ACCOUNTING THEORY AND PRACTICE PROFESSOR JAWAHAR LAL Formerly Head, Department of Commerce, Formerly Dean, Faculty of Commerce and Business, Department of Commerce, Delhi School of Economics, University of Delhi, DELHI. Fourth Revised Edition 2017 ISO 9001:2008 CERTIFIED © AUTHOR No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the publisher. Third Edition : 2009 Edition : 2011, 2012, 2013, 2014, 2015, 2016 Fourth Revised Edition : 2017 Published by : Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd., “Ramdoot”, Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004. Phone: 022-23860170/23863863, Fax: 022-23877178 E-mail: [email protected]; Website: www.himpub.com Branch Offices : New Delhi : “Pooja Apartments”, 4-B, Murari Lal Street, Ansari Road, Darya Ganj, New Delhi - 110 002. Phone: 011-23270392, 23278631; Fax: 011-23256286 Nagpur : Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur - 440 018. Phone: 0712-2738731, 3296733; Telefax: 0712-2721216 Bengaluru : Plot No. 91-33, 2nd Main Road Seshadripuram, Behind Nataraja Theatre, Bengaluru - 560020. Phone: 08041138821, Mobile: 09379847017, 09379847005. Hyderabad : No. 3-4-184, Lingampally, Besides Raghavendra Swamy Matham, Kachiguda, Hyderabad - 500 027. Phone: 040-27560041, 27550139 Chennai : New No. 48/2, Old No. 28/2, Ground Floor, Sarangapani Street, T. Nagar, Chennai - 600 012. Mobile: 09380460419 Pune : First Floor, “Laksha” Apartment, No. 527, Mehunpura, Shaniwarpeth (Near Prabhat Theatre), Pune - 411 030. Phone: 020-24496323/24496333; Mobile: 09370579333 Lucknow : House No 731, Shekhupura Colony, Near B.D. Convent School, Aliganj, Lucknow - 226 022. Phone: 0522-4012353; Mobile: 09307501549 Ahmedabad : 114, “SHAIL”, 1st Floor, Opp. Madhu Sudan House, C.G. Road, Navrang Pura, Ahmedabad - 380 009. Phone: 079-26560126; Mobile: 09377088847 Ernakulam : 39/176 (New No: 60/251) 1st Floor, Karikkamuri Road, Ernakulam, Kochi – 682011. Phone: 0484-2378012, 2378016 Mobile: 09387122121 Bhubaneswar : 5 Station Square, Bhubaneswar - 751 001 (Odisha). Phone: 0674-2532129, Mobile: 09338746007 Kolkata : 108/4, Beliaghata Main Road, Near ID Hospital, Opp. SBI Bank, Kolkata - 700 010, Phone: 033-32449649, Mobile: 07439040301 DTP by : Prerana Enterprises, Mumbai. Printed at : Geetanjali Press Pvt. Ltd., Nagpur. On behalf of HPH. ACCOUNTING THEORY AND PRACTICE Dedicated to the Sacred Memory of My Parents PREFACE To the Fourth Edition It is my esteemed pleasure to place the fourth edition of the book, Accounting Theory and Practice, among the students and other readers. The earlier edition of the book has been highly appreciated by the students and the academic community. This fact has further inspired me to make the revised edition a highly valuable and student-friendly text. Accounting Theory and Practice is intended to provide students with a contemporary and comprehensive course of study in accounting theory and practice. Financial accounting and theory has been in a constant state of evolution and many developments have taken place in this vital discipline. It is also true that without proper understanding of the subject of accounting theory, one will have difficulty in understanding and resolving accounting issues and problems and formulating useful accounting theory to improve financial accounting and reporting. Many efforts have been made to construct accounting theory and to develop a single generally accepted accounting theory. But these attempts are based on different assumptions and methodologies. A universally accepted accounting theory would contribute greatly in the development of accounting principles and standards. There is also a need to develop adequate knowledge about different elements of financial statements and their recognition and measurement and emerging significant issues in the area of accounting theory and practice. The text, Accounting Theory and Practice, discusses thoroughly principal approaches in accounting theory construction; accounting postulates, concepts, and principles; elements of financial statements; accounting standards setting; global convergence and international financial reporting standards; emerging issues of importance in accounting and reporting practices; cash flow statement. The book is divided into five parts consisting of twenty five chapters. Part One: Fundamentals has three chapters—Accounting: An Overview; Accounting Postulates, Concepts and Principles; Accounting Theory: Formulation and Classifications. Part Two: Elements of Financial Statements has seven chapters and focuses on Income Concepts; Revenues, Expenses, Gains and Losses; Assets; Liabilities and Equity; Depreciation Accounting and Policy; Inventory; Accounting and Reporting of Intangibles. Part Three: Accounting Standards deals with Accounting Standards Setting; Global Convergence and International Financial Reporting Standards. Part Four: Corporate Financial Reporting has twelve chapters and presents discussion on some financial reporting issues. The issues covered are Financial Reporting: An Overview; Conceptual Framework; Accounting for Changing Prices; Fair Value Measurement; Segment Reporting; Interim Reporting; Human Resource Accounting; Corporate Social Reporting; Value Added Reporting; Environmental Accounting and Reporting Financial Reporting in Not-for-profit Organizations and Foreign Currency Translation. Part Five: Specialized Topics focuses on Cash Flow Statement. The materials and discussion in the book have been presented in a highly organised and lucid manner and the book provides a clear and detailed analysis of the concepts, approaches, issues and developments in the area of accounting theory. Illustrations have been given about Indian Corporate Practices in some chapters of the book. ‘Corporate Insight’ and ‘Research Insight’ have been given to focus on relevant corporate news and research evidences. Thought provoking, real life questions and multiple choice questions have been given at the end of the chapters. The book will be very useful for M.Com., M.B.A., M. Phil and Ph.D., students of Indian Universities and Management Institutes. The book will also be useful to those who are preparing for professional accounting examinations and who wish to update their knowledge with current accounting issues and research. I am grateful to my friends and colleagues who have provided useful suggestions and comments in the course of writing this book. I owe a special gratitude to my family for showing great patience and understanding during the entire process of completing this project. PROFESSOR JAWAHAR LAL BRIEF CONTENTS Pages Preface to the Fourth Edition PART ONE : FUNDAMENTALS Chapter 1 – Accounting : An Overview......................................................................................................3-17 Chapter 2 – Accounting Postulates, Concepts and Principles...................................................................18-35 Chapter 3 – Accounting Theory : Formulation and Classifications ...........................................................36-55 PART TWO : ELEMENTS OF FINANCIAL STATEMENTS Chapter 4 – Income Concepts...................................................................................................................59-85 Chapter 5 – Revenues, Expenses, Gains and Losses..............................................................................86-100 Chapter 6 – Assets ................................................................................................................................101-132 Chapter 7 – Liabilities and Equity..........................................................................................................133-143 Chapter 8 – Depreciation Accounting and Policy .................................................................................144-159 Chapter 9 – Inventory............................................................................................................................160-189 Chapter 10 – Accounting and Reporting of Intangibles ..........................................................................190-197 PART THREE : ACCOUNTING STANDARDS Chapter 11 – Accounting Standards Setting............................................................................................201-226 Chapter 12 – Global Convergence and International Financial Reporting Standards (IFRSs) ...............227-253 PART FOUR : CORPORATE FINANCIAL REPORTING Chapter 13 – Financial Reporting : An Overview...................................................................................257-297 Chapter 14 – Conceptual Framework.....................................................................................................298-326 Chapter 15 – Accounting for Changing Prices........................................................................................327-374 Chapter 16 – Fair Value Measurement ...................................................................................................375-389 Chapter 17 – Segment Reporting ............................................................................................................390-419 Chapter 18 – Interim Reporting...............................................................................................................420-437 Chapter 19 – Human Resource Accounting............................................................................................438-450 Chapter 20 – Corporate Social Reporting ...............................................................................................451-464 Chapter 21 – Value Added Reporting......................................................................................................465-482 Chapter 22 – Environmental Accounting and Reporting.........................................................................483-500 Chapter 23 – Financial Reporting in Not-for-profit Organizations..........................................................501-507 Chapter 24 – Foreign Currency Translation............................................................................................508-514 PART FIVE : SPECIALIZED TOPICS Chapter 25 – Cash Flow Statement ........................................................................................................517-563 12345678901234567890123456789012123456789012345678901234567890121234567890123456789012345678901212 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12345678901234567890123456789012123456789012345678901234567890121234567890123456789012345678901212 12345678901234567890123456789012123456789012345678901234567890121234567890123456789012345678901212 (1) C 1 HAPTER Accounting : An Overview EVOLUTION OF ACCOUNTING one that has a high degree of freedom at the individual level and typically evidences an effective commitment to measuring the Accounting has evolved and emerged, as have medicine, quality of life attained. These characteristics make it essential law, and most other fields of human activity, in response to the that the members of that society, be provided adequate, social and economic needs of society. Bookkeeping and understandable, and dependable financial information from the Accounting appeared not as a chance phenomenon, but distinctly major institutions that comprise it.” in response to a world need.1 This is true not only of the days of Paciolo2 but also important for presentday accounting survival. Profit calculation now is no longer a simple comparison of Sieveking, one of the few historians who have paid attention to financial values at the beginning and end of a transaction or series the subject, says that bookkeeping developed as a direct result of transactions. It is now related to a complex set of allocations of the establishment of partnership on a large scale. and valuations pertaining to the operational activities of a business enterprise. The concept of accountancy or accounting is now For centuries after the system of double entry bookkeeping broader to include the description of the recording, processing, appeared, accounting was without methodology or any form of classifying, evaluating, interpreting and supplying of economic theory. It was during the nineteenth century that a move from financial information for financial statement presentation and bookkeeping to accounting—a move away from the relatively decision making purposes. In its tasks, accounting has been simple recording and analysis of transactions toward a successful technically and methodologically. comprehensive accounting information system—was seen. The end of the nineteenth century was marked by the most Refinements in cost and management accounting came later extraordinary expansion of the business. Company form of in the twentieth century along with large-scale production and organisation, a phenomenon common in business world, grew at high capital investment. These developments created a need to a great speed. Books about business transactions were written, allocate costs correctly over the units of production, and also to conventions were followed and accounting was recognised as a provide a measure of productivity and efficiency. Thereafter, cost system of analysing and maintaining record about business accounting evolved naturally to meet recognized managerial transactions. In part, the new significance of accounting gained requirements of pricing and costing for competitive purposes, recognition because of separation between ownership and control and to the determination and setting forth of operational and also due to diversification in ownership. The increased information for decision making purposes. reliance on capital as a factor of production necessitated extensive Traditionally, government accounting was linked to taxation record keeping but, finally, in the nineteenth century, a theoretical and revenue control, and to the recording of and accountability framework began to develop. This framework or methodology for receipts and expenditures. The twentieth century development provided a technical means to measure, evaluate, and in budgeting gave a much larger scope to the area of government communicate information of an economic and financial nature. accounting. The budget became a managerial and policy-making Modern business has continuity—never-ending flow of instrument and developed into a mechanism for the forward economic activities. Therefore, accounting has grown to meet a planning of receipts and expenditures. Budgeting nowadays has social requirement and to guide the business and industry developed in such a manner that it forms one of the bases of, and accordingly. Accounting is moving away from its traditional is closely associated with economic planning and programming. procedural base, encompassing record keeping and such related The use of enterprise accounting for the purpose of macro work as the preparation of budgets and final accounts, towards (economic or national) accounting is largely a development of the adoption of a role which emphasises its social importance. this century. For purpose of economic policy and economic Welsch and Anthony3 comment: planning, these national data—to a large extent derived from “The growth of business organisations in size, particularly commercial data—have become of great importance. They have publicly-held corporation, has brought pressure from given rise to a new concept of macro accounting which has stockholders, potential investors, creditors, governmental presented the professional with a new sphere of operations and agencies, and the public at large, for increased financial disclosure. perspective. Macro accounting has particular importance in The public’s right to know more about organisations that directly helping to build the bridge between economics and accounting, and indirectly affect them (whether or not they are shareholders) and thus offers accounting significant scope to make a contribution is being increasingly recognised as essential. An open society is towards macroeconomic policy.4 (3) 4 Accounting Theory and Practice Accounting, thus, has gone through many phases: simple Goldberg8 has looked at the purpose of accounting as to double entry bookkeeping, enterprise, government, and cost and examine and understand the relationships which make up the management accounting and recently towards social accounting. social environment. He explains as follow: These phases have been largely a product of changing economic “What, ultimately, is the objective in accounting: Or, more and social environments. As business and society have become properly perhaps, is there discernible a teleological purpose to more complex over the years, accounting has developed new which the main recognized functions of accountants as concepts and techniques to meet the ever increasing needs for accountants are directed, whether implicitly or explicitly ? One financial information. Without such information, many complex possible answer is that it is control. But control of what ? Since economic developments and social and economic programmes the subject matter of the accounting processes is the activities of might never have been undertaken. human beings, it may seem logical to say that it is control of human beings in some of their activities, in relation, say, to DEFINITION OF ACCOUNTING resources of various kinds. But this may be open to misunderstanding. Some people may, indeed, use the results of What is accounting? This basic question has never been the accounting processes to impose control over the activities of answered precisely and many definitions of the term ‘accounting’ other people. But this attitude may seem unsavoury to some people are available. who might argue that it is a misuse of accounting rather than its Back in 1941, The Committee on Terminology of the use to make it an instrument of control over human beings. To American Institute of Certified Public Accountants (AICPA) such people it may be more consonant with egalitarian views to formulated the following definition,5 which was widely quoted say that the accounting processes enable people to show others for many years: with whom they have dealings, especially, for example, employees and managers, how control over resources may be attained. But “Accounting is the art of recording, classifying and what does control over resources means if it does not mean at summarising in a significant manner and in terms of money, least exerting some strong influence over the activities of some transactions and events which are, in part at least, of a financial people who have access to or influence over the use or location character, and interpreting the results thereof.” or movement of the resources in question? And, since resources In 1966, The American Accounting Association (AAA), in of all kinds come from materials and forces of nature, would it order to emphasise the broader perspective of accounting, be too much to say that the ultimate object of accounting is to provided the following definition of accounting:6 help people to control materials, or, in generalization, to help “Accounting is the process of identifying, measuring and man to control and/or manage the physical environment in which communicating economic information to permit informed the species is placed? judgements and decisions by users of the information.” But it may be claimed that man has a social environment also. The role of accounting here is not so much to enable people More recently, in 1970, the AICPA of USA defined to control their social environment. We should recognize that each accounting with reference to the concept of information:7 human being has a social environment composed of people. With “Accounting is a service activity. Its function is to provide this in mind, we could say that the purpose of accounting here is quantitative information primarily financial in nature about to assist people to examine and understand the relationships which economic activities that is intended to be useful in making make up this social environment. Hence, we might say that the economic decisions.” fundamental purpose of accounting – in this broad, social sense The term, ‘quantitative information’ used in the above – is to help all human beings to understand and live at peace with definition is wider in scope than financial or economic their social environment. information. Both the definitions, AAA (1966), and AICPA (1970) In recent years, however, it has become clear to many people emphasise on using the information for the purposes of decision that some parts of our natural environment cannot endure making. The modern accounting, therefore, is not merely concerned prolonged ‘control’ and continued exploitation without becoming with record keeping but also with a whole range of activities impaired, that is, without undergoing reactions which are involving planning, control, decision making, problem solving, inhospitable to humans, and indeed, to other species of life. Hence, performance measurement and evaluation, coordinating and it might be even more appropriate to say that the purpose of directing, auditing, tax determination and planning, cost and accounting in carrying out their accounting functions should be management accounting. to help people to examine and understand both their natural and their social environment so that they may live in peace with both. Both, managers within an organisation and interested outside Perhaps another way of putting it is this: By communicating parties use accounting information in making decisions that affect to others information resulting from an honest ‘dealing with’, the organisation. The today’s accounting focuses on the ultimate accountants seek to elicit the cooperation of all recognizable needs of those, who use accounting information, whether these parties within the community concerned with or affected by the users are inside or outside the business itself. control of resources, in attaining a consensually acceptable allocation and use of those resources.9” Accounting : An Overview 5 Others have also given their definitions of accounting, but consist of random sets of elements but elements which may be none has succeeded in clearly establishing the nature and scope identified as belonging together because of a common goal. A of accounting. Each definition has merit in that it describes system contains three activities: (i) input, (ii) processing of input, essentially what accountants do, but the boundaries are fuzzy.* and (iii) output. A business organisation is regarded as an open Of the several available definitions of accounting, the one system which has a dynamic interplay with its environment from developed by American Accounting Association Committee is which it draws resources and to which it consigns its product perhaps the best because of its focus on accounting as an aid to and services. decision making.10 Accounting comprises a series of activities linked together among themselves. The accounting activities form a progression ACCOUNTING AND BOOKKEEPING of steps, beginning with observing, then collecting, recording, Bookkeeping should be distinguished from accounting which analysing and finally communicating information to its users. In has been defined clearly above. Bookkeeping is a process of other words, accounting process involves the accumulation, accounting concerned merely with recording transactions and analysis, measurement, interpretation, classification, and keeping records. Bookkeeping is a small and simple part of summarisation of the results of each of the many business accounting. Bookkeeping is mechanical and repetitive while transaction that affected the entity during the year. After this dealing with business transactions. processing, accounting then transmits or projects messages to potential decision makers. The messages are in the form of financial Accounting, on the other hand, aims at designing a statements, and the decision makers are the users. Accounting satisfactory information system which may fulfill informational generally does not generate the basic information (raw financial needs of different users and decision makers. It primarily focuses data) rather the raw financial data result from the day to day on measurement, analysis, interpretation and use of information. transactions of the enterprise. It highlights the relevance and relationship of the information produced by the accounting process and effects of different As an information system, accounting links an information accounting alternatives. It includes budgeting, strategic planning, source or transmitter (generally the accountant), a channel of cost analysis, auditing, income tax preparation, performance communication (generally the financial statements) and a set of measurement, evaluation, control, preparing managerial reports receivers (external users). When accounting is looked upon as a for decision making, etc. process of communication, it is defined as “the process’ of encoding observations in the language of the accounting system, ACCOUNTING AS AN INFORMATION of manipulating the signs and statements of the systems and decoding and transmitting the result.”11 SYSTEM Figure 1.1 displays how accounting as an information system The term ‘system’ may be defined as a set of elements which helps in business and economic decisions made by userdecision operate together in order to attain a goal. A system does not makers. In this service activity, as shown in Fig. 1.1, accounting Accounting Decision Makers s d e e n N o n ati o m mati for or In f n I Business Recording of Processing of Communication Activities and Data Measuring Data (Preparation (As Financial Statements, Transactions Business and Storage Other Statements Transactions of Data) and Reports) Fig. 1.1: Accounting as an Information System in Business and Economic Decisions. *“A good definition, besides providing a description so that people have an understanding of what the object is, should establish clear cut boundaries. Any object that falls within the boundaries of the set is identified as a member of the set and any object that falls outside is then not a member of the set”— Vernon Kam, Accounting Theory, John Wiley and Sons, 1990, p. 33