the specified duty on the
capital goods. However, where the specified duty on the capital goods does not form part of
the financing arrangement and the hirer directly assumes the liability in respect thereof, the
same need not be recorded in the books of the vendor.
REVIEW OF BALANCES IN MODVAT/CENVAT CREDIT RECEIVABLE ACCOUNTS

30. Balances in MODVAT/CENVAT Credit Receivable Accounts, pertaining to both inputs
and capital goods, should be reviewed at the end of the year and if it is found that the
balances of the MODVAT/CENVAT credit are not likely to be used in the normal course of
business within a reasonable time, then, notwithstanding the right to carry forward such
excess credit in the Excise Rules, the non-useable excess credit should be adjusted in the
accounts. The consequence would be that the balances of the MODVAT/ CENVAT Credit
Receivable Accounts in the financial accounts may be lower than the credit available as per
the MODVAT/CENVAT Credit registers. In such a case, a reconciliation statement would have
to be prepared indicating the amounts adjusted so that a track is kept for the difference
between the balances and the difference between the financial accounts and the credit
available as per the excise registers can be explained in subsequent years also.
31. (a) The above adjustment related to input credit should be made to the raw material or
input purchase account. The effect of this would be to increase the cost of purchase
and thereby to increase the cost of inputs for the purpose of accounting for
consumption and valuation of closing stocks. Where it is not possible to debit or
identify this excess credit to a particular lot or lots of materials purchased, such
excess credit may be apportioned over the entire purchases of raw materials,
components etc., entitled to MODVAT/CENVAT credit during the year on pro-rata
basis.
(b) The adjustment of excess credit related to capital goods should be made to the
concerned Capital Goods Account. The excess MODVAT/ CENVAT credit, either
availed or deferred, which relates to fixed assets acquired, should be added to the
cost of the relevant fixed asset. For accounting purposes, depreciation on the
revised unamortised depreciable amount should be provided prospectively over the
residual useful life of the asset. In case the fixed asset no longer exists, the relevant
amount should be written-off in the profit and loss account. To facilitate aforesaid
treatment, MODVAT/CENVAT credit record should be maintained fixed asset-wise
in the relevant RG Register. In relation to capital goods other than fixed assets, the
accounting treatment for the excess MODVAT/CENVAT credit would be the same
as stated in para 31(a) above. It is, therefore, advisable that MODVAT/CENVAT
Credit Receivable (Capital Goods) Account is maintained separately for fixed assets
and other capital goods.
(c) For capital goods acquired on lease, the amount of excess MODVAT/ CENVAT
credit should be written-off on a pro-rata basis along with the lease rentals.
32. Where, at any time during the year, it is revealed that the terms and conditions subject to
which the benefit of MODVAT/CENVAT credit is available, have not been complied with or are
not being capable of compliance, e.g., where the inputs are destroyed prior to the manufacture
of final product or the relevant plant and machinery cannot be put to use for the manufacture
of final product, appropriate adjustments should be made in the accounts to reverse such
credit which cannot be availed of, as recommended in para 31 (a) for inputs and 31 (b) and (c)
for capital goods.
ACCOUNTING TREATMENT FOR DUTY DEMANDS PAID BY DEBIT TO MODVAT/CENVAT

CREDIT BALANCE – INPUTS AND/ OR CAPITAL GOODS
33. An enterprise may choose to discharge excise duty demands made by Central Excise
Department from time to time by way of debit to MODVAT/ CENVAT credit balance pertaining
either to inputs or to capital goods. In that case, the duty demand so paid out of the
MODVAT/CENVAT credit 564 Compendium of Guidance Notes – Accounting balance should be
debited to appropriate account, depending upon the nature of demand and credit should be
given to MODVAT/CENVAT Credit Receivable Account. For example, if the duty demand
pertains to excise duty on finished goods, the same should be debited to excise duty account.
If, on the other hand, it pertains to disallowance of MODVAT/CENVAT credit taken on
purchase of raw materials during the year, the same should be added to the cost of inputs.
Appropriate adjustment in that case would have to be made while valuing inventory of inputs.
If the duty demand pertains to disallowance of MODVAT/CENVAT credit in respect of
purchases effected in earlier years, the accounting treatment would depend on whether the
said inputs are consumed or are available in stock. If they are consumed, the disallowance
should be debited to excise duty account and treated as expense of the current year. If raw
materials are still lying in stock, duty demand should be added to the cost of stock of inputs.
VALUATION OF INVENTORIES OF INPUTS

34. The inventory of inputs should be valued at net of input duty. In other words, the
specified duty paid on inputs will not form part of the cost of inventories. Balance in
MODVAT/CENVAT Credit Receivable (Inputs) Account should be shown in the Balance Sheet
under the head ‘advances’ on the assets side.
35. In some cases ‘inputs’ may be exempted from excise duty in the hands of the supplier,
e.g., job charges are exempt from excise duty provided the prescribed procedures are
observed. Small-scale suppliers who are in the exempted category may also supply the inputs
free from the levy of excise duty. In such circumstances normal valuation rules in determining
the cost of inventories are to be applied as these are not subject to the specified duty on
inputs relief. Where purchases are made from the dealers who are not eligible under the
Central Excise Rules to pass MODVAT/CENVAT credit and, therefore, cannot issue an invoice
in accordance with the aforesaid Rules, the valuation should be made at the actual cost
inclusive of excise duty.
36. In some cases, the same item of input can be obtained from different sources, some of
them may be able to provide the required documents evidencing payment of duty while others
may not be able to provide the required documents. In such cases where it is not possible for
the buyer to take advantage of the MODVAT/CENVAT credit, the closing stock of inputs of
such items should be valued inclusive of the specified duty on inputs. Accounting Treatment for
MODVAT/CENVAT 565 37. If any input is used for the production of more than one final product,
some of which are excisable while others are either not chargeable to excise duty or
chargeable at nil rate of duty, and separate inventory of the input is not maintained, the entire
inventory of inputs should be valued at net of input duty. However, if separate inventory is
being maintained, the inventory of inputs useable for final products chargeable to excise duty
should be valued at net of input duty and the inventory of inputs useable for final products not
chargeable to duty should be valued at the actual cost inclusive of excise duty.
38. While valuing inventories of final products4 , the value of inputs should be net of the duty
on inputs, that is, the purchase cost as reduced by the MODVAT/CENVAT credit.
VALUATION OF INVENTORY OF CAPITAL GOODS

39. Inventories of capital goods should be valued net of MODVAT/ CENVAT credit taken on
capital goods. In other words, specified duties paid on such capital goods will not form part of
their cost.
Note: For Accounting treatment of excise duty with regard to valuation of inventories,
reference may be made to the Guidance Note on Accounting Treatment for Excise Duty,
issued by the Institute of Chartered Accountants of India.
For the appendices given in the Guidance Note , students are advised to refer compendium of
Guidance Notes –Accounting (as on July, 2006)
Guidance Note on
Accounting for Investments in the
Financial Statements of Mutual Funds
INTRODUCTION
1. The Securities and Exchange Board of India (Mutual Funds) Regulations, 1996,
(hereinafter referred to as ‘the Regulations’) have prescribed accounting policies to be
followed by mutual funds for the preparation of their financial statements which, inter alia,
require that “for the purpose of all financial statements, all investments shall be marked to
market and investments shall be carried out in the balance sheet at market value. However, till
necessary guidance notes are issued by the Institute of Chartered Accountants of India to
their members, in the above matter, investments may be continued to be valued at cost, with
the market value shown separately and the reconciliation statement for the changes in
investments valued in the two different ways, shall be provided” [Clause 2(i) of Eleventh
Schedule to the Regulations].
2. Clause (a) of the Ninth Schedule to the Regulations, prescribing Accounting Policies and
Standards, also provides as below:

“For the purposes of the financial statements, mutual fund shall mark all investments to market
and carry investments in the balance sheet at market value. However, since the unrealised
gain arising out of appreciation on investments cannot be distributed, provision has to be
made for exclusion of this item when arriving at distributable income.”
3. Accounting Standard (AS) 13 on ‘Accounting for Investments’, issued by the Institute of
Chartered Accountants of India, does not apply to accounting for investments in the financial
statements of mutual funds. This Guidance Note is being issued primarily with the objective of
providing guidance on accounting for investments in the financial statements of mutual funds,
where they are marked to market, as stipulated in the above requirements of the Regulations.
4. This Guidance Note does not apply to Unit Trust of India (UTI) in view of the fact that UTI
is governed by the provisions of Unit Trust of India Act, 1963, and Rules framed thereunder.
FORMS OF INVESTMENTS
5. Regulation 43 of the Regulations, prescribes that the moneys collected under any
scheme of a mutual fund should be invested only in money market instruments or in the
capital market or in privately placed debentures or securitised debts. If mutual fund collects
money under any money market scheme of a mutual fund, the money collected is to be
invested only in money market instruments in accordance with the directions issued by the
Reserve Bank of India in this regard. A mutual fund can also, in the case of securitised debts,
invest in asset backed securities but the fund is precluded from investing in mortgage backed
securities. The investments that a mutual fund can make are subject to the investment
restrictions specified in the Seventh Schedule to the Regulations.
CLASSIFICATION OF INVESTMENTS
6. The Regulations do not require classification of investments into any categories, such as
current and long term. Annexure 1A of the Eleventh Schedule to the Regulations, which
prescribes the contents of scheme-wise Balance Sheet, requires separate disclosure of
investments into the following types:
(i) Equity shares;
(ii) Preference shares;
(iii) Privately placed debentures/bonds;
(iv) Debentures and Bonds listed/awaiting listing on the recognized stock exchange;
(v) Calls paid in advance;
(vi) Term Loans;
(vii) Central and State Government Securities (including treasury bills);
(viii) Commercial Paper;
(ix) Others.
It may be noted that item (vi), i.e., term loans was meant to cover such transactions permitted
before the Regulations came into force.
COST OF INVESTMENTS
7. As per clause (k) of the Ninth Schedule to the Regulations, the “cost of investments
acquired or purchased should include brokerage, stamp charges and any charge customarily
included in the broker’s bought note. In respect of debt instruments any front-end discount
offered should be reduced from the cost of the investment.” Clause (c) of the said Schedule
requires that when interest-bearing investments are purchased, “interest paid for the period
from the last interest due date upto the date of purchase must not be treated as a cost of
purchase.” In case of investments which carry right to dividend, the cost of investment is
reduced by dividends only if they clearly represent a recovery of a part of the cost, e.g., where
dividends are passed on by the broker at the time of giving delivery either by giving separate
cheque along with the scrips or through credit in his bill. This could arise where (a) the fund
has bought shares on cum-dividend basis but delivery is after time limit of book closure of
dividend, or (b) Non-Pari Passu (NPP) shares are delivered, i.e., contract was for purchase of
old shares, but NPP shares are delivered. National Securities Depository Limited (NSDL)
transaction charges and custodian transaction charges identifiable with respect to a particular
transaction, are considered as cost of investments. However, such charges which are not
identifiable with respect to a particular transaction are not considered as cost of investments.
CARRYING AMOUNT AND THE TREATMENT OF DEPRECIATION AND APPRECIATION

WHEN INVESTMENTS ARE MARKED TO MARKET
8. The market value of investments should be determined on the basis of investment
valuation norms prescribed in the Eighth Schedule to the Regulations.
9. The basic objective of marking the investments to market, in a mutual fund, is to arrive at
the current net asset value of the units. It is felt that this basic objective would be met if the
investments are marked to market for balance sheet purposes. Further, as per the existing
generally accepted accounting principles in India, unrealised profit is not considered for
arriving at the profit (loss) for the period concerned. The recommendations on accounting for
investments in the financial statements of mutual funds contained in the following paragraphs
are based on the aforesaid principles.
10. The investments should be marked to market on the balance sheet date. The provision
for depreciation in the value of investments should be made in the books by debiting the
Revenue Account. The provision so created should be shown as a deduction from the value of
investments in the balance sheet. However, unrealised appreciation should be directly
transferred to the Unrealised Appreciation Reserve, i.e., without routing it through the
Revenue Account with the corresponding debit to the Investments Account. It is recommended
that the Unrealised Appreciation Reserve should be reversed at the beginning of the next
accounting year.
11. Clause 2(i) of the Eleventh Schedule also provides that “where the financial statements
are prepared on a mark to market basis, there need not be a separate provision for
depreciation”. However, keeping in view ‘prudence’ as a factor for preparation of financial
statements and correct disclosure of the amount of depreciation on investments, it is
recommended that the gross value of depreciation on investments should be reflected in the
Revenue Account rather than the same being netted off with the appreciation in the value of
other investments. In other words, depreciation/appreciation on investments should be worked
out on an individual investment basis or by category of investment basis, but not on an overall
(or global) basis for the entire investment portfolio.
DISPOSAL OF INVESTMENTS
12. The profit/loss arising on the disposal of investment would be the difference between the
selling price and the cost. The profit arising on disposal of investment should be recognised
fully in the Revenue Account. The amount of loss on the disposal of investment should also be
recognised fully in the Revenue Account, if it has been sold in the same year in which it was
purchased or if no provision was created for depreciation in the value of investment. However,
if the investment is sold in the subsequent year(s) and provision was created as on the last
balance sheet date for depreciation in the value of investment, the loss should be charged
against the said provision to the extent of balance available in the said account and the
balance of loss, if any, should be charged directly to the Revenue Account.
DISCLOSURE
13. Accounting policy for valuation of investments should be disclosed as required by
Annexure 1A of the Eleventh Schedule to the Regulations.
Guidance Note on
Accounting for Securitisation
(The following is the text of the Guidance Note on Accounting for Securitisation,issued by the
Council of the Institute of Chartered Accountants of India.)
INTRODUCTION
1. Securitisation is the process by which financial assets such as loan receivables,
mortgage backed receivables, credit card balances, hire-purchase debtors, lease receivables,
trade debtors, etc., are transformed into securities. Securitisation is different from ‘factoring’ in
that ‘factoring’ involves transfer of debts without transformation thereof into securities. A
securitisation transaction, normally, has the following features:
♦ Financial assets such as loan assets, mortgages, credit card balances, hire-purchase
debtors, trade debtors, etc., or defined rights therein, are transferred, fully or partly, by
the owner (the Originator) to a Special Purpose Entity (SPE) in return for an immediate
cash payment and/or other consideration. The assets so transferred are the ‘securitised
assets’ and the assets or rights, if any, retained by the Originator are the ‘retained
assets’.
♦ The SPE finances the assets transferred to it by issue of securities such as Pass
Through Certificates (PTCs) and/or debt securities to investors.
♦ A usual feature of securitisation is ‘credit enhancement’, i.e., an arrangement which is
designed to protect the holders of the securities issued by an SPE from losses and/or
cash flow mismatches arising from shortfall or delays in collections from the securitised
assets. The arrangement often involves one or more of the following:
♦ Provision of cash collateral, i.e., a deposit of cash which in specified circumstances can
be used by the SPE for discharging its financial obligation in respect of the securities
held by the investors.
♦ Over collaterisation, i.e., making available to the SPE assets in excess of the securitised
assets, the realization of which can be used in specified circumstances to fund the
shortfalls and/or mismatches in fulfilment of its financial obligations by the SPE.
♦ Recourse obligation accepted by the Originator.
♦ Third party guarantee, i.e., a guarantee given by a third party by accepting the obligation
to fund any shortfall on the part of the SPE in meeting its financial obligations in respect
of the securitisation transaction.
♦ Structuring of the instruments issued by an SPE into senior and subordinated securities
such that the senior securities (issued to investors) are cushioned by the subordinated
securities (issued normally to the Originator) against the risk of shortfalls in realisation of
securitised assets. Payments on subordinated securities are due only after the amounts
due on the senior securities are discharged.
♦ The Originator may continue to service the securitised assets (i.e., to collect amounts
due from borrowers, etc.) with or without servicing fee for the same.
♦ The Originator may securitise or agree to securitise future receivables, i.e., receivables
that are not existing at the time of agreement but which would be arising in future. In
case of such securitisation, the future receivables are estimated at the time of entering
into the transaction and the purchase consideration for the same is received by the
Originator in advance. Securitisation can also be in the form of ‘Revolving Period
Securitisation’ where future receivables are transferred as and when they arise or at
specified intervals; the transfers being on prearranged terms.
A diagrammatic presentation of a typical securitisation transaction is given in Appendix I.
2. This Guidance Note deals with accounting for securitisation transactions in the books of
Originator, specially addressing issues such as when to derecognise, fully or partly, the
securitised assets; treatment of securitisation of future receivables; measurement of
consideration received in the form of securities; etc. The Guidance Note also deals with
accounting for securitisation transactions in the books of SPEs. Another issue dealt with
relates to accounting for investments in the securities such as PTCs and/or debt securities
issued by the SPE, in the books of Investors.
DEFINITIONS
3. The following terms are used in this Guidance Note with the meanings specified:
Call Option is an option that entitles the Originator to repurchase the financial assets
transferred under a securitisation transaction from the SPE. The Option may be at a
predetermined price or at a value to be determined, for example, fair value on the date of
exercise of Call Option.
Clean-up Call Option is an option held by the servicer (who may be the Originator) to purchase
the remaining transferred securitised assets or the remaining beneficial interests in the SPE if
the amount of securitised assets or beneficial interests falls to a level at which the cost of
servicing those assets or beneficial interests becomes burden some in relation to the benefits
of servicing.
Interest Strip is a contractual arrangement to separate the right to all or part of the interest due
on a debenture, bond, mortgage loan or other interest bearing financial asset from the
financial asset itself.
Investor is the person who finances the acquisition of the securitised assets or of beneficial
interest therein by subscribing to PTCs and/or debt securities issued by an SPE.
Originator is an entity that owns the financial assets proposed to be securitised and initiates
the process of securitisation in respect of such assets.
Pass Through Certificates (PTCs) are instruments acknowledging a beneficial interest in the
securitised assets such that the payment of interest on such instruments and the repayment of
the principal are directly or indirectly linked or related to realisations from the securitised
assets.
Principal Strip is the right to the remainder of the financial asset net of all rights that have
been stripped therefrom by one or more contractual arrangements such as by an Interest
Strip.
Recourse Obligation is the obligation of the Originator to reimburse or compensate, fully or
partly, the investors for, or otherwise bear the risk of, shortfalls, such as those, arising from:
♦ • failure of debtors to pay or to pay when due; or
♦ • pre-payments; or
♦ • other defects in securitised financial assets.

Servicing Asset is a contract to service financial assets under which the estimated future
revenues from contractually specified servicing fees, late charges and other related revenues
are expected to more than adequately compensate the servicer (who may be the Originator)
for performing the services. A servicing contract can be either:
♦ • undertaken together with selling or securitising the financial assets being serviced; or
♦ • purchased or assumed separately.
Special Purpose Entity (SPE) is an entity which acquires the financial assets under
securitisation and normally holds them till maturity. SPE is an independent entity, usually
constituted as a trust though it may be constituted in other forms, for example, as a limited
company, formed with small capital for the specific purpose of funding the transaction by issue
of PTCs or debt securities.
ACCOUNTING IN THE BOOKS OF ORIGINATOR

Derecognition of securitised asset
4. Securitised asset should be derecognised in the books of the Originator, if and only if,
either by a single transaction or by a series of transactions taken as a whole, the Originator
loses control of the contractual rights that comprise the securitised asset. The Originator loses
such control if it surrenders the rights to benefits specified in the contract. Determining
whether the Originator has lost control of the securitised asset depends both on the
Originator’s position and that of the SPE. Consequently, if the position of either the Originator
or the SPE indicates that the Originator has retained control, the Originator should not remove
the securitised asset from its balance sheet.
5. The Originator has not lost control over the securitised asset, for example, where
(a) the creditors of the Originator are entitled to attach or otherwise deal with the securitised
assets;
(b) the SPE does not have the right (to the extent it was available to the Originator) to
pledge, sell, transfer or exchange for its own benefit the securitised asset;
(c) the Originator has the right to reassume control of the securitised asset except
(i) where it is entitled to do so by a Call Option, where such Call Option can be justified
on its own commercial terms as a separate transaction between the SPE and the
Originator, for instance, where the Call Option is exercisable at fair value of the
asset on the date of exercise of the Option; or
(ii) where it is entitled to do so by a Clean-up Call Option.
6. Whether the Originator has lost control over the securitised asset should be determined
on the basis of the facts and circumstances of the case by considering all the evidence
available. It would be incorrect to hold that the derecognition criterion prescribed in paragraph
4 is not met in the following cases:
(a) The Originator continues to service the securitised asset. Such servicing by itself would
not lead to a conclusion that the Originator has not lost control over the securitised asset.
(b) An obligation is cast on the Originator to repurchase the securitised asset at a
predetermined price. Such an obligation is not an entitlement to reassume ownership
available to the Originator. Notwithstanding such an obligation the securitised asset
would be beyond the control of the Originator. The obligation accepted by the Originator
should be accounted for in the manner indicated in paragraph 10 of this Guidance Note.
However, where the Originator is both entitled and obligated to repurchase the
securitised asset at a pre-determined price, the Originator is not considered to have lost
control over the securitised asset and, therefore, the same should not be removed from
the balance sheet of the Originator.
7. On derecognition, the difference between the book value of the securitised asset and
consideration received should be treated as gain or loss arising on securitisation and
disclosed separately in the statement of profit and loss. On the other hand, if the derecognition
criterion as prescribed in paragraph 4 is not met, the asset should continue to be recognised
in the books of the Originator and consideration received for the asset so transferred, should
be accounted for as a borrowing secured there against.
8. The consideration received in a form other than cash, e.g., securities issued by the SPE,
should be measured at the lowest of the
(a) the fair value of the consideration;
(b) the net book value of the securitised assets; and
(c) the net realisable value of the securitised assets.
In case the consideration has been received partly in cash and partly in a form other than
cash, the non-cash component of the consideration should be measured at the lowest of the
(a) the fair value of the non-cash component;
(b) the net book value of the securitised assets as reduced by the cash received; and
(c) the net realisable value of the securitised assets as reduced by the cash received.
The fair value is the price that would be agreed upon between knowledgeable, willing parties
in an arm’s length transaction. Quoted market price in an active, liquid and freely accessible
market, if available, is normally the best evidence of fair value. If quoted market price is not
available, estimate of fair value may be based on the market prices of assets similar to those
received as consideration. In case the market prices of similar assets are also not available,
the estimate of fair value may be based on generally accepted valuation techniques such as
the present value of estimated future cash flows. These techniques would require estimates
and assumptions about various matters such as estimates of future revenues, future expenses
and assumptions about interest rates, defaults and likely prepayments. Some of these
estimations, e.g., estimation of future cash flows and discount rates may present significant
difficulties. It would be necessary to make the best estimate based on reasonable and
supportable assumptions and projections. All available evidence should be considered in
developing the requisite estimate and assumptions.
9. In case the securitised assets qualify for derecognition, the entire expenses incurred on
the transaction, say, legal fees, etc., should be expensed at the time of the transaction and
should not be deferred. Where the securitised assets do not qualify for derecognition and,
therefore, the consideration received in respect thereof is treated as a secured borrowing,
such expenses should either be amortised over the term of the secured borrowing or
recognised immediately in the statement of profit and loss.
10. If a securitised asset qualifies to be derecognised as per paragraph 4 and the Originator
has accepted recourse or similar obligation, e.g., the Originator has granted a Put Option at a
predetermined price to the SPE, then the contingent loss arising therefrom, should be
accounted for as per Accounting Standard (AS) 4, ‘Contingencies and Events Occurring After
the Balance Sheet Date’, issued by the Institute of Chartered Accountants of India. This would
require that a provision be made for the contingent loss arising from the obligation, where the
criteria specified in the Standard in this regard are satisfied.
FUTURE RECEIVABLES / REVOLVING SECURITISATION

11. Any purchase consideration received by the Originator on the securitisation of future
receivables should be accounted for as an advance, since the assets proposed to be
securitised would not be existing at the time of the agreement, but would arise in future. The
cost of bringing these assets into existence would also be incurred in future. In such cases,
the criterion for derecognition prescribed in paragraph 4 should be applied as and when the
relevant assets come into existence. Till such time the amounts received, if any, on account of
the proposed securitisation should be reflected as an advance. The other requirements of the
Guidance Note also apply, mutatis mutandis, in case of securitisation of future receivables.
12. In case of revolving period securitisation where financial assets are transferred as and
when they come into existence or at specified intervals and the purchase consideration is paid
to the Originator at the time of such transfer, all requirements of this Guidance Note, except
paragraph 11, apply.
PARTIAL DERECOGNITION
13. An Originator may transfer only a part of the financial asset in a securitisation transaction
instead of transferring the complete asset. Such transfer may occur in two ways. One way is
where a proportionate share of the asset is transferred. For example, the Originator may
transfer a proportionate share of loan (including right to receive both interest and principal), in
such a way that all future cash flows, profit/loss arising on loan will be shared by the Originator
and the SPE in fixed proportions. A second way of transferring a part of a financial asset
arises where the asset comprises the rights to two or more benefit streams, and the Originator
transfers one or more of such benefit streams while retaining the others. For example, the
Originator may securitise the Principal Strip of the loan while retaining the Interest Strip and
Servicing Asset.
14. If the Originator transfers a part of a financial asset while retaining the other part, the part
of the original asset which meets the derecognition criterion as set out in paragraph 4 should
be derecognised whereas the remaining part should continue to be recognised in the books.
Similarly, if any new interest has been created as a result of securitisation transaction, such as
a Call Option, the new interest should be recognised in the books in accordance with the
relevant accounting principles.
15. If the Originator transfers a proportionate part of the asset, the previous carrying amount
of the asset is apportioned among the part transferred and the part retained on the basis of
proportion transferred and proportion retained. For example, if the Originator transfers 75% of
an asset to the SPE, 75% of the carrying amount of the asset should be considered as
securitised. Where the securitised part of the asset qualifies to be derecognised as per the
requirements of paragraph 4, the entity would continue to recognise the remaining part of the
asset at 25% of the carrying amount.
16. In case the asset comprises the rights to two or more benefit streams and one or more of
such benefit streams is/are transferred while retaining the others, the carrying amount of such
financial asset should be apportioned between the part(s) transferred and the part(s) retained
on the basis of their relative fair values as on the date of transfer. The fair values of the parts
should be determined on the basis described in paragraph 8. If fair value of the part of the
asset that is retained cannot be measured reliably, that part should be valued at a nominal
value of Re.1. Similarly, if any new financial asset, e.g., a call option, has been created as a
result of securitisation transaction and its fair value cannot be measured reliably, initial
carrying amount of the asset should be recognised at a nominal value of Re.1.
17. An example illustrating the computations and accounting treatment in case of partial
derecognition is given in Appendix II to this Guidance Note.
ACCOUNTING IN THE BOOKS OF SPECIAL PURPOSE ENTITY

18. The SPE should recognise the asset received under a securitisation transaction, if the
Originator loses control over the securitised asset on the basis of the criterion prescribed in
paragraph 4. The asset so received should be recognised at the amount of consideration, if
the consideration has been paid in cash. In case the consideration has been paid in a form
other than cash, e.g., securities, the asset so received should be recorded either at its intrinsic
value or at the fair value of the consideration, whichever is more clearly evident. If both the
values are equally evident the asset should be valued at the lower of the two values.
19. If the beneficial ownership in the securitised asset has not been transferred to the SPE or
the Originator has not lost control over the asset as per the requirements of paragraph 4, the
SPE should not recognise the asset received. In such a case, the consideration paid should
be recorded as a lending secured against the financial asset received under securitisation
transaction.
20. The amount received by the SPE on issue of PTCs or other securities should be shown
on the liability side of the balance sheet, with appropriate description, keeping in view the
nature of securities issued.
ACCOUNTING IN THE BOOKS OF THE INVESTOR

21. The Investor should account for the PTCs and/or debt securities acquired by it as an
investment in accordance with Accounting Standard (AS) 13, ‘Accounting for Investments’.
However, where in case of an Investor, AS 13 is not applicable because of the Investor being
specifically exempted from the application of AS 13, the investments in PTCs and/or other
securities should be valued and accounted for as per the relevant accounting principles
applicable to the Investor.
DISCLOSURES
22. In addition to the disclosures arising from recommendations made in paragraph 10, the
following disclosures should be made in the financial statements of the Originator:
(i) The nature and extent of securitisation transaction(s), including the financial assets that
have been derecognised.
(ii) The nature and the amounts of the new interests created, if any.
(iii) Basis of determination of fair values, wherever applicable.
23. The following disclosures should be made in the financial statements of the SPE:
(i) The nature of the securitisation transaction(s) including, in particular, a description
of the rights of the SPE vis-à-vis the Originator whether arising from the
securitisation transaction or a transaction associated therewith.
(ii) Basis of determination of fair values, wherever applicable.
24. The Investor should make disclosure of investments in PTCs and/or debt securities as
required by Accounting Standard (AS) 13, ‘Accounting for Investments’. However, where in the
case of an Investor, AS 13 is not applicable because the Investor is specifically exempted
from the application of AS 13, the Investor should make such disclosures as per the relevant
requirements.
Note : For Appendices given in the Guidance Note , students are advised to refer the
Compendium of Guidance Notes Accounting as on July 1, 2006)
GN (A)17 (ISSUED 2003)

GUIDANCE NOTE ON ACCOUNTING FOR
EQUITY INDEX AND EQUITY STOCK FUTURES AND OPTIONS
(The following is the text of the Guidance Note on Accounting for Equity Index and Equity
Stock Futures and Options, issued by the Council of the Institute of Chartered Accountants of
India. With the issuance of this Guidance Note, Guidance Note on Accounting for Equity
Index Futures and Guidance Note on Accounting for Equity Index Options and Equity Stock
Options, issued by the Council of the Institute of Chartered Accountants of India, stand
withdrawn.)
INTRODUCTION
1. During the last few years, a number of new financial instruments have assumed
significance in the Indian economy. With rapid globalisation, this trend is likely to accelerate in
future. Derivatives are a kind of financial instruments whose values change in response to the
change in specified interest rates, security prices, commodity prices, index of prices or rates,
or similar variables. Typical examples of derivatives are futures and forward contracts, swaps
and option contracts.
2. Equity index futures, equity stock futures, equity index options and equity stock options
are traded on some major stock exchanges. For instance, in case of equity index futures and
equity index options, The National Stock Exchange of India Limited (NSE) and The Stock
Exchange, Mumbai (BSE) have introduced trading in S&P CNX NIFTY index and BSE
SENSEX, respectively. In case of equity stock futures and equity stock options, NSE and BSE
have introduced trading in certain securities specified by the Securities and Exchange Board
of India (SEBI).
3. This Guidance Note deals with accounting treatment of equity index futures, equity stock
futures, equity index options and equity stock options (hereinafter collectively referred to as
‘Equity Derivative Instruments’) from the viewpoint of the parties who enter into such contracts
as buyers or sellers.
4. Equity Derivative Instruments are a type of financial instruments, which are bought or
sold with specific motives, e.g., speculation, hedging and arbitrage. The accounting treatment
recommended in this Guidance Note is applicable to all contracts entered into for Equity
Derivative Instruments irrespective of the motive.
Nature of Equity Derivative Instruments
5. In order to understand the nature of various Equity Derivative Instruments, it is essential
to first understand the meaning of the terms ‘forward contract’, ‘futures contract’ and ‘options
contract’.
6. A forward contract is an agreement between two parties whereby one party agrees to buy
from, or sell to, the other party an asset at a future time for an agreed price (usually referred to
as the ‘contract price’). The parties to forward contracts may be individuals, corporates or
financial institutions. At maturity, a forward contract is settled by delivery of the asset by the
seller to the buyer in return for payment of the contract price. For example, a person (X) may
enter into a forward contract with another person (Y) on June 15, 20x3 to buy 10 kgs. of silver
at the end of 90 days at a price of Rs. 8,200 per kg. At the end of the 90 days, Y will deliver
10 kgs. of silver to X against payment of Rs. 82,000. If the price of silver, at the end of the 90
days, is Rs. 8,300 per kg., X would make a profit of Rs. 1,000 and Y would lose Rs. 1,000, as
X could sell silver bought at Rs. 82,000 for Rs. 83,000, whereas Y would have to buy silver for
Rs. 83,000 and sell for Rs. 82,000. On the other hand, if the price of silver at the end of the
90 days is Rs. 7,800 per kg., X would lose Rs. 4,000, whereas Y would make a profit of Rs.
4,000, as X would have to sell silver bought at Rs. 82,000 for Rs. 78,000, whereas Y would
buy silver for Rs. 78,000, which he would sell to X at Rs. 82,000.
7. A futures contract, like a forward contract, is an agreement between two parties to buy or
sell an asset at a certain time in future for an agreed price. Futures contracts are normally
traded on an exchange. To make trading possible, the exchange specifies certain
standardised features of the contract. The exchange may also provide for guarantee
mechanism to ensure that each party to the contract meets its obligations and, consequently,
risk from default by parties is minimised.
8. An Option is a type of derivative instrument whereby a person gets the right to buy or sell
at an agreed amount an underlying asset on or before the specified future date. He is not
under any obligation to do so. The person who gets such right is called ‘Option Buyer’ or
‘Option Holder’. The person against whom the buyer/holder can exercise his right is called
‘Option Seller’ or ‘Option Writer’. Unlike a buyer/holder, the seller/writer of an option has no
right but has an obligation to sell or buy the underlying asset as and when the buyer/holder
exercises his right. In order to acquire the right of Option, the buyer/holder pays to the
seller/writer an Option Premium, which is the price, paid for the right. Every option contract is
for a specific period of time. On the expiry of the specified period, the contract also expires.
On the basis of the rights of the buyer with regard to the time of settlement, the Options can
be classified into two broad categories, viz., American style options and European style
options. In case of American style options, the buyer/holder can exercise his right at any time
before the contract expires or on the Expiry Date, whereas in case of European style options,
the buyer/holder can exercise his right only on the Expiry Date.
9. An Option can either be a ‘Call Option’ or a ‘Put Option’. In case of Call Option,
buyer/holder of the Option gets the right to purchase the underlying asset whereas in case of
Put Option buyer/holder gets the right to sell the underlying asset. In market terminology, a
person buying a Call Option is considered to have made a ‘long call’ and a person buying a
Put Option is considered to have made a ‘long put’. Similarly, a person selling a Call Option or
a Put Option is considered to have made a ‘short call’ or a ‘short put’, respectively. In a Call
Option the seller/writer of the Option has an obligation to sell the underlying asset, whereas in
a Put Option the seller/writer has an obligation to buy the underlying asset. The rights and the
obligations of the parties involved in an option contract can be summarised in a tabular form
as under:
Option Type Buyer/Holder Seller/Writer
Call Right but not an obligation to buy Obligation but no right to sell the
the underlying asset. underlying asset.
Put Right but not an obligation to sell Obligation but no right to buy the
the underlying asset. underlying asset.
10. The price at which the buyer/holder has the right to buy or sell and the seller/writer has
an obligation to sell or buy is known as the ‘Strike’ or ‘Exercise’ price.
11. It may be noted that the buyer/holder of an option can make a loss of no more than the
Option Premium paid to the seller/writer but the possible gain is unlimited. On the other hand,
the Option Seller/Writer’s maximum gain is limited to the Option Premium charged by him from
the buyer/holder but can make unlimited loss.
12. In market terminology, an option contract can be ‘at the money’, ‘in the money’ or ‘out of
the money’. ‘At the money’ means that the current market value of the underlying asset is the
same as the Exercise Price of the Option. A Call Option is said to be ‘in the money’ if the
current market value of the underlying asset is above the Exercise Price of the Option. A Put
Option is said to be ‘in the money’ if the current market value of the underlying asset is below
the Exercise Price of the Option. A Call Option is said to be ‘out of the money’ if the current
market value of the underlying asset is below the Exercise Price of the Option. A Put Option
is said to be ‘out of the money’ if the current market value of the underlying asset is above the
Exercise Price of the Option.
13. Futures and options are both standardised derivative instruments traded on a stock
exchange. The difference between these two types of derivative instruments is in respect of
the rights and obligations of the parties involved in such contracts. In case of a futures
contract, both the parties are under obligation to complete the contract on the specified date.
However, in case of options contract, the buyer/holder has a right, but no obligation to
exercise the Option, whereas the seller/writer has an obligation but no right to complete the
contract.
14. There can be futures and options on commodities, currencies, securities, stock index,
individual stock, etc. In India, SEBI has permitted trading in futures and options in two equity
indexes, viz., BSE SENSEX and S&P CNX NIFTY and certain specified securities listed on the
stock exchanges. Currently, these futures and options contracts are traded on The Stock
Exchange, Mumbai and The National Stock Exchange of India Limited.
EQUITY INDEX FUTURES AND EQUITY STOCK FUTURES

15. An equity index futures contract is a futures contract in which the underlying asset is an
equity index, e.g., S&P CNX NIFTY or BSE SENSEX. In other words, it is a contract to buy or
sell equity index at an agreed amount on a specified future date.
16. An equity stock futures contract is a futures contract in which the underlying asset is a
security, e.g., equity shares of ABC Limited, equity shares of PQR Limited, etc. In other
words, it is a contract to buy or sell a security at an agreed amount on a specified future date.
17. The following are the basic differences between these two types of equity futures:
(a) The underlying asset
In case of equity index futures, the underlying asset is equity index itself (e.g., BSE
SENSEX, S&P CNX NIFTY), whereas in case of equity stock futures, the underlying
asset is a security (e.g., equity shares of a company).
(b) The mode of settlement
By its very nature, the index cannot be delivered on maturity of the contract. As such, the
settlement of an equity index futures contract takes the form of payment of the difference
between the price as agreed in the contract (contract price) and the value of the index on
the maturity date (Settlement Date), in cash. In contrast, an equity stock futures contract
can be settled either through delivery of security for which the contract was entered into
or by receipt/payment of the difference between contract price and the value of the
security for which the contract was entered into, in cash, just like equity index futures. At
present, in India, equity stock futures contracts are settled through cash. However, in
near future equity stock futures may be settled through physical delivery of shares.
18. Examples of Equity Index Futures
(i) In July, Mr. A enters into an equity index futures contract to buy 100 units of BSE
SENSEX of September 20x3 series at a price of, say, Rs. 3,650 per unit. As a
result, Mr. A is under obligation to buy 100 units of BSE SENSEX on the Settlement
Date at the rate of Rs. 3,650 per unit. On the Settlement Date, if the price of BSE
SENSEX is higher than Rs. 3,650, say, Rs. 3,680 per unit, Mr. A will receive Rs. 30
per unit (the difference between the price on the Settlement Date and the contract
price). On the other hand, if, on the Settlement Date, the price of BSE SENSEX is
lower than Rs. 3,650, say, Rs. 3,610 per unit, Mr. A will pay Rs. 40 per unit.
(ii) In July, Mr. B enters into an equity index futures contract to sell 200 units of S&P
CNX NIFTY of September 20x3 series at a price of, say, Rs. 1,100 per unit. As a
result, Mr. B is under obligation to sell 200 units of S&P CNX NIFTY on the
Settlement Date at the rate of Rs. 1,100 per unit. On the Settlement Date, if the
price of the S&P CNX NIFTY is higher than Rs. 1,100, say, Rs. 1,125 per unit, Mr. B
will pay Rs. 25 per unit (the difference between the price on the Settlement Date
and the contract price). On the other hand, if, on the Settlement Date, the price of
S&P CNX NIFTY is lower than Rs. 1,100, say, Rs. 1,050 per unit, Mr. B will receive
Rs. 50 per unit.
19. Examples of Equity Stock Futures
(i) In July, Mr. A enters into an equity stock futures contract to buy 1,000 equity shares
of XYZ Limited of September 20x3 series at a price of, say, Rs. 250 per share. As a
result, Mr. A is under obligation to buy 1,000 equity shares of XYZ Limited on the
Settlement Date at the rate of Rs. 250 per share. On the Settlement Date, Mr. A will
have to settle the contract either through purchase of shares or by payment/receipt
of the difference between the contract price of Rs. 250 per share and the price of
the shares of XYZ Limited on that date, depending upon whether the contract is
delivery-settled or cash-settled. If the contract is delivery-settled, on the Settlement
Date, Mr. A will buy 1,000 equity shares of XYZ Limited at a price of Rs. 250 per
share. On the other hand, if the contract is cash-settled, on the Settlement Date, if
the price of the shares of XYZ Limited is higher than Rs. 250, say, Rs. 280 per
share, Mr. A will receive Rs. 30 per share (the difference between the price on the
Settlement Date and the contract price). However, if, on the Settlement Date, the
price of the shares of XYZ Limited is quoted lower than Rs. 250, say, Rs. 210 per
share, Mr. A will pay Rs. 40 per share.
(ii) In July, Mr. B enters into an equity stock futures contract to sell 500 equity shares of
PQR Limited of September 20x3 series at a price of, say, Rs. 500 per share. As a
result, Mr. B is under obligation to sell 500 equity shares of PQR Limited on the
Settlement Date at the rate of Rs. 500 per share. On the Settlement Date, Mr. B will
have to settle the contract either through sale of shares or by payment/receipt of the
difference between the contract price of Rs. 500 per share and the price of the
shares of PQR Limited on that date, depending upon whether the contract is
delivery-settled or cash-settled. If the contract is delivery-settled, on the Settlement
Date, Mr. B will sell 500 equity shares of PQR Limited at a price of Rs. 500 per
share. On the other hand, if the contract is cash-settled, on the Settlement Date, if
the price of the shares of PQR Limited is higher than Rs. 500, say, Rs. 525 per
share, Mr. B will pay Rs. 25 per share (the difference between the price on the
Settlement Date and the contract price). However, if, on the Settlement Date, the
price of the shares of PQR Limited is lower than Rs. 500, say, Rs. 450 per share,
Mr. B will receive Rs. 50 per share.
EQUITY INDEX OPTIONS AND EQUITY STOCK OPTIONS

20. Equity index options are a type of derivative instruments whereby a person gets the right
to buy or sell an agreed number of units of equity index on a specified future date. Equity
stock options are a type of derivative instruments whereby a person gets the right to buy or
sell an agreed number of units of a security on or before a specified future date. At present, in
India, trading in equity index options is allowed in two indexes, viz., BSE SENSEX and S&P
CNX NIFTY and equity stock options are allowed in certain specified securities listed on the
stock exchanges.
21. The following are the basic differences between these two types of equity options:
(a) The underlying asset
In case of equity index options, the underlying asset is equity index itself (e.g., BSE
SENSEX, S&P CNX NIFTY), whereas in case of equity stock options, the underlying
asset is a security (e.g., equity shares of a company).
(b) The time of settlement
Equity index options are of European style, i.e., buyer/holder can exercise his option only
on the day on which the option expires, whereas equity stock options are of American
style, i.e., the buyer/holder can exercise his option at any time before the Expiry Date or
on the date of expiry itself.
(c) The mode of settlement
By its very nature, the index cannot be delivered on maturity of the contract. As such, the
settlement of an equity index options contract takes the form of payment of the difference
between the Strike/Exercise Price and the value of the index on the Expiry Date, in cash.
In contrast, equity stock options contract can be settled either through delivery of security
for which an options contract was entered into or by payment of the difference between
the Strike/Exercise Price and the value of the security for which the options contract was
entered into, in cash, just like equity index option. At present, in India, equity stock
options are settled through cash. However, in near future equity stock options may be
settled through physical delivery of shares.
22. Examples of Equity Index Options
Call Options
In July, Mr. A (buyer/holder) enters into an equity index options contract to buy a Call Option
for 200 units of S&P CNX NIFTY of September 20x3 series at a price of Rs. 1,100 per unit. As
a result, Mr. A obtains the right to buy 200 units of S&P CNX NIFTY on the Expiry Date at Rs.
1,100 per unit. For this right, Mr. A pays a premium of Rs. 10 per unit of index to the
seller/writer of the option. If, on the Expiry Date, the price of S&P CNX NIFTY is higher than
Rs. 1,100, Mr. A will exercise his right to call. By exercising the right to call, he will receive
the difference between the price on the Expiry Date and the Strike Price. On the other hand, if
the price is below Rs. 1,100, he will not exercise his Call Option.
Put Options
In July, Mr. B (buyer/holder) enters into an equity index options contract to buy a Put Option
for 100 units of BSE SENSEX of September 20x3 series at a price of Rs. 3,650 per unit. As a
result, Mr. B obtains a right to sell 100 units of BSE SENSEX on the Expiry Date at Rs. 3,650
per unit. For this right, Mr. B pays a premium of Rs. 25 per unit of index to the seller/writer of
the option. If, on the Expiry Date, the price of BSE SENSEX is lower than Rs. 3,650, Mr. B will
exercise his right to put. By exercising the right to put, he will receive the difference between
the Strike Price and the price on the Expiry Date. On the other hand, if the price is above Rs.
3,650, he will not exercise his Put Option.
23. Examples of Equity Stock Options
Call Options
In July, Mr. A (buyer/holder) enters into an equity stock options contract to buy a Call Option
for 1,000 equity shares of XYZ Limited of September 20x3 series at a price of Rs. 250 per
share. As a result, Mr. A obtains a right to buy 1,000 equity shares of XYZ Limited at the rate
of Rs. 250 per share on or before the Expiry Date. For this right, Mr. A pays a premium of Rs.
5 per equity share to the seller/writer of the option. If, at any time on or before the Expiry
Date, the price of the equity shares is quoted higher than Rs. 250, Mr. A may exercise his right
to call. In case the contract is delivery-settled, by exercising the right to call, Mr. A will acquire
1,000 equity shares of XYZ Limited at Rs. 250 per share and since the prevailing market price
is higher, he can make a profit by selling these shares in the market. In case the contract is
cash-settled, by exercising the right to call, Mr. A will receive the difference between the
prevailing market price and the Strike Price. On the other hand, if the market price is below
Rs. 250 per share, he will not exercise his Call Option.
Put Options
In July, Mr. B (buyer/holder) enters into an equity stock options contract to buy a Put Option
for 500 equity shares of PQR Limited of September 20x3 series at a price of Rs. 500 per
share. As a result, Mr. B obtains a right to sell 500 equity shares of PQR Limited on or before
the Expiry Date at the rate of Rs. 500 per share. For this right, Mr. B pays a premium of Rs. 15
per equity share to the seller/writer of the Option. If, at any time on or before the Expiry Date,
the price of the equity shares is quoted lower than Rs. 500, Mr. B may exercise the right to
put. In case the contract is delivery-settled, by exercising his right to put, Mr. B will sell equity
shares of PQR Limited at Rs. 500 per share and since the prevailing market price is lower, he
can make a profit by buying these shares in the market. In case the contract is cash-settled,
by exercising the right to put, Mr. B will receive the difference between the Strike Price, i.e.,
Rs. 500 per share and the prevailing market price. On the other hand, if the market price is
above Rs. 500 per share, Mr. B will not exercise his Put Option.
Definitions
24. For the purpose of this Guidance Note, the following terms are used with the meanings
specified:
Call Option: A Call Option is an Option to buy the specified underlying asset on or before the
Expiry Date.
Clearing Corporation/House: Clearing Corporation/House means the Clearing
Corporation/House approved by SEBI for clearing and settlement of trades on the Derivatives
Exchange/Segment. (The terms ‘Clearing Corporation’ and ‘Clearing House’ have been used
interchangeably in this Guidance Note)
Clearing Member: Clearing Member means a member of the Clearing Corporation and
includes all categories of Clearing Members as may be admitted as such by the Clearing
Corporation to the Derivatives Segment.
Client: A Client means a person, on whose instructions and, on whose account, the Trading
Member enters into any contract for the purchase or sale of any contract or does any act in
relation thereto.
Contract Month: Contract Month, in relation to a futures contract, means the month in which
the exchange/Clearing Corporation rules require a contract to be finally settled, and in relation
to an options contract, means the month in which the Expiry Date falls.
Daily Settlement Price: Daily Settlement Price is the closing price of the equity index/stock
futures contract for the day or such other price as may be decided by the Clearing House from
time to time.
Derivatives: Derivatives include,
(a) a security derived from a debt instrument, share, loan, whether secured or unsecured,
risk instrument or contract for differences or any other form of security;
(b) a contract which derives its value from the prices, or index of prices, of underlying
securities.
Derivative Exchange/Segment: Derivative Exchange means an Exchange approved by SEBI
as a Derivative Exchange. Derivative Segment means Segment of an existing Exchange
approved by SEBI as Derivative Segment.
Exercise Date: Exercise Date is the date on which the buying/selling right in the Option is
actually exercised by the Option Buyer/Holder.
Exercise of an Option: Exercise of an Option means enforcing the right by the Option
Buyer/Holder available under the option contract of buying or selling the underlying asset at
the Strike Price.
Expiry Date: Expiry Date is the last date on or upto which the Option can be exercised.
Final Settlement Price: Final Settlement Price is the closing price of the Equity Derivative
Instruments contract on the last trading day of the contract or such other price as may be
specified by the Clearing Corporation, from time to time.
Long Position: Long Position means outstanding purchase obligations in respect of equity
index/stock futures contracts at any point of time.
Open Interest: Open Interest means the total number of Equity Derivative Instruments
contracts that have not yet been offset and closed by an opposite contract nor fulfilled either
by delivery of cash or by actual delivery of underlying security.
Option: Option is a contract, which gives the buyer/holder the right, but not the obligation, to
buy or sell a specified underlying asset at a predetermined price.
Option Buyer/Holder: Option Buyer/Holder is the person who buys a Call or a Put Option.
Option Premium: Option Premium is the price paid by the Option Buyer/Holder to the Option
Seller/Writer to acquire the right in the Option.
Option Seller/Writer: Option Seller/Writer is the person who sells a Call or a Put Option.
Put Option: Put Option is an Option to sell the specified underlying asset on or before the
Expiry Date.
Settlement Date: Settlement Date means the date on which the outstanding obligations in an
equity index/stock futures contract are required to be settled as provided in the bye-laws of the
Derivatives Exchange/Segment.
Short Position: Short Position means outstanding sell obligations in respect of equity
index/stock futures contracts at any point of time.
Strike Price/Exercise Price: Strike Price/Exercise Price is the price specified in the option
contract at which the underlying asset may be purchased or sold by the buyer/holder.
Trading Member: Trading Member means a member of the Derivatives Exchange/Segment
and registered with SEBI.
Trading Mechanism
25. Trading in Equity Derivative Instruments has commenced in India in a separate segment
of existing stock exchanges known as ‘Derivatives Segment’. The Clearing Corporation/House
of the exchange may act as legal counter-party to all deals or may provide an unconditional
guarantee for all the deals in Equity Derivative Instruments on the exchange. Thus, for all
practical purposes, both the parties to an Equity Derivative Instruments contract would be
assured that the obligations of the other party would be met – either by the party itself or, in
the event of default on the part of the party, by the Clearing Corporation.
26. A Client can trade in Equity Derivative Instruments only through a Trading Member of the
exchange. A Clearing Member can also act as a Trading Member. The process of trading is
similar to screen-based trading in securities like shares on an exchange.
27. The exchanges, allowing trading in Equity Derivative Instruments contracts, introduce
standardised contracts where the Settlement Date/Expiry Date, as the case may be, is
specified by the stock exchange and the Clients can enter into contracts with different
contract/Strike Prices, as the case may be, and different premiums, if relevant. The Settlement
Date/Expiry Date adopted by BSE and NSE is the last Thursday of a Contract Month. For
example, the Equity Derivative Instruments contracts of August 2003 series will expire on 28th
August 2003 (being the last Thursday of August 2003). In both BSE and NSE, the Equity
Derivative Instruments contracts will have a maximum of three month trading cycle – the near
month (one), the next month (two) and the far month (three). Thus, in August 2003, one would
be able to enter into futures contracts for the months of August 2003, September 2003 and
October 2003. On 28th August, 2003 (last Thursday of August 2003) the Equity Derivative
Instruments contracts for August 2003 series will be finally settled/will expire and thereafter
trading in November 2003 series will start.
28. Each exchange permitting Equity Derivative Instruments trading also provides the
contract specifications. For example, the NSE has decided to permit contract multiplier of 200
for the S&P CNX NIFTY futures/options contracts, whereas the BSE has decided that the
contract multiplier would be 50 for trading in BSE SENSEX. Similarly, for each individual
stock, market lot has been decided. A person can trade in Equity Derivative Instruments only
in the multiples of the market lot.
29. In order to minimise the risk of failure of parties to a contract in fulfilling their respective
obligations under the contract, the Clearing Corporation, from time to time, prescribes margin
requirements for Clearing/Trading Members. Margins are required to be paid by
Clearing/Trading Members, who, in turn, collect margins from their respective Clients.
Margins can be paid in cash or be provided by way of a bank guarantee or by deposit receipts
or securities or such other mode and would be subject to such terms and conditions as the
Clearing Corporation may specify from time to time. There is a continuing obligation, during
the contract period, to maintain margins at the levels specified by the Clearing Corporation,
from time to time.
30. Every Client is required to pay an initial margin to the Trading Member/Clearing Member
at the time of entering into an Equity Derivative Instruments contract. Such a margin is
calculated by using a Software called ‘Standard Portfolio Analysis of Risk’ (SPAN). SPAN
calculates risk arrays for all the open positions on an overall basis and gives the output in the
form of a risk parameters file. This risk parameters file is made available to all the participants
of Derivatives Segment. Members and Clients use the data from SPAN risk file, together with
their position data, to calculate SPAN margin requirements on their respective positions on
daily basis. SPAN calculates the margin by determining the worst possible loss using 16 risk
scenarios. The Clients pay the deficit margin to, or receive the refund of excess margin from,
the Trading Member/Clearing Member on daily basis.
EQUITY INDEX FUTURES AND EQUITY STOCK FUTURES

31. In addition to the payment of the Initial Margin computed as per paragraph 30 above,
both the parties to the equity index/stock futures contract are required to pay daily ‘Mark-to-
Market Margin’. For computation of ‘Mark-to-Market Margin’, all outstanding contracts,
whether Long or Short, of a Clearing Member in an equity index/stock futures contract are
deemed to have been settled at the Daily Settlement Price. Such a member would be liable to
pay to, or be entitled to collect from, the Clearing House the difference between the price at
which such contract was bought or sold and the Daily Settlement Price of that day, or the
Settlement Price of the previous trading day and the Settlement Price of the contract at the
end of the trading day, as the case may be. The Mark-to-Market Margin would be paid only in
cash. After such settlement with the Clearing House, the member would be deemed to be
Long or Short, as the case may be, in contracts at the Daily Settlement Price. Supposing ‘X’
buys one unit of an equity index future of one month maturity (say, April) on March 29 for Rs.
1,420. If at the end of the day (i.e., March 29) the Daily Settlement Price of the equity index
futures has fallen to Rs. 1,400, he would pay Rs. 20 to the Clearing House. The position for
the subsequent days upto March 31 would be as follows:
Assumed Daily Settlement Price
(Rs.)
March 30 1,435 Receive Rs. 35
March 31 1,430 Pay Rs. 5
Such differences would be directly debited/credited to the separate bank account required to
be maintained by the Clearing Member with the Clearing Corporation. The Clearing Member
would, in turn, debit/credit the bank account of the Trading Member, who, in turn, would
debit/credit the account of the Client.
32. Each party to an equity index/stock futures contract is under an obligation to meet its
commitment at the maturity of the contract. However, either party can, at any time during the
currency of the contract, square-up its future obligations under the contract by entering into a
reverse contract. For example, a person who is a buyer of 300 units of Stock of LMN Co.
Limited September 2003 series can enter into another contract of September 2003 series for
sale of 300 units of Stock of LMN Co. Limited. Any gain or loss on the original contract arising
after the date of entering into the second contract would be offset by an equivalent loss or
gain on the second contract. On entering into a reverse contract, the purchase and sales
contracts offset each other automatically.
33. In case of non-payment of daily settlement dues by the Client, before the next trading
day, the Clearing Member would be at liberty to close out transactions by selling or buying the
futures contracts, as the case may be. The loss incurred in this regard would be met from the
margin money of the Client and the gains, if any, would accrue to the Client. In case of
shortfall caused by loss being in excess of the margin money, the amount would be recovered
from the Client.
EQUITY INDEX OPTIONS AND EQUITY STOCK OPTIONS

34. In case of equity index options and equity stock options contracts, Option Buyer/Holder is
required to pay Option Premium to the Option Seller/Writer to acquire the right in the Options.
When a person buys or sells Options, the premium amount will be debited or credited to the
separate bank account of the Clearing Member with the Clearing Corporation. At the BSE and
the NSE, this premium is normally debited or credited on the next trading day (T+1 Basis).
35. After entering into an option contract, a Client can square-up his position by entering into
a reverse contract of the same series with the same Strike Price. For example, a buyer/holder
having bought S&P CNX NIFTY Call Option of September 20x3 series with Strike Price of Rs.
1,150 can square-up his position by selling/writing S&P CNX NIFTY Call Option of September
20x3 series with Rs. 1,150 as Strike Price. In such a case, the gain or loss of the Client will
be the difference between Option Premium received and paid after reducing/adding the
brokerage charged by the Clearing Member. Thus, profit can be earned by or loss can be
reduced to the difference in the premium amounts by squaring-up the position, before the
Expiry Date.
36. On the expiry of a Call Option, if the market price of the underlying asset is lower than
the Strike Price, the call would expire unexercised. Likewise, if on the expiry of a Put Option,
the market price of the underlying asset is higher than the Strike Price, the Put Option would
expire unexercised. When an Option Buyer/Holder decides to exercise his Option, he gives
the exercise notice through the trading network during the time specified by the Clearing
Corporation. The Clearing Corporation assigns the exercise notice to the Option Seller/Writer
through the Trading Member.
37. Practically, all those Options, which are favourable to the buyer/holder on Expiry Date,
are deemed to be exercised. No special notice is required to be sent by the buyer/holder.
However, the buyer/holder can let a favourable Option expire unexercised, if he so desires,
upon intimation to the stock exchange.
ACCOUNTING TREATMENT IN THE BOOKS OF THE CLIENT

38. Accounting for payments/receipts in respect of initial margin is common for all types of
Equity Derivative Instruments contracts. Paragraphs 39 to 41 hereinafter deal with the same.
Accounting for aspects peculiar to different Equity Derivative Instruments is dealt with
thereafter.
ACCOUNTING FOR INITIAL MARGIN

39. Every Client is required to pay to the Trading Member/Clearing Member, initial margin,
computed as per SPAN, for entering into an Equity Derivative Instruments contract. Such
initial margin paid/payable should be debited to an appropriate account, say, ‘Initial Margin –
Equity Derivative Instruments Account’. Any amount paid/received subsequently on account

of initial margin is also debited/credited to the account.
40. At the balance sheet date, the balance in the ‘Initial Margin – Equity Derivative
Instruments Account’ should be shown separately under the head ‘Current Assets’. Where
any amount has been paid in excess of the initial margin, the excess should be disclosed
separately as a deposit under the head ‘Current Assets’. Where instead of paying initial
margin in cash, the Client provides bank guarantees or lodges securities with the member, a
disclosure in respect of outstanding Equity Derivative Instruments contracts at the year-end
should be made separately for each type of instrument in the notes to the financial statements
of the Client.
41. Sometimes, the Client may deposit a lumpsum amount with the Clearing/Trading Member
in respect of margin money instead of paying/receiving margin money on daily basis. The
amount so paid is in the nature of a deposit and should be debited to an appropriate account,
say, ‘Deposit for Margin Money Account’. The amount of initial margin received into/paid from
such account should be debited/credited to the ‘Deposit for Margin Money Account’ with a
corresponding credit/debit to the ‘Initial Margin – Equity Derivative Instruments Account’. At
the year-end, any balance in the ‘Deposit for Margin Money Account’ should be shown as a
deposit under the head ‘Current Assets’.
ACCOUNTING FOR EQUITY INDEX FUTURES AND EQUITY STOCK FUTURES
ACCOUNTING FOR PAYMENT/RECEIPT OF MARK-TO-MARKET MARGIN

42. Payments made or received on account of Mark-to-Market Margin by the Client would be
credited/debited to the bank account and the corresponding debit or credit for the same should
be made to an appropriate account, say, ‘Mark-to-Market Margin – Equity Index Futures
Account’ or ‘Mark-to-Market Margin – Equity Stock Futures Account’, as the case may be.
43. The amount of Mark-to-Market Margin received into/paid from lumpsum deposit with the
Clearing/Trading Member should be debited/credited to the ‘Deposit for Margin Money
Account’ with a corresponding credit/debit to the ‘Mark-to-Market Margin – Equity Index
Futures Account’ or the ‘Mark-to-Market Margin – Equity Stock Futures Account’, as the case
may be.
ACCOUNTING FOR OPEN INTERESTS IN FUTURES CONTRACTS AS ON THE BALANCE

SHEET DATE
44. The debit/credit balance in the ‘Mark-to-Market Margin – Equity Index Futures Account’
or the ‘Mark-to-Market Margin – Equity Stock Futures Account’, as the case may be,
represents the net amount paid to/received from the Clearing/Trading Member on the basis of
movement in the prices of equity index futures or equity stock futures till the balance sheet
date in respect of open futures contracts. In case the said account(s) has a debit balance on
the balance sheet date, the same should be shown as a current asset. On the other hand, in
case the said account(s) has a credit balance on the balance sheet date, the same should be
shown as a current liability.
45. Keeping in view ‘prudence’ as a consideration for the preparation of financial statements,
a provision for the anticipated loss in respect of open futures contracts should be made. For
this purpose, the net amount paid/received on account of Mark-to-Market Margin on open
futures contracts on the balance sheet date should be determined Index-wise/Scrip-wise.
Where the Index-wise/Scrip-wise balance is a debit balance representing the net amount paid,
provision should be made for the said amount. However, where the Index-wise/Scrip-wise
balance is a credit balance representing the net amount received, the same should be ignored
keeping in view the consideration of ‘prudence’. To facilitate these computations, the Mark-to-
Market Margin account(s) may be maintained Index-wise/Scrip-wise.
46. The provision as created above should be credited to an appropriate account, say,
‘Provision for Loss on Equity Index Futures Account’ or to ‘Provision for Loss on Equity Stock
Futures Account’, as the case may be. In case of any opening balance in the ‘Provision for
Loss on Equity Index Futures Account’ or the ‘Provision for Loss on Equity Stock Futures
Account’, the same should be adjusted against the provision required in the current year and
the profit and loss account should be debited/credited with the balance provision required to
be made/excess provision written back.
47. The ‘Provision for Loss on Equity Index Futures Account’ or the ‘Provision for Loss on
Equity Stock Futures Account’ should be shown as a deduction from the balance of the ‘Mark-
to-Market Margin – Equity Index Futures Account’ or the ‘Mark-to-Market Margin – Equity
Stock Futures Account’, if disclosed as a current asset. On the other hand, if the above-stated
Margin account(s) is disclosed as a current liability, the aforesaid provision account(s) should
be shown as a provision on the liabilities side of the balance sheet.
ACCOUNTING AT THE TIME OF FINAL SETTLEMENT OR SQUARING-UP

Index futures and cash-settled stock futures contracts
48. At the expiry of a series of equity index futures/equity stock futures, the profit/loss, on
final settlement of the contracts in the series, should be calculated as the difference between
the Final Settlement Price and the contract prices of all the contracts in the series. The
profit/loss, so computed, should be recognised in the profit and loss account by corresponding
debit/credit to the ‘Mark-to-Market Margin – Equity Index Futures Account’ or the ‘Mark-to-
Market Margin – Equity Stock Futures Account’, as the case may be.
49. The same accounting treatment as recommended in paragraph 48 should be made when
a contract is squared-up by entering into a reverse contract. If more than one contract in
respect of the relevant series of equity index futures/equity stock futures contract to which the
squared-up contract pertains is outstanding at the time of the squaring-up of the contract, the
contract price of the contract so squared-up should be determined using Weighted Average
Method for calculating profit/loss on squaring-up.
Delivery-settled stock futures contracts
50. Under the delivery-settled stock futures contracts, at the time of final settlement,
securities will be transferred in consideration for cash at the contract price. In such a case,
irrespective of the price of the security on the Settlement Date, the same will be reflected in
the books at its original contract price. Thus, the relevant securities account is debited or
credited for Long and Short futures contract, respectively, by the contract price, by a
corresponding credit/debit to ‘Mark-to-Market Margin – Equity Stock Futures Account’, and
cash/bank account.
ACCOUNTING IN CASE OF DEFAULT
51. When a Client defaults in making payment in respect of Mark-to-Market Margin, the
contract is closed out. The amount not paid by the Client is adjusted against the initial margin
already paid by him. In the books of the Client, the amount of Mark-to-Market Margin so
adjusted should be debited to the ‘Mark-to-Market Margin – Equity Index Futures Account’ or
the ‘Mark-to-Market Margin – Equity Stock Futures Account’, as the case may be, with a
corresponding credit to the ‘Initial Margin – Equity Derivative Instruments Account’. In case,
the amount to be paid on account of Mark-to-Market Margin exceeds the initial margin, the
excess is a liability and should be shown as such under the head ‘Current Liabilities and
Provisions’, if it continues to exist on the balance sheet date. The amount of profit or loss on
the contract so closed out should be calculated and recognised in the profit and loss account
in the manner described in paragraphs 48 and 49.
ACCOUNTING FOR EQUITY INDEX OPTIONS AND EQUITY STOCK OPTIONS
ACCOUNTING FOR PAYMENT/RECEIPT OF THE PREMIUM
52. At the time of entering into an options contract, the buyer/holder of the Option is required
to pay the premium. In the books of the buyer/holder, such premium should be debited to an
appropriate account, say, ‘Equity Index Option Premium Account’ or ‘Equity Stock Option
Premium Account’, as the case may be. In the books of the seller/writer, such premium
received should be credited to an appropriate account, say, ‘Equity Index Option Premium
Account’ or ‘Equity Stock Option Premium Account’, as the case may be.
ACCOUNTING FOR OPEN INTERESTS IN OPTIONS CONTRACTS AS ON THE BALANCE

SHEET DATE
53. The ‘Equity Index Option Premium Account’ and the ‘Equity Stock Option Premium
Account’ should be shown under the head ‘Current Assets’ or ‘Current Liabilities’, as the case
may be. In case of multiple Options, entries recommended in paragraph 52 above may be
made in one ‘Equity Index Options Premium Account’ or ‘Equity Stock Options Premium
Account’, in respect of Options of all indexes/scrips. The balance of this composite account
should be shown under the head ‘Current Assets’ or ‘Current Liabilities’, as the case may be.
54. In the books of the buyer/holder, a provision should be made for the amount by which the
premium paid for the Option exceeds the premium prevailing on the balance sheet date since
the buyer/holder can reduce his loss to the extent of the premium prevailing in the market, by
squaring-up the transaction. The provision so created should be credited to an appropriate
account, say, ‘Provision for Loss on Equity Index Option Account’ or to ‘Provision for Loss on
Equity Stock Option Account’, as the case may be. The provision made as above should be
shown as a deduction from the balance of the ‘Equity Index Option Premium Account’ or the
‘Equity Stock Option Premium Account’ which is shown under the head ‘Current Assets’. The
excess of premium prevailing in the market on the balance sheet date over the premium paid
is not recognised keeping in view the consideration of prudence.
55. In the books of the seller/writer, a provision should be made for the amount by which
premium prevailing on the balance sheet date exceeds the premium received for that Option.
This provision should be credited to ‘Provision for Loss on Equity Index Option Account’ or to
‘Provision for Loss on Equity Stock Option Account’, as the case may be, with a corresponding
debit to profit and loss account. ‘Equity Index Option Premium Account’ or ‘Equity Stock
Option Premium Account’ and ‘Provision for Loss on Equity Index Option Account’ or
‘Provision for Loss on Equity Stock Option Account’ should be shown under the head ‘Current
Liabilities and Provisions’. The excess of premium received over the premium prevailing on
the balance sheet date is not recognised keeping in view the consideration of prudence.
56. In case of multiple open options at the year-end, a Index-wise/Scrip-wise provision
should be made considering all the open options of any Strike Price and any Expiry Date
under that index/scrip taken together as illustrated below:
For Stock Options of ABC Limited In Situations
A B C D
Rs. Rs. Rs. Rs.
Bought
Total premium paid on all open options 2,00,000 1,00,000 1,00,000 1,00,000
bought
Less: Total premium prevailing on 3,00,000 50,000 80,000 1,50,000
Balance Sheet date for all open options
bought
X -1,00,000 50,000 20,000 -50,000
Sold
Total premium prevailing on the 2,50,000 2,00,000 1,50,000 1,30,000
Balance Sheet date for all open options
sold
Less: Total premium received on all 1,00,000 3,00,000 1,00,000 1,80,000
open options sold
Y 1,50,000 -1,00,000 50,000 -50,000
Provision required =X+Y (if positive) 50,000 NIL 70,000 NIL
The amount of provision required in respect of each scrip or index as illustrated above should
be aggregated and a composite ‘Provision for Loss on Equity Stock Options Account’ or
‘Provision for Loss on Equity Index Options Account’ should be credited by debiting the profit
and loss account.
57. In case of any opening balance in the ‘Provision for Loss on Equity Stock Options
Account’ or the ‘Provision for Loss on Equity Index Options Account’, the same should be
adjusted against the provision required in the current year and the profit and loss account be
debited/credited with the balance provision required to be made/excess provision written back.
58. In case of multiple open options at the year-end, the ‘Provision for Loss on Equity Stock
Options Account’ or the ‘Provision for Loss on Equity Index Options Account’, as the case may
be, should be shown as a deduction from the ‘Equity Stock Options Premium Account’ and the
‘Equity Index Options Premium Account’ respectively, if these have a debit balance and are
disclosed under the head ‘Current Assets’. In case the ‘Equity Stock Options Premium
Account’ and the ‘Equity Index Options Premium Account’ have a credit balance and are
disclosed under the head ‘Current Liabilities’, the respective provision account should be
shown under ‘Provisions’ under the head ‘Current Liabilities and Provisions’.
ACCOUNTING AT THE TIME OF FINAL SETTLEMENT

Index options and cash-settled stock options contracts
59. In the books of the buyer/holder: On exercise of the Option, the buyer/holder will
recognise premium as an expense and debit the profit and loss account by crediting the
‘Equity Index Option Premium Account’ or the ‘Equity Stock Option Premium Account’. Apart
from the above, the buyer/holder will receive favourable difference, if any, between the Final
Settlement Price as on the Exercise/Expiry Date and the Strike Price, which will be recognised
as income.
60. In the books of the seller/writer: On exercise of the Option, the seller/writer will
recognise premium as an income and credit the profit and loss account by debiting the ‘Equity
Index Option Premium Account’ or the ‘Equity Stock Option Premium Account’. Apart from the
above, the seller/writer will pay the adverse difference, if any, between the Final Settlement
Price as on the Exercise/Expiry Date and the Strike Price. Such payment will be recognised as
a loss.
Delivery-settled stock options contracts
61. If an Option expires unexercised, the accounting entries will be the same as those in
case of cash-settled options. If the Option is exercised, securities will be transferred in
consideration for cash at the Strike Price. In such a case, the accounting treatment should be
as recommended in the following paragraphs.
62. In case of buyer/holder: For a Call Option, the buyer/holder will receive the security for
which the Call Option was entered into. The buyer/holder should debit the relevant security
account and credit cash/bank. For a Put Option, the buyer/holder will deliver the security for
which the Put Option was entered into. The buyer/holder should credit the relevant security
account and debit cash/bank. In addition to this entry, the premium paid should be transferred
to the profit and loss account, the accounting entries for which should be the same as those in
case of cash settled options.
63. In case of seller/writer: For a Call Option, the seller/writer will deliver the security for
which the Call Option was entered into. The seller/writer should credit the relevant security
account and debit cash/bank. For a Put Option, the seller/writer will receive the security for
which the Put Option was entered into. The seller/writer should debit the relevant security
account and credit cash/bank. In addition to this entry, the premium received should be
transferred to the profit and loss account, the accounting entries for which should be the same
as those in case of cash settled options.
ACCOUNTING AT THE TIME OF SQUARING-UP OF AN OPTION CONTRACT

64. When an Options contract is squared-up by entering into a reverse contract, the
difference between the premium paid and received, after adjusting the brokerage charged, on
the squared-up transactions should be transferred to the profit and loss account.
METHOD FOR DETERMINATION OF PROFIT/LOSS IN MULTIPLE OPTIONS SITUATION

65. For working out profit or loss in case of outstanding multiple options of the same
scrip/index with the same Strike Price and the same Expiry Date, weighted average method
should be followed on squaring-up of transactions. Similarly, for working out profit or loss in
case of outstanding multiple equity stock options of the same scrip with the same Strike Price
and the same Expiry Date, weighted average method should be followed where such Option(s)
is/are exercised before the Expiry Date.
Disclosure
66. The enterprise should disclose the accounting policies and the methods adopted,
including criteria for recognition and the basis of measurement applied for various Equity
Derivative Instruments.
67. Where initial margin is paid by way of a bank guarantee and/or lodging of securities, the
amount of such bank guarantee/book value and market value of the securities in respect of
outstanding Equity Derivative Instruments contracts at the year-end, should be disclosed
separately for each type of instrument.
68. The enterprise should give the details as illustrated below in respect of futures contracts
outstanding at the year-end (Open Interests) for each Equity Index/Stock Futures:
Name of Equity Index/Stock Futures No. of contracts No. of Units
Long Short
XYZ Limited
PQR Limited
Note: All open index/stock futures interests should be added together, irrespective of the
contract price and series for each equity index/stock for the purpose of disclosure.
69. The buyer/holder and the seller/writer of the option should give the details as illustrated
below in respect of option contracts outstanding as at the year-end for each Equity
Index/Stock Option:
Name of the Equity Option Total premium carried forward as at the year end
index/stock net of provisions made
(Rs.)
XYZ Limited 2,00,000
PQR Limited 1,50,000
Note: All open options should be added together, irrespective of the Strike Price and the
Expiry Date for each equity index/stock for the purpose of disclosure.
Illustration
70. Examples illustrating the accounting treatment of important aspects of Equity Derivative
Instruments are given in the Appendix to this Guidance Note.
APPENDIX
(This appendix, which is illustrative only and does not form part of the Guidance Note,
provides examples to illustrate application of the principles explained in this Guidance Note.)
ILLUSTRATION 1: Accounting for INITIAL margin

Suppose Mr. X enters into certain Equity Derivative Instruments contracts on March 28, 20x3.
The Initial Margin on these contracts, calculated as per the SPAN, is Rs. 30,000. The Margin
for the subsequent days, calculated as per the SPAN, is as follows:
On 29th March, 20x3 Rs. 35,000
On 30th March, 20x3 Rs. 25,000
On 31st March, 20x3 Rs. 27,000
SUGGESTED ACCOUNTING TREATMENT

1. The following entries may be passed for the payment/receipt of the Initial Margin:
28/3/x3 Initial Margin – Equity Derivative Instruments A/c Dr. Rs.30,000
To Bank A/c Rs.30,000

(Being initial margin paid on Equity
Derivative Instruments contracts)
29/3/x3 Initial Margin – Equity Derivative Instruments A/c Dr. Rs. 5,000
To Bank A/c Rs. 5,000
(Being further margin paid to the exchange)
30/3/x3 Bank A/c Dr. Rs.10,000

To Initial Margin – Equity Derivative Rs.10,000
Instruments A/c
(Being refund of margin from the exchange)
31/3/x3 Initial Margin – Equity Derivative Instruments A/c Dr. Rs. 2,000
(Being further margin paid to the exchange)
2. The Initial Margin paid on Equity Derivative Instruments will be disclosed in the balance
sheet as follows:
Extracts from the Balance Sheet
CURRENT ASSETS
Initial Margin – Equity Derivative Instruments A/c Rs. 27,000
3. In respect of initial margin, the following disclosure may be made in the notes to
accounts:
‘Initial Margin on Equity Derivative Instruments contracts has been paid in cash only.’
ILLustration 2: Accounting for Equity index futures
(A) ACCOUNTING FOR PAYMENT/RECEIPT OF MARK-TO-MARKET MARGIN

1. Suppose Mr. A purchases the following units of Equity Index Futures:
Date of Name of the Expiry Date/ Contract Price Contract
Purchase Futures contract Series per unit (Rs.) Multiplier (No. of
Units)
28th March, 20x3 EF1 May 20x3 1,420 200
29th March, 20x3 EF2 June 20x3 4,280 50
29th March, 20x3 EF1 May 20x3 1,416 200
2. Daily Settlement Prices of the above units of Equity Index Futures are as follows:
Date EF1 May Series (Rs.) EF2 June Series (Rs.)
28/03/20x3 1,410 -
29/03/20x3 1,428 4,300
30/03/20x3 1,435 4,270
31/03/20x3 1,407 4,290

1. The amount of Mark-to-Market Margin Money received/paid due to increase/decrease in
Daily Settlement Prices is as below:
EF1 May Series (Rs.) EF2 June Series (Rs.) Net Amount (Rs.)
Date Receive Pay Receive Pay Receive Pay
28/03/20x3 - 2,000 - - - 2,000
29/03/20x3 6,000 - 1,000 - 7,000 -
30/03/20x3 2,800 - - 1,500 1,300 -
31/03/20x3 - 11,200 1,000 - - 10,200
2. The amount of Mark-to-Market Margin Money received/paid will be credited/debited to

‘Mark-to-Market Margin – EIF A/c’ by passing the following entries:
Date Particulars L.F. Debit Credit
(Rs.) (Rs.)
March 20x3
28 Mark-to-Market Margin – EIF A/c Dr. 2,000
To Bank A/c 2,000
(Being net MTM Margin Money paid for day)
29 Bank A/c Dr. 7,000
To Mark-to-Market Margin – EIF A/c 7,000
(Being net MTM Margin Money received)
30 Bank A/c Dr. 1,300
To Bank A/c 10,200
(Being net MTM Margin Money paid for day)
Total 20,500 20,500
3. On the above basis, ‘Mark-to Market Margin – EIF A/c’ for the year will appear as follows
in the books of Mr. A:
Mark-to-Market Margin – EIF A/c
Balance
Date Particulars Debit (Rs.) Credit (Rs.) Dr./Cr. Amount (Rs.)
March
28 To Bank 2,000 Dr. 2,000
29 By Bank 7,000 Cr. 5,000
30 By Bank 1,300 Cr. 6,300
31 To Bank 10,200 Dr. 3,900
31 By Balance c/d 3,900
Total 12,200 12,200
(B) ACCOUNTING FOR OPEN INTERESTS ON THE BALANCE SHEET DATE

1. Continuing Illustration 2(A) above, on 31st March, 20x3, Mark-to-Market (MTM) Margin
Money received/paid on all the contracts in each of the indexes is as follows:
Amount paid on the contracts in respect of EF1 Rs. 4,400
Amount received on the contracts in respect of EF2 Rs. 500
2. Keeping in view the consideration of prudence, a provision should be created for
anticipated loss on open contracts in respect of EF1, equivalent to the amount paid, by
passing the following entry, whereas the amount received in open contracts in respect of EF2
would be ignored:
Profit & Loss A/c Dr. Rs. 4,400
To Provision for Loss – EIF A/c Rs. 4,400
(Being provision created for the amount paid to Clearing Member/Trading Member on
account of movement in the prices of the contracts in respect of EF1)
3. In the balance sheet, the debit balance of ‘Mark-to-Market Margin – EIF A/c’ and
‘Provision for Loss – EIF Account’ would be shown as follows:
Liabilities Amount Assets Amount
(Rs.) (Rs.)
Current Liabilities and Provisions Current Assets, Loans and Advances
(A) Current Liabilities (A) Current Assets
(B) Provisions (B) Loans and Advances
Excess of Provision for Mark-to-Market Margin – EIF A/c 3,900
Loss – EIF A/c over Less: Provision for Loss – EIF A/c 4,400
MTM – EIF A/c 500 Excess amount to be shown as Provision 500
4. In respect of open equity index futures contracts, the following disclosures should be
made in the notes to accounts:
Detail of Open Interests in Equity Index Futures contracts
Name of No. of contracts Units
Equity Index Future Long Short
EF1 2 400
EF2 1 50
(C) ACCOUNTING AT THE TIME OF SQUARING-UP/FINAL SETTLEMENT OF THE

CONTRACTS
Continuing Illustration 2(A) above, the following further facts are provided:
1. Equity Index Futures contracts are squared-up at the Daily Settlement Price of the day on
the following dates:
♦ EF2 June Series on 1st April, 20x3
♦ 200 Units of EF1 May Series on 2nd April, 20x3
♦ 200 Units of EF1 May Series on 3rd April, 20x3
2. Daily Settlement Prices of the units of Equity Index Futures, till squaring-up of the
contracts, are as follows:
Date EF1 May Series (Rs.) EF2 June Series (Rs.)
01/04/20x3 1,415 4,250
02/04/20x3 1,430 -
03/04/20x3 1,442 -

1. The amount of Mark-to-Market Margin Money received/paid due to increase/decrease in
Daily Settlement Prices is as below:
Date EF1 May Series EF2 June Series Net Amount (Rs.)
(Rs.) (Rs.)
Receive Pay Receive Pay Receive Pay
01/04/20x3 3,200 - - 2,000 1,200 -
02/04/20x3 6,000 - - - 6,000 -
03/04/20x3 2,400 - - - 2,400 -
2. The amount of profit/loss arising on squaring-up is calculated, using Weighted Average

method, as follows:
Name of the Futures contract EF2 EF1 EF1
Series June 20x3 May 20x3 May 20x3
Date of Squaring-up 1st April, 20x3 2nd April, 20x3 3rd April, 20x3
Contract Price per unit (in Rs.) 4,280 1,4181 1,4181
Settlement Price per unit (in Rs.) 4,250 1,430 1,442
Profit (+) / Loss (-) per unit (in Rs.) (-) 30 (+) 12 (+) 24
Number of Units 50 200 200
Total Profit (+) / Loss (-) (in Rs.) (-) 1,500 (+) 2,400 (+) 4,800
3. On the above basis, the following entries will be passed for the amount of Mark-to-Market
Margin Money received/paid and profit/loss arising on the squaring-up:
1
Weighted Average Price = (1,420 * 200 + 1,416 * 200)/400
Date Particulars L.F. Debit (Rs.) Credit (Rs.)

April 20x3
01 Bank A/c Dr. 1,200
01 Profit & Loss A/c Dr. 1,500
(Being loss on squaring-up)
02 Bank A/c Dr. 6,000
To Profit & Loss A/c 2,400
(Being profit on squaring-up of the contract)
03 Bank A/c Dr. 2,400
To Profit & Loss A/c 4,800
(Being profit on squaring-up of the contract)
Total 18,300 18,300
4. In this case, ‘Mark-to-Market Margin – EIF A/c’ for the year will appear as follows in the
books of Mr. A:
Mark-to-Market Margin – EIF A/c
Balance
Date Particulars Debit (Rs.) Credit (Rs.) Dr./Cr. Amount (Rs.)
April 20x3
01 To Balance b/d 3,900 Dr. 3,900
01 By Bank 1,200 Dr. 2,700
01 By Profit & Loss A/c 1,500 Dr. 1,200
02 By Bank 6,000 Cr. 4,800
02 To Profit & Loss A/c 2,400 Cr. 2,400
03 By Bank 2,400 Cr. 4,800
03 To Profit & Loss A/c 4,800 Nil

Total 11,100 11,100
5. In case the contracts as above are not squared-up, but are settled on the final settlement
date, the same entries as have been passed on squaring-up of the contracts, will be passed at
the time of final settlement.
Illustration 3: Accounting FOr Equity Stock futures
ACCOUNTING FOR EQUITY STOCK FUTURES WHICH ARE SETTLED IN CASH

The accounting treatment for Equity Stock Futures settled in cash would be the same as that
in the case of Equity Index Futures. This is because in both the cases the settlement is done
otherwise than by delivery of the underlying assets.
ACCOUNTING FOR EQUITY STOCK FUTURES WHICH ARE SETTLED BY DELIVERY

Accounting for payment/receipt of Mark-to-Market Margin and for Open Interests on the
balance sheet date will be the same as that in case of cash-settled futures. The accounting at
the time of final settlement of delivery-settled Equity Stock Futures contracts might be
explained with the help of example given hereunder.
1. Suppose Mr. A purchases the following units of Equity Stock Futures (ESF):
Date of Purchase ESF (Name of Settlement Contract Price Contract
the company) Date/Series Per Unit (Rs.) Multiplier (No. of
Units)
28thMarch, 20x3 XYZ Limited May, 20x3 1,420 200
29th March, 20x3 PQR Limited June, 20x3 4,280 50
29th March, 20x3 XYZ Limited May, 20x3 1,416 200
2. The contracts are settled through physical delivery of shares on the Settlement Date, i.e.,
both the contracts for shares of XYZ Limited (May 20x3 Series) are settled by purchasing the
shares on the Settlement Date, viz., May 29, 20x3. Similarly, the contract for shares of PQR
Limited (June 20x3 Series) is settled by purchasing the shares on the Settlement Date, viz.,
June 26, 20x3.
3. Net Mark-to-Market Margin received in respect of the contracts for shares of XYZ Limited
(May 20x3 Series) till the Settlement Date is Rs. 4,000. Net Mark-to-Market Margin paid in
respect of the contract for shares of PQR Limited (June 20x3 Series) till the Settlement Date is
Rs. 3,500.

At the time of final settlement, the shares are required to be purchased/sold against the
payment/receipt of the contract price. The amount paid/received earlier in the form of Mark-to-
Market Margin will be adjusted against the amount payable/receivable. Accordingly, the
following entries will be passed for purchase of shares on the final settlement of the contract:
Date Particulars L. F. Debit (Rs.) Credit (Rs.)
May 20x3
29 Shares of XYZ Limited A/c Dr. 5,67,200
Mark-to-Market Margin – ESF A/c Dr. 4,000 5,71,200
To Cash/Bank A/c
(Being shares purchased on Settlement
Date by payment of the net amount due in
respect of the contracts)
June 20x3
26 Shares of PQR Limited A/c Dr. 2,14,000
To Cash/Bank A/c 2,10,500
To Mark-to-Market Margin – ESF A/c 3,500
(Being shares received on settlement of
contract by payment of the net amount
due)
Illustration 4: Accounting for equity index options
(A) ACCOUNTING FOR PAYMENT/RECEIPT OF PREMIUM AND FOR FINAL

SETTLEMENT OF THE CONTRACTS
1. Suppose Mr. A buys the following equity index options and the seller/writer of these
options is Mr. B:
Date of Type of Options Expiry date Premium Contract Strike
Purchase contract per unit Multiplier price
(Rs.) (No. of (Rs.)
units)
28th March, S&P CNX NIFTY – May 29, 20x3 15 200 880
20x3 Call
28th March, S&P CNX NIFTY – May 29, 20x3 20 200 885
20x3 Put
2. Mr. A. and Mr. B follow the calendar year as the accounting year.

In the books of the buyer/holder, i.e., Mr. A
1. The following entry may be passed to record the amount of premium paid:
28/3/x3 Equity Index Option Premium A/c Dr. Rs. 7,000
(Being premium paid on equity Index options)
2. The following entries may be passed at the time of final settlement of the contracts:
Situation 1 Call Option May 20x3 Strike Price Rs. 880; price on expiry Rs. 875
29/5/x3 Profit and Loss A/c Dr. Rs. 3,000
To Equity Index Option Premium A/c Rs. 3,000
(Being the premium on the options contract
written off on expiry of the option)
Option will not be exercised in this situation.
29/5/x3 Bank A/c Dr. Rs. 2,000
To Profit and Loss A/c Rs. 2,000
(Being the profit on exercise of the option received.)
(Being the premium on the options contract written off on exercise of the option)
Situation 3 Put Option May 20x3 Strike Price Rs. 885; price on expiry Rs. 875
29/5/x3 Bank A/c Dr. Rs. 2,000
(Being the profit on exercise of the option received.)
29/5/x3 Profit and loss A/c Dr. Rs. 4,000
(Being the premium on the options contract written off on exercise of the
option)
(Being the premium on the options contract written off on expiry of the option)
In the books of the seller/writer, i.e., Mr. B
1. The following entry may be passed to record the amount of premium received:
28/3/x3 Bank A/c Dr. Rs. 7,000
(Being the premium on the option collected)
2. The following entries may be passed at the time of final settlement of the contracts:
(Being the premium on the options contract recognised as income on expiry of the
option)
(Being loss on exercise of the option paid)
(Being the premium on the options contract recognised as income on exercise of the
option)
(Being loss on exercise of the option paid)
option)
(Being the premium on the options contract recognised as income on expiry of the
option)
(B) ACCOUNTING FOR OPEN OPTIONS AT THE END OF AN ACCOUNTING PERIOD

Continuing with Illustration 4(A) above, except the following facts:
(a) Mr. A and Mr. B follow the financial year as the accounting year. Consequently, options
entered into in one accounting period are settled in another accounting period.
(b) On 31st March, 20x3: For Call Option May 20x3 Strike Price Rs. 880, closing rate of
premium Rs. 6 per unit. For Put Option May 20x3 Strike Price Rs. 885, closing rate of
premium Rs. 28 per unit.

In the books of the buyer/holder, i.e., Mr. A
1. Net provision required to be made in the books of account would be computed as follows:
Call Option May 20x3 Strike Price Rs. 880
Premium paid Rs. 3,000
Less: Premium on the balance sheet date Rs. 1,200
Provision required Rs. 1,800
Put Option May 20x3 Strike Price Rs. 885
Premium paid Rs. 4,000
Less: Premium as on the balance sheet date Rs. 5,600
Provision required Rs. –1,600
Net provision to be made in the books of account: Rs. 200
2. The following entry may be passed to create provision for the above amount:
31/3/x3 Profit and Loss A/c Dr. Rs. 200
To Provision for Loss on Equity Index Options A/c Rs. 200
(Being provision for loss on options as on 31-3-20x3)
3. In the balance sheet, the balance of ‘Equity Index Options Premium Account’ and
‘Provision for Loss on Equity Index Options Account’ would be shown as below:
Current Assets:
Rs.
Equity Index Options Premium Account 7,000
Less: Provision for Loss on Equity Index Options (200)
6,800
4. In respect of the premium carried forward (net of provisions), the following disclosure
may be made in notes to accounts:
Name of Options (Equity Premium carried forward as at the year-end net of
index/stock) provisions
S&P CNX NIFTY Rs. 6,800
5. At the time of final settlement of these contracts, the same entries would be passed as in
the case of Illustration 4(A) above.
In the books of seller/writer, i.e., Mr. B
1. Net provision required to be made in the books of account may be computed as follows:
Call Option May 20x3 Strike Price Rs. 880
Premium as on the balance sheet date Rs. 1,200
Less: Premium received Rs. 3,000
Provision required Rs. -1,800
Put Option May 20x3 Strike Price Rs. 885
Premium as on the balance sheet date Rs. 5,600
Less: Premium received Rs. 4,000
Provision required Rs. 1,600
Net provision to be made in the books of account: Rs. NIL
(Since the net difference is negative.)
2. In the balance sheet, the balance of ‘Equity Index Options Premium Account’ would be
shown as below:

Current Liabilities and Provisions:
Rs.
Equity Index Options Premium Account 7,000
Provision for Loss on Equity Index Options NIL
3. In respect of the premium carried forward (including provisions), the following disclosure
may be made in notes to accounts:
Name of Options (Equity Total Premium carried forward as at the year-
index/stock) end including provisions made
S&P CNX NIFTY Rs. 7,000
4. At the time of final settlement of these contracts, the same entries would be passed as in
the case of Illustration 4(A) above.
ILLUSTRATION 5: Accounting for equity stock options
ACCOUNTING FOR EQUITY STOCK OPTIONS WHICH ARE SETTLED IN CASH

Accounting entries for Equity Stock Options settled in cash will be the same as that in the case
of Equity Index Options. This is because in both the cases the settlement is done otherwise
than by delivery of the underlying assets.
ACCOUNTING FOR EQUITY STOCK OPTIONS WHICH ARE SETTLED BY DELIVERY

Accounting entries for the payment/receipt of premium and for open options at the balance
sheet date will be the same as that in the case of cash settled options. The accounting entries
at the time of final settlement, presuming that options are exercised, will be as follows:
Suppose Mr. A buys the following Equity Stock Options and the seller/writer of the options is
Mr. B
Date of Type of the Options Expiry date Market Premium Strike Price
Purchase contract Lot per unit (Rs.)
27th June, XYZ Co. Limited – August 28, 100 15 230
20x3 Call 20x3
30th June, ABC Co. Limited – August 28, 200 20 275
20x3 Put 20x3

In the books of the buyer/ holder, i.e., Mr. A
1. The following entries may be passed at the time of exercise of the Call Option:
Equity Shares of XYZ Limited A/c Dr. Rs. 23,000
To Bank A/c Rs.23,000
(Being Call Option exercised and shares acquired)
Profit and Loss A/c Dr. Rs. 1,500
To Equity Stock Option Premium A/c Rs. 1,500
2. The following entries may be passed at the time of exercise of the Put Option:
Bank A/c Dr. Rs. 55,000
To Equity Shares of ABC Limited A/c Rs. 55,000
(Being Put Option exercised and shares delivered)
Profit and Loss A/c Dr. Rs. 4,000
To Equity Stock Option Premium A/c Rs. 4,000
In the books of the seller/writer, i.e., Mr. B

1. The following entries may be passed at the time of exercise of the Call Option by the
buyer:
Bank A/c Dr. Rs. 23,000
To Equity Shares of XYZ Limited A/c Rs. 23,000
(Being shares delivered on exercise of the Call Option)
Equity Stock Option Premium A/c Dr. Rs. 1,500
option)
2. The following entries may be passed at the time of exercise of the Put Option by the
buyer:
Equity Shares of ABC Limited A/c Dr. Rs. 55,000

(Being shares acquired on exercise of the Put Option)
Equity Stock Option Premium A/c Dr. Rs. 4,000
option)

Guidance Note on Accounting for
Employee Share-based Payments
(The following is the text of the Guidance Note on Accounting for Employee Share-based
Payments, issued by the Council of the Institute of Chartered Accountants of India.)
INTRODUCTION
1. Some employers use share-based payments as a part of remuneration package for their
employees. Such payments generally take the forms of Employee Stock Option Plans
(ESOPs), Employee Stock Purchase Plans (ESPPs) and stock appreciation rights. ESOPs are
plans under which an enterprise grants options for a specified period to its employees to
purchase its shares at a fixed or determinable price. ESPPs are plans under which the
enterprise grants rights to its employees to purchase its shares at a stated price at the time of
public issue or otherwise. Stock appreciation rights is a form of employee share-based
payments whereby the employees become entitled to a future cash payment or shares based
on the increase in the price of the shares from a specified level over a specified period. Apart
from using share-based payments to compensate employees for their services, such
payments are also used by an employer as an incentive to the employees to remain in its
employment or to reward them for their efforts in improving its performance.
2. Recognising the need for establishing uniform sound accounting principles and practices
for all types of share-based payments, the Accounting Standards Board of the Institute of
Chartered Accountants of India is developing an Accounting Standard covering various types
of share-based payments including employee share-based payments. However, as the
formulation of the Standard is likely to take some time, the Institute has decided to bring out
this Guidance Note. The Guidance Note recognises that there are two methods of accounting
for employee share-based payments, viz., the fair value method and the intrinsic value method
and permits as an alternative the intrinsic value method with fair value disclosures. Once the
Accounting Standard dealing with Sharebased Payments comes into force, this Guidance Note
will automatically stand withdrawn.
SCOPE
3. This Guidance Note establishes financial accounting and reporting principles for
employee share-based payment plans, viz., ESOPs, ESPPs and stock appreciation rights. For
the purposes of this Guidance Note, the term ‘employee’ includes a director of the enterprise,
whether whole time or not.
4. For the purposes of this Guidance Note, a transfer of shares or stock options of an
enterprise by its shareholders to its employees is also an employee share-based payment,
unless the transfer is clearly for a purpose other than payment for services rendered to the
enterprise. This also applies to transfers of shares or stock options of the parent of the
enterprise, or shares or stock options of another enterprise in the same group1 as the
enterprise, to the employees of the enterprise.
5. For the purposes of this Guidance Note, a transaction with an employee in his/her
capacity as a holder of shares of the enterprise is not an employee share-based payment. For
example, if an enterprise grants all holders of a particular class of its shares the right to
acquire additional shares or stock options of the enterprise at a price that is less than the fair
value of those shares or stock options, and an employee receives such a right because he/she
is a holder of shares or stock options of that particular class, the granting or exercise of that
right is not subject to the requirements of this Guidance Note.
6. For the purposes of this Guidance Note, a grant of shares to the employees at the time of
public issue is not an employee share-based payment if the price and other terms at which the
shares are offered to employees are the same or similar to those at which the shares have
been offered to general investors, for example, in a public issue an enterprise grants shares to
its employees as a preferential allotment while the price and other terms remain the same as
those to other investors.
DEFINITIONS
7. For the purpose of this Guidance Note, the following terms are used with the meanings
specified:
Employee Stock Option is a contract that gives the employees of the enterprise the right, but
not the obligation, for a specified period of time to purchase or subscribe to the shares of the
enterprise at a fixed or determinable price.
Employee Stock Option Plan is a plan under which the enterprise grants Employee Stock
Options.
Employee Stock Purchase Plan is a plan under which the enterprise offers shares to its
employees as part of a public issue or otherwise.
Equity is the residual interest in the assets of an enterprise after deducting all its liabilities.
Exercise means making of an application by the employee to the enterprise for issue of shares
against the option vested in him in pursuance of the Employee Stock Option Plan.
Exercise Period is the time period after vesting within which the employee should exercise his
right to apply for shares against the option vested in him in pursuance of the Employee Stock
Option Plan.
Expected Life of an Option is the period of time from grant date to the date on which an option
is expected to be exercised.
Exercise Price is the price payable by the employee for exercising the option granted to him in
pursuance of the Employee Stock Option Plan.
Fair Value is the amount for which stock option granted or a share offered for purchase could
be exchanged between knowledgeable, willing parties in an arm’s length transaction.
Grant Date is the date at which the enterprise and its employees agree to the terms of an
employee share-based payment plan. At grant date, the enterprise confers on the employees
the right to cash or shares of the enterprise, provided the specified vesting conditions, if any,
are met. If that agreement is subject to an approval process, (for example, by shareholders),
grant date is the date when that approval is obtained.
Intrinsic Value is the amount by which the quoted market price of the underlying share in case
of a listed enterprise or the value of the underlying
Accounting for share determined by an independent valuer in case of an unlisted enterprise,
exceeds the exercise price of an option.
Market Condition is a condition upon which the exercise price, vesting or exercisability of a
share or a stock option depends that is related to the market price of the shares of the
enterprise, such as attaining a specified share price or a specified amount of intrinsic value of
a stock option, or achieving a specified target that is based on the market price of the shares
of the enterprise relative to an index of market prices of shares of other enterprises.
Reload Feature is a feature that provides for an automatic grant of additional stock options
whenever the option holder exercises previously granted options using the shares of the
enterprise, rather than cash, to satisfy the exercise price.
Reload Option is a new stock option granted when a share of the enterprise is used to satisfy
the exercise price of a previous stock option.
Repricing of an employee stock option means changing the existing exercise price of the
option to a different price.
Stock Appreciation Rights are the rights that entitle the employees to receive cash or shares
for an amount equivalent to any excess of the market value of a stated number of enterprise’s
shares over a stated price. The form of payment may be specified when the rights are granted
or may be determined when they are exercised; in some plans, the employee may choose the
form of payment.
Vest is to become entitled to receive cash or shares on satisfaction of any specified vesting
conditions under an employee share-based payment plan.
Vesting Period is the period between the grant date and the date on which all the specified
vesting conditions of an employee share-based payment plan are to be satisfied.
Vesting Conditions are the conditions that must be satisfied for the employee to become
entitled to receive cash, or shares of the enterprise, pursuant to an employee share-based
payment plan. Vesting conditions include service conditions, which require the employee to
complete a specified period of service, and performance conditions, which require specified
performance targets to be met (such as a specified increase in the enterprise’s share price
over a specified period of time).
Volatility is a measure of the amount by which a price has fluctuated (historical volatility) or is
expected to fluctuate (expected volatility) during a period. The volatility of a share price is the
standard deviation of the continuously compounded rates of return on the share over a
specified period.
ACCOUNTING
8. For accounting purposes, employee share-based payment plans are classified into the
following categories:
(a) Equity-settled: Under these plans, the employees receive shares.
(b) Cash-settled: Under these plans, the employees receive cash based on the price (or
value) of the enterprise’s shares.
(c) Employee share-based payment plans with cash alternatives: Under these plans, either
the enterprise or the employee has a choice of whether the enterprise settles the
payment in cash or by issue of shares.
9. A share-based payment plan falling in the above categories can be accounted for by
adopting the fair value method or the intrinsic value method. The accounting treatment
recommended hereinbelow is based on the fair value method. The application of the intrinsic
value method is explained thereafter in paragraph 40.
EQUITY-SETTLED EMPLOYEE SHARE-BASED PAYMENT PLANS

Recognition
10. An enterprise should recognise as an expense (except where service received qualifies
to be included as a part of the cost of an asset) the services received in an equity-settled
employee share-based payment plan when it receives the services, with a corresponding
credit to an appropriate equity account, say, ‘Stock Options Outstanding Account’. This
account is transitional in nature as it gets ultimately transferred to another equity account such
as share capital, securities premium account and/or general reserve as recommended in the
subsequent paragraphs of this Guidance Note.

11. If the shares or stock options granted vest immediately, the employee is not required to
complete a specified period of service before becoming unconditionally entitled to those
instruments. In the absence of evidence to the contrary, the enterprise should presume that
services rendered by the employee as consideration for the instruments have been received.
In this case, on the grant date, the enterprise should recognise services received in full with a
corresponding credit to the equity account.
12. If the shares or stock options granted do not vest until the employee completes a
specified period of service, the enterprise should presume that the services to be rendered by
the employee as consideration for those instruments will be received in the future, during the
vesting period. The enterprise should account for those services as they are rendered by the
employee during the vesting period, on a time proportion basis, with a corresponding credit to
the equity account.
Determination of vesting period
13. A grant of shares or stock options to an employee is typically conditional on the
employee remaining in the employment of the enterprise for a specified period of time. Thus, if
an employee is granted stock options conditional upon completing three years’ service, then
the enterprise should presume that the services to be rendered by the employee as
consideration for the stock options will be received in the future, over that three-year vesting
period.
14. There might be performance conditions that must be satisfied, such as the enterprise
achieving a specified growth in profit or a specified increase in the share price of the
enterprise. Thus, if an employee is granted stock options conditional upon the achievement of
a performance condition and remaining in the employment of the enterprise until that
performance condition is satisfied, and the length of the vesting period varies depending on
when that performance condition is satisfied, the enterprise should presume that the services
to be rendered by the employee as consideration for the stock options will be received in the
future, over the expected vesting period. The enterprise should estimate the length of the
expected vesting period at grant date, based on the most likely outcome of the performance
condition. If the performance condition is a market condition, the estimate of the length of the
expected vesting period should be consistent with the assumptions used in estimating the fair
value of the options granted, and should not be subsequently revised. If the performance
condition is not a market condition, the enterprise should revise its estimate of the length of
the vesting period, if necessary, if subsequent information indicates that the length of the
vesting period differs from previous estimates.
Measurement
15. Typically, shares (under ESPPs) or stock options (under ESOPs) are granted to
employees as part of their remuneration package, in addition to a cash salary and other
employment benefits. Usually, it is not possible to measure directly the services received for
particular components of the employee’s remuneration package. It might also not be possible
to measure the fair value of the total remuneration package independently, without measuring
directly the fair value of the shares or stock options granted. Furthermore, shares or stock
options are sometimes granted as part of a bonus arrangement, rather than as a part of basic
pay, e.g., as an incentive to the employees to remain in the employment of the enterprise or to
reward them for their efforts in improving the performance of the enterprise. By granting
shares or stock options, in addition to other remuneration, the enterprise is paying additional
remuneration to obtain additional benefits. Estimating the fair value of those additional
benefits is likely to be difficult. Because of the difficulty of measuring directly the fair value of
the services received, the enterprise should measure the fair value of the employee services
received by reference to the fair value of the shares or stock options granted.
Determining the fair value of shares or stock options granted
16. An enterprise should measure the fair value of shares or stock options granted at the
grant date, based on market prices if available, taking into account the terms and conditions
upon which those shares or stock options were granted (subject to the requirements of
paragraphs 18 to 21). If market prices are not available, the enterprise should estimate the fair
value of the instruments granted using a valuation technique to estimate what the price of
those instruments would have been on the grant date in an arm’s length transaction between
knowledgeable, willing parties. The valuation technique should be consistent with generally
accepted valuation methodologies for pricing financial instruments (e.g., use of an option
pricing model for valuing stock options) and should incorporate all factors and assumptions
that knowledgeable, willing market participants would consider in setting the price (subject to
the requirements of paragraphs 18 to 21).
17. Appendix I contains further guidance on the measurement of the fair value of shares and
stock options, focusing on the specific terms and conditions that are common features of a
grant of shares or stock options to employees.
Treatment of vesting conditions
18. Vesting conditions, other than market conditions, should not be taken into account when
estimating the fair value of the shares or stock options at the grant date. Instead, vesting
conditions should be taken into account by adjusting the number of shares or stock options
included in the measurement of the transaction amount so that, ultimately, the amount
recognised for employee services received as consideration for the shares or stock options
granted is based on the number of shares or stock options that eventually vest. Hence, on a
cumulative basis, no amount is recognized for employee services received if the shares or
stock options granted do not vest because of failure to satisfy a vesting condition (i.e., these
are forfeited2 ), e.g., the employee fails to complete a specified service period, or a
performance condition is not satisfied, subject to the requirements of paragraph 20.
19. To apply the requirements of paragraph 18, the enterprise should recognise an amount
for the employee services received during the vesting period based on the best available
estimate of the number of shares or stock options expected to vest and should revise that
estimate, if necessary, if subsequent information indicates that the number of shares or stock
options expected to vest differs from previous estimates. On vesting date, the enterprise
should revise the estimate to equal the number of shares or stock options that ultimately vest,
subject to the requirements of paragraph 20.
2The term ‘forfeiture’ is used to refer only to an employee’s failure to earn a vested right to obtain
shares or stock options because the specified vesting conditions are not satisfied.
20. Market conditions, such as a target share price upon which vesting (or exercisability) is
conditioned, should be taken into account when estimating the fair value of the shares or stock
options granted. Therefore, for grants of shares or stock options with market conditions, the
enterprise should recognise the services received from an employee who satisfies all other
vesting conditions (e.g., services received from an employee who remains in service for the
specified period of service), irrespective of the fact whether that market condition is satisfied.
Treatment of a reload feature
21. For options with a reload feature, the reload feature should not be taken into account
when estimating the fair value of options granted at the grant date. Instead, a reload option
should be accounted for as a new option grant, if and when a reload option is subsequently
granted.
After vesting date
22. On exercise of the right to obtain shares or stock options, the enterprise issues shares on
receipt of the exercise price. The shares so issued should be considered to have been issued
at the consideration comprising the exercise price and the corresponding amount standing to
the credit of the relevant equity account (e.g., Stock Options Outstanding Account). In a
situation where the right to obtain shares or stock option expires unexercised, the balance
standing to the credit of the relevant equity account should be transferred to general reserve.
Appendix II contains various illustrations of the accounting for equity settled employee share-
based payment plans that do not involve modifications to the terms and conditions of the
grants.
Modifications to the terms and conditions on which shares or stock options were
granted, including cancellations and settlements
23. An enterprise might modify the terms and conditions on which the shares or stock options
were granted. For example, it might reduce the exercise price of options granted to employees
(i.e., reprice the options), which increases the fair value of those options.
24. The enterprise should recognise, as a minimum, the services received measured at the
grant date fair value of the shares or stock options granted, unless those shares or stock
options do not vest because of failure to satisfy a vesting condition (other than a market
condition) that was specified at grant date. This applies irrespective of (a) any modifications to
the terms and conditions on which the shares or stock options were granted, or (b) a
cancellation or settlement of that grant of shares or stock options. In addition, the enterprise
should recognise the effects of modifications that increase the total fair value of the employee
share-based payment plan or are otherwise beneficial to the employee.
25. The requirements of paragraph 24 should be applied as follows:
(a) If the modification increases the fair value of the shares or stock options granted (e.g., by
reducing the exercise price), measured immediately before and after the modification, the
enterprise should include the incremental fair value granted in the measurement of the amount
recognised for services received as consideration for the shares or stock options granted. The
incremental fair value granted is the difference between the fair value of the modified shares
or stock options and that of the original shares or stock options, both estimated as at the date
of the modification. If the modification occurs during the vesting period, the incremental fair
value granted is included in the measurement of the amount recognised for services received
over the period from the modification date until the date when the modified shares or stock
options vest, in addition to the amount based on the grant date fair value of the original shares
or stock options, which is recognized over the remainder of the original vesting period. If the
modification occurs after the vesting date, the incremental fair value granted is recognised
immediately, or over the vesting period if the employee is required to complete an additional
period of service before becoming unconditionally entitled to those modified shares or stock
options.
(b) Similarly, if the modification increases the number of shares or stock options granted, the
enterprise should include the fair value of the additional shares or stock options granted,
measured at the date of the modification, in the measurement of the amount recognised for
services received as consideration for the shares or stock options granted, consistent with the
requirements in (a) above. For example,
if the modification occurs during the vesting period, the fair value of the additional shares or
stock options granted is included in the measurement of the amount recognised for services
received over the period from the modification date until the date when the additional shares
or stock options vest, in addition to the amount based on the grant date fair value of the
shares or stock options originally granted, which is recognised over the remainder of the
original vesting period.
(c) If the enterprise modifies the vesting conditions in a manner that is beneficial to the
employee, for example, by reducing the vesting period or by modifying or eliminating a
performance condition (other than a market condition, changes to which are accounted for in
accordance with (a) above), the enterprise should take the modified vesting conditions into
account when applying the requirements of paragraphs 18 to 20.
26. Furthermore, to apply the requirements of paragraph 24, if the enterprise modifies the
terms or conditions of the shares or stock options granted in a manner that reduces the total
fair value of the employee share-based payment plan, or is not otherwise beneficial to the
employee, the enterprise should nevertheless continue to account for the services received as
consideration for the shares or stock options granted as if that modification had not occurred
(other than a cancellation of some or all the shares or stock options granted, which should be
accounted for in accordance with paragraph 27). For example:
(a) if the modification reduces the fair value of the shares or stock options granted,
measured immediately before and after the modification, the enterprise should not take into
account that decrease in fair value and should continue to measure the amount recognised for
services received as consideration for the shares or stock options based on the grant date fair
value of the shares or stock options granted.
(b) if the modification reduces the number of shares or stock options granted to an
employee, that reduction should be accounted for as a cancellation of that portion of the grant,
in accordance with the requirements of paragraph 27.
(c) if the enterprise modifies the vesting conditions in a manner that is not beneficial to the
employee, for example, by increasing the vesting period or by modifying or adding a
performance condition (other than a market condition, changes to which are accounted for in
accordance with (a) above), the enterprise should not take the modified vesting conditions into
account when applying the requirements of paragraphs 18 to 20.
27. If the enterprise cancels or settles a grant of shares or stock options during the vesting
period (other than a grant cancelled by forfeiture when the vesting conditions are not
satisfied):
(a) the enterprise should account for the cancellation or settlement as an acceleration of
vesting, and should therefore recognize immediately the amount that otherwise would have
been recognised for services received over the remaining vesting period.
(b) any payment made to the employee on the cancellation or settlement of the grant should
be deducted from the relevant equity account (e.g., Stock Options Outstanding Account)
except to the extent that the payment exceeds the fair value of the shares or stock options
granted, measured at the cancellation/settlement date. Any such excess should be recognised
as an expense.
(c) if new shares or stock options are granted to the employee as replacement for the
cancelled shares or stock options, the enterprise should account for the granting of
replacement shares or stock options in the same way as a modification of the original grant of
shares or stock options, in accordance with paragraphs 24 to 26. For the purposes of the
aforesaid paragraphs, the incremental fair value granted is the difference between the fair
value of the replacement shares or stock options and the net fair value of the cancelled shares
or stock options, at the date the replacement shares or stock options are granted. The net fair
value of the cancelled shares or stock options is their fair value, immediately before the
cancellation, less the amount of any payment made to the employee on cancellation of the
shares or stock options that is deducted from the relevant equity account in accordance with
(b) above.
28. If an enterprise settles in cash vested shares or stock options, the payment made to the
employee should be accounted for as a deduction from the relevant equity account (e.g.,
Stock Options Outstanding Account) except to the extent that the payment exceeds the fair
value of the shares or stock options, measured at the settlement date. Any such excess
should be recognised as an expense.
Appendix III contains illustrations on modifications to the terms and conditions on which stock
options were granted.
CASH-SETTLED EMPLOYEE SHARE-BASED PAYMENT PLANS

29. An enterprise might grant rights such as stock appreciation rights to employees as part of
their remuneration package, whereby the employees will become entitled to a future cash
payment (rather than shares), based on the increase in the share price of the enterprise from
a specified level over a specified period of time. Or an enterprise might grant to its employees
a right to receive a future cash payment by granting to them a right to shares (including shares
to be issued upon the exercise of stock options) that are redeemable, either mandatorily (e.g.,
upon cessation of employment) or at the option of the employee.
Recognition
30. An enterprise should recognise as an expense (except where service received qualifies
to be included as a part of the cost of an asset) the services received in a cash-settled
employee share-based payment plan when it receives the services with a corresponding
increase in liability by creating a provision therefor.
31. The enterprise should recognise the services received, and the liability to pay for those
services, as the employees render service. For example, some stock appreciation rights vest
immediately, and the employees are therefore not required to complete a specified period of
service to become entitled to the cash payment. In the absence of evidence to the contrary,
the enterprise should presume that the services rendered by the employees in exchange for
the stock appreciation rights have been received. Thus, the enterprise should recognise
immediately the services received and a liability to pay for them. If the stock appreciation
rights do not vest until the employees have completed a specified period of service, the
enterprise should recognise the services received, and a liability to pay for them, as the
employees render service during that period.
Measurement
32. For cash-settled employee share-based payment plan, the enterprise should measure
the services received and the liability incurred at the fair value of the liability. Until the liability
is settled, the enterprise should remeasure the fair value of the liability at each reporting date
and at the date of the settlement, with any changes in fair value recognised in profit or loss for
the period.
33. The liability should be measured, initially and at each reporting date until settled, at the
fair value of the stock appreciation rights, by applying an option pricing model taking into
account the terms and conditions on which the stock appreciation rights were granted, and the
extent to which the employees have rendered service to date.
Appendix IV contains an illustration of a cash-settled employee share based payment plan.
EMPLOYEE SHARE-BASED PAYMENT PLANS WITH CASH
ALTERNATIVES
Employee share-based payment plans in which the terms of the arrangement provide
the employee with a choice of settlement
34. If an enterprise has granted the employees the right to choose whether a share-based
payment plan is settled in cash or by issuing shares, the plan has two components, viz., (i)
liability component, i.e., the employees’ right to demand settlement in cash, and (ii) equity
component, i.e., the employees’ right to demand settlement in shares rather than in cash. The
enterprise should first measure, on the grant date, fair value of the employee share-based
payment plan presuming that all employees will exercise their option in favour of cash
settlement. The fair value so arrived at should be considered as the fair value of the liability
component. The enterprise should also measure the fair value of the employee share-based
payment plan presuming that all employees will exercise their option in favour of equity
settlement. In case the fair value under equity- settlement is greater than the fair value under
cash settlement, the excess should be considered as the fair value of the equity component.
Otherwise, the fair value of the equity component should be considered as zero. The fair value
of the equity component should be accounted for in accordance with the recommendations in
respect of ‘Equity-settled employee share-based payment plan’. The fair value of the liability
component should be accounted for in accordance with the recommendations in respect of
‘Cash-settled employee share-based payment plan’.
35. At the date of settlement, the enterprise should remeasure the liability to its fair value. If
the enterprise issues shares on settlement rather than paying cash, the amount of liability
should be treated as the consideration for the shares issued.
36. If the enterprise pays in cash on settlement rather than issuing shares, that payment
should be applied to settle the liability in full. By electing to receive cash on settlement, the
employees forgo their right to receive shares. The enterprise should transfer any balance in
the relevant equity account (e.g., Stock Options Outstanding Account) to general reserve.
Appendix V contains an illustration of an employee share-based payment plan with cash
alternatives.
Employee share-based payment plans in which the terms of the arrangement provide
the enterprise with a choice of settlement
37. For an employee share-based payment plan in which the terms of the arrangement
provide the enterprise with the choice of whether to settle in cash or by issuing shares, the
enterprise should determine whether it has a present obligation to settle in cash and account
for the sharebased payment plan accordingly. The enterprise has a present obligation to settle
in cash if the choice of settlement in shares has no commercial substance (e.g., because the
enterprise is legally prohibited from issuing shares), or the enterprise has a past practice or a
stated policy of settling in cash, or generally settles in cash whenever the employee asks for
cash settlement.
38. If the enterprise has a present obligation to settle in cash, it should account for the
transaction in accordance with the requirements in respect of ‘Cash-settled employee share-
based payment plan’.
39. If no such obligation exists, the enterprise should account for the transaction in
accordance with the requirements in respect of ‘Equitysettled employee share-based payment
plan’. Upon settlement:
(a) If the enterprise elects to settle in cash, the cash payment should be accounted for as a
deduction from the relevant equity account (e.g., Stock Options Outstanding Account) except
as noted in (c) below.
(b) If the enterprise elects to settle by issuing shares, the balance in the relevant equity
account should be treated as consideration for the shares issued except as noted in (c) below.
(c) If the enterprise elects the settlement alternative with the higher fair value (e.g., the
enterprise elects to settle in cash the amount of which is more than the fair value of the shares
had the enterprise elected to settle in shares), as at the date of settlement, the enterprise
should recognise an additional expense for the excess value given, i.e., the difference
between the cash paid and the fair value of the shares that would otherwise have been issued,
or the difference between the fair value of the shares issued and the amount of cash that
would otherwise have been paid, whichever is applicable.
INTRINSIC VALUE METHOD

40. Accounting for employee share-based payment plans dealt with heretobefore is based on
the fair value method. There is another method known as the ‘Intrinsic Value Method’ for
valuation of employee sharebased payment plans. Intrinsic value, in the case of a listed
company, is the amount by which the quoted market price of the underlying share exceeds the
exercise price of an option. For example, an option with an exercise price of Rs. 100 on an
equity share whose current quoted market price is Rs. 125, has an intrinsic value of Rs. 25 per
share on the date of its valuation. If the quoted market price is not available on the grant date
then the share price nearest to that date is taken. In the case of a nonlisted company, since
the shares are not quoted on a stock exchange, value of its shares is determined on the basis
of a valuation report from an independent valuer. For accounting for employee share-based
payment plans, the intrinsic value may be used, mutatis mutandis, in place of the fair value as
described in paragraphs 10 to 39.
Examples of equity-settled employee share-based payment plan and cashsettled employee
share-based payment plan, using intrinsic value method, are given in Illustration 1 of Appendix
II and the Illustration in Appendix IV, respectively.
RECOMMENDATION
41. It is recommended that accounting for employee share-based payment plans should be
based on the fair value approach as described in paragraphs 10 to 39. However, intrinsic
value method as described in paragraph 40 is also permitted.
GRADED VESTING
42. In case the options/shares granted under an employee stock option plan do not vest on
one date but have graded vesting schedule, total plan should be segregated into different
groups, depending upon the vesting dates. Each of such groups would be having different
vesting period and expected life and, therefore, each vesting date should be considered as a
separate option grant and evaluated and accounted for accordingly. For example, suppose an
employee is granted 100 options which will vest @ 25 options per year at the end of the third,
fourth, fifth and sixth years. In such a case, each tranche of 25 options would be evaluated
and accounted for separately.
An illustration of an employee share-based payment plan having graded vesting is given in
Appendix VI.
EMPLOYEE SHARE-BASED PAYMENT PLAN ADMINISTERED THROUGH A TRUST

43. An enterprise may administer an employee share-based payment plan through a trust
constituted for this purpose. The trust may have different kinds of arrangements, for example,
the following:
(a) The enterprise allots shares to the trust as and when the employees exercise stock
options.
(b) The enterprise provides finance to the trust for subscription to the shares issued by the
enterprise at the beginning of the plan.
(c) The enterprise provides finance to the trust to purchase shares from the market at the
beginning of the plan.
44. Since the trust administers the plan on behalf of the enterprise, it is recommended that
irrespective of the arrangement for issuance of the shares under the employee share-based
payment plan, the enterprise should recognise in its separate financial statements the
expense on account of services received from the employees in accordance with the
recommendations contained in this Guidance Note. Various aspects of accounting for
employee share-based payment plan administered through a trust under the arrangements
mentioned above, are illustrated in Appendix VII, for the purpose of preparation of separate
45. For the purpose of preparation of consolidated financial statements as per Accounting
Standard (AS) 21, ‘Consolidated Financial Statements’, issued by the Institute of Chartered
Accountants of India, the trust created for the purpose of administering employee share-based
compensation, should not be considered. This is because the standard requires consolidation
of only those controlled enterprises which provide economic benefits to the enterprise and,
accordingly, consolidation of entities, such as, gratuity trust, provident fund trust, etc., is not
required. The nature of a trust established for administering employee share-based
compensation plan is similar to that of a gratuity trust or a provident fund trust as it does not
provide any economic benefit to the enterprise in the form of, say, any return on investment.
EARNINGS PER SHARE IMPLICATIONS

46. For the purpose of calculating Basic Earnings Per Share as per Accounting Standard
(AS) 20, ‘Earnings Per Share’, shares or stock options granted pursuant to an employee
share-based payment plan, including shares or options issued to an ESOP trust, should not be
included in the shares outstanding till the employees have exercised their right to obtain
shares or stock options, after fulfilling the requisite vesting conditions. Till such time, shares or
stock options so granted should be considered as dilutive potential equity shares for the
purpose of calculating Diluted Earnings Per Share. Diluted Earnings Per Share should be
based on the actual number of shares or stock options granted and not yet forfeited, unless
doing so would be anti-dilutive.
47. For computations required under paragraph 35 of AS 20 with regard to shares or stock
options granted pursuant to an employee share-based payment plan, the assumed proceeds
from the issues should include the exercise price and the unamortised compensation cost
which is attributable to future services.
An example to illustrate computation of Earnings Per Share in a situation where the enterprise
has granted stock options to its employees is given in Appendix VIII.
DISCLOSURES
48. An enterprise should describe the method used to account for the employee share-based
payment plans. Where an enterprise uses the intrinsic value method, it should also disclose
the impact on the net results and EPS – both basic and diluted – for the accounting period,
had the fair value method been used.
49. An enterprise should disclose information that enables users of the financial statements
to understand the nature and extent of employee share-based payment plans that existed
during the period.

50. To give effect to the principle in paragraph 49, the enterprise should disclose at least the
following:
(a) a description of each type of employee share-based payment plan that existed at any
time during the period, including the general terms and conditions of each plan, such as
vesting requirements, the maximum term of options granted, and the method of
settlement (e.g., whether in cash or equity). An enterprise with substantially similar types
of plans may aggregate this information, unless separate disclosure of each arrangement
is necessary to satisfy the principle in paragraph 49.
(b) the number and weighted average exercise prices of stock options for each of the
following groups of options:
(i) outstanding at the beginning of the period;
(ii) granted during the period;
(iii) forfeited during the period;
(iv) exercised during the period;
(v) expired during the period;
(vi) outstanding at the end of the period; and
(vii) exercisable at the end of the period.
(c) for stock options exercised during the period, the weighted average share price at the
date of exercise. If options were exercised on a regular basis throughout the period, the
enterprise may instead disclose the weighted average share price during the period.
(d) for stock options outstanding at the end of the period, the range of exercise prices and
weighted average remaining contractual life (comprising the vesting period and the
exercise period). If the range of exercise prices is wide, the outstanding options should
be divided into ranges that are meaningful for assessing the number and timing of
additional shares that may be issued and the cash that may be received upon exercise of
those options.
51. An enterprise should disclose the following information to enable users of the financial
statements to understand how the fair value of shares or stock options granted, during the
period, was determined:
(a) for stock options granted during the period, the weighted average fair value of those
options at the grant date and information on how that fair value was measured, including:
(i) the option pricing model used and the inputs to that model, including the weighted
average share price, exercise price, expected volatility, option life (comprising the
vesting period and the exercise period), expected dividends, the risk-free interest
rate and any other inputs to the model, including the method used and the
assumptions made to incorporate the effects of expected early exercise;
(ii) how expected volatility was determined, including an explanation of the extent to
which expected volatility was based on historical volatility; and
(iii) whether and how any other features of the option grant were incorporated into the
measurement of fair value, such as a market condition.
(b) for other instruments granted during the period (i.e., other than stock options), the
number and weighted average fair value of those instruments at the grant date, and
information on how that fair value was measured, including:
(i) if fair value was not measured on the basis of an observable market price, how it
was determined;
(ii) whether and how expected dividends were incorporated into the measurement of
fair value; and
(iii) whether and how any other features of the instruments granted were incorporated
into the measurement of fair value.
(c) for employee share-based payment plans that were modified during the period:
(i) an explanation of those modifications;
(ii) the incremental fair value granted (as a result of those modifications); and
(iii) information on how the incremental fair value granted was measured, consistently
with the requirements set out in (a) and (b) above, where applicable.
52. An enterprise should disclose the following information to enable users of the financial
statements to understand the effect of employee share-based payment plans on the profit or
loss of the enterprise for the period and on its financial position:
(a) the total expense recognised for the period arising from employee share-based payment
plans in which the services received did not qualify for recognition as a part of the cost of
an asset and hence were recognised immediately as an expense, including separate
disclosure of that portion of the total expense that arises from transactions accounted for
as equity-settled employee share-based payment plans;
(b) for liabilities arising from employee share-based payment plans:
(i) the total carrying amount at the end of the period; and
(ii) the total intrinsic value at the end of the period of liabilities for which the right of the
employee to cash or other assets had vested by the end of the period (e.g., vested
stock appreciation rights).
Appendix IX contains illustrative disclosures.
EFFECTIVE DATE
53. This Guidance Note applies to employee share-based payment plans the grant date in
respect of which falls on or after April 1, 2005.
APPENDIX I
ESTIMATING THE FAIR VALUE OF SHARES OR STOCK OPTIONS GRANTED

1. The appendix discusses measurement of the fair value of shares and stock options
granted, focusing on the specific terms and conditions that are common features of a grant of
shares or stock options to employees. Therefore, it is not exhaustive.
SHARES
2. The fair value of the shares granted should be measured at the market price of the
shares of the enterprise (or an estimated value based on the valuation report of an
independent valuer, if the shares of the enterprise are not publicly traded), adjusted to take
into account the terms and conditions upon which the shares were granted (except for vesting
conditions that are excluded from the measurement of fair value in accordance with
paragraphs 18 to 20 of the text of the Guidance Note).
3. For example, if the employee is not entitled to receive dividends during the vesting
period, this factor should be taken into account when estimating the fair value of the shares
granted. Similarly, if the shares are subject to restrictions on transfer after vesting date, that
factor should be taken into account, but only to the extent that the post-vesting restrictions
affect the price that a knowledgeable, willing market participant would pay for that share. For
example, if the shares are actively traded in a deep and liquid market, post-vesting transfer
restrictions may have little, if any, effect on the price that a knowledgeable, willing market
participant would pay for those shares. Restrictions on transfer or other restrictions that exist
during the vesting period should not be taken into account when estimating the grant date fair
value of the shares granted, because those restrictions stem from the existence of vesting
conditions, which are accounted for in accordance with paragraphs 18 to 20 of the text of the
Guidance Note.
STOCK OPTIONS
4. For stock options granted to employees, in many cases market prices are not available,
because the options granted are subject to terms and conditions that do not apply to traded
options. If traded options with similar terms and conditions do not exist, the fair value of the
options granted should be estimated by applying an option pricing model.
5. The enterprise should consider factors that knowledgeable, willing market participants
would consider in selecting the option pricing model to apply. For example, many employee
options have long lives, are usually exercisable during the period between vesting date and
the end of the life of the option, and are often exercised early. These factors should be
considered when estimating the grant date fair value of the options. For many enterprises, this
might preclude the use of the Black-Scholes-Merton formula, which does not allow for the
possibility of exercise before the end of the option’s life (comprising the vesting period and the
exercise period) and may not adequately reflect the effects of expected early exercise. It also
does not allow for the possibility that expected volatility and other model inputs might vary
over the option’s life. However, for stock options with relatively short contractual lives
(comprising the vesting period and the exercise period), or that must be exercised within a
short period of time after vesting date, the factors identified above may not apply. In these
instances, the Black-Scholes-Merton formula may produce a value that is substantially the
same as a more flexible option pricing model.
6. All option pricing models take into account, as a minimum, the following factors:
(a) the exercise price of the option;
(b) the life of the option;
(c) the current price of the underlying shares;
(d) the expected volatility of the share price;
(e) the dividends expected on the shares (if appropriate); and
(f) the risk-free interest rate for the life of the option.
7. Other factors that knowledgeable, willing market participants would consider in setting
the price should also be taken into account (except for vesting conditions and reload features
that are excluded from the measurement of fair value in accordance with paragraphs 18 to 21
of the text of the Guidance Note).
8. For example, a stock option granted to an employee typically cannot be exercised during
specified periods (e.g., during the vesting period or during periods specified, if any, by
securities regulators). This factor should be taken into account if the option pricing model
applied would otherwise assume that the option could be exercised at any time during its life.
However, if an enterprise uses an option pricing model that values options that can be
exercised only at the end of the options’ life, no adjustment is required for the inability to
exercise them during the vesting period (or other periods during the options’ life), because the
model assumes that the options cannot be exercised during those periods.
9. Similarly, another factor common to employee stock options is the possibility of early
exercise of the option, for example, because the option is not freely transferable, or because
the employee must exercise all vested options upon cessation of employment. The effects of
expected early exercise should be taken into account, as discussed in paragraphs 16 to 21 of
this Appendix.
10. Factors that a knowledgeable, willing market participant would not consider in setting the
price of a stock option should not be taken into account when estimating the fair value of stock
options granted. For example, for stock options granted to employees, factors that affect the
value of the option from the perspective of the individual employee only are not relevant to
estimating the price that would be set by a knowledgeable, willing market participant.
Inputs to option pricing models
11. In estimating the expected volatility of and dividends on the underlying shares, the
objective is to approximate the expectations that would be reflected in a current market or
negotiated exchange price for the option. Similarly, when estimating the effects of early
exercise of employee stock options, the objective is to approximate the expectations that an
outside party with access to detailed information about employees’ exercise behaviour would
develop based on information available at the grant date.
12. Often, there is likely to be a range of reasonable expectations about future volatility,
dividends and exercise behaviour. If so, an expected value should be calculated, by weighting
each amount within the range by its associated probability of occurrence.
13. Expectations about the future are generally based on experience, modified if the future is
reasonably expected to differ from the past. In some circumstances, identifiable factors may
indicate that unadjusted historical experience is a relatively poor predictor of future
experience. For example, if an enterprise with two distinctly different lines of business
disposes of the one that was significantly less risky than the other, historical volatility may not
be the best information on which to base reasonable expectations for the future.
14. In other circumstances, historical information may not be available. For example, a newly
listed enterprise will have little, if any, historical data on the volatility of its share price.
Unlisted and newly listed enterprises are discussed further below.
15. In summary, an enterprise should not simply base estimates of volatility, exercise
behaviour and dividends on historical information without considering the extent to which the
past experience is expected to be reasonably predictive of future experience.
Expected early exercise
16. Employees often exercise stock options early, for a variety of reasons. For example,
employee stock options are typically nontransferable. This often causes employees to
exercise their stock options early, because that is the only way for the employees to liquidate
their position. Also, employees who cease employment are usually required to exercise any
vested options within a short period of time, otherwise the stock options are forfeited. This
factor also causes the early exercise of employee stock options. Other factors causing early
exercise are risk aversion and lack of wealth diversification.
17. The means by which the effects of expected early exercise are taken into account
depends upon the type of option pricing model applied. For example, expected early exercise
could be taken into account by using an estimate of the expected life of the option (which, for
an employee stock option, is the period of time from grant date to the date on which the option
is expected to be exercised) as an input into an option pricing model (e.g., the Black-Scholes-
Merton formula). Alternatively, expected early exercise could be modelled in a binomial or
similar option pricing model that uses contractual life as an input.
18. Factors to consider in estimating early exercise include:
(a) the length of the vesting period, because the stock option typically cannot be
exercised until the end of the vesting period. Hence, determining the valuation
implications of expected early exercise is based on the assumption that the options
will vest. The implications of vesting conditions are discussed in paragraphs 18 to
20 of the text of the Guidance Note.
(b) the average length of time similar options have remained outstanding in the past.
(c) the price of the underlying shares. Experience may indicate that the employees tend
to exercise options when the share price reaches a specified level above the
exercise price.
(d) the employee’s level within the organisation. For example, experience might
indicate that higher-level employees tend to exercise options later than lower-level
employees (discussed further in paragraph 21 of this Appendix).
(e) expected volatility of the underlying shares. On average, employees might tend to
exercise options on highly volatile shares earlier than on shares with low volatility.
19. As noted in paragraph 17 of this Appendix, the effects of early exercise could be taken
into account by using an estimate of the option’s expected life as an input into an option
pricing model. When estimating the expected life of stock options granted to a group of
employees, the enterprise could base that estimate on an appropriately weighted average
expected life for the entire employee group or on appropriately weighted average lives for
subgroups of employees within the group, based on more detailed data about employees’
exercise behaviour (discussed further below).
20. Separating an option grant into groups for employees with relatively homogeneous
exercise behaviour is likely to be important. Option value is not a linear function of option term;
value increases at a decreasing rate as the term lengthens. For example, if all other
assumptions are equal, although a two-year option is worth more than a one-year option, it is
not worth twice as much. That means that calculating estimated option value on the basis of a
single weighted average life that includes widely differing individual lives would overstate the
total fair value of the stock options granted. Separating options granted into several groups,
each of which has a relatively narrow range of lives included in its weighted average life,
reduces that overstatement.
21. Similar considerations apply when using a binomial or similar model. For example, the
experience of an enterprise that grants options broadly to all levels of employees might
indicate that top-level executives tend to hold their options longer than middle-management
employees hold theirs and that lower-level employees tend to exercise their options earlier
than any other group. In addition, employees who are encouraged required to hold a minimum
amount of their employer’s shares or stock options, might on average exercise options later
than employees not subject to that provision. In those situations, separating options by groups
of recipients with relatively homogeneous exercise behaviour will result in a more accurate
estimate of the total fair value of the stock options granted.
Expected volatility
22. Expected volatility is a measure of the amount by which a price is expected to fluctuate
during a period. The measure of volatility used in option pricing models is the annualised
standard deviation of the continuously compounded rates of return on the share over a period
of time. Volatility is typically expressed in annualised terms that are comparable regardless of
the time period used in the calculation, for example, daily, weekly or monthly price
observations.
23. The rate of return (which may be positive or negative) on a share for a period measures
how much a shareholder has benefited from dividends and appreciation (or depreciation) of
the share price.
24 The expected annualised volatility of a share is the range within which the continuously
compounded annual rate of return is expected to fall approximately two-thirds of the time. For
example, to say that a share with an expected continuously compounded rate of return of 12
per cent has a volatility of 30 per cent means that the probability that the rate of return on the
share for one year will be between –18 per cent (12% –30%) and 42 per cent (12% + 30%) is
approximately two-thirds. If the share price is Rs.100 at the beginning of the year and no
dividends are paid, the year-end share price would be expected to be between Rs. 83.53
(Rs.100 × e–0.18) and Rs.152.20 (Rs. 100 × e0.42) approximately two-thirds of the time.
25. Factors to be considered in estimating expected volatility include:
(a) Implied volatility from traded stock options on the shares of the enterprise, or other
traded instruments of the enterprise that include option features (such as
convertible debt), if any.
(b) The historical volatility of the share price over the most recent period that is
generally commensurate with the expected term of the option (taking into account
the remaining contractual life of the option and the effects of expected early
exercise).
(c) The length of time shares of an enterprise have been publicly traded. A newly listed
enterprise might have a high historical volatility, compared with similar enterprises
that have been listed longer. Further guidance for newly listed enterprises is given
in paragraph 26 of this Appendix.

(d) The tendency of volatility to revert to its mean, i.e., its long-term average level, and
other factors indicating that expected future volatility might differ from past volatility.
For example, if share price of an enterprise was extraordinarily volatile for some
identifiable period of time because of a failed takeover bid or a major restructuring,
that period could be disregarded in computing historical average annual volatility.
(e) Appropriate and regular intervals for price observations. The price observations
should be consistent from period to period.
For example, an enterprise might use the closing price for each week or the highest price
for the week, but it should not use the closing price for some weeks and the highest price
for other weeks.
Newly listed enterprises
26. As noted in paragraph 25 of this Appendix, an enterprise should consider historical
volatility of the share price over the most recent period that is generally commensurate with
the expected option term. If a newly listed enterprise does not have sufficient information on
historical volatility, it should nevertheless compute historical volatility for the longest period for
which trading activity is available. It could also consider the historical volatility of similar
enterprises following a comparable period in their lives. For example, an enterprise that has
been listed for only one year and grants options with an average expected life of five years
might consider the pattern and level of historical volatility of enterprises in the same industry
for the first six years in which the shares of those enterprises were publicly traded.
Unlisted enterprises
27. An unlisted enterprise will not have historical information upon which to base an estimate
of expected volatility. It will therefore have to estimate expected volatility by some other
means. The enterprise could consider the historical volatility of similar listed enterprises, for
which share price or option price information is available, to use as the basis for an estimate
of expected volatility. Alternatively, volatility of unlisted enterprises can be taken as zero.
Expected dividends
28. Whether expected dividends should be taken into account when measuring the fair value
of shares or stock options granted depends on whether the employees are entitled to
dividends or dividend equivalents. For example, if employees were granted options and are
entitled to dividends on the underlying shares or dividend equivalents (which might be paid in
cash or applied to reduce the exercise price) between grant date and exercise date, the
options granted should be valued as if no dividends will be paid on the underlying shares, i.e.,
the input for expected dividends should be zero. Similarly, when the grant date fair value of
shares granted to employees is estimated, no adjustment is required for expected dividends if
the employees are entitled to receive dividends paid during the vesting period.
29. Conversely, if the employees are not entitled to dividends or dividend equivalents during
the vesting period (or before exercise, in the case of an option), the grant date valuation of the
rights to shares or options should take expected dividends into account. That is to say, when
the fair value of an option grant is estimated, expected dividends should be included in the
application of an option pricing model. When the fair value of a share grant is estimated, that
valuation should be reduced by the present value of dividends expected to be paid during the
vesting period.
30. Option pricing models generally call for expected dividend yield. However, the models
may be modified to use an expected dividend amount rather than a yield. An enterprise may
use either its expected yield or its expected payments. If the enterprise uses the latter, it
should consider its historical pattern of increases in dividends. For example, if policy of an
enterprise has generally been to increase dividends by approximately 3 per cent per year, its
estimated option value should not assume a fixed dividend amount throughout the option’s life
unless there is evidence that supports that assumption.
31. Generally, the assumption about expected dividends should be based on publicly
available information. An enterprise that does not pay dividends and has no plans to do so
should assume an expected dividend yield of zero. However, an emerging enterprise with no
history of paying dividends might expect to begin paying dividends during the expected lives of
its employee stock options. Those enterprises could use an average of their past dividend
yield (zero) and the mean dividend yield of an appropriately comparable peer group.
Risk-free interest rate

32. Typically, the risk-free interest rate is the implied yield currently available on zero-coupon
government issues, with a remaining term equal to the expected term of the option being
valued (based on the option’s remaining contractual life and taking into account the effects of
expected early exercise). It may be necessary to use an appropriate substitute, if no such
government issues exist or circumstances indicate that the implied yield on zero-coupon
government issues is not representative of the riskfree interest rate. Also, an appropriate
substitute should be used if market participants would typically determine the risk-free interest
rate by using that substitute, rather than the implied yield of zero-coupon government issues,
when estimating the fair value of an option with a life equal to the expected term of the option
being valued.
Capital structure effects
33. Typically, third parties, not the enterprise, write traded stock options. When these stock
options are exercised, the writer delivers shares to the option holder. Those shares are
acquired from existing shareholders. Hence the exercise of traded stock options has no
dilutive effect.
34. In contrast, if stock options are written by the enterprise, new shares are issued when
those stock options are exercised. Given that the shares will be issued at the exercise price
rather than the current market price at the date of exercise, this actual or potential dilution
might reduce the share price, so that the option holder does not make as large a gain on
exercise as on exercising an otherwise similar traded option that does not dilute the share
price.
35. Whether this has a significant effect on the value of the stock options granted depends
on various factors, such as the number of new shares that will be issued on exercise of the
options compared with the number of shares already issued. Also, if the market already
expects that the option grant will take place, the market may have already factored the
potential dilution into the share price at the date of grant.
36. However, the enterprise should consider whether the possible dilutive effect of the future
exercise of the stock options granted might have an impact on their estimated fair value at
grant date. Option pricing models can be adapted to take into account this potential dilutive
effect.
APPENDIX II
Equity-Settled Employee
Share-based Payment Plans
ILLUSTRATION 1 : STOCK OPTIONS WITH SERVICE
CONDITION ONLY
(A) Accounting during the vesting period
At the beginning of year 1, an enterprise grants 300 options to each of its 1,000 employees.
The contractual life (comprising the vesting period and the exercise period) of options granted
is 6 years. The other relevant terms of the grant are as below:
Vesting Period 3 years
Exercise Period 3 years
Expected Life 5 years
Exercise Price Rs. 50
Market Price Rs. 50
Expected forfeitures per year 3%
The fair value of options, calculated using an option pricing model, is Rs. 15 per option. Actual
forfeitures, during the year 1, are 5 per cent and at the end of year 1, the enterprise still
expects that actual forfeitures would average 3 per cent per year over the 3-year vesting
period. During the year 2, however, the management decides that the rate of forfeitures is
likely to continue to increase, and the expected forfeiture rate for the entire award is changed
to 6 per cent per year. It is also assumed that 840 employees have actually completed 3 years
vesting period.
Suggested Accounting Treatment
Year 1
1. At the grant date, the enterprise estimates the fair value of the options expected to vest
at the end of the vesting period as below:
No. of options expected to vest
= 300 x 1,000 x 0.97 x 0.97 x 0.97 = 2,73,802 options
Fair value of options expected to vest
= 2,73,802 options x Rs. 15 = Rs. 41,07,030
2. At the balance sheet date, since the enterprise still expects actual forfeitures to average
3 per cent per year over the 3-year vesting period, no change is required in the estimates
made at the grant date. The enterprise, therefore, recognises one-third of the amount
estimated at (1) above (i.e., Rs. 41,07,030/3) towards the employee services received by
passing the following entry:
Employee compensation expense A/c Dr. Rs. 13,69,010
To Stock Options Outstanding A/c Rs. 13,69,010
(Being compensation expense recognised in respect of the ESOP)
3. Credit balance in the ‘Stock Options Outstanding A/c’ may be disclosed in the balance
sheet under a separate heading, between ‘Share Capital’ and ‘Reserves and Surplus’.
Year 2
1. At the end of the financial year, management has changed its estimate of expected
forfeiture rate from 3 per cent to 6 per cent per year. The revised number of options expected
to vest is 2,49,175 (3,00,000 x .94 x .94 x .94). Accordingly, the fair value of revised options
expected to vest is Rs. 37,37,625 (2,49,175 x Rs. 15). Consequent to the change in the
expected forfeitures, the expense to be recognised during the year are determined as below:
Revised total fair value Rs. 37,37,625
Revised cumulative expense at the end of
year 2= (Rs. 37,37,625 x 2/3) =Rs. 24,91,750
Expense already recognised in year 1 =Rs. 13,69,010
Expense to be recognised in year 2 =Rs. 11,22,740
2. The enterprise recognises the amount determined at (1) above (i.e., Rs. 11,22,740)
towards the employee services received by passing the following entry:
Year 3
1. At the end of the financial year, the enterprise would examine its actual forfeitures and
make necessary adjustments, if any, to reflect expense for the number of options that actually
vested. Considering that 840 employees have completed three years vesting period, the
expense to be recognised during the year is determined as below:
No. of options actually vested = 840 x 300 = 2,52,000
Fair value of options actually vested

(Rs. 2,52,000 x Rs. 15) = Rs. 37,80,000
Expense already recognised Rs. 24,91,750
Expense to be recognised in year 3 Rs. 12,88,250
2. The enterprise recognises the amount determined at (1) above towards the employee
services received by passing the following entry:
(Being compensation expense recognised in respect of ESOP)
(B) Accounting at the time of exercise/expiry of the vested options
Continuing Illustration 1(A) above, the following further facts are provided:
(a) 200 employees exercise their right to obtain shares vested in them in pursuance of the
ESOP at the end of year 5 and 600 employees exercise their right at the end of year 6.
(b) Rights of 40 employees expire unexercised at the end of the contractual life of the option,
i.e., at the end of year 6.
(c) Face value of one share of the enterprise is Rs. 10.
1. On exercise of the right to obtain shares, the enterprise issues shares to the respective
employees on receipt of the exercise price. The shares so issued are considered to have been
issued on a consideration comprising the exercise price and the corresponding amount
standing to the credit of the Stock Options Outstanding Account. In the present case, the
exercise price is Rs. 50 per share and the amount of compensation expense recognised in the
‘Stock Options Outstanding A/c’ is Rs. 15 per option. The enterprise, therefore, considers the
shares to be issued at a price of Rs. 65 per share.
2. The amount to be recorded in the ‘Share Capital A/c’ and the ‘Securities Premium A/c’,
upon issuance of the shares, is calculated as below:
Particulars Exercise Date Exercise
Year-end 5 Date
Year-end 6
No. of employees exercising option 200 600

No. of shares issued on exercise @ 300per employee 60,000 1,80,000

Exercise Price received @ Rs. 50 per share 30,00,0000 1,80,000
Corresponding amount recognised in the
‘Stock Options Outstanding A/c’
@ Rs. 15 per option 9,00,000 27,00,000
Total Consideration 39,00,000 1,17,00,000
Amount to be recorded in ‘Share
Capital A/c’ @ Rs. 10 per share 6,00,000 18,00,000
Amount to be recorded in ‘Securities
Premium A/c’ @ Rs. 55 per share 33,00,000 99,00,000
Total 39,00,000 1,17,00,000
3. The enterprise passes the following entries at end of year 5 and year 6, respectively, to
record the shares issued to the employees upon exercise of options vested in them in
pursuance of the Employee Stock Option Plan:
Year 5 Bank A/c Dr. Rs. 30,00,000
Stock Options Outstanding A/c Dr. Rs. 9,00,000
To Share Capital A/c Rs. 6,00,000
To Securities Premium A/c Rs. 33,00,000
(Being shares issued to the employees against the options vested
in them in pursuance of the Employee Stock Option Plan)
Year 6 Bank A/c Dr. Rs. 90,00,000
To Securities Premium A/c Rs. 99,00,000
(Being shares issued to the employees against the options vested
in them in pursuance of the Employee Stock Option Plan)
4. At the end of year 6, the balance of Rs. 1,80,000 (i.e., 40 employees x 300 options x Rs.
15 per option) standing to the credit of the Stock Options Outstanding Account, in respect of
vested options expiring unexercised, is transferred to general reserve by passing the following
entry:
To General Reserve Rs. 1,80,000
(Being the balance standing to the credit of the Stock Options
Outstanding Account, in respect of vested options expired unexercised, transferred to the

general reserve)
(C) Intrinsic Value Method
The accounting treatment suggested in Illustrations 1(A) and 1(B) above is based on the fair
value method. In case the enterprise follows the intrinsic value method instead of the fair
value method, it would not recognise any compensation expense since the market price of the
underlying share at the grant date is the same as the exercise price and the intrinsic value of
the options is nil. However, in case the market price of the underlying share at the grant date
is more than the exercise price, say, Rs. 52 per share, then the difference of Rs. 2 between
the market value and the exercise price would be the intrinsic value of the option. In such a
case, the enterprise would treat the said intrinsic value as compensation expense over the
vesting period on the lines of Illustrations 1(A) and 1(B) above.
ILLUSTRATION 2: GRANT WITH A PERFORMANCE CONDITION, IN WHICH THE LENGTH

OF THE VESTING
PERIOD VARIES
At the beginning of year 1, the enterprise grants 100 stock options to each of its 500
employees, conditional upon the employees remaining in the employment of the enterprise
during the vesting period. The options will vest at the end of year 1 if the earnings of the
enterprise increase by more than 18 per cent; at the end of year 2 if the earnings of the
enterprise increase by more than an average of 13 per cent per year over the twoyear period;
and at the end of year 3 if the earnings of the enterprise increase by more than an average of
10 per cent per year over the three year period. The fair value of the options, calculated at the
grant date using an option pricing model, is Rs. 30 per option. No dividends are expected to
be paid over the three-year period.
By the end of year 1, the earnings of the enterprise have increased by 14 per cent, and 30
employees have left. The enterprise expects that earnings will continue to increase at a similar
rate in year 2, and, therefore, expects that the options will vest at the end of year 2. The
enterprise expects, on the basis of a weighted average probability, that a further 30
employees will leave during year 2, and, therefore, expects that options will vest in 440
employees at the end of year 2.
By the end of year 2, the earnings of the enterprise have increased by only 10 per cent and,
therefore, the options do not vest at the end of year 2. 28 employees have left during the year.
The enterprise expects that a further 25 employees will leave during year 3, and that the
earnings of the enterprise will increase by at least 6 per cent, thereby achieving the average of
10 per cent per year.
By the end of year 3, 23 employees have left and the earnings of the enterprise have
increased by 8 per cent, resulting in an average increase of 10.67 per cent per year.
Therefore, 419 employees received 100 shares each at the end of year 3.
1. In the given case, the length of the vesting period varies, depending on when the
performance condition is satisfied. In such a situation, as per paragraph 14 of the text of the
Guidance Note, the enterprise estimates the length of the expected vesting period, based on
the most likely outcome of the performance condition, and revises that estimate, if necessary,
if subsequent information indicates that the length of the vesting period is likely to differ from
previous estimates.
2. The enterprise determines the compensation expense to be recognised each year as
below:
Particulars Year 1 Year 2 Year 3
Length of the expected vesting period 2 years 3 years 3 years
(at the end of the year)
No. of employees expected to meet 440 417 419
vesting conditions employees employees employees
No. of options expected to vest 44,000 41,700 41,900
Fair value of options expected to vest @ 13,20,000 12,51,000 12,57,000
Rs. 30 per option (Rs.)
Compensation expense accrued till the 6,60,000 8,34,000 12,57,000
end of year (Rs.) [13,20,000/2] (12,51,000 * 2/3)
Compensation expense recognised till Nil 6,60,000 8,34,000
the end of previous year (Rs.)
Compensation expense to be 6,60,000 1,74,000 4,23,000
recognized for the year (Rs.)
ILLUSTRATION 3 : GRANT WITH A PERFORMANCE CONDITION, IN WHICH THE

NUMBER OF STOCK OPTIONS VARIES
At the beginning of year 1, an enterprise grants stock options to each of its 100 employees
working in the sales department. The stock options will vest at the end of year 3, provided that
the employees remain in the employment of the enterprise, and provided that the volume of
sales of a particular product increases by at least an average of 5 per cent per year. If the
volume of sales of the product increases by an average of between 5 per cent and 10 per cent
per year, each employee will receive 100 stock options. If the volume of sales increases by an
average of between 10 per cent and 15 per cent each year, each employee will receive 200
stock options. If the volume of sales increases by an average of 15 per cent or more, each
employee will receive 300 stock options.
On the grant date, the enterprise estimates that the stock options have a fair value of Rs. 20
per option. The enterprise also estimates that the volume of sales of the product will increase
by an average of between 10 per cent and 15 per cent per year, and therefore expects that,
for each employee who remains in service until the end of year 3, 200 stock options will vest.
The enterprise also estimates, on the basis of a weighted average probability, 20 per cent of
employees will leave before the end of year 3.
By the end of year 1, seven employees have left and the enterprise still expects that a total of
20 employees will leave by the end of year 3. Hence, the enterprise expects that 80
employees will remain in service for the three-year period. Product sales have increased by 12
per cent and the enterprise expects this rate of increase to continue over the next 2 years.
By the end of year 2, a further five employees have left, bringing the total to 12 to date. The
enterprise now expects that only three more employees will leave during year 3, and therefore
expects that a total of 15 employees will have left during the three-year period, and hence 85
employees are expected to remain. Product sales have increased by 18 per cent, resulting in
an average of 15 per cent over the two years to date. The enterprise now expects that sales
increase will average 15 per cent or more over the three-year period, and hence expects each
sales employee to receive 300 stock options at the end of year 3.
By the end of year 3, a further two employees have left. Hence, 14 employees have left during
the three-year period, and 86 employees remain. The sales of the enterprise have increased
by an average of 16 per cent over the three years. Therefore, each of the 86 employees
receives 300 stock options.
Since the number of options varies depending on the outcome of a performance condition that
is not a market condition, the effect of that condition (i.e., the possibility that the number of
stock options might be 100, 200 or 300) is not taken into account when estimating the fair
value of the stock options at grant date. Instead, the enterprise revises the transaction amount
to reflect the outcome of that performance condition, as illustrated below.
Year Calculation Compensation Cumulative
expense for compensation
period (Rs.) expense (Rs.)
1. 80 employees × 200 options × Rs. 20 × 1/3 1,06,667 1,06,667
2. (85 employees × 300 options × Rs. 20 × 2/3) 2,33,333 3,40,000
Rs. 1,06,667 –
3. (86 employees × 300 options × Rs. 20 × 3/3) – 1,76,000 5,16,000
Rs. 3,40,000
ILLUSTRATION 4: GRANT WITH A PERFORMANCE CONDITION, IN WHICH THE

EXERCISE PRICE VARIES
At the beginning of year 1, an enterprise grants 10,000 stock options to a senior executive,
conditional upon the executive remaining in the employment of the enterprise until the end of
year 3. The exercise price is Rs. 40. However, the exercise price drops to Rs. 30 if the
earnings of the enterprise increase by at least an average of 10 per cent per year over the
three-year period.
On the grant date, the enterprise estimates that the fair value of the stock options, with an
exercise price of Rs. 30, is Rs. 16 per option. If the exercise price is Rs. 40, the enterprise
estimates that the stock options have a fair value of Rs. 12 per option. During year 1, the
earnings of the enterprise increased by 12 per cent, and the enterprise expects that earnings
will continue to increase at this rate over the next two years. The enterprise, therefore,
expects that the earnings target will be achieved, and hence the stock options will have an
exercise price of Rs. 30. During year 2, the earnings of the enterprise increased by 13 per
cent, and the enterprise continues to expect that the earnings target will be achieved.
During year 3, the earnings of the enterprise increased by only 3 per cent, and therefore the
earnings target was not achieved. The executive completes three years’ service, and therefore
satisfies the service condition. Because the earnings target was not achieved, the 10,000
vested stock options have an exercise price of Rs. 40.
Because the exercise price varies depending on the outcome of a performance condition that
is not a market condition, the effect of that performance condition (i.e. the possibility that the
exercise price might be Rs. 40 and the possibility that the exercise price might be Rs. 30) is
not taken into account when estimating the fair value of the stock options at the grant date.
Instead, the enterprise estimates the fair value of the stock options at the grant date under
each scenario (i.e. exercise price of Rs. 40 and exercise price of Rs. 30) and ultimately
revises the transaction amount to reflect the outcome of that performance condition, as
illustrated below:
expense for compensatio
period (Rs.) n expense
(Rs.)
1 10,000 options × Rs. 16 × 1/3 53,333 53,333
2. (10,000 options × Rs. 16 × 2/3) Rs. 53,333 53,334 1,06,667
3. (10,000 options × Rs. 12 × 3/3) – Rs. 1,06,667 13,333 1, 20,000
ILLUSTRATION 5: GRANT WITH A MARKET CONDITION

At the beginning of year 1, an enterprise grants 10,000 stock options to a senior executive,
conditional upon the executive remaining in the employment of the enterprise until the end of
year 3. However, the stock options cannot be exercised unless the share price has increased
from Rs.50 at the beginning of year 1 to above Rs. 65 at the end of year 3. If the share price is
above Rs. 65 at the end of year 3, the stock options can be exercised at any time during the
next seven years, i.e. by the end of year 10.
The enterprise applies a binomial option pricing model, which takes into account the possibility
that the share price will exceed Rs. 65 at the end of year 3 (and hence the stock options
become exercisable) and the possibility that the share price will not exceed Rs. 65 at the end
of year 3 (and hence the options will not become exercisable). It estimates the fair value of the
stock options with this market condition to be Rs. 24 per option.
Because paragraph 20 of the text of the Guidance Note requires the enterprise to recognise
the services received from an employee who satisfies all other vesting conditions (e.g.,
services received from an employee who remains in service for the specified service period),
irrespective of whether that market condition is satisfied, it makes no difference whether the
share price target is achieved. The possibility that the share price target might not be achieved
has already been taken into account when estimating the fair value of the stock options at the
grant date. Therefore, if the enterprise expects the executive to complete the three-year
service period, and the executive does so, the enterprise recognises the following amounts in
years 1, 2 and 3:
1. 10,000 options × Rs. 24 × 1/3 80,000 80,000
2. (10,000 options × Rs. 24 × 2/3) – Rs. 80,000 80,000 1,60,000

3. (10,000 options × Rs. 24) – Rs. 1,60,000 80,000 2,40,000
As noted above, these amounts are recognised irrespective of the outcome of the market
condition. However, if the executive left during year 2 (or year 3), the amount recognised
during year 1 (and year 2) would be reversed in year 2 (or year 3). This is because the service
condition, in contrast to the market condition, was not taken into account when estimating the
fair value of the stock options at grant date. Instead, the service condition is taken into
account by adjusting the transaction amount to be based on the number of shares or stock
options that ultimately vest, in accordance with paragraphs 18 and 19 of the text of the
Guidance Note.
ILLUSTRATION 6: GRANT WITH A MARKET CONDITION, IN WHICH THE LENGTH OF

THE VESTING PERIOD VARIES
At the beginning of year 1, an enterprise grants 10,000 stock options with a ten-year life to
each of ten senior executives. The stock options will vest and become exercisable
immediately if and when the share price of the enterprise increases from Rs. 50 to Rs. 70,
provided that the executive remains in service until the share price target is achieved.
The enterprise applies a binomial option pricing model, which takes into account the possibility
that the share price target will be achieved during the ten-year life of the options, and the
possibility that the target will not be achieved. The enterprise estimates that the fair value of
the stock options at grant date is Rs. 25 per option. From the option pricing model, the
enterprise determines that the mode of the distribution of possible vesting dates is five years.
In other words, of all the possible outcomes, the most likely outcome of the market condition is
that the share price target will be achieved at the end of year 5. Therefore, the enterprise
estimates that the expected vesting period is five years. The enterprise also estimates that two
executives will have left by the end of year 5, and therefore expects that 80,000 stock options
(10,000 stock options x 8 executives) will vest at the end of year 5.
Throughout years 1-4, the enterprise continues to estimate that a total of two executives will
leave by the end of year 5. However, in total three executives leave, one in each of years 3, 4
and 5. The share price target is achieved at the end of year 6. Another executive leaves
during year 6, before the share price target is achieved.
Paragraph 14 of the text of the Guidance Note requires the enterprise to recognise the
services received over the expected vesting period, as estimated at grant date, and also
requires the enterprise not to revise that estimate. Therefore, the enterprise recognises the
services received from the executives over years 1 to 5. Hence, the transaction amount is
ultimately based on 70,000 stock options (10,000 stock options × 7 executives who remain in
service at the end of year 5). Although another executive left during year 6, no adjustment is
made, because the executive had already completed the expected vesting period of 5 years.
Therefore, the enterprise recognises the following amounts in years 1-5:
1 80,000 options × Rs. 25 × 1/5 4,00,000 4,00,000
2. (80,000 options × Rs. 25 × 2/5) – Rs. 4,00,000 4,00,000 8,00,000
3. (80,000 options × Rs. 25 × 3/5) – Rs. 8,00,000 4,00,000 12,00,000
4. 4 (80,000 options × Rs. 25 × 4/5) – Rs. 12,00,000 4,00,000 16,00,000
5. (70,000 options × Rs. 25) – Rs. 16,00,000 1,50,000 17,50,000
ILLUSTRATION 7: EMPLOYEE SHARE PURCHASE PLAN

An enterprise offers all its 1,000 employees the opportunity to participate in an employee stock
purchase plan. The employees have two weeks to decide whether to accept the offer. Under
the terms of the plan, the employees are entitled to purchase a maximum of 100 shares each.
The purchase price will be 20 per cent less than the market price of the shares of the
enterprise at the date the offer is accepted, and the purchase price must be paid immediately
upon acceptance of the offer. All shares purchased must be held in trust for the employees,
and cannot be sold for five years. The employee is not permitted to withdraw from the plan
during that period. For example, if the employee ceases employment during the five-year
period, the shares must nevertheless remain in the plan until the end of the five-year period.
Any dividends paid during the five-year period will be held in trust for the employees until the
end of the five-year period.
In total, 800 employees accept the offer and each employee purchases, on average, 80
shares, i.e., the employees purchase a total of 64,000 shares. The weighted-average market
price of the shares at the purchase date is Rs. 30 per share, and the weighted-average
purchase price is Rs.24 per shares.
Paragraph 15 of the text of the Guidance Note provides that the enterprise should measure
the fair value of the employee services received by reference to the fair value of the shares or
stock options granted. To apply this requirement, it is necessary first to determine the type of
instrument granted to the employees. Although the plan is described as an employee stock
purchase plan (ESPP), some ESPPs include option features and are therefore, in effect, stock
option plans. For example, an ESPP might include a ‘lookback feature’, whereby the employee
is able to purchase shares at a discount, and choose whether the discount is applied to the
share price of the enterprise at the date of grant or its share price at the date of purchase. Or
an ESPP might specify the purchase price, and then allow the employees a significant period
of time to decide whether to participate in the plan. Another example of an option feature is an
ESPP that permits the participating employees to cancel their participation before or at the
end of a specified period and obtain a refund of amounts previously paid into the plan.
However, in this example, the plan includes no option features. The discount is applied to the
share price at the purchase date, and the employees are not permitted to withdraw from the
plan.
Another factor to consider is the effect of post-vesting transfer restrictions, if any. Paragraph 3
of the Appendix I to the Guidance Note states that, if shares are subject to restrictions on
transfer after vesting date, that factor should be taken into account when estimating the fair
value of those shares, but only to the extent that the post-vesting restrictions affect the price
that a knowledgeable, willing market participant would pay for that share. For example, if the
shares are actively traded in a deep and liquid market, post-vesting transfer restrictions may
have little, if any, effect on the price that a knowledgeable, willing market participant would pay
for those shares.
In this example, the shares are vested when purchased, but cannot be sold for five years after
the date of purchase. Therefore, the enterprise should consider the valuation effect of the five-
year post-vesting transfer restriction. This entails using a valuation technique to estimate what
the price of the restricted share would have been on the purchase date in an arm’s length
transaction between knowledgeable, willing parties. Suppose that, in this example, the
enterprise estimates that the fair value of each restricted share is Rs. 28. In this case, the fair
value of the instruments granted is Rs. 4 per share (being the fair value of the restricted share
of Rs. 28 less the purchase price of Rs. 24). Because 64,000 shares were purchased, the total
fair value of the instruments granted is Rs. 2,56,000.
In this example, there is no vesting period. Therefore, in accordance with paragraph 11 of the
text of the Guidance Note, the enterprise should recognise an expense of Rs. 2,56,000
immediately.
Appendix III
Modifications to the Term and Conditions
of Equity-Settled Employee Share-based
Payment Plans
ILLUSTRATION 1: GRANT OF STOCK OPTIONS THAT ARE SUBSEQUENTLY REPRICED

At the beginning of year 1, an enterprise grants 100 stock options to each of its 500
employees. The grant is conditional upon the employee remaining in service over the next
three years. The enterprise estimates that the fair value of each option is Rs. 15. On the basis
of a weighted average probability, the enterprise estimates that 100 employees will leave
during the three-year period and therefore forfeit their rights to the stock options.
Suppose that 40 employees leave during year 1. Also suppose that by the end of year 1, the
share price of the enterprise has dropped, and the enterprise reprices its stock options, and
that the repriced stock options vest at the end of year 3. The enterprise estimates that a
further 70 employees will leave during years 2 and 3, and hence the total expected employee
departures over the three-year vesting period is 110 employees. During year 2, a further 35
employees leave, and the enterprise estimates that a further 30 employees will leave during
year 3, to bring the total expected employee departures over the three-year vesting period to
105 employees. During year 3, a total of 28 employees leave, and hence a total of 103
employees ceased employment during the vesting period. For the remaining 397 employees,
the stock options vested at the end of year 3.
The enterprise estimates that, at the date of repricing, the fair value of each of the original
stock options granted (i.e., before taking into account the repricing) is Rs. 5 and that the fair
value of each repriced stock option is Rs. 8.
Paragraph 24 of the text of the Guidance Note requires the enterprise to recognise the effects
of modifications that increase the total fair value of the employee share-based payment plans
or are otherwise beneficial to the employee. If the modification increases the fair value of the
shares or stock options granted (e.g., by reducing the exercise price), measured immediately
before and after the modification, paragraph 25(a) of the text of this Guidance Note requires
the enterprise to include the incremental fair value granted (i.e., the difference between the
fair value of the modified instrument and that of the original instrument, both estimated as at
the date of the modification) in the measurement of the amount recognised for services
received as consideration for the instruments granted. If the modification occurs during the
vesting period, the incremental fair value granted is included in the measurement of the
amount recognised for services received over the period from the modification date until the
date when the modified instruments vest, in addition to the amount based on the grant date
fair value of the original instruments, which is recognised over the remainder of the original
vesting period.
The incremental value is Rs. 3 per stock option (Rs. 8 – Rs. 5). This amount is recognised
over the remaining two years of the vesting period, along with remuneration expense based on
the original option value of Rs. 15.
The amounts recognised towards employees services received in years 1-3 are as follows:
expnse for compensatio
period (Rs.) n expense
(Rs.)
1 (500 – 110) employees ×100 options × Rs. 15 × 1,95,000 1,95,000
1/3
2. (500 – 105) employees × 100 options × (Rs. 15 2,59,250 4,54,250
× 2/3 + Rs. 3 × 1/2) – Rs. 1,95,000
3. (500 – 103) employees × 100 options × (Rs. 15 2,60,350 7,14,600
+ Rs. 3) – Rs. 4,54,250
ILLUSTRATION 2: GRANT OF STOCK OPTIONS WITH A VESTING CONDITION THAT IS

SUBSEQUENTLY MODIFIED
At the beginning of year 1, the enterprise grants 1,000 stock options to each member of its
sales team, conditional upon the employees remaining in the employment of the enterprise for
three years, and the team selling more than 50,000 units of a particular product over the three-
year period. The fair value of the stock options is Rs. 15 per option at the date of grant.
During year 2, the enterprise increases the sales target to 1,00,000 units. By the end of year
3, the enterprise has sold 55,000 units, and the stock options do not vest. Twelve members of
the sales team have remained in service for the three-year period.
Paragraph 19 of the text of the Guidance Note requires, for a performance condition that is not
a market condition, the enterprise to recognise the services received during the vesting period
based on the best available estimate of the number of shares or stock options expected to
vest and to revise that estimate, if necessary, if subsequent information indicates that the
number of shares or stock options expected to vest differs from previous estimates. On
vesting date, the enterprise revises the estimate to equal the number of instruments that
ultimately vested. However, paragraph 24 of the text of the Guidance Note requires,
irrespective of any modifications to the terms and conditions on which the instruments were
granted, or a cancellation or settlement of that grant of instruments, the enterprise to
recognise, as a minimum, the services received, measured at the grant date fair value of the
instruments granted, unless those instruments do not vest because of failure to satisfy a
vesting condition (other than a market condition) that was specified at grant date.
Furthermore, paragraph 26(c) of the text of this Guidance Note specifies that, if the enterprise
modifies the vesting conditions in a manner that is not beneficial to the employee, the
enterprise does not take the modified vesting conditions into account when applying the
requirements of paragraphs 18 to 20 of the text of the Guidance Note.
Therefore, because the modification to the performance condition made it less likely that the
stock options will vest, which was not beneficial to the employee, the enterprise takes no
account of the modified performance condition when recognising the services received.
Instead, it continues to recognise the services received over the three-year period based on
the original vesting conditions. Hence, the enterprise ultimately recognizes cumulative
remuneration expense of Rs. 1,80,000 over the three-year period (12 employees × 1,000
options × Rs. 15).
The same result would have occurred if, instead of modifying the performance target, the
enterprise had increased the number of years of service required for the stock options to vest
from three years to ten years. Because such a modification would make it less likely that the
options will vest, which would not be beneficial to the employees, the enterprise would take no
account of the modified service condition when recognising the services received. Instead, it
would recognise the services received from the twelve employees who remained in service
over the original three-year vesting period.
Appendix IV
Cash-Settled Employee
Share-based Payment Plans
Continuing, Illustration 1(A) of Appendix II, suppose the enterprise has granted stock
appreciation rights (SARs) to its employees, instead of the options whereby the enterprise
pays cash to the employees equal to the intrinsic value of the SARs as on the exercise date.
The SARs are granted on the condition that the employees remain in its employment for the
next three years. The contractual life [comprising the vesting period (3 years) and the exercise
period (2 years)] of SARs is 5 years.
The other facts of the Illustration are the same as those in Illustration 1(A) of Appendix II.
However, it is also assumed that at the end of year 3, 400 employees exercise their SARs,
another 300 employees exercise their SARs at the end of year 4 and the remaining 140
employees exercise their SARs at the end of year 5.
The enterprise estimates the fair value of the SARs at the end of each year in which a liability
exists and the intrinsic value of the SARs at the end of years 3, 4 and 5. The values estimated
by the enterprise are as below:
Year Fair Value Intrinsic Value

1 Rs. 15.30
2 Rs. 16.50
3 Rs. 19.20 Rs. 16.00
4 Rs. 21.30 Rs. 21.00
5 Rs. 26.00
1. The expense to be recognised each year in respect of SARs are determined as below:
Year 1
No. of SARs expected to vest (as per the original estimate)
1,000 x 300 x 0.97 x 0.97 x 0.97 = 2,73,802 SARs
Provision required at the year-end
2,73,802 SARs x Rs. 15.30 x 1/3 = Rs. 13,96,390
Less: provision at the beginning of the year Nil
Expense for the year Rs. 13,96,390
Year 2
No. of SARs expected to vest (as per the revised estimate)
1,000 x 300 x 0.94 x 0.94 x 0.94 = 2,49,175 SARs
2,49,175 SARs x Rs. 16.50 x 2/3 = Rs. 27,40,925
Less: provision at the beginning of the year Rs. (13,96,390)
Year 3
No. of SARs actually vested
840 employees x 300 SARs 2,52,000 SARs
No. of SARs exercised at the year-end
No. of SARs outstanding at the year-end 1,32,000 SARs
Provision required in respect of SARs outstanding at the year-end
1,32,000 SARs x Rs. 19.20 = Rs. 25,34,400
Plus: Cash paid on exercise of SARs by employees
1,20,000 SARs x Rs. 16.00 = Rs. 19,20,000
Total Rs. 44,54,400
Year 4
No. of SARs outstanding at the beginning of the year 1,32,000 SARs
300 employees x 300 SARs 90,000 SARs
No. of SARs outstanding at the year-end 42,000 SARs
Provision required in respect of SARs outstanding
at the year-end
42,000 SARs x Rs. 21.30 = Rs. 8,94,600
Plus: Cash paid on exercise of SARs
90,000 SARs x Rs. 21.00 = Rs.18,90,000

Total Rs. 27,84,600
Year 5
No. of SARs outstanding at the beginning of the
year 42,000 SARs
No. of SARs outstanding at the year-end Nil
Provision required in respect of SARs outstanding at
the year-end Nil
42,000 SARs x Rs. 26.00 =Rs.10,92,000
Total Rs. 10,92,000
2. The enterprise passes the following entry, in each of the years, to recognise the
compensation expense determined as above:
Employee compensation
expense A/c Dr. _________
To Provision for payment
of SARs A/c _________
(Being compensation expense recognised in respect of SARs)
3. The enterprise passes the following entry, in the years 3, 4 and 5, to record the cash paid
on exercise of SARs:
Provision for payment of
SARs A/c Dr. _________
To Bank A/c _________
(Being cash paid on exercise of SARs)

4. Balance in the ‘Provision for payment of SARs Account’, outstanding at year-end, is
disclosed in the balance sheet, as a provision under the heading ‘Current Liabilities and
Provisions’.
Intrinsic Value Method
The accounting treatment suggested above is based on the fair value method. In case the
enterprise has followed the intrinsic value method instead of the fair value method, it would
make all the computations suggested above on the basis of intrinsic value of SARs on the
respective dates instead of the fair value. To illustrate, suppose the intrinsic value of SARs at
the grant date is Rs. 6 per right. The intrinsic values of the SARs on the subsequent dates are
as below:
Year Intrinsic Value
1 Rs. 9.00
2 Rs. 12.00
3 Rs. 16.00
4 Rs. 21.00
5 Rs. 26.00
In the above case, the enterprise would determine the expense to be recognised each year in
respect of SARs as below:
Year 1
No. of SARs expected to vest (as per the original estimate)
1,000 x 300 x 0.97 x 0.97 x 0.97 = 2,73,802 SARs
2,73,802 SARs x Rs. 9.00 x 1/3 = Rs. 8,21,406
Year 2
No. of SARs expected to vest (as per the revised estimate)
1,000 x 300 x 0.94 x 0.94 x 0.94 = 2,49,175 SARs
2,49,175 SARs x Rs. 12.00 x 2/3 = Rs. 19,93,400

Year 3
No. of SARs actually vested
No. of SARs outstanding at the year-end 1,32,000 SARs
at the year-end
1,32,000 SARs x Rs. 16.00 = Rs. 21,12,000
Plus: Cash paid on exercise of SARs by employees
1,20,000 SARs x Rs. 16.00 = Rs. 19,20,000
Total Rs. 40,32,000
Accounting for Employee Share-based Payments 337
Year 4
No. of SARs outstanding at the beginning of
the year 1,32,000 SARs
No. of SARs outstanding at the year-end 42,000 SARs
at the year-end
42,000 SARs x Rs. 21.00 = Rs. 8,82,000
90,000 SARs x Rs. 21.00 = Rs. 18,90,000
Total Rs. 27,72,000

Year 5
No. of SARs outstanding at the beginning of
the year 42,000 SARs
No. of SARs outstanding at the year-end Nil
at the year-end Nil
42,000 SARs x Rs. 26.00 = Rs. 10,92,000
Total Rs. 10,92,000
Appendix V
Employee Share-based
Payment Plan with Cash Alternatives
Illustration : An enterprise grants to an employee the right to choose either a cash payment
equal to the value of 1,000 shares, or 1,200 shares. The grant is conditional upon the
completion of three years’ service. If the employee chooses the equity alternative, the shares
must be held for three years after vesting date. The face value of shares is Rs. 10 per share.
At grant date, the fair value of the shares of the enterprise (without considering post-vesting
restrictions) is Rs. 50 per share. At the end of years 1, 2 and 3, the said fair value is Rs. 52,
Rs. 55 and Rs. 60 per share respectively. The enterprise does not expect to pay dividends in
the next three years. After taking into account the effects of the post-vesting transfer
restrictions, the enterprise estimates that the grant date fair value of the equity alternative is
Rs. 48 per share.
At the end of year 3, the employee chooses:
Scenario 1: The cash alternative
Scenario 2: The equity alternative

1. The employee share-based payment plan granted by the enterprise has two components,
viz., (i) a liability component, i.e., the employees’ right to demand settlement in cash, and (ii)
an equity component, i.e., the employees’ right to demand settlement in shares rather than in
cash. The enterprise measures, on the grant date, the fair value of two components as below:
Fair value under equity settlement
1,200 shares x Rs. 48 = Rs. 57,600
Fair value under cash settlement
1,000 shares x Rs. 50 = Rs. 50,000
Fair value of the equity component
(Rs. 57,600 – Rs. 50,000) = Rs. 7,600
Fair value of the liability component Rs. 50,000
2. The enterprise calculates the expense to be recognised in respect of the liability
component at the end of each year as below:
Year 1
1,000 x Rs. 52.00 x 1/3 = Rs. 17,333
Expense for the year Rs. 17,333
Year 2
1,000 x Rs. 55.00 x 2/3 = Rs. 36,667
Less: provision at the beginning of the year Rs. 17,333
Year 3
1,000 x Rs. 60.00 = Rs. 60,000
Less: provision at the beginning of the year Rs. 36,667
3. The expense to be recognised in respect of the equity component at the end of each year
is one third of the fair value (Rs. 7,600) determined at (1) above.
4. The enterprise passes the following entry at the end of each of the years to recognise
compensation expense towards liability component determined at (2) above:
To Provision for liability component of
employee share-based payment plan __________
(Being compensation expense recognised in respect of liability component of employee share-
based payment plan with cash alternative)
5. The enterprise passes the following entry at the end of each of the year to recognise
compensation expense towards equity component determined at (3) above:
To Stock Options Outstanding A/c _________
(Being compensation expense recognised in respect of equity component of employee share-
based payment plan with cash alternative)
6. Provision for liability component of employee share-based payment plan, outstanding at
year-end, is disclosed in the balance sheet, as a provision under the heading ‘Current
Liabilities and Provisions’. Credit balance in the ‘Stock Options Outstanding A/c’ is disclosed
under a separate heading, between ‘Share Capital’ and ‘Reserves and Surplus’.
7. The enterprise passes the following entry on the settlement of the employee share-based
payment plan with cash alternative:
Scenario 1: The cash alternative
Provision for liability component of employee
share-based payment plan Dr. Rs. 60,000
(Being cash paid on exercise of cash alternative under the employee
share-based payment plan)
Stock Options Outstanding A/c Dr. Rs. 7,600
To General Reserve Rs. 7,600
(Being the balance standing to the credit of the Stock Options Outstanding Account
transferred to the general reserve upon exercise of cash alternative)

Scenario 2: The equity alternative
Stock Options Outstanding A/c Dr. Rs. 7,600
Provision for liability component of employee share-based
payment plan Dr. Rs. 60,000
To Share Capital A/c
(1,000 shares x Rs. 10) Rs. 10,000
To Securities Premium A/c Rs. 57,600
(Being shares issued on exercise of equity alternative under the employee share-based
payment plan)
Appendix VI
Graded Vesting
Continuing Illustration 1(A) of Appendix II, suppose that the options granted vest according to
a graded schedule of 25 per cent at the end of the year 1, 25 per cent at the end of the year 2,
and the remaining 50 per cent at the end of the year 3. The expected lives of the options that
vest at the end of the year 1, 2 and 3 are 2.5 years, 4 years and 5 years respectively. The fair
values of these options, computed based on their respective expected lives, are Rs. 10, Rs.
13 and Rs. 15 per option, respectively. It is also assumed that expected forfeiture rate is 3%
per year and does not change during the vesting period.
1. Since the options granted have a graded vesting schedule, the enterprise segregates the
total plan into different groups, depending upon the vesting dates and treats each of these
groups as a separate plan.
2. The enterprise determines the number of options expected to vest under each group as
below:
Vesting Date (Year-end) Options expected to vest
1 300 options x 1,000 employees x 25% x 0.97 = 72,750 options
2 300 options x 1,000 employees x 25% x 0.97 x .97= 70,568 options
3 300 options x 1,000 employees x 50% x 0.97
x .97 x .97 =1,36,901 options
Total options expected to vest 2,80,219 options
3. Total compensation expense for the options expected to vest is determined as follows:
Vesting Date Expected Vesting Value per Compensation
(Year-end) (No. of Options) Option (Rs.) Expense (Rs.)
1 72,750 10 7,27,500
2 70,568 13 9,17,384
3 1,36,901 15 20,53,515
Total 36,98,399
4. Compensation expense, determined as above, is recognised over the respective vesting

periods. Thus, the compensation expense of Rs. 7,27,500 attributable to 72,750 options that
vest at the end year 1, is allocated to the year 1. The expense of Rs. 9,17,384 attributable to
the 70,568 options that vest at the end of year 2 is allocated over their 2-year vesting period
(year 1 and year 2). The expense of Rs. 20,53,515 attributable to the 1,36,901 options that
vest at the end of year 3 is allocated over their 3-year vesting period (year 1, year 2 and year
3). Total compensation expense of Rs. 36,98,399, determined at the grant date, is attributed
to the years 1, 2 and 3 as below:
Vesting Date Cost to be recognised
(End of year) Year 1 Year 2 Year 3
1 7,27,500
2 4,58,692 4,58,692
3 6,84,505 6,84,505 6,84,505
Cost for the year 18,70,697 11,43,197 6,84,505
Cumulative cost 18,70,697 30,13,894 36,98,399
Intrinsic Value Method
The accounting treatment suggested above is based on the fair value method. In case the
enterprise has followed the intrinsic value method instead of the fair value method, it would
make computations suggested above on the basis of intrinsic value of options at the grant
date (which would be the same for all groups) instead of the fair value. To illustrate, suppose
the intrinsic value of the option at the grant date is Rs. 6 per option. In such a case, total
compensation expense for the options expected to vest would be
Vesting Date Expected Vesting Value per Compensation
(End of year) (No. of Options) Option (Rs.) Expense (Rs.)
1 72,750 6 4,36,500
2 70,568 6 4, 23,408
3 1,36,901 6 8,21,406
Total 16,81,314
Total compensation expense of Rs. 16,81,314, determined at the grant date, would be
attributed to the years 1, 2 and 3 as below:
Vesting Date Cost to be recognised
(End of year) Year 1 Year 2 Year 3
1 4,36,500
2 2,11,704 2,11,704
3 2,73,802 2,73,802 2,73,802
Cost for the year 9,22,006 4,85,506 2,73,802
Cumulative cost 9,22,006 14,07,512 16,81,314
Appendix VII
Accounting for Employee Share-based Payment
Plans Administered Through a Trust
ILLUSTRATION 1: ENTERPRISE ALLOTS SHARES TO THE ESOP TRUST AS AND WHEN

THE EMPLOYEES EXERCISE STOCK OPTIONS
At the beginning of year 1, an enterprise grants 300 stock options to each of its 1,000
employees, conditional upon the employees remaining in the employment of the enterprise for
one year. The fair value of the stock options, at the date of grant, is Rs. 15 per option and the
exercise price is Rs. 50 per share. The options can be exercised in one year after the date of
vesting. The other relevant terms of the grant and assumptions are as below:
(a) The grant is administered by an ESOP trust appointed by the enterprise. According to the
terms of appointment, the enterprise agrees to allot shares to the ESOP trust as and
when the stock options are exercised by the employees.
(b) The number of employees expected to complete one year vesting period, at the
beginning of the plan, is 900, i.e., 100 employees are expected to leave during the
vesting period and, consequently, the options granted to them are expected to be
forfeited.
(c) Actual forfeitures, during the vesting period, are equal to the expected forfeitures and
900 employees have actually completed one year vesting period.
(d) All 900 employees exercised their right to obtain shares vested in them in pursuance of
the ESOP at the end of year 2.
(e) Apart from the shares allotted to the trust, the enterprise has 10,00,000 shares of Rs. 10
each outstanding at the end of year 1. The said shares were issued at a premium of Rs.
15 per share. The full amount of premium received on issue of shares is still standing to
the credit of the Securities Premium Account. The enterprise has not made any change
in the share capital upto the end of year 2, except that arising from transactions with the
employees pursuant to the Employee Stock Option Plan.
The accounting treatment, in this case, would be the same as explained in the case where the
enterprise itself is administering the Employee Stock Option Plan (ESOP) although the
enterprise issues shares to the ESOP Trust instead of issuing shares to the employees
directly. The accounting treatment in this case is explained hereinbelow.
Year 1
1. At the grant date, the enterprise estimates the fair value of the options expected to vest
at the end of the vesting period as below:
No. of options expected to vest
(1,000 – 100) employees x 300 options = 2,70,000 options
Fair value of options expected to vest
2,70,000 options x Rs. 15 = Rs. 40,50,000
2. At the end of the financial year, the enterprise examines its actual forfeitures and makes
necessary adjustments, if any, to reflect expense for the number of options that actually
vested. Considering that actual forfeitures, during the vesting period, are equal to the
expected forfeitures and 900 employees have actually completed one year vesting period, the
enterprise recognises the fair value of options expected to vest (estimated at 1 above) towards
the employee services received by passing the following entry:
3. Credit balance in the ‘Stock Options Outstanding Account’ is disclosed in the balance
sheet under a separate heading, between ‘Share Capital’ and ‘Reserves and Surplus’, as
below:
Liabilities Amount (Rs.)
Share Capital
Paid-up Capital:
10,00,000 equity shares of Rs. 10 each 1,00,00,000
Stock Options Outstanding Account 40,50,000
Reserves and Surplus
Securities Premium A/c (10,00,000 shares x Rs. 15) 1,50,00,000

Year 2
1. On exercise of the right to obtain shares by the employees, the enterprise allots shares
to the ESOP Trust for issuance to the employees. The shares so issued are considered to
have been issued on a consideration comprising the exercise price and the fair value of the
options. In the present case, the exercise price is Rs. 50 per share and the fair value of the
options is Rs. 15 per option. The enterprise, therefore, considers the shares to be issued at a
price of Rs. 65 per share.
2. The amount to be recorded in the ‘Share Capital Account’ and the ‘Securities Premium
Account’, upon issuance of the shares, is calculated as below:
Particulars Computations
No. of employees exercising option 900
No. of shares issued on exercise @ 300 per employee 2,70,000
Exercise Price @ Rs. 50 per share 1,35,00,000
Fair value of options @ Rs. 15 per option 40,50,000
Total Consideration 1,75,50,000
Amount to be recorded in ‘Share Capital A/c’
@ Rs. 10 per share 27,00,000
Amount to be recorded in ‘Securities Premium A/c’
@ Rs. 55 per share 1,48,50,000
Total 1,75,50,000
3. The ESOP Trust receives exercise price from the employees exercising the options
vested in them in pursuance of the Employee Stock Option Plan. The Trust passes on the
exercise price so received to the enterprise for issuance of shares to the employees. The
enterprise allots shares to the ESOP Trust for issuance to the employees exercising the
options vested in them in pursuance of the Employee Stock Option Plan. To recognise the
transaction, the following entry is passed:
Bank A/c Dr. Rs.1,35,00,000
To Securities Premium A/c Rs. 1,48,50,000
(Being shares allotted to the ESOP Trust for issuance to the employeesagainst the options
vested in them in pursuance of the Employee Stock Option Plan)
4. The Share Capital Account and the Securities Premium Account are disclosed in the
balance sheet as below:
Share Capital
Paid-up Capital:
12,70,000 equity shares of Rs. 10 each fully paid 1,27,00,000
(Of the above, 2,70,000 shares of Rs. 10 each have been issued to the
employees pursuant to an Employee Share-based Payment Plan. The
issue price of the share was Rs. 65 per share out of which Rs. 15 per share
were received in the form of employee services over a period of one year).
Securities Premium A/c 2,98,50,000
Computation of Earnings Per Share
For the purpose of calculating Basic EPS, stock options granted pursuant to the employee
share-based payment plan would not be included in the shares outstanding till the employees
have exercised their right to obtain shares, after fulfilling the requisite vesting conditions. Till
such time, stock options so granted would be considered as dilutive potential equity shares for
the purpose of calculating Diluted EPS.
ILLUSTRATION 2: ENTERPRISE PROVIDES FINANCE TO THE ESOP TRUST FOR

SUBSCRIPTION TO SHARES ISSUED BY THE ENTERPRISE AT THE BEGINNING OF THE
PLAN
Continuing Illustration 1 above, suppose the enterprise provides finance, at the grant date, to
the ESOP trust for subscription to the shares of the enterprise equivalent to the number of
shares expected to vest. With the help of finance provided by the enterprise, the trust
subscribes to the shares offered by the enterprise at a cash price of Rs. 50 per share, at the
beginning of the plan. The Trust would issue shares to the employees as and when they
exercise the right vested in them in pursuance of the Employee Stock Option Plan (ESOP).
The other facts of the case are the same as in Illustration 1.
The computations of employee compensation expense, amount to be recognised in the Share
Capital Account and the Securities Premium Account, etc., would be the same as that in
Illustration 1 above.
Year 1
1. The enterprise passes the following entry to record provision of finance [Rs. 1,35,00,000
(i.e., 2,70,000 shares x Rs. 50)] to the ESOP trust:

Amount recoverable from ESOP
Trust A/c Dr. Rs. 1,35,00,000
To Bank A/c Rs. 1,35,00,000
(Being finance provided to the ESOP trust for subscription of shares)
2. The enterprise passes the following entry to record the allotment of 2,70,000 shares to
the ESOP Trust at Rs. 65 per share [comprising the exercise price (Rs. 50) and the fair value
of options (Rs. 15)]:
Bank A/c Dr. Rs. 1,35,00,000
Amount recoverable from ESOP
Trust A/c Dr. Rs. 40,50,000
To Securities Premium A/c Rs. 1,48,50,000
(Being shares allotted to the ESOP Trust in respect of the Employee Stock Option Plan)
3. The enterprise passes the following entry to recognise the employee services received
during the year:
4. The Share Capital Account, the Securities Premium Account, credit balance in the ‘Stock
Options Outstanding Account’ and debit balance in the ‘Amount recoverable from ESOP Trust
Account’ are disclosed in the balance sheet as below:
Share Capital
Paid-up Capital:
Less: Amount recoverable from ESOP Trust 27,00,000 1,00,00,000
(face value of 2,70,000 share allotted to the Trust)

Securities Premium Account 2,98,50,000
Less: Amount recoverable from ESOP Trust 1,48,50,000 1,50,00,000
(Premium on 2,70,000 share allotted to the Trust)
5. Apart from other required disclosures, the enterprise gives a suitable note in the Notes to
Accounts to explain the transaction and the nature of deduction of the ‘Amount recoverable
from ESOP Trust’ made from the ‘Share Capital’ and the ‘Securities Premium Account’.
Year 2
1. On exercise of the right to obtain shares, the ESOP trust issues shares to the respective
employees after receiving the exercise price of Rs. 50 per share. The ESOP Trust passes on
the exercise price received on issue of shares to the enterprise. The enterprise passes the
following entry to record the receipt of the exercise price:
Bank A/c Dr. Rs. 1,35,00,000
To Amount recoverable from
ESOP Trust A/c Rs. 1,35,00,000
(Being amount received from the ESOP Trust against finance provided to it at the beginning of
the Employee Stock Option Plan)
2. The enterprise transfers the balance standing to the credit of the ‘Stock Options
Outstanding Account’ to the ‘Amount recoverable from ESOP Trust Account’ by passing the
following entry:
To Amount recoverable from ESOP
Trust A/c Rs. 40,50,000
(Being consideration for shares issued to the employees received in the form of employee
services adjusted against the relevant account)
3. The Share Capital Account and the Securities Premium Account are disclosed in the
balance sheet as below:
Share Capital
Paid-up Capital:
12,70,000 equity shares of Rs. 10 each fully paid (Of the above, 2,70,000 1,27,00,000
shares of Rs. 10 each have been issued to the employees (through

ESOP Trust) pursuant to an Employee Share-based Payment Plan. The
issue price of the share was Rs. 65 per share out of which Rs. 15 per
share were received in the form of employee services over a period of
one year).
For the purpose of calculating Basic EPS, shares allotted to the ESOP Trust pursuant to the
employee share-based payment plan would not be included in the shares outstanding till the
employees have exercised their right to obtain shares, after fulfilling the requisite vesting
conditions. Till such time, the shares so allotted would be considered as dilutive potential
equity shares for the purpose of calculating Diluted EPS.
ILLUSTRATION 3: ENTERPRISE PROVIDES FINANCE TO THE ESOP TRUST TO

PURCHASE SHARES FROM THE MARKET AT THE BEGINNING OF THE PLAN
Continuing Illustration 2 above, suppose the enterprise does not issue fresh shares to the
ESOP Trust. Instead, it provides finance, at the grant date, to the trust to purchase shares of
the enterprise from the market, equivalent to the number of shares expected to vest. With the
help of finance provided by the enterprise, the ESOP Trust purchases 2,70,000 shares from
the market @ Rs. 52 per share at the beginning of the plan. The other facts remain the same
as in Illustration 2 above.
Year 1
1. The enterprise passes the following entry to record provision of finance [Rs. 1,40,40,000
(i.e., 2,70,000 shares x Rs. 52)] to the ESOP trust:
Amount recoverable from
ESOP Trust A/c Dr. Rs. 1,40,40,000
To Bank A/c Rs. 1,40,40,000
(Being finance provided to the ESOP trust for purchase of shares in respect of the ESOP)
2. The enterprise passes the following entry at the end of the year to recognise the
employee services received during the year:
3. Credit balance in the ‘Stock Options Outstanding Account’ is disclosed on the liability
side of the balance sheet under a separate heading, between ‘Share Capital’ and ‘Reserves
and Surplus’. Debit balance in the ‘Amount recoverable from ESOP Trust Account’ is disclosed
on the asset side under a separate heading, between the ‘Investments’ and the ‘Current
Assets, Loans and Advances’. On this basis, the relevant extracts of the balance sheet appear
as below:
Share Capital
Paid-up Capital:
Assets Amount (Rs.)
Investments —
Amount recoverable from ESOP Trust 1,40,40,000
Current Assets, Loans and Advances —
4. Apart from the other required disclosures, the enterprise gives a suitable note in the
‘Notes to Accounts’ to explain the transaction and the nature of the ‘Amount recoverable from
ESOP Trust’.
Year 2
1. On exercise of the right to obtain shares by the employees, the ESOP trust issues shares
to the respective employees after receiving the exercise price. The exercise price so received
is passed on to the enterprise.
The amount received, in this manner, is Rs. 1,35,00,000 (i.e., 900 employees x 300 options x
Rs. 50). The enterprise passes the following entry to record the receipt of the exercise price:
Bank A/c Dr. Rs. 1,35,00,000
To Amount recoverable from
ESOP Trust A/c Rs. 1,35,00,000
(Being amount received from the ESOP trust against the finance provided to it in respect of
the Employee Stock Option Plan)
2. The enterprise transfers an amount equivalent to the difference between the cost of
shares to the ESOP Trust and the exercise price from the ‘Stock Options Outstanding
Account’ to the ‘Amount recoverable from ESOP Trust Account’. In the present case, there is a
difference of Rs. 2 per share (i.e., Rs. 52 – Rs. 50) between the cost of shares and the
exercise price. The number of shares issued to the employees is 2,70,000. The enterprise,
accordingly, transfers an amount of Rs. 5,40,000 from the ‘Stock Options Outstanding
Account’ to the ‘Amount recoverable from ESOP Trust Account’ by passing the following entry:
To Amount recoverable
from ESOP Trust A/c Rs. 5,40,000
(Being the difference between the cost of shares to the ESOP Trust and the exercise price
adjusted)
3. The balance of Rs. 35,10,000 (i.e., Rs. 40,50,000 – Rs. 5,40,000)
standing to the credit of the ‘Stock Options Outstanding Account’ is transferred to the ‘General
Reserve’ by passing the following entry:
To General Reserve Rs. 35,10,000
(Being balance in the ‘Stock Options Outstanding Account’ transferred to the ‘General
Reserve’, at the end of the Employee Stock Option Plan)
4. The Share Capital Account, the Securities Premium Account and the General Reserve
are disclosed in the balance sheet as below:
Share Capital
Paid-up Capital:
10,00,000 equity shares of Rs. 10 each fully paid 1,00,00,000
General Reserve xx,xx,xxx
Add: Amount transferred from the Stock
Options Outstanding Account 35,10,000 yy,yy,yyy
5. The enterprise gives a suitable note in the ‘Notes to Accounts’ to explain the nature of
the addition of Rs. 35,10,000 made in the ‘General Reserve’.

In this case, the enterprise does not issue any new shares either at the beginning of the
Employee Stock Option Plan or on exercise of stock options by the employees. Instead, the
ESOP Trust purchases the shares from the market at the beginning of the plan and the
employees exercising options vested in them are granted shares out of the shares so
purchased. The shares purchased by the Trust represent the shares that have already been
issued by the enterprise and the same should continue to be included in the shares
outstanding for the purpose of calculating Basic EPS as would have been done prior to the
purchase of the shares by the Trust. Since the exercise of stock options granted under the
plan does not result into any fresh issue of shares, the stock options granted would not be
considered as dilutive potential equity shares for the purpose of calculating Diluted EPS.
Appendix VIII
Illustration : At the beginning of year 1, an enterprise grants 300 stock options to each of its
1,000 employees, conditional upon the employees remaining in the employment of the
enterprise for two years. The fair value of the stock options, at the date of grant, is Rs. 10 per
option and the exercise price is Rs. 50 per share. The other relevant terms of the grant and
assumptions are as below:
(a) The number of employees expected to complete two years vesting period, at the
beginning of the plan, is 900. 50 employees are expected to leave during the each of the
year 1 and year 2 and, consequently, the options granted to them are expected to be
forfeited.
(b) Actual forfeitures, during the vesting period, are equal to the expected forfeitures and
900 employees have actually completed two-years vesting period.
(c) The profit of the enterprise for the year 1 and year 2, before amortisation of
compensation cost on account of ESOPs, is Rs. 25,00,000 and Rs. 28,00,000
respectively.
(d) The fair value of shares for these years was Rs. 57 and Rs.60 respectively.
(e) The enterprise has 5,00,000 shares of Rs. 10 each outstanding at the end of year 1 and
year 2.
Compute the Basic and Diluted EPS, ignoring tax impacts, for the year 1 and year 2.
Suggested Computations
(a) The stock options granted to employees are not included in the shares outstanding till the
employees have exercised their right to obtain shares or stock options, after fulfilling the
requisite vesting conditions. Till such time, the stock options so granted are considered
as dilutive potential equity shares for the purpose of calculating Diluted EPS. At the end
of each year, computations of diluted EPS are based on the actual number of options
granted and not yet forfeited.
(b) For calculating diluted EPS, no adjustment is made to the net profit attributable to equity
shareholders as there are no expense or income that would result from conversion of
ESOPs to the equity shares.
(c) For calculating diluted EPS, the enterprise assumes the exercise of dilutive options. The
assumed proceeds from these issues are considered to have been received from the
issue of shares at fair value. The difference between the number of shares issuable and
the number of shares that would have been issued at fair value are treated as an issue of
equity shares for no consideration
(d) As per paragraph 47 of this Guidance Note, the assumed proceeds to be included for
computation, mentioned at (c) above, include (i) the exercise price; and (ii) the
unamortized compensation cost related to these ESOPs, attributable to future services.
(e) The enterprise calculates the basic and diluted EPS as below:
Particulars Year 1 Year 2
Net profit before amortisation of ESOP
cost Rs. 25,00,000 Rs. 28,00,000
Less: Amortisation of ESOP cost (Rs. 13,50,000) (Rs. 13,50,000)
[(900 employees × 300 options × Rs. 10)/2]
Net profit attributable to equity shareholders Rs. 11,50,000 Rs. 14,50,000
Number of shares outstanding 5,00,000 5,00,000
Basic EPS Rs. 2.30 Rs. 2.90
Number of options outstanding (Options
granted less actual forfeitures) 2,85,000 2,70,000
[1,000 employees [2,85,000× 300
options – options – (50 employees (50 employees
× 300 options)] × 300 options)]
Unamortised compensation cost per Rs. 5 Rs. 0
option [Rs. 10 – Rs. 10/2]
Number of dilutive potential equity 10,000 45,000
shares [2,85,000 –[2,70,000 –({(2,85,000 * 50)

(2,70,000 + (2,85,000 * 50)/60)]* 5)}/57)]
No. of equity shares used to compute
diluted earnings per share 5,10,000 5,45,000
Diluted EPS Rs. 2.255 Rs. 2.66
Appendix IX
An example has been given in this appendix to illustrate the disclosure requirements in
paragraphs 49 to 52 of the text of the Guidance Note. The students are advised to refer this
appendix from the compendium of Guidance Notes.

Guidance Note on Accounting for
Fringe Benefits Tax
(The following is the text of the Guidance Note on Accounting for Fringe Benefits Tax, issued
by the Council of the Institute of Chartered Accountants of India1 .)
1. The Finance Act, 2005, has introduced Chapter XII-H on ‘Income-tax on Fringe Benefits’
[hereinafter referred to as ‘Fringe Benefits Tax’]. The relevant extracts from Chapter XII-H of
the Income-tax Act, 1961 (hereinafter referred to as ‘the Act’), governing the Fringe Benefits
Tax, have been reproduced in the Annexure to this Guidance Note. This Guidance Note is
being issued to provide guidance on accounting for Fringe Benefits Tax, particularly with
regard to the recognition and presentation of Fringe Benefits Tax in the financial statements.
The Guidance Note does not deal with accounting for ‘fringe benefits’ as such.
2. The salient features of Fringe Benefits Tax are as below:
(a) Fringe Benefits Tax is tax payable by an employer in respect of fringe benefits provided
or deemed to have been provided by the employer to his employees during the previous
year.
(b) Fringe Benefits Tax is in addition to the income-tax charged under the Act.
(c) Fringe Benefits Tax is payable at the specified rate on the value of fringe benefits. The
value of fringe benefits is calculated in accordance with the provisions of section 115WC
of the Income-tax Act, 1961, reproduced in the Annexure to this Guidance Note.
(d) An employer is required to pay Fringe Benefits Tax even if no income-tax on the total
income is payable.
(e) The term ‘employer’ means:
(i) a company;
(ii) a firm;
(iii) an association of persons or a body of individuals, whether incorporated or not, but
excluding any fund or trust or institution eligible for exemption under clause (23C) of
section 10 or registered under section 12AA of the Act;
(iv) a local authority; and
(v) every artificial juridical person, not falling within any of the preceding sub-clauses.
(f) The term ‘fringe benefits’ means any consideration for employment provided by way of –
(i) any privilege, service, facility or amenity, directly or indirectly, provided by an
employer, whether by way of reimbursement or otherwise, to his employees
(including former employee or employees);
(ii) any free or concessional ticket provided by the employer for private journeys of his
employees or their family members; and
(iii) any contribution by the employer to an approved superannuation fund for
employees.
The privilege, service, facility or amenity does not include perquisites in respect of which
tax is paid or payable by the employee.
(g) The fringe benefits shall be deemed to have been provided by the employer to his
employees, if the employer has, in the course of his business or profession (including
any activity whether or not such activity is carried on with the object of deriving income,
profits or gains), incurred any expense on or made any payment for the purposes stated
in section 115WB(2) of the Act. Examples of the purposes stated under the said section
are entertainment, festival celebrations, gifts, maintenance of guest house, employees’
welfare, hotel, boarding and lodging, conveyance, tour and travel (including foreign
travel), etc.
(h) Every employer who during a previous year has paid or made provision for payment of
fringe benefits to his employees, is required to furnish a return of fringe benefits to the
Assessing Officer in the prescribed form, on or before the due date, in respect of the
previous year.
(i) Fringe Benefits Tax, like any other direct tax, is not an allowable expenditure for the
purpose of computation of taxable income.
NATURE OF FRINGE BENEFITS TAX

3. With a view to recommend a proper and uniform accounting treatment for the Fringe
Benefits Tax, it is necessary to understand the nature of Fringe Benefits Tax which is
discussed in paragraph 4.
4. The Fringe Benefits Tax has been introduced under the Income-tax Act, 1961, as
‘additional income-tax’, vide section 115WA(1) which provides as below:
“In addition to the income-tax charged under this Act, there shall be charged for every
assessment year commencing on or after the 1st day of April, 2006, additional income-tax (in
this Act referred to as fringe benefit tax) in respect of the fringe benefits provided or deemed
to have been provided by an employer to his employees during the previous year at the rate of
thirty per cent on the value of such fringe benefits.”
Thus, the above stated tax is an additional income-tax payable by the employer on the value
of fringe benefits provided or deemed to have been provided to its employees.
RECOGNITION AND MEASUREMENT OF FRINGE BENEFITS TAX

5. An employer becomes liable to pay Fringe Benefits Tax as soon as it incurs an expense
which is considered to be a fringe benefit as per the requirements of Chapter XII-H of the
Income-tax Act, 1961, even though the actual payment of the tax and/or assessment of the tax
takes place on a later date. Accordingly, the employer should recognise, in the financial
statements for the period, expense for the Fringe Benefits Tax paid/payable in respect of all
expenses giving rise to such tax incurred during that period.
6. As discussed in paragraph 2(c) above, the Fringe Benefits Tax is payable at the specified
rate on the value of fringe benefits. The value of fringe benefits is calculated in accordance
with the provisions of section 115WC of the Act. The employer should, therefore, measure the
amount of the Fringe Benefits Tax keeping in view the aforesaid provisions of the Act.
PRESENTATION OF FRINGE BENEFITS TAX IN FINANCIAL STATEMENTS

7. Paragraph 5 of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior
Period Items and Changes in Accounting Policies’, issued by the Institute of Chartered
Accountants of India, provides as below:
“5. All items of income and expense which are recognised in a period should be
included in the determination of net profit or loss for the period unless an Accounting
Standard requires or permits otherwise.”
Since the Fringe Benefits Tax is an additional tax for the employer, it should be included in the
determination of net profit or loss for the period, i.e., the Fringe Benefits Tax, should be
charged to the profit and loss account.
8. In the context of presentation of the Fringe Benefits Tax in the profit and loss account of
companies, it has been considered whether the tax is covered by the requirement of clause
3(vi) of Part II of Schedule VI to the Companies Act, 1956, which provides as below:
“The amount of charge for Indian income-tax and other Indian taxation on profits, including,
where practicable, with Indian income-tax any taxation imposed elsewhere to the extent of the
relief, if any, from Indian income-tax and distinguishing, where practicable, between income-
tax and other taxation.”
As discussed in paragraph 4 above, the Fringe Benefits Tax is an additional income-tax.
Accordingly, the Fringe Benefits Tax is covered by the above clause and should be shown
separately, if material.
9. Keeping in view the above, the Fringe Benefits Tax should be disclosed as a separate
item after determining profit before tax on the face of the profit and loss account for the period
in which the related fringe benefits are recognised. An illustration of the disclosure of Fringe
Benefits Tax may be as below:
Profit before tax xxx
Less: Income-tax expense:
Current tax xxx
Deferred tax xxx xxx
Fringe Benefits Tax xxx xxx
Profit after tax xxx
10. The amount of the Fringe Benefits Tax (net of the advance tax thereon), outstanding if
any, at the year-end, should be disclosed as a provision in the balance sheet.
Annexure
The Relevant Extracts from Chapter XII-H of the Income-tax Act, 1961, Governing the
Fringe Benefits Tax (For assessment year 2006-07)
A.—Meaning of certain expressions
Definitions
115W. In this Chapter, unless the context otherwise requires,—
(a) “employer” means,—
(i) a company;
(ii) a firm;
(iii) an association of persons or a body of individuals, whether incorporated or not, but
excluding any fund or trust or institution eligible for exemption under clause (23C) of
section 10 or registered under section 12AA;
(iv) a local authority; and

(v) every artificial juridical person, not falling within any of the preceding sub-clauses;
(b) “fringe benefit tax” or “tax” means the tax chargeable under section 115WA.
B.—Basis of charge
Charge of fringe benefit tax
115WA. (1) In addition to the income-tax charged under this Act, there shall be charged for
every assessment year commencing on or after the 1st day of April, 2006, additional income-
tax (in this Act referred to as fringe benefit tax) in respect of the fringe benefits provided or
deemed to have been provided by an employer to his employees during the previous year at
the rate of thirty per cent on the value of such fringe benefits.
(2) Notwithstanding that no income-tax is payable by an employer on his total income
computed in accordance with the provisions of this Act, the tax on fringe benefits shall be
payable by such employer.
Fringe benefits
115WB. (1) For the purposes of this Chapter, “fringe benefits” means any consideration for
employment provided by way of—
(a) any privilege, service, facility or amenity, directly or indirectly, provided by an
employer, whether by way of reimbursement or otherwise, to his employees
(including former employee or employees);
(b) any free or concessional ticket provided by the employer for private journeys of his
employees or their family members; and
(c) any contribution by the employer to an approved superannuation fund for
employees.
(2) The fringe benefits shall be deemed to have been provided by the employer to his
employees, if the employer has, in the course of his business or profession (including
any activity whether or not such activity is carried on with the object of deriving income,
profits or gains) incurred any expense on, or made any payment for, the following
purposes, namely:—
(A) entertainment;
(B) provision of hospitality of every kind by the employer to any person, whether by way
of provision of food or beverages or in any other manner whatsoever and whether or
not such provision is made by reason of any express or implied contract or custom
or usage of trade but does not include—
(i) any expenditure on, or payment for, food or beverages provided by the employer
to his employees in office or factory;

(ii) any expenditure on or payment through paid vouchers which are not transferable
and usable only at eating joints or outlets;
(C) conference (other than fee for participation by the employees in any conference).
Explanation.—For the purposes of this clause, any expenditure on conveyance, tour and
travel (including foreign travel), on hotel, or boarding and lodging in connection with any
conference shall be deemed to be expenditure incurred for the purposes of conference;
(D) sales promotion including publicity:
Provided that any expenditure on advertisement,—
(i) being the expenditure (including rental) on advertisement of any form in any print
(including journals, catalogues or price lists) or electronic media or transport
system;
(ii) being the expenditure on the holding of, or the participation in, any press
conference or business convention, fair or exhibition;
(iii) being the expenditure on sponsorship of any sports event or any other event
organised by any Government agency or trade association or body;
(iv) being the expenditure on the publication in any print or electronic media of any
notice required to be published by or under any law or by an order of a court or
tribunal;
(v) being the expenditure on advertisement by way of signs, art work, painting,
banners, awnings, direct mail, electric spectaculars, kiosks, hoardings, bill boards
or by way of such other medium of advertisement; and
(vi) being the expenditure by way of payment to any advertising agency for the
purposes of clauses (i) to (v) above, shall not be considered as expenditure on
sales promotion including publicity;
(E) employees’ welfare.
Explanation.—For the purposes of this clause, any expenditure incurred or payment
made to fulfil any statutory obligation or mitigate occupational hazards or provide first aid
facilities in the hospital or dispensary run by the employer shall not be considered as
expenditure for employees’ welfare;
(F) conveyance, tour and travel (including foreign travel);
(G) use of hotel, boarding and lodging facilities;
(H) repair, running (including fuel), maintenance of motor cars and the amount of
depreciation thereon;
(I) repair, running (including fuel) and maintenance of aircrafts and the amount of
depreciation thereon;
(J) use of telephone (including mobile phone) other than expenditure on leased
telephone lines;
(K) maintenance of any accommodation in the nature of guest house other than
accommodation used for training purposes;
(L) festival celebrations;
(M) use of health club and similar facilities;
(N) use of any other club facilities;
(O) gifts; and
(P) scholarships.
(3) For the purposes of sub-section (1), the privilege, service, facility or amenity does not
include perquisites in respect of which tax is paid or payable by the employee.
Value of fringe benefits
115WC. (1) For the purpose of this Chapter, the value of fringe benefits shall be the
aggregate of the following, namely:—
(a) cost at which the benefits referred to in clause (b) of subsection
(1) of section 1I5WB, is provided by the employer to the general public as reduced by the
amount, if any, paid by, or recovered from, his employee or employees:
Provided that in a case where the expenses of the nature referred to in clause (b) of sub-
section (1) of section 115WB are included in any other clause of sub-section (2) of the said
section, the total expenses included under such other clause shall be reduced by the amount
of expenditure referred to in the said clause (b) for computing the value of fringe benefits;
(b) actual amount of contribution referred to in clause (c) of subsection
(1) of section 115WB;
(c) twenty per cent of the expenses referred to in clauses (A) to
(K) of sub-section (2) of section 115WB;
(d) fifty per cent of the expenses referred to in clauses (L) to (P)
of sub-section (2) of section 115WB.
(2) Notwithstanding anything contained in sub-section (1),—
(a) in the case of an employer engaged in the business of hotel, the value of fringe benefits
for the purposes referred to in clause (B) of sub-section (2) of section 115WB shall be
“five per cent” instead of “twenty per cent” referred to in clause (c) of sub-section (1);
(b) in the case of an employer engaged in the business of construction, the value of fringe
benefits for the purposes referred to in clause (F) of sub-section (2) of section 115WB
shall be “five per cent” instead of “twenty per cent” referred to in clause (c) of sub-section
(1);
(c) in the case of an employer engaged in the business of manufacture or production of
pharmaceuticals, the value of fringe benefits for the purposes referred to in clauses (F)
and (G) of sub-section (2) of section 115WB shall be “five per cent” instead of “twenty per
cent” referred to in clause (c) of sub-section (1);
(d) in the case of an employer engaged in the business of manufacture or production of
computer software, the value of fringe benefits for the purposes referred to in clauses (F)
and (G) of sub-section (2) of section 115WB shall be “five per cent” instead of “twenty-
per cent” referred to in clause (c) of sub-section (1);
(e) in the case of an employer engaged in the business of carriage of passengers or goods
by motor car, the value of fringe benefits for the purposes referred to in clause (H) of
sub-section (2) of section 115WB shall be “five per cent” instead of “twenty per cent”
referred to in clause (c) of sub-section (1);
(f) in the case of an employer engaged in the business of carriage of passengers or goods
by aircraft, the value of fringe benefits for the purposes referred to in clause (I) of sub-
section (2) of section 115WB shall be taken as Nil.
C.— Procedure for filing of return in respect of fringe benefits,assessment and payment of tax
in respect thereof
Return of fringe benefits
115WD. (1) Without prejudice to the provisions contained in section 139, every employer who
during a previous year has paid or made provision for payment of fringe benefits to his
employees, shall, on or before the due date, furnish or cause to be furnished a return of fringe
benefits to the Assessing Officer in the prescribed form and verified in the prescribed manner
and setting forth such other particulars as may be prescribed, in respect of the previous year.
Explanation.—In this sub-section, “due date” means,—
(a) where the employer is—
(i) a company; or
(ii) a person (other than a company) whose accounts are required to be audited under
this Act or under any other law for the time being in force, the 31st day of October of
the assessment year;
(b) in the case of any other employer, the 31st day of July of the assessment year.
Payment of fringe benefit tax

115WI. Notwithstanding that the regular assessment in respect of any fringe benefits is to be
made in a later assessment year, the tax on such fringe benefits shall be payable in advance
during any financial year, in accordance with the provisions of section 115WJ, in respect of the
fringe benefits which would be chargeable to tax for the assessment year immediately
following that financial year, such fringe benefits being hereafter in this Chapter referred to as
the “current fringe benefits”.
Advance tax in respect of fringe benefits
115WJ. (1) Every assessee who is liable to pay advance tax under section 115WI, shall on his
own accord, pay advance tax on his current fringe benefits calculated in the manner laid down
in sub-section (2).
(2) The amount of advance tax payable by an assessee in the financial year shall be thirty
per cent of the value of the fringe benefits referred to in section 115WC, paid or payable in
each quarter and shall be payable on or before the 15th day of the month following such
quarter:
Provided that the advance tax payable for the quarter ending on the 31st day of March of the
financial year shall be payable on or before the 15th day of March of the said financial year.
(3) Where an assessee, has failed to pay the advance tax for any quarter or where the
advance tax paid by him is less than thirty per cent of the value of fringe benefits paid or
payable in that quarter, he shall be liable to pay simple interest at the rate of one per cent on
the amount by which the advance tax paid falls short of, thirty per cent of the value of fringe
benefits for any quarter, for every month or part of the month for which the shortfall continues.

Guidance Note on Accounting for Credit
Available in respect of Minimum
Alternative Tax under
The Income-tax Act, 1961
(The following is the text of the Guidance Note on Accounting for Credit Available in Respect
of Minimum Alternative Tax Under the Income-tax Act,1961, issued by the Council of the
Institute of Chartered Accountants of India.)
INTRODUCTION
1. The Finance Act, 1997, introduced section 115JAA in the Income-tax Act, 1961
(hereinafter referred to as the ‘Act’) providing for tax credit in respect of MAT paid under
section 115JA (hereinafter referred to as ‘MAT credit’) which could be carried forward for set-
off for five succeeding years in accordance with the provisions of the Act. Section 115JA was
inserted by the Finance Act, 1996, w.e.f. 1.4.1997. The said section provided for payment of
Minimum Alternative Tax (hereinafter referred to as ‘MAT’) by certain companies, where the
total income, as computed under the Income-tax Act, 1961, in respect of any previous year
relevant to the assessment year commencing on or after 1st day of April, 1997, but before the
1st day of April, 2001, was less than 30% of its book profit. In such a case, the total income of
the company chargeable to tax for the relevant previous year was deemed to be an amount
equal to thirty per cent of its book profit.
2. The Finance Act, 2000, w.e.f. 1.4.2001, introduced section 115JB according to which a
company is liable to pay MAT under the provisions of the said section in respect of any
previous year relevant to the assessment year commencing on or after the 1 st day of April,
2001. The MAT under this section is payable where the normal income-tax payable by such
company in the previous year is less than 7.5 per cent (10 per cent proposed by the Finance
Bill, 2006) of its book profit which is deemed to be the total income of the company. Such
company is liable to pay income-tax at the rate of 7.5 per cent (10 per cent proposed by the
Finance Bill, 2006) of its book profit.
The Finance Act, 2005, inserted sub-section (1A) to section 115JAA, to grant tax credit in
respect of MAT paid under section 115JB of the Act with effect from assessment year 2006-
07.
3. The salient features of MAT credit under section 115JAA as applicable, in respect of tax
paid under sections 115JA and 115JB, are as below:
(a) A company, which has paid MAT, would be allowed credit in respect thereof.
(b) The amount of MAT credit would be equal to the excess of MAT over normal income-tax
for the assessment year for which MAT is paid.
(c) No interest is allowable on such credit.
(d) The MAT credit so determined can be carried forward for set-off for five succeeding
assessment years from the year in which MAT credit becomes allowable. The Finance
Bill, 2006, has proposed that credit in respect of MAT paid under section 115JB can be
carried forward upto seven succeeding assessment years (hereinafter referred to as the
‘specified period’).
(e) The amount of MAT credit can be set-off only in the year in which the company is liable
to pay tax as per the normal provisions of the Act and such tax is in excess of MAT for
that year.
(f) The amount of set-off would be to the extent of excess of normal income-tax over the
amount of MAT calculated as if section 115JB had been applied for that assessment year
for which the set-off is being allowed.
ACCOUNTING TREATMENT
Whether MAT credit is a deferred tax asset
4. An issue has been raised whether the MAT credit can be considered as a deferred tax
asset within the meaning of Accounting Standard (AS) 22, Accounting for Taxes on Income,
issued by the Institute of Chartered Accountants of India. In this context, the following
definitions given in AS 22 are noted:
“Timing differences are the differences between taxable income and accounting income
for a period that originate in one period and are capable of reversal in one or more
subsequent periods.”
“Accounting income (loss) is the net profit or loss for a period, as reported in the
statement of profit and loss, before deducting income tax expense or adding income tax
saving.”
“Taxable income (tax loss) is the amount of the income (loss) for a period,determined in
accordance with the tax laws, based upon which income tax payable (recoverable) is
determined.”
5. From the above, it is noted that payment of MAT, does not by itself, result in any timing
difference since it does not give rise to any difference between the accounting income and the
taxable income which are arrived at before adjusting the tax expense, namely, MAT. In other
words, under AS 22, deferred tax asset and deferred tax liability arise on account of
differences in the items of income and expenses credited or charged in the profit and loss
account as compared to the items of income that are taxed or items of expense that are
allowed as deduction, for the purposes of the Act. Thus, deferred tax assets and deferred tax
liabilities do not arise on account of the amount of the tax expense itself. In view of this, it is
not appropriate to consider MAT credit as a deferred tax asset for the purposes of AS 22.
Whether MAT credit can be considered as an ‘asset’
6. Although MAT credit is not a deferred tax asset under AS 22 as discussed above, yet it
gives rise to expected future economic benefit in the form of adjustment of future income tax
liability arising within the specified period. A question, therefore, arises whether the MAT credit
can be considered as an ‘asset’ and in case it can be considered as an asset whether it
should be so recognised in the financial statements.
7. The Framework for the Preparation and Presentation of Financial Statements, issued by
the Institute of Chartered Accountants of India, defines the term ‘asset’ as follows:
“An asset is a resource controlled by the enterprise as a result of past events from which
future economic benefits are expected to flow to the enterprise.”
8. MAT paid in a year in respect of which the credit is allowed during the specified period
under the Act is a resource controlled by the company as a result of past event, namely, the
payment of MAT. MAT credit has expected future economic benefits in the form of its
adjustment against the discharge of the normal tax liability if the same arises during the
specified period.
Accordingly, MAT credit is an ‘asset’.
9. According to the Framework, once an item meets the definition of the term ‘asset’, it has
to meet the criteria for recognition of an asset so that it may be recognised as such in the
financial statements. Paragraph 88 of the Framework provides the following criteria for
recognition of an asset:
“88. An asset is recognised in the balance sheet when it is probable that the future economic
be measured reliably.”
10. In order to decide when it is ‘probable’ that the future economic benefits associated with
the asset will flow to the enterprise, paragraph 84 of the Framework, inter alia, provides as
below:
“84. The concept of probability is used in the recognition criteria to refer to the degree of
uncertainty that the future economic benefits associated with the item will flow to or from the
enterprise. The concept is in keeping with the uncertainty that characterises the environment
in which an enterprise operates. Assessments of the degree of uncertainty attaching to the
flow of future economic benefits are made on the basis of the evidence available when the
financial statements are prepared.”
11. The concept of probability as contemplated in paragraph 84 of the Framework relates to
both items of assets and liabilities and, therefore, the degree of uncertainty for recognition of
assets and liabilities may vary keeping in view the consideration of ‘prudence’. Accordingly,
while for recognition of a liability the degree of uncertainty to be considered ‘probable’ can be
‘more likely than not’ (as in paragraph 22 of Accounting Standard (AS) 29, ‘Provisions,
Contingent Liabilities and Contingent Assets’) for recognition of an asset, in appropriate
conditions, the degree may have to be higher than that. Thus, for the purpose of consideration
of the probability of expected future economic benefits in respect of MAT credit, the fact that a
company is paying MAT and not the normal income tax, provides a prima facie evidence that
normal income tax liability may not arise within the specified period to avail MAT credit. In
view of this, MAT credit should be recognised as an asset only when and to the extent there is
convincing evidence that the company will pay normal income tax during the specified period.
Such evidence may exist, for example, where a company has, in the current year, a deferred
tax liability because its depreciation for the income-tax purposes is higher than the
depreciation for accounting purposes, but from the next year onwards, the depreciation for
accounting purposes would be higher than the depreciation for income-tax purposes, thereby
resulting in the reversal of the deferred tax liability to an extent that the company becomes
liable to pay normal income tax.
12. Where MAT credit is recognised as an asset in accordance with paragraph 11 above, the
same should be reviewed at each balance sheet date. A company should write down the
carrying amount of the MAT credit asset to the extent there is no longer a convincing evidence
to the effect that the company will pay normal income tax during the specified period.
Presentation of MAT credit in the financial statements
Balance Sheet
13. Where a company recognises MAT credit as an asset on the basis of the considerations
specified in paragraph 11 above, the same should be presented under the head ‘Loans and
Advances’ since, there being a convincing evidence of realisation of the asset, it is of the
nature of a pre-paid tax which would be adjusted against the normal income tax during the
specified period. The asset may be reflected as ‘MAT credit entitlement’.
14. In the year of set-off of credit, the amount of credit availed should be shown as a
deduction from the ‘Provision for Taxation’ on the liabilities side of the balance sheet. The
unavailed amount of MAT credit entitlement, if any, should continue to be presented under the
head ‘Loans and Advances’ if it continues to meet the considerations stated in paragraph 11
above.
15. According to paragraph 6 of Accounting Standards Interpretation (ASI) ‘Accounting for
Taxes on Income in the context of Section 115JB of the Income-tax Act, 1961’, issued by the
Institute of Chartered Accountants of India, MAT is the current tax. Accordingly, the tax
expense arising on account of payment of MAT should be charged at the gross amount, in the
normal way, to the profit and loss account in the year of payment of MAT. In the year in which
the MAT credit becomes eligible to be recognised as an asset in accordance with the
recommendations contained in this Guidance Note, the said asset should be created by way of
a credit to the profit and loss account and presented as a separate line item therein.

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FINAL COURSE STUDY MATERIAL

© The Institute of Chartered Accountants of India

Website : www.icai.org E-mail : bosnoida@icai.org

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

CHAPTER 8 – FINANCIAL REPORTING FOR FINANCIAL INSTITUTIONS

Unit 1: Mutual Funds

Unit 1: Concept of Valuation

Unit 1: Value Added Statement

1.2 ORGANISATION OF MUTUAL FUNDS

funds of a mutual fund.

1.3 MUTUAL FUND SCHEMES

1.4 EVALUATION OF MUTUAL FUNDS

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

Rs. lakh Rs. Lakh Rs. lakh

Fund management expenses paid (4.50 – 0.25) 4.25

1.5 VALUATION OF PORTFOLIO

1.6 ANNUAL REPORTING

1.7 ACCOUNTING POLICIES

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

made in respect of such investment.

1.8 CONTENTS OF BALANCE SHEET AND REVENUE ACCOUNT

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

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

1.9 MARKING INVESTMENTS TO MARKET

Investment in B Ltd. shares 16

1.10 DISPOSAL OF INVESTMENTS

Rs. 000 Rs. 000

1.11 RECOGNITION OF DIVIDEND INCOME

1.12 COST OF INVESTMENTS

1.13 DATE OF RECOGNITION OF TRANSACTIONS

the net income of the fund is determined.

1.14 DIVIDEND EQUALISATION

77.4 3.6 81.0

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

Old unit holders New unit holders

Date Rs. lakh Rs. lakh

31/03/07 Dividend Equalisation 5

31/03/07 Revenue A/c 86

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

2.2 DEFINITION OF NBFC

2.3 REGISTRATION AND REGULATION OF NBFC

2.4 MINIMUM NET OWNED FUND

2.5 TYPES OF NBFC REGULATED BY RBI

(c) Loan company;

2.6 PUBLIC DEPOSITS

2.7 LIQUID ASSET REQUIREMENTS

2.8 PRUDENTIAL ACCOUNTING NORMS

2.9 INCOME RECOGNITION

2.10 ACCOUNTING FOR INVESTMENTS

2.11 ASSET CLASSIFICATION

2.12 NON-PERFORMING ASSET (NPA)

2.13 PROVISIONING REQUIREMENTS

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

2.14 DISCLOSURE IN THE BALANCE SHEET

2.15 REQUIREMENT AS TO CAPITAL ADEQUACY

(d) Hybrid debt and

2.16 ASSET-LIABILITY MANAGEMENT (ALM)

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

Provided that it is–

equity as well as of debt;

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

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

3.2 CAPITAL ADEQUACY REQUIREMENT