Contents

Study Note 1 : Fundamentals of Accounting

1.1 Basics 1
1.2 Generally Accepted Accounting Principles 11
1.3 Accounting Concepts and Conventions 11
1.4 Capital & Revenue Transactions 26
1.5 Accounting for Depreciation 56
1.6 Rectification of Errors 71

Study Note 2 : Accounting for Special Transactions

2.1 Bills of Exchange 93

2.2 Consignment Accounting 112
2.3 Joint Venture Accounts 133
2.4 Insurance Claim (Loss of Stock and Loss of Profit) 151

Study Note 3 : Preparation of Financial Statments of Profit Oriented Organizations

3.1 Introduction 169

3.2 Bad Debts 169
3.3 Preparation of Financial Statements 180

Study Note 4 : Preparation of Financial Statments of Non-Profit Organizations

4.1 Preparation of Financial Statements of Non-Profit Organization 213

Study Note 5 : Preparation of Financial Statements from Incomplete Records

5.1 Preparation of Financial Statements from Incomplete Records 249

Study Note 6 : Partnership

6.1 Admission of Partner 275
6.2 Retirement of Partner 303
6.3 Death of Partner 327
6.4 Dissolution of a Partnership Firm 330
6.5 Insolvency of a Partner 338
Study Note - 1
FUNDAMENTALS OF ACCOUNTING

This Study Note includes

1.1 Basics
1.2 Generally Accepted Accounting Principles
1.3 Accounting Concepts and Conventions
1.4 Capital & Revenue Transactions
1.5 Accounting for Depreciation
1.6 Rectification of Errors

1.1 BASICS

Business is an economic activity undertaken with the motive of earning profits and to maximize the wealth for the
owners. Business cannot run in isolation. Largely, the business activity is carried out by people coming together with
a purpose to serve a common cause. This team is often referred to as an organization, which could be in different
forms such as sole proprietorship, partnership, body corporate etc. The rules of business are based on general
principles of trade, social values, and statutory framework encompassing national or international boundaries.
While these variables could be different for different businesses, different countries etc., the basic purpose is to
add value to a product or service to satisfy customer demand.
The business activities require resources (which are limited & have multiple uses) primarily in terms of material,
labour, machineries, factories and other services. The success of business depends on how efficiently and
effectively these resources are managed. Therefore, there is a need to ensure that the businessman tracks the use
of these resources. The resources are not free and thus one must be careful to keep an eye on cost of acquiring
them as well.
As the basic purpose of business is to make profit, one must keep an ongoing track of the activities undertaken in
course of business. Two basic questions would have to be answered:
(a) What is the result of business operations? This will be answered by finding out whether it has made profit or
loss.
(b) What is the position of the resources acquired and used for business purpose? How are these resources
financed? Where the funds come from?
The answers to these questions are to be found continuously and the best way to find them is to record all the
business activities. Recording of business activities has to be done in a scientific manner so that they reveal correct
outcome. The science of book-keeping and accounting provides an effective solution. It is a branch of social
science. This study material aims at giving a platform to the students to understand basic principles and concepts,
which can be applied to accurately measure performance of business. After studying the various chapters
included herein, the student should be able to apply the principles, rules, conventions and practices to different
business situations like trading, manufacturing or service.
Over years, the art and science of accounting has evolved together with progress of trade and commerce at
national and global levels. Professional accounting bodies have been doing intensive research to come up with
accounting rules that will be applicable. Modern business is certainly more complex and continuous updating
of these rules is required. Every stakeholder of the business is interested in a particular facet of information about
the business. The art and science of accounting helps to put together these requirements of information as per
universally accepted principles and also to interpret the results. It is interesting to note that each one of us has
an accountant hidden in us. We do see our parents keep track of monthly expenses. We make a distinction
between payment done for monthly grocery and that for buying a house or a car. We understand that while
grocery is a monthly expense and buying a house is like creating a resource that has indefinite future use. The
most common accounting record that each one of us knows is our bank passbook or a bank statement, which

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the bank maintains for us. It tracks each rupee that we deposit or withdraw from our account. When we go to
supermarket to buy something, the cashier at the counter will record things we buy and give us a ‘bill’ or ‘cash
memo’. These are source documents prepared for the transaction between the supermarket and us. While these
are simple examples, there could be more complex business activities. A good working knowledge of keeping
records is therefore necessary. Professional accounting bodies all over the world have been functioning with the
objective of providing this body of knowledge. These institutions are engaged in imparting training in the field of
accounting. Let us start with some basic definitions, concepts, conventions and practices used in development of
this art as well as science.
Definitions
In order to understand the subject matter with clarity, let us study some of the definitions which depict the scope,
content and purpose of Accounting. The field of accounting is generally sub-divided into:
(a) Book-keeping
(b) Financial Accounting
(c) Cost Accounting and
(d) Management Accounting
Let us understand each of these concepts.
(a) Book-keeping
The most common definition of book-keeping as given by J. R. Batliboi is “Book-keeping is an art of recording
business transactions in a set of books.”
As can be seen, it is basically a record keeping function. One must understand that not all dealings are, however,
recorded. Only transactions expressed in terms of money will find place in books of accounts. These are the
transactions which will ultimately result in transfer of economic value from one person to the other. Book-keeping
is a continuous activity, the records being maintained as transactions are entered into. This being a routine and
repetitive work, in today’s world, it is taken over by the computer systems. Many accounting packages are
available to suit different business organizations.
It is also referred to as a set of primary records. These records form the basis for accounting. It is an art because, the
record is to be kept in such a manner that it will facilitate further processing and reporting of financial information
which will be useful to all stakeholders of the business.
(b) Financial Accounting
It is commonly termed as Accounting. The American Institute of Certified Public Accountants defines Accounting
as “an art of recoding, classifying and summarizing in a significant manner and in terms of money, transactions
and events which are in part at least of a financial character, and interpreting the results thereof.”
Recording of The first step in the cycle of accounting is to identify transactions that will find place in books of accounts.
Transaction
Transactions having financial impact only are to be recorded. E.g. if a businessman negotiates with the customer
regarding supply of products, this will not be recorded. The negotiation is a deal which will potentially create a
transaction and will have exchange of money or money’s worth. But unless this transaction is finally entered into,
it will not be recorded in the books of accounts.
Secondly, the recording of the business transactions is done based on the Golden Rules of accounting (which
Based on
golden Rule are explained later) in a systematic manner. Transaction of similar nature are grouped together and recorded
accordingly. e.g. Sales Transactions, Purchase Transactions, Cash Transactions etc. One has to interpret the
transaction and then apply the relevant Golden Rule to make a correct entry thereof.
Thirdly, as the transactions increase in number, it will be difficult to understand the combined effect of the same
Summerizing by referring to individual records. Hence, the art of accounting also involves the step of summarizing them. With
the aid of computers, this task is simplified in today’s accounting world. The summarization will help users of the
business information to understand and interpret business results.
Lastly, the accounting process provides the users with statements which will describe what has happened to the
Business Position business. Remember the two basic questions we talked about, one to know whether business has made profit or
loss and the other to know the position of resources that are used by the business.
It can be noted that although accounting is often referred to as an art, it is a science also. This is because it is
based on universally applicable set of rules. However, it is not a pure science as there is a possibility of different
interpretation.

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(c) Cost Accounting

According to the Chartered Institute of Management Accountants (CIMA), Cost Accountancy is defined as
“application of costing and cost accounting principles, methods and techniques to the science, art and practice
of cost control and the ascertainment of profitability as well as the presentation of information for the purpose of
managerial decision-making.”
It is a branch of accounting dealing with the classification, recording, allocation, summarization and reporting
of current and prospective costs and analyzing their behaviours. Cost Accounting is frequently used to facilitate
internal decision making and provides tools with which management can appraise performance and control costs
of doing business. It primarily involves relating the costs to the different products produced and sold or services
rendered by the business. While Financial Accounting deals with business transactions at a broader level, Cost
Accounting aims at further breaking it up to the last possible level to indentify costs with products and services. It
uses the same Financial Accounting documents and records. Modern computerized accounting packages like
ERP systems provide for processing Financial as well as Cost Accounting records simultaneously.
This branch of accounting deals with the process of ascertainment of costs. The concept of cost is always applied
with reference to a context. Knowledge of cost concepts and their application provide a very sound platform for
decision making. Cost Accounting aims at equipping management with information that can be used for control
on business activities.
(d) Management Accounting Used by internal Managers of the organisation
Management Accounting is concerned with the use of Financial and Cost Accounting information to managers
within organizations, to provide them with the basis in making informed business decisions that would allow them to
be better equipped in their management and control functions. Unlike Financial Accounting information (which,
for public companies, is public information), Management Accounting information is used within an organization
(typically for decision-making) and is usually confidential and its access available only to a selected few.
According to the Chartered Institute of Management Accountants (CIMA), Management Accounting is “the
process of identification, measurement, accumulation, analysis, preparation, interpretation and communication
of information used by management to plan, evaluate and control within an entity and to assure appropriate
use of and accountability for its resources. Management Accounting also comprises the preparation of financial
reports for non management groups such as shareholders, creditors, regulatory authorities and tax authorities”.
Basically, Management Accounting aims to facilitate management in formulating strategies, planning and
constructing business activities, making decisions, optimal use of resources, and safeguarding assets of business.
These branches of accounting have evolved over years of research and are basically synchronized with the
requirements of business organizations and all entities associated with them. We will now see what are they and
how accounting satisfies various needs of different stakeholders.
Difference between Book-keeping and Accountancy:
The Significant difference between Book-keeping and Accountancy are:

Sl Points of Book Keeping Accountancy

No. difference
1. Meaning Book-keeping is considered as end. Accountancy is considered as
beginning.
2. Functions The primary stage of accounting function is The overall accounting functions are
called Book-keeping. guided by accountancy.
3 Depends Book-keeping can provide the base of Accountancy depends on Book-
Accounting. keeping for its complete functions.
4. Data The necessary data about financial Accountancy can take its decisions,
performances and financial positions are prepare reports and statements from the
taken from Book-keeping. data taken from Book-keeping.
5. Recording of Financial transactions are recorded on the Accountancy does not take any principles,
Transactions basis of accounting principles, concepts concepts and conventions from Book-
and conventions. keeping.

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Difference between Management Accounting and Financial Accounting: M a i n s Q u e s t i o n

The significant difference between Management Accounting and Financial Accounting are: 5-10 marker
Management Accounting Financial Accounting Primary base
1. Management Accounting is primarily based on 1. Financial Accounting is based on
the data available from Financial Accounting. the monetary transactions of the enterprise.
2. It provides necessary information to the 2. Its main focus is on recording and classifying
management to assist them in the process of monetary transactions in the books of accounts
planning, controlling, performance evaluation and preparation of financial statements at the end
and decision making. of every accounting period.
3. Reports prepared in Management Accounting are 3. Reports as per Financial Accounting are meant for
Internal Users External Users
meant for management and as per management the management as well as for shareholders and
requirement. creditors of the concern.
4. Reports may contain both subjective and objective 4. Reports should always be supported by relevant
figures. figures and it emphasizes on the objectivity of data.
5. Reports are not subject to statutory audit. 5. Reports are always subject to statutory audit. Bound to follow
Accounting Standrd
6. It evaluates the sectional as well as the entire 6. It ascertains, evaluates and exhibits the financial
performance of the business. strength of the whole business.

Accounting Cycle
When complete sequence of accounting procedure is done which happens frequently and repeated in same
directions during an accounting period, the same is called an accounting cycle.

Recording of
Transaction

Financial
Journal
Statement

Closing Not Required Ledger

Entries

Adjusted Trial Trial

Balance Balance

Adjustment
Entries

Accounting Cycle

Steps/Phases of Accounting Cycle

The steps or phases of accounting cycle can be developed as under:
(a) Recording of Transaction: As soon as a transaction happens it is at first recorded in subsidiary book.
(b) Journal: The transactions are recorded in Journal chronologically.

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(c) Ledger: All journals are posted into ledger chronologically and in a classified manner.
(d) Trial Balance: After taking all the ledger account’s closing balances, a Trial Balance is prepared at the end
of the period for the preparations of financial statements.
(e) Adjustment Entries: All the adjustments entries are to be recorded properly and adjusted accordingly
before preparing financial statements.
(f) Adjusted Trial Balance: An adjusted Trail Balance may also be prepared.
(g) Closing Entries: All the nominal accounts are to be closed by the transferring to Trading Account and Profit
and Loss Account.
Financial Statements: Financial statement can now be easily prepared which will exhibit the true financial position
and operating results.
Objectives of Accounting
The main objective of Accounting is to provide financial information to stakeholders. This financial information
is normally given via financial statements, which are prepared on the basis of Generally Accepted Accounting
Principles (GAAP). There are various accounting standards developed by professional accounting bodies all
over the world. In India, these are governed by The Institute of Chartered Accountants of India, (ICAI). In the
US, the American Institute of Certified Public Accountants (AICPA) is responsible to lay down the standards. The
Financial Accounting Standards Board (FASB) is the body that sets up the International Accounting Standards.
These standards basically deal with accounting treatment of business transactions and disclosing the same in
financial statements.
The following objectives of accounting will explain the width of the application of this knowledge stream:
(a) To ascertain the amount of profit or loss made by the business i.e. to compare the income earned versus the
expenses incurred and the net result thereof.
(b) To know the financial position of the business i.e. to assess what the business owns and what it owes.
(c) To provide a record for compliance with statutes and laws applicable.
(d) To enable the readers to assess progress made by the business over a period of time.
(e) To disclose information needed by different stakeholders.
Let us now see which are different stakeholders of the business and what do they seek from the accounting
information. This is shown in the following table.

Stakeholder Interest in business Accounting Information

O wners / Inv es tors / Profits or losses Financial statements, Cost Accounting
existing and potential records, Management Accounting reports
Lenders Assessment of capability of the business Financial statement and analysis thereof,
to pay interest and principal of money reports forming part of accounts, valuation
lent. Basically, they monitor the of assets given as security
solvency of business
Customers and suppliers Stability and growth of the business Financial and Cash flow statements to
assess ability of the business to offer better
business terms and ability to supply the
products and services
Government Whether the business is complying with Accounting documents such as vouchers,
various legal requirements extracts of books, information of purchase,
sales, employee obligations etc. and
financial statements
Employees and trade Growth and profitability Financial statements for negotiating pay
unions packages
Competitors Performance and possible tie-ups in the Accounting information to find out possible
era of mergers and acquisitions synergies

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Users of Accounting Information

Accounting provides information both to internal users and the external users. The internal users are all the
organizational participants at all levels of management (i.e. top, middle and lower). Generally top level
management requires information for planning, middle level management which requires information for
controlling the operations. For internal use, the information is usually provided in the form of reports, for instance
Cash Budget Reports, Production Reports, Idle Time Reports, Feedback Reports, whether to retain or replace an
equipment decision reports, project appraisal report, and the like.
There are also the external users (e.g. Banks, Creditors). They do not have direct access to all the records of an
enterprise, they have to rely on financial statements as the source of information. External users are basically,
interested in the solvency and profitability of an enterprise.
Types of Accounting Information
Accounting information may be categorized in number of ways on the basis of purpose of accounting information,
on the basis of measurement criteria and so on. The various types of accounting information are given below:
I. Accounting information relating to financial transactions and events.
(a) Financial Position- Information about financial position is primarily provided in a Balance Sheet. The
financial position of an enterprise is affected by different factors, like -
(i) Information about the economic resources controlled by the enterprise and its capacity in the
past to alter these resources is useful in predicting the ability of the enterprise to generate cash
and cash equivalents in the future.
(ii) Information about financial structure is useful in predicting future borrowing needs and how future
profits and cash flows will be distributed among those with an interest in the enterprise; it is also
useful in predicting how successful the enterprise is likely to be in raising further finance.
(iii) Information about liquidity and solvency is useful in predicting the ability of the enterprise to meet
its financial commitments as they fall due. Liquidity refers to the availability of cash in the near
future to meet financial commitments over this period. Solvency refers to the availability of cash
over the longer term to meet financial commitments as they fall due.
(b) Financial Performance- Information about financial performance is primarily provided in a Statement of
Profit and Loss which is also known as Income Statement.
Information about the performance of an enterprise and its profitability, is required in order to assess
potential changes taking place in the economic resources that it is likely to control in the future.
Information about variability of performance is also important in this regard. Information about
performance is necessary in predicting the capacity to generate cash flows from its available resource.
It is an important input in forming judgments about the effectiveness of an enterprise to utilize resources.
(c) Cash Flows—Information about cash flows is provided in the financial statements by means of a cash
flow statement.
Information concerning cash flows is useful in providing the users with a basis to assess the ability of the
enterprise to generate cash and cash equivalents and the needs of the enterprise to utilise those cash
and cash equivalent.
These information may be classified as follows:
(i) on the basis of Historical Cost,
(ii) on the basis of Current Cost,
(iii) on the basis of Realizable Value,
(iv) on the basis of Present Value

II. Accounting information relating to cost of a product, operation or function.

III. Accounting information relating to planning and controlling the activities of an enterprise for internal reporting.

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This information may further be classified as follows:

(i) Information relating to Finance Area
(ii) Information relating to Production Area
(iii) Information relating to Marketing Area
(iv) Information relating to Personnel Area
(v) Information relating to Other Areas (such as Research & Development).
IV. Accounting information relating to Social Effects of business decisions.
V. Accounting information relating to Environment and Ecology.
VI. Accounting information relating to Human Resources.

Basic Accounting Terms

In order to understand the subject matter clearly, one must grasp the following common expressions always used
in business accounting. The aim here is to enable the student to understand with these often used concepts
before we embark on accounting procedures and rules. You may note that these terms can be applied to any
business activity with the same connotation.
(i) Transaction: It means an event or a business activity which involves exchange of money or money’s worth
between parties. The event can be measured in terms of money and changes the financial position of a person
e.g. purchase of goods would involve receiving material and making payment or creating an obligation to
pay to the supplier at a future date. Transaction could be a cash transaction or credit transaction. When
the parties settle the transaction immediately by making payment in cash or by cheque, it is called a cash
transaction. In credit transaction, the payment is settled at a future date as per agreement between the
parties.
(ii) Goods/Services : These are tangible article or commodity in which a business deals. These articles or
commodities are either bought and sold or produced and sold. At times, what may be classified as ‘goods’
to one business firm may not be ‘goods’ to the other firm. e.g. for a machine manufacturing company,
the machines are ‘goods’ as they are frequently made and sold. But for the buying firm, it is not ‘goods’ as
the intention is to use it as a long term resource and not sell it. Services are intangible in nature which are
rendered with or without the object of earning profits.
(iii) Profit: The excess of Revenue Income over expense is called profit. It could be calculated for each transaction
or for business as a whole.
(iv) Loss: The excess of expense over income is called loss. It could be calculated for each transaction or for
business as a whole.
(v) Asset: Asset is a resource owned by the business with the purpose of using it for generating future profits.
Assets can be Tangible and Intangible. Tangible Assets are the Capital assets which have some physical
existence. They can, therefore, be seen, touched and felt, e.g. Plant and Machinery, Furniture and Fittings,
Land and Buildings, Books, Computers, Vehicles, etc. The capital assets which have no physical existence
and whose value is limited by the rights and anticipated benefits that possession confers upon the owner are
known as lntangible Assets. They cannot be seen or felt although they help to generate revenue in future,
e.g. Goodwill, Patents, Trade-marks, Copyrights, Brand Equity, Designs, Intellectual Property, etc.
Assets can also be classified into Current Assets and Non-Current Assets.
Current Assets – An asset shall be classified as Current when it satisfies any of the following :
(a) It is expected to be realised in, or is intended for sale or consumption in the Company’s normal Operating
Cycle,
(b) It is held primarily for the purpose of being traded ,
(c) It is due to be realised within 12 months after the Reporting Date, or
(d) It is Cash or Cash Equivalent unless it is restricted from being exchanged or used to settle a Liability for
at least 12 months after the Reporting Date.

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Non-Current Assets – All other Assets shall be classified as Non-Current Assets. e.g. Machinery held for long
term etc.
(vi) Liability: It is an obligation of financial nature to be settled at a future date. It represents amount of money
that the business owes to the other parties. E.g. when goods are bought on credit, the firm will create an
obligation to pay to the supplier the price of goods on an agreed future date or when a loan is taken from
bank, an obligation to pay interest and principal amount is created. Depending upon the period of holding,
these obligations could be further classified into Long Term on non-current liabilities and Short Term or current
liabilities.
Current Liabilities – A liability shall be classified as Current when it satisfies any of the following :
(a) It is expected to be settled in the Company’s normal Operating Cycle,
(b) It is held primarily for the purpose of being traded,
(c) It is due to be settled within 12 months after the Reporting Date, or
(d) The Company does not have an unconditional right to defer settlement of the liability for at least 12
months after the reporting date (Terms of a Liability that could, at the option of the counterparty, result
in its settlement by the issue of Equity Instruments do not affect its classification)
Non-Current Liabilities – All other Liabilities shall be classified as Non-Current Liabilities. E.g. Loan taken for 5 years,
Debentures issued etc.
(vii) Internal Liability : These represent proprietor’s equity, i.e. all those amount which are entitled to the proprietor,
e.g., Capital, Reserves, Undistributed Profits, etc.
(viii) Working Capital : In order to maintain flows of revenue from operation, every firm needs certain amount
of current assets. For example, cash is required either to pay for expenses or to meet obligation for service
received or goods purchased, etc. by a firm. On identical reason, inventories are required to provide the
link between production and sale. Similarly, Accounts Receivable generate when goods are sold on credit.
Cash, Bank, Debtors, Bills Receivable, Closing Stock, Prepayments etc. represent current assets of firm. The
whole of these current assets form the working capital of a firm which is termed as Gross Working Capital.
Gross Working Capital = Total Current Assets
= Long term internal liabilities plus long term debts plus the current liabilities
minus the amount blocked in the fixed assets.
There is another concept of working capital. Working capital is the excess of current assets over current
liabilities. That is the amount of current assets that remain in a firm if all its current liabilities are paid. This
concept of working capital is known as Net Working Capital which is a more realistic concept.
Working Capital (Net) = Current Assets – Currents Liabilities.
(ix) Contingent Liability : It represents a potential obligation that could be created depending on the outcome
of an event. E.g. if supplier of the business files a legal suit, it will not be treated as a liability because no
obligation is created immediately. If the verdict of the case is given in favour of the supplier then only the
obligation is created. Till that it is treated as a contingent liability. Please note that contingent liability is not
recorded in books of account, but disclosed by way of a note to the financial statements.
(x) Capital : It is amount invested in the business by its owners. It may be in the form of cash, goods, or any other
asset which the proprietor or partners of business invest in the business activity. From business point of view,
capital of owners is a liability which is to be settled only in the event of closure or transfer of the business.
Hence, it is not classified as a normal liability. For corporate bodies, capital is normally represented as share
capital.
(xi) Drawings : It represents an amount of cash, goods or any other assets which the owner withdraws from
business for his or her personal use. e.g. if the life insurance premium of proprietor or a partner of business is
paid from the business cash, it is called drawings. Drawings will result in reduction in the owners’ capital. The
concept of drawing is not applicable to the corporate bodies like limited companies.
(xii) Net worth : It represents excess of total assets over total liabilities of the business. Technically, this amount is
available to be distributed to owners in the event of closure of the business after payment of all liabilities.

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That is why it is also termed as Owner’s Equity. A profit making business will result in increase in the owner’s
equity whereas losses will reduce it.
(xiii) Non-current Investments : Non-current Investments are investments which are held beyond the current
period as to sale or disposal. e. g. Fixed Deposit for 5 years.
(xiv) Current Investments : Current investments are investments that are by their nature readily realizable and are
intended to be held for not more than one year from the date on which such investment is made. e. g. 11
months Commercial Paper.
(xv) Debtor : The sum total or aggregate of the amounts which the customer owe to the business for purchasing
goods on credit or services rendered or in respect of other contractual obligations, is known as Sundry
Debtors or Trade Debtors, or Trade Receivable, or Book-Debts or Debtors. In other words, Debtors are those
persons from whom a business has to recover money on account of goods sold or service rendered on
credit. These debtors may again be classified as under:

(i) Good debts : The debts which are sure to be realized are called good debts.

(ii) Doubtful Debts : The debts which may or may not be realized are called doubtful debts.

(iii) Bad debts : The debts which cannot be realized at all are called bad debts.

It must be remembered that while ascertaining the debtors balance at the end of the period certain
adjustments may have to be made e.g. Bad Debts, Discount Allowed, Returns Inwards, etc.
(xvi) Creditor : A creditor is a person to whom the business owes money or money’s worth. e.g. money payable
to supplier of goods or provider of service. Creditors are generally classified as Current Liabilities.

(xvii) Capital Expenditure: This represents expenditure incurred for the purpose of acquiring a fixed asset which
is intended to be used over long term for earning profits there from. e. g. amount paid to buy a computer
for office use is a capital expenditure. At times expenditure may be incurred for enhancing the production
capacity of the machine. This also will be a capital expenditure. Capital expenditure forms part of the
Balance Sheet.

(xviii) Revenue expenditure: This represents expenditure incurred to earn revenue of the current period. The
benefits of revenue expenses get exhausted in the year of the incurrence. e.g. repairs, insurance, salary &
wages to employees, travel etc. The revenue expenditure results in reduction in profit or surplus. It forms part
of the Income Statement.

(xix) Balance Sheet: It is the statement of financial position of the business entity on a particular date. It lists all
assets, liabilities and capital. It is important to note that this statement exhibits the state of affairs of the
business as on a particular date only. It describes what the business owns and what the business owes to
outsiders (this denotes liabilities) and to the owners (this denotes capital). It is prepared after incorporating
the resulting profit/losses of Income Statement.

(xx) Profit and Loss Account or Income Statement: This account shows the revenue earned by the business
and the expenses incurred by the business to earn that revenue. This is prepared usually for a particular
accounting period, which could be a month, quarter, a half year or a year. The net result of the Profit and
Loss Account will show profit earned or loss suffered by the business entity.

(xxi) Trade Discount: It is the discount usually allowed by the wholesaler to the retailer computed on the list price
or invoice price. e.g. the list price of a TV set could be ` 15000. The wholesaler may allow 20% discount
thereof to the retailer. This means the retailer will get it for ` 12000 and is expected to sale it to final customer
at the list price. Thus the trade discount enables the retailer to make profit by selling at the list price. Trade
discount is not recorded in the books of accounts. The transactions are recorded at net values only. In
above example, the transaction will be recorded at ` 12000 only.

(xxii) Cash Discount: This is allowed to encourage prompt payment by the debtor. This has to be recorded in the
books of accounts. This is calculated after deducting the trade discount. e.g. if list price is ` 15000 on which
a trade discount of 20% and cash discount of 2% apply, then first trade discount of ` 3000 (20% of ` 15000)
will be deducted and the cash discount of 2% will be calculated on ` 12000 (`15000 – ` 3000). Hence the
cash discount will be ` 240/- (2% of ` 12000) and net payment will be ` 11,760 (`12,000 - ` 240)

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 FINANCIAL ACCOUNTING

Theory Base of Accounting

Basic Assumptions Basic Principles Modifying Principles

(a) Business Entity Concept (a) Revenue Realization Concpet (a) Materiality Concept
(b) Going Concern Concept (b) Matching Concept (b) Consistency Concept
(c) Money Measurement Concept (c) Full Disclosure Concept (c) Conservatism Concpet
(d) Accounting Period Concept (d) Dual Aspect Concept (d) Timeliness Concept
(e) Accrual Concept (e) Verifiable Objective Evidence Concpet (e) Industry Practice Concept
(f) Historical Cost Concept
(g) Balance Sheet Equation Concpet

A. BASIC 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 owner’s 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 owner’s 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

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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
Absoulute Value to inflation, exchange rate changes, etc. This fact is not considered when recording the transaction.
is considered
(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?
To circumvent this problem, the business entity is supposed to be paused after a certain time interval. This
time interval is called an accounting period. This period is usually one year, which could be a calendar year
i.e. 1st January to 31st December or it could be a fiscal year in India as 1st April to 31st March. The business
organizations have the freedom to choose their own accounting year. For certain organizations, reporting of
financial information in public domain are compulsory. In India, listed companies must report their quarterly
unaudited financial results and yearly audited financial statements. For internal control purpose, many
organizations prepare monthly financial statements. The modern computerized accounting systems enable
the companies to prepare real-time online financials at the click of button.
Businesses are living, continuous organisms. The splitting of the continuous stream of business events into
time periods is thus somewhat arbitrary. There is no significant change just because one accounting period
ends and a new one begins. This results into the most difficult problem of accounting of how to measure
the net income for an accounting period. One has to be careful in recognizing revenue and expenses for
a particular accounting period. Subsequent section on accounting procedures will explain how one goes
about it in practice.
(e) The Accrual Concept
The accrual concept is based on recognition of both cash and credit transactions. In case of a cash
transaction, owner’s 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.
Today’s accounting systems based on accrual concept are called as Accrual System or Mercantile System
of Accounting.

B. BASIC PRINCIPLES
(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 won’t 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.

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(b) The Matching Concept

As we have seen the sale of goods has two effects: (i) a revenue effect, which results in increase in owner’s
equity by the sales value of the transaction and (ii) an expense effect, which reduces owner’s 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
True and fair view, materiality, objectivity and consistency of accounting data which should disclose the true and fair view of
material fact, the state of affairs of a firm. This principle is going to be popular day by day as per Companies Act, 1956
Consistency 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 owner’s 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 + Owner’s equity

Cash ` 25,00,000 = Liabilities ` nil + Mr. Suresh’s 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 + Owner’s equity

Cash ` 40,00,000 = Liabilities ` 15,00,000 + Mr. Suresh’s equity ` 25,00,000

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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 owner’s 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.

C. 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.

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 FINANCIAL ACCOUNTING

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.
The prudence principle deviates from
(c) The Prudence Concept conventional accounting as it provides for all possible losses,
but does not anticipate profits
Accountants who prepare financial statements of the business, like other human being, would like to 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 consider income only when it is received
(ii) Immediately recognize expenses when reasonably sure Consider Expenses if its not accrued also.
This, of course, does not mean to overdo and create window dressing in reporting. e.g. if the business has
sold ` 20 Lacs worth goods on the last day of accounting period and also received a cheque for the same,
one cannot argue that the revenue should not be recognized as it is not certain whether the cheque will
be cleared by the bank. One cannot stretch the conservatism concept too much. But at the same time,
if the business has to receive ` 5 lacs from a customer to whom goods were sold quite some time ago and
no payments are forthcoming, then while determining the net income for the period, the accountant must
judge the likelihood of the recoverability of this money and the prudence will prevail to make a provision for
this amount as doubtful debtors.
Let us take another example. A business had purchased goods for ` 10 lacs before the end of an accounting
period. If sold at the usual selling price, the goods would fetch the price of ` 12.50 lacs. Due to innovative
product introduced by the competition, the goods are likely to be sold for ` 9 lacs only. At what value should
the goods be shown in the balance sheet? Would it be at ` 10 lacs being the actual cost of buying? Or would
it be at ` 9 lacs? Here, the conservatism principle will come in play. The stock of goods will be valued at ` 9
lacs, being the lower of cost or net realisable value, as per AS-2.
(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
date-wise in the books. Delay in recording such transaction may lead to manipulation, misplacement of

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Distinction between Accrual Basis of Accounting and Cash Basis of Accounting M a i n s

Accrual basis of accounting differs from Cash basis of accounting in the following respects:

Basis of Distinction Accrual Basis of Accounting Cash Basis of Accounting

1. Prepaid/Outstanding Expenses/ Under this, there may be prepaid/ Under this, there is no
accrued/unaccrued Income in outstanding expenses and accrued/ prepaid/outstanding
Balance Sheet. unaccrued incomes in the Balance expenses or accrued/
Sheet. unaccrued incomes.
2. Higher/lower Income in case of Income Statement will show a Income Statement will
prepaid expenses and accrued relatively higher income show lower income.
income
3. Higher/lower income incase Income Statement will show a Income Statement will show
of outstanding expenses and relatively lower income. higher income.
unaccrued income
4. Recognition under the Companies This basis is recognized under the This basis is not recognized
Act. 1956. Companies Act, 1956. under the Companies Act,
1956.
5. Availability of options to an Under this, an accountant has Under this an accountant
accountant to manipulate the options. has no option to make a
accounts by way of choosing the choice as such.
most suitable method out of several
alternative methods of accounting
e.g. FIFO/LIFO/SLM/ WDV

Hybrid or Mixed Basis

Is the combination of both the basis i.e. Cash as well as Accrual basis. Incomes are recorded on Cash basis but
expenses are recorded on Accrual basis.
This is not a system of accounting on its own. It is a combination of the Cash Basis Accounting and Accrual Basis
Accounting. This system is based on the concept of conservatism.
Under the hybrid system of accounting, incomes are recognised as in Cash Basis Accounting i.e. when they are
received in cash and expenses are recognised on accrual basis i.e. during the accounting period in which they
arise irrespective of when they are paid.

Illustration 7.
Mr. Anil Roy, a junior lawyer, provides the following particulars for the year ended 31st December, 2012:
`
Fees received in cash in 2013 60,000
Salary paid to Staff in 2013 8,000
Rent of office in 2013 14,000
Magazine and Journal for 2013 1,000
Travelling and Conveyance paid in 2013 3,000
Membership Fees paid in 2013 1,600
Office Expenses paid in 2013 10,000

Additional Information:-
Fees include ` 3,000 in respect of 2012 and fees not yet received is ` 7,000. Office rent includes ` 4,000 for previous
year and rent of ` 2,000 not yet paid. Membership fees is paid for 2 years.
Compute his net income for the year 2013, under – (a) Cash Basis, (b) Accrual Basis and (c) Mixed or Hybrid Basis.

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Fundamentals of Accounting

Solution:
Statement of Income (Cash Basis)
For the year ended 31st December, 2013

Particulars Amount (`) Amount (`)

Fees received 60,000
Less :
Salary 8,000

Office Rent 14,000

Magazine & Journal 1,000
Travelling & Conveyance 3,000
Membership Fees 1,600
Office Expenses 10,000 37,600
Net Income 22,400

(ii) Mr. Anil Roy

Statement of Income (Accrual Basis)
For the year ended 31st December, 2013

Particulars Amount (`) Amount (`)

Fees received 60,000
Add: Accrued fees for 2012 7,000
67,000
Less: Fees for 2011 received in 2012 3,000 64,000
Less :
Salary 8,000
Office Rent 14,000
Add: Outstanding rent 2,000
16,000
Less: Rent for 2011 paid in 2012 4,000 12,000
Magazine & Journal 1,000
Travelling & Conveyance 3,000
Membership Fees 1,600
Less: Advance fee paid for 2013 ( ½ x 1600) 800 800
Office Expenses 10,000 34,800
Net Income 29,200

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 FINANCIAL ACCOUNTING

Mr. Anil Roy

Statement of Income (Mixed or Hybrid Basis)
For the year ended 31st December, 2013

Particulars Amount (`) Amount (`) Amount (`)

Fees received 60,000
Less :
Salary 8,000
Office Rent 14,000
Add: Outstanding rent 2,000
16,000
Less: Fees for 2011 4,000 12,000
Magazine & Journal 1,000
Travelling & Conveyance 3,000
Membership Fees 1,600
Less: Advance 800 800
Office Expenses 10,000 34,800
Net Income 25,200

1.4 CAPITAL & REVENUE TRANSACTIONS

The concepts of capital and revenue are of fundamental importance to the correct determination of accounting
profit for a period and recognition of business assets at the end of that period. The distinction affects the
measurement of profit in a number of accounting periods.
Capital has been defined by economists as those assets which are used in the production of goods and rendering
of services for further production of assets. In accounting, on the other hand, the capital of a business is increased
by that portion of the periodic income which has not been consumed by the owner.
The relationship between capital and revenue is that of between a tree and its fruits. It is the tree which produces
the fruits, and it is the fruit that can be consumed. If the tree is tendered with care, it will produce more fruits,
conversely, if the tree is destroyed, there will be no more fruits. Likewise, revenue comes out of capital and capital
is the source of revenue. Capital is invested by a person in the business so that it may produce revenue. Moreover,
as a fruit may give birth to another new tree, different revenues may also produce further new capital.
Capital can be brought in by a person into the business in different forms-cash or kind. When capital is brought in
the form of cash, it is spent away on various items of assets that make the business a running concern. Capital of
the firm is thus, represented by its inventory of assets.
Capital of a business can be increased in a two fold way:
1. When the owner brings in more capital to the business; and/or
2. When the owner does not consume the entire periodic income.
When the owner brings in further capital to his business, the amount is credited to the Capital Account. Likewise,
the net income for a period is credited to the Capital Account, and if his drawings are less than that income, the
capital is increased by the difference. Example, Capital ` 500, Profit ` 300, drawings ` 350. So the revised capital
will be ` 450 (` 500 + ` 300 - ` 350)

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The difference between the two terms ‘revenue’ and ‘receipt’ should be carefully distinguished. A receipt is the
inflow of money into business, whereas revenue is the aggregate exchange value received for goods and services
provided to the customers.
Capital and Revenue Expenditures
Capital expenditure is the outflow of funds to acquire an asset that will benefit the business for more than one
accounting period. A capital expenditure takes place when an asset or service is acquired or improvement of a
fixed asset is effected. These assets are expected to provide benefits to the business in more than one accounting
period and are not intended for resale in the ordinary course of business. In short, it is an expenditure on assets
which is not written off completely against income in the accounting period in which it is acquired.
Revenue expenditure is the outflow of funds to meet the running expenses of a business and it will be of benefit for
the current period only. A revenue expenditure is incurred to carry on the normal course of business or maintain
the capital assets in a good condition.
It may be pointed out here that an expenditure need not necessarily be a payment made to somebody in
cash - it may be made by the exchange of another asset, or by assuming a liability. Expenditure incurrence
and expenditure recognition are distinct phenomena. Expenditure incurrence refers to the receipt of goods and
services, whereas expenditure recognition is a matter to be decided whether the expenditure is of capital or
revenue nature. For example, the buying of an asset is a capital expenditure but charging depreciation against
profit is a revenue expenditure, over the entire life of that asset. On the application of periodicity, accrual and
matching concepts, accountants identify all revenue expenditures for a given period for ascertaining profit. An
expenditure which cannot be identified to a particular accounting period is considered of capital nature.
The accounting treatment of capital and revenue expenditure are as under:
Revenue expenditures are charged as an expense against profit in the year they are incurred or recognised.
Capital Expenditures are capitalised-added to an Asset Account.
The following are the points of distinction between Capital Expenditure and Revenue Expenditure:

Sl. Capital Expenditure Sl. Revenue Expenditure

No. No.
1. The economic benefits of Capital Expenditures are 1. The economic benefits of Revenue
enjoyed for more than one accounting period. Expenditures are enjoyed within a particular
accounting period.
Basically one
time heavy 2. Capital Expenditures are of non-recurring in 2. Revenue Expenditures are of recurring in
investment nature. nature.
3. All Capital Expenditures eventually become 3. Revenue Expenditures are not generally
Revenue Expenditures like depreciation capital expenditures.
4. Capital Expenditures are not matched with 4. All Revenue Expenditures are matched with
Capital Receipts. Revenue Receipts.

Rules for Determining Capital Expenditure

An expenditure can be recognised as capital if it is incurred for the following purposes:
An expenditure incurred for the purpose of acquiring long term assets (useful life is at least more than one accounting
period) for use in business to earn profits and not meant for resale, will be treated as a capital expenditure. For
example, if a second hand motor car dealer buys a piece of furniture with a view to use it in business; it will be
a capital expenditure. But if he buys second hand motor cars, for re-sale, then it will be a revenue expenditure
because he deals in second hand motor cars.
When an expenditure is incurred to improve the present condition of a machine or putting an old asset into
working condition, it is recognised as a capital expenditure. The expenditure is capitalised and added to the cost
of the asset. Likewise, any expenditure incurred to put an asset into working condition is also a capital expenditure.
For example, if one buys a machine for ` 5,00,000 and pays ` 20,000 as transportation charges and `40,000 as

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 FINANCIAL ACCOUNTING

installation charges, the total cost of the machine comes upto ` 5,60,000. Similarly, if a building is purchased for
`1,00,000 and ` 5,000 is spent on registration and stamp duty, the capital expenditure on the building stands at
`1,05,000.
If an expenditure is incurred, to increase earning capacity of a business that will be considered as of capital
nature. For example, expenditure incurred for shifting the factory for easy supply of raw materials. Here, the cost
of such shifting will be a capital expenditure.
Preliminary expenses incurred before the commencement of business is considered capital expenditure. For
example, legal charges paid for drafting the memorandum and articles of association of a company or brokerage
paid to brokers, or commission paid to underwriters for raising capital.
Thus, one useful way of recognising an expenditure as capital is to see that the business will own something which
qualifies as an asset at the end of the accounting period.

Some examples of Revenue Expenditure

(i) Salaries and wages paid to the employees;
(ii) Rent and rates for the factory or office premises;
(iii) Depreciation on plant and machinery;
(iv) Consumable stores;
(v) Inventory of raw materials, work-in-progress and finished goods;
(vi) Insurance premium;
(vii) Taxes and legal expenses; and
(viii) Miscellaneous expenses.

Replacement of Fixed Assets

The above rules of capital and revenue expenditure do not hold good when an existing asset is replaced
for another. If an asset is replaced with a similar kind of asset, the expenditure incurred is treated as Revenue
Expenditure. For example, if a set of weighing machines in a shop becomes defective and is replaced with a
similar set, the cost of replacement should be treated as revenue expenditure and it should be charged to the
Profit and Loss Account. However, if an asset is replaced with an asset which is superior than the previous one, the
expense is partly capital and partly revenue. For example, if a manual typewriter costing ` 5,000 is replaced with
an electronic typewriter costing ` 15,000, then ` 5,000 will be revenue expenditure and the excess value of the new
typewriter over the old one, ` 10,000 will be capital expenditure. Deferred revenue expenditure refers to those expenses
which will be incurred in the current accounting period
Deferred Revenue Expenditures but the benefits of the expenses will be applicable over
several accounting periods.
Deferred revenue expenditures represent certain types of assets whose usefulness does not expire in the year
of their occurrence but generally expires in the near future. These type of expenditures are carried forward and
are written off in future accounting periods. Sometimes, we make some revenue expenditure but it eventually
becomes a capital asset (generally of an intangible nature). If one undertake substantial repairs to the existing
building, the deterioration of the premises may be avoided. We may engage our own employees to do that work
and pay them at prevailing wage-rate, which is of a revenue nature. If this expenditure is treated as a revenue
expenditure and the current year’s-profit is charged with these expenses, we are making the current year to
absorb the entire expenses, though the benefit of which will be enjoyed for a number of accounting years. To
overcome this difficulty, the entire expenditure is capitalised and is added to the asset account. Another example
is an insurance policy. A business can pay insurance premium in advance, say, for a 3 year period. The right does
not expire in the accounting period in which it is paid but will expire within a fairly short period of time (3 years).
Only a portion of the total premium paid should be treated as a revenue expenditure (portion pertaining to the
current period) and the balance should be carried forward as an asset to be written off in subsequent years.
Now, Preliminary Expenses are not shown in the balance Sheet as per para 56 of AS-26, it is a part of other expenses
which is shown in the Profit and Loss A/c (Part II of Schedule III in case of a Company). It is a part of revenue
expenditure, e.g., expenditure incurred on Scientific Research is recognized as an expense when it is incurred”. In
short, the whole amount of expenditure is treated as expense for the current year only and will not proportionately
be transferred as deferred charge.

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Capital and Revenue Receipts

A receipt of money may be of a capital or revenue nature. A clear distinction, therefore, should be made between
capital receipts and revenue receipts.
A receipt of money is considered as capital receipt when a contribution is made by the proprietor towards the
capital of the business or a contribution of capital to the business by someone outside the business. Capital receipts
do not have any effect on the profits earned or losses incurred during the course of a year.
Additional capital introduced by the proprietor; by partners, in case of partnership firm, by issuing fresh shares, in
case of a company; and, by selling assets, previously not intended for resale.
A receipt of money is considered as revenue receipt when it is received from customers for goods supplied or fees
received for services rendered in the ordinary course of business, which is a result of the firm’s activity in the current
period. Receipts of money in the revenue nature increase the profits or decrease the losses of a business and must
be set against the revenue expenses in order to ascertain the profit for the period.
The following are the points of difference between capital receipts and revenue receipts:

Sl. Revenue Receipt Sl. Capital Receipt

No. No.
1. It has short-term effect. The benefit is enjoyed 1. It has long-term effect. The benefit is enjoyed
within one accounting period. for many years in future.
2. It occurs repeatedly. It is recurring and regular. 2. It does not occur again and again. It is
nonrecurring and irregular.
3. It is shown in profit and loss account on the 3. It is shown in the Balance Sheet on the liability side.
credit side, as an income for the year
4. It does not produce capital receipt. 4. Capital receipt, when invested, produces revenue
receipt e.g. when capital is invested by the owner,
business gets revenue receipt
(i.e. sale proceeds of goods etc.).
5. This does not increase or decrease the value of 5. The capital receipt decreases the value of asset or
asset or liability. increases the value of liability e.g. sale of a fixed
asset, loan from bank etc.
6. Sometimes, expenses of capital nature are to be 6. Sometimes expenses of revenue nature are to be
incurred for revenue receipt, e.g. purchase of incurred for such receipt e.g. on obtaining loan (a
shares of a company is capital expenditure but capital receipt) interest is paid until its repayment.
dividend received on shares is a revenue receipt.

Capital and Revenue Profits

While ascertaining the trading profit of a business for a particular period, a proper distinction is to be made
between capital and revenue profits. If profit arises out of an ordinary nature, being the outcome of the ordinary
function and object of the business, it is termed as ‘Revenue Profit’. But, when a profit arises out of a casual and
non-recurring transaction, it is termed as Capital Profit. Revenue profit arises out of the sale of the merchandise
that the business deals in.
Capital Profit arises from: Revenue Profit- From day to day business outcome.
Capital Profit- Out of non-recurring impact.
(a) Profit prior to incorporation;
(b) Premium received on issue of shares;
(c) Profit made on re-issue of forfeited shares;
(d) Redemption of Debenture at a discount;
(e) Profit made on sale or revaluation of a Fixed Asset.
Generally, capital profits arise out of the sale of assets other than inventory at a price more than its book value or
in connection with the raising of capital or at the time of purchasing an existing business. For example, if an asset,
whose book value is ` 5,000 on the date of sale, is sold for ` 6,000 then ` 1,000 will be considered as capital profit.

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Likewise, issue of shares at a premium is also a capital profit. Revenue profits are distributed to the owners of the
business or transferred to General Reserve Account, being shown in the balance sheet as a retained earning.
Capital profits are generally capitalised-transferred to a capital reserve account which can only be utilised for
setting off capital losses in future. Capital profits of a small amount (arising out of selling of one asset) is taken to
the Profit and Loss Account and added with the revenue profit-applying the concept of materiality.
Capital and Revenue Losses
While ascertaining losses, revenue losses are differentiated from capital losses, just as revenue profits are distinguished
from capital profits. Revenue losses arise from the normal course of business by selling the merchantable at a price
less than its purchase price or cost of goods sold or where there is a declining in the current value of inventories.
Capital losses may result from the sale of assets, other than inventory for less than written down value or the
diminution or elimination of assets other than as the result of use or sale (flood, fire, etc.) or in connection with
raising capital of the business (issue of shares at a discount) or on the settlement of liabilities for a consideration
more than its book value (debenture issued at par but redeemed at a premium). Treatment of capital losses
are same as that of capital profits. Capital losses arising out of sale of fixed assets generally appear in the Profit
and Loss Account (being deducted from the net profit). But other capital losses are adjusted against the capital
profits. Where the capital losses are substantial, the treatment is different. These losses are generally shown on the
balance sheet as fictitious assets and the common practice is to spread that over a number of accounting years
as a charge against revenue profits till the amount is fully exhausted.
Illustration 9.
State whether the following are capital, revenue or deferred revenue expenditure.
(i) Carriage of ` 7,500 spent on machinery purchased and installed.
(ii) Heavy advertising costs of ` 20,000 spent on the launching of a company’s new product.
(iii) ` 200 paid for servicing the company vehicle, including ` 50 paid for changing the oil.
(iv) Construction of basement costing ` 1,95,000 at the factory premises.
Solution:
Not required
(i) Carriage of ` 7,500 paid for machinery purchased and installed should be treated as a Capital Expenditure.
(ii) Advertising expenses for launching a new product of the company should be treated as a Revenue
Expenditure. (As per AS-26)
(iii) ` 200 paid for servicing and oil change should be treated as a Revenue Expenditure.
(iv) Construction cost of basement should be treated as a Capital Expenditure.
Illustration 10.
Classify the following items as capital or revenue expenditure :
(i) An extension of railway tracks in the factory area;
(ii) Wages paid to machine operators;
(iii) Installation costs of new production machine;
(iv) Materials for extension to foremen’s offices in the factory; not required
(v) Rent paid for the factory;
(vi) Payment for computer time to operate a new stores control system,
(vii) Wages paid to own employees for building the foremen’s offices. Give reasons for your classification.
Solution :
(i) Expenses incurred for extension of railway tracks in the factory area should be treated as a Capital Expenditure
because it will yield benefit for more than one accounting period.
(ii) Wages paid to machine operators should be treated as a Revenue Expenditure as it will yield benefit for the
current period only.

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Fundamentals of Accounting

(iii) Installation costs of new production machine should be treated as a Capital Expenditure because it will
benefit the business for more than one accounting period.
(iv) Materials for extension to foremen’s offices in the factory should be treated as a Capital Expenditure because
it will benefit the business for more than one accounting period.
(v) Rent paid for the factory should be treated as a Revenue Expenditure because it will benefit only the current
period.
(vi) Payment for computer time to operate a new stores control system should be treated as Revenue Expenditure
because it has been incurred to carry on the normal business.
(vii) Wages paid for building foremen’s offices should be treated as a Capital Expenditure because it will benefit
the business for more than one accounting period.
Illustration 11. can be used as example
State with reasons whether the following are Capital Expenditure or Revenue Expenditure:
(i) Expenses incurred in connection with obtaining a licence for starting the factory were ` 10,000.
(ii) ` 1,000 paid for removal of stock to a new site.
(iii) Rings and Pistons of an engine were changed at a cost of ` 5,000 to get full efficiency.
(iv) ` 2,000 spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the Plaintiff. The
suit was not successful.
(v) ` 10,000 were spent on advertising the introduction of a new product in the market, the benefit of which will
be effective during four years.
(vi) A factory shed was constructed at a cost of ` 1,00,000. A sum of ` 5,000 had been incurred for the construction
of the temporary huts for storing building materials.
Solution :
(i) ` 10,000 incurred in connection with obtaining a license for starting the factory is a Capital Expenditure. It is
incurred for acquiring a right to carry on business for a long period.
(ii) ` 1,000 incurred for removal of stock to a new site is treated as a Revenue Expenditure because it is not
enhancing the value of the asset and it is also required for starting the business on the new site.
(iii) ` 5,000 incurred for changing Rings and Pistons of an engine is a Revenue Expenditure because, the change
of rings and piston will restore the efficiency of the engine only and it will not add anything to the capacity
of the engine.
(iv) ` 2,000 incurred for defending the title to the firm’s assets is a Revenue Expenditure.
(v) ` 10,000 incurred on advertising is to be treated as a Revenue Expenditure. [As per As-26]
(vi) Cost of construction of Factory shed of ` 1,00,000 is a Capital Expenditure, similarly cost of construction of
small huts for storing building materials is also a Capital Expenditure.
Illustration 12.
State clearly how you would deal with the following in the books of a Company :
(i) The redecoration expenses ` 6,000.
(ii) The installation of a new Coffee-making Machine for ` 10,000.
(iii) The building of an extension of the club dressing room for ` 15,000.
(iv) The purchase of snacks & food stuff ` 2,000.
(v) The purchase of V.C.R. and T.V. for the use in the club lounge for ` 15,000. not required
Solution :
(i) The redecoration expenses of ` 6,000 shall be treated as a Revenue Expenditure.
(ii) The installation of a new Coffee - Making Machine is a Capital Expenditure because it is the acquisition of an
asset.

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1/7/13 To Balance b/d 100

Dr. Loss by Theft Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
25/6/13 To Cash A/c 1,000 30/6/13 By Balance c/d 1,000
1,000 1,000
1/7/13 To Balance b/d 1,000

Dr. Interest Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
30/6/13 To Balance c/d 2,400 30/6/13 By Bank A/c 2,400
2,400 2,400
1/7/13 By Balance b/d 2,400

Trial Balance as on 30.6.13

Dr. Cr.
Name of Account (`) (`)
Cash A/c 9,46,400 -----
Capital A/c ----- 7,50,000
Loan from Wife A/c ----- 2,50,000
Purchases A/c 51,500 -----
Aniket’s A/c ----- -----
Vishakha’s A/c ----- -----
Sales A/c ----- 21000
Bank A/c 22,400 -----
Loss by Fire A/c 5,500 -----
Commission A/c ----- 3500
Discount A/c 100 -----
Loss by Theft A/c 1,000 -----
Interest A/c ----- 2,400
Total 10,26,900 10,26,900

1.5 ACCOUNTING FOR DEPRECIATION

A business or concern holds fixed assets for regular use and not for resale. The capability of a fixed asset to render
service cannot be unlimited. Except land, all other fixed assets have a limited useful life. The benefit of a fixed asset
is received throughout its useful life. So its cost is the price paid for the ‘Series of Services’ to be received or enjoyed
from it over a number of years and it should be spread over such years.
Depreciation means gradual decrease in the value of an asset due to normal wear and tear, obsolescence etc. In
short, depreciation means the gradual diminution, loss or shrinkage in the utility value of an asset due to wear and
tear in use, effluxion of time or introduction of technology in the market. A certain percentage of total cost of fixed
assets which has expired and as such turned into expense during the process of its use in a particular accounting
period.
“Depreciation accounting is a system of accounting which aims to distribute the cost or other basic value of
tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of
assets) in a systematic and rational manner. It is a process of allocation, not of valuation. Depreciation for the year
is the portion of the total charge under such a system that is allocated to the year. Although the allocation may

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properly take into account occurrences during the year, it is not intended to be the measurement of the effect of
all such occurrences.”
The above definition may be criticized as under:
(i) It does not classify properly what is meant by systematic and rational manner. The word ‘rational’ may mean
that it should reasonably be related to the expected benefits in any case.
(ii) Historical cost and any other kind of cost should be allocated or not does not defined by this definition.
(iii) Some Accountants are in a belief that depreciation is nothing but an arbitrary allocation of cost. According
to them, all the conventional methods say allocation of historical cost over a number of years is arbitrary.
Certain Useful Terms
Amortization - Intangible assets such as goodwill, trademarks and patents are written off over a number of
accounting periods covering their estimated useful lives. This periodic write off is known as Amortization and that is
quite similar to depreciation of tangible assets. The term amortization is also used for writing off leasehold premises.
Amortization is normally recorded as a credit to the asset account directly or to a distinct provision for depreciation
account. Though the write off of intangibles that have no limited life is not approved by some Accountants, some
concerns do amortize such assets on the ground of conservatism.
Depletion - This method is specially suited to mines, oil wells, quarries, sandpits and similar assets of a wasting
character. In this method, the cost of the asset is divided by the total workable deposits of the mine etc. And
by following the above manner rate of depreciation can be ascertained. Depletion can be distinguishable
from depreciation in physical shrinkage or lessening of an estimated available quantity and the latter implying a
reduction in the service capacity of an asset.
Obsolescence – The term ‘Obsolescence’ refers to loss of usefulness arising from such factors as technological
changes, improvement in production methods, change in market demand for the product output of the asset or
service or legal or medical or other restrictions. It is different from depreciation or exhaustion, wear and tear and
deterioration in that these terms refer to functional loss arising out of a change in physical condition.
Dilapidation - In one sentence Dilapidation means a state of deterioration due to old age or long use. This term
refers to damage done to a building or other property during tenancy.
Nature of Depreciation
Depreciation is a term applicable in case of plant, building, equipment, machinery, furniture, fixtures, vehicles,
tools etc. These long-term or fixed assets have a limited useful life, i.e. they will provide service to the entity (in the
form of helping in the generation of revenue) over a limited number of future accounting periods. Depreciation
implies gradual decrease in the value of an asset due to normal wear and tear, obsolescence etc. In short,
depreciation means the gradual diminution, loss or shrinkage in the utility value of an asset due to wear and tear in
use, effluxion of time or introduction of technology in the market. It makes a part of the cost of assets chargeable
as an expense in profit and loss account of the accounting periods in which the assets helped in earning revenue.
Thus, International Accounting Standard (IAS)-4 provides that “Depreciation is the allocation of the depreciable
amount of an asset over its estimated useful life.”
In Accounting Research Bulletin No. 22, AICPA observed that “Depreciation for the year is the portion of the total
charge under such a system that is allocated to the year. Although the allocation may properly take into account
occurrences during the year, it is not intended to be the measurement of the effect of all such occurrences.”
Causes of Depreciation
A. Internal Causes
(i) Wear and tear : Plant & machinery, furniture, motor vehicles etc. suffer from loss of utility due to vibration,
chemical reaction, negligent handling, rusting etc.
(ii) Depletion (or exhaustion) : The utility or resources of wasting assets (like mines etc.) decreases with
regular extractions.
B. External or Economic Causes
(i) Obsolescence : Innovation of better substitutes, change in market demand, imposition of legal
restrictions may result into discarding an asset.
(ii) Inadequacy : Changes in the scale of production or volume of activities may lead to discarding an
asset.
C. Time element : With the passage of time some intangible fixed assets like lease, patents, copy-rights etc., lose
their value or effectiveness, whether used or not. The word “amortization” is a better term to speak for the
gradual fall in their values.

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D. Abnormal occurrences : An accident, fire or natural calamity can damage the service potential of an asset
partly or fully. As a result the effectiveness of the asset is affected and reduced.

Characteristics of Depreciation
The Characteristics of Depreciation are:
(i) It is a charge against profit.
(ii) It indicates diminution in service potential.
(iii) It is an estimated loss of the value of an asset. It is not an actual loss.
(iv) It depends upon different assumptions, like effective life and residual value of an asset.
(v) It is a process of allocation and not of valuation.
(vi) It arises mainly from an internal cause like wear and tear or depletion of an asset. But it is treated as any
expense charged against profit like rent, salary, etc., which arise due to an external transaction.
(vii) Depreciation on any particular asset is restricted to the working life of the asset.
(viii) It is charged on tangible fixed assets. It is not charged on any current asset. For allocating the costs of
intangible fixed assets like goodwill. etc, a certain amount of their total costs may be charged against
periodic revenues. This is known as amortization.

Objective and Necessity for Providing Depreciation

Eric Kohler defined depreciation as “the lost usefulness, expired utility, the diminution in service yield.” Its
measurement and charging are necessary for cost recovery. It is treated as a part of the expired cost for an asset.
For determination of revenue, that part or cost should be matched against revenue. The objects or necessities of
charging depreciation are:
(i) Correct calculation of cost of production: Depreciation is an allocated cost of a fixed asset. It is to be calculated
and charged correctly against the revenue of an accounting period. It must be correctly included within the
cost of production.
(ii) Correct calculation of profits: Costs incurred for earning revenues must be charged properly for correct
calculation of profits. The consumed cost of assets (depreciation) has to be provided for correct matching of
revenues with expenses.
(iii) Correct disclosure of fixed assets at reasonable value: Unless depreciation is charged, the depreciable
asset cannot be correctly valued and presented in the Balance Sheet. Depreciation is charged so that the
Balance Sheet exhibits a true and fair view of the affairs of the business.
(iv) Provision of replacement cost: Depreciation is a non-cash expense. But net profit is calculated after charging
it. Through annual depreciation cash resources are saved and accumulated to provide replacement cost at
the end of the useful life of an asset.
(v) Maintenance of capital: A significant portion of capital has to be invested for purchasing fixed assets. The
values of such assets are gradually reduced due to their regular use and passage of time. Depreciation on
the assets is treated as an expired cost and it is matched against revenue. It is charged against profits. If it is
not charged the profits will remain inflated. This will cause capital erosion.
(vi) Compliance with technical and legal requirements: Depreciation has to be charged to comply with the
relevant provisions of the Companies Act and Income Tax Act.
Methods of Charging Depreciation
There are different concepts about the nature of depreciation. Moreover, the nature of all fixed assets cannot be
the same. As a result, different methods are found to exist for charging depreciation. A broad classification of the
methods may be summarized as follows:
Capital/Source of Fund
(i) Sinking Fund Method
(ii) Annuity Method
(iii) Insurance Policy Method
Time Base
(i) Fixed Installment Method
(ii) Reducing Balance Method
(iii) Sum of Years’ Digit Method

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(iv) Double Declining Method

Use Base
(i) Working Hours Method
(ii) Mileage Method
(iii) Depletion Service Hours Method
(iv) Unit method
Price Base
(i) Revaluation Method
(ii) Repairs Provision Method
Depreciation as per Property, Plant and Equipment (AS-10) Revised
[AS 6 has been replaced by this part of AS 10 Property Plant and Equipment]
► The Property, Plant and Equipment (PPE) are generally known as tangible fixed assets in contrast to the
intangible property (AS-26).
These tangible assets are:
• Held for use in production or supply of goods and services, for rental to others, or for administrative purposes;
• Expected to be used during more than one period;
• Not held for sale in the normal course of business.
Examples of Property, Plant and Equipment: land, building, plant and machinery, furniture and fitting and
office equipment etc.
► Once an item of property, plant and equipment qualifies for recognition as an asset, it is initially measured at
cost.
► The cost of items of PPE comprises:
• Purchase price, including import duties, non-refundable purchase taxes, less trade discounts and rebates.
• Costs directly attributable to bring the asset to the location and condition necessary for it to be used in a
manner intended by management.
• Initial estimates of cost of dismantling/decommissioning, removing, and site restoration at present value if
the entity has an obligation that it incurs on acquisition of the asset or as a result of using the asset other
than to produce inventories. AS-29 prescribes the discounting of such provisions and provision is made at
present value by applying pre-tax discount rate.
► Examples of directly attributable costs include:
• Employee benefits of those involved in the construction or acquisition of an asset
• Site preparation cost
• Initial delivery and handling costs
• Installation and assembly costs
• Costs of testing, less the net proceeds from the sale of any product arising from test production
• Borrowing costs to the extent permitted by AS-16, Borrowing Costs
• Professional fees
► Examples of costs that are not directly attributable costs and therefore must be expensed in the income
statement include:
• Costs of opening a new facility (often referred to as preoperative expenses)
• Costs of introducing a new product or service including Advertising and promotional costs
• Costs of conducting business in a new location or with a new class of customer
• Training costs
• Administration and other general overheads

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► Depreciation as per AS 10
• Depreciable amount should be allocated on a systematic basis over useful life.
• Useful life and residual value must be reviewed at least at each financial year end. If expectations differ
from previous estimates the changes are to be accounted for as a change in an accounting estimate.
In accordance with AS-5 “Net Profit or loss for the period, Prior Period Items and Changes in Accounting
Policies” (i.e., adjusting depreciation charge for current and future periods)
• Depreciation charge for each period should be recognized as an expense unless it is included in the
carrying amount of another asset.
• AS-10 does not specify a method to be used.
• AS-10 requires that each part of an item of PPE that has a cost that is significant when compared to the
total cost of the item should be depreciated separately.
• Asset management policy may involve disposal of assets after a specified time therefore useful life may be
shorter than economic life.
• Repair and maintenance policies may also affect useful life (e.g., by extending it or increasing residual
value) but do not negate the need for depreciation.
• Residual value is estimated value of depreciable assets at the end of its useful life.
• Depreciable amount is net of residual value. Residual value is often insignificant and immaterial to the
calculation of the depreciable amount.
• Depreciation is always recognized, even if fair value exceeds carrying amount, except when residual
value is greater than carrying amount (in which case the depreciation charge is zero).
• Depreciation period
- Depreciation commences when an asset is available for use.
- Depreciation ceases at the earlier of the date the asset is:
• derecognised and
• held for disposal
• Depreciation does not cease when an asset is idle or retired from active use (unless it is fully depreciated).
However, depreciation may be zero under the “units of production method”.
• Land and buildings are separable assets and are separately accounted for, even when they are acquired
together:
- Land normally has an unlimited useful life and is therefore not depreciated.
- Buildings normally have a limited useful life and are depreciable asset.
• Where land has a limited useful life (e.g., a landfill site, mine, quarry) it is depreciated.
► Depreciation methods as per 10
- Straight line - a constant charge over useful life
- Diminishing balance - a decreasing charge over useful life
- Sum of the units - charge based on expected use or output
• The depreciation method should also be reviewed at least of each financial year end and, if there has
been a significant change in the expected pattern of consumption of the future economic benefits
from those assets, the method should be changed to suit this changed pattern. When such a change in
depreciation takes place the change should be accounted for as a change in accounting estimate and
the depreciation charge for the current and future periods should be adjusted.
• Three impertinent factors to be calculated:
- Useful Life
- Cost of Asset
- Residual value
• As per Schedule II of the Companies Act, 2013, depreciation to be charged on the basis of useful life
of asset. Revised AS-10 also prescribes the same. Provided that where a company adopts a useful life
different from what is specified in the Schedule or uses a residual value different from the limit specified
above, the financial statements shall disclose such difference and provide justification in this behalf duly
supported by technical advice.

60 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA