Financial Statements The - I

Financial Statements: The Balance Sheet I 39
UNIT 3 FINANCIAL STATEMENTS: THE

BALANCE SHEET I
Structure:
3.0 Learning Objectives
3.1 Definition
3.2 Characteristics of Assets
3.3 Objectives of Asset Valuation
3.4 Types of Assets
3.5 Lease
3.6 Accounting Problems in Long-term Assets
3.7 Nature of Depreciation
3.8 Depreciation Methods
3.9 Degree of Acceleration in Depreciation Methods
3.10 Disposal of Fixed Assets
3.11 Evaluation of Accelerated Methods
3.12 Factors Influencing the Selection of Depreciation Method
3.13 Summary
3.14 Key Words/Abbreviations
3.15 Learning Activity
3.16 Unit End Questions (MCQ and Descriptive)
3.17 References
CU IDOL SELF LEARNING MATERIAL (SLM)

40 Financial Reporting and Analysis
3.0 Learning Objectives

After studying this unit, you will be able to:
 Understand the requirement for preparing financial statements
 Explain the meaning of assets and classify different types of assets
 Understand the salient features of new AS-10 and Ind AS-16 with respect to property,
plant and equipment
 Calculate depreciation expense using different methods
3.1 Definition
Financial accounting has basic elements like assets, liabilities, owners’ equity, revenue, expenses
and net income (or net loss) which are related to the economic resources, economic obligations,
residual interest and changes in them. Similarly, balance sheet which displays financial position of a
business enterprise has basic elements like assets, liabilities and owners’ equity. Assets denote
economic resources of an enterprise that are recognised and measured in conformity with generally
accepted accounting principles. Assets also include certain deferred charges that are not resources
but that are recognised and measured in conformity with generally accepted accounting principles.1
The Institute of Chartered Accountants of India defines assets as “tangible objects or intangible
rights owned by an enterprise and carrying probable future benefits”.2
3.2 Characteristics of Assets

Assets have the following main characteristics:
1. Future Economic Benefits: ‘Future economic benefit’ or ‘service potential’ is the essence
of an asset. This means that the asset has capacity to provide services or benefits to the enterprises
that use them. In a business enterprise, that service potential or future economic benefit eventually
results in net cash inflows to the enterprise. Money (cash, including deposit in banks) is valuable
because of what it can buy. It can be exchanged for virtually any goods services that are available
or it can be saved and exchanged for them in the future. Money’s command over resources—its
purchasing power—is the basis of its value and future economic benefits.
Assets other than cash provide benefits to a business enterprise by being exchanged for cash
or other goods or services, by being used to produce or otherwise increase the value of other assets,
or by being used to settle liabilities. Services provided by other entities, including personal services,
cannot be stored and are received and used simultaneously. They can be assets of a business
enterprise only momentarily—as the enterprise receives and uses them—although their use may

create or add value to other assets of the enterprise. Rights to receive services of other entities for
specified or determinable future periods can be assets of particular business enterprises.
2. Control by a Particular Enterprise: To have an asset, a business enterprise must control
future economic benefit to the extent that it can benefit from the asset and generally can deny or
regulate access to that benefit by others, e.g., by permitting access only at a price.
Although the ability of an enterprise to obtain the future economic benefit of an asset and to
deny or control access to it by others rests generally on foundation of legal rights, legal enforceability
of a right is not an indispensable prerequisite for an enterprise to have an asset if the enterprise
otherwise will probably obtain the future economic benefit involved. For example, exclusive access
to future economic benefit may be maintained by keeping secret a formula or process.
Some future economic benefits cannot meet the test of control. For example, public highways
and stations and equipment of municipal fire and police departments may qualify as assets of
governmental units but they cannot qualify as assets of individual business enterprises. Similarly,
general access to things such as clean air or water resulting from environmental laws or requirements
cannot qualify as assets of individual business enterprises, even if the enterprises have incurred
costs to help clean up the environment. These examples should be distinguished from similar future
economic benefits that an individual enterprise can control and thus are its assets. For example, an
enterprise can control benefits from a private road on its own property, clean air it provides in a
laboratory or water it provides in a storage tank, or a private fire department or private security
force, and the related equipment probably qualifies as an asset even if it has no other use to the
enterprise and cannot be sold except as scrap.
3. Occurrence of a Past Transaction or Event: Assets imply the future economic benefits
of present assets only and not the future assets of an enterprise. Only present abilities to obtain
future economic benefits are assets and these assets are the result of transactions or other events or
circumstances affecting the enterprise. For example, the future economic benefits of a particular
building can be an asset of a particular entity only after a transaction or other event—such as a
purchase or a lease agreement—has occurred that gives it access to and control of those benefits.
Similarly, although an oil deposit may have existed in a certain place for millions of years, it can be
an asset of a particular enterprise only after the enterprise has discovered it in circumstances that
permit the enterprise to exploit it or has acquired the rights to exploit it from whoever had them.
This characteristic of assets excludes from assets items that may in the future become an
enterprise’s assets but have not yet become its assets. An enterprise has no asset for a particular
future economic benefit if the transactions or events that give it access to and control of the benefit
are yet in the future. For example, an enterprise does not acquire an asset merely by budgeting the
purchase of a machine, and does not lose an asset from fire until a fire destroys or damages some
assets.

Once acquired, an asset continues as an asset of the enterprise until the enterprise collects it,
transfers it to another entity, or uses it, or some other event or circumstance destroys the future
benefit or removes the enterprises ability to obtain it.
In addition to the above, assets commonly have other features that help identify them—for
example, assets may be acquired at a cost and they may be tangible, exchangeable or legally
enforceable. However, those features are not essential characteristics of assets. Their absence, by
itself, is not sufficient to preclude an item’s qualifying as an asset. That is, assets may be acquired
without cost, they may be intangible, and although not exchangeable they may be usable by the
enterprise in producing or distributing other goods or services.
3.3 Objectives of Asset Valuation

Financial accounting requires quantification of assets in terms of monetary units which is known
as valuation. In other accounting such as managerial accounting, other measures, e.g., physical
units may be useful for the managerial purposes. The questions of asset valuation, it is argued,
should be decided in terms of user of the information, and the purpose for which the information is
to be used. In financial accounting, the following are the objectives of asset valuation:
1. Income determination: In accounting, valuation is a prerequisite in the income
measurement. In the capital maintenance concept, valuation of assets is needed to compute income
from the increase in these valuations over time. In behavioural accounting theory, valuations should
help the decision makers in making proper predictions and decisions. Two basic approaches to
valuation for income determination purposes are: (a) the emphasis may he placed on the valuation of
the inputs as they expire. For example, the cost of goods sold may be valued on a current basis, by
the use of LIFO or current replacement costs, while the ending inventories are left in terms of
residuals, (b) the non-monetary assets may be restated at the balance sheet date or periodically
during the year, permitting assumed matching as these asset expire.
2. Determination of financial position: A basic purpose of financial accounting is to determine
the financial position of a business enterprise, and balance sheet determines the financial position.
Balance sheet uses valuations for meaningful preparation of statement of financial position. Investors
are generally interested in predicting the future cash flows to shareholders in the form of dividends
and other distributions, in order to make proper decision—about purchase and sale of shares. Income
statements, cash flow statements and funds flow statements are relevant for this purpose, and a
position statement should also provide relevant information for the making of these predictions. In
order for a statement of financial position to provide information relevant to a prediction of future
cash flows, it should include quantitative measurements of resources and commitments for comparisons
with other periods or with other firms. Valuations of assets held by the firm can provide relevant
information only if the investor can detect some relationship between such measurements and expected
cash flows.3

3. Managerial Decisions: Valuation figures are also useful to management in making operating
decisions. However, the informational requirements of management are quite different from the
informational requirements of the investors and creditors. Investors and creditors are interested
primarily in predicting the future course of the business from an evaluation of the past and from
other information; but management must continually make decisions that determine the future course
of action. Therefore, management has greater need for information, regarding valuations arising
from different courses of action. For example, opportunity costs, marginal or differential costs, and
present values from expected differential cash flows are relevant for many types of managerial
decisions. But just because they are relevant to managerial decisions does not necessarily mean that
they are also relevant to the decision of investors and creditors. Therefore, these valuations do not
need to be reported in the position statement; they can be made readily available to management in
supplementary reports.
Asset Valuation Concepts

Generally, the following four valuation concepts are popularly used:
1. Historical Cost — It measures historical cost of units of money.
2. Current entry price (e.g., replacement cost) — It measures current entry price, i.e.,
replacement cost in units of money.
3. Current exit price (e.g., net realisable value) — It measures net realisable value (i.e.,
current exit price) in units of money.
4. Present value of expected cash flows — It measures present value in units of money.
Each of these valuation models yields a different financial statement, with different meaning
and relevance to its users. The above valuation models can be classified in different ways. First,
they may be classified with respect to whether they focus on the past, present or future. Hence,
historical cost focuses on the past, replacement cost and net realisable value focuses on the present,
and present value focuses to the future. Second, we may classify these measures with respect to
the kind of transactions from which they are derived. Hence, historical cost and replacement cost
concern the acquisition of assets or the incurrence of liabilities, while net realisable value and present
value concern the disposition of assets or the redemption of liabilities. Thirdly, classification may be
done with respect to the nature of event originating the measure.
Hence, historical cost is based on an actual event, present value on an expected event, and
replacement cost and net realisable value on hypothetical event.
1. Historical Cost
Cost has been the most common valuation concept in the traditional accounting structure.
Assets are generally recorded initially on the basis of the exchange prices at which the acquisition
transactions take place. They are then presented in financial statements at this acquisition cost or

some unamortised portion of it. Therefore, cost is the exchange price of goods and services at the
time they are acquired. When the consideration given in the exchange consists of non-monetary
assets, the exchange price is determined by the current fair value of assets given up in the exchange.
Cost is thus the economic sacrifice expressed in monetary terms required to obtain a specific asset
or a group of assets. Very often, cost is not represented by a single exchange price, but it includes
many sacrifices of economic resources necessary to obtain the asset in the form, location, and time
in which it can be useful to the operations of the firm. Thus, all of these sacrifices should be included
in the concept of cost valuation. But it should be recognised that the term cost is used in many
senses and for various purposes. In many cases, it includes only a part of the total sacrifices and in
other cases, it includes too much.
One of the main disadvantages of historical cost valuation is that the value of the assets to the
firm may change over time; after long periods of time, it may have no significance whatever as a
measure of the quantity of resources available to the enterprise. Historical cost valuation is also
disadvantageous because it fails to permit the recognition of gains and losses in the periods in which
they may actually occur. Also, because of changes over time, costs of assets acquired in different
time periods cannot be added together in the balance sheet to provide interpretable sums. The
historical cost valuation concept has the added practical disadvantage of blocking out other possibly
more useful valuation concepts.
Historical cost accounting has the following advantages relative to other alternative methods of
asset valuation.
1. It automatically requires the recording of all actual transactions in the past. The market
value of finished goods can be ascertained without knowing how the goods were actually produced.
But there is no way to determine the historical cost of the goods without a record of how the goods
were actually produced and how the materials and labour that contributed to the production of the
goods were actually obtained. Thus, implicit in financial statements under historical cost is a supporting
record of all actual transactions in the past.
2. Historical cost is essential for the proper functioning of accountability, the concept upon
which our modern economic society is built. Without historical cost data, a manager will have a
difficult time demonstrating that he has properly utilised the resources entrusted to him by the
shareholders.
For example, if a manager purchases merchandise for ` 1,00,000 when he could have purchased
it for ` 90,000, the manager may be held accountable for the opportunity loss. The manager may,
however, be able to demonstrate that without his special care and talent in bargaining, the firm
would have bought the merchandise for ` 1,20,000. Many speculations and hypothesis may be
offered concerning what the firm could have done but the evaluation of accountability must always
depend on what has actually happened.

3. Though different methods of asset valuation serve different needs of the users, they certainly
do not undermine the need of recording and reporting transactions regularly.
4. Historical cost being sunk cost does not influence the optimality of the decision. Yet, there
are at least three reasons why historical cost is relevant to a decision:
(a) Historical cost affects evaluation and selection of decision rules.
(b) Historical cost provides input to the “satisfying” notion.
(c) Historical cost is used as a basis for a decision objective imposed upon the decision maker
by his environment.4
Historical cost is also relevant to economic decisions because a decision maker cannot neglect
the intricate social systems based on historical cost. The most typical example is the income tax.
Since taxable income is based on historical cost, a decision maker cannot analyse the full financial
impact of his decision unless he knows the historical cost of the resource in question. In addition,
there are many instances, where a decision maker must take into account historical cost because his
environment is based on historical cost. Cost-plus contracts, pricing in a regulated industry and
incentive compensation based on accounting profit are such examples.
2. Current Entry Price (Replacement Cost)
Current entry price, i.e., current replacement costs and historical costs are the same only on
the date of acquisition of an asset. After that date the same asset or its equivalent may be obtainable
for a larger or smaller exchange price. Thus current costs represent the exchange price that would
be required today to obtain the same asset or its equivalent. If a good market exists in which similar
assets are bought and sold, an exchange price can be obtained and associated with the asset owned;
this price represents the maximum value to the firm (unless net realisable value is greater), except
for very short periods until a replacement can be obtained. It should be noted, however, that this
current exchange price is cost price only if it is obtained from quotations in a market in which the
firm would acquire its assets or services; it cannot be obtained from quotations in the market in
which the firm usually sells its assets or services in the normal course of its operations, unless the
two markets are coincident.
Current cost has become an important valuation basis in accounting, particularly as a means of
presenting information regarding the effect of inflation on an enterprise. In a number of other situations,
current cost is an appropriate measure of fair value, either in establishing an initial acquisition price
(as in certain exchanges of non-monetary assets) or in establishing a maximum value (as in determining
the present value of a capital lease for the lessee). Because of the potential increase in relevance of
current costs as compared with historical costs, its use is likely to increase in the future.

3. Current Exit Price (Net Realisable Value)

It represents the amount of cash or generalised purchasing power that could be obtained by
selling each asset under conditions of orderly liquidation, which may be measured by quoted market
prices for goods of a similar kind and condition. This current cash equivalent is assumed to be
relevant because it represents the position of the firm in relation to its adaptive behaviour to the
environment. That is, it is assumed to be the contemporary property of all assets, which is relevant
for all actions in markets and thus uniformly relevant at a point in time. Past prices are irrelevant to
future actions, and future prices are nothing more than speculation Therefore, the current cash
equivalent concept avoids the necessity to aggregate past, present and future prices.
One of the major difficulties with the current cash equivalent concept is that it provides justification
for excluding from the position statement all items that do not have a contemporary market price.
For example, non-vendible specialised equipment, as well as most intangible assets, would be written
off at the time of acquisition because of an inability to obtain a current market price. However, it is
suggested to modify the procedures somewhat to provide approximations of the current cash
equivalents by the use of specific price indexes and by making subjective depreciation computations.
The main deficiency in using the current cash equivalent concept for all assets is that it does not take
into consideration the relevancy of the information to the prediction and decision needs of the users
of financial statements, although it does provide the investor with contemporary information regarding
the financial position of the firm and some alternatives available to it.
The concept has been criticised because it has a non-additive property, the summation of the
current cash equivalents of the individual assets is not equal to the cash equivalent of the assets of
a group; and the sale of assets in combination or the sale of the firm as a whole may be just as
relevant or more relevant than the sale of individual assets in the adaptive behaviour of the firm.
These criticisms, however, do not deny the current cash equivalent concept as having semantic
interpretation as an accounting measurement.
4. Present Value of Expected Cash Flows
Present value refers to the present value of net cash flows expected to be received from the
use of asset or the net outflows expected to be disbursed to redeem the liability. This valuation
concept requires the knowledge or estimation of three basic factors—the amount or amounts to be
received, the discount factor and the time periods involved. When expected cash receipts require a
waiting period, the present value of these receipts is less than the actual amount expected to be
received. And the longer the waiting period, the smaller is the present value. Conceptually, the
present value is determined by the process of discounting. But discounting involves not only an
estimate of the opportunity cost of the money, but also an estimate of the probability of receiving the
expected amount. The longer the waiting period, the greater is the uncertainty that the amount will
be received. Furthermore, a single amount may be received after a time period or different amounts
are to be received at different time periods. In later case, each amount must be discounted at the
appropriate discount rate for the specific waiting period.

Present value model, although considered theoretically best model, has been found largely as
impractical. It has many limitations such as the following:
(i) The expected cash receipts generally depend upon subjective probability distributions that,
are not verifiable by their nature.
(ii) Even though opportunity discount rates might be obtainable, the adjustment for risk preference
must be evaluated by management or accountants, and it might be difficult to convey the
meaning of the resultant valuation to the readers of financial statements
(iii) When two or more factors, including human resources as well as physical assets, contribute
to the product or service of the firm and the subsequent cash flow, a logical allocation to the
separate service factors is generally impossible. It has been suggested that the marginal
net receipts associated with the asset can be used, but the sum of the individual marginal
net receipts is not likely to add to the total net receipts from the product or services.
(iv) The discounted value of the differential cash flows of all of the separate assets of the firm
cannot be added together to obtain the value of the firm. This is partly due to the jointness
of the contributions of the separate assets, but it is also due to the fact that some assets,
such as intangibles, cannot be separately identified.
In spite of the above difficulties, the discounted cash flow concept has some merit as a valuation
concept for single ventures where there are no joint factors requiring separate accounting or where
the aggregation of assets can be carried far enough to include all of the joint factors. But it is also
relevant for monetary assets where waiting is the primary factor determining the net benefit to be
received in cash by the firm. For example, if bill receivable is fairly certain of being collected and if
the timing of the payment is specified by contract, the discounted value of the bill represents the
amount of cash that the firm would be indifferent to holding as compared to holding bill. The minimum
amount, however, would be the amount of cash that could be obtained by discounting or selling the
bill to a bank or other financial institution. The longer the waiting period, however, the greater the
uncertainties will usually be, making the discounted cash receipts concept less applicable. On the
other hand, when the waiting period is short, the discounting process can usually be ignored for
monetary assets because the amount of the discount is usually not material.
Evaluation of Valuation Concepts

In the valuation of assets, there is no single concept or procedure that is ideal in the presentation
of the statement of financial position, in the determination of income, or in the presentation of other
information relevant to decisions of investors, creditors, and other users of financial statements.
From a structural point of view, historical cost valuation is frequently assumed to be the ideal in so
far as it is based on double-entry bookkeeping, which requires the recording of all resources changes
and permits their subsequent identification. However, formal structures can also be devised for
other valuation concepts.

An objective of asset valuation from an interpretational point of view is to provide a relative

measurement of the resources available to the firm in the generation of future cash flows. Historical
cost valuation lacks interpretation and current replacement costs permit greater interpretation if the
measurements are taken from used-asset markets rather than restating historical costs by the use of
specific price indexes. Net realisable and current cash equivalents permit interpretations if the
valuations are taken from prices existing in markets.
Realisable value may be useful in a situation where its amount and recoverability are known
almost with certainty and the main bottleneck in the cycle of activities is in purchasing. Replacement
cost is useful when the true goal of an entity is to reproduce the existing resource mix on a larger
scale. That target is not attained until assets are replaced at their proper levels. Realisable value
may be justified when the entity’s aim is to return the maximum amount of money to the owners.
Replacement cost and realisable value are suitable when resources are disposed of or replaced
at frequent intervals. However, a business enterprise controls many resources which it does not
intend to dispose of or replace. A decision to shut down or replace a plant may occur only once
every ten years for any given plant. During this ten-year period, management does not consider
disposal or replacement plans, not because they are unaware of this alternative but because during
most of the plant’s economic life such an alternative is not likely to be more profitable than continuing
the existing operation.
There is no doubt that replacement cost and realisable value provide useful information if they
are tailor-made for a specific decision and reported at the appropriate time. The question raised
here is whether the continuous recording and reporting of such data, and especially whether
performance measurement based on such data, are likely to be of any use.
About different valuation concepts, Ijiri concludes:
“Though each of these (alternative asset valuation) methods can be rationalised and justified
under some conditions, there is no convincing argument that one is better than the others in every
situation.5
Lower of Cost or Market (LCM) Rule

The lower of cost or market valuation approach is a rule which has long and widely observed
in financial accounting. The rule was originally justified in terms of conservatism which meant that
there should be no anticipation of profit and that all foreseeable losses should be provided for in the
value report to shareholders.
The lower of cost or market concept has a long history in financial accounting. There is some
question whether the cost or market rule is a basic accounting concept or merely an accepted
accounting procedure. It does not use any valuation concept different from the concepts discussed
above, but because it does not apply any one of the valuation concepts consistently, it can be considered

a different concept at least in its application, or it can be considered an eclectic application of various
valuation concepts.
Limitations of LCM Rule: The LCM rule has obtained support from the accounting bodies all
over the world. However, LCM rule has the following limitations:
1. As a method of conservatism, it tends to understate total asset valuations. Individual asset
valuations may also be understated. This understatement may not harm creditors but it is
deceiving to shareholders and potential investors.
2. The conservatism in asset valuations is offset by an unconservative statement of net income
in a future period. A lower asset valuation in the current period will result in a larger
reported profit or smaller loss in some future period when the asset valuation is charged off
as an expense. Because gains are not reported currently, the resulting net income will be
less useful as a predictive device or as a measure of efficiency.
3. The LCM rule suffers from inherent inconsistency. Thus, if replacement cost is objective,
definite, verifiable and more useful when it is lower than acquisition cost it also possesses
these attributes when it is higher than acquisition cost.
4. A less convincing argument is that the cost or market rule applies to decreases in cost as
well as to diminished utility due to deterioration, obsolescence, or decreased earning capacity.
There may not be any changes in net realisable value just because costs have changed.6
3.4 Types of Assets

Different assets possessed by a business enterprise appear on the balance sheet. These assets
are classified as follows:
1. Fixed Assets: Fixed assets are tangible assets and refer to a firm’s property, plant and
equipment. Fixed assets are assets held with the intention of being used for the purpose of producing
or providing goods or services and is not held for sale in the normal course of business.
2. Investments: Investments are created by a firm through purchase of shares and other
securities. Investment by a firm can be made for long term or short term.
3. Intangible assets: Intangible assets do not have physical substance but they are the
resources that benefit an enterprise’s operations. Intangible assets provide exclusive rights or privileges
to the owner. Examples are patents, copyrights, trademarks. Some intangible assets arise from the
creation of a business enterprise—organisation costs or reflect a firm’s ability to generate above
normal earnings—that is goodwill.
The term intangible asset is not used with cent per cent accuracy and precision in accounting.
By convention, only some assets are considered as intangible assets. For example, some resources

lack physical substance such as prepaid insurance, receivables, and investments, but are not classified
as intangible assets.
4. Current assets: Current assets include cash and assets that will be converted into cash or
used up during the normal operating cycle of the business or one year, whichever is longer. Examples
are debtors, closing stocks, marketable securities, besides the cash. The normal operating cycle of a
business is the average period required for raw materials merchandise to be converted into finished
product and sold and the resulting accounts receivables to be collected. Prepaid expenses such as
rent, insurance, etc. are normally consumed during the operating cycle rather than converted into
cash. These items are considered current assets, however because the prepayments make cash
outflows for services unnecessary during the current period.
Plant and Equipment

Plant, equipment and other property cover a wide range of assets which are carried at cost,
less depreciation. For plant and equipment, historical cost has generally has found to be a satisfactory
basis, partly because there is no objective basis for any different value and partly because such
assets are in reality deferred charges against future production and could not or normally would not,
be sold separately.
Frequently, current valuations have been suggested as a means of obtaining better measurement
of capital resources than can be obtained by using historical costs, particularly when the difference
between the two is caused by relatively permanent changes in the structure of prices or changes in
the price level rather than by ephemeral changes caused by temporary shortages in supply. Current
values are generally suggested as a means of obtaining current measurements of depreciation.
However, it should be noted that the allocation of current costs is just as arbitrary as the allocation
of historical costs.
The current cost of plant and equipment means the current market price of a similarly used
asset in the same condition and of the same age as the assets owned. It is, therefore, the price that
would have to be paid for the assets if it were not already owned by the firm. Alternative costs
include: (a) the acquisition costs of an identical new items purchased in current market adjusted for
depreciation to date, (b) the current price or reproduction cost of new improved asset adjusted for
technological differences and depreciation and (c) historical cost restated by specific price level
indexes.
As per Companies (Accounting Standards) Amendment Rules, 2016, Property, Plant and
Equipment are tangible items that are:
(a) held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes; and
(b) expected to be used during more than a period of 12 months.

Investments
In financial accounting, investments are defined as shares and other legal rights—acquired by a
firm through the investment of its funds. Investments may be long-term or short-term depending
upon the intention of the firm at the time of acquisition. Where intended to be held for a period of
more than one year, they are in the nature of fixed assets; where they are held for a shorter period
they are in the nature of current assets. Shares in subsidiaries and associated companies are usually
not held for resale and hence would be classified as being of the nature of fixed assets. It is the
practice, however, to show investments separately in the balance sheet and not to include them
under the heading of ‘fixed assets’. Investments are recorded at their cost of acquisition and whilst
substantial decreases in value may be written off against current income, appreciations in value are
not recognised until realised.
Current Assets
Current assets are defined as “cash and other assets that are expected to be converted into
cash or consumed in the production of goods or rendering of services in the normal course of
business”. Items are included in current assets on the basis of whether they are expected to be
realised within one year or within the normal operating cycle of the enterprise, whichever is the
longer. However, the classification of items as current or non-current in practice is largely based on
convention rather than on any one concept.
The operating cycle is defined as the time it takes to convert cash into the product of the
enterprise and then to convert the product back into cash again. This concept permits an operational
demarcation between short- and long-term commitments. Plant and equipment items are omitted
from the current assets classification because their turnover periods cover many product turnover
periods.
One of the difficulties in the way the operating cycle concept is applied in practice is that if it is
less than one year, the one year rule still applies; the result is that the current assets classification
does not disclose consistently the frequency of the circulations of assets. But even if the operating
cycle criterion were applied consistently, there would still be some major difficulties because of the
complexity of many business enterprises and the resultant inability to determine the length of the
operating cycle. Because of these difficulties regarding the interpretation of the operating cycle and
because of the lack of evidence regarding the relevance of the current assets classification to any
specific user’s needs, other methods of classifying assets should be investigated.7
Classification of Current Assets

Current assets are set off from non-current assets because of their importance in a company’s
current position. Current position is another concept, subsidiary to the overall notion of financial
condition, which has to do with a company’s ability to meet its immediate maturing obligations in the
ordinary course of the business with the assets at hand.

Within the classification of current assets, one typically finds the following:
1. Cash: Cash balances available for withdrawal are normally shown in a single account with
the title cash. Separate disclosure should be made of cash that is restricted as to withdrawal. Cash
and the various forms of money are expressed in terms of their current value, which is definite.
Therefore, any gains or losses resulting from the exchange of other assets for the given amount of
cash or money forms should have been recognised; no gain or loss should be recognised from the
holding of cash and money forms except possibly in consideration of purchasing power gains and
losses during periods of price-level changes. Holdings of convertible foreign currency or money
should be expressed in terms of the domestic equivalent at the balance sheet date.
2. Receivable: Receivables encompass monetary claims against debtors of the firm. They
should be reported by source—those arising from: (a) customers, (b) parent and subsidiary companies,
(c) other affiliated companies and (d) certain related parties such as directors, officers, employees,
and major shareholders. The term accounts receivable is commonly used to refer to receivables
from trade customers that are not supported by written notes. Receivable, typically presented at
face values, with the required reduction for uncollectible accounts and unearned interest reported in
adjacent contra accounts.
3. Marketable securities: Marketable securities represent temporary investments mad to
secure a return on funds that might otherwise be unproductive. Whether an investment classified as
temporary or not depends largely on management intent. To be considered a temporary investment,
a security must not only be marketable, but management must plan to dispose it if it needs to raise
cash.
Under conventional accounting procedures, securities (when held for current working capital
purposes) are generally recorded on the basis on the lower of cost or market. The argument for this
method has been that cost is generally the most relevant basis for measuring the gains or losses
realised when the securities are sold. If market price rises above cost, the increase value is not
generally recorded because it is thought that this gain is unrealised in the technical sense of the word
and because it possibly may disappear before the asset is sold. If the market value of the securities
is less than cost, however, it is thought that the losses should be recorded and the securities should
not be shown in the balance sheet in excess of their current realisable value.
4. Inventories: Inventories include those items of tangible property that: (a) are held for sale
in the ordinary course of business and (b) are in process of production for such sale, or be currently
consumed in the production of goods or services to be available. The cost of inventory includes all
expenditures that were incurred directly or indirectly to bring an item to its existing condition and
location. Inventory is recorded at cost except when the utility of goods is no longer as great as it
cost. Several cost flow assumptions may be used to allocate costs between cost of goods sold and
ending inventory. The most widely used are: (a) FIFO, (b) LIFO and (c) average cost.

5. Prepaid expenses: Prepaid expenses include prepaid rent, insurance and interest. They are
not current assets in the sense that they will be converted into cash; rather they are item that if not
prepaid would have required the use of cash. They are sometimes referred to as deferred charges,
because the charge to income resulting from the prepayment is delayed until it can be properly
matched with appropriate revenues.
Other current assets represent those accounts that could not be included in and may include
deferred income taxes, advances or deposits held by a supplier, and property held for resale.
Intangible Assets
As stated earlier, intangible assets are of different types such as goodwill, patents, copyrights,
trademarks, franchises, deferred charges and the like.
Goodwill
Goodwill arises when a business enterprise buys another firm and pays more than the fair
market value of the firm’s net assets. The excess amount that the buyer pays is known as goodwill
and is recorded as an asset in the books of buying firm. Goodwill represents the potential of a
business to earn above a normal rate of return on the investments made. When compared to similar
competing firms, if a particular firm consistently earns higher profits, then such a firm is said to
possess goodwill.
A firm may be said to have goodwill due to many factors such as superior customer relations,
advantageous location, efficient management, high quality of goods and services, exceptional
personnel relations, favourable financial sources, superior technology.
Furthermore, goodwill cannot be separated from entity and sold separately. Goodwill is created
internally at no identifiable cost and it can stem from any factor that can make return on investment
high. Because measuring goodwill is difficult, it is recorded as an intangible asset only when it is
actually purchased at a measurable cost, i.e., only when another firm is purchased and the amount
paid to acquire it exceeds the market value of identifiable net assets involved.
Patents
A patent is an exclusive right and privilege, given by law, which provides the patent holder
(owner) the right to use, manufacture and sell the subject of patent and the patent itself. Patents are
normally acquired in two ways: (i) by purchase, in which case patents are valued at the purchase
cost including incidental expenses, stamp duty, etc. and (ii) by development within the enterprise, in
which case all costs identified as incurred in developing patents are capitalised. The patents should
be amortised over their legal term of validity or over their working life, whichever is shorter. Patent

laws aim to protect the inventors by protecting them from unfair imitators who might (mis)use the
invention for commercial gain. A patent that is purchased is recorded at its cash equivalent cost. A
patent which is developed internally by a business firm is recorded, at its registration and legal costs.
Copyrights
A copyright is similar to a patent. A copyright gives the owner the exclusive right to publish, use
and sell a specific written work, musical or art work. It protects the owner against the unauthorised
reproduction of his literary or other work. Copyright is recorded at the purchase price, if purchased,
or at registration and legal fees, if acquired internally.
Trademarks
Trademarks and trade names give the owner-company the exclusive and continuing right to
use certain names or symbols, usually to identify a brand or family of products. Trademarks are
recorded at purchase price, if purchased and at registration and legal costs, if not purchased but
acquired internally within a firm.
Franchises and Licences

Franchises and licences give exclusive rights to operate or sell a specific brand of products in
a given geographical area. They represent investments made to acquire them. If they are purchased,
they are recorded at the cost paid for it. Alternatively, they are recorded at registration and legal
costs.
Know-how
Know-how should be recorded in the books only when some consideration in money or money’s
worth has been paid for it. Know-how can be of two types:
(i) relating to manufacturing processes and
(ii) relating to plans, designs and drawings of buildings or plant and machinery.
Know-how costs relating to manufacturing process are usually charged off to expenses in the
year in which it is incurred. The know-how related to plans, designs and drawings of building or
plant and machinery should be capitalised under the relevant assets heads. Where the know-how is
so capitalised, depreciation should be calculated on the total cost of such assets including the cost of
know-how.
If know-how is paid as a composite sum for manufacturing processes and other plan designs
and drawings, then the amount should be apportioned amongst the various purposes on a reasonable
basis. Where the consideration for the know-how is a series of annual payments such as royalties,
technical assistance fees, contribution to research etc., then such payments are charged to the profit
and loss statement each year.

Deferred Charges
Deferred charges are the expenses paid in advance and are like prepaid expenses. Deferred
charges are long-term prepaid expenses and benefit several future years. They are also known as
organisation costs, i.e., costs incurred in organising a company and related pre-operating or start-up
costs of preparing the company. Some examples of deferred charges are:
1. Legal fees.
2. Fees paid to the government agencies.
3. Preliminary expenses incurred in the formation of a company.
4. Pre-operating expenses incurred from the commencement of business upto the
commencement of commercial production.
5. Advertisement and sales promotion expenditure incurred on the launch of a new product.
These expenditures are likely to be quite large and the revenue earned from new product
in the initial years may not be adequate to write-off such expenditure.
6. Research and development costs.
It should be noted that during the pre-operating or start-up period, no revenue is earned and is
therefore nothing against which to match these costs. Generally, deferred charges are capitalised
and amortised over a (relatively short) period of time when the benefits are expected to be earned
over a number of future periods. Some business firms show them as expenses in the period when
they are incurred.
ACCOUNTING STANDARD (AS) 10

PROPERTY, PLANT AND EQUIPMENT
(As per Companies (Accounting Standards) Amendment Rules, 2016
Notified on 30th March, 2016)
The objective of this Standard is to prescribe the accounting treatment for property, plant and
equipment so that users of the financial statements can discern information about investment made
by an enterprise in its property, plant and equipment and the changes in such investment. The
principal issues in accounting for property, plant and equipment are the recognition of the assets, the
determination of their carrying amounts and the depreciation charges and impairment losses to be
recognised in relation to them.
This Standard should be applied in accounting for property, plant and equipment except when
another Accounting Standard requires or permits a different accounting treatment.
* Net assets means tangible assets plus intangible assets like patents, licences and trademarks minus

Recognition
The cost of an item of property, plant and equipment should be recognised as an asset if, and
only if:
(a) it is probable that future economic benefits associated with the item will flow to the enterprise;
and
(b) the cost of the item can be measured reliably.
An enterprise evaluates under this recognition principle all its costs on property, plant and
equipment at the time they are incurred:
(a) initially to acquire or construct an item of property, plant and equipment; and
(b) subsequently to add to, replace part of, or service it.
Measurement at Recognition
An item of property, plant and equipment that qualifies for recognition as an asset should be
measured at its cost.
Elements of Cost
The cost of an item of property, plant and equipment comprises:
(a) its purchase price, including import duties and non refundable purchase taxes, after deducting
trade discounts and rebates.
(b) any costs directly attributable to bringing the asset to the location and condition necessary
for it to be capable of operating in the manner intended by management.
(c) the initial estimate of the costs of dismantling, removing the item and restoring the site on
which it is located, referred to as ‘decommissioning, restoration and similar liabilities’, the
obligation for which an enterprise incurs either when the item is acquired or as a consequence
of having used the item during a particular period for purposes other than to produce
inventories during that period.
Examples of directly attributable costs are:
(a) costs of employee benefits (as defined in AS-15, Employee Benefits) arising directly from
the construction or acquisition of the item of property, plant and equipment.
(b) costs of site preparation;
(c) initial delivery and handling costs;
(d) installation and assembly costs;

(e) costs of testing whether the asset is functioning properly, after deducting the net proceeds
from selling any items produced while bringing the asset to that location and condition
(such as samples produced when testing equipment); and
(f) professional fees.
Measurement of Cost
The cost of an item of property, plant and equipment is the cash price equivalent at the recognition
date. If payment is deferred beyond normal credit terms, the difference between the cash price
equivalent and the total payment is recognised as interest over the period of credit unless such
interest is capitalised in accordance with AS-16.
Measurement after Recognition
An enterprise should choose either the cost model or the revaluation model as its accounting
policy and should apply that policy to an entire class of property, plant and equipment.
Cost Model
After recognition as an asset, an item of property, plant and equipment should be carried at its
cost less any accumulated depreciation and any accumulated impairment losses.
Revaluation Model
After recognition as an asset, an item of property, plant and equipment whose fair value can be
measured reliably should be carried at a revalued amount, being its fair value at the date of the
revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment
losses. Revaluations should be made with sufficient regularity to ensure that the carrying amount
does not differ materially from that which would be determined using fair value at the balance sheet
date.
The fair value of items of property, plant and equipment is usually determined from market
based evidence by appraisal that is normally undertaken by professionally qualified valuers.
If an item of property, plant and equipment is revalued, the entire class of property,
plant and equipment to which that asset belongs should be revalued.
A class of property, plant and equipment is a grouping of assets of a similar nature and use in
operations of an enterprise. The following are example of separate classes:
(a) land;
(b) land and buildings;
(c) machinery;
(d) ships;

(e) aircraft;
(f) motor vehicles;
(g) furniture and fixtures;
(h) office equipment; and
(i) bearer plants.
Ind AS-16: Property, Plant and Equipment – Salient Features

The following are the salient features of Ind AS-16:
1. Ind AS-16 deals with accounting for property, plant and equipment. It covers the aspects of
AS-10 (Accounting for Fixed Assets) and AS-6 (Depreciation Accounting).
2. It not only defines plant, property and equipment, but also lays down specific criteria which
should be satisfied for recognition of items of property, plant and equipment (PPE):
(a) it is probable that future economic benefits associated with the item will flow to the
entity, and
(b) the cost of the item can be measured saliably.
3. Ind AS-16 provides uniform recognition principles to determine the recognition as an item
of PPE for both internal and subsequent costs.
4. It requires the inclusion of initial estimates of the costs of dismantling and removing the
item and restoring the site on which it is located in the cost of respective item of PPE.
5. It permits an entity to choose between cost model or revaluation model as its accounting
policy and to apply that policy to an entire class of PPE
3.5 Lease
A business firm, while deciding to procure fixed assets, can use any of the following choices to
use the asset by:
(i) purchasing the fixed asset whether with owned or loaned funds;
(ii) purchasing fixed asset on instalment basis;
(iii) purchasing on hire purchase basis;
(iv) getting the asset on lease.

The business firm becomes the owner of the asset immediately in first two cases. It becomes
the owner of the asset in the third case on payment of the last instalment. However, it does not
become the owner in the fourth case. It merely gets the right to use the asset.
The lease is an agreement whereby the lessor transfer to the lessee, in return for rent, the right
to use an asset for an agreed period of time. Lessor is a person, who under an arrangement, provides
to another person, the lessee, the right to use an asset for an agreed period of tune in return for rent.
As per the agreement, the lessor remains the owner of the leased goods whereas lessee, for all
practical purposes, is the user of the asset. However, the substance of the leasing agreement is that
lessee for all practical purposes, uses the assets and acts like owner.
Types of Lease
AS-19 titled ‘Leases’ issued by the Institute of Chartered Accountant of India mentions two
types of leases:
1. Finance Lease
2. Operating Lease
Finance Lease
A finance lease is that lease which transfers, substantially, all the risks and rewards incidental
to the ownership of an asset. The title (ownership) of the asset may or may not be transferred.
Generally, the finance lease is for a term equivalent to the useful economic life of the asset and is
non-revocable.
The following are the features of finance lease:
(i) The lessor transfers the title to the lessee at the end of the lease period at the price agreed
at the beginning of the lease.
(ii) The lessee has the option to buy the asset at the end of the lease period.
(iii) The lease cannot normally be cancelled.
(iv) The full cost of the asset will generally be repaid by the lessee to the lessor.
(v) Lessee is responsible for insurance and maintenance of the asset.
(vi) Lessee has the right of uninterrupted use of the asset till lease payments are made.
(vii) At the end of the lease term the lessor can take back the possession of the asset from the
lessee or there can be a purchase/renewal option.
Operating Lease
Operating lease is renewed a number of times during the economic life of an asset. Lease
period is generally lower than the economic life of the asset. In operating lease, the risk and rewards
incidental to the ownership of the asset remain with the lessor. Usually, the asset is taken back by the
lessor at the end if the lease and is again leased to another party or to the same party for another term.
The rental payable under an operating lease is charged to the Profit and Loss Account.
Whether a lease is a finance lease or an operating lease depends on the substance of the
transactions rather than its form. AS-19 identifies certain circumstances that would normally lead to
a lease being classified as finance lease. The circumstances are:
(a) When the lease transfers ownership of the asset to the lessee by the end of the lease term.
(b) When the lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than the fair value of the asset at the date, when such option is to be
exercised.
(c) The lease term is for the major part of economic life of the asset even if title is not transferred.
(d) When at the inception of the lease the present value of the minimum lease payments
amount to at least substantially the fair value of the leased asset.
(e) When the leased asset is of a specialised nature and only the lessee can use it without the
major modifications being made.
AS-19 goes further to give indicators of the situations, which individually or in combination
could lead to a lease being classified as a finance lease. Such situations include the following:
(a) If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are
borne by the lessee;
(b) The lessee can continue the lease for a second period at a rent, which is substantially lower
than the market rent.
Difference between Finance Lease and Operating Lease

The following are the differences between finance lease and operating lease.
Finance Lease Finance Lease
1 In finance lease, the lease period is normally related 1 An operating lease is normally of a smaller
to the useful life of the asset. duration and has no relation to the economic life
of the asset.
2. The lessee has to bear the risk in a finance lease. 2. The lessee is protected against the risk of
obsolescence in an operating lease.
3. A finance lease is normally non-revocable. 3. A operating lease can be revoked.
4. Lessee normally bears the expenses relating to 4. Under an operating lease, the cost of maintenance,
the leased asset. repairs, taxes, insurance, etc. are borne by lessor.
5. In a Finance lease, the lease rentals would cover 5. Under an Operating lease, the lease rentals are
the leasor’s original investment cost plus a generally not sufficient to fully cover the cost of
reasonable return on the investment. the asset.

Ind AS-17: Leases – Main Features

Ind AS-17 is applied in accounting for all leases other than:
Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources;
and
Licensing agreements for such items as motion picture films, video recordings, plays, manuscripts,
patents and copyrights
However, this Standard shall not be applied as the basis of measurement for:
Property held by lessees that is accounted for as investment property (Ind AS-40,
‘Investment Property’)
Investment property provided by lessors under operating leases (Ind AS-40,
‘Investment Property’)
Biological assets within the scope of Ind AS-41, ‘Agriculture’ held by lessees under finance
leases
Biological assets within the scope of Ind AS-41, provided by lessors under operating leases
1. Lease Concept
A lease is an agreement whereby:
• The lessor conveys to the lessee
• In return for a payment or series of payments
• The right to use an asset
• For an agreed period of time
2. Finance Lease
A finance lease is a lease that transfers substantially all the risks and rewards incidental to
ownership of an asset.
Where,
Risks include the possibilities of losses from idle capacity or technological obsolescence and of
variations in return because of changing economic conditions.
Rewards may be represented by the expectation of profitable operation over the asset’s economic
life and of gain from appreciation in value or realisation of a residual value.
3. Operating Lease
An operating lease is a lease other than a finance lease.

4. Non-cancellable Lease
A non-cancellable lease is a lease that is cancellable only:
(a) upon the occurrence of some remote contingency;
(b) with the permission of the lessor;
(c) if the lessee enters into a new lease for the same or an equivalent asset with the same
lessor; or
(d) upon payment by the lessee of such an additional amount that, at inception of the lease,
continuation of the lease is reasonably certain.
5. Accounting Treatment of Lease
Books of Lessor
Finance Lease
Books of Lessee
Lease Accounting
Books of Lessor
Operating Lease
Books of Lessee
6. Leases in the Financial Statements of Lessees

(a) Finance Leases
Initial recognition: At the commencement of the lease term, lessees shall recognise
finance leases as assets and liabilities in their balance sheets at amounts equal to the
fair value of the leased property or, if lower, the present value of the minimum lease
payments, each determined at the inception of the lease.
The discount rate to be used in calculating the present value of the minimum lease
payments is the interest rate implicit in the lease, if this is practicable to determine, if
not, the lessee’s incremental borrowing rate shall be used.
Any initial direct costs of the lessee are added to the amount recognised as an asset.
Subsequent measurement:
• Minimum lease payments shall be apportioned between the finance charge and
the reduction of the outstanding liability.
• The finance charge shall be allocated to each period during the lease term so as to
produce a constant periodic rate of interest on the remaining balance of the liability.

• Contingent rents shall be charged as expenses in the periods in which they are
incurred.
• A finance lease gives rise to depreciation expense for depreciable assets as well
as finance expense for each accounting period.
• The depreciation policy for depreciable leased assets shall be consistent with that
for depreciable assets that are owned, and the depreciation recognised shall be
calculated in accordance with Ind AS-16, “Property, Plant and Equipment’ and Ind
AS-38, Intangible Assets’.
(b) Operating Leases: Lease payments under an operating lease shall be recognised as an
expense on a straight-line basis over the lease term unless either:
(a) another systematic basis is more representative of the time pattern of the user’s benefit
even if the payments to the lessors are not on that basis; or
(b) the payments to the lessor are structured to increase in line with expected general
inflation to compensate for the lessor’s expected inflationary cost increases.
7. Leases in the Financial Statements of Lessors
(a) Finance Leases
Initial recognition: Lessors shall recognise assets held under a finance lease in their balance
sheets and present them as a receivable at an amount equal to the net investment in the lease.
Subsequent measurement: The recognition of finance income shall be based on a pattern
reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease.
(b) Operating Leases: Lessors shall present assets subject to operating leases in their balance
sheet according to the nature of the asset.
Selling Price =
Fair Value
Selling Price = Fair

Operating Lease
Value
Sale and Leaseback
(Books of Seller
Lessee)
Selling Price = Fair
Finance Lease Value

Lease income from operating leases (excluding amounts for services such as insurance and
maintenance) shall be recognised in income on a straight-line basis over the lease term, unless either:
(a) another systematic basis is more representative of the time pattern in which use benefit
derived from the leased asset is diminished, even if the payments to the lessors are not on
that basis; or
(b) the payments to the lessor are structured to increase in line with expected general inflation to
compensate for the lessor’s expected inflationary cost increases. If payments to the lessor
vary according to factors other than inflation, then this condition is not met.
8. Sale and Leaseback Transactions
A sale and leaseback transaction involves the sale of an asset and the leasing back of the same
asset. The lease payment and the sale price are usually interdependent because they are negotiated
as a package. The accounting treatment of a sale and leaseback transaction depends upon the type
of lease involved.
(i) If a Sale and Leaseback Transaction Results in a Finance Lease: If a sale and
leaseback transaction results in a finance lease, any excess of sales proceeds over the carrying
amount shall not be immediately recognised as income by a seller-lessee. Instead, it shall be deferred
and amortised over the lease term.
(ii) If a Sale and Leaseback Transaction Results in an Operating Lease:
CASE I: When Sale Price = Fair Value: If a sale and leaseback transaction results in an
operating lease, and it is clear that the transaction is established at fair value, any profit or loss shall
be recognised immediately.
CASE II: When Sale Price < Fair Value: If the sale price is below fair value, any profit or
loss shall be recognised immediately except that, if the loss is compensated for by future lease
payments at below market price, it shall be deferred and amortised in proportion to the lease payments
over the period for which the asset is expected to be used.
CASE III: When Sale Price > Fair Value: If the sale price is above fair value, the excess
over fair value shall be deferred and amortised over the period for which the asset is expected to be
used.

Profit or loss equivalent to the

profit or loss resulting from an Finance income over the lease
outright sale of the asset being term
leased, at normal selling prices,
reflecting any applicable
volume or trade discounts
For operating leases, if the fair value at the time of a sale and leaseback transaction is less than
the carrying amount of the asset, a loss equal to the amount of the difference between the carrying
amount and fair value shall be recognised immediately.
9. Accounting Treatment in the Books of Manufacturer or Dealer Lessors
• Manufacturer or dealer lessors shall recognise selling profit or loss in the period, in
accordance with the policy followed by the entity for outright sales.
• If artificially low rates of interest are quoted, selling profit shall be restricted to that which
would apply if a market rate of interest were charged.
• Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging
a lease shall be recognised as an expense when the selling profit is recognised.
• Manufacturers or dealers often offer to customers the choice of either buying or leasing an
asset. A finance lease of an asset by a manufacturer or dealer lessor gives rise to two
types of income:
Major Changes in Ind AS-17 vis-a-vis Notified AS-19

(i) Land: The existing standard excludes leases of land from its scope. Ind AS-17 does not
have such scope exclusion. It has specific provisions dealing with leases of land and building
applicable Further, Ind AS-17 is not applicable as the basis of measurement for
• property held by lessees/provided by lessors under operating leases but treated as
investment property and
• biological assets held by lessees/provided by lessors under operating leases that are
covered in the Standard on Agriculture.
The existing standard does not contain such provisions,
(ii) Definition of Residual Value: The definition of residual value appearing in the existing
standard has been deleted in Ind AS-17.

(iii) Initial Direct Costs: Consequent upon the difference between the existing standard and Ind
AS 17 in respect of treatment of initial direct costs incurred by a non-manufacturer/non-
dealer-lessor in respect of a finance lease (see point 5 below), the term Initial direct costs’
has been specifically defined in Ind AS-17 and definition of the term ‘interest rate implicit in
the lease’ as per the existing standard has been modified in Ind AS-17.
(iv) Inception of Lease and Commencement of Lease: Ind AS-17 makes a distinction between
inception of lease and commencement of lease. In the existing standard, though both the
terms are used at some places, these terms have not been defined and distinguished. Further,
Ind AS-17 deals with adjustment of lease payments during the period between inception of
the lease and the commencement of the lease term. This aspect is not dealt within the
existing standard. Also, as per Ind AS-17, the lessee shall recognise finance leases as
assets and liabilities in balance sheet at the commencement of the lease term whereas as
per the existing standard such recognition is at the inception of the lease.
(v) Treatment of Initial Direct Costs: Treatment of initial direct costs under Ind AS-17 differs
from the treatment prescribed under the existing standard. This is tabulated below:
Subject Existing standard Ind AS-17

Finance lease – Lessee Added to the amount Same as per the existing standard.
accouting recognised as asset.
Finance lease – Lessor
accouting
Non-manufacturer/Non- Either recognised as expense Interest rate implicit in the lease is
dealer immediately or allocated against defined in such a way that the initial
the finance income over the direct costs included automatically in
lease term. the finance lease receivable; there is
no need to add them separately.
Manufacturer/dealer Recognised as expense at the Same as per the existing standard.
commencement of the lease
term.
Operating lease – No discussion No discussion
Lessee accounting
Operating lease – Either deferred and allocated Added to the carrying amount of the
Lessor accounting to income over the lease term leased asset and recognized asexpense
in proportion to the recognition over the lease term on the same basis
of rent income, or recognized as lease income.
as expense in the period in
which incurred.

(vi) Current/Non-current Classification of Lease Liabilities: Ind AS-17 requires current/non-

current classification of lease. Liabilities of such classification is made for other liabilities.
Also, it makes reference to Ind AS-105, ‘Non-current Assets Held for Sale and
Discontinued Operations’. These matters are not addressed in the existing standard
(vii) Sale and Leaseback Transaction: As per the existing standard, if a sale and leaseback
transaction results in a finance lease, excess, if any, of the sale proceeds over the carrying
amount shall be deferred and amortised by the seller-lessee over the lease term in proportion
to depreciation of the leased asset. While Ind AS-17 retains the deferral and amortisation
principle, it does not specify any method of amortisation.
Before taking up depreciation, it should be understood that the costs relating to the use of long-
term assets should be properly calculated and matched against the revenue earned (these use cost
have helped in generating) so that periodic net income can be determined. These use costs or
expense or periodic write-off are known by different names for different category of assets as
shown below:
Types of Long-term Assets Term of Expense or Write-off or Use Cost
1. Tangible assets:
(i) Land None
(ii) Plant, building, equipment tools,
furniture, fixtures, vehicles. Depreciation
(iii) Natural resources such as oil,
timber, coal, mineral deposits. Depletion
2. Intangible assets such as patent,
copyrights, trademarks, goodwill Amortisation
Among the above assets, land is a tangible asset that has an indefinite or unlimited useful life.
Therefore, it is not subject to depreciation or periodic write off to expenses.
Depletion is the name of expenses or write-off in the case of natural resources. Depletion
refers to the systematic and rational allocation of the acquisition cost of natural resources to future
periods in which the use of those natural resources contributes to revenue. Natural resources are
exhausted or used up through mining, cutting, pumping, etc.
The term amortisation is used in case of intangible assets. Amortisation refers to the systematic
and rational allocation of the acquisition cost of intangible assets to future periods in which the
benefits contribute to revenue. It is the periodic write off to expenses of the intangible asset’s cost
over its expected useful life.
The term depreciation refers to periodic allocation of the acquisition cost of tangible long-term
asset over its useful life. Depreciation has been discussed in detail later.
3.6 Accounting Problems in Long-term Assets

Basically, there are two problems relating to accounting of long-term assets. First, what is the
original acquisition cost of a particular long-term asset. Second, how should the amount of expense or
period write off be determined and allocated against yearly revenue to reflect the asset’s consumption.
The other related issues are how should subsequent expenditures such as repairs, maintenance and
additions be treated, how should disposal of long-term assets be recorded. These accounting problems
are graphically presented in Figure 3.1.
De
c
o r D line in
ecli As
ne set
in U ’s E
nex con
pire om
d( ic S
Un ign
use ifi
d) C cance
ost
Fig. 3.1: Accounting Problems of Long-term Assets

For accounting purposes, the acquisition cost of a long-term asset having a limited useful life
indicates the prepaid cost of a bundle of future services or benefits that will help earn future revenues.
Acquisition cost of long-term assets are like inventories and prepaid expenses. Acquisition cost
includes all expenditures necessary to get the long-term assets in place and ready for use.
Cost of a long-term asset is easy to determine when the asset is purchased for cash. In this
case, cost of asset is equal to cash paid for the asset plus expenditures for freight, insurance while
in transit, sales tax, special foundations, installation and other necessary costs. When a second hand
asset is purchased, the initial costs of getting it ready for use, such as expenditures for new parts,
repairs and painting are added to the cost of assets.
Some costs associated with the acquisition of an asset are not added to the cost of asset, if they
are found not necessary to get the asset ready for use and therefore, do not increase asset’s usefulness.
Expenditures resulting from carelessness or errors in installing the asset, from vandalism or from
other unusual occurrences do not increase the usefulness of the assets and should be treated as
expenses.
If a debt is incurred for the purchase of the asset, the interest charges are not the cost of the
asset but are the cost of borrowing money to purchase the asset. They are, therefore, an expense

for the period. But interest incurred during the construction period of an asset is treated as part of the
cost of an asset.
The cost of land includes not only the negotiated price but also other expenditures such as
broker’s commissions, title fees, surveying fees, Lawyer’s fees, accrued taxes paid by the purchaser,
assessment for local improvements such as streets and sewage systems, cost of draining, clearing,
levelling, and grading. Any salvage recorded from the old building will be deducted from the cost of
the land.
Improvements to land such as parking lots, private sidewalks, driveways, fences are not added
to the cost of land but to a separate account, Land Improvement Account. These expenditures are
depreciated over the estimated lives of the improvements.
When an existing or old building or used machinery is purchased, its cost includes the purchase
price plus all repair, renovation and other expenses incurred by the purchaser prior to use of asset.
Ordinary repair costs incurred after the asset is placed in use are normal operating expenses when
incurred.
When a business constructs its own buildings, the cost includes all reasonable and necessary
expenditures such as those for materials, labour, some related overhead and indirect costs, architects’
fees, insurance during construction, interest on construction loans during the period of construction,
lawyer’s fees. If outside contractors are used in the construction, the net contract price plus other
expenditures necessary to put the building in usable condition are included.
Sometimes, basket purchases (also known as group purchases, package purchases) of assets
are made by the purchaser wherein two or more types of long-term assets are acquired in a single
transaction and for a single lumpsum. In basket or package purchases, cost of each asset acquired
must be measured and recorded separately. For example, assume that a purchaser has purchased
land and the building situated on the land for a lumpsum payments of ` 8,50,000. The total purchase
price can be divided between these two assets on the basis of relative market or appraisal values, as
shown below.
Asset Estimated Per cent of Allocation of Estimated
Market Value (`) Total (%) Purchase Price (`) Useful Life
Land 1,00,000 10 85.000 Indefinite
Building 9,00,000 90 7,65.000 30 years
10,00,000 100 8,50.000
When a long-term asset is purchased and a noncash consideration is included in part or in full
payment for it, the cash equivalent cost is measured as any cash paid plus current market value of
the non-cash consideration given. Alternatively, if the market value of the noncash consideration

given cannot be determined, the current market value of the asset purchased is used for measurement
purposes.
As a general rule, long-term assets are recorded at cost due to the basic criterion of objectivity.
However, there could be some exceptions to this rule of cost basis. For example, if an asset acquires
an asset by donation or pays substantially less than the market value of the asset, the asset is
recorded at its fair market value. Similarly, if the value of land increases sharply after its acquisition
due to some abnormal factors such as discovery of mineral deposits or oil, the amount originally
recorded as the cost of land may be increased to reflect current value of the land.
3.7 Nature of Depreciation

As stated earlier, depreciation is a term applicable in case of plant, building, equipment, furniture,
fixtures, vehicles, tools. 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 allocating the cost of a tangible fixed or
long-term asset over its useful life. Depreciation makes a part of the cost of asset chargeable as an
expense in profit and loss account of the accounting periods in which the asset has helped in earning
revenue. Thus, allocating the capitalised cost of an asset into expense for different accounting
periods is known as depreciation.
The Institute of Chartered Accountants of India defines depreciation as follows:
“Depreciation is a measure of the wearing out, consumption or other loss of value of depreciable
asset arising from use, effluxion of time or obsolescence through technology and market changes.
Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting
period during the expected useful life of the asset. Depreciation includes amortisation of assets
whose useful life is predetermined.”
SSAP 12 of UK also defines the depreciation in the same manner.
“Depreciation is the measure of the wearing out, consumption or other loss of value of a fixed
asset whether arising from use, effluxion of time or obsolescence through technology and market
changes.”
International Accounting Standards Committee (now IASB) defines this term as follows:
“Depreciation is the allocation of the depreciable amount of an asset over its estimated useful
life. Depreciation for the accounting period is charged to income either directly or indirectly.”
Depreciation accounting is based on matching concept wherein an attempt is made to match a
part of acquisition cost of an asset (shown as depreciation expense) with the revenue generated by
the use of such asset. To determine the amount of depreciation, three items are needed: (i) actual
acquisition cost, (ii) estimated net residual value and (iii) estimated useful life. Of these three items,

two are estimates, residual value and useful life. Due to this, it can be said that the amount of
depreciation recorded in an accounting period is only an estimate. To take an example, assume an
asset was purchased for ` 1,00,000 and it has a life of 10 years. At the end of 10 years, the asset can
be sold for ` 10,000. It means that decline in value of ` 90,000 (` 1,00,000 – ` 10,000) is an expense
of generating the revenue realised during the ten year periods that the asset was used. Therefore, in
order to determine correct net income figure, ` 90,000 of expense shall be allocated to these periods
and matched against the revenue. Failure to do so would overstate income for these periods.
Depreciation expense for each accounting year can be determined as following:
Acquisition cost ` 1,00,000
Less: Salvage or residual value ` 10,000
Amount to be depreciated over useful life ` 90,000
Estimated useful life ` 90,000 10 years
Annual depreciation expense 10 years = ` 9,000
It should be understood that depreciation accounting becomes necessary due to the asset
except land losing its economic utility, significance or potential. Many factors cause decline in the
utility of the asset for the business such as wear and tear, passage of time, obsolescence, technological
change, etc.
3.8 Depreciation Methods

The different depreciation methods aim to allocate the cost of an asset to different accounting
periods in a systematic and rational manner. However, the different methods tend to allocate different
amount as the amount of depreciation. Broadly, depreciation methods can be divided into two
categories:
1. Straight-line Method.
2. Accelerated Method.
1. Straight-line Method
Under straight-line method, a constant amount is written off as depreciation every year over
useful life of the asset. The straight line method is based on the assumption that depreciation depends
only on the passage of time. The depreciation expense for each accounting period is computed by
dividing the depreciable cost (cost of the depreciating asset less its residual value) by the estimated
useful life, as shown below:
Annual depreciation = Original Cost – Salvage Value
Period of useful life

To take an example, assume that cost of an asset in ` 1,00,000, salvage value ` 10,000, useful

life 5 years. The amount of depreciation under straight line method will be ` 18,000 for each accounting
year, as calculated below:
Annual depreciation = Cost – Salvage Value
Useful life
= ` 1,00,000 – ` 10,000
5 years
= ` 18,000
The rate of depreciation under straight line method is the same in each year. In the above
example, it is 20%.
` 18,000 1 years
´ 100 or ´ 100
` 90,000 5 years
Using the above figures, the depreciation schedule for the five years period of the asset’s life
will be as follows:
Depreciation Schedule
(Straight-line Method)
Cost Annual Depreciation Accumulated Book Value or Carrying

(` ) (` ) Depreciation (`) Value of Asset (`)
Date of purchase 1,00,000 — — 1,00,000
End of first year 1,00,000 18,000 18 000 82,000
End of second year 1,00,000 18,000 36,000 64,000
End of third year 1,00,000 18,000 54,000 46,000
End of fourth year 1,00,000 18,000 72,000 28,000
End of fifth year 1,00,000 18,000 90,000 10,000
Depreciation expense is deducted from revenue in determining net income. Accumulated

depreciation is deducted from the related asset account on the balance sheet to compute the asset’s
book value or carrying value. From the above depreciation schedule, three things can be noticed:
(i) depreciation is the same each year, (ii) accumulated depreciation increases uniformly and
(iii) book value or carrying value of asset decreases uniformly until it reaches the estimated residual
value.
The straight line method is considered to be simple, logical, consistent and stable. It is suited to
an asset with a relatively uniform periodic usage and a low obsolescence factor. It implies an
approximately equal decline in the economic usefulness of asset each period. It is particularly useful
in the case of capital intensive industries like, iron and steel because it enables a uniform rate of
depreciation to be charged against profits and thus makes for cost and price calculations on a more
uniform basis and keep these at lower levels.

2. Accelerated Method
Under accelerated method of providing depreciation, larger amounts are written off in the
earlier years of an asset’s life and comparatively smaller amounts in the later years. This method is
based on the assumption that revenue declines as an asset ages. A new asset is more productive than
an old one since mechanical efficiency declines and maintenance cost rises with age. Better matching
of revenue and expenses therefore requires larger depreciation initially when an asset contributes
more and smaller depreciation later when it contributes less. Accordingly, depreciation charge declines
year after year.
The following methods are known as accelerated methods of depreciation:
(i) Written down value method also known as diminishing balance method.
(ii) Sum-of-the-years digit method.
(iii) Double declining method.
Written Down Value Method (or Diminishing Balance Method)

In this method, the depreciation charge is calculated by multiplying the net book value of the
asset (acquisition cost less accumulated depreciation) at the start of each period by a fixed rate. The
estimated salvage value is not subtracted from the cost in making the depreciation calculation, as is
the case with other depreciation methods. Because the net book value declines from period to
period, the result is a declining periodic charge for depreciation throughout the life of the asset.
Under this method, it is impossible to reduce asset value to zero because there is always some
balance to reduce asset even further. When the asset is sold or retired or abandoned, the written
down value appearing in books is written off as depreciation for the final period.
Under the declining balance method, as strictly applied, the fixed depreciation rate used is one
that will charge the cost less salvage value of the asset over its service life. The formula for computing
the rate is:
S
r 1 n
C
In this formula, r = rate of depreciation
n = number of years of asset’s life
s = salvage value
c = cost of the asset
Remember, if the residual or scrap value of an asset is zero, the rate of depreciation cannot be
determined using the above formula.

Sum-of-the-years-digits (SYD) Method

This method of depreciation charges large amounts of assets costs to expense in the early years
of life and lesser amount in later years. To compute the depreciation, first list numerically the years of
an asset’s life and sum this arithmetical progression. Then use the highest number in the series as the
numerator and the sum of the series as the denominator of a fraction that is multiplied by the cost
(less salvage) of the asset. For each subsequent year, use the next lower number in the series; in this
way the fraction decreases each year.
Example:
Value of machinery ` 66,000
Salvage value ` 3,000
Life is 6 years
Sum-of-the-year’s Digits (6 years) = 1 + 2 + 3 + 4 + 5 + 6 = 21
First year’s Depreciation = 6/21 ´ (66,000 – 3,000)
= 6/21 ´ 63,000
= ` 18,000
Second Year’s Depreciation = 5/21 ´ (66,000 – 3,000)
= ` 15,000
Sixth year’s Depreciation = 1/21 ´ (66,000 – 3,000)
= ` 3,000
The depreciation expenses on the income statement is higher in the early years than with
straight line depreciation. On the other hand, the sixth year’s depreciation by the straight-line method
still be ` 10,500.
The machinery would be shown on the balance sheet at the end of second year as follows:
Machinery ` 66,000
Less: Accumulated depreciation ` 33,000
` 33,000
Note that a smaller asset balance is left with the SYD depreciation than with straight line. This
smaller balance is caused by the writing off larger amount to expense these years. Both methods
will arrive at a ` 3,000 balance (the salvage) at the end of the 6 years’ life.
Double Declining Method

This method is similar to the SYD method in charging larger amounts of depreciation to the
early years of an asset’s life. In this method, a constant rate is applied to the asset balance, that is,

to the cost less accumulated depreciation. The rate that is usually used for new assets is twice the
straight line rate under straight line method of depreciation. Using the previous example:
Straight-line Rate = 1/Number of years = 1/6
Declining Balance Rate = 1/6 ´ 2 = 2/6 = 1/3
First Year’s Depreciation = 66,000 ´ 1/3 = ` 22,000
2nd Year’s Depreciation = 1/3 ´ (66,000 – 22,000) = ` 14,666. 70
Depreciation of entire 6 years
Year Cost (`) Rate Depreciation Expenses (`) Asset Book Value, end of year (`)
1 66,000 1/3 22,000.0 44,000.0

2 1/3 14,666.7 29333.3
3 1/3 9777.8 19555.6
4 1/3 6518.5 13037.0
5 1/3 4345.7 8691.3
6 1/3 2897.1 5794.2
The following points should be noted:

(i) The assets book value will never reach zero.
(ii) The rate is applied to the net asset balance at the end of previous year (this balance goes
down each year and is a declining balance).
(iii) No salvage is deducted as in other methods; the rate is applied to the original asset balance
instead.
There are distinctive features of the declining balance method. In no other method is a constant
rate applied to a declining balance. All other methods deduct salvage. But in the declining balance
method a salvage value is, in effect, built into the method itself. This is so because a balance of
undepreciated cost will always remain, no matter how often a rate is applied.
In this method (as per the above example), salvage value of ` 5,794.12 is automatically provided
for. However, an asset should not be depreciated below its salvage value of ` 3,000.
3.9 Degree of Acceleration in Depreciation

The degree of accelerations depends upon the method of providing depreciation, viz., straight
line, diminishing balance or sum-of-the-year-digits method. The following table provides a comparative
view of the pattern of write-off of the cost of an asset under simple and accelerated methods, viz.,
written down value, straight line and sum-of-the-year-digits method.

Date: Cost ` 1000

W.D. Rate 20%
Scrap Value ` 50
Life 14 years
Corresponding straight-line rate 6.79%
Comparative Amounts of Depreciation
Number of W.D.V. Straight-line Sum-of-the-years Digits

Years Annual Depreciation Annual Depreciation Annual Depreciation
1 200 67.9 126.7
2 160 67.9 117.,6
3 128 67.9 108.6
4 102.4 67.9 99.5
5 81.0 67.9 90.5
6 65.5 67.9 81.4
7 52.4 67.9 72.4
8 42.0 67.9 63.3
9 33.6 67.9 54.3
10 26.8 67.9 45.2
11 21.5 67.9 36.2
12 17.2 67.9 27.1
13 13.7 67.9 18.1
14 50.0 67.3 9.1
(Balancing Figure) (Balancing Figure)
If we compare the amount of depreciation in the above table, we find that written down value
method contains the highest degree of acceleration out of the three methods mentioned here. If a
company has the discretion to choose depreciation for tax purposes, then the choice will depend
upon the financial objective of the company and its particular circumstances. If the objective is to
charge lower depreciation in the initial years of an asset’s life and report higher ‘book profit’, the
company should adopt the straight-line method. A company may decide to follow sum-of-the-years-
digits methods only when it wants to follow an accelerated method of depreciation having a lower
degree of acceleration as compared to W.D.V. method.
Figure 3.2 displays the difference between straight-line method and an accelerated method,
say written down value method.

S.L. Method
Depreciation
WDV Method
Fig. 3.2: Display of straight-line method and written down value method
AS-6: Depreciation
The ICAI has issued (revised) accounting standard in August 1994 on depreciation and this has
been made mandatory in respect of accounts for periods commencing on or after 1st April, 1995.
This standard deals with depreciation accounting and applies to all depreciable assets, except the
following items to which special considerations apply:
(i) forests, plantations and similar regenerative natural resources;
(ii) wasting assets including expenditure on the exploration for and extraction of minerals, oils,
natural gas and similar non-regenerative resources;
(iii) expenditure on research and development;
(iv) goodwill;
(v) livestock.
This standard also does not apply to land unless it has a limited useful life for the enterprise.
The provisions of AS-6 with regard to disclosure and accounting standard of depreciation are briefly
as follows:
1. Disclosure
(i) The depreciation methods used, the total depreciation for the period for each class of
assets, the gross amount of each class of depreciable assets and the related accumulated
depreciation are disclosed in the financial statement alongwith the disclosure of other
accounting policies. The depreciation rates or the useful lives of the assets are disclosed
only if they are different from the principal rates specified in the statute governing the
enterprise.
(ii) In case the depreciable assets are revalued, the provision for depreciation is based on the
revalued amount on the estimate of the remaining useful life of such assets. In case the

revaluation has a material effect on the amount of depreciation, the same is disclosed separately
in the year in which revaluation is carried out.
(iii) A change in the method of depreciation is treated as a change in an accounting policy and is
disclosed accordingly.
2. Computation of Depreciation
(i) The depreciable amount of a depreciable asset should be allocated on a systematic basis to
each accounting period during the useful life of the asset.
(ii) The depreciation method selected should be applied consistently from period to period. A
change from one method of providing depreciation to another should be made only if the
adoption of the new method is required by statute or for compliance with an accounting
standard or if it is considered that the change would result in a more appropriate preparation
or presentation of the financial statements of the enterprise. When such a change in the
method of depreciation is made, depreciation should be recalculated in accordance with
the new method from the date of the asset coming into use. The deficiency or surplus
arising from retrospective recomputation of depreciation in accordance with the new method
should be adjusted in the accounts in the year in which the method of depreciation in
changed. In case the change in the method results in deficiency in depreciation in respect
of past years, the deficiency should be charged in the statement of profit and loss. In case
the change in the method results in surplus, the surplus should be credited to the statement
of profit and loss. Such a change should be treated as a change in accounting policy and its
effect should be quantified and disclosed.
(iii) The useful life of a depreciable asset should be estimated after considering the following
factors:
(a) expected physical wear and tear;
(b) obsolescence;
(c) legal or other limits on the use of the asset.
(iv) The useful lives of major depreciable assets or classes of depreciable assets may be reviewed
periodically. Where there is a revision of the estimated useful life of an asset, the unamortised
depreciable amount should be charged over the revised remaining useful life.
(v) Any addition or extension which becomes an integral part of the existing asset should be
depreciated over the remaining useful life of that asset. The depreciation on such addition
or extension may also be provided at the rate applied to the existing asset. Where an
addition or extension retains a separate identity and is capable of being used after the
existing asset is disposed of, depreciation should be provided independently on the basis of
an estimate of its own useful life.

(vi) Where the historical cost of a depreciable asset has undergone a change due to increase or
decrease in long-term liability on account of exchange fluctuations, price adjustments,
changes in duties or similar factors, the depreciation on the revised unamortised depreciable
amount should be provided prospectively over the residual useful life of the asset.
(vii) Where the depreciable asset is revalued, the provision for depreciation should be based on
the revalued amount and on the estimate of the remaining useful lives of such assets. In
case the revaluation has a material effect on the amount of depreciation, the same should
be disclosed separately in the year in which revaluation is carried out.
(viii) If any depreciable asset is disposed of, discarded, demolished or destroyed, the net surplus
or deficiency, if material, should be disclosed separately.
(ix) The following information should be disclosed in the financial statements:
(a) the historical cost or other amount substituted for historical cost of each class of
depreciable assets;
(b) total depreciation for the period for each class of assets; and
(c) the related accumulated depreciation.
(x) The following information should also be disclosed in the financial statements along with
the disclosure of other accounting policies:
(a) depreciation methods used; and
(b) depreciation rates or the useful lives of the assets, if they are different from the
principal rates specified in the statute governing the enterprise.
3.10 Disposal of Fixed Assets

A business enterprise may sell a fixed asset or trade in on the purchase of new plant and
equipment if the asset is no longer useful in the business. In this case, depreciation must be recorded
upto the disposal date; regardless of the manner of the asset’s disposal. If the disposal date does not
match with the closing date of an accounting period, depreciation should be recorded for a partial
period (the period from the date depreciation was last recorded to the disposal date). Whenever sale
of plant or any other fixed asset takes place, there are likely to the three possibilities:
(i) Sale of the fixed asset for more than book value;
(ii) Sale of the fixed asset for less than the book value;
(iii) Sale of the fixed asset exactly equal to its book or carrying value.
In the first case, the sale proceeds exceeds the carrying value of the asset and thus, gain
(difference between the sale proceeds and carrying value) is recorded and added to net income of
the period.

In the second case, since the sale proceeds are less than the carrying value, the loss will be
recorded and deducted from the net income of the period.
In the third case, there is neither gain or loss.
Plant Asset Discarded—If a fixed asset lasts longer than its estimated useful life and as a result
is fully depreciated, it should not continue to be depreciated. That is, no depreciation should be done
beyond the point the carrying value of the asset equals its residual value. If the residual value is zero,
the book value of a fully depreciated asset is zero until the asset is disposed of. If such an asset is
discarded, no gain or loss results. If a fully depreciated asset is still used in the business, this fact
should be supported by its cost and accumulated depreciation remaining in the asset account. If the
asset is no longer used in the business, the cost and accumulated depreciation should be written off.
Under all circumstances, the total accumulated depreciation should never exceed the total depreciable
cost.
3.11 Evaluation of Accelerated Methods

The use of accelerated methods of depreciation provide certain benefits and is useful to business
enterprises in many respects. Some benefits which may occur to business entities are as follows:
1. Cash Flow: In terms of cash flow, initial depreciation serves the purposes of an interest
free loan to the tax payer in respect of the year of erection of building or installation of machinery
and plant. Since it results in postponement of the tax liability of the assessee, the amount of tax
saved in the initial years result in a net addition to cash flow, which is repaid through a higher tax
liability during the later years.
Depreciation is an expense that does not use funds currently. In the preparation of changes in
financial position, depreciation is added back to net income in calculating funds provided by operations.
Because it is added back to net income, the funds from operations is often defined as net income
plus depreciation. However, depreciation is not a source of fund. Funds from other operations come
from revenues from customers, not by making accounting entries. In fact, depreciation expense
results from an outflow of funds in an earlier period, that is only now being recognised as an operating
expense. The following example explains the fact that depreciation does not produce funds. Assume
a company has net income in 2009 of ` 20,000 resulting from revenues of ` 1,25,000, expenses
other than depreciation of ` 95,000 and ` l0,000 of depreciation. Now, assume the depreciation
increases to ` 25,000 while other expenses and revenues are unchanged, net income is ` 5,000
(ignore income taxes in both examples). The following Exhibit 3.1 shows that changes in depreciation
do not affect funds from operations, funds from operations would be the same ` 30,000 in both
situations.

Exhibit 3.1: Impact of Depreciation on Funds from Operations

Income Statement ` Funds from Operations `
(i) Depreciation ` 10,000
Revenue 1,25,000 Net Income 20,000
Less: Expense except Depreciation 95,000 Add: Expenses not using capital:
30,000 Depreciation 10,000
Depreciation Expenses 10,000 Total funds from operations 30,000
Net Income 20,000
(ii) Depreciation ` 25,000
Revenue 1,25,000 Net Income 5,000
Less: Expenses except Depreciation 95,000 Add: Expenses not using capital:
30,000 Depreciation 25,000
Depreciation Expenses 25,000 30,000
Net Income 5,000
Depreciation does help determine cash flow, however, by its effect on the measurement of
taxable income and thus tax expenses. The more rapid the rate of depreciation charges for tax
purposes, the slower the rate of tax payment. For this reason, accelerating depreciation for tax
purposes stimulates acquisition of depreciable assets and is viewed as significant in increasing the
rate of capital formation. In India, depreciation provision as a source of funds for joint stock companies
accounted for more than 50% of the funds utilised in gross fixed assets formation and thus it occupies
an important role to play in the internal financing of industry. An increasing dependence on this
source of finance would suggest lessening reliance of companies on the capital market.
2. Tax Advantage: Many companies may adopt accelerated depreciation methods for tax
return purposes because of the tax advantage that they entail. Higher depreciation charges mean
lower income and lower taxes. If accelerated methods are used for tax purposes they do not have
to be used for financial reporting purposes. Every rupee that can be justified as a deduction saves
the company about 50% in tax money. Since the total tax deduction is limited to the total cost of the
asset, the different depreciation methods merely shift the years in which the deduction is made.
Insofar as the deduction is made in earlier years rather than later, this saves interest but more than
that it put the tax payer into possession of funds at an earlier date and this increases his flexibility of
financial management.
3. Benefit to Growing Company: The postponement of the liability under accelerated
depreciation may be very useful for a growing firm investing more and more in fixed capital and
more so far a new firm which may take sometimes to stabilise its business. When a company is
expanding, the higher depreciation charges will help in expansion and investment which are essentially
needed for the company.

4. Replacement of Assets: Accelerated depreciation may induce the tax payer to replace old
machinery or equipment before the end of its useful life by new and improved model and also gain
the tax advantage. But this would be just one of the considerations in deciding the proper time for
replacement. Accelerated depreciation methods allow a business to recover more of the investments
in a fixed asset in the first few years of the asset’s life. This is an important factor in any situation in
which there is a high rate of technological change. It is also important when inflation is a factor and
depreciation is limited to the original cost of a long-term asset
Accelerated depreciation does provide an incentive to invest in fixed assets and it helps particularly
a growing firm than a stationary or a declining one. As far as the form of accelerated depreciation is
concerned, the diminishing balance or sum-of-the-years-digits method seems preferable to a straight
line method particularly in respect of plant and machinery. Selective use of initial depreciation and at
varying rates for investment in priority sectors is likely to serve a better purpose than its general use.
In case of underdeveloped economies, initial depreciation has a special role to play for encouraging
investment in backward region and also in small and medium sized enterprises.
3.12 Factors Influencing the Selection of Depreciation Method

Depreciation has a significant effect in determining the financial position and result of operations
of an enterprise by calculating net income as well as deduction from taxable income. The quantum
of depreciation to be provided in an accounting period involves the exercise of judgement by
management in the light of technical, commercial, accounting and legal requirements and accordingly
may need periodical review. If it is considered that the original estimate of useful life of an asset
requires any revision, the unamortised depreciable amount of the asset is charged to revenue over
the revised remaining useful life. Alternatively, the aggregate depreciation charged to date is
recomputed on the basis of the revised useful life and the excess or short depreciation so determined
is adjusted in the accounting period of revision.
There are several methods of allocating depreciation over the useful life of the assets. Those
most commonly employed in industrial and commercial enterprises are the straight line method and
the reducing balance method. The management of a business selects the most appropriate method(s)
based on various important factors, e.g., (i) type of asset, (ii) the nature of the use of such asset and
(iii) circumstances prevailing in the business. A combination of more than one method is sometimes
used. In respect of depreciable asset which do not have material value, depreciation is often allocated
fully in the accounting period in which they are acquired.
The following factors influence the selection of a depreciation method:
1. Legal Provisions: The statute governing an enterprise may be the basis for computation of
the depreciation. In India, in the case of company, the Companies Act, 1956 provides that the
provision of depreciation, unless permission to the contrary is obtained from the Central Government,
should either be based on reducing balance method at the rate specified in the Income Tax Act/

Rules or on the corresponding straight line depreciation rates which would write off 95% of the
original cost over the specified period. Where the management’s estimate of the useful life of an asset
of the enterprise is shorter than that envisaged under the provision of the relevant statute, the
depreciation provision is appropriately computed by applying a higher rate. If the management’s
estimate of the useful life of the assets is longer than that envisaged under the statute, depreciation
rate lower than that envisaged by statute can be applied only in accordance with the requirements of
the statute.
For tax purpose, the asset would be written off as quickly as possible. Of course, a firm can
deduct only the acquisition cost, less salvage value, from otherwise taxable income over the life of
the asset. Earlier deductions are, however, worth more than later ones because a rupee of taxes
saved today is worth more than a rupee of taxes saved tomorrow. That is, the goal of the firm in
selecting a depreciation method for tax purpose should be to maximise the present value of the
reductions in tax payments from claiming depreciation When tax rates remain constant over time
and there is a flat tax rate (for example, income is taxed at a 40% rate), this goal can usually be
achieved by maximising the present value of the depreciation deductions from otherwise taxable
income.
Depreciation is a tax-deductible expense. Therefore, any profit a business enterprise sets aside
towards depreciation is free of tax. Those enterprises who make huge profit and choose to pay a lot
of tax, should wisely go for more depreciation rather than pay more tax. They can follow accelerated
methods of depreciation, can seek ways of increasing the amount of depreciation and amortisation
on their assets so as to salt away more tax-free funds.
2. Financial Reporting: The goal in financial reporting for long-lived assets is to seek a
statement of income that realistically measures the expiration of those assets. The only difficulty is
that no one knows, in any satisfactory sense, just what portion of the service potential of a long-lived
asset expires in any one period. All that can be said is that financial statements should report
depreciation charges based on reasonable estimates of assets expiration so that the goal of fair
presentation can more nearly be achieved. UK Accounting Standards SSAP 12 issued in December
1977 argues:
“The management of a business has a duty to allocate depreciation as fairly as possible to the
periods expected to benefit from the use of the asset and should select the method regarded as most
appropriate to the type of asset and its use in the business.
Provision for depreciation of fixed assets having a finite useful life should be made by allocating
the cost (or revalued amount) less estimated residual values of the assets as fairly as possible to the
periods expected to benefit from their use.”
3. Effect on Managerial Decision: The suitability of a depreciation method should not be
argued only on the basis of correct portrayal of the objective facts but should also be decided in
terms of their various managerial effects.

Depreciation and its financing effect take the less basic but still realistic approach that, regardless
of any effect which depreciation may have upon the total revenue stream, the recognition of depreciation
either through the cost of product or as an element in administration and marketing expenses, does
cut down the showing of net income available for dividends and thus restricts the outflow of cash.
The actual tax saving argument is sometimes short sighted, but the saving of interest and the increased
financial flexibility are actual and constitute the real pressure behind depreciation accounting. Business
managers consider these points, but they have the added responsibility of protecting management
against the possible distortions of reported cost and misleading incomes which these pressures might
engender.
A depreciation method which would lead to unwise dividends, distributing cash which was later
needed to replace the asset, would be a poor method. A depreciation method which matches the
asset costs distributed period by period against the revenues produced by the asset, thus helping
management to make correct judgements regarding operating efficiency, would be a good method.
4. Inflation: Depreciation is a process to account for decline in the value of assets and for this
many methods such as straight line, different accelerated methods are available. In recent years,
inflation has been a major consideration in selecting a method of depreciation. To take an example,
suppose one bought a car for ` 5,00,000 five years ago and wrote-off ` 1,00,000 every year to
account for depreciation using straight line method, expecting that a new car can be purchased after
five years. However, five years later, it is found that the same car costs ` 10,00,000 whereas only
` 5,00,000 has been saved through depreciation.
Why a new car or new asset cannot be purchased with the accumulated amount of depreciation?
The difficulty has been created by the inflation. In fact, inflation has eaten into the money saved
through depreciation over the five years. This means that a business enterprise (or the owner of
car) eats into the asset faster than the rate of depreciation as the cost of replacing the asset is
increasing.
The accelerated methods of depreciation tend to write-off ` 5,00,000 (the price of car in the
above example) over the five years. But higher amounts are written off in the beginning as depreciation,
and hence, larger amounts are accumulated through depreciation which increases the ‘replacement
capability’ of a business enterprise.
The problem created by inflation in depreciation accounting has contributed in the emergence
of the concept of inflation accounting. In inflation accounting, an attempt is made to increase the
depreciation amount in line with inflation so that enough money to replace the asset at its current
inflated cost can be accumulated.
5. Technology: Depreciation is vital because it decides the regenerating capacity of industry
and enables enterprises to set aside an amount before submitting profits to taxation, for replacing
machines. Realistically, the depreciation that enterprises are eligible for and capable of accumulating
should cover the purchase price of assets, when the time comes for replacement.

But the critical question is, when exactly does the time for replacement come? Life of machine
is no longer an engineering concept. Many electronic companies had to write-off their assets in
three years because new technologies came in and old machines overnight became scrap. Commercial
life of machines is decided by technological progress. The arrival of new machines is not governed
by the depreciation policies of government. Therefore, the shorter the period over which the enterprise
is able to recover depreciation, the better its chances to adapt to the new technology and survive. In
an industry which are exposed to rapid technological progress, a fixed depreciation rate is the surest
way to force it into bankruptcy.
Accumulating depreciation enough for buying new technology does not depend merely on a
rate of depreciation. Business enterprises should have profit to provide for depreciation resulting
into adequate money for the replacement at the proper time. An industry in which profits are likely
to be high in the initial years will have to provide more depreciation in those years than in the later
years when the profit is likely to be low.
Technological progress as a dimension of depreciation has become more important than the
engineering life of machines. A constant rate of depreciation may be followed when an enterprise is
making profit at a constant rate. It is only when profit are fluctuating that the company in years of
high profits will provide for higher depreciation. If it is not able to do that because of fixed rate of
depreciation imposed by the government, it will be overtaxed. As a result, it will not be able to retain
enough earnings after payment of tax and dividends to make up for its inability to provide normal
depreciation in years of adversity. At the end of the useful life of machines, the company will not
have the resource to invest in new machines. It will succumb to technological progress.
6. Capital Maintenance: During inflation, depreciation, if based on historical cost of assets,
helps a business firm to gather an amount equivalent to the historical cost of the asset less its
salvage value. This treatment of depreciation facilitates in maintaining only the ‘money capital’ or
financial capital of business enterprises. However, this results into matching between historical
amount of depreciation and sales in current Rupees. The result is that reported net income is overstated
and dividend is distributed from the net income which is not real but fictitious. This way of income
measurement and maintaining only financial capital during inflation results into erosion of real capital
of business enterprises.
However, if depreciation is provided on replacement or current value of assets, it gives matching
between current cost (depreciation) and current revenues. This does not involve any hoarding income
as is found when depreciation is determined on historical cost. Depreciation on current value of
assets provides real operating income in the profit and loss account. This means that capital of
business enterprise would be maintained in real terms. Valuation of fixed assets in terms of current
cost reflects the current value of operating capability of business enterprises.

Illustrative Problem: Bannelos Enterprises Inc. constructed a new plant at a cost of ` 20,000,000
at the beginning of 2009. The plant was estimated to have a useful life of 20 years with no salvage
value at the end of the 20 years. The company expects earnings, before deducting depreciation on the
plant and income taxes, of ` 50,00,000 each year. Income taxes are estimated at 40% of income
before taxes
Required:
(i) Compute depreciation for each of the next four years by both the straight-line method and
the double-rate method.
(ii) What tax advantage can be expected in each of the next four years by using double-rate
depreciation for tax purposes instead of straight-line depreciation?
(iii) What difference, if any, would it make in the situation if the company decides to adopt
declining balance method instead of double rate method? (Assume salvage value of the
plant to be equal to 5% of its original cost.)
(M.Com., Delhi)
Solution
(i) Depreciation in straight-line and double rate method
Straight-line Double Rate
Rate of depreciation 5% 10%
Depreciation:
Ist year ` 10,00,000 ` 20,00,000
IInd year 10,00,000 18,00,000
IIIrd year 10,00,000 16,20,000
IVth year 10,00,000 14,58,000
(ii) Tax Saving
Tax saved @ 40%
`
Ist year= ` 20,00,000 – ` 10,00,000 = ` 10,00,000
4,00,000
IInd year= ` 18,00,000 – ` 10,00,000 = ` 8,00,000
3,20,000
IIIrd year= ` 16,20,000 – ` 10,00,000 = ` 6,20,000
2,48,000
IVth year= ` 14,58,000 – ` 10,00,000 = ` 4,58,000
1,83,200

(iii) First, compute diminishing balance rate using the following formula
S
1n
C
5
1  20  14%
100
After this, one should find out the amount of depreciation @ 14% under diminishing balance
method. Amounts of depreciation in this method can be compared with amounts of depreciation
under double rate method as calculated above and 40% of these differences will be the amount of
tax saved each year.
Problem: The Board of Directors decided on 31.3.2016 to increase the sale price of certain
items retrospectively from 1st January, 2016. In view of this price revision with effect from 1st
January, 2016, the company has to receive ` 15 lakhs from its customers in respect of sales made
from 1st January, 2016 to 31st March, 2016. Accountant cannot make up his mind whether to
include ` 15 lakhs in the sales for 2015-16. Advise.
Solution
Price revision was effected during the current accounting period 2015-16. As a result, the
company stands to receive ` 15 lakhs from its customers in respect of sales made from 1st January,
2016 to 31st March, 2016. If the company is able to assess the ultimate collection with reasonable
certainty, then additional revenue arising out of the said price revision may be recognised in 2015-16
as per AS-9.
Problem: You have been asked to advise a business-to-business manufacturing company how
to detect fraudulent financial reporting. Management does not understand how early revenue
recognition by backdating invoices from next year to this year would affect financial statements.
Further, management wants to know which accounts could be audited for evidence of fraud in the
case of early revenue recognition.
(a) Using your own numbers, make up an example to show management the effect of early
revenue recognition.
(b) Prepare a short report to management explaining the accounts that early revenue recognition
would affect. Suggest some ways management could find errors in those accounts.

Solution
(a) The example should be similar to the following:
(Amount in lakhs)
Actual Fraudulent
Year 1 Year 1
(Actual) (Fraud)
Revenue ` 100 ` 120
Cost of Goods Sold 50 60
Gross Profit ` 50 ` 60
Year 2 Year 2
(Actual) (Assuming No Additional Fraud)
Revenue ` 100 ` 80
Cost of Goods Sold 50 40
Gross Profit ` 50 ` 40
(b) Accounts Receivable and Revenue would be overstated. Inventory would be understated
because the goods that are still in physical inventory would be reported to be sold. Cost of
Goods Sold would be overstated. To find the errors, try the following:
• Confirm accounts receivable with customers. If customers say they did not owe the
money or purchase the goods as of the end of the year, then the company's records
may be wrong.
• Count the inventory, physically. The physical count should reveal inventory that has
been reported to be sold as of the end of the year.
• Analyze the accounts to see if Accounts Receivable are old, which may indicate
customers do not owe the money. Determine whether year-end Accounts Receivable
are growing faster than the company is growing.
3.13 Summary
Assets denote the economic resources of an enterprise that are recognised and measured in
conformity with GAAP. Assets valuation helps in determining income and financial position of an
enterprise along with the managerial decision making. Four valuation concepts are used for assets
valuation. First is historical concept, which is based on an actual event, present value on an expected
event, and replacement cost and net realisable value on hypothetical event. One of the main
disadvantages of historical cost valuation is that the value of the assets to the firm may change over
time; after long periods of time it may have no significance whatever as a measure of the quantity of

resources available to the enterprise. It also fails to permit the recognition of gains and losses in the
periods in which they may actually occur. Second is current entry price it measures replacement cost
in units of money. Third is current exit price it measured net realisable value in units of money. One
of the major difficulties with the current cash equivalent concept is that it provides justification for
excluding from the position statement all items that do not have a contemporary market price. Fourth
is present value of expected cash flows it measured present value in units of money. This valuation
concept requires the knowledge or estimation of three basic factors—the amount or amounts to be
received, the discount factor and the time periods involved. The discounted cash flow concept has
some merit as a valuation concept for single ventures where there are no joint factors requiring
separate accounting or where the aggregation of assets can be carried far enough to include all of
the joint factors.
Lower of Cost or Market (LCM) Rule: The lower of cost or market valuation approach is
a rule which has long and widely observed in financial accounting. The rule was originally justified in
terms of conservatism which meant that there should be no anticipation of profit and that all foreseeable
losses should be provided for in the value report to shareholders. LCM rule has the following limitations:
(1) It tends to understate total asset valuations. (2) The conservatism in asset valuations is offset by
an unconservative statement of net income in a future period. A lower asset valuation in the current
period will result in a larger reported profit or smaller loss in some future period when the asset
valuation is charged off as an expense. (3) The LCM rule suffers from inherent inconsistency.
(4) A less convincing argument is that the cost or market rule applies to decreases in cost as well as
to diminished utility due to deterioration, obsolescence, or decreased earning capacity. There may
not be any changes in net realisable value just because costs have changed
Various types of assets possesses by a business enterprise are fixed assets, investments, current
assets and intangible assets. Fixed assets or tangible assets which are held with the intention of
being used for the purpose of producing goods and services and is not held for sale in normal course
of business. Investments are created by a firm through purchase of shares and other securities
these may be long-term or short-term. Intangible assets do not have physical substance but they are
the resources that benefit an enterprise operation. Current assets include cash and assets that can
be converted in cash within one year. The operating cycle is defined as the time it takes to convert
cash into the product of the enterprise and then to convert the product back into cash again. Current
assets are classified into cash, receivables, marketable securities, inventories and prepaid expenses.
Deferred charges are the expenses paid in advance, these are long-term prepaid expenses and
benefit several future years. They are also known as organisation costs. Some examples of deferred
charges are: (1) Legal fees, (2) Fees paid to the government agencies, (3) Preliminary expenses
incurred in the formation of a company, (4) Pre-operating expenses incurred from the commencement
of business upto the commencement of commercial production, (5) Advertisement and sales promotion
expenditure incurred on the launch of a new product and (6) Research and development costs.

Cost Model says that after recognition as an asset, an item of property, plant and equipment
should be carried at its cost less any accumulated depreciation and any accumulated impairment
losses. Revaluation Model says that after recognition as an asset, an item of property, plant and
equipment whose fair value can be measured reliably should be carried at a revalued amount, being
its fair value at the date of the revaluation less any subsequent accumulated depreciation and
subsequent accumulated impairment losses.
Salient Features of Ind AS-16, Property, Plant and Equipment: (1) It deals with accounting
for property, plant and equipment. It covers the aspects of AS-10 (Accounting for fixed Assets) and
AS-6 (Depreciation Accounting). (2) It lays down specific criteria which should be satisfied for
recognition of items of property, plant and equipment (PPE): (a) it is probable that future economic
benefits associated with the item will flow to the entity, and (b) the cost of the item can be measured
saliably. (3) It provides uniform recognition principles to determine the recognition as an item of
PPE for both internal and subsequent costs. (4) It requires the inclusion of initial estimates of the
costs of dismantling and removing the item and restoring the site on which it is located in the cost of
respective item of PPE. (5) It permits an entity to choose between cost model or revaluation model
as its accounting policy and to apply that policy to an entire class of PPE.
The lease is an agreement whereby the lessor transfer to the lessee, in return for rent, the right
to use an asset for an agreed period of time. Lessor is a person, who under an arrangement, provides
to another person, the lessee, the right to use an asset for an agreed period of tune in return for rent.
As per the agreement, the lessor remains the owner of the leased goods whereas lessee, for all
practical purposes, is the user of the asset. However, the substance of the leasing agreement is that
lessee for all practical purposes, uses the assets and acts like owner.
Types of Lease: (1) Finance Lease and (2) Operating Lease. A finance lease is that lease
which transfers, substantially, all the risks and rewards incidental to the ownership of an asset. The
title (ownership) of the asset may or may not be transferred. Operating lease is renewed a number
of times during the economic life of an asset. Lease period is generally lower than the economic life
of the asset.
A sale and leaseback transaction involves the sale of an asset and the leasing back of the same
asset. The accounting treatment of a sale and leaseback transaction depends upon: (1) If a Sale and
Leaseback Transaction Results in a Finance Lease Sale and Leaseback. (2) If a Sale and Leaseback
Transaction Results in an Operating Lease: (I) When Sale Price = Fair Value, the transaction is
established at fair value, any profit or loss shall be recognised immediately. (II) When Sale Price <
Fair Value, any profit or loss shall be recognised immediately except that, if the loss is compensated
for by future lease payments at below market price, it shall be deferred and amortised in proportion
to the lease payments over the period for which the asset is expected to be used. (III) When Sale
Price > Fair Value, the excess over fair value shall be deferred and amortised over the period for
which the asset is expected to be used.

Depletion is the name of expenses or write-off in the case of natural resources. The term
amortisation is used in case of intangible assets. Depreciation refers to periodic allocation of the
acquisition cost of tangible long-term assets over its useful life. Different methods of depreciation are
Straight line method and accelerated method. Accelerated method further can be divided into written
down value method, sum-of-the-years digit method and double declining method. The management
of a business selects the most appropriate method(s) based on various important factors, e.g., (i) type
of asset, (ii) the nature of the use of such asset and (iii) circumstances prevailing in the business. The
following factors influence the selection of a depreciation method: (1) Legal Provisions, (2) Financial
Reporting, (3) Effect of managerial decision, (4) Inflation, (5) Technology and (6) Capital maintenance.
3.14 Key Words/Abbreviations

 Liquidity: It means how easily an asset can be converted into cash.
 Salvage value: It is the estimated resale value of an asset at the end of its useful life.
3.15 Learning Activity

1. On 1st January, 2015, Compro Technology, purchased equipment having an estimated
salvage value equal to 20% of its original cost at the end of a 10-year life. The equipment
was sold on 31st December, 2019, for 50% of its original cost. If the equipment’s disposition
resulted in a reported loss, which depreciation methods did Compro use.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
2. A depreciable asset has an estimated 15% salvage value. At the end of its estimated useful
life, the accumulated depreciation would equal the original cost of the asset under which
depreciation methods?
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________

3. A machine with a five-year estimated useful life and an estimated 10% salvage value was
acquired on 1st January, 2015. On 31st December, 2018, accumulated depreciation, using
the sum-of-the-years’ digits method.
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
_________________________________________________________________
3.16 Unit End Questions (MCQ and Descriptive)
A. Descriptive Type Questions
1. Explain the main features of Schedule III of Companies Act, 2013.

2. “Assets are probable future economic benefits obtained or controlled by a particular entity
as a result of past transactions or events.” Explain this statement.
3. Explain the meaning of the term ‘valuation.’ What are the objectives associated with valuation
of assets?
4. “Different asset valuation models yield different financial statements meaning and relevance
to its users.” Evaluate this statement.
5. Give arguments in favour of historical cost as a method of asset valuation and income
determination.
6. “Though each of alternative asset valuation methods can be rationalised and justified under
some condition, there is no convincing arguments that one is better than the others in every
situation.” Explain this statement critically
7. Why do companies in India resort to revaluation of fixed assets for reporting purposes?
Does it influence income measurement? Would you suggest some regulatory measure in
this regard?
8. State the different bases of valuation of assets, both current and non-current. Which base,
in your view, is most suitable in the period of rising prices?
9. Discuss different methods of current value accounting to approximate current value of
assets.
10. Discuss the provisions given in AS-6 on Depreciation.

11. “Several methods of depreciation have been suggested and used from time to time that
result in a decreasing depreciation charges over the expected life of an asset.” Explain
these methods. Also state the conditions which are claimed as justification for the declining
charge methods.
12. “Replacing the asset is not essential to the existence of depreciation. Depreciation is the
expiration or disappearance of service potential from the time an asset is put into use until
the time it is retired from service.” Explain this statement.
13. Mention the factors influencing the selection of a depreciation method.
14. Discuss the disclosure guidelines given in AS-6, ‘Depreciation Accounting’ about
depreciation.
15. Vidarva Chemical Ltd. purchased a machinery from Madras Machine Manufacturing Ltd.
(MMM Ltd.) on 30th September, 2016. Quoted price was ` 162 lakhs. MMM Ltd. offers
1% trade discount. Sales tax on quoted price is 5%. Vidarva Chemical Ltd. spent ` 42,000
for transportation and ` 30,000 for architect's fees. They borrowed money from ICICI
` 150 lakhs for acquisition of the assets @ 20% p.a. Also, they spent ` 18,000 for material
in relation to trial run. Wages and overheads incurred during trial run were ` 12,000 and
` 8,000 respectively. The machinery was ready for use on 15th November, 2016. It was
put to use on 15th April, 2017. Find out the original cost. Also, suggest the accounting
treatment for the cost incurred in the interval between the date the machine was ready for
commercial production and the date at which commercial production actually begins.
16. Fine Ltd. acquired a machine on 1st April, 2009 for ` 14 crore that had an estimated useful
life of 7 years. The machine is depreciated on straight line basis and does not carry any
residual value. On 1st April, 2013, the carrying value of the machine was reassessed at `
10.20 crore and the surplus arising out of the revaluation being credited to revaluation
reserve. For the year ended 31st March, 2015, conditions indicating an impairment of the
machine existed and the amount recoverable ascertained to be only ` 140 lakhs.
You are requested to calculate the loss on impairment of the machine and show how this
loss is to be treated in the books of Fine Ltd.
Fine Ltd. had followed the policy of writing down the revaluation surplus by the increased
charge of depreciation resulting from the revaluation.
17. Ergo Industries Ltd. gives the following estimates of cash flows relating to fixed asset on
31st December, 2016. The discount rate is 15%.

Year Cash Flow (` in lakhs)

2017 4,000
2018 6.000
2019 6,000
2020 8,000
2021 4,000
Residual value at the end of 2021 =` 1,000 lakhs
Fixed Asset purchased on 1st January, 2014 =` 40,000 lakhs
Useful life = 8 years
Net selling price on 31st December, 2016 =` 20,000 lakhs
Calculate on 31st December, 2016
(a) Carrying amount at the end of 2016
(b) Value in use on 31st December, 2016
(c) Recoverable amount on 31st December, 2016
(d) Impairment loss to be recognised for the year ended 31st December, 2016
(e) Revised carrying amount
(f) Depreciation charge for 2017
18. Global Ltd. has initiated a lease for three years in respect of an equipment costing `1,50,000
with expected useful life of 4 years. The asset would revert to Global Limited under the
lease agreement. The other information available in respect of lease agreement is:
(i) The unguaranteed residual value of the equipment after the expiry of the lease term is
estimated at ` 20,000.
(ii) The implicit rate of interest is 10%.
(iii) The annual payments have been determined in such a way that the present value of the
lease payment plus the residual value is equal to the cost of asset.
Ascertain in the hands of Global Ltd.:
(i) The annual lease payment,
(ii) The unearned finance income,
(iii) The segregation of finance income, and also,
(iv) Show how necessary items will appear in its profit and loss account and balance sheet
for the various years.

B. Multiple Choice/Objective Type Questions

1. Which of the following is an essential characteristic of an asset?
(a) The claim to an asset’s benefits are legally enforceable
(b) An asset is tangible
(c) An asset is obtained at a cost
(d) An asset provides future benefits.
2. On 31st December, 2017, Brooks Co. decided to end operations and dispose of its assets
within three months. At 31st December, 2017, the net realisable value of the equipment
was below historical cost. What is the appropriate measurement basis for equipment included
in Books’ 31st December, 2017 balance sheet?
(a) Historical cost (b) Current reproduction cost
(c) Net realisable value (d) Current replacement cost
3. During 2017, King Company made the following expenditures relating to its plant building:
`
Continuing and frequent repairs 40,000
Repainted the plant building 10,000
Major improvements to the electrical wiring system 32,000
Partial replacement of roof tiles 14,000
How much should be charged to repair and maintenance expense in 2017?
(a) ` 96,000 (b) ` 82,000
(c) ` 64,000 (d) ` 54,000
4. A building suffered uninsured fire damage. The damaged portion of the building was
refurbished with higher quality materials. The cost and related accumulated depreciation
of the damaged portion are identifiable. To account for these events, the owner should
(a) Reduce accumulated depreciation equal to the cost of refurbishing
(b) Record a loss in the current period equal to the sum of the cost of refurbishing and the
carrying amount of the damaged portion of the building

(c) Capitalise the cost of refurbishing and record a loss in the current period equal to the
carrying amount of the damaged portion of the building
(d) Capitalise the cost of refurbishing by adding the cost to the carrying amount of
the building
5. Which of the following statements concerning patents is correct?
(a) Legal costs incurred to successfully defend an internally developed patent should be
capitalised and amortised over the patent’s remaining economic life
(b) Legal fees and other direct costs incurred in registering a patent should be capitalised
and amortised on a straight-line basis over a five-year period
(c) Research and development contract services purchased from others and used to develop
a patented manufacturing process should be capitalised and amortised over the patent’
economic life
(d) Research and development costs incurred to develop a patented item should be
capitalised and amortised on a straight-line basis over seventeen years
6. Chain Hotel Corporation recently purchased Elgin Hotel and the land on which it is located
with the plan to tear down the Elgin Hotel and build a new luxury hotel on the site. The cost
of the Elgin Hotel should be—
(a) Depreciated over the period from acquisition to the date the Hotel is scheduled to be
torn down
(b) Written off as an extraordinary loss in the year the Hotel is torn down
(c) Capitalised as part of the cost of the land
(d) Capitalised as part of the cost of the new Hotel.
7. As generally used in accounting, what is depreciation?
(a) It is a process of asset valuation for balance sheet purposes
(b) It applies only to long-lived intangible assets
(c) It is used to indicate a decline in market value of a long-lived asset
(d) It is an accounting process which allocates long-lived asset cost to accounting periods
8. Which of the following statements is the assumption on which straight-line depreciation is
based?
(a) The operating efficiency of the asset decrease in later years
(b) Service value declines as a function of time rather than use

(c) Service value declines as a function of obsolescence rather than time

(d) Physical wear and tear are more important than economic obsolescence
9. A principal objection to the straight-line method of depreciation is that it
(a) Provides for the declining productivity of an aging asset
(b) Ignores variations in the rate of asset use
(c) Trends to result in a constant rate of return on a diminishing investment base
(d) Gives smaller periodic write offs than decreasing charge methods
10. The straight-line method of depreciation is not appropriate for
(a) A company that is neither expanding nor contracting its investments in equipment because
it is replacing equipment as the equipment depreciates
(b) Equipment on which maintenance and repairs increase substantially with age
(c) Equipment with useful lives that are not affected by the amount of use
(d) Equipment used consistently every period
11. In accordance with generally accounting principles, which of the following methods of
amortisation is normally recommended for intangible assets?
(a) Sum-of-the-years-digits (b) Straight-line
(c) Units of production (d) Double-declining balance
12. ABC Co. uses the sum-of-the-years digits method to depreciate equipment purchased in
January 2015 for ` 20,000. The estimated salvage value of the equipment is ` 2,000 and
the estimated useful life is four years. What should ABC report as the asset’s carrying
amount as of 31st December, 2017?
(a) ` 1,800 (b) ` 2,000
(c) ` 3,800 (d) ` 4,500
13. When a company changes from the straight-line method of depreciation for previously
recorded assets to the double-declining balance method, which of the following should be
reported?
Cumulative effects of Proforma effects of
change in accounting principle retroactive application
(a) No No
(b) No Yes

(c) `Yes Yes

(d) Yes No
14. On 1st January, 2015, Flax Co. purchased a machine for ` 5,28,000 and depreciated it by
the straight-line method using an estimated useful life of eight years with no salvage value.
On 1st January, 2018, Flax determined that the machine had a useful life of six years from
the date of acquisition and will have a salvage value of ` 48,000. An accounting change
was made in 2018 to reflect these additional data. The accumulated depreciation for this
machine should have a balance at 31st December, 2018 of
(a) ` 2,92,000 (b) ` 3,08,000
(c) ` 3,20,000 (d) ` 3,52,000
15. Jindal Company takes a fully year’s depreciation expense in the year of an asset’s acquisition,
and no depreciation expense in the year of disposition. Data relating to one of Jindal’s
depreciable assets at 31st December, 2016 are as follows:
Acquisition year 2014
Cost ` 1,10,000
Residual value 20,000
Accumulated depreciation 72,000
Estimated useful life 5 years
Using the same depreciation method as used in 2014, 2015, and 2016, how much depreciation
expense should Jindal record in 2018 for this asset?
(a) ` 12,000 (b) ` 18,000
(c) ` 22,000 (d) ` 24,000
16. On 2nd January, 2015, Union Co. purchased a machine for ` 2,64,000 and depreciated it by
the straight-line method using an estimated useful life of eight years with no salvage value.
On 2nd January, 2018, Union determined that the machine had a useful life of six years
from the date of acquisition and will have a salvage value of ` 24,000. An accounting
change was made in 2018 to reflect the additional data. The accumulated depreciation for
this machine should have a balance at 31st December, 2018, of
(a) ` 1,76,000 (b) ` 1,60,000
(c) ` 1,54,000 (d) ` 1,16,000

17. On 18th June, 2017, Dell Printing Co. incurred the following costs for one of its printing
presses:
`
Purchase of collating and stapling attachment 84,000
Installation of attachment 36,000
Replacement parts for overhaul of press 26,000
Labour and overhead in connection with overhaul 14,000
The overhaul resulted in a significant increase in production. Neither the attachment nor
the overhaul increased the estimated useful life of the press. What amount of the above
costs should be capitalised?
(a) ` 0 (b) ` 84,000
(c) ` 1,20,000 (d) ` 1,60,000
6. Derby Co. incurred costs to modify its building and to rearrange its production line. As a
result, an overall reduction in production costs is expected. However, the modifications did
not increase the building’s market value, and the rearrangement did not extend the production
line’s life. Should the building modification costs and the production line rearrangement
costs be capitalised?
Building modification costs Production line rearrangement costs
(a) Yes No
(b) Yes Yes
(c) No No
(d) No Yes
7. Which method of recording uncollectible accounts expense is consistent with accrual
accounting?
Allowances costs Direct write-off
(a) Yes No
(b) Yes Yes
(c) No No
(d) No Yes
20. You are the Chief Accountant of a sugar factory, whose cost of production per tonne of
sugar is given below:

30-6-2015 30-6-2016
(`) (`)
Sugarcane cost 1,700 1,900
Sugarcane transport and supervision 50 55
Other process chemicals 45 50
Fuel 15 16
Salaries, wages and bonus 60 75
Repairs, renewals and maintenance 125 135
Packing materials and expenses 75 85
Interest 250 150
Selling overheads 20 20
Administration overheads 85 95
Depreciation 300 300
Total Cost 2,725 2,881
Free market sale price 2,800 4,800
Controlled market sale price 2,600 2,600
Export price 1,650 5,400
Salaries, wage and bonus include administration salaries ` 20.
You have been valuing the closing stock of sugar consistently at cost or market price
whichever is lower. For the purpose of arriving at cost, you have been taking the total cost
as given above.
The auditor objects to the method of arriving at cost adopted in view of Accounting Standard
No. 2 on valuation of inventory and he wants to exclude the depreciation, interest,
administration and selling overheads.
Keeping the stipulations of the Accounting Standard - 2 in view, give your opinion on:
(a) What shall be the cost for the purpose of valuation of stock in both the above years?
(b) In view of the accumulation of heavy stock, the directors want to be consistent with
the method of valuation of stocks as in the past in order to present a reasonable financial
position. Will you be able to convince the auditors that the method of arriving at total
cost is the correct method and, if yes, how?
(c) If the author’s opinion is adopted, what shall be the nature of disclosure in the published
accounts, if any?
(d) What shall be the basis for valuing stock in each of the above years?

Note:
Local sales price include excise duty of ` 500 per tonne.
[Ans.
(a) Total cost: Year 2015 – ` 2,350; Year 2016 – ` 2,596
(b) Depreciation of factory assets is a part of factory overhead and must be included in
product costs. Auditor’s opinion to exclude it is not reasonable.
(c) Auditor’s opinion amounts to change in accounting policy and as per AS-2, it should be
disclosed.
(d) Lower of cost and minimum of realisable values: Year 2015 – ` 1,650; Year 2016 –
` 2,100]
Answers
1. (d), 2. (c), 3. (c), 4. (c), 5. (a), 6. (c), 7. (d), 8. (b), 9. (b), 10. (b), 11. (b), 12. (c), 13. (c),
14. (c), 15. (a), 16. (b), 17. (d), 18. (b), 19. (b)
3.17 References
1. Accounting Principles Board, Statement No. 14, Basic Concepts and Accounting
Principles Underlying Financial Statements of Business Enterprises, New York: AICPA,
1970, pp. 49-50.
2. The Institute of Chartered Accountants of India, Guidance Note on Terms Used in
Financial Statements, New Delhi: ICAI, September 1983, p. 8.
3. Eldon S. Hendriksen, Accounting Theory, Homewood: Richard D. Irwin, 1984, p. 256.
4. Yuji Ijiri, ibid., p. 88.
5. The Institute of Chartered Accountants of India, AS-6, Depreciation Accounting, New
Delhi: The Institute of Chartered Accountants of India, November 1982, para 3.1.
6. International Accounting Standards Committee, IAS 4, Depreciation Accounting, March
1976.
7. Eldon S. Hendriksen, Accounting Theory, ibid., pp. 268-269
8. Eldon S. Hendriksen, ibid., p. 282.
9. Yuji Ijiri, Theory of Accounting Measurement, ibid., p.96

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Financial Statements: The Balance Sheet I 39

UNIT 3 FINANCIAL STATEMENTS: THE

CU IDOL SELF LEARNING MATERIAL (SLM)

3.0 Learning Objectives

3.2 Characteristics of Assets

CU IDOL SELF LEARNING MATERIAL (SLM)

CU IDOL SELF LEARNING MATERIAL (SLM)

3.3 Objectives of Asset Valuation

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Asset Valuation Concepts

CU IDOL SELF LEARNING MATERIAL (SLM)

CU IDOL SELF LEARNING MATERIAL (SLM)

CU IDOL SELF LEARNING MATERIAL (SLM)

3. Current Exit Price (Net Realisable Value)

CU IDOL SELF LEARNING MATERIAL (SLM)

Evaluation of Valuation Concepts

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An objective of asset valuation from an interpretational point of view is to provide a relative

Lower of Cost or Market (LCM) Rule

CU IDOL SELF LEARNING MATERIAL (SLM)

3.4 Types of Assets

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Plant and Equipment

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Classification of Current Assets

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CU IDOL SELF LEARNING MATERIAL (SLM)

CU IDOL SELF LEARNING MATERIAL (SLM)

Franchises and Licences

CU IDOL SELF LEARNING MATERIAL (SLM)

ACCOUNTING STANDARD (AS) 10

CU IDOL SELF LEARNING MATERIAL (SLM)

CU IDOL SELF LEARNING MATERIAL (SLM)

CU IDOL SELF LEARNING MATERIAL (SLM)

Ind AS-16: Property, Plant and Equipment – Salient Features

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Difference between Finance Lease and Operating Lease

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Ind AS-17: Leases – Main Features

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6. Leases in the Financial Statements of Lessees

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Selling Price = Fair

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Profit or loss equivalent to the

Major Changes in Ind AS-17 vis-a-vis Notified AS-19

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Subject Existing standard Ind AS-17

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(vi) Current/Non-current Classification of Lease Liabilities: Ind AS-17 requires current/non-

3.6 Accounting Problems in Long-term Assets

Fig. 3.1: Accounting Problems of Long-term Assets

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Land 1,00,000 10 85.000 Indefinite

Building 9,00,000 90 7,65.000 30 years

10,00,000 100 8,50.000

CU IDOL SELF LEARNING MATERIAL (SLM)

3.7 Nature of Depreciation