Management Accounting U1-U10 PDF

UNIT 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Objectives After going through this unit, you will be able to:  Explain scope of Management Accounting  Distinguish between: a. Management Accounting & Financial Accounting, b. Management Accounting & Cost Accountin...

UNIT 1 INTRODUCTION TO MANAGEMENT ACCOUNTING Objectives After going through this unit, you will be able to:  Explain scope of Management Accounting  Distinguish between: a. Management Accounting & Financial Accounting, b. Management Accounting & Cost Accounting, c. Management Accounting & Financial Management Structure 1.1 Introduction 1.2 Definition of Management Accounting 1.3 Scope of Management Accounting 1.4 Significance of Management Accounting 1.5 Financial Accounting Vs Management Accounting 1.6 Cost Accounting Vs Management Accounting 1.7 Financial Management Vs Management Accounting 1.8 Summary 1.9 Self Assessment Questions 1.1 INTRODUCTION In last few years many changes have taken place in Global & Indian economy. Corporate environment is becoming extremely dynamic day by day. There are many opportunities as well as challenges for every business. Companies have to continuously improve their products & processes to gain sustainable competitive advantage. Companies are evolving market driven strategies so as to give maximum satisfaction to customer & win the market. Companies are improving their accounting information system so that information is available for decision making & control. Management accounting is the use of accounting information to achieve corporate excellence 1.2 DEFINITION OF MANAGEMENT ACCOUNTING 1. International Federation of Accountant (IFAC) has defined Management Accounting process as “the process of Identification, Measurement, Accumulation, Analysis Preparation, and Interpretation & Communication of information both financial and operating used by management to plan, evaluate and control within an organization and to assure use of and accountability for its resources. 2. As per international Federation of Accountants “Management Accounting is the process of: Identification, measurement, recognition and valuation of business transactions or other economic events that have occurred or may occur.Accumulation i.e. disciplined and consistent 1  approach to recording and classifying appropriate business transactions and other economic events. 3. Analysis i.e. identifying the reasons for and the relationship of business activities with economic events and circumstances. 4. Preparation and Interpretation i.e. meaningful coordination of accounting and /or planning data to satisfy a specific need of management & present information in logical format and draw appropriate conclusions drawn from that data. Communication i.e. reporting of pertinent information to management and other internal and external users. 5. ICWAI published Glossary of Management accounting terms defines Management Accounting as “a system of collection and presentation of relevant economic information relating to an enterprise for Planning, Controlling and Decision making”. 6. Official Terminology of CIMA has defined Management Accounting as “ the provision of information required by management for following purposes Formulation of policies 1. Planning and controlling the activities of the enterprise 2. Decision taking on alternative course of action 3. Disclosure to those external to the entity (shareholders and others ) 4. Disclosure to employees 5. Safeguarding Assets”. 7. American Accounting Association defines Management Accounting as “the application of appropriate techniques and concepts in processing historical and projected economic data of an entity to assist management in establishing plans for reasonable economic objectives and in the making of rational decisions with a view towards these objectives.” Above definitions highlight following features of Management Accounting: 1) Prepares & communicates financial & operational information to management for planning, controlling & optimum use of available resources. 2) Accumulation, analysis & communication of accounting information to managers & others for improving the management process. 3) Collecting , analysis & communicating economic information of company for: a. Planning b. Controlling c. Decision making d. Policy formulation e. Safeguarding assets of Company. f. Achieving economic objectives of Company. g. Increasing organizational effectiveness. 1.3 SCOPE OF MANAGEMENT ACCOUNTING 1. Management Accounting includes: i. Financial Accounting ii. Cost Accounting iii. Financial Management 2. It ensures both statutory as well as internal control requirements relating to financial information of a company. 2 3. Scope of Management Accounting includes : A) Management Information System (M.I.S.). i) To Establish & Operate Accounting Information System. ii) To Establish & Operate Costing Information System. iii) To Establish & Operate Management Information System (M.I.S.) iv) To Establish & Operate Tax Management System. v) To Compile & Maintain Vital Data Required for Planning B) Management by Exception This involves installation of effective feedback system which is useful for controlling various activities of the company. Management accountant analyses & reports the deviations from expected results, identifies reasons for such deviations & highlights the corrective measures wherever necessary. Reporting is done only for those areas which are not giving expected results. C) Management by Objective Every manager must perform his functions & every activity must be carried out in such a way that it is useful for achieving organizational objectives. Management accounting provides necessary information system for this. D) Communication System To provide appropriate system & procedure for properly communicating plans of management to various levels of organization. This helps in achieving coordination of various activities of organization & useful in defining role of individual activity in overall plans of company. Both these functions are necessary for directing the efforts of various individuals towards objectives of organization. E) Analysis & Interpretation Management accounting analyses accounting, costing & financial data of company & interprets this data which is useful for decision making and control. For this, techniques such as marginal costing, standard costing, budgetary control, financial analysis & ratio analysis have been used by management accountant. 1.4 SIGNIFICANCE OF MANAGEMENT ACCOUNTING Management accounting is a powerful tool available to management to improve efficiency & profitability of organization. It is useful to management in following areas: i) Establish, coordinate & administer plans of company to be useful for profit planning, capital budgeting & financing of business. ii) It highlights deviations from standards, which can be analyzed for corrective actions & fixing responsibilities as well as for evaluation of divisional performance. iii) Internal audit is useful for protecting business assets. iv) It provides information relating to external and internal environment of business. This information is vital for formulating strategies & polices of company v) Marginal costing technique is useful for taking many vital decisions such as product mix, make or buy, continue operations or shut down, and so on. vi) Financial analysis is useful to know trend of profitability, solvency & liquidity of company. 3  vii) Ratio analysis indicates financing pattern, solvency, and liquidity, and profitability, effective use of available resources, financial strength & market value of company’s shares. 1.5 FINANCIAL ACCOUNTING VS. MANAGEMENT ACCOUNTING 1. Financial Accounting is governed by statutory framework. Financial statements must be prepared within the framework of Companies Act. And Income Tax Act. Management accounting has no statutory requirements 2. Basic function of Financial Accounting is to record the transactions of the business, to prepare & publish financial statements to be used by internal as well as external users for their decision making. 3. Basic function of Management Accounting is to prepare M.I.S. reports to be used by management for decision making & controlling of business. 4. Information given by Financial Accounting is publicly available to anybody Information given by Management Accounting is confidential and is available only to management of company. 5. Financial statements given by Financial Accounting are to be made available as & when required by the Act. 6. Management Accounting reports are to be made available as and when required by management of company. 7. Reports generated by Financial Accounting are detailed and accurate but they are generated slowly. 8. Reports generated by management accounting are fast but approximate. 9. Financial accounting provides the information for entire company. Management accounting provides the information for various segments of company. 10. Format of financial accounting reports is standardized as per provisions of Companies Act. 11. Format of management accounting reports is tailor made as per requirements of management. 1.6 COST ACCOUNTING VS. MANAGEMENT ACCOUNTING 1. Cost Accounting is concerned more with the ascertainment, allocation, distribution and accounting aspects of costs. Management accounting is concerned more with impact and effect aspect of costs. 2. Cost Accounting data serves as a base to which the tools and techniques of management accounting can be applied. The Management Accounting data is derived, both from the cost accounts and financial accounts. 3. Management Accountant is generally placed at a higher level of hierarchy than the Cost Accountant. 4. The approach of Cost Accountant is much narrower than that of Management Accountant, who may have to use certain economic and statistical data along with the costing data to 4  enable the management to be more accurate and precise in its functions of planning, decision making and control. 5. Management Accounting, in addition to the tools and techniques like marginal costing, break- even analysis, budgetary control, standard costing, etc. available to cost accounting, also make use of other techniques like funds flow, cash flow, ratio analysis etc. which are not within the scope of cost accounting. 6. Cost Accounting does not include financial accounting and has nothing to do with tax accounting. Management Accounting includes both financial accounting as well as cost accounting. It also embraces tax planning and tax accounting 7. Cost Accounting is more concerned with short term planning. Management Accounting is concerned equally with short range and long range planning. 8. Cost Accounting is concerned merely with assisting in management functions and does not provide for evaluation and performance of management. Management Accounting is concerned, both with assisting management in its functions, as well as evaluating the performance of the management as an institution. 9. Cost Accounting is mostly historical in its approach and projects the past.Management Accounting is futuristic in its approach. Management Accounting is more predictive in nature than Cost Accounting. 10. Cost Accounting system can be installed without Management Accounting while Management Accounting system cannot be installed without proper Cost accounting system. 1.7 FINANCIAL MANAGEMENT VS. MANAGEMENT ACCOUNTING 1. Financial Management establishes & executes programmes for the provision of capital required by the business. Management Accounting develops plans, budgets for control of existing operations and, if necessary, to expand / discontinue activities. 2. Main function of Financial Management is to establish and maintain an adequate market for the company’s securities and to maintain adequate liaison with investment bankers, financial analysts and shareholders. Main function of Management Accounting is to develop standards for costs and capacity and to update these standards as necessary. 3. Main concern of Financial Management is to maintain adequate sources for the company’s current borrowing from commercial banks and other lending institutions. Main concern of management accounting is to develop a chain of responsibility reporting and to monitor performance against plans. 4. Financial management monitors credit and collection of accounts due to company. Management accounting monitors level of dissatisfaction and people’s reaction to and use of accounting information. 5. Financial Management assures protection of company’s funds through appropriate policies & control measures. Management Accounting assures of business assets protection through internal control, & internal auditing. 5 1.8 SUMMARY 1. In the era of liberalization & competitive environment accounting information should be useful to management for achieving business excellence & sustainable competitive advantage. This is provided by management accounting. 2. Management accounting covers financial accounting, cost accounting & financial management. Tools provided by management accounting include marginal costing, financial analysis & ratio analysis. 3. Management accounting is useful for planning, controlling, protecting assets of organization & for taking many vital decisions such as make or buy, continue or shut down business & soon. 4. Management accounting is different from financial accounting. While former is governed by requirements of management, later by statutory framework. 5. Management accounting is also different from cost accounting. It makes use of costing as well as financial management techniques. 6. Management accounting differs from financial management. While former is concerned with only utilization of Company’s funds, later covers procurement, utilization & distribution of funds. 6 UNIT 2 BASICS OF FINANCIAL ACCOUNTING Objectives After going through this unit, you will be able to:  Understand basic accounting terms & accounting concepts  Understand differenttypes of organization & their relevancein financial accounting  Grasp significance of account principles, accounting standards & accounting policies & their importance in preparing & presenting financial statements. Structure 2.1 Introduction 2.2 Basic Accounting Terms 2.3 Forms Of Business Organization: 2.4 Meaning & Significance Of Accounting 2.5 Users Of Accounting Information 2.6 Accounting Principles 2.7 Accounting Standards (A.S.) 2.8 Accounting Standard (As) 20: Earnings Per Share 2.9 Accounting Policies 2.10 Generally Accepted Accounting Principles [G. A. A. P.] 2.11 Methods Of Accounting 2.12 Summary 2.13 Self Assessment Questions 2.14 Model Answres 2.1 INTRODUCTION Financial statements are required not only for owners, but also for many outside parties. Companies have to depend for funds on financial market, Financial Institutes (FIs) & in many cases on Foreign Institutional Investors (FII). These entities demand good accounting practices & procedures by companies which ensure that financial statements give true and fair view of affairs of company. This makes every management professional to know and follow good accounting practices. This unit highlights conceptual frame work required for preparation, presentation and understanding of financial statements. 2.2 BASIC ACCOUNTING TERMS (A) Types of Profit 1. Profit is excess of revenue over the expenses to earn that revenue 2. Profit = Revenue – Expenses 3. Following are the types of profit: (i) Revenue Profits Profits earned by company in ordinary course of business (ii) Capital Profits 7  Profits realized from sale, transfer or exchange of assets of business not held by the Company for sale in ordinary course of business. (iii) Gross Profit (G.P. or G/P) Excess of proceeds of goods & services sold during certain period over their cost before taking into account administrative, selling & financing expenses G.P. = (Sales) – (Cost of goods sold) i.e. [C.O.G.S.] (C.O.G.S.) = (Op. stock + Purchases – Clo. stock) + (Direct manufacturing expenses) (iv) Operating Profit (E.B.I.T.) or (P.B.I.T.) a) Net profit arising from normal operations & non operating activities but without considering interest expenses. b) It is also referred as Profit or Earning before Interest & Tax (PBIT or EBIT) (PBIT) = (Sales) + (Other income) - (C.O.G.S., Admin, selling & Depreciation Exp.) (v) Net Profit (N.P. or Profit before Tax i.e. P.B.T.) a) Excess of revenue over expenses of business. Income tax is payable on this profit. (vi) Profit after Tax (PAT): a) Profit left after paying income tax. From this amount b) Dividend on preference sharesis paid c) Dividend on equity shares is paid d) Remaining amount is kept as reserves of company (Also known as retained earnings) (B) Types of Dividend i) Preference Dividend Dividend paid to preference shareholders. It is paid before dividend is paid to equity shareholders. Rate of this dividend is fixed.It is paid out of P.A.T. ii) Equity Dividend Dividend paid to equity shareholders. Rate of this dividend is not fixed. It is paid out of amount available after paying preference dividend & transfer to reserves. (C) Types of Reserve i) Revenue Reserve This is the reserve created out of revenue profits. This reserve can be used for any purpose as desired by Board of Directors of company. ii) Capital Reserve It is a reserve created out of capital profits. It is not available for distribution as dividend. This reserve can be used by management under the restrictions of Companies Act 1956. (D) Types of Liabilities 1. Long Term Liabilities i) Equity Capital (Permanent Capital) Capital collected by company from public. Those who subscribe for capital are called equity shareholders or only shareholders. Capital is divided in small denomination of Rs.10 and each such denomination is called as share. Thus if company has capital of Rs.50 crores then there will be 5 crores equity shares. It is permanent capital of company. Equity capital has following components: 8  a) Authorized share capital is the capital with which company is registered. This amount is specified in memorandum of association. Company cannot collect capital more than this e.g. company has authorized share capital of Rs.100 crores. b) Issued share capital is that part of authorized capital which is issued to public for subscription e.g. issued capital is Rs.70 crores. c) Subscribed share capital is that part of issued share capital which public has agreed to subscribe e.g. subscribed capital is Rs.55 crores. d) Paid-up share capital is that part of subscribed capital which public has actually paid the amount. For example, paid-up capital is Rs.50 crores. This is the actual capital received by company (ii) Preference capital (Long Term Capital) This is a capital subscribed by preference shareholders which is to be repaid or redeemed by company after specific period of time. Features of preference shares are: a) They receive dividend ahead of equity shareholders b) Dividend is at fixed rate c) When company is liquidated they receive their capital ahead of equityShareholders. (iii) Debenture Capital (Long Term Capital) a) It is a secured loan taken by company from public at large. b) Generally company issues debenture of Rs.100 each. If investor subscribes for 100 debentures, it means company has taken loan of Rs.10, 000 from him. It is a secured loan for specific period of time after which loan is repaid i.e. debentures are repaid or redeemed by company. c) During the period for which loan is taken company must pay interest on debentures. If company fails to pay interest or principal debenture holders can bring action through court & company has to make the payment by selling the assets which are secured against debentures. Many times company is wound up. (iv) Term Loan (Long Term Capital) It is a long term (5 to 10 years) secured loan taken by company from banks or Financial Institutions (FIs). a) Short Term Liabilities b) Current Liabilities These are the liabilities which are payable by company within one year & include Sundry Creditors, Bills Payable(B/P), Bank overdraft ( o/d), Short Term Loans taken, Outstanding Expenses, Advances Received, Proposed Dividend, Provision for Taxes c) Contingent Liabilities Liabilities which are contingent or dependent on happening or not happening future events which are uncertain. They are not shown in balance sheet but are shown as foot note below balance sheet. (E) Types of Assets (i) Fixed Assets 9  Assets held by company for purpose of producing goods or providing services. These assets are not held for resale in ordinary course of business. Fixed assets are of two types: a) Tangible Fixed Assets:-They have physical identity e.g. land, building, plant,machinery, furniture, motor car etc. b) Intangible Fixed Assets:-They do not have physical identity e.g..goodwill, patent. trademark, copy-right, know-how etc. Depreciation is charged on these assets (other than on goodwill). (ii) Current Assets Assets which can be converted into cash within one year or consumed in production or for rendering services in ordinary course of business & include: Stock, Sundry debtors, Bills receivables (B/R), Short term loans given, Advances paid Pre- paid expenses, Bank & cash balance, marketable securities. (iii) Investments: These are the investments made by our company in shares, debentures of different companies, Govt. securities, partnership firms & immovable properties. (iv) Fictitious Assets These are actually not assets but are shown as assets. They do not have any real value. Items included in this group are losses of company, preliminary expenses & misc. expenses not written off, loss on Issue of debentures/shares. (F) Types of Expenses (i) Revenue Expenditure It is an expenditure incurred to generate revenue for a particular accounting period. It is incurred in ordinary course of business & expires in same accounting period e.g. cost of goods sold, rent, salaries, and commission paid etc. It is shown in income statement (ii) Capital Expenditure Expenditure to acquire any tangible & intangible fixed assets for receiving future benefits. Thus benefits arising out of capital expenditure last for more than one financial year. (iii) Deferred Revenue Expenditure This is revenue expenditure by nature but its matching with revenue may be deferred considering the benefits to be accrued in future. E.g. heavy expenditure on advertising. So long as deferred revenue expenditures is not written off it is shown on asset side under “Misc. expenditure not written off” as fictitious assets. (G) General Accounting Terms 1. Business Exchange of goods and or services for earning profit 2. Freight or Carriage inward Transport charges paid by company to bring raw material from supplier to factory. It is a direct expense. 3. Freight or Carriage outward Transport charges paid by company to bring finished goods from factory to customer. It is selling & distribution expense. 4. Trade Discount Reduction granted by a supplier from list price of goods on business consideration other than for prompt payment. It is not shown in books of accounts. 10 5. Cash Discount Reduction granted to our company by supplier or by company to customer from invoice price in consideration of immediate payment or payment within stipulated period. It is shown in books of accounts. 6. Debit Note It is a document sent by our company to supplier which indicates that balance in supplier’s account is being reduced by amount of purchase returns or purchase allowances. 7. Credit Note It is a document sent by our company to customer who indicates that balance in customer’s account is being reduced by amount of sales returns or sales allowance. 8. Bills Receivable (B/R) It is a bill of exchange raised by our company on customer and accepted by him for the amount due from him. It is shown as current asset of company. 9. Bills Payable (B/P) It is a bill of exchange raised by supplier on our company and accepted by us for the amount due to him. It is shown under current liabilities. 10. Provision An amount written off or retained by way of providing for: a. Depreciation or b. Diminition in value of asset or c. Known liability amount of which cannot be determined with substantial accuracy. 11. Liquid Assets Current assets other than pre-paid expenses & inventory. These assets can be easily converted into cash. 12. Amortization The gradual & systematic writing off of an asset or an account over an appropriate period e.g. depreciation, preliminary expenses. 13. Sales Returns Value of goods returned by customers to our company. It is also known as Returns Inward. 14. Purchase Returns Value of goods returned by our company to suppliers. It is also known as Returns Outward. 15. Sundry Debtors Customers of company to whom goods have been sold on credit. 16. Sundry Creditors: Suppliers of company from whom goods have been purchased on credit. 17. Marketable Securities Securities which can be easily converted into cash e.g. government securities short term investment & other money market instruments. These are shown as current assets. 18. Pre-paid expenses Payment for expenses in an accounting period, the benefit of which will accrue in the next accounting period. It is current asset. 19. Outstanding Expenses Payment for expense not made in an accounting period, the benefit of which accrues in same accounting period. It is current liability. 20. Advance Received 11  It is an amount received by company from customer for which goods or services have not been provided. It is current liability. 21. Bad Debts Bad debts are debts owed to company that are considered to be irrecoverable. It is a loss to the company and shown under selling & distribution expenses. 22. Bank Overdraft (O/D) It is a limit specified by bank upto which company can have negative balance. Bank charges interest on negative balance on day basis. 23. Solvency Ability of company to pay its dues on due dates. When company cannot pay so it is said to be insolvent. 24. Liquidity Ability of company to generate cash as and when required. 25. Drawings Capital withdrawn from business by the owner. 2.3 FORMS OF BUSINESS ORGANIZATION There are four types of organizations. While introducing accounting system it is important to know the type, as requirements & acts applicable to each type for implementing accounting system are different. Following are the types of organization: Type of organization Features Proprietary concern - Single owner - Capital is provided by him - Liability of owner is unlimited - Provisions of Companies Act not applicable - Tax audit applicable if turnover is more than Rs.40 lakhs - No minimum capital requirement Partnership firm - Owners- minimum 2 & maximum 20 (10 for banking business) - Capital provided by partners - Formed by partnership deed properly registered - Profits & losses are shared in ratio agreed as per deed - Liability of partners is joint, several & unlimited - Provisions of Companies Act not applicable - Tax audit applicable if turnover is more than Rs.40 lakhs - No minimum capital requirements Pvt. Ltd. Co. - Owners: minimum 2 & maximum 50 (called shareholders or members) - Capital provided by shareholders - Formed as per procedure of Companies Act - Liability of shareholder is limited to capital provided by him. 12  - Provisions of Companies Act applicable - Minimum capital required is Rs.1 lakh Public Ltd. Co. - Owners: minimum 7 & maximum any (called shareholders or members) - Capital provided by shareholders - Formed as per procedure of Companies Act - Liability of shareholder is limited to capital provided by him. - Provisions of Companies Act applicable - Minimum capital required is Rs. 5 Lakhs 2.4 MEANING & SIGNIFICANCE OF ACCOUNTING Meaning a. Process of identifying, measuring & communicating economic information of company to the users of this information for decision & control. b. Book-keeping is a part of accounting & it is concerned merely with recording transactions & keeping records. c. Accounting mainly focuses on measurement, analysis, interpretation & use of economic information by managers for making decisions & control activities. d. As an information system it involves 3 stages. I) Input : Economic events measured in financial terms II) Process : Recording, classifying, summarizing, analyzing & interpreting of input information through computer. III) Output : Communication of information to the users e. Accounting cycle involves following stages I) Entering financial transactions in journal. II) Posting in ledger accounts III) Preparation of trial balance IV) End products - income statement and balance sheet Significance a. Records all business transactions timely and accurately. b. Educates businessman to be systematic and accurate c. Protects business from theft & dishonesty d. Useful for control on cash flows e. Highlights areas of excess expenses f. Gives information for decision making and control to all who are connected with business g. Useful for knowing profitability, solvency and liquidity of company. h. To know tax liability of co. i. Useful for business valuation at the time of corporate restructuring j. Provides evidence in court of law k. Useful for SWOT analysis l. Useful for strategy formulations m. Tool for financial planning n. Divisional performance measurement o. Better cooperation & coordination 13 2.5 USERS OF ACCOUNTING INFORMATION Users Use of Information 1. INVESTORS i)To know profitability of company ii)To assess growth and survival of company iii)To decide on quantum of investment 2. LENDERS i)To judge profitability ii)To assess capacity of co. to pay interest and principal iii)To assess long term survival of co. 3.CREDITORS i)To assure that their credit will be honoured ii)To judge credibility of firm iii)To judge continuity of business 4.CUSTOMERS i)To ensure continuous availability of product ii)To know profitability of company iii)To know credit policy of company 5.GOVT.AGENCIES i)To assess Excise duty/ Sales Tax/Income tax due fromcompany. ii)To study wage structure of company for national wage policy iii)To know Import / Export for assessing net foreign iv)exchange earned by company. 6.EMPLOYEES i)To study profitability of company ii)To know expenses on employees by company iii)To ensure continuity of business 2.6 ACCOUNTING PRINCIPLES Meaning: i) Accounting principles are general rules derived for accounting procedures & practices. ii) Accounting principles must be followed for recording financial transactions & for preparing financial statements of company. Significance: 1. Separate Entity I) Business is to be treated seperate from its owners. II) Distinction must be made between personal & business transactions III) Assets & liabilities of business are different from that of owners. IV) Applicable to all types of organization Examples: (a) Money provided by owners is to be treated as capital of owners and regarded as liability of firm. (b) Drawings by owners are recorded by business i.e. capital withdrawn from business. 2. Going Concern i) Business entity has a continuity of life for indefinitely long period. ii) Concept recognizes value of the assets and liabilities of the business on the basis of their productivity and not on the basis of their current realizable value. iii) As per this concept assets and liabilities of concern are shown in the form of Balance sheet 14  iv) Concept helps other business units to make contracts with our business units for business dealings in future. v) Ex: prepaid expenses are recognized as assets since benefits will be utilized in future, when business will continue. 3. Money Measurement i) In accounting all transactions are expressed and interpreted in terms of money ii) Helps to express heterogeneous economic activities in terms of money iii) Fact or event which cannot be expressed in money is not recorded in books of accounts iv) As per this concept fixed assets like land, machinery, and furniture are expressed in terms of money and not in terms of area or quantity. 4. Cost Concept i) Asset is recorded at its cost in the books of accounts i.e. price which is paid at the time of acquiring it. ii) Asset when acquired is recorded at its cost price and gradually reduced by way of depreciation. iii) Amount of depreciation is to be calculated on the basis of cost price and the effective life of the asset. iv) The market value of the asset is not to be taken into account for the purpose of valuation or depreciation of the asset. v) This method is closely related to the going concern concept method. 5. Accounting Period i) Business is assumed to continue indefinitely as per going concern concept ii) Business has to choose intervals for ascertaining financial position and the operational results at each such interval, known as accounting period, which is generally one year. iii) In India every limited co. must publish its financial results two times. Half yearly & yearly. Many statutory bodies & financial institutions require many companies to submit even quarterly results. iv) Interested parties such as investors, creditors, shareholders etc. need periodical reports to judge business performance and for decision making. v) Concept is applicable to: a) Valuation of Assets & Liabilities b) Financial Analysis c) Revenue & Capital Expenditure d) Presentation of true & fair view of Financial Position e) Estimation of Profits vi) Concept helps to measure income generated during specific accounting period which also helps to distribute the same periodically by way of dividend vii) Concept recognizes the measurement of operating results of each period. viii) Reveals clear demarcation of accrued or deferred items of incomes & expenses. ix) The segregation of expenditure between capital & revenue arises from this concept. Revenue item has benefit for one accounting period whereas capital expenditure has benefit for more than one accounting period. 15 6. Dual Aspect i) Every transaction has double effect – Receiving benefit and giving benefit ii) Thus there will be double entry for each transaction i.e. To every debit, there must becredit iii) Accounting equation: Assets = Capital +Liabilities is based on this concept 7. Accrual Concept i) Incomes and expenses should be recognized as and when they are earned or incurred, irrespective of whether money is received or paid for any transaction. ii) Companies Act 1956 provides that accrual concept has to be maintained practically for all accounting purposes by all companies. Exs.: iii) Rent paid for 15 months in first month of year in advance. In this case rent for only 12 months should be recognized as expense for the year. Remaining 3 months rent should be treated as advance payment of rent for next year. iv) Credit sales of year = Rs.20 lakhs Cash collected from debtors = Rs.15 lakhs Sales of Rs.20 lakhs should be considered for finding income of firm & not Rs.15 lakhs. 8 Matching Concept i) Revenue earned in an accounting year is matched with all expenses incurred during same period to generate that revenue. ii) Examples: (a) Depreciation for the year is the cost of asset to earn revenue for same year. (b) Prepaid expenses are excluded to decide income of year (c) Outstanding expenses are added to decide income of year 9. Prudence or Conservatism. i) Prudence is the inclusion of a degree of caution in making estimates under conditions of uncertainty. ii) It states that: a) Anticipate no profits but provide for all possible losses b) Assets or incomes should not be overstated & liabilities or expenses should not be understated c) Expected losses should be accounted for but not the anticipated gains 10. Realization i) Governed by concept of prudence ii) Revenue should only be brought into account when it is actually realized or when there is certainty to realize revenue. iii) EX: Provision for doubtful debts is excluded from sales and only that sale is considered which business is certain to realize for knowing profit of business. 11. Materiality i) It means relative importance. ii) Whether a matter should be disclosed or not in the financial statement depends on its materiality i.e. whether it is material or not. iii) In the accounting sense an item is recorded only when it is considered to be useful or important to the user of financial statement iv) Amount may be material under one situation but immaterial under another situation. 16  E.g. sale of Rs. 4 lakhs is material when turnover is Rs.40 lakhs but it is immaterial when turnover is Rs.4, 000 cr. v) It is useful to management to avoid unnecessary wastage on time & money on immaterial amounts. vi) Material items should be separately disclosed in published financial statements, whereas immaterial items may not be disclosed separately but may be considered in a consolidated form. 12. Consistency i) Accounting methods, practices & policies used by business must be consistent from one period to another period. ii) Gives confidence to the user of accounting information iii) Useful for comparison of business performance year after year iv) Ex: Same method of depreciation i.e. either S.L.M. or W.D.V. should be consistently used year after year. 13. Full Disclosure i) Financial statements is a means of disclosing and not concealing. ii) Financial statements must disclose all relevant and reliable information. iii) Disclosure must be full, fair & adequate 2.7 ACCOUNTING STANDARDS (A.S.) (a) Indian Accounting Standards i) It is a regulatory framework within which financial statements are prepared. ii) They seek to describe the accounting principles & the methods of applying them in preparation & presentation of financial statements. iii) In India, Institute of Chartered Accountants of India (ICAI) as an apex accounting body sets accounting standards which are applicable to Indian business entities operating in India in preparation & presentation of financial statements. iv) Council of ICAI has set up Accounting Standard Board (ASB) to formulate accounting standards which are applicable to all companies formed & governed by Companies Act 1956. ASB has representatives from govt. bodies & industry. v) Till today institute has issued 29 Accounting standards on various aspects of business. vi) The basic objective of A. S. is to standardize the diverse accounting policies & practices with a view to bring comparability of financial information and to produce reliable accounting statements acceptable universally. vii) It is mandatory for every Ltd. Co. to prepare financial statements on basis of accounting standards. viii) As per income tax Act 1961 it is essential to use certain accounting standards for ascertaining income for calculating tax liability of company. (b) International Accounting Standards (I.A.S.) (i) In last decade there is globalization of investors.They are investing in securities issued by companies of other countries. (ii) Companies are getting listed at several stock exchanges in different parts of world besides being listed at the national stock exchanges of their country e.g. Infosys Ltd is incorporated 17  in India and has made public issue of securities in U.S.A. Capital Market and is listed at NASDAQ. (iii) Infosys is required to prepare its financial statements as per U.S. accounting practices in addition to , as per Indian Accounting Standards (iv) Decisions regarding investments in the companies of different countries require an understanding, analysis & interpretation of financial statements of these companies which are prepared on the basis of accounting practices prevailing in the country of origin. (v) Thus understanding & harmonizing accounting standards of different countries has become essential for listing of securities at stock exchanges of different countries. (vi) International Accounting Standards try to bring uniformity between accounting standards of different countries. This makes preparation, analysis & interpretation of global financial statements easy & more useful. (vii) Some basic features of I.A.S. are: 1) Set of financial statements include : Income Statement, Balance Sheet, Statement showing change in equity, Cash flow statement, Accounting policies, Explanatory notes. 2) Assets & liabilities are classified as current & non-current 3) Inventories should be valued at lower of cost or net realizable value. They should be valued by FIFO or WACO method. 4) Business or geographic segments should be identified as reportable segment. 5) Employee benefits are classified as: short term benefits, post employment benefits, other long term benefits, termination benefits, equity compensation benefits. 6) Borrowing costs include interest on bank overdraft & borrowings, finance charges on lease and exchange differences related to foreign currency borrowings. (c) Important Accounting Standards The Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India has in line with the International Standards, issued following twenty nine standards to be followed by all Companies in India, as they become applicable. 1. 1. Disclosures of Accounting Policies (AS 1) 2. Valuation of Inventories (AS 2) 3. Cash flow statement (AS 3) 4. Contingents and Events Occurring After the BalancesheetDate(AS 4) 5. Net profit or loss for the period, prior period Items and Changes in Accounting Policies (AS 5) 6. Depreciation Accounting (AS 6) 7. Accounting for Construction Contract (AS 7) 8. Accounting for Research and Development (AS 8) 9. Revenue Recognition (AS 9) 10. Accounting for Fixed Assets (AS 10) 11. Accounting for the Effects of Changes in Foreign Exchanges Rates (AS 11) 12. Accounting for Government Grants (AS 12) 13. Accounting for Investment (AS 13) 14. Accounting for Amalgamation (AS 14) 15. Accounting for Retirement Benefit in the Financial Statement of Employers (AS 15) 16. Borrowing Cost (AS 16) 18  17. Segment Reporting (AS 17) 18. Related Party Disclosures (AS 18) 19. Leases (AS 19) 20. Earnings Per Share (AS 20) 21. Consolidated Financial Statement (AS 21) 22. Accounting for taxes on income (AS 22) 23. Accounting for Investments in Associates in Consolidated Financial Statements (AS 23) 24. Discontinuing Operations (AS 24) 25. Interim Financial Reporting (AS 25) 26. Intangible Assets (AS 26) 27. Financial reporting of Interest in Joint Venture (AS 27) 28. Impairment of Assets (AS 28) 29. Provisions, Contingent Liabilities and Contingent Assets. (AS 29). Some of the important Accounting Standards required for Accounting and Management purposes have been given below: (Source: website www.icai.org of ICAI). Accounting Standard (AS) :- 1: Disclosure of Accounting Policies Introduction 1) This statement deals with the disclosure of significant accounting policies followed in preparing and 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 the 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, 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 forms 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 19  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. 2: 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, recognized 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.) 3: 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. 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 pries. 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. 4: 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. a) Methods of depreciation, depletion and amortization b) Treatment of expenditure during construction c) Conversion or translation of foreign currency items 20  d) Valuation of inventories e) Treatment of goodwill f) Valuation of investments g) Treatment of retirement benefits h) Recognition of profit on long-term contracts i) Valuation of fixed assets j) Treatment of contingent liabilities. 15) The above list of examples is not intended to be exhaustive. 5: 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 recognized only when realized 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 the financial statements. 6: 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 lace 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 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 21  the accounting policies which has nonmaterial 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. 7: Accounting Standard (AS) 2: Valuation of Inventories 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 there of to net realizable 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 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 realizable value in accordance with well established practices in those industries. 2. The inventories referred to in paragraph 1 (d) are measured at net realizable 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 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: i. held for sale in the ordinary course of business; ii. in the process of production for such sale; or iii. in the form of materials or supplies to be consumed in the production process or in the rendering of services. Net realizable 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 & held for resale, for example, merchandise purchased by 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 22  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. Measurement of Inventories 5. Inventories should be valued at the lower of cost and net realizable 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. 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 labor. 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 recognized 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 23  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 realizable 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 recognize 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 24  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 utilization. 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 Realizable 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 realizable value is consistent with the view that assets should not be carried in excess of amounts expected to be realized from their sale or use. 21. Inventories are usually written down to net realizable 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 realizable value are based on the most reliable evidence available at the time the estimates are made as to the amount the inventories are expected 25  to realize. 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 realizable value also take into consideration the purpose for which the inventory is held. For example, the net realizable 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 realizable 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 realizable value, the materials are written down to net realizable value. In such circumstances, the replacement cost of the materials may be the best available measure of their net realizable value. 25. An assessment is made of net realizable 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 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. Accounting Standard (AS) 3: Cash Flow Statements 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 utilize 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 26  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 a 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. AS 3 (revised 1997) 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 27  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 information 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 installment 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. 28  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. There fore, 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: i. Cash payments to acquire fixed assets (including intangibles). ii. These payments include those relating to capitalized research and development costs and self-constructed fixed assets; iii. cash receipts from disposal of fixed assets (including intangibles) iv. 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); v. 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); vi. cash advances and loans made to third parties (other than advances and loans made by a financial enterprise); vii. cash receipts from the repayment of advances and loans made to third parties (other than advances and loans of a financial enterprise); viii. 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 ix. 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: 29  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 unrealized 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. 22. Cash flows arising from the following operating, investing or financing activities may be reported on a net basis: 30  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. Arate 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. 27. Unrealized 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 a 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 31  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. 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 recognized as an expense in the statement of profit and loss or capitalized 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 underlying transactions. Therefore, taxes paid are usually classified 32  as cash flows from operating activities. However, when it is practicable to identify the tax cash flow with an individual 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 flow 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 invitee /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 relevant 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. 33  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 by 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