28 COMMON LAPSES / OVERSIGHT MADE IN ACCOUNTING POLICIES

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1 28 COMMON LAPSES / OVERSIGHT MADE IN ACCOUNTING POLICIES AS 1 Disclosure of Accounting Policies Still few enterprises mention in their accounting policy, accounts are prepared on going concern and accounts are maintained on accrual basis. Para 9 of AS 1, categorically states that disclosure is necessary if fundamental accounting assumptions viz. going concern, consistency and accrual are not followed in preparation and presentation of financial statements. Such assumption is not stated specifically as their acceptance and use are assumed. Thus, disclosure is only required to be made in accounting policy or by way of notes to accounts, if any of the three above-referred assumptions are not followed by the enterprise in preparing and presenting the financial statements. Few enterprises don t disclose the policy regarding the timing of recognition of revenue from main source of revenue viz. sales. As sales form important or significant item in the financial statements, disclosure by way of an accounting policy as to when sales is recognised as revenue is required. Few enterprises state in their accounting policy for revenue recognition that sales include excise duty and VAT. Guidance note issued by ICAI on Accounting of state-level Value Added Tax (VAT) states that VAT is collected from customers on behalf of the VAT authorities and therefore should not be recognised as an income of the enterprise. Similarly, payment of VAT should not be treated as an expense in the financial statements of the enterprise. In view of above, VAT collected from customers should be credited to VAT Payable account and should be treated as an item of liability in the balance sheet. Enterprises should not show sales inclusive of VAT but would be advised to follow the abovereferred accounting treatment along with appropriate disclosure stating, Sales is inclusive of excise and net of VAT. AS 2 Valuation of Inventories Few enterprises still mention raw materials, components, stores and spare parts, goodsin-process and by-products are valued at cost. Para 6 of AS 2, requires inventories, to be valued at lower of cost and net realisable value. Meaning thereby, Raw Materials, Components, Work-in-Progress, stores and spares and finished goods should be valued at lower of cost and net realisable value. Whereas Para 10 of AS 2 also states that by-products as well as scrap or waste materials, by their nature are immaterial, and are often measured at net realisable value. Thus, enterprises at the time of disclosing in accounting policies as well as at the time of preparation of the financial statements should consider the above principles of valuation. Few enterprises fail to disclose the cost formula, whereas few enterprises mention finished goods are valued at lower of cost or market value. Para 26 of AS 2 states that the financial statements should disclose the accounting policies adopted in measuring inventories, including the cost formula used. The accounting policies adopted in measuring inventories would mean whether the inventories are valued at lower of cost and net realisable value. Cost formula, in case of items such as raw materials, stores and spares, trading finished goods, etc. would mean valuation worked out on basis of first-in-first out (FIFO) or weighted average. In case of finished goods, cost formula is ascertained on absorption costing.

2 Further, there is a difference between market value and net realisable value. As per AS 2, Net realisable value is the estimated selling price in the ordinary course of business less the estimated cost of completion and the estimated costs necessary to make the sale. Whereas market value is the price at which goods are invoiced not considering the estimated cost of completion and the estimated costs necessary to make the sale. Thus, enterprises may disclose the following accounting policy in the financial statements: Stock of stores and spares, raw and packing materials are valued at lower of cost or net realisable and for this purpose, cost is determined on first-in-first out basis. However, the aforesaid items are not valued below cost if the finished products in which they are used are expected to be sold at or above cost. Work-in-progress and finished goods are valued at lower of cost and net realisable value and for this purpose, cost is determined on absorption costing. By-products are valued at net realisable value. Traded goods are valued at lower of cost or net realisable value. Cost is determined on first in first out basis. AS 3 Cash Flow Statements Certain non-financial enterprises have shown interest paid as cash flow from operating activities whereas interest received as cash flow from financing activities. As per Para 30 of AS 3, cash flow arising from interest paid should be classified as cash flow from financing activities, while interest received should be classified as cash flow from investing activities. Many enterprises show interest paid during the year by adjusting the opening and closing figures of interest accrued and due and interest accrued but not due, as appearing in the balance sheet with interest figure as appearing in profit and loss statement. However, interest as capitalised to fixed assets pursuant to compliance of AS 16, Borrowing costs is ignored in the above exercise. As per Para 31 of the AS 3, the total amount of interest paid during the period is disclosed in the cash flow statement whether it has been recognised as an expense in the statement of profit and loss or capitalised in accordance with AS 16, Borrowing costs. Thus, interest capitalised to fixed assets should be shown under interest payments as cash flow from financing activities, whereas fixed assets paid for and not purchased (net of interest payments which are capitalised) should be shown as cash flow from investing activities. Many enterprises merely disclose the cash and cash equivalents of the beginning and closing period to complete the cash flow statement. As per Para 42 of AS 3, an enterprise should disclose the components of cash and cash equivalents and should present a reconciliation of the amounts of its cash flow statement with the equivalent items reported in the balance sheet. Para 45 of AS 3, further state that the enterprise should also disclose, the amount of significant cash and cash equivalent balances held by the enterprise that are not available for use by it. In view of above two paragraphs, more particularly Para 45, cash and cash equivalent balances will also have bank fixed deposits which are pledged or offered as lien to bank or will have unpaid dividend account in bank balance which is not available for use by it except payment to unclaimed dividend shareholders. Hence, enterprises at the time of disclosing the break-up of cash and cash equivalents should also disclose the amount held by the enterprise that are not available for use by it. Unlisted companies, which are a Level I enterprise are required to prepare and present Cash Flow Statements.

3 Though Cash Flow from operating activities is prepared as per indirect method, many of the enterprises don t disclose as per which method Cash Flow Statement is prepared in their financial statements? Para 18 of AS 3, states enterprise should report cash flow from operating activities using either: (a) (b) the direct method or the indirect method. It may be worthwhile to mention here that stock exchange listed enterprises by virtue of clause 32 of the listing agreement are required to prepare and present cash flow statement in their financial statements using only indirect method. Hence, it has become a habit or a practice in the corporate sector to prepare cash flow statement as per indirect method. However, the method used in preparing cash flow statement needs to be disclosed, as AS 3 permits two methods i.e. direct and indirect method. AS 5 Net profit or loss for the period, prior period items and changes in Accounting Policies. Few enterprises are still terming profit / loss on sale of fixed assets or investments, restructuring activities such as voluntary retirement benefits, litigation settlements, etc. as extraordinary items. Thus, profit or loss is shown before extraordinary items and after extraordinary items after considering the above items as extraordinary items. Para 12 under the heading Profit or loss from ordinary activities of AS 5, reads: when items of income and expense within profit or loss from ordinary activities are of such size, nature or incidence that their disclosure is relevant to explain the performance of the enterprise for the period, the nature and amount of such items should be disclosed separately. Such non-recurring or exceptional items should not be called extraordinary items. An enterprise could do well to disclose at the most profit / loss before exceptional items, deduct such aforelisted items stating them as exceptional / non-recurring items and then show profit / loss after exceptional items. Alternatively, such items may be considered in the profit and loss statement with a separate disclosure in the income and expense as stated in Para 12 of the AS 5. Few enterprise disclose prior period items in their profit and loss account but fail to mention the nature of these items either in the schedules or in the notes. Para 15 of AS 5 reads The nature and amount of prior period items should be separately disclosed in the statement of profit and loss in a manner that their impact on the current profit or loss can be perceived. Thus AS 5, not only requires prior period item to be disclosed separately but the nature should also be disclosed. However, the materiality concept can also be considered while disclosing the nature of the expense. If insignificant amounts of various account heads constitute prior period items, merely disclosing amount of prior period items should be sufficient compliance of the AS 5. AS 6 Depreciation Few enterprises adjust the excess depreciation arising due to revaluation of fixed assets directly against the revaluation reserves, without routing it through the profit and loss statement. Depreciation on fixed assets (including the portion arising due the revaluation) is an item of expense and accordingly as per the provisions of Companies Act, 1956, AS 6 and AS 10 is required to be charged to the profit and loss statement. Charging only net depreciation to profit and loss statement would also amount to violation of AS 5.

4 AS 9 Revenue Recognition Few enterprises have not deducted excise duty from the amount of sales on the face of the profit and loss statement. The same has either been shown as expense or as deduction from sales in a schedule. The ICAI has issued ASI 14, in March 2004, for AS 9, revenue recognition, whereby amount of turnover is required to be disclosed on the face of the statement of profit and loss statement as under: Turnover (Gross) Less: Excise Duty Turnover (Net) XX XX ---- XX The above ASI 14, has further been improvised by issuing revised ASI 14, as a result the amount of excise duty to be shown as deduction from turnover should be the total excise duty for the year except the excise duty related to the difference between the closing stock and opening stock. The excise duty related to the difference between the closing stock and opening stock should be recognised separately in the statement of profit and loss, with an explanatory note in the notes to accounts to explain the nature of the two amounts of excise duty. AS 11 Accounting for the effects of changes in foreign exchange rates. Few enterprises have not disclosed the amount of exchange differences included in the net profit or loss for the period. Para 40(a) of AS 11, which deals with disclosure, reads as under. An enterprise should disclose, the amount of exchange differences included in the net profit or loss for the period. Thus, not disclosing basic requirement of AS 11 would also constitute non-compliance of AS11. Many enterprises have mentioned current assets and current liabilities denominated in foreign currency on the balance sheet date have been converted at the exchange rates prevailing at the year end. This is not in conformity with Para 11 of the AS 11. As per Para 11(a), monetary items such as cash, receivables and payables (and not current assets and current liabilities) should be reported using the closing rate. Whereas, as per Para 11(b) & (c) non-monetary items such as fixed assets, inventories and investments in equity are carried in terms of historical cost or at fair values if determined in accordance with the relevant accounting standard. From above, it is clear that usages of terminology current assets and current liabilities and monetary assets and non-monetary assets have very different meanings. It may be mentioned that the policy followed by the enterprise stating current assets and current liabilities may give differing results since certain items such as inventory, etc. form part of current assets but not of monetary assets. Thus, enterprise should be careful in selecting the terminology / words used in the accounting policies. Most of the enterprises have used the following sentence as part of their accounting policy in relation to foreign exchange transactions: Any income or expense on account of exchange difference either on settlement or on translation is recognised in the profit and loss account except in cases where they relate to acquisition of fixed assets in which they are adjusted to the carrying cost of such assets. As per schedule VI of the Companies Act, 1956, only exchange differences arising on repayment of liability for any fixed asset acquired out of India from foreign currency loan can only be adjusted to the cost of fixed asset. Meaning thereby, after , if any fixed asset is acquired from India in respect of foreign currency loan, then any exchange difference arising on repayment of liability for such fixed asset is to be recognised in profit and loss statement and cannot be adjusted to the cost of fixed asset.

5 However, as stated earlier MOST of the enterprises still continue to follow old AS 11 and not revised AS 11. However, it is not so that no enterprise is following the revised AS 11. Tata Motors and Tata Steel are found to have followed the revised AS 11, while disclosing the accounting policy under the head foreign currency transactions. The correct accounting policy in reference to above context can be spelled out as under: Exchange difference arising on settlement or translation are recognised as income or expense in the year in which they arise except in respect of liabilities incurred for acquisition of fixed assets from a country outside India and liabilities incurred prior to , where such exchange difference is adjusted in the carrying cost of fixed assets. AS 13 Accounting for Investments Few enterprises are mentioning in their accounting policies for investments: Provision is being made for any permanent diminution in the value of long-term investments. As per Para 17 of AS 13, Accounting for Investments, Long-term investments are carried at cost. However, when there is a decline, other than temporary, in the value of a long-term investment, the carrying amount is reduced to recognise the decline. It may be noted that there is a difference between Permanent diminution in the value of investment and other than temporary diminution in value of investments. Normally, no diminution in value of investments may be termed as permanent. The use of the word permanent than other than temporary is of a higher degree, meaning thereby no provision is made for diminution in value of investment other than temporary unless it is permanent. Enterprises should refrain from using words which connote a different meaning than what is contemplated by the AS, resulting in a non-compliance of the provisions of AS. Few enterprises have merely mentioned, Investments are valued at cost in their accounting policy. As per AS 13, Investments are to be classified as current and long-term investments. Longterm investments should be carried at cost. However, provision for diminution is required to be made to recognise a decline, other than temporary, in the value of investment. Such reduction is determined on an individual investment basis. Investments classified, as current investments should be carried in the financial statements at the lower of cost and fair value determined either on individual investment basis or by category of investment but not on overall (or global) basis. Thus, enterprise should not only classify investments into current and long term investments but should also spell out how each category of investment is carried in the financial statements. AS 17 Segment Reporting Few of the enterprises, have not disclosed segment reporting or mentioned any note as to reason why segment reporting as required under AS 17 is not disclosed. The ICAI has issued ASI 20, in 2005, where in it is concluded that if there is neither more than one business segment nor more than one geographical segment, than segment information as per AS 17 is not required to be disclosed. However, the fact that there is only one business segment and geographical segment should be disclosed by way of note in the financial statements. (a) Most of the enterprises, which prepare consolidated financial statements, give segment information in both, separate financial statements of the parent as well as in consolidated financial segment. (b) Few enterprises are giving information in segment reporting which are not reconciled with figures appearing in profit and loss statement and balance-sheet.

6 (a) Para 4 of AS 17, reads : If a single financial report contains both consolidated financial statements and the separate financial statements of the parent, segment information need be presented only on the basis of the consolidated financial statements. In the context of reporting of segment information in consolidated financial statements, the reference in this statement to any financial statement items should construed to be the relevant item as appearing in the consolidated financial statements. Most of the companies are disclosing segment information in both, in standalone results and consolidated financial statements. However, Reliance Industries Ltd. is a company, which is showing segment information only in consolidated financial statement, with an appropriate disclosure note in the separate financial statement. (b) Para 46 of AS 17 reads : An enterprise should present a reconciliation between the information disclosed for reportable segments and the aggregated information in the enterprise financial statements. In presenting the reconciliation, segment revenue should be reconciled to enterprise revenue, segment result should be reconciled to enterprise net profit or loss, segment assets should be reconciled to enterprise assets, and segment liabilities should be reconciled to enterprise liabilities. In view of above Para, enterprises are required to reconcile the figures as given in segment reporting with that as appearing in profit and loss statement and balance sheet, in respect of sales, net profit, liabilities and assets. AS 19 Leases It has been observed in case of many listed enterprises, in spite of the fact that they have taken vehicles on hire purchase agreements or taken premises on rent, no disclosure as required by AS 19 is made in the financial statements. As per Para 4 of AS 19, The definition of a lease includes agreements for the hire of an asset which contains a provision giving the hirer an option to acquire title to the asset upon the fulfillment of agreed conditions. All hire purchase agreements are covered under AS 19. Similarly, if premises are taken on rent, it would amount to taking assets on operating lease, and disclosures as per Para 25 of AS 19 is required to be made in the financial statements. In view of peculiarity in nature of rent agreements, an accounting policy as narrated hereunder may be disclosed in notes to accounts : (i) (ii) (iii) The company has taken various residential, office and godown premises under operating lease or leave and license agreements. These are generally not noncancellable and range between 11 months and 3 years under leave and licence or longer for other leases and are renewable by mutual consent on mutually agreeable terms. The company has given refundable interest free security deposit under certain agreements. Lease payments are recognised in the profit and loss account under Rent in schedule X. The future minimum lease payments under non-cancellable operating lease - not later than one year Rs.xxx (P.Y. Rs.xxx) - later than one year and not later than five years Rs.xxx (P.Y. Rs.xxx) It is worthwhile to mention here that, if the enterprise is not a Level I enterprise, disclosure as required by Para 25(a), (b) and (e) of AS 19, is not required to be made. However, such fact of non-disclosure should be made in the financial statements.

7 AS 20 Earnings per Share Many enterprises have disclosed earnings per share in the statement given pursuant to part IV of schedule VI to the Companies Act, As per ASI 12, issued by the ICAI in 2004, every company which is required to give information under part IV of schedule VI to the Companies Act, 1956 should calculate and disclose earnings per share in accordance with AS 20. Further, on and after , if an enterprise is not a Level I enterprise, than it need not disclose diluted earnings per share and information required by Para 48(ii) of the AS. From the above, it is clear that if an enterprise is not a listed, or is not a bank or financial institution or is not into insurance business or not having turnover in excess of Rs.50 crores or has no borrowings including public deposits in excess of Rs.10 crores at any time during the accounting period or is not a holding or subsidiary of any of the above stated at any time during the accounting period, than in that case the enterprise should disclose only the basic earnings per share on the face of statement of profit and loss account and is not required to disclose diluted earnings per share or the information required by Para 48(ii) of the AS. AS 22 Accounting for taxes on Income Few enterprises disclose advance income tax and provision for taxation both being component of current tax separately in balance sheet. Advance income tax is shown under loans and advances, whereas provision for taxation is shown under provisions. Thus, both figures are grossed-up and shown under respective heads. As per Para 27 of AS 22, an enterprise should offset assets and liabilities representing current tax if the enterprise: (a) (b) has a legally enforceable right to set-off the recognised amounts and intends to settle the asset and the liability on a net basis. Keeping above in view, the enterprise should offset advance income tax against provision for taxation and show only the net amount in the balance sheet. Disclosing two amounts separately is contrary to AS 22. Certain enterprises don t disclose the break-up of deferred tax in the notes to accounts. Para 31 of AS 22 reads, The break-up of deferred tax assets and deferred tax liabilities into major components of the respective balances should be disclosed in the note to accounts. Thus, it is imperative that break-up of deferred tax assets and deferred tax liabilities into major components should be disclosed in the notes to financial statements. Some enterprises, having unabsorbed depreciation or carry forward losses under the Income-tax laws have mentioned in their accounting policies that DTA is recognised and carried forward only to the extent that there is reasonable certainty that the asset will be adjusted in future. Para 17 of AS 22 states Where an enterprise has unabsorbed depreciation or carry forward of losses under tax laws, deferred tax assets should be recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realised. Para 32 further states, the nature of evidence supporting the recognition of deferred tax asset should be disclosed, if an enterprise has unabsorbed depreciation or carry forward of losses under tax laws. Thus, from above Paras it is seen that not only virtual certainty supported by convincing evidence that sufficient future taxable income will be available against creation of DTA is required to be ascertained and disclosed but also the nature of evidence supporting the recognition of such deferred tax assets is also required to be disclosed. Readers attention is further also drawn to ASI 9, issued by ICAI in this context.

8 AS 26 Intangible Assets Certain companies are showing technical know-how, computer software, trademarks, etc. as a normal item of fixed assets along with other tangible fixed assets. As per Para 90 of AS 26, Intangible Assets, the financial statements should disclose the following for each class of intangible assets, distinguishing between internally generated intangible asset and other intangible assets. Enterprises, if they have trademark, technical know-how, computer software etc., should depict them under the head Intangible assets. Not only that, as per Para 90, enterprises are required to disclose whether they are internally generated or not. AS 29 Provisions, Contingent Liabilities and Contingent Assets Few enterprises mentioned that the liability in respect of warranty cost is recognised in the year in which the claim actually arises i.e. no provision is being created for warranties given on products sold during the year, the claim in respect of which may arise in future. Not creating any provision, for warranties given on the products sold, the claim in respect of which may arise in future is contrary to the accrual basis of accounting which is a requirement under the Companies Act, 1956, AS 4, as well as AS 29, Provisions, contingent liabilities and contingent assets. Enterprises should, based on their past experience and future estimates make a provision for such warranties and do not account for them on claim basis i.e. cash basis. Enterprises have started making provisions for warranties and other provisions pursuant to requirement of AS 29. However, many of these enterprises have either not given details as required by Para 66, or if given details as per Para 66 than have not given details as required by Para 67. Para 66 and 67 of the AS 29, Provisions, Contingent liabilities and Contingent assets requires an enterprise to disclose, in respect of provisions; (i) (a) Carrying amount at the beginning and at the end (b) (c) (d) additional provisions made during the period; amount used during the period, unused amounts reversed during the period. (ii) (a) a brief description of the nature of the obligation and the expected timing of any resulting outflow of economic benefits (b) an indication of the uncertainties about these outflows As seen from above, enterprises, should not only disclose movements for provisions but are one also required to disclose the expected timing of the payment for these provisions. Also for contingent liabilities, Para 68 of AS 29 states that whenever practicable, enterprise should also disclose an indication of the uncertainties relating to any outflow.

9 Balance Sheet of Life Opening balance : Birth Closing balance : Death Fixed Asset : Soul Fixed Depoist : Brain Current Asset : Heart Current Account : Idea Capital : Achievement Inventories : Character General Reserve : Friend Good will : Behaviour Interest accrued : Patience Dividend : Love Bonus issue : Children Patents : Education Investment : Wisdom Experience : Premium A/c. The Aim should be to Tally the Balance Sheet Accurately, and The Goal should be to get the Best Presented Accounts Award.