Accounting Theory and Practice

Definition of Accounting - Need for Accounting Art Ws Science-Scope of

Accounting, Relationship Accounting with other disciplines, History of
Accounting Systems.
Accounting-An Introduction
Accounting is generally termed as the language of business throughout the
world. The language is the means of communication of ideas or feelings by
the use of conventionalised signs, gestures, marks and articulated vocal
sound. In the same way, the accounting language seaves as a means to
communicate matters relating to various aspects of business operations. As
the

individual

business

enterprises

keep

their

accounting

records

separately, the offer to communicate is essentially from a business

enterprise to various individuals, groups and institutions that are having
interest in the operations and results of that enterprise. Now, although
accounting is generally recognised with the business, trade and profession,
the business enterprise is not the only kind of organisation that makes use
of accounting. Legal entities ranging from individual to governments use
and prepare accounting to obtain information on the financial condition
and performance of the entity in question. Just as the business enterprises
(like firms, companies, societies and institutions keep their accounts, so can
the nations and even the individual owners of the business and profession
entities.
It is necessary to have a good knowledge of accounting-grammar (in the
shape of construction of accounts, conventions, concepts, postulates,
principles, standards etc.) to interpret accounting information for purposes
of communication, reporting, decision making or appraisal.
Definition of Accounting
The role of accounting then is that of communicating the results of the
operations of a business. How does accounting accomplish this ? This is
best

understood

by

commonly

accepted

definition

of

accounting

Accounting is the art of recording, classifying and summarising in a

significant manner and in terms of money, transactions and events which

are, in part at least, of financial character and interpreting the results

thereof. (AICPA)
American Accounting Association defines accounting as the process of
identifying, measuring and communicating economic information to permit
informed judgements and decision by users of the information.
From the above the following attributes of accounting emerge :
(i) Recording: It is concerned with the recording of financial transactions in
an orderly manner, soon after their occurrence In the proper books of
accounts.
(ii) Classifying: It Is concerned with the systematic analysis of the recorded
data so as to accumulate the transactions of similar type at one place. This
function
is performed by maintaining the ledger in which different accounts are
opened to which related transactions are posted.
(iii) Summarising: It is concerned with the preparation and presentation of
the classified data in a manner useful to the users. This function involves
the preparation of financial statements such as Income Statement, Balance
Sheet,
Statement of Changes in Financial Position, Statement of Cash Flow,
Statement of Value Added.
(iv) Interpreting: Now a days, the aforesaid three functions are performed by
electronic data processing devices and the accountant has to concentrate
mainly on the interpretation aspects of accounting. The accountants should
interpret the statements in a manner useful to action. The accountant
should explain not only what has happened but also (a) why it happened,
and (b) what is likely to happen under specified conditions.
Objectives of Accounting
The following are the main objectives of accounting:

i) To keep systematic records : Accounting is done to keep a systematic

record of financial transactions, like purchase of goods, sale of goods, cash
receipts and cash payments.
ii) To ascertain the operational profit or loss : Accounting helps in
determining the net profit earned or loss suffered on account of running the
business. This is done by keeping a proper record of revenues and expenses
of a particular period.
iii) To ascertain the financial position of the business : The businessman is
not only interested in knowing the operating result, but also interested in
knowing the financial position of his business i.e., where it stands. In other
words, he wants to know what the business owes to others and what others
owe to business.
iv) To facilitate rational decision making : Apart from the owners, there are
various other parties who are interested in knowing about the position of
business, such as tax authorities, the management, the bank, the creditors,
etc. The required information is furnished to all these parties through
accounting system.
Accounting as science or art
Science is a systematised body of knowledge. It establishes a relationship of
cause and effect in the various related phenomenon. It is also based on
some fundamental principles. Accounting has its own principles e.g. the
double entry system, which explains that every transaction has two fold
aspect i.e. debit and credit. It also lays down rules of journalising. So we
can say that accounting is a science.
Art requires a perfect knowledge, interest and experience to do a work
efficiently. Art also teaches us how to do a work in the best possible way by
making the best use of the available resources. Accounting is an art as it
also requires knowledge, interest and experience to maintain the books of
accounts in a systematic manner. Everybody cannot become a good
accountant. It can be concluded from the above discussion that accounting
is an art as well as a science.
Relationship Accounting with other disciplines

Accounting is a dynamic and applied subject. Even though it is a

independent study, it has relationship with other subjects.
The subjects with the its relations are very much close are discussed below;
Accounting and Management
Accounting and Management are very closely related. Because management
depends entirely on Accounting as information store in making decisions in
financial affairs.
Accounting provides all kinds of financial information in project planning
and implementation of a business concern.
As a result the management can take decisions comfortably regarding
project planning and implementation.
The scope of Management is extended from individual life to the various
field of social life. The overall development of trading, non-trading,
government, semi-government, autonomous bodies etc. depends on
management.
In- the modem age the responsibilities of making decisions, planning and
management have been shifted from owners to professional managerial
persons.
For this reason all functions of managers are directed to the development of
business concern.
In this respect Accounting helps the management in taking timely
decisions, interpreting and analyzing overall and information based
matters.
Managers cannot take the best and most dynamic course of action for their
respective business concerns without the information based financial
statements and other statements of accounts.
As a matter of fact, the success of management fully depends on accounting
information.
Accounting and Economics
The relation of Economics with Accounting is very close. Economics is a
science related to human activities to fulfill demand with limited wealth.
Economics analyses how people earn and spend, how purchasers and
sellers behave under different circumstances etc.
On the other hand Accounting records transactions of income and
expenditure measurable in terms of money and provides necessary and
relevant information to purchasers and sellers for taking decisions.
Economics studies the behaviors of buyers and sellers as a whole.
On the other hand Accounting provides all required financial information to
individual buyers and sellers for taking economic decision.

So, these two subjects are interrelated. In this perspective bringing about a
synthesis between the concept of economics and accounting, the concept of
social sciences is being applied. .
Accounting and Mathematics
Accounting and Mathematics are closely related. Accounting is the language
of business. On the other hand Mathematics is the language of Accounting.
At different stages of accounting addition, subtraction, multiplication and
division of arithmetic are applied.
Accounting expresses all its transactions and events of financial changes in
the language of mathematics. At all stages of accounting i.e. in preparing
journal, ledger, trial balance and financial statements mathematical
principles are applied.
For this reason the processes of keeping accounts become easy and short.
So, Mathematics is an indispensable part of Accounting.
Accounting and Computer Science
There is a close and effective relationship between Accounting and
Computer Science. The word computer has been derived from the word
compute. The word compute means counting and the meaning of computer
is counter.
It is possible to solve mathematical problems involving millions or even
billions of figures within a few seconds by computer and these can be
preserved in it as well.
In Accounting accounts of various transactions are to be recorded and the
results are to be determined.
It takes huge time and labor and even then the accuracy of Accounting
cannot be hundred percent ensured. Computer has eliminated all these
obstacles.
Because using all kinds of information and data relating transactions as per
definite table and program in computer, preparation of accurate accounting
is possible within very short time.
It saves time and labor. Besides, with the help of computer, preparation of
various accounts as per need, preservation and verification of validity of
ratio are possible very quickly.
In the developed countries of the modem world the application of computer
is growing fast in solving accounting problems.
In our country also the application of computer is increasing in the field of
accounting problems. Therefore, the relation between Accounting and
Computer is very close.
Accounting and Statistics

Accounting and Statistics are deeply related. The main object of these two
sciences is to make arithmetical figures understandable and logical and to
present these in the form of statements making them usable to owner,
directors or all others concerned. It makes the act of planning and decisionmaking easier.
The main function of statistics is to collect classify, analyses the
quantitative data of various events and to present them to the individuals or
organizations concerned.
For this reason a statistician presents the data in quite a short form of
reports to the individuals or organization concerned so that they can take
decision depending on this information.
On the other hand, in Accounting after completion of some accounting
processes of transactions, final accounts and financial statements are
prepared and on the basis of various information of such financial
statements; the owners and the directors of the organization concerned can
take decisions.
Accounting and Law
The prevailing laws of a land control trade and commerce mostly, So,
Accounting and Law are closely related.
The accountant and accounts officer must have clear knowledge of
partnership law, company law, tax law, industrial law, cooperative law and
other relevant laws. Because accounts of an organization are kept following
accepted principles and in accordance with relevant laws.
For example, accounts of every company are kept properly and accurately in
the light of company law. In partnership business accounts are maintained
in the light of partnership act or agreement as the case may be.
Keeping accounts, auditing of accounts of a company are mandatory as per
specific provision of the companies act. Similarly, accounts of other
organizations are to be kept in accordance with the provisions of the
relevant law.
In this context lawyers are to know the provision of laws relating to methods
of accounting, direction and controlling.
Otherwise, it is impossible on their part to extend their help in settling
conflicts and cases properly. Therefore, both Accounting and Law are closely
related subjects.
Accounting and Political Science
The main object of Political Science is to ensure law and order for
establishing rule of law in the society. Political science gives directives in
achieving welfare for the people of the society as a whole.

For this reason issues like national income and expenditure; national
development expenditure and probable income from national prospects etc.
arise from political science.
Keeping proper accounts of this national income, expenditure and providing
information in this regard are the tasks of Accounting. Besides maintaining
accounts and auditing of accounts of government tax administration,
expenditure of various projects, income tax, etc. are performed by
accounting.
Therefore there exists a close relationship between Accounting and Political
Science.
Accounting and Engineering
Among the important branches of modem social sciences accounting and
Engineering axe prominent.
These two subjects jointly work in the process of production and building.
Special type of plant and machineries are needed in factories. These plants
and machines are made by the engineers engaged in engineering work.
The estimation regarding types of goods and quantity of goods to be
produced and amount of expenditure to be involved in machineries etc. of a
concern is to be accounted for.
For this reason the entrepreneurs, directors, managers of a production
oriented business concern should have the knowledge of engineering.
Function of accountant is to find out the ratio between money invested in
plant and machineries and results arising out of it and present the same to
the managers in the form of statements.
Without the knowledge of engineering an accountant cannot provide
accurate information regarding plant and machineries.
So, in the modem age of complex and large scale production the knowledge
of accounting as well as engineering is essential for achieving target by
running a business successfully.
HISTORY OF ACCOUNTING
Accounting is as old as money itself. However, the act of accounting was not
as developed as it is today because in the early stages of civilisation, the
number

of transactions to be recorded were so small that each

businessman was able to record and check for himself all his transactions.
Accounting was practised in India twenty three centuries ago as is clear
from

the

book

named

"Arthashastra"

written

by

Kautilya,

King

Chandragupta's minister. This book not only relates to politics and

economics, but also explain the art of proper keeping of accounts.

However, the modern system of accounting based on the principles of

double entry system owes it origin to Luco Pacioli who first published the
principles of Double Entry System in 1494 at Venice in Italy. Thus, the art
of accounting has been practised for centuries but it is only in the late
thirties that the study of the subject 'accounting' has been taken up
seriously
The Structure of Accounting Theory
-Accounting theory contains
i. A statement of the objectives of financial statements.
ii. A statement of the postulates and theoretical concepts.
iii. A statement of the accounting principles based on postulates and
theoretical concepts.
iv. A body of accounting techniques derived from the accounting principles.Definition
i. Accounting postulate (assume)
- self evident statements generally accepted by virtue of their conformity to
the objectives of FS that portray economic, political, sociological and legal
environments in which accounting must operate.
ii.Theoretical concepts- portray the nature of accounting entities operating
in a freeeconomy characterized by private ownership of property.
iii.Accounting principles- general decision rules derived from both objectives
andtheoretical concepts of accounting that govern the development of
accountingtechniques.
iv.Accounting techniques- specific rules derived from the accounting
principles thataccount specific transactions and events faced by the
accounting entity.
Conceptual Framework
What is CF?

A coherent system of interrelated objectives and fundamentals that lead to

consistent standards andthat prescribes the nature, function and limits of
financial accounting and reporting.
Serve as a guidelines to form a general rules.
Consist of 3 levels:Highest level- states the scope and objectives of financial reporting.
Middle level- identifies and defines the qualitative characteristics of
financialinformation

such

as relevance, reliability

comparability

and

timeliness and basicelements of accounting reports such as asset,

liabilities, income, expenses and profit.
Lower level- deals with principles and rules of recognition and measurement
of the basic elements and type of information to be displayed in financial
reports.
Act as a constitution for the standard-setting process.
Benefits of CF
Guide the FASB in establishing accounting standards
Provide a frame of reference for resolving accounting questions in the
absence of specific promulgated standards.
Determine the bounds of judgment in preparing financial statement.
Enhance comparability by decreasing the number of alternative accounting
methods.
Overall scope of CF
1st level is objectives which identify the goals and purpose of accounting.
2nd level- fundamentals include the qualitative characteristics of accounting
info and definitions of the elements of financial statement.
3rd level- operational guidelines that the accountant uses in establishing
and applying accountingstandards include the recognition criteria, financial
statements vs financial reporting andmeasurement.

4th level- the display mechanisms that accounting uses to convey info
include reported earnings,reporting funds flow and liquidity and reporting
financial position.
Why CF is needed?
Lack of a general theory
Permissiveness

of

accounting

practice-

accounting

standards

allows

alternative accounting practicesto be applied to similar circumstances.

Inconsistency of practices
Defense

against

political

interference-

accounting

policies

can

be

implemented by making a value judgment but there is no way of proving

that the value judgments of any individual are better for society.
Objectives of CF
Information for decision making :the objective of general purpose financial
reporting is to provide information to users that are useful inmaking and
evaluating

decisions

about

the

allocation

of

scarce

resources.IASB

Framework focus on information needs of a wide range of usersFASB

Concepts Statement No.1, Objectives of Financial Reporting by Business
Entity emphasizesusefulness in investment and credit decisions.Decision-theory approachOverall theory of accounting ---> individual
accounting system --->prediction model of user ---->Decision model of user
Useful in assessing cash flow prospects- about enterprise resources, claims
to those resources andchanges in them.
Approaches to the Development of Accounting Theory
1.Pragmatic theories
Descriptive pragmatic approach

It is an inductive approach where it

based on continual observation of the behaviour of accountants in order to

copy their accounting procedures and principles.
Criticism- does not include an analytical judgement of the quality of an
accountants actions. Does not provide for accounting techniques to be

challenge and does not allow for change. Focus in accountants behaviour
not on measuring the attributes of the firm.
Psychological

pragmatic

approach

Observe

users

response

to

accountants outputs (e.g. financial reports). Reaction by user is taken as

evidence that financial statements are useful and relevant info.
Criticisms:- Users react in a illogical manner, have preconditioned response
and may not react when they should.
2. Syntactic and Semantic theories Traditional historical cost accounting
largely a syntactic theory. Some accounting theorists argue that theory has
a semantic content on the basis of its inputs. There is no independent
empirical operation to verify the calculated outputs.
3.Normative

theories

(prescriptive)

Concerned

with

policy

recommendations & with what should be done and how accounting should
be practiced. Based on subjective opinion of what accounts should be report
and the best way to do that.
Focus: Deriving true income in accounting period where concentrate on
deriving a single measure for assets and a unique profit figure. Discussing
type of accounting info useful in making decision (decision usefulness)
Assumptions are rarely subject to any empirical testing
Theory: Based on analytic / syntactic, and Empirical propositions
Make assumptions about the nature of a firms operations based on their
observations.
4.Positive theories (descriptive) Referred as positive methodology (testing
theories to real world). Focus on empirically (experimental) testing some of
the assumptions made by normative accounting theorists.
Survey opinions.
Test importance of accounting outputs in marketplace.
Explain on what and how and predict accounting practice.
Enable regulators to assess the economic consequences of the various
accounting practices they consider.

Assume that accounting info is an economic and political commodity and

that people actin their own self-interest.
Concern:
Explaining reasons for accounting practices.
Predicting role of accounting & associated info in economic decision
making.
Normative & positive theories complement each other.
Traditional Approach
3.Nontheoritical Approaches
a.Pragmatic approach Characterized by its conformity to real-world
practices (useful).
Consists of the construction of a theory that conforms to real-world
practices and suggests practical solutions.
Accounting techniques & principles chosen - usefulness to users of info &
relevance to decision-making process.
b.Authoritarian approach
Used by professional organizations.
Consists of pronouncements for regulation of accounting practices.
Attempt to provide practical solutions.
Pragmatic & authoritarian ---> accounting theory predicted on the basis of
ultimate uses of financial reports.

4.Deductive approach
5.Inductive approach
6.Ethical approach
Consist

of

the

concept

of

fairness

(fair,

unbiased

and

impartial

representation), justice(equitable treatment of all interested parties), equity

and

truth

(true

and

accurateaccounting

statements

without

misrepresentation).
7.Sociological approach
Formalization of an accounting theory emphasizes the social effects of
accountingtechniques.
A given accounting principles is evaluated for acceptance.
Accounting data will be useful in making social welfare judgements.
Assumes the existence of established social values that may be used as
criteria.
Concepts of internalizing social costs & social benefits of the business;
accountingshould serve public interests.
Has contributed to the evolution of new accounting subdiscipline known
associoeconomic accounting to encourage business entities to account for
the impact of their private production activities on the social environment
through measurement anddisclosure in financial statements.
8.Economic approach
Emphasizes the controlling behaviour of macroeconomic indicators that
result from the adoption of various accounting techniques.
Focus on general economic welfare.
The choice of different accounting techniques depends on their impact on
the nationaleconomic good.
Accounting policies and techniques should reflect economic reality and
depend on economic consequences.
9. Electic approach
Combination of approaches in developing accounting theory.
Numerous

attempts

by

individuals

&

professional

&

governmental

organizations to participate in the establishment of concepts & principles in

accounting. Emerge new approaches (regulatory, behavioral, event, positive)

ACCOUNTING ASSUMPTIONS
(a) Business Entity Concept
As per this concept, the business is treated as distinct and separate from
the individuals who own or manage it. When recording business
transactions, the important question is how will it affect the business
entity? How they affect the persons who own it or run it or otherwise
associated with it is irrelevant.
Application of this concept enables recording of transactions of the business
entity with its owners or managers or other stakeholders. For example, if
the owner pays his personal expenses from business cash, this transaction
can be recorded in the books of business entity. This transaction will take
the cash out of business and also reduce the obligation of the business
towards the owner.
At times it is difficult to separate owners from the business. Consider an
individual, who runs a small retail outlet. In the eyes of law, there is no
distinction made between financial affairs of the outlet with that of the
individual. The creditors of the retail outlet can sue the individual and
collect his claim from personal resources of the individual. However, in
accounting, the records are kept as distinct for the retail outlet and the
individual respectively. For certain forms of business entities, such as
limited companies this distinction is easier. The limited companies are
separate legal persons in the eyes of law as well.
The entity concept requires that all the transactions are to be viewed,
interpreted and recorded from business entity point of view. An accountant
steps into the shoes of the business entity and decides to account for the
transactions. The owners capital is the obligation of business and it has to
be paid back to the owner in the event of business closure. Also, the profit
earned by the business will belong to the owner and hence is treated as
owners equity.
(b) Going Concern Concept
The basic principles of this concept is that business is assumed to exist for
an indefinite period and is not established with the objective of closing it

down. So unless there is good evidence to the contrary, the accountant

assumes that a business entity is a going concern - that it will continue to
operate as usual for a longer period of time. It will keep getting money from
its customers, pay its creditors, buy and sell goods, use assets to earn
profits in future. If this assumption is not considered, one will have to
constantly value the worth of the assets and resource. This is not
practicable. This concept enables the accountant to carry forward the
values of assets and liabilities from one accounting period to the other
without asking the question about usefulness and worth of the assets and
recoverability of the receivables. The going concern concept forms a sound
basis for preparation of a Balance Sheet.
(c) Money Measurement Concept
A business transaction will always be recoded if it can be expressed in
terms of money. The advantage of this concept is that different types of
transactions could be recorded as homogenous entries with money as
common denominator. A business may own ` 3 Lacs cash, 1500 kg of raw
material, 10 vehicles, 3 computers etc. Unless each of these is expressed in
terms of money, we cannot find out the assets owned by the business. When
expressed in the common measure of money, transactions could be added
or subtracted to find out the combined effect. In the above example, we
could add values of different assets to find the total assets owned.
The application of this concept has a limitation. When transactions are
recorded in terms of money, we only consider the absolute value of the
money. The real value of the money may fluctuate from time to time due to
inflation, exchange rate changes, etc. This fact is not considered when
recording the transaction.
(d) The Accounting Period Concept
We have seen that as per the going-concern concept the business entity is
assumed to have an indefinite life. Now if we were to assess whether the
business has made profit or loss, should we wait until this indefinite period
is over? Would it mean that we will not be able to assess the business
performance on an ongoing basis? Does it deprive all stakeholders the right

to the accounting information? Would it mean that the business will not pay
income tax as no income will be computed?
(e) The Accrual Concept
The accrual concept is based on recognition of both cash and credit
transactions. In case of a cash transaction, owners equity is instantly
affected as cash either is received or paid. In a credit transaction, however,
a mere obligation towards or by the business is created. When credit
transactions exist (which is generally the case), revenues are not the same
as cash receipts and expenses are not same as cash paid during the period.
When goods are sold on credit as per normally accepted trade practices, the
business gets the legal right to claim the money from the customer.
Acquiring such right to claim the consideration for sale of goods or services
is called accrual of revenue. The actual collection of money from customer
could be at a later date.
Similarly, when the business procures goods or services with the agreement
that the payment will be made at a future date, it does not mean that the
expense effect should not be recognized. Because an obligation to pay for
goods or services is created upon the procurement thereof, the expense
effect also must be recognized.
Todays accounting systems based on accrual concept are called as Accrual
System or Mercantile System of Accounting.
BASIC PRINCIPLES/ CONCEPTS
(a) The Revenue Realisation Concept
While the conservatism concept states whether or not revenue should be
recognized, the concept of realisation talks about what revenue should be
recognized. It says amount should be recognized only to the tune of which it
is certainly realizable. Thus, mere getting an order from the customer wont
make it eligible to recognize as revenue. The reasonable certainty of
realizing the money will come only when the goods ordered are actually
supplied to the customer and he is billed. This concept ensures that income
unearned or unrealized will not be considered as revenue and the firms will
not inflate profits.

Consider that a store sales goods for ` 25 lacs during a month on credit. The
experience and past data shows that generally 2% of the amount is not
realized. The revenue to be recognized will be ` 24.50 lacs.
Although conceptually the revenue to be recognized at this value, in
practice the doubtful amount of ` 50 thousand (2% of ` 25 lacs) is often
considered as expense.
(b) The Matching Concept
As we have seen the sale of goods has two effects: (i) a revenue effect, which
results in increase in owners equity by the sales value of the transaction
and (ii) an expense effect, which reduces owners equity by the cost of goods
sold, as the goods go out of the business. The net effect of these two effects
will reflect either profit or loss. In order to correctly arrive at the net result,
both these aspects must be recognized during the same accounting period.
One cannot recognize only the revenue effect thereby inflating the profit or
only the expense effect which will deflate the profit. Both the effects must
be recognized in the same accounting period. This is the principle of
matching concept.
To generalize, when a given event has two effects one on revenue and the
other on expense, both must be recognized in the same accounting period.
(c) Full Disclosure Concept
As per this concept, all significant information must be disclosed.
Accounting data should properly be clarified, summarized, aggregated and
explained for the purpose of presenting the financial statements which are
useful for the users of accounting information. Practically, this principle
emphasizes on the materiality, objectivity and consistency of accounting
data which should disclose the true and fair view of the state of affairs of a
firm. This principle is going to be popular day by day as per Companies
Act, 1956 major provisions for disclosure of essential information about
accounting data and as such, concealment of material information, at
present, is not very easy. Thus, full disclosure must be made for
such material information which are useful to the users of accounting
information.

(d) Dual Aspect Concept

The assets represent economic resources of the business, whereas the
claims of various parties on business are called obligations. The obligations
could be towards owners (called as owners equity) and towards parties
other than the owners (called as liabilities).
When a business transaction happens, it will involve use of one or the other
resource of the business to create or settle one or more obligations. e.g.
consider Mr. Suresh starts a business with the investment of ` 25 lacs.
Here, the business has got a resource of cash worth ` 25 lacs (which is its
asset), but at the same time it has created an obligation of business towards
Mr. Suresh that in the event of business closure, the money will be paid
back to him. This could be shown as:
Assets = Liabilities + Capital
In other words, Cash brought in by Mr. Suresh (` 25 lacs) = Liability of
business towards Mr. Suresh (` 25 lacs)
We know that liability of the business could be towards owners and parties
other than owners, this equation could be re-written as:
Assets = Liabilities + Owners equity
Cash ` 25,00,000 = Liabilities ` nil + Mr. Sureshs equity ` 25,00,000
This is the fundamental accounting equation shown as formal expression of
the dual aspect concept. This powerful concept recognizes that every
business transaction has dual impact on the financial position.
Accounting systems are set up to simultaneously record both these aspects
of every transaction; that is why it is called as Double-entry system of
accounting. In its present form the double entry system of accounting owes
its existence to an Italian expert Mr. Luca Pacioli in the year 1495.
Continuing with our example of Mr. Suresh, now let us consider he borrows
` 15 lacs from bank. The dual aspect of this transaction-on one hand the
business cash will increase by ` 15 lacs and a liability towards the bank will
be created for ` 15 lacs.
Assets = Liabilities + Owners equity

Cash ` 40,00,000 = Liabilities ` 15,00,000 + Mr. Sureshs equity ` 25,00,000

The student must note that the dual aspect concept entails recognition of
the two effects of each transaction. These effects are of equal amount and
reverse in nature. How to decide these two aspects?
The golden rules of accounting are used to arrive at this decision. After
recording both aspects of the transaction, the basic accounting equation
will always balance or be equal.
The above concepts find the application in preparation of the Balance Sheet
which is the statement of assets and liabilities as on a particular date. We
will now see some more concepts that are important for preparation of Profit
and Loss Account or Income Statement.
(e)

Verifiable Objective Evidence Concept

Under this principle, accounting data must be verified. In other words,

documentary evidence of transactions must be made which are capable of
verification by an independent respect. In the absence of such verification,
the data which will be available will neither be reliable nor be dependable,
i.e., these should be biased data. Verifiability and objectivity express
dependability, reliability and trustworthiness that are very useful for the
purpose of displaying the accounting data and information to the users.
(f) Historical Cost Concept
Business transactions are always recorded at the actual cost at which they
are actually undertaken. The basic advantage is that it avoids an arbitrary
value being attached to the transactions. Whenever
an asset is bought, it is recorded at its actual cost and the same is used as
the basis for all subsequent accounting purposes such as charging
depreciation on the use of asset, e.g. if a production equipment is bought for
` 1.50 crores, the asset will be shown at the same value in all future periods
when disclosing the original cost. It will obviously be reduced by the
amount of depreciation, which will be calculated with reference to the actual
cost. The actual value of the equipment may rise or fall subsequent to the
purchase, but that is considered irrelevant for accounting purpose as per
the historical cost concept.

The limitation of this concept is that the Balance Sheet does not show the
market value of the assets owned by the business and accordingly the
owners equity will not reflect the real value. However, on an ongoing basis,
the assets are shown at their historical costs as reduced by depreciation.
(g) Balance Sheet Equation Concept
Under this principle, all which has been received by us must be equal to
that has been given by us and needless to say that receipts are clarified as
debits and giving is clarified as credits. The basic equation, appears as :Debit = Credit
Naturally every debit must have a corresponding credit and vice-e-versa. So,
we can write the above in the following form
Expenses + Losses + Assets = Revenues + Gains + Liabilities
And if expenses and losses, and incomes and gains are set off, the equation
takes the following form
Asset = Liabilities
or, Asset = Equity + External Liabilities
i.e., the Accounting Equation.
CONVENTIONS/ MODIFYING PRINCIPLES
(a) The Concept of Materiality
This is more of a convention than a concept. It proposes that while
accounting for various transactions, only those which may have material
effect on profitability or financial status of the business should have special
consideration for reporting. This does not mean that the accountant should
exclude some transactions from recording. e.g. even ` 20 worth conveyance
paid must be recorded as expense.
What this convention claims is to attach importance to material details and
insignificant details should be ignored while deciding certain accounting
treatment. The concept of materiality is subjective and an accountant will
have to decide on merit of each case. Generally, the effect is said to be

material, if the knowledge of an event would influence the decision of an

informed stakeholder.
The materiality could be related to information, amount, procedure and
nature. Error in description of an asset or wrong classification between
capital and revenue would lead to materiality of information.
Say, If postal stamps of ` 500 remain unused at the end of accounting
period, the same may not be considered for recognizing as inventory on
account of materiality of amount. Certain accounting treatments depend
upon procedures laid down by accounting standards. Some transactions are
by nature material irrespective of the amount involved. e.g. audit fees, loan
to directors.
(b) The Concept of Consistency
This concept advocates that once an organization decides to adopt a
particular method of revenue or expense recognition in line with the other
concepts, the same should be consistently applied year after year, unless
there is a valid reason for change in the method. Lack of consistency would
result in the financial information becoming non-comparable between the
different accounting periods. The insistence of this concept would result in
avoidance of window dressing the results by choosing the accounting
method by convenience and thereby either inflating or understating net
income.
Consider an example. An asset of ` 10 lacs is purchased by a business. It is
estimated to have useful life of 5 years. It will follow that the asset will be
depreciated over a period of 5 years at the rate of ` 2 lacs every year. The
estimate of useful life and the rate of depreciation cannot be changed from
one period to the other without a valid reason. Suppose the firm applies the
same depreciation rate for the first three years and due to change in
technology the asset becomes obsolete, the whole of the remaining amount
could be expensed out in the fourth year.
However, it may be difficult to be consistent if the business entities have two
factories in different countries which have different statutory requirement
for accounting treatment.

(c) The Conservatism Concept

Accountants who prepare financial statements of the business, like other
human being, would liketo give a favourable report on how well the business
has performed during an accounting period.
However, prudent reporting based on skepticism builds confidence in the
results and in the long run best serves all the divergent interests of users of
financial statements. This philosophy of prudence leads to the conservatism
concept.
The concept underlines the prudence of under-stating than over-stating the
net income of an entity for a period and the net assets as on a particular
date. This is because business is done in situations of uncertainty. For
years, this concept was meant to anticipate no profits but recognize all
losses. This can be stated as
(i) Delay in recognizing income unless one is reasonably sure
(ii) Immediately recognize expenses when reasonably sure
(d) Timeliness Concept
Under this principle, every transaction must be recorded in proper time.
Normally, when the transaction is made, the same must be recorded in the
proper books of accounts. In short, transaction should be recorded datewise in the books. Delay in recording such transaction may lead to
manipulation, misplacement of vouchers, misappropriation etc. of cash and
goods. This principle is followed particularly while verifying day to day cash
balance. Principle of timeliness is also followed by banks, i.e. every bank
verifies the cash balance with their cash book and within the day, the same
must be completed.
(e) Industry Practice
As there are different types of industries, each industry has its own
characteristics and features. There may be seasonal industries also. Every
industry follows the principles and assumption of accounting to perform
their own activities. Some of them follow the principles, concepts and

conventions in a modified way. The accounting practice which has always

prevailed in the industry is followed by it.
e.g Electric supply companies, Insurance companies maintain their
accounts in a specific manner. Insurance companies prepare Revenue
Account just to ascertain the profit/loss of the company and not Profit and
Loss Account. Similarly, non trading organizations prepare Income and
Expenditure Account to find out Surplus or Deficit.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
A widely accepted set of rules, conventions, standards, and procedures for
reporting financial information, as established by the Financial Accounting
Standards Board are called Generally Accepted Accounting Principles
(GAAP). These are the common set of accounting principles, standards and
procedures that companies use to compile their financial statements. GAAP
are a combination of standards (set by policy boards) and simply the
commonly

accepted

ways

of

recording

and

reporting

accounting

information.
GAAP is to be followed by companies so that investors have a optimum level
of consistency in the financial statements they use when analyzing
companies for investment purposes. GAAP cover such aspects like revenue
recognition, balance sheet item classification and outstanding share
measurements.
Accounting Standards
To promote world-wide uniformity in published accounts, the International
Accounting Standards Committee (IASC) has been set up in June 1973 with
nine nations as founder members. The purpose of this committee is to
formulate and publish in public interest, standards to be observed in the
presentation of audited financial statements and to promote their worldwide acceptance and observance. IASC exist to reduce the differences
between

different

countries

accounting

practices.

This

process

of

harmonisation will make it easier for the users and preparers of financial
statement to operate across international boundaries. In our country, the
Institute of Chartered Accountants of India has constituted Accounting

Standard Board (ASB) in 1977. The ASB has been empowered to formulate
and issue accounting standards, that should be followed by all business
concerns in India.

Amendment to AS 2, 4, 6, 10, 13, 14, 21 and 29 issued by the

Institute of Chartered Accountants of India, pursuant to issuance of

amendments to Accounting Standards by the MCA (September 2016)

AS 1 Disclosure of Accounting Policies

AS 2 Valuation of Inventories

AS 3 Cash Flow Statements

AS 4 Contingencies and Events Occuring after the Balance Sheet Date

AS 5 Net Profit or Loss for the period,Prior Period Items and Changes

in Accounting Policies

AS 6 Depreciation Accounting

AS 7 Construction Contracts (revised 2002)

AS 9 Revenue Recognition

AS 10 Accounting for Fixed Assets

AS 11 The Effects of Changes in Foreign Exchange Rates (revised

2003),

AS 12 Accounting for Government Grants

AS 13 Accounting for Investments

AS 14 Accounting for Amalgamations

AS 15 Employee Benefits (revised 2005)

AS 16 Borrowing Costs

AS 17 Segment Reporting

AS 18 Related Party Disclosures

AS 19 Leases

AS 20 Earnings Per Share

AS 21 Consolidated Financial Statements

AS 22 Accounting for Taxes on Income.

AS 23 Accounting for Investments in Associates in Consolidated

Financial Statements

AS 24 Discontinuing Operations

AS 25 Interim Financial Reporting

AS 26 Intangible Assets

AS 27 Financial Reporting of Interests in Joint Ventures

AS 28 Impairment of Assets

AS 29 Provisions,Contingent` Liabilities and Contingent Assets

THE CONCEPT OF HUMAN RESOURCE ACCOUNTING (HRA)
The subject of offering measures of the values of people to the organisation
through human resource accounting is an essential component of HRP at
all levels. According to
Flamholtz and Lace (1981): "Human Resourie Accounting may be defined as
the measurement and reporting of the cost and value of people as
organisational resources. It involves accounting for investment in people
and their replacement costs, as well as accounting for the economic values
of people to an organisation." ,
They further explain the value of an employee to the firm as "the present
value of the difference between wage and marginal revenue productn. An
employee's value drives from the ability of the firm to pay less than the
marginal revenue product. Thus, it involves measuring the costs incurred
by business firms and other organisations to recruit, select, hire, train and
develop human resources. It also involves measuring economic value of
people to organisations. In short, they intend to make it clear that the term
'human resource' recognises people who form organisational resources.

To quote Davidson, "Human resource accounting in the measurement of the

cost and value is a term used to describe a variety of proposals that seek to
report and emphasise the importance of human resources knowledgeable,
trained and loyal employees in a company's earning process and total
'assets".
In the words'of R;L. $Voddmff Jr., Vice President, RG. .Barry Corporation,
the company which undertook pioneering work (1960s) in developing
human resource accounting - "human resource accounting is an attempt to
identify and report investment made in resources of the organisation that
are not presently accounted. for under conventional accounting practice".
Woodruff further considers it to be an information system that tells
management what changes over time are occurring to the human resources
of the business.
Need for HRA:
The need for human asset valuation arose as a result of growing concern for
human relations management in the industry.
Behavioural scientists concerned with management of organizations pointed
out the following reasons for HRA:
1. Under conventional accounting, no information is made available about
the human resources employed in an organization, and without people the
financial and physical resources cannot be operationally effective.
2. The expenses related to the human organization are charged to current
revenue instead of being treated as investments, to be amortized over a
period of time, with the result that magnitude of net income is significantly
distorted. This makes the assessment of firm and inter-firm comparison
difficult.
3. The productivity and profitability of a firm largely depends on the
contribution of human assets. Two firms having identical physical assets
and operating in the same market may have different returns due to
differences in human assets. If the value of human assets is ignored, the
total valuation of the firm becomes difficult.

4. If the value of human resources is not duly reported in profit and loss
account and balance sheet, the important act of management on human
assets cannot be perceived.
5. Expenses on recruitment, training, etc. are treated as expenses and
written off against revenue under conventional accounting. All expenses on
human resources are to be treated as investments, since the benefits are
accrued over a period of time.
Objectives of HRA:
Rensis Likert described the following objectives of HRA:
1. Providing cost value information about acquiring, developing, allocating
and maintaining human resources.
2. Enabling management to monitor the use of human resources.
3. Finding depreciation or appreciation among human resources.
4. Assisting in developing effective management practices.
5. Increasing managerial awareness of the value of human resources.
6. For better human resource planning.
7. For better decisions about people, based on improved information system.
8. Assisting in effective utilization of manpower.
Methods of Valuation of Human Resources:
There are certain methods advocated for valuation of human resources.
These methods include historical method, replacement cost method, present
value method, opportunity cost method and standard cost method. All
methods have certain benefits as well as limitations.
Benefits of HRA:
There are certain benefits for accounting of human resources, which are
explained as follows:
1. The system of HRA discloses the value of human resources, which helps
in proper interpretation of return on capital employed.

2. Managerial decision-making can be improved with the help of HRA.

3. The implementation of human resource accounting clearly identifies
human resources as valuable assets, which helps in preventing misuse of
human resources by the superiors as well as the management.
4. It helps in efficient utilization of human resources and understanding the
evil effects of labour unrest on the quality of human resources.
5. This system can increase productivity because the human talent,
devotion, and skills are considered valuable assets, which can boost the
morale of the employees.
6. It can assist the management for implementing best methods of wages
and salary administration.
Limitations of HRA:
HRA is yet to gain momentum in India due to certain difficulties:
1. The valuation methods have certain disadvantages as well as advantages;
therefore, there is always a bone of contention among the firms that which
method is an ideal one.
2. There are no standardized procedures developed so far. So, firms are
providing only as additional information.
3.

Under

conventional

accounting,

certain

standards

are

accepted

commonly, which is not possible under this method.

4. All the methods of accounting for human assets are based on certain
assumptions, which can go wrong at any time. For example, it is assumed
that all workers continue to work with the same organization till retirement,
which is far from possible.
5. It is believed that human resources do not suffer depreciation, and in fact
they always appreciate, which can also prove otherwise in certain firms.
6. The lifespan of human resources cannot be estimated. So, the valuation
seems to be unrealistic.
Development of Human Resource Accounting (HRA):

Recent years have witnessed the emergence of numerous trea-tises on the

relative merits of human resource accounting. While the unprecedented
pervasiveness of human resource literature suggests that the topic is new to
our era, the debate itself is by no means novel. Indeed, the concept of
human resource accounting is deeply rooted in the history of economic
thought.
To provide a desirable perspective of the current debate and thus a basis for
an accurate assessment of the probable impact of human resource
accounting, a familiarity with the development of the concept is necessary.
The intent of this article is to trace the historical evolution of human
resource accounting to its present stage of development. Its purpose is to
impart the perspective essential to a thorough understanding of the pros
and cons of human resource accounting systems.
Human Capital In Early Economic Thought
Throughout history economists have been concerned with the concept of
human capital, but their treatment was limited to including human beings
and their skills in a definition of capital.
Several motives for treating human beings as capital and valuing them in
monetary terms were expounded. Of these a central motive is apparentto
serve as a basis for making a decision or to influence the decisions of
others.
Meanwhile, a small group of relatively unknown economists un-dertook to
develop techniques to measure the worth of human capital. Basically, two
methods of estimating the value of human beings emerged(i) the cost-ofproduction and (ii) the capitalized earnings procedures.
In the cost-of-production approach costs incurred in producing a human
asset are estimated. The capitalized earnings procedure consists of
estimating the present value of an individuals future in-come stream. As
described below, these two early approaches parallel closely the two basic
approaches to human resource ac-counting currently advocated in the
current literature.
Early Valuation Methods
Specific methods of human asset valuation, while consistent with one of the
two general approaches, varied widely from one advocate to another. One of

the first attempts to estimate the money value of human beings was made
around 1691 by Sir William Petty [10]. Petty considered labor the father of
wealth and thus felt that labor must be included in any estimate of
national wealth. Accordingly, this first attempt at human asset valuation
estimated the value of the stock of human capital by capitalizing the wage
bill in perpetuity at the market interest rate; the wage bill being determined
by deducting property income from national income.
The first truly scientific procedure for finding the money value of human
beings was devised in 1853 by Farr [4]. He advocated the substitution of a
property tax for the existing English income tax system. The former would
include property consisting of the capi-talized value of earning capacity. His
procedure for estimating capitalized earning capacity was to calculate the
present value of an individuals net future earnings.
Ernst Engels writings around 1883 recommended a cost-of-pro-duction
procedure for estimating the monetary value of human beings [3]. He
reasoned that expenditures for rearing children were costs to their parents
and that this cost might be estimated and taken as a measure of their
monetary value.1
In 1867, a composite version reflecting Farrs capitalized earn-ings and
anticipating Engels cost-of-production approach surfaced when Wittstein
argued that an individuals lifetime earnings are equal to his lifetime
maintenance cost plus education [19].
Alfred Marshall was perhaps the most forceful proponent of the concept of
human assets [14]. His theoretical approach took on a capitalized-netearnings flavor. However, departing from his con-ceptual arguments,
Marshall held that it would be out of touch with the marketplace to treat
humans as capital in practical analysis,
Human Resources As Consumption Expenditures
Marshalls view of human capital as being unrealistic was per-haps a
major contribution to the virtual exclusion of the concept of human
resources from the main stream of economic thought from the beginning of
the twentieth century to the recent renewal of interest. Marshalls view, if
not a causal factor, is certainly descriptive of the general view that it was
neither appropriate nor practical to apply the concept of capital to human
beings.

Besides this accepted assessment, various other reasons prob-ably help

explain the exclusion of humans from the concept of economic capital.
Generally, the mere thought of investments in humans was offensive to
most people. Additionally, it has been all too convenient in marginal
productivity analysis for economists to treat labor as if it were a unique
bundle of innate abilities that are wholly free of capital.
These reasons were probably sufficient to exclude human capital from the
core of economic thought for several decades. Expenditures for humans
were viewed as consumption, in economic jargon, rather than as
investments. This treatment by economists had a significant impact upon
the treatment accorded human resource expenditures by accountants.
Several of the underlying concepts of modern accounting theory are derived
from classical economic theory and many of these matured during the
period in which human capital was excluded from practical consideration
by economists. Because of the close conceptual relationship between early
accounting and economics, accounting theorists ignored human assets as
the concept was simultaneously ignored in economic analysis.2 When
economists began to treat investments in human resources as
consumption rather than investments, accountants established that
these expenditures were expense rather than assets.
Renewed Interest in Labor Intensive-Specialized Economy
The advent of massive governmentally supported social programs in the
decade of the 1960s rekindled the interest of economists in human assets.
Particularly, economists sought to influence the direction of the massive
investment in these social programs. They sought to evaluate these
programs in -terms of return on investment. This desire led to the necessity
of thinking of such expenditures as capital rather than consumption
expenditures.
Increasingly massive investments by industry in human assets have been
cited as compounding the impact of the error of excluding human assets
from capital [17]. The large increases in real earnings of workers, essentially
unexplained by classical analysis, can reasonably be attributed to return on
investment in humans,
Moreover, Mincer has demonstrated the causal relationship between
amount of training and interoccupational differentials in personal income
[15].

The contribution of labor toward the growth rate of real national income is
increasing as a percentage while the percentage contrib-uted by physical
capital is decreasing. Labors increasing marginal product can be attributed
in part to expenditures for training. Re-search by Thurow directed attention
toward the existence of human capital resulting from investments in
training programs [18].
The Beginning of Human Resource Accounting
The revival of interest by economists in the topic of human capital was
accompanied by, or perhaps caused, an examination of the concept of
human resource accounting by accounting theorists. Until then,
accountants had considered the problem of valuing human resources to be
part of the larger problem of valuing goodwill.
The recent research in this area attempts to distinguish economic values
attributable to the human resources of a firm from the values attributable
to other components of goodwill. These projects and limited implementation
of research results is subsumed under the title of human resource
accounting.
Research in human resource accounting reflects the two routes evidenced in
contemporary accounting theory. One segment of the research is directed
toward the investigation of concepts for the measurement of human
resource costs: original cost, replacement cost, and opportunity cost.
Another segment investigates the determinants of the value of human
resources of employees as a group or of individual employees. This
branching of current research in human resource accounting closely
parallels the cost-of-produc-tion and capitalized earnings measurement
approaches taken by early economists many decades ago.
Attempts to measure human resource cost have resulted in the development
of three different concepts and measurement models. The first of these
measurement concepts, original cost, is illustrated in the works of
Brummet, Flamholtz, and Pyle who individually and collectively have
developed concepts, models, and techniques for measuring the historical
cost of human resources [1]. Concern has been expressed over the historical
cost conceptnamely, that the real economic value of the investment may
be significantly different than its cost [15].
The model of Brummet, et. al. is a generalized model which can be extended
to incorporate replacement costs. Other researchers have developed models

for the measurement of human resource replacement cost [6]. The end
result of the operation of such models is a measure o f the cost to replace
individuals occupying organizational position.
Perceived deficiencies in the replacement cost approach to measurements
led others to develop the concept of opportunity cost to value human
resources. Hekimian and Jones, for example, have suggested a system of
competitive bidding to obtain managerial assessments of opportunity cost of
human assets. Like the other measurement concepts, opportunity cost
measurement has its critics as well [8].
Essentially, the suggestions to value human assets at historical or original
cost are accounting adaptations of the cost of produc-tion techniques
developed by Engels in 1883 and suggested by Shultz in 1960. Proposals to
obtain replacement or opportunity cost measures parallel the current
conceptual debate in accounting theory to fi nd an acceptable alternate to
historical cost.
While one segment of accounting research in human resource accounting
has been directed toward measurement concepts, an-other is directed
toward the investigation of the determinants of the value of human assets.
The development of this theory is proceeding from two different approaches.
Growing out of the studies on organization and leadership at the University
of Michigans Institute for Social Research, Likert [13] and others have
attempted to develop a model of determinants of a groups value to an
organization. Hermanson proposed two possible techniques for the
monetary valuation of the total human assets of a firm [7]. Additionally,
Brummet, Flamholtz, and Pyle [1] as well as Lev and Schwartz [12] have
suggested methods to arrive at the value of employees as a group. In a
different approach, Flamholtz has attempted to develop a model of the
determinants of an individuals value to a firm [5].
With the exception of Likerts model, the methods proposed for determining
the value of employees or groups of employees to an organization are similar
in principle to the proposal of the econo-mist William Farr. At the core of
the proposals is the realization that the value of people to an organization is
the present worth of the future services they are expected to renderthe
capitalized earnings approach.
Likerts model per se is not intended to measure the value of human
resources, but the efficiency of various types of management systems.

Likert, Flamholtz, Pyle, and Brummet have suggested that measurement of

the present state of the causal and intervening variables would provide a
basis to forecast future end-result variables. The forecasted end-result
variables would serve as a basis to forecast future contributions by
employees. This would serve as a basis to value human resources.
Hermansons suggested methods attempt to provide protection against
manipulation by management. The proposals utilize capi-talized current
excess earnings or modified future employee earn-ings as a measure of
human capital. In both proposals the impact of the economic concept of
value is apparent.
The proposal of Lev and Schwartz to capitalize future compensation is an
adaptation directly comparable to that of William Farr. Flamholtzs
suggestion for the valuation of an individual utilizes a series of
capitalizations corresponding to the service states the individual is expected
to occupy.
Methods of Valuation of Human Resources Accounting
There are several methods of HR valuation and accounting and these are
broadly divided into two categories: The monitory measures and nonmonetary measures.
Monetary measures include
(a) Historical cost method
It suggests capitalizing the expenditure of the firm incurred on recruitment
and selection, training and development of the employees and treats them
as the assets of the organization for the purpose of HR accounting. This
method suffers from a limitation that the capitalization of costs does not
reflect its true value. The total performance has to be judged in relation
with the total cost associated with the HR to reflect its value.
(b) Replacement cost method
The cost of replacement of individual and the re-building cost of
organization is assessed to reflect the HR asset value of the individuals and
the organization. However this method may not reflect either the actual cost
or the contribution associated with HR
(c) Opportunity cost method
This model envisages the computation of monetary value and the allocation
of people to the most promising activity and thereby assesses the

opportunity cost of main employees through competitive bidding among the

investment centre.
(d) Economic value method
The value of human resource is evaluated on the basis of contribution they
are likely to make in the organization during their stay with the
organization. The payments made to the employees in the form of salary,
allowances and benefits are estimated and discounted appropriately to
arrive at the present economic value of the individual.
(2) Non-monetary measures:
(a) Expected realizable value method
The elements of expected realizable value like the productivity,
transferability and promote-ability are measure using personal research,
appraisal techniques or other objective methods. The productivity is
measured by objective indices and managerial assessment. The promoteability and transferability are measured in terms of potential using
psychometric tests and subjective evaluations.
(b) Discounted present value of future earnings
This method was use by Rencis Likert who proposed three sets of variablescasual, intermediate, output. These helped in measuring the effectiveness
over a period of time. Casual variable include leadership style and
behaviour, the intermediate variable are morale, motivation, commitment to
goals etc. and these in turn affect the output variables like production,
sales, profit etc.
Historical cost approach:
This approach is also called as aqvisition cost model.This approach is
developed by Brummet, Flamholmay tz and Pyle but the first attempt
towards employee valuation made by a foot ware manufacturing company R.
G. Barry Corporation of Columbus, Ohio with the help of machingon
university in the year 1967 . This method measures the organizations
investment in employees using the five parameters: recruiting, acquisition;
formal training and, familiarization; informal training, Informal
familiarization; experience; and development. this model suggest instead of
charging the costs to p&l accounting it should be capitalized in balance
sheet.the process of giving an status of asset to the expenditure item is
called as capitalization. in case of human resource it is necessary to
amortize the capitalized amount over a period of time. so here one will take
the age of the employee at the time of recruitment and at the time of

retirement. out of these a few employee may leave the organization before
attaining the superannuation. This is similar to physical asset e.g:- If
company spends one lakh on an employee recruited at 25years he lives the
organization at the age 50. he serves the company for 25 years but actually
his retirement age was 55years. the company has recovered rupees
83333.33 so the unamortized amount of rupees 16666.66 should be
charged to p&l account i.e.
100000\30=3333.33
3333.33*25=83333.33
100000-83333.33=16666.67
This method is the only method of human resource accounting which is
based on sound accounting principals and policies.
Limitations:

The valuation method is based on false assumption that the dollar is

stable.

Since the assets cannot be sold there is no independent check of

valuation.

This method measures only the costs to the organization but ignores
completely any measure of the value of the employee to the organization
(Cascio 3).
Replacement Cost approach
This approach measures the cost of replacing an employee. According to
Likert
(1985)
replacement
cost
include
recruitment,
selection,
compensation, and training cost (including the income foregone during the
training period). The data derived from this method could be useful in
deciding whether to dismiss or replace the staff.
Limitations:

Substitution of replacement cost method for historical cost method

does little more than update the valuation, at the expense of importing
considerably more subjectivity into the measure. This method may also lead
to an upwardly biased estimate because an inefficient firm may incur
greater cost to replace an employee (Cascio 3-4).
Present Value of Future Earnings:
Lev and Schwartz (1971) proposed an economic valuation of employees
based on the present value of future earnings, adjusted for the probability
of employees death/separation/retirement. This method helps in
determining what an employees future contribution is worth today.
According to this model, the value of human capital embodied in a person
who is y years old, is the present value of his/her future earnings from
employment and can be calculated by using the following formula:
E(Vy) = Py(t+1) I(T)/(I+R)t-y

T=Y
Y
where E (Vy) = expected value of a y year old persons human capital T =
the persons retirement age Py (t) = probability of the person leaving the
organisation I(t) = expected earnings of the person in period I r = discount
rate
Limitations:

The measure is an objective one because it uses widely based statistics

such as census income return and mortality tables.

The measure assigns more weight to averages than to the value of any
specific group or individual (Cascio 4-5).
Value to the organization:
Hekimian and Jones (1967) proposed that where an organization had
several divisions seeking the same employee, the employee should be
allocated to the highest bidder and the bid price incorporated into that
divisions investment base. For example a value of a professional athletes
service is often determined by how much money a particular team, acting in
an open competitive market is willing to pay him or her.
Limitations:

The soundness of the valuation depends wholly on the information,

judgment, and impartiality of the bidder (Cascio 5).
Expense model:
According to Mirvis and Mac, (1976) this model focuses on attaching dollar
estimates to the behavioral outcomes produced by working in an
organization. Criteria such as absenteeism, turnover, and job performance
are measured using traditional organizational tools, and then costs are
estimated for each criterion. For example, in costing labor turnover, dollar
figures are attached to separation costs, replacement costs, and training
costs.
Accounting for Price Level Changes/ Inflation Accounting
"Inflation is the most important fact of our time, the single greatest peril to
our economic health". - Bernard M. Baruch
Prices of various goods and services have been rising at an alarming rate"Though the history of mankind is a history of rising prices, inflation has
become a world wide phenomena since the second world war. In a country
like India the problem is more acute with its developing economy".
Governments ever rising administrative expenditure, enlarging plan outlays
without corresponding increase in productivity and various types of
subsidies have given an impetus to inflation. Each one of us experience the

impact of inflation in everyday life. Neither can we wish away inflation nor
can we remain insensitive spectators.
Problems associated with inflation must be brought in to sharp focus to
understand their magnitude.
Money is the medium of expression of values in modern life. Effects of
various economic activities are measured and expressed in terms of money.
For measuring anything, it is mandatory that the measure itself is constant.
Money as a medium of expression of value and measure of economic activity
is expected to have a constant value. But this expectation has been
Sanjeev Pandit, Inflation Accounting. Meenakshi Prakashan, Meerut 1989
India, P.i. belied. "Constant value of money"'has remained a very unrealistic
assumption. Changing value of' money has resulted in a chaos and
distortion while reporting results of economic activities of business
enterprises.
According to the American Institute of certified Public Accountants
(AICPA), "Inflation Accounting is a system for accounting which purports to
record as a built in mechanism all economic events in terms of current
cost".
Inflation and its Impact on Financial Statements :
The monetary postulate underlying historical cost accounting does not
holdgood during the period of changing prices. Consequently, a host of
problems began to creep in to the accounts with the movement - upwards or
downwards - in prices. Such problems have the effect of distorting the
accounting results in various ways. These distortions are manifested in the
form, among others, of an overstatement of profits and an understatement
of assets during inflation conversely there is an understatement of profits
and an overstatement of assets when there is deflation. Mainly two types of
assets are included in the Balance Sheet. One is current assets and the
other is fixed assets.
Fixed assets are the main victims of inflation or in other sense the effect of
inflation is more pronounced in the case of these types of assets: The
depreciation is calculated on the historical cost basis which is usually lower
than that of those calculated at replacement value.
Second the operating expenses and incomes are taken at current prices,
stock shows at cost or market price whichever is lower. Purchasing power
gains,losses occurs simply because the firm is holding some monetary
liabilities and assets which gain or lose purchasing power during inflation.
Since nominal values of assets, profits and other items from corporate
accounts form the basis of many other decisions having important effects,
like calculation of tax liability, action under MRTP Act, actions regarding

various controls imposed by the Government and so on. "The distortion in

corporate accounts introduced by inflation may have a much wider effect
than a mere misrepresentation of accounts". This malady may be corrected
only by inflation accounting.
Current purchasing power accounting
Price change has two broad impacts on the accounting approaches which
have been described. First, general price change through inflation
undermines the stability of the value of the currency unit. Reducing the
purchasing power of the pound through inflation means that comparison of
amounts measured in pounds at different times is distorted.
One response to the problems of price change is to restate the financial
statements produced on a historical cost basis by adjusting for the change
in purchasing power. The procedure is to restate the opening and closing
statements of financial position by indexing all items in the opening
statement of financial position and all non-monetary items including
owners capital in the closing statement of financial position using general
price level indices. Monetary items in the closing statement of financial
position would require no adjustments as they are already stated in current
terms. The capital increase shown between the restated statements of
financial position would be the current purchasing power profit. This
approach involves only limited adjustment from historical cost and, since
these can be based on publicly available indices such as the retail price
index (RPI), reliability is not substantially reduced. The unit of
measurement that would then be employed would be the pound of current
purchasing power at the year end. The purchasing power of the owners
capital would be maintained since it is restated in these terms. This is
commonly referred to as real financial capital maintenance.
However, the valuation model which adjusts asset values for general
changes in prices may result in asset values that are considered to be an
entire fiction. Assets do not all change prices in line with inflation. In
addition, the increase that is being reported would be a combination of
realised and unrealised gains, since the upward revaluation of assets by
indexing them would be, increasingly, a value without the external evidence
that would meet the needs of prudence and realisation. A version of this
approach, known as current purchasing power accounting (CPPA) was put
forward in the UK but, given the limitation identified and others, it has been
largely rejected.
Current cost accounting

The second major aspect of price change is the specific price changes in
asset values. The historical cost approach, which recognises revenues only
when they are realised, will produce periodic profits which represent both
the results of the current years operations and gains made in previous
periods which are only realised in the current period (although gains which
are unrealised in the current period are excluded).
One response to this problem is to recognise unrealised gains in the period
to which they relate but to treat these not as part of operating profit.
Instead, they can be regarded as holding gains, i.e. gains from continuing to
own assets during price rises. Measuring profit in relation to opening and
closing capital restated to include holding gains of the period produces a
concept of physical/operating capital maintenance, i.e. identifying the gains
that can be withdrawn while permitting a business to own the same
physical assets. Profit would be restated by eliminating holding gains. This
is aptly described as operating profit, showing the ability of a business to
produce revenues over and above the current cost of producing them
through operating activities. Any adjustments necessary to eliminate
holding gains from profit would be those necessary to restate historical
costs, included in the comprehensive income statement, to current costs.
A version of this approach known as current cost accounting (CCA) includes
such adjustments in three components. These are a depreciation
adjustment, modifying depreciation to one based on the current cost of
assets rather than the historical cost; a cost of sales adjustment, adjusting
inventory values and purchases to current costs; and a monetary working
capital adjustment, adjusting for the price change of purchases during the
creditor period and sales during the debt collection period. There has been
much debate about whether there should also be a fourth adjustment,
known as a gearing adjustment. This is intended to reflect the benefits of
having debt capital during periods of increasing prices. The last two
adjustments are relatively complicated, and generally regarded as beyond
the introductory level.
Considerable subjectivity is involved in identifying suitable specific price
level indices for each of the possible specific price changes. The resulting
reduction in reliability together with the costs of implementing the approach
with all its complexities are considered to outweigh the advantages,
particularly where the period of holding assets is relatively short and hence
the impact of the adjustments is small. Current cost accounting has been
widely abandoned as a result.