FINANCIAL ACCOUNTING
A Managerial Perspective
R. Narayanaswamy
Indian Institute of Management Bangalore
Delhi-110092
2014
FINANCIAL ACCOUNTING: A Managerial Perspective, Fifth Edition
R. Narayanaswamy
© 2014 by PHI Learning Private Limited, Delhi. All rights reserved. No part of this book may be reproduced in any
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ISBN-978-81-203-4949-0
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Twenty-second Printing (Fifth Edition)..........................…..........................…..........................April, 2014
Published by Asoke K. Ghosh, PHI Learning Private Limited, Rimjhim House, 111, Patparganj Industrial Estate,
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Haryana.
To
My Family and My Students
Introduction........1
Interview with Mr. N. R. Narayana Murthy, Infosys Limited........5
Part One
THE BASIC ACCOUNTING MODEL
1. Accounting, Markets, and Governance
Walking on Eggshells........11
The Chapter in a Nutshell........11
Understanding Business Organizations........12
What is Accounting........14
Users of Accounting Information........16
Financial and Management Accounting........22
Accounting Measurement Assumptions........22
Generally Accepted Accounting Principles and the Accounting Environment........25
Forms of Business Organization........29
Accounting, Capital Market, and Corporate Governance........33
The Accounting Equation........36
Financial Statements........42
What do Accountants Do?........45
Accounting as an Academic Discipline........50
Fraud and Ethical Issues in Accounting........50
Looking Back........52
Review Problem........53
Assignment Material........55
2. Processing Transactions
Does Microsoft Tick all the Right Boxes?........63
The Chapter in a Nutshell........63
Accounts........64
Commonly Used Accounts........65
The Double-entry System: The Basis of Modern Accounting........68
Comprehensive Illustration: Fashion Concepts Company........71
Recording Transactions........80
Trial Balance........83
Looking Back........87
Review Problem........88
Assignment Material........91
3. Measuring Income
How much does that Car Cost?........104
The Chapter in a Nutshell........104
Income Measurement........105
Accrual Accounting........107
The Adjustment Process: Converting Cash into Accrual........111
Adjusting Entries........112
Worksheet: The Accountant’s Invaluable Tool........120
Using the Worksheet........128
Overview of the Accounting Cycle........130
Closing Entries........132
Post-closing Trial Balance........137
Reversing Entries........138
Pro Forma Financial Measures ........141
Looking Back........142
Review Problem........142
Assignment Material........146
4. Accounting for Merchandising Transactions
Phantom Sales........163
The Chapter in a Nutshell........163
Income Measurement for a Merchandising Organization........164
Revenue from Sales........165
Cost of Goods Sold........171
Operating Expenses........175
Worksheet for a Merchandising Organization........176
Financial Statements........180
Looking Back........184
Review Problem........185
Assignment Material........186
Comprehensive Case 1........199
Interview with Mr. Prabhakar Kalavacherla, International Accounting Standards
Board........203
Part Two
MEASURING AND REPORTING ASSETS, LIABILITIES, AND EQUITY
5. Internal Control Systems, Cash and Receivables
Satyam’s Truth........207
The Chapter in a Nutshell........207
Internal Control Systems........208
Internal Control for Cash........214
Cash and Cash Equivalents........217
Bank Reconciliation........218
Trade Receivables........222
Bills Receivable........228
Revenue from Construction Contracts, Franchises, and Leases........233
Pledging, Assignment, and Factoring........235
Financial Analysis of Receivables........237
Looking Back........238
Review Problem........238
Assignment Material........240
6. Inventories
And then the Music Stopped ........254
The Chapter in a Nutshell........254
Current Assets........255
Inventory Valuation and Income Measurement........255
Determining the Physical Inventory........258
Inventory Costs........259
Cost Formulas........259
Inventory Valuation........264
Conservatism, Neutrality, and Prudence........265
Comparability........266
Estimating Inventory Value........266
Perpetual Inventory System........269
Manufacturing Costs........271
Financial Analysis of Inventories........272
Managing the Operating Cycle........273
Looking Back........275
Review Problem........276
Assignment Material........277
7. Fixed Assets
Depreciation and Cash ........286
The Chapter in a Nutshell........286
Fixed Assets in Perspective........287
Property, Plant and Equipment........287
Cost of Acquisition........288
Depreciation........291
Depreciation Methods........293
Capital and Revenue Expenditures........303
Depreciation for Income Tax Purposes........306
Disposal of Depreciable Assets........307
Myths About Depreciation........310
Revaluation of Property, Plant and Equipment........312
Intangible Assets........314
Natural Resources........318
Impairment of Assets........322
Financial Analysis of Fixed Assets........323
Looking Back........323
Review Problem........324
Assignment Material........325
8. Investments
When the Party Ends… ........337
The Chapter in a Nutshell........337
Investments in Perspective........338
Financial Instruments and Financial Assets........338
Equity and Debt Instruments........338
Impairment of Financial Assets........345
Equity Investments for Business Purposes........347
Subsidiaries........348
Consolidated Financial Statements........349
Business Combination ........351
Consolidated Financial Statements and Business Combination Illustrated........353
Joint Ventures........358
Associates........363
Investments in Separate Financial Statements........366
Investment Property........367
Looking Back........368
Review Problem........369
Assignment Material........370
9. Liabilities
OOPS! My Bond Prices have Gone Up ........381
The Chapter in a Nutshell........381
Liabilities in Perspective........382
Classification of Liabilities........382
Current Liabilities........383
Contingent Liabilities........386
Long-term Liabilities ........387
Income Taxes........403
Off-balance Sheet Financing........416
Looking Back........418
Review Problem........419
Assignment Material........420
10. Shareholders’ Equity
Affluent Promoters and Sick Companies........435
The Chapter in a Nutshell........435
The Corporate Organization........436
Share Capital........438
Accounting for Share Capital........439
Preference Share Capital........442
Reserves and Surplus........443
Buy-back of Shares and Treasury Stock........445
Bonus Shares........447
Dividends........449
Share-based Payment........450
Statement of Changes in Equity ........453
Earnings Per Share........454
Looking Back........457
Review Problem........458
Assignment Material........459
Comprehensive Case 2........467
Interview with Mr. P. R. Ramesh, Deloitte India........471
Part Three
ANALYZING AND INTERPRETING FINANCIAL STATEMENTS
11. Analyzing Financial Statements: Statement of Profit and Loss and Balance
Sheet
Till Debt do us Part ........477
The Chapter in a Nutshell........477
Objectives of Financial Statement Analysis........478
Sources of Information........479
Standards of Comparison........480
Earnings Quality........482
Techniques of Financial Statement Analysis........488
Profitability Analysis........493
Advanced Profitability Analysis: Focus on Operations........497
Liquidity Analysis ........500
Solvency Analysis........503
Capital Market Standing........506
Understanding Annual Reports and Earnings Releases........509
Corporate Disclosure Policy........510
Efficient Market Hypothesis and Financial Statement Analysis........511
Earnings Management........513
Looking Back........515
Review Problem........516
Assignment Material........517
12. Analyzing Financial Statements: Cash Flow Statement
A Vulnerable King ........531
The Chapter in a Nutshell........531
Cash Flow Statement in Perspective........532
Uses and Structure of the Cash Flow Statement........533
Preparing the Cash Flow Statement........536
Determining Net Cash Flow from Operating Activities........538
Reporting Cash Flows........548
Interpreting the Cash Flow Statement........550
Free Cash Flow........552
Looking Back........553
Review Problem........553
Assignment Material........556
Comprehensive Case 3........573
13. Analyzing Financial Statements: Banks
The Banker to Every Indian ........575
The Chapter in a Nutshell........575
Understanding Banks........576
Bank Regulation........576
Legal Framework for Financial Statements........578
Balance Sheet........579
Statement of Profit and Loss........585
The Drivers of a Bank’s Performance........586
Capital Adequacy ........593
Basel Accords ........594
Basel III Reforms........596
Off-balance Sheet Activities........602
Looking Back........603
Review Problem........604
Assignment Material........605
Comprehensive Case 4........613
Interview with Professor Shyam Sunder, Yale University........615
Appendix A: Hindustan Unilever Consolidated Financial Statements........619
Appendix B: Time Value of Money........622
Appendix C: Summary of Formulas........631
Glossary........635
Answer Check for Selected Problems........643
Index........645
v Financial Statements: Who Cares?
Business and non-business organizations use financial statements to tell the
world about their accomplishments and activities, successes and setbacks,
opportunities and challenges, and prospects and problems.
Investors, lenders, equity and bond analysts, managers, employees, alliance
partners, competitors, suppliers, customers, government officers, regulators,
politicians, activists, donors, lawyers, and judges use financial statements.
v This Book
It is designed as a first-level course offered in business schools, universities,
and professional programmes.
Its distinctive features are:
Developing the accounting model from the basics of business.
Stress on the why of accounting rather than the how of bookkeeping.
Emphasis on financial analysis from the beginning.
Attention to accounting regulations and legal requirements.
Problems and cases that strengthen conceptual foundation and encourage
practical application.
Anyone who follows plain English and knows basic math (+, –, ×, ÷) can read
this book.
v New to This Edition
Chapter 13 on Analyzing Financial Statements: Banks.
Discussion on pro forma financial measures and statement of changes in
equity.
Comprehensive Cases 1 to 4.
Interview with Mr. P. R. Ramesh, Chairman, Deloitte India.
New pedagogical features: Chapter Vignette, Earnings Quality Analysis,
Financial View, Learning Aid, In Practice, and Companies Act Impact.
Revised and updated text and figures in almost all chapters.
v Student Resources
Interactive Study Guide available at www.phindia.com/narayanaswamy5e
provides support in solving the problems in the assignment material.
v Instructor Resources
Instructor’s Manual is available to adopting instructors from the publisher.
I welcome suggestions and feedback. My e-mail address is narayan@iimb.ernet.in
R. Narayanaswamy
v A tone-setting vignette at the start of every chapter motivates the student to think about the
significance of the chapter.
v Figures simplify ideas
v Test Your Understanding helps the student try a short problem on a specific point.
v Answers to Test Your Understanding
v Review Problem covers the key points in a chapter in a numerical form.
v Learning Objectives specify what the student can expect after studying a chapter.
v Handhold reassures understanding.
v Looking Back contains a crisp summary of the chapter for exam-eve revision.
v Interview has insights from leading practitioners and thinkers.
v In Practice Illustrates how investors, managers, regulators, and others use accounting
information.
v Companies Act Impact highlights the major changes in accounting, auditing, and corporate
governance as a result of the Companies Act 2013.
v Financial View presents the business implications of financial numbers and practices.
v Earnings Quality Analysis examines the effect of business activities and accounting policies
on the prediction of future profits.
v Decision-making requires students to apply their learning in a specific setting.
v Survey describes managers’ choices and opinions.
v Learning Aid explains tricky ideas.
v IFRS Impact describes how financial statements would change under IFRS.
v Debate encourages the class to come up with alternative view on controversies.
v Research Insight provides answers from academic research to managers’ questions.
v Questions help revise the chapter quickly
v Business Decision Cases involve working with unstructured information and encourage
students to identify and think about questions that may not be obvious.
v Financial Analysis has ideas that students can explore in projects and papers.
v The Online Interactive Study Guide available at www.phindia.com/narayanaswamy5e has
sheets for solving problems, besides a number of self-test questions.
v Problems Sets have numerical problems that students can solve to master application of the
principles.
v Interpreting Financial Reports have cases based on published financial reports, press reports,
and other sources that throw light on real-world accounting.
v Comprehensive Cases develop the student’s ability to understand company annual reports.
I thank my colleagues, students, friends, and other well-wishers for their critical observations and encouraging
words on the Fourth Edition.
I am grateful to the following eminent individuals for sharing their thoughts on accounting, auditing,
governance, and related matters with me for the benefit of the readers of this book:
N.
R.
Narayana
Murthy
Executive Chairman of the Board, Infosys Limited
Kalavacherla
Prabhakar
Member, International Accounting Standards Board
P. R. Ramesh
Chairman of the Board of Deloitte India and Partner, Deloitte Haskins & Sells LLP
Shyam
Sunder
The James L. Frank Professor of Accounting, Economics and Finance at the Yale School of Management,
Professor in the Department of Economics and Professor (Adjunct) at the Yale Law School
I thank the following colleagues for their valuable feedback:
Manoj Anand
Vrishali Bhat
Madhumita Chakraborty
Dinesh Gupta
Pankaj Gupta
V. Hariprasad
Bhawana Jain
M. Kannadhasan
Reena Kohli
N. R. Parasuraman
P. Padmanabha Pillai
Nandan Prabhu
Krishna Prasad
M. Durga Prasad
K. K. Ramesh
Latha Ramesh
Srinivasan Rangan
Padmini Srinivasan
Ullas Rao
M. Ravisundar
Rajiv Shah
Manish Singh
Rajesh, S. P.
V. Sridevi
Ashok Thampy
Ashish Varma
Sushma Vishnani
Vandana Zachariah
Indian Institute of Management Lucknow
T. A. Pai Management Institute Manipal
Indian Institute of Management Lucknow
University Business School Chandigarh
Jaipuria Institute of Management Noida
Indian Institute of Management Indore
Amrita School of Business Coimbatore
Indian Institute of Management Raipur
Indian Institute of Management Rohtak
S. D. M. Institute for Management Development Mysore
National Law School of India University Bangalore
School of Management, Manipal University
Justice K. S. Hegde Institute of Management Nitte
T. A. Pai Management Institute Manipal
Indian Institute of Management Kozhikode
Christ University Bangalore
Indian Institute of Management Bangalore
Indian Institute of Management Bangalore
S. D. M. Institute for Management Development Mysore
ICICI Securities Mumbai
T. A. Pai Management Institute Manipal
L. M. Institute of Management Lucknow
Chinmaya Institute of Technology Kannur
IFIM Business School Bangalore
Indian Institute of Management Bangalore
Institute of Management Technology Ghaziabad
Jaipuria Institute of Management Lucknow
Loyola Institute of Business Administration Chennai
Never the one to fail, my secretary, S. V. Subramanyam was a big source of support.
As in the past, the Publishers, PHI Learning, and their editorial and production team, in particular, Shivani
Garg and Ajai Kumar Lal Das had to live with my never-ending changes in the content and style of the
manuscript. I cannot thank them enough.
I owe a deep debt of gratitude to Indian Institute of Management Bangalore for the superior library, computing
and other resources and the right ambience for the work.
This book would not have been possible without the whole-hearted cooperation and support that I received at
home. My wife, Geeta, and my daughter, Vasudha, showed understanding and patience whenever I was busy
working on the manuscript.
The usual disclaimer applies.
R. Narayanaswamy
A Fairy Tale
Welcome to Utopia, the land where everyone is good. So the people there trust one
another. There are two kinds of Utopians: the Investopians, frugal people who save
money for which they have no immediate use; and the Corporatopians, industrious
people who forever need money for doing business. The Investopians hand over
their savings to the Corporatopians, who are smart businessmen and
businesswomen. When the Corporatopians make a lot of money, they gladly give the
Investopians much bigger amounts, greatly appreciating their generosity and good
nature. The Investopians and the Corporatopians live happily and never fight. The
spirit of comity and goodwill on display between them inspires a healing and
oneness throughout Utopia. So the Utopians have nothing to do except frolic in
fields of lilies where pixies dance in midair, the sound of a harp wafting from a
hill… .
Everyone else should know financial reporting.
This book is about understanding, analyzing and interpreting financial
statements and related reports: statement of profit and loss, balance sheet, cash
flow statement, statement of changes in equity, accounting policies, explanatory
notes, schedules, and auditors’ report. Let us see some examples from the real world
to get a flavour of accounting.
Disclosing Bad News
On January 21, 2011, Wipro announced results for the December 2010
quarter. Its chairman, Azim Premji, said: “We have underperformed in the
third quarter relative to the competition and in relation to our potential.…
Our competitors have performed better in the fast-growing sectors of health
care and financial services. They had the advantage of growing faster.” Such
open admission of weakness in public is rare.
Warren Buffett, the legendary investor, and chief of Berkshire Hathaway,
confessed: “During 2008, I did some dumb things in investments.” He wrote:
“I made at least one major mistake of commission and several lesser ones that
also hurt.” He added in his characteristic style: “Furthermore, I made some
errors of omission, sucking my thumb when new facts came in that should
have caused me to re-examine my thinking and promptly take action.”
Anyone would need extraordinary courage to say such a thing.
Question: Why did the heads of Wipro and Berkshire Hathaway talk ill of
themselves and volunteer to disclose bad news?
Hollywood Fantasies
The Warner Bros’ blockbuster Harry Potter and the Order of the Phoenix (2007)
made a $167 million loss. This may sound strange for a movie that grossed $938
million worldwide. But that is what an accounting statement available on the
Internet says.1 Hollywood accounting practices have been a source of continuing
disagreement between the studios that release movies and “the talent” – the actors,
directors and writers – that make them. The core of the dispute is the definition of
‘net profit’. Attorneys for the talent argue that the studio will include an array of
costs in profit statement sent to the talent. Michael Moore, who made Fahrenheit
9/11 (2004), alleged in a suit that the producer Harvey Weinstein improperly
deducted expenses from Moore’s share of the film’s profits – including the cost of a
private jet to fly Weinstein from the US to Europe. A leading lawyer says,
“Hollywood accounting is an oxymoron, like airline food.”
Question: Are Hollywood’s profits a fantasy, like some of its movies?
The Smoke-and-Mirrors Company
On January 7, 2009, Ramalinga Raju, the then chairman and managing director of
Satyam Computers Services Limited stunned the world by disclosing that he had
manipulated the company’s financial statements for several years. The total size of
the manipulation was `70 billion. Raju confessed to having overstated revenue and
cash. Satyam was audited by a member of a Big Four accounting firm and it had an
impressive board of directors.
Question: How did a fraud of this size go undetected?
Accounting for the Bizarre
Suppose that a borrower takes a loan of `10,000 and the interest rate is 12 per cent
per annum. After a year, the borrower’s financial condition worsens, so the cost of
borrowing goes up to 15 per cent. Therefore, the borrower gains. You read it right.
This is what fair-value accounting would say. In 2008, Barclays reported a £1.66
billion gain it booked from the reduced value of its own debt.
Question: Does it make sense that a firm would gain by moving towards
bankruptcy?
An Airline is Grounded
Kingfisher Airlines, a venture of Vijay Mallya that was flying high (in more than
one sense of the word), was arguably among the best airlines ever: good food,
excellent in-flight entertainment, and courteous crew. It stopped flying in 2012,
because it could not repay its bank loans. It never made a profit since it was set up
in 2005.
Question: Why did Kingfisher fail?
The Environment of Financial Reporting
Many economic forces operate on firms that produce financial reports. These forces
determine the amount of information that a firm provides and how the firm
measures and presents the information. The following figure illustrates the major
economic forces.
The economic forces – capital markets, product markets, labour and other
markets, and regulation – vary in magnitude and direction. For example, investors
often want more information about a firm, whereas the firm’s managers would
argue for providing less information because of the presence of competitors. Thus,
financial statements are the product of the interplay of the forces that drive firms.
The Road Ahead
The above examples will give you a glimpse of the nature and purpose of financial
reporting. Let us see what lies ahead. This book has three parts.
Part One, consisting of Chapters 1 to 4, describes the basic accounting model of
analyzing and processing transactions and presenting the information from
transactions in the form of financial statements. After completing this part, you can
find out for yourself whether Hollywood’s profits are unreal.
Part Two, made up of Chapters 6 to 10, introduces the reader to the principles
and standards that underlie a firm’s accounting policies and the managerial and
other considerations that shape the policies. When you have understood the
material in this part, you should be able to explain why Barclays’ accounting makes
sense.
Part Three, containing Chapters 11 to 13, explains the tools and techniques that
are useful in analyzing financial statements. With the help of these you should be in
a position to understand why Kingfisher Airlines failed despite its excellent food
and entertainment. You will learn about firms’ motivations for providing voluntary
disclosures and the types of voluntary disclosures provided by them, and will be
able to explain why some firms such as Wipro and Berkshire Hathaway disclose
‘bad news’.
1 http://m.deadline.com/2010/07/studio-shame-even-harry-potter-pic-loses-money-because-of-warner-bros-phonybaloney-accounting/
“I want our shareholders to treat us first as trustworthy people and then as smart people. Our desire is to
deliver whatever we promise”.
Question: How important is financial reporting to a technology company like Infosys?
Answer: First of all, the raison d’être of a corporation is to maximize the
shareholder value on a sustainable basis, while ensuring fairness, transparency and
accountability to every one of the stakeholders: customers, investors, employees,
vendor-partners, the government of the land, and the society. The annual report
and the quarterly report that Infosys produces are definitive instruments for the
investor community to understand our strategy, performance, compliance with the
generally accepted accounting principles, revenue recognition policies, risk
mitigation procedures, systems and controls, human resources policies, and
segmentation of revenue. In other words, it is a single window for our investors to
look into our operations and our aspirations. It is our view and not the view of the
analysts. It is a statutory document. Obviously, companies will have to ensure that
it is truthful and it does not communicate any false hope. Also, when you deal with
customers, they want to know your strategy, your position in the market, financial
strength; who your directors are; your stock movement; and your segmentation of
revenue. In other words, even though prospective customers do not buy your shares,
they want to ensure that they have good understanding of your financial strength
because they are hinging their future on you to some extent. So, the financial
reporting document is very important.
Question: What is the disclosure philosophy of Infosys?
Answer: Well, our philosophy has been When in doubt, disclose and Under-promise
and over-deliver, throughout the 20 years of our listed existence. However, we
missed our targets during 2011–2013. In other words, in the last 80 quarters, we
have taken the view that we will get market data on what the future is likely to be,
we will assess our strengths, weaknesses and our readiness to take advantage of
market opportunities, and then we will come out with a view of the future that
every member of the board has agreed with. We want to make sure that we can
deliver whatever we have agreed upon. We do not make our decisions based on what
the analysts say or the public expects.
Question: How can financial reporting become a part of a company’s business strategy?
Answer: The annual report covers the major aspects of our business operations.
Our prospects and our customers use this document as the definitive instrument to
assess our viability in the future because of our strategy, our operation and our
financial strength. Quite often, our success in selling to our customers and prospects
depends on their perception of our strength. This document is very helpful in our
investors’ and customers’ understanding of our strategy. I have seen many of our
customers refer to specific pages of the document and ask us to detail out what we
have said about the company’s plans.
Question: Does the practice of earnings guidance result in excessive pressure on managers’
performance?
Answer: Yes and no. My view has been that management is all about our ability to
make considered judgments under a situation of competing pressures, and
competing priorities. So, we, managers, must accept that there will be pressures.
There are different opinions on whether the earnings guidance should be quarterly,
six-monthly or yearly, and whether it should be only for the top line or both the top
and the bottom line. I am not sure whether the quarterly guidance for both top line
and bottom line is any worse than other guidance schemes. My one belief is that it
is all about the mindset of the management. Because of globalization, there is
tremendous growth and competition in the marketplace. Companies are growing
much faster today than they were growing 15 years ago. So, I am not a great
believer in the perception that quarterly guidance leads to any extra pressure on
the management. What kind of a CEO are you if you do not have a plan to achieve a
certain revenue and a certain profit in the next three months? But, if you know
what your future is likely to be in the next three months and if you do not share it
with your investors at large, then you are creating asymmetry of information,
particularly in a company where there are several owner-managers. That is not fair
to the investors at large. I will give an example. In 2001, we announced that we
would grow by 30 per cent. The previous year, we had grown by 100 per cent. So, I
stood up and said, “There is considerable fog on the windshield and we can only
promise 30 per cent.” Our stock price came down from `5,000 + to `1,500 or `1,600. I
did not lose my sleep. Our view was that we had a fairly good system of collection of
data, and we had people in the trenches with a very good view of what was likely to
happen. Our forecasting, analytics and tools confirmed that the only sales growth
figure we could give our investors was 30 per cent. We told our investors that
Infosys was not the company to invest in if they were looking for higher than 30 per
cent sales growth. Many of them left. Our share price came down to `1,500 or
`1,600. So, the problem does not lie in giving quarterly guidance. The challenge lies
in dealing with the short-term mindset of investors.
Question: Does providing voluntary financial disclosures result in competitive
disadvantage to companies like yours?
Answer: Providing voluntary disclosures, transparency and following principles of
good governance have always created goodwill for the company. We were the first
Indian company to give revenue segmentation details, details of our attrition, hiring
and many other performance data. I am not sure how much such a focus on
transparency adds to our market capitalization. This is particularly so because of
hedge funds and the tendency of people to move quickly from stock to stock. I have
always believed and acted according to the adage: When in doubt, disclose.
Question: Many technology companies have argued against expensing stock options. What
is your view?
Answer: I personally believe that there should be some norm for allocating stock.
That is, the regulator should fix a certain cap on the number of options as a
percentage of the total number of outstanding stocks. There should be no other
restrictions including expensing of options. If we can incentivize our employees to
perform better, then our earnings per share will likely be better. So, even though we
dilute the total number of shares by a percentage, the overall benefit to the
investors is likely to be much more than that percentage. I have found that stock
ownership by employees brings better focus on cost control in the company. For
example, right from the beginning, people at Infosys understood that every rupee
saved went to the bottom line and that translated to something like `25 in market
capitalization. So, options do create an incentive for employees to control cost.
Question: How do the shareholders of a company benefit from the presence of
independent directors on the board?
Answer: The shareholders benefit in many ways. Good corporate governance is
minimization of agency costs. The role of the independent directors, if exercised
properly, is to ensure that agency costs are minimized. Second, the independent
directors ensure that the owner-managers do not benefit from the asymmetry of
information through insider trading. They are expected to prevent any related party
transactions. They review the strategy of the company and suggest changes. They
would be the ombudsmen and ombudswomen for risk mitigation. After all, risk
mitigation is extremely important to protect your shareholders. Independent
directors also ensure that there are proper procedures and controls. But whether
this happens in practice depends on how cooperative the owner-managers are.
Question: Given that many retail investors do not have any formal accounting training,
would it not be better for them to have a summary annual report?
Answer: This is a question that we have debated often. Determining the level of
detail to disclose is not easy. At the end of the day, shareholder democracy is like
democracy in a nation. Every vote is as important whether the voter is rich or poor,
educated or illiterate, powerful or weak, and urban or rural. Therefore, it is best to
provide as detailed information as possible to every shareholder. If a shareholder is
not as conversant in accounting as he would like to be, let him take the report to an
expert and get the expert’s opinion on critical issues. The only disadvantage of
providing a detailed report is the cost of paper and cost of printing. Let the
shareholders decide what they want. Who am I to decide? After all, we are spending
their own money for printing the annual report.
Question: Does quarterly reporting discourage risk-taking as the horizon is very short?
Answer: No. There will be activities that are going to take a long time. It is
important for the management of a corporation to tell the investors that they would
be taking up a major initiative, that it would bring down the profits by x percentage
in the ensuing n1 years, and that the profits would likely be increasing by a
multiple of x percentage in the ensuing n2 years following the period of reduced
profits. This is what investing for a better future is all about and the shareholders
will accept it. The problem is that, in most cases, most CEOs are not certain
whether their investments will indeed bear fruit. So, they want to make investment
in a clandestine manner, so that they mask their failures and they look great if they
succeed. Consequently, they do not even want to report such investments.
Question: Has globalization raised the standards of corporate governance in India?
Answer: Corporate governance is all about maximizing shareholder value on a
sustainable basis, while ensuring fairness, transparency and accountability to
customers, investors, employees, vendor-partners, the government of the land, and
the society. Today, international investors have multiple choices of countries for
investing – US, Europe, China, Australia, South East Asia, Africa and South
America. Therefore, they compare us with the rest of the world before they take any
decision to invest in us. Therefore, we must benchmark ourselves on a global basis.
Thanks to globalization and opening up of our borders, we have multinational
corporations operating in India. In general, these multinational corporations have
better corporate governance practices. Therefore, Indian companies are also forced
to adopt those practices. Today, our employees have global skills, aspirations and
opportunities. Therefore, they seek opportunities in the best companies. If we want
to retain them, we have to adopt such global best practices and perhaps improve
upon them. So, because of globalization, I believe that our benchmarking in terms of
how we handle our employees, customers and investors has improved. Most
importantly, the importance of the price-earnings ratio has dawned on Indian
businessmen. They realize that every rupee they save translates to multiple rupees
in market capitalization. So, they realize that it is much better not to blur the
distinction between corporate resources and personal resources.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Understand the working of business organizations.
Define accounting and explain its role in making economic and business decisions.
Identify the major users of accounting information.
Distinguish between financial and management accounting.
Discuss the assumptions underlying accounting measurement and explain their significance.
Explain the meaning of GAAP and identify the institutions that influence Indian GAAP.
Describe and evaluate the common forms of business organization.
Explain the role that accounting plays in capital market and corporate governance.
Explain the accounting equation and analyze the effects of typical transactions on the equation.
Describe the five major financial statements and explain how they are interrelated.
Describe the career opportunities for accountants.
Appreciate accounting as an academic discipline.
Understand the importance of ethics in accounting.
WALKING ON EGGSHELLS
Financial statements are frequently regarded as epitomizing all that is right and
wrong with an organization. For example, when Air India loses big money, critics
pull up the airline (often justifiably). Equally, a business that makes a lot of money is
castigated, a response that may look unfair and contrary to the spirit of enterprise.
The Rolling Stone writer, Matt Taibbi, described Goldman Sachs as “a great
vampire squid wrapped around the face of humanity”, when the bank’s profitability
made it a symbol of Wall Street greed and excess in the wake of the 2008 financial
crisis. Thus, you can either like or dislike good or bad financial performance but
cannot ignore it. If, as a manager, you understand how accounting works, you will
be able to formulate an informed response to criticism.
THE CHAPTER IN A NUTSHELL
Accounting is an efficient system that expresses the numerous activities of
organizations in a concise manner. The purpose of accounting is to measure and
report the performance of organizations. Financial statements are useful to
investors, lenders, analysts, managers, governments and many others. Accounting
principles and accounting standards enhance the usefulness of information in the
financial statements for making economic and business decisions. Capital market
channels savings into investment. High-quality accounting reports are a must for
orderly markets and good governance. Accounting can be complex. Yet, the simple
relation between resources and claims, presented in this chapter, captures its
essence.
Understanding Business Organizations
Peter Drucker, the great management philosopher, said: “With
respect to the definition of business purpose and business mission,
there is only one focus, one starting point. It is the customer. The
customer delivers the business.” Business organizations bring
together materials, technology, people, and money in order to satisfy their
customers’ needs and thereby seek to earn a profit.
Business organizations provide products and services. They convert inputs into
outputs by applying processes. The conventional view is that a product has form and
substance and the seller transfers it physically to the buyer. Soaps, pens, cars,
computers, and medicines are examples of products that we use in our everyday life.
Merchandising (or trading) organizations such as Pantaloons, Wal-Mart, and
Amazon.com buy and sell products; they do not make them. These organizations
connect producers with consumers. Manufacturing organizations make products
that vary greatly in complexity: Amul makes butter and cheese; Sony’s equipment
have intricate electronics; Boeing aircraft requires complex engineering.
Services are work done by one person that benefits another. Unlike products,
services do not have form or substance. The recipient of a service can experience it
personally but cannot transfer it to another person. Repairing cars, hairstyling,
writing computer programs, performing cardiac surgery, providing legal advice,
managing hotels, and transporting passengers are familiar examples of services.
Service organizations such as the State Bank of India, Goldman Sachs, and
Lakme Beauty Salon provide professional or personal services. Increasingly, the
line between products and services is disappearing. Is the iPod, the iPad, or the
Sony PlayStation a product or service? These would seem to be more of a service
packaged as a product. A significant portion of the cost of a car – commonly
considered a product – is the cost of embedded software that controls fuel mix,
brakes and air conditioning.
Business organizations perform complex operations. Yet, in essence they are cash
generating-cum-dispensing machines: they receive cash from customers for
providing goods and services and pay suppliers for materials, equipment, labour,
electricity and transportation. To illustrate this idea, let us think of a biotechnology
firm – Nzyme Company – that produces fermentation agents for food and beverages.
It hires buildings and equipment and employs scientists and other professionals.
The company receives cash from its customers in three ways: (a) for sales made in
the past collected in the current period, (b) for sales made in the current period; and
(c) for sales to be made in the future for which it receives advance payments from its
customers. The company pays its scientists and other employees salaries and other
benefits and its suppliers for materials, office and factory space, electricity, and
laboratory equipment and supplies. It pays income tax and other taxes to the
government. It distributes a part of the surplus cash to its owners in the form of
dividends. Figure 1.1 presents the activities of this business. As you can imagine,
business operations are far more involved. We will add more details as we proceed.
What is Accounting
Accounting is one of the fastest-growing professions and ranks
among the most popular fields of study in colleges, universities,
and business schools. It offers interesting, challenging, and
rewarding careers. Business enterprises, government agencies,
charities, and individuals need information to make sound
decisions. The accounting system provides relevant and reliable financial
information to interested parties.
Accounting is often called the language of business. The function of a language is
to facilitate communication among individuals in a society. Accounting is the
common language used to communicate financial information in the world of
business. Clearly, individuals who aspire to be professional accountants should be
experts in accounting. Many others, such as investors, managers, employees, civil
servants, police investigators, lawyers, judges, and regulators, have to constantly
deal with business organizations. All of them should have good knowledge of
accounting terms, principles and techniques.
Here are some typical responses of MBA students on why they think they need to
study accounting (besides the predictable one, “Accounting is in the curriculum, so I
have no choice.”):
“Since a company’s financial statements affect stock prices, a manager should know accounting.”
“Accounting will help me in understanding what the accountant is trying to say.”
“The accountant is good at numbers and, as a manager, I have to be good at interpreting the
numbers.”
“I want to be an investment banker. Accounting information will help me to value firms.”
“I would like to learn about indicators that would help me evaluate the financial health of a
business.”
“A manager has to analyze financial reports and make critical business decisions based on them.”
“Start-up entrepreneurs should know financial accounting, so that they can manage the accounting
and finance function of their business.”
“With a consulting career in mind, I am interested in finding out how to use the financial statements
to evaluate the performance of business enterprises.”
“The law requires the chief executive officer (CEO), along with the chief financial officer (CFO), to
certify the financial statements. At the least, the CEO should know the meaning of the various items
appearing in the statements.”
Managers have a responsibility to provide truthful, relevant and timely
information. The MBA Oath initiated by the students of Harvard Business School
has this to say on reporting:
I will report the performance and risks of my enterprise accurately and honestly.
After what happened in the technology bubble of the 1990s and the global financial
crisis in 2008, managers need to reassure everyone that their enterprises’ financial
reports are trustworthy. For this, they should have a sound understanding of
financial statements.
Accounting provides “information that is useful in making business and economic
decisions – for making reasoned choices among alternative uses of scarce resources
in the conduct of business and economic activities.”1 It is a principal means of
communicating financial information to owners, lenders, managers, and any others
who have an interest in an enterprise. Accounting is not an end in itself. Indeed,
this book presents accounting as an information development and communication
function that supports economic decision-making.
The Accounting Information System
An oft-quoted publication of the American Accounting Association states,
“essentially, accounting is an information system.”2 A system converts inputs into
outputs using processes. The accounting system processes business transactions to
provide information to various interested parties. There are external and internal
users of the information thus produced. The external users are those who are
outside the firm and include investors and lenders. Managing directors, marketing
managers, production managers, materials managers, human resource managers,
and financial controllers are examples of the internal users of accounting
information. Figure 1.2 depicts the accounting information system.
Accounting Information and Economic Decisions
Accounting information is useful in making a number of decisions that affect the
income or wealth of individuals and organizations. Accounting reports are designed
to meet the common information needs of most decision-makers. Examples of
decisions that are based on accounting information include the following:3
(a) Decide when to buy, hold or sell an equity investment.
(b) Assess the stewardship or accountability of management.
(c) Assess the ability of the enterprise to pay and provide other benefits to its
employees.
(d) Assess the security for amounts lent to the enterprise.
(e) Determine taxation policies.
(f) Determine distributable profits and dividends.
(g) Prepare and use national income statistics.
(h) Regulate the activities of enterprises.
The information given in a language can be useful only to persons who
understand that language. For example, if a restaurant’s menu is in Italian, a
customer should know enough Italian to be able to make sense of the items and
their ingredients. In the same way, a decision-maker who intends to use accounting
information should have a fair understanding of business and economic activities
and be willing to study the information with reasonable diligence. Decision-makers
should know the intricacies of accounting; it is an indispensable part of their toolkit.
Users of Accounting Information
Investors and lenders are the most obvious users of accounting
information. Other users include analysts, advisers, managers,
employees, trade unions, suppliers, customers, governments,
regulatory agencies, and the public. Business enterprises and
managers increasingly emphasize the interests of co-workers, customers and the
society in which they operate and the need to create sustainable economic, social,
and environmental prosperity worldwide. It is further evidence of the broader
constituency for financial reporting.
Investors
Investors are the major recipients of the financial statements of business
enterprises. They may be retail investors with small shareholdings or large mutual
funds, hedge funds or private equity firms. As chief providers of risk capital,
investors are keen to understand both the profit from their investments and the
associated risk, i.e. the likelihood of loss or low profit.
Accounting information enables investors to identify promising investment
opportunities. Investors need information to decide which investments to buy,
retain, or sell, as well as the timing of the purchases or sales of those investments.
They also require information to monitor management performance and to assess
the ability of the enterprise to pay dividends. In recent years, investors have started
questioning executive compensation in light of the performance reported in the
financial statements. For example, in 2012, the shareholders of WPP, an
advertising company, rebuked their top management for asking for outsize pay
when the company’s performance was not considered outstanding.
While present investors have a legal right to receive periodic financial reports,
potential investors too are interested in financial information. Private equity funds
are on the lookout for investing in ailing businesses that they can restructure and
sell at a substantial profit. Hedge funds use accounting and other information to
earn
high profits. Activist investors seek to force managers to act in the interests of
shareholders.
Lenders
Lenders such as banks and debentureholders want to know about the financial
stability of a business that approaches them for funds. They are interested in
information that would enable them to determine whether their borrowers will be
able to repay the loans and pay the related interest on time.
Banks use credit evaluation benchmarks based on information derived from
financial statements when deciding on the amount of the loan, interest rate,
repayment period, and security. They also use the information for monitoring the
financial condition of borrowers. Thus, many lenders stipulate dos and don’ts, or
covenants, for borrowers that often require the use of accounting information. For
example, a loan agreement may impose an upper limit on a borrower’s total debt
from all sources or compel the borrower to keep a minimum level of cash. If a
borrower fails to comply with the stipulations, the lender may raise the interest
rate, ask for additional security, and even demand repayment of the loan.
Analysts and Advisers
Investors and creditors seek the assistance of information specialists in assessing
prospective returns. Equity analysts, bond analysts, stockbrokers, and credit rating
agencies offer a wide array of information services. These information specialists
serve the needs of investors by providing them with skilled analyses and
interpretation of financial reports. Equity analysts collect information about firms
also through other means such as face-to-face meetings and conference calls with
company executives and field visits. Sell-side analysts work for brokerages, banks
and research firms who use their reports to recommend to their clients whether to
buy, sell or hold certain investments. In contrast, buy-side analysts are employed in
mutual funds and other investment firms ad produce research reports for in-house
use by their employers. Proxy advisory firms recommend to shareholders whether
they should support or oppose resolutions proposed by the board of directors.
Managers
Managers both produce financial information for use by others and use it in many of
their decisions. They need information for planning and controlling operations, for
making special decisions, and for formulating major plans and policies. Some of this
information is available from the accounting system which they use to evaluate
potential investment projects. Since managers are responsible for reporting
enterprise performance to owners and others, they monitor the key financial
indicators that appear in the financial reports. Besides, they compare their firm’s
performance with that of their competitors. Sometimes, the managers of a business
may be interested in acquiring other firms. Increasingly, managers receive a
commission or bonus related to profit or other accounting measures, and they have
a natural interest in understanding how those numbers are computed.
Further, when faced with a hostile takeover attempt, managers communicate
additional firm-related financial information with a view to boosting the firm’s stock
price. As you can imagine, managerial motives in financial reporting can vary
depending on the context of the business, and can conflict with those of investors
and other users of financial statements.
Employees and Trade Unions
Employees are keen to know about their employer’s general operations, stability
and profitability. Current employees have a natural interest in the financial
condition of the enterprise because their jobs and salaries depend on the financial
performance of the firm. A noteworthy instance is the strong support from the
Railway employee unions to the 2012 Railway Budget proposal to raise passenger
fares to restore the financial performance of the Indian Railways.4 Potential
employees may use financial information in order to gauge the enterprise’s
prospects. Past employees, who depend on their former employer for their postretirement benefits, such as pensions and health care, have a continuing interest in
the enterprise’s performance and prospects. Trade unions use financial reports for
negotiating enhancements in wages, bonus and other benefits.
Suppliers and Trade Financiers
Suppliers regard the enterprise as an outlet for their products or services. They use
financial information to assess the likelihood of the enterprise continuing to buy
from them, especially if it is a major customer. Suppliers plan their production and
capacity expansion on the basis of the expected demand from their customers. Trade
financiers provide short-term financial support. Both suppliers and trade financiers
want information that enables them to determine whether the enterprise will pay
them on the dot. While lenders take a long-term view, suppliers and trade
financiers usually focus on the enterprise’s near-term financial condition.
Customers
Present, prospective and past customers use information about the financial affairs
of an enterprise in deciding whether and how much business to do with it.
Customers would like to be certain that they can count on their suppliers for future
purchases and after-sales support. This is particularly important for products and
services that are proprietary. For example, car owners depend on the manufacturer
for warranty repairs and continued supply of spare parts. The users of a computer
software look to the software firm for periodic upgrade of the product. When an
airline keeps incurring losses, customers become anxious about higher ticket prices,
flight cancellations, mileage points accumulated under frequent flyer programmes
and even aircraft safety.
When Satyam Computer Services was hit by an accounting scandal, some of its
important clients were concerned and began to review their contracts and look at
other suppliers. Insurance policyholders need confidence that their insurer will
have the financial resources to pay their claims. In all these cases, the supplier’s
financial reports can be useful to the customers. At the same time, when suppliers
make large profits, customers may suspect that they are being overcharged. For
example, if your mobile phone company makes huge profits, you would like the
company to cut call charges. Sometimes companies have to respond to customers’
perceptions of profiteering by behaving in morally acceptable ways. In 2012
Starbucks, the coffee shop, offered to pay the UK government $16 million more in
income tax than what was legally payable because its customers were furious about
how little tax the firm paid in their country.
Government and Regulatory Authorities
The three levels of government in India – Central, state and local – allocate
resources and are concerned with the activities of enterprises. They require
information in order to regulate the business practices of enterprises, determine
taxation policies, investigate crime, and provide a basis for national income and
similar statistics.
The Ministry of Corporate Affairs (MCA) is among those in the Government of
India that take a keen interest in the financial affairs of business enterprises. The
Serious Fraud Investigation Office (SFIO) attached to the MCA investigates
corporate fraud. The Ministry of Finance is concerned with tax administration and
the working of the economy. A number of regulatory agencies are government or
quasi-government bodies, such as the Securities and Exchange Board of India
(SEBI), the Reserve Bank of India (RBI), the Insurance Regulatory and
Development Authority (IRDA), the Telecom Regulatory Authority of India (TRAI),
and the Competition Commission of India (CCI). These agencies use financial
reports in order to identify abuses and violations and to protect the interests of
investors and consumers. SEBI stipulates extensive disclosures in the financial
statements and offer documents. IRDA requires life and non-life insurance
companies to provide public disclosures of accounting practices, valuation of
investments, and pension and post-retirement obligations, so that policyholders and
investors can understand the financial health of their insurer. Others such as stock
exchanges have a legitimate interest in financial reports of publicly held enterprises
to ensure efficient operation of capital markets.
The Public
The activities of business enterprises affect the members of the public in a variety of
ways. For example, businesses employ people from the local community and
patronize local suppliers; so the prosperity of the local community depends on their
success. It is said that, whenever the software industry slows down, business in
upmarket restaurants and pubs in Bangalore falls. Financial statements assist the
public by providing information about the trends and recent developments in the
prosperity of the enterprise and the range of its activities. Political parties, public
affairs groups, consumer groups, newspapers and magazines, television channels,
anti-globalization and anti-business activists, and environment protection groups
have a general interest in the affairs of business enterprises. The nature and extent
of their interest often vary considerably. They use the information in the financial
statements to put forward their point of view. For example, when there was a
blowout in the Deep Horizon well in the Gulf of Mexico in 2010, the profits of BP
and other large oil companies came under public scrutiny. Extractive industries
such as oil, gas and mining are frequent targets of attack on the basis of their
profits that activist groups argue are ill-gotten. Of course, investment banks are
always under attack for a variety of reasons.
Exhibit 1.1 summarizes the major users of accounting information and some
typical questions for which they look for answers in accounting reports. Whether
someone is a legitimate user of accounting information differs from one country to
another. For example, in the US and the UK, financial statements are meant
primarily for shareholders and lenders. But countries in Continental Europe, such
as Germany, France and Sweden, explicitly recognize employees and trade unions
as having a stake in financial reports.
EXHIBIT 1.1 Users of Accounting Information
Investors, lenders and many others use accounting information to make important economic decisions.
Users
Investors, analysts,
advisers
Examples
Queries/Concerns
Retail investors
Mutual funds, private equity funds,
hedge funds
Equity analysts and bond analysts
Credit rating agencies
Investment banks
Shareholder activists
Proxy advisory firms
v Should I buy, hold or sell the company’s shares?
v Will the investment yield good dividends regularly?
v Is the enterprise in which I have invested, or thinking of investing, performing well?
v Are there governance problems in the company?
v Are the shares a good medium- to long-term investment?
Banks
Bank depositors
v Can my borrower pay the principal and interest on time?
Lenders
Debentureholders
Leasing companies
v What should be the security and interest rate for a loan?
Managers
Chief executive officers
Chief finance officers
Marketing managers
Production managers
Profit centre heads
v How is my business performing relative to my competitors?
v Which projects should I invest in?
v Do the financial reports communicate my firm’s true value?
v Will it be profitable for me to buy out my business?
Employees, trade unions
Factory and office workers
Trade unions
Trade union federations
v How much increase in wages and bonus can my employer afford?
v Can my employer continue to be in business?
v Can my employer honour its future obligations for pension, health and other postretirement benefits?
Suppliers, trade financiers
Suppliers of materials, services and
utilities
Short-term financiers
v Will my customer be a major source of business?
v Can my customer pay for its purchases on time?
v Can my borrower repay on time?
Customers
Present, past and prospective
customers
v Is my supplier a reliable and competitive source?
v Can I count on my supplier to provide spare parts for equipment?
v Does my supplier have the financial resources to honour its warranty obligations?
Government, regulatory
authorities
Income tax officers
Excise and service tax officers
Commercial tax officers
Ministry of Finance
Ministry of Corporate Affairs
Securities and Exchange Board of India
Reserve Bank of India
Competition Commission of India
Stock exchanges
Insurance Regulatory and Development
Authority
v Is a business evading income tax, excise duty, service tax, sales tax or other
government levies?
v Should the government subsidize an industry, increase taxes, or give it protection
from dumping?
v Does a bank follow prudent financial norms?
v Does a business make required disclosures of its financial affairs?
v Does a business make abnormal profits by stifling competition in its industry?
v Does an insurance company follow prudential norms?
The public
Local community
Political parties
Public affairs groups
Consumer groups
Environmental activists
v Does a business exploit local suppliers, small businesses or labour?
v Does a business earn profits by compromising on product safety or damaging the
environment?
v Is a business abusing its monopoly by overcharging its customers?
Financial and Management Accounting
The accounting system provides information to persons inside and
outside the enterprise. Financial accounting is the preparation
and communication of financial information for use primarily by
those outside the enterprise. Its chief purpose is to provide
information about the performance of the enterprise’s
management to its owners. Management accounting is the preparation and
communication of financial and other information to the management, which helps
it carry out its responsibilities in planning and controlling operations. Management
accounting information is more detailed and timely than what is available to
external users.
Accounting Measurement Assumptions
The purpose of accounting is to measure and communicate an
enterprise’s economic activities. Numerous events affect a
business. Examples include receiving cash from customers, paying
income tax, using office supplies, and buying equipment on credit.
Business transactions are events that result in the transfer or
exchange of value between two or more parties, e.g. buying goods,
collecting cash, and repaying a loan. Transactions may involve monetary exchanges,
such as buying a computer for cash, or non-monetary exchanges such as swapping a
building for a piece of land. Also, there may be one-way transfers, e.g. donations and
thefts. Certain external events do not involve a transfer or exchange, for example, a
flood or an earthquake. Accounting also records internal events such as
consumption of materials and use of equipment, which take place within the
enterprise.
Accounting measures events only if they affect the financial position of the
enterprise. As a result, important events affecting a business, such as the launching
of new brands by its competitors, will not find a place in accounting records. The
concept of business transaction defines the activities that find a place in the
financial statements and, therefore, limits the kind of information the users of the
statements can reasonably look for. Appointing talented managers, launching new
products, and identifying profitable business opportunities are important
developments for a business, but accounting does not have the tools to measure and
report on them.
Four major assumptions underlie all accounting measurement:
1.
2.
3.
4.
Reporting entity
Going concern
Periodicity
Money measurement.
We now examine these assumptions.
Reporting Entity
Accountants treat a business as a reporting entity which is distinct and separate
from its owners and other firms. The reporting entity defines the scope of the
activities to be included in the financial statements. At a minimum, the reporting
entity assumption requires that the financial statements deal with only the
business enterprise’s transactions and exclude the owner’s personal financial
affairs. Suppose that Seema owns a boutique, a grocery store, and a travel agency.
If she wants to know how each business is doing, she should keep separate
accounting records for the transactions of each of them in order to prepare separate
financial reports for them. Her personal possessions such as her car, jewellery, and
house, and any personal loans she has taken will not find a place in the records of
any of her three businesses. Without the reporting entity assumption, the personal
financial affairs of the owners and the activities of other enterprises would be
mingled with the transactions of a business that we are interested in, and hence no
meaningful financial information about the business can be produced.
A reporting entity may be a separate legal entity distinct from other enterprises, a
combination of enterprises, or a segment of an enterprise. For example, Hindustan
Unilever Limited and its subsidiary, Pond’s Exports Limited are separate legal
entities. The company prepares its ‘separate’ or ‘standalone’ financial statements,
and its subsidiaries too prepare their own financial statements.
A reporting entity can also be a group of interconnected enterprises. Thus, the
Hindustan Unilever group prepares consolidated financial statements for the group
by combining the separate financial statements of the individual companies.
Hindustan Unilever is, in turn, a part of the Unilever group that prepares
consolidated financial statements for the group’s worldwide activities.
Business or geographical segments of an enterprise too can be reporting entities.
For example, Hindustan Unilever views its business segments, such as soaps and
detergents, personal products, and beverages, as separate reporting entities and
reports their performance. Tata Consultancy Services reports on the performance of
its business segments such as services for banking, financial services and insurance,
manufacturing, retail and distribution, and telecom as separate reporting entities.
IBM provides information on a geographical basis for the Americas, Europe/Middle
East/Africa and Asia Pacific.
Thus, the definition of reporting entity depends on the purpose and context of
financial reporting. This book often uses terms such as ‘business’ and ‘enterprise’ to
mean a reporting entity.
Going Concern
Unless there is substantial evidence to the contrary, accountants assume that the
business is a continuing enterprise or a going concern. The assumption makes
sense because many business enterprises survive difficult economic circumstances.
The going concern assumption is critical to the users of an enterprise’s financial
statements. In 2009, the auditors of General Motors, the automobile company,
warned about the company’s viability to continue as a going concern without more
US government loans, making it difficult for the company to negotiate with its
lenders. GM’s shares fell by 15 per cent as a result.
The going concern assumption justifies an accounting system based on cost,
typically the amount of cash paid to acquire an asset. If we were to assume
imminent liquidation of a business, cost would become irrelevant and we need to
record assets at their likely sale prices. In recent years, accounting regulators have
been gradually moving away from historical cost to other measures (e.g. fair value)
on the ground that historical cost is uninformative, especially for assets for which
dependable market prices are available. Fair value is “the amount for which an
asset could be exchanged, or a liability settled, between knowledgeable, willing
parties in an arm’s length transaction.”5 Fair value is not the same as a fire sale
price, or distress selling price. Determining fair value for assets that do not have a
ready market (e.g. customized mortgage products) is tricky. For this reason, fairvalue accounting along with the conduct of banks has become the lightning rod for
criticism in the recent economic crisis.
When preparing financial statements, management shall review the going
concern assumption. It should disclose any material uncertainties related to events
or conditions that may cast significant doubt on the ability of the business to
continue as a going concern. Suppose that an enterprise has to repay a `100 million
loan in the next three months but does not have that much cash and will not be able
to raise the amount by the payment date. The management hopes that the lender
will renew the loan for a two-year period. If the renewal is in doubt, there is a going
concern uncertainty that must be disclosed. Persistent losses may call for a going
concern rethink. When an entity does not prepare its financial statements on a
going concern basis, it should disclose that fact, the basis used, and the reason why
it is not regarded as a going concern. Going concern exceptions are rare in India,
though there are always reports of a few companies in serious trouble.
Periodicity
We assume a long life for a business. But investors, creditors, government, and
others cannot wait indefinitely for information for making decisions. The
periodicity assumption requires that the activities of an enterprise be divided into
artificial time periods, usually as long as a year, but sometimes as short as a
quarter.
The periodicity assumption creates numerous difficulties and is the root cause of
many accounting controversies. For example, it is necessary to estimate the useful
life of equipment that spans several years. Such estimates are based on the
management’s assumptions and judgment, and these are often subjective.
Money Measurement
Under the money measurement assumption, we express and record all business
transactions in terms of money. Therefore, if we cannot measure something in
terms of money, it will have no place in accounting. Money is the only common
denominator for all businesses. The use of money as the unit of measurement
enables us to compare financial information of different enterprises. As we know, in
India, the rupee is the monetary unit.
Accountants assume that money is a stable unit of measure in the same way as
the metre is a stable measure of distance. However, money is an unstable measure,
since it loses or gains value depending on movements in the general price level.
Thus, a 2014 rupee is much lower in value than a 1945 rupee because of sustained
inflation in the last six decades in this country. Nevertheless, accountants generally
assume that money is a stable measurement unit.
Generally Accepted Accounting Principles and the Accounting Environment
The information contained in financial reports should be reliable
and intelligible. Besides, we should be able to make meaningful
comparisons between a firm’s past financial history and the
financial information of other enterprises. Therefore, we need a
body of broad concepts and detailed practices to guide business
enterprises in preparing financial reports. The set of conventions,
rules, and procedures, which define accepted accounting practice, constitute
generally accepted accounting principles (GAAP). GAAP represents the
fundamental positions that have been generally agreed upon, often tacitly, by
accountants and encompasses contemporary permissible accounting practice.
Unlike the laws of physics or chemistry, accounting principles and practices are not
the product of any laboratory research. GAAP includes accounting measurement
assumptions – reporting entity, going concern, periodicity and money measurement.
It has evolved in response to the economic circumstances of users of information.
The sources of Indian GAAP (IGAAP) include Indian accounting standards, the
Companies Act 2013, and the accounting profession’s pronouncements.
You will learn more about GAAP throughout this book.
Institutions that Influence Indian GAAP
Many Indian and international institutions influence the accounting practices
followed in preparation and presentation of financial reports by business
enterprises in India. There are also international bodies that take a keen interest in
accounting and reporting. Figure 1.3 presents the major institutions that influence
and shape IGAAP.
The Ministry of Corporate Affairs (MCA), Government of India, is charged
with the administration of the Companies Act 2013 (that replaced the Companies
Act 1956), a comprehensive legal code on companies. The Act lays down the form
and content of financial reports of companies. The MCA articulates the
government’s view on financial reporting and accounting requirements.
Under the Companies Act, the government prescribes accounting and auditing
standards in consultation with the National Financial Reporting Authority
(NFRA). The fifteen-member NFRA recommends accounting and auditing
standards monitors and enforces compliance with the standards. In December 2006,
the government laid down accounting standards (AS) under the Companies
(Accounting Standards) Rules. In February 2011, the government issued another
set of standards (Ind AS) that are closer to international standards. This book
discusses AS, Ind AS and corresponding international standards.
Parliament established the Securities and Exchange Board of India (SEBI)
in 1992 “to protect the interests of investors in securities and to promote the
development of, and to regulate, the securities market.” SEBI regulates companies
listed in stock exchanges in India. It has successfully overhauled the type and
amount of information provided in the prospectus at the time of public issue of
securities. It has an interest in ensuring adequate, true and fair disclosure of
financial information and has stated that it would work with the accounting
profession and others on improving the standards of financial reporting. SEBI plays
an active role in expanding corporate accounting and disclosure, and has taken a
number of major initiatives such as requiring listed companies to publish cash flow
statements, quarterly financial results, quarterly segment reports, and consolidated
financial statements.
The Institute of Chartered Accountants of India (ICAI), constituted under
the Chartered Accountants Act 1949, is responsible for regulating the profession of
CAs and functions under the regulatory supervision of the Ministry of Corporate
Affairs. It has played a leading role in developing accounting and auditing practices.
The ICAI has issued many recommendations dealing with a variety of accounting
and auditing matters. Its views on accounting have the weight of professional
opinion and a significant persuasive influence on accounting practice. The ICAI
provides the technical resources for developing accounting and auditing standards.
The Income Tax Authorities, including the Central Board of Direct Taxes
(CBDT), commissioners of income tax, and income tax officers, enforce the Income
Tax Act which authorizes the levy and collection of income tax. The law contains
detailed provisions for determining taxable income. The income tax authorities
interpret and administer these provisions. Income tax is an important outgo for
many business enterprises and they attempt to minimize it by taking advantage of
loopholes in tax rules and regulations. A business enterprise may choose to follow
an accounting practice that is specified in the tax law so as to reduce its tax
expense. In a few cases, businesses must follow the accounting practices specified by
the tax law. You will see later why good tax accounting is not necessarily good
financial accounting. Nevertheless, tax rules constitute one of the strongest
influences on accounting practice. The CBDT has constituted an Accounting
Standards Committee. In October 2012, the Committee issued 14 draft tax
accounting standards (TAS) for public comment. The minimum alternative tax
(MAT) is a levy based on accounting profit. This contrasts with normal tax that is
based on taxable income. A company must pay MAT if it reports an accounting
profit even if it does not have taxable income. MAT has arguably increased the
influence of tax in accounting decisions.
The Reserve Bank of India (RBI), as the central bank of the country, regulates
the functioning of the financial sector in India. It has an interest in financial
reporting by financial institutions. The RBI specifies accounting and reporting
requirements for banks and finance companies. It has laid down detailed rules for
income recognition and provisioning for bad debts broadly in line with international
practices and issued guidelines for accounting for hedging transactions by banks.
The Insurance Regulatory and Development Authority (IRDA) regulates the
functioning of the insurance business in India. It has laid down accounting and
disclosure rules and financial statement formats for insurance companies.
Under the Constitution of India, the President appoints the Comptroller and
Auditor-General of India (CAG) to audit the accounts of the Government of
India, State governments and government organizations. The CAG’s office reviews
the financial statements of government departments and public sector enterprises
and sends its observations to Parliament.
Cross-border investment and trade requires financial information that is
comparable for businesses around the world. The International Accounting
Standards Board (IASB) develops a single set of accounting standards that will
eventually be acceptable worldwide as the basis for listing of securities. The IASB’s
standards are known as International Financial Reporting Standards (IFRS)
or International Accounting Standards (IAS). For convenience, we will refer to
these as IFRS. The IASB works with national accounting standard-setters to
achieve convergence in accounting standards around the world. It consists of 14
individuals (12 full-time and two part-time members) appointed by the Trustees of
the International Accounting Standards Committee Foundation.
The International Federation of Accountants (IFAC) is primarily concerned
with bringing about greater international harmony in matters such as education,
ethics, and auditing practices. The International Organization of Securities
Commissions (IOSCO) is an association of securities regulators, such as SEBI and
the US Securities and Exchange Commission (SEC). IOSCO plays an influential
role in improving accounting and disclosure regulation in securities markets around
the world.
Accounting Standards and Policies
As we noted earlier, GAAP is the collection of conventions and rules that
accountants have accepted over a period of time. An accounting standard
specifies the acceptable methods from the wide array of accounting choices.
Accounting policies comprise the principles, bases, conventions, rules, and
procedures that enterprises adopt in preparing and presenting financial statements.
Business enterprises select a variety of accounting policies from those regarded as
permissible by the accounting profession. Interpretation of financial information is
complicated by the adoption of diverse policies in many areas of accounting. At a
minimum, companies should disclose their accounting policies.6 The institutional
arrangements for establishing accounting standards differ from one country to
another. For example, in India, the government prescribes the accounting
standards. In the US, the private sector Financial Accounting Standards Board
(FASB) sets the accounting standards. FASB’s standards have the support of the
SEC.
Converging IGAAP with IFRS
India has committed that its national accounting standards will converge with
IFRS. Convergence would enable Indian authorities to carve out exceptions to IFRS
when they are applied in India. In contrast, adoption would require accepting IFRS
without changes. The government’s notification issued in February 2011 contains
some “carve-outs” from international standards. The term ‘Ind AS’ refers to Indian
standards converged with IFRS. The MCA had proposed adoption of Ind AS
beginning April 1, 2011 in phases. However, as of January 1, 2014, the government
has not notified the effective date for Ind AS.
Convergence with IFRS is likely to bring about major changes in Indian financial
reporting. IFRS follows the fair value measurement basis, whereas Indian
standards largely follow historical cost. Indian companies may face significant
problems in their transition to IFRS because of the absence of active markets for
some assets in India. Also, companies must improve their documentation of
management decisions and judgments on financial reporting. Throughout this book,
you will learn about issues in transition from IGAAP to IFRS.
IFRS and US GAAP are the two accounting systems competing for international
acceptance. These differ in terms of the amount of detail, quality of application and
acceptability across nations. US GAAP is more detailed and applied more
consistently. Because the IASB is an international standard-setter, IFRS has more
worldwide acceptability. Fortunately, the IASB and FASB are working on joint
projects with a view to narrowing down the differences between their standards. In
2007, the SEC agreed to allow non-US companies that raise capital in the US to
follow IFRS instead of having to comply with US GAAP. A common set of
accounting standards around the world will reduce accounting and auditing costs
for businesses and make international financial comparisons easier. IFRS became
mandatory in the European Union effective January 1, 2005. As of January 1, 2014,
there were 40 standards (IFRSs/IASs) and 26 Interpretations.
Principles or Rules?
Principles-based standards place greater reliance on substance and lay down the
broad principles that govern the accounting and disclosure requirements. In
contrast, rules-based standards prescribe detailed conditions and stipulations and
place greater reliance on bright lines, industry-specific guidelines, and exceptions.
As one commentator put it, “If you tell your child to be at home at a reasonable
hour, you are using a principles-based guideline. But if you tell your child to be
home by
11 p.m. and then provide for 15 different contingencies that might justify a different
time, you are using rules-based guidelines.” Many consider US GAAP to be rulesbased and IFRS to be principles-based. It would be fair to say that in the continuum
from details to principles, US GAAP is closer to details. A crude measure of the level
of detail is the number of pages of the standards and associated literature: US
GAAP runs into more than 25,000 pages and IFRS comes to about 3,500 pages.
Because of the US legal environment, American managers and auditors face a much
greater risk of shareholder lawsuits and the prescriptive nature of US standards
makes it easier for them to defend their assumptions and judgments.
Business organizations attempt to measure economic performance by applying
accounting principles and rules and management’s assumptions and estimates. The
following equation sums up this position:
Accounting performance = Economic performance + Measurement error +
Bias
Forms of Business Organization
From commercial and legal angles, business may be organized in
many ways. The common forms of organizing business are sole
proprietorship, partnership, limited company, and limited liability
partnership.
Sole Proprietorship
In sole proprietorship, a single individual carries on a business. He keeps all the
profits the business earns. The sole proprietor’s liability is unlimited, i.e. if the
business does not do well, he is personally liable for paying off the debts. He could
even lose his shirt. The sole proprietary form is often most appropriate when the
business is very small and is not expected to grow much. There is no specific law to
regulate sole proprietorship businesses.
Partnership
A partnership has a minimum of two and a maximum of 100 persons trading
together as one firm. The partners share the firm’s profits and losses equally, unless
they agree otherwise. Each partner has unlimited liability for all the debts and
obligations of the firm and is responsible for the liabilities in the firm of his fellow
partner or partners as well as his own. The Indian Partnership Act regulates
partnership businesses, but the regulation is minimal. Professional practices, such
as those of architects, lawyers, and accountants, are usually partnership firms.
Limited Company
A limited company, or commonly company, is a legal entity unlike a sole
proprietorship or partnership. Under the law, it has most of the rights of a natural
person. The Companies Act 2013 governs the functioning of companies. Companies
must, among other things, prepare periodical financial statements and get them
audited. The financial statements are available for inspection on a public register.
Companies can be either public or private. The shares of a public company are
available to the general public and they may be listed for trading on a stock
exchange. The company will have the word “Limited” after its name. In contrast,
the shares of private companies (that form the bulk of the number of companies) are
not for sale to the public, and these companies have “Private Limited” suffixed to
their names.
The members of companies undertake to contribute an agreed amount to the
company’s capital. This limits the liability of the members to pay the company’s
debts. Even if the company cannot meet its debts, it cannot ask for an amount above
the agreed amount. In the company form of organization, total strangers come
together, whereas a partnership business is formed by individuals (sometimes
family members) who have often known each other intimately over a long period of
time. Limited liability is so common that business would be unthinkable without it.
Limited Liability Partnership
A limited liability partnership (LLP), created by the Limited Liability
Partnership Act 2008, is a hybrid between a company and a partnership. It is a
separate legal entity with perpetual existence, similar to a company. Only
individuals can be partners in a partnership, but an LLP can have individuals or
corporate bodies as partners. Except in the case of fraud, the liability of the
partners is limited to their shareholdings and the partners are not personally liable.
An LLP must have at least two partners; there is no upper limit. Every partner of
an LLP is an agent of the LLP, but is generally not bound by anything done by the
other partners. An LLP may designate one or more partners as managing or
executive partner for compliance with legal requirements. The LLP form is
especially suitable for professional services firms. In order to meet competition from
international firms, Indian firms should become bigger, and that means they should
be able to have more than 100 partners (the limit for a partnership). Also, the
partners of an LLP will have protection from professional negligence litigation. An
LLP combines the flexibility of a partnership with limited liability for its partners.
LLP is yet to become popular in India.
Exhibit 1.2 summarizes the major features of sole proprietorship, partnership and
limited company that are the more common forms of organization. Other forms of
business organization include statutory corporations, mutual funds, and cooperative
societies. This book deals mainly with public companies, though the accounting
principles that we discuss apply to all forms of organization.
Legal Formalities for a Limited Company
Forming a limited company is more complicated than forming a sole proprietorship
or a partnership business. The founders or promoters of a proposed company must
register it with the Registrar of Companies in the state in which the company’s
registered office is to be located. They must submit the memorandum of
association which should include the name of the company, its objects, a statement
of the limited liability of its members, the amount of share capital, and how the
share capital is divided into shares. The company must also submit the articles of
association which cover internal matters, such as meetings, voting, and issue of
new shares. Once the legal formalities for formation of a company have been
complied with, the Registrar issues a certificate of incorporation, bringing the
company into existence as a separate legal entity.
Although limited companies are fewer in number than proprietary or partnership
concerns, they carry on a large part of the economic activity, especially large-scale
trading, manufacturing and services. The main advantages of the company form of
business over sole proprietary and partnership forms are limited liability of
shareholders, free transferability of ownership, perpetual existence, professional
management, and ease of raising capital.
The Corporate Organization
The corporate organization structure consists of the shareholders, board of
directors, and corporate officers. The shareholders appoint the board of directors to
manage the company. Corporate officers assist the board of directors in carrying out
its responsibilities to the shareholders. Figure 1.4 shows the typical organization
structure of a company.
At the apex of the corporate organization are its shareholders who are the owners
of a company. The capital of a company is divided into units of ownership called
shares. The shares of a public company are freely transferable from one person to
another. Individual shareholders generally own small numbers of shares, while
institutional shareholders, such as banks, insurance companies, and mutual funds,
may hold a substantial portion of the share capital. The shareholders appoint the
company’s directors and determine their remuneration. They delegate the authority
to manage the company to the board of directors. The shareholders appoint an
individual auditor or a firm of auditors as the external auditor.
The primary duties of the board of directors are to conduct the business of the
company and to protect the interests of the shareholders. The directors are mainly
concerned with formulating policies and monitoring the performance of the officers.
Specific duties of the board include approving major contracts, recommending
dividends for approval by shareholders, and fixing the salaries of officers. Typically,
the board consists of company officers and outsiders.
The board of directors appoints officers to conduct the company’s everyday
business. Executives usually included in this group are the chief executive
officer (president or managing director), several vice-presidents, a treasurer, a
controller, and a company secretary. The chief financial officer (or vice-president,
finance and accounting) has overall responsibility for financial management and
accounting and auditing matters. The controller is the chief accounting officer of
the company and is responsible for the maintenance of accounting records and
preparation of financial statements, budgets, and tax returns. The treasurer is the
custodian of the company’s funds and is responsible for planning and controlling the
company’s cash position. The company secretary maintains minutes for meetings
of directors and shareholders, represents the company in many legal and
contractual matters, and ensures compliance with laws. The internal auditor
reviews the company’s financial and other decisions and reports his findings to the
board. The designations of the officers differ from company to company.
The separation of ownership and management in the corporate form increases the
chances of managers pursuing their goals and interests, rather than those of the
shareholders. This results in agency costs, a term for the ill-effects of the
disconnect between managers’ and shareholders’ interests. The following quote from
Adam Smith’s classic sums up this point:
The directors of such [public] companies, however, being the managers rather of other people’s money than of their
own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the
partners in a private co-partnership frequently watch over their own. Like the stewards of a rich man, they are apt to
consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation
from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the
affairs of such a company.7
We will now see how accounting can help in moderating agency problems.
Accounting, Capital Market, and Corporate Governance
Let us do a thought experiment. Suppose that you have identified
a highly cost-effective technology for generating solar power. This
project requires an initial investment of `100 million. Your own
savings and even generous support from your relatives and
friends is not anywhere near that amount. You know that many
individuals are interested in clean energy projects. You approach
them with your detailed project proposal, colourful promotional material, and
superb multimedia presentation. Many of them tell you about how they invested in
ventures relying on entrepreneurs’ promises of wonderful returns but finally did not
get back even their initial investment. “Of course, we do not mean to question your
intentions or competence,” they add politely, as they lead you to the door. “Just that
we don’t know whom to trust.” You have a good project but you cannot find the
money for it. What will you do? While you may have been spared a similar
experience, the anecdote would sound familiar to many entrepreneurs. But as we
will see shortly, the story does not necessarily have to end this way.
The Lemons Principle and the Problem of Adverse Selection
The inability of an entrepreneur to find funds is a classic case of the working of the
lemons principle: the presence of people in the market offering inferior goods
tends to drive the market out of existence if it is difficult to separate good quality
from bad. The principle was first formally stated by George A. Akerlof, Professor of
Economics at the University of California, Berkeley in one of the most cited
economics papers – the paper won him the Nobel Prize.8
To understand how the lemons principle works, think of the market for used cars.
Potential buyers know less about the quality of used cars than the sellers, a
condition referred to as information asymmetry. If we assume that half the used
cars are of good quality and the rest are bad (known as ‘lemons’ in the used-car
market), buyers have a 50:50 chance of getting a good car or a lemon. Assume that
the worth of a good car is `80,000 and that of a lemon is `30,000. The price the
buyers would be willing to pay would be roughly equal to the weighted average of
the prices for good cars and lemons. In our example, this would be `55,000,
calculated as follows: `80,000 × 0.5 + `30,000 × 0.5. As this average price is less
than the true worth of good cars, some sellers of good cars will leave the market.
However, sellers of lemons will remain because the price is attractive: After all,
their cars are worth `30,000, but they stand a chance of getting `55,000. The
market now has a larger proportion of lemons, say 60 per cent. As a result, the
average price will fall below the previous average. In our example, the average price
will now become `50,000. Some more sellers of good cars will now leave the market.
This process repeats until the market has only lemons. When this happens, buyers
refuse to buy used cars.
The lemons principle is at work in adverse selection, a process by which
‘undesirable’ buyers or sellers are more likely to participate in a market. It can be
applied to a variety of settings including the capital market. The capital market
consists of entrepreneurs (sellers of business ideas) and savers or potential
investors (buyers of those ideas). An entrepreneur may be either good or bad. As
savers are unable to spot good entrepreneurs, they offer a weighted average price
for the investments. That price would be too low for good entrepreneurs and they
will leave the market, as a result of which there is a larger proportion of bad
entrepreneurs in the market. In the end, there are only bad entrepreneurs, but
savers refuse to part with their funds and the capital market breaks down. In a
corporate setting, firms and managers substitute for entrepreneurs.
Signalling Quality
All of us know that vibrant capital markets exist in Mumbai, London, New York
and in many other financial centres of the world. So, what makes these markets
work despite the lemons principle? We find the answer in a well-known paper by
Michael Spence, Professor of Economics at Stanford University – he was awarded
the Nobel Prize for this research.9 Professor Spence argued that job applicants with
superior skills or abilities would invest time and resources in acquiring superior
educational qualifications in order to distinguish themselves from less skilled
applicants. This is signalling.
Signals should be costly in order to be effective. If signals are costless, everyone
can send them; so the signal is of no use. For example, if you want to become a
successful academic, you will invest time and resources in getting admission to the
PhD programme of a good university and complete the programme. This is a costly
signal because a less competent person has a low chance of completing a doctorate
from such an institution. In the used-car example, a seller of a good car could give a
performance warranty for a certain period of time. Signalling mitigates information
asymmetry. Going back to cars, manufacturers utilize warranties to address quality
concerns. For example, in August 2010, General Motors offered a “lifetime”
warranty (defined as 160,000 km) on all its new Open and Vauxhall cars in Europe
saying that it was making the offer as a “strong statement of confidence” in the
quality of its cars. Earlier in that year, Toyota Motor Corp. and Kia offered variants
of lifetime warranty.
Extending Professor Spence’s idea of educational signalling to the capital market,
good entrepreneurs and managers can differentiate themselves in a number of
ways, such as consistently paying higher dividends, giving credible guarantees of
higher returns, appointing reputable accounting firms to audit their financial
statements, having respectable outsiders as independent directors, and conforming
to superior standards of accounting and disclosure. All these are costly signals
because incompetent or dishonest managers cannot mimic these signals in much the
same way that an unintelligent person cannot complete PhD from a top school.
Going back to the Wipro example in the Introduction, the company was signalling
its superior standards of transparency and concern for investors by promptly
reporting its weaker performance and prospects, even though it was painful to do
so.
High-quality financial reporting mitigates the problem of adverse selection by
reducing information asymmetry and thus facilitates orderly functioning of the
capital market, making it possible for entrepreneurs to raise funds at reasonable
rates and investors to earn fair returns. Accounting standards, managerial
behaviour, and audit quality determine the quality of accounting information. A
well-organized capital market guided by reliable public information encourages
people to save and invest, leading to greater production of goods and services and
higher employment, and thus contributes significantly to the economic
advancement of people. On the contrary, when markets are driven by manipulated
financial numbers or wild expectations, they are prone to frequent speculative
bubbles that inevitably burst and cause enormous damage to investor wealth and
confidence. Enron has become the byword for accounting manipulation. India has
Satyam. The Internet stock bubble of the 1990s is an example of investors going by
hopes of incredible growth prospects rather than sound business and financial
information. When Bernard Madoff’s Ponzi scheme failed, the investors lost $20
billion. Ponzi schemes that have been reported in India include emu farms in Tamil
Nadu, the potato investment scheme in West Bengal, the cattle-and-ghee scheme in
Uttar Pradesh, and the usual chit fund investment scams in many states.
Moral Hazard and Corporate Governance
Moral hazard describes a situation where a decision-maker takes unwarranted
risks or puts in inadequate effort because he or she has been provided with some
kind of safety net. For example, individuals may not park their cars securely when
their cars are insured; financial traders often gamble to earn large bonuses, because
the penalty for losing money is mild. Suppose that you have invested in a business
using high-quality accounting information. With your cash now firmly in their
pockets, the managers may not only stop exerting themselves to the point of being
indifferent to selection of projects but may even give themselves an executive jet,
high managerial pay and generous perquisites, and huge separation benefits. This
is an example of moral hazard. Accounting plays an important role in dealing with
this problem by disciplining managerial actions. Executive compensation contracts
specify performance standards in accounting terms, such as net profit and return on
investment. If a minimum level of profitability is specified, managers would select
only projects that are at or above that level and reject ‘bad’ projects. As a result,
accounting becomes a key instrument for motivating, directing, monitoring and
evaluating managerial performance and, thus, ensuring good corporate governance.
Financial markets exist to transfer capital from investors to entities that need
funding and to provide liquidity. By providing high-quality information in a timely
manner, accounting aids in reducing agency costs and thereby enables business
organizations to raise capital on fair terms and makes them utilize the capital
efficiently.
The Accounting Equation
The accounting equation shows the relationship between the
economic resources of a business and the claims against those
resources. At all times, the following relationship holds:
Economic resources = Claims
Economic resources are assets. The claims consist of creditors’
claims or liabilities, and owners’ claims or equity. (Recall that a
business is separate from its owner for accounting purposes. So the owner too has a
claim on the business.) The accounting equation may now be modified as follows:
Assets = Liabilities + Equity
We can analyze any business transaction in terms of its effect on the accounting
equation, regardless of its size and complexity. The balance sheet shows the
position of assets, liabilities and equity.
Assets
An asset is a resource “controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity.”10 An enterprise
should consider a resource its asset if (a) it controls the resource, and (b) the
resource is expected to provide future benefits. You enjoy going to a public park that
has trees, plants, flowers and a jogging track (benefits), but since you cannot
prevent anyone else from using it (no control), you should not regard the park as
your asset. You are the unquestioned master of your broken iPod (control), but since
you are not going to use it (no benefits), you will not count it among your assets.
Cash is possibly the ideal asset because it can buy other assets. Amounts
receivable from customers are a major part of a bank’s assets. Inventories that will
become cash on being sold are a retailer’s assets. A manufacturer’s land, buildings,
plant and equipment are its assets, because it uses them to provide goods to its
customers and gets cash. Some assets, such as land, buildings, plant, and
inventories, have physical form. Assets such as patents and copyrights confer
exclusive rights but have no physical form. Other assets, such as amounts
receivable from customers and investments in bonds, are legally enforceable claims
on others. What is common to all assets is that they have the capacity to provide
benefits to their owners. To sum up, an asset is what an enterprise ‘owns’. Think of
assets as receivable. As an exercise, list the chief assets of Biocon, Dell, ICICI Bank,
Microsoft, and Wipro.
Liabilities
A liability is “a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits.”11 A liability is the mirror image of an asset in that it
usually requires payment of cash. Some liabilities, such as loans payable and
salaries payable, are in precise amounts. Other liabilities, such as warranties
payable, income tax payable, and pensions payable, must be estimated. Most
liabilities result from contracts e.g. amount payable for using electricity, or
statutory requirements e.g. amount payable for employer’s contribution to provident
fund. A liability may also arise from a constructive obligation that an enterprise
regards as payable even without a legally enforceable claim. For instance, an
enterprise may follow a policy of full refund for goods returned even after the
contractual period in order to foster customer goodwill; this may give rise to a
liability. In sum, a liability is what an enterprise ‘owes’. Think of liabilities as
payable. Can you list the chief liabilities of BHEL, Dr. Reddy’s Laboratories, SBI,
Siemens, Sony, and TCS?
Equity
Equity is “the residual interest in the assets of the entity after deducting all its
liabilities.”12 Thus, it is the difference between the enterprise’s assets and its
liabilities. The equity of a business enterprise is increased through investments of
assets by owners and profits from operations and is decreased through distributions
of assets to owners from the enterprise and losses from operations. Think of equity
as residual.
The equity of a company is called shareholders’ equity. Its components include
share capital, share premium, and retained profit. Share capital is the amount
contributed by the shareholders towards the company’s capital and is entered in the
company’s share capital account. Share premium is the excess of shareholders’
contribution over share capital. The activities of a business result in revenues and
expenses. Revenues are amounts charged to customers for goods and services
provided. For example, airlines earn revenue by transporting passengers and cargo.
Expenses are generally the costs of earning revenues. The expenses of running an
airline include aircraft lease rent, fuel, salaries of crew and ground staff, interest on
borrowings, and income tax. Net profit is the excess of revenues over expenses, and
net loss is the excess of expenses over revenues. Dividends are distributions of
assets by a company to its shareholders. Net profits increase equity, and net losses
and dividends decrease equity. Retained earnings represent the amount of net
profit kept in the business. You will learn more about the components of equity as
you progress. Can you name the chief revenues and expenses of Arvind Mills,
Goldman Sachs, Google, Jet Airways, SAIL, and Vodafone?
Analyzing the Effect of Business Transactions
On March 1, 20XX, Suresh starts Softomation as a proprietary business for
providing customized computer software. Softomation has the following
transactions in March:
Owner invests On March 1, 20XX, Suresh invests `50,000 in cash. The first
balance sheet of the new business will show cash of `50,000 and equity of `50,000.
(The items affected by the transaction appear in italics):
The Indian convention is to show liabilities and equity on the left of the balance
sheet and assets on the right.
Takes a loan On March 2, Suresh takes a loan of `20,000 from Manish for
Softomation. This transaction increases both assets (cash) and liabilities (loan
payable):
Buys equipment for cash On March 3, Softomation buys for cash a computer
costing `58,000. This transaction decreases one asset (cash) and increases another
asset (equipment), but the total assets do not change:
Buys supplies on credit On March 4, Softomation purchases supplies for `6,000
on credit. The effect is that both assets (supplies) and liabilities (trade payables)
increase:
13
Provides services for cash On March 19, Softomation completes its maiden
software for a retail store and receives a fee of `12,000. Revenue increases the
owner’s claim on the business. So the receipt of revenue increases both assets (cash)
and equity:
Pays supplier On March 21, Softomation pays its creditor for supplies, `2,000. As
a result, both assets (cash) and liabilities (trade payables) decrease:
Pays expense On March 29, Softomation pays employees’ salaries, `4,000, and
office rent, `1,200. Expenses reduce the owner’s claim on the business. This
transaction decreases both assets (cash) and equity:
Provides services on credit On March 30, Softomation completes a software for a
shoe store. The customer agrees to pay the agreed fee of `8,000 a week later. In this
case, Softomation has earned the revenue but has not received it in cash. So we
count it as revenue.14 The effect of this transaction is that both assets (trade
receivables) and equity increase:
15
Owner withdraws cash from business On March 31, Suresh withdraws `3,500
for personal use. In accordance with the reporting entity assumption, we should
treat this payment by the business as a withdrawal of capital by the owner, and not
as a business expense.16 There is a decrease in both assets (cash) and equity:
Here is the list of the above transactions.
Exhibit 1.3 presents the effect of these transactions on the accounting equation.
Change in balance is in italics.
Revenues increase equity, and expenses, drawings (or dividends) decrease equity.
Therefore, we can rewrite the accounting equation, Assets = Liabilities + Equity, as
follows:
Assets = Liabilities + Capital + Revenues – Expenses – Drawings (or
Dividends)
Financial Statements
Financial statements provide information about an enterprise’s
financial performance and financial position. Financial statements
present the financial effects of transactions and other events by
grouping them into broad classes, or elements. Revenues and
expenses are the elements related to the measurement of
performance; assets, liabilities, and equity are the elements related to the
measurement of financial position. A complete set of financial statements normally
consists of the statement of profit and loss, statement of retained earnings, balance
sheet, cash flow statement, statement of changes in equity, and explanatory notes.
Financial statements are a central feature of accounting because they are the
principal means of communicating accounting information to those outside an
enterprise. Business enterprises publish five major financial statements:
1. The statement of profit and loss reports the financial performance of an
enterprise during a period.
2. The statement of retained earnings explains what the enterprise did with its
earnings, i.e. how much it distributed and how much it retained.
3. The balance sheet shows the financial position of the enterprise at a point in
time.
4. The cash flow statement summarizes the cash inflows and outflows of the
enterprise resulting from its operating, investing, and financing activities
during a period.
5. The statement of changes in equity explains how equity changed as a result
of net profit, dividends, return of capital and other transactions.
Exhibit 1.4 shows Softomation’s financial statements.
We now briefly analyze these statements.
Statement of Profit and Loss
The statement of profit and loss (or profit and loss account or income
statement) summarizes the activities of an enterprise in a period by disclosing the
revenues earned and the expenses incurred. By measuring the net profit earned by
a business, it indicates its degree of operating success. From Exhibit 1.4, we note
that in March 20XX Softomation earned a revenue of `20,000 from services, and
incurred expenses totalling `5,200, consisting of salaries expense of `4,000 and rent
expense of `1,200. Thus, it reported a net profit of `14,800 for the period. You might
have noticed that the statement of profit and loss is a summary of the revenues and
expenses that appear in the ‘Equity’ column in Exhibit 1.3. We note that
Softomation’s revenues are from its business activities.
What do you think of Softomation’s performance?
Statement of Retained Earnings
The statement of retained earnings explains what Softomation did with its net
profit. This statement is a bridge between the statement of profit and loss and the
equity section of the balance sheet. A business may distribute its earnings to the
owners, retain the earnings, or distribute a portion of the earnings and retain the
rest. Suresh withdrew `3,500 of Softomation’s March earnings of `14,800 and
retained `11,300. The payout, the ratio of distribution to net profit, is over 23 per
cent. Since distribution of profit is not an expense, it appears in the statement of
retained earnings, and not in the statement of profit and loss. It is a “below the line”
item. The retention indicates the extent of the owner’s ploughing back the earnings
into the business. As a result of the retention, Suresh’s stake in Softomation has
gone up, and this should be reassuring to the firm’s present and potential creditors.
Do you think Suresh was right in withdrawing a part of Softomation’s profit?
Balance Sheet
The balance sheet presents an enterprise’s assets, liabilities and equity at a point
in time. It summarizes the resources, and the claims to those resources by owners
and creditors, of the enterprise on a certain date. As shown in Exhibit 1.4, at the
end of March 20XX, Softomation has assets totalling `85,300 equal to the total of
liabilities of `24,000 and equity of `61,300.
Do you think Softomation is a financially sound business?
Cash Flow Statement
The cash flow statement describes the investments in assets made during the
period and how those investments are financed and how much the owners took from
the business. It reports the cash effects of not only the enterprise’s operations but
also its investing (i.e. buying assets) and financing (i.e. cash received from or paid to
owners and lenders) activities. The cash flow statement in Exhibit 1.4 describes how
Softomation managed to end the month with a cash balance of `13,300. Current
operations resulted in net cash increase of `4,800. Investment in equipment
resulted in cash outflow of `58,000. Owner’s investment, net of withdrawal, and
loan provided net cash of `66,500.
What does the statement tell us about Softomation’s cash flow?
Statement of Changes in Equity
The statement of changes in equity (or statement of shareholders’ equity)
describes the changes in the components of equity, such as share capital and
retained earnings. Changes in share capital result from introduction or withdrawal
of capital by the owners. Changes in retained earnings result from net profit and
distributions to the owners.
What can we learn from the changes in Softomation’s equity?
At this stage, our aim is to get a glimpse of financial statements. You will study
the principles and procedures followed in the preparation, analysis and
interpretation of financial statements in later chapters. You will find it greatly
useful to keep referring to company annual reports as you progress through the book.
Appendix A has the 2013 financial statements of Hindustan Unilever.
How are the Financial Statements Interrelated?
The statement of profit and loss, statement of retained earnings, balance sheet, cash
flow statement, and the statement of changes in equity are related to each other.
Take, for example, the transaction on March 1: Suresh began business with cash,
`50,000. This transaction affects cash and equity, both balance sheet items. Since it
results in cash inflow, it appears also in the cash flow statement. Look at the
transaction on March 21: Paid creditor for supplies, `2,000. It reduces liabilities and
cash, both balance sheet items. Since it results in cash outflow, it is also an item in
the cash flow statement. The effect of some transactions may be confined to one of
the statements. Consider the transaction on March 4: Bought supplies on credit,
`6,000. It affects the balance sheet because supplies is an asset and the credit
purchase creates a liability for a payable. When Softomation pays the supplier on
March 21, cash decreases, affecting the balance sheet (cash and payables) and the
cash flow statement – operating cash outflow. The owner’s withdrawal of `3,500 on
March 31 affects the statement of retained earnings – drawings, the cash flow
statement – financing cash outflow, and the statement of changes in equity.
Preview of Financial Statement Analysis
Softomation earned a net profit of `14,800 on revenue of `20,000 and assets of
`85,300. The company’s profit margin, the ratio of profit to revenue, is 74 per cent.
The company’s return on assets, the ratio of net profit to assets, is 17.35 per cent.
The company’s asset turnover, the ratio of revenue to assets, is 0.24. The margin
looks impressive considering that this is the first month of the business. The return
on assets also looks good. The asset turnover is quite low for a service enterprise but
then it is too early to expect full utilization of assets. Hopefully, the sales will pick
up and the asset turnover will improve over time. The large payout of profits is
unusual at the early stages of a business. A significant portion of the assets is of a
long-term nature and needs to be financed by long-term capital. Receivables are 80
per cent of sales and it could be a matter of concern if the trend continues. Current
operations produced net cash of `4,800 as against a profit of `14,800. That could
mean the profits are mostly stuck in receivables.
What do Accountants Do?
Many think that the work of accountants is bookkeeping – the
process of recording transactions. However, bookkeeping forms
only a small part of accounting and is possibly the simplest.
Accounting, on the other hand, includes the design of efficient
information systems, budgeting, cost analysis, tax planning,
auditing, and the analysis and interpretation of information. Accountants play an
important role in society and offer a wide range of services to business as well as the
government. For the purposes of our discussion, the area of accounting may be
divided into the following broad fields:
Public accounting;
Private accounting;
Government accounting; and
Not-for-profit accounting
Public Accounting
Accounting firms engaged in public accounting provide a variety of accounting
services to the public for a fee. They vary in size from large national or international
accounting firms employing thousands of persons to numerous one-person practices.
CAs are, similar to doctors and lawyers, licensed to practise their profession to
ensure that the public gets services of an acceptable standard. To become a CA, it is
necessary to pass a rigorous and comprehensive examination conducted by the ICAI
and undergo at least three years of practical training in accounting, auditing, tax
and other related areas. On successful completion of the examination and training,
the individual can apply for a certificate of practice which is the licence to practise
as a CA. CAs can practise individually or in partnership with other CAs
Accounting firms provide a wide variety of services. The principal services offered
include (a) auditing, (b) forensic accounting and risk management, (c) tax services,
(d) advisory services, (d) bankruptcy, and (e) small business services. These are
described below.
Auditing (or assurance) It involves the examination of financial statements and
generally forms an important part of the work of a CA. Companies must have their
financial statements audited by an outside CA. The major duties of a company’s
auditor are examining and verifying the company’s financial statements;
appraising the company’s procedures for collecting, recording, and reporting
financial information; testing the controls by which the company protects its
financial systems from frauds and errors; and publishing an opinion as to whether
the company’s financial statements give a “true and fair view” of its financial
affairs.
Auditing enhances the credibility of financial reports prepared by an enterprise.
By ensuring that the financial statements are correct and complete, auditing
increases their reliability and usefulness for making economic decisions by
investors, creditors, analysts, and others. Credible financial reports are essential for
society to have trust in public companies. The following comment in The Wall Street
Journal sums up the importance of auditing:
Accountants, more specifically, auditors, are charged with making sure corporations properly report their financial
condition. They are, when everything is working right, the truth police, a check on a corporation’s darker
thoughts.17
Auditors must be both technically competent in their work and independent of the
enterprise whose financial statements they audit. A rigorous system of training and
examination certifies that auditors possess the requisite technical skills. But it is
not always easy for auditors to be independent of the enterprise that engages and
pays them. At a minimum, auditors should scrupulously avoid transactions and
client relationships that could compromise their ability to express an independent
professional opinion on its financial statements.
Forensic accounting and risk management Growing financial fraud has led to
the emergence of forensic accounting, a field that specializes in uncovering fraud in
organizations. More often than not, there is likely to be some kind of employee
involvement in fraud. Forensic accountants spend a lot of time interviewing
suspects and witnesses. These days a lot of information handling is automated. So
forensic accountants require high-level computer skills. The very nature of the work
of forensic accountants makes their world mysterious. Even so, there have been
occasional reports of the work done by them, such as tracking down assets held in
Swiss banks and investigating ghost payroll. Risk management, an allied field, aims
at identifying potential weakness and failures in financial systems in order to
design robust controls. With the rise of white-collar crime, such as tax evasion,
money laundering and bribery, the demand for forensic accountants and risk
management specialists is growing.
Tax services Business enterprises have to consider the tax consequences of
alternative courses of action. Tax services include not only the preparation of tax
returns and compliance with tax laws but also planning business activities with a
view to minimizing taxes. It is often possible to effect considerable savings in tax
expense by appropriately arranging one’s business affairs. While evasion of taxes is
definitely unlawful, it is perfectly legitimate for everyone to reduce their tax
expense. To be successful in tax practice, an accountant should be up-to-date with
changes in tax statutes, rules, notifications and circulars, and court decisions.
Advisory services An important part of the revenues of large accounting firms
comes from advisory services, an omnibus term for a wide variety of consulting
activities. These services go beyond the traditional boundaries of accounting and
auditing. Examples of consulting assignments include rethinking business strategy,
designing organizations, recruiting personnel, reviewing costs, designing
information systems, improving inventory control, helping companies go public, and
advising on restructuring. Specialists such as actuaries, computer consultants,
MBAs, engineers, and economists are employed in consulting. Although auditing
continues to be the mainstay for most accounting practices, its relative importance
is declining as the demand for advisory services grows. Large accounting firms are
now “professional services firms”. Nearly one-fourth of the amounts the companies
in the CNX S&P 500 companies paid their auditors in 2013 was for non-audit
services.
Bankruptcy Bankruptcy is the inability of a business to pay all of its obligations.
When a business files for bankruptcy, its assets are sold and the amounts due to its
creditors are paid out of those sale proceeds. Bankruptcy administrators do not have
the glamour of investment bankers. But when the music stops and an investment
bank is wound up, its bankruptcy administrators stand to gain. For example, fees
paid to lawyers and accountants for unwinding Lehman Brothers in the US and
Europe were estimated to surpass $2 billion.18 The operation involved settling
derivative contracts, selling off the bank’s subsidiaries and real estate, and dealing
with litigation by and against the bank.
Small business services Many accounting firms provide a variety of services for
small businesses. Setting up an accounting system, compiling financial statements,
preparing budgets and forecasts, and assisting the client in obtaining a bank loan
are examples of small business services.
Private Accounting
An accountant is said to be in private accounting when she is employed by a
business enterprise. Private accountants are employed by organizations in such
diverse businesses as steel making, manganese mining, banking, airlines, software,
real estate, and hotels. Typical designations of these accountants are financial vicepresident, financial controller, works accountant, and management accountant. In
recent years, individuals with backgrounds in finance and accounting have become
chief executives in a number of companies. Among the areas in which private
accountants specialize are management accounting, internal auditing, and
information systems.
Management accounting Accountants in management accounting provide
information to management for making business decisions and formulating longterm policies. Management accounting information has use in several areas
including cost control, product costing, capital investment appraisal, profitability
analysis, corporate planning, budgeting, pricing policies, and cash flow and liquidity
management. Members of the Institute of Cost Accountants of India, known as cost
accountants, specialize in management accounting. A large number of CAs
employed in business enterprises too perform management accounting functions.
Internal auditing In addition to the audit by outside accounting firms, most large
corporations have their own internal audit departments. Internal auditors are
concerned with reviewing internal controls, assessing compliance with established
policies, ascertaining the extent to which company’s assets are safeguarded, and
recommending improvements to operations. External auditors are primarily
concerned with the fairness of the financial statements of a business. The
Companies Act 2013 requires companies to appoint an internal auditor, who shall
be a CA or a cost accountant.
Information systems A rapidly growing field for accountants is the design and
development of information systems for processing accounting data. Since large
corporations make extensive use of technology for processing transactions, a good
working knowledge of computer hardware and software is indispensable for
specialization in this field. Information system auditors examine the adequacy of
security in computerized accounting systems.
Government Accounting
Government departments and agencies receive and pay huge sums of money. We
are familiar with government organizations such as the Indian Railways, India
Post, the Income Tax Department, the Police, and the Defence Services. Unlike
business enterprises, the sole objective of government is not to make a profit from
its operations. Still, it is essential that the sums due to the government are collected
when due, and payments are properly authorized and result in expected benefits.
The government should be cost effective in its operations, so that taxes and other
levies can be kept low.
Sources of government revenues include income tax, excise and customs duties,
value added tax, and various types of fees and cesses. Examples of payments made
by government include salaries and allowances of personnel in civil and defence
services, pensions of retired government employees, costs of goods and services
procured for projects, and benefits under various welfare programmes for the poor.
Efficient and proper handling of revenues and expenses requires extensive systems
for checking and recording documents and preparation of financial reports for
internal use and for Parliament. Government accounting systems are mostly run by
members of central services such as the Indian Audit and Accounts Service, the
Indian Civil Accounts Service, the Indian Railway Accounts Service, and the Indian
Defence Accounts Service. The Controller-General of Accounts is the head of the
Central government’s accounting function and is part of the Ministry of Finance.
The Comptroller and Auditor-General of India (CAG), an independent authority
under the Constitution of India, audits the transactions and accounts of government
and public sector undertakings. The CAG communicates its major observations and
recommendations to Parliament. The CAG’s audit reports are discussed in
committees of Parliament, such as the Public Accounts Committee (PAC) and the
Committee on Public Undertakings. In this way, Parliament is able to exercise
control over the government’s financial management. The CAG is more concerned
with the propriety and efficiency of the actions of officers of the government, unlike
company auditors who are mainly concerned with the fair presentation of
information in financial statements in compliance with accounting standards.
In recent times, the CAG’s reports on defence purchases and award of mobile
telephone licences have attracted a lot of attention. Proper accounting and
independent auditing are instrumental in ensuring government’s accountability.
The CAG occasionally audits non-government companies at the request of the
government. In 2014, the Delhi government asked the CAG to conduct a special
audit of electricity distribution companies in Delhi in response to complaints that
they were profiteering at the expense of consumers. In 2010, the Department of
Telecommunication asked the CAG to audit the records of some telecommunication
companies when there were doubts whether the companies under-reported to avoid
paying the government’s share of licence fee and spectrum charges. In 2009, the
Ministry of Petroleum asked the CAG to audit the expenditure that Reliance
Industries incurred in developing the Krishna- Godavari basin gas field D6 because
of allegations of inflating gas field costs.
Not-for-Profit Accounting
Religious and charitable institutions are established for providing certain types of
services to the public. Unlike business enterprises, these organizations are not
profit-oriented. Donations and endowments made by philanthropic individuals are
the major sources of revenues for non-business organizations. These organizations
need financial reports for assuring present and potential donors that the funds are
utilized efficiently, effectively and properly for the stated purposes.
Accounting as an Academic Discipline
Accounting is not only a profession but also a field of intellectual
enquiry, similar to medicine, law, architecture and engineering.
Accounting academics publish their research in scholarly journals
such as The Accounting Review, the Journal of Accounting and
Economics, and the Journal of Accounting Research. Accounting researchers apply
economic and behavioural theories to financial reporting and disclosure, and other
areas of accounting.
Examples of problems that researchers have examined include:
(a) How does accounting influence stock prices?
(b) How do firms benefit from improving their disclosure?
(c) Under what conditions is accrual accounting more informative than cash
accounting?
(d) Why do accountants take note of losses quicker than gains?
(e) What are the major factors in selecting accounting methods and disclosure
levels?
(f) Is it possible to predict future profits from past profits?
(g) Does disclosure affect managerial behaviour?
(h) Is executive pay related to financial performance?
You can get an idea of the research questions that academic accountants
investigate by looking at academic accounting journals.
19
Fraud and Ethical Issues in Accounting
With more managers trying to cut ethical corners to accomplish
enterprise objectives, ethical standards in business are declining
and this has serious implications for the accounting profession.
Fraudulent accounting and weak internal control systems have
been the principal causes of many recent corporate scandals,
including the ones that affected Satyam, Enron, WorldCom, Tyco, and Xerox.
Falling ethical standards often, but not always, result from high pressure to show
results that most managers face in business organizations. Increasingly, managerial
compensation is linked to profit and other accounting measures of performance.
Hence, the temptation to manipulate the accounting reports is at times irresistible.
A KPMG survey reported that the pressure to perform and exceed market
expectations has increased the risk of fraud.20
Stock-based incentive methods such as stock options have the unintended effect of
inducing managers to boost their company’s stock prices by unethical methods.
Further, analysts and fund managers generally expect companies to produce instant
results forcing managers to tweak the quarterly or annual earnings numbers rather
than focus on the long-term growth of the business. Booking incomplete or fictitious
sales as revenues, improperly deferring current expenses to future periods, and
making unwarranted changes in accounting policies are examples of accounting
tricks that have been used often to manipulate the earnings. Keep an eye on the
possibility of manipulation and fraud while you examine the financial statements.
Professional accountants frequently encounter ethical dilemmas. For example, a
controller may find a conflict between professional standards and the expectations
of a superior. An external auditor may be caught in a conflict between the wishes of
a company being audited and the application of accounting standards. In the face of
sudden decreases in revenue or market share, unrealistic budget pressures,
particularly for short-term results, or financial pressure resulting from bonus plans
that depend on short-term economic performance, managers are often tempted to
bend the accounting rules.
Unfortunately, many ethical questions that arise in practice cannot be answered
by adhering to GAAP or following the rules of the profession. The accountant must
decide on the basis of the facts and circumstances of each case whether it is
necessary “to blow the whistle” or not. In deciding on the appropriate course of
action, the accountant should consider the potential legal, economic, social, and
psychological consequences of each alternative course.
Ethical questions often involve conflicting considerations, and balancing these
pressures is far from easy. For example, though the accountant may be ethically
obliged to inform an external agency of a wrongful act committed by the client, the
code of ethical conduct for accountants prohibits the accountant from revealing
confidential information about a client. Nevertheless, it is important for the
accountant to recognize an ethical dilemma, identify and evaluate the various
alternatives available for resolving the dilemma, and select the most ethical
alternative considering all the circumstances and consequences.
In case you are still unconvinced, note that the punishment for accounting and
financial fraud is too severe. Jeff Skilling, Enron’s former chief executive, was
sentenced to 24 years, while Bernie Ebbers of WoldCom got 25 years of
imprisonment. Bernard Madoff, the fraudster who ran a Ponzi scheme, was
sentenced to 150 years in jail. Closer home, Satyam’s directors and auditors, who
have been charged with serious offences under the Indian Penal Code and the
Companies Act, are standing trial for fraudulent accounting. Accountants and
managers would be tempting fate if they engage in fraudulent reporting.
Looking Back
Italicized words indicate key ideas, concepts and terms from this chapter.
Understand the working of business organizations Business organizations offer products and services
in order to satisfy customer needs and thereby earn a profit. Receiving and paying cash is central to the
activities of business organizations.
Define accounting and explain its role in making economic and business decisions The
accounting information system processes business transactions to provide financial reports. Accounting
develops and communicates information that is useful in making sound decisions about the use of scarce
resources.
Identify the major users of accounting information Investors, creditors, analysts, employees,
management, governments, and regulatory agencies are the major users of accounting information.
Distinguish between financial and management accounting Financial accounting makes available
financial information mainly to an enterprise’s outsiders. Management accounting provides financial and
other information to an enterprise’s management.
Discuss the assumptions underlying accounting measurement and explain their significance
Accounting measures business transactions and other economic events which affect a firm. Reporting entity,
going concern, periodicity, and money measurement make it possible to summarize in money terms the results of
business transactions for a period separately for each business.
Explain the meaning of GAAP and identify the institutions that influence the development of
Indian GAAP Generally accepted accounting principles consist of conventions, rules and procedures that
define accepted accounting practice. The accounting profession, government, and tax authorities have a major
influence on GAAP. Accounting standards specify the acceptable methods from the wide variety of accounting
choices. Accounting policies define the application of GAAP by an enterprise in preparing financial statements.
Describe and evaluate the common forms of business organization A business may be organized as
a sole proprietorship, partnership, or a company. The corporate form of organization is considered
particularly appropriate for a large-scale business.
Explain the role that accounting plays in capital market and corporate governance The operation
of the lemons principle makes it difficult to access markets. High-quality financial reporting reduces
information asymmetry and thus enables entrepreneurs to raise funds at reasonable rates and investors to earn
fair returns. Accounting addresses the twin agency problems of adverse selection and moral hazard.
Explain the accounting equation and analyze the effects of typical transactions on the equation
The accounting equation states that at a given time, the sum of assets must equal the sum of liabilities and
equity: Assets = Liabilities + Equity. The equation helps us understand the effect of transactions.
Describe the five major financial statements and explain how they are inter-related The
statement of profit and loss condenses an enterprise’s revenues and expenses. The statement of retained
earnings gives the distribution and retention of earnings. The balance sheet presents an enterprise’s assets,
liabilities and equity. The cash flow statement sums up the major sources of cash receipts and cash payments.
The statement of changes in equity describes the changes in the components of equity.
Describe the career opportunities for accountants Accountants provide auditing, tax and advisory
services. They are employed in business organizations, government and not-for-profit organizations.
Appreciate accounting as an academic discipline Accounting involves theory and practice. Academic
accountants study the role of accounting in economic and behavioural contexts.
Understand the importance of ethics in accounting Accountants should recognize ethical dilemmas
and select the most ethical alternative after considering all consequences.
Review Problem
On January 1, 20XX, Manohar started QualPhoto Company. The following transactions took place during the
first month:
Required
1. Analyze the effect of these transactions on the accounting equation.
2. Prepare a statement of profit and loss, a statement of retained earnings, a
balance sheet, a cash flow statement, and a statement of changes in equity.
Solution to the Review Problem
2. Financial Statements21
ASSIGNMENT MATERIAL
Questions
1.
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3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
What is the purpose of a business?
What are the common types of business organizations?
Why should a manager know accounting?
Give five examples of economic decisions that are based on accounting
information.
Identify typical users of financial reports.
How does financial accounting differ from management accounting?
Do you think the money measurement assumption is realistic?
Do you think historical cost information is useful?
Who issues International Financial Reporting Standards (IFRS)?
How does limited liability encourage risk-taking?
Is it a good practice for a company’s chief financial officer to be also its
company secretary?
Give five examples of costly signals that well-managed companies can give.
State the accounting equation.
What is the function of financial statements?
What can we learn from the cash flow statement about a business
enterprise?
How is auditing useful to investors and creditors?
Can the external auditors be certain that there are no instances of frauds or
errors in a company?
Do you think accounting firms should be prohibited from providing nonaudit services?
How does internal auditing differ from external auditing?
How might an accountant go about resolving an ethical dilemma?
Problem Set A
The transactions of Kamat Travel Services during a month are as follows:
(a) Bought furniture for cash.
(b) Received amount due from a customer.
(c) Bought a car on credit.
(d) Paid amount due to a supplier.
(e) Appointed office assistant.
(f) Cash withdrawn by the proprietor for personal purposes.
(g) Received cash for services to be provided next month.
(h) Provided services on credit.
(i) Received interest on bank deposit.
(j) Sold unused equipment at purchase price.
(k) Owner invested cash in the business.
Using the format given below, state whether each transaction resulted in increase or decrease or had no effect
on the company’s assets, liabilities and equity. Consider the total effect on assets, liabilities, and equity.
The following items appeared in the March 31, 20XX balance sheet of Roshni Company.
Prepare the March 31, 20XX balance sheet.
On January 1, 20XX, Darshan set up Instant Dry Cleaning Enterprise investing
`60,000. The activities of the business resulted in the following revenues and expenses
for 20XX: revenue from services, `103,000; rent expense, `11,200; electricity expense,
`42,000; salaries expense, `16,600; and delivery expense, `2,500. The assets and
liabilities of the business on December 31, 20XX consisted of the following items: building, `66,700; equipment,
`25,000; supplies, `2,300; trade receivables, `17,800; cash, `25,000; loan payable, `34,000; expenses payable,
`6,600. During the year, Darshan withdrew `4,500 in cash for personal use and made a further investment of
`10,000 in the business.
Prepare the 20XX statement of profit and loss and balance sheet.
Problem Set B
The following table shows the effect of six transactions of Gopal Company on the accounting
equation. The amounts are in rupees.
Required
Write a brief explanation for each of the transactions. If several explanations are possible, write all of them.
On March 1, 20XX, Rina Motawala established an audit practice as a sole proprietorship
and concluded the following transactions in the first month:
(a) Rina brought in to the business her personal laptop costing `50,000.
(b) Provided services for cash, `23,000.
(c) Bought office equipment on credit, `25,000.
(d) Billed clients for services, `16,000.
(e) Paid rent deposit for office, `10,000.
(f) Collected payments from clients in (d), `12,300.
(g) Withdrew cash for personal use, `9,000.
(h) Paid electricity expense, `1,700.
(i) Paid salary to office assistant, `2,000.
Required
Analyze the effect of the transactions on the accounting equation.
On August 1, 20XX, Sriram set up Medi Labs Company. The following transactions took
place during the first month:
(a) Sriram invested `50,000 cash in the company’s share capital.
(b) Bought equipment on credit, `40,000.
(c) Took a bank loan, `30,000.
(d) Invoiced customers for services, `15,000.
(e) Provided services for cash, `18,000.
(f) Bought supplies for cash, `3,000.
(g) Paid staff salary, `10,000.
(h) Paid electricity charges, `6,000.
(i) Bought equipment for cash, `5,000.
(j) Repaid a part of the bank loan, `10,000.
(k) Paid dividends, `5,000.
Required
Analyze the effect of the transactions on the accounting equation.
Prasanna set up practice as an architect. After one month, the business had the following
balances: Cash, `20,000; Trade Receivables, `7,000; Office Supplies, `10,000; Office
Equipment, `30,000; Trade Payables, `9,000; Equity, Prasanna’s Capital, `58,000. The
following transactions took place in the second month:
(a) Billed clients for services, `29,000.
(b) Paid assistant’s salary, `2,500.
(c) Provided services and received cash, `14,000.
(d) Collected payments due from clients, `26,000.
(e) Bought equipment on credit, `11,000.
(f) Paid equipment supplier, `3,000.
(g) Paid electricity expense, `1,300.
(h) Bought office supplies on credit, `2,800.
(i) Took a bank loan, `15,000.
(j) Bought office equipment for cash, `16,000.
(k) Withdrew cash for personal use, `12,000.
Required
Analyze the effect of the transactions on the accounting equation. First enter the beginning balances.
On September 1, 20XX, Meera Kumar started Instaprogram Company to provide
computer programming services. On September 30, the company had the following
balances: Cash, `10,000; Trade Receivables, `5,000; Computer Supplies, `1,000; Office
Equipment, `35,000; Trade Payables, `13,300; Share Capital, `24,500; Retained
Earnings, `13,200. The following transactions took place in October 20XX:
(a) Bought computer supplies for cash, `1,800.
(b) Billed clients for professional services, `59,900.
(c) Purchased office equipment for cash `3,000.
(d) Provided services for cash, `20,000.
(e) Paid suppliers, `11,000.
(f) Paid office rent, `1,100.
(g) Collected from clients billed in September, `4,000.
(h) Bought equipment on credit, `20,000.
(i) Collected from clients in (b), `56,400.
(j) Paid programmers’ salaries, `28,000.
(k) Paid dividends, `6,750.
Required
1. Analyze the effect of the transactions on the accounting equation. First enter
the beginning balances.
2. Prepare the company’s October 20XX statement of profit and loss, statement
of retained earnings, balance sheet, cash flow statement and statement of
changes in equity.
Problem Set C
The following table shows the effect of six transactions of Hrishikesh Company on the
accounting equation. The amounts are in rupees.
Required
Write a brief explanation for each of the transactions. If several explanations are possible, write all of them.
On September 1, 20XX, Rashmi Sinha established Lovely Beauty Salon. The business
engaged in the following transactions in the first month:
(a) Rashmi Sinha invested `50,000 cash in the business.
(b) Bought equipment for cash, `15,000.
(c) Took a bank loan, `25,000.
(d) Bought supplies on credit, `3,000.
(e) Paid rent, `12,500.
(f) Withdrew cash for personal use, `5,000.
(g) Paid suppliers for the purchase in (d), `1,500.
(h) Received fee for services provided, `29,000.
(i) Returned supplies costing `500.
Required
Analyze the effect of the transactions on the accounting equation.
On January 1, 20XX, Pramod Krishnan set up Interior Decor Company. The following
transactions took place during the first month:
(a) Pramod Krishnan invested `50,000 cash in the company’s share capital.
(b) Took a bank loan, `25,000.
(c) Billed customers for services, `14,000.
(d) Paid assistants’ salary, `5,000.
(e) Bought furniture for cash, `20,000.
(f) Bought office supplies on credit, `3,000.
(g) Received cash for services provided, `38,000.
(h) Paid fuel expense, `8,000.
(i) Paid office rent, `4,000.
(j) Paid for the purchase in (f), `3,000.
(k) Received cash from customers billed, `11,000.
Required
Analyze the effect of the transactions on the accounting equation.
Farouk set up a recruitment agency. After two months, he had the following account
balances: Cash, `23,000; Trade Receivables, `15,000; Office Supplies, `6,000; Office
Equipment, `20,000; Trade Payables, `24,000; Farouk’s Capital, `40,000. The following
transactions took place later:
(a) Bought a computer on credit, `15,000.
(b) Received agency commission, `25,000.
(c) Paid office rent, `4,000.
(d) Billed clients for professional services, `35,000.
(e) Collected payments from clients billed earlier, `38,000.
(f) Took a bank loan, `10,000.
(g) Bought office supplies for cash, `7,500.
(h) Paid staff salary, `12,000.
(i) Withdrew cash for personal use, `7,000.
(j) Paid the computer supplier, `13,000.
(k) Repaid a part of bank loan, `8,000.
Required
Analyze the effect of the transactions on the accounting equation. First enter the beginning balances.
After four months of operations, Channel Video Company had the following account
balances on August 31, 20XX: Cash, `5,000; Trade Receivables, `10,000; Equipment,
`11,700; DVDs, `36,000; Trade Payables, `7,000; Share Capital, `25,000; Retained
Earnings, `30,700. The following transactions took place in September:
(a) Collected from customers billed in August, `4,000.
(b) Paid amounts due on August 31.
(c) Took a bank loan, `10,000.
(d) Paid assistant’s salary, `600.
(e) Bought DVDs for cash, `5,000.
(f) Bought equipment on credit, `20,000.
(g) Received DVD hire charges, `15,000.
(h) Paid store rent, `2,000.
(i) Paid suppliers, `3,000.
(j) Billed customers for DVD hire charges, `3,500.
(k) Paid dividends, `2,500.
Required
1. Analyze the effect of the transactions on the accounting equation. First enter
the beginning balances.
2. Prepare the company’s September statement of profit and loss, statement of
retained earnings, balance sheet, cash flow statement and statement of
changes in equity.
Business Decision Cases
On August 1, 20XX, Ajay and Jeevan quit as senior executives in a mutual fund to set up
MoneyCare Company, an investment advisory service. Each of them deposited `50,000 in
MoneyCare’s bank account in exchange for 5,000 shares. Also, they raised an interest-free
loan of `20,000 for the company from their friend. They rented an office for the company in the city, costing
`5,000 per month payable on the last day of the month. At the landlord’s insistence, they paid a deposit of
`70,000, refundable on MoneyCare vacating the place.
They leased two computers for one year on a monthly rental of `6,000 per computer and subscribed to a
financial database for a fee of `11,000 per month. Computer rental and database fee were payable at the
beginning of the month. They appointed a secretary on a monthly salary of `9,000 and an assistant on a
monthly salary of `5,000.
Depending on their credit rating, MoneyCare’s customers paid in one of the following ways:
1. Before receiving service.
2. Immediately on receiving service.
3. Within one month after receiving service.
During August, MoneyCare provided services for `70,800 and raised invoices with the following payment
terms:
Fifteen customers with invoices totalling `62,100 could pay until end of
September.
Two customers with invoices totalling `8,700 had to pay immediately.
MoneyCare’s other transactions in August were as follows:
Paid computer rental, database fee, office rent and salaries as agreed.
Received from customers amounts totalling `24,100 including `15,400 from
customers who chose to pay early.
Paid for office supplies costing `1,800 but did not use them.
Received `9,000 from a customer for service to be provided in September.
Earned interest income of `460 on the bank account.
Required
1. Prepare MoneyCare’s financial statements for August.
2. What do you think of the company’s financial performance?
Interpreting Financial Reports
Jet Airways (India) Ltd. is a major airline in India. The following items are taken from the
recent financial statements of the company:
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
1. Aircraft fuel consumed
Employees’ remuneration and benefits
Deferred tax liability
Travel agents’ commission
Purchase of investments
Provision for gratuity
Proceeds from sale of fixed assets
Net cash from operating activities
Share capital
Repayment of term loans and subordinated debt
Interest and finance charges
Frequent flyer points not availed of
Inventories
Aircraft lease rental
Wealth tax paid
Capital expenditure – aircraft and others
Dividend paid
Short-term borrowings
Unpaid dividend
Deposit with service tax department
Required
1. Identify the financial statement – statement of profit and loss, statement of
retained earnings, balance sheet, or cash flow statement – in which you
would expect to see each of the items and indicate whether it is a revenue,
expense, asset, liability, equity, operating cash flow, investing cash flow, or
financing cash flow.
2. Give any five items that do not appear in the above list but you would expect
to see in the complete set of financial statements of Jet Airways.
Infosys is a leading information technology services company listed in Indian stock exchanges
and in NASDAQ in the US. The company’s 2013 annual report contains the following
statement:
The financial statements are prepared in accordance with the accounting standards issued by the Institute
of Chartered Accountants of India and the requirements of the Companies Act 1956, to the extent
applicable to us, and guidelines issued by SEBI on the historical cost convention, as a going concern and on
the accrual basis. There are no material departures from prescribed accounting standards in the adoption
of the accounting standards.
The Board of Directors accepts responsibility for the integrity and objectivity of these financial
statements. The accounting policies used in the preparation of the financial statements have been
consistently applied except as otherwise stated in the notes accompanying the respective tables. The
estimates and judgments related to the financial statements have been made on a prudent and reasonable
basis, in order that the financial statements reflect in a true and fair manner the form and substance of
transactions, and reasonably present our state of affairs and profits for the year.
We have taken sufficient care to maintain adequate accounting records in accordance with the
provisions of the Companies Act 1956, to safeguard the assets of the Company and to prevent and detect
fraud and other irregularities.
Required
Briefly describe the responsibility of the various agencies or parties in relation to the company’s financial
reporting and allied matters and how the above statement benefits them.
Financial Analysis
Search the Internet for reports about the accounting scandal in Satyam.
Required
1. Explain the essential elements of the scandal based on your understanding
of accounting at this stage.
2. Prepare a report comparing the Satyam scandal with accounting scandals in
the US highlighting any similarities and differences between them.
An article titled “Are sugar mills doing really badly?” in Business Line, October 24, 2013
argued that the Indian sugar industry was understating its profits in order to extract
benefits from the government and banks. In a rejoinder the industry association refuted the
charges (“Baseless charges against sugar industry”, in Business Line, October 29, 2013). Read these reports.
Required
1. Examine the arguments in the two articles. Do you agree with them?
Explain why or why not.
2. Prepare an analysis of the financial statements of a sample of sugar
companies and comment on your results.
3. What are the conflicting pressures on sugar companies’ financial reporting?
How should they resolve them?
The job of an investment adviser is to recommend profitable investment opportunities. These
include stocks, bonds, real estate, commodities, and art. The adviser should maximize the
return, or profit, from an investment keeping in view the related risks, or the chances of loss
or a low profit. Your friend is looking at options for investing a large fortune she has inherited from her uncle.
She has heard that lately the stock market has been doing well and the stock prices of many companies have
zoomed. She wants you, a financial wizard in the making (or so she thinks!), to tell her how to invest.
Required
1. Prepare a report setting out the information an individual should have in
order to decide on investing in stocks and where the information will be
available.
2. List the advantages and disadvantages of alternative investment
opportunities and explain how studying the information in the financial
statements would be useful in making an informed decision.
Answers to Test Your Understanding
1.1 (a) Furniture; (b) Online messaging (in case you didn’t know!); (c) Online auction and shopping; (d) Sports
goods; (e) Luxury; (f) Electronics; (g) Air conditioners, ATMs, semi-conductors, chemicals; (h) Mobile
telephony.
1.2 (a) Are there any unusual, one-time or non-recurring items that contributed to the net profit in Q2FY14 i.e.
second quarter of 2013–14?; (b) Does the net profit in Q2FY14 indicate a turnaround in performance?; (c) Why
was profit growth out of step with revenue growth? (d) How risky is the company’s dependence on its top five
customers?; (e) What is the company’s policy for management of foreign exchange risk?; (f) What was the
profit margin? What does any change in the margin imply?; (g) What is the outlook for Q3FY14?
1.3 (a) The reporting entity assumption requires that the transactions of the business be separated from the
personal affairs of the owner. Hence, electricity charges for the owner’s home cannot be recorded as a
business expense; (b) The going concern assumption coupled with the historical cost principle requires assets
to be recorded at their cost of purchase, regardless of their subsequent market value; (c) The reporting entity
assumption requires that the transactions of the business be separated from the personal affairs of the owner.
Hence, the smartphone bought for the owner’s personal use cannot be recorded as an asset of the business.
1.4 (a) Bought a building on credit; (b) Collected payments from customers for past sales; (c) Owner invested
capital in cash; (d) Paid suppliers for past purchases; (e) Owner withdrew cash from business for private use.
1.5 Net profit = EquityDec. 31, 20X2 – EquityDec. 31, 20X1 – Investments20X2 + Drawings20X2
= (`99,000 – `71,000) – (`85,000 – `67,000) – `35,000 + `24,500 = Net loss, `500.
1.6 The report talks about several things. The headline mentions growth in net profit. The next quote referring
to growth in revenues talks of “inflows”, normally a term used for cash inflows. But that was probably not
intended. The growth in balance sheet usually means the size of a bank’s loans and investments. It is possible
to have different growth rates for net profit, revenues and assets. The statements do not appear to be
inconsistent with the headline.
1.7 (a) Statement of profit and loss: revenue increases by `13,000; (b) Balance sheet: cash increases by `4,000,
trade receivables increase by `9,000, and equity increases by `13,000; (c) Cash flow statement: cash inflow
from operations increases by `4,000.
1 Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business Enterprises,
Financial Accounting Standards Board, 1978.
2 A Statement of Basic Accounting Theory (Sarasota, Florida: American Accounting Association, 1966), p. 64.
Professors John A. Christensen and Joel S. Demski provide an analytical study of accounting as an information
system in Accounting Theory: An Information Content Perspective, New York: Irwin/McGraw-Hill, 2003.
3 The Conceptual Framework for Financial Reporting, International Accounting Standards Board, September
2010.
4 Railmen threaten agitation against any rollback of fare hike, The Hindu, March 18, 2012.
5 IAS 2:6/Ind AS 2:6
6 IAS 1:117/Ind AS 1:117.
7 Adam Smith, The Wealth of Nations, Edwin Cannan (Ed.), Bantam Dell, New York, 2003, p. 941.
8 George A. Akerlof, The market for ‘lemons’: Quality uncertainty and the market mechanism, Quarterly
Journal of Economics, August 1970. Interestingly, one of the illustrations of the lemons principle in the paper
relates to the practice of adulterating rice with stones by Indian shopkeepers and the resultant costs of
dishonesty to the buyer and to honest business.
9 Michael Spence, Job market signalling, Quarterly Journal of Economics, August 1973.
10 IASB F.49(a)
11 IASB F.49(b).
12 IASB F.49(c).
13Commonly used alternative terms for trade payables are creditors and accounts payable.
14 We are getting ahead of the story. In Chapter 3, you will see why we reckoned the revenue though cash was
not received.
15 Commonly used alternative terms for trade receivables are debtors and accounts receivable.
16 If we mistakenly treat the withdrawal as an expense, the amount of equity would be the same. But profit
would be lower by `3,500, and that would be incorrect.
17 Tracy Byrnes, Besmirched auditors remain vital to the investment world, The Wall Street Journal, April 12,
2002.
18 Jennifer Hughes, Tellis Demos and Nicole Bullock, Lehman unwinding fees to pass $2 billion, Financial
Times, September 14, 2010.
19 Ray Ball and Philip Brown, An empirical evaluation of accounting income numbers, Journal of Accounting
Research, Autumn, 1968.
20 KPMG, India Fraud Survey Report, 2012.
21 The financial statements broadly follow the format specified in the Companies Act 2013. Chapter 4 discusses
the classification and presentation requirements of the Act.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
Describe an account and a ledger.
Recognize commonly used accounts.
Describe the double-entry system and apply the rules for debit and credit.
Analyze the effect of business transactions using debits and credits.
Record transactions in the journal.
Post entries from the journal to the ledger.
Prepare a trial balance and know its limitations.
DOES MICROSOFT TICK ALL THE RIGHT BOXES?
Xbox is a popular video gaming product. By June 2013, Microsoft had sold 75
million units and its subscription service at $50 a year had 46 million subscribers
and was growing fast. Is Xbox profitable? Microsoft’s Entertainment and Devices
division, which includes the Windows phone and Surface tablet businesses,
generated $10 billion in sales and $700 million in profit in the previous one year
and contributed 7 per cent of Microsoft’s profits. Since 2003, when Microsoft
began reporting profits by segments, E&D has $71 billion in revenues but an
operating loss of $2.6 billion. How much has been the return on Xbox? It is hard
to know because of the other businesses rolled into E&D. A good accounting
system should help Microsoft find out the profitability of Xbox. Whether Microsoft
will disclose that information is a different matter.
THE CHAPTER IN A NUTSHELL
Many business organizations have to process thousands of transactions. They have
to record transactions systematically so that they can prepare financial and other
statements. They use formal records to keep track of the multitude of transactions
that affect them. Accountants use special procedures to record the effects of any
type of business transactions, regardless of the size and complexity of the business.
The wonderful double-entry system of debits and credits is the accountant’s
‘robot’ that processes transactions with amazing efficiency. Metaphorically, in
Chapter 1, we walked into the drawing room of the organization, looking at
financial statements, information asymmetry, markets, and governance – all highlevel matter. In this chapter, we review the ‘wiring and plumbing’ of accounting,
something that is not quite aesthetic but makes the house (including the drawing
room) safe and healthy.
Accounts
Companies host earnings calls to discuss their quarterly
performance and share the management’s outlook. Analysts
following a company participate in the call and the company’s
senior managers respond to their queries. Given below are some questions that
analysts asked at some of Apple’s earnings calls:
“Can you just talk a little bit about gross margins?”
“How much of the sequential decline in gross margin is related to the iPhone
in the September quarter?”
“You now have more than $50 billion in cash. You’re generating more than
$20 billion a year in cash; it rests very comfortably on your balance sheet,
earning less than 1 per cent interest. What is your aspiration for that cash?
And why are you not more open to returning some of that cash to
shareholders in the form of buybacks or dividend?”
“Could you discuss the impact of air freight on your gross margins in the third
calendar quarter if it was material, and whether you expect that to continue
into December?”
“What percentage of sales came from Apple online stores?”
Ideally, the accounting department should work to provide instantaneous answers
to such questions. Designing accounting systems that respond effectively to the
ever-rising demand for information from management, investors, lenders,
government, regulators, and others is a major challenge that the accountant faces.
An accounting system classifies transactions into meaningful categories in order
to prepare financial statements and other reports. To facilitate quick and easy
retrieval of data, the company records transactions in accounts. An account is an
individual record of increases and decreases in an item, which is likely to be of
interest or importance. An accounting system has separate accounts for revenue,
expenses, asset, liability, and equity items. Regardless of whether a company keeps
manual or electronic records, it is essential to have a proper system of classification
of transactions into various accounts. The way an enterprise records its activities is
how it will appear to the world. Writer and Nobel laureate, Garcia Gabriel Marquez
says, “What matters in life is not what happens to you but what you remember and
how you remember it.” The accounting system determines what transactions and
other events an organization ‘remembers’ and ‘how’ it remembers them.
The Ledger
In a manual accounting system, each account appears on a separate page or card. A
file or loose-leaf binder holds these pages or cards together. A ledger is the file or
binder that contains the entire group of accounts of a business. The accounting
principles for maintaining accounts in electronic form are the same as the ones for
writing in the manual ledger.
Accounts in the ledger are usually arranged in the following order: assets,
liabilities, equity, revenues, and expenses. A chart of accounts is a complete
listing of the account titles used in an organization. Exhibit 2.1 presents an
illustrative chart of accounts. Accounts also have codes. In fact, the accounting
department usually refers to accounts in terms of their codes rather than their
titles. In the chart below, the first digit tells us whether an account is an asset,
liability, or equity item and the next two digits identify the specific account. Thus,
all asset accounts begin with 1, liability accounts begin with 2, and so on. Every
organization should develop a chart of accounts that is most appropriate for its
purposes. For example, a large company may use a 10-digit system in order to
identify the division or business unit, plant, product line, and so on. The codes in
Exhibit 2.1 are for illustrative purposes only; this book does not use codes. A chart
of accounts is much more detailed than the line items that appear in published
financial statements.
Commonly Used Accounts
The number of accounts and specific account titles used by an
enterprise depend on the nature and complexity of the
enterprise’s business. For example, an automobile company will
keep detailed accounts for its plant and equipment, whereas a
bank will need meticulous information about its various deposits, investments and
loans, and its cash kept in various forms. Again, a small bakery that sells for cash
can possibly manage with a few accounts, while a large multinational company will
have thousands of accounts.
In deciding on the level of detail in the accounts, a firm should consider relevant
requirements in the Companies Act, the Income Tax Act, and other laws. For
example, the Companies Act requires disclosure of directors’ remuneration; the
Income Tax Act disallows many kinds of entertainment expenses. It is necessary to
keep separate accounts of all such items.
We will now consider some of the accounts commonly used by most businesses.
Asset Accounts
Assets are what an enterprise owns. Most enterprises keep separate accounts for
recording increases and decreases in each major asset. The following are some of the
usual asset accounts:
Land The land account shows land owned by the enterprise and kept for use in its
business.
Buildings The buildings account records acquisition and disposal of buildings used
by an enterprise to carry out its operations. An enterprise records its building and
the land on which it stands in separate accounts. (Do you know why?) Also, there
are separate accounts for different types of buildings such as factory buildings,
warehouses, and office buildings.
Equipment A business often owns different types of equipment and records each
major type of equipment in a separate account. Thus, the plant and machinery
account shows various kinds of factory equipment. The office equipment account
records photocopiers, fax machines and computers. The furniture and fittings
account records chairs, tables and cupboards.
Prepaid expenses Sometimes, a business pays for services before they have been
received or used. Usually, it is not possible to get a refund of the amount for the
benefits not received. When you buy a prepaid phone service, you pay first and use
the service later. Any unused portion of the service can be used later, but there will
be no refund. Rent, insurance, magazine subscriptions, and property taxes are other
examples of prepayments. The prepaid expenses account records all such amounts,
to the extent the related benefits have not expired. If a refund for the unused
portion of a service is possible, the amount may appear in the advances to suppliers
account.
Trade receivables Business enterprises often sell goods and services on credit so
that customers can pay after the specified period of credit. The trade receivables
account records the amounts receivable from customers for sales of goods or services
on credit. In addition, there are separate accounts for individual customers’
accounts.
Bills receivable A bill receivable is a legal document containing a right to receive
a certain sum of money at a specified date. It is a more formal means of extending
credit than an open account. The bills receivable account contains the amounts due
from a firm’s customers on bills accepted by them.
Cash The cash account shows receipts and payments of cash. Cash includes coins,
currency, cheques, and amounts deposited in banks in various types of accounts.
Separate accounts exist for each bank with whom a business has transactions.
Firms that have major overseas operations keep accounts with banks abroad in the
currency of the country.
Liability Accounts
Liabilities are what an enterprise owes. Liabilities can be short-term or long-term.
The following are some of the usual liability accounts:
Bills payable A bill payable is a legal document signifying an obligation to pay a
certain sum of money at a specified date. It is the mirror image of a bill receivable.
The bills payable account contains the amounts due to a firm’s suppliers on bills
accepted by the firm.1
Trade payables The trade payables account shows increases and decreases in
amounts owed to suppliers for purchases of goods or services on credit. There are
separate accounts for individual suppliers’ accounts.
Unearned revenue This is the supplier’s version of prepaid expenses. Amounts
received from customers for services to be provided represent liabilities because the
supplier has an obligation to provide the services. The unearned revenue account
records these amounts. In case the enterprise has the option of refunding the
amounts, it can use advances from customers as the account title.
Other short-term liabilities Wages payable, income tax payable, interest
payable, and dividends payable are examples of other liability accounts.
Long-term liabilities These include a wide variety of debentures, loans from
banks and other financial institutions, and long-term deposits.
Equity Accounts
Equity is the difference between a firm’s assets and liabilities. Transactions that
affect equity include investment and withdrawal of assets by owners, earning of
revenues, incurring of expenses, and payment of dividends. Firms keep separate
accounts for each of these categories for the purpose of reporting to shareholders,
preparing tax returns, and providing information to management for planning and
controlling business operations.
Share capital Proprietary and partnership firms use an owner’s capital account for
the proprietor or separate capital for each of the partners. Companies record
shareholders’ contributions towards capital in the share capital account.
Retained earnings The profit earned by a company less dividends paid belongs to
the company’s shareholders. It appears in the retained earnings account. Retained
earnings represent the claims of the shareholders against the general assets of the
company. These should not be confused with the assets themselves. Retained
earnings increase when the company earns a net profit and decrease as a result of
unprofitable operations or payment of dividends. A company records revenues,
expenses, and dividends in separate accounts and later summarizes them in
retained earnings.
Revenues and expenses Revenues increase equity and expenses decrease it.
When revenues exceed expenses, the business earns a net profit. When expenses
exceed revenues, the business incurs a net loss. Firms keep separate accounts for
each major revenue and expense item, so that the users of financial statements can
identify the sources of revenues and the nature of expenses. Some of the commonly
used revenue accounts are revenue from services, sales, commission income,
interest income, and professional fees. Commonly used expense accounts include
salaries expense, rent expense, insurance expense, consumables expense, and
supplies expense. In practice, enterprises may use different account titles.
Relatively insignificant amounts are recorded in a miscellaneous revenue account or
a miscellaneous expense account.
Drawings The owner of a sole proprietorship or a partner of a partnership business
may withdraw cash or other assets from the business. A withdrawal results in a
decrease in both assets and equity. A drawing account records all withdrawals. You
can think of this account as a negative capital account. The shareholders cannot
withdraw assets from the company except when the company pays dividends or
buys back the share capital.
Dividends Dividends are distributions of assets that reduce the retained profits of
a company. The board of directors recommends dividends and the shareholders
declare them as payable. Note that dividends are not an expense.
Recognition is the process of incorporating an item that meets the definition of
an element (revenue, expense, asset, liability, or equity). Derecognition is the
process of removing an item that no longer meets the definition of an element.
The Double-entry System: The Basis of Modern Accounting
In Chapter 1, we analyzed the effect of a transaction on the
accounting equation. Recall that each transaction affects two
columns. For example, receiving cash from customers for past
invoices increases cash and decreases trade receivables. Thus, we
record each transaction in two accounts so that the accounting
equation, Assets = Liabilities + Equity, is always in balance. This balancing is as
important to the accountant as safe landing is to an airline pilot: the number of
times an aircraft takes off must equal the number of times it lands. This principle of
duality is valid regardless of the complexity of a transaction. The double-entry
system records every transaction with equal debits and credits. As a result, the
total of debits must equal the total of credits. Luca Pacioli (pronounced pot-chee-ohlee), an Italian monk, first articulated the double-entry system in 1494 in his book
titled Summa de Arithmetica, Geometria, Proportioni et Proportionalita (which
means “Everything about Arithmetic, Geometry, and Proportions”).2
The T Account
The common form of an account has three parts:
1. A title that describes the name of the asset, liability, or equity account;
2. A left side, or the debit side; and
3. A right side, or the credit side.
This form of account is called a T account because it looks like the letter T, as
shown below.
Debits and credits Accountants use the terms debit and credit, respectively, to
refer to the left side and right side of an account. To debit an account is to enter an
amount on the left side of the account and to credit an account is to enter an amount
on the right side of the account. It must be noted that, in accounting, debit and
credit do not have any value connotations such as bad or good and unfavourable or
favourable. They are simply the accountant’s terms for left and right – and nothing
more.
The T Account explained In Chapter 1, Softomation had several transactions
involving receipt or payment of cash. When we record these transactions in the cash
account, the cash receipts appear on the left or debit side of the account and the
cash payments on the right or credit side, as shown below:
The totals–cash receipts `82,000, and cash payments, `68,700 – are in bold so as
to distinguish them from the transaction entries. The debit and credit totals, or
footings in accounting lingo, are merely an intermediate step in determining the
cash on hand at the end of the month. The difference in amounts between the total
debits and the total credits in an account is the balance.
If the total debits exceed the total credits, the account has a debit balance.
If the total credits exceed the total debits, the account has a credit balance.
The cash account of Softomation has a debit balance of `13,300 (`82,000 –
`68,700). This balance represents the cash available with Softomation on March 31.
Standard Form of Account
The T account described earlier is, no doubt, a convenient way to explain the effects
of transactions on individual accounts. In practice, accountants draw up accounts in
a form known as the standard form, similar to the one in Exhibit 2.2. The standard
form shows the balance after every transaction and is, therefore, even more useful
and efficient to use than the T account. Your bank statement is an everyday
example of the standard form.
You would have observed that the cash account has the same information as that
in the cash column in Exhibit 1.4. It is just that receipts and payments appear on
separate columns.
Debit and Credit Rules
Under the double-entry system, we enter increases in assets on the debit side of the
account, and increases in liabilities and equity on the credit side. Figure 2.1
describes the recording procedure in terms of the accounting equation:
The rules for debit and credit for assets, liabilities, and equity are as follows:
1. Assets Debit increase in asset to asset account. Credit decrease in asset to
asset account.
2. Liabilities and equity Credit increase in liability or equity to liability or
equity account. Debit decrease in liability or equity to liability or equity
account.
From Chapter 1, you know the expanded form of the accounting equation:
Assets = Liabilities + Capital + Revenues – Expenses – Drawings (or
Dividends)
We can rewrite this equation as follows:
Assets + Expenses + Drawings (or Dividends) = Liabilities + Capital +
Revenues
We can now extend the rules for recording increase and decrease in equity to
revenues, expenses, drawings, and dividends. Thus, we credit revenues to increase
them; we debit expenses, drawings, and dividends to increase them. Exhibit 2.3
summarizes the rules for debit and credit.
The double-entry system is the workhorse of accounting. Shortly, you will be able
to appreciate its great value in organizing and processing information. However, the
significance of the double-entry system goes far beyond its usefulness as a system of
accounting mechanics. The German economic historian, Werner Sombart, praised
accounting and its bookkeeping tool saying:3
One can scarcely conceive of capitalism without double-entry bookkeeping; they are related as are form and
content. It is difficult to decide, however, whether in double-entry bookkeeping, capitalism provided itself
with a tool to make it more effective, or whether capitalism derives from the ‘spirit’ of double-entry
bookkeeping.
Remember that knowing debits and credits is a big help in communicating with
accounting professionals.
Comprehensive Illustration: Fashion Concepts Company
To illustrate the procedure for recording transactions, let us take
up a company that we call Fashion Concepts Company, a
business that supplies new designs for dresses. In this
illustration, you will learn how to record a transaction in terms of
debits and credits. We have the following four steps for each
transaction:
Analyze the transaction in terms of increase and decrease in asset, liability and equity items, and
specify the relevant accounts. View the transaction from the standpoint of the business enterprise
as the reporting entity.
State the debit and credit rules relevant to the transaction. Exhibit 2.3 has the rules.
Record the transaction entry showing the accounts to debit and credit.
Present the related accounts after recording the transaction entry.
Conventionally, the unit of currency is not entered in the accounting records.
June 1 Rakesh invested `50,000 cash in Fashion Concepts Company and received 5,000 shares of `10 each in the share capital
of the company.
June 2 Bought office supplies for cash, `2,000.
June 3 Paid office rent for June, `1,500.
June 4 Bought equipment from Agrawal Company for `9,000 with a down payment of `3,000 and agreed to pay the balance in
six equal instalments on the last day of the month beginning June.
June 5 Signed an agreement with EthnicWear for developing a special design. The agreement provided for payment of a fee of
`2,000 by EthnicWear on completion of the work.
June 6 Paid for a one-year fire insurance policy that will expire May 31, next year, `720.
June 7 Received fee for designs supplied, `2,000.
June 8 Collected from Kidswear, a customer, for services to be provided later, `1,500
June 9 Bought office supplies on credit from Mohan Company, `3,500.
June 10 Billed Shah Company for designs completed, `9,000.
June 14 Paid Mohan Company on account, `1,000.4
June 18 Collected from Shah Company, `4,000.
June 21 Appointed an office manager on a monthly salary of `1,500.
June 27 Paid telephone bill, `200.
June 28 Paid office assistant’s June salary, `800.
June 29 Received (but did not pay) electricity bill, `150.
5
June 30 Paid Agrawal Company, `1,000.
June 30 Paid a dividend, `2,200.
The balance of an account is the result of recording more increase than decrease.
We debit asset, expense, drawing, and dividend accounts to record increase, and
credit to record decrease in those accounts. As a result, asset and expense accounts
usually have debit balances. Since we credit liability, share capital and revenue
accounts to record increase and debit to record decrease, these accounts usually
have credit balances. The usual balance for an account is its normal balance. The
following table summarizes the normal balances for the various types of accounts:
Exhibit 2.4 presents the ledger of Fashion Concepts at the end of June. The
accounts are grouped into asset, liability and equity categories.
Liabilities = 9,150
Verification of the Accounting Equation
Recording Transactions
The Journal
The journal is a chronological record of an enterprise’s
transactions. The word ‘journal’ derives from the Latin word
diurnalis meaning “diurnal” which implies “of or during the day
time”. The journal is called the book of original entry or primary
book because this is the accounting record where we first record transactions. It
provides in one place a complete record of all transactions with necessary
explanations. A journal entry has the transaction date, the individual accounts
and the related debit and credit amounts, and a brief explanation of the transaction.
Journalizing is the process of recording transactions in the journal.
The General Journal
Companies usually maintain several kinds of journals. The nature of operations and
the frequency of a particular type of transaction in a company determine the
number and design of journals. In this chapter, we use the general journal, the
most commonly used type of journal. It has separate columns to record the following
information about each transaction:
1.
2.
3.
4.
5.
Date;
Individual accounts;
Debit and credit amounts;
Brief explanation of the transaction; and
Posting reference.
Exhibit 2.5 illustrates the general journal using two transactions of Fashion
Concepts Company.
The procedure for recording transactions in the general journal is as follows:
1. Enter the year, month, and date of the transaction in the Date column.
v There is no need to repeat the year and month for subsequent entries until
the start of a new page, or a new month.
2. Write the account titles under the Description column.
v Enter the account to debit on the first line of the entry next to the left
margin. If there are several accounts to debit, enter them one after the
other.
v Enter the account to credit on the line below the account(s) to debit and
indent it to set the account apart from the account(s) to debit. If there are
several accounts to credit, enter them one after the other.
v Use the account titles from the company’s chart of accounts.
v A compound entry is a journal entry that has more than one debit and/or
credit items.
3. Enter the amount of the debit in the Debit column alongside the account to
debit and the amount of the credit in the Credit column alongside the
account to credit.
4. Write a brief explanation of the transaction.
5. The Post. Ref. (Posting Reference) is left blank at the time of making the
journal entry.
Transferring Information to the Ledger
Posting is the process of transferring information from the
journal to the ledger. We enter each amount in the Debit column
in the journal on the debit side of the appropriate account and
each amount on the Credit column on the credit side of the
appropriate account. The frequency of posting could be daily, weekly, or monthly,
depending on the number of transactions.
Posting has the following steps:
1. Locate in the ledger the account(s) debited in the journal entry.
2. Enter the date of the transaction in the account.
3. Enter the relevant journal page number in the Post. Ref. column of the
account.
4. Enter the debit amount appearing in the journal in the Debit column of the
account.
5. Enter the account code or the ledger page number in the Post. Ref. column of
the journal.
6. Repeat steps 1 to 5 for the account(s) credited in the journal entry.
Exhibit 2.6 illustrates these steps separately for the debit and credit parts of a
journal entry. Entering the account code in the “Post. Ref.” column of the journal is
the last step in posting. It indicates that the accountant has transferred all the
information in the journal entry to the ledger. In addition, the account codes in this
column are a convenient means for locating any additional information about an
amount appearing in an account. Since this book does not use account codes, you do
not have to complete this column.
The next step in the recording process is the preparation of a trial balance.
Trial Balance
Under the double-entry system, the debit and credit amounts
must be equal. The trial balance is a device for verifying the
equality of debits and credits. Pacioli is said to have advised that a
person should not go to sleep at night until the debits equalled the
credits. Exhibit 2.7 shows a trial balance for Fashion Concepts Company. The trial
balance lists each account in the ledger that appears in Exhibit 2.4, with the debit
balances in the left column, and the credit balances in the right column. Each
column has a total, and the two totals must be equal. When this happens, the trial
balance is said to be “in balance.”
The equality of the debit and credit totals of the trial balance proves that we have
recorded equal debits and credits in the accounts. Further, it verifies that we have
computed account balances correctly. However, we could have made errors that do
not affect the equality of debits and credits:
Errors of principle Posting a journal entry to a wrong account will not
affect the trial balance. For example, suppose that for payment of office rent
we debited Equipment instead of Rent Expense. The trial balance will still
balance.
Errors of omission and repetition The trial balance will not reveal either
the complete omission of a transaction from the ledger, or the recording of the
same transaction more than once.
Compensatory errors The recording of the same erroneous amount for both
the debit and credit of a transaction will not show up in the trial balance.
Locating Errors
If the debit and credit totals of the trial balance do not agree, the following types of
errors are possible:
1.
2.
3.
4.
5.
Recording different amounts for debit and credit in the journal;
Posting a debit as a credit and/or a credit as a debit;
Computing an account balance incorrectly;
Copying the amount of an account balance to the trial balance incorrectly;
Copying a debit balance in an account as a credit balance, or a credit balance
in an account as a debit balance, to the trial balance;
6. Omitting an account balance from the trial balance; and
7. Totalling the trial balance incorrectly.
Sometimes, you may find that your trial balance does not balance. Usually, the
difference in the trial balance arises from a combination of errors rather than a
single error. Unfortunately, there exists no sure-fire method of locating a difference.
You must often proceed patiently, checking journal entries, postings, and the
balancing of each account. At times, knowing a few short cuts such as the following
may help:
If the amount of trial balance difference is divisible by 9 without remainder, it
could indicate transposition of digits in an amount (e.g. recording 4,921 as
4,291).
If the amount of difference is divisible by 2 without remainder, look in the
trial balance for an amount equal to the quotient. The existence of such a
number in the trial balance, or in the journal may indicate taking a debit as a
credit or vice versa.
Rather than having to locate a trial balance difference, especially in an
examination, it would be better to follow the quality manager’s mantra: Do it right
the first time. Your aim should be to avoid errors altogether by being careful in
transaction processing.
Correcting Errors
The accountant must correct an error when he locates it. If he discovers an error in
a journal entry before posting, he can cross out the wrong amount and insert the
correct amount immediately above. Erasing errors may give the impression of a
cover-up.
Correcting entries rectify incorrect journal entries or wrong postings of journal
entries. A useful way to determine the correcting entry is to compare the incorrect
entry with the correct entry and then make a correcting entry in the journal. For
example, assume that the accountant made the following journal entry to record the
payment of electricity expense of `4,300 and posted it to the ledger:
This entry is incorrect because it debits Rent Expense instead of Electricity
Expense. The correct entry is as follows:
The following is the correcting entry:
Note that the credit to Cash is proper and does not need correction.
When the trial balance is not “in balance”, the normal practice is to place the
difference initially in a Suspense account. Then, the accounting records are to be
scrutinized to locate the errors. Finally, the correcting entries are to be recorded by
debiting or crediting Suspense and the relevant accounts.
Suppose that an accountant has a trial balance that shows the following totals:
Debits...............................69,000
Credits..............................77,730
The accountant opens a Suspense account with a debit of 8,730 representing the
difference in trial balance:
We now post the correcting entries to the related accounts including the Suspense
account. The Suspense account will appear as follows:
Note that, after all the errors have been corrected, the Suspense account will not
have any balance.
Looking Back
Describe an account and a ledger An account records increases and decreases in specific asset, liability,
and equity items. The ledger is a file or binder containing all the accounts, of an enterprise usually
arranged according to a chart of accounts.
Recognize commonly used accounts You will often come across accounts for the following items:
Assets: land; buildings; equipment; prepaid expenses; trade receivables; bills receivable; cash.
Liabilities: bills payable; trade payables; unearned revenue; wages payable; debentures.
Equity: capital; revenue from services; salaries expense; rent expense; drawings; dividends.
Describe the double-entry system and apply the rules for debit and credit The double-entry system
records each business transaction with equal debits and credits. Debit is on left side and credit is on right
side. The rules for debit and credit are: (a) debit increases and credit decreases assets; and (b) debit decreases
and credit increases liabilities and equity.
Analyze the effect of business transactions using debits and credits The three-step procedure for
analyzing transactions is: (i) analyze the effect of a transaction in terms of increases and decreases in
assets, liabilities, and equity; (ii) apply the rules for debit and credit; and (iii) record the entry.
Record transactions in the journal The journal is a chronological record of transactions. The journal
entry for a transaction has the date of the transaction, the individual accounts and the related debit and
credit amounts, and a brief explanation of the transaction.
Post entries from the journal to the ledger Posting consists of entering each amount on the debit
column of the journal on the debit side of the appropriate account and each amount on the credit column on
the credit side of the appropriate account.
Prepare a trial balance and know its limitations When the total of debit balances equals the total of
credit balances, the trial balance is “in balance.” The trial balance cannot detect some kind of errors.
Review Problem
Ganesh quit his job and started Woodcraft Company. The transactions of the business for September are as
follows:
20XX
Sep. 1 Began business by investing cash `10,000 in company’s share capital.
4 Paid two months’ rent in advance for a shop, `2,000.
5 Bought equipment for cash, `1,200.
7 Bought supplies on credit, `700.
10 Received payment for remodelling a kitchen, `8,600.
14 Paid for an advertisement that appeared in the local newspaper, `1,400.
17 Received payment for furnishing office room, `11,200.
23 Billed customers for work done other than on cash terms, `13,100.
25 Paid assistant’s wages, `1,500.
28 Paid electricity charges, `240.
29 Received part payment from customers billed on September 23, `4,800.
30 Paid a dividend, `2,500.
Required
1. Prepare journal entries for the above transactions.
2. Post the journal entries to the ledger.
3. Prepare a trial balance.
Solution
1. Journal entries
2. Ledger
3. Trial balance
ASSIGNMENT MATERIAL
Questions
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
Define account and ledger.
What determines the number and types of accounts for a business?
“Debits = Credits.” Explain.
Why do we enter transactions first in the journal and then post them to the
ledger?
State the rules of debit and credit for (a) assets, (b) liabilities, and (c) equity.
What is the meaning of a debit balance and a credit balance? Is a debit
balance always favourable and a credit balance always unfavourable?
“Debit means increase and credit means decrease.” Comment.
Why are the rules of debit and credit the same for liabilities and equity?
What is the normal balance of the trade receivables account? When can it
have an abnormal balance?
What is a chart of accounts?
What is a compound entry?
State whether each of the following is an asset account, a liability account,
or an equity account:
(a) Salaries expense
(b) Bills payable
(c) Supplies
(d) Dividends
(e) Cash
(f) Trade receivables
(g) Prepaid insurance
(h) Interest income
(i) Interest expense payable
Why do we prepare a trial balance? Name the types of errors it cannot
detect.
When do we open a suspense account? How do we clear it?
What is XBRL? How is it useful?
What is cloud computing? How will it change accounting?
Problem Set A
Rakesh set up Mechanotronics Ltd. Record the following transactions by entering debits and
credits directly in the company’s accounts using the transaction letters as the key.
(a) Rakesh invested cash in the company’s share capital, `10,000.
(b) Paid rent deposit for office premises, `5,000.
(c) Provided services for cash, `3,500.
(d) Purchased office equipment on credit, `2,500
(e) Paid office rent for the month, `750.
(f) Billed customers for services provided, `3,300.
(g) Paid for office equipment in (d), `1,500.
(h) Paid assistant’s wages, `250.
(i) Paid dividends, `1,000.
Shalini Arora set up Ace Marketing Ltd. to provide consultancy. During a short period,
the company completed the following transactions:
(a) Shalini invested cash in Ace’s share capital, `20,000.
(b) Billed customers for services provided, `5,600.
(c) Paid assistant’s salary, `600.
(d) Bought computer on credit, `4,400.
(e) Received cash from customers billed earlier, `1,350.
(f) Took a bank loan, `5,000.
(g) Paid for computer in (d), `2,000.
(h) Received fee for professional services, `8,250.
(i) Paid dividends, `1,100.
Prepare journal entries to record the transactions.
Time Value Company provides training on time management. The following are the
account balances of the company on September 30, 20XX:
Prepare a trial balance.
The trial balance of your company does not balance. Your review of the records reveals
the following errors:
(a) A cash payment of `900 for salaries expense was recorded as a debit of `600 to Salaries
Expense and a credit of `900 to Cash.
(b) Supplies Expense with a balance of `750 was listed in the trial balance as `7,500.
(c) A purchase of supplies for `500 on account was posted as a debit to Supplies and a credit to Cash.
(d) Rent Expense of `4,000 was posted as a debit to Cash and a credit to Rent Expense.
(e) A cash payment of `3,800 to Trade Payables was recorded as a debit to Trade Payables of `3,800 and a
credit to Cash of `3,300.
(f) A cash receipt of `1,200 from customers was posted twice to Trade Receivables and Cash.
(g) Electricity Expense with a balance of `800 was omitted from the trial balance.
Using the format given below, for each error indicate whether the trial balance will balance (Yes) or will not
balance (No). If it will not balance, specify the amount of the difference and the trial balance column (Debit,
Credit) that will have a larger total. The errors are independent of each other.
State the effect of the following errors on the trial balance and prepare journal entries, where
needed, to correct them. Use the format given.
(a) A cash receipt of `1,900 for services yet to be provided was debited to Cash and credited to
Revenue from Services.
(b) A purchase of supplies of `4,400 on credit was recorded as a debit to Supplies of `4,400 and a credit to
Cash of `4,400.
(c) An interest payment of `1,000 was debited to Bank Loan Payable and credited to Cash.
(d) Cash payment of `3,600 to suppliers was recorded as a debit to Trade Payables of `6,300 and credit to
Cash of `3,600.
Format:
(a) Effect: The trial balance will balance. Revenue from Services is overstated by `1,900 and Unearned
Revenue is understated by `1,900.
Problem Set B
Kannan started Vogue Garments. The following transactions took place in the first month:
(a) Kannan invested cash in the company’s share capital, `25,000.
(b) Paid rent deposit for premises, `5,000.
(c) Appointed an assistant on a monthly salary of `1,000.
(d) Bought supplies on credit, `4,000.
(e) Took a bank loan, `15,000.
(f) Bought equipment for cash, `18,000.
(g) Provided services for cash, `7,800.
(h) Received cash for services to be provided later `3,500.
(i) Paid electricity expense, `1,050.
(j) Paid for supplies in (d), `3,000.
(k) Billed customers for services provided, `8,000.
(l) Paid salary for the month, `1,600.
(m) Paid rent for the month, `500.
(n) Collected amounts due from customers, `5,500.
Required
1. Record the transactions by entering debits and credits directly in the
accounts using the transaction letters as the key.
2. Prepare a trial balance at the month end.
On August 1, 20XX, Santanu Bhattacharya established Access Marketing Ltd. to
provide research services. The following transactions were concluded in August:
Aug. 1 Bhattacharya invested cash in the company’s share capital, `50,000.
2 Bought office equipment on credit, `16,000.
3 Bought office supplies for `3,000 on part payment of `2,000.
4 Took office premises on rent at a monthly rent of `3,500 payable on the fifth of each month.
5 Paid office rent for the month.
7 Provided services for cash, `12,000.
10 Billed customers for services provided, `5,900.
13 Paid on account for the equipment bought on August 2, `8,000.
17 Paid insurance premium for the next month, `750.
19 Received but not paid electricity bill for the month, `550.
22 Paid telephone expense, `800.
24 Bought office supplies for cash, `1,000.
27 Received cash for services to be provided in the next month, `6,700.
29 Paid salaries expense, `4,000
31 Paid a dividend, `5,000.
Required
1. Prepare journal entries to record the transactions in the general journal.
2. Post the journal entries to the ledger.
3. Prepare a trial balance on August 31, 20XX.
Amrapali Ltd. provides haircare services. The account balances of Amrapali at the end of
February are as follows:
During March, the company carried out the following transactions:
Mar. 1 Paid salaries payable for February, `500.
2 Paid rent for the month, `300.
3 Received payment from customers billed earlier, `1,010.
4 Bought supplies for cash, `320.
5 Appointed an assistant on a monthly salary of `100.
7 Paid insurance premium for the period April to December 20XX, `540.
8 Received cash for services to be provided, `715.
9 Bought equipment on credit, `1,900.
13 Paid for supplies bought on credit last month, `635.
16 Bought supplies on credit, `500.
18 Returned some of the supplies bought on March 16 as these were defective, `100.
20 Billed customers for services provided, `430.
27 Paid electricity expense for the month, `125.
29 Provided part service for cash received on March 8, `600.
30 Paid on account for equipment purchased on March 9, `950.
31 Paid a dividend, `1,000.
Required
1. Prepare journal entries to record the transactions in the general journal.
2. Enter the February 28 balances in the appropriate accounts from the trial
balance. Write Balance in the explanation space of the account.
3. Post the journal entries to the ledger. Open additional accounts as may be
necessary.
4. Prepare a trial balance on March 31, 20XX.
Keshav Menon, after completing a PhD in Geology, established Terrafiles Ltd. to provide
geological data analysis services to mining enterprises.
PART 1
The company engaged in the following transactions in May:
May 1 Menon invested cash in the company’s share capital, `25,000.
2 Paid insurance premium for May to July, `300.
3 Hired an office assistant on a monthly salary of `1,000.
4 Ordered a computer, `15,000.
5 Paid rent for the month, `400.
15 Provided services for cash, `17,800.
18 Received cash from a customer for services to be provided later, `11,250.
23 Received the computer ordered and made a part payment of `8,000.
28 Paid telephone expense for the month, `450.
29 Paid office assistant’s salary for May.
30 Bought supplies on credit, `635.
Required
1. Prepare journal entries to record the transactions in the general journal.
2. Post the journal entries to the ledger.
3. Prepare a trial balance on May 31.
PART 2
The company carried out the following transactions in June:
June 1 Billed customers for services provided, `16,350.
2 Paid electricity expense, `1250 and rent expense, `400.
6 Bought supplies for cash, `250.
10 Provided services for `10,500 to the customer who had paid an advance on May 18 and refunded the
balance.
13 Returned defective supplies bought on June 6 and received refund, `150.
18 Provided services for cash, `3,250.
20 Paid the balance amount due in respect of the computer received on May 23.
27 Paid for supplies bought on May 30.
28 Paid office assistant’s salary for June.
29 Received part payment from customers billed on June 1, `12,750.
30 Paid dividend, `750.
Required
1. Prepare journal entries to record the transactions in the general journal.
2. Enter the May 31 balances in the appropriate accounts. Write Balance in the
explanation space of each account.
3. Post the journal entries to the ledger.
4. Prepare a trial balance on June 30.
The balance sheet of Faunus Catering Services Ltd. on April 30, 20XX is as follows:
During May, the company completed the following transactions:
May 1 Billed customers for services provided, `12,100.
2 Paid cleaning expense for the month, `1,800.
3 Ordered supplies on one month credit, `240.
7 Purchased equipment on credit, `8,000.
12 Provided services for `7,000 to a customer who had paid advance in April.
17 Received supplies ordered on May 3.
21 Received cash from customers billed in April, `3,200.
28 Paid salaries for May, `2,000.
29 Took a bank loan, `10,000.
30 Paid for equipment bought on May 7.
31 Provided services for cash, `5,400.
Required
1. Prepare journal entries to record the transactions in the general journal.
The inventory of supplies on May 31 was `2,110. Record the difference
between this amount and the May 31 balance of the Supplies account as the
supplies expense for May.
2. Enter the April 30 balances in the appropriate accounts. Write Balance in
the explanation space of each account.
3. Post the journal entries to the ledger.
4. Prepare the May statement of profit and loss, statement of retained
earnings, and balance sheet.
Problem Set C
Lakshman Singh set up WideAwake Security Company in January 20XX to provide
security services. The following transactions took place in the first month:
(a) Singh invested cash in the company’s share capital, `50,000.
(b) Appointed five security guards on a monthly salary of `500 each.
(c) Rented office space and paid a deposit of `10,000.
(d) Paid advertisement charges, `1,800.
(e) Received cash from customers for services to be provided, `11,000.
(f) Purchased supplies for cash, `5,000.
(g) Purchased equipment on credit, `25,000.
(h) Paid rent for the first three months, `3,000.
(i) Billed customers for services provided, `7,300.
(j) Paid telephone expense, `775.
(k) Provided services for cash, `5,450.
(l) Paid security guards’ salaries.
(m) Paid for equipment in (g), `6,000.
(n) Returned defective supplies and received refund, `1,000.
Required
1. Record the transactions by entering debits and credits directly in the
accounts using the transaction letters as the key.
2. Prepare a trial balance at the month end.
On July 1, 20XX, Uma Rao established GreenThumb Ltd. to provide gardening services.
During the first month of operations of her business, the following transactions were
done:
July 1 Uma Rao invested cash in the company’s share capital, `25,000.
2 Entered into contract with a customer to provide services, `5,100.
3 Bought gardening supplies for cash, `3,000.
4 Bought gardening equipment on credit, `15,700.
6 Took office space on rent and paid current month’s rent, `1,500.
7 Appointed an assistant on a salary of `850 per month.
9 Billed customers for services provided, `6,200.
12 Paid for an advertisement placed in the local newsletter, `540.
14 Paid for equipment bought on July 4, `7,500.
15 Bill customers for services provided under the contract signed on July 2, `2,700.
18 Received payments from customers billed on July 9, `2,400.
26 Provided services for cash, `3,900.
28 Paid assistant’s salary.
29 Paid electricity expense, `710.
31 Paid insurance premium in advance, `1,050.
Required
1. Prepare journal entries to record the transactions in the general journal.
2. Post the journal entries to the ledger.
3. Prepare a trial balance on July 31, 20XX.
Reliance Tennis Ltd. offers lessons to amateur players. The company’s account balances at the end of October
are as follows:
During November, Reliance Tennis was engaged in the following transactions:
Nov. 1 Provided services for cash, `3,600.
2 Paid salaries for the month, `2,500.
3 Repaid part of bank loan, `2,000.
5 Provided services to a customer who had paid an advance in October, `2,400.
6 Purchased supplies for cash, `700.
8 Paid tennis court maintenance charges, `900.
9 Received a bill for advertisement placed during the month, `300.
12 Received cash for services to be provided later, `1,400.
14 Paid electricity bill for the month, `650.
17 Billed customers for services provided, `1,180.
19 Returned defective supplies bought on credit in October, `200.
26 Received payments from customers billed previously, `2,900.
28 Paid suppliers for past purchases of supplies, `440.
29 Paid insurance premium for December, `830.
30 Paid dividend, `1,100.
Required
1. Prepare journal entries to record the transactions in the general journal.
2. Enter the October 31 balances in the appropriate accounts from the trial
balance. Write Balance in the explanation space of the account.
3. Post the journal entries to the ledger. Open additional accounts as may be
necessary.
4. Prepare a trial balance on November 30, 20XX.
Zeenat Bukhari, after completing a Master’s degree in computer science, established
Computer Care Ltd. to provide maintenance services.
PART 1
During August, she completed the following transactions:
Aug. 1 She invested cash in the company’s share capital, `50,000.
2 Appointed two programmers on a monthly salary of `3,000 each.
3 Provided services for cash, `4,700.
4 Placed order for equipment, `15,000.
7 Paid rent for August, `1,500.
13 Purchased supplies on credit, `2,200.
16 Paid salary advance to the programmers, `500 each.
19 Paid insurance premium for the next year, `4,000.
20 Received equipment ordered on August 4 and agreed to pay for it on September 9.
28 Billed customers for services provided, `10,250.
29 Paid the balance of programmers’ salaries for August.
30 Received electricity bill, `1,600 and telephone bill, `650 for August payable on September 3.
Required
1. Prepare journal entries to record the transactions in the general journal.
2. Post the journal entries to the ledger.
3. Prepare a trial balance on August 31.
PART 2
During September, she completed the following transactions:
Sep. 1 Received cash for services to be provided later, `3,900.
3 Paid electricity charges and telephone charges for August.
4 Purchased supplies for cash, `1,300.
7 Paid rent for September and October, `3,000.
9 Paid for equipment received on August 20.
15 Received on account cash from customers billed on August 28, `6,700.
16 Provided services for cash, `11,800.
18 Paid for supplies bought on credit on August 13.
21 Purchased equipment on credit, `10,000.
24 Returned a part of the supplies bought on September 4 and received refund, `500.
27 Provided services to customers who had paid advance on September 1, `4,500.
28 Paid programmers’ salary for the month.
29 Paid annual maintenance charges for equipment, `770.
30 Paid dividend, `2,000.
Required
1. Prepare journal entries to record the transactions in the general journal.
2. Enter the August 31 balances in the appropriate accounts. Write Balance in
the explanation space of each account.
3. Post the journal entries to the ledger.
4. Prepare a trial balance on September 30.
The balance sheet of Phoenix Drycleaners Ltd. on July 31, 20XX is as follows:
During August, the company completed the following transactions:
Aug. 1 Provided services for cash, `4,800.
2 Paid electricity expense for the month, `170.
7 Paid rent for the month, `1000.
14 Provided services to customers who had paid advance and refunded `200.
15 Bought supplies for cash, `900.
24 Received cash on account from customers billed earlier, `4,150.
27 Paid fuel charges, `630.
28 Paid salaries for the month, `1,600.
29 Paid suppliers on account, `1,390.
30 Paid dividend, `1,100.
Required
1. Prepare journal entries to record the transactions in the general journal.
The inventory of supplies on August 31 was `1,120. Record the difference
between this amount and the August 31 balance of the Supplies account as
the supplies expense for August.
2. Enter the July 31 balances in the appropriate accounts. Write Balance in the
explanation space of each account.
3. Post the journal entries to the ledger.
4. Prepare the August statement of profit and loss, statement of retained
earnings, and balance sheet.
Business Decision Cases
After working for over a decade in a leading software company, Vinay and Sheela
Kapoor decided to set up their own software firm, Kapoor Software Ltd. on June 1.
Each of them deposited `30,000 in the company’s bank account in exchange for 3,000
shares of `10 each.
Amit Lal, an old friend of the Kapoors, joined the company as office manager on a monthly salary of `7,000,
no matter how many days he showed up at work. Amit paid into the bank all customer receipts and made all
payments by cheque. Although Amit had no knowledge of accounting, he carefully filed the company’s letters,
invoices and other papers. Also, he noted down details of cheques received and issued in his diary. The following
information is available from Amit’s file and diary.
June 1:
Borrowed `25,000 from Canara Bank.
Sheela ordered a computer costing `40,000.
June 2:
Hired an office room on a monthly rental of `2,500 payable on the first day of
the month and paid the rent for June.
June 3:
Vinay appointed two programmers on a salary of `250 per day each for the
number of days they worked.
June 6:
Received the computer and paid `15,000. The balance amount is payable in
three equal instalments on the fifth of every month beginning July.
Ordered on Gupta & Co. supplies for `7,300.
June 8:
Received supplies costing `3,900.
June 10:
Raised invoices on customers, `29,200, for providing services.
June 16:
One box of CDs costing `710 varied slightly from the purchase specification,
and Gupta & Co. was informed of the rejection; all other items were as
ordered and were paid for.
June 19:
Received cheques for `14,100 from customers in payment of bills.
June 20:
Raised invoices on customers for `19,400 for providing services.
June 23:
Received a cheque for `9,800 from a customer as payment for services to be
provided in July.
June 27:
Gupta & Co. requested me to accept the rejected supplies and said that they
would be willing to give a discount of `90 on the CDs to make up for the
deviation. I checked with Vinay and he told me to accept the supplies. I
accepted the supplies and paid Gupta & Co.
June 28:
Received cheques for `7,100 in payment of bills.
June 29:
Vinay asked me to repay the bank loan. I paid `14,000 of the loan with
interest of `340.
June 30:
During the month, the company had 21 working days. One of the assistants
reported for work on all working days and the other worked for only 17 days.
I paid the June salaries.
The inventory of supplies is worth about `2,400.
Received the June electricity bill for `450, but could not pay it.
July 1:
Paid office rent for July.
Paid the June electricity bill.
July 3:
Received the remaining supplies.
July 4:
Paid for the supplies.
July 5:
Paid the first instalment for the computer.
Required
1. Prepare the June financial statements of Kapoor Software Ltd.
2. The Kapoors propose to pay themselves a dividend of `10 per share.
Comment on their proposal.
Interpreting Financial Reports
Tata Consultancy Services Ltd. is a leading information technology services company listed in Indian stock
exchanges. The following is the company’s 2013 consolidated balance sheet, suitably modified
for use in this case:
Required
1. Determine the missing amounts indicated by the letters.
2. For the year ended March 31, 2013, TCS reported a net profit of `139,173
million and paid dividends of `43,249 and dividend-distribution tax of `7,273
million. Compute the amount of (a) retained earnings for the year and (b)
other equity items on the balance sheet.
Financial Analysis
Study the financial statements of an Indian health care services company.
Required
1. Develop a chart of accounts that would satisfy the information needs of the
typical users of the financial statements of the company.
2. Discuss the factors that you had in mind while developing the chart.
The XBRL technology will have a major effect on the financial reporting supply chain. The
website of XBRL International says:
XBRL is a language for the electronic communication of business and financial data which is
revolutionising business reporting around the world. It provides major benefits in the preparation,
analysis, and communication of business information. It offers cost savings, greater efficiency, and
improved accuracy and reliability to all those involved in supplying or using financial data.
Required
1. Prepare a report explaining the benefits and costs of XBRL to the
stakeholders in financial reporting.
2. Develop a basic taxonomy for a typical set of financial statements of an
Indian road transport company.
Cloud computing has significant implications for the way business is managed. It is
said to be one of the major technological advancements in the recent past.
Required
Prepare a report on how cloud computing would change accounting systems.
Answers to Test Your Understanding
2.1 Assets: (c), (d) and (g). Liabilities: (h), (j) and (m). Equity: (a), (b), (e), (f), (i), (k) and (l).
2.2 (a) Mahesh Pherwani invested cash, `3,100 and photography equipment, `9,000 in Pherwani Photoshop
Ltd.’s share capital.
(b) Bought photography supplies on credit, `1,400.
(c) Paid rent in advance, `1,600.
(d) Received cash for services provided, `4,700.
(e) Bought photography equipment on credit, `2,000.
(f) Paid suppliers on account, `550.
(g) Billed customers for services provided, `8,100.
(h) Paid salaries, `1,700.
2.3 (b) Asset (Equipment) increased. Debit asset to record increase. Debit Equipment, 13,000. Asset (Cash)
decreased. Credit asset to record decrease. Credit Cash, 13,000.
(c) Asset (Cash) increased. Debit asset to record increase. Debit Cash, 6,000. Revenue (Revenue from Services)
increased. Credit revenue to record increase. Credit Revenue from Services, 6,000.
(d) Asset (Prepaid Rent) increased. Debit asset to record increase. Debit Prepaid Rent, 1,200. Asset (Cash)
decreased. Credit asset to record decrease. Credit Cash, 1,200.
(e) Asset (Trade Receivables) increased. Debit asset to record increase. Debit Trade Receivables, 3,500.
Revenue (Revenue from Services) increased. Credit revenue to record increase. Credit Revenue from
Services, 3,500.
(f) Asset (Supplies) increased. Debit asset to record increase. Debit Supplies, 4,600. Liability (Trade Payables)
increased. Credit liability to record increase. Credit Trade payables, 4,600.
(g) Asset (Cash) increased. Debit asset to record increase. Debit Cash, 1,700. Asset (Trade Receivables)
decreased. Credit asset to record decrease. Credit Trade Receivables, 1,700.
(h) Expense (Electricity Expense) increased. Debit expense to record decrease. Debit Electricity Expense, 120.
Asset (Cash) decreased. Credit asset to record decrease. Credit Cash, 120.
(i) Liability (Trade Payables) decreased. Debit liability to record decrease. Debit Trade Payables, 4,600. Asset
(Cash) decreased. Credit asset to record decrease. Credit Cash, 4,600.
(j) Dividends increased. Debit dividends to record increase. Debit Dividends, 500. Asset (Cash) decreased.
Credit asset to record decrease. Credit Cash, 500.
2.4 Debit: (a), (c), (d), (e), (f), (g), (i), and (k). Credit: (b), (h), (j), (l), and (m).
2.5
2.6 (a) The trial balance will not balance. Salaries Expense is understated by `800.
(b) The trial balance will not balance. Cash is overstated by `1,260.
(c) The trial balance will balance. Insurance Expense is understated, and Equipment overstated, by `180.
(d) The trial balance will balance. Both Supplies and Trade Payables are understated by `2,900.
1 For the present, for credit sales and credit purchases, we will use trade receivables and trade payables, and not
bills receivable and bills payable.
2 Luca Pacioli was the best friend and a teacher of Leonardo da Vinci, the renowned painter, scientist and
inventor, and taught him mathematics and geometry. Pacioli is believed to have helped the artist with the
painting of The Last Supper. Interestingly, Pacioli also penned the world’s oldest magic text, De Viribus
Quantitatis (On the Powers of Numbers). It would appear that accounting skill and sleight of hand have had
something in common for a long time.
3 Quoted in Joel Demski, John Fellingham, Yuji Ijiri, and Shyam Sunder, Some thoughts on the intellectual
foundations of accounting, Accounting Horizons, June 2003, pp. 157–168.
4 ‘On account payment’ is a part payment.
5 We are getting of the story here. In Chapter 3, you will see why we reckoned the expense even though cash
was not paid.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Define and explain net profit, revenue, and expense.
Define accrual accounting and distinguish between the accrual system and the cash system.
Explain the realization principle and its effect on recording revenue.
Elucidate the matching principle and its effect on recording expenses.
Define deferrals and accruals and explain the need for adjustments.
Prepare adjusting entries.
Develop a worksheet.
Prepare financial statements from a worksheet.
Record adjusting entries from a worksheet.
Describe the accounting cycle.
Record closing entries.
Prepare a post-closing trial balance and explain its purpose.
Prepare reversing entries.
Explain pro forma financial measures.
HOW MUCH DOES THAT CAR COST?
Read this news item:
Audi has launched an integrated finance, service, insurance and extended warranty package in India for customers of the A4,
A6 sedans and the Q5 SUV. Called ‘Audi CarLife-Advance’, this initiative aims to provide the benefits of a leasing service,
while still letting the customer have ownership of the vehicle. The services are available bundled under a single monthly
payment.
Audi cars come with a two-year (unlimited kilometre) manufacturer’s warranty that covers
manufacturing or material defects*. The buyer can avail of a three-year warranty against any
paintwork defects*. As further reassurance, every car is protected by an anti-corrosion
perforation warranty that can extend up to 12 years**. It’s not the end of the road when your
car’s warranty expires. You can continue to enjoy your peace of mind by extending the
warranty period for another two years or 100,000 km at a nominal cost*. The company gives a
one-year comprehensive insurance and “depreciation shield” (i.e. the company will bear the
cost difference between the actual repair costs and the damage claim). The company’s finance
subsidiary provides an interest-free loan for the purchase. The company provides roadside
assistance free of cost* (24 x 7, 365 days, two dedicated toll numbers, multilingual services,
replacement car, on-site minor repairs, despatch of spare keys in case of loss, etc.).
* Conditions apply.
** Period of warranty depends on the make of the car.
Now it is clear that the automobile company is selling not just a car but a package of
products and services. The customer is paying for all of them. The price of the car is to be
allocated to the various items: car, warranty, extended warranty, interest-free loan, insurance
and roadside assistance.
Not all the revenue is earned when the car is sold. Interest income would be earned over a
period of time. It is not possible to say precisely how much warranty, extended warranty and
roadside assistance the car would need; so the likelihood of these services has to be estimated.
Oblivious of these complexities the buyer steers his gleaming car out of the showroom. The
company’s accountants start work on how to split the price between the car and the other
items that form part of the deal.
THE CHAPTER IN A NUTSHELL
Profits are the lifeblood of a business. Owners, lenders, and managers frequently use profit as a
measure of success of a business. An important function of accounting is to measure and report
the income of a business as a basis for evaluating its achievement of this objective. In this
chapter, you will learn how accountants define and measure income. You will appreciate the
difficulties in relating revenues and expenses to specific reporting periods and understand their
implications for analyzing financial statements. Further, you will understand the need for
adjusting entries and their effect on income measurement. You will also be acquainted with
accrual, the core of the accounting model. Finally, you will learn how to prepare financial
statements.
Income Measurement
Business enterprises carry out a continuous stream of production,
marketing, and other commercial activities aimed at earning
profits. These activities often span two or more time periods and
do not lend themselves to tidy separation into equal time periods. In these
circumstances, the most accurate measure of the success or failure of a firm would
be available when it winds up its operations and goes out of business. However, in
today’s business environment, firms find it necessary to communicate their income
frequently. Shareholders are provided with annual financial reports, dividends are
distributed based on periodical profit, and income tax is computed on annual
income. Listed companies must publish quarterly financial reports. For internal
purposes, income is measured even more often.
Responding to these needs, accountants seek to measure the income of a period by
assigning the results of the activities of enterprises to specific time periods. GAAP
provides the framework of periodic income measurement. Users of financial reports,
who grasp these principles, recognize the merits as well as the limitations of the
accountant’s definition of income.
Despite a great deal of effort, a clear definition of income remains elusive.
Economists speak of income as the amount by which an entity becomes better off at
the end as against the beginning of a period. Unfortunately, the degree of “betteroffness” of an entity is largely a matter of personal opinion and can seldom be
objectively measured. The term ‘income’ has different meanings in different contexts
and no single definition is likely to fit all the contexts satisfactorily. Accountants
prefer to use the more explicit term ‘net profit’ instead of income.
Net Profit
Net profit is the increase in equity from the operations of the business. Changes in
equity because of further investments by, and distributions to, owners affect the
equity of a business but do not form part of net profit. Accountants generally
measure net profit as the excess of revenues over expenses. If expenses exceed
revenues, the difference is net loss. The period for which a company reports net
profit is its reporting period, financial year, or fiscal year. Under the income
tax law, companies must compute and pay tax on their income for the Government’s
fiscal year, April 1 to March 31.
Revenues
Revenue is “the gross inflow of economic benefits during the period arising in the
course of the ordinary activities of an entity when those inflows result in increases
in equity, other than increases relating to contributions from equity participants.”1
Business enterprises earn revenues by selling products or performing services. In
return, they usually receive either cash or accept promises to pay in the future.
Revenue is measured at the fair value of the consideration received or receivable.
However, when the inflow is deferred, the fair value of the consideration may be
less than the nominal amount receivable. Suppose that a consulting firm bills two
clients `15 million each for services provided in a year. Customer A pays the
amount immediately. The consulting firm will recognize a revenue of `15 million.
Customer B will pay the amount in three annual instalments of `5 million. The fair
value of the revenue from Customer B is the discounted value of the future receipts
and it will be less than the nominal amount of `15 million.
Sometimes, a business may receive some other assets (e.g. a customer’s products)
or services, or settle its liabilities, in payment for goods or services provided. In that
event, the amount of revenue recorded is the fair value of the asset or service
received, or liability settled. Thus, for a given reporting period, revenue earned is
the sum of cash, receivables, and the value of other assets and services received
from customers or liabilities reduced for the sale of goods or performance of services
during that period. Revenues come from an enterprise’s ongoing major or central
operations.
Revenues increase equity, but not all increase in equity arises from revenues. For
example, investment by shareholders increases equity, but it is not revenue. Again,
though revenues typically increase assets, some transactions may increase assets
without increasing revenues. For example, the purchase of office supplies on credit
increases assets and liabilities, but does not result in revenue. Further, revenues
may decrease liabilities. For example, when a business provides services for which
it has already received payment, unearned revenue – a liability – decreases and
equity increases.
Business organizations use various names to describe their revenues, such as
sales, fees, interest, dividends, royalties, rent, and guarantee commission.
Expenses
Expenses are “decreases in economic benefits during the reporting period in the
form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than relating to distributions to equity participants.”2
Businesses incur expenses to generate revenues. Expenses usually involve either
immediate payments (e.g. current month’s salaries) or promises to pay in the future
for services received (e.g. salaries payable) that have not yet been paid for. Typical
expenses include cost of sales, depreciation, interest, rent, and income tax. Expenses
relate to an enterprise’s ongoing major or central operations.
Expenses decrease equity and either decrease assets or increase liabilities. But
not all decrease in equity or increase in liabilities results from expenses. For
example, dividends decrease equity, but they are not expenses. As we shall see just
now, expenses are not the same as payments although many expenses entail
payments. For example, payment to a supplier for goods bought in the past involves
a payment, but it does not represent an expense. In some cases, cash may be paid
out before the expense is incurred, such as payment for next month’s rent or for
equipment. These payments represent assets in the balance sheet until they are
used and are expensed as their usefulness expires in the course of business.
Enterprises use various account titles to describe their major categories of
expenses to describe the nature of the expense. Typical account titles used in most
businesses include raw materials consumed, salaries expense, interest expense,
advertising expense, rent expense, and depreciation expense.
Gains and Losses
Gains are increases in equity from peripheral or incidental transactions and
events. Losses are the opposite of gains in that they are decreases in equity from
peripheral or incidental transactions and events. Gains and losses frequently result
from change in value of investments, disposal of used equipment, fines and
damages, theft, and natural disasters. Distinctions between revenues, gains,
expenses, and losses in a particular business depend largely on its major activities.
For example, investments in securities are sources of revenues and expenses for
banks and venture capital companies, but sources of gains and losses for
manufacturing or trading companies. Distinguishing gains from revenues and
losses from expenses is important in understanding how much of an enterprise’s
profit is derived from activities that are related to its main business. Earnings
quality refers to the probability of earnings trends continuing and the extent to
which earnings could represent distributable cash. Earnings are said to be of high
quality if, among others, they are derived primarily from continuing operations that
are not volatile from year to year. Therefore, high quality earnings are more
predictable than low quality earnings.
Accrual Accounting
Accrual accounting “depicts the effects of transactions and
other events and circumstances on a reporting entity’s economic
resources and claims in the periods in which those effects occur
even if the resulting cash receipts and payments occur in a
different period.”3 In other words, the accrual system recognizes
revenues when a business sells goods or performs services regardless of when it
receives cash. It recognizes expenses when it incurs them, that is, when it uses
goods or consumes services, no matter when it pays for them. Net profit equals the
revenues earned less expenses incurred during a period.
An alternative to accrual accounting is the cash system of accounting. The
cash system reports revenues on receiving cash and expenses on paying cash. It
does not consider rights to receive revenues and obligations to pay expenses. In this
system, net profit is the difference between revenue receipts and expense payments.
The cash system distorts financial performance by not matching revenues earned
and expenses incurred. In establishing the objectives of financial reporting, the
IASB concluded:4
[Accrual] is important because information about a reporting entity’s economic resources and claims and changes in
its economic resources and claims during a period provides a better basis for assessing the entity’s past and future
performance than information solely about cash receipts and payments during that period.
Information about a reporting entity’s financial performance during a period, reflected by changes in its economic
resources and claims …, is useful in assessing the entity’s past and future ability to generate net cash inflows. That
information indicates the extent to which the reporting entity has increased its available economic resources, and
thus its capacity for generating net cash inflows through its operations rather than by obtaining additional resources
directly from investors and creditors.
Information about a reporting entity’s financial performance during a period may also indicate the extent to which
events such as changes in market prices or interest rates have increased or decreased the entity’s economic
resources and claims, thereby affecting the entity’s ability to generate net cash inflows.
The Companies Act 2013 requires companies to follow accrual accounting. The
income tax law allows (and in some cases requires) the cash system under certain
circumstances. Traditionally, governments have followed the cash system for their
own accounting, but are moving to accrual. According to the International Monetary
Fund, 12 countries prepare full accrual financial statements, 52 countries are on
partial accrual and 120 countries follow the cash system.5 The countries that follow
accrual include Australia, New Zealand, and the UK. The Government of India has
decided to move to the accrual system and has issued four Indian Government
Financial Reporting Standards (IGFRS). So far, 21 State governments have agreed
in principle to introduce accrual accounting.
Realization Principle
Revenue recognition is the process of formally recording revenue
in a reporting period. The realization principle, or the revenue
recognition principle, requires that revenue be recognized at
the time it is earned. This differs significantly from the view of
some managers that a business earns revenue when they have
performed their part. For example, marketing managers almost always claim that
they have earned revenue the moment they get a customer order. (The more
sanguine among them may even take a customer’s smile as a confirmed order.) As
an example, this is what an effusive estate agent said about earning revenue:
I know people don’t change. I am, and always will be, optimistic. Invariably things work out. In business, this
means that in my head I’ve banked deals as soon as parties accept offers instead of waiting till the point of
exchange, which is customarily when the parties involved breathe a sigh of relief.
By waiting until the parties “breathe a sigh of relief”, the accountant is sure to
spoil the estate agent’s party. Recall the proverb, “Don’t count your chickens before
they are hatched.” Not all the eggs will hatch to become chickens. Of course, not all
the chickens may survive until they are meant to be sold, especially in these days of
bird flu. Accountants understand that earning revenue from sales or services is a
continuous process since an organization’s activities that give rise to revenue take
place all the time. For example, the earning process for a manufacturing firm
involves various activities, such as acquiring raw materials and services, producing
finished products, selling the products, and collecting payment from customers. But
it is difficult to determine how much revenue an organization earns at each step in
the earning process. A business recognizes revenue when the earning process is
complete or virtually complete and an exchange has taken place. For most
businesses, this occurs at the time they provide services or sell goods to their
customers.
When the outcome of a transaction involving the rendering of services can be
estimated reliably, revenue is recognized by reference to the stage of completion of
the transaction at the end of the reporting period. The outcome of a transaction can
be estimated reliably when all the following conditions are satisfied:
1. The amount of revenue can be measured reliably.
2. It is probable that the economic benefits associated with the transaction will
flow to the entity.
3. The stage of completion of the transaction at the end of the reporting period
can be measured reliably.
4. The costs incurred for the transaction and the costs to complete the
transaction can be measured reliably.6
When the outcome of a transaction cannot be estimated reliably, revenue should
be recognized only to the extent of the expenses recognized that are recoverable.
When the outcome of a transaction cannot be estimated reliably and it is not
probable that the costs will be recovered, the costs incurred are recognized as an
expense.
Let us now see how to apply conditions 1 and 2. We will see the application of
conditions 3 and 4 in Chapters 4 and 5.
Reliable measurement of revenue The contract should state the price or may lay
down a method of determining the price. For example, the loan contract between a
bank and a borrower may state that the interest rate shall be 12 per cent.
Alternatively, the contract may specify that the interest rate will be the LIBOR
(London interbank offered rate) at the start of each year during the period of the
loan plus two per cent. Thus, the price should be certain or ascertainable. If the
price is not clear, revenue recognition will not be possible. In our example, the
contract should also specify whether the LIBOR is for one month, three months, six
months, and so on. In the case of goods, the sale contract should specify the price or
a method of determining the price. For example, the contract may provide that the
parties shall trade crude oil at the price prevailing on the New York Mercantile
Exchange on the date of sale. If the price is not clear, revenue recognition will not be
possible. In our example, the contract should also specify the type of crude, such as
Abu Dhabi Umm Shaif, Iran Light, Nigeria Light, and US Alaska.
Flow of economic benefits The buyer should have paid the price or it should be
certain that the buyer will pay. If collection of the revenue is not certain at the time
of sale, the seller should postpone revenue recognition until collection becomes
certain. However, when an uncertainty about collection arises after revenue is
recognized, the estimated uncollectible amount is recognized as an expense; the
revenue originally recognized is not adjusted.
But why this insistence on “completion of the earning process”? Managers have
incentives to take an optimistic, rather than a realistic, view of their firm’s revenue.
Reporting revenue sooner would result in higher sales and profit. Good growth in
sales and profit will give managers a higher remuneration, advance their career
prospects in the firm, and enhance their professional reputation in the job market.
Understandably, managers often wish to recognize revenue prematurely. By
insisting on completion of the earning process and exchange of goods and services,
the realization principle keeps in check the managers’ tendency to be aggressive in
recognizing revenue.
Another way to think about revenue recognition is to look at the balance sheet
effect of earning revenue. In this view, revenue recognition is simultaneous with an
increase in an asset or a decrease in a liability. For example, a business that
provides services in exchange for immediate or future payment records an asset –
cash or receivable – and a revenue. If it had received advance payment, it records a
decrease in a liability – unearned revenue. Thus, revenue recognition and its
balance sheet effect are two ways of looking at the same transaction.
Further, the transaction needs to be identified based on the substance of the
contract. Sometimes a transaction may have separately identifiable components
(“multiple service elements”), such as a contract to develop an information system
and maintain it for a certain period. The contract revenue should be allocated to the
development and the maintenance components on the basis of their fair value and
recognized in the periods over which these services are provided. The sale of the
Audi car discussed at the beginning of this chapter is another example. In contrast,
two or more transactions may be linked in such a way that they actually constitute
a single transaction (“bundled offers”). For example, a mobile phone customer enters
into a contract with a phone company for a package that may include a handset,
talktime, SMS, and so on. On the face of it, these are separate transactions.
However, the handset is often sold at a discount and the provider expects to recover
it in the form of subsequent services. In this case, the amounts paid for the handset
and other services do not represent their respective fair value; so they cannot be
treated as a measure of the revenue. The transactions have to be treated as a single
transaction and revenue should be recognized based on the fair value of the
components. In short, revenue recognition can get complicated when a business
performs services in several stages, spread over several periods.
You will learn more about revenue recognition in Chapters 4 and 5.
The Matching Principle
The matching principle requires recording expenses in the
same reporting period in which the revenues were earned as a
result of the expenses. The matching exercise is essentially an
attempt at comparing accomplishment with effort. Expense
recognition is relatively straightforward when there is a cause-and-effect
relationship between effort and accomplishment. For example, an enterprise
recognizes cost of goods sold and sales commissions in the same period in which it
recognizes the related sales revenue.
It is not possible to associate some expenses that have future benefits with
revenue-producing transactions. Accountants associate such expenses with specific
reporting periods and allocate them by a “systematic and rational” procedure. For
instance, depreciation allocates the costs of assets (e.g. buildings, plant, and
vehicles) to the periods which are expected to benefit from their use. However, many
expenses have no discernible future benefits, but are incurred to obtain benefits
that are exhausted in the period in which the expenses are incurred. Salesmen’s
salaries and office rent fit this description and are usually recognized as expenses in
the period in which they are incurred. Finally, there are expenses on activities that
have uncertain outcomes, such as research and development and brand building.
Accountants expense them, because the benefits are uncertain and are difficult to
measure reliably.
Expense recognition, similar to revenue recognition, has a balance sheet effect.
Expense recognition is simultaneous with a decrease in an asset or an increase in a
liability. For instance, a business that pays rent for its office premises records a rent
expense and a decrease in cash, an asset. If the rent has not been paid, a liability
will be recorded. Thus, expense recognition and its balance sheet effect are two
ways of looking at the same transaction.
The Adjustment Process: Converting Cash Into Accrual
Accounting adjustments help in achieving the goals of accrual
accounting: allocating revenues and expenses to appropriate
periods. Deferral is the lag in the recognition of an expense
already paid or a revenue already received. It relates to past cash
receipts and payments. Deferral is needed for expenses and revenues that must be
apportioned between two or more reporting periods. Examples of deferral are
prepaid insurance, supplies, equipment, and unearned revenue. Accrual is the
recognition of an expense incurred but not paid or a revenue earned but not
received. It relates to expected future cash receipts and payments. Accrual is
required for unrecorded expenses and revenues. Examples of accrual are salaries
payable, accrued interest expense, accrued interest income, and unbilled revenue.7
Figure 3.1 illustrates the adjustment process.
Adjusting Entries
Adjusting entries are journal entries prepared at the end of the
reporting period to ensure that revenues are recorded in the period
in which they are earned, and expenses are recognized in the
period in which they are incurred. They have two distinctive characteristics that
you will find useful to remember:
1. An adjusting entry affects both a balance sheet item (asset or liability) and a
statement of profit and loss item (revenue or expense). For example, recording
a revenue (a statement of profit and loss item) that has been earned, but not
received, creates a receivable (a balance sheet item) for the revenue. Again,
recording an expense (a statement of profit and loss item) that has been
incurred, but not paid, creates a payable (a balance sheet) item.
2. An adjusting entry does not affect cash. This should be obvious. After all, if
cash is received or paid in the same period in which the expense is incurred
or revenue is earned, there would be no need for an adjusting entry in the
first place.
Adjusting entries result in deferrals and accruals. To illustrate typical adjusting
entries, we shall continue with the example of Fashion Concepts Company,
introduced in Chapter 2.
Apportioning Recorded Expenses
A business often pays for benefits that last more than one reporting period. Under
the accrual system of accounting, payment of cash does not necessarily result in an
expense. Accountants usually record these expenditures by debiting an asset
account to show the service or benefit that a business will receive in the future. At
the end of the reporting period, the accountant transfers the portion of the asset
that has been used during the period from the asset account to an expense account.
Adjustments for prepaid expenses, office supplies, and depreciation involve
apportionment of asset costs between reporting periods. An adjusting entry to
apportion a recorded cost consists of a debit to an expense account and a credit to an
asset account.
Prepaid expenses These are the costs of services that a business has bought and
paid for, but has not used at the end of the reporting period. Insurance and rent are
often paid in advance. By the end of a reporting period, that portion of the services
which was used during the period has become an expense and the unused portion of
these items represents an asset. Without adjustments for prepaid expenses, both
the statement of profit and loss and balance sheet will be incorrect. In this case, the
financial statements will understate the expenses and overstate the assets and the
equity.
Fashion Concepts Company has a prepaid expense for insurance. On June 6, the
company paid `720 for a one-year fire insurance policy that will expire on May 31
next year. We recorded it by debiting an asset, prepaid insurance. The expenditure
of `720 will protect the company against fire loss for one year. At the end of June,
1/12th of the protection expired and we record it as insurance expense. We analyze
the adjustment as follows:
Prepaid Insurance, an asset, now has a balance of `660, which represents the
unexpired cost relating to the remaining 11 months of insurance cover. The balance
in Insurance Expense is equal to the insurance cost that expired in June. As you
may have inferred, without this adjustment, Fashion Concepts would have
understated June expenses by `60 and overstated assets and equity by `60 on June
30.
Office supplies Recall from Chapter 2 that in June, Fashion Concepts bought
office supplies costing `5,500. Surely, the company was gradually using the supplies
as work progressed. But we did not record a journal entry during the period to
record the cost of consumption of supplies, because there is no need for this
information on a day-to-day basis. Suppose that a physical count of the supplies at
the close of business on June 30 shows that `3,400 of supplies are still on hand.
Thus, the cost of supplies used is `2,100 (`5,500 – `3,400). We analyze and record
the adjustment as follows:
The asset account, Office Supplies, now has a balance of `3,400, which is equal to
the cost of supplies on hand at the end of the reporting period. The expense account,
Office Supplies Expense, has a balance of `2,100, which equals the cost of supplies
used in June. Without this adjusting entry, June expenses will be less and the net
profit will be more by `2,100. Besides, both assets and equity will be more by `2,100
on the June 30 balance sheet.
Depreciation A business enterprise usually owns a number of assets, such as
buildings, equipment, computers, and vehicles. These assets provide service for a
number of years. We can think of the cost of an asset as a long-term prepayment for
the benefits from the asset. Therefore, accountants allocate the cost of an asset to
expense in the current and future periods as the asset is used up. Depreciation is
the portion of the asset’s cost allocated to a reporting period.
Buildings and some equipment have long useful lives, sometimes up to 30 years or
even longer. It is often impossible to know exactly the useful life of such assets.
Accountants use a number of methods to estimate the depreciation expense for a
period. A simple approach is to assume that the asset yields equal benefits in each
year of its life.
To illustrate, assume that Fashion Concepts Company’s equipment has a useful
life of five years, without any value at the end. The monthly depreciation expense is
`150 (`9,000/60 months). The company debits this amount to Depreciation Expense.
It credits a separate account called Accumulated Depreciation for the amount
allocated to the period instead of making a direct credit to the asset account. You
will see in a moment why the company credits accumulated depreciation instead of
the asset itself. The accumulated depreciation is a contra-asset account. A contra
account is an account that appears as an offset or deduction from a related account
in the balance sheet. The adjusting entry to record depreciation is as follows:
Depreciation expense will appear as expense in the statement of profit and loss.
Besides, the June 30 balance sheet will now report the office equipment as follows:
As you can see, the use of the contra account permits disclosure of both the
original cost of the asset and the total cost expired to date. The difference between
the original cost of the asset and its accumulated depreciation is called the book
value or carrying amount. It represents the unexpired cost of the asset.
Without the adjustment for depreciation, June expenses will be less and net profit
will be more by `150. Besides, both assets and equity will be more by `150 on the
June 30 balance sheet.
Apportioning Unearned Revenues
Many kinds of businesses receive advance payments from their customers. For
example, property owners collect rent in advance, airlines receive fares ahead of
travel, media companies accept magazine subscriptions for future periods, and
insurance companies insist on advance payment of premium. When an enterprise
collects revenue in advance, it is obliged to provide goods or services in the future.
Therefore, unearned revenue is a liability. It is the service provider’s mirror
image of a prepaid expense. For example, a customer would record a prepaid
expense for insurance premium paid in advance, while the insurance company
would show it as unearned revenue. Unearned revenue becomes revenue earned
through providing goods or services. At the end of the reporting period, an adjusting
entry transfers an appropriate amount to revenue.
From Chapter 2, recall that Fashion Concepts collected a sum of `1,500 from
Kidswear for services to be provided later. Suppose that later in the month the
company supplied a design for `900 and the customer accepted it. The adjustment
for the conversion of unearned revenue into revenue earned is as follows:
As a result of the adjusting entry, the Revenue from Services account now shows a
revenue earned of `11,900. The balance of `600 in the Unearned Revenue account
represents the liability for services still to be provided.
Recording Accrued Expenses
Businesses record most expenses when they pay them. At the end of a reporting
period, they may have incurred but not recorded some expenses, because payment is
not due. Expenses incurred but not paid or recorded are known as accrued
expenses. An adjusting entry is needed to recognize these obligations. Salaries,
interest, and income tax are examples of expenses that normally need an accrual
adjustment.
Recall that on June 21, Fashion Concepts Company appointed an office manager
on a monthly salary of `1,500. The manager’s salary for the ten days in June is an
expense of that month. Therefore, it is necessary to recognize a proportionate salary
expense of `500 although it was not paid. We analyze the adjusting entry for
accrued salaries as follows:
The Salaries Expense account now has a balance of `1,300 representing the salaries
expense for the month. The Salaries Payable account shows the salaries payable but
not yet paid, `500. Without this adjustment, June expenses will be less and net
profit will be more by `500. Besides, liabilities will be less and equity will be more
by `500 on the June 30 balance sheet.
Recording Accrued Revenues
Usually, a business records revenue at the time it sells goods or services on credit.
However, at the end of a reporting period, some revenue may remain unrecorded
although it may have been earned. Earned revenue that is unrecorded is called
accrued revenue or unbilled revenue. For example, suppose that interest is
payable on a bank deposit on January 1 and July 1 for the preceding half-year. The
interest income of the depositor for three months (January 1 to March 31) is accrued
revenue on March 31. Accrued revenue is an asset, because it represents cash to be
received from the customer after billing. We will now see how to recognize accrued
revenue.
Assume that Fashion Concepts had completed work on a design to be supplied to
a customer for a fee of `700 by June 30. The company will bill the customer when it
supplies him with the design. Nevertheless, the company has virtually completed
the earning process and will recognize the fee by the following adjusting entry:
Unbilled Revenue, an asset, has a balance of `700 which represents revenue
earned but neither billed nor received. The balance in Revenue from Services is
equal to the fee income the company earned in June, representing the company’s
accomplishment regardless of when, or indeed whether or not, the company received
cash. If this adjustment is not made, Fashion Concepts’ June revenue and net profit
will be less by `700 and assets and equity will be less by `700 on the June 30
balance sheet.
Unbilled revenue is common in services. Billing is done after completion of project
milestones. Work done between two billing dates is unbilled revenue. Accrued
revenue is the mirror image of accrued expense.
Figure 3.2 shows the effect of the adjustment process on revenues, expenses,
assets, and liabilities.
8
Worksheet: The Accountant’s Invaluable Tool
In order to prepare the financial statements, accountants must
collect data on deferrals and accruals. Examples are inventory of
supplies, estimated useful lives of assets, salaries payable, and
unbilled revenue. Working papers consist of these collections of data,
computations, memoranda, preliminary drafts of financial statements, and other
useful analyses and informal papers prepared by accountants. These assist
accountants in organizing the information that goes into the formal financial
statements so that no important information is omitted. They also provide evidence
of supporting computations which are useful in explaining to auditors the numbers
appearing in the financial statements.
A type of working paper commonly used by accountants is the worksheet. A
worksheet is a columnar sheet of paper used to summarize information needed to
prepare financial statements and to record adjusting and closing entries. It is also
an informal device for assembling the required information in one place. It is not
part of the formal accounting records. The accountant prepares it for his use and
keeps it with himself. It is not meant for use by the owners or managers of the
business and is, therefore, not made public. Completing the worksheet assures the
accountant that potential errors will be discovered. However, it is not designed to
replace the financial statements or to dispense with the need to journalize and post
year-end entries, or make up for the absence of good internal controls. The
worksheet is particularly useful when there are numerous accounts and adjusting
entries. These days, accountants use computers and spreadsheet software to
prepare worksheets.
The standard form of the worksheet appears in Exhibit 3.1. The heading consists
of the name of the organization and the date. The worksheet can cover any period,
such as a year, half-year, quarter, or even a month. The date is the balance sheet
date. The worksheet has a column for account title. Then there are six more pairs of
columns for the following:
1. Trial Balance: This is the trial balance before making adjustments.
2. Adjustments: These show the adjustments to the accounts for deferrals and
accruals.
3. Adjusted Trial Balance: This shows the account balances after considering
the effect of the adjustments.
4. Statement of Profit and Loss: These columns are for revenue and expense
items that will appear in the statement of profit and loss.
5. Statement of Retained Earnings: These columns are for beginning and
ending balances, net profit, and dividends.
6. Balance Sheet: These columns are for asset, liability, and equity items that
will appear in the balance sheet.
Each pair of columns consists of a debit and a credit column making a total of 12
columns for entering amounts.
To prepare a worksheet, the accountant carries out following five steps:
1. Enter the account balances in the Trial Balance columns.
2. Enter the adjustments in the Adjustments columns.
3. Enter the account balances after adjustment in the Adjusted Trial Balance
columns.
4. Extend each account balance in the Adjusted Trial Balance columns to the
Statement of Profit and Loss, the Statement of Retained Earnings, or the
Balance Sheet columns.
5. Total the Statement of Profit and Loss, the Statement of Retained Earnings,
and the Balance Sheet columns.
We will now explain these steps using the Fashion Concepts Company illustration
that we have developed from Chapter 2 onwards.
Step 1: Enter the account balances in the Trial Balance columns To begin
with, you should copy the account titles and balances from the ledger into the Trial
Balance columns. Exhibit 3.1 shows this step. You should now total the Trial
Balance columns and enter the totals.
For the sake of convenience, the sequence of accounts generally follows the
chart of accounts.
You should proceed to the next step only if the Trial Balance column totals
agree.
The account titles and balances are the same as those in Exhibit 2.7, except for
Accumulated Depreciation, Equipment.
Step 2: Enter the adjustments in the Adjustments columns Earlier in this
chapter, you saw the required adjustments for Fashion Concepts Company. Here is
a summary of these adjustments:
Adjustment (a) : Expiration of prepaid insurance, `60.
Adjustment (b) : Consumption of office supplies, `2,100.
Adjustment (c) : Depreciation expense, `150.
Adjustment (d) : Revenue earned out of unearned revenue, `900.
Adjustment (e) : Salaries expense accrued, `500.
Adjustment (f) : Unbilled revenue, `700.
You should now enter these in the Adjustments columns of the worksheet. Exhibit
3.2 explains this step.
Note that each adjustment has a separate letter identification, so that you
can cross-reference the debit part of the entry to the credit part.
You should enter the adjusting amount on the line on which the account
appears in the trial balance. If an account title does not appear in the trial
balance, you should add it on the line immediately below the trial balance.
For example, Insurance Expense does not have an amount in the trial
balance; so it appears below the last trial balance item in Exhibit 3.2.
After you have entered all the adjustments, you should total the Adjustments
columns and enter the totals.
You should proceed to the next step only if the Adjustments column totals
agree.
Step 3: Enter the account balances after adjustment in the Adjusted Trial
Balance columns In this step, you should combine each account balance in the
trial balance with the corresponding adjustment(s)9 in the Adjustments columns
and enter the resulting balance on the same line in the Adjusted Trial Balance
columns. Exhibit 3.3 illustrates this step.
The combined amounts entered in the Adjustments columns will be identical
to the ledger account balances after posting the entries to the ledger.
Accountants call adding or subtracting numbers on a row crossfooting. Let
us see how crossfooting works.
— Equipment has a debit balance of `9,000 in the Trial Balance. Since there are
no adjustments to Equipment, you should enter the amount of `9,000 in the
debit column of the Adjusted Trial Balance.
— The next line is Accumulated Depreciation, Equipment, which has no balance
in the Trial Balance. Hence, you should enter the credit of `150 appearing in
the Adjustments in the credit column of the Adjusted Trial Balance.
— The next item, Office Supplies, shows a debit balance of `5,500 in the Trial
Balance and a credit of `2,100 in the Adjustments. Combining the two
amounts results in a debit balance of `3,400 and you should enter it in the
debit column of the Adjusted Trial Balance.
— You should process each account balance in a similar manner.
— After you have entered all account balances, you should total the Adjusted
Trial Balance columns to check the correctness of the crossfooting.
— You should proceed to the next step only if the Adjusted Trial Balance column
totals agree.
Step 4: Extend each account balance in the Adjusted Trial Balance
columns to the Statement of Profit and Loss, the Statement of Retained
Earnings or the Balance sheet columns. You should extend revenue and
expense accounts to the Statement of Profit and Loss columns, and asset, liability,
and equity accounts to the Balance Sheet columns. Exhibit 3.4 explains this step.
You should extend the accounts one by one, starting from the first one, to
avoid leaving out any account. For instance, you should first extend the debit
balance of the Equipment account to the debit column of Balance Sheet,
because assets appear on the balance sheet. Next, extend the credit balance of
the Accumulated Depreciation, Equipment to the credit column of the
Balance Sheet, because it is a contra asset. Repeat the procedure for the
remaining entries.
Most items are straightforward and not much difficult.
The item, Dividends, is tricky. Remember that dividend is not an expense, but
is a reduction of equity, because of distribution of assets to the shareholders.
Therefore, Dividends forms part of the Statement of Retained Earnings.
Step 5: Total the Statement of Profit and Loss, the Statement of Retained
Earnings and the Balance Sheet columns. Net profit or loss is the difference
between the totals of the Statement of Profit and Loss columns. If the credit total is
more, it is a net profit. If the debit total is more, it is a net loss. Exhibit 3.5 explains
this step.
You should enter the difference in the Statement of Profit and Loss column
that has a smaller total. With the difference included, the Statement of Profit
and Loss totals will now match:
You should enter the amount of net profit in the Statement of Retained
Earnings credit column. (Do you know why?) If it is a net loss, enter the
amount in the Statement of Retained Earnings debit column:
You should enter the amount of retained earnings in the Balance Sheet credit
column. (Do you know why?) If it is accumulated net loss, enter the amount in
the Balance Sheet debit column.
With the amount of net profit (or net loss) included, the Balance Sheet totals
will now match. This makes sense. After all, you extended the amounts from
the Adjusted Trial Balance to the Statement of Profit and Loss, the
Statement of Retained Earnings, or the Balance Sheet columns, totalled the
columns, and entered their amounts at the foot of each column.
 If
the debit and credit totals do not match, then there is an error in extending
the amounts from the Adjusted Trial Balance columns. However, there may be
errors even if the column totals matched. For example, if you had entered the
balance of Cash in the Statement of Profit and Loss debit column instead of the
Balance Sheet debit column, the Balance Sheet column totals would be equal.
But the net profit, assets, and equity would be understated.
Using the Worksheet
After completing the worksheet, the accountant uses it to prepare
the financial statements and record adjusting and closing entries
in the general journal.
Preparing the Financial Statements
Once the worksheet is ready, preparation of the formal financial statements is a
relatively easy step. The account balances in the Statement of Profit and Loss
columns provide the information necessary to prepare the formal statement of profit
and loss. The Balance Sheet columns contain the information needed to prepare the
statement of retained earnings and the balance sheet. Exhibit 3.6 presents these
statements for Fashion Concepts Company.
Recording Adjusting Entries
Recall that the worksheet is not part of the formal accounting
records. Therefore, after completing the worksheet, the accountant
enters the adjusting entries in the general journal and posts them
to the ledger accounts. The necessary information is available from
the Adjustments columns of the worksheet. Exhibit 3.7 presents the adjusting
entries for Fashion Concepts Company. Note that these entries are the same as the
ones described earlier in this chapter. The entries are dated on the last day of the
reporting period.
The Adjustments columns of the worksheet have the information needed to prepare the adjusting entries.
Overview of the Accounting Cycle
The accounting cycle comprises the sequence of accounting
processes. It begins with analyzing transactions and ends with
carrying forward the balances in balance sheet accounts to the
next reporting period. The accounting cycle produces numerous records, entries,
documents, reports, and statements. By far the most important output of the
accounting cycle is an enterprise’s financial statements. Figure 3.3 summarizes the
steps in the accounting cycle and identifies the chapters in which they figure. The
accountant performs the steps in the accounting cycle one after the other and
repeats them in each reporting period.
Temporary and Permanent Accounts
Revenue and expense accounts are temporary accounts (or nominal accounts),
because their balances relate only to the current reporting period. The accountant
closes these accounts at the end of the reporting period by transferring their
balances through statement of profit and loss to retained earnings in equity. In
Exhibit 3.5, revenue from services, salaries expense, office supplies expense, and
depreciation expense are examples of temporary accounts. Note that dividends is
also a temporary account.
By contrast, accounts that appear in the balance sheet are permanent accounts
(or real accounts). The accountant carries forward the ending balances of these
accounts to the next period as their beginning balances to the next period. These
accounts exist as long as the specific asset, liability, or equity items recorded in the
accounts exist. In Exhibit 3.5, equipment, accumulated depreciation, office supplies,
and salaries payable are examples of permanent accounts. Note particularly that,
whereas depreciation expense is a temporary account, accumulated depreciation is a
permanent account since the equipment continues to exist.
Closing Entries
Closing entries are journal entries that transfer the balances in
temporary accounts at the end of a reporting period to a balance
sheet equity account. As you know revenue, expense, and dividend
accounts are temporary accounts. After preparing the statement of profit and loss
and statement of retained earnings for the current period, we no longer require the
balances in the revenue, expense, and dividend accounts. These amounts pertain to
the current period and they should not be carried forward to the next period.
Therefore, at the end of a reporting period, we should reset the balances in these
accounts to zero. We do this by transferring their balances to the statement of profit
and loss. The balance of the statement of profit and loss equals the net profit or net
loss for the period.
Preparing Closing Entries
The steps in the preparation of closing entries are as follows:
Step 1. Transfer the balances in revenue accounts to the Statement of Profit and
Loss.
Step 2. Transfer the balances in expense accounts to the Statement of Profit and
Loss.
Step 3. Transfer the balance in the Statement of Profit and Loss to the Retained
Earnings account.
Step 4. Transfer the balance in the Dividends account to the Retained Earnings
account.
Typically, a proprietary business transfers the balances in the Statement of Profit
and Loss and the Drawings account to the Capital account, since it is not necessary
to make a distinction between capital introduced by the owner and the accumulated
profits of the business. For the same reason, when the business is a partnership
firm, these balances are transferred to the Partners’ Capital accounts.
Closing Revenue Accounts
Before posting the closing entries, revenue accounts have credit balances. Therefore,
each revenue account must receive a debit for an amount equal to its balance to
close the account. The Statement of Profit and Loss receives the credit to complete
the double entry. The following journal entry closes Revenue from Services, the only
revenue account of Fashion Concepts Company:
Exhibit 3.8 shows the effect of closing the revenue account. Note that the closing
entry clears the revenue account by transferring its balance as a credit to the
Statement of Profit and Loss. By doing so, it resets the balance in the revenue
account to zero, thus causing that account to begin the next reporting period anew.
Closing Expense Accounts
As you know, expense accounts have debit balances. Therefore, each expense
account must receive a credit for an amount equal to its balance to close the
account. The Statement of Profit and Loss receives the corresponding debit. The
following compound entry closes the expense accounts of Fashion Concepts
Company:
Exhibit 3.9 shows the effect of closing the expense accounts. Note that the closing
entry clears the expense accounts by transferring their balances as a debit to the
Statement of Profit and Loss. Thus, it resets the balances in the expense accounts to
zero, thus causing those accounts to begin the next reporting period anew.
Closing the Statement of Profit and Loss
After closing the revenue and expense accounts, the Statement of Profit and Loss
now summarizes balances formerly reported in the individual revenue and expense
accounts. The balance of the Statement of Profit and Loss is equal to the net profit
or net loss for the period. When revenues exceed expenses, there is a net profit and
the Statement of Profit and Loss has a credit balance. On the other hand, when
expenses exceed revenues, there is a net loss and the account has a debit balance. In
either case, we must close the Statement of Profit and Loss to the Retained
Earnings account. For Fashion Concepts Company, the entry is as follows:
Exhibit 3.10 presents the effect of this entry. Note that, as a result of the entry,
the balance in the Statement of Profit and Loss becomes zero by transferring it to
Retained Earnings.
Closing the Dividends Account
The Dividends account shows the amount of profit distributed during the period. We
transfer the debit balance in Dividends to Retained Earnings, as follows:
Exhibit 3.11 describes the effect of this entry. As a result of the entry, the balance
in Dividends becomes zero and the balance in Retained Earnings is reduced by the
amount of dividends paid during the period.
Prepare a statement of retained earnings.
The Accounts after Closing
Exhibit 3.12 presents the accounts of Fashion Concepts Company after posting the
adjusting and closing entries. Note that the revenue, expense, and dividend
accounts (temporary accounts) now have zero balances and are ready for use when
transactions are recorded in the next period. The company carries the balances in
the asset, liability, and equity accounts (permanent accounts) to the next period.
Post-closing Trial Balance
After all closing entries have been posted, it is useful to prepare a
post-closing trial balance to verify the equality of the debits
and credits in the ledger. Since all temporary accounts should
have zero balances at this point, the post-closing trial balance will
contain only balance sheet accounts that are carried forward to
the next reporting period, i.e. asset, liability, share capital, and retained earnings
accounts. Recall that these are permanent accounts. Exhibit 3.13 presents the postclosing trial balance for Fashion Concepts Company. Note that the balances are the
same as those reported in the company’s balance sheet in Exhibit 3.6.
Reversing Entries
In accounting for accrual items, accountants use some optional
entries, called reversing entries. They simplify the recording of
a subsequent transaction related to an adjusting entry. A
reversing entry, as the name implies, is the exact reverse of the adjusting entry to
which it relates. The amounts and the accounts are the same; the debits and credits
are just reversed.
Note the following important points on reversing entries:
You can reverse adjusting entries only for accruals, such as salaries payable
and unbilled revenue.
You should not reverse adjusting entries for deferrals, such as prepaid
insurance, supplies, depreciation, and unearned revenue.
Earlier in this chapter, we recorded the following adjusting entry for Fashion
Concepts Company’s salaries payable, `500:
Again, on June 30, we closed Salaries Expense and transferred the balance to
Statement of Profit and Loss. Salaries Payable appears on the June 30 balance
sheet and we will carry it forward to July.
We will first see the accounting procedure without reversing entries and then see
the position with adjusting entries.
Without Reversing Entry
Transaction entry Suppose that Fashion Concepts pays its manager on the 21st of
every month. The company records the transaction as follows:
Ledger in July After posting this entry, the Salaries Expense account and the
Salaries payable account would look as follows:
The balance of `1,000 on July 21 in Salaries Expense represents the salaries for the
first 20 days of July. Since the accrued salaries for June have been paid, Salaries
Payable does not show any balance.
With Reversing Entry
Reversing entry
The reversing entry is made as of the first day of the next
reporting period. The reversing entry for the salaries accrued in June is as follows:
Transaction entry On July 21, Fashion Concepts records the following entry when
it pays salaries:
As you can see, this entry is just like any transaction and there is no need to look
into the records to find out the accrued salaries component.
Ledger in July After posting this entry, the Salaries Expense account and the
Salaries Payable account would look as follows:
The balance of `1,000 in the Salaries Expense account equals the expense of the
current period. (Just after posting the reversing entry, Salaries Expense shows a
credit balance of `500, shown in brackets to indicate that it is an abnormal balance.)
Since the accrued salaries for June have been paid, Salaries Payable does not show
any balance.
As you can see, the reversing entry makes it easier to record the payment. The
final effect on the accounts is the same, with or without reversing entries.
Pro Forma Financial Measures
Pro forma literally means “as a matter of form”. A pro forma
financial measure (or non-GAAP financial measure) is a
measure of past or future financial performance, financial
position, or cash flows that excludes items that are a part of the
comparable measure in the GAAP financial statements. Earnings before interest
and tax (EBIT) and earnings before interest tax, depreciation, and amortization
(EBITDA) are examples of commonly used pro forma measures. EBIT, or operating
profit, differs from the GAAP measure, because it excludes interest income and
interest expense, non-recurring or exceptional items and income tax. EBITDA
excludes the effect of interest income and interest expense, income tax,
depreciation, and amortization, all of which are included in the GAAP measure of
net profit. Depreciation is as much a cost of doing business as the cost of raw
materials. So it is not proper to exclude depreciation for reporting performance. Pro
forma measures can be thought of as “as ifs” or “what ifs”.
Pro forma financial information can be useful in explaining the components of
earnings. For example, the exclusion of non-recurring gains and losses can help
investors focus on earnings from normal or regular operations. However, pro forma
measures can become misleading if they are computed differently from one period to
another. This is not difficult, because there are no standard definitions of pro forma
measures. Also, they may be used to distract the investor from GAAP numbers
when the latter are likely to give an unfavourable impression. For instance, a loss
may be cast as a profit by exclusion of some types of losses. Companies should avoid
the temptation of using pro forma numbers to report “EBS” (everything but bad
stuff), as Lynn Turner, a former chief accountant of the US Securities and Exchange
Commission put it.
Pro forma reporting became widespread during the 1990s Internet boom years.
Many Internet firms could not report a GAAP profit, but were under enormous
pressure from the equity market to report some profit to justify their high stock
prices. So they came up with performance measures of dubious value such as
EBITDA. Some companies were egregious, even by the lenient ways of pro forma
reporting. For example, Amazon.com, the well-known Internet retailer, while
discussing its 2000 fourth quarter results in its January 2001 press release, first
described its revenue and then cited its narrowing quarterly “U.S. pro forma
operating loss” of $16 million. That figure excluded interest expense, losses on
equity investments, stock-based compensation expense, amortization of intangible
assets, and write-downs for impaired assets. This gave rise to a new pro forma
measure: EBITDAM (earnings before interest, tax, depreciation, amortization, and
marketing expenses); the only major item not added back was the cost of goods sold.
Even though the Internet bubble burst in 2001, the pro forma habit remains. In
fact, we are seeing new acronyms. Kingfisher used EBITDAR (earnings before
interest, tax, depreciation, amortization, and aircraft lease rentals) in attempt to
come up with some positive measure of earnings. In the quarter ended June 30,
2010, Goldman Sachs, the investment bank, added back $550 million in fine
imposed by the U.S. Securities and Exchange Commission; the measure came to be
known as EBITDAF: earnings before interest, tax, depreciation, amortization, and
fine. The Companies Act 2013 makes it possible to disclose additional line items,
sub-line items, and sub-totals. Many companies have taken advantage of this
provision and have started disclosing EBITDA and other pro forma measures, even
though they do not correctly portray the performance in accordance with GAAP.
Looking Back
Define and explain net profit, revenue, and expense Net profit is the increase in equity from the
operations of the business. It is the excess of revenues over expenses. Revenues and expenses result from
selling goods or providing services.
Define accrual accounting and distinguish between the accrual system and the cash system The
accrual system of accounting recognizes revenues when a business provides goods or services and expenses
when it incurs them, regardless of when it receives or pays cash. The cash system reports cash receipts and cash
payments.
Explain the realization principle and its effect on recording revenue The realization principle
requires revenue to be recognized at the time it is earned.
Elucidate the matching principle and its effect on recording expenses The matching principle
requires recording expenses in the period in which the revenue is earned. Matching is an attempt at
comparing accomplishment with effort.
Define deferrals and accruals and explain the need for adjustments A deferral is the delay of the
recognition of an expense already paid or a revenue already received. An accrual is the recognition of an
expense that has not been paid or a revenue that has not been received. Adjusting entries ensure recognition of
revenues and expenses in the period to which they relate.
Prepare adjusting entries An adjusting entry for an expense consists of (a) a debit to an expense and (b)
a credit to a liability, an asset, or a contra asset. An adjusting entry for a revenue consists of (a) a debit to
either an asset or a liability and (b) a credit to a revenue.
Develop a worksheet The accountant adds information on adjustments to the trial balance information in
the worksheet. The result is an adjusted trial balance that becomes the basis for preparing the statement of
profit and loss and the balance sheet.
Prepare financial statements from a worksheet The Statement of Profit and Loss, the Statement of
Retained Earnings, and the Balance Sheet columns of the worksheet have the information needed for
preparing the financial statements.
Record adjusting entries from a worksheet The Adjustments columns of the worksheet provide the
information needed for recording adjusting entries.
Describe the accounting cycle The accounting cycle comprises the sequence of accounting processes. It
begins with analyzing transactions and ends by carrying forward the balances to the next reporting period.
Record closing entries The Statement of Profit and Loss columns of the worksheet contain the
information needed for preparing closing entries.
Prepare a post-closing trial balance and explain its purpose A post-closing trial balance contains all
balance sheet account balances. It helps us in verifying the equality of the debits and credits in the ledger
after closing the temporary accounts.
Prepare reversing entries A reversing entry is the exact reverse of an adjusting entry for an accrual.
Explain pro forma financial measures Pro forma, or non-GAAP measures, exclude items that are a
part of the comparable GAAP measure. EBITDA is an example of a pro forma measure. Pro forma
measures have their place, but they can be sometimes misleading.
Review Problem
Backbay Company provides local mail delivery service in the financial district of Mumbai. The trial balance of
the company is as follows:
Additional information:
(a) Prepaid rent represents rent for February to April.
(b) The inventory of office supplies at the end of February was `3,200.
(c) Revenue earned for services performed but not yet billed at the end of February was `1,600.
(d) Revenue earned for services performed, paid for in advance, was `210.
(e) Depreciation on office equipment for February was `250.
(f) Accrued salaries at the end of February were `540.
Required
1. Prepare adjusting entries and post them directly to the T accounts.
2. Prepare an adjusted trial balance.
3. Prepare the February statement of profit and loss, statement of retained
earnings, and balance sheet.
Solution
1. Preparing and posting adjusting entries to T accounts
2. Preparing adjusted trial balance
3. Preparing financial statements
ASSIGNMENT MATERIAL
Questions
1. Define the terms: net profit, revenue, and expense.
2. Why is periodic income measurement necessary?
3. What is accrual accounting? How does it differ from the cash system of
accounting?
4. Pillai Travel Company provides conducted tours to Jaipur, Agra, and Delhi.
It receives full payments from its customers in advance. Can the amounts be
treated as revenue immediately on receipt?
5. “The matching principle poses major challenges to the accountant.” Do you
agree?
6. Why are adjusting entries necessary?
7. What do you understand by deferrals and accruals? Give two examples for
each of them.
8. “Expenses are used-up assets.” Explain.
9. What is a contra account? Give an example of a contra account used in the
adjusting process.
10. Harish Company follows the practice of expensing insurance premiums
when paid. What entry should it record at the end of the period to reflect the
amount of prepaid insurance?
11. What is an accrued expense? Give two examples.
12. Why is an adjusted trial balance prepared?
13. Differentiate between temporary accounts and permanent accounts. Give two
examples of each.
14. What are the benefits of preparing a worksheet?
15. Is it possible to prepare the financial statements without preparing a
worksheet?
16. How does the accountant determine the amounts in the Adjusted Trial
Balance columns of a worksheet?
17. In which column or columns of the worksheet would the net profit amount
appear?
18. What are the objectives of the closing process?
19. Why is a post-closing trial balance prepared?
20. How does a post-closing trial balance differ from an adjusted trial balance?
21. What is a reversing entry? How do reversing entries make the bookkeeping
process easier?
22. Is it possible to find out from an entity’s financial statements whether the
entity uses reversing entries?
23. Adjustments are recorded for the following items: (a) services provided but
not billed; (b) depreciation expense; (c) services provided for amounts
received earlier; (d) interest expense payable; (e) supplies expense. Which of
these can be reversed?
Problem Set A
Compute the following for 20X1:
(a) Fee revenue;
(b) Interest income;
(c) Rent expense;
(d) Salaries expense; and
(e) Interest expense.
Prepare the December 31 adjusting entries from the following information:
(a) The company’s inventory of office supplies on November 30 was `2,850. The company bought
supplies costing `4,710 in December. The inventory of office supplies on December 31 totalled
`1,930.
(b) The company paid rent for six months at `2,500 per month in advance on December 1 and charged it to
Prepaid Rent.
(c) The company had not paid the December salary of `4,900 at the month-end.
(d) On December 9, a customer paid an advance of `9,300 for future services. The company provided services
worth `7,100 to the customer in December.
(e) The company made a three-year bank deposit of `20,000 on December 1. The deposit carried interest at 12
per cent per annum.
(f) The company bought equipment costing `13,000 on November 1. The equipment had an estimated useful
life of 10 years, at the end of which it was expected to fetch `1,000.
(g) Income tax payable for the year is estimated at `2,100.
Prepare the 20X8 statement of profit and loss, statement of retained earnings, and
balance sheet from the following adjusted trial balance of Quick Car Service Limited:
The worksheet of Sheetal Company Limited is as follows:
Required
Complete the worksheet.
The Statement of Profit and Loss, the Statement of Retained Earnings and the Balance
Sheet columns of the worksheet of Manoj Company Limited are as follows:
Required
Prepare closing entries on December 31, 20XX.
Required
Prepare the adjusting entries on July 31, 20XX from the information.
Problem Set B
A review of the accounting records of Jeet Company on March 31, 20X4 reveals the
following information relevant to the preparation of year-end adjusting entries:
(a) There are five salaried employees. The company pays salaries on the first day of the
following month. Three of the employees receive a salary of `2,500 per month and the
other two `2,200 per month.
(b) The company owns a car and a computer. The car was bought on June 1, 20X2 for `70,000 and was
estimated to be useful for ten years. The computer was acquired on February 1, 20X4 for `12,000 and was
estimated to be useful for five years. Neither asset has any salvage value at the end of its useful life.
(c) There are two bills receivable:
(i) The six-month bill for `20,000, dated December 1, 20X3 carries interest at 15 per cent per annum.
(ii) The nine-month bill for `30,000, dated January 1, 20X4 carries interest at 16 per cent per annum.
Interest is receivable at the time of maturity of the bills.
(d) On October 23, 20X3, the company paid `20,000 for advertisement campaigns in two magazines and
debited Prepaid advertisement. One of these is a monthly which was paid `12,000 to carry the
advertisement in the following 12 issues published on the second day of every month. The other is a
fortnightly that was paid `8,000, and it agreed to carry the advertisement in the following 20 issues
published on the fifth and 20th day every month.
(e) The company pays sales commission of 2 per cent on sales on the fifth day of the month following the sales.
From April 20X3 to March 31, 20X4 the company paid sales commission of `17,000. The sales for the year
were `875,000. March 20X3 sales were `45,000.
(f) On January 12, 20X4, the company received `28,000 for future services. The company provided services for
`11,000 on February 17, 20X4, but did not record it.
Required
Prepare adjusting entries on March 31, 20X4.
Jain Real Estate Company began operations on April 1, 20X2. The following
transactions took place in the first month of the company’s operations:
Apr. 1 Began business by depositing `20,000 in bank in the company’s bank account in
exchange for 2,000 shares.
5 Paid three months’ office rent in advance, `3,600.
7 Bought office supplies for cash, `610.
9 Received fees for services provided, `9,200.
16 Paid assistant’s salary for the first fortnight, `1,600.
19 Billed customers for services provided, `9,700.
24 Paid telephone bill for the month, `470.
28 Received advance payments from customers, `2,600.
30 Received but not paid electricity bill, `130.
Required
1. Prepare journal entries for the transactions according to the cash system.
2. Prepare journal entries for the transactions according to the accrual system.
Prepare adjusting entries for the following items:
(a) The inventory of supplies on April 30 was `180
(b) The salary for the second fortnight was `1,600.
3. Compute the net profit under the cash system and the accrual system.
The following additional information is available:
(a) The swimming pool has an estimated life of five years and the tennis court has an estimated life of eight
years. Neither has any scrap value.
(b) The inventory of supplies on July 31 is `1,190.
(c) Subscription revenue of `1,200 is due from members who have been admitted on a provisional basis.
(d) Unearned subscription includes an amount of `300 for July.
(e) Staff salaries for the last week totalling `1,290 have not been paid.
(f) The local electricity company sent a bill for `280 for July after the close of the month’s transactions.
(g) Insurance premium of `1,200 was paid on a one-year policy effective from July 1.
Required
1. Prepare adjusting entries and post them to the T accounts.
2. Prepare an adjusted trial balance, a statement of profit and loss, a
statement of retained earnings, and a balance sheet.
Computer Corner Ltd. was set up on April 1, 20X8 to teach word processing,
spreadsheet, and database packages. The trial balance of the company at the end of
the first year of operation is as follows:
The following additional information is available:
(a) The building was acquired on April 1, 20X8 and has an estimated life of 10 years. Two computers were
bought on May 1, 20X8 at a cost of `9,000 each and are expected to be useful for three years.
(b) The inventory of supplies on March 31 is `650.
(c) Fee revenue of `3,100 is due from students for March.
(d) Unearned revenue includes fees of `1,600 for March
(e) Salaries of instructors for March totalling `1,100 have not been paid.
(f) The telephone bill for March has not been received and is estimated to be `80.
(g) Insurance premium of `4,800 was paid on October 1, 20X8 for a one-year policy effective from that date.
(h) The Bills Payable account represents a three-month bill for `2,600 given to a supplier on February 1,
20X9. The bill carries interest at 12 per cent per annum.
Required
1. Prepare adjusting entries and post them to T accounts.
2. Prepare an adjusted trial balance, a statement of profit and loss, a
statement of retained earnings, and a balance sheet.
3. Discuss how the figure of revenue from services might differ if the company
were to follow the cash system instead of the accrual system.
Required
1. Enter the trial balance amounts on a worksheet and complete the worksheet
using the following information:
(a) Estimated depreciation on office equipment, `1,000.
(b) Inventory of office supplies, `930.
(c) Services provided to clients paid for in advance but not taken as revenue,
`460.
(d) Services provided but not yet billed, `370.
(e) Unpaid salaries, `490.
(f) Unpaid cleaning expense, `240.
(g) Estimated income tax expense, `300.
2. Prepare a statement of profit and loss, a statement of retained earnings, and
a balance sheet.
3. Prepare adjusting and closing entries.
In 20XX, Anil Mathew started Mathew Adwaves Ltd. to provide advertising services and
completed the following transactions during the first two months:
July 1 Began business by depositing `20,000 in the company’s bank account in exchange for 2,000
shares of `10 each.
1 Paid three months’ rent in advance, `3,000.
1 Paid the premium on a one-year insurance policy, `900.
5 Bought office equipment on credit from Kiran Company, `6,000, payable in two equal instalments on July
31 and August 31.
7 Bought office supplies for cash, `2,390.
8 Bought art supplies on credit from Fairdeal Company, `4,510.
9 Billed customers for services provided, `6,800.
18 Received cash for services to be provided later, `1,800.
27 Received cash from customers billed on July 9, `4,900.
29 Paid salaries for July, `2,100.
31 Paid Kiran Company, `3,000.
Aug. 1 Billed customers for services provided, `7,400.
3 Received cash from customers billed on July 9, `1,900.
5 Provided services for cash received on July 18.
9 Paid suppliers for art supplies, `2,100.
13 Bought art supplies on credit, `4,200.
17 Received cash from customers billed on August 1.
24 Bought office supplies for cash, `1,300.
29 Paid salaries for August, `2,300.
30 Paid dividend, `120.
31 Paid Kiran Company, `3,000.
Required
1. Prepare journal entries to record the July transactions.
2. Open the necessary ledger accounts and post the July journal entries.
3. Prepare a trial balance for July on a worksheet form and complete the
worksheet using the following information:
(a) One month’s rent has expired, `1,000.
(b) One month’s insurance has expired, `75.
(c) Inventory of unused office supplies, `1,790.
(d) Inventory of unused art supplies, `1,830.
(e) Estimated depreciation on office equipment, `100.
(f) Estimated income tax, `120.
4. Prepare the July statement of profit and loss, statement of retained
earnings, and balance sheet.
5. Prepare and post the July adjusting and closing entries.
6. Prepare the July post-closing trial balance.
7. Prepare and post journal entries to record the August transactions.
8. Prepare a trial balance for August on a worksheet form and complete the
worksheet using the following information:
(a) One month’s rent has expired, `1,000.
(b) One month’s insurance has expired, `75.
(c) Inventory of unused office supplies, `1,990.
(d) Inventory of unused art supplies, `3,240.
(e) Estimated depreciation on office equipment, `100.
(f) Estimated income tax, `915.
9. Prepare the August statement of profit and loss, statement of retained
earnings, and balance sheet.
10. Prepare and post the August adjusting and closing entries.
11. Prepare the August post-closing trial balance.
On April 1, 20X6, Manish Mukherjee set up Realtime Consultancy Ltd. with a share
capital of `30,000. He did not maintain proper accounts of the company’s transactions
although he barely noted some details in his personal diary. Mukherjee’s secretary has
kept files containing invoices raised on customers and cash memos and invoices for
purchases of office supplies.
With great difficulty you have assembled the following information from Mukherjee’s diary, the files kept by
his secretary, and the company’s bank statements:
Required
1. Prepare the March trial balance on a worksheet form and complete the
worksheet.
2. Prepare the 20X7 statement of profit and loss, statement of retained
earnings, and balance sheet.
3. Prepare the March post-closing trial balance.
Problem Set C
A review of the accounting records of Suresh Company on July 31, 20X7 reveals the
following information relevant to the preparation of year- end adjusting entries:
(a) There are two bills payable:
(i) The three-month bill for `10,000 signed on July 1, 20X7 carries interest at 12 per cent
per annum.
(ii) The eight-month bill for `15,000 dated January 1, 20X7 carries interest at 14 per cent per annum.
Interest is payable at the time of maturity of the bills.
(b) The company has two insurance policies. Policy No. F154 covers fire risk for two years and was taken on
September 1, 20X6 by paying a premium of `12,000. Burglary risk is covered by Policy No. B113 taken on
February 1, 20X7 for one year on payment of premium of `4,800.
(c) The Unearned Revenue account shows a balance of `6,000. It represents retainer fee received on March 1,
20X7 from a client for an annual maintenance contract effective from that date.
(d) There are eight salaried employees. Salaries are disbursed on the third day of the following month. Five
employees receive a salary of `3,200 per month and the others `2,800 per month.
(e) Sales commissions are 3 per cent of sales, payable on the seventh day of the month following the sales.
During the year ended July 31, 20X7, the company paid sales commissions totalling `18,400. Sales for the
year were `670,000. July 20X6 net sales were `60,000.
(f) The company owns a van and a computer. The van was bought on March 1, 20X5 for `80,000 and was
estimated to be useful for eight years. The computer was bought on March 1, 20X7 for `18,000 and was
estimated to be useful for three years. Neither asset has any salvage value at the end of its useful life.
Required
Prepare adjusting entries on July 31, 20X7.
Sandur Furniture Company was set up on November 1, 20X7 to repair home furniture.
The following transactions took place in the first month of the company’s operations:
Nov. 1 Began business by depositing `15,000 in the company’s bank account in exchange
for 1,500 shares.
2 Paid premium on an insurance policy for one year, `1,800.
4 Paid for advertisements in a local monthly magazine to be carried in the three issues
beginning current month, `4,800.
6 Bought office supplies for cash, `890.
10 Billed customers for services provided, `9,700.
16 Paid assistant’s salary for the first fortnight, `900.
17 Received payment from customers billed on November 10, `4,100.
27 Received fees for services provided, `6,500.
28 Received advance payments from customers, `1,400.
29 Paid electricity bill for the month, `120.
30 Received but not paid property tax demand, `250.
Required
1. Prepare journal entries for the transactions according to the cash system.
2. Prepare journal entries for the transactions according to the accrual system.
Prepare adjusting entries for the following items:
(a) The inventory of supplies on November 30 was `210.
(b) The salary for the second fortnight was `900.
3. Compute the net profit under the cash system and the accrual system.
The following additional information is available:
(a) The building is expected to be useful for 10 years and the office equipment has an estimated useful life of
four years. None of these assets are expected to have any salvage value.
(b) The inventory of office supplies on January 31 is `970.
(c) Services for `900 were provided to customers in January although no bills have been raised.
(d) Services for `720 were provided to customers who had made full advance payments.
(e) Salaries of staff for the second fortnight totalling `3,100 have not been paid.
(f) The telephone company sent a bill for `480 for January after the close of the month’s transactions.
(g) The company paid six months’ rent as advance on January 1.
Required
1. Prepare adjusting entries and post them to the T accounts.
2. Prepare an adjusted trial balance, a statement of profit and loss, a
statement of retained earnings, and a balance sheet.
The following additional information is available:
(a) The computer bought on March 1, 20X4 is expected to be useful for 3 years.
The office equipment bought on May 1, 20X4 has an estimated useful life of 10 years.
(b) The inventory of supplies on November 30 is `1,240.
(c) Fee revenue of `6,200 is due from customers.
(d) Unearned revenue includes fees of `2,100 earned in November.
(e) Salaries of architects for November totalling `2,600 have not been paid.
(f) The company paid 12 months’ rent in advance on January 1, 20X4 at `1,000 per month.
(g) The Bills Receivable account represents a six-month bill for `3,400 given by a customer on August 1, 20X4.
The bill carries interest at 15 per cent per annum.
(h) Income tax of `2,500 is payable on November 30.
Required
1. Prepare adjusting entries and post them to the T accounts.
2. Prepare adjusted trial balance, statement of profit and loss, statement of
retained earnings, and the balance sheet.
3. Discuss how the figure of revenue from services might differ if the company
were to follow the cash system instead of the accrual system.
Required
1. Enter the trial balance amounts on a worksheet and complete the worksheet
using the following information:
(a) Estimated depreciation on packaging equipment, `3,000.
(b) Estimated depreciation on office equipment, `1,000.
(c) Inventory of packaging supplies, `2,360.
(d) Inventory of office supplies, `1,190.
(e) Prepaid rent includes rent for January to March, 20X6 at `840 per
month.
(f) Accrued interest on the bill payable at 15 per cent per annum from
September 1, 20X5.
(g) Services provided to clients that had been paid for in advance but not
taken as revenue as revenue, `1,040.
(h) Unbilled revenue, `1,390.
(i) Unpaid salaries, `970.
(j) Prepaid advertisement, `400.
(k) Unpaid telephone expense, `200.
(l) Estimated income tax expense, `1,600.
2. Prepare a statement of profit and loss, a statement of retained earnings, and
a balance sheet.
3. Prepare adjusting and closing entries.
In 20XX, Raju Designs Ltd. completed the following transactions during the first two months:
Nov. 1 Deposited `50,000 in the bank in the company’s bank account in exchange for 5,000
shares.
1 Paid one month’s rent, `2,000.
1 Paid the premium on a one-year insurance policy, `2,400.
3 Bought office equipment for cash, `3,000.
5 Bought office supplies on credit, `3,460.
9 Received cash for services provided, `4,900.
15 Paid assistant’s salary for the first fortnight, `700.
18 Billed customers for services provided, `4,300.
20 Paid for office supplies bought on November 5, `2,300.
28 Paid electricity bill for the month, `270.
29 Received cash from customers billed on November 18, `3,100.
29 Paid assistant’s salary for the second fortnight, `700.
30 Paid dividend, `1,000.
Dec. 1 Paid the monthly rent, `2,000.
7 Bought office supplies on credit, `1,900.
9 Billed customers for services provided, `7,800.
10 Received cash from customers billed on November 18, `1,200.
15 Paid assistant’s salary for the first fortnight, `700.
18 Paid suppliers for office supplies bought on December 7, `1,500.
29 Paid electricity bill for the month, `310.
30 Paid assistant’s salary for the second fortnight, `700.
31 Paid dividend, `1,200.
Required
1. Prepare journal entries to record the November transactions.
2. Open the necessary ledger accounts and post the November journal entries.
3. Prepare a trial balance for November on a worksheet form, and complete the
worksheet using the following information:
(a) One month’s insurance has expired, `200.
(b) Inventory of unused office supplies, `2,910.
(c) Estimated depreciation on office equipment, `50.
(d) Estimated income tax, `1,500.
4. Prepare the November statement of profit and loss, statement of retained
earnings, and balance sheet.
5. Prepare and post the November adjusting and closing entries.
6. Prepare the November post-closing trial balance.
7. Prepare and post journal entries to record the December transactions.
8. Prepare a trial balance for December on a worksheet form and complete the
worksheet using the following information:
(a) One month’s insurance has expired, `200.
(b) Inventory of unused office supplies, `4,050.
(c) Estimated depreciation on office equipment, `50.
(d) Estimated income tax, `1,400.
9. Prepare the December statement of profit and loss, statement of retained
earnings, and balance sheet.
10. Prepare and post the December adjusting and closing entries.
11. Prepare the December post-closing trial balance.
On January 1, 20X3, Veena and Mohan established VM Interior Decor Ltd. with a share
capital of `20,000. In early January 20X4, just a few days before the accounting records
were to be sent to the CA, there was a major fire in the office, which practically
destroyed all the books and vouchers. Their office assistant, however, managed to pull
out a few things including some files and scribbling pads.
After poring over the documents for several hours, they have been able to put together the following
information:
Required
1. Prepare the December trial balance on a worksheet form and complete the
worksheet.
2. Prepare the 20X3 statement of profit and loss, statement of retained
earnings, and balance sheet.
3. Prepare the December 20X3 post-closing trial balance.
Business Decision Cases
Sudipto Bhattacharyya is a professor of accounting in a leading business school. He has
received the following message from a former student:
Dear Professor Bhattacharyya,
I belong to the MBA Class of 1997 and was your student in the financial accounting course. Currently, I am
Vice President, Sales and Operations in the India office of findomega.com, the well-known Internet search
engine listed in the National Stock Exchange of India. I need your advice on how to get out of a mess in my
workplace.
As you would know, findomega.com provides targeted advertising as part of its search services. It works as
follows. When a user searches the Internet using our engine, findomega.com provides the requested
information. In addition, it gives the names and related web links of five advertisers (who are our customers)
for the products or services that the user may be potentially interested in. If the user clicks on any of those
web links, we charge the customer concerned. Otherwise, we do not charge our customers. Of course, we
never charge the Internet search user anything. Lately, we have localized the search and have made it
possible to get information based on postal code and street name. This is generating a lot of additional
revenue for us.
My job is to contact potential customers and sell the idea of targeted advertising. Initially, businesses were
not much enthusiastic, but the rising Internet penetration in India is making our service more attractive.
When I get a customer to sign up with my company, I ask for clearance from my immediate boss who is the
company’s Director of Sales and Marketing, whom I report to. (My boss reports to the company’s Managing
Director in India, who in turn reports to the company’s regional office in Hong Kong.) Once my boss approves
the deal by e-mail, I sign a contract with the customer. The contract is in a standard form that has been
cleared by the Legal Department. The signed contract goes to Accounting for billing the customer based on
the number of clicks, and the customer pays within one week. My boss is very happy with my work and he
thinks that I am an asset to the company. Even in this recession, I have been able to get new business though
it is not always easy, and I have always met my tight performance targets.
In early December I received an interesting proposal. The prospective customer, an online travel agency,
offered an innovative arrangement under which findomega.com will carry their advertisement 500 times that
month. In return, the customer will carry an advertisement of our service the same number of times that
month on their website at no charge. Since the company is cutting on payment for advertising and promotion,
the proposal looked attractive to me. In addition, I would benefit from the additional business that would
count towards my target and bonus. I e-mailed my boss and he promptly asked me to go ahead with the deal.
I signed the contract. I had to make minor changes to the contract for the peculiarities of the arrangement
since there was no precedent. The main change was that the contract required mutual billing by the two
parties at the rates that my company typically charged for similar advertisements with cash payment
arrangement. In order to settle the transaction, my company would record an equal amount of advertising
and promotion expense.
This morning I received a memo from the Managing Director asking me to explain my signing the deal
without previous approval from anyone. What has upset me is the insinuation that I have done something
improper and, much worse, I have potentially benefited from the deal. The fact is that my boss knows that I
got nothing from the deal. I understand that he too has received a similar memo.
I would like to add that findomega.com was set up by a group of computer programmers. It is one of the most
innovative services and is the best in its league. My boss who has been with the company from its early days
feels that these days the company is excessively concerned with procedures, more so after it went public a few
years ago. It appears that in the past the atmosphere in the company used to be informal and that is what
encouraged the employees to innovate and take big risks.
I remember that in your classes you would stress that ethical conduct is not negotiable. Do you think what I
did was wrong?
Best regards,
Amit
Memo
From: Managing Director
March 2, 20XX
To: Vice President, Sales and Operations
In December you signed a contract for barter advertising. The contract is not in the standard form. According
to the Compliance Department, this violates company policy. The company’s auditors have questioned
recognizing revenue from the contract in the fourth quarter ended December 31. The Internal Audit
Department has pointed out that if the contract were excluded, you would have fallen short of the quarterly
target by 15 per cent. I question your motivation and sense of judgment. Please send your written
explanation in three days.
Required
1. Evaluate Amit’s action.
2. What is, in your opinion, the Managing Director’s point about revenue
recognition?
3. Do you agree with Amit that the company’s procedures could stifle
innovation and risk-taking?
4. Draft a response from Professor Bhattacharyya to Amit.
Interpreting Financial Reports
Established in 1976, Computer Associates grew from a three-person start-up into the
world’s fourth largest independent software company. The company had 18,000
employees and was the dominant supplier of mainframe utility software. In the fiscal
year ended March 2000, the company reported profits of $696 million on sales of $6.1
billion, five times the sales and profits it posted a decade earlier. It has a market value of $20.3 billion.
11 Adapted from two reports by Alex Berenson in The New York Times: A Software Company Runs Out of
Tricks, April 29, 2001; Computer Associates Officials Defend Accounting Methods, May 1, 2001.
On April 16, 2001, Computer Associates reported another successful quarter in spite of the slowdown in
technology spending that had hurt other big software companies like Oracle. It said that on a “pro forma, pro
rata” basis, its revenue had risen to $1.44 billion for the quarter, from $1.39 billion in the period a year earlier.
Profits were 47 cents a share, it said, up from 39 cents a share. During a conference call later, Mr. Sanjay
Kumar, the Chief Executive, and Ira Zar, the Chief Financial Officer, accepted analysts’ congratulations. “Today
really is a great day for us at Computer Associates,” Mr. Kumar said. He attributed the company’s strong pro
forma results to a new software licensing model that it unveiled on October 25, 2000. The company promised
that its “new business model” would allow it to offer customers more flexible contract terms, including month-tomonth licenses. In addition, the new model would help the company by giving it a more predictable revenue
stream. “The new business model turned out to be a competitive advantage for us,” Mr. Kumar said in the
conference call. Over the next three days, the company’s stock soared $7.41 to $37, a gain of 25 per cent. After
falling steeply from its January 2000 high of $75 to $18.13 in December, the stock rebounded strongly in 2001.
According to generally accepted accounting principles (GAAP), the company’s revenue fell almost 60 per cent,
to $732 million, from $1.91 billion. After earning a profit of $1.13 a share, or about $700 million, in 2000, the
company lost 29 cents a share, or about $175 million, in 2001. The divergence followed an equally big gap in the
company’s quarter ended December 31, 2000. For that period, it reported pro forma revenue of $1.4 billion and
profits of $247 million, while by the stricter standards it had revenue of $783 million and a loss of $342 million.
The company said that its pro forma numbers more accurately reflected its results, after the change in its
licensing terms.
Big software companies usually offer clients software for a large initial fee that enables them to use it for a
year, followed by annual fees to continue using it and receive product upgrades and technical support. The
annual fees are usually 15–20 per cent of the first year’s fee. Customers can also sign a long-term contract and
spread the initial fee, plus the annual fees, over the term of the contract. The fees increase along with the power
of the computers used to run the software.
Required
1. What do you understand by the term ‘pro forma’ results? How do they differ
from GAAP results?
2. How is the company’s accounting related to its “business model”?
3. What is the major criticism of the accounting policy of Computer Associates?
What would be your response if you were to speak in defence of the
company?
Financial Analysis
Companies use pro forma measures in their earnings releases, financial statements, and
management discussion and analysis. Study the use of these measures by the CNX S&P
500 companies for the last five years.
Required
1. List the pro forma measures used by the companies.
2. Explain why companies use pro forma measures.
3. Compare the pro forma numbers with GAAP numbers. Do you see any
patterns?
4. Are there any changes in the choice of the measures over time? Do you agree
with the reasons?
5. How is your study important for analyzing financial statements?
Study the financial statements of a sample of airlines.
Required
1. List the major items of accrual and deferral. Explain for each item why an
accrual or deferral is necessary.
2. Compare the levels of accrual and deferral over a two-year period. What did
you learn from the comparison?
3. Accrual accounting requires the board of directors and the management to
make a number of estimates and judgments relating to the financial
statements on a prudent and reasonable basis. As an analyst, how can you
assure yourself that the companies that you track meet this condition?
4. How is your study important for analyzing financial statements?
Study the financial statements of a sample of telecommunication companies.
Required
1. Formulate a set of critical issues in revenue recognition and
matching in this business.
2. Examine the accounting policies of these companies. Are you satisfied with
them? Why or why not?
3. Accrual accounting requires the board of directors and the management to
make a number of estimates and judgments relating to the financial
statements on a prudent and reasonable basis. As an analyst, how can you
assure yourself that the companies that you track meet this condition?
4. How is your study important for analyzing financial statements?
Answers to Test Your Understanding
1 IAS 18:7/Ind AS 18:7. IASB’s Exposure Draft Revenue from Contracts with Customers issued in 2012 will
replace IAS 18. The draft defines income as “increases in economic benefits during the reporting period in the
form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants.” It defines revenue as “income arising in the
course of an entity’s ordinary activities.” Taken together, there is no substantial change in the definition of
revenue for our purposes.
2 IASB F. 70(b).
3 IASB Conceptual Framework OB 17.
4 IASB Conceptual Framework OB17, OB18, OB19.
5 International Monetary Fund, Fiscal Transparency, Accountability, and Risk, August 2, 2012.
6 IAS 18:20/Ind AS 18:20.
7 You would have noted that from Chapter 1 onwards we have been considering revenue billed but not collected
to be revenue at the transaction stage itself. It is also an accrual item. However, since firms routinely record it
as a transaction item, we are not including it again. In this chapter, we pay particular attention to accrual
items that are normally not considered in transaction processing, but are recorded at the end of the fiscal year.
8 Patricia M. Dechow, Accounting earnings and cash flows as measures of firm performance: The role of
accounting accruals, Journal of Accounting and Economics, July 1994.
9 Some accounts may have more than one adjustment. For example, Revenue from Services has two
adjustments in this illustration.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Identify the components of the statement of profit and loss of a merchandising organization.
Record transactions related to sales of merchandise.
Explain how to determine substance over form in sales transactions.
Calculate the cost of goods sold using the periodic inventory system.
Record transactions related to purchases of merchandise.
Describe the common freight terms and record transportation costs.
Understand operating expenses.
Prepare a worksheet and closing entries for a merchandising organization.
Prepare financial statements.
PHANTOM SALES
On April 30, 2012, Adidas announced that the company would be taking a €125 million writeoff for commercial irregularities in its India operations and a further restructuring charge of €70
million. On May 23, Reebok India, owned by Adidas, filed a complaint with Gurgaon Police
accusing its former managing director, Subhinder Singh Prem, and chief operating officer, Vishnu
Bhagat of commercial irregularities that had cost the company over `8.7 billion. The charges
included “channel stuffing”, the practice of pushing stocks to retailers usually on credit in order
to show high sales growth targets. As a result, inventories would go down and receivables
would go up. Reebok India charged Prem and Bhagat with inflating sales figures to get the
maximum bonus, increment, and incentives. The case was also investigated by the Serious Fraud
Investigation Office (SFIO) of the Ministry of Corporate Affairs. The accounting firm, Ernst &
Young, submitted a forensic analysis of the case to the police.
THE CHAPTER IN A NUTSHELL
In Chapters 1–3, you learned how to record transactions and prepare the financial statements
of service organizations. In this chapter, you will see a more complex type of business that links
producers and consumers: The merchandising organization. These organizations buy goods for
resale.
The principle of income measurement for a merchandising organization is the
same as that for a service organization: net profit results from matching expenses
with revenues. The statement of profit and loss of a merchandising organization has
three components:
Revenue from sales;
Cost of goods sold; and
Operating expenses.1
In common parlance, revenue is top line, costs and expenses are middle line, and
net profit is bottom line. For the sake of simplicity, at this stage we do not consider
one-time and non-recurring items, such as gains and losses on disposal of
investments and fixed assets.
The primary source of revenue for a merchandising organization is the sale of
goods, often referred to as revenue from sales or, simply, sales. The cost of
goods sold is the total cost of merchandise sold during the period. This expense is
directly related to the sales. The cost of goods sold is deducted from sales to arrive
at an intermediate income amount called gross profit. Gross profit, expressed as a
percentage of sales, is the gross profit ratio (or gross margin). Thus, a gross
profit of 20 per cent on sales of `200,000 would mean that a business earned
`40,000 after meeting the cost of goods sold. From Exhibit 4.1, we learn that Vijay
Electronics earned a net sales revenue of `439,120 and incurred `298,700 for the
goods that were sold, thus earning a gross profit of `140,420. The gross profit ratio
is nearly 32 per cent.
Operating expenses are expenses incurred in running the business. They are
normally separated by function. Selling expenses arise from activities connected
with selling and distributing the goods and include storage charges, salaries for the
sales staff and commissions, and the cost of delivering goods to customers.
Administrative expenses are those associated with general services, such as
accounting, personnel, corporate office, and general administration. After
calculating gross profit, we deduct operating expenses to arrive at profit before
interest and tax (PBIT), or operating profit.
Interest expense for borrowing and interest income from lending money are nonoperating items. For a business to be profitable, its sales should cover not only the
cost of goods sold but also its operating and interest expenses. Net profit, or profit
after tax (PAT), equals operating profit adjusted for non-operating items less
income tax.
Revenue from Sales
Management, investors, and analysts monitor sales trends. An
increasing trend indicates not only sales growth but also a
probability of an increase in earnings. On the other hand, a falling
trend might portend a downturn in a company’s fortunes. Sales
are compared with the previous year’s sales (year on year, or “YoY”). Quarterly
sales are compared with sales in the previous quarter (quarter on quarter, or “QoQ”)
and the year-ago quarter. Besides, sales are compared with competitors’ sales.
These comparisons help to spot major trends in sales. Sales are a better indicator of
the future than profits. For example, Microsoft continues to report good profits from
its established personal computer products but future growth will be in mobile
devices.
Sales
Sales consist of cash sales and credit sales. Under accrual accounting, revenue is
considered to be earned in the reporting period in which the ownership of the goods
passes from the seller to the buyer. As a result, a business recognizes revenue at the
time of the sale even though it may collect the payment later.
Revenue from the sale of goods is recognized when all the following conditions are
satisfied:
1. The entity has transferred to the buyer the significant risks and rewards of
ownership of the goods.
2. The entity retains neither continuing managerial involvement to the degree
usually associated with ownership nor effective control over the goods sold.
3. The amount of revenue can be measured reliably.
4. It is probable that the economic benefits associated with the transaction will
flow to the entity.
5. The costs incurred or to be incurred in respect of the transaction can be
measured reliably.2
Chapter 3 discusses conditions 3 and 4. We will see condition 5 in Chapter 5. Let
us now see how to apply conditions 1 and 2.
Transfer of the risks and rewards of ownership The buyer should be the
economic owner of the goods, even if there is no transfer of legal ownership. The
litmus test of ownership is who will get to keep the profit if the price of the goods
goes up or bear the loss if the price goes down. If the answer is ‘buyer’, it is a sale.
Usually, the transfer of the risks and rewards of ownership occurs with physical
delivery of the goods or transfer of legal title. Thus, in a vast majority of
transactions (e.g. retail sales) delivery indicates sale. The Indian Sale of Goods Act
lays down the principles for determining when legal title is transferred. If the seller
retains an insignificant risk of ownership, the transaction is a sale. For example,
many supermarkets offer terms such as “money back if not completely satisfied.”
Here the seller recognizes the revenue and a liability for returns based on past
experience and other relevant factors.
No continuing involvement or control of the goods The spirit of a sale is that
the buyer can decide what to do with the goods once the sale is over. For example,
the seller of a piece of equipment cannot tell the buyer how much to produce, at
what price to sell the output, whom to sell it to, or what to do with the used
equipment. Exceptions include compliance with safety regulations or prevention of
resale for illegal use or to specified parties for legitimate reasons such as export ban
by the government.
Invoice is a document that contains the details of a sale, such as the name of the
product, number of units sold, unit price, total price, taxes and duties, total amount
billed, and the payment and shipping terms. The seller prepares the invoice at the
time of sale and sends it to the buyer. A retailer prepares the invoice at the point of
sale. A wholesaler who supplies goods to retailers prepares the invoice after the
shipping department notifies the accounting department that it has shipped the
goods to the customer. Figure 4.2 shows a wholesaler’s invoice.
Vijay Electronics records the sale transaction in Figure 4.2 as follows:
The balance in the Sales account shows the total amount of cash and credit sales
made during the reporting period. Since the seller may collect amounts due on
credit sales in a subsequent period, there may be a significant difference between
cash collections from sales and the amount of sales.
Sales Returns and Allowances
Most wholesalers and retailers allow their customers to return goods which are
found to be unsatisfactory or defective. Companies following a policy of “satisfaction
guaranteed” allow goods to be returned if the customer does not like them. A sales
return is a merchandise returned by a buyer. Sometimes, the customer may find
after the sale that the goods have minor defects and may agree to keep the goods if
the seller allows a reduction of the sales price, called sales allowance. A seller may
grant sales allowances for a number of reasons, including inferior quality, damage,
deterioration in transit, or variation in specifications. In all cases of sales returns
and allowances, the seller sends the buyer a document called credit note, which
indicates that the balance in the customer’s account is being reduced.
We could record sales returns and allowances as debits, because they cancel a
portion of the sales revenue. However, information about the amount of sales
returns and allowances is useful to management and is, therefore, shown
separately. High returns could be an indication of the low quality of the goods or of
high pressure selling. Besides, handling returned goods is a costly and timeconsuming affair. For these reasons, we debit Sales Returns and Allowances, a
contra-revenue account. Suppose that on May 23 Vijay Electronics issues a credit
note for `145 for the May 19 transaction. The following entry records this
transaction:
Trade Discounts
A trade discount is a percentage reduction granted to a customer from the
specified list price or catalogue price. Trade discounts serve several purposes. Trade
discounts enable firms to quote different prices to different types of customers and
grant quantity discounts. Also, the cost of printing catalogues is reduced, since a
seller can use a catalogue for a longer period of time and announce discounts
whenever prices change.
Normally, the seller does not record trade discounts in the accounts. For example,
suppose that the list price of a CD is `10, but the seller gives a discount of 10 per
cent for buying a box of 10 CDs. If you buy a box, the seller would record a revenue
of `90.
Sales Discounts
When a company sells goods on credit, it specifies the terms of payment on the
invoice. These terms vary from industry to industry. For example, the invoice in
Figure 4.2 shows the terms of payment as “net 45”. This is sometimes shortened as
“n/45”. The term “n/45” means that the entire amount of invoice is due 45 days after
May 19, 20X8 (invoice date), which is not later than July 3, 20X8. If the invoice is
due 10 days after the end of the month, the terms will be “n/10/eom”.
Sometimes, credit terms include discounts for early payment, called cash
discounts. By offering an incentive for payment before the due date, the seller is
able to speed up its cash inflows. Cash discount is different from trade discount.
While the former is a deduction from the invoice price for prompt payment, the
latter is a deduction from the catalogue price to determine the invoice price. A cash
discount is called a sales discount by the seller and a purchase discount by the
buyer. Credit terms of “2/10, n/45” mean that the buyer will get a 2 per cent
discount of the invoice amount for paying within 10 days of the invoice date;
alternatively, he may take 45 days and pay the full invoice amount without
discount.
The seller records the sales discounts at the time the customer pays since he does
not know at the time of sale when the customer will pay. The Sales Discounts
account shows the amount of sales discounts. Managers can examine the amount of
sales discounts to evaluate the company’s credit and collection policy. The Sales
Discounts account appears in the statement of profit and loss as an expense.
Suppose that a sale for `1,000 on June 12 is on terms of “2/10, n/30”. On June 22,
the buyer pays `980. The seller records the following entries:
The sales discount is calculated on the invoice amount less any sales returns and
allowances.
For presentation in the statement of profit and loss, the seller deducts sales
returns and allowances, trade discounts, and taxes and duties (e.g. value added tax,
sales tax, and goods and services tax), and reports only the net sales. Sales
discounts are not deducted.
Exhibit 4.2 shows Vijay Electronics’ presentation of revenue, assuming sales of
`461,020 and sales returns and allowances of `21,900.
Substance over Form in Revenue Recognition
Accountants recognize revenue from sale of goods on the basis of
the intention of the contracting parties and the legal provisions
for transfer of title to the goods. They have to go beyond the legal
form of a transaction and find out whether it meets the
conditions for revenue recognition. Sales transactions are
structured in complex ways for business, tax, and regulatory reasons. Revenue
recognition should be based on the economic substance of a transaction. That means
determining whether the significant risks and rewards of ownership have been
transferred to the buyer, the price is certain and the buyer will pay. We will now
consider some special terms of sales to decide when to recognize revenue.
Bill and hold sales In ‘bill and hold’ sales delivery is delayed at the buyer’s
request, but the buyer takes title and accepts billing. Revenue is generally
recognized when the buyer takes title, if it is probable that (a) delivery will be made,
(b) the item is on hand, identified, and ready for delivery to the buyer, (c) the buyer
acknowledges the deferred delivery instructions, and (d) the usual payment terms
apply.
Conditional sales Goods may be shipped subject to conditions to be fulfilled by the
seller or the buyer, such as those described below:
Installation and inspection If the contract requires installation by the seller and
inspection by the buyer, the seller normally recognizes revenue when the buyer
accepts delivery and installation and inspection are complete.
On approval In a sale on approval, the buyer has to communicate his acceptance
or rejection of the goods within a specified time period. If there is uncertainty about
the possibility of return, revenue is recognized when the buyer accepts the goods or
the specified time period for rejection has elapsed without any communication from
the buyer.
Consignment In a consignment “sale”, the recipient undertakes to sell the goods on
behalf of the shipper. The shipper is the owner of the goods and the recipient is the
shipper’s agent. The shipper recognizes revenue when the recipient sells the goods
to a third party.
Cash on delivery Revenue is recognized when the goods are delivered and cash is
received by the seller or its agent.
Lay away sales In a lay away sale, goods will be delivered when the buyer makes
the final payment in a series of instalments. Revenue from such sales is recognized
when the goods are delivered. However, when past experience indicates that most
such sales are consummated, revenue may be recognized when a significant deposit
is received provided the goods are on hand, identified, and ready for delivery to the
buyer.
Sale and repurchase agreements In a sale and repurchase agreement, the seller
concurrently agrees to repurchase the same goods at a later date, or the seller has
an option to repurchase the goods, or the buyer has an option to require the
repurchase of the goods by the seller. Even though legal title may have been
transferred, the seller retains the risks and rewards of ownership. Sale and
repurchase agreements are usually product financing arrangements in which the
seller raises a loan with the goods being given as collateral. The cash inflow to the
buyer is a loan receipt and not a revenue. The difference between repurchase and
sale prices represents the finance charge for the loan. The transaction does not give
rise to revenue.
Sales to distributors, dealers, or others for resale Revenue from such sales is
generally recognized when the risks and rewards of ownership have passed.
However, when the buyer is acting, in substance, as an agent, the sale is treated as
a consignment “sale”.
Instalment sales Revenue from instalment sale of goods has two parts: (1) the
cash price or the price for immediate payment, and (2) interest on future
instalments. The revenue representing the cash price should be recognized at the
date of sale. This is just like recognizing revenue from a normal cash or credit sale.
The interest element should be recognized as revenue as it is earned, using the
effective interest method.3
Subscription to publications When the items are of similar value in each time
period, revenue is recognized on a straight-line basis over the period in which the
items are despatched. When the items vary in value from period to period, revenue
is recognized on the basis of the sales value of the item despatched in relation to the
total estimated sales value of all items covered by the subscription.
Cost of Goods Solds
The second most important part of a statement of profit and loss
of a merchandising organization is the cost of goods sold.
Merchandise inventory, or inventory, is the quantity of goods
on hand and available for sale at a given time. The inventory on
hand at the beginning of the reporting period is called the beginning inventory,
or opening inventory. The inventory at the end of the period is called the ending
inventory, or closing inventory. The ending inventory appears on the balance
sheet as an asset. It will become a part of cost of goods sold in a later period when it
is sold. This year’s beginning inventory was last year’s ending inventory. Cost of
goods available for sale is the sum of the beginning inventory and the net cost of
purchases. Cost of goods sold is the cost to the seller of goods sold to customers
and it is the largest item of expense for merchandising companies. It is determined
by computing the cost of (a) the beginning inventory, (b) the net purchases, and (c)
the ending inventory. For presentation in the statement of profit and loss, the buyer
deducts the amount of purchase returns and allowances as well as purchase
discounts, and reports only the net purchases.
Exhibit 4.3 shows the cost of goods sold section of Vijay Electronics’ statement of
profit and loss. The merchandise inventory on January 1, 20X2 was `47,300.
Assume purchases of `326,900, purchase returns and allowances of `13,200 and
purchase discounts of `1,400. So the amount of net purchases is `312,300. Freight
paid on purchases is `28,100. The net cost of purchases consisting of net purchases
and freight is `340,400. Vijay Electronics could have sold merchandise of `387,700
during 20X2. This is the cost of goods available for sale. On December 31, 20X2, the
merchandise inventory was `89,000. This is the unsold inventory. Subtracting the
ending inventory from the cost of goods available for sale, we get the cost of goods
sold of `298,700.
Figure 4.3 illustrates the flow of goods during a reporting period. Beginning
inventory and net cost of purchases, when combined, make up cost of goods
available for sale. The latter is explained by cost of goods sold and ending inventory.
The Periodic Inventory System
The amount of merchandise inventory is determined by using either the periodic
inventory system or the perpetual inventory system. Under the periodic
inventory system, the Merchandise Inventory account is updated only periodically
after a physical count has been made. Hence the name. Usually, the physical count
takes place at the end of the reporting period. Some stores, particularly smaller
ones, use periodic inventory.
Net Cost of Purchases
The term net cost of purchases means purchases less discounts and purchase
returns and allowances plus transport and handling costs on the purchases.
Government levies, such as import duties, purchase taxes, value added tax (VAT),
goods and services tax (GST), and octroi, also form a part of the cost of purchases if
they are not recoverable by the buyer when he sells the goods. The term net
purchases refers to purchases less discounts, returns, and allowances.
Purchases
Under the periodic inventory system, a merchandising company
debits the Purchases account to record the cost of merchandise
bought for resale during the reporting period. Suppose that Vijay
Electronics purchased merchandise costing `50,000 on September
9. The required journal entry is:
Think of the Purchases account as a combination of an expense account and a
temporary asset account. The balance of the account does not indicate how much of
the goods has been sold. The Purchases account is used only for goods acquired for
resale (after processing in the case of manufacturing organizations). Other assets
such as office equipment, office supplies, and vehicles acquired for use in the
business are recorded in the appropriate asset accounts.
Purchase Returns and Allowances
When a buyer finds merchandise purchased to be unsatisfactory, he may return the
goods or accept an allowance on the price. The buyer sends a debit note to notify
the seller that the latter’s balance is being reduced. Depending on the terms of
purchase and trade practice, the buyer may either debit the seller’s account
immediately or wait for the seller’s acceptance of the debit note before recording the
debit. Purchase returns and allowances are recorded by crediting the Purchase
Returns and Allowances account, as illustrated below:
As illustrated in Exhibit 4.3, the statement of profit and loss presents the
purchases net of purchase returns. The use of a separate account for returns
provides information for monitoring the efficiency of the purchase function and the
quality and reliability of the suppliers. High rates of purchase returns could
indicate the need for reviewing purchasing practices and eliminating certain
vendors.
Purchase Discounts
Often, the credit terms for purchase permit the buyer to deduct a stated cash
discount if the buyer pays the invoice within a specified time period. Under the
gross price method, discounts taken are recorded in the Purchase Discounts
account. Suppose that the terms for a purchase of `1,000 of goods on January 3 are
2/10, n/30. If the buyer pays the invoice latest by January 13, he can take a 2 per
cent discount. Thus, the buyer must pay only `980 to settle the invoice. The
following entry records the transactions:
Well-managed companies take advantage of the discounts allowed by their
suppliers. If a buyer avails purchase discounts as a matter of policy, purchases can
be recorded at the invoice price less discounts. This procedure is known as the net
price method. If the invoice is paid after the discount period, the amount of
discount is debited to Discounts Lost account. Under the net price method, the
January 3 purchase is recorded as follows:
The purchase discount is calculated on the invoice amount less any purchase
return and allowances.
Deciding on discounts How does a buyer decide whether to take advantage of
discounts by using cash or borrowing? Suppose that a company buys goods for
`1,000 with terms 2/10, n/30. It must pay `980 in 10 days or `1,000 in 30 days. By
advancing payment by 20 days, the buyer earns a discount of `20. This is equivalent
to investing `980 and earning an interest income of `20 for a period of 20 days. On
an annual basis, the equivalent interest rate works out to 36.73 per cent, as
computed below:
If the interest rate on borrowing is less than 36.73 per cent per year, the buyer
should borrow and pay within the discount period, since it is beneficial to take the
discount.
Freight on Purchases
Transportation costs are often an important part of the cost of
merchandise purchased. The cost of merchandise includes any
transportation charges necessary to bring the goods to the buyer’s
place of business. A separate Freight In account is used to record
inward freight charges incurred on merchandise purchased. The following entry
records a freight of `150 paid on a purchase:
The normal balance of the Freight In account is debit. As illustrated in
Exhibit 4.3, freight paid on purchases is added to net purchases to get the net cost
of purchases. Freight In is an adjunct account, an account whose balance is added
to the balance of another account. An adjunct account is the opposite of a contra
account (e.g. accumulated depreciation), the balance of which is deducted from
another account. Transit insurance on purchases is treated similar to freight in.
The invoice normally indicates whether the seller or the buyer is to pay the
freight. FOB shipping point means “free on board at shipping point”, i.e. the
buyer incurs all transportation costs after the merchandise has been loaded on a
train or truck. FOB destination means “free on board to destination”, i.e. the seller
ships the goods to their destination without charge to the buyer. Thus, if the terms
are FOB shipping point, the buyer pays the freight; if the terms are FOB
destination, the seller pays the freight. The freight terms in the invoice in Figure
4.2 are FOB destination and, therefore, Vijay Electronics must pay the freight.
Freight terms are also significant for another reason. Ownership of goods
generally passes to the buyer at the FOB point. Therefore, if the terms are FOB
shipping point, the buyer should include goods in transit at the year end in its
ending inventory. If the terms are FOB destination, the seller should include goods
in transit at the year end in its ending inventory.
Inventory Losses
Merchandise inventory is lost in a variety of ways, such as spoilage, employee theft,
and shoplifting. Under the periodic inventory system, inventory losses are
automatically included in the cost of goods sold. To illustrate this point, let us
assume the following: cost of goods available for sale, `100,000; spoilage, `2,000;
ending inventory, `17,000. Thus, the cost of goods sold is `83,000 (cost of goods
available for sale, `100,000 – ending inventory, `17,000). Had there been no
spoilage, the ending inventory would have been `19,000, and the cost of goods sold
would have been `81,000 (`100,000 – `19,000), or `2,000 lower than that calculated
earlier.
Despite their best efforts, businesses suffer inventory losses. Under the periodic
inventory system, the loss is tucked away in the cost of goods sold and a measure of
the loss is not available. A rough-and-ready method of computing inventory loss
under the periodic inventory system is explained later in this chapter. In Chapter 6,
you will see another system – the perpetual inventory system – that provides better
information about inventory loss.
Operating Expenses
The third most important part of a statement of profit and loss of a
merchandising organization is operating expenses (also known
as selling, general and administrative expenses or SGA). These are
expenses other than cost of goods sold, interest, and income tax
and are incurred in running the normal business of a company. These expenses are
often grouped into useful categories such as selling and administrative expenses.
Selling expenses include expenses of storing and preparing goods for sale,
promoting sales, actually making sales, and delivering goods to customers.
Examples include salaries, sales commissions, sales staff travel, advertising, store
rent, depreciation on store equipment, and delivery expense. (Freight charges paid
on purchases are a part of cost of goods sold.) Administrative expenses are
incurred in the overall management of a business and include expenses relating to
office salaries, office rent, office telephone, board meeting, depreciation on office
equipment, and research and development.
Worksheet for a Merchandising Organization
The procedures for preparing the worksheet for a service
organization described in Chapter 3 apply to a merchandising
organization. In addition to the usual asset, liability, equity,
revenue, and expense items for a service organization, the
worksheet for a merchandising business has other items, such as
sales, sales returns and allowances, sales discounts, purchases, purchase returns
and allowances, purchase discounts, and merchandise inventory. Exhibit 4.4
presents the worksheet for Vijay Electronics.
Trial Balance The amounts in the Trial Balance columns are the account balances
on December 31, 20X2. The inventory of `47,300 that appears in the Trial Balance
columns is the company’s inventory on December 31, 20X1.
Adjustments We make the following adjustments:
(a) Depreciation expense, office equipment, `4,000
(b) Depreciation expense, store equipment, `6,000
(c) Expiration of prepaid insurance, `1,200
(d) Unpaid sales salaries, `2,430
(e) Unpaid office salaries, `1,800
(f) Unpaid store rent, `200
(g) Income tax payable, `26,000.
Account titles affected by adjustments appear in italics.
Adjusted Trial Balance We combine each account balance in the trial balance
with the corresponding adjustments in the Adjustments columns and enter the
resulting balance on the same line in the Adjusted Trial Balance columns. This
procedure is similar to that followed in Chapter 3.
Statement of Profit and Loss, Statement of Retained Earnings, and
Balance Sheet We extend each account balance appearing in the Adjusted Trial
Balance to either the Statement of Profit and Loss columns or the Balance Sheet
columns. As in Chapter 3, we extend revenue and expense items to the Statement of
Profit and Loss columns, and assets, liabilities, and equity items to the Balance
Sheet columns. Retained earnings and dividends go to the Statement of Retained
Earnings column. Recall from Chapter 3 that dividends is not an expense item.
Inventory We enter the beginning inventory amount of `47,300 in the Statement
of Profit and Loss debit column to indicate that it has been used up during the year.
Under the periodic inventory system, the business takes physical inventory on
December 31, 20X2 to determine the ending inventory. The amount is `89,000.
After extending all adjusted account balances to the proper worksheet columns, the
next step is to insert the ending inventory amount in the Statement of Profit and
Loss credit column. The effect of this procedure is to reduce the amount of cost of
goods sold. Next, we enter the ending inventory amount in the Balance Sheet debit
column so that the inventory balance of `89,000 will appear on the balance sheet as
an asset.
Determining Net Profit Net profit is the difference between the totals of the
Statement of Profit and Loss columns. We enter the amount in the Balance Sheet
credit column to balance the two columns.
Purposely, we do not use the labels, revenue, and expense to describe the
Statement of Profit and Loss column totals. This contrasts with our understanding
in Chapter 3. The item, Sales returns and allowances, is not an expense though it
appears in the Statement of Profit and Loss debit column. It merely offsets revenue
from sales. Again, the Statement of Profit and Loss credit column has ending
inventory, purchase return and allowances, and purchase discounts. These are not
part of the revenue of the business; they are offsetting items for cost of goods sold.
Closing Entries
The closing entries for Vijay Electronics are as follows:
Calculating cost of goods sold The following accounts are relevant to the
calculation of cost of goods sold:
Statement of Profit and Loss debit column
Beginning inventory
Purchases
Freight in
Statement of Profit and Loss credit column
Ending inventory
Purchase returns and allowances
Purchase discounts
The sum of the debits minus the sum of the credits equals cost of goods sold,
`298,700:
Financial Statements
Accountants group items that appear on the financial statements
into meaningful categories so that users can understand the
information with relative ease. Schedule III to the Companies Act
2013 (earlier Schedule VI to the Companies Act 1956) lays down the form and
content of the balance sheet and the statement of profit and loss. In this chapter, we
will see the statement of profit and loss, the balance sheet, and the statement of
retained earnings.4 We will see the statement of changes in equity in Chapter 10
and the cash flow statement in Chapter 12.
Statement of Profit and Loss
There are two ways of grouping items in the statement of profit and loss: (1)
functional and (2) natural. In the functional classification, items are grouped
according to the different activities of a business, such as manufacturing, trading,
marketing, and administration. Cost of goods sold is subtracted from sales to get
gross profit, and operating expenses are subtracted from gross profit to get
operating profit. In the natural classification, purchases and expenses are added
and their total is subtracted from sales to get profit. Here, it is not possible to find
out the amount of gross profit. Exhibit 4.5 presents the statement of profit and loss
of Vijay Electronics Limited in functional and natural forms.
Functional classification is more informative than natural classification, because
it contains performance measures such as gross profit and operating profit that are
useful for analyzing the financial statements. The form for the statement of profit
and loss specified in Schedule III is based on natural classification. However,
companies are free to provide additional information based on functional
classification.
Key relationships Besides looking at overall business profitability, it is also
necessary to compute intermediate profit figures. For example, a company may earn
a high gross margin on sales. However, because of heavy advertising and sales
commission, the final profit realized may be relatively small. The statement of profit
and loss allows a user of financial statements to look at both the big picture and
how net profit was derived.
Statement of Retained Earnings
Schedule III does not require a statement of retained earnings. It is a requirement
in many countries. Exhibit 4.6 presents the statement of retained earnings of Vijay
Electronics.
Balance Sheet
The balance sheet of Vijay Electronics appears in Exhibit 4.7. Balance sheet items
are grouped into meaningful categories, such as shareholders’ funds, non-current
liabilities, current liabilities, non-current assets, and current assets.
Here is a quick look at the major groupings of balance sheet items (you will learn
more about these items in the chapters mentioned):
Shareholders’ funds consist of share capital and reserves and surplus. These
represent the residual interest of the shareholders (Chapter 10).
Non-current liabilities are liabilities that are not classified as current liabilities.
Current liabilities are payable within a company’s normal operating cycle or
twelve months after the reporting date. Typical items are trade payables and
income tax payable (Chapter 9).
Non-current assets are assets that are not classified as current assets. Fixed
assets are assets held for use in the business and not for sale. Land, building,
plant and machinery, furniture and fittings, and vehicles are examples of fixed
assets (Chapter 7). Non-current investments are investments in financial assets,
such as government securities and shares, that are not classified as current
investments (Chapter 8).
Current assets are realizable within a company’s normal operating cycle or 12
months after the reporting date. Typical items are inventories (Chapter 6),
trade receivables and cash and bank balances (Chapter 5), and current
investments (Chapter 8).
Materiality Threshold
The materiality threshold (also known as the materiality principle) saves us
from having to make tedious calculations or disclosing needless detail, not
warranted in most cases. An item is material if it is sufficiently large or important
for users of the information to be influenced by it. The following quote summarizes
the idea of materiality.
Information is material if its omission or misstatement could influence the economic decisions of users taken on the
basis of the financial statements. Materiality depends on the size of the item or error judged in the particular
circumstances of its omission or misstatement.5
The materiality threshold helps in balancing the costs and benefits of disclosures
and accounting methods. Materiality is an important consideration in making
financial reporting decisions. It provides answers to questions such as these: Should
an enterprise physically verify every inventory or property, plant, and equipment
item, or can it be selective? How should it select business segments for disclosure of
their performance? How many items of expenses should it disclose? There are no
clear answers to such questions. For example, while a payment of `10,000 is most
probably not material for a business that reports a profit of `250 million, the item
would be material if the payment was made in contravention of a law. Schedule III
requires disclosure of any item of income or expenditure which exceeds 1 per cent of
the revenue from operations or `100,000, whichever is higher. Judgment is required
in applying the materiality test.
Looking Back
Identify the components of the statement of profit and loss of a merchandising organization
These are (i) revenue from sales, (ii) cost of goods sold, and (iii) operating expenses.
Record transactions related to sales of merchandise The Sales account records cash sales and credit
sales of merchandise. Separate accounts record sales returns and allowances and sales discounts.
Explain how to determine substance over form in sales transactions Revenue recognition should be
based on the economic substance of a transaction and not its mere legal form. The test is whether the
significant risks and rewards of ownership have been transferred to the buyer, the price is certain and the buyer
will pay.
Calculate the cost of goods sold using the periodic inventory system Cost of goods sold = Beginning
inventory + Net cost of purchases – Ending inventory; Net cost of purchases = Net purchases + Freight on
purchases; Net purchases = Purchases – Purchase returns and allowances – Purchase discounts. Under the
periodic system, a business takes physical inventory at the end of each year.
Record transactions related to purchases of merchandise A business that uses the periodic inventory
system debits the Purchases account for purchases of merchandise. Separate accounts record purchase
returns and allowances and purchase discounts.
Describe the common freight terms and record transportation costs In FOB shipping point, the
buyer pays the freight. In FOB destination, the seller pays the freight. Ownership of the goods generally
passes at the FOB point.
Understand operating expenses Operating expenses are expenses other than cost of goods sold, interest,
and tax.
Prepare a worksheet and closing entries for a merchandising organization Beginning inventory is
entered in the Statement of Profit and Loss debit column, and ending inventory in the Statement of Profit
and Loss credit column as well as in the Balance Sheet debit column. All expense accounts, beginning inventory,
and revenue accounts are closed by transferring their balances to the statement of profit and loss.
Prepare financial statements Financial statements present items in meaningful categories. The
statement of profit and loss presents revenue from sales, cost of goods sold, and operating expenses. The
balance sheet shows asset, liability and equity items under meaningful groups. Schedule III to the Companies
Act 2013 lays down the form and content of the financial statements.
Review Problem
Pravin Trading Company had the following transactions with Uday Store during May:
May 13 Sold merchandise with list price of `60,000 at a discount of 30 per cent; terms 1/10, n/60, FOB
destination.
15 Paid freight, `700.
18 Accepted merchandise (sold on May 13) returned due to inferior quality, `2,000.
19 Sold merchandise with list price of `80,000 at a discount of 30 per cent; terms 1/10, n/60, FOB destination.
20 Paid freight, `400.
21 Received payment for the May 13 sale.
30 Received payment for the May 19 sale.
Required
1. Prepare journal entries in Pravin Trading’s records.
2. Prepare journal entries in Uday Store’s records using (a) the gross price
method and (b) the net price method.
Solution
ASSIGNMENT MATERIAL
Questions
1. Name five characteristic account titles that you would expect to see in a
retailer’s financial statements.
2. Explain the difference between trade discount and cash discount.
3. Explain why the amount of collections from customers during a period may
differ from the net sales appearing on the statement of profit and loss.
4. How is the cost of goods sold determined under the periodic inventory
system?
5. Give two examples of contra accounts in a merchandising organization.
6. What is an adjunct account? Give an example of an adjunct account for a
wholesaler.
7. Kiran Company sells goods at prices exceeding purchase prices. Can it
report a net loss?
8. Is the Sales Returns and Allowances account an expense account? Explain.
9. Complete the following relationships:
(a) Cost of goods sold + Gross profit = ?
(b) Operating profit + Operating expenses = ?
(c) Cost of goods available for sale – Net cost of purchases = ?
(d) Ending inventory + Cost of goods sold = ?
(e) Net cost of purchases – Net purchases = ?
Chen Company had the following transactions with Chang Company during April:
Apr 3 Purchased `2,000 of merchandise; terms 2/10, n/30.
9 Purchased `9,000 of merchandise; terms 2/10, n/30.
14 Paid the invoice for the April 3 purchase.
19 Paid the invoice for the April 9 purchase.
The beginning and ending merchandise inventories were `3,900 and `4200, respectively.
Required
Extend the account balances to their proper columns after entering the inventory amounts in the worksheet.
From the data given in Problem 4A.4, prepare the closing entries.
Problem Set B
Harcharan Company completed the following transactions during June.
June 1 Purchased merchandise on credit from Gurpreet Company, terms 2/10, n/30, FOB destination, `4,800.
2 Sold merchandise on credit to Manpreet Company, terms 2/10, n/30, FOB destination,
`7,100.
2 Paid Inderjeet Company freight charges on merchandise sold, `150.
4 Purchased office supplies on credit from Inderbir Company, terms n/30, `180.
5 Issued a credit note to Manpreet Company for unsatisfactory merchandise returned, `300.
6 Sold merchandise for cash, `1,900.
8 Purchased merchandise on credit from Krishan Company, terms 2/10, n/30, FOB shipping point, `6,300.
9 Paid Inderjeet Company freight charges on merchandise purchased, `170.
10 Sold merchandise on credit to Kartar Company, terms 2/10, n/30, FOB shipping point, `9,800.
11 Paid Gurpreet Company for the purchase on June 1.
12 Received a cheque from Manpreet Company for June 2 sales after allowing for the merchandise returned
on June 5.
13 Issued a credit note to Kartar Company for unsatisfactory merchandise returned, `800.
14 Paid Inderbir Company for the purchase on June 4.
15 Issued a debit note to Krishan Company for unsatisfactory merchandise returned, `600.
18 Paid Krishan Company for the purchase on June 8 after allowing for the merchandise returned on June
15.
24 Purchased merchandise on credit from Gurpreet Company, terms 2/10, n/30, FOB shipping point, `7,200.
29 Purchased a computer for office use on credit from Maninder Company, terms n/30, `2,400.
30 Received a cheque from Kartar Company for June 10 sales after allowing for the merchandise returned on
June 13.
Required
Prepare general journal entries to record the transactions. Assume that Harcharan Company follows the
periodic inventory system and records purchases initially at gross purchase price.
The following is a partial list of account balances of Vision Opticals for the year ended June
30, 20X6:
The beginning and ending merchandise inventories were `47,000 and `69,000, respectively.
Required
1. Prepare a statement of profit and loss in functional form for the year ended
June 30, 20X6.
2. Comment on the performance of the business, pointing out possible areas for
improvement.
Required
1. Copy the trial balance into the Trial Balance columns of a worksheet and
complete the worksheet using the following information:
(a) Estimated depreciation on store furniture, `1,500.
(b) Ending office supplies inventory, `1,640.
(c) Store rent at `600 per month paid on February 1, 20X2 for 24 months.
(d) The current insurance policy was taken for one year from August 1,
20X2.
(e) Office salaries accrued, `400.
(f) Estimated income tax, `14,000.
(g) Ending merchandise inventory, `36,400.
2. Prepare a statement of profit and loss in functional form for the year ended
January 31, 20X3. The following are to be considered selling expenses: sales
discounts; sales salaries expense; advertising expense; delivery expense;
store rent; and depreciation expense, store furniture.
3. Prepare the closing entries.
Required
1. Copy the trial balance into the Trial Balance columns of a worksheet and
complete the worksheet using the following information:
(a) Estimated depreciation on store equipment, `500.
(b) Estimated depreciation on office furniture, `300.
(c) Ending office supplies inventory, `590
(d) The current insurance policy was taken for one year from April 1, 20X3.
(e) Advertisement expired, `1,300.
(f) Office salaries accrued, `200.
(g) Sales commissions accrued, `400.
(h) Unpaid store rent, `300.
(i) Unpaid office rent, `200.
(j) Estimated income tax, `4,000.
(k) Ending merchandise inventory, `38,710.
2. Prepare the March 20X4 statement of profit and loss, statement of retained
earnings, and balance sheet for the store.
3. Prepare the closing entries.
In 20X2, Kiran set up Venus Trading Ltd. to deal in spices and engaged in the following
transactions during the first month:
Oct. 1 Began business by investing cash in the company’s share capital, `25,000.
1 Paid two months’ store rent in advance, `2,000.
1 Paid premium on a one-year insurance policy, `600.
2 Purchased store equipment for cash, `3,000.
2 Purchased office supplies for cash, `4,100.
5 Purchased merchandise on credit from Jai Hind Traders, terms 2/10, n/30, FOB destination, `7,000.
6 Sold merchandise on credit to Vijay Company, terms 2/10, n/30, FOB destination, `14,000.
10 Paid Hari Carriers freight charges on merchandise sold, `400.
14 Issued credit note to Vijay Company for unsatisfactory merchandise returned, `1,000.
15 Paid Jai Hind Traders for the purchase on October 5.
16 Received a cheque from Vijay Company for October 6 sales after allowing for the merchandise returned on
October 14.
20 Sold merchandise for cash, `4,300.
24 Purchased merchandise on credit from Nav Bharat Traders, terms 2/10, n/30, `8,600.
27 Paid telephone bill for the month, `460.
30 Paid store salaries, `800, office salaries, `250.
31 Paid dividend, `5,000.
Required
1. Prepare journal entries to record the transactions using the gross price
method.
2. Open the necessary ledger accounts and post the July journal entries.
3. Prepare a trial balance for October on a worksheet form and complete the
worksheet using the following information:
(a) Ending merchandise inventory, `8,720.
(b) Inventory of unused office supplies, `3,580.
(c) One month’s store rent expired, `1,000.
(d) One month’s insurance expired, `50.
(e) Estimated depreciation on store equipment, `50.
(f) Estimated income tax, `1,000.
4. Prepare the October statement of profit and loss, statement of retained
earnings, and the balance sheet.
5. Prepare and post the adjusting and closing entries for October.
6. Prepare the October post-closing trial balance.
Problem Set C
Bijoy Company completed the following transactions during September:
Sep. 1 Purchased merchandise on credit from Jyotirmoy Company, terms 2/10, n/30, FOB
destination, `7,900.
3 Sold merchandise on credit to Mrinal Company, terms 2/10, n/30, FOB destination, `9,300.
3 Paid Subhas Company freight charges on merchandise sold, `210.
4 Purchased office supplies on credit from Joy Company, terms n/60, `510.
5 Sold merchandise for cash, `700.
7 Issued credit note to Mrinal Company for unsatisfactory merchandise returned, `500.
8 Purchased merchandise on credit from Shameek Company, terms 2/10, n/30, FOB shipping point, `4,200.
9 Paid Subhas Company freight charges on merchandise purchased, `310.
10 Sold merchandise on credit to Jayant Company, terms 2/10, n/30, FOB shipping point, `8,600.
11 Paid Jyotirmoy Company for the purchase on September 1.
13 Received a cheque from Mrinal Company for September 3 sales after allowing for the merchandise
returned on September 7.
13 Issued credit note to Jayant Company for unsatisfactory merchandise returned, `200.
14 Paid Joy Company for the purchase on September 4.
15 Issued debit note to Shameek Company for unsatisfactory merchandise returned, `100.
18 Paid Shameek Company for the purchase on September 8 after allowing for the merchandise returned on
September 15.
27 Purchased merchandise on credit from Jyotirmoy Company, terms 2/10, n/30, FOB shipping point, `6,100.
29 Purchased a delivery van for office use on credit from Anand Company, terms n/30, `11,000.
30 Received a cheque from Jayant Company for September 10 sales after allowing for the merchandise
returned on September 13.
Required
Prepare general journal entries to record the transactions. Assume that Bijoy Company follows the periodic
inventory system and records purchases initially at gross purchase price.
The beginning and ending merchandise inventories were `23,100 and `46,900, respectively.
Required
1. Prepare a statement of profit and loss in functional form for the year ended
March 31, 20X8.
2. Comment on the performance of the business, pointing out the areas that
might have to be examined closely.
Required
1. Copy the trial balance into the Trial Balance columns of a worksheet and
complete the worksheet using the following information:
(a) Estimated depreciation on store equipment, `1,000.
(b) Ending office supplies inventory, `390.
(c) Store rent from April 1, 20X6 to September 30, 20X6 was paid at `900 per
month and rent for the following 12-month period was paid at `1,000 per
month in October 20X6.
(d) The current insurance policy was taken for one year from April 1, 20X6.
(e) Sales salaries accrued, `900.
(f) Estimated income tax, `5,000.
(g) Ending merchandise inventory, `23,100.
2. Prepare a statement of profit and loss in functional form for the company for
the year ended March 31, 20X7. The following expenses are to be considered
selling expenses: sales discounts; sales salaries expense; advertising
expense; delivery expense; store rent expense; and depreciation expense,
store equipment.
3. Prepare the closing entries.
Required
1. Copy the trial balance into the Trial Balance columns of a worksheet and
complete the worksheet using the following information:
(a) Estimated depreciation on store furniture, `1,000.
(b) Ending office supplies inventory, `730.
(c) Store rent at `300 per month paid on August 1, 20X5 for the following
twelve- month period.
(d) The current insurance policy was taken for one year from September 1,
20X4.
(e) Office salaries accrued, `100.
(f) Sales salaries accrued, 500.
(g) Unpaid advertisement, `900.
(h) Estimated income tax, `9,000.
(i) Ending merchandise inventory, `23,180.
2. Prepare a statement of profit and loss, a statement of retained earnings, and
a balance sheet for the store for the year ended August 31, 20X5.
3. Prepare the closing entries.
Raj established Alpha Trading Limited to deal in food grains and engaged in the following
transactions during the first month:
Feb. 1 Began business by investing cash in the company’s share capital, `40,000.
1 Paid six months’ store rent in advance, `12,000.
1 Paid premium on a one-year insurance policy, `3,600.
2 Purchased store equipment for cash, `18,000.
3 Purchased office supplies for cash, `3,700.
4 Purchased merchandise on credit from Shamlal Traders, terms 1/10, n/60, FOB shipping point, `9,000.
5 Paid Ibrahim Company freight on merchandise purchased, `860.
9 Sold merchandise on credit to Manoj Company, terms 1/10, n/60, FOB shipping point, `18,000.
10 Sold merchandise for cash, `11,600.
11 Issued debit note to Shamlal Traders for unsatisfactory merchandise returned, `300.
14 Paid Shamlal Traders for the purchase on February 4 after allowing for the merchandise returned on
February 11.
17 Issued credit note to Manoj Company for unsatisfactory merchandise returned, `1,000.
19 Received cheque from Manoj Company for February 9 sales after allowing for unsatisfactory merchandise
returned on February 17.
24 Purchased merchandise on credit from Nav Bharat Traders, terms 1/10, n/60, `19,000.
26 Paid electricity bill for the month, `240.
27 Paid store salaries, `1,200; office salaries, `500.
28 Paid dividend, `8,000.
Required
1. Prepare journal entries to record the transactions using the gross price
method.
2. Open the necessary ledger accounts and post the February journal entries.
3. Prepare a trial balance for February on a worksheet form and complete the
worksheet using the following information:
(a) Ending merchandise inventory, `18,400.
(b) Inventory of unused office supplies, `2,300.
(c) One month’s store rent has expired, `2,000.
(d) One month’s insurance has expired, `300.
(e) Estimated depreciation on store equipment, `150.
(f) Estimated income tax, `4,000.
4. Prepare the February statement of profit and loss, statement of retained
earnings, and balance sheet for February.
5. Prepare and post adjusting and closing entries for February.
6. Prepare a post-closing trial balance for February.
Business Decision Cases
Platinum Trends is a leader in branded jewellery. It started operations in 20X3. It sells its
products to dealers in major cities in the country. Jewellery is subject to changes in fashion
trends. The company bills the dealers on delivery of the products and recognizes revenue
immediately. Payment terms are “2/10, n/30”. All invoices are paid within the credit period and 15 per cent of
the payments are received within the discount period. The dealers manage to sell a significant portion of their
purchases and return the unsold products to the company. Sales return in the industry have ranged between 19
per cent and 26 per cent in the past five years. The following table gives the company’s sales and returns for the
past three years (March 31 fiscal year):
The dealers are allowed to return any unsold products throughout year. Over 70 per cent of the sales happen
in the festival season (September to January) and the remaining sales are spread almost evenly through the
year. The company accounts for sales returns during the year.
In June 20X8, Samir Jain, an analyst with Altus Securities, a reputable brokerage, questioned the company’s
accounting for sales returns in an equity research report titled “A Lacklustre Jewel: Dubious Accounting by
Platinum Trends”. Relevant extracts from the report are as follows:
Platinum Trends has consistently outperformed its industry peers. The company’s sales growth of over 18
per cent and margins of 50 per cent are significantly superior to the industry median of 12 per cent and 32
per cent, respectively. The company’s management is focused on the upper end of the market. Almost all of
the new products introduced in the last year have done well. We believe the company’s biggest strengths
are its strong brand, ingenious design, and a committed dealer network.
Even so, we have an issue with Platinum Trends’ accounting for sales returns. While the company accounts
for all actual returns, it does not account for returns that are probable as of the balance sheet date. What
this means is that products sold in a year may be returned in the following year, because they are no
longer the flavour of the season. This would increase the revenue in the year, of sale and reduce the
revenue in the year of return.
Industry trends suggest that sales returns exceed 20 per cent. Our view is that the company’s delay in
recognition of returns could result in overstatement of revenue and, what is worse, allow the company to
move its revenue from one period to another.
In view of the above, we recommend SELL on Platinum Trends’ shares.
The company has issued the following press release in response to the research report:
Platinum Trends is the industry leader in design, innovation, and branding and has received a number of
awards competing with international jewellers including Bulgari, Cartier, and Pomellato. Sales growth
and margins are consistently above the industry peers. The company’s shares have returned over 70 per
cent over the past three years (as against the NSE 500 return of 34 per cent) and are now a matter of pride
for its investors, much the same its products are for its customers. We are deeply disappointed by the
negative research report of Altus Securities.
The company recognizes revenue in accordance with the two major conditions in the accounting standards:
1.
The seller of goods has transferred to the buyer the significant risks and rewards of ownership of the
goods and the seller retains no effective control of the goods transferred to a degree usually associated
with ownership; and
2.
No significant uncertainty exists regarding the amount of the consideration that will be derived from
the sale of the goods.
The company has complied with both these conditions. While there is some probability that the goods may
be returned by our dealers, the amount of consideration is certain. Once the company sells the products,
the ownership passes to the dealers and the company has no control over the goods. Therefore, the
company cannot record return of such products. The company accounts for returns from its dealers
immediately and refunds the amounts promptly. In our view, accounting for expected returns, as
contrasted with actual returns, is fraught with risk. That kind of accounting would be based on estimation
and not on facts.
Required
1.
Evaluate the analyst’s comment and the company’s response on the company’s accounting for sales
returns.
2.
Develop an accounting policy for revenue recognition including sales returns.
Interpreting Financial Reports
Biocon Limited was founded by Kiran Mazumdar-Shaw in 1978 to manufacture enzymes. Over
the years, it has evolved into a high-profile biopharmaceutical enterprise. The company went
public in 2004. In 2012, the company reported revenue of `20.87 billion and net profit of `3.38
billion (2011: sales `18,576; net profit `3.40).
In its 2011 annual report, the chairman’s review talked about its “strategic partnership” with Pfizer as
follows:
The Biocon–Pfizer partnership is indeed a significant inflection point in our growth path. Our companies
bring together a winning combination of marketing, manufacturing, and research excellence which will
build a formidable global footprint in diabetes care.
Spurred by the success of our insulins, we entered into an exciting agreement with Pfizer to address a
large and lucrative global biosimilar insulin opportunity.
The most visible and high profile partnership that we recently announced was with the world’s leading
pharmaceutical company, Pfizer, to commercialize our insulins portfolio. Pfizer will have exclusive and a
few co-exclusive rights to commercialize these products globally, while Biocon will be responsible for the
clinical development, manufacture, and supply of these biosimilar insulin products. We firmly believe this
landmark partnership will drive considerable growth in the foreseeable future.
The Highlights section of the report described the terms of the agreement with Pfizer:
In October 2010, Biocon signed a definitive global agreement with Pfizer Inc., the world’s leading
biopharmaceutical company, for the worldwide commercialization of Biocon’s biosimilar versions of insulin
and insulin analog products. Pfizer will have exclusive rights to commercialize these products globally,
with certain exceptions, including co-exclusive rights for all of the products with Biocon in certain other
markets. Pfizer will also have coexclusive rights with existing Biocon licensees, with respect to some of the
products, primarily in a number of developing markets. Biocon will remain responsible for the clinical
development, manufacture, and supply of these biosimilar insulin products, as well as for regulatory
activities to secure their approval in various geographies. Biocon’s recombinant human insulin
formulations are approved in 27 countries in developing markets, and commercialized in 23, while glargine
has been launched in its first market, India.
Under the terms of the agreement, Pfizer will make upfront payments totaling $200 million. Biocon is also
eligible to receive development and regulatory milestone payments of up to $150 million and will receive
additional payments linked to Pfizer’s sales of its four insulin biosimilar products across global markets.
In March 2012, Biocon and Pfizer terminated the agreement. This is what the company’s chairman’s review had
to say in 2012:
The year under review also saw the dissolution of our global partnership for Biosimilar Insulin and Insulin
Analogs with pharma major, Pfizer. A change in priority within Pfizer’s biosimilars division led to a
preference for in house biosimilar programs that were perceived to deliver higher returns. This led the two
companies to reach an agreement for amicable parting of ways which was believed to be in best mutual
interest. In terms of business continuity, there will be minimal impact as Biocon will continue to develop
its programs for global registrations as per plan, utilizing the retained payments received from Pfizer. We
remain committed to our commercialization endeavour, albeit on a different path that will shift from a
single global partner to multiple regional alliances.
The benefit of licensing income to our PAT was sharply down to `390 million this fiscal from the
exceptional levels recorded last fiscal of `990 million. However, improvements elsewhere maintained total
PAT at near last year’s level. Going forward, our development expenses for Insulins program will be set off
against the retained payments we have received from Pfizer.
Note 41 to the 2012 financial statements described the accounting for the termination of the agreement as
follows:
In October 2010, Biocon and Pfizer entered into a global commercialization and supply agreement. Biocon
was responsible for the clinical development, clinical trials and other activities to secure regulatory
approval in various geographies. Pfizer had exclusive rights to commercialize Biocon’s biosimilar insulin
portfolio.
Pursuant to this agreement, Biocon received upfront payment and few milestone payments. Biocon had
significant obligations relating to clinical development and regulatory activities. Consequently amounts
received under the global commercialization and supply agreement were being recognized in the statement
of profit and loss under percentage completion method.
In March 2012, Biocon and Pfizer terminated the global commercialization and supply agreement due to
their individual priorities for their respective biosimilars businesses. Pursuant to the termination and
transition agreement, the exclusive rights to commercialize reverted to Biocon and Pfizer has no further
obligations to Biocon. Biocon is committed to the biosimilar insulins program and is continuing the
development/clinical trial activities on a global scale.
Biocon has evaluated the prevalent regulatory framework, industry practices, and ethics/governance
requirements relating to clinical trials/regulatory submissions already initiated under the global
commercialization agreement and has determined that it has continuing obligations to complete the
aforesaid clinical development and regulatory activities for the global markets. Accordingly, Biocon will
recognize the balance amount of `4,929 million (net of amounts incurred towards costs of fulfilling
contractual obligations) [included in Deferred revenue] received from Pfizer, in the consolidated statement
of profit and loss in future periods in line with costs to be incurred towards such clinical trial and
development activities.
The auditors, S.R. Batliboi Associates made the following comment on the company’s accounting for the
termination of the contract:
Without qualifying our opinion,
(a) we draw attention to note 41 in the consolidated financial statements regarding management’s
decision to defer recognition of amounts in the consolidated statement of profit and loss, pertaining to
payments received pursuant to the Termination and Transition Agreement entered into with a
customer for reasons as more fully discussed in the aforesaid note.
Espirito Santo Securities, a brokerage, questioned the company’s accounting and argued that the company
should have taken the amount of upfront fee as an exceptional item instead of deferring it to future periods
commenting that the accounting policy was “aggressive”. But Biocon refuted the charges stating that “the
accounting method followed in the case of fees received from Pfizer is in compliance with GAAP and appropriate
disclosures have been provided.” It mentioned that “the licensing agreement with Pfizer was not an outright
licensing deal, but a development licensing deal that mandated Biocon to incur development costs for obtaining
regulatory approvals.”6
Required
1.
2.
Evaluate Biocon’s accounting for the fee received from Pfizer.
What do you think of the brokerage’s view of the company’s accounting? Specifically, is Biocon’s
accounting “aggressive”?
3.
Comment on the auditor’s position on the matter.
Financial Analysis
Study the statement of profit and loss and balance sheet of a sample of BSE 500 companies.
Required
1.
2.
Analyze the components of these statements and classify them into categories.
List any items in the balance sheet that do not appear in the format specified in the Companies Act.
What do you think of the location of these items?
3.
Prepare a list of items and related amounts that appear in “other income” and “exceptional items”.
What do you learn from this information?
Study the statement of profit and loss and balance sheet of a sample of BSE 500 companies.
Required
1.
From the data available, attempt to determine the cost of goods sold, gross profit, operating expenses,
and net profit of the companies. List the problems in this exercise. State the assumptions you make
with reasons.
2.
Some Indian companies disclose the cost of goods sold, gross profit, operating expenses, and net profit
in their US GAAP or IFRS statements. Compare your results with these numbers and comment on
any differences.
3.
Prepare a report on your study explaining the relevance of what you learnt for the purpose of
analyzing and interpreting financial statements.
Answers to Test Your Understanding
4.1 With cash discount: 1. May 23; 2. February 10; 3. October 31; 4. August 10; 5. February 22. Without cash
discount: 1. June 12; 2. March 16; 3. December 29; 4. September 14; 5. April 13.
4.2 (a) Sold merchandise on credit, `12,000.
(b) Accepted merchandise returned by customer, `600.
(c) Collected amount due on invoice, `11,400.
(d) Sold merchandise on credit, `9,000.
(e) Collected amount due on invoice, `8,910, after allowing cash discount of `90.
4.3 This is a sale and repurchase transaction. In substance, there is no sale. Manohar Company should treat
the amount received as a loan and the difference of `1,800 between the sale and repurchase prices as
interest on the loan.
4.4 Equivalent annual rate of interest = {360/20}  {1/(100 – 1)} = 18.18 per cent. It is not attractive to borrow
at 26 per cent and “invest” at 18.18 per cent. So the discount should not be availed.
4.5 Cost of goods sold = `11,000 + `210,000 – `7,000 – `3,000 + `18,000 – `17,000 = `212,000.
1 Published financial statements of Indian companies do not usually disclose the cost of goods sold and
operating expenses. As a result, it is not possible to calculate some of the measures described in this chapter.
2 IAS 18:14/Ind AS 18:14/AS 9:10 and 9:11.
3 Chapters 8 and 9 explain the effective interest method.
4 The Companies Act 2013 uses the term profit and loss account, while Schedule III uses the term statement of
profit and loss.
5 IASB F.30.
6 Biocon looks for life beyond Pfizer, Business Line July 9, 2012.
Being able to read company annual reports is possibly the best reality check on your
accounting. Comprehensive Cases help you find out how well you have understood
the contents of annual reports. Solving the Comprehensive Cases involve finding
answers to a set of questions that cover the basics. Answering the questions will
increase your comfort with the annual report.
There are three Comprehensive Cases in this book that are based on the annual
report of Hindustan Unilever Limited, the consumer goods company. These Cases
help you understand the contents of the annual report in easy steps.
Having completed Chapters 1 to 4, you should be able to answer the following
questions:
What is accounting?
Who uses accounting information? What does he or she do with it?
How can we process transactions efficiently?
Why do we have accrual?
What are the main sections of the annual report? Who are the individuals or
agencies responsible for them?
What accounting principles do we apply to the items in the financial
statements?
STEP 1: Basics of Business, Financial Statements, and Accounting Systems
Business:
1. What is the company’s business?
2. What are its main products and services. Name some of the company’s brands.
3. Who are likely to be the company’s major suppliers? Does the company have
suppliers from abroad?
4. Who are likely to be the company’s major customers? Does the company export
its products? To which countries?
5. How many employees does it have? Why is this information important?
Annual Report:
6. Read the “Contents” page. Mark the items that relate to financial statements as
“FS” and the rest as “NFS”.
7. What information does the company provide in items that you have marked as
“NFS”? Is the information useful? How? Who is the intended audience? Will they
be able to understand the information?
8. When was the annual general meeting to be held? What were the items to be
discussed?
Financial Statements:
9. Identify the company’s reporting entities.
10. Locate the following financial statements: the statement of profit and loss, the
statement of retained earnings, the balance sheet, the cash flow statement, and
the statement of changes in equity.
11. List the company’s asset, liability, and equity items.
12. Verify that the financial statements satisfy the accounting equation.
13. How is the information in the notes to the financial statements useful? Give
five examples of how the notes explain the items in the financial statements.
14. Identify the matters covered by the accounting policies.
15. Where are the accounting measurement assumptions stated?
16. Who is responsible for the information in the financial statements?
17. Think of information that you think would be useful but not disclosed in the
financial statements. Why do you think the information is not disclosed?
18. Think of information not reported in the financial statements but would be
available internally.
Auditors:
19. Who are the company’s auditors?
20. Are they a member of a Big Four firm? If yes, which one?
21. Who appoints the auditors?
22. To whom is the auditors’ report addressed? Why?
23. List the main items on which the auditors report.
24. What is the auditors’ opinion on the financial statements?
25. Does the auditors’ report contain any recommendation to present and potential
investors?
26. How much was the auditors’ remuneration?
27. Did the auditors provide any non-audit services to the company? If yes, how
much was the payment for those services? Why is this information important?
Accounting Systems and Records:
28. What are the company’s major items of revenue? Where will the information
about revenues come from for preparing the financial statements?
29. What are its major items of expenses? Where will the information about
expenses come from for preparing the financial statements?
30. How would you assure yourself that the accounting system is reliable?
31. Prepare journal entries to record changes in the following items in the balance
sheet, assuming that the changes represent cash receipt or payment:
(a) Security deposits from distributors;
(b) Trade payables;
(c) Advances from customers;
(d) Purchase of buildings;
(e) Security deposits with government authorities; and
(f) Computer software.
32. Prepare journal entries to record the following items in the cash flow
statement:
(a) Income tax paid;
(b) Interest paid;
(c) Interest received;
(d) Dividend received;
(e) Purchase of current investments; and
(f) Dividend paid.
33. The company’s trial balance certainly balanced. Think of some errors that
could have occurred and how these might have been corrected.
STEP 2: Income Measurement
General:
1. The statement of profit and loss has more than one “profit” number. Why?
2. Give five examples each of accruals and deferrals in the financial statements.
3. Give five examples each of temporary accounts and permanent accounts in the
financial statements.
4. Give an example of an item that would qualify for reversing and illustrate how
it would be reversed using the information in the financial statements.
5. Prepare a diagram showing the flow of merchandise from the company to the
consumer.
6. Compare the company’s presentation of revenue, expenses, and profit with the
statement of profit and loss in Exhibit 4.1. How do they differ?
7. Identify the beginning and ending inventories.
Revenue:
8. Is the classification of revenue informative? Why or why not?
9. When does the company recognize sales revenue?
10. Identify the company’s gains and other non-operating income.
11. Locate any references to accounting principles related to revenues in the
financial statements and related information.
12. When does the company recognize revenue from services? Why?
13. When does the company recognize dividend income? Why?
14. How does the company treat trade discounts?
Expenses:
15. Is the classification of expenses informative? Explain.
16. When does the company recognize expenses?
17. Identify the company’s losses and other non-operating expenses.
18. Locate any references to accounting principles related to expenses in the
financial statements and related information.
19. Is it possible to calculate the cost of goods sold? What additional information
would you need?
20. How much was the freight on purchases?
21. What was the amount of purchases?
22. What was the total amount spent on employees?
23. How much did the company spend on advertising? As a percentage of revenue?
“Neutrality is important. There should be no attempt to tilt financial information one way or the other.”
Question: In India, proprietorships, partnerships, and other traditional forms of business
organization are more pervasive in production, consumption, employment, channelling
savings, and capital formation than listed companies are. Many listed companies are also
family-managed and/or family-controlled. How would India benefit from adopting the
IASB’s standards? What are the costs?
Answer: It is not just in India that non-corporate organizations play an important
role. In the US, 80 per cent of the employment is in small and medium enterprises
(SMEs). The situation is similar in much of Asia, Brazil, and elsewhere. I think
there are benefits to IFRS adoption for India, such as a lower cost of capital.
Question: India is planning to converge its national accounting standards with, rather than
adopt, IFRS. As a result, there may be carve-outs of accounting treatments in some
standards, some standards may be implemented with a lag, and a few standards may not be
implemented at all. What is the IASB’s experience with convergence in other countries?
Answer: Convergence rather than adoption would mean all the hard work that goes
with adoption, perhaps not all the benefits. If there are concerns, these could be
addressed by active participation at the front end of standard-setting. Early
discussions would bring up the issues in time. The Board values healthy dialogues
with constituents. Much of the world has fully adopted IFRS. That includes
Australia, Canada, and
New Zealand. Some countries, such as France, India, and Malaysia, have issues
with the agriculture standard, because of the fair value accounting requirement.
India, Korea, and possibly others have problems with foreign currency gains and
losses. As for Europe, in practice, it is adoption despite the carve-out on macrohedging.
Question: Fair value accounting that is the bedrock of IFRS came in for a lot of criticism
during the recent financial crisis. Some even argued that being pro-cyclical, fair value
accounting aggravated the crisis. What is your view?
Answer: Fair value is one of the tools. We should not ignore it. It appears that fair
value did not cause or aggravate the crisis. For example, a study of large banks by
Sanders Shaffers at the Federal Reserve Bank of Boston does not reveal a clear link
between fair value accounting, regulatory capital rules, pro-cyclicality, and financial
contagion. It appears to me that loan loss accounting based on incurred loss was the
problem, not fair value accounting.
Question: How successful has the IASB been in persuading the United States Securities and
Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) to move
to IFRS? What are the major problem areas?
Answer: We are bridging the gaps between the two. There are some lingering
differences. Take, for example, revenue. The 150 or so pronouncements in US GAAP
may be too many and the IASB’s two standards may be too few. There are
differences in leases and insurance. But we are progressing. The US authorities are
worried for losing control over standard-setting.
Question: There is a view in the accounting community in India that conservatism in
financial reporting coupled with the Reserve Bank of India’s prudential regulations
protected the country’s financial institutions from the financial crisis. For example, a Bear
Stearns or Lehman did not happen in India. But conservatism does not have a place in
IFRS. How would the IASB address Indian accountants’ concerns about moving to
neutrality from conservatism?
Answer: India does not have financial institutions or products similar to what the
West has. If you do not have Lehman-like financial institutions, there can be no
Lehman-like failures. Neutrality is most important, because different people have
different needs. So there should be no attempt to tilt financial information one way
or the other.
Question: During the financial crisis the IASB modified its fair value accounting
requirements in response to pressure from national governments in Europe. Does it mean
that accounting standard-setting cannot be an entirely technical activity?
Answer: It is inevitable for policymakers to ask whether the accounting standards
are good for them. It also happened in the US. As long as we live in a society, we are
not immune to the influence of larger forces. We need to strengthen the governance
of institutions. The IASB has learnt its lessons from the financial crisis.
Question: Auditors monitor compliance with IFRS and governments and securities
regulators are responsible for enforcement of financial reporting regulations. Given the
wide variation in the quality of auditing and enforcement across countries, how does the
IASB plan to improve comparability in the way the standards are applied?
Answer: We are not a regulatory body. Regulation is left to auditors and securities
regulators. We do not hold the silver bullet. Standards are building blocks. Will you
miss a building block? We expect everyone who comes to the party to behave in a
socially acceptable way. For the orchestra to perform, everyone has to play their
part well. IOSCO (International Organization of Securities Commissions) can do
something.
Question: Financial statements are getting longer and more difficult to read. Would it be a
good idea to ask companies to produce a simplified set of financial statements for use by
non-professional users?
Answer: Is the human body becoming more complex or is the science of medicine
exploring more conditions? It is not possible to reduce business to one or two lines.
That said, disclosure overload is an issue and is being addressed. The European
Financial Reporting Advisory Group (EFRAG) have taken up disclosure norms. The
New Zealand Institute of Accountants has also taken up this issue. It is fascinating
that in the financial crisis the view was that disclosure was inadequate. It is
important to make financial statements more accessible to users. Some answers are
being talked about. Can standard notes be put on the company website? Can there
be abbreviated financial statements? There is a lot of activity. I do not know when it
will come to fruition. Of late, FASB and the IASB are talking of disclosure
objectives.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Define internal control and explain the need for internal control systems.
Describe the features of a good internal control system.
Explain internal control procedures for cash receipts and payments.
Explain the importance of cash management.
Prepare a bank reconciliation and explain its purpose.
Define trade receivables and explain accounting for uncollectible accounts.
Estimate uncollectible accounts.
Record transactions in bills receivable.
Explain revenue recognition for construction contracts, franchises, and leases.
Describe pledging, assignment, and factoring of receivables.
Analyze the quality of receivables.
SATYAM’S TRUTH
One of Eric and Bill’s Bottom Liners comic strip says: “Remember, past performance is no
guarantee that there was actually any past performance.” On January 7, 2009, Ramalinga Raju,
the then chairman and managing director of Satyam Computer Services Limited stunned the
world by disclosing that he had manipulated the company’s financial statements for several
years. On that day, Satyam’s stock plunged to `40.25 at the National Stock Exchange, after
opening at `179, and touched a low of `6.30 on January 9, 2009, the next trading day. The
Sensex crashed seven per cent. As a news report put it, it was “a unique case of upheavals at a
single company pulling down the Indian stock market.”1
The total size of the manipulation was initially put at `70 billion. In the quarter ended
September 30, 2008, Satyam reported a revenue of `27 billion and an operating margin of `6.5
billion (24 per cent of revenue), as against the actual revenue of `21 billion and an operating
margin of `0.61 billion (3 per cent of revenue). This resulted in reporting fictitious cash of
nearly `6 billion in that quarter alone. Significantly, the company was listed in the New York
Stock Exchange (besides in India) and was audited by a member of PricewaterhouseCoopers, a
Big Four accounting firm. It had an impressive board of directors: its outside directors were
eminent individuals, including a retired Cabinet Secretary, the inventor of the Pentium chip, a
professor of accounting at an iconic US business school, a dean of a leading business school in
India, and a retired director of a top engineering school in India. Satyam had received accolades
and awards for corporate governance. Raju had appeared many times on magazine covers and
television programmes.
In a widely circulated statement, Raju said: “It was like riding a tiger, not knowing how to get
off without being eaten.” This is the key point about any accounting fraud: it is easy to start a
fraud but impossible to exit without being caught. A fraud often unravels in the wake of an
industry downturn, a family dispute, a disgruntled employee blowing the whistle, or a problem
with the political establishment. News reports and government documents suggest that there
were fictitious invoices and these were later shown as realized and represented by fictitious
bank balances. The Satyam trial is on.
THE CHAPTER IN A NUTSHELL
Financial accounting performs a custodial function by prescribing and monitoring systems for
control over an enterprise’s assets. In this chapter, you will appreciate the need for internal
control systems and identify the features of good systems. You will learn about devices
organizations use to maintain strict control over cash. Business organizations extend credit to
their customers. You will study the problem of accounting for uncollectible accounts and learn
how to estimate bad debts. You will learn about bills receivable, a widely used means for
extending credit. Finally, you will learn how to analyze the quality of a company’s trade
receivables from the information available in the financial statements.
Internal Control Systems
Assets such as cash and receivables are highly vulnerable to theft
and embezzlement. Sound internal control systems are necessary
to ensure protection of an enterprise’s assets. Effective control
systems have become critical for business success, given the rise
in white collar crime.
Definition
Internal control is “a process effected by an entity’s board of directors,
management, and other personnel, designed to provide reasonable assurance
regarding the achievement of objectives in the following categories:
1. Effectiveness and efficiency of operations;
2. Reliability of financial reporting; and
3. Compliance with applicable laws and regulations.”2
We note from the definition that internal control is a process, effected by people at
every level of an organization, can provide reasonable assurance, not absolute
assurance, to an entity’s management and board, and is geared to the achievement
of objectives in one or more separate but overlapping categories. An internal control
system extends beyond matters that relate directly to the functions of the
accounting system. Internal controls comprise accounting controls and
administrative controls, as illustrated in Exhibit 5.1.
In many cases, an administrative control is the starting point for establishing
accounting control. For example, a requirement that every employee must submit a
report describing the purpose and result of an official travel is related to the
accounting control for payment of official travel expense. In practice, some controls
may be meant for both managerial decision-making and custody of property. For
instance, a product cost classification may be used for recording the value of
inventories (an accounting matter), as also for product pricing (an administrative
matter).
Administrative controls span different functional areas and are dealt with in
courses in management accounting, production management, and marketing
management. Since the accountant is responsible for establishing systems for the
safeguarding of assets and the reliability of records, a study of the elements of
accounting controls is an important part of a course in financial accounting.
Features of a Good Internal Control System
A good internal control system is essential for prevention and early
detection of fraud. We will now see the features of a good internal
control system.
Separation of duties The organizational structure should provide
for the segregation of functional responsibilities. No individual should be
responsible for all phases of a transaction. Segregation of operations, custody, and
accounting significantly reduce the chances of fraud, since fraud would become more
difficult if two or more individuals have to collude.
In a sale transaction, one employee may enter the quantity of the item sold, a
second employee may input its price, and a third may post the invoice to the
customer’s ledger.
Authorizing and recording transactions
A competent official in the
organization must authorize transactions, preferably by signing or initialling a
document. Then the accounting department must record the transactions, by first
classifying them on the basis of a carefully devised scheme and then summarizing
them according to the classification. There are several mechanisms to verify the
correctness of the recording process. For example, preparation of a trial balance is a
check on the proper recording of debits and credits.
Sound administrative practices All major instructions and procedures should
be in writing. Many organizations have manuals that describe the procedures to be
followed by employees in carrying out their duties. They lay down the standards of
work and specify the responsibilities of individual managers. Also, they prepare
budgets and circulate them to key managers.
Sound personnel policies Reliable and competent personnel are fundamental to
the success of a control system. The organization should verify past experience cited
in job applications and investigate significant gaps in experience. At times, it may
turn out that a candidate was serving a jail sentence during an unexplained gap in
employment. Mass recruitment is risky, because it does not allow for proper preemployment screening. Wherever necessary, an organization should engage the
services of specialist investigation agencies. (In fact, some organizations employ
detectives to verify the background of selected candidates.) There should be
periodical rotation of employees on different jobs and regular supervision of their
work. Many organizations require employees in key positions to take vacation every
year in order to let them have a well-deserved break as well as to find out what they
were doing. Fidelity bonds insure the company against employee theft.
Internal audit Human ingenuity is inexhaustible. Dishonest employees find out
ways of defrauding the organization despite the existence of many controls. The
organization should always be alert to possibilities of embezzlements, frauds, and
errors. Managers should regularly investigate the systems they are working with.
Internal auditors are not directly involved in operations and they should perform
regular reviews of internal control systems. They can evaluate both the overall
efficiency of operations and the effectiveness of the internal control system.
According to an Ernst & Young survey,
41 per cent of respondents said that they employed internal audit to detect fraud.3
The Companies Act 2013 requires companies to appoint an internal auditor, who
shall be a CA or a cost accountant.
Code of conduct and ethics policy Well-managed companies have a written code
of conduct and ethics policy manual that every employee must strictly follow. These
deal with a number of financial and non-financial matters. A Deloitte survey of
banks suggests that 73 per cent of respondents have implemented an employee code
of conduct.4 A few companies, e.g. Tata Steel, have appointed ethics counsellors to
implement the code of conduct throughout the organization.
Whistle-blowing A whistle-blower is a person who informs on person or
organization engaged in illegal activities. Increasingly, whistle-blowing is
recognized as an important method of fraud detection. The existence of a strong
whistle-blowing mechanism is also useful in deterring fraud. In a survey of Indian
managers by PricewaterhouseCoopers, 71 per cent of respondents confirmed having
a formal whistle-blowing mechanism in place and 97 per cent of the respondents’
organizations allowed anonymity of the complainant.5 In some countries including
the US and the UK, whistle-blowers get legal protection and financial rewards. For
example, the Dodd-Frank Wall Street Reform and Consumer Protection Act
provides for payments in some cases to whistle-blowers. The Stock Exchange
Listing Agreement in India requires listed companies to have a whistle-blower
policy to report concerns about unethical behaviour, actual or suspected fraud or
violation of the company’s code of conduct or ethics policy and to protect whistleblowers against victimization. Whistle-blowers may also have direct access to the
chairman of the audit committee in exceptional cases.
The company’s senior management sets the standards of ethical conduct. An
Ernst & Young survey of Indian managers suggests that “weak tone at the top” is a
major factor facilitating bribery and corruption.6 Ethical conduct has become an
important consideration in investment evaluation after the Satyam scandal.
Besides, there are specific laws in some countries prohibiting payment of bribes. For
example, the US Foreign Corrupt Practices Act 1977 prohibits all US persons and
US-listed foreign companies from payment of bribes (variously known as
“kickbacks”, “facilitation payments” and “speed money”). The UK Bribery Act 2010
has made the following criminal offences: bribing another, being bribed, bribing a
foreign official, and, for commercial organizations, failing to prevent bribery. The
UK Act prohibits bribery in both the public and the private sectors. In comparison,
the Indian Prevention of Corruption Act 1988 is narrow in scope (it applies only to
bribing a “public servant”, i.e. someone who holds a position in government) and
even more weak in enforcement. Certainly, it has not prevented bribery in the
country. India’s corruption rank (least corrupt = 1, most corrupt = 194) is 94,
according to a report.7 Another report states that in India political parties scored
highest on the perceived level of corruption among a set of 12 major institutions.8
Internal Control in a Computer Environment
Business organizations use computers in their operations including controlling
production, managing inventory levels, maintaining accounting records, and
generating financial reports. They can perform complex operations at great speed
with an extremely high degree of accuracy. From a control standpoint, the computer
brings with it a host of problems and questions. The accountant should be fully
aware of them. Frauds that would have necessitated the collusion of several
employees can be perpetrated in a computer environment by a couple of employees
without much difficulty. There are numerous horror stories of computer frauds.
According to the KPMG India Fraud Survey 2012, 53 of respondents identified
cyber crime as the top fraud concern for the future.
Given its tremendous capabilities, as also its considerable potential for fraud, it is
not difficult to understand why the computer looks like an angel and a devil at the
same time. The features of a good internal control system described earlier are
equally relevant in a computer environment. In addition, periodic audit of a
company’s information systems by a qualified information systems auditor, such as
a Certified Information Systems Auditor (CISA) from the Information System Audit
and Control Association, is necessary.
Internal Control and the External Auditor
The external auditor has a keen interest in a company’s internal control system. He
has no personal knowledge of the transactions recorded in the company’s books. So
he has to rely on the soundness of the internal control system in carrying out the
audit to be able to assure the users of financial statements that the statements are
free from material errors and frauds. The quality of a company’s internal control
would have a bearing on the auditor’s selection of audit procedures as well as his
deciding on the extent of testing. Some organizations explicitly recognize the
external auditors’ interest in the internal control system and involve them actively
while initiating new procedures or changing existing procedures. The Companies
Act 2013 requires external auditors to report whether the company has adequate
internal financial controls in place and whether the controls are effective in
operation.
Board of Directors, Independent Directors, and Audit Committee
The board of directors approves the company’s financial statements. The report of
the board to the shareholders must include a directors’ responsibility statement
(DRS). The DRS shall state that:
(a) the applicable accounting standards have been followed along with proper
explanation relating to material departures;
(b) the directors have selected such accounting policies and applied them
consistently and made judgments and estimates that are reasonable and
prudent;
(c) the directors have taken proper and sufficient care for the maintenance of
adequate accounting records for safeguarding the assets of the company and for
preventing and detecting fraud and other irregularities;
(d) the directors have prepared the financial statements on a going concern basis;
(e) the directors, in the case of a listed company, have laid down internal financial
controls to be followed by the company and that such internal financial controls
are adequate and were operating effectively; and
(f) the directors have devised proper systems to ensure compliance with the
provisions of all applicable laws and that such systems were adequate and were
operating effectively.
Independent directors and audit committee are important mechanisms to monitor
the functioning of the board of directors. Independent directors are part-time
directors who do not have any business or financial relationship with the company.
The purpose of the audit committee, a committee of the board of directors, is to
ensure that the directors act in the interests of the shareholders. The
responsibilities of the audit committee are, among others, to monitor the integrity of
the financial statements of the company and review the company’s internal
financial control and risk management systems. The audit committee recommends
the appointment and remuneration of auditors and reviews and monitors the
auditor’s independence and the performance and effectiveness of the audit process.
Internal Control for Cash
The amount of cash is often small relative to the size of a business.
Even so, most organizations pay greater attention to control of cash
than to items such as inventories and property, plant, and
equipment items. The reason is that cash, being the most liquid
asset, is susceptible to embezzlement, theft, fraud, and defalcation than other
assets. An employee can walk away with the company’s cash, but taking away
physical items is not that easy. In fact, handling cash can prove to be the severest
test of integrity for employees experiencing financial troubles. The organization
should maintain strict control over cash receipts and payments. A system of
internal control for cash should provide for protection of both cash receipts and cash
disbursements. Wherever possible, duties involving the control of cash should be
separated so that cash cannot be stolen without the collusion of two or more
employees.
Control over Cash Receipts
Cash receipts consist of cash over-the-counter for sales and cash in the form of
cheques, bank drafts, and bank transfers. All cash receipts should be recorded
immediately upon receipt to prevent errors and frauds. An official receipt is issued
for every remittance received by a business.
Control over Cash Disbursements
Most large embezzlements are effected through payment of fictitious invoices. Cash
should be paid only on the basis of specific authorization supported by documents
evidencing the validity and amount of the claim. All the relevant documents
supporting the claim are put together in a voucher and the procedure for control of
disbursements is, therefore, referred to as the voucher system. In addition,
maximum possible use should be made of the principle of separation of duties in the
purchase of goods and services and the payments made for them.
The internal control plan requires the involvement of seven agencies in a
purchase transaction. These are the user department, the purchase department, the
accounting department, the receiving department, the cash office, the supplier, and
the bank. Besides, every action is documented and subject to verification by another
department.
We will use a simple illustration to explain the voucher system. Suppose that
Vinay Motor Company needs 200 car tyres. The manager of the company’s service
department prepares a purchase requisition (Exhibit 5.2) for 200 car tyres and
sends it to the purchasing department. Thereafter, the purchasing department
places a purchase order (Exhibit 5.3) on a supplier. The purchase order describes
the items ordered and specifies the price, shipping instructions, packing, and
payment terms. Copies of the purchase order go simultaneously to the accounting
department, with a copy of the purchase requisition, for arranging payment.
The supplier ships the tyres to Vinay Motor Company and sends an invoice. The
form of the invoice is similar to that in Figure 4.2. The supplier sends the invoice
directly to the accounting department of Vinay Motor Company requesting
payment. The goods are delivered to the receiving department of Vinay Motor
Company. When the shipment arrives, the receiving department counts the goods
and checks them for damage and agreement with the purchase order. Then, it
prepares a receiving report and sends a copy of this report to the accounting
department for arranging payment. After the receiving report arrives, the
accounting department compares the invoice with the purchase order. If everything
is in order, it approves the invoice for payment and prepares a voucher that
contains the three supporting documents. The payment voucher (Exhibit 5.4)
specifies the account to be debited and the net amount payable to the supplier. The
accounting department sends the voucher to the cash office for payment shortly
before it is due. In some systems, another person (sometimes called auditor) reviews
the voucher once again. The cash office prepares the cheque for the amount shown
on the voucher and forwards it to the supplier with a remittance advice showing
details of the payment and a pre-printed acknowledgement to be completed by the
supplier.
Figure 5.1 summarizes the general internal control plan for payment of supplier
invoices. The procedure described above is also followed in the case of other bills,
such as those relating to office supplies, stores supplies, and services, with minor
modifications.
Cash and Cash Equivalents
Cash consists of coins and currency, cheques, money orders, and
money on deposit in bank, including deposits in current or savings
accounts and time deposits. Cash includes any item that banks
will accept for immediate deposit; thus, post-dated cheques are not cash. Cash
equivalents are “short-term, highly liquid investments, that are readily
convertible to known amounts of cash and which are subject to an insignificant risk
of changes in value.”9 Generally, an investment qualifies as a cash equivalent only
when it has a short maturity of, say, three months or less from the date of
acquisition. Treasury bills, certificates of deposit, commercial paper, and money
market deposits are examples of cash equivalents.
The objectives of cash management are as follows:
1.
2.
3.
4.
Ensuring that cash needs are well planned;
Establishing independent accountability for cash collections;
Ensuring recording of all payments; and
Protecting cash resources from theft and embezzlement.
Liquidity refers to the ease with which an asset can be converted into other
assets, or used to buy services or satisfy obligations. Clearly, cash is the most liquid
asset. Every business must own some cash so that bills for purchases and operating
expenses can be paid on time and emergency needs can be met.
We note that there is an insignificant amount kept in the form of cash (i.e. notes
and coins) for making certain kinds of payments. HUL can withdraw the balance in
a current account any time, but can withdraw the balance in a deposit account only
after the term of the deposit. Banks pay interest on deposit accounts, but not on
current accounts. In 2013, HUL held the bulk of its surplus cash in deposits (91 per
cent). Relative to 2012, HUL appeared to prefer deposits to short-term investments,
probably because of the better returns from deposits. Deposits for terms exceeding
three months constituted a major portion of the deposits, because they offer higher
interest rates than very short-term (three months or less) deposits. So you can see
how the company tries to balance the conflicting demands of liquidity and
profitability: keep some money in current accounts and very short-term deposits for
paying employees, suppliers, and taxes but the bulk in short-term deposits for
earning some return.
Business must often make relatively small payments for items such as postage,
local travel, minor repairs, and cleaning of premises. If such payments are made by
cheque, numerous cheques would have to be written. Besides, cash payments are
required when some parties would not accept cheques. Under the imprest system,
a fixed cash advance is given and is periodically replenished for expenses incurred
during a period. To enable such payments most companies establish a petty cash
fund for disbursing small cash amounts.
Bank Reconciliation
The extensive use of banking arrangements is an important step
in controlling cash transactions. Most organizations require each
day’s cash receipts to be deposited intact into a bank account and
all disbursements to be made by cheque or bank transfer. The
bank’s records of deposits received and cheques paid provide a check on the internal
cash records of the business. Almost every business has one or more current
accounts. The bank sends the customer a monthly statement detailing the activity
that has taken place in the account. The bank statement shows the beginning
balance, deposits, cheques paid, and other transactions during the month, and the
ending balance. Exhibit 5.5 shows a bank statement.
Preparing a Bank Reconciliation
The balance on a bank statement, or balance per bank, rarely agrees with the
balance in the customer’s records, or balance per book. This happens, because the
bank has not carried out some transactions of the customer, or the customer has not
recorded some items appearing in the bank statement, or both. The constituent,
banking term for customer, prepares a bank reconciliation to explain the
difference between the two balances. The following are the most common reasons
for the difference:
The steps to be followed in preparing a bank reconciliation are:
Step 1. Compare the deposits listed on the bank statement with the deposits shown
in the customer’s records. Add any deposits not recorded by the bank to the
balance per bank.
Step 2. Compare the paid cheques listed on the bank statement with the cheques
shown in the customer’s records. Deduct cheques issued but not yet presented to
the bank from the balance per bank.
Step 3. Add any credit advices for bills receivable collected, interest, and other items
to the balance per book.
Step 4. Deduct any debit advices for service charges, interest, and other items from
the balance per book.
Step 5. Identify any errors in the bank statement and/or customer’s records and add
or deduct the related amounts to the balance per bank or per book, as
appropriate.
Step 6. Confirm that the adjusted book balance is equal to the adjusted bank
balance.
Illustration Suppose that Vinay Motor Company’s records show a balance of
`7,699 on June 30. Suppose further that by applying the procedures described above
we find the following differences:
(a) Cheque # 5483 for `1,900 dated June 27 deposited on June 30 has not been
collected.
(b) Cheques issued and recorded by Vinay Motor but not yet presented to the bank
for payment are as follows:
(c) A credit advice states that the bank collected a bill receivable for `900 together
with interest of `12.
(d) Cheque # 2112 was recorded in the company’s records incorrectly as `5,481.
(e) A credit advice states that the bank credited interest of `87.
(f) A debit advice states that the bank levied quarterly service charge of `130.
Exhibit 5.6 presents the bank reconciliation for Vinay Motor on June 30, 20XX.
We use the serial numbers above as reference.
Note that the adjusted balance of `8,631 is different from both the balance per bank
and the balance per book.
Adjusting and correcting the accounting records after reconciliation After
the bank records the cheque under collection and pays the outstanding cheques, its
records will show `8,631. However, Vinay Motor must record journal entries for
certain items in order to reconcile the cash balance to the correct amount. The
required entries are as follows:
Bank reconciliation when the bank balance is overdrawn When a customer
has issued cheques on the bank for more amount than the balance in its account
and the bank pays these cheques, it is a case of overdraft. Either the customer’s
records or the bank statement or both may indicate an overdraft. In that event,
follow the above procedure for preparing bank reconciliation, but show the overdraft
amount with a minus sign.
Trade Receivables
Trade receivables are short-term assets that arise from the sale
of merchandise or services on credit. Manufacturers, wholesalers,
and retailers allow their customers some time to pay after the date
of sale. Economic growth depends, in part, on the availability of
credit for purchases by individuals as well as business enterprises.
Advanced and sophisticated economies are characterized by a high percentage of
credit sales. At the retail level, there has been a major increase in credit. With the
rise of consumerism, many Indians are shedding their traditional debt shyness.
“Buy now, pay later” seems to be the new slogan of consumerist India. The use of
credit cards, also called plastic money, is on the rise. Consumer finance is available
for buying a wide range of goods. Besides, home loans are quite common. The rapid
rise in consumer credit has overshadowed the even greater use of credit by
manufacturers and wholesalers.
Experience has shown that extending credit can increase revenue and net profit
significantly for many businesses. Of course, the additional profit generated from
credit sales should exceed the additional expenses incurred in extending credit.
These expenses include interest, credit investigation and rating of customers,
additional record-keeping, and uncollectible amounts. Inadequate control over
receivables is often a major cause of business failure. Therefore, business
enterprises are keen to ensure that they sell to customers who will pay on time. The
credit department investigates customers’ credit standing. It asks for information
on customers’ financial resources (including audited financial statements, where
appropriate) and other information to determine whether they will be willing and
able to pay. In addition, the credit department often obtains a report from a
reputable credit rating agency.
In this chapter, we consider short-term receivables, i.e. amounts receivable in not
more than one year. We discuss accounting for amounts receivable over longer
periods, e.g. a five-year loan, in Chapter 8.
Uncollectible Accounts
Regardless of how diligently the credit department investigates customers, some
customers will not pay. These are known as uncollectible accounts, or bad
debts. Uncollectible accounts may arise due to several factors, such as errors in
judgment of credit department personnel, unexpected financial problems of
customers, and a downturn in general economic conditions resulting in an increase
in business failures. Some amount of uncollectible accounts is an inevitable cost of
doing business on credit, since not giving credit may result in loss of business in a
competitive market.
A basic rule of measuring business income is the matching principle that requires
expenses to be matched with the revenue earned during a period. Bad debt losses
are a part of the costs of doing business on credit and must be recognized in the
period in which the revenue from credit sales is recognized. These differ from other
expenses in that it is difficult to determine the time at which a receivable actually
becomes uncollectible. A customer may not pay an invoice on the due date, but it
does not mean that he will not pay. He may be experiencing a temporary cash
problem or, as it happens sometimes, may have simply forgotten to pay. Bad debts
pertaining to a reporting period may not be known until later. Since business
organizations must prepare periodic financial statements, they must estimate the
bad debt expense.
To illustrate, let us assume that Sanjay Company made credit sales in the amount
of `20,000 in the first year of operation and collected `14,000 during the year. The
trade receivables at the end of the year amounted to `6,000. Suppose the company
estimates that accounts totalling `900 may become uncollectible. It would record
the following adjusting entry at the end of that year:
Estimating Bad Debt Expense
Accountants estimate uncollectible accounts on the basis of the
company’s past experience, general economic conditions, and
current payment trends. The aim is to produce a reasonable
estimate of the amount of trade receivables expected to be
eventually realized. Since the process of estimation involves considerable personal
judgment, it is possible to produce a number of estimates that range from “highly
pessimistic” to “highly optimistic”. As a matter of prudence, accountants frequently
tend to estimate the amount at the upper end of the reasonable range so as to
produce a relatively low value for trade receivables and a conservative net profit
figure. The relevant adjusting entry is recorded after the company’s management
approves the accountant’s estimate. Two methods are used to develop the estimates:
the percentage of receivables method and the percentage of sales method.
Percentage of receivables method Here, the enterprise estimates uncollectible
accounts as a percentage of trade receivables appearing on its balance sheet. It may
prepare an estimate based on a flat percentage of trade receivables at the year end.
It is more common to prepare an ageing schedule that classifies trade receivables
by age of the invoices that remain unpaid after the expiry of the credit period. For
example, an invoice that remains unpaid 26 days after the credit period would
appear in the column titled 1–30 days. Exhibit 5.7 presents a standard ageing
analysis.
As a receivable gets older, the probability that it will be uncollectible increases
(“out of sight, out of mind”). An analysis of the past accounting records will
generally show the approximate percentage of trade receivables in each age
category that will become uncollectible. The enterprise reviews these percentages
periodically and revises them, when appropriate. Exhibit 5.8 gives the percentages
of uncollectible accounts in the various age categories derived from past records. We
apply these percentages to the amounts of trade receivables in Exhibit 5.7. The last
column of Exhibit 5.8 shows the estimated amount of uncollectible accounts for each
age category and the total estimated uncollectible accounts.
The required balance in the Provision for Doubtful Debts as on March 31, 20X8 is
`10,231. Suppose that a provision of `2,812 is available. We must recognize bad
debt expense of `7,419, as follows:
After posting the adjusting entry, the general ledger accounts would appear as
follows:
By focusing on the amount of receivables, the percentage of receivables method
takes a balance sheet approach to the problem of estimation of uncollectible
accounts.
Ageing of trade receivables is useful in many ways apart from aiding in
calculation of required provision for uncollectible accounts. For example, credit
controllers find the ageing analysis of trade receivables handy in identifying
customers who have delayed payments and in deciding on the line of action to be
taken. Auditors use the ageing analysis to see if the provision for uncollectible
accounts is adequate.
Percentage of sales method In this method, the enterprise estimates
uncollectible accounts as a percentage of the “net credit sales” of a reporting
period.10 In this method we ask: How much of this year’s net credit sales is expected
to be not collected? It is appropriate if there is a predictable percentage relationship
between the amount of bad debts and the amount of net credit sales.
To illustrate, assume that Sanjay Company had the following net credit sales and
uncollectible accounts relating to those sales in the last three years:
The average rate of uncollectible accounts to net credit sales over the three-year
period is: 1,400/70,000 = 0.02.
Suppose Sanjay Company’s net credit sales for Year 4 are `32,000. The amount of
provision for doubtful debts for the year would be `640, i.e. 0.02  `32,000. The
company would record the following adjusting entry at the end of Year 4:
By focusing on the amount of sales, the percentage of sales method takes an
income statement approach to the problem of estimation of uncollectible accounts.
The enterprise should review the estimate periodically and revise the percentage in
light of changes in collection trends. Some would argue that the percentage of sales
method leads to a better matching of revenues and expenses by recognizing
estimated uncollectible accounts in the same period in which the credit sales are
recognized.
A bad debt loss is an impairment in the value of a receivable. Under current rules,
an incurred loss is recognized, but an expected loss is not to be recognized. Taking a
‘haircut’ of sales or receivables (“day-one credit loss”) goes against the prohibition of
recognizing an impairment loss on initial recognition of a financial asset.11 The
percentage of sales method follows an expected loss approach and is, therefore, not
acceptable.12
Writing off Uncollectible Accounts
When it is clear that a specific customer account is uncollectible, the enterprise
writes off the account balance by debiting Provision for Doubtful Debts and
crediting Trade Receivables. The specific customer account in the trade receivables
ledger also gets a credit. For example, suppose that Bala (one of the customers
appearing in Exhibit 5.7) becomes insolvent on July 3, 20X8 and Sanjay Company
determines that the receivable of `480 is uncollectible. The following entry records
the write-off:
Note that we record the write-off in Provision for Doubtful Debts, not in Bad Debt
Expense. This is because we have already recognized an estimated bad debt
expense. After posting the write-off entry, the general ledger accounts would appear
as follows:
The entry reduces the balances in the asset account (trade receivables) and the
contra-asset account (provision for doubtful debts) accounts by the same amount. As
a result, the estimated realizable value of trade receivables after the write-off is the
same as that before the write-off:
Recovery of Uncollectible Accounts
Sometimes, a customer may pay after a write-off. We record the payment by
preparing two entries. The first entry reverses the write-off to the extent of the
payment, and the second entry is the usual entry to record receipt of cash from
customer.
To illustrate, assume that on May 12, 20X9 Sanjay Company receives a cheque for
`200 from Bala’s insolvency administrator. The following pair of entries records this
transaction:
Some enterprises credit bad debt recoveries to Miscellaneous Income. Such a
procedure is not appropriate since it omits information on subsequent payment by
the customer. The information is useful in making future credit-granting decisions
about the customer. However, under the direct write-off method (explained below),
recovery of a write-off is treated as miscellaneous income.
The Direct Write-off Method
Some companies use the direct write-off method under which they charge an
account to expense at the time of determining it to be uncollectible. The journal
entry involves a debit to Bad Debt Expense and a credit to Trade Receivables. Since
the direct write-off method does not result in proper matching of revenues and
expenses, it is not generally accepted. It may be used when credit sales are
insignificant and occasional. In such a case, any uncollectible accounts will be small
and, therefore, immaterial in relation to total revenue and net profit. For example,
assume that Minu Company determines that an amount of `520 to be uncollectible
on September 23. The following adjusting entry records the write-off:
Bills Receivable
A bill of exchange, or simply a bill, is an instrument in writing
containing an unconditional order in writing signed by the maker
directing a certain person to pay on demand, or at a fixed or
determinable future time, a certain sum of money to, or to the
order of, a certain person, or to the bearer of the instrument. Businesses use bills in
credit sales to facilitate smooth flow of money. Bills can be transferred with ease
and the law provides simpler rules of evidence for bills in a dispute. Consequently,
it is easier to realize bills than trade receivables. Also, bills are self-liquidating in
that, once a bill falls due for payment, the payment procedure is almost automatic
and the buyer’s bank pays the bill routinely. That is why businessmen prefer bills to
open customer accounts. The Negotiable Instruments Act 1881 lays down the law on
bills, cheques, and promissory notes.13
A bill involves the following transactions:
Drawing The drawer (seller) draws up the bill, signs it, and addresses it to
the drawee (buyer) for acceptance.14 Interest may or may not be payable.
Acceptance The drawee conveys his assent to the bill and becomes the
acceptor. He should pay the holder of the bill.
Presentation for payment by drawer The drawer can retain the bill. On
the due date, the drawer presents the bill to the acceptor for payment. If the
acceptor pays, he honours the bill. If not he dishonours the bill. In the latter
case, the drawer gets a certificate from a notary public noting and protesting
the dishonour. The acceptor is legally bound to pay the amount due, i.e. the
amount of the bill, any interest, and noting and protesting fee.
Discounting Before the due date, the drawer (endorser) can transfer the bill
to another person (endorsee). This is discounting the bill. Before the due date,
an endorsee can further endorse the bill.
Presentation for payment by endorsee On the due date, the last endorsee
– the holder – presents the bill to the acceptor for payment. If the acceptor
does not pay, the holder gets a certificate from a notary public noting and
protesting the dishonour. The endorsee collects the amount due from its
endorser. In a similar fashion, every endorsee collects the amount due from
its endorser and the bill traces its way back to the drawer who pays its
endorsee and collects the amount due from the acceptor. Figure 5.2 illustrates
these transactions.
Receiving a Bill
To illustrate the recording of transactions in bills receivable, suppose that on
September 3, Vibha Company sells goods on credit to S. Krishna for `10,000 and
draws a 12 per cent, 90-day bill on him for `10,000. S. Krishna accepts and returns
the bill the same day. Vibha Company is the drawer as well as the payee. S.
Krishna is the acceptor. It is a bill receivable to Vibha Company and a bill
payable to S. Krishna. Figure 5.3 shows the bill.
On receipt of the accepted bill, Vibha Company records the following entry:
Computing Interest
The amount printed on the bill is its face value or the principal and the amount
due is the maturity value. The maturity value of a bill is the sum of its face value
plus any interest. Interest rates are normally stated in terms of a period of one year.
Interest should be computed for the period stated in days or months in the bill. For
convenience, we shall assume that a year comprises 360 days. Interest is computed
using the formula:
Interest = Principal  Rate  Time
The interest on our bill is `300, computed as: `10,000  12%  90/360. So the
maturity value of the bill is `10,300.
Determining Maturity Date
The date on which a bill falls due for payment is the maturity date.15 The
maturity date of our bill is computed as follows:
Collecting a Bill
On December 2, when Vibha Company receives the principal plus interest from S.
Krishna, the entry is as follows:
Dishonouring a Bill
If the acceptor fails to pay at maturity, the dishonoured bill should be removed from
Bills Receivable and recorded in Trade Receivables. We debit Trade Receivables in
the general ledger and the acceptor’s account in the trade receivables ledger. The
drawer must get the fact of dishonour recorded by a notary public. The notary
certifies the dishonour and sends the acceptor a notice of protest. The acceptor is
legally obliged to pay the notary’s protest fee, together with the maturity value of
the bill.
Suppose that S. Krishna did not pay the bill on maturity. The following entry
records the dishonour dishonour and a protest fee of `50:
We credit Bills Receivable, irrespective of whether the bill is honoured or not. This
is because a bill ceases to be a bill on its maturity. The Bills Receivable account
should, therefore, comprise only those bills that have not yet fallen due for payment.
Some accountants do not favour recognition of interest on dishonoured bills on the
ground that interest may not be realized. Mere dishonour does not mean that the
account is uncollectible. However, the accountant would keep in mind the dishonour
of the bill while deciding on the amount of provision for doubtful debts. Failing to
recognize the interest is not an appropriate course.
Discounting a Bill
A bill receivable may be easily converted into cash before the due date. This often
happens because the holder (the drawer or an endorsee) needs cash and cannot wait
until maturity of the bill. Discounting a bill involves selling it to a bank or to some
other buyer (usually a finance company) with recourse to the holder. When a bill is
discounted, the holder endorses and delivers the bill to the bank in exchange for
cash. The bank deducts in advance an interest charge called discount from the
maturity value and pays the holder the balance, called proceeds. The discount is
the bank’s finance charge for the period from the date of discounting to the date of
maturity of the bill. This period is known as the discount period.
To illustrate, assume that on October 3, Vibha Company discounted the bill at the
bank at 15 per cent. We calculate the discount period as follows:
We compute the proceeds as follows:
Vibha Company records the discounting as follows:
If the proceeds are less than the face value, we debit the difference to interest
expense. For example, suppose that the bank discounts the bill at 18 per cent. The
amount of discount would be `309, calculated as follows:
Discount = `10,300  18% 
= `309
The transaction would be recorded as follows:
Contingent liability The endorser of a discounted bill receivable is contingently
liable for payment of the bill. This means that the endorser (Vibha Company, in our
example) must pay the bank if the acceptor (S. Krishna) dishonours the bill. If the
acceptor pays the bill, the contingent liability ends. If the acceptor defaults, the
contingent liability becomes an actual liability. On the balance sheet date, the
endorser is contingently liable for all the bills receivable discounted by him, which
have not yet matured. Financial reporting rules require disclosure of the nature and
amount of any contingent liability. Accordingly, the contingent liability for current
bills receivable discounted must be disclosed. Chapter 9 discusses contingent
liabilities.
Dishonouring a discounted bill If the acceptor pays a discounted bill on the
maturity date, the drawer or any subsequent endorser does not record any journal
entries. If the acceptor defaults on the bill, the drawer or other endorser is required
to pay the endorsee (often a bank). In the latter case, the bank should follow the
procedure of noting and protesting. Every endorser is liable to pay his endorsee. The
dishonoured bill will finally trace its way back to the drawer who can collect the
amount from the acceptor. To illustrate, assume that S. Krishna dishonoured the
bill and the bank sent Vibha Company a notice of protest and levied a protest fee of
`50. Vibha Company will pay the bank `10,350 and record the following entry:
End of period adjustment for interest income Interest income accrues on a
day-to-day basis, but usually is only recorded at the bill’s maturity date. If, however,
the bill is outstanding at the end of a reporting period, accrued interest should be
computed and recorded to recognize the interest earned. For example, assume
Vibha Company’s reporting period ends on September 30. The following entry
records accrued interest for 27 days (the number of days held in September as
calculated in determining the maturity date) on the bill:16
The following entry records the collection of the bill on December 2:
This entry eliminates the bill and interest receivable and recognizes `210 of
interest for the 63 days the bill was held in the current reporting period.17
Revenue from Construction Contracts, Franchises, and Leases
Accounting for receivables and revenue recognition are closely
related. In Chapters 3 and 4, we have seen the basic principles of
revenue recognition and some special cases such as bill and hold
sales, conditional sales, and lay away sales. We will now see
revenue recognition for construction contracts, franchises, and
leases that involve special considerations.
Construction Contracts
A construction contract is “a contract specifically negotiated for the construction
of an asset or a combination of assets that are closely interrelated or interdependent
in terms of their design, technology, and function or their ultimate purpose or
use.”18 Long-term construction contracts differ from sales of goods in that the
revenue-earning process in these contracts is usually spread over several financial
years. Examples include contracts for construction of bridges, tunnels, dams, ships,
aircraft, buildings, and complex pieces of equipment.
We follow the percentage of completion method for construction contracts.
Under this method, contract revenue and contract costs are recognized by reference
to the stage of completion of the contract activity at the end of the reporting
period.19 The advantage of this method is that it reflects revenues and costs in
periods in which the related economic activity occurs. When the outcome of a
contract can be estimated reliably, the percentage of completion method should be
used. Otherwise, the contract revenue should be recognized only to the extent of
costs incurred which are expected to be recovered. When it is probable that the total
contract costs will exceed the total contract revenue, the expected loss is recognized
as an expense immediately.
Suppose that Ace Construction Company enters into a contract for construction of
a bridge in 20X7 at a fixed price of `2,500,000. The details of the progress of the
contract are as follows:
In 20X7, Ace Construction should report a gross profit of `155,000, calculated as
follows: revenue, `775,000 – costs, `620,000. The gross profit would be `181,000 in
20X8 and `84,000 in 20X9. You should verify these numbers to make sure that you
understand the method. If, as a result of uncertainties, Ace Construction cannot
estimate the percentage of completion reliably, it will not recognize any revenue or
profit in either 20X7 or 20X8. In 20X9, it will recognize the entire revenue and
profit on completion of the contract.
Franchises
A franchise is a contractual arrangement under which the franchiser grants the
franchisee the right to manufacture or sell certain products or services, to use
certain trademarks, or to perform certain functions, usually within an agreed area.
The franchiser protects his unique concept or product through a patent, copyright or
trademark. NIIT, Holiday Inn, and McDonald’s are examples of some popular
franchises. Franchising has been growing rapidly in India in recent years.
Franchisers derive their revenue from two sources:
1. Sale of initial franchises; and
2. Continuing franchise operations.
The initial franchise fee may be recorded as revenue only when the franchiser
makes substantial performance of the service he is obliged to provide, i.e. when the
franchiser has no obligation to refund any cash received and has performed all the
initial services required under the contract. Initial services provided by the
franchiser usually cover assistance in site selection and acquisition of plant and
display signs. Continuing franchise fees may be recognized as revenue when the
franchiser earns the right to receive them.
Leases
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.”20 Shortage of capital, attractive tax incentives, and easy availability have
made leasing a booming industry in India and abroad. The substance of the leasing
arrangement determines the accounting by lessors for lease rentals and profit.
An operating lease is a rental arrangement under which the lessor provides an
asset to a lessee, but does not transfer the risks and rewards of ownership of the
asset. In India, operating leasing is yet to assume significant proportions and is
currently limited to providing cars and equipment, such as photocopiers. The lessor
has to depreciate the asset on operating lease in accordance with its normal
depreciation policy for similar assets and recognize rentals as revenue on a
systematic basis representing the pattern of the earnings process implicit in the
lease. A straight-line basis may be appropriate in many cases. Estimating the
residual value is an important task in accounting for an asset on operating lease.
A finance lease is a lease “that transfers substantially all the risks and rewards
incidental to ownership of an asset.”21 The lessor (usually a leasing company)
transfers the risks and rewards of ownership of an asset to the lessee. A finance
lease is usually non-cancellable for a specified period and secures for the lessor the
recovery of his capital outlay plus a return for the funds invested. Finance leasing
is, in substance, a financing arrangement. The income from it should, therefore, be
recognized in proportion to the amount outstanding from the lessee. Usually, the
residual value of a leased asset in a finance lease will not be significant.
Sales-type leases are entered into by manufacturers and dealers who use
leasing as a means of promoting their products. Unlike a finance lease, in a salestype lease, the lessor has to account for the profit on sale. Otherwise, accounting is
similar in both these leases.
We will discuss lessee accounting in Chapter 9.
Pledging, Assignment, and Factoring
Sometimes, the seller needs cash and cannot wait until the end of
the credit period for the buyer to pay. The seller can pledge, assign
or factor the receivables and raise cash.
Pledging and Assignment
Pledging is an agreement for using receivables as security for a loan. The lender
makes the loan on the basis of his relationship with the borrower and the overall
quality of the receivables. Assignment is an arrangement for a formal transfer of
the receivables to the lender. Usually, the lender investigates the quality of the
receivables and identifies the specific receivables to be assigned. In both cases, the
buyer whose account has been pledged does not know about this event and will
continue to pay the seller, as usual. The seller must repay the loan, whether or not
the buyer pays the seller on the due date. Pledging and assignment have no effect
on accounting for receivables. In its financial statements, the borrower continues to
present the receivables as his assets and the loan as a liability and discloses the fact
that the receivables have been pledged or assigned. Any prepaid finance charge is
expensed over the borrowing period.
To illustrate, assume that Ganesh Company assigns `100,000 of trade receivables
with the National Bank. The bank levies a finance charge of 2 per cent of the
amount of trade receivables. Ganesh Company would record the transaction as
follows:
Ganesh Company does not remove the trade receivables; instead, it recognizes a
liability. Since the company retains the risks and rewards of ownership of the
receivables, it includes both the trade receivables and the borrowing in its balance
sheet. Further, the company records a discount of `2,000 which is a prepaid charge
and will be expensed over the borrowing period.
Factoring
Factoring is transfer of receivables without recourse. The factor, i.e. the party who
buys the receivables, assumes the risk of uncollectible accounts and absorbs any bad
debts. The transaction involves derecognition, the process of removal of the
receivables from the seller’s balance sheet. The lender retains a portion of the
receivables. This is known as a holdback and is intended to cover unexpected sales
returns and allowances. The difference between the amount of trade receivables and
the amount realized is a loss on sale of trade receivables.
Suppose, in the above illustration, Ganesh Company factors `100,000 of trade
receivables with Standard Factors on a without-recourse basis. The factor levies a
finance charge of 2 per cent of the amount of trade receivables and retains an
amount equal to 5 per cent of the trade receivables. Ganesh Company would record
the transaction as follows:
Ganesh Company will record a loss of `2,000 in statement of profit and loss for
the current reporting period.
Note that, in the above case, Ganesh Company removes the trade receivables
since it does not retain the risks and rewards of ownership of the receivables. This
follows from the requirement that for derecognition there should be “a transfer of
the contractual rights to receive the cash flows of the financial asset”.22
Financial Analysis of Receivables
Financial ratios are relationships between two or more variables
appearing in financial statements. Investors, lenders, and
managers compute a number of financial ratios to evaluate the
financial performance of a firm. In assessing the liquidity of a
business, managers and lending officers are particularly concerned with the
collectibility of a company’s trade receivables. To evaluate the age and realizability
of a company’s trade and bills receivables, they compute some ratios from the
financial statements. The average collection period (also known as days sales
outstanding or DSO) is perhaps the best overall measure of the quality of a
company’s trade receivables. It is computed as follows:
The average collection period of 85 days means that the customers of Mega
Company took, on average, 85 days to pay their invoices. If the company’s standard
credit period is 60 days, it would appear that the customers delayed payments by 25
days. Possible reasons for delay may include a recession in the economy, poor credit
rating of customers, and laxity in collection.
The management often compares a company’s average collection period with its
past experience and with the collection period in the industry. Ideally, the ratio
should be computed using credit sales in the denominator. Since financial
statements do not give the break-up of total sales into cash and credit sales, we
have to use the total sales. If the ratio of credit sales to total sales remains more or
less unchanged over time, the comparison of average collection period from one
period to another will not be affected much.
Looking Back
Define internal control and explain the need for internal control systems Internal control is
designed to provide reasonable assurance regarding the achievement of objectives in effectiveness and
efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations.
Describe the features of a good internal control system A good internal control system includes
separation of duties, authorizing and recording transactions, sound administrative practices, sound
personnel policies, and regular internal audit. An effective board, truly independent directors and an active
audit committee can strengthen the control environment.
Explain internal control procedures for cash receipts and payments An enterprise should record all
cash receipts immediately and pay cash only on the basis of specific authorization supported by a voucher.
Explain the importance of cash management Cash is the most liquid asset since it can be easily
converted into other assets or used to buy services or satisfy obligations. Keeping excessive cash is not
advisable.
Prepare a bank reconciliation and explain its purpose A bank reconciliation explains the difference
between the cash balance appearing on the bank statement and the balance according to an enterprise’s
records.
Define trade receivables and explain accounting for uncollectible accounts Trade receivables arise
from the sale of merchandise or services on credit. Being a part of the cost of doing business on credit, bad
debt expense must be recognized in the period in which the revenues from credit sales are recognized.
Estimate uncollectible accounts The percentage of sales method estimates uncollectible accounts as a
percentage of the net credit sales of a reporting period. The percentage of receivables method estimates
uncollectible accounts as a percentage of trade receivables appearing on a firm’s balance sheet.
Record transactions in bills receivable The following are the typical transactions in bills receivable:
receiving a bill receivable after acceptance; collecting a bill on maturity; discounting a bill; dishonouring a
bill; accruing interest.
Explain revenue recognition for construction contracts, franchises, and leases The percentage of
completion method recognizes revenue by reference to the stage of completion of the contract activity.
Initial franchise fee may be recorded as revenue only when the franchiser makes substantial performance of the
service it is obliged to provide; continuing franchise fees are recognized as revenue when the franchiser earns
the right to receive them. Rentals from operating lease are recognized usually on a straight-line basis. Income
from finance lease is recognized in proportion to the amount outstanding from the lessee.
Describe pledging, assignment, and factoring of receivables Pledging and assignment of receivables
involve raising a loan with the receivables as collateral. In factoring, a business transfers its trade
receivables outright to a finance company without recourse. The purpose of all three is to get cash from a credit
sale faster rather than wait until the end of the credit period.
Analyze the quality of receivables The average collection period is a popular measure of the quality of
receivables and indicates the speed with which a business converts its receivables into cash. We can
compare a company’s average collection period with its past experience and with that of other firms in the
industry.
Review Problem
Akshay Company’s March 31 balance sheet contained the following information relating to receivables:
The following transactions took place in April:
Apr. 3 Sold merchandise to Ram and accepted a 12 per cent, 90-day bill in the amount of `10,000.
8 Wrote off the `1,600 balance receivable from Vimal.
18 Discounted at State Bank the bill received from Ram on April 3 at 14 per cent.
21 Unexpectedly received a cheque for `920 from Jagannath. The amount had been written off last
September.
24 Accepted a 12 per cent, 90-day, `5,000 bill in settlement of the past-due account receivable of Manoj.
29 Received payment from Jyoti on her 12 per cent, 30-day bill of March 30 in the amount of `3,000.
Required
1. Prepare journal entries in the general journal to record the above
transactions.
2. Suppose it is decided to keep a balance of `18,700 in the provision for
doubtful debts account. Prepare the journal entry to adjust the provision.
Solution
2. Journal entry to adjust the provision for doubtful debts:
To recognize the bad debt expense (`18,700 – `16,620)23
ASSIGNMENT MATERIAL
Questions
1. Cash forms a small part of the assets of most organizations. Then why do
organizations pay so much attention to controlling cash?
2. Are certificates of deposit classified as cash? Why?
3. Distinguish between accounting control and administrative control.
4. Why should the cashier not be allowed to maintain the customers ledger?
5. “A good internal control system is an assurance that no error or fraud is
possible.” Comment.
6. Although the computer is faster and more accurate than the human brain,
frauds are more easily perpetrated in a computer environment. Do you
agree?
7. What is a voucher? List some of the documents that you would expect to see
in a voucher for purchase of goods.
8. Why is a bank reconciliation prepared?
9. Why do companies sell on credit though some customers do not pay?
10. Distinguish between the percentage of receivables and the percentage of sales
methods.
11. Why should bills receivable discounted but not yet matured be shown as a
contingent liability?
12. When is the percentage of completion method inappropriate?
13. “A factor is a financier and an insurer rolled into one.” Do you agree?
14. Can the chief buyer be allowed to look after the goods receiving function?
Problem Set A
Required
Compute the cash balance to be reported on Shiny Company’s August 31 balance sheet. Prepare, if necessary,
journal entries for the company.
Prepare an ageing analysis of the trade receivables under the following age categories: Not yet due; 1–30 days
past due; 31–60 days past due; 61–90 days past due; 91–120 days past due; over 120 days past due.
Required
Determine the amount of revenue that Win Company should recognize in each of the years under the
percentage of completion method.
Problem Set B
The November 30 bank statement of Veekay Company disclosed a balance of `6,311. On
this date, the company’s records showed a bank balance of `3,961. Your review reveals the
following:
(a) Cheques under collection on November 30, `1,910.
(b) Outstanding cheques, `784.
(c) The cash deposit of `4,780 on November 11 was recorded by the bank as `4,708.
(d) A bill receivable of `4,000 and interest of `200 were collected by the bank but have not been recorded in
the company’s accounts.
(e) A cheque for `490 received from a customer bounced and came with the bank statement.
(f) The bank levied a service charge of `135.
(g) A cheque for `7,825 paid on November 18 was recorded by the bank as `7,852.
Required
1. Prepare a bank reconciliation for Veekay Company for November.
2. Prepare any journal entries necessary for the company as at November 30.
3. Determine the cash balance that Veekay Company would report on the
November 30 balance sheet.
The following information is available from the accounting records of the company:
Due to a cheque preparation error, cheque number 603 was cancelled. The following items appeared in the
bank reconciliation on March 31: Outstanding cheque, cheque number 594 dated March 18, `983; cheque under
collection, `690. On April 30, the bank debited service charge of `60, and credited `618 on collection of a threemonth bill receivable of `600 with interest at 12 per cent per annum. The debit of `1,180 in the bank statement
on April 27 relates to the dishonour of the cheque received from Mayur deposited on April 23.
Required
1. Prepare bank reconciliation for Arun Company for April.
2. Prepare adjusting entries, where necessary, in the general journal.
3. Determine the cash balance that Arun Company would report on the April
30 balance sheet.
During the month, the following transactions took place:
1.
2.
3.
4.
5.
Sales on account, `328,000.
Sales returns and allowances on credit sales, `4,300.
Collections from customers, `372,900.
Accounts written off as uncollectible, `9,720.
Uncollectible account unexpectedly collected, `1,870.
Based on the company’s past experience, uncollectible accounts are estimated at 2 per cent of net credit sales.
Required
1. Prepare journal entries to record each of the five items summarized above.
2. Prepare the journal entry to adjust the provision for doubtful debts.
3. Post the entries to the Trade Receivables account and the Provision for
Doubtful Debts account.
4. Show how trade receivables and provision for doubtful debts would appear
on the March 31 balance sheet.
The following information is taken from the accounting records of Jaykay Company on
December 31 (year end):
The company uses the percentage of receivables method to estimate bad debts. Based on its analysis of
customers’ accounts on December 31 and past experience with collections, the company estimates the following
percentages of trade receivables to be uncollectible in the various age categories:
Required
1. Calculate the amount that should appear in the December 31 balance sheet
as the provision for doubtful debts.
2. Prepare the general journal entry to record the bad debt expense for the
year.
3. Post the journal entry to the Provision for Doubtful Debts account and show
the account after posting this entry.
4. On February 16 of the following year, Jaykay Company decided to write off a
receivable of `4,200. What effect will this have on: (a) the company’s net
profit for that year; and (b) estimated net realizable value of its trade
receivables?
Required
Prepare general journal entries to record the above transactions, assuming that Bhandari Company used the
provision method of accounting for uncollectible accounts. Show interest computations and round off to the
nearest rupee.
Problem Set C
The April 30 bank statement for Binoy Company showed a balance of `6,874. On this date,
the bank balance in the company’s ledger was `2,994. Your review reveals the following:
Cheques under collection on April 30, `298.
Outstanding cheques, `1,718.
A cheque for `2,194 issued to a supplier was recorded by the bank as `2,914.
A bill receivable of `5,000 and interest of `300 collected by the bank have
not been recorded in the company’s accounts.
5. A cheque for `730 received from a customer was returned by the bank owing
to lack of funds with the bank.
6. Bank service charges, `90.
7. In accordance with the company’s standing instruction, on April 23 the bank
paid insurance premium of `1,300 for the company’s car.
1.
2.
3.
4.
Required
1. Prepare a bank reconciliation for Binoy Company for April.
2. Prepare any journal entries necessary for the company as at April 30.
3. Determine the cash balance that Binoy Company would report on the April
30 balance sheet.
The following information is available from the accounting records of the company:
Balance on November 30: `16,722
Balance on December 31: `25,134.
Due to a cheque preparation error, cheque number 330 was cancelled. The following items appeared in the
bank reconciliation on November 30: Outstanding cheque, cheque number 316 dated November 17, `749; cheque
under collection, `2,100. On December 31, the bank debited service charge of `95, and credited `721 on
collection of a three-month bill receivable of `700 with interest at 12 per cent per annum. The amount in cheque
number 326 was entered as `967, which was duly paid by the bank.
Required
1. Prepare bank reconciliation for Bala Company for December.
2. Prepare adjusting entries, where necessary, in the general journal.
3. Determine the cash balance that Bala Company would report on the
December 31 balance sheet.
During the month, the following transactions took place:
1.
2.
3.
4.
5.
Sales on account, `697,200.
Sales returns and allowances on credit sales, `9,700.
Collections from customers, `412,200.
Accounts written off as uncollectible, `8,280.
Uncollectible account unexpectedly collected, `930.
Based on the company’s past experience, uncollectible accounts are estimated at 3 per cent of net credit sales.
Required
1. Prepare journal entries to record each of the five items summarized above.
2. Prepare the journal entry to adjust the provision for doubtful debts.
3. Post the entries to the Trade Receivables account and the Provision for
Doubtful Debts account.
4. Show how trade receivables and provision for doubtful debts would appear
on the September 30 balance sheet.
The following information is taken from the accounting records of Harinder Company as at
March 31 (year end):
The company uses the percentage of receivables method to estimate bad debts. Based on its analysis of
customers’ accounts as at March 31 and past experience with collections, the company estimates the following
percentages of trade receivables to be uncollectible in the various age categories:
Required
1. Calculate the amount that should appear in the March 31 balance sheet as
the provision for doubtful debts.
2. Prepare the general journal entry to record the bad debt expense for the
year.
3. Post the journal entry to the Provision for Doubtful Debts account and show
the account after posting this entry.
4. On April 19 of the following year, Harinder Company decided to write off a
receivable of `3,290. What effect will this have on: (a) the company’s net
profit for that year; and (b) the estimated net realizable value of its trade
receivables?
Required
Prepare general journal entries to record the above transactions, assuming that Samyukt Company uses the
provision method of accounting for uncollectible accounts. Show interest computations and round to the nearest
rupee.
Business Decision Cases
Shyam set up Baron Company in 20X2 to sell a wide range of home appliances. Sales rose from
`113,000 in the first year to `978,500. Initially, the emphasis was on cash sales and credit was
given only in exceptional cases. Shyam quickly realized that he was losing business, because
other dealers in home appliances were offering credit varying from 30 days to 90 days. From 20X2 onwards, he
too began to offer credit for 30 days. As a result, the company’s 20X3 sales rose sharply to `328,000, credit sales
accounting for 70 per cent. In later years, the percentage of sales on credit steadily increased as most customers
preferred to pay later, all the more so since the credit was interest-free.
Soon Shyam started experiencing uncollectible accounts which jumped from `1,240 in 20X3 to `28,160 in
20X6. However, as a matter of prudence, he has been setting aside a provision for doubtful debts equal to 5 per
cent of credit sales. Information relating to sales, provision, and trade receivables from the time the company
was set up is given in the following table:
From the accounting year ending 31 March 20X7, Shyam has decided to base the company’s provision for
doubtful debts on the ageing analysis of trade receivables, since he believes this approach would result in a more
scientific valuation of trade receivables. The company’s accountant has prepared the following ageing analysis
and estimate of uncollectible accounts:
Required
1. Prepare a schedule explaining the changes in the Provision for Doubtful
Debts account from the company’s inception to March 31, 20X6.
2. Prepare the journal entry to record the bad debt expense for the year ending
March 31, 20X6.
3. Show how trade receivables and provision for doubtful debts would appear
on Baron Company’s balance sheet as at March 31, 20X6.
4. Why do you think Baron Company changed the method of providing for
uncollectible debts? What disclosure, if any, about accounting for trade
receivables is required in the company’s financial statements for the year
ending March 31, 20X6? How will the change affect the company’s income
tax expense?
Dhillon Sports Company, based in Jalandhar, manufactures a variety of sports goods.
Sometime ago, it was troubled by a severe cash crunch, because of a shortage of bank
credit. The company considered several alternatives for improving its liquidity. Finally, it
accepted the offer from Punjab Factors to buy its trade receivables on the following terms:
1. Punjab Factors will assess a finance charge of 4 per cent of trade receivables.
2. Punjab Factors will retain 5 per cent of the amount of trade receivables to
cover sales discounts, allowances, and returns.
3. Dhillon Sports will handle any returned goods, claims, and allowances for
defective supplies.
4. Punjab Factors will handle the sales discounts, but charge the cost of such
discounts to Dhillon Sports and absorb any bad debts.
On April 1, Dhillon Sports transferred trade receivables of `600,000 to Punjab Factors. During April, Punjab
Factors collected trade receivables of `435,000; sales returns and allowances were `7,400; sales discounts were
`4,300; it wrote off uncollectible accounts of `7,200. On May 1, Dhillon Sports and Punjab Factors made a final
cash settlement.
Required
1. Prepare the journal entries to record the transactions in the books of Dhillon
Sports Company, assuming that the firm’s accounting year ends on April 30.
2. How will the effect of the transfer of the trade receivables to Punjab Factors
appear on Dhillon Sports Company’s balance sheet as at April 30?
3. Dhillon Sports had received another offer for credit on the security of its
trade receivables at an interest rate of 30 per cent per annum. The offer was
rejected by the firm’s finance manager who felt that it was too costly. Should
the company have accepted the offer? Describe the factors you would
consider relevant in comparing the two offers.
Interpreting Financial Reports
On September 14, 2011, Kweku Mawuli Adoboli, a trader working in the London-based
Delta One desk of the Swiss investment bank UBS AG (“UBS”), went home from office and
sent a “bombshell email” confessing to booking false trades. He was quickly called back for
many hours of questioning by the bank and its lawyers. On September 15, he was arrested
for fraud and false accounting – dishonesty that exposed the bank to unhedged risks and
resulted in loss of $2.3 billion, a record unauthorized trading loss in Britain. The 32-yearold worked for UBS’s Global Synthetic Equities (GSE) division, buying and selling exchange traded funds (ETF),
which track stocks and commodities. Adoboli was charged with abusing his position to expose UBS to risk of
loss. The charges related to the periods between October 2008 and December 2009 and from January to
September 2011. UBS learnt of the unauthorized trades after Adoboli informed the bank of his actions. The
following is a summary of the charges:
Count 1: False accounting: Falsified records between October 1, 2008 and June 1, 2011 in relation to ETF
transactions in order to conceal the exposure of UBS to risk and/or the true profit and loss.
Count 2: False accounting: Falsified records between October 1, 2008 and June 1, 2011, other than in Count 1,
in relation to ETF transactions by entering and/or holding a zero notional/cash only trade(s) in order to
conceal profit or loss.
Count 3: Fraud by abuse of position: Committed fraud between October 1, 2008 and June 1, 2011, while
occupying a position of trust as a senior trader with GSE in which he was expected to safeguard or not to
act against the financial interests of UBS Bank.
Count 4: False accounting: Falsified records between May 31, 2011 and September 15, 2011 in relation to ETF
transactions in order to conceal the exposure of UBS to risk and/or the true profit and loss.
Count 5: False accounting: Falsified records between May 31, 2011 and September 15, 2011, other than in Count
4, in relation to ETF transactions by entering and/or holding a zero notional/cash only trade(s) in order to
conceal profit or loss.
Count 6: Fraud by abuse of position: Committed fraud between May 31, 2011 and September 17, 2011, while
occupying a position of trust as a senior trader with GSE in which he was expected to safeguard the
financial interests of UBS by causing losses to UBS Bank calculated at $2.2502 billion dollars.
The ETF desk was originally part of the Global Equities division and was supervised by a senior, Londonbased trader. In April 2011, the ETF desk was transferred to GSE, a new business sector. GSE had been formed
in early 2011, when UBS restructured its existing Global Equities business sectors. The desk’s new supervisor
within GSE was based in New York. While plans for him to relocate to London later in 2011 were underway, no
arrangements for local supervision of the Desk in the interim period were put in place. There was no concrete
hand-over of responsibilities between the Desk’s old and new supervisors. There were four traders on the ETF
desk. The desk’s mandate permitted client and proprietary trading in certain cash equity products. Trading for
the bank’s own account (“proprietary trading”) was chiefly undertaken by the two most senior traders (one of
whom was Adoboli), who also undertook client trading. The two junior traders mainly undertook client trading.
The desk was subject to net delta limits, which represented the maximum level of risk that the desk could enter
into at any given time unless specifically authorized to do otherwise. The intended intraday net delta limit was
$50 million, while the overnight net delta limit was $25 million. These limits were increased in April 2011 when
the desk moved to GSE, to $100 million and $50 million respectively. The desk’s trading mandate and risk
limits were not formally documented at desk level, but were instead communicated to the traders verbally.
News of the loss pushed UBS’s stock down 8.5 per cent. The bank said that no client positions were affected,
implying that the trading was proprietary. The fraud revelations added to the woes of UBS, which was already
facing charges of facilitating tax evasion by its clients in the US and involved in the LIBOR manipulation
scandal. The discovery was especially frustrating for chief executive Oswald Grübel, who was brought in to fix
the bank after it lost $50 billion in bad mortgage loans in the financial crisis.
Adoboli, the son of a retired United Nations official, was born in Ghana and educated in Britain. He worked
in the back office before becoming an ETF trader. He was identified as a future leader for UBS’s elite Ascent
programme. His salary jumped from £95,000 in 2007 to £370,000 in 2010. He made a $400,000 loss on a trade in
2008, but hid the loss rather than tell his manager about it. Profits were held off the books and later drip-fed
back to offset the ETF desk’s losses, a mechanism called “umbrella”. By 2009 and 2010, Adoboli’s scheme was
going well and the umbrella’s $40 million profit gave him confidence to do bigger trades. His activities did not
ring alarm bells in the bank at the time. He claimed in his trial that his colleagues on the ETF desk and others
in the back office knew of his activities and turned a blind eye to his breaching of risk limits so long as he was
making profits.
In the trial Adoboli said he made the losses of $2.3 billion in three phases:
Between June 23 and June 30, 2011 Adoboli created a short position betting the markets would fall,
and masked his unhedged real trades with a fictitious long position. While UBS believed its reported
risk on June 24 was $53 million, it was said to be $147 million. On June 23, Adoboli was praised by his
new line manager, John DiBacco for making $6 million of profit in one day – a record for the bank. Soon
after he sent an email pulling him up for not asking for permission to exceed risk limit. By late June he
was under huge pressure from senior managers and traders to abandon his bearish view of the markets
and take a long position.
In the market sell-off his losses accelerated in July and peaked at $11.8 billion on August 8, at a time
when the bank believed its exposure was $2.3 billion. Because of his stress he said he “just went a bit
catatonic” and split up with his girlfriend.
He took another short position between August 11 and September 13 using ETFs with extended
settlement dates, but there were losses and his risk exposure remained static at about $7 billion. By
August the back office was chasing Adoboli for discrepancies in his reporting. William Steward, a back
office accountant at UBS, had been alerted to a gap of $3.57 billion when the books did not balance.
On November 20, 2012, the London Southwark Crown Court convicted Adoboli of two counts (count 3 and
count 6) of fraud by abuse of position but acquitted him on four counts of false accounting. The court sentenced
him to seven years’ imprisonment. On November 25, 2012, the UK regulator Financial Services Authority (FSA)
imposed a fine of £29.7 million (after a 30 per cent discount for early-stage settlement) on UBS for “failing to
take reasonable care to organize and control its affairs responsibly and effectively, with adequate risk
management systems” and “failing to conduct its business from the London Branch with due skill, care and
diligence”. On November 21, 2012, the Swiss regulator FINMA reprimanded UBS for “severe violation of its
obligation to assure fit and proper conduct of its business operations”, directed UBS to appoint an independent
third party to report on the bank’s strengthening of its risk management and control capability, and required
the appointment of a third party to ensure operational effectiveness of controls against unauthorized trading.
The UK regulator noted that UBS failed to:
(i) adequately supervise the GSE business with due skill, care and diligence;
(ii) put adequate systems and controls in place to detect the unauthorized trading in a timely manner; and
(iii) have adequate focus on risk management systems and to sufficiently escalate or take sufficient action in
respect of identified risk management issues.
The accounting firm KPMG, appointed by UBS at the request of the FSA and FINMA to conduct an
investigation into the circumstances surrounding the loss, found that the following strategies were used to
conceal the unauthorized trading in the trade capture systems:
(i) The Front Office risk system allowed internal futures trades to be booked to a generic counterparty of
‘internal’ and did not require an automatic mirror trade or identification of the particular counterparty.
(ii) Genuine external trades were booked into the futures settlement system but were late in being booked
into the Front Office risk system which allowed manipulation of the profit and loss.
(iii) There was no automatic filter in the trade inputs systems which identified off market or large notional
transactions and the amendment of a price in the Front Office risk system did not alter the price in the
Front Office deal capture system.
The investigation found that Front Office supervision was inadequate, with reported desk limits breaches not
adequately acted upon by line management and that the back office function teams relevant to the desk
demonstrated a lack of capability to effectively identify, challenge and escalate significant and sustained control
issues. In sum, the three standard lines of defence – (a) the supervision and control of the trading desk within
the Front Office and the verification and settlement of trades, undertaken by the Operations Division, (b)
specific risk control tasks within the Finance, Risk and Compliance Divisions, and (c) the Group Internal Audit
undertaken by UBS – failed.
FINMA, the Swiss regulator, noted a number problems with the bank’s control environment and reward and
recognition systems. Relationships between supervisors and the traders on the desk were characterized by too
much trust and not enough discipline and control. Risk limit breaches brought to the attention of the desk’s
supervisor were not investigated, or disciplinary action taken. Product Control accepted the significant
increases in the desk’s proprietary trading revenues without performing any satisfactory analysis. Issues such
as persistent and mis-booked trades, trades with huge notional values, and frequent and material reconciliation
breaks were not brought to the attention of senior Operations and Product Control management, or to the desk’s
supervisors in the Front Office. Despite several breaches of the bank’s compliance policies relating to personal
account dealing and spread betting, and despite a reputation for poor adherence to control standards, Adoboli
was highly remunerated and had been chosen to participate in a highly selective internal scheme for talented
employees. This financial and non-financial recognition provided implicit incentives for risk-seeking behaviour.
Required
1. Describe the operations of the Delta One trading desk focusing on the bank’s
control system.
2. What do you understand by Adoboli’s “unauthorized trading”? What were
the breaches in the controls? How did Adoboli manage to breach them? Why
were the breaches not detected before Adoboli’s confession?
3. The judge said in his sentencing remarks:
The tragedy for you is that you had everything going for you. Your father was in a responsible position
which enabled you to be educated at a private school. I am not saying that you come from a privileged
background, but you had some advantages that other people do not enjoy. In addition, you had your
own natural talents. You are highly intelligent. You are plainly very articulate. And as I told the jury,
you appear to have a considerable amount of charm. Your fall from grace as a result of these
convictions is spectacular.
Then, why did Adoboli do the wrong thing?
On April 30, 2012, the German sportswear giant Adidas announced that “commercial
irregularities” at its Reebok India operations could impact its past consolidated results to a
pre-tax maximum of €125 million (`8.7 billion) and restructuring costs associated with
changes being brought in by the new management “including changes to commercial business practices” could
lead to an additional one-off charge of €70 million. Adidas made a fourth quarter operating loss of €239 million,
compared with analyst expectations for profit of €28.6 million. The announcement followed the sudden and
unexplained departure in the previous week of two of Adidas India’s top executives, the managing director,
Subhidher Singh Prem, and the chief operating officer, Vishnu Bhagat. On May 21, the company filed a criminal
complaint against the two alleging that receipts were falsified, Reebok merchandise was siphoned off, Adidasowned goods were hidden in four different warehouses and goods were sent to non-existent distributors. On May
29, the government asked the Serious Fraud Investigation Office to investigate the matter. Prem sued Adidas
for defamation and recovery of his past dues amounting to `127 million. Prem and four others were arrested on
September 19, 2012.
The Adidas brand ranks fourth worldwide, but in India it is the market leader. This became possible mainly
because of the company’s wide distribution network of over 1,000 stores. The “India growth story” played no
mean part in the company’s aggressive expansion. “Establish the brand now in a rapidly growing market and
money will come later” seemed to be the belief. A key element of the company’s business strategy was a
“minimum guarantee”, a promise of a minimum income to a franchisee regardless of the sales. Prem reasoned
that this was necessary to encourage shop owners to stock a brand. In contrast to Reebok India’s practice, global
sports goods companies sell to wholesalers, who take responsibility for selling the goods. If the products sell, the
wholesalers make money but the risks of not selling are also theirs. A major risk in the “minimum guarantee”
model is that the franchisees may not put in their best efforts, since they were assured of a minimum income.
The effect was that the profitable stores were subsidizing the loss-making ones. In 2005, Adidas acquired
Reebok for $3.8 billion, but the two businesses continued to operate as separate entities. Reebok continued to
focus on growth and market share and was more aggressive. In contrast, Adidas operated in a more disciplined
manner, even while continuing to use the minimum guarantee approach. In late 2010, the company decided to
withdraw from the minimum guarantee model and close the loss-making stores. It became known later that a
third of 1,000 outlets in India would likely be shut. Reebok’s revenue was `7.72 billion in 2009 and `7.83 billion
in 2010. It made a profit of `128 million in 2009 and a loss of `401 million in 2010. Suspecting that all was not
well at its Indian unit, Adidas asked KPMG to conduct a forensic audit of its books.
Required
1. Describe what happened in Reebok India.
2. Was there a failure of internal controls? Explain.
3. Examine other possible reasons for the happenings.
Financial Analysis
Auditors comment on the internal control systems under the Companies (Auditors’
Report) Order 2003. These comments appear in the Annexure to the Auditors’ Report.
Study the comments for a sample of companies.
Required
1. Prepare a summary of the auditors’ comments classifying them suitably and
grading them as: Highly serious; Very serious; Serious; Not too serious; Not
serious. Explain your grading.
2. Develop a plan for addressing the comments explaining what action you
would like to be taken.
Study the annual reports of a sample of companies that execute long-term contracts. Note
that you should look not only for the obvious ones like Larsen & Toubro and Gammon
India, but also for companies that provide services over several reporting periods.
Required
1. Prepare an analysis of the accounting policies. Classify them suitably and
comment on the extent to which they differ where the sample companies are
in the same industry.
2. Explain how your study is useful in analyzing and interpreting the financial
statements of the sample companies.
Study the annual reports of a sample of companies in the same industry (e.g. consumer
goods, pharmaceuticals, and software). In order to develop perspective, you should have
at least 5 companies for at least 5 years for each industry and should cover at least 5
industries.
Required
1. Prepare an analysis of the extent of doubtful debts and the average
collection period for the companies in an industry.
2. Explain how your analysis of the quality of receivables is useful in analyzing
and interpreting the financial statements of the sample companies.
IFR 5.1 describes the fraud in UBS.
Required
1. Explain why bank frauds happen with almost predictable regularity.
2. Recommend suitable measures to prevent bank frauds.
Answers to Test Your Understanding
1 Satyam spooks market, Business Line, January 8, 2009.
2 Internal Control—Integrated Framework (Committee of Sponsoring Organizations of the Treadway
Commission, September 1992).
3 Ernst & Young, Fraud and Corporate Governance: Changing Paradigm in India, 2012.
4 Deloitte, India Banking Fraud Survey, 2012.
5 PricewaterhouseCoopers, Whistle-blowing: Effective Means to Combat Economic Crime, 2012
6 Ernst & Young, Fraud and Corporate Governance: Changing Paradigm in India, 2012.
7 Transparency International, Global Corruption Barometer, 2013.
8 Transparency International, Corruption Perception Index, 2013.
9 IAS 7:6/Ind AS 7:6/AS 3:5.2.
10 Net credit sales” equals total sales less cash sales and sales returns and allowances.
11 IAS 39: AG 92.
12 The IASB’s ED/2013/3, Financial Instruments: Expected Credit Losses, proposes an expected loss approach.
13 A cheque is a bill of exchange drawn on a specified banker and payable on demand. A promissory note is an
instrument in writing (not being a bank-note or a currency note) containing an unconditional undertaking
signed by the maker, to pay on demand or at a fixed or determinable future time a certain sum of money only
to, or to the order of a certain person, or to the bearer of the instrument. Bills, cheques, and promissory notes
are different in several respects, but the accounting procedure for them is similar.
14 The drawer may make the bill payable either to himself or to another person. The person to whom the bill is
payable is the payee. In this chapter, we assume the drawer to be the payee.
15 We do not consider the customary three-day grace period.
16 We are being consistent with the procedure for determining the maturity date. Alternatively, we can include
the date of the bill. In this case, we will calculate accrued interest for 28 days, but interest income allocated to
the next period will be for 62 days (instead of 63 days).
17 As an exercise, you may like to try the reversing entry described in Chapter 3.
18 IAS 11:3/Ind AS 11:3/AS 7:2.1.
19 IAS 11:22/Ind AS 11:22/AS 7:21.
20 IAS 17:4/Ind AS 17:4/AS 19:3.1.
21 IAS 17:4/Ind AS 17:4/AS 19:3.2.
22 IAS 39:18(a)/AS 30:17(a).
23 The existing balance in the provision for doubtful debts account is 16,620, calculated as follows: 17,300 + 920
– 1,600.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Describe current assets.
Define inventories and apply the matching principle to inventory valuation.
Analyze the effect of an inventory error.
Describe how to measure the physical inventory.
Distinguish between product costs and period expenses.
Apply the inventory costing methods.
Explain the lower-of-cost-or-market principle of inventory valuation.
Appreciate the role of conservatism, neutrality, and prudence in financial reporting.
Explain the significance of comparability.
Estimate the value of inventory by the retail inventory and standard cost methods.
Explain the perpetual inventory system.
Compute the cost of goods sold for a manufacturing organization.
Evaluate the efficiency of inventory management using financial analysis.
Understand the importance of managing the operating cycle.
AND THEN THE MUSIC STOPPED
On July 31, 2013, the National Spot Exchange Limited (NSEL), a leading market for trading in
commodities, announced suspension of trading in all contracts. Reports suggested that there
were major violations of commodities trading regulations. Some traders had built up huge
trading positions, but the exchange let them “roll over” the positions instead of forcing them to
settle the positions. The fear was that if the exchange did not allow “roll over”, traders would
have defaulted and that would have led to a payments crisis. So the exchange allowed them to
build up larger positions thereby postponing the settlement, but the problem did not go away. It
snowballed into a huge crisis estimated to be `56 billion. When the irregularities surfaced
finally, the size of the fraud turned out to be so large that the exchange had to shut down.
Deloitte, Haskins & Sells, the auditor of NSEL’s parent company, Financial Technologies Limited,
withdrew their audit report stating that the financial statements had become unreliable. There
were allegations of manipulation of inventories suggesting that the physical inventories were
much less than claimed. The case is going on.
THE CHAPTER IN A NUTSHELL
We now move to manufacturing organizations that have more complex activities than service
and merchandising organizations. This chapter deals with inventories of items such as raw
materials, work in progress, finished goods, spares, and consumables. Inventories are frequently
the largest item of current assets in the balance sheet of manufacturing organizations. Inventory
valuation is central to income measurement. You will study the principles of inventory valuation
and figure out how the cost assigned to the ending inventory affects the reported net profit.
You will understand the operation of the perpetual inventory system and the techniques of
estimating inventory value. Effective inventory management avoids excessively high or
dangerously low inventories. You will find out how to analyze the quality of a company’s
inventories from the information available in the financial statements. Finally, you will
understand the importance of the operating cycle.
Current Assets
Assets are classified as current or non-current depending on when
they can be converted into cash. An enterprise should classify an
asset as a current asset when:
(a) it expects to realize the asset or intends to sell or consume it in its normal
operating cycle;
(b) it holds the asset primarily for the purpose of trading;
(c) it expects to realize the asset within 12 months after the reporting period; or
(d) the asset is cash or cash equivalent unless the asset is restricted from being
exchanged or used to settle a liability for at least 12 months after the reporting
period.1
The operating cycle of a business is the time between the acquisition of assets
for processing and their realization in cash. When an enterprise’s normal operating
cycle is not clearly identifiable, it is assumed to be 12 months.2 Cash, receivables,
and inventories are the three major current asset categories. Inventories generally
constitute the largest current asset category and the second largest assets (after
fixed assets) in the financial statements of manufacturing organizations. An asset,
which is not a current asset, is classified as a non-current asset.
Inventory Valuation and Income Measurement
Defining Inventories
Inventories are goods that are meant for eventual conversion into
cash in the normal course of business. Like receivables, they are
part of the operating cycle of a business. Inventories are “assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process
or in the rendering of services.”3
Item (a) refers to finished goods, (b) to semi-finished goods or work in progress,
and (c) to raw materials, stores, spares, consumable items, and packing materials.
A merchandising organization merely buys and sells goods, barring some
repacking, and reports the cost of unsold goods as merchandise inventory.
Manufacturing organizations, however, buy raw materials and convert these into
finished goods to be sold. As a result, a manufacturing organization has many kinds
of inventories, such as raw materials, work in progress, and finished goods.
Raw materials These consist of goods yet to be introduced into the production
process.
Steel and paint are raw materials for Tata Motors.
Crude oil is a raw material for Indian Oil.
Can you think of some of raw materials for P&G, NTPC and Asian Paints?
Work in progress (or work in process) In any production process, some units
will be in the process, but are yet to be completed.
Partly assembled cars and car parts for Tata Motors.
Crude oil in the pipeline for Indian Oil.
What could be the items of work in progress for L&T, Biocon and Cisco?
Finished goods Goods that have been produced completely, but remaining unsold
comprise the finished goods inventory of a manufacturer.
Fully finished cars for Tata Motors.
Petrol awaiting despatch at the refineries for Indian Oil.
Name some items of finished goods for ITC, Marico and L’Oreal.
Other items In addition, most manufacturing firms also keep an inventory of
factory supplies, such as coolants, fasteners, cleaning materials, packing materials,
and machinery spares. The commonly used classification for such items is stores and
spares. Further, a separate inventory of manufacturing tools is maintained under
the title loose tools. Firms that carry packing materials of significant value show
them separately.
Long-term assets retired from regular use and held for sale are not inventories.
The valuation of inventories can have a significant effect on their financial
performance and financial position. Therefore, it is important to value and present
inventories properly in the financial statements.
Matching Inventory Costs with Revenues
You may recall from Chapter 4 that we obtain the cost of goods sold by deducting
ending inventory from the cost of goods available for sale. The cost assigned to the
ending inventory directly affects the determination of the cost of goods sold. Thus, if
we assign a higher value to the ending inventory, the cost of goods sold will decrease
and the gross profit will increase. In contrast, if we assign a lower value to the
ending inventory, the cost of goods sold will increase and the gross profit will
decrease. Clearly, inventory valuation affects both the statement of profit and loss
and the balance sheet.
Revenue from operations arises in a continuous, repetitive process by which
enterprises acquire and sell goods, and acquire further goods for additional sales.
The matching principle requires matching expenses with revenues earned in a
reporting period. The matching process for inventories consists of determining the
amount that an enterprise should deduct from the cost of goods available for sale
during the reporting period and carry forward as inventory. By doing so, it can
match properly the resulting cost of goods sold with the revenue for the period.
Therefore, the value of inventory at a certain date is the sum of costs attributable to
the goods held by a business.
Effect of Inventory Error
An error in the value of the year-end inventory will misrepresent
the cost of goods sold, gross profit, net profit, current assets, and
equity. Since the ending inventory of one year becomes the
beginning inventory of the next, the error will carry forward and affect the profit for
the next period. Besides, major errors in inventory values will substantially
undermine the credibility of the financial statements. Since inventory is often the
largest among the current assets of a business, even a 5 per cent error in inventory
valuation can materially misstate the net profit. Sometimes, the effect of an error
may be to convert a loss-making company into a profit-making one and vice versa.
Suppose that a business overstates its Year 1 ending inventory by `1,000. The
effect of this error is to overstate the profit for Year 1. As a result of the error, the
enterprise will overstate Year 2 beginning inventory and understate Year 2 profit,
thus offsetting the error. Exhibit 6.1 illustrates the effect of this error.
A comparison of the correct and incorrect ending inventory columns shows that
the overstatement of `1,000 in the ending inventory in 20X1 results in
understatement of the cost of goods sold and overstatement in both gross profit and
net profit by an equal amount. The error also causes overstatement of the 20X1
current assets, total assets and equity by `1,000. The error reverses in 20X2,
resulting in understatement of the 20X2 gross profit and net profit by an equal
amount. Note that the sum of the net profit for 20X1 and 20X2 is `5,100 and is
unaffected by the inventory error, because the 20X1 ending inventory becomes the
20X2 beginning inventory. Since the error is fully offset in 20X2, the 20X2 current
assets, total assets, and equity are correct.
Determining the Physical Inventory
The first step in proper inventory valuation is to determine the
physical inventory that belongs to the business. Under the periodic
inventory system, the units on hand must be counted at the end of
the reporting period to determine the ending inventory. The actual
physical count of all items of inventory is commonly referred to as taking an
inventory. Although continuous records of inventory transactions are maintained in
the perpetual inventory system, physical inventory is also taken to verify the
balances shown in the records.
Standard inventory taking procedures exist in most organizations. Pre-numbered
inventory tickets, at least one for each inventory item, are issued to each
department in the company. An employee counts the units (or measures, weighs,
etc. as appropriate) and enters in the inventory ticket the description of the item
and the number of units counted, and initials the ticket. Another employee verifies
the count and initials the inventory ticket. A supervisor makes sure that inventory
tickets have been tagged to all the items and may recount some items at random.
All the inventory tickets are then collected and sent to the accounting department
which verifies that all the pre-numbered tickets issued have been returned. The
information on the inventory tickets is summarized on an inventory summary sheet
for completion of the physical inventory process.
Goods in Transit
A business must include goods in transit in ending inventory if it owns them. The
terms of shipment determine whether the buyer or the seller is the legal owner of
the goods. In Chapter 4, we noted:
If the terms are FOB shipping point, title normally passes to the buyer
when the goods are delivered to the goods carrier (i.e. when the carrier
accepts the goods for transport).
If the terms are FOB destination, title normally passes to the buyer when
the goods arrive at their destination.4
Goods on Consignment
You may recall the discussion on consignment in Chapter 4. Even though the
consignee has physical possession of the goods, the consignor owns the goods. Goods
on consignment are, therefore, part of the consignor’s inventory and should be
excluded from the consignee’s inventory. Goods transferred to a dealer or distributor
for resale, as an agent for the owner of the goods, are similar to goods on
consignment. Frequently, materials belonging to a firm are issued to an outside
agency to carry out manufacturing process such as machining or painting. The firm
must include these goods in its ending inventory.
Inventory Costs
Pricing the inventory is one of the most contentious topics in
accounting. Since the value placed on ending inventory may have
a dramatic effect on reported net profit, users of financial
statements, particularly investors, managers, and tax authorities,
show keen interest in inventory pricing. The accountant is faced
with conflicting objectives for inventory valuation. Proper income determination is
the guiding principle of inventory valuation for financial reporting, while
minimizing income tax payable is considered the desirable objective for tax
reporting. In this context, it is important to distinguish between product costs and
period expenses.
Product Costs
Also known as inventoriable costs, these comprise all costs of purchase, costs of
conversion, and other costs incurred in bringing the inventories up to their present
location and condition.5
(a) The costs of purchase consist of the invoice price including duties and taxes
(other than those subsequently recoverable from the tax authorities), freight in,
and other expenditure directly attributable to the acquisition. Purchase
discounts, rebates, and other similar items are deducted.
(b) The costs of conversion consist of direct manufacturing costs (usually
production labour cost) and indirect manufacturing costs, or production
overhead. Examples of indirect manufacturing costs include factory
depreciation, helpers’ wages, supervisors’ salaries, factory rent, power, and
factory insurance.
Period Expenses
Expenses incurred in general administration, storage, selling, distribution, research
and development, and interest charges are not part of inventoriable costs, and are
referred to as period expenses since these are expensed in the period in which
they are incurred. Also, losses and abnormal expenses, such as excessive spoilage,
double freight, re-handling costs, penalties, fines, demurrage, detention charges,
and idle facility expense, are treated as period expenses. Interest charges are
treated as product costs in certain situations in which the value of inventory
increases with ageing (e.g. wine, timber, and rice). In such cases, IAS 23/Ind AS
23/AS 16 applies.
Cost Formulas
The prices of most of the merchandise change during the year. So
a business buys units of a specific item of inventory at different
prices on different dates. When this happens, the accountant has
to assume the order in which units have been sold so that the cost
of goods available for sale can be allocated between the ending inventory and the
cost of goods sold. In this context, it is necessary to distinguish between physical
flow and cost flow.
Physical flow refers to the actual sequence in which goods are physically used or
sold in the operations of the business. In contrast, cost flow refers to the
association of costs with the assumed sequence in which the goods are used or sold.
Four methods are commonly used to assign cost based on a different cost flow
assumption:
1. Specific identification;
2. First-in, First-out (FIFO);
3. Last-in, First-out (LIFO)6; and
4. Weighted-average cost (WAC).
We will now see how these methods work using the following data:
Specific Identification
This method assigns specific costs to each unit sold and each unit on hand. It may
be used if the units in the ending inventory can be identified as coming from specific
purchases. The specific identification method is particularly suited to inventories of
high-value, low-volume items, e.g. jewellery and designer dresses. Each unit in
inventory must be affixed with an identification tag. To illustrate, assume that the
December 31 inventory consisted of 60 units from the March 27 purchase, 70 units
from the June 12 purchase, and 20 units from the September 19 purchase. The cost
of the ending inventory is computed as follows:
We compute the cost of goods sold by subtracting the ending inventory from the
cost of goods available for sale, as follows:
The specific identification method does not involve any assumption about cost
flow. It matches the cost to the physical flow of the inventory and eliminates the
effect of cost flow assumptions on reported net profit. The method is costly to
implement. Besides, it is unlikely to produce better information when the inventory
consists of homogeneous or high-volume items.
First-in, First-out (FIFO)
The FIFO method assumes that the first units acquired are the first units sold.
Therefore, the cost of the units in the ending inventory is that of the most recent
purchases. Although FIFO is a cost flow assumption, physical flow too often follows
the first-in, first-out sequence. In our illustration, the cost of the 150 units in the
ending inventory would be `850, computed as follows:
Since the cost of the ending inventory under FIFO is based on the most recent
purchase prices, the inventory value reflects the conditions prevalent closer to the
balance sheet. A major criticism of FIFO is that it leads to an improper matching of
costs with revenues since the cost of goods sold is computed on the basis of old
prices which are possibly unrealistic. For example, in times of rising prices, the
application of FIFO produces the highest amount of net profit although much of this
profit results from matching current revenues with low purchase prices paid in the
past. Nevertheless, FIFO is one of the popular inventory costing methods.
Last-in, First-out (LIFO)
The LIFO method assumes that the last units acquired are the first units sold.
Therefore, the cost of the units in the ending inventory is that of the earliest
purchases. Under LIFO, the cost of the 150 units in the ending inventory would be
`350, computed as follows:
LIFO ensures that the current revenues are matched with the most recent
purchase prices, thus resulting in realistic reported profits. Often, the LIFO cost of
goods sold will be a good approximation of the current cost of the units sold. The
chief disadvantage of LIFO is that the balance sheet value of inventories may be
dated and unrealistic.LIFO is not permitted in India.
Weighted-average Cost (WAC)
The WAC method assumes that the goods available for sale are homogeneous.
Average cost is computed by dividing the cost of goods available for sale, which
consists of the cost of the beginning inventory and all purchases, by the number of
units available for sale. The weighted-average unit cost, which results from this
computation, is applied to the units in the ending inventory.7 In our illustration,
the unit cost under this would be `4, computed as follows:
The cost of goods sold is `1,400, computed as follows:
WAC is appropriate when the inventory units involved are homogeneous or when
it is difficult to make a cost flow assumption. Besides, the cost figure for the ending
inventory reported under this method is influenced by all the purchase prices paid
during the year and thus evens out the effect of price increases and decreases on
ending inventory value. The major criticism of WAC is that it assigns no more
importance to current prices than to past prices paid several months ago.
Comparing Alternative Inventory Costing Methods
Of the above four most common methods for costing inventory, the specific
identification method is based on actual costs, whereas the other three methods are
based on cost flow assumptions. Exhibit 6.2 presents a comparison of the effects of
the methods on the firm’s financial statements. We assume sales of 350 units at `10
each.
From this illustration, it is clear that LIFO reports the lowest gross profit in a
period of rising prices, because it charges the highest costs to the goods sold. In
contrast, FIFO reports the highest gross profit, because it charges the lowest costs
to the goods sold. The results will be reversed in a period of falling prices. WAC, by
avoiding the extremes of FIFO and LIFO, produces a gross profit somewhere
between the two. It is difficult to generalize about specific identification, because
the results depend on the prices paid for the lots selected for sale. In a period of
constant prices, the four methods will produce identical results. We now summarize
in the following table the effects of FIFO, LIFO and WAC on ending inventory, cost
of goods sold, and gross profit:
Which method should a business select? The answer depends on many factors,
such as the effect of each method on the financial statements and income tax.
A basic problem in determining the “best” inventory formula is that the ending
inventory value affects both balance sheet and statement of profit and loss. The
problem is aggravated when there is a prolonged period of increasing or decreasing
prices. Here is a summary of the methods:
FIFO inventory value is more realistic since it is closer to current cost, but it
produces a net profit unrelated to current input costs.
LIFO does a fair job of matching current selling prices and cost of goods sold,
which is closer to current replacement costs, but often produces an outdated
inventory value.
Both LIFO and WAC allow a business to manipulate net profit by changing
the timing of additional purchases.
The use of LIFO in a period of rising prices produces a lower net profit, leading to
a lower income tax expense and more cash availability for investment purposes.
LIFO liquidation occurs when the year-end inventory quantity falls below the
beginning level. In that event, the cost of goods sold will be charged the ridiculously
low prices paid many years ago, and the business will be forced to pay income tax on
the difference between the current purchase price and the old LIFO cost. Therefore,
a business using LIFO must arrange for timely purchases to maintain the inventory
level. Sometimes, it may lead to unnecessary inventory accumulation.
For income tax purposes, a business is free to adopt any method of inventory
valuation acceptable for accounting. Once adopted, the method must be followed
consistently.
Inventory Profits
It is clear from Exhibit 6.2 that LIFO reports the lowest profit in a period of
inflation. Even so, it may still fall short of recovering the current cost of goods sold.
Continuing with the illustration, assume that the current replacement cost is `8 per
unit. If the company is to replace the goods sold during the year at this price, its
profit is only `2 ( `10 – `8) for every unit sold and the real gross profit is `700; LIFO
reports an inventory profit of `1,150 ( `1,850 – `700). As you would have thought,
FIFO and WAC report much larger fictitious inventory profits of `1,650 ( `2,350 –
`700) and `1,400 ( `2,100 – `700), respectively. LIFO reports the lowest inventory
profit, because the LIFO cost of goods sold is based on the latest purchase prices.
Since inventory profits result purely from inflation, they must be retained and
reinvested in inventory. If they are distributed as taxes and dividends, there will be
a reduction in a firm’s capital, and the firm will run short of cash for inventory
purchases.
Inventory Valuation
Cost is the primary basis for valuation of inventory. However, in
certain circumstances, it may be more appropriate to report
inventory at an amount below cost. When the value of the
inventory declines by reason of damage, deterioration,
obsolescence, or fall in market prices, a loss occurs. In these circumstances, we need
to depart from the cost basis, and recognize the loss by writing down the ending
inventory to market. This is the lower-of-cost-or-market (LCM) principle:
“Inventories should be valued at the lower of cost and net realisable value.”8 An
enterprise holds inventories for eventual conversion into cash. The practice of
writing inventories down below cost is consistent with the view that assets should
not be carried in excess of amounts expected to be realized from their sale or use.
The LCM principle provides a practical means of measuring value and
determining the loss to be recognized in a reporting period. Cost is computed using
a cost formula. Market means net realizable value (NRV), defined as “the
estimated selling price in the ordinary course of business less the estimated costs of
completion and the costs necessary to make the sale.”9
Normally, we should write down inventories to net realizable value item by item.
However, in some circumstances, it may be appropriate to group similar or related
items. In the latter case, we compare the total cost and the total market value for
each category of items. Here, the category should consist of items relating to a
product line, which have similar purposes or end uses. Aggregate classification such
as finished goods or all the inventories is not acceptable. Exhibit 6.3 illustrates the
application of the LCM principle using the two approaches.
Writing down inventories to net realizable value is a principle rather than a rule.
Application of the LCM principle calls for judgment so as to ensure that the writedowns do not result in understatement of income, deliberately or otherwise. For
example, normal quantities of raw materials and components held for use in
production are not written down below cost if the finished goods are expected to be
sold at or above the cost incurred. Similarly, inventory of maintenance supplies and
consumable stores is ordinarily valued at cost. Also, a temporary decline in selling
prices may not warrant the recognition of a loss. The enterprise should review the
net realizable value at each reporting date. The write-down is reversed to the extent
of an increase in net realizable value. In other words, the reversal is limited to the
amount of the original write-down.
Conservatism, Neutrality, and Prudence
Some cite conservatism in support of arbitrary write-downs
below cost. This idea is sometimes expressed simplistically as
“recognize all losses, but anticipate no profits”. It was widely
applied in the early days of accounting when lenders were the
principal users of financial statements. In those days, lending
decisions were made mainly on the basis of the value of assets
that would be available to the lenders if the borrower defaulted. Lenders face an
asymmetric loss function: while they are adversely affected by their borrowers’
losses, they do not benefit from their gains. Naturally, they prefer understatement
of the value of the borrower’s assets to overstatement. This provided an economic
logic for the practice.
In recent times, since shareholders have increasingly become the focus of financial
reporting, the statement of profit and loss has emerged as the more important
statement. If the ending inventory valued at below cost is sold in the next period at
or above cost, the write-down understates the profit for the first period and
overstates the profit for the second period. As a result, there will be distortion in
reporting over time. Neutrality, a characteristic that makes financial statements
useful, means that the information contained in financial statements must be free
from bias, upward or downward. Financial statements should not aim at producing
a predetermined result or outcome. Biased information would not be reliable.
Neutrality is a principal qualitative characteristic of financial statements.
As a result, accountants interpret conservatism as prudence: a cautious attitude
in making assumptions, judgments, and estimates under conditions of uncertainty
such that assets or income are not overstated and liabilities or expenses are not
understated. Examples include the collectibility of doubtful debts, the probable
useful life of plant and equipment items, the number of product warranty claims
that may occur, the life expectancy of retired employees entitled to pension, and the
tax treatment of a contentious item. However, deliberate understatement of assets
or income, or deliberate overstatement of liabilities or expenses is not acceptable, as
this would affect the reliability of financial statements.
That said, we should be aware that conservatism or prudence continues to have
an important economic role in financial reporting. The managers of a company know
more about the company’s problems and prospects than its shareholders. When
their remuneration or reappointment is related to the company’s profit, they have
reason to be forthcoming in sharing good news about the company’s performance or
prospects but may hold back bad news. As a result, accountants and shareholders
require early recognition of losses, mitigating information asymmetry to an extent.
Requiring managers to report losses promptly would discourage them from taking
up unprofitable projects. This results in better monitoring of managers’ actions by
boards, investors, and analysts. Thus, timely recognition of losses is more than just
good accounting; it is an important corporate governance mechanism. As you can
see, conservatism in financial reporting is an important mechanism to address the
moral hazard problem that we discussed in Chapter 1.
10
Comparability
Comparability (or consistency) requires the application of the
same accounting policies from one reporting period to the next. If
an enterprise could freely change its accounting policies, the
amounts of profit would not be comparable over time. The
comparability requirement safeguards users of financial statements against
managers making arbitrary and opportunistic changes in measuring income and
presenting information in the financial statements. It enables investors, creditors,
and other users to compare meaningfully the financial statements of an enterprise
over time in order to identify trends in its financial position and performance. You
have seen in Exhibit 6.2 how different inventory methods can produce different
profit numbers. Further, frequent accounting changes would destroy the credibility
of an enterprise’s financial reports and adversely affect the reputation of its
management.
While accountants frown on frequent and arbitrary changes in accounting
methods, the comparability requirement does not come in the way of a change
needed for improving financial reporting. An enterprise shall change an accounting
policy only if the change (a) is required by an accounting standard; or (b) results in
the financial statements providing reliable and more relevant information about the
effects of transactions, other events or conditions on an enterprise’s financial
position, financial performance or cash flows.11
Comparability is so important that it is a principal qualitative characteristic of
financial statements. The effect of an accounting policy change on profit and the
reasons for the change should be disclosed. Users of financial statements must
study the footnotes carefully to understand the inventory method used and the
effect of any accounting changes on profit in order to make meaningful comparisons.
The need for comparability does not mean mere uniformity and should not be
allowed to become an impediment to the introduction of improved accounting
standards or the provision of high quality information.
Estimating Inventory Value
In a periodic inventory system, a physical inventory must be
taken to determine the ending inventory value. Since frequent
inventory taking disrupts normal operations and involves
considerable expense, a physical inventory is usually taken at the
end of the reporting period. However, the management often
needs to prepare quarterly or half-yearly financial statements to report to the
shareholders and lenders and to monitor the company’s performance. Besides, there
are occasions when physical inventory cannot be taken and must be estimated – for
instance, when the inventory has been destroyed in a fire. Estimates are also
needed for insurance claims. Estimation procedures, if they are reasonable, are also
a useful check on physical inventory.
Two commonly used estimation techniques are:
Retail inventory method; and
Standard cost method.
Retail Inventory Method
Large merchandising firms such as supermarkets use the retail inventory
method. They carry a large number of different items which are marked with
selling prices. To determine the cost of the items in inventory, it is necessary to look
up the purchase invoices. This is a formidable task for most of them. The retail
inventory method helps in estimating the ending inventory value. To use this
method, it is necessary to maintain records of the beginning inventory and
purchases made during the period both at cost and at retail. “At retail” means the
sticker prices of the inventory items.
We estimate the ending inventory as follows:
1. Compute the amount of goods available for sale both at cost and at retail.
2. Divide the goods available for sale at cost by the goods available at retail to
obtain the ratio of cost to retail.
3. Deduct sales from goods available for sale at retail to determine the ending
inventory at retail.
4. Multiply the ending inventory at retail by the ratio of cost to retail to
convert the inventory into cost.
The retail inventory method assumes that the ending inventory consists of the
same mix of goods as contained in the goods available for sale and that the selling
prices of merchandise originally established do not change. In practice, the
composition of inventory often varies during a period. Also, the selling prices of
many items change, because of special rebates or increases in market prices.
Despite these difficulties, the retail inventory method is considered a satisfactory
one, and may be used to convert a physical inventory taken at retail to a cost
amount. The retail method is acceptable “if the results approximate cost”.12
The gross profit method is a variant of the retail inventory method. It works on
the assumption that the percentage of gross profit to net sales remains
approximately the same from one period to another. It is not normally acceptable for
financial reporting, because it provides only an estimate, but it is useful in
estimating inventory lost or destroyed by fire, flood or theft, when proper inventory
records are not available or have been destroyed. The income tax and the sales tax
authorities use this method to detect suppression of revenue.
Under the gross profit method, we estimate the amount of ending inventory as
follows:
1. Compute the cost of goods available for sale.
2. Estimate the cost of goods sold by deducting the estimated gross profit from
sales.
3. Deduct the estimated cost of goods sold from the cost of goods available for
sale to arrive at the estimated ending inventory.
Standard Cost Method
The standard cost method uses a predetermined cost of making a product.
Standard costs are based on the standards for material consumption and prices,
labour efficiency and wage rates, and expected level of operations laid down by the
management. These are used primarily for control of operational costs in
management accounting and their use in financial accounting is somewhat limited.
The use of standard costs results in savings in record-keeping costs and evens out
wide fluctuations in the cost of goods sold. Significant differences between standard
costs and actual costs must be distributed between the cost of goods sold and the
inventories.
Perpetual Inventory System
So far, the discussion of inventories has focused on the periodic
inventory system. Under this system, we record purchases and
determine the cost of goods sold at the end of a reporting period
when a physical inventory is taken. The main disadvantage of
the system is the lack of real-time information about inventory levels. Management
often needs up-to-the-minute information to respond quickly to customers’
enquiries, avoid shortages, and reduce interest and other expenses associated with
carrying inventory.
The perpetual inventory system overcomes the problems of periodic inventory.
Under this system, an enterprise maintains a continuous record of all purchases
and sales of merchandise, resulting in constant updating of the amount of inventory
on hand. With this information, it can carry out many tasks such as the following:
1. Promptly answer questions from customers and salespersons about the
availability of an item.
2. Record merchandise in real time and thus avoid running out of stock.
3. Calculate the cost of goods sold and the related profit for each sale.
Not long ago, only companies that sold a limited range of products used the
perpetual inventory system, because the cost and effort of maintaining the system
were too high for most types of businesses. However, with the availability of
computers at relatively low costs, many firms are switching from periodic to
perpetual inventory.
Recording Accounting Entries
The perpetual inventory system updates the merchandise inventory account after
each purchase and sale. We debit merchandise inventory for purchases and inward
freight and credit the account for purchase returns and discounts. So, in the
perpetual inventory system, we do not need accounts such as Purchases, Purchase
Returns and Allowances, and Freight In. For example, assume that a stationer
purchases pens at `20 each and sells them at `25 each. He began the current period
with six pens, which cost a total of `120. Exhibit 6.4 shows some typical entries
made under periodic and perpetual inventory systems.
In sum, the perpetual inventory system:
Does not require a Purchases account or a Purchase Return and Allowances
account. Here, purchases and returns and allowances are recorded in the
Merchandise Inventory account.
Uses a Cost of Goods Sold account to record the cost of the merchandise sold.
Requires no entry to record the ending inventory since a continuous record of
inventory is available. The closing entries simply transfer the balance in the
Cost of Goods Sold account to Statement of Profit and Loss.
Entries to record sales and payment to supplier are identical under the two
systems. Also, under both inventory systems, the Sales account must be closed.
Maintaining Perpetual Inventory Records
When there are many items in inventory, the Merchandise Inventory account serves
as a control account for a subsidiary inventory ledger, also known as the priced
stores ledger. An individual record is maintained for each item in inventory in the
inventory ledger. The record is kept in a card in a manual system and in a computer
file in an electronic system. In either case, the record for each item shows the
number of units and cost of each purchase, the number of units and cost of each
sale, and the resulting balance of inventory on hand. Exhibit 6.5 gives an example
of a perpetual inventory record.
The method of inventory costing in Exhibit 6.5 is FIFO. Under LIFO, the cost of
15 writing pads sold on July 17 would be `180, in contrast to the FIFO figure of
`135. The LIFO cost of the 30 writing pads sold on July 28 would be `360, in
comparison to the FIFO cost of `330. The ending inventory is `360 under FIFO and
would be `285 under LIFO. As an exercise, verify the LIFO numbers.
Internal Control and Perpetual Inventory System
The perpetual inventory system enhances control over inventories. It helps prevent
stockout as well as unnecessary investment in inventories by ensuring that the
inventory level is maintained between maximum and minimum levels.
Nevertheless, it is necessary to retain other elements of internal control described
earlier. Since it is possible to take physical inventory at any time, shortages can be
investigated immediately when noticed.
Manufacturing Costs
A merchandising organization has just one item of inventory:
merchandise inventory. On the other hand, a manufacturing
organization has several kinds of inventory, such as raw
materials, work in progress, finished goods, consumable stores
and spare parts, and packing materials. For a manufacturing
organization, cost of goods available for sale is the sum of the beginning inventory of
finished goods and the cost of goods manufactured during the period. Cost of goods
sold equals cost of goods available for sale minus the ending inventory of finished
goods. The computation of the cost of goods manufactured is an internal matter and
is not shown in published statements. Exhibit 6.6 shows an example of the cost of
goods sold statement, including the cost of goods manufactured section.
Financial Analysis of Inventories
A business needs inventories, similar to cash and receivables, to
meet day-to-day operating needs. Keeping some inventory is often
inevitable given purchasing lead times and unexpected delays in
arrival of materials. Production stoppages and inability to meet
customer requests could result if adequate inventories are not
kept. However, the investment in inventories represents idle funds on which a
business does not earn any profit. Therefore, it is necessary to optimize inventory
levels. Inventory turnover is a measure of the efficiency of inventory
management. It is computed as follows:
Since cost of goods sold is not reported in the financial statements, we will take it
as the sum of all costs excluding interest charges and income tax.
To illustrate, assume the following data for Bhava Company:
This means that the inventories have been turned over or rotated 12 times during
the period. In other words, the company held inventories, on average, for one
month. The average inventory holding period is computed as:
Inventory turnover of 12 times implies average inventory holding of one month,
calculated as follows:
A low inventory holding period (or high inventory turnover) is generally an
indicator of efficient inventory management, since it implies rapid movement of
merchandise leading to lower investment in inventory. Conversely, a high inventory
holding period (or low inventory turnover) indicates poor management of inventory
since it implies a higher investment in inventory than necessary. The average
holding period for an enterprise may be compared with its past experience and with
industry average.
Managing the Operating Cycle
The operating cycle is the continual conversion of cash into
inventories, then into receivables and back into cash in the normal
course of business. A firm buys inventories on credit or for cash,
sells them on credit or for cash, collects cash from its customers,
and pays its suppliers. The operating cycle time is the time it takes
to get back cash.
An efficient business buys inventories when needed, converts them into
receivables by smart selling, collects cash from its customers by laying down credit
standards and ensuring timely payment, and manages to get a long credit period
from its suppliers. The shorter the length of a firm’s operating cycle, the greater the
firm’s efficiency in managing its current assets (receivables and inventories). The
length of the operating cycle is a measure of how fast a business gets back its cash.
It indicates the enterprise’s efficiency in selling, collecting, and paying. The
operating cycle enables us to integrate our understanding of receivables and
inventories, the two major current asset items. The other important component is
payables, which we will see in Chapter 9.
Figure 6.1 illustrates the operating cycle under different conditions. Figure 6.1(a)
depicts a firm that has cash purchases and cash sales. The operating cycle time is
the inventory holding period, i.e. the time it takes to sell the inventories. The
emphasis is on selling the goods quickly. This is typical of most small businesses
such as roadside vendors of fruits, vegetables, and fish. Their inventory holding
period is usually zero, i.e. they sell the goods the same day. Of course, the vendors
do not worry about collections since they sell for cash.
Figure 6.1(b) describes a firm with cash purchases and credit sales. Here, the
operating cycle time consists of the inventory holding period and the credit period
for the receivables. There are some small businesses of this type. They need to
worry about selling and collecting.
Figure 6.1(c) describes a firm with credit purchases and cash sales. While the
suppliers provide inventory financing, the enterprise sells for cash. So there are
payables, but no receivables. The operating cycle time equals the inventory holding
period minus the credit period for the payables. This is typical of most
supermarkets. They should work on rapid inventory movement and better credit
terms from their suppliers. If the suppliers’ credit period is equal to the inventory
holding period, the operating cycle time is zero. This means that the suppliers get
paid as soon as the goods are sold; so the enterprise does not use its cash for
financing current assets. In exceptional cases, it may pay its suppliers after getting
cash from sales; here the cycle time would be negative.13
Figure 6.1(d) describes a firm with credit purchases and credit sales. The
enterprise’s suppliers provide inventory financing and the enterprise provides credit
to its customers. The operating cycle time equals the inventory holding period plus
the credit period for the receivables minus the credit period for the payables. This is
typical of most manufacturing and service businesses. The enterprise’s bargaining
power with both its customers and suppliers and its selling efficiency will determine
the cycle time in this case.
Looking Back
Describe current assets A current asset is intended to be converted into cash within one year or within
the operating cycle. Inventories are current assets.
Define inventories and apply the matching principle to inventory valuation Inventories are assets
held for sale in the ordinary course of business, or in the process of production for such sale, or for
consumption in the production of goods or services for sale. The matching process for inventories consists of
determining the amount that should be deducted from the cost of goods available for sale during the reporting
period and carried forward as inventory.
Analyze the effect of an inventory error An error in the value of the year-end inventory will distort cost
of goods sold, gross profit, net profit, current assets, and equity. An error will also distort the profit for the
next period.
Describe how to measure the physical inventory The units on hand are counted at the end of the
reporting period to determine the ending inventory. Goods in transit and goods on consignment must be
included in the owner’s inventory.
Distinguish between product costs and period expenses Product costs are the costs of bringing
inventories to their present location and condition and they constitute the cost of inventories. The
remaining costs are period expenses and are expensed as incurred.
Apply the inventory costing methods Cost is the primary basis for valuation of inventory. The cost
formulas allowed in India are specific identification, FIFO, and WAC. Each method is based on a different
cost flow assumption. The specific identification method assigns specific costs to each unit sold and each unit on
hand. FIFO assumes that the first units acquired are the first units sold. WAC assumes that the goods available
for sale are homogeneous. LIFO (not allowed in India) assumes that the last units acquired are sold first.
Explain the lower-of-cost-or-market (LCM) principle of inventory valuation The LCM principle
requires a loss to be recognized by writing down the ending inventory to market.
Appreciate the role of conservatism, neutrality, and prudence in financial reporting Lenders face
an asymmetric loss function. So they prefer understatement of the borrower’s assets. With shareholders
emerging as the more important users of accounting information, both understatement and overstatement of
profits are unfair. Even so, conservatism forces managers to report bad news faster than they would report on
their own. Neutrality is an important characteristic of financial statements: there should be no bias in reporting.
Prudence is the exercise of caution in reporting while dealing with uncertainties.
Explain the significance of comparability Comparability requires the application of the accounting
policies over time. Accounting changes would make it difficult to compare reported performance.
Estimate the value of inventory by the retail inventory and the standard cost methods When
interim financial statements are to be prepared or when the inventory has been destroyed in an accident,
the ending inventory must be estimated. Under the retail inventory method, the ending inventory at retail
prices is multiplied by the ratio of cost to retail to arrive at the cost. The standard cost method uses a
predetermined cost of making a product based on management’s standards.
Explain the perpetual inventory system Under the perpetual inventory system, an enterprise keeps a
continuous record of all purchases and sales of merchandise. The Merchandise Inventory account records
purchases, freight in and purchase returns and discounts. A Cost of Goods Sold account is used to record the
sale of merchandise.
Compute the cost of goods sold for a manufacturing organization For a manufacturing
organization, the cost of goods available for sale is the sum of the beginning inventory of finished goods and
the cost of goods manufactured during the period. The cost of goods sold equals the cost of goods available for
sale minus the ending inventory of finished goods.
Evaluate the efficiency of inventory management using financial analysis The investment in
inventories represents idle funds. It is necessary to optimize the level of inventories. Inventory turnover is a
measure of the efficiency of inventory management. High inventory turnover implies rapid movement of
merchandise leading to lower investment in inventory.
Understand the importance of managing the operating cycle The operating cycle of a business
indicates the speed with which a business converts its inventories and receivables back into cash. The
shorter the cycle, the faster the speed of cash conversion.
Review Problem
Suman Company has the following inventory, purchases, and sales data for August:
The company uses the periodic inventory system. The physical inventory count on August 31 shows 300 units
on hand.
Required
Compute the cost of the inventory on hand on August 31 and the cost of goods sold for August under each of the
following methods: (1) FIFO, (2) LIFO, and (3) WAC.
Solution
The cost of goods available for sale is computed as follows:
ASSIGNMENT MATERIAL
Questions
1. “Manipulation of inventory valuation is self-defeating.” Explain.
2. What characteristics should an asset possess to be classified as inventory?
3. Under what circumstances might interest charges be included in product
costs?
4. Why do we need inventory costing methods?
5. Which inventory costing method assumes that the goods available for sale
are homogeneous?
6. Explain the income tax benefits resulting from the use of LIFO during
periods of inflation if LIFO is allowed for tax purposes.
7. If goods are shipped FOB destination, which party to the transaction must
pay the freight bill?
8. Define the term ‘market’ as used in the phrase “lower of cost or market”.
9. Comment on the following statement: “While naked conservatism is
unacceptable, an attitude of healthy scepticism is justified in the face of
uncertainty”.
10. How does conservatism protect shareholders from moral hazard?
11. Explain how the comparability principle improves the usefulness of financial
statements.
12. Chaman Lal, an officer in the commercial taxes department of the
Government of Punjab, recently raided a merchandising firm in Ludhiana
on information that it was evading sales tax. Explain how he can use the
gross profit method to detect evasion of tax.
13. Suppose you compute the cost of goods sold under the perpetual and the
periodic inventory systems using the following inventory methods: specific
identification, FIFO, LIFO, and WAC. Which of these methods will produce
(a) same and (b) different amounts for cost of goods sold under the two
systems?
14. How are inventories classified in the balance sheet of a manufacturing
enterprise?
15. Can a company following the perpetual inventory system dispense with
year-end physical inventory taking?
Problem Set A
Assume that the ending inventory on July 31 consisted of 50 units from the beginning inventory, 60 units
from the July 14 purchase, and 90 units from the July 23 purchase. The company uses the periodical inventory
system.
Required
Determine the cost of the ending inventory and the cost of goods sold using the following methods: (a) specific
identification, (b) FIFO, (c) LIFO, and (d) WAC.
Required
Using the periodic inventory system, compute the cost of ending inventory and cost of goods sold. Use the FIFO
and LIFO inventory costing methods.
Assume that Watawala Company, mentioned in Problem 6A.2, uses the perpetual
inventory system.
Required
Compute the cost of ending inventory and cost of goods sold, using the FIFO and LIFO
inventory costing methods.
Required
Compute the ending value by applying the lower-of-cost-market principle to (a) each item of inventory and (b)
groups of similar items, assuming that products A, B, C, and D constitute one group and products E and F, the
other group.
Problem Set B
The company uses the periodic inventory system. A review of the accounting records revealed the following
items:
1. Merchandise costing `420 was shipped to a customer on March 31, 20X7,
FOB shipping point. Physical inventory had been completed before the
shipping. The sale revenue of `530 was recognized on April 12, 20X7 when
the sales invoice was prepared.
2. Merchandise costing `290 shipped FOB shipping point by a supplier on
March 27, 20X8 was received on April 2, 20X8. The goods were not included
in the inventory on March 31, but reported as purchases on April 17, 20X8
when the invoice arrived.
3. Goods received on consignment on March 25, 20X7 were kept in a separate
bay. However, one lot costing `160 was included inadvertently in the ending
inventory on March 31, 20X7.
4. On March 27, 20X7, goods costing `630 were shipped FOB destination to a
customer. A sales invoice for `720 was prepared on April 6. The goods, which
were in transit on March 31, 20X7, were not included in the physical
inventory taken on that day.
5. The total of one of the inventory sheets was recorded in the inventory
summary sheet on March 31, 20X8 as `1,430 instead of `1,340.
Required
1. Determine the correct ending inventory figures for 20X7 and 20X8. Itemize
each correction to arrive at total corrections.
2. Prepare revised statement of profit and loss for the years ended March 31,
20X7 and 20X8.
3. Compute the total net profit for the two-year period, both before and after
the revisions. Why are these figures similar or different?
The company incurred operating expenses of `58,000 during the year. It uses the periodic inventory system.
Required
1. Prepare a schedule to compute the cost of goods available for sale during the
year.
2. Determine the ending inventory on March 31, 20X3 using the following
inventory costing methods:
(a) FIFO
(b) LIFO
(c) WAC
3. Prepare a statement of profit and loss under each of the above inventory
costing methods.
Required
1. Record the beginning inventory and the transactions on a perpetual
inventory card using the FIFO method.
2. Record the beginning inventory and the transactions on a perpetual
inventory card using the LIFO method.
3. Prepare journal entries to record the sale of 20 units at `160 each on
February 14 to Jain Brothers and the purchase on February 29 from Vipul
Company from the LIFO inventory card, assuming that the two transactions
were on credit.
Sales commission is payable on all items at 10 per cent in Product Group I and at 20 per cent in Product
Group II. Delivery charges of `20 per unit are payable on product code R098.
Required
Compute the amount at which ending inventory is to be reported applying the LCM
principle to (a) each item of inventory or (b) groups of similar items.
Bashir Company sold 50,000 audio CDs at `28 during the year. Its beginning inventory
consisted of 10,000 CDs at `18 per CD. The following purchases were made during the
year: 15,000 CDs @ `19; 10,000 CDs @ `21; 20,000 CDs @ `22; 10,000 CDs @ `23.
Operating expenses were `185,000. Income tax is payable at 40 per cent.
Required
1. Compute net profit using the FIFO and LIFO methods.
2. Which method is more advantageous to the company for (a) income tax
reporting and (b) shareholder reporting? Why? What trade-offs, if any, are
involved in this context? Assume that the company must use the same
method for both purposes.
3. Suppose that the company makes a purchase of 15,000 CDs at `25 on the
last day of the reporting period. How will the purchase affect the company’s
net profit and income tax expense under the two inventory costing methods?
Problem Set C
The company uses the periodic inventory system. A review of the accounting records revealed the following
items:
1. Merchandise costing `3,700 was shipped to a customer on December 29,
20X3, FOB destination. The sales invoice for `4,300 was prepared on
December 30, 20X3. The goods were received by the customer on January 3,
20X4 and were not included in the physical inventory on December 31, 20X3.
2. Merchandise costing `2,400 sent on consignment to a dealer was not
included in the ending inventory on December 31, 20X4.
3. Merchandise costing `4,100 shipped FOB shipping point by a supplier on
December 29, 20X3 was received on January 6, 20X4. The goods were not
included in the inventory on December 31, but reported as purchases on
January 9, 20X4 when the invoice arrived.
4. On December 31, 20X3, goods costing `4,400 were shipped FOB destination
by a supplier. The goods were in transit on December 31, 20X3 and were not
included in the physical inventory on that day, but were reported as
purchases on January 14, 20X4 when the invoice arrived.
5. The total of one of the inventory sheets was recorded in the inventory
summary sheet on December 31, 20X4 as `7,500 instead of `5,700.
Required
1. Determine the correct ending inventory figures for 20X3 and 20X4. Itemize
each correction to arrive at the total corrections.
2. Prepare revised statement of profit and loss for the years ended December
31, 20X3 and 20X4.
3. Compute the total net profit for the two-year period both before and after
the revisions. Why are these figures similar or different?
The company incurred operating expenses of `16,000 during the year. It uses the periodic inventory system.
Required
1. Prepare a schedule to compute the cost of goods available for sale during the
year.
2. Determine the ending inventory on December 31, 20X7 using the following
inventory costing methods:
(a) FIFO
(b) LIFO
(c) WAC
3. Prepare a statement of profit and loss under each of the above inventory
costing methods.
Required
1. Record the beginning inventory and the transactions on a perpetual
inventory card using the FIFO Method.
2. Record the beginning inventory and the transactions on a perpetual
inventory card using the LIFO Method.
3. Prepare journal entries to record the sale of 90 units at `90 each on
November 8 to Rohini Company and the purchase on November 26 from
Tanvir Company from the LIFO inventory card, assuming that both
transactions were on credit.
Sales commission is payable on all items at 10 per cent. Delivery charges of `10 per unit are payable on all
items in Product Group II.
Required
Compute the amount at which ending inventory is to be reported applying the LCM principle to (a) each item of
inventory or (b) groups of similar items.
Jupiter Company sold 20,000 crates of a soft drink at `120 during the year. Its beginning
inventory consisted of 1,000 crates at `70 per crate. The following purchases were made
during the year: 5,000 crates @ `75; 8,000 crates @ `76; 9,000 crates @ `80. Operating
expenses were `365,000. Income tax is payable at 30 per cent.
Required
1. Compute the net profit using the FIFO and LIFO methods.
2. Which method is more advantageous to the company for (a) income tax
reporting, and (b) shareholder reporting? Why? What trade-offs, if any, are
involved in this context? Assume that the company must use the same
method for both purposes.
3. Suppose the company makes a purchase of 4,000 crates at `85 on the last
day of the reporting period. How will the purchase affect the company’s net
profit and income tax expense under the two inventory costing methods?
Business Decision Cases
The warehouse of Giridhar Clothing Company was destroyed in a fire that broke out on the
night of May 7, resulting in extensive damage to the company’s inventories. Even in the best
of times, the company did not maintain proper accounting records. In the past, a CA firm was
engaged to prepare the financial statements based on information compiled from the
company’s invoice files, correspondence, and bank statements. Inventory was last taken on March 31, the end of
the last reporting period. Both purchases, and sales were on FOB shipping point terms. While all purchases
were on credit, there was a small amount of cash sales. There were no purchases or sales in transit on May 7.
All cheques and cash received were deposited into bank every day. Payments to suppliers and transporters were
by cheque. Cash was withdrawn from bank for making specific cash payments for office and warehouse rent,
insurance premium, and miscellaneous office and selling expenses. The following information was culled from
the company’s records for the current period:
Further examination of the folders revealed that all invoices pertaining to unpaid purchases and unpaid sales
listed in the March 31 balance sheet were settled by April 15.
The insurance company’s surveyor assessed the damage to the inventories at `500 (net of estimated salvage
of `500), and would issue a cheque for the amount without any proof of loss. The insurance company was willing
to consider a claim for a higher amount if it was supported by proper evidence. Giridhar Clothing Company’s
gross profit averaged 20 per cent of sales in the past two years.
Required
1. Prepare an estimate of the cost of inventory destroyed in the fire. Assume
that the surveyor’s estimate of salvage is reasonable.
2. What was the percentage of gross profit implicit in the insurance company’s
proposed settlement?
3. You are informed that selling prices went up by 2 per cent during the
current period. How would your answer to 1 change in light of this
information?
Interpreting Financial Reports
Elite Advisers was co-founded by Miriam Mascherin and Michel Tamisierin 2007. The company
specializes “in the creation of niche and elitist products”, according to its website. It invests in fine
wine and collectable watches. Elite Advisers manages Nobles Crus, a Luxembourg-based
specialized fund that invests in wine. The website states: “The wines in the portfolio are valued every month on
the basis of four price lists, two of which come from wine merchants in Continental Europe and the United
Kingdom, and two of which come from leading auction houses such as Sotheby’s or Christie’s. In total, around
sixty wine merchants may be used as a basis for the valuation. This comprehensive valuation process also
includes an annual review of our merchants to ensure their pricing policy is correct and their quality standards
meet our criteria.” Nobles Crus launched with €2 million in 2008 and had grown to €109 million by 2012.
Interest in wine funds has grown as investors are looking at alternatives to a troubled equity market.
On September 30, 2012, the Financial Times questioned the valuation of the holdings of Nobles Crus. The
fund reported a gain every month since the start of 2011, though the benchmark Liv-ex Fine Wine index
declined to 260.08 in September 2012 from a peak of 364.69 in June 2011. For example, one of the wines, a
Lafite Rothschild 1996, was valued by Nobles Crus at €1,718, more than double the Liv-ex price of €855. Elite
Advisers said that Noble Crus valued its wines by taking the average of two prices from auction houses, without
removing commission, and two from wine merchants. Live-ex valuations are based on actual transaction prices
on its Fine Wine Exchange. Responding to the criticism of its valuation method, Nobles Crus stated that it had
been working on an “automatic and scientific valuation system with two renowned finance professors and that
this valuation method would be implemented next year. Also, it engaged Ernst & Young, a Big Four accounting
firm, and a wine auction house to provide an independent third party review of the fund’s portfolio, valuation,
and valuation methodology.
Required
1. How should wine investment funds account for their holdings?
2. Comment on Nobles Crus’ accounting policy.
3. Evaluate Nobles Crus’ response to the criticism of its accounting?
Financial Analysis
Study a sample of company annual reports for five years.
Required
1. Prepare an analysis of the inventory valuation methods followed by the
companies.
2. Do you see any patterns? Explain.
3. Why is your study important for analyzing financial statements?
Study a sample of company annual reports for five years.
Required
1. Locate companies that changed their inventory valuation policies.
2. Explain possible managerial motivations for the changes from the
information available.
3. Why is your study important for analyzing financial statements?
Study a sample of annual reports of companies in any one industry for five years.
Required
1.
2.
3.
4.
Prepare an analysis of the inventory holding period for the companies.
Do you see any industry patterns? Explain.
Analyze trends seen, if any, in the holding period.
Why is your study important for analyzing financial statements?
Study a sample of annual reports of companies in any one industry for five years.
Required
1.
2.
3.
4.
Prepare an analysis of the operating cycle for the companies.
Do you see any industry patterns? Explain.
Analyze trends seen, if any, in the operating cycle.
Why is your study important for analyzing financial statements?
Answers to Test Your Understanding
6.1 The error would overstate the net profit and equity for 20X1, and understate the net profit for 20X2, by
`5,000. The correction would reduce the net profit and equity for 20X1, and increase the net profit for 20X2,
by `5,000. Neither the error nor its correction would affect the net profit for 20X3 or the equity for 20X2 and
20X3.
6.2 FOB shipping point.
6.3 The carrying amount is `74,500. The net realizable value is `66,000, calculated as follows: Estimated selling
price, `70,000 – Sales commission at 5%, `3,500 – Delivery expense, `500. LCM = `66,000. The write-down is
`8,500.
6.4
If the physical inventory at retail was `1,620, the loss due to shoplifting, etc. at retail is `180, or `120 at cost.
6.5
6.6 Cost of goods sold = Beginning finished goods inventory, `2,310 + Cost of goods manufactured, `17,680 –
Ending finished goods inventory, `1,870 = `18,120.
6.7 Average inventories = (`1,200 + `2,600)/2 = `1,900; Inventory turnover = `5,700/ `1,900 = 3 times; Average
inventory holding period = 360 days/3 = 120 days.
1 IAS 1.66/Ind AS 1.66 and Schedule III to the Companies Act 2013.
2 IAS 1.68/Ind AS 1.68. Schedule III to the Companies Act 2013 has a similar definition: “Operating cycle is the
time between the acquisition of assets for processing and their realisation in cash or cash equivalents. Where
the normal operating cycle cannot be identified, it is assumed to have a duration of twelve months.”
3 IAS 2:6/Ind AS 2.6/AS 2:3.1.
4 Other common shipment terms include EXW (ex works), CFR (cost and freight) and CIF (cost, insurance, and
freight). The principles discussed in Chapter 4 and in this chapter should be applied to these contracts to
determine the legal owner of the goods.
5 IAS 2:10/Ind AS 2:10/AS 2:5.
6 LIFO is permitted in the US. IAS 2/Ind AS 2/AS 2 do not permit LIFO, but we describe the method in order
to cover the traditional methods.
7 Weighted-average costs may be computed by means of a continuous, a periodic, or a moving periodic
calculation.
8 IAS 2:9/Ind AS 2:9/AS 2:5.
9 IAS 2:6/Ind AS 2:6/AS 2:3.2.
10 S. Basu, The conservatism principle and the asymmetric timeliness of earnings, Journal of Accounting and
Economics, December 1997.
11 IAS 8:14/Ind AS 8:14/AS 5:29.
12 IAS 2:21/Ind AS 2:21/AS 2:18
13 A negative operating cycle is possible. Dell, the computer manufacturer, could manage that by taking
advance payments from customers and delaying payments to suppliers.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Describe the nature and types of fixed assets.
Determine the cost of fixed assets.
Explain depreciation.
Compute depreciation under popular methods.
Distinguish between capital expenditure and revenue expenditure.
Understand the difference between accounting and tax depreciation.
Account for discarding, sale, or exchange of depreciable assets.
Dispel the myths about depreciation.
Explain revaluation of fixed assets.
Describe and account for intangible assets.
Account for natural resources.
Explain impairment of assets.
Analyze the utilization of fixed assets.
DEPRECIATION AND CASH
Deciding on the right amount of depreciation often involves conflicting considerations. A higher
depreciation charge reduces the reported profit and is not going to go down well with a
company’s shareholders. Also, managers may not be enthusiastic about a higher expense, since
that would reduce the size of the bonus pool and thereby their bonus. On the other hand, the
minimum alternative tax (MAT) may provide a motivation for increasing the depreciation
charge.
Lanco Infratech, a power and construction business, reported a net profit of `705 million for
the quarter ended September 30, 2010 (Q2FY11), a decline of 43 per cent over the quarter
ended September 30, 2009 (Q2FY10). The company’s revenue increased six per cent over the
same period. The depreciation charge increased four times, because of a change in the method.
The charge for Q2FY11 was nearly one-half of that for FY10. This was despite a smaller growth
in the fixed assets. Under the new method, the depreciation charge was `1,370 million,
compared with `498 million under the old method. The company’s advertisement and press
release highlighted that the cash profit went up by 60 per cent year on year and EBITDA by 48
per cent. The company’s spokesperson said that the company opted for higher depreciation in
order “to conserve cash.” But depreciation does not entail cash outgo. So what was that
supposed to mean?
THE CHAPTER IN A NUTSHELL
In this chapter, you will learn about fixed assets: investments in assets that are used to provide
goods or services. These assets represent a major source of future revenue potential to the
enterprise, and may give some indication as to future cash flows. Fixed asset accounting has
several objectives: to give investors, creditors, management, and tax and regulatory authorities
accurate information about these assets; to account for use and disposal of these assets; and to
plan for acquisitions through realistic budgeting. You will learn about revaluation of fixed assets
and accounting for intangible assets and natural resources.
Fixed Assets in Perspective
A fixed asset is held for the purpose of producing or supplying
goods or services and not for sale in the normal course of business.
Unlike inventories, fixed assets are meant for use by an enterprise
for conducting its business, and not for resale. A manufacturing
enterprise’s fixed assets would often include land, buildings, machinery, furniture
and fixtures, and office equipment. Fixed assets are non-current assets.
Whether an asset is a fixed asset or not depends on the purpose for which it is
held. For example, the land on which a company’s factory is built is its fixed asset.
However, if it plans to use its land for property development, it will be a current
asset. So the intention of the owner in holding an asset determines its classification
as a fixed asset or a current asset. This classification provides the basis for its
valuation.
Fixed assets, also known as long-lived assets or long-term assets, are of the
following types:
1. Property, plant and equipment These are tangible items, i.e. they have
physical existence and can be seen and felt. An enterprise:
(a) holds these assets for use in the production or supply of goods or services,
for rental purposes, or for administrative purposes; and
(b) expects to use them during more than one period.1
Examples: Land, buildings, plant, aircraft, vehicles, furniture, and office
equipment.
2. Intangible assets Unlike tangible assets, these have no physical existence;
they represent legal rights with associated economic benefits. Also, these are
separately identifiable. Intangible assets exclude monetary assets such as
receivables and investments.2
Examples: Brand names, mastheads and publishing titles, patents, licences
and franchises, copyrights, and designs.
3. Natural resources These constitute a category by themselves because of
their special characteristics.
Examples: Oil, natural gas, minerals, and forests.
Property, Plant and Equipment
Accounting for property, plant and equipment involves the following issues:
Determining the cost of acquisition of an item of property, plant and
equipment.
Allocating the cost of the item to several reporting periods.
Recording the disposal of the item.
Figure 7.1 describes the accounting issues that arise in the various stages of the
life cycle of an item of property, plant and equipment.
Cost of Acquisition
Traditionally, the accounting profession has placed considerable
emphasis on the objectivity of valuation. You may recall from
Chapter 1 that the case for the historical cost system rests on the
going concern assumption. Accountants prefer cost as the basis of valuation of
property, plant and equipment, because cost is easier to measure and verify than
other measures, such as market value. Also, cost would often approximate the
service value of an asset in an arm’s length transaction. The general principle is
that an enterprise can recognize a property, plant and equipment item as an asset
only if it meets the following criteria:
It is probable that the item will give future economic benefits to the
enterprise.
The cost of the item can be measured reliably.
Property, plant and equipment items acquired for safety or environmental
reasons, e.g. electrostatic precipitators used in a cement plant to reduce emissions,
also qualify for recognition as assets, because without them it will not be possible to
use the main asset.
The cost of property, plant and equipment comprises the following:3
1. Purchase price, including import duties and purchase taxes;
It excludes refundable or adjustable taxes, such as goods and services
tax, value added tax, and duty drawback.
Trade discounts and rebates are deducted in arriving at the purchase
price.
2. Any directly attributable costs of bringing the asset to the location and
condition for its intended use; and
3. Estimated costs of the obligation for dismantling and removing the item and
restoring the site on which it is located.
Examples of directly attributable costs include:
(a) Stamp duty and registration fees for transfer of title to land or building;
(b) Professional fees, e.g. fees of architects, engineers, and lawyers;
(c) Commission and brokerage for purchase;
(d) Cost of site preparation;
(e) Freight, transit insurance, and handling costs;
(f) Cost of testing; and
(g) Installation costs, such as special foundations for plant.
The principle is that expenditures that result in future economic benefits or are
normal or unavoidable should be capitalized, i.e. they should be treated as part of
the asset’s cost, and expenditures that do not result in improving the service
potential of the asset should be charged to current income. Often, some expenditure
on start-up and trial production is necessary to bring a plant to its working
condition. Such pre-production expenditure is capitalized. Again, customs duty paid
on imported machine is capitalized, because it is a necessary cost. Avoidable or
abnormal costs are not capitalized. For example, if a machine is damaged during
installation, the related repair expense should not be capitalized. This is because it
should be possible to install the machine without damaging it and the repair does
not make the machine more useful than it was when it arrived in good condition.
Administration and other general overhead costs and costs of opening a new store
do not specifically relate to acquiring an asset or bringing it to the “location and
working condition” for its intended use, and should not be capitalized.
Borrowing Costs4
Borrowing costs are interest and other costs that an enterprise incurs in
connection with the borrowing of funds.5 These costs include interest expense
calculated using the effective interest method, and finance charges in respect of
finance leases.6 An enterprise shall capitalize borrowing costs which are directly
attributable to a qualifying asset: an asset that necessarily takes a substantial
period of time to get ready for its intended use or sale. A large petroleum refinery
that often takes three to five years to be commissioned is an example of a qualifying
asset. “Substantial period of time” usually means one year for many types of assets.
Determining whether an asset is a qualifying asset requires the exercise of
management judgment. Inventories, manufacturing plants, power generation
facilities, intangible assets, and investment properties can be qualifying assets,
depending on the circumstances.
The principles for capitalization of borrowing costs are as follows:
1.
2.
3.
4.
5.
What to capitalize Capitalize borrowing costs that are directly
attributable to a qualifying asset. Costs are “directly attributable” only when
they could have been avoided if the expenditure on an asset had not been
made.
Example: Interest cost on funds borrowed specifically for obtaining an asset.
What not to capitalize Do not capitalize the actual or imputed costs of
equity. This is because the cost of equity capital is not a borrowing cost.
When to capitalize Start capitalization from the date when the enterprise
first meets all of the following conditions:
(a) It incurs expenditures for the asset.
(b) It incurs borrowing costs.
(c) It undertakes activities that are necessary to prepare the asset for its
intended use or sale.
When to suspend Suspend capitalization of borrowing costs during
extended periods in which an enterprise suspends active development of the
asset for its intended use or sale.
When to stop Stop capitalization of borrowing costs when substantially all
the activities necessary to prepare the asset for its intended use or sale are
complete. Thereafter, borrowing costs are expensed when incurred.
Basket Purchases
An enterprise may buy a group of assets for a composite sum. In such cases, it
should allocate the total purchase price to the various assets on the basis of fair
value: the amount for which an asset could be exchanged between knowledgeable,
willing parties in an arm’s length transaction. In practice, professional valuers
determine the fair value of an asset.
A fair allocation of the purchase price is important to resolve conflicting
accounting and tax considerations:
1. The estimated useful lives of various assets are often different. For example,
land is normally not depreciated, while buildings are depreciated over their
useful lives. In our example, if the enterprise had allocated `12,500 each to
land and building, it would not have depreciated an amount of `5,000 that
was added excessively to the cost of the land (i.e. allocated amount, `12,500
– fair value, `7,500), resulting in a lower depreciation expense for the
building.
2. Think of a firm motivated by tax considerations. It would like to exaggerate
the cost allocated to depreciable assets, since that would result in lower
income tax expense. Therefore, the tax department too is keen on a fair
allocation of the lump sum purchase price.
The best way to resolve this conflict is to use fair value as the basis of allocation.
Of course, there can be different views on an asset’s fair value.
Donated Assets
When a business gets assets by donation, e.g. land given free or at a nominal price
by government, there is no cost of acquisition to the business. Therefore, donated
assets should be shown at zero value. But to record them at zero value does not
reflect the economic reality of an increase in an enterprise’s assets.
Self-constructed Assets
When an enterprise constructs an asset, using its resources, it has to arrive at the
cost to be recorded in the accounts. It can trace the costs of materials and direct
labour directly to the construction. Since assigning indirect costs of construction,
such as power and supervision may be difficult, some companies prefer to expense
these items. Internal profit, i.e. the profit the company would have earned had it
done the same work for a customer, cannot be charged to the asset since their
inclusion would violate the realization principle. Also, cost inefficiencies in the
production of self-constructed assets, regardless of the reasons, should not be
included as part of the cost.
Components of Assets
Sometimes, the cost of a part of an asset may be significant in relation to its total
cost. Each such part must be depreciated separately.7 For example, the major parts
of an aircraft include airframe, engines, and interiors, such as seats and galleys.
These have different useful lives and maintenance requirements. The airframe has
a long useful life. Engines go through periodical major and minor overhaul and
require replacement after their life. Seats and galleys require frequent replacement
as they wear out much faster. It is necessary to allocate the cost of the asset to its
significant parts and depreciate the parts separately. Another example is an
offshore drilling platform that has a life of 20 years, but its mechanical parts
require replacement every three years. The mechanical parts will be treated as a
component separate from the platform.
Business enterprises use property, plant and equipment over a
number of reporting periods. Neither expensing the entire cost in
the year of acquisition of the asset nor retaining the cost on the
books until disposal of the asset provides for satisfactory measurement of periodic
income. Allocation of the asset cost to the periods receiving benefits from the asset
is necessary to provide periodic information on the results of operations to investors,
lenders, management, regulators and others who use the information.
Accountants think of depreciation as allocation of the cost of an asset to the
periods that are expected to benefit from its use. It is the gradual conversion of the
cost of an asset into expense. Depreciation “is the systematic allocation of the
depreciable amount of an asset over its useful life.”8 The principle is that “the
depreciable amount of an asset shall be allocated on a systematic basis over its
useful life.”9 “Systematic basis” is the key requirement. Therefore, arbitrary
assignment of the cost of an asset to reporting periods is not acceptable.
Another key implication of the definition is that it is necessary to charge
depreciation even if the market value of an asset has appreciated, because
depreciation is a process of allocation of past cost, and not valuation. Depreciation
begins from the time an asset is available for use (even if it is not actually used). It
continues even when the asset becomes idle or is retired from active use unless the
asset is fully depreciated. Depreciation stops once the asset is classified as “held for
sale” or when the asset is disposed of.
Land normally has an indefinite useful life (with some exceptions such as quarries
and landfill sites) and is, therefore, not depreciated. Plant and equipment items
have a limited useful life and are depreciated. For this reason, land and buildings
should be treated as separate assets. Revisit the discussion on basket purchases, if
necessary.
The depreciation accounting process involves the following steps:
1. Establishing the depreciable amount.
2. Estimating the useful service life.
3. Choosing an appropriate cost allocation method.
Establishing the Depreciable Amount
The depreciable amount of an asset is its cost, less residual value. The residual
value of an asset is the estimated amount that an enterprise would currently
realize from its disposal, after deducting the estimated costs of disposal if the asset
were already of the age and condition expected at the end of its useful life. If the
residual value of an asset equals or exceeds the asset’s carrying amount, there will
be no depreciation charge.
Estimating the Useful Life
The useful life (also known as useful service life or useful economic life) of an asset
is either (a) the period over which an asset is expected to be available for use by the
enterprise, or (b) the number of production or similar units expected to be obtained
from the asset by the enterprise.
The useful life of an asset is not the same thing as its physical life. The latter
depends on an asset’s physical wear and tear and the enterprise’s maintenance
policy. For example, if a plant works excessive hours, or is not subject to regular
preventive maintenance, its ability to produce goods in the future will be reduced.
Quite often, the useful life of an asset for an enterprise is shorter than its physical
life, because of other factors, such as the following:
Technological improvements result in supersession of assets currently in use.
Example: Many organizations replace their existing computers in good condition
when superior computers come into the market.
Changes in product markets may make an asset obsolete.
Example: Many jute mills went out of business after synthetic fibres came.
Limits on asset lives are specified by regulatory agencies on ecological and
safety considerations.
Example: Safety laws specify much shorter legal life for nuclear power plants
than their physical or technological life.
Contractual terms may constrain the use of an asset after a period of time.
Example: A building on leasehold land is not available to the lessee after the lease
for the land expires.
Some companies voluntarily may adopt asset replacement policies that
shorten the useful lives of assets based on safety and operating cost
considerations.
Example: Many airlines replace their aircraft before their physical life, because
aged planes are less safe to fly and entail more fuel and maintenance costs.
In sum, the physical life of an asset is, at best, a good starting point for estimating
its service life. Often, the useful life of an asset is less than its physical life due to
technological, marketing, and legal factors. An enterprise generally estimates useful
life based on its past experience with similar assets and the experience of other
firms in the industry. Estimation of the useful life is a matter of managerial
judgment.
Depreciation Methods
The final step in the depreciation process is to decide the method
of apportioning the asset’s depreciable amount. Several methods
are available to allocate the depreciable amount over an asset’s
useful life. Depreciation accounting controversies centre on the
choice of a suitable allocation method. Theoretically, the best method is the one that
matches the consumption of an asset accurately with the benefits received from it in
each period. These benefits can be in the form of additional revenue expected to be
generated by the asset, or likely savings in the costs of material, labour, power, and
so on. However, these measurements are extremely difficult. Over the years,
accountants have developed a number of methods that purport to allocate an asset’s
cost in a systematic manner to the periods in which the asset is used.
The common depreciation methods are as follows:
1. Straight-line method
2. Accelerated methods
• Written-down-value method
• Sum-of-the-years’-digits method
3. Production-units method
Straight-line Method
The straight-line method distributes the depreciable amount equally over the life
of an asset. This method assumes that depreciation arises solely from the passage of
time and that the effect of usage on the service value of the asset is insignificant.
The yearly depreciation expense is computed by dividing the depreciable amount
(cost of the asset less residual value) by the number of years of useful life. Assume
that a bus costs `800,000 and is expected to realize `80,000 at the end of its
estimated useful life of six years. The annual depreciation expense is calculated as:
The depreciation schedule for the asset is as follows:
The journal entry to record the depreciation expense in each year is as follows:
The straight-line method is the simplest and the most widely used method. It is
used for assets that depreciate mainly with time and are little affected by the extent
of usage. For example, buildings decline in service value as they age and it is
immaterial whether they are used or not. However, service from most assets
declines as they get older. We know that older cars give less mileage than new cars
and cost more in repairs. By assuming that assets give equal benefits in each
reporting period, the straight-line method undercharges depreciation in the earlier
years.
Accelerated Methods
The accelerated depreciation methods provide relatively larger amounts of
depreciation in the early years of an asset’s useful life and smaller amounts in later
years. These methods assume that certain types of plant, equipment and vehicles
are most efficient when they are new and decline in service as they age. The
accelerated methods assume that depreciation depends only on time, but, unlike the
straight-line method, they do not assume that the asset is equally useful in each
year. Charging higher depreciation in the early years would be consistent with the
matching principle if the benefits received in those years are higher.
The accelerated depreciation methods also assume that certain assets lose service
value, because of rapid technological changes. In such cases, the need for early
replacement justifies the use of accelerated depreciation rates. Besides, repair
expenses are lower in the early years; so the sum of repair and depreciation expense
tends to be constant over the life of the asset. We now describe two accelerated
methods:
(a) the written-down-value method, and (b) the sum-of-the-years’-digits method.
Written-down-value Method
In this method, depreciation is computed at a fixed rate on an asset’s carrying
amount at the beginning of a reporting period. Thus, the depreciation expense for
Year 1 will be a certain per cent of the beginning carrying amount, which is cost.
From Year 2 onwards, the depreciation charge would be related to the cost of the
asset less accumulated depreciation at the beginning of the year. Since the fixed
percentage is applied to the beginning carrying amount, the depreciation expense
will keep decreasing from year to year. This method is also known as the
diminishing-balance method. The depreciation rate can be calculated using the
following formula:
To illustrate the written-down-value method, let us take the bus example again.
The depreciation schedule for the bus under the written-down-value method is as
follows:
Yearly depreciation is computed by applying the depreciation rate to the carrying
amount at the beginning of the year. For example, depreciation expense for Year 1 =
`800,000  31.87 per cent = `254,960. Depreciation expense for Year 2 is `545,040 
31.87 per cent = `173,705.
The journal entries to record the depreciation expense for the first two years are
as follows:
Since the written-down-value method is the only method acceptable for tax
purposes for most assets, record-keeping costs are reduced by adopting the method
for accounting purposes as well. However, the tax depreciation rates contain an
incentive element for quick replacement of assets; hence, using these rates for
accounting depreciation will have the effect of writing off assets faster than can be
justified by the matching principle. Therefore, even if a firm follows the writtendown-value method, it should make independent asset life estimates for accounting.
Sum-of-the-years’-digits Method
This method is rarely used in India. Being an accelerated depreciation method, it
charges a large part of the cost of an asset in the early years. Under this method, we
calculate depreciation expense for a year as the product of the depreciable amount
and the factor, (k/S). The value of the numerator, k, would be n for Year 1, (n – 1) for
Year 2, (n – 2) for Year 3, ..., and 1 for Year n, n being the useful life of the asset
expressed in years. S equals the sum of the numbers, 1 to n, and is computed as 1 +
2 + 3 +  + n. The formula n(n + 1)/2 gives the value of the denominator.
Using the sum-of-the-years’-digits method, we calculate depreciation expense for
Year 1 as:
The depreciation schedule is as follows:
Note that depreciation expense for Years 1 to 6 is in the reverse ratio, 6:5:4:3:2:1.
Production-units Method
The production-units method assumes that depreciation arises solely from the
use of an asset and that time plays a trivial role in the depreciation process. Under
this method, the depreciable amount of an asset is divided by the total estimated
output during its useful life to obtain the unit depreciation rate. Yearly depreciation
expense is calculated by multiplying the unit rate by the yearly output. For
example, if the bus has an estimated useful life of 200,000 km, the unit depreciation
would be worked out as follows:
Let us assume that the bus log shows that its usage was 10,000 km in the first
year, 30,000 km in the second, 70,000 km in the third, 20,000 km in the fourth,
50,000 km in the fifth, and 20,000 km in the sixth year. The depreciation schedule
under the production-units method would be as follows:
The production-units method is appropriate when it is possible to estimate the
productive capacity of an asset with a fair degree of accuracy and there is a direct
relationship between an asset’s use and its loss of service potential. Productive
capacity may be expressed in terms of the number of units of output (machines),
hours (aircraft), kilometres (cars), or tonnes (mining equipment), as appropriate to
the asset. Where an asset’s output fluctuates widely from one period to another, the
production-units method results in a better matching of costs and revenues than the
straight-line method which computes a constant depreciation expense, regardless of
the output.
An accurate record of asset use, such as a properly written machine log, is a
prerequisite to the application of the production-units method. Very few companies
follow this method, most probably because the additional data-collection costs
involved in the method outweigh the benefits of better allocation of depreciation
resulting from its adoption.
Comparing the Depreciation Methods
A comparison of the four methods described earlier shows that straight-line
depreciation is equal over the six-year period (`120,000). By contrast, the
accelerated methods (written-down-value and sum-of-the-years’-digits) begin with
much higher amounts than straight-line (212 per cent and 171 per cent of straightline depreciation, respectively), and taper off to amounts below straight-line. The
pattern generated by the production-units method follows the pattern of output,
which fluctuates from year to year. The straight-line method produces a higher
carrying amount than the accelerated methods in the early years. Exhibit 7.1
compares these methods.
Figures 7.2(a) and 7.2(b) show depreciation expense and carrying amount under
the straight-line and written-down-value methods.
Selecting a Depreciation Method
Which depreciation method should an enterprise select? The method used should
reflect the pattern in which the enterprise expects to consume the asset’s future
economic benefits.10 Accounting standards do not provide specific guidance on how
to select the method. In principle, the method chosen should result in a fair
allocation of depreciation to the periods in which an enterprise benefits from the use
of an asset. Such a method will be consistent with the matching principle. The
enterprise’s management is in the best position to judge the expected pattern in
which an enterprise expects to consume an asset’s benefits.
While the straight-line method is the simplest of the depreciation methods, it does
not match costs and revenues when the output of an asset fluctuates. In such
situations, the production-units method is a better choice. The written-down-value
method may result in reduced record-keeping costs if an enterprise follows the tax
depreciation rates for financial reporting as well.
Factors such as the relative simplicity of a method, managerial motives, savings
in record-keeping costs, tax laws, and legal requirements influence the choice of the
method. Many listed companies use the straight-line method, because it enables
them to report higher earnings to their shareholders in the early years of new
projects. Also, communicating the effect of the straight-line method to investors is
relatively uncomplicated.
Analysts would view a company that uses accelerated depreciation as being more
prudent in measuring its earnings and hence having a higher earnings quality since
higher depreciation charges in the early years of an asset’s life result in lower profit.
Legal Requirements Relating to Depreciation
Schedule II to the Companies Act 2013 specifies the useful life and residual value of
various tangible assets. These provisions will apply as follows:
1. Prescribed class of companies: The useful life and residual value of an asset
shall not normally be different from those specified in Schedule II. If a
company uses a different useful life or residual value, it must disclose the
justification for doing so. The “prescribed class of companies” would include
listed companies.
2. Other companies: The useful life of an asset shall not be longer and residual
value shall not be higher than those specified in Schedule II.
Thus, companies in the “prescribed class” the specified useful lives and residual
value can adopt shorter or longer useful life and higher or lower residual value, if
they have reasons. Ordinarily, the residual value of an asset is often insignificant,
but it should generally be not more than 5% of the original cost of the asset. Exhibit
7.2 gives the useful lives for selected assets from Schedule II.
Companies must disclose their depreciation method(s) and depreciation rates or
useful lives of assets, if the rates followed are different from the Schedule II rates.
Schedule II states that the useful life or residual value of any specific asset, as
notified by a regulatory authority, shall be applied in calculating the depreciation to
be provided for such asset irrespective of the requirements of Schedule II. For
example, electricity companies must follow the rates and method notified by the
Central Electricity Regulatory Commission.
Some Issues in Depreciation Accounting
Depreciation for Partial Reporting Periods When an asset is bought during a
reporting period, depreciation for the period is proportionate to the period (or pro
rata) it is held. Assume that an enterprise buys a machine with an estimated useful
life of 10 years and a residual value of `10,000 for `250,000 on January 1, 20XX and
that the financial year ends on March 31, 20XX. The straight-line depreciation for
three months would be `6,000, calculated as follows:
Assets of Low Value Items such as loose tools, dies, moulds, and spare parts have
a short life and have to be replaced constantly. For practical convenience, many
companies charge off assets of low value to current period’s income. It is tedious to
maintain records for such numerous items. The practice of writing off assets of low
value is acceptable if the amounts are not material in relation to the net profit of an
enterprise. This is an example of how the materiality principle may be applied.
Revising Useful Life and Residual Value Useful life and residual value
estimates are seldom precise. Therefore, enterprises must review them at each
reporting date. If current expectations differ from previous estimates, they must
revise the estimates. New developments such as unanticipated physical damage or
unforeseen obsolescence would require changing the previous estimates. Also, more
experience in using the asset may suggest the need for changing the estimate. A
change in accounting estimate is recognized prospectively by including it in the
financial performance and financial position in the current and future periods.11
The enterprise expenses the depreciable amount at the time of the change over the
remaining useful life of the asset.
Changing the Depreciation Method An enterprise should apply the same
depreciation method over time, so that users of financial statements can compare
the numbers. The depreciation method should reflect the pattern in which the
enterprise expects to consume the future economic benefits from the asset. New
information could suggest a different pattern. The method must be reviewed at each
reporting date. If there is a significant change in the pattern of consumption of the
future benefits, the enterprise must change the method to reflect the new pattern. A
change in the depreciation method is treated as a change in accounting estimate
and recognized prospectively in the financial performance and financial position in
the current and future periods.12 Appropriate disclosures are required.
Depreciating Components of an Asset When the cost of a part of an asset is
significant in relation to its total cost, the cost of the asset must be allocated to its
significant parts. Also, it must depreciate separately each of those parts. That
means the enterprise must estimate the useful life and the residual value of each
such part and select a depreciation method that is appropriate for each. This
involves significant managerial effort, especially for large enterprises with
numerous assets. At times, a significant part of an asset may have a useful life and
depreciation method, which are the same as the useful life and the depreciation
method of another significant part of the same asset. Such parts may be grouped in
determining the depreciation charge.
Fully Depreciated Assets An enterprise must not remove a fully depreciated
asset from the accounting records, so long as it is in good working condition and
continues to be used. This is necessary in order to maintain control over fixed
assets. Also, there will be no depreciation charge for a fully depreciated asset. Since
the objective of depreciation is to allocate the cost of an asset over its useful life, the
total depreciation for an asset cannot exceed its cost. The cost and accumulated
depreciation should be removed when the asset is no longer used in a business.
13
Capital and Revenue Expenditures
An enterprise incurs costs on an asset after its initial acquisition.
If the costs meet the recognition criteria for items of property,
plant and equipment – (a) probable future economic benefits and
(b) reliable measurement, they can be capitalized. Otherwise, they
have to be expensed. Capital expenditures are expenditures for
the acquisition of assets. Subsequent expenditures that extend the useful life,
improve the quality of output, or reduce operating costs of an existing asset beyond
their originally estimated levels are capital expenditures. For example, the
construction of an additional floor in a hotel increases the hotel’s revenue-earning
capacity. So there are probable future economic benefits and the cost of construction
can be reliably measured. Using similar reasoning, providing air-conditioning in
inter-city coaches and replacing co-axial telecommunication lines by optical fibre
cables are capital expenditures.
Revenue expenditures are expenditures for ordinary repairs, maintenance,
fuel, insurance, or other items needed to maintain and use buildings, and plant and
equipment. They go to expense accounts and reduce the profit of the period in which
they are incurred, because the benefits from these expenditures do not last beyond
that period. Legal expenses incurred to defend title to an asset are revenue
expenditures. An enterprise may relocate its factory, or rearrange and reinstall a
group of machines in a plant, for improving efficiency, and incur substantial
expenditures for this purpose. These expenditures may benefit a number of periods.
If these expenditures cannot be separated from normal operating expenses, they are
expensed when incurred.
Ordinary repairs are expenditures incurred to maintain assets in good working
condition. These are the costs of day-to-day servicing of assets that include the costs
of labour, materials, and small parts. Periodic replacements of fused bulbs and
worn-out car tyres, oiling and cleaning of equipment, and painting of buildings are
treated as ordinary repairs since these expenditures are fairly regular and their
benefit does not last beyond the year in which they are incurred. Ordinary repairs
are expensed as incurred. Major repairs are different as they benefit a number of
periods. For example, the benefit of relining a furnace or refurbishing aircraft
interiors such as seats and galleys will go beyond the current year. Hence, most
businesses capitalize such items and depreciate them over the periods in which they
expect to benefit from the expenditures.
Some assets require regular major inspections, whether or not any parts are
replaced. For example, civil aviation authorities stipulate major periodic inspections
for faults as a condition for operating an aircraft. The dry-docking of a ship is
another example of such an event. The cost of each major inspection that meets the
recognition criteria is capitalized as a component of the related asset and
depreciated over the period until the next inspection. At that time, any remaining
amount relating to previous inspection is derecognized. At the time of acquisition of
an asset that requires major inspection, the estimated cost of the next major
inspection is separated from the asset’s cost and depreciated over the period until
the next inspection. In effect, we follow the component approach for depreciation of
significant parts of an asset for major repairs and major inspections.
A practical approach is to treat any expenditure that will benefit several reporting
periods as a capital expenditure, and any expenditure that will benefit only or
mostly the current reporting period as a revenue expenditure.
For practical purposes, many enterprises establish policies stating what
constitutes a capital or revenue expenditure. For example, small expenditures on
capital items may be charged to income, because the amounts involved are
frequently thought to be not material in relation to the reported profit. For example,
the cost of a stapler, which may last many years, would be treated as supplies
expense rather than as an asset.
Effect of a Capital-Revenue Error
A capital expenditure is normally debited to an asset account and does not reduce
the income of the current period. The amount will be depreciated in the future
periods. A revenue expenditure is accounted by debiting an expense account and is
deducted in computing the income of the current period. Any error in distinguishing
between capital and revenue expenditures will result in distorting the reported
profits of current and future reporting periods.
Suppose that a firm erroneously charges the cost of equipment to repairs. The
effect of this error will be to overstate the expense and thus understate the
profit for the current period. In future periods, profits will be overstated,
because of the absence of depreciation charge.
If the firm capitalizes current repairs, the result will be to understate repairs
expense, thereby overstating the profit of the current period. Profits in future
periods will be understated to the extent of the depreciation expense
computed on the amount of repairs.
The effect of error in treating a capital expenditure as a revenue expenditure and
vice versa is self-reversing, similar to an inventory error.
Conflicting Motives
The distinction between capital and revenue expenditures is not always
straightforward. Hence, firms wishing to boost their profits frequently attempt to
capitalize expenditures which, on closer scrutiny, may have to be written off as
revenue expenditures. Auditors review the firm’s treatment of nebulous expenditure
items to ensure that current expenses are not capitalized. In contrast, for tax
purposes, most businesses, in case of doubt, choose to expense an outlay rather than
capitalize it, because expensing the item has the effect of reducing their taxable
income and tax expense. Of course, tax officials will scrutinize such items carefully
to ensure that capital expenditure is not allowed as business expense. As may be
expected, tax payers and the tax department usually differ on the appropriate
treatment of many an expenditure. Therefore, the Supreme Court and the High
Courts have to decide numerous disputes leading to the development of a large body
of case law on the subject.
Now think of a firm that is even more tax-driven. It would be too happy to
expense costs incurred in acquiring assets, such as brokerage and lawyer’s
fee, immediately and reduce its taxable income for the current period. There
have been bizarre instances of companies splitting up a large capital
expenditure into small amounts and expensing them in order to save tax.
Depreciation for Income Tax Purposes
Depreciation benefits under the income tax law are frequently
confused with the depreciation charge in the financial statements.
For reporting to shareholders and lenders, financial statements
must be prepared in conformity with accounting principles and
standards. In contrast, income tax returns and related statements
must comply with income tax regulations. While financial accounting and tax
accounting are similar in some respects, they differ significantly in other areas.
Depreciation is an example.
Income-tax rules permit tax payers to claim depreciation benefits at the
prescribed rates using the written-down-value method.14 The government seeks to
encourage business enterprises to invest in new assets by allowing them to charge
off assets rapidly. So, in many countries including India, the tax law permits
accelerated write-off of asset costs by prescribing recovery periods that are shorter
than the estimated useful lives for accounting purposes as well as permitting
recovery of a large portion of the cost of the investments in the early years. Also, the
tax law requires legal ownership and use of an asset, but accounting depreciation is
based on economic ownership. The stipulations for accounting and tax depreciation
are different, simply because the objectives of financial reporting differ from those of
taxation. Exhibit 7.3 gives a sample of the tax depreciation rates.
To illustrate the calculation of tax depreciation, let us revert to our bus example
and apply a tax depreciation rate of 30 per cent.
You might have noticed that for tax purposes the business can claim nearly 66 per
cent of the asset cost in the first three years, although the asset has an estimated
useful life of six years.
Different methods of depreciation may be used for reporting to shareholders and
income tax authorities. In this sense, there is nothing devious about businesses
maintaining “two sets of accounting records”: one for shareholders and the other for
tax authorities. Most large enterprises use straight-line depreciation in their
financial statements, because it is convenient to use and makes it possible to show
higher earnings in the early years. But they use the written-down-value method for
tax purposes, postponing payment of income taxes. Thus, they have the best of both
worlds. Tax rates of depreciation are not usually acceptable for shareholder
reporting.
Disposal of Depreciable Assets
When an asset wears out or becomes obsolete, it is no longer
useful. An enterprise scraps or sells it, or exchanges it for
another asset. Seldom is the disposal value of an asset equal to
its carrying amount; so it is usually necessary to recognize a gain
or a loss on disposal.
Accounting entries differ depending on the manner of disposal of a used asset: (a)
discarding; (b) holding for disposal; (c) selling; or (d) exchanging for another asset.
Depending on the manner of disposal, the entries must do the following:
1. Record depreciation for the part of the period ending with the date of
disposal;
2. Remove the cost of the asset and the accumulated depreciation from the
books;
3. Show any receipt or payment of cash;
4. Recognize any gain or loss on disposal; and
5. Recognize any new asset acquired.
To illustrate the procedure for disposal, suppose that Amit Company acquired a
photocopier on April 1, 20X1, for `170,000 with an estimated useful life of eight
years and residual value of `10,000. Amit charges straight-line depreciation. The
company disposes of the photocopier on June 30, 20X6, i.e. after using it for five
years and three months. The financial year-end is March 31. Just before the
disposal, the asset and accumulated depreciation would have appeared in the books
as follows:
The carrying amount of the asset is now `65,000. We will now see the procedure
for recording the disposal of the asset in different ways.
Discarding an Asset
Suppose that Amit Company abandons the photocopier without realizing any
amount. It will remove the asset and accumulated depreciation accounts and
recognize the asset’s carrying amount as loss. The following entry will record the
disposal:
Holding an Asset for Sale
Suppose that the company withdraws the asset from its intended use and plans to
sell it later. As before, it will remove the asset and accumulated depreciation
accounts, and recognize the lower of the asset’s carrying amount and estimated net
realizable value (i.e. fair value less costs to sell) as a “non-current asset held for
sale”. It will recognize the carrying amount of the asset less estimated net realizable
value as loss. Assume that the photocopier is estimated to sell for `10,000 after
deducting estimated selling costs. The following entry records the disposal:
Selling an Asset
Suppose that Amit Company sells the photocopier for `50,000 after meeting the
selling costs. It will remove the asset and accumulated depreciation accounts, record
the net sale proceeds, and recognize the difference between the carrying amount of
the asset less net sale proceeds as gain or loss. It will record the transaction as
follows:
If the asset is sold for an amount greater than its carrying amount, a gain will
result. Assume that the net sale proceeds are `90,000. The following entry records
the gain:
If the net sale proceeds equal the carrying amount of the asset, no gain or loss
arises. In that case, Amit removes the asset and accumulated depreciation accounts
and records the net sale proceeds, as follows:
Exchanging an Asset for Another Asset
Suppose that Amit Company exchanges the existing photocopier for another asset
or a combination of another asset and a cash payment. At what amount should it
record the asset received? Should it recognize a gain or loss on exchange?
The principle is that an asset acquired in an exchange should be measured at fair
value if (i) the exchange transaction has “commercial substance”; and (ii) the fair
value of either the asset received or the asset given up can be reliably measured. An
acquired asset not measured at fair value is recorded at the carrying amount of the
asset given up. If both the fair value of the asset received and the fair value of the
asset given up can be estimated with equal reliability, the asset received should be
measured at the fair value of the asset given up. If the fair value of the asset
received can be measured with more reliability, that value is used. The fair value or
carrying amount is adjusted for any cash paid or received.
An exchange transaction has commercial substance if:
1. the configuration (risk, timing, and amount) of the cash flows of the two
assets differs; or
2. the net present value of the post-tax cash flows of the operations of the
enterprise affected by the transaction changes as a result of the exchange.15
In either case, the difference should be significant relative to the fair value of the
assets exchanged.
Suppose that Amit Company exchanges the photocopier with a fair value of
`75,000 and cash amount of `25,000 for a scanner with a fair value of `100,000.
Assume that the cash flow configuration of the two assets is different. So the
transaction has commercial substance. The company will record the scanner at its
fair value of `100,000 and the gain on the exchange of `10,000, the difference
between fair value and carrying amount of the photocopier:
Now let us suppose that Amit Company exchanges the photocopier with a fair
value of `75,000 and cash of `25,000 for a new photocopier with a fair value of
`100,000. On the face of it, there is a gain of `10,000. But the transaction lacks
commercial substance, because the company’s cash flow configuration is not
expected to change as a result of the exchange. In effect, the company is in the same
position as it was before the transaction, and there is no gain, really. So it
recognizes the asset received at the carrying amount of the asset given up, adjusting
for the cash paid:
In other words, the cost of the asset received is reduced by the amount of notional
gain.
Gains and Losses under Tax Laws
For tax purposes, gains and losses on disposal of depreciable assets are calculated in
respect of a “block of assets”, a group of assets that have the same depreciation rates
within the asset classes of buildings, furniture, machinery and plant, ships, and
intangible assets. Under the tax laws, there is no need to maintain item-wise
records. The block increases with addition of assets and decreases with disposals. So
long as the proceeds from the sale of an asset (or the fair value of the asset obtained
in exchange) are less than the depreciable amount of the block to which the asset
pertains, no gain arises for tax purposes. A gain will arise for tax purposes only if
the carrying amount of the block at the time of the disposal is less than the value of
the asset being disposed. A loss will arise only if all the assets in a block have been
disposed of and a balance remains in the block after deducting the disposal value of
the asset already being disposed.
Myths About Depreciation
To accountants, depreciation is the allocation of an asset’s cost to
the periods over which it is expected to be useful. Many users of
financial statements seem to have fanciful notions of depreciation.
Here are three such notions:
Myth 1: Depreciation is a source of cash.
Myth 2: Depreciation is intended to provide funds for replacement.
Myth 3: Depreciation is a valuation process.
Let us now deal with them.
Myth 1: Depreciation is a Source of Cash
Many users of financial statements believe that depreciation is a source of cash. The
greater the provision for depreciation, they figure, the higher the firm’s cash
generation. They could be imagining that accumulated depreciation represents
wads of currency notes waiting to be used when fixed assets are to be replaced.
Depreciation expense is similar to any other expense in that it reduces net profit.
But it does not entail a cash outflow, unlike other expenses, e.g. salaries. This is not
the same thing as a cash inflow. Depreciation expense is just the result of an
accounting entry to allocate the cost of an asset to different reporting periods. The
accumulated depreciation account is a contra asset account in that it represents the
amount of the cost an asset already written off. Note that the cash account has a
debit balance, whereas the accumulated depreciation account has a credit balance.
Consider a sample journal entry for recording depreciation expense.
This entry does not affect cash. We can appreciate this better with the help of a
cash flow statement. Suppose that you start a business with cash of `10,000. You
pay cash and buy equipment costing `6,000 with an estimated useful life of four
years and zero residual value. You charge straight-line depreciation. In the first
year, your business makes cash sales for `8,000 and cash purchases for `5,000. The
cash flow statement for the first year would be as follows:
Note that depreciation does not appear as an inflow in the statement. The ending
cash balance will be `7,000, whether the depreciation rate is 0, 25, or 100 per cent.
It is thus clear that depreciation accounting has nothing to do with the generation
of cash. Smart businessmen have always known that there is only one source of
cash from operations, and that is the cash provided by sales to customers.
Myth 2: Depreciation is Intended to Provide Funds for Replacement
As we have seen, accumulated depreciation does not exist in the form of cash. Very
few businesses earmark a part of their cash balance for asset replacement, since
investment in plant and equipment is much more profitable. Occasionally, we may
come across a company that has a depreciation fund, a reserve represented by
cash or investment in securities earmarked for financing asset replacement.
In addition, there is the problem of inflation. Asset prices rise in times of inflation;
so, the cost of a new asset that will replace an existing asset will be greater than the
amount of profit retained based on the historical cost of the asset. Recall that the
purpose of depreciation is to spread the cost of an asset. The depreciation charge is
related to the historical cost of an asset, not its replacement cost. As a result,
dividends and other payments are made based on ‘illusory’ profits, leaving
insufficient funds for replacement of property, plant and equipment. In fact, this is
one of the major weaknesses of the historical cost system.
Businesses can handle the problem of finding cash in several ways:
1. Revalue the fixed assets and relate the depreciation charge to the replacement
cost of the assets. This is the modified historical cost system, described in
the next section. While many companies have revalued their fixed assets,
unfortunately, they continue to provide depreciation based on the historical
costs of the assets to avoid reporting lower profit to shareholders.
2. Set aside in a reserve a supplementary depreciation equal to the excess of
current value depreciation over the historical cost-based charge. This may be
done with or without revaluation of assets. The supplementary depreciation
would form part of a company’s distributable reserves. This is a ‘below the
line’ item.
3. Prepare comprehensive inflation-adjusted statements and decide on
dividend payout on the basis of the revisedk net profit.
These approaches reduce the amount of cash available for distribution and thus
reduce the cash outflow. In India, hardly any company does any of these things.
Myth 3: Depreciation is a Valuation Process
Financial statements do not purport to show the fluctuating market values of fixed
assets. Therefore, we depreciate an asset even if its market value has increased. For
example, buildings have gone up in value in many parts of the world. Yet the
accountant depreciates buildings, because they have a finite useful life over which
their cost must be expensed. Accounting depreciation does not mean a decline in the
market value of an asset. Consequently, the balance sheet values of fixed assets
seldom reflect their current market values.
Revaluation of Property, Plant and Equipment
Traditionally, fixed assets have been shown in the financial
statements at their cost of acquisition. Persistent and high rates
of inflation have led to substantial differences between the
historical costs and current market values of assets. Some argue that the
information on asset values given in the balance sheet is irrelevant to the needs of
managers, investors, and other users, because the balance sheet does not reflect the
current worth of a business. Responding to this criticism, many businesses
recognize the current replacement values of their property, plant and equipment
assets.
The disconnect between historical costs and current values is particularly evident
in the case of land and buildings, since property values have tended to appreciate
significantly in many cities and major towns. Revaluation enables a company to
present a healthier balance sheet by lowering the debt-equity ratio, a measure of the
extent of a firm’s reliance on borrowings and an indicator of its long-term solvency.
Also, a company may revalue its assets with the aim of lifting its stock price by
informing investors of its current value. A rise in the stock price would make the
company a less attractive takeover target.
Enterprises can choose either the historical cost model or the revaluation model
for property, plant and equipment.16 Under the historical cost model, the asset
appears at its cost less any accumulated depreciation and impairment losses. Under
the revaluation model, the asset appears at its fair value at the date of the
revaluation less accumulated depreciation and impairment losses. Regular
revaluations are necessary to ensure that the asset’s carrying amount does not
differ materially from its fair value. Selective revaluation of assets can lead to a
confusing mixture of costs and values on different dates. Therefore, when a firm
revalues an item of property, plant and equipment, it should revalue the entire class
of assets to which the item belongs. Examples of classes are land, land and
buildings, machinery, ships, aircraft, motor vehicles, furniture and fixtures, and
office equipment. Usually, enterprises obtain periodic appraisals of assets from
professionally qualified valuers. A look at published reports over the years would
show that the number of Indian companies revaluing their assets has been
increasing.17
Revaluation Reserve
An increase in an asset’s carrying amount arising from revaluation goes directly to
equity as revaluation reserve. As a matter of prudence, a decrease in the carrying
amount is charged to the statement of profit and loss. An increase will go to the
statement of profit and loss to the extent it reverses a past charge, and a decrease
will go to revaluation reserve to the extent it reverses a past surplus. Revaluation
surplus is an unrealized gain. Based on legal and accounting principles, it is a
capital reserve, a reserve that is not available for distribution as dividends or for
issue of bonus shares. (You will learn more about these in Chapter 10.)
Accounting for Revaluation
To illustrate the accounting for revaluation, assume that Victor Company bought a
plant on January 1, 20X0 for `15,000 with an estimated useful life of five years and
depreciated it using the straight-line method. On December 31, 20X2, the plant
would appear in the balance sheet as follows:
Assume further that the current purchase price of a new plant is `25,000. If the
existing plant is revalued, the above numbers would be revised as follows:
The journal entry to record the revaluation is as follows:
The credit of `9,000 to Accumulated Depreciation is the “backlog” depreciation for
three years for the difference between depreciation based on revaluation and on
cost.
Depreciation on Revalued Assets
An enterprise opts for revaluation, because it wants to present the current value of
its assets. It follows that the charge for consumption of assets should also be in
current value terms. From the time of revaluation, the depreciation charge should
be based on the revalued amount. In the above example, the depreciation expense
for 20X3 would be `5,000, as compared to `3,000 under the cost model.
Intangible Assets
An intangible asset is an “identifiable non-monetary asset,
without physical substance.”18 Intangible assets are long-term
assets that can generate future earnings. The value of an
intangible asset arises from the long-term rights, privileges, or advantages it
confers on its owner. Identifiability, control, and future benefits are necessary in
order to recognize an item as an intangible asset. An intangible asset meets the
identifiability criterion when it (a) can be separated or divided from the enterprise
and sold or transferred, and (b) arises from contractual or other legal rights. A
copyright is an intangible asset, because it is identifiable separately from other
assets, it arises from a legal right, and the owner has exclusive control over its use,
and he expects future benefits from it. Other examples of intangible assets are
aircraft landing rights, brand names, mastheads, trademarks, customer lists,
computer software, patents, motion picture films, fishing licences, mobile phone
licences, website development costs, carbon credits, import quotas, and franchises.
An enterprise certainly benefits from supplier relationships, customer loyalty,
employee skills, and market share. Unfortunately, these do not meet the definition
of an intangible asset (particularly, identifiability and control) and hence
enterprises cannot recognize them in the financial statements.
Intangible Assets and Competitive Advantage
Professor Baruch Lev of New York University, a leading authority on intangible
assets, says:
Wealth and growth in today’s economy are primarily driven by intangible (intellectual) assets. Physical and financial assets
are rapidly becoming commodities, yielding an average return on investment. Abnormal profits, dominant competitive
positions, and sometimes even temporary monopolies are achieved by the sound deployment of intangibles, along with
other types of assets.19
It is easy for a business to acquire tangible assets such as buildings and
equipment. Hence, having such assets cannot give a business an edge over its rivals.
Intangible assets, such as the reputation of a brand, strength of research and
development, and highly trained and motivated employees, are much more difficult
to develop, acquire or copy. The competitive advantage that gives a firm the ability
to earn a better rate of return relative to its industry peers comes mainly from
intangible assets.
Today, much of a firm’s worth is represented by intangible assets. As the role of
service industries with a large number of intangible assets continues to rise, the
question of recognizing these assets is becoming important for a large number of
companies and the users of their financial statements. Efforts are on to develop
more objective methods of valuing intangible assets. Accounting for intangibles is
likely to occupy the agenda of accounting regulators in the coming decades.
Recording Acquisition of Intangible Assets
The general principle is that an enterprise can recognize an intangible asset only if
it meets two criteria:
1. It is probable that it will give future economic benefits to the enterprise.
2. The cost of the asset can be measured reliably.
The first step in accounting for an intangible asset is to arrive at its cost of
acquisition. The principles are the same as those for tangible assets. Thus, the cost
of an intangible asset comprises its purchase price, import duties and other taxes,
and any directly attributable costs of bringing the asset to working condition for its
intended use.20 Directly attributable costs include costs of employee benefits, e.g.
salaries, pensions and other benefits, professional fees, such as lawyers’ fees, and
costs of testing whether the asset is functioning properly. Trade discounts, rebates,
and refundable taxes are deducted in arriving at the purchase price.
Suppose that a publisher buys the copyright for a book titled How to Live Happily
Forever for `100,000. The company pays `5,000 for its lawyer’s services and `2,000
for copyright filing and registration. We record the purchase of the copyright as
follows:
Amortization of Intangible Assets
Amortization is “the systematic allocation of the depreciable amount of an
intangible asset over its useful life.”21 Amortization is the term used for
depreciation of intangible assets. Many intangible assets have finite useful lives. A
number of factors, such as likely obsolescence, competitors’ actions, and contractual
and legal terms on the use of the asset, determine the useful life of an intangible
asset. For example, the useful life of a patent for a CT scanner will depend on its
typical product life cycle (introduction, growth, maturity, decline, and exit), likely
technological developments, competitors’ products, regulatory requirements, and so
on. The method used for amortization is usually the straight-line method though
other methods such as the written-down-value method and the production-units
method may be appropriate in some cases.
Suppose that the publisher expects How to Live Happily Forever to be sold over
the next five years, although the copyright has a legal life of sixty years. The
following entry records the yearly amortization charge:
Exhibit 7.4 outlines the accounting for selected intangible assets. The Income Tax
Rules provide that for tax purposes the following intangible assets can be amortized
at the rate of 25 per cent on a WDV basis: know-how, patents; copyrights;
trademarks; licences; franchises; or any other business or commercial rights of
similar nature.
Internally Generated Intangible Assets
Brands Names such as Amul, Apple, Bournvita, Coke, Colgate, CNBC, Dettol, Lux,
Maggi, Nescafe, Nike, Nirma, LG, Sony, Surf, Van Heusen, and Visa are among the
scores of brands that dominate the daily lives of millions of Indian consumers.
Brands command enormous loyalty from consumers who frequently remain largely
indifferent to the brand’s ultimate ownership. (Do you know who owns the Complan
brand?) Brands are increasingly recognized as the most important of all marketing
tools, and this is why businesses are investing heavily in acquiring and developing
brands. Yet, in India, as in most other countries, brands do not appear in the
balance sheet.
Accounting standards permit the recording of acquired brands, but prohibit
recognition of “home-grown” or internally generated brands (and other similar items
including mastheads, publishing titles, and customer lists).22 The reason is that
home-grown brands are indistinguishable from the cost of developing a business as
a whole. Whether acquired or home-grown, brands require considerable
expenditure, generate substantial income, and add value to their owner. Businesses
argue that disallowing recognition of home-grown brands results in balance sheets
that reflect only the value of acquired brands, and companies that have generated
brands internally do not have the benefit of showing the strength of their brands in
their balance sheets. Excluding brands from the financial statements understates
the value of companies and potentially exposes them to the risk of hostile takeover.
Goodwill Goodwill means many things to many people. Businessmen use the term
goodwill to refer to a company’s advantages, such as excellent reputation, enviable
location, and superior personnel. While few will doubt the contribution of these
factors to a company’s well-being, placing a monetary value on them is extremely
difficult. Since personal opinions play an important part in measuring these items,
it is not possible to value goodwill objectively. The inclusion in financial statements
of subjective amounts as goodwill may give a misleading view of the worth of a
business and undermine the reliability of these statements. Internally generated
goodwill does not have the essential characteristics of an intangible asset, because it
is neither separable from the enterprise nor does it arise from contractual or other
legal rights. Therefore, it is not possible to recognize any internally generated
goodwill.23
Research and Development (R&D) Companies in hi-tech industries spend
considerable sums of money on pure research as well as development of new and
improved products, processes, and materials. In most cases, there is little, if any,
direct relationship between the amount of current R&D costs and future benefits,
because the amount and timing of such benefits are usually uncertain. Accountants
distinguish between research and development phases:
Research involves gaining new knowledge and understanding (e.g. searching
for a new drug molecule).
Development involves the application of research findings for the production
of better materials, products or processes (e.g. designing and testing a new
drug).
An enterprise should expense any amounts spent on research as incurred, because
it is not possible to demonstrate the existence of any future economic benefits at the
research phase. The development phase of a project is further advanced than the
research phase. If it is not possible to distinguish between these two phases of a
project, the amounts spent on the project should be expensed as incurred.
An intangible asset arising from development should be recognized if and only if
an enterprise can demonstrate all of the following:24
(a) The technical feasibility of completing the intangible asset so that it will be
available for use or sale;
(b) Its intention to complete and use or sell the intangible asset;
(c) The ability of the enterprise to use or sell the intangible asset;
(d) How the intangible asset will generate probable future economic benefits (e.g.
the existence of a market for the output of the intangible asset);
(e) The availability of adequate technical, financial, and other resources to
complete the development of, and to use or sell, the intangible asset; and
(f) The ability of the enterprise to measure the expenditure attributable to the
intangible asset during its development reliably.
It is not possible to reinstate past amounts expensed as part of the cost of an
intangible asset at a later date. The financial statements should disclose the
aggregate amount of R&D expenditure recognized as an expense during the period.
Companies are required to give the following information on R&D in the directors’
report:
1. Specific areas of the company’s R&D activity;
2. Benefits derived as a result of R&D activities;
3. Future plan of action; and
4. Expenditure on R&D, showing capital and revenue expenditures separately.
It appears that many Indian companies view these requirements as a burden
rather than as an opportunity to communicate their long-term growth prospects to
their shareholders and others. So the discussion on R&D matters in the directors’
report often tends to become routine and less informative.
Comprehensive reporting on R&D activities will enable users of financial
statements to take a long-term view of companies instead of unduly focusing on
earnings per share. While managers constantly fault the “short-termism” of
analysts and institutional investors, they disclose too little about expenditure on
R&D to help users make informed judgments about how companies are spending
their money and the likely future benefits. Increasingly, large institutional
shareholders are seeking to bring about greater disclosure of R&D efforts.
Companies are concerned about the fallout of the additional information becoming
available to their competitors and must balance the benefits of improved disclosure
to their investors and the competitive costs of such disclosure.
Natural Resources
Natural resources may be either non-renewable or renewable.
Accounting for extracting non-renewable resources (e.g. mines and
oil wells) and for developing renewable resources (e.g. forests and
plantations) involve different kinds of complexities. We now examine accounting for
non-renewable resources.
Enterprises in extractive industries such as mines, oil, and natural gas look for
and take out natural resources that lie underneath the earth. The oil and gas
industry has seven broad phases:
1. Prospecting It involves analyzing historical geological data and carrying
out topographical, geological and geophysical studies. Since the information
generated from prospecting activities do not give rise to enforceable rights,
the associated costs would not be recognized as an asset. Prospecting costs
are expensed as incurred.
2. Acquisition of mineral rights This entails acquiring licence from a
government to explore a defined area for oil and gas. The legal rights may
take several forms, such as property titles conferring outright ownership of
3.
4.
5.
6.
7.
the oil and gas property, lease or concession arrangements that are granted
by the owner of the rights (usually a government), or production sharing
contracts with governments. These rights meet the definition of an asset,
because the enterprise that owns them alone can engage in exploration in
the defined area and the rights have a positive value. A common process for
selling exploration rights is to auction new exploration blocks to the highest
bidder. The amount paid by the winning bidder would represent a legal
rights asset.
Exploration It involves searching for oil and gas. Exploration costs in the
oil and gas industry include the costs of seismographic shooting, core
drilling, and drilling of an exploratory well.
Evaluation It calls for determining the technical feasibility and commercial
viability of extracting oil and gas. Evaluation takes place only if oil and gas
have been found. Evaluation costs include the costs of drilling appraisal
wells and costs of detailed engineering studies to determine how best the
reservoir can be developed to obtain maximum recovery.
Development It refers to gaining access to the oil and gas deposit.
Development costs include the costs of constructing platforms or preparing
drill sites from which to drill wells to gain access to and produce oil and gas
and installing equipment and facilities necessary for bringing oil and gas to
the surface. Development costs should be recognized as part of the legal
rights asset to the extent they have future economic benefits.
Production It involves extracting oil and gas from the earth and making
the produce marketable or transportable. Production costs include lifting the
extracted oil and gas and removal of impurities, transportation, and storage.
Besides, the costs accumulated as asset until the development phase should
be depreciated/amortized over the quantity of reserves to reflect the
consumption. Property, plant and equipment used in production should be
depreciated similarly. Some assets may have a shorter life, while others can
be redeployed in other locations. In that case, the component approach
should be followed and the assets depreciated separately.
Closure and decommissioning These involve dismantling and removing
the assets and restoring the site on which it is located. The exploration
licence usually imposes an obligation for closure and decommissioning. The
related liability should be dealt with as discussed in Chapter 9.
Oil and gas enterprises face significant uncertainties. To begin with, there is no
direct relationship between the amount of exploration costs and the prospects of
finding oil and gas. For example, a small expenditure may lead to a major find,
while a large expenditure may yield nothing. Even if an exploration is successful,
the quantity of oil and gas that can be extracted would depend on geological,
technical, and economic conditions. The uncertainties persist during the
development and production phases. The political and regulatory environment often
exacerbates the uncertainties. It would seem that the oil and gas industry has a lot
in common with research and development.
IFRS 6 deals with accounting for exploration and evaluation costs. Currently,
there are two methods of accounting followed in the oil and gas industry: (a) the
successful efforts method, and (b) the full-cost method. IFRS 6 permits both.
Successful Efforts Method Only those costs that lead directly to the discovery,
acquisition, or development of mineral resources are capitalized. Other costs are
expensed as incurred. Each property, licence, concession or production sharing
contract is treated as a cost centre for determining success.
Full Cost Method All exploration and evaluation costs are capitalized. Here the
cost centre is much larger than a licence area. It is often a country but may even be
a group of countries.
The successful efforts method requires the immediate expensing of the exploration
costs of a dry well, but the full cost method allows the costs of a dry well to be
retained as part of a larger cost centre that would have both successful and
unsuccessful wells. As you can see, the successful efforts method is more prudent.
The IASB has issued a discussion paper on accounting in extractive industries.25
Non-renewable assets, such as mines, oil, and natural gas are in essence stockpiles
of inventories that are exploited over a number of reporting periods. Depletion is
the act of recovering the natural resources available, such as mining coal or
pumping out oil. The term also means the allocation of the cost of a natural resource
to the units extracted in a period. Depletion, unlike depreciation, focuses on the
narrow physical phenomenon of exhaustion of a resource. The accounting procedure
for depletion is similar to the production-units method of depreciation. To illustrate
accounting in the oil and gas industry, assume that BigOil is interested in bidding
for three licence areas in the Krishna-Godavari basin and incurs the following costs
in 20X1 (all amounts in this illustration are in million):
Under both the successful efforts method and the full cost method, BigOil
expenses geological survey and topographical study costs as incurred, since these
occur prior to acquisition of licences (in practice, there will be separate entries on
many dates):
BigOil bids for all three licence areas, but wins Licence Areas 1 and 2. It incurs
the following further costs in 20X1:
Both the successful efforts method and the full cost method will record the
expenditures as follows:
Exploration and evaluation expenditure of `320,500 will be carried as an
intangible item in the 20X1 balance sheet.
Exploration and evaluation activities continue in 20X2 and the company incurs
the following expenditures:
In late 20X2, the company finds oil in Area 1, but determines that Area 2 is not
commercially feasible and so abandons further efforts. The company estimates the
reserves in Area 1 to be 100 million tonnes.
Both the successful efforts method and the full cost method will record the
expenditures initially as follows:
From now on, the two methods will differ. We will describe the successful efforts
method first.
Successful Efforts Method
BigOil defines each licence area as a cost centre. At the time of deciding to abandon
Area 2, BigOil records the following under the successful efforts method:
The Exploration and Evaluation Expenditure account now has a balance of
`138,000, representing only the expenditure on Area 1 so far (recall that we
expensed prospecting expense). BigOil transfers that amount and the balance in
Development Expenditure to an oil asset, as follows:
Suppose that BigOil produces 5 million tonnes in 20X3. It records the depletion of
the well as follows:
Full Cost Method
Suppose that BigOil defines the entire Krishna-Godavari basin as a cost centre.
Here BigOil does not write off the expenditure on the unsuccessful licence area.
Instead, it carries forward it as an asset along with the costs incurred on the
successful licence area. At the time of the decision to continue with Area 1 and
abandon further activities in Area 2, BigOil transfers the balance of `334,500 in
Exploration and Evaluation Expenditure (i.e. the entire amount spent so far except
prospecting expense) and the development expenditure, as follows:
A comparison of the two methods shows that BigOil would report a lower profit
under the successful efforts method by recognizing the cost of the dry well in 20X2,
but recognizes lower depletion expense in future. But the full cost method defers the
loss from the dry well to the future, hence it recognizes a higher depletion expense.
Impairment of Assets
Depreciation accounting aims at planned expensing of an asset’s
carrying amount over its useful life. It assumes that an enterprise
will be able to recover the carrying amount from its future
revenue. However, unanticipated events, such as physical damage, changes in
product markets, technological progress, new government regulations, and economic
and political developments, often diminish an asset’s value. For example, audio and
video cassettes are not in demand after CDs and DVDs came, and facilities that
once churned out millions of metres of those tapes are not worth much now. The
balance sheet value of an asset should stand for its expected “future economic
benefits”. If the benefits are expected to be less valuable, the asset has been
impaired and accountants require the asset to be written down to the amount that
the enterprise believes it to be worth now.
Impairment loss is the amount by which an asset’s carrying amount exceeds its
recoverable amount. Recoverable amount is the higher of (a) its fair value less
costs to sell, and (b) its value in use. “Fair value less costs to sell” is the amount
obtainable from an asset’s sale in an arm’s-length transaction between
knowledgeable, willing parties, less disposal costs. Value in use is the present value
of the future cash flows expected to be derived from an asset. Appendix B presents
the idea of present value. Where a group of assets, rather an individual asset,
generates cash inflows, we determine impairment at the group level referred to as a
cash-generating unit (CGU). The output of the coke oven battery in a steel plant
does not have a market. The steel plant is the CGU. The following discussion
applies to both asset and CGU, though for convenience we refer to asset.
Evidence of impairment may be available from (a) external indicators such as a
decline in an asset’s market value, adverse developments in an enterprise’s product
market, technological, economic or legal environment, increase in interest rates, the
carrying amount of an enterprise’s assets less liabilities exceeding its market
capitalization, and (b) internal indicators such as an asset’s obsolescence or physical
damage, asset becoming idle, and plans for disposal of an asset or for restructuring
the operation to which an asset belongs.
Note the following points on how an enterprise should account for impairment.
The firm should:
1. Assess at the end of each reporting period whether there is any indication
that an asset (tangible or intangible) may be impaired. If any such
indication is available, the enterprise should estimate the recoverable
amount of the asset. If it is not possible to estimate the recoverable amount
of an individual asset, the firm should estimate the recoverable amount of
the CGU to which the asset belongs.
2. Recognize an impairment loss as an expense in the statement of profit and
loss.
3. Depreciate/amortize the asset’s revised carrying amount less any residual
value on a systematic basis over its remaining useful life.
4. Assess at the end of each reporting period whether there is any indication
that an impairment loss recognized in prior periods may no longer exist or
may have decreased. If any such indication is available, the firm should
estimate the recoverable amount of the asset and recognize a reversal of
impairment loss immediately in the statement of profit and loss.
After the reversal, it should depreciate/amortize the revised carrying amount of
the asset less any residual value on a systematic basis over its remaining useful life.
In practice, companies set up a contra-asset account similar to accumulated
depreciation/amortization, to recognize impairment loss rather than reduce the cost
of an asset.
Financial Analysis of Fixed Assets
The more effectively an enterprise employs its fixed assets to
provide goods and services, the greater the revenue that it can
generate from its operations. Managers must evaluate whether
the enterprise is utilizing its fixed assets effectively. Fixed asset
turnover is a measure of a firm’s efficiency in utilizing its fixed assets. It indicates
how many times a firm turned over the fixed assets in a period and thereby
generated sales. If the turnover is high, the firm is able to get a lot of sales out of
every rupee of investment in fixed assets and is, therefore, managing its fixed assets
efficiently. On the other hand, if the turnover is low, the firm has idle or underutilized fixed assets. Averages rather than year-end amounts of assets are often a
better measure of the level of assets held during the year. The fixed asset turnover
measure is computed as follows:
To illustrate, assume the following data for Varun Company:
To be able to say how good the turnover of 2.5 times is, we should know the
company’s business. A capital-intensive business, such as steel or cement, requires
huge initial investment in property, plant and equipment and a fixed asset turnover
of 2.5 times would appear to be impressive. However, businesses such as consulting
or travel agency do not need much fixed assets. Therefore, we should compare the
fixed asset turnover for enterprises in the same business to find out where an
enterprise stands in relation to its competitors. Also, we can study the movement of
an enterprise’s ratio over time to see if there are any trends.
Looking Back
Describe the nature and types of fixed assets An enterprise holds fixed assets for its own use, and not
for resale. Fixed assets may be tangible – have physical existence, or intangible – economic rights or
benefits, or may be natural resources.
Determine the cost of fixed assets The cost of a fixed asset comprises its purchase price, import duties
and taxes on purchase, any directly attributable costs of bringing the asset to working condition for its
intended use, and estimated dismantling, removing and restoration costs.
Explain depreciation Depreciation is the allocation of the cost of an asset to the periods that are expected
to benefit from its use. The useful life of an asset is usually less than its physical life, because of factors
such as obsolescence and legal limits on the asset’s use.
Compute depreciation under popular methods In India, straight-line and written-down-value methods
are the most commonly used methods. Proper matching of costs and revenues, ease of application, recordkeeping costs, tax laws, and legal requirements influence the selection of a depreciation method.
Distinguish between capital expenditure and revenue expenditure Capital expenditures are for the
purchase or expansion of fixed assets, and revenue expenditures are for ordinary repairs, maintenance, or
fuel. Misclassification of expenditures can distort reported profits.
Understand the difference between accounting and tax depreciation Accounting depreciation aims
at a systematic allocation of the cost of an asset. Tax depreciation is more generous and has economic and
social objectives.
Account for the discarding, sale, or exchange of depreciable assets When an asset is discarded,
sold, or exchanged for a new asset, the cost and the accumulated depreciation of the asset are removed from
the books, and a gain or loss on disposal is recognized.
Dispel the myths about depreciation Depreciation is not a source of cash. For any business, cash
provided by sales to customers is the only source of cash from operations. Depreciation is not intended to
provide funds for replacement. It should be charged even if there is an increase in the market value of an asset.
Explain revaluation of fixed assets Departing from the pure historical cost system, in recent years
many companies have revalued fixed assets so that the carrying amounts are closer to the current
replacement values.
Describe and account for intangible assets Intangible assets, such as brands, are becoming important
in many industries. Accountants record these at cost and amortize them over the useful lives of these
assets. Enterprises usually expense R&D costs, but if they can demonstrate the technical and commercial
feasibility of the potential product or process, they can amortize them.
Account for natural resources The accounting procedure for a natural resource depletion, consists of
charging off the cost of the resource over the estimated quantity of the asset.
Explain impairment of assets An asset is impaired if the value recoverable from its future use is less
than its carrying amount. Impairment loss is the difference between the two amounts. An enterprise must
recognize the impairment loss by writing down the carrying amount of the impaired asset.
Analyze the utilization of fixed assets Fixed asset turnover is a measure of a firm’s efficiency in
utilizing its fixed assets. A high turnover indicates that the firm is able to generate a lot of revenue per
rupee invested in fixed assets.
Review Problem
Ganesh Construction Company bought an earth moving machine for `200,000. The equipment was expected to
be useful for six years, or 15,000 hours, with an estimated residual value of `20,000 at the end of that time. The
equipment logged 2,000 hours in the first year.
Required
Compute the depreciation expense for the first year under each of the following methods: (1) Straight-line, (2)
Written-down-value, (3) Sum-of-the-years’-digits, and (4) Production-units.
Solution
ASSIGNMENT MATERIAL
Questions
1. What are the chief characteristics of fixed assets?
2. How is accounting for fixed assets useful to a business?
3. “Interest costs on debt incurred for financing an asset can be charged to the
asset account.” Do you agree? Explain.
4. What does depreciation mean in accounting?
5. Why is land not depreciated?
6. Is it necessary to charge depreciation on a building when its market value is
expected to exceed the cost of acquisition? Why or why not?
7. Why is the useful life of an asset often less than its physical life?
8. Navin Printers has bought a high-speed laser printer for the first time. How
can it estimate the printer’s useful life?
9. How is the straight-line method different from the accelerated method?
10. When can a business justify the use of an accelerated method?
11. When is the production-units method more appropriate than other
depreciation methods?
12. Why is the straight-line method popular despite its shortcomings?
13. What non-accounting considerations could influence the selection of a
depreciation method?
14. Explain the relevance of Schedule II (Schedule XIV) depreciation rates to
financial reporting.
15. Is it necessary to follow the same depreciation method for accounting and
tax purposes?
16. “There is nothing devious about companies maintaining one set of
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accounting records for shareholders and another set for tax authorities.”
Explain.
How is depreciation for partial periods recorded?
How does a revision in the remaining useful life of an asset affect past and
future depreciation expense?
How are assets of low value accounted for?
When can a company change the depreciation method, and how is the
change accounted and reported?
When can assets be grouped for depreciation purposes?
What will be the effect on reported profit of charging routine maintenance to
an asset account?
A car hire company recently replaced the petrol engines in its cars with
diesel engines. How should it account for the expenditure?
Evaluate the following statement: “It is not necessary to show on the balance
sheet an asset that has been fully depreciated because the omission does not
affect its carrying amount.”
Sudhir Enterprises exchanges its computer for a new model by paying a
small amount. At what cost is the new computer to be recorded?
How are the gains and losses on disposal treated under tax laws? How does
the tax treatment differ from the accounting treatment?
What does accumulated depreciation represent? Does it represent cash
available for purchase of new assets? Explain why or why not.
In highly inflationary periods, how can a company ensure that adequate
funds are available for replacement of assets?
Why do companies revalue their property, plant and equipment?
Explain how the change to IFRS would affect the depreciation of revalued
assets.
When can brands be shown on the balance sheet, and at what amounts?
How in general is the period of time for amortization of an intangible asset
determined, and what pattern of amortization is generally followed?
Why is testing for asset impairment necessary when an asset is already
being depreciated?
“Natural resources are inventories in the garb of fixed assets.” Do you agree?
Problem Set A
Required
Prepare a journal entry to show the depreciation expense for 20X8 and to give effect to the change in the
depreciation method under (a) IGAAP and (b) IFRS.
Shree Sugar Mills installed a new plant costing `600,000 with an estimated useful life of
seven years and an estimated residual value of `40,000. In the first year, the company’s
cash revenues were `3,000,000 and cash expenses were `2,000,000. For tax purposes, the
plant is eligible for depreciation at the rate of 25 per cent. The income tax rate is 30 per
cent.
Required
Compute for the first year the profit after tax (assuming straight-line depreciation) and the cash flow from
operations after tax.
Leo Consultants bought a screen projector on April 1, 20X4 for `40,000. It had an
estimated useful life of nine years and an estimated residual value of `4,000. Straightline depreciation was charged. The equipment was disposed of on September 30, 20X9.
The company’s reporting period corresponds to the calendar year.
Required
Prepare journal entries to record the disposal under each of the following independent cases, making sure to
update depreciation. The equipment was:
1.
2.
3.
4.
Scrapped as having no sale value.
Sold for `18,000.
Sold for `21,200.
Sold for `16,500.
5. Exchanged for an equipment with a similar configuration having an invoice
price of `50,000. The existing equipment was allowed `16,000, and the
balance was paid in cash.
6. Exchanged for an equipment with a different configuration having an
invoice price of `50,000. The existing equipment was allowed `3,000, and the
balance was paid in cash.
7. Exchanged for an equipment with a similar configuration having an invoice
price of `50,000. The existing equipment was allowed `23,000, and the
balance was paid in cash.
Rayalaseema Granite Company bought a granite quarry for `6,000,000. The quarry was
estimated to contain 1,000,000 tonnes of granite. It incurred an expenditure of `1,000,000 in
developing the quarry site. The company extracted and sold 300,000 tonnes of granite in the
first year.
Required
1. Prepare a journal entry to record the depletion expense for the first
year.
2. Show how the quarry would appear on the balance sheet of Rayalaseema
Granite Company at the end of the first year.
(a) Vinay Shah paid `200,000 to be the exclusive franchisee of Computerland
for a training school in three districts in Gujarat. The franchise is valid for
four years and may be renewed by mutual consent.
(b) In 20X4, Chopra Company spent `200,000 in developing a new software
product, Big Bull, to be used by stockbrokers and financial analysts. The
technological feasibility of the software was established in 20X5, during
which the company spent a further `1,000,000. The product was successfully
completed in 20X5. The company expects the product to yield `5,000,000 in
revenues over five years beginning 20X6.
Required
Compute the annual amortization of the franchise and software product.
Problem Set B
Image Processing Products developed a research laboratory in 20X3. The costs incurred in
connection with this project and debited to the Laboratory Project account are as follows:
The laboratory was commissioned on October 1, 20X3. The company’s reporting period ends on December 31.
Required
1. Prepare a statement listing each item in one of these four columns: Land,
Land Improvements, Building, and Equipment.
2. Prepare a journal entry on October 1 for capitalizing the costs associated
with the project.
3. Prepare a journal entry to show the depreciation expense for 20X3 using the
straight- line method. The useful life of building and land improvements is
estimated at 25 years, while that of equipment is 10 years. There is no
residual value at the end.
Kiran Computers bought a machine for making printed circuit boards (PCBs) for `800,000.
The machine was expected to be useful for five years and an estimated residual value of
`40,000. The machine is expected to produce 50,000 PCBs. It produced 15,000 PCBs in
Year 1; 12,000 PCB’s in Year 2; 3,000 PCBs in Year 3; 16,000 PCBs in Year 4; and 4,000
PCBs in Year 5.
Required
1. Compute the depreciation expense for each year under each of the following
methods: (a) straight-line, (b) written-down-value, (c) sum-of-the-years’digits, and (d) production-units.
2. Comment on the trend of yearly depreciation expense and carrying amount.
The delivery van logged 6,000 km in the year ended March 31, 20X6.
Required
1. Compute the depreciation expense for the period ended March 31 in 20X4,
20X5, and 20X6. The amount is to be rounded off to the nearest rupee.
2. Show how these assets would appear on the balance sheet on March 31 each
year.
KBU Corporation provides air transport services for short distances. It acquired an
aircraft costing `100 million. The aircraft was expected to last 50,000 flying-hours with
an estimated residual value of `4,000,000. At the beginning of Year 4, the company
carried out a modification to the aircraft engine at a cost of `8,000,000. At the time, the
aircraft had completed 30,000 flying-hours. After the modification, the aircraft will have a remaining estimated
useful life of 30,000 flying-hours and an estimated residual value of `7,500,000. In Year 4, the aircraft flew
8,000 hours.
Required
1. Prepare journal entries to record the cost of the modification and the
depreciation expense for Year 4.
2. Repeat Requirement 1, assuming that the modification was not carried out.
In the beginning of Year 4, the aircraft was estimated to have a remaining
useful life of 10,000 flying-hours and a residual value of `4,000,000. In Year
4, the aircraft flew 8,000 hours.
Mary Industries Limited started business with equity capital of `2,500,000 in cash. Soon
after, it bought machinery costing `2,000,000 for cash. The machinery had an estimated
useful life of 10 years and an estimated residual value of `100,000. In the first year, the
company’s revenues (in cash) were `7,000,000 and cash operating expenses were
`4,500,000. The machinery was depreciated on the straight-line basis. For tax purposes, the machinery was
eligible for depreciation at the rate of 25 per cent. Income tax rate is 35 per cent.
Required
1. Prepare the statement of profit and loss and the cash flow statement for
Year 1. Using a reconciliation statement, explain the difference between the
profit after tax and the cash flow from operations.
2. Repeat Requirement 1, assuming that the machinery has an estimated
useful life of eight years and an estimated residual value of `100,000. Does
the cash flow from operations differ from that in Requirement 1? Explain.
3. Repeat Requirement 1, assuming that the company uses the income tax
depreciation for accounting purposes as well. How do the results differ from
your answer to Requirement 1?
After using these assets for three years, the company decided to change its depreciation policy as follows:
(a) Change the method of depreciation for machinery to the straight-line method;
(b) Revise the remaining useful life of building to 30 years, keeping its residual value at `100,000.
These changes are to be implemented in the financial statements for Year 4.
Required
1. Prepare a journal entry to record the change in Azad Company’s
depreciation policy.
2. Compute the depreciation expense for Year 4 without giving effect to the
change in depreciation policy. What is the effect of the change on the profit
before tax for Year 4?
3. What disclosures concerning the change should the company make in its
financial statements for Year 4?
4. What would be the position under IFRS?
Sharief Company purchased a diesel generator for `1,000,000. The generator had an
estimated useful life of eight years with an estimated residual value of `40,000 at the
end of that time.
Required
Prepare journal entries to record the disposal of the generator at the end of the third year in each of the
following independent situations. Straight-line depreciation was charged.
1. The generator was sold for `390,000.
2. It was sold for `700,000.
3. It was exchanged for an equipment with a different configuration having an
invoice price of `1,100,000. The generator was allowed `720,000, and the
balance was paid in cash.
4. It was exchanged for an equipment with a similar configuration having an
invoice price of `1,100,000. The generator was allowed `720,000, and the
balance was paid in cash.
5. Same as Requirement 3 except that the generator was allowed `580,000.
6. Same as Requirement 4 except the generator was allowed `580,000.
Ahuja Dyestuff Company bought machinery on April 1, 20X1 for `600,000. The machinery
was expected to have a useful life of ten years. The company followed the straight-line
depreciation method. In 20X6, the company engaged a firm of professional valuers to
determine the current value of the machinery. The valuers reported that on April 1, 20X6
similar machinery with an estimated useful life of 10 years would cost `1,000,000. The company’s year-end is
March 31.
Required
1. Prepare a journal entry to record the revaluation.
2. Compute the depreciation expense for the year ended March 31, 20X7 under
(a) IFRS, and (b) IGAAP.
Manali Company bought a patent for a chemical product from Baroda Company for
`1,200,000. The patent has an estimated remaining useful life of six years and was carried in
Baroda Company’s books at `1,000,000.
Required
Prepare journal entries to record the purchase and the annual amortization of the patent by Manali Company.
Problem Set C
The expansion was financed partly by borrowings of `3,500,000, on which interest is payable at 15 per cent per
year. The principal amount will be repaid in equal annual instalments over the next six years. Interest for 20X7
was debited to Interest Expense. Work on the project commenced on February 1, 20X7. The new plant was
commissioned on December 1, 20X7. It is to be assumed that the borrowings were applied equally to the
building and the plant.
A production supervisor was posted to assist in the project. He spent one month on preparation of the land,
one month on improvements, four months on construction of the building, and another four months on
installation of the machinery. The supervisor’s annual salary of `60,000 was charged to Salaries Expense.
Required
1. Prepare a statement listing each item in one of these four columns: Land,
Land Improvements, Building, and Plant and Machinery.
2. Prepare a journal entry on December 31, 20X7, for capitalizing the costs
associated with the project.
3. Prepare a journal entry to show the depreciation expense for 20X7, using the
straight- line method. The estimated useful life of building and land
improvements is 25 years, while that of equipment is 10 years. There is no
estimated residual value at the end.
Bond Company bought for `600,000 a piece of equipment for detecting defective bottles.
The equipment has an estimated useful life of six years and an estimated residual value
of `60,000. It is expected to last 50,000 hours. The machine worked 10,000 hours in Year
1; 18,000 hours in Year 2; 2,000 hours in Year 3; 11,000 hours in Year 4; 6,000 hours in
Year 5; and 3,000 hours in Year 6.
Required
1. Compute the yearly depreciation expense for each year under each of the
following methods: (a) straight-line, (b) written-down-value, (c) sum-of-theyears’-digits, and (d) production-units.
2. Comment on the trend of yearly depreciation expense and book value.
The van logged 10,000 km in the year ended June 30, 20X8.
Required
1. Compute the depreciation expense for the period ended June 30 in 20X6,
20X7, and 20X8. The amount is to be rounded to the nearest rupee.
2. Show how these assets would appear on the balance sheet on June 30 each
year.
Goa Tourism Company offers local sight- seeing trips. It acquired an air-conditioned
coach costing `1,500,000. The coach was expected to be useful for six years, with an
estimated residual value of `45,000 at the end of that time. At the beginning of Year 4,
the company carried out an overhaul of the coach at a cost of `150,000. As a result, it is
expected that the coach will have a remaining useful life of five years and an estimated residual value of
`100,000. Straight-line depreciation is provided.
Required
1. Prepare journal entries to record the cost of the overhaul and the
depreciation expense for Year 4.
2. Repeat Requirement 1, assuming that the overhaul was not carried out. In
the beginning of Year 4, the coach was estimated to have a remaining useful
life of five years and a residual value of `45,000.
Amit Textiles started business with a capital of `4,000,000 in cash. Soon after, it
purchased machinery costing `3,700,000 for cash. The machinery had an estimated useful
life of seven years and an estimated residual value of `200,000. In the first year, the
company’s revenues (in cash) were `10,000,000 and cash operating expenses were
`6,500,000. The machinery was depreciated on straight-line basis. For tax purposes, the machinery was eligible
for depreciation at the rate of 25 per cent. Income tax rate was 30 per cent.
Required
1. Prepare the statement of profit and loss and the cash flow statement for
Year 1. Using a reconciliation statement, explain the difference between the
profit after tax and the cash flow from operations.
2. Repeat Requirement 1, assuming that the machinery has an estimated
useful life of five years and an estimated residual value of `200,000. Does
the cash flow from operations differ from that in Requirement 1? Explain.
3. Repeat Requirement 1, assuming that the company uses the income tax
depreciation for accounting purposes as well. How do the results differ from
your answer to Requirement 1?
After using these assets for four years, the company decided to change its depreciation policy as follows:
(a) Change the method of depreciation for machinery to the straight-line method;
(b) Revise the remaining useful life of building to 40 years, keeping its residual value at `90,000.
These changes are to be implemented in the financial statements for Year 5.
Required
1. Prepare a journal entry to record the depreciation expense after the change
in policy.
2. Compute the depreciation expense for Year 5 without giving effect to the
change in depreciation policy. What is the effect of the change on the profit
before tax for Year 5?
3. What disclosures concerning the change should the company make in its
financial statements for Year 5?
4. What would be the position under IFRS?
Standard Manufacturing Company purchased a robot for its assembly operations. The
cost of the robot was `1,400,000. It had an estimated useful life of four years. It could be
sold for an estimated `100,000 at the end of four years.
Required
Prepare journal entries to record the disposal of the robot at the end of the second year in each of the following
independent situations. Straight-line depreciation was charged.
1. The robot was sold for `660,000.
2. It was sold for `810,000.
3. It was exchanged for a robot with a different configurations having an
invoice price of `1,700,000. The robot was allowed `910,000, and the balance
was paid in cash.
4. It was exchanged for a robot with a similar configuration having an invoice
price of `1,700,000. The robot was allowed `910,000 and the balance was
paid in cash.
5. Same as Requirement 3 except the robot was allowed `690,000.
6. Same as Requirement 4 except the robot was allowed `690,000.
7. The robot was totally damaged in an accident. The insurance company paid
compensation of `470,000 in full settlement.
Premium Automobile Ltd. purchased a building on January 1, 20X3 for `900,000. The
building was expected to have a useful life of 25 years. The company charged straight-line
depreciation. In 20X8, the company commissioned a firm of professional valuers to
determine the current value of the building. The valuers reported that on January 1, 20X8,
a similar building with an estimated useful life of 25 years would cost `1,400,000. The company’s reporting
period corresponds to the calendar year.
Required
1. Prepare a journal entry to record the revaluation.
2. Compute the depreciation expense for 20X8 on the basis of (a) IFRS, and (b)
IGAAP.
Reddy Ice Creams acquired for `600,000 a franchise to open ice cream parlours in two southern
Indian states. The franchise has an estimated useful life of four years.
Required
Prepare a journal entry to record the purchase and the annual amortization of the franchise by Reddy Ice
Creams.
Business Decision Cases
Mohini Sharma is an investment analyst in Esbeeye Securities, a medium-sized stock
brokerage firm. She specializes in the stocks of non-ferrous metal companies. As a part of her
job, she provides reviews on these stocks in the firm’s newsletter. The newsletter is a
monthly publication and is sent to Esbeeye’s clients who are mostly private, non-institutional
shareholders.
In early July 20X8, Mohini prepared an analysis of aluminium companies based on their annual reports for
the year ended March 31, 20X8. She has come across the following footnote appearing in the financial
statements of Bengal Aluminium Company:
During the year, the company has changed the method of depreciation for the main smelter from the
written-down-value method to the straight-line method. If the company had not made this change, the
depreciation expense for the current year would have been higher by `141,586,327.
No other reference to the depreciation method change was available in the company’s report, except an item
in the statement of profit and loss, “Excess provision for depreciation written back, `782,312,370”, shown ‘above
the line’. Until last year, aluminium companies have followed similar accounting policies. The main smelter of
Bengal Aluminium was bought on April 1, 20X5, for `3,000 million with an estimated useful life of 10 years and
was expected to fetch `150 million at the end of that time.
There are five major producers in the aluminium industry and they vary widely in terms of sales and total
assets. On these dimensions, National Aluminium Company comes closest to Bengal Aluminium Company.
Sales and profits after tax (in million) of the two companies in recent years are as follows:
Mohini’s immediate problem is how to evaluate Bengal Aluminium’s 20X8 results in light of (a) the company’s
past performance, and (b) the 20X8 results of National Aluminium. Her other concern is to find out the
management’s motives for the depreciation policy switch.
Required
1. What would have been Bengal Aluminium’s profit after tax for the year
ended March 31, 20X8 but for the change in depreciation method?
2. Compute the ratio of profit after tax to sales for the two companies for each
year.
3. What could have been the motives for Bengal Aluminium’s depreciation
policy switch?
4. Do you consider the company’s disclosure of the accounting change
adequate?
5. Draft a short paragraph on the accounting change which Mohini should
consider including in her report on aluminium stocks.
Interpreting Financial Reports
Jet Airways is the largest private airline in India. Set up in 1993, the company has both
domestic and international operations. Excerpts from the company’s press release on its June
2008 quarter results are as follows:
29 July 2008
Highlights for quarter ended June 30, 2008 vs. June 30, 2007
Operational
System-wide ASKMs of 8,154 million, up 71.4%
System-wide RPKMs of 5,498 million, up 67.2%
System wide seat factor of 67.4% vs 69.1%
3.15 million revenue passengers carried up 18%
Financial
Revenue of `28,992 million (US$ 673.7 million), up 46.2%
Profit before tax `2,191 million (US$ 50.9 million) vs profit of `495 million (US$12.2
million), up 343%
Profit after tax of `1,434 million (US$ 33.3 million) vs profit of `309 million (US$7.6
million), up 401%
During this quarter, we have changed our accounting policy for charging depreciation on our narrow body
aircraft used for the domestic operations and we will now charge depreciation on a straight-line method
(SLM) basis as compared to a written-down-value (WDV) basis. This method is in line with the method
that we follow to depreciate our wide body aircraft that we use for International operations.
The impact on account of this change in method was `9,159 million (US$ 213 million) for the quarter at the
company level.
The company’s recent quarterly results are as follows:
A business newspaper carried a report on Jet Airways.26
Required
1. What could be the possible reasons for the accounting change by Jet
Airways? Which of these likely explain the company’s action? Why?
2. Analyze the performance of Jet Airways in the June 2008 quarter.
3. What does the expression “depreciation payout” in the news report mean?
Do you agree with its use?
4. Comment on the disclosure on the accounting change in the company’s
quarterly earnings announcement and press release.
5. From the standpoint of users of financial statements, what safeguards are
available against attempts by corporate management to make arbitrary
accounting changes?
Financial Analysis
Study a sample of company annual reports for five years.
Required
1. Prepare an analysis of the depreciation methods followed by the companies.
2. Do you see any patterns? Explain.
3. Comment on possible managerial motivations for depreciation method
changes by the sample companies. Your comments should be based on the
information available in the financial statements and other portions of the
annual report.
4. Why is your study important for analyzing financial statements?
Study a sample of company annual reports.
Required
1. Locate companies that present fixed assets at revalued amounts.
2. Comment on possible managerial motivations for revaluation in the case of
the sample companies. Your comments should be based on the information
available in the financial statements and other portions of the annual
report.
3. How important is revaluation to the sample companies? To assess this,
calculate the percentage of revaluation reserve to total reserves and surplus.
4. Suppose that the companies decide to charge depreciation based on revalued
amounts rather than original costs. How much would this change affect
their profit?
5. Who are the valuation experts engaged by the companies? How much did the
companies pay them for their services?
Study a sample of company annual reports.
Required
1. Prepare a list of intangible assets that the companies show in their financial
statements. Comment on any patterns.
2. How significant are intangible assets to the companies? Calculate the
percentage of intangible assets to the total fixed assets.
3. Prepare a list of intangible assets that the companies would have but do not
show in their financial statements.
4. Comment on the accounting policies for intangible assets.
5. Explain why this study is important for analyzing and interpreting financial
statements.
Study a sample of company annual reports for five years.
Required
1. Analyze instances of asset impairment. How does impairment affect the
reported profit?
2. Explain why this study is important for analyzing and interpreting financial
statements.
Study a sample of company annual reports for five years.
Required
1. Analyze accounting policies for R&D. Do you see any patterns?
2. Explain why this study is important for analyzing and interpreting financial
statements.
Study a sample of annual reports of companies in any one industry for five years.
Required
1.
2.
3.
4.
Prepare an analysis of the companies’ fixed asset turnover.
Do you see any industry patterns? Explain.
Explain any trends in the operating cycle.
Why is your study important for analyzing financial statements?
Answers to Test Your Understanding
7.1 Capitalize: (a), (b), (d), (e), (g), (h) and (i). Expense: (c) and (f), because demurrage and repair charges are not
normal to importing the plant, and do not increase the value or the productive capacity of the asset. Normal
spoilage during trial run, item (h), is often an unavoidable cost of putting a machine to use.
7.2
1 IAS 16:6/Ind AS 16.6/AS 10:6.1.
2 IAS 38:8/Ind AS 38.8/AS 26:6.1.
3 IAS 16:16/Ind AS 16:16/AS 10:9.1
4 The principles for treating borrowing costs as inventoriable costs are the same as those discussed in this
section.
5 IAS 23:5/Ind AS 23:5/AS 16:3.1.
6 These terms are explained in Chapters 8 and 9.
7 IAS 16:43/Ind AS 16:43.
8 IAS 16:6/Ind AS 16:6/AS 6:3.1.
9 IAS 16:50/Ind AS 16.50.
10 IAS 16:60/Ind AS 16:60.
11 AS 8:36/Ind AS 8:36/AS 5:23.
12 IAS 8:61/Ind AS 8.61.
13 David M. Kreps, Microeconomics for Managers, W.W. Norton & Co., New York, 2004.
14 The straight-line method is prescribed for companies engaged in generation and distribution of power.
15 Net present value is the difference between the present value of the cash inflows from an asset and the cash
outflow for acquisition of the asset. Appendix B on time value of money explains present value calculation.
16 IAS 16:29/Ind AS 16:29/AS 10:13.
17 Revaluations are also common in many British Commonwealth countries including the United Kingdom,
Australia, and New Zealand. Revaluations are prohibited in the United States.
18 IAS 38:8/Ind AS 38:8/AS 26:6.1.
19 Baruch Lev, Intangibles: Management, measurement, and reporting, Brookings Institution Press,
Washington D.C., 2001.
20 IAS 38:27/Ind AS 38:27/AS 26:8.
21 IAS 38:8/Ind AS 38:8/AS 26:6.7.
22 IAS 38:63/Ind AS 38:63/AS 26:50.
23 IAS 38:6/Ind AS 38:6/AS 26:35. However, “purchased” goodwill is recognized. We will see this in Chapter 8.
24 IAS 38:57/Ind AS 38:57/AS 26:44.
25 IASB, Extractive Industries, DP/2010/1 April 2010.
26 Tarun Shukla, One-time gain masks Jet’s `7,755 million loss in Q1, Mint, July 30, 2008.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
Describe the nature and types of investments.
Define and describe financial instruments and financial assets.
Account for equity and debt instruments held as financial investments.
Explain impairment of financial assets.
Distinguish between equity investments held as operating investments from those
held as financial investments.
Define a subsidiary and explain control.
Explain consolidated financial statements.
Explain business combination and goodwill.
Prepare consolidated financial statements applying the acquisition method of
business combination.
Define a joint venture and explain joint control.
Explain proportionate consolidation for jointly controlled entities.
Define an associate and explain significant influence.
Explain the equity method for associates.
Account for investments in separate financial statements.
Define and account for investment property.
WHEN THE PARTY ENDS…
For a long time life was simple: accountants recorded everything at their historical cost. Then
someone said that historical cost was irrelevant and assets must appear at their fair value in the
financial statements. That divided the world neatly into two camps: those who stood by
historical cost (“cost is a fact, value is an opinion”) and those who embraced fair value (“cost is
about the past, value is about the future”). Many reasons have been advanced for the financial
crisis in 2008: Alan Greenspan, bankers’ greed, Chinese savings, derivatives, easy liquidity, rating
agencies, regulatory failure, southern Europeans…. Politicians held fair value responsible for
first blowing the bubble and then bursting it. They contended: “When the markets were
booming, fair value went up and investors made paper profits. This led to further investments in
those assets causing their prices to rise even further leading to a bubble. When the bubble
burst, the markets fell and everyone rushed to sell the assets and this deepened the crisis.”
The problem got complicated, because there were many financial products for which there
were no public markets and these had to be valued using some models. Warren Buffett, the
investment superstar, said that many financial assets were marked to myth. Did fair value
accounting cause the financial crisis?
THE CHAPTER IN A NUTSHELL
Companies often invest in shares and debentures of other entities. Accounting for investments
is one of the most complex areas. This chapter presents an overview of the common
accounting issues in investments. You will get a grasp of the basics necessary for analyzing and
interpreting the financial statements.
Investments in Perspective
A business enterprise may hold investments for earning an income
and benefiting from increase in their value or for acquiring a say in
the running of companies with which it intends to have business
relations. What sets apart an investment from other assets is that
it is not intended to be available for the investor’s production, selling or
administrative activities. Investments may be financial claims on other enterprises,
such as equity shares or debt instruments or land and building held for the purpose
of earning a rental income and a possible rise in their market value. Financial
claims may be held for the purpose of short-term gain or for strengthening longterm business interests. Accounting for investments should reflect the investor’s
intention and time horizon.
Financial Instruments and Financial Assets
A financial instrument is any contract that gives rise to a
financial asset of one entity and a financial liability or equity
instrument of another entity.1 Thus, a financial instrument may
be a financial asset, a financial liability or equity. In this chapter, we consider
financial assets. Chapters 9 and 10 discuss financial liabilities and equity.
A financial asset is any of the following:
(a) Cash;
(b) An equity instrument of another entity;
(c) A contractual right to receive cash or another financial asset from another
entity.
The owner of a financial asset has a contractual claim on the entity that has
issued the financial instrument. The instrument may be a debt instrument (another
entity’s financial liability) that gives its owner a right to periodical interest
payments and principal repayment, or an equity instrument (another entity’s equity
shares) that carries a right to any dividends distributed and residual assets.
Equity and Debt Instruments
A company may want to invest its surplus cash in order to earn a
return. Some enterprises, such as banks, are in the business of
lending. The intention in making such investments is to earn a
financial return in the form of interest, dividend, and capital
appreciation. Think of these as financial investments. (Later in this chapter, we will
consider investments in equity instruments made as part of business operations.)
Accountants classify financial assets into four categories:
1.
2.
3.
4.
Financial assets at fair value through profit or loss;
Held-to-maturity investments;
Loans and receivables; and
Available-for-sale financial assets.
Financial Assets at Fair Value through Profit or Loss
A financial asset at fair value through profit or loss (or FAFVPL) is either (a)
classified as held for trading or (b) designated as a FAFVPL at the time of initial
recognition. A financial asset classified as held-for-trading is acquired principally
for the purpose of selling it in the near term. An entity holding a financial asset for
trading intends to generate a profit from short-term price fluctuations by active and
frequent buying and selling of the asset. Held-for-trading financial assets are also
known as trading securities. Since the investor intends to sell these securities as
part of its business, these assets are worth just the amount they are expected to
fetch in the market when sold. So accountants measure them at fair value: the
amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s-length transaction. If there is an active
market for an instrument meaning that the share is bought and sold regularly, the
quoted market price is usually its fair value. For this reason, this valuation
principle is commonly known as mark-to-market accounting. Investments in equity
and debt instruments held by mutual funds are examples of FAFVPL.
On initial recognition, FAFVPL are measured at fair value. Transactions costs,
such as brokerage, are not considered. The investor recognizes in its statement of
profit and loss (a) any realized or unrealized gains and losses, measured as the
change in the fair value of the securities since their purchase or the last balance
sheet date, and
(b) any dividend or interest income earned during a period.
If an instrument does not have a quoted market price in an active market,
accountants use valuation techniques to establish its fair value. If it is not possible
to establish the fair value of an equity instrument reliably, it cannot be designated
as a FAFVPL. Instead, such instruments are measured at cost. This method is
followed for unlisted or unquoted equity instruments. For financial assets carried
at cost, the investor recognizes in its statement of profit and loss any dividend
income earned during a period.
Debt investments carry contractual rights to payment of interest and repayment
of principal. Equity securities do not carry such rights. Accounting for investments
in debt instruments at fair value through profit or loss is broadly similar to that for
equity investments.
Held-to-Maturity Investments
A business enterprise may invest in another company’s debentures in order to
provide medium-term or long-term financing. Banks, insurance companies, and
other financial institutions routinely invest in debt securities, e.g. government
securities and corporate bonds, as part of their operations. Also, industry
regulations require banks and insurance companies to invest a portion of their
investments to be held in government securities.
Held-to-maturity investments are financial assets that (a) have fixed or
determinable payments and fixed maturity and (b) the investor has the positive
intention and ability to hold to maturity.2 The terms of a debt instrument specify (a)
the principal amount, or face value, (b) the interest rate, or coupon, and (c) the
repayment date. The coupon is applied to the face value of the instrument to
compute the amount of periodical interest. Thus, if an investor intends to hold a
debenture until the repayment date and has the financial resources to live up to
that intention, it would be a held-to-maturity (HTM) investment. A debt instrument
with a variable interest rate can be a HTM investment. A perpetual debt
instrument that provides for interest payments for an indefinite period cannot be
classified as a HTM investment, because there is no maturity date. Equity
instruments cannot be HTM investments, because they have an indefinite life.
Investments in the HTM classification exclude the following:
(a) Those that the investor upon initial recognition designates as at fair value
through profit or loss;
(b) Those that the investor designates as available for sale; and
(c) Those that meet the definition of loans and receivables.
Initially, HTM investments are measured at fair value. Transactions costs, such
as brokerage, are considered. Subsequently, the investments are measured at
amortized cost using the effective interest method. Amortized cost is the amount
at which a financial asset is measured at initial recognition minus principal
repayments and adjusted for periodic amortization of the difference between the
amount of initial recognition and the amount payable on maturity. The effective
interest method calculates the amortized cost of a financial asset and allocates the
interest income at the rate that exactly discounts estimated future interest receipts
to the carrying amount of the financial asset. This rate is also known as the
internal rate of return (IRR). Suppose that F0 is the fair value of an investment,
I1, …, In are interest, S the sum payable on maturity, n the period of investment,
and i the effective interest rate.3 The effective interest rate is given by solving the
following equation for i:
The equation can be solved by trial and error, plugging in different values for i or
by using the IRR function in a spreadsheet. The effective interest rate is also known
as the market interest rate (or yield). You should review Appendix B to understand
the idea of time value of money.
For most financial assets, fair value is a more appropriate measure than
amortized cost. The HTM classification is an exception and must satisfy the test of
intention and ability to hold the investment to maturity.4 Therefore, it is expected
to be used only in limited circumstances. Classification as a HTM investment would
be ‘tainted’ if the entity has sold or reclassified a ‘not insignificant’ amount of such
investments before maturity during the current financial year or the two preceding
financial years. The remaining portion of such an investment will have to be
reclassified as available for sale.
Loans and Receivables
Loans and receivables are financial assets with fixed or determinable payments
and fixed maturity, but are not quoted in an active market. They differ from HTM
investments in two ways:
1. It does not matter whether the investor intends to hold a loan or receivable
to maturity.
2. Assets in the loans and receivables category are not subject to the penalty
arising from the ‘tainting’ provisions.
Trade receivables, bank deposits, and loans and advances given by banks to
customers are examples of items in this classification. A financial asset that is
quoted in an active market, e.g. a quoted debenture, does not qualify for
classification as a loan or receivable. Financial assets that do not meet the
definition of loans and receivables, e.g. because they are quoted in an active market,
may be classified as HTM investments if they meet the relevant conditions.
Loans and receivables exclude the following:
(a) Those that the investor intends to sell immediately or in the near term, which
shall be classified as held for trading, and those that the investor upon initial
recognition designates as at fair value through profit or loss.
(b) Those that the entity upon initial recognition designates as available for sale.
(c) Those for which the investor may not recover substantially all of his initial
investment, other than because of credit deterioration, which shall be classified
as available for sale.
Initially, loans and receivables are measured at fair value. Transactions costs,
such as brokerage, are considered. Subsequently, these assets are measured at
amortized cost using the effective interest method, similar to HTM investments.
Short-term receivables with no stated interest rate may be measured at the original
invoice amount if the effect of discounting is immaterial.
Available-for-Sale Financial Assets
Available-for-sale financial assets (or available-for-sale securities) are financial
assets that are (a) either designated as available for sale or (b) not classified as
loans and receivables, HTM investments or FAFVPL. The available-for-sale (AFS)
classification is effectively a default classification. Initially, AFS financial assets are
measured at fair value. Transactions costs such as brokerage are considered.
Subsequently, these investments are measured at fair value, but unrealized gains
and losses are taken to other comprehensive income, a component of equity,
rather than routed through the statement of profit and loss. The investor recognizes
any dividend or interest income earned from AFS securities assets in the statement
of profit and loss. Think of these as financial assets at fair value through balance
sheet.
Impairment of Financial Assets
Financial assets carried at amortized cost (i.e. HTM investments
and loans and receivables), financial assets carried at cost, and
AFS financial assets are subject to review for impairment.5 An
entity must assess at each reporting whether there is any “objective evidence” of
impairment. The evidence comes from an event that occurred after the initial
recognition of a financial asset and that ‘loss event’ has an impact on the estimated
future cash flows of the financial asset or group of assets that can be reliably
estimated. Examples of loss events include significant financial difficulty of the
borrower, default in interest or principal payments, the lender granting to the
borrower a concession that the lender would not otherwise consider, and the
probability that the borrower will enter bankruptcy.
Impairment results from a combination of several loss events rather than a single
event. Also, the loss event must have happened after the initial recognition, but
before the reporting date. This is the incurred loss approach that the IASB has
accepted. In this approach, losses expected as a result of future events, no matter
how likely, are not recognized. For example, a bank expects from past experience
that one per cent of the principal amount of loans cannot be collected. The incurred
loss approach does not allow the bank to recognize an immediate impairment loss of
one per cent of loans given. In March 2013, the IASB published proposals for
moving to an approach based on expected loss.6
We now consider measuring the impairment of financial assets.
Financial Assets Carried at Amortized Cost
If there is objective evidence that an impairment loss has been incurred on loans
and receivables or HTM investments, that loss should be measured as the difference
between the carrying amount of the asset and the present value of estimated future
cash flows discounted at the financial asset’s original effective interest rate (i.e. the
effective interest rate computed at initial recognition). An investor can reduce the
asset’s carrying amount either directly or use an allowance (i.e. provision) account.
The amount of impairment or bad debt loss may decrease in a subsequent period.
If the decrease can be related objectively to a new event (e.g. an improvement in the
debtor’s credit rating), the previously recognized impairment loss is reversed either
directly or by adjusting an allowance account. The reversal shall not result in a
carrying amount larger than what the amortized cost would have been at the date of
reversal had the impairment not been recognized. The amount of the reversal shall
be recognized in the statement of profit and loss.
Financial Assets Carried at Cost
If there is objective evidence that an impairment loss has been incurred on an
unquoted equity instrument that is not carried at fair value, that loss should be
measured as the difference between the carrying amount of the financial asset and
the present value of estimated future cash flows discounted at the current market
rate of return for a similar financial asset. Such impairment losses shall not be
reversed.
Available-for-sale Financial Assets
When a decline in the fair value of an AFS financial asset has been recognized in
other comprehensive income and there is “objective evidence” (refer to the
discussion on ‘loss event’) that the asset has been impaired, the cumulative loss that
had been recognized in other comprehensive income shall be reclassified from equity
to statement of profit and loss. The amount of the cumulative loss is the difference
between the acquisition cost (net of any principal repayment and amortization) and
current fair value, less any impairment loss on that financial asset previously
recognized in the statement of profit and loss. Impairment losses recognized in the
statement of profit and loss for an investment in an equity instrument shall not be
reversed through statement of profit and loss. If the fair value of a debt instrument
increases in a subsequent period and the increase can be objectively related to a
new event, the impairment loss shall be reversed and the amount of the reversal
shall be recognized in the statement of profit and loss.
Table 8.1 summarizes the position on measurement of financial assets.
TABLE 8.1 Measurement of Financial Assets
Equity Investments for Business Purposes
A company may invest in another company’s equity shares as part
of its long-term plan of developing a closer business relationship
with the company in which it invests, or investee. This type of
investment is no different from investments in property, plant and
equipment, and intangible assets in one’s own business. In effect,
a business can expand its operations without investing in its own
assets by buying the shares of another company. There are several reasons why a
company may choose to acquire another company, such as the following:
Acquiring an existing company with readily available manufacturing
facilities, distribution networks, experienced employees, and long-standing
suppliers and customers, rather than setting up a business from scratch,
gives a head start.
Starting a greenfield venture is considerably more risky, because of problems
in land acquisition and getting government approvals, delays in project
completion, developing brands, and so on.
There may be legal and regulatory requirements to set up a separate entity or
there may be tax considerations.
Think of equity investments of the kind described above as operating investments,
which are different from financial investments that we discussed earlier. Though
these investments are in equity instruments and hence are financial assets, they
are made for business purposes (e.g. obtaining technology, expanding production,
enlarging product markets, sourcing raw materials, and accessing distribution
networks), rather than for getting dividend income or benefiting from capital
appreciation in the shares. Accounting should reflect the investor’s investment
objective. The appropriate accounting for investments would depend on
management’s intent, i.e. whether the investor plans to sell the shares quickly and
make a profit, or it intends to hold on to the investment for a long, unspecified
period in the future and is going to gain or lose depending on the investee’s longterm performance. A simple way to figure out this is to look at the investment time
horizon.
Accounting for equity investments made for business purposes differs depending
on the nature of the investor’s interest in an investee. The principle of substance
over form is the basis for the accounting for such investments. According to this
principle, we should account for and present transactions and other events in
accordance with their substance and economic reality and not merely their legal
form. Depending on the degree of the investor’s say in running the investee’s
business, we classify an investee as a subsidiary, a joint venture or an associate,
and apply different accounting methods.
Subsidiaries
Control
A subsidiary is an enterprise over which an investor – i.e. parent
– has control. Control is the power to govern an investee’s
financial and operating policies so as to benefit from its activities.7
A subsidiary may be an incorporated entity such as a company, or may be an
unincorporated entity such as a partnership. A group consists of a parent and all
its subsidiaries. If an investor owns, directly or indirectly, more than half of an
investee’s voting power, accounting rules presume that the investor has control,
unless, in exceptional circumstances, it can be clearly demonstrated that such
ownership does not constitute control.
Control also exists when an investor owns half or less of an investee’s voting
power when there is (a) power over more than half of the voting rights by virtue of
an agreement with other investors; (b) power to govern the investee’s financial and
operating policies under a statute or an agreement; (c) power to appoint or remove
the majority of the investee’s board of directors; or (d) power to cast the majority of
votes at meetings of the investee’s board of directors. The one-half voting power test
is a fuzzy line, an example of the principle-based nature of IFRS, but the reference
to “exceptional circumstances” makes it harder to cross the line.
Financial and operating policies would include matters such as approval of the
annual budget, raising of capital, approval of investment and acquisition proposals,
and dividend policy. Other important financial and operating policies include
deciding on an entity’s strategic direction, product pricing, production, employee
appointments, and winding up the entity.
Consolidated Financial Statements
Business enterprises often conduct their activities through several
entities under the ultimate control of the group’s parent for a
variety of legal, tax, and other reasons. For example, the parent
may be a shell company registered in a tax haven, such as St. Kitts, with
investments in many subsidiaries. The parent would have no revenues or expenses
of its own. In such cases, the parent’s financial statements, or standalone financial
statements, do not present a complete view of its activities.
Consolidated financial statements are the financial statements of a group
comprised a parent and all its subsidiaries presented as if they were a single
economic entity. For example, the financial statements of Infosys Limited pertain to
that company. In contrast, its consolidated financial statements for 2013 cover both
that legal entity and its 35 group companies, such as Infosys Technologies
(Australia) Pty Limited, Infosys Consulting India Limited, Infosys BPO Limited,
and Lodestone Holding AG. Consolidated financial statements are more useful to
users of financial statements, because they present information about the group as
a whole. In spite of the consolidated financial statements, the parent and its
subsidiaries are separate legal entities that enter into contracts in their respective
names, continue to have their respective assets, liabilities and share capital, and
often prepare their own financial statements.
The parent applies consolidation for its investments in subsidiaries in the
consolidated financial statements. The consolidation procedure consists of three
important steps:
1. Combine line items: Line items such as revenues, expenses, assets,
liabilities, and equity of the parent are added with those of the subsidiaries
in the group. For this reason, the consolidation method is also known as lineby-line consolidation.
2. Eliminate intragroup items: Financial statement items that represent
transactions or claims within the group, such as the parent’s investment in a
subsidiary or a loan payable by a subsidiary to the parent, are eliminated in
the consolidation.
3. Identify non-controlling interests: Non-controlling interests (or minority
interests) representing the share of a subsidiary’s profit or loss and equity
not attributable to the parent are determined and presented separately.
Accountants think that recognizing income simply on the basis of dividends or
even applying the equity method (discussed later in this chapter) may not be an
adequate measure of the income earned from an investor from an enterprise that he
controls. Consolidated financial statements reflect the substance and economic
reality of the parent’s control over a subsidiary.
Business Combination
A business combination is a transaction or other event in which
an entity obtains control over a business.8 The entity that obtains
control is the acquirer and the acquired business is the acquiree.
Several structures are possible for a business combination. The choice of a structure
depends on the acquirer’s business, legal, tax, and other objectives. Consider the
following possibilities:
Parent and subsidiary continue as legal entities: A parent-subsidiary
relationship is a common form of a business combination. Here, the acquirerparent and the acquiree-subsidiary continue to be separate legal entities. In
this case, we consolidate the parent’s and the subsidiary’s financial
statements.
Acquiree merges with the acquirer: The acquiree’s business legally merges
into the acquirer’s business and the acquiree ceases to exist as a legal entity.
In this case, the acquiree’s assets and liabilities are already on the acquirer’s
financial statements.
Acquirer and acquiree merge with a new entity: The combining entities
transfer their net assets to a newly formed entity and cease to be legal
entities.
A business combination requires a business, usually understood to mean applying
processes to inputs to produce outputs (e.g. making steel by melting and purifying
iron ore and manganese and adding carbon). The mere acquisition of an asset or a
group of assets (e.g. acquiring a steel melting shop) does not constitute a business
combination.
The key element in a business combination is acquisition. It means that one of the
parties to a business combination can always be identified as the acquirer. Recall
the idea of control from the earlier discussion on parent and subsidiary. Often, the
parties engaged in a business combination describe the transaction as a “true
merger” or “merger of equals”, implying that there is no acquisition by anyone of
them. Such talk may be intended to help the parties assure their shareholders that
they continue to have control over the future of their businesses, but has no
significance for accounting purposes. In accounting, every business combination is
an acquisition and one party is the acquirer and the other, the acquired. There are
no two ways about it.9
Goodwill
Often, the consideration for an acquisition is a cash payment, an issue of shares or a
mix of cash and shares. The consideration covers the value to the acquirer of the
acquiree’s identified assets less liabilities and, usually, a premium known as
goodwill that represents the future economic benefits from assets that are not
identified. Suppose that a business has highly satisfied customers, talented staff,
and a good location. The acquirer has to pay for not only the acquiree’s net assets,
i.e. tangible assets and identifiable intangible assets less liabilities but also the
future benefits from superior customer relations, reliable suppliers, employee
talent, and advantageous location. That excess is the goodwill component of the
purchase price.
Irrespective of whether there is any indication, goodwill acquired in a business
combination should be tested annually for impairment.10 For the purpose of
testing, it should be allocated to each of the acquirer’s cash-generating units
(explained in Chapter 7) that are expected to benefit from the combination.
Acquisition Method
A business combination must be accounted for by applying the acquisition
method, also known as the purchase method, as of the acquisition date. The
elements of this method are as follows:
1. The acquirer recognizes the identifiable assets acquired, the liabilities
assumed, and any non-controlling interest in the acquiree.
2. The acquirer measures each identifiable asset acquired and liability
assumed at its acquisition-date fair value.
3. The acquirer recognizes goodwill, measured as the excess of (a) over (b)
below:
(a) the sum of:
(i) the fair value of the consideration;
(ii) the amount of any non-controlling interest in the acquiree (this will be
zero if it is a 100 per cent acquisition); and
(iii) the fair value of the acquirer’s previously held equity interest, if any
(this will be zero if the acquirer gains control in a single investment, rather
than investing in instalments);
(b) the net identifiable assets acquired.
There are two acceptable methods for measuring non-controlling interest in the
acquiree:11
Fair value
Non-controlling interest’s proportionate share of the acquiree’s identifiable
net assets.
The fair value method views the group as an economic entity, rather than from
the viewpoint of the controlling shareholder group. It does not distinguish between
the controlling and non-controlling interest. The second method views the group
through a controlling interest viewpoint and does not consider goodwill relating to
the non-controlling interest.
Consolidated Financial Statements and Business Combination Illustrated
On January 1, 20XX, Libra Company acquired for cash 75 per cent
of the outstanding shares of Virgo Company at `32 per share. On
that date, Virgo Company’s share price was `30. Exhibit 8.1
presents the balance sheets of Libra Company and Virgo Company
just prior to the acquisition.
The consideration for the acquisition is `48,000, i.e. 1,500 shares  `32 per share.
Libra Company records the acquisition as follows:
We conclude that Libra Company obtains control of Virgo Company by means of
owning more than half of the latter’s voting shares. So Libra Company is the
acquirer and Virgo Company is the acquiree. The acquisition date is January 1,
20XX, the date on which control is obtained.
Exhibit 8.2 presents the financial statements of the two companies immediately
after the acquisition.
The appraisal report on Virgo Company as of the acquisition date indicated the
following:
Property, plant and equipment was worth 20 per cent higher.
A patent worth `3,000 came to light.
Inventories included obsolete items costing `1,000.
Trade receivables included irrecoverable amounts of `2,000.
A trade payable of `1,000 had been omitted.
The fair values of the remaining assets and liabilities were equal to their
carrying amounts.
Exhibit 8.3 presents the effect of the fair value adjustments in Virgo Company’s
balance sheet.
Note the following in the fair value adjustments:
1. Both property, plant and equipment and accumulated depreciation increase
by 20 per cent. We need to report the two separately in the consolidated
balance sheet.
2. Patent is an identifiable asset with a fair value. So we include it in the fair
value calculation, though the acquiree did not recognize it.
Libra Company pays `32 per share when the market price is `30 per share,
implying a control premium of `3,000 on the 1,500 shares acquired. The
consideration of `48,000 consists of three components:
(a) The acquirer’s share of fair value of identifiable net assets
(i.e. 75% of `52,000).................................................................................`39,000
(b) ‘Normal’ goodwill (i.e. 1,500 shares × `30 per share– `39,000)...............6,000
(c) Control premium.............................................................................................3,000
The acquirer pays a goodwill of `9,000, the sum of ‘normal’ goodwill and control
premium. The non-controlling interest’s share of goodwill is `2,000, calculated as
follows: fair value of non-controlling interest, `15,000 (i.e. 500 shares × `30 per
share) – non-controlling interest’s share of fair value of identifiable net assets,
`13,000 (i.e. 25% of `52,000).
Under the fair value method, we consider goodwill paid by the acquirer and noncontrolling interest’s share of goodwill. Libra Company will record net assets of
`52,000, consideration of `48,000, goodwill of `11,000 (= acquirer’s goodwill, `9,000
+ non-controlling interest’s share, `2,000), and fair value of non-controlling interest,
`15,000. Exhibit 8.4 presents the worksheet on January 1, 20XX that Libra
Company will prepare to consolidate the balance sheets of the two companies
applying fair value.
An alternative method is to consider goodwill paid by the acquirer, but ignore
non-controlling interest’s share of goodwill. In other words, we recognize noncontrolling interest’s proportionate share of the acquiree’s identifiable net assets.
Applying this method, Libra Company will record net assets of `52,000,
consideration of `48,000, goodwill of `9,000, and non-controlling interest’s
proportionate share of the acquiree’s identifiable net assets, `13,000. Exhibit 8.5
presents the worksheet according to this method.
Exhibit 8.6 presents the consolidated balance sheet of Libra Company and Virgo
Company after the business combination on January 1, 20XX according to the two
methods.
The difference between the two methods is in the treatment of goodwill. The fair
value method allocates goodwill to both controlling and non-controlling interests.
Under proportionate share of fair value of net assets, goodwill is allocated only to
controlling interest; non-controlling interest is calculated based on its share of the
fair value of net assets, i.e. excluding goodwill. There is a consequent difference in
the amount of non-controlling interest.
Consolidation Requirements
Dates of financial statements The financial statements of the parent and its
subsidiaries shall be prepared as of the same date. When the parent and a
subsidiary report on different dates, the subsidiary has to prepare additional
financial statements as of the date of the parent’s financial statements, unless it is
impracticable to do so. If the dates are different, adjustments are made for the
effects of significant transactions or events that occur between those dates. In any
case, the difference between the dates cannot exceed three months.
Accounting policies Uniform accounting policies shall be followed for like
transactions and other events in similar circumstances. For example, if the
consolidated financial statements follow the straight-line method of depreciation for
a certain class of assets, while a subsidiary follows the written-down-value method
for the same class of assets, appropriate adjustments are made to the subsidiary’s
financial statements, so that the depreciation for that class of assets is based on the
straight-line method.
Non-controlling interests Non-controlling interests are presented in the
consolidated balance sheet within equity, separately from the equity of the parent’s
shareholders.
Intragroup balances and transactions In the consolidated financial statements,
the parent’s investment in a subsidiary and the subsidiary’s equity are eliminated.
Intragroup balances shall be eliminated fully. While the reason for this is obvious in
the case a 100 per cent subsidiary, it may not be intuitive in a partially-owned
subsidiary. Remember that consolidated financial statements seek to present the
group as an economic entity. There is no place in them for transactions and
balances within the group. For example, suppose that the parent with 70 per cent
shareholding holds an investment of `10,000 out of its subsidiary’s bonds payable of
`100,000. In its consolidated financial statements, the parent will eliminate both (a)
its investment of `10,000 in the bonds appearing as an asset in its balance sheet
and (b) an amount of `10,000 from the bonds payable appearing in the subsidiary’s
balance sheet. Thus, the consolidated financial statements will show a liability of
`90,000 for bonds payable by the group to outsiders. Consider an example of an
intragroup transaction. Suppose that the parent sold inventory costing `10,000 to
its subsidiary at `12,000 and the inventory is in the subsidiary’s balance sheet at
the year end. The parent’s statement of profit and loss would include the `12,000
revenue and the `10,000 cost of goods sold. In the consolidated financial statements,
the revenue of `12,000, the cost of goods sold of `10,000, and the unrealized profit
(unrealized from the group’s standpoint) of `2,000 will be eliminated. The unsold
inventory will appear at `10,000 after deducting the unrealized gain.
Exemption from Consolidation
A parent need not prepare consolidated financial statements if it is a non-public
entity, i.e. an entity that is not of interest to the wider investing public. That would
be possible only if it meets all the following conditions:
(a) The parent is a shell company The parent is itself a wholly-owned subsidiary.
The parent is nothing more than a shell company; real control lies with the
parent’s parent, and no other investor would care. The parent’s consolidated
financial statements would be of no value. If the parent is a partially-owned
subsidiary of another entity, that entity’s other owners should have been
informed about the parent not presenting consolidated financial statements,
and they should not object to it.
(b) There is no public market for the parent’s debt or equity The parent’s bonds or
equity shares are not traded in a domestic or foreign stock exchange or an overthe-counter market. This means that the parent’s bonds or equity shares are
not listed. Those who want to buy or sell the parent’s bonds or shares can do so
only in a private market. If the bonds or equity shares are listed but there is no
trading in them, this condition is probably not met.
(c) The parent is not about to raise capital from the public The parent did not file
its financial statements with a security regulator for the purpose of issuing
bonds or equity shares. It means that the parent is not intending to make a
public offering. Together with condition (b) it means that the parent’s bonds or
shares are not currently traded, nor is an effort being made to create a public
market for them.
(d) The parent’s parent produces consolidated financial statements The parent’s
ultimate parent or an intermediate parent produces consolidated financial
statements that are publicly available. This is to avoid unduly burdening the
parent, when its parent or some entity in the chain of control prepares
consolidated financial statements in accordance with International Financial
Reporting Standards.
In other words, exemption from consolidation is only available to a “non-public
entity”, i.e. (a) the entity that is itself either a wholly-owned subsidiary or whose
minority shareholders do not object to non-consolidation, (b) it is neither listed nor
about to be listed, and (c) its ultimate or intermediate parent presents IFRScompliant consolidated financial statements.
Joint Ventures
Joint Control
A joint venture is a contractual arrangement whereby two or
more parties undertake an economic activity that is subject to
joint control: the contractually agreed sharing of control to
govern an economic activity so as to obtain benefits from it.12
Control is the power to govern the financial and operating policies of an economic
activity, so as to obtain benefits from it. A party to a joint venture that has joint
control is a venturer. Each venturer has joint control over that joint venture along
with the other venturers. Joint control exists only when the strategic financial and
operating decisions relating to the activity require the unanimous consent of the
venturers. The venturers agree to pool their voting power. An investor in a joint
venture is a party to a joint venture who does not have joint control.
The essentials of a joint venture are (a) two or more parties are bound by a
contractual arrangement; and (b) the contractual arrangement establishes joint
control. The existence of a contractual arrangement distinguishes a joint venture
from an associate, i.e. an entity in which an investor has significant influence.
Simply stated, “no contractual arrangement, no joint venture”. Joint control means
that no single venturer can have its way disregarding the views of the other
venturers. The contractual arrangement, usually in writing, deals with such
matters as the joint venture’s activity, duration, and reporting obligations, the
appointment of the joint venture’s board of directors, and the venturers’ voting
rights, venturers’ capital contributions, and the sharing by the venturers of the joint
venture’s output, income, expenses or profits.
Forms of Joint Venture
Joint ventures can be of three broad types:
1. Jointly controlled operations;
2. Jointly controlled assets; and
3. Jointly controlled entities.
Jointly Controlled Operations
In a jointly controlled operation, each venturer uses its own assets, such as
property, plant and equipment, and inventories. Often, the operation is similar to,
and carried out alongside, those operations. Each venturer pays its own expenses
and takes a share of the revenue from the operations. For the venturers it is
business as usual. For example, suppose that some leading automobile
manufacturers form a joint venture. One makes engines, another makes
transmission, yet another makes chassis, and so on. One of them assembles the
parts and sells the car. The venturer who makes engines uses its own
manufacturing facilities, pays its own production costs, and gets a share of the
revenue from the sale of the car that represents the agreed value of the engine. It
does not pay any of the costs of the other manufacturers. Jointly controlled
operations are a relatively loose arrangement and the accounting reflects this. A
venturer recognizes the assets that it controls and the liabilities that it incurs. It
also recognizes the expenses that it incurs and its share of the joint venture’s
revenue.
Jointly Controlled Assets
The venturers may have joint control of assets. A jointly controlled asset may be an
asset contributed by a venturer or acquired for the purpose of the venture. The asset
may belong to one of the venturers or there may be joint ownership of the asset. The
venturers agree to take a share of the output from the assets and each bears an
agreed share of the expenses incurred. There is no separate entity that owns the
assets. Jointly controlled assets are common in the oil, gas, and mineral extraction
industries, e.g. an oil pipeline. Each venturer uses the pipeline to transport its own
products and bears an agreed share of the operating expenses.
A venturer recognizes the following in its financial statements in respect of a
jointly controlled asset, e.g. a jointly controlled oil refinery:
1. Its share of a jointly controlled asset, e.g. a share of the refinery’s cost;
2. Its liabilities, e.g. loans raised to finance its share of the refinery;
3. Its share of the liabilities incurred jointly with the other venturers in
relation to the venture, e.g. the refinery’s Trade payables;
4. Income from the sale of its share of the output, e.g. revenue from the
refinery’s sales of oil, and its share of the expenses of the joint venture, e.g.
the refinery’s operating and maintenance expenses; and
5. Expenses that it has incurred in respect of its interest in the joint venture,
e.g. interest expense on its loans to finance the refinery.
A venturer does not make any adjustments or follow other consolidation
procedures for a jointly controlled asset, because it already recognizes the relevant
assets, liabilities, income, and expenses in its financial statements. This is similar
to a jointly controlled operation.
Jointly Controlled Entities
A jointly controlled entity is a joint venture that takes the legal form of a
corporation, partnership or other entity in which each venturer has an interest. A
contractual arrangement between the venturers establishes joint control over the
entity’s economic activity. The entity controls, and often owns, the joint venture’s
assets, incurs liabilities and expenses, and earns revenues. Each venturer is
entitled to a share of the entity’s profits and sometimes to a share of its output.
Jointly controlled entities are common in the oil and natural gas industry.
Companies, such as Shell, BP, and ONGC, take up a prospective block for
exploration and development by a contractual arrangement with the government
that owns and auctions the block.
A jointly controlled entity differs from a jointly controlled asset in two ways:
1. Venturers transfer certain assets and liabilities into a jointly controlled
entity, but there is no such transfer in a jointly controlled asset.
2. A jointly controlled entity maintains its own accounting records and
prepares and presents financial statements, but there are no separate
financial statements for a jointly controlled asset.
Proportionate Consolidation
A venturer in a jointly controlled entity accounts for its interest in
the entity applying proportionate consolidation. Under this
method, the venturer recognizes its share of jointly controlled
entity’s assets, liabilities, income, and expenses with similar line
items in its financial statements. For example, a venturer in a
50:50 jointly controlled entity would recognize on its balance sheet its own assets
and liabilities and 50 per cent of the jointly controlled entity’s assets and liabilities.
There are two formats for presenting this:
1. Combine the items line by line The venturer combines its share of that
entity’s inventories with its inventories, its share of that entity’s receivables
with its receivables, and so on.
2. Show separate line items The venturer shows its share of that entity’s
inventories next to its inventories, its share of that entity’s receivables next
to its receivables, and so on.
These two formats differ in presentation and not in content. They report identical
amounts of profit or loss, and of each major classification of assets, liabilities,
income, and expenses. Accountants believe that proportionate consolidation better
reflects the substance and economic reality of a venturer’s interest in a jointly
controlled entity, that is, control over the venturer’s share of that entity’s future
economic benefits. The principal difference between consolidation for partly-owned
subsidiaries and proportionate consolidation for joint ventures is that in the latter
there is no non-controlling interest. An alternative to the proportionate
consolidation method is the equity method, followed for associates, discussed in the
next section.
Proportionate Consolidation Requirements
Dates of financial statements The financial statements of the venturer and its
jointly controlled entities shall be prepared as of the same date. When the venturer
and a jointly controlled entity report on different dates, the jointly controlled entity
has to prepare additional financial statements as of the date of the venturer’s
financial statements, unless it is impracticable to do so. If the dates are different,
adjustments are made for the effects of significant transactions or events that occur
between those dates. In any case, the difference between the dates cannot exceed
three months.
Accounting policies Uniform accounting policies shall be followed for the like
transactions and other events in similar circumstances. For example, if the
consolidated financial statements follow FIFO for inventory valuation, while a
jointly controlled entity follows WAC, appropriate adjustments are made to the
jointly controlled entity’s financial statements so that the application of the
inventory valuation method is uniform.
Goodwill Goodwill can arise on acquisition of a jointly controlled entity. Any excess
of the fair value of the consideration given to acquire a share in a jointly controlled
entity over the net of the fair values of the identifiable assets acquired and the
liabilities assumed is goodwill. The accounting for goodwill and fair value
adjustments is similar to that for a subsidiary in a business combination.
Intragroup balances In the consolidated financial statements, the venturer’s
investment in a jointly controlled entity and the venturer’s share of jointly
controlled entity’s equity. Intragroup balances shall be eliminated to the extent of
the venturer’s interest. For example, suppose that a venturer in a 60:40 joint
venture has made a loan of `10,000 to the jointly controlled entity. In its
consolidated financial statements, the venturer will eliminate its share of (a) the
loan receivable appearing as an asset in its balance sheet and (b) the loan payable
appearing in the jointly controlled entity’s balance sheet. Thus, the venturer’s
consolidated financial statements will show a loan receivable of `4,000, i.e. `10,000
× (100% – 60%) and an equal amount of loan payable. Suppose that the venturer
sold inventory costing `10,000 to the jointly controlled entity at `12,000 and the
inventory is in the jointly controlled entity’s balance sheet at the year end. The
venturer’s statement of profit and loss would include the revenue of `12,000 and the
cost of goods sold of `10,000. In the venturer’s consolidated financial statements, the
revenue and the cost of goods sold will appear at `4,800 and `4,000, respectively, i.e.
40 per cent of the transaction amounts. Thus, the unrealized profit of `1,200, i.e. 60
per cent of `2,000, has been eliminated. The unsold inventory will appear at `10,800
after deducting the unrealized gain.
Exemption from Proportionate Consolidation and Equity Method
A venturer having an interest in a jointly controlled entity is exempted from
applying proportionate consolidation or the equity method when it meets the
following conditions:
(a) The interest is classified as “held for sale” in accordance with IFRS 5: It is
accounted for in accordance with that IFRS.
(b) The venturer is a parent that is a “non-public” entity: Recall that a parent that
is a non-public entity need not present consolidated financial statements. It is
also exempted from applying proportionate consolidation or the equity method.
(c) The venturer is not a parent, but a “non-public” entity: A venturer classified as
a “non-public entity” is exempted from applying proportionate consolidation or
the equity method.
Associates
Significant Influence
An associate is an enterprise over which an investor has
significant influence: the power to participate in an entity’s
financial and operating policy decisions.13 An associate may be an
incorporated entity such as a company, or may be an
unincorporated entity such as a partnership. If an investor holds 20 per cent or
more of an investee’s voting power, accountants presume that the investor has
significant influence unless it can be clearly demonstrated that this is not the case.
Conversely, if an investor holds less than 20 per cent of an investee’s voting power,
the rules presume that the investor does not have significant influence unless such
influence can be clearly demonstrated. Thus, the 20 per cent of voting power test is
a fuzzy line, not a bright line. This is an example of the principle-based nature of
IFRS.
An investor can have significant influence even when another investor has
majority ownership in the investee. For determining whether an investor has
significant influence, we should consider the investor’s direct ownership and
indirect ownership, such as through subsidiaries. Significant influence may be
evident in a number of ways, such as the investor’s representatives being on the
investee’s board of directors, the investor’s participation in investee’s dividend and
other policy decisions, material purchases, sales and other transactions between the
investor and the investee, interchange of managerial personnel between the
investor and the investee, and the investor providing essential technical
information to the investee.
The Equity Method: One-line Consolidation
The investor accounts for an investment in an associate by applying
the equity method. In this method, the investor recognizes the
investment at cost at the time of acquisition and adjusts it for
subsequent changes in the investor’s share of the associate’s net assets. When the
investee earns a profit, its net assets increase; when it incurs a loss, its net assets
decrease. Reflecting these changes, the carrying amount of the investment increases
by the amount of the investor’s share of the associate’s profit and decreases by the
amount of its share of the associate’s loss. Concurrently, the investor recognizes in
its statement of profit and loss its share of the associate’s profit or loss in every
period. Dividends received from the associate reduce the carrying amount of the
investment. Recognizing a dividend income would result in double counting,
because the investor would have already recorded as income its share of the
associate’s profit or loss.
Accountants think that recognizing income simply on the basis of dividends may
not be an adequate measure of the income earned by an investor on an investment
in an associate, because the dividends received may bear little relation to the
associate’s performance. The investor has an interest in the associate’s performance
that goes beyond passively receiving dividends. The associate’s performance as
measured by its earnings is a better indicator of its performance and the investor’s
share of those earnings provides a superior measure of the return on the investment
in the associate. Thus, the equity method reflects the economic substance of the
investment, rather than its mere legal form of receiving dividends. The equity
method of accounting is also known as one-line consolidation, because it shows the
investor’s interest in the associate in a single line rather than in the manner of lineby-line consolidation followed for subsidiaries. The equity method is applied in the
consolidated financial statements.
The investor ascertains the fair value of the associate’s assets and liabilities at the
time of acquisition. Note that the investor also considers assets and liabilities not
recognized by the associate. The excess of the cost of acquisition over the investor’s
share of the fair value is goodwill. To illustrate, suppose that Ajay Company
acquires a 30 per cent interest in Deepak Company for `200,000. At that date, the
carrying amount of Deepak’s net assets was `500,000. The fair value of Deepak’s net
assets was equal to their carrying amount except for a piece of land that had a book
value of `40,000 and a fair value of `50,000. Ajay calculates a goodwill of `47,000, as
follows:
The fair value adjustment in the above illustration relates to land, a nondepreciable asset. So the investor does not depreciate the amount of `3,000. Fair
value adjustment relating to a depreciable asset should be charged over the asset’s
remaining useful life. For example, suppose that the fair value adjustment related
to an item of property, plant and equipment with a remaining useful life of 10 years.
Ajay should recognize a yearly charge of `300 for 10 years in its consolidated
statement of profit and loss and reduce the carrying amount of the investment.
Furthermore, the investor should adjust the carrying amount for his share of any
changes in the associate’s other comprehensive income arising from revaluation of
property, plant and equipment, foreign exchange translation differences and
marking to market AFS securities.
Note that the investor includes goodwill in the carrying amount of the investment
and does not record it separately. For this reason, goodwill is not tested for
impairment separately, unlike goodwill acquired in a business combination.
Instead, the entire carrying amount of the investment is tested for impairment as a
single asset.
Exemption from the Equity Method
An investor having an associate is exempted from applying the equity method when
the following conditions are meet:
1. The investment is classified as “held for sale” in accordance with IFRS 5: It is
accounted for in accordance with that IFRS.
2. The investor is a parent that is a “non-public” entity: Recall that a parent
that is a non-public entity need not present consolidated financial
statements. Such a parent is also exempted from applying the equity
method.
3. The investor is not a parent but is a “non-public” entity. An investor that is a
non-public entity is exempted from applying the equity method.
Figure 8.2 illustrates the key ideas in accounting for business investments.
Investments in Separate Financial Statements
Separate financial statements are “those presented by a parent,
an investor in an associate or a venturer in a jointly controlled
entity, in which the investments are accounted for on the basis of
the direct equity interest rather than on the basis of the reported
results and net assets of the investees.”14 These are the financial statements of an
enterprise reporting as a legal entity, ignoring the effect of the substance and
economic reality of its relationship with any other entities. They show that entity’s
revenues, expenses, assets, liabilities, and equity. In India, these are commonly
known as standalone financial statements. In the separate financial statements,
an entity accounts for investments in subsidiaries, jointly controlled entities and
associates as follows:
1. Investment: The direct equity interest in a subsidiary, associate or jointly
controlled entity is measured at (a) cost or (b) fair value in accordance with
IFRS 9. Cost is the cost of acquisition of the investment.
2. Dividend income: The investor recognizes dividend from a subsidiary,
associate or jointly controlled entity when its right to receive the dividend is
established. In India, that happens when dividend is declared.
A public entity that does not prepare consolidated financial statements applies
either proportionate consolidation or the equity method for its jointly controlled
entities and the equity method for its associates in its financial statements. Note
that these financial statements are not separate financial statements as defined
above, because proportionate consolidation and the equity method are based on the
reported results and net assets of the investees.
Investment Property
Investment property is property (land, building or both) held to
earn rentals or for capital appreciation or both.15 Investment
property excludes property held for use in the production or supply
of goods or services or for administrative purposes or for sale in the
ordinary course of business. For example, a business enterprise may buy an
apartment for several reasons. If the enterprise intends to use it in its own
business, it should be classified as property, plant and equipment. If its intention is
to sell it as part of its business (e.g. a real estate dealer), it is a part of its
inventories. If it invests in the apartment with a view to benefiting from an
anticipated increase in its market value rather, it is an investment property.
Investment property is recognized as an asset when and only when:
(a) It is probable that the future economic benefits that are associated with the
investment property will flow to the entity; and
(b) The cost of the investment property can be measured reliably.
An investment property is measured initially at its cost. Transaction costs are
included in the initial measurement. Professional fees for legal services and
property transfer taxes, such as stamp duty and registration fee, are examples of
transaction costs. For measurement after recognition, an entity can choose between
the fair value model or the cost model, but it must apply the same model to all of its
investment property.
Fair Value Model
The fair value model can be applied except when it is not possible to determine the
fair value of an investment property reliably on a continuing basis. A gain or loss
arising from change in the fair value of investment property is recognized in the
statement of profit and loss for the period to which it relates. The fair value of
investment property shall reflect the market conditions at the end of the reporting
period.
Cost Model
An entity that chooses the cost model shall measure its investment properties at
cost less depreciation, similar to property, plant and equipment. Investment
property measured at cost is subject to impairment.
Looking Back
Describe the nature and types of investments Investments are assets that are not intended to be
available for the investor’s production, selling or administrative activities. Investments may be financial
claims on other enterprises or land and building held for renting out and increase in value.
Define and describe financial instruments and financial assets A financial instrument is a contract
that gives rise to a financial asset of one entity and a financial liability of another entity. A financial asset
can be cash, an equity instrument of another entity, or a contractual right to receive cash or another financial
asset from another entity.
Account for equity and debt instruments held as financial investments Financial assets are
classified depending on the investor’s intention. Financial assets at fair value through profit or loss are
measured at fair value and holding gains and losses and dividend or interest income are recognized in
statement of profit and loss. These are usually held-for-trading financial assets. If it is not possible to establish
fair value of equity instruments reliably, they are carried at cost. For financial assets carried at cost dividend
income is recognized in statement of profit and loss. Held-to-maturity investments and loans and receivables are
measured at amortized cost using the effective interest method. Available-for-sale financial assets are measured
at fair value but gains and losses are taken to other comprehensive income, a balance sheet item; dividend or
interest income is recognized in statement of profit and loss.
Explain impairment of financial assets Financial assets carried at amortized cost (i.e. HTM
investments and loans and receivables), financial assets carried at cost, and AFS financial assets are
assessed at each reporting date to find out whether there is any “objective evidence” of impairment. Impairment
loss must be recognized in statement of profit and loss.
Distinguish between equity investments held as operating investments from those held as
financial investments Equity instruments may be held as part of a long-term business plan, rather than
for near-term trading. These are operating investments, rather than financial investments; the intention is to
acquire another company for business, regulatory or tax purposes instead of building a business from scratch.
Define a subsidiary and explain control A subsidiary is an enterprise over which an investor – parent –
has control: the power to govern an investee’s financial and operating policies so as to benefit from its
activities. Owning more than half of an investee’s voting power gives control. Control may also result from a
shareholder agreement.
Explain consolidated financial statements Consolidated financial statements are the financial
statements of a group consisting of a parent and all its subsidiaries presented as if they were a single
economic entity. The consolidation procedure combines line items of the individual companies, eliminates
intragroup items, and identifies and presents non-controlling interests.
Explain business combination and goodwill A business combination is a transaction in which an entity
obtains control over a business. A parent-subsidiary relationship is a common form of a business
combination. The key element in a business combination is acquisition, meaning that one of the parties can be
identified as the acquirer. Goodwill is the premium paid over the fair value of the net assets. A business
combination must be accounted for by the acquisition method.
Prepare consolidated financial statements applying the acquisition method of business
combination The first step is to determine the acquisition date – the date on which the acquirer obtains
control. The next step is to establish the fair values of the acquiree’s identifiable assets and liabilities including
any assets or liabilities not recognized on the acquiree’s balance sheet. Non-controlling interest can be measured
applying the fair value method that allocates goodwill to both controlling and non-controlling interests, or using
the proportionate share of fair value of net assets that allocates goodwill only to the controlling interest. The
financial statements of the parent and its subsidiaries shall be prepared as of the same date and following
uniform accounting policies. Non-controlling interest is presented separately from the equity of the parent’s
shareholders. The parent’s investment in a subsidiary and the subsidiary’s equity and all intragroup balances
are eliminated. A parent need not prepare consolidated financial statements if it is a non-public entity.
Define joint venture and explain joint control A joint venture is a contractual arrangement whereby
two or more parties (venturers) undertake an economic activity that is subject to joint control: the
contractually arranged sharing of control to govern an economic activity, so as to obtain benefits from it. Joint
control exists only when the strategic financial and operating decisions relating to the activity require the
unanimous consent of the venturers.
Explain proportionate consolidation for jointly controlled entities Under proportionate
consolidation, the venturer recognizes its share of jointly controlled entity’s assets, liabilities, income and
expenses with similar line items in its financial statements. The financial statements of the venturer and its
joint ventures shall be prepared as of the same date and following uniform accounting policies. Goodwill is the
excess of the fair value of the consideration given to acquire a share in a jointly controlled entity over the net of
the fair values of the identifiable assets acquired and the liabilities assumed. A venturer need not apply
proportionate consolidation if it is a non-public entity.
Define an associate and explain significant influence An associate is an entity over which an investor
has significant influence: the power to participate in an entity’s financial and operating policy decisions.
Significant influence is presumed if an investor holds 20 per cent or more of an investee’s voting power.
Explain the equity method for associates Under the equity method, the investor recognizes the
investment at cost at the time of acquisition and adjusts it for subsequent changes in the investor’s share of
the associate’s net assets. The carrying amount of the investment increases (decreases) by the amount of the
investor’s share of the associate’s profit (loss) and the investor recognizes its share in its statement of profit and
loss. The investor does not recognize dividend income from the associate in its statement of profit and loss but
reduces it from the carrying amount of the investment.
Account for investments in separate financial statements Separate financial statements are those
presented by a parent, an investor in an associate or a venturer in a jointly controlled entity, in which the
investments are accounted for on the basis of the direct equity interest measured at cost or fair value. The
investor recognizes dividend income from a subsidiary, associate or jointly controlled entity. The investor does
not apply consolidation, proportionate consolidation or the equity method in these statements.
Define and account for investment property Investment property is land, building or both held to earn
rentals, or for capital appreciation, or for both. An investment property is initially measured at its cost.
Subsequently, an entity can follow the fair value model or the cost model.
Review Problem
On August 1, 20X5, Pushpak Company bought Navin Company’s `100,000, 15 per cent, 10-year debentures for
`86,304. It has the intention and ability to hold the investment to maturity. Interest is payable on June 30 and
December 31 in arrears. The company’s year-end is March 31. Prepare journal entries to record the following:
1. Purchase of debentures on August 1, 20X5.
2. Receipt of semi-annual interest on December 31, 20X5 and amortization of
discount.
3. Accrual of interest on March 31, 20X6 and amortization of discount.
Solution
The effective interest rate is 9 per cent. The investment will be recorded initially at its fair value of `86,304,
verified as follows: 7,500  9.1285 + 100,000  0.1784. Note that we discount the cash flows at 9 per cent for 20
periods. We apply the amortized cost method as follows:
ASSIGNMENT MATERIAL
Questions
1.
2.
3.
How are investments different from other assets?
What is a financial asset?
Why is it important to treat equity shares held as financial investments differently from those held as
operating investments?
4.
Name the four categories into which equity and debt instruments held as financial assets are
classified.
5.
6.
7.
When are financial assets carried at cost?
Why is fair value accounting known as mark-to-market accounting?
How does accounting differ between financial assets at fair value through profit or loss and availablefor-sale financial assets?
8.
9.
10.
What is the essential difference between held-to-maturity investments and loans and receivables?
Explain amortized cost using the effective interest method.
Explain the tainting provisions for held-to-maturity investments. Do these also apply to loans and
receivables?
11.
12.
13.
14.
What is “objective evidence” in the context of impairment of a financial asset?
How is impairment loss on held-to-maturity investments or loans and receivables measured?
Can impairment loss on a financial asset be reversed subsequently?
Vinod Company holds 45 per cent of the voting shares of Raja Company. It has entered into a binding
agreement with the latter’s shareholders who hold 15 per cent of the voting shares that they will vote
as directed by Vinod Company. Is Raja Company a subsidiary of Vinod Company?
15.
16.
17.
How are consolidated financial statements more useful than a parent’s financial statements?
What is the criterion for an acquisition?
Suppose that the consideration for an acquisition is equal to the net of the fair values of the assets
acquired and liabilities assumed. Would it be correct to say that there is no goodwill in this
acquisition?
18.
19.
20.
Explain the two methods of measuring non-controlling interest.
Distinguish between control and joint control.
When is a parent exempted from preparing consolidated financial statements?
21.
22.
23.
24.
25.
26.
How is a venturer different from an investor in a joint venture?
How is significant influence different from joint control?
Why is the equity method known as one-line consolidation?
How is the treatment of goodwill different for a joint venture and an associate?
What are separate financial statements?
How is the treatment of dividend income in separate financial statements different from that in
consolidated financial statements?
27.
Renu Company has surplus land that it intends to sell. Is this investment property?
Problem Set A
On March 1, Thomas Company buys `100,000 of 10%, 15-year debentures. Interest is
payable semi-annually on August 31 and February 28 or 29 in arrears. Compute the fair
value of the debentures if the market interest rate on March 1 is (a) 18 per cent, (b) 10
per cent, or (c) 8 per cent.
On October 17, 20X1, Suhrid Company bought 2,000 equity shares of Piyush Company at
`24 per share as part of its cash management. On January 12, 20X2, Piyush Company paid
an interim dividend of `2 per share. On March 31, 20X2, Suhrid Company’s fiscal year end,
Piyush Company’s share traded at `27. On July 15, 20X2, Piyush Company paid a final
dividend of `4 per share. On January 19, 20X3, Piyush Company paid an interim dividend
of `3 per share. On March 31, 20X3, Piyush Company’s share traded at `25.
Required
Prepare journal entries to record the transactions.
On January 1, 20X1, Dinesh Company invested surplus cash in 1,000 of Chand Company’s
15 per cent, `100 debentures bought at `97 per debenture, ex-interest. Interest is payable
on June 30 and December 31 in arrears. On September 30, 20X1, Dinesh Company’s fiscal
year end, the debenture traded at `93 plus accrued interest. On September 30, 20X2, the
debenture traded at `94 plus accrued interest. Interest was received as stated.
Required
Prepare journal entries to record the transactions.
On November 3, 20X1, Ashwin Company bought as AFS assets 1,000 equity shares of
Vipul Company at `45 per share. On March 14, 20X2, it received an interim dividend of
`3 per share. The share had a fair value of `49 on March 31, 20X2, Ashwin Company’s
fiscal year-end. On September 12, 20X2, Vipul Company paid a final dividend of `5 per share. On March 9,
20X3, it paid an interim dividend of `2 per share. On March 31, 20X3, the share traded at `42.
Required
Prepare journal entries to record the transactions.
On January 1, 20XX, Francis D’Costa paid `200,000 for a senior solicitor’s practice with the
following assets and liabilities: equipment, `20,000; furniture, `15,000; prepaid rent, `8,000;
electricity expense payable, `700; salaries payable, `3,000.
Required
Prepare the journal entry to record the acquisition.
Problem Set B
Required
1.
2.
3.
Prepare journal entries assuming that all are trading securities.
Prepare journal entries assuming that all are available-for-sale securities.
Prepare journal entries assuming that the investments in Abhijit Company and Victor Company are
trading securities and the investment in Vincent Company is an AFS security.
4.
Prepare journal entries assuming that the investments in Abhijit Company and Victor Company are
trading securities but the current market value of Victor Company is not a reliable guide to the fair
value of the investment.
The appraisal report as of acquisition date indicated the following:
Property, plant and equipment had a fair value of `20,000
Inventories included obsolete items costing `2,000
A trade payable of `1,000 omitted
Fair values of the remaining assets and liabilities were equal to their
carrying amounts.
Kiran Company’s payables included an amount of `2,000 due to Shalom Company.
Required
1. Prepare the balance sheets of the two companies immediately after
acquisition.
2. Prepare a statement showing fair value adjustments as of acquisition date.
3. Prepare a consolidation worksheet as of acquisition date.
4. Prepare a consolidated balance sheet as of acquisition date.
Abhinav Company acquired for cash 80 per cent of the outstanding shares of Prakriti
Company on September 30, 20XX at `20 per share. On that date, Prakriti Company’s
share price was `18. The balance sheets of the two companies just prior to the acquisition
were as follows:
The appraisal report as of acquisition date indicated the following:
Property, plant and equipment had a fair value of `45,000
Inventories included obsolete items costing `3,000
A trade payable of `2,000 was omitted
Fair values of the remaining assets and liabilities equalled their carrying
amounts.
Abhinav Company’s investments included Prakriti Company’s bonds of `8,000.
Required
1. Prepare the balance sheets of the two companies immediately after the
acquisition.
2. Prepare a statement showing fair value adjustments as of the acquisition
date.
3. Prepare a consolidation worksheet as of acquisition date applying (a) fair
value, and (b) non-controlling interest’s proportionate share of identifiable
net assets.
4. Prepare a consolidated balance sheet as of acquisition date applying (a) fair
value, and (b) non-controlling interest’s proportionate share of identifiable
net assets.
On March 31, 20X1, Amar Company acquired for cash 30 per cent of the equity shares of
Lahar Company for `45,000. On that date, Lahar Company’s balance sheet was as follows:
equity share capital, `40,000; retained earnings, `60,000; property, plant and equipment,
`100,000. The property, plant and equipment had a remaining useful life of five years and a
fair value of `140,000. On June 11, 20X1, Lahar Company paid a dividend of `10,000. On March 31, 20X2, the
company reported a net profit of `17,000 for the year ended that date. Amar Company’s fiscal year-end is June
30.
Required
1. Prepare journal entries to record these transactions by Amar Company.
2. Prepare an analysis of the carrying amount of the investment in Amar
Company’s balance sheet on (a) June 30, 20X1, and (b) June 30, 20X2.
Problem Set C
Required
1. Prepare journal entries assuming that all are trading securities.
2. Prepare journal entries assuming that all are AFS securities.
3. Prepare journal entries assuming that the investments in Akash Company
and Surya Company are trading securities and the investment in Antariksh
Company is an AFS security.
4. Prepare journal entries assuming that the investments in Akash Company
and Antariksh Company are AFS securities but the current market value of
Surya Company is not a reliable guide to the fair value of the investment.
The appraisal report as of acquisition date indicated the following:
Property, plant and equipment was worth `27,000.
A licence worth `5,000 had not been recognized.
Inventories included obsolete items costing `1,000.
Trade receivables included an irrecoverable amount of `2,000.
The fair values of the remaining assets and liabilities were equal to their
carrying amounts.
Shabnam Company’s investments included Hamid Company’s bonds of `2,000.
Required
1. Prepare the balance sheets of the two companies immediately after the
acquisition.
2. Prepare a statement showing fair value adjustments as of acquisition date.
3. Prepare a consolidation worksheet as of acquisition date.
4. Prepare a consolidated balance sheet as of acquisition date.
The appraisal report as of acquisition date indicated the following:
Property, plant and equipment was worth `156,000.
Inventories included obsolete items costing `7,000.
Trade receivables included an irrecoverable amount of `4,000.
A trade payable of `3,000 had been omitted.
The fair values of the remaining assets and liabilities were equal to their carrying amounts.
Uttam Company’s investments included Anupam Company’s bonds of `8,000.
Required
1. Prepare the balance sheets of the two companies immediately after the
acquisition.
2. Prepare a statement showing fair value adjustments as of acquisition date.
3. Prepare a consolidation worksheet as of acquisition date applying (a) fair
value, and (b) non-controlling interest’s proportionate share of identifiable
net assets.
4. Prepare a consolidated balance sheet as of acquisition date applying (a) fair
value, and (b) non-controlling interest’s proportionate share of identifiable
net assets.
On September 30, 20X1, Vinod Company acquired for cash 25 per cent of the equity shares of
Sachin Company for `51,000. On that date, Sachin Company’s balance sheet was as follows:
equity share capital, `20,000; retained earnings, `100,000; property, plant and equipment,
`120,000. The property, plant and equipment had a remaining useful life of 10 years and a
fair value of `180,000. On November 14, 20X1, Sachin Company paid a dividend of `12,000. On September 30,
20X2, Sachin Company reported a net profit of `32,000 for the year ended that date. Vinod Company’s fiscal
year-end is December 31.
Required
1. Prepare journal entries to record these transactions by Vinod Company.
2. Prepare an analysis of the carrying amount of the investment in Vinod
Company’s balance sheet on (a) December 31, 20X1, and (b) December 31,
20X2.
Business Decision Cases
You are the chief financial officer of Flexi Bank. Vikram Suri, the bank’s chief executive, has worked
in large banks in New York and London. Flexi Bank’s loan and investment portfolio grew from
`3,000 million to `9,000 million in the three years since he joined. Suri believes that the bank must
take full advantage of India’s rapid economic progress but thinks that it has been too conservative. He is
pushing for aggressive corporate and consumer lending and active investing in the financial markets and thinks
that the bank’s “current accounting policies are unhelpful in presenting the bank’s extraordinary growth story.”
Required
1. What do you think could the chief executive have meant when he says that
the bank’s “current accounting policies are unhelpful in presenting the
bank’s extraordinary growth story”? Do you agree with him?
2. Prepare a note setting out how institutional safeguards, including
accounting principles, are necessary to protect the bank’s investors,
creditors, and employees – you and the chief executive, included.
Interpreting Financial Reports
On March 4, 2008, the shares of ICICI Bank, the largest non-government bank in India, ended 5
per cent lower than the previous close.16 The trigger was an announcement in Parliament that as
on January 31, 2008 ICICI Bank had suffered mark-to-market losses of $264 million (about `15,560
million) on account of exposure to overseas credit derivatives and investments in fixed income assets. Read the
related news report.
Required
1. Explain the following terms: mark-to-market loss; credit derivative; fixed
income asset.
2. Prepare a note setting out the principles of valuation of credit derivatives
and fixed income assets and issues in applying the principles.
Unicredit, one of the largest banks in Europe, announced on April 23, 2008 that it would be
recording write-downs of about €1 billion ($1.6 billion) in January and February because of the
global financial crisis.17 Read the related news report. The bank had already announced a loss of €1
billion in its asset-backed securities. Unicredit’s largest holdings of these securities included interests in real
estate and car loans and only a tiny exposure to the subprime sector. There will be a further write-down of €350
million as a result of adverse movements in spreads in bonds and credit default swaps.
Required
1. Explain the following terms: asset-backed security; subprime sector; credit
default swap.
2. Prepare a note setting out the principles of valuation of asset-backed
securities and issues in applying the principles.
Financial Analysis
Companies often pay large amounts of goodwill to acquire other entities in happy times.
Unfortunately, they invariably find that they overpaid.
Required
1. Prepare a report using actual company data on the amount of goodwill paid
for acquisitions. You can select a sample of companies across industries or a
couple of industries for this study.
2. Track the performance of the acquisitions over the next few years. Does the
post-acquisition performance of the companies indicate that the goodwill
was overvalued?
3. Examine company practices for recognizing impairment of goodwill.
In the wake of the financial crisis, there was a lot criticism of fair value accounting.
Commentators argued that fair value accounting was defective in both theory and practice
for valuing securities that had illiquid markets or when the market had seized up. A few
went to the extent of saying that fair value accounting caused the financial crisis and its procyclicality
aggravated the crisis.
Required
1. Prepare a report outlining the arguments for and against fair value
accounting.
2. What does “procyclicality” mean in the context of fair value accounting?
3. Examine how the International Accounting Standards Board and the
Financial Accounting Standards Board responded to concerns about fair
value accounting.
Answers to Test Your Understanding
8.4 At the market interest of 16 per cent per annum, or 8 per cent per semi-annual period, Viraj Company
pays `8,036, the fair value of the debentures. This amount is given by the following calculation: 600/1.081 +
 + 600/1.0820 + 600/1.0820. The following table shows the application of the effective interest method.
Note that we allocate the discount of `1,964 to each period over the life of the debenture. The following entry
records the interest income for the first period.
8.5 The interest rate is approximately 12.98 per cent. We round it to 13 per cent.
We adjust the rounding difference in the last year’s interest income. Amortized cost is used for determining
interest income. Year-end valuation is based on fair value. The following entry records the redemption of the
debentures:
The gain will be transferred to the statement of profit and loss.
8.6 The shareholding is as follows:
Tanvi Company does not own more than half of Varun Company’s voting rights. To test for control, suppose
that Tanvi Company votes for a dividend proposal. By virtue of the shareholder agreement, Abhay Company
also must vote in favour of the proposal. The agreement gives Tanvi Company control over more than half of
Varun Company’s voting rights. Therefore, Tanvi Company controls Varun Company.
8.7 The shareholding is as follows:
Manoj Company neither owns nor controls more than half of Anant Company’s voting rights. By virtue of
the shareholder agreement, Manoj Company has the power to decide on the number of electric cars to be
produced and Anant Company’s board of directors must accept Manoj Company’s decision. Besides, Manoj
Company provides the manufacturing technology. Production decisions and technology are extremely
important, because they greatly affect a lot of other matters such as profitability, capital investment and
dividend distribution. The agreement gives Manoj Company the power to govern Anant Company’s financial
and operating policies. Therefore, Manoj Company controls Anant Company.
8.8
8.9 Taken alone, Vijay Company’s 38 per cent, Vikram Company’s 13 per cent or Vir Company’s 49 per cent
does not give any of them control over Dare Company. However, by virtue of the contractual arrangement
between them, Vijay Company and Vikram Company control 51 per cent of Dare Company’s voting power,
enough to get their proposals accepted and Vir Company’s proposals rejected, regardless of which way Vir
Company votes. Therefore, Vijay Company and Vikram Company have joint control over Dare Company,
their joint venture, and both are its ventures. Vir Company has neither control nor joint control (even
though it holds the largest voting block); it is an investor in the joint venture.
8.10 Janet Company should show a net receivable from Josephine Company of `10,000, calculated as follows:
own contribution, `60,000 – 50% of liabilities of jointly controlled operation, `50,000. Josephine Company
should show a net payable to Janet Company of `10,000, calculated as follows: own contribution, `40,000 –
50% of liabilities of jointly controlled operation, `50,000. The jointly controlled operation is not a separate
legal entity. Therefore, Janet Company cannot show a receivable of `30,000 (representing its share of its
contribution) and a payable of 20,000 (representing its share of Josephine Company’s contribution).
8.11
Jyoti’s carrying amount of the investment in Pradeep Company is as follows:
1 IAS 32:11/Ind AS 32:11.
2 IAS 39:9/Ind AS 39:9.
3 In other words, fair value is the present value of the cash flow stream. Chapter 9 explains this calculation.
4 IAS 39:AG 20/Ind AS 39:AG20.
5 There is no need to review FAFVPL for impairment, since they are marked to fair value and any gain or loss is
recognized.
6 The IASB’s ED/2013/3, Financial Instruments: Expected Credit Losses, proposes an expected loss approach.
7 Ind AS 27:4. IFRS 10.A defines the term differently. Also, there are differences in the terms used in the two
standards.
8 IFRS 3:Appendix A/Ind AS 103:Appendix A.
9 Until some years ago, it was possible to treat a business combination as a merger, meaning the coming
together of equals, rather than as an acquisition. That is no longer possible.
10 IAS 36:10(b)/Ind AS 36:10(b).
11 IFRS 3:19/Ind AS 103:19
12 Ind AS 31:3. IFRS 11:A and IAS 28:3 define the term differently. Also, there are differences in the terms used
in Ind AS and IAS/IFRS.
13 IAS 28:2/Ind AS 28:2.
14 Ind AS 27:4. IAS 27:4 defines the term differently.
15 IAS 40:16/Ind AS 40:16.
16 ICICI Bank takes $264-m hit on overseas credit exposure, Business Line, March 5, 2008.
17 Adrian Michaels, Unicredit to write down €1 billion, Financial Times, April 24, 2008.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Define liabilities.
Describe current and non-current liabilities and secured and unsecured liabilities.
Define and record definite and estimated liabilities.
Explain how to report contingent liabilities.
Describe the principal features of debentures.
Record the issue of debentures and account for interest expense.
Account for debenture redemption and retirement.
Account for compound financial instruments.
Explain the operation of a debenture redemption fund.
Account for mortgages, leases, and employee benefits.
Account for current and deferred tax.
Explain off-balance sheet financing arrangements.
OOPS! MY BOND PRICES HAVE GONE UP
In October 2012, JP Morgan reported that it lost $211 million, because the yield on its bonds
decreased. This may sound absurd, but it is true. How does this happen? Yield is the interest
rate at which the market discounts the future interest and principal payments to determine the
value of a bond. When the yield decreases, the value goes up. Unfortunately, this has an adverse
effect. Banks must mark their financial liabilities to market. So when the value of its bonds goes
up, the bank must recognize the increase as a mark-to-market loss. In 2012, bond yields were
falling, because investors were clamouring for the extra yield that was available from banks’
bonds, pushing up prices and lowering bond yields. In 2008, when liquidity was scarce, bond
prices plummeted and, applying fair value accounting, banks recognized impressive gains from
the decrease in their liabilities. When a bank’s credit rating falls, its yield goes up and the fair
value of its debt falls. The difference is a gain.
THE CHAPTER IN A NUTSHELL
In this chapter, you will learn about liabilities: amounts payable by an organization to persons
for past transactions or events. Liabilities may relate to current operations or long-term needs.
Liabilities related to operations affect income measurement, since an expense and a payable are
closely related. Debentures are an important means of raising long-term financing. In this
chapter, you will learn how to determine and record liabilities and debenture transactions. You
will also learn about the issues in recognizing long-term leases and pensions and other postretirement benefits payable. Accounting profit and taxable income differ significantly for many
firms. Deferred tax accounting captures the effect of these differences. Off-balance sheet
liabilities are as important as those recognized.
Liabilities in Perspective
A liability is a “present obligation of the entity arising from past
events, the settlement of which is expected to result in an outflow
from the entity of resources embodying economic benefits.”1 In
other words, liabilities arise from past transactions or events that will require the
future payment of assets or performance of services. Buying goods on credit,
accepting advance payment from a customer, and receiving a bank loan are
examples of past transactions. Each of these transactions gives rise to a liability
that must be settled sometime in the future.
Not every expected future payment is recognized in the accounting records as a
liability. The balance sheet presents the financial position of an enterprise at the
reporting date and not its possible position in the future. To qualify as a liability, a
present obligation must have arisen from a past transaction. In the course of
business, companies enter into contracts for future transactions. For example, a
company may sign a three-year contract with a supplier for purchase of copper for
`10 million per year. This is a commitment to pay for purchases to be made in the
future. The company is not obliged to pay until the merchandise is purchased. Since
there is no present obligation, no liability is recorded when the contract for
purchase of goods is signed.
For an obligation to be recognized as a liability, it should exist independently of
an enterprise’s future actions, i.e. it should be unavoidable regardless of what the
enterprise does. An action that an enterprise intends to take voluntarily does not
give rise to a liability. For example, a leather-processing plant should recognize as a
liability the cost of undoing damage already caused to the surrounding paddy fields.
However, if it plans to install cleaning equipment to eliminate or reduce future
damage, it should not make a provision for the estimated cost of the equipment.
Classification of Liabilities
We can classify liabilities in several ways. Standard classifications
are (i) current and non-current, and (ii) secured and unsecured.
Current and non-current liabilities Liabilities are classified
depending on when they are due. An enterprise should classify a
liability as a current liability when:
(a) it expects to settle the liability in its normal operating cycle;
(b) it holds the liability primarily for the purpose of trading;
(c) the liability is due to be settled within 12 months after the reporting period; or
(d) the entity does not have an unconditional right to defer settlement of the
liability for at least 12 months after the reporting period.2
Current liabilities are normally paid by using existing current assets, creating
other current liabilities or fulfilling contractual obligations to provide goods or
services. Examples are trade payables, bills payable, bank overdraft, unearned
revenue, and income tax payable. A liability which is not a current liability is a
non-current liability, or long-term liability. Debentures payable, long-term
bank loans, and pensions payable are examples of non-current liabilities.
Secured and unsecured liabilities Liabilities are also classified on the basis of
the security available to the creditor in case of default. A secured liability is
backed by a pledge, hypothecation or mortgage of the borrower’s specific assets or
asset classes in favour of the creditor. If the borrower defaults, the creditor can sell
the assets and use the proceeds to settle the dues. An unsecured liability is
incurred based on the borrower’s general credit standing, and the creditor has a
legal claim only against the borrower’s net assets. Information about the security
provided is given in the financial statements.
Schedule III to the Companies Act 2013 follows the current/non-current
classification and requires disclosure of the security provided.
Current Liabilities
Current liabilities can be definite liabilities or estimated
liabilities. We will discuss these now.
Definite Liabilities
Definite liabilities are current obligations that can be determined precisely. The
accounting problems concerning definite liabilities relate to ascertaining the
existence and the amount of the liabilities and recording them properly as they
arise. Examples are trade payables, interest payable, bills payable, VAT and GST
payable, and current portions of long-term debt. In Part One, we saw how to
account for trade payables and make adjustments for accrued liabilities and
unearned revenue. We now consider some other items of definite liabilities.
Bills payable When a business buys merchandise or equipment on credit or takes
loans, it issues a bill payable to the seller or lender. Sometimes, a bill payable may
substitute a past-due account payable. The accounting procedure for bills payable is
the mirror image of the procedure for bills receivable, discussed in Chapter 5.
Figure 9.1 shows a bill payable for `10,000 drawn by Hindustan Finance (drawer)
on Sapna Corporation (drawee and acceptor) for a borrowing.
VAT and GST Value added tax (VAT) is a state government levy on sales
transactions. The seller collects the VAT from the customer and periodically remits
the collections to the state government. The seller credits the amount of VAT
collected on each sale to a VAT Payable account. The balance in the account
represents a current liability. When the seller remits the tax, he debits VAT
Payable and credits Cash. In course of time, the proposed goods and services tax
(GST) is expected to replace VAT and other levies such as the Central excise duty.
As you can see, Madhur Company effectively pays tax on `200, the value added by
it.
Current maturities of long-term debt A portion of long-term debt may be
payable in the course of next 12 months. Suppose that a loan of `100,000 is to be
paid in annual instalments of `10,000 in the next 10 years. The instalment of
`10,000 payable in the next financial year is a current liability.
Estimated Liabilities
An estimated liability (or provision) is “a liability of uncertain timing or
amount.”3 Estimated liabilities are definite obligations; only their precise timing or
amount cannot be determined presently. The difficulty is in making a reasonable
estimate of the amount of the liability. Examples of estimated liabilities include
income tax, product warranties, and pensions. We consider the first two below and
employee benefits later.
Income tax A company is a separate taxable entity. It must file tax returns and
pay income tax. The Central government levies corporate income tax in accordance
with the Income Tax Act 1961. The computation of taxable profit of a large
corporation is often very complex, because it must take into consideration not only
the provisions of the Act but also the decisions of the courts and the instructions
issued by the Central Board of Direct Taxes. Besides, disputes with the tax
authorities over the amount of tax payable involve time-consuming legal
procedures. Consequently, the precise amount of income tax liability is seldom
known when the financial statements are prepared. Since income tax is an expense
in the year in which income is earned, the liability should be estimated and
recorded. To illustrate, assume that the estimated income tax expense is `36,500.
The following entry records the liability:
Product warranties A product warranty is a promise to the customer under which
the seller or manufacturer is legally obliged during a certain period to bear the cost
of replacement parts or repair costs, if the product fails to perform.4 The cost of the
warranty is an expense of the period in which the product is sold since the warranty
helped the sale. However, the exact amount of expense is not known at the time of
sale and the warranty expense is estimated based on past experience.
Contingent Liabilities
A contingent liability is “(a) a possible obligation that arises
from past events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the entity; or (b) a present
obligation that arises from past events, but is not recognized, because (i) it is not
probable that an outflow of resources embodying economic benefits will be required
to settle the obligation; or (ii) a reliable estimate of the amount of the obligation
cannot be made.”5 A contingent liability will be confirmed by the outcome of an
uncertain future event. Alternatively, either it may result from a remote possibility
or a reliable estimate of the liability cannot be made. In other words, a contingent
liability is “iffy”. Once the uncertainty surrounding the outcome of the event is
resolved, a contingent liability will either become a full-fledged liability or be
altogether eliminated. In Chapter 5, we considered the contingent liability for bills
discounted. Disputed taxes, product liability suits against the company, and wage
demands are also examples of contingent liabilities.
The accounting treatment of contingencies would depend on the expected outcome
of the contingency. If it is probable that the contingency will happen (i.e. probability
> 0.5) and the amount of the resulting loss can be reasonably estimated, the
contingent liability should be recognized as a liability. However, if either the
contingency is not probable (though it could occur) or the amount of the contingent
loss cannot be reasonably estimated, the contingency should be disclosed in the
notes to the financial statements. A contingency which may be only remotely
possible need not be disclosed. Contingent liabilities may develop in unexpected
ways. So they must be assessed continually and if they are probable and reliable
estimates can be made, they should be recognized.
Long-term Liabilities
While current liabilities can provide cash for recurring business needs, they are
neither adequate nor satisfactory for financing the long-term requirements of a
business. A company requires large funds for a fairly long period of time to finance
expansion and restructuring of business. Also, it may incur other kinds of long-term
obligations. Debentures, mortgages, leases, and pensions are examples of long-term
or non-current liabilities.
Long-term liabilities differ from current liabilities in four ways:
1. The period of repayment of long-term debt is usually longer than 10 years.
In some cases, the period may be as long as 30 years or even longer.
2. Long-term borrowing is accompanied by considerable formality, such as
approval by the board of directors and shareholders, and by the government
in certain situations.
3. Long-term liabilities usually require interest payments.
4. Long-term liabilities have to be discounted.
A financial liability is (a) a contractual obligation to deliver cash or a financial
asset to another entity or to exchange financial assets or financial liabilities with
another entity under conditions that are potentially unfavourable, or (b) a contract
that will or may be settled in the entity’s own equity instruments. Long-term
liabilities are typically financial liabilities and they usually carry interest.
We will now describe the principal types of long-term liabilities.
Debentures Payable
A debenture (also called a bond), an important form of longterm borrowing, consists of a written promise to pay a principal
amount at a specified time and interest at a specified rate. A
debenture issue consists of a large number of debentures of small
denominations rather than one large bond. For example, a borrowing of `10 million
could consist of 10,000 debentures of `1,000, thus enabling many investors to
participate in the issue. A debenture certificate is issued to each lender as evidence
of the issuing company’s obligation to the debentureholder. The debenture trust deed
(also known as bond indenture) is a legal document that states the rights and
obligations of the debentureholders and the issuer. This deed contains a number of
covenants for the protection of the lenders. The covenants deal with many matters
including the interest rate to be paid, the maturity date and amount, restrictions on
dividends, and further borrowing by the issuer.
A company may sell the debentures directly to the public or to an underwriter,
an investment firm which will sell the debentures to the public later. Even in a
public issue of debentures, the debenture issuer often engages underwriters who are
paid a commission in return for a promise to buy the debentures not taken up by the
public. The issuer appoints a bank as debenture trustee to represent the large
number of debentureholders. The primary function of the trustee is to ensure that
the issuer complies with the terms of the trust deed.
Interest paid on debentures is a cost of borrowing and it is tax-deductible, i.e.
allowed as an expense for computing taxable profit. So the effective cost of
borrowing is lower than the nominal interest rate stated on the debenture. The
shareholders of a company would benefit, if the interest rate is lower than the
prospective return on the company’s investment. Chapter 11 explains how
shareholders may benefit from debt financing.
Characteristics of debentures The terms of a debenture issue are a matter of
contract between the borrower and the lender. They reflect the borrower’s financing
needs and the lender’s expectations. Debentures with a wide variety of features are
in use. We shall now see some of them.
Secured and unsecured debentures Debentures which are backed by specific
assets to ensure their repayment are secured debentures. Most debentures issued in
India are secured. Mortgage, pledge, and hypothecation are the most common forms
providing security.
A mortgage is a legal arrangement for securing a borrowing with immovable
assets such as land, building or embedded plant and machinery.
Pledge and hypothecation are means of securing movable assets such as
inventories and receivables. In a pledge, the borrower gives physical
possession of the asset to the lender, e.g. pawning jewellery with a bank as
security for a loan. In a hypothecation, the borrower is allowed to use the
asset, e.g. running a vehicle that has been given as security.
Unsecured debentures are backed only by the general creditworthiness of the
issuer, not by a legal interest in any specific assets.
Term and serial debentures When all the debentures of an issue fall due for
payment on the same date, they are called term debentures. In contrast, serial
debentures mature in instalments on a series of specified dates. For example, a `10
million issue of serial debentures may mature at the rate of `1 million per year for
10 years.
Convertible debentures The debentureholder has the option of exchanging these
debentures for shares of the issuing company. A convertible debenture has a
stipulated conversion rate of some number of shares for each debenture.
Callable bonds These bonds contain a provision that gives the issuer the right to
call the debenture before its maturity date. The price the issuer must pay, known as
the call price, is specified in the debenture trust deed. If the yield falls before the
maturity date, the issuer can pay back the costly borrowing and substitute it with a
cheaper borrowing.
Zero-coupon bonds Also known as deep discount bonds, these debentures do not
carry any periodic interest payment, or coupon. Zero-coupon bonds have two special
features: (a) they have a low issue price and a high maturity value, and (b) they are
issued for long periods.
Debenture ratings Credit rating agencies assign ratings indicating their opinion
on the relative safety of timely principal and interest payment on debentures and
other debt securities. Credit ratings are useful to present and potential investors in
understanding the degree of risk associated with investment in debentures. Note
that a rating is not a recommendation to purchase, sell, or hold a debenture nor is it
an evaluation of the company. It is just the professional judgment of a group of
independent experts relating to a specific instrument issued by a company. Credit
ratings influence companies’ borrowing rates. Thus, a company with a AAA rating
for its debentures will be able to borrow at a lower interest rate than another with
an inferior rating. A debenture that is rated BB or lower by Standard & Poor’s (or
equivalent by other rating agencies) is known as a high-yield bond or junk bond.
A debenture that is rated BBB or above is known as an investment grade bond.
Issuing debentures The Companies Act 2013 contains
provisions regarding a company’s borrowing powers. In addition, a
company’s memorandum and articles of association may also set
limits on the borrowing powers of its board of directors. The
accounting procedure for issue of debentures varies depending on the terms of the
issue. All debentures have a face value (or par value), the principal amount that
must be repaid on the maturity date of the debentures. Face value of the debentures
is not entered in the accounting records. Being financial liabilities, debentures are
recorded at their fair value.
Debenture prices and interest rates The debenture certificate specifies the
interest rate, or coupon, payable on the debenture. The coupon is applied to the
face value of the debentures to compute the amount of interest that will be paid
each year. Suppose that on January 1, 20X0, Maya Company issues `100,000 of 12
per cent, 10-year debentures. Interest is payable semi-annually on June 30 and
December 31 in arrears, i.e. after the period to which it relates. Maya Company will
pay an interest of `12,000 a year, or `6,000 every six months, until maturity. Thus,
the coupon establishes the amount of periodical interest payment. The actual
interest rate incurred by the company will equal the interest rate available to the
investors from loans carrying similar risks.
Yield, or market interest rate or effective interest, is the rate of interest that
investors will expect on debentures of a particular risk category. The greater the
risk associated with an investment, the higher the interest rate required by
investors. Yield is the investor’s opportunity cost. Yield keeps changing all the time
and is affected by several factors besides the risk category of a debenture such as
the Reserve Bank of India’s benchmark rates, inflation expectations, liquidity
conditions, and the level and terms of government borrowing.
If the coupon equals the yield, the investor will get a fair return and the
debenture will be priced at par. Here, the fair value would equal the face value.
However, the coupon can (and often does) differ from the yield. For example, if the
market rate is 16 per cent, Maya Company will not be able to issue its debentures at
par. This is because a potential investor can earn an interest income of `8,000 per
period by lending at the yield, but could earn only `6,000 on Maya Company’s
debentures. If Maya Company wants investors to purchase its debentures, it must
issue the debentures at a discount, i.e. below par. On the other hand, if the yield is
10 per cent, Maya Company will be able to issue the debentures at a premium, i.e.
above par. Debenture prices are often stated in terms of a percentage of par. For
example, if a debenture is issued at 104, it means that a debenture of face value
`100 is sold at a premium of 4 per cent. An issue price of 98 would mean that the
debenture is sold at a discount of 2 per cent. If the coupon differs from the yield, we
obtain the issue price by discounting at the yield the following two kinds of cash
flow:
1. A series of interest payments; and
2. A single principal payment at maturity.
The present value of the debenture issue, calculated as above, is its fair value.You
should review Appendix B to understand the idea of time value of money.
We will now see how to account for issue of debentures.
Debentures issued at par Assume that on January 1, 20X0, Maya Company
issues `100,000 of 12 per cent, 10-year secured debentures at par. Interest is
payable semi-annually on June 30 and December 31. The entry to record the issue is
as follows:
Debentures issued at a discount or premium Assume that Maya Company
issues debentures for `80,359 when the market rate of interest is 16 per cent. We
record the issue of the debentures as follows:
In Maya Company’s balance sheet, Debentures Payable will appear at `80,359 as
a liability under Long-term Borrowings.
If Maya Company issues the debentures for `112,463 when the yield is 10 per
cent, the following entry records the issue:
In Maya Company’s balance sheet, Debentures Payable will appear at `112,463 as
a liability under Long-term Borrowings.
The discount or premium is to be amortized over the life of the debenture, as
explained below.
Effective interest method for amortization of debenture discount and
premium The effective interest method discussed in Chapter 8 calculates the
amortized cost of a financial asset and allocates the interest income at the rate that
exactly discounts estimated future interest receipts to the carrying amount of the
financial asset. Applying the semi-annual yield of 8 per cent to the proceeds of
`80,359, we get the interest expense for the period ended June 30, 20X0: `80,359 
8% = `6,429. The interest payment is `6,000. The difference of `429 is the amount of
discount amortization for the period. The following entry records the interest
payment and amortization:
Exhibit 9.1 presents the debenture discount amortization schedule for Maya
Company. Note that interest expense (Column B) is a constant 8 per cent of the
carrying amount appearing in the previous row. The amortization in an interest
period equals the difference between the effective interest expense and the interest
paid in the period.
The procedure for amortizing premium is similar to that illustrated in Exhibit 9.1.
Year-end accrual of debenture interest expense Suppose that Maya
Company’s reporting period ends on March 31. The following entry records interest
accrued for three months:
Debentures issued between interest dates Assume that Maya Company issued
the debentures on April 1, 20X0 (i.e. between interest payment dates) and the
reporting period ends on March 31. In this case, the issuer pays interest for the
partial period for which the debentures were held. The entry to record the interest
payment for the first semi-annual interest period is as follows:
Debenture issue expenses The issue of debentures involves transaction costs,
such as expenses of printing debenture certificates and offer documents,
accountants’ and lawyers’ fees, advisers’ fees, brokers’ and underwriters’
commissions, regulators’ filing fees, and marketing expenses. These are incremental
costs directly attributable to the issue. At the time of initial recognition, transaction
costs are deducted from the amount originally recognized for liabilities. The
effective interest method is applied to the amount net of transaction costs.
Derecognition of debentures A financial liability is removed
from the balance sheet when it is extinguished. Extinguishment
can happen in several ways, for example: (a) the debtor settles the
obligation by paying cash or giving other assets; (b) the creditor
waives its contractual rights to receive the amount of the obligation; or (c) the
obligation expires leaving the creditor without a legal right to recover the amount.
In each case, the debtor is legally released from its obligation to pay the creditor.
Derecognition involves the removal of a previously recognized financial liability
from an entity’s balance sheet. Legal release is a requirement for derecognition. We
examine three cases of derecognition of debentures: redemption, retirement, and
conversion. The first two are discussed below, and the last in the next section.
Redemption is the payment of debentures at maturity. When Maya Company
redeems its debentures, it derecognizes the liability:
Retirement is the early redemption of a debenture. An issuer may retire its debt,
because it wants to reduce the amount of debt or issue new debt at a lower interest
rate. Debentures may contain a call feature that enables the issuer to buy-back and
retire the debentures before maturity. Even when there is no call feature, issuers
may retire debentures by purchasing them on the open market. In either case, the
issuer recognizes a gain or loss for the difference between the consideration paid for
the debentures retired and the related carrying amount on the balance sheet. A gain
arises if the purchase price of the debentures is less than the carrying amount and a
loss occurs if the purchase price is greater than the carrying amount.
As an example, assume that on January 1, 20X4 Maya Company retired at 82 the
12 per cent debentures it had issued for `80,359 on January 1, 20X0. On this date,
the carrying amount of the debentures was `84,919 (Exhibit 9.1, Semi-annual
Interest Period 8, column E). The retirement of the debentures is recorded as
follows:
Any transaction costs incurred in connection with retirement should be adjusted
in calculating the gain or loss. If the issuer retires a part of the debentures, the
carrying amount to be considered is proportionate to the portion retired.
Compound financial instruments These are financial
instruments that contain both a liability and an equity component.
A common form of a compound financial instrument is a
convertible debenture. It is a debenture with an embedded
conversion option. It can be converted into the issuing company’s equity shares. The
conversion feature makes the debentures more attractive to debentureholders by
giving them an opportunity to benefit from a rise in the price of the issuing
company’s equity shares. Furthermore, the debentureholder receives interest at the
specified rate until conversion and is therefore subject to less risk relative to an
equity shareholder. The advantage to the issuing company is that convertible
debentures carry a lower yield than non-convertible debentures.
Convertible debentures come with numerous variations. A convertible debenture
may contain terms that compel the holder to convert the debenture or leave it to the
holder’s option. Depending on the terms, the interest rate may be either variable or
fixed. The holder may have a call option (i.e. right to buy) to convert into a specified
number of shares. Here again, the holder may be able to convert at maturity of the
debenture (European call option) or before maturity (American call option). We will
now examine the accounting issues in convertible debentures with relatively simple
features.
Issue of convertible debentures The basic requirement here is to measure and
recognize the liability and equity components separately. The components are as
follows:
Financial liability: The issuer’s obligation to pay interest and redeem the
debenture; and
Equity instrument: The holder’s right to call for the issuer’s shares.
The issuer has to record the two components separately. This is ‘split accounting’.
The issuer determines the fair value of the liability component and determines the
equity component as the residual amount.6
Conversion at maturity On conversion of a convertible debenture at maturity, the
entity derecognizes the liability component and recognizes it as equity. Both the
original equity component and the new equity component are allocated to other line
items such as share capital, share premium, and so on in accordance with legal
requirements. There is no gain or loss on conversion at maturity.7
Conversion before maturity The holders may exercise the conversion option
before maturity if the equity share is trading at above the conversion price. There is
no specific guidance on the accounting treatment if the holder opts to convert the
debenture early. We can take the view that since the instrument ‘matures’ on the
date that the holder converts in accordance with the contractual terms of the
instrument, the position is essentially the same as that for conversion at maturity.
The amount recognized in equity should be the carrying amount of the liability for
the debt with adjustment for cash received or paid.
If the conversion price agreed upon is more than the face value of the share, the
excess will go to the Share Premium account.
Debenture redemption fund Companies should have cash to
pay back the debentures when they mature. Some debenture trust
deeds require companies to make periodic cash deposits to a
debenture redemption fund, or sinking fund. The debenture
trustees invest the cash in high-quality income-earning securities. The periodic
deposits plus the earnings on the investments accumulate in the fund. When the
debentures mature, the trustees sell the investments and use the proceeds to pay
the debentureholders, and return any excess cash to the issuing company; the
company must make up any deficiency. The sinking fund assets appear as part of
the long-term investments of the issuing company.
To illustrate the operation of a debenture redemption fund, assume that Kiran
Company issues `100,000 of five-year debentures on January 1. The trustee expects
to earn a return of 10 per cent on the investments, net of expenses of administering
the fund. Referring to Appendix B, Table 2, we find that if `1 is invested at the end
of every year for five years at 10 per cent, it will cumulate to `6.1051 at the end of
year 5. The amount of sinking fund deposit is `16,380, calculated as100,000/6.1051.
At the end of five years, the value of the sinking fund investments will be equal to
the face value of the debentures, as shown in Exhibit 9.2.
The entries to record the amount deposited every year are as follows:8
At the end of every year, the trustees will report the earnings on the investments
to the issuer. The issuer then records the sinking fund earnings in its accounts and
reports them on its statement of profit and loss. For example, if the investments
yielded 10 per cent in the second year, Kiran Company would record the earnings as
follows:
Income from investments would appear on the statement of profit and loss.
At the end of the fifth year, the investments will be sold and the proceeds utilized
to repay the debentures. Any gain or loss will be recognized at this time. For
example, let us assume that the investments are sold for `102,500. The sale will be
recorded as follows:
Gain on sale of investments would appear on the statement of profit and loss.
Mortgages Payable
A mortgage is a legal arrangement in which a borrowing is
secured by specific immovable assets such as land, building, and
plant and machinery. If the borrower does not pay, the lender has
the legal right to have the specific assets sold and pay himself out
of the proceeds. A home loan is a common example of mortgage in which the
borrower gives his house as security for repayment of loan in monthly instalments
over a fairly long period.
Mortgages are of different types. At one extreme is conditional mortgage which
must be registered with a government authority, in which the borrower’s legal title
to the property is transferred to the lender and is re-transferred to the borrower
when the loan is repaid. At the other end, equitable mortgage is a relatively
simple arrangement in which the borrower deposits with the lender the title deeds
for the property and takes them back when the loan is repaid. Between these there
are many types.
Mortgage payments are generally made in equal instalments that comprise both
interest and principal components. Each payment is applied first to the accrued
interest and the remainder reduces the principal. In the early years of repayment,
the principal balance is high. Therefore, a major portion of the instalment goes
towards interest. As the repayment period progresses, the principal component
gradually decreases until the balance payable reaches zero.
To illustrate, assume that on January 1 a mortgage debt of `100,000 was
obtained. The mortgage carries interest at 18 per cent per annum and is repayable
in 48 monthly instalments of `2,937. Exhibit 9.3 shows the repayment schedule for
the first three months including break-up of principal and interest. The entry to
record the first monthly payment on February 1 is as follows:
Leases
As you learnt in Chapter 5, 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.”9 Leasing makes it possible to acquire an asset for use
without having to invest own or borrowed funds. There are two types of lease:
finance lease and operating lease.
Figure 9.2 illustrates their key features.
Finance lease This is a lease “that transfers substantially all the risks and
rewards incidental to ownership of an asset.”10 In a finance lease, the lessor
(usually a leasing company) transfers the risks and rewards of ownership of an
asset to the lessee for a series of rental payments under a non-cancellable lease
contract. Acquisition of assets on finance lease is equivalent to obtaining a secured
loan. The principle of substance over form requires entities to account for and
present transactions and events in accordance with their economic substance and
reality, and not merely their legal form. While the legal form of a finance lease
agreement is that the lessee does not acquire legal ownership of the leased asset,
the substance is that the lessee acquires the economic benefits of the use of the
asset for a major part of its useful life. In the following situations (only illustrative,
not exhaustive) a lease is normally classified as a finance lease:
1. The lease transfers ownership of the asset to the lessee by the end of the
lease term;
2. The lessee has a “bargain purchase” option, i.e. an option to purchase the
asset at a price that is expected to be sufficiently lower than the fair value at
the date the option becomes exercisable for it to be reasonably certain, at the
inception of the lease, to be exercisable;
3. The lease term is for the major part of the economic life of the asset even if
title is not transferred;
4. At the inception of the lease the present value of the minimum lease
payments amounts to at least substantially all of the fair value of the leased
asset; and
5. The leased assets are of such a specialized nature that only the lessee can
use them without major modifications.
In practice, “major part of the economic life of the asset” is taken to be 75 per cent
and “at least substantially all of the fair value of the leased asset” is taken to be 90
per cent. The classification of a lease as an operating or a finance lease will depend
on the substance of the transaction rather than on the form of the contract.
A finance lease must be recognized in the lessee’s balance sheet as an asset and
an obligation, a practice known as lease capitalization. Exhibit 9.4 presents the
definitions of key terms in lease accounting.
Finance lease A lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title may
or may not eventually be transferred.
Operating lease A lease other than a finance lease.
Inception of the lease The earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of
the lease.
Lease term The non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the
lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain
that the lessee will exercise the option.
Minimum lease payments The payments over the lease term the lessee is or can be required to make, excluding contingent rent, costs for
services and taxes to be paid and reimbursed to the lessor, together with (a) for a lessee, any amounts guaranteed by the lessee or by a party
related to the lessee; or (b) for a lessor, any residual value guaranteed to the lessor by (i) the lessee; (ii) a party related to the lessee; or (c) a
third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.
Fair value The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length
transaction.
Interest rate implicit in the lease The discount rate which, at the inception of the lease, causes the aggregate of the present value of (a) the
minimum lease payments and (b) the unguaranteed residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any
initial direct costs of the lessor.
Lessee’s incremental borrowing rate of interest The rate of interest the lessee would have to pay on a similar lease or, if that is not
determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term and with a similar security, the
funds necessary to purchase the asset.
Source: IAS 17:4
To illustrate lease capitalization, assume that Abdullah Company signs an
agreement with a leasing company to lease equipment from that date. The
information about the lease is as follows:
1. The term of the lease is four years and the lease agreement is noncancellable. The equipment reverts to the lessor at the end of the period.
2. Lease rental of `28,679 must be paid at the beginning of each year. The first
rental is payable on signing the agreement.
3. The equipment has a fair value of `102,000 at the inception of the lease, an
estimated useful life of four years, and no residual value.
4. Abdullah Company’s incremental borrowing rate is 12 per cent.
5. The lessor is known to charge an interest rate of 10 per cent on the lease.
6. Abdullah Company uses the straight-line method for depreciation of similar
equipment.
The procedure for lease capitalization is as follows:
1. Determine whether the agreement is a finance lease. The agreement is clearly
a finance lease because it is non-cancellable for the entire useful life of the
equipment. Therefore, it passes the test of substantial transfer of risks and
rewards incident to ownership of the asset.
2. Compute the present value of the minimum lease payment. The minimum
lease payments consist of the annual lease rentals payable by the lessee at
the beginning of each year. Since the lessor’s interest rate is known (10 per
cent), it is used as the discount rate disregarding the lessee’s incremental
borrowing rate. The present value calculation is as follows:
Note that the table shows the present value of annuity due, i.e. the annuity
payable at the beginning of the period, whereas Appendix B, Table 4 is
based on the annuity payable at the end of the period.
3. Take the lower of fair value and the present value of minimum lease
payments. Since the present value of minimum lease payments of `100,000
is less than the fair value of `102,000, the lease will be recorded by the
lessee as an asset and a liability at `100,000.
The following entry would record the transaction:
On the lessee’s balance sheet on Leased Equipment is shown in the fixed assets
section and Finance Lease Obligation appears as a non-current liability. Abdullah
Company must depreciate the asset and record the following entry for each period:
The first lease rental is paid immediately on signing the agreement and is
therefore fully offset against the lease obligation. The second, third and fourth lease
rentals consist of two elements: (a) repayment of the principal and (b) an interest
cost. Exhibit 9.5 shows the computation of interest expense in each period. Using
this information, the entry to record the first lease payment is as follows:
Accounting for leases is one of the most controversial topics. Lessees have resisted
capitalization of leases to avoid reporting large amounts of lease obligations since
such reporting adversely affects key financial indicators such as the debt-equity
ratio. So, when lessee accounting was tightened by specifying the conditions under
which capitalization would be required, the lessees ensured that the lease did not
satisfy those conditions. For example, the lessees set the lease term at marginally
less than 75 per cent to escape capitalization. Considering the practical difficulties
involved in enforcing strict compliance with the spirit of any capitalization rule, the
IASB has proposed a radical overhaul of leases accounting that would require
capitalization of a “right-of-use asset” and a lease liability for all leases of more than
12 months. A lessee can choose to recognize a right-of-use asset and a lease liability
for leases of 12 months or less but is not required to do so.11
Operating lease It is defined as “a lease other than a finance lease”. Operating
lease is a short-term rental arrangement such as renting office space, car or
photocopier. The lessee expenses operating lease payments. Normally, the lessee
recognizes the expense on a straight-line basis over the lease period unless another
systematic basis is more representative of the time pattern of the user’s benefits.
The lessee does not make any other accounting entries for operating leases.
Employee Benefits
Many organizations provide a variety of benefits to their employees. Employee
benefits are “all forms of consideration given by an entity in exchange for service
rendered by employees.” Employee benefits can be of the following types:12
(a) Short-term employee benefits: These are given to current employees and
include wages, salaries and employer’s provident fund contributions and nonmonetary benefits such as medical care, housing and cars. Paid annual leave,
paid sick leave, profit-sharing, and bonuses payable within 12 months after the
end of the period in which the employees serve are also short-term benefits.
(b) Post-employment benefits: These are given to retired employees and include
gratuity, pension, and post-employment health care.
(c) Other long-term benefits: These are given to current employees and include
long-service leave, sabbatical leave, jubilee or other service benefits, and profitsharing, bonuses and deferred compensation if not payable within 12 months
after the end of the period.
(d) Termination benefits: These are benefits payable as a result of either an
enterprise’s decision to terminate an employee’s employment before the normal
retirement date or an employee’s decision to accept voluntary redundancy
(voluntary retirement) in exchange for those benefits.
We will now illustrate how to recognize the first two benefits. The same principles
apply to the other two.
Short-term benefits Employees are entitled to compensated absence (i.e. paid
leave) for reasons such as vacation, sickness, short-term disability, and maternity.
Compensated absences may be non-accumulating or accumulating. Nonaccumulating compensated absences must be used in the reporting period in which
the employees get the entitlement and must be recognized when absences occur.
Examples are maternity or paternity leave and sick leave. Accumulating
compensated absence can be carried forward to and used in future periods (e.g.
earned leave). An enterprise must recognize the expected cost of accumulating
compensated absence when the employees render service that increases their
entitlement to future compensated absences.
Accumulating compensated absence may be either vesting (employees can get cash
payment for unused leave) or non-vesting (employees cannot get cash payment for
unused leave). In either case, an obligation exists which the enterprise must
recognize. The obligation would equal the additional amount that the enterprise
expects to pay for the unused entitlement.
Post-employment benefits These benefits are of two types:
1. Defined contribution plans: Here the enterprise agrees to contribute to a
separate trust fund to provide for the payment of post-employment benefits
to its employees. The amount of annual contribution is determined by
agreement between the enterprise and its employees. The benefits depend
solely on the amounts contributed to, and income accumulated in, the fund
(e.g. provident fund13).
2. Defined benefit plans: In these plans, the enterprise is required to provide
post-employment benefits to its employees, determined by reference to a
formula normally based on employees’ remuneration and years of service.
The enterprise must estimate the amount of annual contribution necessary
to meet the retirement obligations that will arise in the future (e.g. pension
and gratuity).
Accounting for the cost of benefits under a defined contribution plan is fairly
straightforward. The enterprise recognizes its contribution as an expense as part of
the payroll and a corresponding payment, or liability if the contribution has not
been paid.
When a defined benefit plan is funded, the annual contributions are paid to a
separate trust fund which pays the benefits. When the plan is not funded, the
enterprise pays the benefits as they fall due. In a defined benefit plan, the employer
is obliged to provide the promised retirement benefits regardless of the funding
arrangements made. For example, if the trust fund does not have sufficient assets,
the employer must make up the shortfall; any excess may be taken back by the
employer.
Determining liability under defined benefit plans is complex. For this reason, an
actuary – an expert on insurance risk assessment – is engaged to prepare a
valuation of the company’s liability for pension and other benefits. Primarily
designed to calculate funding requirements, actuarial valuations are generally used
to determine the expense to be recognized during each period. The annual expense
includes the following items:
Current service cost;
Interest cost; and
Expected return on plan assets.
Other items are actuarial gains and losses, past service costs, and the effects of
any curtailments or settlements. For the sake of simplicity, we do not consider them
in this discussion.
Income Taxes
Income tax expense and income tax payable are important items in
the financial statements. The income tax regulations determine
taxable profit. Accounting principles and a company’s accounting
policies are the basis for measuring accounting profit. The systems
of computing taxable profit and accounting profit differ, because the objectives are
different: the tax law seeks to raise revenue to meet the cost of government
operations, whereas accounting principles are designed to provide financial
statements that are useful for making investment and credit decisions. Therefore,
taxable profit and accounting profit differ frequently and sometimes significantly.
Accounting Profit and Taxable Profit
Accounting profit is profit or loss for a period before deducting tax expense. It is
the outcome of applying accounting principles, standards and policies to an
enterprise’s transactions and other events. Revenue recognition, matching, accrual,
going concern, and prudence are the key determinants of accounting profit.
Consider the following accounting practices:
1. The accrual system recognizes receivables and payables, not just receipts
and payments.
2. Though depreciation expense does not involve a cash outflow in the current
period, it is necessary to recognize it in order to match expenses with related
revenues.
3. Revenue is recognized only when goods or services are provided to
customers.
The carrying amounts for assets and liabilities that appear on the financial
statements are the effect of applying accounting rules. For example, the carrying
amount of a receivable reflects revenue recognized in accordance with accounting
principles. The carrying amount of a piece of equipment signifies the amount that
management expects to recover from the item over its remaining useful life.
Unearned revenue represents the amount for which an enterprise is liable to
provide goods or services in the future for payment already received.
Taxable profit (tax loss) is the profit (loss) for a period, determined in
accordance with the rules established by the taxation authorities; income tax is
payable (recoverable) on this income.14 The taxation system sometimes works
differently from the accounting system. The tax authorities calculate the value of an
enterprise’s assets and liabilities in accordance with the tax laws. For example, tax
depreciation rates are higher, and tax generally follows accelerated depreciation.
Therefore, the carrying amount of a depreciable item for accounting purposes is
different from that for tax purposes.
Current Tax
Current tax is the amount of income tax payable (recoverable) in respect of the
taxable profit (tax loss) for a period. Think of current tax as the amount that a
business needs to pay as income tax to avoid falling foul of the law. It must write a
cheque for that amount in favour of the government. Usually, current tax is payable
in instalments, called advance tax, during the period in which the taxable profit is
earned. Any excess payment (short payment) is a current tax asset (current tax
liability). In a few countries (not in India), there is a system of ‘carryback of tax
loss’, meaning that a tax loss can be set off against taxable profit of past periods on
which current tax was paid. In that case, the right of carryback will be recognized
as an asset.
To illustrate, suppose that Vipul Company’s accounting profit is `40,000 each year
for three years. At the beginning of Year 1, it buys a computer for `30,000 and
depreciates it equally over three years. Assume that for tax the asset is expensed
equally over two years. The income tax rate is 30 per cent. This is a simplification
because tax generally follows the written-down-value method. Exhibit 9.6 presents
the calculation of Vipul Company’s taxable profit and current tax expense.
Minimum alternative tax Tax payable on taxable profit is normal tax. Minimum
alternative tax (MAT) is a tax calculated on accounting profit. A company must
pay the higher of normal tax and MAT. The effect of MAT is that companies with
zero taxable profit pay tax and companies with a low taxable profit pay a larger tax
than they would have had to in the absence of MAT.
To illustrate, assume a MAT rate of 15 per cent and a normal tax rate of 30 per
cent for three years. Let us look at four cases for Abhinav Company:
Case 1: It has no taxable profit, but has an accounting profit. It pays MAT of `3,000.
Case 2: It has a taxable profit, but normal tax is less than MAT. It pays MAT of
`3,000.
Case 3: Normal tax is equal to MAT. It pays normal tax of `3,000.
Case 4: Normal tax is more than MAT. It pays normal tax of `3,600.
MAT credit MAT is current tax and is expensed as incurred. However, MAT paid
can be carried forward and adjusted against normal tax payable in a specified
number of future years. This is known as MAT credit, which is treated as a
recoverable during that period. In Year 1, assume either Case 1 or Case 2: Abhinav
Company paid MAT of `3,000. It can claim credit for the amount from normal tax
payable in the future. Suppose that in Year 2, it has a taxable profit of `15,000 and
an accounting profit of `14,000. Its normal tax is `4,500 and MAT is `2,100. So it
pays normal tax, but can claim MAT credit. Since it must pay a minimum of `2,100,
it claims MAT credit of `2,400 and pays normal tax of `2,100. It carries forward the
unutilized MAT credit of `600 (i.e. Year 1 MAT paid, `3,000 – Year 2 MAT credit
utilized, `2,400). Suppose that in Year 3, it has a taxable profit of `18,000 and an
accounting profit of `15,000. Its normal tax is `5,400 and MAT is `2,250. It pays
normal tax of `4,800, after claiming the remaining MAT credit of `600.
Deferred Tax
An enterprise expects to recover or settle the carrying amount of an asset or liability
recognized in the financial statements. Because of the difference between
accounting and tax, recovery or settlement of that carrying amount could make
future tax payments larger or smaller. In such cases, the enterprise should
recognize a deferred tax liability or deferred tax asset. Tax base and temporary
differences are the building blocks of deferred tax accounting.
Tax base The tax base of an asset or liability is the amount attributed to that
asset or liability for tax purposes.15
Tax base of an asset The tax base of an asset is the amount that will be deductible
for tax purposes against any taxable economic benefits that will flow to an entity
when it recovers the asset’s carrying amount. If those benefits will not be taxable,
the tax base of the asset is equal to its carrying amount.
Tax base of a liability The tax base of a liability is its carrying amount less any
amount that will be deductible for tax purposes in respect of that liability in future
periods. In the case of revenue received in advance, the tax base of the resulting
liability is its carrying amount less any amount that will be not be taxable in future
periods. Exhibit 9.7 summarizes these ideas.
In Vipul’s Company’s illustration (Exhibit 9.6), the tax depreciation for the
computer was `15,000 in Year 1. Future benefits from the computer are taxable
(Case A). So the tax base of the computer at the end of Year 1 is its tax-deductible
amount of `15,000 (cost, `30,000 – cumulative tax depreciation, `15,000). By the
end of Year 2, the asset will be fully depreciated for tax purposes. As a result, the
tax base will be zero at the end of both Year 2 and Year 3. Exhibit 9.8 presents the
calculation of the tax base for the asset.
Temporary differences These are differences between the carrying amount of an
asset or liability in the balance sheet and its tax base.16 Temporary differences are
of two kinds:
Taxable temporary differences
Deductible temporary differences.
Taxable temporary differences and deferred tax liabilities Taxable
temporary differences result in taxable amounts in determining taxable profit of
future periods when the carrying amount of the asset or liability is recovered or
settled. An asset’s carrying amount is a measure of its future economic benefits; its
tax base measures the amount that is allowed as a deduction for tax purposes. As
you know, the two are often not equal because the objectives of accounting and
taxation are different. When the carrying amount exceeds the tax base, the amount
of taxable economic benefits will exceed the tax allowance for the asset. In other
words, an enterprise expects to earn an amount equal to the asset’s carrying
amount, but the tax authorities will only allow it to claim its tax base. The
difference is a temporary difference on which it must pay tax. Hence there would be
a future outflow, a form of liability. This gives rise to a deferred tax liability: the
amount of income tax payable in future periods in respect of taxable temporary
differences. The liability is measured using the applicable tax rate. Note that the
carrying amount and the tax base would be equal both at the beginning and at the
end of an asset’s useful life. The difference between them originates in periods in
which the tax depreciation allowance is more than the accounting depreciation
expense – the position in the early part of the asset’s life because of generous tax
benefits for new assets. The position reverses in subsequent years. All taxable
temporary differences give rise to a deferred tax liability.
For Vipul Company, the tax base of the computer at the end of Year 2 and Year 3
is zero. The company depreciates the asset cost of `30,000 on a straight-line basis
over its estimated useful life of three years. So, the annual depreciation expense is
`10,000. At the end of Year 1, the carrying amount is `20,000 (cost, `30,000 –
accumulated depreciation, `10,000), the tax base is `15,000, and the taxable
temporary difference is `5,000. This represents taxable future economic benefits
from the asset. At the tax rate of 30 per cent, deferred tax liability is `1,500 at the
end of Year 1. Exhibit 9.9 presents deferred tax liability calculations for Vipul
Company’s computer.
Deferred tax expense and income tax expense Income tax expense comprises
current tax expense and deferred tax expense. Deferred tax expense is measured
as the change in deferred tax liability over the period. Vipul Company’s deferred tax
expense for Year 1 is `1,500 (deferred tax liability at the end of Year 1, `1,500 –
deferred tax liability at the beginning of Year 1, `0), for Year 2 is `1,500 (deferred
tax liability at the end of Year 2, `3,000 – deferred tax liability at the end of Year 1,
`1,500), and for Year 3 is – `3,000 (deferred tax liability at the end of Year 3, `0 –
deferred tax liability at the end of Year 2, `3,000). Exhibit 9.10 presents the
calculation of Vipul Company’s deferred tax expense and income tax expense.
The `1,500 amount of deferred tax expense each in Year 1 and Year 2 results from
originating temporary differences and the amount of – `3,000 in Year 3 is the effect
of reversing of those differences. Exhibit 9.11 shows the presentation of income tax
expense in Vipul Company’s statement of profit and loss.
Marginal tax rate, effective tax rate, and deferred tax accounting Marginal
tax rate (or statutory tax rate) is the rate at which an enterprise must pay tax on
its taxable profit. The marginal tax rate determines an enterprise’s current tax
expense. Vipul Company’s marginal tax rate is 30 per cent. In Year 1 the company
has to pay current tax of `10,500 on its taxable profit of `35,000. Parliament enacts
the statute that specifies the marginal tax rate and may change the rate from one
year to another. Effective tax rate is the rate at which an enterprise pays tax on
its profit. It is measured as the ratio of income tax expense to accounting profit. It
tells us about an enterprise’s tax burden. If we take tax as only current tax, Vipul
Company’s effective tax rate for is 26.25 per cent (10,500/40,000) in both Year 1 and
Year 2 and 37.5 per cent in Year 3 (15,000/40,000). This is an incomplete idea of the
effect of tax on the enterprise, because it ignores the effect of temporary differences
between accounting and tax, which are bound to even out over time. We have seen
how this works in the case of depreciation. Considering only current tax expense
results in gross distortion of the enterprise’s tax burden and is likely to mislead the
users of the financial statements on the true taxation cost. Therefore, we should
learn to think of income tax expense as consisting of both current tax expense and
deferred tax expense. Applying this concept, we get an effective tax rate of 30 per
cent for each year (12,000/40,000). This is reasonable. If the profit from operations
and the marginal tax rate are constant over time, the enterprise’s tax burden should
also be constant. Exhibit 9.12 sums up the position of taxable profit, accounting
profit, deferred tax and tax rates.
As a result of this entry, deferred tax liability of `1,500 originates in Year 1. At
the end of Year 1, the Deferred Tax Liability account would show a balance of
`1,500, as shown below:
When we record the income tax expense for Year 2, a further deferred tax liability
of `1,500 originates. As a result of this entry, the balance in the Deferred Tax
Liability account increases by `1,500 and, at the end of Year 2, the account would
show a balance of `3,000. The Deferred Tax Liability account shows the effect of this
entry:
Other taxable temporary differences In practice, depreciation is often the most
significant item of taxable temporary difference. Other examples include the
following:
(a) Interest revenue received in arrears and included in accounting profit on a
time proportionate basis but included in taxable profit on a cash basis.
(b) Revenue from sale of goods included in accounting profit when goods are
delivered but included in taxable profit when cash is collected subsequent to
delivery.
(c) Development costs capitalized and amortized but deducted in determining
taxable profit in the period in which they were incurred.
(d) Prepaid expenses already deducted on a cash basis in determining the taxable
profit of the current or previous periods.
Taxable temporary differences, such as depreciation and the other examples
above arise when income or expense is included in accounting profit in one period
but included in taxable profit in a different period. Such temporary differences are
often described as ‘timing differences’ and result from transactions that affect the
statement of profit and loss. Taxable temporary differences may also result from
other transactions. Revaluation of assets is an example. Tax authorities do not
allow higher depreciation because of revaluation in the current period or in future
periods. So the tax base of an asset is not increased by the difference between an
asset’s fair value and carrying amount. But this difference represents future
economic benefits from either using or disposing of the asset and these benefits are
taxable. As a result, revaluation gives rise to a deferred tax liability.
Initial recognition exemption There is no deferred tax accounting for a
transaction that affects neither accounting profit nor taxable profit. Suppose that a
business buys an asset costing `1,000 with an estimated useful life of five years and
no residual value. The tax rate is 30 per cent. Assume that depreciation of the asset
is not deductible for tax purposes and that on disposal any gain would not be
taxable and any loss would not be deductible. The tax base (i.e. tax-deductible
amount) of the asset is nil from its purchase to disposal. The taxable temporary
difference is, and will be, `1,000. However, the deferred tax liability of `400 (30 per
cent of `1,000) that results from only the initial recognition of the asset is never
going to be settled. Deferred tax liability should not be recognized for this item
initially or subsequently.
The case of goodwill arising in a business combination is similar, because tax
authorities do not allow reductions in the carrying amount of goodwill as a
deductible expense in determining taxable profit.17
Deductible temporary differences and deferred tax assets Deductible
temporary differences result in amounts that are deductible in determining taxable
profit of future periods when the carrying amount of the asset or liability is
recovered or settled. Accounting profit includes the effect of provisions for estimated
liabilities and estimated losses in the value of assets. Tax authorities deal with
them differently. Consider the following examples of deductible temporary
differences.
Estimated liabilities: Financial statements show estimated warranty
provisions in order to match expenses with sales revenue. However, the tax
authorities do not allow provisions for estimated expenses. They allow
warranty expenses only on payment or when a definite liability exists.
Estimated losses: Financial accounting recognizes estimated losses from bad
debts. But the tax authorities allow only actual bad debt losses. Unrealized
losses from investment are similar.
Expenses allowed on payment: The income tax law allows deduction of certain
expenses (such as central excise, customs duties, and sales tax) for computing
taxable profit on payment. But the financial statements recognize these items
on accrual.
Income taxed on receipt: Sometimes a receipt can be taxed but recognized as
income in accounting later.
The right of an enterprise to claim these and other similar items in determining
taxable profit in a future period (when the related liability is paid or the loss in the
asset’s value is realized) would result in a lower taxable profit in that period. The
difference is a temporary difference that represents a tax saving, a future economic
benefit. It gives rise to a deferred tax asset: the amount of income tax recoverable
in future periods in respect of deductible temporary differences.
To illustrate, suppose that Simran Company has an accounting profit of `60,000
per year for three years. It recognizes a provision for doubtful debts of `12,000 in
accounting in Year 1, but the actual loss is `9,000 in Year 2 and `3,000 in Year 3.
The tax authorities allow only actual uncollectible amounts for determining taxable
profit. Assume a tax rate of 30 per cent. Exhibit 9.13 presents the calculation of the
company’s current tax expense.
Year 1: The carrying amount of the provision for doubtful debts is `12,000 and its
tax base is nil.18 The temporary difference is `12,000. Since the tax authorities will
allow the actual bad debt loss in future periods, this is a deductible temporary
difference (i.e. it will be deducted for determining future taxable profit). Since the
related income tax is recoverable, the provision gives rise to a deferred tax asset of
`3,600 (30 per cent of `12,000) that originates in Year 1. The following entry records
the income tax expense consisting of current tax expense and deferred tax income
(i.e. future tax benefit) and recognizes the deferred tax asset:
As a result of this entry, deferred tax asset of `3,600 originates in Year 1. At the
end of Year 1, the Deferred Tax Asset account has a balance of `3,600, as shown
below:
Year 2: In Year 2, the tax authorities allow a bad debt loss of `9,000. As a result,
deferred tax asset reverses to the extent of `2,700 (30 per cent of `9,000). Simran
Company records the following entry to recognize the income tax expense and the
reversal:
As a result of this entry, the balance in the Deferred Tax Asset account would be
reduced by `2,700 and, at the end of Year 2, the account would show a balance of
`900. The Deferred Tax Liability account below shows the effect of this entry:
Year 3: In Year 3, the tax authorities allow the remaining bad debt loss of `3,000
and the balance of the deferred tax asset of `900 (30 per cent of `3,000) reverses.
The following entry records the income tax expense and the reversal:
We can now summarize the Deferred Tax Asset account:
Accounting for deferred tax asset removes the difference between Simran
Company’s marginal tax rate and effective tax rate. Exhibit 9.14 sums up the
position of taxable profit, accounting profit, deferred tax and tax rates. Here again
we note that defining income tax expense as consisting of both current and deferred
tax measures the tax burden accurately.
As a result of this entry, the income tax expense for 20X1 is reduced by `4,500.
This reduction in income tax expense can be thought of as deferred tax income, i.e. a
lower charge to income tax expense because of deferred tax asset. The following
entry records the income tax expense, reversal of deferred tax asset and tax payable
in 20X2:
An enterprise recognizes deferred tax assets only when it is probable that taxable
profits will be available against which the deductible temporary differences can be
utilized. It is probable that taxable profit will be available when, and to the extent
that, there are sufficient taxable temporary differences relating to the same tax
authority and the same taxable entity which are expected to reverse (a) in the same
period as the expected reversal of the deductible temporary difference or (b) in
periods in which a tax loss arising from the deferred tax asset can be carried
forward. In such circumstances, the deferred tax asset is recognized in the period in
which the deductible temporary differences arise.
Deferred tax assets can also arise from the carryforward unused tax losses and
unused tax credits. We discuss these now.
Unused tax loss carryforward The tax authorities allow current period tax losses
to be carried forward to future periods and deducted from future taxable profits,
subject to conditions. Tax loss carryforwards would represent future economic
benefits, provided an enterprise can make profits in the future and claim the
deduction from future taxable profits. In India, tax loss can be carried forward for
eight years, after which it lapses. The tax depreciation component of tax loss
(commonly known as unabsorbed depreciation in India) can be carried forward for
an indefinite number of years. To illustrate, suppose that Maria Company has a tax
loss of `30,000 in Year 1 and there are no taxable temporary differences. It is
probable that sufficient taxable profit will be available in Year 2 against which the
tax loss can be utilized. The tax rate is 30 per cent. The company records the
following entry at the end of Year 1:
The tax recoverable of `9,000 (30 per cent of `30,000) is an asset.
Suppose that Maria Company’s taxable profit in Year 2 is `50,000, equal to its
accounting profit. The following entry records the income tax expense for Year 2:
Maria Company’s current tax expense is `15,000 (30 per cent of `50,000). To the
extent of the deferred tax asset of `9,000 from past taxable loss, it does not have to
pay tax. Therefore, the net tax payable is `6,000. The following entries record these
transactions:
Deferred tax asset arising from tax loss carryforward is similar to a receivable
from the tax department and is realized by paying a lower tax in the future. Note
that it does not reverse, unlike a deferred tax asset arising from taxable temporary
differences, but is adjusted at the time of paying tax.
Unused tax credit carryforward In India, the tax authorities allow the minimum
alternative tax (MAT) paid in a year to be adjusted against normal tax payable
within a specified number of future years. This is an example of tax credit forward.
Unused tax credits would represent future economic benefits if an enterprise can
make sufficient taxable profit in future periods and avail of the credits.
To illustrate, suppose that in Year 1, Vaibhav Company has an accounting profit
of `20,000 and has no taxable profit or taxable temporary differences. Assume that
the MAT rate is 15 per cent, the normal tax rate is 30 per cent and the unused MAT
credit carryforward period is 10 years. So it pays a MAT of `3,000 that can be
adjusted against normal tax in future periods. The following entries record this
transaction:
Suppose that in Year 2 it has a taxable profit of `25,000, equal to the accounting
profit. Its normal tax is `7,500. After adjusting the MAT credit of `3,000 from Year
1, it pays `4,500. The following entries record this transaction:
Deferred tax asset arising from unused tax credit carryforward is similar to a
receivable from the tax department and is realized by paying a lower tax in the
future. Note that it does not reverse, unlike a deferred tax asset arising from
taxable temporary differences, but is adjusted at the time of paying tax.
The condition for recognizing deferred tax assets arising from the carryforward of
unused tax losses and unused tax credits is the same as that for recognizing
deferred tax assets arising from deductible temporary differences, i.e. it is probable
that sufficient taxable profit will be available against which deductible temporary
differences can be utilized. However, the existence of unused tax losses is strong
evidence that future taxable profit may not be available. Therefore, when an
enterprise has a history of recent tax losses, it recognizes a deferred tax asset from
unused tax losses or unused tax credits only to the extent that the entity has
sufficient taxable temporary differences or there is convincing other evidence that
sufficient taxable profit will be available against which unused tax losses or unused
tax credits can be utilized by the enterprise. In such circumstances, the amount of
the deferred tax assets and the nature of the evidence should be disclosed.
Some items that do not appear as assets or liabilities in the balance sheet, and
hence have no carrying amount, could have a tax base. For example, research costs
are expensed as incurred for determining accounting profit but may be allowed for
tax purposes in one or more future periods. The tax base of the research costs and
the related deductible temporary difference is the amount that will be allowed by
the tax authorities.
Off-balance Sheet Financing
Off-balance sheet financing refers to the availing of a source of
finance which is not legally required to be shown as a liability in
the balance sheet of an enterprise. In other words, the financing is
not apparent from the balance sheet.
The motivations for off-balance sheet financing include:
A possible increase in the borrowing capacity of the enterprise as the debtequity ratio is kept low;
Better view of the liquidity position of the enterprise; and
Improved return on assets.
In a world characterized by intense competition for funds and better terms for
raising capital, these motivations can be significant. As one business writer
commented, “The basic drives of man are a few: to get enough food, to find shelter,
and to keep debt off the balance sheet.”
Conceptually, the issues concerned with off-balance sheet financing centre on the
fundamental question of economic substance versus legal form. Conventionally,
enterprises recognize only assets owned and liabilities owed in the balance sheet.
The question is whether the balance sheet should list the enterprise’s legal assets
and liabilities or show its economic resources and obligations. The answer is far
from simple and that is why there is so much controversy among accountants over
what to do about off-balance sheet financing. Accounting regulators have eliminated
many forms of off-balance sheet financing, but some variations of these keep
surfacing from time to time. We will now see some transactions with potential for
off-balance sheet financing.
Transfer of receivables with recourse As discussed in Chapter 5, a transfer of
receivables with recourse in the form of pledging or assignment should be treated as
a borrowing, and not as a sale, by the transferor. This is because the so-called ‘sale’
of receivables is nothing more than a financing transaction, the receivables merely
serving as a collateral security for the borrowing. The difference between the
proceeds and the receivables is an interest cost. It cannot derecognize the
receivables. An entity shall derecognize a financial asset (such as a receivable) only
when it transfers the asset i.e. it “transfers the contractual rights to receive the
cash flows of the financial asset”.19 If an entity “retains substantially all the risks
and rewards of ownership of the financial asset, the entity should continue to
recognize the financial asset.”20
Product financing arrangement This is a transaction in which an enterprise
(the sponsor) sells and agrees to repurchase inventory at a later date. The
repurchase price equals the original sale price plus holding and financing costs. The
substance of a product financing arrangement, regardless of its legal form, is that of
a financing arrangement rather than a sale or purchase by the sponsor. As a result,
the sponsor finances its inventory without reporting either the liability or the
inventory. Product financing arrangements are often referred to as parking
transactions because the seller simply “parks” the inventory on the balance sheet of
another enterprise.
To illustrate, assume that Kapil Company sells inventory costing `8,000 to Saif
Company for `10,000 and agrees to repurchase the same inventory for `10,500 in 30
days. Kapil Company should enter the transaction as follows:
The difference of `500 between the sale price and the purchase price is interest.
Unconditional purchase obligation This results when one party is required to
transfer funds to another party in return for future delivery of specified quantities
of goods or services at specified prices. Conventionally, accounting principles do not
require the recording of transactions in respect of which the performance of the
parties to the contract is not completed. These are known as executory
transactions. Exchanges are recorded when the transfer of resources or obligations
occurs. However, if the existence of significant unfilled purchase commitments are
not disclosed, the financial statements may be misleading.
In a take-or-pay contract, a buyer agrees to pay specified periodic amount for
certain products or services. The buyer must make the specified periodic
payments, even though he does not take delivery of the products or services.
In a throughput contract, one party agrees to pay specified periodic amounts
to another party for the transportation or processing of a product. The
periodic payments must be made, even though the minimum quantities
specified in the agreement in each period have not been sent to the other
party transporting or processing the product.
The characteristic feature of the take-or-pay or throughput contracts is that the
periodic payments are unconditional and are not dependent on the occurrence of a
specified event or the fulfilment of a condition. So they are different from contingent
liabilities. In India, companies must disclose the following as commitments: (a)
estimated amount of contracts remaining to be executed on capital account and not
provided for; (b) uncalled liability on shares and other investments partly paid; and
(c) other commitments.
Financial instruments There has been an explosion of different types of financial
instruments in recent years. Derivative financial instruments, such as forward
contracts, futures contracts, swaps and options are used extensively in risk
management. Suppose that Indian Oil wants to protect itself against an increase in
the price of crude oil in the international market. It can enter into a forward
contract for purchase of crude at a specified price on a certain date. In this manner,
the company can ensure that it will be able to buy oil at the contracted price even if
the price goes up. A futures contract is a standardized forward contract traded in a
market. Both forwards and futures are binding on both parties. In an interest rate
swap, a party who wants to borrow at a fixed rate for protection but finds the
borrowing too expensive swaps the interest payments with another borrower who
has a fixed-rate loan but wants a floating rate. This is a convenient way to limit
exposure to rising interest rates for a borrower with a substantial amount of
variable debt. Further, companies with low credit ratings that cannot borrow in the
fixed-rate market can swap into it. Of course, a risk-taker can swap a fixed-rate
borrowing for a floating rate. Banks, insurance companies, and large manufacturing
and trading firms have huge exposures under derivative contracts. An option is a
right but not an obligation to buy or sell shares, commodities or other items. Unlike
forwards and futures, an option is not binding on the holder.
Looking Back
Define liabilities Liabilities are present obligations for the future payment of assets or performance of
services and are the result of past transactions or events. Liabilities are unavoidable regardless of en
enterprise’s future actions.
Describe current and non-current liabilities and secured and unsecured liabilities Current
liabilities are typically expected to be settled in an enterprise’s normal operating cycle or within 12 months
after the reporting period. Other liabilities are non-current. Secured liabilities are backed by the borrower’s
identified assets. Unsecured liabilities are incurred based on the borrower’s general credit standing.
Define and record definite and estimated liabilities Definite liabilities can be determined precisely.
Estimated liabilities are of uncertain timing or amount.
Explain how to report contingent liabilities A contingent liability depends on the outcome of an
uncertain event. It should be recognized if it is probable and the related loss can be reasonably estimated.
Describe the principal features of debentures Debentures may be: secured or unsecured, term or
serial, convertible or non-convertible, callable or non-callable, coupon or zero-coupon.
Record the issue of debentures and account for interest expense Debentures are recorded at their
fair value obtained by discounting the principal and interest payments at the yield. Interest expense is
calculated using the effective interest method.
Account for debenture redemption and retirement Redemption is the payment of debentures at
maturity. Retirement is early redemption. A gain or loss is recognized for the difference between the price
paid for the debentures retired and their carrying amount.
Account for compound financial instruments A compound financial instrument, such as a convertible
debenture, is part equity and part debt. The basic requirement is to measure and recognize the liability and
equity components separately.
Explain the operation of a debenture redemption fund A debenture redemption fund is meant to
ensure availability of sufficient cash to pay back the debentures. The fund consists of the deposits and
interest earned on them.
Account for mortgages, leases and employee benefits Mortgage payments are separated into interest
and principal components. A lessee recognizes a finance lease as an asset and an obligation. Employee
benefits such as long-term leave, pensions and post-employment health care are recognized as liabilities based
on actuarial estimates.
Account for current and deferred tax Accounting profit and taxable profit almost always differ. Current
tax is expensed as incurred. The tax effect of taxable temporary differences is recognized as deferred tax
liabilities and of deductible temporary differences as deferred tax assets. Unutilized MAT credit that meets
certain conditions is treated as an asset.
Explain off-balance sheet financing arrangements Off-balance sheet items do not appear as liabilities
in the balance sheet but are disclosed. Accounting regulators are coming down heavily on many forms of offbalance sheet financing transactions.
Review Problem
On August 1, 20X5, Navin Company issued `500,000, 15%, 10-year debentures for `480,000. Interest is payable
on June 30 and December 31 in arrears. The company’s year end is March 31. The yield was 18 per cent.
Prepare journal entries to record the following:
1. Issue of debentures on August 1, 20X5.
2. Payment of semi-annual interest on December 31, 20X5 and amortization of
discount.
3. Accrual of interest on March 31, 20X6 and amortization of discount.
Solution
The issue proceeds are `431,519, calculated as follows: 37,500  9.1285 + 500,000  0.1784. We discount the cash
flows at 9 per cent for 20 periods.
ASSIGNMENT MATERIAL
Questions
1. Distinguish between an obligation and a liability.
2. Why is it important to distinguish between current liabilities and long-term
liabilities?
3. How does an estimated liability differ from a definite liability? Give three
examples each of definite and estimated liabilities.
4. How should contingent liabilities be reported?
5. How are long-term liabilities different from current liabilities?
6. Why is the debenture trust deed important?
7. How does the call feature of a debenture help the issuer?
8. What are the common forms of providing security for a debt?
9. How is yield determined?
10. For a debenture issued at a discount, why does the interest expense increase
over the life of the debenture?
11. How should debenture redemption premium be accounted for?
12. What is a compound financial instrument? Give two examples.
13. How does a debenture redemption fund protect the debentureholders’
interest?
14. Pensions are deferred wages. Do you agree?
15. Why is it necessary to accrue interest cost on pension liability?
16. Distinguish between accounting profit and taxable profit.
17. Explain tax base?
18. Can a temporary taxable difference or temporary deductible difference result
from a transaction that does not affect the statement of profit and loss? Give
an example.
19. Distinguish between unused tax loss carryforward and unused tax credit
carryforward.
20. What is a product financing arrangement?
21. Are purchase obligations liabilities? Why or why not?
22. What are take-or-pay contracts and throughput contracts?
23. Are operating leases a source of off-balance sheet financing? Explain.
Problem Set A
On April 1, 20X1, Vani Company issues `1,000,000 of 10%, 15-year debentures. Interest
is payable semi-annually on March 31 and September 30 in arrears. Compute the issue
price of the debentures if the yield on April 1 equals (a) 18 per cent, (b) 10 per cent, or (c)
8 per cent.
On January 1, 20X3, Easy Ways Company issued `300,000, 18%, 10-year debentures.
Interest is payable on June 30 and December 31 in arrears. The company’s financial year
ends on December 31.
Required
1. Prepare journal entries to record the issue if the proceeds were (a) `280,000,
and (b) `310,000.
2. Prepare journal entries in 20X3 to record interest expense.
On January 1, 20XX, Veer Company issued `500,000 of 15 per cent, 5-year, `1,000
debentures convertible into 30 equity shares of face value of `10 at par. Interest is payable
on June 30 and December 31 in arrears. On June 30, 20XX, after paying interest and
amortizing discount, unamortized discount was `20,000. On that date, `200,000 of the debentures were
converted.
Required
Prepare the journal entry to record the conversion of the debentures.
On February 1, 20X5, Vivian Company issued `100,000 of 18 per cent, 10-year debentures
for `88,000. Interest is payable on January 31 and July 31. The company’s financial yearend is March 31.
Required
Prepare journal entries to record accrual of interest and amortization of discount on March 31, 20X5 and
payment of interest and amortization of discount on August 1, 20X5.
On January 1, 20X7, Kamal Company issued `200,000 of 12 per cent, 20-year
debentures. The debenture trust deed requires the company to create a sinking fund and
invest the assets in investment grade securities that yield an annual return of 10 per
cent. Investments and interest receipts will take place on December 31.
Required
Prepare journal entries to record payment of the deposit on December 31, 20X7 and receipt of the earnings from
the deposit on December 31, 20X8.
On January 1, 20X1, Jeet Company took furniture on lease for 18 months. The lease rental is
`10,000 per month in the first year and `4,000 per month in the second year. All payments are
made at the end of quarter, beginning March 31, 20X1. The furniture had an estimated useful
life of five years.
Required
Prepare journal entries to record payment of the lease rental expense.
Ritu Company reported an accounting profit of `50,000 and tax loss of `20,000 for the year
ended March 31, 20XX. The tax rate is 35 per cent and the minimum alternative tax rate is 10 per cent.
Required
Prepare the journal entry to record the income tax expense for the year.
Problem Set B
Lucky Traders had the following bills payable transactions:
Mar. 11 Purchased merchandise from Khan Company on a 90-day, 18 per cent bill for `20,000.
Apr. 24 Borrowed from Vijaya Bank on a 60-day, 16 per cent bill for `30,000.
May 4 Purchased merchandise on account from Khan Company, `8,000.
June 9 Paid the 90-day bill payable to Khan Company.
10 Issued a 90-day, 18 per cent bill in settlement of the amount due to Khan Company.
June 23 Paid Vijaya Bank.
Sep. 8 Paid Khan Company.
17 Purchased merchandise from Khan Company on a 90-day bill for `10,400.
Required
1. Prepare journal entries to record the transactions.
2. Prepare the adjusting entry on May 31, the company’s year-end, to record the accrued interest payable on the
two bills.
Siraj Company sells geysers under a warranty contract that requires the company to replace
defective parts free of charge, but the customer must pay the labour charges. In the past, 5 per
cent of the sales required warranty replacement costing `150 per piece. During March, the
company sold 700 pieces at an average price of `4,300. During the month, the company
received 60 pieces under the warranty and these were returned after repairs costing `7,430. The company
collected labour charges of `600.
Required
1. Prepare journal entries to record (a) the cost of warranty repairs completed
during the month, assuming that the company follows the cash system of
accounting for warranty; and (b) receipt of service revenue.
2. Prepare journal entries to record (a) the cost of warranty repairs completed
during the month; (b) the estimated liability for warranty for sales during
the month, assuming that the company follows the accrual system of
accounting for warranty; and (c) receipt of service revenue.
3. Assume that the company follows the accrual system and at the beginning of
the month, the estimated warranty liability account had a credit balance of
`71,230. Compute the balance of the account at the end of the month. How
would it appear on the balance sheet on March 31?
4. Describe the circumstances in which the cash system of accounting for
warranty can be followed.
On July 1, 20X0, Arjun Company issued `300,000 of 12 per cent, 8-year secured
debentures at `246,895. The debentures yield 16 per cent. Interest is payable on June 30
and December 31 in arrears. The debentures are due for redemption on July 31, 20X8.
The company’s year-end is December 31.
Required
1. Prepare a discount amortization schedule.
2. Prepare journal entries to record the following: (a) issue of debentures; (b)
interest expense on December 31, 20X0; (c) interest expense on June 30,
20X1; and (c) redemption of debentures.
On August 1, 20X0, De Silva Company issued `200,000 of 16 per cent, 9-year debentures for
`182,490, callable at market price on or after July 31, 20X7. The market rate of interest was 18
per cent per annum. The debenture trust deed requires the company to deposit `14,728 with the
trustee at the end of every reporting period during the life of the debentures. The company’s year end is July 31.
Interest is paid on January 31 and July 31. The sinking fund investments are expected to earn a return of 10
per cent per year. All deposits were made and the amounts were invested as stipulated in the trust deed. After
payment of interest on July 31, 20X8, the company called the debentures at the market price of 95.6, sold the
investments for `165,110, and paid the debentureholders.
Required
1. Prepare a schedule showing accumulation of sinking fund investments up to
July 31, 20X8.
2. Prepare a debenture discount amortization schedule up to July 31, 20X8.
3. Prepare journal entries to record the following transactions: (a) issue of
debentures; (b) sinking fund investment on July 31, 20X1; (c) sale of sinking
fund investments; and (d) retirement of debentures.
On August 15, 20X1, the board of directors of Mahendra Company approved the issue of
`150,000 of 10 per cent, 10-year convertible debentures and of `100,000 of 16 per cent, 8year callable debentures. Each 10 per cent debenture of `100 is convertible into six shares
of `10 face value. The company’s year end is March 31. The company completed the
following transactions pertaining to the debentures:
Required
Prepare journal entries to record the debenture transactions.
Part I
An equipment lease agreement has the following features:
(a) The term of the lease is four years and the lease agreement is non-cancellable. The
equipment reverts to the lessor at the end of the period.
(b) Lease rental of `28,679 must be paid at the beginning of each year. The first rental is payable on signing
the agreement.
(c) The equipment has a fair value of `100,000 at the inception of the lease, an estimated useful life of eight
years, and no residual value.
(d) The lessor’s incremental borrowing rate is 12 per cent.
(e) The lessor is known to charge an interest rate of 10 per cent on the lease.
(f) The lessee uses the straight-line method for depreciation of similar equipment.
Part II
Same facts as in Part I, except that the equipment has (a) a fair value of `106,830 and (b) an unguaranteed
residual value of `10,000.
Part III
Same facts as in Part I, except that the equipment has (a) a fair value of `103,415 and (b) a residual value of
`5,000, guaranteed by the lessee.
Part IV
Same facts as in Part I, except that the equipment has (a) a fair value of `103,415 and (b) a residual value of
`5,000, guaranteed by an independent third party financially capable meeting the obligation.
Part V
Same facts as in Part I, except that the equipment has (a) a fair value of `113,660 and (b) an unguaranteed
residual value of `20,000.
Part VI
Same facts as in Part I, except that the equipment has (a) a fair value of `113,660, (b) an unguaranteed residual
value of `20,000, and (c) a useful life of five years.
Required
Answer the following questions separately for each Part.
1. What are the minimum lease payments from the standpoint of (a) the
lessee? (b) the lessor?
2. Is this a finance lease? Why or why not?
3. What is the interest rate implicit in the lease?
4. How should the lessee record the lease?
Additional information:
(a) Other current liabilities include (i) unearned revenue, `1,000, (ii) sales tax payable, `400, and (iii) fine
payable, `100. Items (i) and (ii) are taxed or deducted on the cash basis; item (c) is not tax-deductible.
(b) Tax depreciation on equipment is `3,000.
(c) Other expenses include (i) estimated bad debt expense, `500 and (ii) fine, `150. Item (i) is not taxdeductible, but a write-off of `50 will be allowed. Item (ii) is not tax-deductible.
(d) Short-term loans and advances include advance tax, `1,500.
(e) Income tax rate is 30 per cent; MAT rate is 10 per cent.
Required
1. Calculate the company’s (a) current tax expense, (b) temporary differences,
and (c) deferred tax assets and liabilities, if any.
2. Prepare the journal entry to record the income tax expense for 20XX.
Problem Set C
Required
1. Prepare journal entries to record the transactions.
2. Prepare the adjusting entry on September 30, the company’s year-end, to
record the accrued interest payable on the bills.
Jaya Company sells toasters under a warranty contract that requires the company to replace
defective parts free of charge, but the customer must pay the labour charges. In the past, 3 per
cent of the sales required replacement under warranty, costing `200 per piece. During July,
the company sold 1,200 pieces at an average price of `6,000. During the month, the company
received 20 pieces under warranty and these were returned after repairs costing `3,190. The company collected
labour charges of `400 from customers under the terms of the warranty.
Required
1. Prepare journal entries to record (a) the cost of warranty system repairs
completed during the month, assuming that the company follows the cash
system of accounting for warranty; and (b) receipt of service revenue.
2. Prepare journal entries to record (a) the cost of warranty repairs completed
during the month; (b) the estimated liability for warranty for sales during
the month, assuming that the company follows the accrual system of
accounting for warranty; and (c) receipt of service revenue.
3. Assume that the company follows the accrual method and at the beginning
of the month, the estimated warranty liability account had a credit balance
of `47,160. Compute the balance of the account at the end of the month. How
would it appear on the balance sheet on July 31?
4. Describe the circumstances in which the cash system of accounting for
warranty can be followed.
On January 1, 20X4, Arjun Company issued `500,000 of 16 per cent, 5-year secured
debentures at `438,534. The debentures yield 20 per cent. Interest is payable on June 30
and December 31. The debentures are due for redemption on January 1, 20X9. The
company’s year-end is December 31.
Required
1. Prepare a debenture discount amortization schedule.
2. Prepare journal entries to record the following: (a) issue of the debentures on
January 1, 20X4, (b) payment of interest and amortization of the discount on
July 1, 20X4; (c) payment of the interest and amortization of the discount on
January 1, 20X5; and (d) redemption of debentures on January 1, 20X9.
3. What would have been the balance in the discount on debentures payable
account on December 31, 20X6 if the company had followed the straight-line
method amortization? Assume that the interest payment due on January 1,
20X7 is accrued on December 31, 20X6.
On January 1, 20X2, Christina Company issued `500,000 of 14 per cent, 7-year debentures for
`458,797, callable at market price on or after December 31, 20X7. The market rate of interest was
16 per cent per annum. The debenture trust deed requires the company to deposit `49,559 with
the trustee at the end of every reporting period during the life of the debentures. The company’s fiscal year ends
on December 31. Interest is paid on June 30 and December 31. The sinking fund investments are expected to
earn a return of 12 per cent per year. All deposits were made and the amounts were invested as stipulated in
the trust deed. On December 31, 20X7, the company called the debentures at the market price of 96.4, sold the
investments for `404,310, and paid the debentureholders.
Required
1. Prepare a schedule showing accumulation of sinking fund investments up to
December 31, 20X7.
2. Prepare a debenture discount amortization schedule up to December 31,
20X7.
3. Prepare journal entries to record the following transactions: (a) issue of
debentures; (b) sinking fund investment on December 31, 20X2; (c) sale of
sinking fund investments; and (d) retirement of debentures.
On March 22, 20X4, the board of directors of Ranatunga Company approved the issue of
`200,000 of 12 per cent, 15-year convertible debentures and of `300,000 of 18 per cent, 10year callable debentures. Each 12 per cent debenture of `100 is convertible into four
shares of `10 face value. The company’s financial year-end is November 30. The company
completed the following transactions pertaining to the debentures:
Required
Prepare journal entries to record the debenture transactions.
Part I
An equipment lease agreement has the following features:
(a) The term of the lease is six years and the lease agreement is non-cancellable. The equipment reverts to
the lessor at the end of the period.
(b) Lease rental of `30,044 must be paid at the beginning of each year. The first rental is payable on signing
the agreement.
(c) The equipment has a fair value of `150,000 at the inception of the lease, an estimated useful life of ten
years, and no residual value.
(d) The lessor’s incremental borrowing rate is 9 per cent.
(e) The lessor is known to charge an interest rate of 8 per cent on the lease.
(F) The lessee uses the straight-line method for depreciation of similar equipment.
Part II
Same facts as in Part I, except that the equipment has (i) a fair value of `159,453 and (ii) an unguaranteed
residual value of `15,000.
Part III
Same facts as in Part I, except that the equipment has (i) a fair value of `155,042 and (ii) a residual value of
`8,000, guaranteed by the lessee.
Part IV
Same facts as in Part I, except that the equipment has (i) a fair value of `155,042 and (ii) a residual value of
`8,000, guaranteed by an independent third party financially capable of meeting the obligation.
Part V
Same facts as in Part I, except that the equipment has (i) a fair value of `168,906 and (ii) an unguaranteed
residual value of `30,000.
Part VI
Same facts as in Part I, except that the equipment has (i) a fair value of `170,166, (ii) an unguaranteed residual
value of `32,000, and (iii) a useful life of eight years.
Required
Answer the following questions separately for each Part.
1. What are the minimum lease payments from the standpoint of (i) the lessee?
(ii) the lessor?
2. Is this a finance lease? Why or why not?
3. What is the interest rate implicit in the lease?
4. How should the lessee record the lease?
Additional information:
(a) Other current liabilities include (i) interest received in advance, `120, (ii) employer’s provident fund
contribution payable, `160, and (iii) donation payable, `140. Items (i) and (ii) are taxed or deducted on the
cash basis; item (iii) is not tax-deductible.
(b) Tax depreciation on equipment, `1,000.
(c) Other income include interest on tax-free bonds, `100.
(d) Other expenses include (i) estimated bad debt expense, `300 and (ii) donation, `180. Item (i) is not taxdeductible, but a write-off of `40 will be allowed. Item (ii) is not tax-deductible.
(e) Short-term loans and advances include (i) interest receivable on tax-free bonds, `40 and (ii) advance tax,
`350.
(f) Income tax rate is 30 per cent; MAT rate is 10 per cent.
Required
1. Calculate the company’s (a) current tax expense, (b) temporary differences,
and (c) deferred tax assets and liabilities, if any.
2. Prepare the journal entry to record the income tax expense for 20XX.
Business Decision Cases
Chandra Rubber Company manufactures a range of rubber products having industrial as well
as domestic applications. The company’s corporate head office is in Kochi. A significant part of
the revenues is earned from exports to the United States and to several countries in Europe.
On May 15, 20X6, Suresh Nair, chief financial officer of the company, was reviewing the
company’s financial statements for the year ended March 31, 20X6. In the course of his review, he noticed the
following items:
1. The company has received a notice from Rai & Co., lawyers, claiming
damages of `250,000 under the Consumer Protection Act. The notice stated
that a seven-year old child in Mumbai was injured while riding a toy car
made from rubber produced by the company. This is the first time Chandra
Rubber has received a product liability claim. The company has decided to
accept the claim to avoid adverse publicity, although its legal advisers feel
that the amount of damages can be reduced to about `150,000 in a legal
proceeding.
2. The assessment order for the year ended March 31, 20X4 issued by the
Assistant Commissioner of Income Tax disallowed expenses of `180,000
incurred by the company for the visit of the managing director to
Switzerland in November 20X3 on the ground that “it was not incurred
wholly and exclusively for business purposes”. As a result, the company is
required to pay income tax of `72,000 and penalty of `36,000. The company’s
accountants advised the company to appeal the assessment order to the
Commissioner of Income Tax and were reasonably certain that the
Commissioner would allow half of the travel and completely waive the
penalty since there was no intention to avoid payment of tax. Accordingly,
the company has filed an appeal to the Commissioner of Income Tax. If the
company were to lose the appeal, it can go on further appeal to the Income
Tax Appellate Tribunal and, if necessary, to the High Court. Similarly, the
Income Tax Department can go on appeal to these authorities, should it lose
the appeal.
3. Walt Disney Company has sued the company in a Delhi court claiming
exemplary damages of `10 million for infringement of its intellectual
property rights since the characters portrayed in the company’s recent
promotion campaign closely resembled Aladdin, a Walt Disney copyright.
The company’s legal advisers expect the case to be settled at an amount
ranging from `100,000 to `500,000 and estimate the probable amount at
`200,000. The company does not want to publicize the case since it could
lead to sanctions against the company in the United States, a major
destination for its exports.
4. A past employee of the company has filed an appeal in the Calcutta High
Court against the company for wrongful dismissal and has claimed back
wages of `40,000 and damages of `100,000. The company’s legal department
believes that it has an iron-clad case since the employee was caught redhanded while removing the company’s materials outside the factory. The
company won the case in the labour court in October 20X4 and again in the
district court in January 20X6.
5. The residents of a village near the company’s main plant in Howrah have
written to the West Bengal State Pollution Control Board demanding
closure of the plant alleging air and water pollution. The company feels that
the case is not sustainable since it complies with relevant pollution control
standards and the effluents are treated as required by law. However, the
company may have to close down operations in the plant if the Board
determines that there has been a violation by the company; alternatively,
the company can continue operations after installing pollution control
equipment costing `150 million. Either way, the company will face
significant financial problems. The Board is under enormous pressure from
environmental activists to close down the plant. On May 10, 20X6, the Board
has informed the company that it was deputing a team of officers for an onthe-spot study in the next two weeks. At the moment, there is no clue as to
which way the matter will go. Information from several sources indicates
that the Pollution Control Boards in many States have taken a fairly
stringent view of similar cases on orders from the Supreme Court.
Required
1. How should the chief financial officer report each of the above items in the
company’s financial statements for the year ended March 31, 20X6? Explain.
2. The chief executive of the company is apprehensive about the negative effect
of reporting items 1, 2, 3 and 5 on the company’s stock prices. He asks the
chief financial officer to come up with a solution without violating the law or
any accounting principle. What considerations, accounting and ethical, are
involved?
The finance manager of Softscape Corporation is considering two alternatives for financing
the company’s proposed acquisition of computers costing `1,000,000. The equipment has
an estimated useful life of three years at the end of which it is expected to have a residual
value of `100,000. The company can borrow at 20 per cent per annum from its bank and pay for the acquisition.
The loan is repayable in six equal semi-annual instalments that include principal and interest. Expro Finance, a
leasing company, has given a proposal for leasing the equipment at a semi-annual lease rental of `229,605 over
the lease period. In the latter case, the equipment reverts to the lessor at the end of the lease period. Loan
instalments and lease rentals are paid at the end of each semi-annual period. It follows the straight-line method
of depreciation.
Required
1. Compute the amount of expense that must be recognized in each of the three
years under the borrowing and leasing alternatives, assuming (a)
capitalization and (b) no capitalization.
2. Prepare the journal entry to record the lease at the time of inception of the
contract.
3. Evaluate the leasing and borrowing alternatives.
4. The marketing manager of Expro Finance informed Softscape that the
proposed lease would be “off-balance sheet”. What does it mean? In your
view, should Softscape capitalize the lease?
Interpreting Financial Reports
Essar Oil Limited is one of the largest oil refining companies in India. The company opted to
defer payment of sales tax collected by it for sales from its refinery on the basis of a scheme of
the Government of Gujarat. This meant that the company could retain the sales tax collected
for some years before remitting it to the government. Sales tax is normally payable in the month following the
month in which it is collected. The deferred sales tax liability was effectively an interest-free loan that was
intended to encourage companies to set up business in Gujarat. However, the refinery could not start operations
by August 15, 2003, the specified time-limit for availing of the deferral benefit, because of a cyclonic storm in
1998 and a High Court stay in 1999. As a result, the company would not be eligible for sales tax deferral. In
January 2004, the Supreme Court lifted the stay and the company could resume work on the project. The
company requested the government to extend the time-limit, but the government did not grant extension. In
response to the company’s petition, on April 22, 2008 the High Court directed the government to consider the
company’s application for deferral. From May 1, 2008, the company started deferring sales tax payment. On
July 14, 2008, the government challenged the High Court’s order in the Supreme Court. On January 17, 2012,
the Supreme Court set aside the High Court’s order.
Since May 1, 2008, the company transferred its liability to pay deferred sales tax to a related party at its
present value. As a result, the company did not show any deferred sales tax liability and recognize the difference
between the deferred sales tax payable and its present value as a gain in its statement of profit and loss for each
year. The following table gives these amounts:
Required
1. What were the possible managerial considerations for removing the deferred
sales tax liability from Essar Oil’s financial statements?
2. What are the accounting requirements for derecognizing a liability? Did
Essar Oil meet those requirements?
3. Comment on the quality of the disclosures in Essar Oil’s financial
statements on the accounting for removal of the liability.
Kingfisher Airlines Ltd. was one of the largest aviation companies in India. The company’s
jaunty slogan “Welcome to a world without passengers” was meant to say that the passenger
is “made to feel like a guest and not just a passenger”. Unfortunately for the company, the
slogan soon acquired its literal meaning.
The company’s financial statements for the year ended March 31, 2012 contained the following information
on deferred taxes:
Note 39:
Deferred tax asset on unabsorbed depreciation and business losses has been recognized on the basis of
business plan prepared by the management which takes into account certain future receivables arising out of
contractual obligations. The management is of the opinion that there is virtual certainty supported by
convincing evidence that sufficient future taxable income will be available against which the deferred tax
asset can be realized.
The auditors’ report (paragraph 10) contained the following observation (italics in original):
Attention of the members is invited to note 39 regarding recognition of deferred tax credit on account of
unabsorbed losses and allowances during the year aggregating to `11,181 million (year ended March 31, 2011
`4,934 million) (Total amount recognized up to March 31, 2012 `40,458 million). This does not satisfy the
virtual certainty test for recognition of deferred tax credit as laid down in AS 22.
A note to the company’s financial statements for the year ended March 31, 2013 stated:
Note 39:
Deferred tax credit earlier recognized up to March 31, 2012 aggregating to `40,459 lacs has been
derecognized during the year by debit to surplus account (reserves and surplus) in the balance sheet.
Required
1. Do you agree with the company’s position on deferred taxes? Explain.
2. Identify possible management motives for the position adopted and examine to what extent they might apply
in this case.
21
On January 29, 2008, Lehman Brothers reported record revenues of nearly $60 billion and
record earnings in excess of $4 billion for fiscal year ending November 30, 2007. During
January 2008, Lehman’s stock traded as high as $65.73 per share and averaged in the high
to mid-fifties, implying a market capitalization of over $30 billion. Less than eight months later, on September
12, 2008, Lehman’s stock closed under $4. On September 15, 2008, Lehman filed for bankruptcy, the largest
ever. The examiner’s report referred to “balance sheet manipulation” by Lehman executives.
Lehman employed off-balance sheet devices, known as “Repo 105” and “Repo 108” transactions, to
temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to
create a materially misleading picture of the firm’s condition in late 2007 and 2008. Repo 105 transactions
utilized fixed income securities and required a minimum of $105 worth of securities in exchange for $100 cash
borrowed; Repo 108 transactions utilized fixed income securities and required a minimum of $108 worth of
securities in exchange for $100 cash borrowed. Repo 105 (we use this term to refer to both Repo 105 and Repo
108) transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman
and other investment banks used to secure short-term financing with a critical difference: Lehman accounted
for Repo 105 transactions as sales.
Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce
its publicly reported net leverage. It did not disclose the cash borrowing from the Repo 105 transactions. It used
the cash from Repo 105 transactions to pay other liabilities, thereby reducing both the total liabilities and the
total assets reported on its balance sheet and lowering its leverage ratios.
Required
1. How is a standard repo transaction accounted? How is Repo 105 transaction
accounted? Why does the accounting differ?
2. According to the examiner’s report, “Lehman’s auditors, Ernst & Young,
were aware of but did not question Lehman’s use and nondisclosure of the
Repo 105 accounting transactions.” Do you agree with the auditors’ position?
3. What safeguards would be useful in dealing with practices, such as Repo
105?
Barclays PLC is a large UK-based bank with operations in many countries. Excerpts from its
results for the year 2008 follow:
Performance Highlights
In a very difficult economic environment in 2008, Barclays has steered a course that has enabled us to be
solidly profitable despite strong headwinds. We are well positioned to maintain Barclays’ competitive
strengths through the undoubted challenges that will come in 2009 and beyond.
—Marcus Agius, Chairman
We thank our customers and clients for the business they directed to Barclays in 2008. High levels of activity
on their behalf have enabled us to report substantial profit generation in difficult conditions. We benefited
from a number of gains on acquisitions and disposals. These contributed to headline profit, and to capital, but
the main driver of our results was a solid operating profit performance and record income generation. We
commit to reducing the size of our balance sheet over time, and we will maintain our capital ratios at levels
that are well ahead of regulatory requirements. We intend to recommence dividend payments during the
second half of 2009.
—John Varley, Chief Executive
Group profit before tax was £6,077m, down 14% on 2007. Profit included:
— Gains on acquisitions of £2,406m, including £2,262m relating to Lehman Brothers North American
business
— Profit on disposal of the closed life assurance book of £326m
— Gains on Visa IPO and sales of shares in MasterCard of £291m
— Gross credit market losses and impairment of £8,053m
— Gains on own credit of £1,663m
Group Performance
Barclays delivered profit before tax of £6,077m in 2008, a decline of 14% on 2007. The results included the
following significant items:
Gains on acquisition of £2,406m, including £2,262m gain on acquisition of Lehman Brothers North
American business
Profit on disposal of Barclays Closed UK Life assurance business of £326m
Gains on Visa IPO and sales of shares in MasterCard of £291m, distributed widely across the Group
Gross credit market losses and impairment of £8,053m, or £4,957m net of related income and hedges of
£1,433m and gains on own credit of £1,663m.
Required
1.
2.
Was Barclays “solidly profitable”? Why or why not?
What does the item “Gains on own credit” mean? Do you think it should be included in profit? Why or
why not?
3.
One commentator said: “That is insane. These ‘profits’ do not exist.” Do you agree?
Financial Analysis
Study the disclosures of post-employment benefits, such as pensions and health care,
appearing in the financial statements of a sample of companies. You will find them in
schedules, statement of accounting policies, and notes.
Required
1. Prepare a comparative summary of the assumptions on discount rates,
expected return on plan assets and salary increase. Why do these
assumptions differ for your sample companies?
2. Prepare a sensitivity analysis of changes in these assumptions. What do you
learn from this analysis?
3. Explain how this study is useful in analyzing and interpreting financial
statements.
Study the income tax expense (current and deferred) in the statement of profit and loss
and the items appearing in the schedule of deferred tax assets and deferred tax liabilities
in the balance sheet of a sample of companies.
Required
1.
Prepare a list of items for which companies recognize deferred tax assets and deferred tax liabilities.
Explain why each of the items in your list qualifies for deferred tax accounting.
2.
Analyze the composition of income tax expense in the statement of profit and loss. Calculate current
tax, deferred tax liability, and deferred tax asset for each of the items.
3.
Explain how this study is useful in analyzing and interpreting financial statements.
Answers to Test Your Understanding
9.3 We allocate the issue costs between the liability and the equity components in proportion to the allocation
of the proceeds. The net proceeds will be as follows:
9.4
9.5
9.6 1. `3,000; 2. Nil; 3. `30,000; 4. `9,000; 5. `700.
9.7
9.8
9.9 1. Carrying amount, `8,000; Tax base, `7,000; Taxable temporary difference, `1,000; Deferred tax liability,
`300.
2. Carrying amount, `100; Tax base, nil; Taxable temporary difference, `100; Deferred tax liability, `30.
3. Carrying amount, `2,000; Tax base, `2,000; Temporary difference, nil.
4. Carrying amount, `300; Tax base, `300; Taxable temporary difference, nil;
5. Carrying amount, `500; Tax base, `500; Temporary difference, nil.
6. Carrying amount, `20,000; Tax base, nil; Deductible temporary difference, `20,000; Deferred tax asset,
`6,000.
7. Carrying amount, `200; Tax base, nil; Deductible temporary difference, `200; Deferred tax asset, `60.
8. Carrying amount, `4,000; Tax base, `4,000; Temporary difference, nil.
9. Carrying amount, `600; Tax base, `600; Deductible temporary difference, nil.
10. Carrying amount, `1,000; Tax base, `1,000; Temporary difference, nil.
9.10
1 IAS 37:10/Ind AS 37:10/AS 29:10.2.
2 IAS 1.69/Ind AS 1:69 and Schedule III to the Companies Act 2013.
3 IAS 37:10/Ind AS 37:10.
4 A waggish definition of warranty period: the period soon after which a product is certain to fail.
5 IAS 37:10/Ind AS 37:10/AS 29:10.4.
6 IAS 32:28/Ind AS 32:28.
7 IAS 32:AG32/Ind AS 32:AG 32.
8 The Companies Act 2013/Companies Act 1956 requires transfer of an amount equal to the amount of deposit
from Retained Earnings to Debenture Redemption Reserve. At the time of repayment of the debentures, the
balance in Debenture Redemption Reserve is transferred back to Retained Earnings.
9 IAS 17:4/Ind AS 17:4/AS 19:3.1.1.
10 IAS 17:4/Ind AS 17:4/AS 19:3.2.
11 IASB Exposure Draft Leases May 2013
12 IAS 19:7/Ind AS 19:7/AS 16:7.1.
13 Assurance of a minimum interest rate on the balance in the provident fund account could make it a defined
benefit plan.
14 It is also known as taxable income (tax loss). For convenience, we will use taxable profit.
15 IAS 12:5/Ind AS 12:5.
16 IAS 12:5/Ind AS 12:5.
17 In India, taxation is based on standalone financial statements.
18 This is a contra asset and is treated similar to Case D (any other liability) in Exhibit 9.7.
19 IAS 39:18(a)/Ind AS 39:18(a)/AS 30:17(a).
20 IAS 39:20(b)/Ind AS 39:20(b)/AS 30:19(b).
21 This case is based on newspaper reports and draws substantially on the report of Anton R. Valukas,
Examiner.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Describe the features of a corporate organization.
Explain the components of capital stock.
Record issue of share capital.
Describe the features of preference shares.
Describe the different kinds of reserves.
Explain buy-back of shares and treasury operations and how to account for them.
Account for issue of bonus shares.
Account for payment of dividends.
Explain the need for share-based payment and account for it.
Explain the statement of changes in equity.
Compute earnings per share.
AFFLUENT PROMOTERS AND SICK COMPANIES
Can a company promoter be affluent while his company is sick? When a company is performing
badly, sometimes the person who controls the company is seen flaunting his wealth and living
an opulent life. The shareholders are not getting any dividends, the stock price is plummeting,
the company is not paying back its depositors, and the banks have to write off their loans or
take significant “haircuts”. Understandably, the company’s shareholders, depositors, and
bankers resent the promoter’s uncaring conduct in such circumstances. Legally, they can do
nothing about it, because the company is a separate legal entity and its shareholders have
limited liability: the idea that the shareholders are not bound to pay for the company’s debts
beyond their agreed contribution. Limited liability applies to its company’s promoters as much
as to its other shareholders. However, limited liability cannot be a legal defence in cases of
fraud, tax evasion, misuse of company resources, and criminal activities. Further, the promoter
will be personally liable if he has given personal guarantees for loans taken by the company. Of
course, there could be a moral argument for the promoter to suffer, despite limited liability,
when his company is not doing well. While the debate is on, the promoter is probably busy
watching IPL matches and attending parties.
THE CHAPTER IN A NUTSHELL
In this chapter, you will learn about shareholders’ equity – the item that represents the
interests of a company’s shareholders. Shareholders’ equity equals the excess of a company’s
assets over its liabilities and consists of share capital and reserves. You will see the various
types of share capital and reserves. You will learn how to account for issue and buy-back of
share capital and for issue of bonus shares. You will be able to compute earnings per share, an
important summary measure of a company’s financial performance for investors. You will also
learn about accounting for stock options, an important mechanism for motivating and rewarding
employees.
The Corporate Organization
A corporation is an artificial legal person and is created by a
charter. It comprises many members. The word ‘corporation’ is
derived from the Latin word corpus, meaning ‘body’. It refers to a
body of people that acts on behalf of all them. Corporations, in the
sense of shareholders forming a private business enterprise for
profit, existed in the Mauryan empire in ancient India.1
Corporations come into existence in different ways:
1. A chartered corporation is constituted by a royal charter issued by a king
or queen.
Example: The British East India Company was chartered by Queen
Elizabeth I of England in 1600.
2. A statutory corporation is established by an Act of Parliament or a state
legislature.
Example: The Reserve Bank of India was set up under the Reserve Bank of
India Act 1934.
3. A company is a typical corporate business organization. In India companies
are registered under the Companies Act 2013 or the earlier Companies Acts.
Examples: Tata Motors Limited, Wipro Limited, and Bharat Heavy
Electricals Limited.
The Companies Act is a comprehensive code covering formation, management,
and liquidation of companies. A company is registered by filing the memorandum of
association and the articles of association with the Registrar of Companies. You
may revisit Exhibit 1.2 for a comparison of the common forms of business
organization. We will now see the key features of a corporate organization.
Separate legal existence A company is a separate legal entity distinct from its
members. It has most of the rights and obligations of a natural person. It can buy,
sell or own assets, borrow money, and employ people; it is liable to pay taxes; it can
even be declared bankrupt. Since a company has a distinct legal entity, it can have
several contractual relationships with its members. For example, a company’s
shareholder can also be its employee, customer, supplier or lender. Companies do
not have certain rights that only natural persons can have; for example, they cannot
vote at, or contest, elections.
Limited liability of shareholders Since a company is a separate legal entity, it is
obliged to pay its debts from its assets. The liability of the members is limited to the
amount they have agreed to invest in the company, less any amount already
invested by them. If the shareholders have paid the entire amount agreed to by
them, they cannot be asked to make good any shortfall in the company’s assets. In
contrast, a proprietor’s or the partners’ personal assets (such as home, vehicle, and
jewellery) can be taken to pay off the creditors of the business. Limited liability
enables individuals to participate in risky ventures by limiting their risk to
predetermined amounts.
Free transferability of ownership rights The ownership rights of a company,
called shares, can be freely transferred by one shareholder to another. Transfer of
shares does not affect the company’s business operations. Free transferability of
shares, coupled with the existence of an active stock market, enables individuals
and financial institutions to buy and sell the shares at will and makes it easy for the
company to raise capital. Private companies restrict share transfers.
Perpetual existence A company continues to exist until it is dissolved by a legal
process. The death or incapacity of any or even all of its members does not affect the
continued existence of the company.
Common seal A company’s actions are authenticated by affixing its common seal to
a document. It is made of metal and embossed on important documents, such as
share certificates and contracts.
Professional management A company’s shareholders elect a board of directors,
but do not take part in its day-to-day activities. The board appoints a chief executive
and other officers to manage the business. The separation of ownership from
management enables the company to entrust the business to individuals who have
the necessary qualifications and experience.
Government regulation The privilege of limited liability has its costs. Companies
are subject to detailed regulation by the government and regulatory agencies. They
must file the financial statements and numerous reports and documents.
A company may be a public company or a private company. A public company is
one in which anyone may hold shares. There must be at least seven members to
incorporate a public company, but there is no upper limit on the number. A public
company must have at least three directors. It can raise capital from the public. A
listed company is a public company whose shares are listed with a stock exchange
where the shares may be bought and sold. The National Stock Exchange (NSE) and
the Bombay Stock Exchange (BSE) are the most important stock exchanges in
India. A private company needs at least two members and it cannot have more
than 200 members. A member of a private company can transfer his shares subject
to the company’s restrictions. A private company cannot invite capital from the
public. A private company must have at least two directors. The Companies Act
2013 has introduced one-person company, a private company with limited liability
formed by a single individual.
Share Capital
The shareholders’ equity of a company consists of two parts:
Share capital
Reserves and surplus.
In this section, you will learn about share capital. Share capital represents the
initial as well as later issues of capital by a company. Exhibit 10.1 illustrates the
presentation of share capital using the 2013 annual report of Tata Steel Limited.
We will now consider some of the terms related to share capital.
Capital stock The capital stock of a company is divided into a number of units,
called shares of stock or, simply, shares. Each share has a distinctive number.
The ownership of shares in a company is evidenced by a share certificate that
indicates the kind and number of shares as well as their distinctive serial numbers.
The share certificate is signed by the company secretary and bears the company’s
common seal. Initially, the certificate is sent to the individual who applied for the
shares. When a shareholder transfers shares, she must complete a share transfer
form and send along with it the share certificate to the company for recording the
change in share ownership. Large companies which may have thousands of
shareholders appoint registrars and transfer agents to handle the numerous
ownership changes in their shares. Many companies keep their shares in electronic
form, known as dematerialized or demat shares, to avoid the paperwork associated
with share transfers.
A company may be authorized to issue either only equity share capital or both
equity share capital and preference share capital. Equity share capital represents
the residual equity in the company since equity shareholders can be paid only
after all other claims have been paid. As the real owners of the company, equity
shareholders appoint the company’s directors and declare dividends. Preference
shareholders enjoy certain privileges over equity shareholders. You may have
noticed that Tata Steel has issued only equity shares (also known as ordinary
shares).
Authorized capital The Memorandum of Association specifies the maximum
number of shares of stock that may be issued by a company and the par value of
each share. This is the authorized capital. Generally, a company obtains
authorization for more shares than it plans to issue initially, so that it can issue
additional shares later. A company can increase its authorized capital with its
shareholders’ approval. Tata Steel’s authorized capital has 2,050 million equity
shares and 625 million preference shares.
Issued, subscribed, and paid-up capital Issued capital is the number of shares
issued by a company. Subscribed capital is the number of shares taken up by the
public. Paid-up capital is the amount of share capital that has been received by
the company. For example, a company may have an authorized capital of 100,000
equity shares of `10 each. Of these, it may have issued 40,000 shares and the public
may have taken up 25,000 shares. If the company has called up and received `6 on
each share, its paid-up capital will be `150,000 (25,000 shares × `6 per share). Tata
Steel has issued 972,126,020 equity shares, of which 971,215,229 have been fully
subscribed and paid up. It has not issued any preference shares.
Par value It represents the minimum amount that a shareholder must pay on each
share. The par value (or face value) of a company’s stock constitutes the company’s
legal minimum capital. Each shareholder can be compelled to pay the par value of
the shares held by him. Tata Steel’s equity shares have a par value of `10.
Companies are prohibited from returning any part of the minimum capital except
by following a special procedure. This is intended to protect the company’s creditors
from the possibility of the shareholders withdrawing assets from the company and
leaving behind a virtual shell.
Accounting for Share Capital
A company may issue capital stock with or without a par value.
Par value stock specifies an amount that must be recorded as
share capital. Any amount received in excess of par value is
securities premium or share premium, which is part of shareholders’ equity.
No-par stock is capital stock that does not have a par value. In the latter case, a
company may assign a stated value which becomes its legal capital. If there is no
stated value, the entire proceeds are taken as share capital. Indian law does not
permit issue of no-par stock. A company may issue share capital for cash or other
assets or for services. The procedure for recording issue of share capital is identical
for equity shares and preference shares.
Issue of share capital with par value When a company issues shares for cash, it
credits the par value to Share Capital and the rest of the proceeds to Securities
Premium. For example, assume that Deepak Company issues 1,000 equity shares of
`10 per equity shares at `15 (including premium `5) requiring full payment. The
following entry records this transaction:
Issue of share capital at a discount, i.e. at less than par, is rare. The company
should debit the discount to the Discount on Issue of Share Capital account. If
Deepak Company issues its shares at `9.50 per share, the entry would be as follows:
The principle is that financial instruments are measurement at fair value. Since
the discount is not an asset, it is deducted from the amount of reserves and surplus.
Shares cannot be normally issued at a discount.
Issue of share capital without par value When a company issues no-par stock,
it credits the entire proceeds from the issue to the Share Capital account. For
example, assume that Deepak Company issued 1,000 shares of no-par value at `15
per share. The following entry records this transaction:
The law may require a company to designate a part of the proceeds as “stated
value” which cannot be withdrawn. Assume that the no-par stock in the above
example has a stated value of `7. In this case, it will record the above transaction as
follows:
To record issue of no-par value equity shares at a stated value
Issue of share capital for non-cash assets and services A company may issue
share capital in exchange for non-cash assets such as land, buildings, and plant, or
for services. It should record the exchange at the fair value of the assets or services
received if their fair value can be estimated reliably. If not, the assets or services
should be recorded by reference to the fair value of the shares issued.2
To illustrate, assume that Deepak Company’s lawyers agree to accept 500 shares
of `10 par value for preparation of legal documents and other services rendered in
connection with formation of the company. The fair value of the services is `8,000.
The following entry records this transaction:
Preliminary expenses are recognized as expenses as incurred.3
If the fair value of the goods or services cannot be estimated reliably and if
Deepak Company’s shares are listed, the market price of the shares may be used.
Suppose that the company issues 10,000 equity shares of `10 each to acquire a piece
of land but the fair value of the land is not evident. If the company’s shares trade at
`18, we record the exchange as follows:
Sweat equity refers to equity shares issued by a company to its directors or
employees for providing intangible assets such as know-how. The accounting for
issuing such shares is similar to the above. Sweat equity can be issued at a
discount.
Rights issue of share capital When a company intends to make additional issue
of share capital, the law gives the company’s existing shareholders the preemptive
right to subscribe to the new shares. This right enables them to maintain their
proportion of the company’s share capital. The offer of shares to the existing
shareholders of a company in pursuance of the right of preemption is known as a
rights issue, or “rights”. Generally, the price of rights is lower than the current
market price of the shares. An existing shareholder who receives a rights offer may
(a) take up all the shares offered to him, (b) take up less than the number of shares
offered to him, (c) renounce his rights in favour of another person (who need not be
a current shareholder of the company), or (d) ignore the rights offer. The procedure
for recording proceeds from rights issues is the same as that for the first issue of
share capital.
Receipt of Share Capital in Instalments
Companies generally receive share capital in several instalments in order to match
the cash receipts with their requirements as well as to minimize the pressure on the
investors to find the cash. Typically, the terms of the offer specify the part of the
issue price payable with the share application and require the balance to be paid on
allotment and on calls by the board of directors for further payment. Application
money is refunded for rejected applications.
To illustrate, assume that Deepak Company issued 10,000 shares of `10 each at
par payable as follows: `3 with application, `2 on allotment, and the balance when
called. On April 3, the company received applications for 15,000 shares. On May 20,
the company’s board allotted 10,000 shares and refunded the application money for
the remaining shares. The amounts payable on allotment were received on June 25.
On August 7, the board made the first call for `3 per share and the amounts were
received on September 16. The second and final call was made on November 22 and
the amounts were received on December 29. Entries to record these transactions are
as follows:
Forfeiture of Shares
Sometimes, a shareholder is unable to pay the amounts due on allotment or any of
the calls. In that event, the board of directors can take back the shares and retain
the amount paid on the shares and the shareholder forfeits his shares. These are
called forfeited shares. The company debits the total amount due on allotment or
calls on the forfeited shares to Share Capital and credits Share Allotment or Share
Call. The amount already paid goes to Shares Forfeited. Assume that, in the above
example, Deepak Company did not receive the amount of second call on 100 shares
until December 29 and the shares were forfeited on January 17. The following entry
records the forfeiture:
The balance in Shares Forfeited is regarded as a part of the company’s share
capital. It is not available for distribution to shareholders. From Exhibit 10.1, Tata
Steel has 389,516 forfeited shares.
Preference Share Capital
Companies can issue two classes of share capital: (a) equity, and
(b) preference. Preference shareholders enjoy preference over
equity shareholders in two aspects:
Payment of periodic dividends
Distribution of assets on liquidation of the company.
Preference shares usually carry a fixed rate of dividend which is payable when the
company has earned adequate profits and when the dividend is declared in the
company’s annual general meeting. Preference shareholders get the dividend before
equity shareholders. On liquidation, they are paid after paying the creditors but
before the equity shareholders. There are many types of preference shares
depending on the rights attached to them. We now discuss some of them.
Cumulative and non-cumulative preference shares The holders of cumulative
preference shares receive dividends for one or more year(s) in which no dividend
was paid. The preference dividends not declared in a period are called dividends in
arrears. To illustrate, assume that Pratibha Company has 10,000 of 10 per cent,
`10 par value cumulative preference shares. The annual dividend is `10,000. If
dividends are in arrears for three years, preference shareholders are entitled to
receive a total dividend of `40,000 at the end of Year 4 before any payment is made
to equity shareholders, as shown below:
Dividends in arrears are not a liability, because no obligation exists until the
dividend is declared by the company. However, the amount of the arrears must be
disclosed in the notes to the financial statements. Arrears of past dividends are not
payable in non-cumulative preference shares.
Participating and non-participating preference shares Participating
preference shares carry the right to share in the profits of the company after the
equity shareholders are paid a certain rate of dividend. These shares can also carry
the right to share in the assets of the company over and above their face value. The
holders of non-participating preference shares can only receive the fixed dividend
and cannot share in the surplus left after paying equity dividend.
To illustrate, assume that Khalid Company has `100,000 of 12 per cent par value
participating preference shares and `1,000,000 of par value equity shares. It must
pay `12,000 of preference dividends (`100,000  12%) and `120,000 of equity
dividends (`1,000,000  12%) before the participating right takes effect. Additional
dividends are distributed between the preference and the equity shareholders on
the basis of their respective par values. The total share capital is `1,100,000
(`100,000 + `1,000,000). The ratio of distribution is 1/11 (`100,000/`1,100,000) for
preference shareholders and 10/11 (`1,000,000/`1,100,000) for equity shareholders.
If the company pays `110,000 of additional dividends, preference shareholders will
receive `10,000 (1/11 of `110,000) and equity shareholders will receive `100,000
(10/11 of `110,000).
Redeemable and non-redeemable preference shares Redeemable preference
shares are repayable after the period of holding stated in the share certificate.
There may be a redemption premium. Non-redeemable preference shares cannot be
repaid except at the time of liquidation. In India, companies cannot issue nonredeemable preference shares or preference shares redeemable after eight years
from the date of issue.
Assume that a `10 par value preference share is redeemable with a premium of `2
per share. On redemption, a preference shareholder will receive the following: (a)
the par value of the share; (b) the redemption premium; (c) any dividends in arrears
if the shares are cumulative; and (d) the proportionate dividend for the current
year. The redemption feature is useful to the issuing company because it can pay
back the preference share capital when it has surplus cash or it can substitute the
preference capital by debt with a lower interest rate. The law requires a company to
transfer an amount equal to the par value of the preference share capital redeemed
to capital redemption reserve except when the redemption is made out of the
proceeds of a fresh issue of share capital. The balance in capital redemption reserve
is, for the most part, similar to share capital.
Convertible and non-convertible preference shares Convertible preference
shares can be converted into equity at a predetermined ratio. Non-convertible
preference shares always remain preference shares. Suppose that Parag Company
issued `200,000 of 10 per cent, `10 par value preference shares with two preference
shares convertible into one equity share of `10 five years later. At the end of five
years, the company’s 20,000 preference shares will stand converted into 10,000
equity shares of `10 par value and the balance of `100,000 becomes securities
premium.
Reserves and Surplus
Reserves are the other component of the shareholders’ equity of a
company. In the balance sheet, reserves appear under the grouping
Reserves and Surplus which comprises retained earnings as well
as non-earnings items. There are several kinds of reserves:
A capital reserve is not available for distribution to shareholders as
dividends:
Examples: Securities premium capital redemption reserve.
Revenue reserves, or free reserves, arise from the business operations of a
company and are available for payment of dividends.
Examples: Statement of profit and loss (i.e. retained earnings); general
reserve.
Statutory reserves are set up to comply with the requirements of a law
such as the Income Tax Act in order to avail of certain tax benefits. They are
not available for distribution to shareholders during the period specified in
the law.
Examples: Investment allowance reserve; export profit reserve.
Realized reserves arise from receiving cash or other assets received in an
exchange transaction.
Example: Profit on sale of equipment.
Unrealized reserves are the result of accounting entries without any
underlying exchange transaction.
Example: Revaluation reserve.
We will now discuss some of the reserves.
Securities Premium Securities premium, similar to share capital, cannot be
returned to the shareholders. However, Section 52 of the Companies Act 2013
provides that the balance in the securities premium account can be utilized for the
following purposes:
1. Issuing fully paid bonus shares.
2. Writing off the preliminary expenses of the company.
3. Writing off the expenses of, or commission paid or discount allowed on, an
issue of shares or debentures of the company.
4. Providing for the premium payable on the redemption of redeemable
preference shares or debentures of the company.
Capital redemption reserve The amount required for redemption of redeemable
preference shares must come out of the proceeds of a fresh issue of shares.
Otherwise, the company must transfer an amount equal to the par value of the
shares redeemed to the capital redemption reserve account. Also, when a company
buys back its own equity shares, it must transfer an amount equal to the nominal
value of the shares to capital redemption reserve. It is similar to share capital in
that the amount cannot be returned to the shareholders. However, the company can
issue fully paid bonus shares out of the capital redemption reserve.
Debenture redemption reserve The debenture trust deed may require the
company to transfer an amount equal to the annual sinking fund deposit to
debenture redemption reserve from retained earnings. A transfer may be required
even when there is no sinking fund. The purpose of the transfer is to prevent the
company from distributing the amount as dividends so that the company’s assets
are not reduced to the detriment of its creditors. The balance in debenture
redemption reserve is transferred to retained earnings at the time of repayment of
the debentures and is not available for issue of bonus shares until the debentures
are repaid.
Investment allowance reserve The Income Tax Act has a special allowance,
known as investment allowance, for investment in plant and machinery. A condition
for the allowance is that the company must transfer a specified percentage of the
amount of the allowance to an investment allowance reserve. The balance in the
account is not available for dividends or bonus shares for eight years from the year
of investment. Besides, the company must satisfy many other conditions.
Appropriations
Many companies transfer amounts from the statement of profit and loss to various
reserves, such as general reserve, contingency reserve, dividend equalization
reserve, and development reserve. This process is known as appropriation. Note
that this process does not affect dividend distribution since a company can pay
dividends out of its current or past profits regardless of how it is designated. For
this reason, companies in many countries do not make appropriations of profits;
instead, they keep the balance in the retained earnings account. It may be noted
that transfers to certain reserves such as investment allowance reserve and export
profit reserve are required by law. As already stated, such reserves are not
distributable. Appropriations and dividends appear in the statement of retained
earnings, and are known as ‘below the line’ items.
Accumulated other comprehensive income As you learnt in Chapter 8, gains
and losses resulting from measuring available-for-sale securities at fair value are
taken to other comprehensive income, a component of equity, rather than
routed through the statement of profit and loss. Translation gains and losses
resulting from foreign operations and gains and losses on cash flow hedges are also
examples of other comprehensive income items. Accumulated other comprehensive
income is cumulative other comprehensive income.
Buy-back of Shares and Treasury Stock
In many countries, companies are allowed to reacquire their own
shares. Here are some common reasons why companies may
reacquire their shares:
1. A company has surplus cash, but does not have any plans for
capital expenditure or acquisitions. So it wants to return a part of the cash
to its shareholders.
2. The managers worry about a hostile takeover. By buying back their shares,
they reduce the number of shares available to the hostile bidder in the
market and thus hope to thwart the takeover.
3. The managers believe that the company’s stock is undervalued and want to
signal their belief that the stock is worth more.
4. The managers believe that the company is overcapitalized and it is difficult
to service the large share capital base by paying high dividends. So they
want to reduce the share capital.
Reacquiring own shares may be by means of a buy-back or treasury stock
operations.
Buy-back of Share Capital
Buy-back reduces the number of shares and the paid-up capital. The Companies Act
2013 permits a company to buy-back its own shares for cancellation. Section 68 of
the Act lays down the following main conditions:
1. A company can buy-back its shares to the extent of its free reserves and
securities premium or out of the proceeds of a fresh issue of shares, or other
specified securities.
2. Buy-back shall not be less than 10 per cent or more than 25 per cent of the
company’s paid-up capital and free reserves.
3. Buy-back should be authorized by the company’s Articles of Association and
a resolution of the shareholders.
4. The excess of the buy-back price over the paid-up capital is debited to free
reserves.4
For example, suppose that Samir Company has 10,000 shares of `10 each and a
balance of `50,000 in the Securities Premium account. The company decides to buy
back 200 shares at `25. The entry to pay the shareholders is as follows:
The Companies Act requires transfer to the capital redemption reserve account of
a sum equal to the paid-up capital of the shares bought back. The following entry is
records this transfer:
Treasury Stock Operations
Treasury stock is a company’s own share capital that was issued and reacquired
by the company as investment. As the term suggests, treasury stock operation is
part of a company’s cash management activities. Treasury stock is often a
temporary investment until the company identifies long-term investment
opportunities. It may be either preference shares or equity shares and may be held
for any period of time, reissued or retired. Dividends are not paid on treasury stock
and these shares do not carry voting rights in the meetings of shareholders.
Treasury stock is not considered as part of shares outstanding and is, therefore,
excluded for calculation of earnings per share. Currently, treasury stock is not
allowed in India.
Purchase When a company purchases its own shares, it reduces both the assets
and the shareholders’ equity by equal amounts. To illustrate, assume that Shweta
Company purchases 1,000 of its fully paid shares at `22 per share. The transaction
is recorded as follows:
The cost of the treasury stock appears in the shareholders’ equity section as a
deduction. Note that the purchase does not change the amount of issued share
capital. However, it reduces the amount of outstanding share capital representing
the number available for trading.
Reissue Treasury stock may be reissued at, above, or below cost. If reissued at cost,
the entry to record the transaction is the reverse of the entry to record the purchase.
If the treasury stock is sold at “above cost”, the amount received in excess of cost
goes to the Securities Premium, Treasury Stock account. For example, if Shweta
Company sells 500 of the treasury shares purchased at `22 per share for `25 per
share, the transaction would be recorded as follows:
When treasury stock is reissued at below cost, the excess of cost over the sale
price is debited to Securities Premium, Treasury Stock to the extent of the balance
available. Any remaining excess is debited to Retained Earnings. For example, if
Shweta Company sells its remaining shares of treasury stock at `15 per share, the
entry to record the sale is as follows:
Retirement A company may acquire its own shares to retire the share capital
rather than holding it as treasury stock. When shares are retired, the shareholders’
equity amounts related to the retired shares are removed from the accounts. If the
purchase price of the treasury stock is more than the original issue price, the
difference is debited to Retained Earnings. If the purchase price is less than the
original issue price, the difference is credited to Securities Premium, Treasury
Stock. For example, assume that Shweta Company decides to cancel the treasury
stock purchased for `22,000. Assuming that the `10 equity shares were originally
issued at a premium of `4 each, the entry to record the retirement is as follows:
If the company had paid `12 per share for the treasury stock, the entry would be
as follows:
Bonus Shares
Bonus shares are additional shares of a company’s share capital
distributed to its shareholders without their having to pay for
them. The board of directors proposes the terms of distribution of
bonus shares to the company’s shareholders, who finally approve the distribution.
The issue of bonus shares does not affect the company’s assets or total shareholders’
equity. Its effect is a transfer of retained earnings or other items in reserves and
surplus to share capital. For this reason, the issue of bonus shares is also known as
capitalization of reserves. Companies issue bonus shares for various reasons
including the following:
1. Profitable companies that are engaged in a major capital expenditure
programme prefer to issue bonus shares rather than pay current dividends
to avoid strain on their cash.
2. Companies issue bonus shares in order to reduce the market price per share
by increasing the number of shares in circulation.
3. Directors use bonus issues to signal to the shareholders their confidence in
the company’s prospects. In theory, a bonus issue should not have any effect
on a company’s stock price. However, evidence suggests that it is not always
so in practice, indicating the signalling effect of bonus issue.
Bonus shares can be issued out of retained earnings or other reserves permitted
by the company law. The credit balances in the following accounts, among others,
can be capitalized:
Statement of profit and loss (i.e. retained earnings);
General reserve;
Securities premium; and
Capital redemption reserve.
The balances in revaluation reserve and other similar accounts that do not
represent a realized increase in the company’s assets are not available for bonus
issues.
To illustrate the accounting procedure for a bonus issue, assume that Xavier
Company has the following shareholders’ equity on March 31:
Assume further that the board of directors declares a 50 per cent bonus issue
(meaning one bonus share for two existing shares) on August 10, distributable on
September 30 to shareholders in the company’s record on September 15. The bonus
shares are to be issued by capitalizing the entire amount in the Securities Premium
account, and the Retained Earnings account for the balance amount required. The
entry to record the transaction is as follows:
After the bonus issue, the company has 15,000 equity shares.
A stock split, similar to a bonus issue, results in an increase in the number of
shares available in the market and does not affect the total shareholders’ equity.
However, after a stock split, the par value of the share is reduced and the reserves
remain unchanged. If Xavier Company makes a stock split of two for one, it will
have 20,000 shares of `5 par value after the split. The stock split will not have any
effect on any of the reserves. Both bonus shares and stock splits are applicable to all
shares including treasury stock.
Dividends
A dividend is a distribution of cash to shareholders. A company’s
board of directors recommends payment of dividend and the
shareholders approve the payment by a declaration at the
company’s annual general meeting. This is also known as the final
dividend. The board can declare interim dividends during the year. The amount
of dividend cannot ordinarily exceed the total of the current and past profits of the
company. Any dividend in excess of profit is a return of the legal minimum capital
and is prohibited except in special circumstances such as liquidation or capital
reduction.
In addition to profits, the company must have sufficient cash or other liquid
assets, so that the dividend outgo does not affect its normal operations. Tax
considerations may also be important. For example, dividend payment would entail
payment of dividend distribution tax. Dividends are stated in terms of either
percentage of paid-up capital or rupees per share. For instance, a company may
declare a dividend of 25 per cent or `2.50 per share, and a shareholder owning 100
fully paid shares of `10 each will receive a dividend of `250. Dividends are paid by
means of a special cheque known as dividend warrant or by bank transfer.
Dividends cannot be paid in kind.
The shares of a listed company are traded in the market. After declaring a
dividend, the company fixes a date known as the date of record for the purpose of
determining the right of shareholders to receive the dividend. On this date, the
company will temporarily stop recording share transfers in order to prepare the list
of shareholders eligible for dividend. Dividends will be paid to those who hold the
shares on the date of record. All purchases of shares up to this date are cumdividend, i.e. the buyer will receive the dividend. After this date, the purchases are
ex-dividend i.e. the seller will receive the dividend.
To sum up, the following four steps are important in connection with dividends:
Share-based Payment
A share-based payment arrangement is an agreement under
which an employee receives shares or stock options or the
employer incurs a liability to the employee in amounts based on
the price of the employer’s stock. Share-based payment is often an
important part of the total compensation and is common in technology and banking
firms. In many investment banks, compensation in stock is a significant part of the
total compensation. Stock issued to employees can dilute the value of the holdings of
investors. Share-based payment arrangements are also used to pay for goods and
services. You have already seen in this chapter how to record share capital issued
for professional services received. Now you can have a look at employee
compensation in the form of stock options. A stock option plan gives employees
the right to acquire shares in the future. Stock options became popular in the 1990s
with start-up technology companies choosing to compensate their employees in the
form of options, rather than pay large cash salaries.
To begin with, let us briefly review the case for stock options. As you know, a
company is owned by its shareholders, but managed by the chief executive and
other officers under the supervision of the board of directors. This separation of
ownership and management is the essence of the corporate form of business. In
theory, this arrangement is beneficial to the shareholders, since the company is run
by professional managers who understand the complexities of the business better.
A major drawback of the corporate form is the agency problem, i.e. managers may
not act in the interests of shareholders. For example, most managers may not feel
any need to improve the company’s performance, if they do not get to participate in
the benefits of better performance. A manager who holds stock options has the right
to buy a company’s shares in the future at a fixed price even if the price goes up.
Generally, stock price is positively related to company performance. So a manager
who holds stock options has more incentive to strive for better performance.
Therefore, stock options are thought to be useful in aligning managerial behaviour
with shareholders’ interests.
Several types of stock option plans are in vogue. An employer selects a plan based
on several considerations such as the plan’s effect on employee motivation, tax, and
industry practices. The plan that is best for a steel company may not be suitable for
a software company. Share-based payment plans, including stock option plans, are
thought of as a means of compensating, attracting, motivating, and retaining good
employees. Fast-growing, knowledge-based start-up companies that normally do not
pay large salaries find them particularly useful. Most stock option plans require
employees to put in a minimum service period to be eligible for the options and
specify a period thereafter within which the options must be exercised; otherwise
the options will lapse. Exhibit 10.2 presents the definitions of key terms in stock
options.
The fair value method measures the cost of share-based payment at the fair
value of the stock options on the grant date.5 This value is determined using an
option-pricing model that considers factors such as current price of the stock,
exercise price, expected life of the option, risk-free interest rate, expected volatility,
and expected dividend yield. The Black-Scholes model and the binomial model
are among the most widely used methods for pricing options. The intrinsic value
method, which most Indian companies follow, calculates the compensation element
as the excess of the fair value (usually the market price) at the grant date over the
exercise price of the share. Thus, if the exercise price equals the market price at the
grant date, there is no compensation element. In both the methods, the cost is
expensed over the vesting period, the minimum service period required to be able to
exercise the options.
To illustrate, let us assume that on January 1, 20X4 Abhay Company grants its
managers 1,000 stock options. Each option entitles the holder to buy one share of
`10 par value at `100, the market price on the grant date. The options will vest on
January 1, 20X8 and may be exercised until December 31 that year. On the basis of
an option-pricing model, the options have a fair value of `55 each on the grant date.
The company follows the calendar year. The following discussion illustrates how to
apply the fair value and the intrinsic value methods.
Recognizing compensation expense Under the fair value method, compensation
cost equals the fair value of the stock option at the grant date. In our example, the
fair value of the options is `55,000 [i.e. 1,000  `55]. The intrinsic value of the
options is zero, because the market price equals the exercise price. Compensation
expense is recognized on a straight-line basis over the vesting period of four years.
The yearly compensation expense is `13,750 [i.e. `55,000/4 years] under the fair
value method. From 20X4 to 20X7, the company records the following entry to
recognize the compensation expense for the year:
Outstanding Stock Options is a part of shareholders’ equity.
Exercise of the options Let us assume that 900 options are exercised on
November 1, 20X8. The company receives the exercise price of `100 and removes the
outstanding stock option of `55:
Expiry of the options Suppose that the remaining options are not exercised and
hence they lapse. Abhay Company should not make subsequent adjustment to total
equity. Therefore, the entity should not subsequently reverse the amount recognized
for services received from the employees.6
Which method? Many believe that the intrinsic value method does not reflect the
cost of compensation which is a cost of doing business just as salaries and materials
costs are. Companies mostly issue stock options “at the money”, i.e. they set the
exercise price of the shares under option equal to their market price on the grant
date, as in our example. If the stock price increases, the options will move “into the
money” and the employees holding stock options will benefit. Companies believe
that this motivates employees to perform better. The employees exercise the
options, if the stock is “in the money” at exercise date, that is, if the market price is
greater than the exercise price. Since at the time of grant there is no compensatory
element, the intrinsic value method does not recognize any expense for such options
although these may have a value. The fact remains that, when options are in the
money, the shareholders lose and the employees gain, similar to what happens
when a company pays salaries. Think of a firm that pays all its expenses including
salaries by means of stock options. The firm’s revenue will equal its profit. This is
irrational. To see why, compare this firm with another firm that has the same
amount of revenue and assets, but pays all its expenses with cash. The latter will
report lower earnings. The intrinsic value method confuses a firm’s operating
activities (payment of salaries) with financing activities (selling options) and nets
out the effect of the two. Both FASB and the IASB mandate the fair value method.7
Statement of Changes in Equity
The statement of changes in equity explains the changes in a
company’s share capital and reserves and surplus. The statement
of changes in equity presents the following information:
Number of shares and amount of share capital for each type or class of shares
such as preference, equity, Class A, and Class B;
Securities premium;
Reserves such as capital reserve, capital redemption reserve, and general
reserve;
Accumulated other comprehensive income; and
Retained earnings.
The purpose of the statement of changes in equity is to present in one place the
changes in the various items that make up the shareholders’ equity. Changes in
equity usually result from the following:
1. Owner changes:
These result from a company’s transactions with its shareholders and can be
of the following types.
(a) Exchanges and transfers: Share issues may be for cash or non-cash
consideration or on conversion of a liability into equity. Share buy-back and
dividends require cash payment.
(b) Issue of bonus shares: A bonus issue does not involve cash or other assets
changing hands. It involves changes in the composition of equity.
2. Non-owner changes:
These result from a company’s transactions with persons other than its
shareholders and can be of the following types.
(a) Recognized in the statement of profit and loss: Net profit is the result of
changes in the value of assets and liabilities that are recognized in the
statement of profit and loss. It increases retained earnings.
(b) Recognized directly in equity: Some gains and losses are not routed
through the statement of profit and loss, but recognized directly in equity.
For example, changes in the value of available-for-sale assets, net of tax, are
recognized as other comprehensive income. Again, revaluation reserve is
taken directly to equity.
Basic Earnings Per Share
Earnings per share is reported only for equity share capital. The computation of
EPS depends on a company’s capital structure. A simple capital structure consists
only of equity share capital and has no convertible debentures, convertible
preference share capital, and stock options” – instruments that can increase the
number of equity shares. A company which has a simple capital structure could
have non-convertible preference share capital.
Accountants calculate the basic earnings per share by dividing the net profit or
loss for the period attributable to equity shareholders (the numerator) by the
weighted average number of equity shares outstanding (the denominator) during
the period.8 The objective of basic EPS information is to provide a measure of the
interests of each equity share in the performance of the entity in a period. In
consolidated financial statements, we consider the profit or loss attributable to the
parent company’s equity shareholders (i.e. excluding the portion attributable to noncontrolling interests). For example, assume that Trishul Company has 100,000
equity shares and has reported a profit after tax of `500,000 for the year ended
March 31, 20X1. We now compute the company’s basic earnings per share:
If Trishul Company has non-convertible preference shares, we must deduct the
preference dividend before computing earnings per share on equity shares. Assume
that Trishul Company has `50,000 of `10 par value, 10 per cent cumulative
preference shares. We now recompute the company’s basic earnings per share:
Issue and buy-back of shares If a company had issued or bought back equity
shares during the year, the amount of resources available during the period is not
constant. So we compute EPS based on the weighted-average number of shares.
Assume that Trishul Company had 100,000 shares on April 1, 20X1 and issued
50,000 additional shares on July 1, 20X1. The company bought back 30,000 shares
on January 1, 20X2. The weighted-average number of shares and EPS for the year
ended March 31, 20X2 are computed as follows:
Bonus issue and stock split When a company issues bonus shares, the number of
shares and the amount of share capital increase, but the amount of shareholders’
equity remains unchanged. There is no change in the resources available to the
company as bonus shares are issued without consideration. In the event of an issue
of bonus shares during a period, we calculate the EPS as if the issue had occurred
prior to the beginning of the period.
Continuing with the above example, assume that on October 1, 20X2 Trishul
Company issued two equity shares for every equity share outstanding on that date.
The number of shares after the bonus issue is 360,000, consisting of 120,000
original shares and 240,000 bonus shares. Suppose that the company has a profit
after tax (PAT) of `522,000 for the year ended March 31, 20X3. We calculate the
EPS for the year as follows:
In order to make the figures comparable over time, we adjust the EPS for the
previous period using the same denominator. Thus, we recalculate the EPS for 20X2
as `1.39 (`500,000/360,000 shares).
Rights issue As with any issue of shares, the number of outstanding shares
changes when there is a rights issue. Therefore, the weighted-average number of
shares during the period should be used to calculate the EPS. However, a rights
issue is different because the issue price is generally lower than the current market
price of the share. Therefore, it has a bonus element. The denominator number of
equity shares for calculating the EPS for all periods prior to the rights issue is the
number of equity shares outstanding prior to the issue, multiplied by the following
adjustment factor:
We first calculate the theoretical ex-rights fair value per share by adding the
aggregate fair value of the shares immediately prior to the exercise of the rights to
the proceeds from the exercise of the rights, and dividing by the number of shares
outstanding after the exercise of the rights.
Continuing further with the above example, assume that on September 1, 20X3
Trishul Company made a rights issue of one share for every four shares outstanding
(i.e., it issued 90,000 shares) at a price of `20 per share. The rights were to be
exercised not later than November 1, 20X3, and the market price on that date was
`30. The theoretical ex-rights fair value per share is `28, calculated as follows:
We now calculate the adjustment factor:
Suppose that the profit after tax for the year ended March 31, 20X4 is `545,000.
The EPS is calculated as follows:
Note that the factors 7/12 and 5/12 are used to calculate the weighted average
number of shares for the increase in the number of shares on November 1, 20X3.
Diluted Earnings Per Share
When a company has a simple capital structure, the computation of EPS is fairly
straightforward. Many companies, however, have a complex capital structure which
includes securities that may be converted into equity share capital. The conversion,
if effected, has the potential of reducing or diluting the EPS by increasing the
number of equity shares. Dilution is a reduction in EPS or an increase in loss per
share resulting from the assumption that convertible instruments are converted,
options or warrants are exercised, or equity shares are issued upon the satisfaction
of specified conditions.9 Accountants compute the diluted earnings per share
under the assumption that all potentially dilutive securities would be converted into
equity shares. The objective of diluted EPS is to provide a measure of the interests
of each equity share in the performance of the entity in a period, while giving effect
to all dilutive potential equity shares outstanding. In consolidated financial
statements we consider the profit or loss attributable to the parent company’s
equity shareholders (i.e. excluding the portion attributable to non-controlling
interests). The net profit for the period is recomputed by adding back the after-tax
amount of preference dividend, interest on convertible debentures, and any other
changes that would result from the conversion of the potentially dilutive securities.
This is because after the conversion of these securities, the company will not have to
pay preference dividend and convertible debenture interest. We will now illustrate
the calculation of diluted earnings per share using convertible debentures and stock
options.
Convertible debentures To illustrate the dilutive effect of convertible debentures,
assume that Trident Company has 100,000 equity shares and 1,000 of 10 per cent
debentures of `100 convertible into 10 equity shares each. For the year ended
March 31, 20X1, the company has a profit after tax of `500,000 and the income tax
rate is 35 per cent. We calculate the company’s basic earnings per share as follows:
The calculation of the diluted earnings per share is as follows:
10
As a result of the potential dilution, there is a decrease of 39 paise in Trident’s
earnings per share.
Stock options To illustrate the dilutive effect of stock options, assume that Trident
Company has 100,000 equity shares and 10,000 equity shares under stock options.
The fair value of an equity share is `50, and the exercise price is `40. The company
has a profit after tax of `500,000. The excess of the fair value over the exercise price
is expressed in terms of equity shares and added to the number of equity shares
outstanding. As before, the basic earnings per share works out to `5. The
calculation of the diluted earnings per share is as follows:
The drop of 10 paise in the earnings per share is the measure of the ‘free’ element
implicit in the stock option. The option holders can buy 10,000 shares at `10 per
share lower than the market price. The ‘loss’ to the existing shareholders would be
`100,000. At the current market price of `50, this is equivalent to the company
issuing 2,000 shares for free ( `100,000/50). So the denominator becomes 102,000
shares. Since there will be no additional earnings to the company from the 2,000
‘free’ shares, the profit after tax is unchanged at `500,000.
Looking Back
Describe the features of a corporate organization The key features of a corporation are separate legal
entity, limited liability of shareholders, free transferability of ownership rights, perpetual existence,
common seal, professional management, and regulation by the government.
Explain the components of capital stock Share capital is divided into a number of shares. Authorized
capital is the maximum number of shares that may be issued. Issued capital is the number of shares issued
to the shareholders. Subscribed capital is the number of shares actually taken by the shareholders. Paid-up
capital is the amount of share capital for which payment has been received by the company.
Record issue of share capital Capital stock has a par value. Share capital may be issued at a price equal
to face value (at par), above face value (at a premium) or below face value (at a discount). Also, shares may
be issued in exchange for non-cash assets or for services.
Describe the features of preference shares Preference shares enjoy preference over equity shares in
matters of payment of periodic dividends and distribution of assets on a company’s liquidation. Preference
shares usually carry a fixed rate of dividend. There are many types of preference shares depending on the rights
attached to them.
Describe the different kinds of reserves Revenue reserves can be distributed as dividends, but not
capital reserves. Statutory reserves are created to comply with the requirements of a law. Realized reserves
are those that represent cash or other assets received by a company in an exchange transaction. Unrealized
reserves result from accounting entries without any exchange transaction.
Explain buy-back of shares and treasury operations and how to account for them A company can
buy back its shares for cancellation out of its free reserves, securities premium account or the proceeds of a
fresh issue of shares. Buy-back reduces the number of shares and the paid-up share capital. Treasury stock is a
temporary investment by a company in its own share capital.
Account for issue of bonus shares Bonus shares are additional shares of a company’s share capital given
to its shareholders. A bonus issue transfers retained earnings or other items in reserves and surplus to
share capital. Revaluation reserve is not available for issue of bonus shares.
Account for payment of dividends A dividend is a distribution of cash to shareholders. The board of
directors recommends dividends and the shareholders declare the dividend. Accounting for dividends
requires recording first proposed dividend as an estimated liability, then recognizing dividend payable, and
finally eliminating dividend payable on payment of dividend.
Explain the need for share-based payment and account for it The fair value method requires
recognition as compensation expense the value of stock options over the vesting period.
Explain the statement of changes in equity The statement of changes in equity presents owner and
non-owner changes in a reporting period.
Compute earnings per share When a company has only equity share capital (simple capital structure),
its basic earnings per share equals the profit after tax divided by the number of equity shares. When a
company’s capital structure includes potentially dilutive securities (complex capital structure), such as
convertible debentures and options, the company must present, in addition, a diluted earnings per share
computed under the assumption that all potentially dilutive securities were converted into equity shares.
Review Problem
On January 1, Inder Ltd. was incorporated with an authorized capital of 50,000 shares. On January 5, the
company issued 20,000 shares of `10 each at par payable as follows: `2 with application, `2 on allotment, and
the balance when called. On January 10, the company received applications for 25,000 shares. On January 18,
the company’s board allotted 25,000 shares. The amounts payable on allotment were received on February 15.
On March 20, the board made the first call for `4 per share and the amounts were received on April 22. The
second and final call was made on June 10 and the amounts were received on July 27.
Prepare journal entries to record the transactions.
ASSIGNMENT MATERIAL
Questions
1.
2.
State three differences between a partnership and a company.
Why are companies subject to more government regulation than sole proprietorships and
partnerships?
3.
4.
5.
6.
What is the significance of the shareholders’ preemptive right?
Whom does legal capital help?
How does a dividend differ from a bonus?
“Securities premium is a waste of shareholders’ money because dividend is payable only on the share
capital component.” Do you agree?
7.
8.
9.
10.
11.
12.
13.
What is the principle for recording issue of share capital for services or non-cash assets?
Why are stock option plans more popular with software companies?
Why do the book value and market value of a company’s shares differ?
What is a stock split? How is it different from a bonus issue?
How is treasury stock similar to and different from a company’s other investments?
What is appropriation? Why do companies make appropriations?
Why is a company with a complex capital structure required to report two earnings per share
amounts?
Problem Set A
The share capital of Veer Company consists of 10,000 equity shares of `10 par value and
2,000 10 per cent, cumulative preference shares of `10 par value. The company declared
and paid total dividends in the first four years of operation as follows: first year, `800;
second year, `1,200; third year, `14,000; fourth year, `17,000.
Required
1.
2.
Determine the rate of dividend on each class of share capital in each of the four years.
Determine the rate of dividend on each class of share capital in each of the four years, assuming that
the preference share capital is non-cumulative.
On September 1, 20X1, Guna Company issued one bonus share for every share held by its
shareholders by capitalizing all of its securities premium and retained earnings, to the
extent required. On that date, the company had 100,000 equity shares of `10 par value, all
fully paid-up, held by 1,230 shareholders. The company had a balance of `710,000 in the securities premium
account and `491,200 in the statement of profit and loss.
Required
Prepare the journal entry to record the issue of bonus shares.
Required
Prepare journal entries to record the transactions.
Shamsher Company earned a profit after tax of `210,000 for the year ended December 31,
20XX. The company had 20,000 equity shares at the beginning of the year. On October 1,
20XX, it issued 40,000 shares.
Required
Compute the company’s weighted-average earnings per share for the year.
Problem Set B
Required
1.
2.
Prepare journal entries to record the transactions.
Prepare the shareholders’ equity section of the company’s balance sheet as at December 31, 20XX.
On February 1, 20XX, Pranav Company issued 500,000 shares of `10 par value at `15 with the
option to retain up to an additional 20 per cent of the shares in the event of oversubscription.
Payment was due as follows: with application `5, including premium of `2; on allotment `5,
including premium of `3; the balance when called in at least two instalments. The following
transactions took place in connection with the issue:
Required
1. Prepare journal entries to record the transactions.
2. Prepare the shareholders’ equity section of the balance sheet as at December
31, 20XX.
Sharad Company has 1,000 of 10 per cent, `100 par value convertible preference shares and
50,000 equity shares of `10 par value. During the last five years, the company paid out the
following amounts in dividends:
No dividends were in arrears for the years prior to 20X1.
Required
1. Compute the amount of dividend on preference shares and equity shares
separately under each of the following assumptions: (a) The preference
shares are non-cumulative and non-participating; (b) The preference shares
are cumulative and non-participating; and (c) The preference shares are
cumulative and fully participating.
2. At the option of the company, the preference share capital can be converted
into equity after 20X5 at the rate of one equity share for one preference
share. Will the existing equity shareholders benefit from the conversion
assuming that the company expects to earn and distribute a profit after tax
of `96,000 for 20X6? Assume that the preference shares are cumulative and
fully participating.
Mohan Company reported an after-tax net profit of `317,000 for 20XX. On January 1, 20XX,
the company had 96,000 equity shares of `10 par value and 1,000 of 12%, `100 nonconvertible, cumulative preference shares. Information about transactions that affected the
share capital account follows:
Mar. 1 Declared a 1:4 bonus.
May 1 Issued 60,000 shares at a premium of `25.
July 1 Purchased 12,000 shares to be held as treasury stock.
Aug. 1 Reissued 6,000 shares of treasury stock.
Oct. 1 Cancelled 2,000 shares of treasury stock.
On December 31, the company declared preference dividends of `12,000.
Required
1. Compute the basic earnings per share for 20XX.
2. Suppose that Mohan Company did not declare preference dividends because
it did not have cash. How would this affect the computation of earnings per
share assuming that the preference shares were non-convertible, noncumulative?
3. Suppose that Mohan Company had dilutive securities throughout 20XX.
Assuming that all dilutive securities had been converted at the beginning of
the year, the weighted number of equity shares would have been 250,000.
Compute the diluted earnings per share.
During the year ended March 31, 20X5, Raja Company was engaged in the following transactions:
Required
1.
2.
3.
Prepare journal entries to record the transactions.
Prepare a statement of retained earnings for the year ended March 31, 20X5.
Prepare a schedule of reserves and surplus on March 31, 20X5.
Problem Set C
Required
1.
2.
Prepare journal entries to record the transactions.
Prepare the shareholders’ equity section of the balance sheet as at March 31, 20X6.
On January 1, 20XX, Amal Company issued 100,000 shares of `10 par value at `12 with the
option to retain up to an additional 10 per cent of the shares in the event of oversubscription.
Payment was due as follows: with application `5, including premium of `2; on allotment `3; the
balance when called in at least two instalments. The following transactions took place in
connection with the issue:
Required
1.
2.
Prepare journal entries to record the transactions.
Prepare the shareholders’ equity section of the balance sheet on December 31, 20XX.
No dividends were in arrears for the years prior to 20X4.
Required
1.
Compute the amount of dividend on preference shares and equity shares separately under each of the
following assumptions: (a) The preference shares are non-cumulative and non-participating; (b) The
preference shares are cumulative and non-participating; (c) The preference shares are cumulative and
fully participating.
2.
At the option of the company, the preference share capital can be converted into equity after 20X8 at
the rate of two equity shares for one preference share. Will the existing equity shareholders benefit
from the conversion assuming that the company expects to earn and distribute a profit after tax of
`2,87,500 for 20X9? Assume that the preference shares are cumulative and fully participating.
On December 31, the company declared preference dividends of `15,000.
Required
1.
2.
Compute the basic earnings per share for 20X3.
Suppose that Avik Company did not declare preference dividends because it did not have cash. How
would this affect the computation of earnings per share, assuming that the preference shares were
non-convertible, non-cumulative?
3.
Suppose that Avik Company had dilutive securities throughout 20X3. Assuming that all dilutive
securities had been converted at the beginning of the year, the weighted number of equity shares
would have been 450,000. Compute the diluted earnings per share.
During the year ended December 31, 20X2, Prabhakar Company engaged in the following transactions:
Business Decision Cases
On May 5, the board of directors decided to recommend a dividend of 10 per cent on both preference and
equity share capital. The net profit for the year had been transferred to retained earnings from which the
dividends would be paid.
Required
1.
2.
Compute the book value per equity share on March 31, 20X9.
Tarapore Company’s equity share was quoting at `120 on the balance sheet date. Why did the price
differ from the book value of the share?
3.
What was the maximum ratio of bonus issue the company could have made on the balance sheet date?
The company would like a balance of `650,000 to be left in the retained earnings after the bonus issue.
The management of Cholamandalam Chemicals Limited is considering a proposal for
expansion of plant capacity that would enable it to produce a range of new chemical products.
The expansion plan is estimated to cost `1,000,000. After several rounds of discussions with the
company’s investment bankers, the following three alternatives have emerged:
1.
2.
3.
Issue 10,000, 10% cumulative, non-participating preference shares of `100 at par.
Issue 5,000, 10% cumulative, participating preference shares of `100 at `200.
Issue 40,000 equity shares of `10 at `25.
The company estimates that the additional investment would give a return of 25 per cent per year after
payment of all expenses including income tax. Net profit for the latest year is `140,000. Currently, the
shareholders’ equity of the company consists of the following: authorized capital of 10,000; 10 per cent
cumulative, non-participating preference shares of `100 and `5,000; 10 per cent cumulative, participating
preference shares of `100, and 100,000 equity shares of `10; issued capital of 60,000 equity shares of `10 fully
paid; and retained earnings of `275,000. The company plans to distribute the entire net profit in the coming
year.
Required
1.
From the standpoint of the company’s existing shareholders, which is the best alternative? Should the
company proceed with the expansion? Explain.
2.
What other factors should the company consider in making the decision?
Interpreting Financial Reports
Housing Development Finance Corporation Limited (HDFC) is the largest home mortgage
lender in India. The financial statements for the year ended March 31, 2013 had the
following note:
Note 5.2
During the year, `5,015.6 million (previous year `5,488.3 million) has been utilized out of the Securities
Premium account in accordance with Section 78 of the Companies Act 1956. Out of the above, `nil (previous
year `1.7 million) has been utilized by one of the subsidiary companies towards debenture issue expenses,
`163.9 million (previous year `165.7 million) has been utilized by one of the subsidiary companies towards
buy-back of equity shares, `1.0 (previous year `nil) has been utilized by one of the subsidiary companies
towards share issue expenses and `4,850.7 million (net of tax `2,232.5 million) [(previous year `5,320.9
million) (net of tax `nil)] has been utilized by HDFC Ltd. towards the proportionate premium payable on the
redemption of zero-coupon secured redeemable non-convertible debentures. HDFC Ltd. has also written back
`nil ( `937.6 million) on conversion of FCCBs to the Securities Premium account.
In a report titled “The last bastion falls”, two analysts from Macquarie Equities Research downgraded their
rating on HDFC’s stock to “underperform” from “outperform” citing a likely structural de-rating of the lender as
its earnings quality and return on equity were being driven by its corporate customers and aggressive
accounting practices. The analysts stated:
Over the past two years, HDFC Ltd. has been adopting aggressive accounting practices by passing
provisioning through reserves and also making the adjustments for zero-coupon bonds (ZCBs) through
reserves. We believe FY11 and FY12 earnings are overstated by 38% and 24% respectively and reported
return on equity [ROE] would have been 600 and 400 bps (basis points) lower at 16% and 18% respectively, if
the adjustments had been made through the P&L. In other words, earnings
growth has been managed, in our view.
HDFC responded that the ZCBs were used to raise funds for investment in subsidiaries’ businesses. Since
under Indian accounting principles, the income from subsidiaries (barring dividends) was not taken into
account, HDFC was charging the interest costs on ZCBs to the securities premium account. On provisions,
HDFC said that it was a one-time requirement pertaining to past assets and was transitory in nature.
Required
1.
2.
3.
Explain the transaction described in the note.
Comment on the company’s accounting for interest on ZCBs and provisions for standard assets.
Examine the possible aims that the company intended to achieve via the transaction and the related
accounting.
Financial Analysis
Identify a sample of companies that have stock options and study their annual reports.
Required
1.
Explain why the companies may have stock option plans. Provide any references to relevant
information in the financial statements and other parts of the annual report.
2.
3.
4.
How do the companies account for stock options? Summarize the methods and their features.
Comment on the quality of disclosure on stock option plans.
Restate the net profit of the companies that follow the intrinsic value method for the fair value
method. Some companies provide information in the footnotes that would enable you to do this
exercise. How would the adoption of the intrinsic value method affect the profit of these companies?
Collect annual reports of a sample of companies.
Required
1.
Prepare a list of reserves that appear in the balance sheet of these companies. Classify them according
to the categories described in this chapter.
2.
3.
How much of the reserves is available for (a) dividend payment and (b) bonus issue?
Most companies have a general reserve. Explain why they keep this reserve rather than keep the
amount in the statement of profit and loss.
Identify companies that have had a share buy-back in the last five years.
Required
1.
Explain on the basis of the information provided in the offer document why each company bought back
its shares. Do you agree with the reasons given?
2.
3.
Analyze the cash position of the companies before and after buy-back.
Dividend payment is an alternative to buy-back. Explain why the companies preferred buy-back to
dividend.
Identify a sample of companies that have had a bonus issue in the last five years.
Required
1.
2.
3.
What do you think are the reasons for bonus issue in each of the sample companies?
Identify the reserves that the companies capitalized.
Dividend payment is an alternative to bonus issue. Explain why the companies preferred bonus to
dividend.
Answers to Test Your Understanding
10.1 `35,000, its paid-up capital.
10.2
10.3 The excess over par value is securities premium and is part of shareholders’ equity. Since it is from a
capital transaction, it is not an item of income.
10.4 Investment allowance reserve represents retained profits by another name and exists to comply with the
tax law. The purpose of the reserve is to prevent paying the amount as dividends. The reserve is not to be
confused with a cash or bank balance. Availability of cash is an entirely different matter.
10.5
10.6
1 Vikramaditya S. Khanna, The Economic History of the Corporate Form in Ancient India, University of
Michigan, Ann Arbor, Michigan, 2005.
2 IFRS 2:10/Ind AS 102:10.
3 IAS 38:69(a)/Ind AS 38.69(a)/AS 26:56(a).
4 For the purpose of buy-back , “free reserves” includes securities premium account (Explanation II to Section 68
of the Companies Act 2013).
5 IFRS 2:10/Ind AS 102:10.
6 IFRS 2:23/Ind AS 102:23.
7 Wayne Guay, S.P. Kothari, and Richard Sloan provide an economic analysis of the issues in accounting for
share-based payment in “Accounting for employee stock options”, American Economic Review, May 2003, pp.
405–409.
8 IAS 33:10/Ind AS 33:10/AS 20.
9 IAS 33:5/Ind AS 33:5.
10 The after-tax cost of interest is given by the pre-tax rate multiplied by (100 – tax rate) i.e. 10% × (100 – 35)%.
By now, you should have a clear understanding of the asset, liability, and equity
items that appear in the financial statements. You should be in a position to explain
how accountants measure and present the common items and should be able to
apply the accounting principles and standards and the relevant legal requirements.
STEP 1: Internal Control Systems and Current Assets
Internal Control Systems:
1. What do you learn from the directors’ responsibility statement?
2. Locate any references to internal control systems in the auditors’ report.
3. Study the composition of the audit committee and the business and financial
expertise of its members.
4. How is the certificate of the CEO and CFO on the financial statements useful?
Cash:
5. Evaluate the adequacy of the company’s cash.
6. Make a rough estimate of the company’s surplus cash.
7. How can the company utilize its surplus cash?
Receivables:
8. Did the company provide for its doubtful debts?
9. What percentage of the company’s receivables is classified as doubtful?
10. Comment on the age of the receivables.
11. What additional information about receivables would be useful?
12. How much receivables did the company write off?
13. What was the bad debt expense for the period?
14. Calculate the average collection period. State your assumptions.
15. Does the company have any bills receivable?
16. Locate any references to receivables in the auditors’ report. How are they
useful?
Inventories:
17. Identify the various types of inventories.
18. What cost formula(s) did the company use?
19. Locate any references to inventories in the auditors’ report. How are they
useful?
20. Calculate the company’s average inventory holding period. State your
assumptions.
21. Calculate the company’s operating cycle. State your assumptions.
22. What did the directors say about company’s inventory management efforts?
STEP 2: Tangible Assets, Intangible Assets, and Investments
Tangible Assets:
1. Give three examples of the company’s property, plant and equipment items.
2. How does it measure property, plant and equipment?
3. What depreciation method(s) does it use?
4. What is the estimated useful life of computers? Is this higher or lower than those
specified in Schedule II or Schedule XIV?
5. Are there any fully depreciated property, plant and equipment items?
6. What was the gain or loss on disposal of property, plant and equipment items?
7. How does it measure impairment loss?
8. Locate any observations on property, plant and equipment in the auditors’
report. How are they useful?
Intangible Assets:
9. Give two examples of the company’s intangible assets.
10. How does it measure intangible assets?
11. How much did the company spend on R&D?
Investments:
12. Identify the company’s investments in equity and debt securities. How does its
classification compare with the one used in this book?
13. Identify its subsidiaries. What is the percentage of its shareholding in each of
them?
14. What is the amount of non-controlling interest (minority interest) in the
company’s subsidiaries?
15. How can you find out whether the company is a subsidiary of Unilever?
16. Does it have any associates? If yes, name them.
17. Does it have any joint ventures? If yes, name them.
18. Study its accounting for investments. How does it compare with the principles
discussed in this book?
19. What is the amount of goodwill on consolidation? How does it account for it?
STEP 3: Current Liabilities and Non-current Liabilities
Current Liabilities:
1. How are short-term borrowings different from short-term liabilities?
2. Does the company have any bills payable?
3. What are the company’s estimated liabilities?
4. What additional information about trade payables would be useful?
5. Is proposed dividend a liability?
Non-current Liabilities:
6. What are the company’s long-term liabilities?
7. How are long-term borrowings different from long-term liabilities?
8. How does the company define deferred tax? Is it same or different from the
definition used in this book?
9. What
employee benefits does the company recognize as liabilities?
10. What are the company’s assumptions in estimating the liability for retirement
benefits?
Contingent Liabilities and Commitments:
11. What are the company’s contingent liabilities? Why are they not recognized?
12. How are contingent liabilities different from commitments?
STEP 4: Shareholders’ Equity
Share Capital:
1. What is the face value of the company’s shares?
2. What types of share capital does the company have?
3. Has the company issued any shares for services or non-cash assets?
4. What percentage of the company’s share capital does Unilever hold?
Reserves:
5. Group the reserves according to the categories discussed in the chapter.
6. What is Employee Stock Options Outstanding?
7. What are the terms of Export Profit Reserve?
8. What are the terms of Development Allowance Reserve?
9. Are there any accumulated other comprehensive income items?
Buy-back, Bonus, and Dividends:
10. Was there a share buy-back? If yes, what were the terms? How did it affect the
various items in the shareholders’ equity?
11. Has the company issued any bonus shares? If yes, how many?
12. Was there a final or interim dividend? How much was the total dividend for the
period? Was all of it paid?
13. Is the dividend specified as a percentage of the paid-up amount or as rupees per
share?
14. What is the dividend distribution tax? What is the tax rate?
Share-based Payment Arrangement:
15. Does the company have a share-based payment arrangement? How does it
account for the related expense?
Earnings per Share:
16. How much is the basic EPS?
17. What is the weighted average number of equity shares for calculating EPS? Is it
different from the year-end number? Why or why not?
18. Does the company have any potentially dilutive securities? If yes, what were
these? How would they be dilutive?
Others:
19. What is the length of the notice for the annual general meeting? Is it sufficient?
“Auditors’ lives would no longer be the same and without doubt be extremely challenging.”
Question: What are the major challenges for accountants and auditors today?
Answer: The accountants of today face many challenges. The CFO is generally
perceived to be the second most important person in the organization after the CEO
and is the face of the organization to regulators. This imposes upon him the onerous
task of compliance with ever increasing regulations and dealing with regulators.
The explosion of on-line information sources, competing real time news feeds in the
form of TV channels devoted exclusively to business, the rapid developments in
technology, the advent of “information on the move”, access to information on handheld mobile devices, and globally inter-connected markets – in sum the thirst for
real-time and relevant information – have significantly impacted the quality and
timeliness of financial reporting by accountants. Accounting standards which have
not kept pace with newer business arrangements and emerging financial products
pose additional challenges to accountants. After all, standards are akin to a house
we raise over our heads. They define the perimeter within which a person, family,
business or society can function. We live by the standards we set and it is to our
peril that we dismantle them or lower the bar.
Given the tendency to flood the financial statements with endless disclosures, it is
important for the accountant to pay attention to the quality and the relevance of
disclosures. It has often been noted that the lengthier a disclosure, the more it
obfuscates the underlying facts. Samuel Johnson once said: “Where secrecy or
mystery begins, vice or roguery is not far off”. Possibly he had disclosures
accompanying financial statements in mind! The challenges an auditor of today
faces are no less than that of an accountant but on a different canvas – the ever
increasing expectation from investors and regulators, the oft-misconstrued role that
an auditor lends insurance rather than assurance, the need to keep abreast of the
sophisticated and rapid changes in the technological environment and, therefore,
the need to retool, stakeholder activism and increased independent oversight, just
to cite a few.
Question: How has Satyam changed reporting and auditing in India?
Answer: In my view Satyam has had a limited and temporary impact on reporting
and auditing in India. This is evident from the frauds which have surfaced in the
last two years. The absence of a robust system of internal control over financial
reporting (equivalent to the Sarbanes-Oxley Act requirement), compliance with
independent director and audit committee requirements in form rather than
substance by a large number of companies, and the limited regulatory oversight on
financial reporting and the attest function has resulted in companies and auditors
being complacent. The slow and time-consuming systems of enforcement and
punishment have not instilled the necessary fear or concern for quality of financial
reporting or attestation. The auditing profession enjoys the unique mandate of
“independence” which stems from statute and bears the burden of not only being
objective and independent at all times but also having to appear at all times to be
objective and independent. This is a very strong public expectation and is only
expected to grow in days to come.
Question: How would the Companies Act 2013 affect auditors?
Answer: The Companies Act 2013 affects auditors at two levels. By the creation of
the National Financial Reporting Authority (NFRA) there would be an independent
oversight on auditors. NFRA would, among others, inspect audit firms to monitor
audit quality and would also have the powers of enforcement and punishment. At
an individual level, auditors would be impacted by rotation rules, limits on number
of audits (which will now include private companies), enhanced reporting
responsibilities – with auditors now having to report directly to the Central
Government on suspected frauds, wider restrictions on non-audit services, more
stringent punishment against audit partners and firms, disgorgement of fees, class
action suits, etc. Auditors’ lives would no longer be the same and without doubt be
extremely challenging.
Question: What are the pros and cons of auditor rotation? On balance, is rotation good?
Answer: The argument in favour of rotation is the threat of familiarity where the
compelling view is that too close an association of an auditor with his client would
impair his ability to take an independent view. This view is mainly anecdotal and
not on the basis of any empirical data. Studies across the world have shown that
frauds have happened more during the periods of auditor change than otherwise. In
US, the Public Company Accounting Oversight Board (PCAOB) recently took up the
discussion on audit firm rotation, but did not find support. While the European
Union has taken steps towards mandatory audit firm rotation, it is worth noting
that the draft law approved by the European Parliamentary Legal Affairs
Committee requires public interest entities such as banks, insurance firms, and
listed companies to rotate audit firms every 14 years which period could be
extended to 25 years when certain safeguards are put in place. The original
proposal had called for rotation every six years, but a majority of the committee
judged that period to be a costly and unwelcome intervention in the audit market.
The UK Competition Commission has put paid to the proposal to force leading
companies to change audit firms periodically. Instead, the Commission was of the
view that a re-tender once every five years would have a similar effect to a policy of
mandatory rotation, but with less cost.
The core issue is audit quality. This is not addressed by mere rotation. There is no
guarantee that audit quality would be enhanced by changing audit firms and also
no guarantee that the benefit, if any, of such enhancement in quality will outweigh
the costs of change. There is a high probability that the new auditors will have so
much less knowledge about the company that it will take years for them to
duplicate the understanding that previously existed with the incumbent auditors.
There is a need to have an effective and independent oversight on the audit quality
delivered by audit firms. It is also necessary to correct the profile of the profession
first before introducing audit rotation. We need to have a sufficiently large number
of firms with skills, experience, and scale for corporates to make an effective choice.
It should also be borne in mind that while auditors are perceived to be guardians of
financial truth, as noted by Oscar Wilde, truth is rarely pure and never simple. It is
worth remembering that auditors, being an integral part of society, are not immune
from the ebb and flow of custom. But they are bound to defend the terrain of their
truth. On balance, I believe that mandatory rotation is bad, but there should be a
periodic evaluation of auditor performance and rigorous, independent oversight on
audit quality, while at the same time ensuring that those charged with governance
and quality of financial reporting are held accountable and face severe penalties for
negligence.
Question: What is holding back IFRS implementation in India?
Answer: India’s roll out of IFRS in 2011 was deferred primarily due to two reasons.
(a) the Companies Act 1956 had to be amended to remove provisions inconsistent
with IFRS and (b) tax issues relating to fair value measurement, treatment of other
comprehensive income (OCI) and the treatment of the effect of the one-time
adjustments to values of assets and liabilities on first-time implementation of IFRS
needed resolution. Although the Companies Act 2013 has dealt with the first issue,
the issue of tax treatment has not fully been resolved notwithstanding the proposal
to introduce Tax Accounting Standards (which is undesirable) as a quick-fix
solution. In the meantime IFRS has moved ahead requiring further revision to the
Ind AS standards which were earlier aligned to IFRS. Yet another issue is the
standard on financial instruments (IFRS 9/IAS 39) which is yet to take a final and
complete shape. In the insurance sector, the standard on insurance contracts (IFRS
4) is under revision and is expected to be effective only in 2018. There are other
issues which are being debated which may delay the implementation of IFRS: (i)
whether two sets of standards should co-exist and apply to different classes of
entities or should there be one set of standards with exemption for certain classes of
companies; (ii) the need for a separate set of standards for small and medium
enterprises (SMEs); (iii) whether IFRS-equivalent standards should be made
applicable in a phased manner or should there be a ‘big bang’ approach. There has
been sufficient awareness created about the need for transitioning to IFRS and a lot
of time has been spent on training practitioners. It is now time to cut the umbilical
cord to the old framework and bring in the new reporting framework by
implementing IFRS-equivalent standards across the board in all public interest
entities.
Question: Are Indian companies and banks ready for fair value accounting?
Answer: In my understanding, a large part of the Indian corporate sector including
the banking sector is not fully ready for fair value accounting. There is an
imperative need for more guidance and training, accreditation and oversight of
valuers. It is also necessary for corporates and banks to prepare for the significant
effect of transition to fair value accounting. Even a simple mark-to-market effect of
foreign currency assets and liabilities has seen Indian corporate sector seeking
relief.
Question: What do Indian accountants have to do to come up with a global accounting
firm similar to the Big Four?
Answer: The Big Four have grown to their size by a series of mergers, acquisitions,
and alliances. Indian accountants have to first change their mindset and transition
from being family-run firms to become fully professionally managed firms. The next
steps would possibly involve merging with other like-minded firms or acquisitions or
alliances. This would necessarily mean a willingness to re-align existing
management control or seniority, change in the way of working and ability to
handle the challenges large firms face, etc. It would mean transforming the existing
firms to multi-disciplinary firms by partnering with non-CAs and also widening the
geographical presence and changing from being pure local firms to firms with
national or international operations.
Learning Objectives
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Describe the objectives of financial statement analysis.
Describe the sources of financial information.
Explain the standards of comparison for financial statement analysis.
Assess a company’s earnings quality.
Explain horizontal analysis, trend analysis, vertical analysis, and ratio analysis.
Explain profitability and perform DuPont analysis.
Distinguish between the performance of operations from the profitability of financial activities.
Analyze liquidity.
Analyze solvency.
Evaluate a company’s capital market standing.
Question management communications.
Understand the forces that influence corporate disclosure policy.
Describe the implications of the efficient market hypothesis for financial statement analysis.
Describe earnings management and identify motives for managing earnings.
TILL DEBT DO US PART
“No dream too big” proclaims the cover of the Jaypee group’s annual reports. It was probably
meant to epitomize the group’s approach to business growth. In the event, it ended up as a
statement on the size of its debt. Debt ballooned eight-fold from `62 billion in 2007 to `530
billion in 2013. Over the same period, revenue increased five times. The group invested in
power projects that involve long gestation even in the best of times. It commissioned 2,200
MW of capacity over since 1992 and over projects totalling 10,000 MW were under
construction. High-profile projects such as the Ganga Expressway were stuck in government
approvals. The 5,000-acre Sports City along the Yamuna Expressway stalled, because of the
slump in the real estate market. The group’s golf course resort and hotels suffered, because of
the economic slowdown. The group made gross losses of `3.7 billion in 2013 and its interest
cover sank to 1.4 times. The mounting debt forced the company to sell its cement plant in
Gujarat to UltraTech at what was regarded as a bargain price.
THE CHAPTER IN A NUTSHELL
The primary objective of financial reporting is to provide information to present and potential
investors, creditors, and others in making rational investment, credit, and other decisions.
Effective decision-making requires evaluation of the past performance of companies and
assessment of their future prospects. In this chapter, we describe a number of techniques used
by investors, creditors, and analysts for analyzing and interpreting the information contained in
financial statements. We look closely at the components of earnings to see if they are
sustainable. You will learn how to perform horizontal, vertical, and trend analyses. Analysts
attempt to condense the mass of data in financial statements into a handful of financial
indicators that convey the story of a business. You will learn how to calculate and interpret
those indicators. The intense competition for capital spurs firms to provide additional
information in order to attract investors. You will see how firms can benefit from providing
voluntary disclosure. Finally, you will learn about managerial motives for earnings management.
Objectives of Financial Statement Analysis
Financial statement analysis is the collective name for the tools
and techniques that are intended to provide relevant information
to decision-makers. The purpose of the analysis is to assess a
company’s financial health and performance. Financial statement
analysis consists of comparisons for the same company over periods of time and for
different companies in the same industry or different industries.
Financial statement analysis enables investors and creditors to
evaluate past performance and financial position; and
predict future performance.
Evaluation of Past Performance and Financial Position
The starting point in the analysis of a company is to look at the record. Information
about past performance is useful in judging future prospects. For example, trend of
past sales, earnings, cash flow, profit margin, and return on investment provide a
basis for evaluating the efficiency of a company’s performance and aid in assessing
its prospects. An assessment of current status will show where the company stands
at present, in terms of items such as inventories, borrowings, and cash position. To
a large extent, the expectations of investors and creditors about future performance
are shaped by their evaluation of past performance and current position.
Individual investors are often passive and they rarely intervene in the working of
a company as long as it is reasonably successful. Their evaluation of the company
helps them assess prospects for their investments. Investors who are dissatisfied
with a company’s performance will typically sell their shares in the company. In
contrast, institutional investors (e.g. LIC, SBI, Franklin Templeton) are generally
more active and may insist on major business and management changes when the
company does not fare well. Creditors are concerned with management’s compliance
with loan indentures and may take legal action if covenants are broken.
Prediction of Future Performance
Investors and creditors use information about the past to assess a company’s
prospects. They look ahead by looking back, so to speak. Investors expect an
adequate return from the company in the form of dividends and stock price
appreciation. Creditors expect the company to pay interest and repay the principal
in accordance with the terms of lending. Therefore, they are interested in predicting
the earning power and debt-paying ability of the company. You may recall the
discussion in Chapter 1 on users of financial statements and their information
needs.
Investors and creditors try to balance expected risks and returns. The returns
they receive should be commensurate with the risks they perceive. Future returns
are far more difficult to predict when they are expected to fluctuate widely;
prediction becomes much easier when the fluctuations are within a narrow range.
Thus, investors and creditors will invest in, or lend to, high-risk ventures only if
they expect adequately high returns. Similarly, they will accept low returns only if
the expected risk is low. For example, it is relatively easier to predict an electricity
company’s future performance than a movie company’s fortunes. Therefore, equity
investors would be willing to accept a relatively low return from an electricity
company, but they would want a higher return in the form of dividends and stock
price increase from a movie company. For the same reason, loans to a movie
company will carry a higher interest rate than loans to an electricity company.
Sources of Information
Individual investors and creditors must often depend on published
sources of information about a company. The most common
sources of information about listed companies are company
reports, stock exchanges, business periodicals and television, and
information services.
Company Reports
Every company publishes an annual report which contains valuable financial and
other information about the company. Annual reports are the beginning and ending
points in obtaining information about individual companies. As a starter, they
provide an overview of the company’s business, current status, and past
performance. At the end of the information gathering process, annual reports are
used to corroborate the vast array of company-specific data assembled from various
sources.
A typical Indian company annual report contains the following documents:
Directors’ report and management discussion and analysis;
Financial statements;
Schedules and notes to the financial statements; and
Auditor’s report.
In addition, some companies provide tables and charts showing current period
highlights and trend of performance for the past five or ten years, the chairman’s
letter to the shareholders, and a lot of other information that is difficult to audit,
such as brand valuation, human assets valuation, corporate social responsibility
initiatives and, of course, impressive photographs of products, people, and facilities.
The annual report is sent to the shareholders of the company free of charge and is
usually available on the company’s website. Listed companies are also required to
publish quarterly statements of financial results in leading newspapers within one
month after the quarter. These are typically not audited but they go through a
“limited review” by the auditors.
Stock Exchanges
Listed companies must file copies of their annual reports, as well as additional
documents such as a statement of distribution of share ownership and quarterly
results, with the stock exchanges in which they are listed. The Bombay Stock
Exchange (BSE) is the oldest stock exchange in Asia. It has a library of annual
reports and other documents filed with it. The National Stock Exchange of India
(NSE) is the leading stock exchange in terms of trading activity. The BSE and the
NSE have a number of publications that give financial and other information about
companies. A lot of useful information is also available on their websites. The listing
agreement requires companies to inform the stock exchange promptly of major
developments affecting them, including management and auditor changes, director
resignations, board meetings, bonus and dividend decisions, strikes, accidents, and
plant closures.
Business Periodicals and Television
Business newspapers and magazines are important and, often, timely sources of
financial and business news. Major financial and business publications in India
include The Economic Times, Business Line, Business Standard, Financial Express,
and Business Today. These publications give stock prices and carry news items and
analytical write-ups on companies. General newspapers too devote a few pages to
business news. Increasingly, the two leading international business newspapers,
the Financial Times and The Wall Street Journal provide good coverage of economic
and business developments in India. Television channels provide round-the-clock
coverage of political and economic events. Channels such as CNBC-TV18, NDTV
Profit, Bloomberg UTV and ET Now focus on business and economic news.
Information Services
Credit rating agencies bring out periodical company and industry studies. Several
studies of financial ratios are available, notably the ones published by the Centre
for Monitoring Indian Economy (CMIE). Useful databases include Prowess and
Capitaline that provide Indian company data and Thomson Reuters’ DataStream for
international company data and I/B/E/S that has analyst forecasts.
Economic reports and forecasts are available from the government and the
Reserve Bank of India (RBI) as well as from private sources. Industry-specific data
come from the government, trade associations, and a variety of other sources.
Analysts in brokerage firms and investment advisory services prepare periodic
reports on companies and industries for their clients and sometimes for outsiders.
Sophisticated users of financial statements invariably seek more information for
their purposes. For example, banks and financial institutions often demand
additional information for processing loan requests. Similarly, credit rating agencies
need considerably more information from companies requesting ratings than that
available from published reports. In addition, there are many agencies that
undertake private information search for a fee. Professional analysts collect
information during plant visits and field trips.
Standards of Comparison
Financial analysts look for pertinent standards of comparisons to
determine whether the results of their financial statement analysis
are favourable or unfavourable. For this purpose, comparisons are
made with the following:
1.
2.
3.
4.
Rule-of-thumb indicators;
Past performance of the company;
Internal standards; and
Industry standards.
We will now discuss them.
Rule-of-thumb Indicators
Financial analysts and bankers use rule-of-thumb or benchmark financial ratios.
For example, it is generally thought that a current ratio of 2:1 or above is
satisfactory. Rule-of-thumb measures are useful in making broad comparisons of
companies in different industries. Nevertheless, they should be used with great
caution since individual circumstances often differ. For example, a firm with a
current ratio of 2:1 may have slow-moving inventories and old receivables, while
another firm having a current ratio of 1.5:1 may have fast-moving inventories and
receivables within the credit period.
Past Performance
Financial analysts compare a company’s current performance with its past
performance. Five- or ten-year summaries of selected financial data appear in some
annual reports. Also, financial track record is cited in company prospectuses and
advertisements. A look at the past performance will show broadly whether the
company is improving or declining. Also, a study of past ratios and percentages may
assist in extrapolating them.
However, there are problems with historical comparisons:
1. Fundamental changes in a company’s environment, such as government
regulation, competition, and state of technology, can make it difficult to
project past trends into the future.
2. Accounting policy changes (e.g. changes in depreciation and inventory
valuation) will affect comparability of the past figures.
3. Non-operating items (e.g. foreign exchange gains and losses and gain on sale
of assets and investments) are not predictable.
4. Comparisons with the company’s own past can, at times, create an illusion of
growth. For instance, an annual rise of 10 per cent in a company’s sales may
in itself sound good, but would not be considered adequate if the market is
growing by 30 per cent a year. The success of a business in the long run
depends on whether it outperforms its competitors rather than its own past.
Internal Standards
Companies follow internal standards for monitoring and rewarding performance.
There are broad corporate goals for profit, return on assets, sales growth, market
share, new product launches and so on. Budgets specify detailed targets for profit
centres, business units and departments. Standard costs are predetermined costs of
making a product and are based on the standards for material consumption and
prices, labour efficiency and wage rates, and expected level of operations laid down
by the management. These are used primarily for control of operational costs.
Internal standards are greatly useful in evaluating an enterprise’s performance.
They are directly relevant to the enterprise’s circumstances and are, therefore,
likely to be more meaningful as a basis for comparison. They are regularly revised
in light of changes in the enterprise’s economic and business environment.
Unfortunately, they are not routinely available to outsiders. Nevertheless, analysts
can question the management in conference calls and analyst briefings about
internal expectations specified in budgets and other internal documents.
Industry Standards
The performance of a company can be compared with that of other companies in the
industry. Comparisons with industry standards help overcome the limitations of
historical comparisons. For example, if a company has a gross margin of 7 per cent,
while the industry average is 12 per cent, its operations are not as profitable as
some of its peers.
Industry comparisons can be misleading for the following reasons:
1. Comparisons are difficult for diversified companies that operate in several
unrelated lines of business. For example, Hindustan Unilever’s products
include soaps, detergents, toothpaste, and food. What is a comparable firm
for the company? Procter & Gamble is in detergents, but it is also in
products that HUL is not in. ITC is in food, but it is also in a big way in
hotels and tobacco. Colgate makes toothpaste but not any of HUL’s other
products. Comparing HUL’s performance with that of Procter & Gamble,
Colgate or ITC would be of limited value. To an extent, segment reporting
can mitigate this problem.
2. Companies often follow different accounting policies. Inventory valuation
methods, useful life estimates for fixed assets, and revenue recognition
practices differ across companies.
3. Yet another difficulty is the lack of uniformity in reporting periods. Most
companies follow the March 31 year-end, but a few do not. For instance,
HUL reports for the year ended March 31, while Procter & Gamble’s fiscal
year ends on June 30. The Companies Act 2013 requires companies to use
the March 31 fiscal year, unless they qualify for exemption.
Earnings Quality
A key objective of financial statement analysis is to estimate
future earnings from current earnings. Unfortunately, the profit
reported in the annual report is a ‘noisy’ measure of a company’s
operating performance. The analyst needs to identify the major
sources of revenue and profit, such as divisions and product lines, as well as
understand the extent to which a company’s earnings are dependent on each of
them. An important part of the exercise of recomputing a company’s earnings is to
identify and segregate non-operating items so that the resulting earnings number
represents probable future earnings from regular and continuing activities.
Earnings quality refers to the probability of earnings trends continuing and the
extent to which earnings could represent distributable cash. Earnings are said to be
of high quality if:
(a) they can be distributed in cash;
(b) they are derived primarily from continuing operations that are not volatile
from year to year; and
(c) the methods used in measuring profit are conservative.
In contrast, earnings are said to be of low quality if they have only a small
percentage of distributable cash, are derived from non-operating sources, and are
computed using liberal accounting methods. Examples of low-quality earnings are
as follows:
1. Change to liberal accounting estimates.
Examples: Increasing useful life of fixed assets; understating provision for
doubtful debts.
2. Change to liberal accounting methods.
Examples: Switching to the straight-line method from the written-downvalue method in the early part of an asset’s life; moving to FIFO from WAC
in inflationary times.
3. Non-recurring items contributing significantly to results.
Examples: Gain on sale of subsidiary; receipt of a large tax refund.
4. Earnings that are cyclical.
Examples: Earnings of shipping and cement companies.
5. Earnings subject to wide variations due to uncontrollable factors.
Examples: Earnings of coffee and tea plantation companies.
Let us now see how a company’s earnings quality may be affected by the
following:
Choice of accounting policies;
Prior period errors;
Discontinued operations;
Changes in accounting policies; and
Non-operating and non-recurring items.
Choice of Accounting Policies
Accounting standards lay down the broad framework for the preparation and
presentation of financial statements. Within this framework, management has
considerable flexibility in selecting accounting methods and estimating key
accounting determinants, such as useful life of assets and the amount of provision
for doubtful debts. Reported income numbers are often affected significantly by the
accounting methods and estimates used. Conservative accounting methods and
estimates tend to produce a lower profit. Exhibit 11.1 gives examples of accounting
policy choices in areas in which management exercises a great deal of discretion and
judgment:
The bewildering variety of accounting policies complicates comparisons of
earnings of companies even within the same industry. At a minimum, companies
should disclose in the summary of accounting policies the measurement bases used
in preparing the financial statements (e.g. historical cost, current cost, net
realizable value, fair value or recoverable value), other accounting policies that are
relevant to an understanding of the financial statements, management’s judgments
and assumptions it makes about the future and other sources of estimation
uncertainty.1
To illustrate the effect of alternative accounting policies, suppose that two
companies, Conservative Company and Liberal Company, were set up in 20X1 in
the same industry. Conservative’s accounting policies are: WAC for inventory
valuation, WDV for depreciation, and full write-off of product development costs.
Liberal Company follows the FIFO method for inventory valuation, SLM, and onefifth amortization of product development costs. Both companies have identical
revenues, expenses, and purchases, and have 10,000 equity shares. Assume a 30 per
cent income tax rate. Exhibit 11.2 presents the statement of profit and loss of the
two companies.
There is a huge difference between the earnings per share (EPS) of the two
companies. As a result of its more stringent accounting policies, Conservative
Company reports earnings per share of `16.90, while Liberal Company’s EPS is
`45.40. Clearly, we should keep in mind differences in the accounting methods
between the two companies while comparing their results. The more stringent
inventory valuation policy has helped Conservative save `30,000 in tax (difference
in cost of goods sold, `100,000 × tax rate, 30 per cent). Thus, in terms of net cash
flow from operations, Conservative is better off by `30,000 as compared to Liberal.
From the discussion in Chapter 6,
you would know that the effect of the difference will reverse in future years. For
example, the higher year-end inventory will have the effect of increasing cost of
goods sold next year, thereby decreasing next year’s net profit. So Liberal’s higher
earnings per share is transitory. This example does not consider the deferred tax
effect of any of the differences. As an exercise, you can recompute the EPS with
deferred tax accounting.
In this illustration, the recomputation of the earnings of Liberal on a basis
comparable to Conservative is not too difficult mainly because all the information
required for this purpose is available. Unfortunately, in the real world, much of the
information required to make the recomputation is not available since companies do
not often disclose all the information that is needed for reworking the numbers.
Meaningful comparisons are not possible, unless the analyst knows the accounting
policies followed.
Prior Period Errors
Prior period errors are “omissions from, and misstatements in, the entity’s
financial statements of one or more prior periods arising from a failure to use, or
misuse of, reliable information that (a) was available when financial statements for
those periods were authorized for issue; and (b) could reasonably be expected to
have been obtained and taken into account in the preparation and presentation of
those financial statements.”2 Prior period errors include the effect of mathematical
mistakes, mistakes in applying accounting policies, oversights or misinterpretations
of facts, and fraud. Examples include inaccuracy in totalling inventory sheets and
flawed depreciation calculations arising from use of incorrect asset lives or omission
to consider residual values. Prior period errors are different from changes in
accounting estimates (e.g. revision of asset lives or provision for doubtful debts),
which are inherently approximations that are routinely revised as additional
information becomes available in subsequent periods.
An enterprise shall correct material prior period errors retrospectively in the first
set of financial statements authorized for issue after their discovery by (a) restating
the comparative amounts for the prior period(s) presented in which the error
occurred; or (b) if the error occurred before the earliest prior period presented,
restating the opening balances of assets, liabilities and equity for the earliest prior
period presented.3 A prior period error shall be corrected by retrospective
restatement except to the extent that it is impracticable to determine either the
period-specific effects or the cumulative effect of the error. Retrospective
restatement corrects the recognition, measurement and disclosure of amounts of
elements of financial statements as if a prior period error had never occurred.
Besides, an entity shall disclose (a) the nature of the prior period error; (b) for
each prior error presented, to the extent practicable, the amount of the correction
for each financial statement line item affected, (c) the amount of the correction at
the beginning of the earliest prior period presented; and (d) if retrospective
restatement is impracticable for a particular period, the circumstances that led to
the existence of that condition, and a description of how and from which period the
error has been corrected. Financial statements of subsequent periods need not
repeat these disclosures.
Since the financial statements of large companies are generally audited by
reputable accounting firms, it is fair to expect these statements to be free from
material errors and omissions. So, prior period items are rare in published reports.
When there are prior period errors, the analyst should segregate them and
recompute the amounts beginning with the year in which the error occurred.
Discontinued Operations
Most large companies are engaged in many types of business. The different
activities are organized as separate groups of products, services, or customers.
Sometimes, a company may discontinue operations in certain major business
segments either because they are not profitable or for other reasons. A
discontinued operation is “a component of an entity that either has been
disposed of, or is classified as “held for sale”, and (a) represents a separate major
line of business or geographical area of operations, (b) is part of a single coordinated
plan to dispose of a separate major line of business or geographical area of
operations, or (c) is a subsidiary acquired exclusively with a view to resale.”4 A
component of an entity comprises operations and cash flows that can be clearly
distinguished, operationally and for financial reporting purposes, from the rest of
the entity. In other words, a component of an entity will have been a cashgenerating unit or a group of such units.
For predicting earnings from regular, on-going activities, the analyst should
separate the results of continuing operations. In addition, the analyst should
exclude any gain or loss from the disposal of a business segment as a part of
recomputation of the earnings. Separate disclosure of discontinued operations is
necessary to facilitate evaluation of the ongoing activities of the business.
Unfortunately, such disclosure is rare in India.
Changes in Accounting Policies
We know that an enterprise should follow accounting policies consistently for
similar transactions within each period and from one period to the next so that the
results of different periods can be compared. For example, if an entity switches to
SLM from WDV, the profit in the current period will not be comparable with that in
the previous period. Therefore, an entity shall change an accounting policy only if
the change (a) is required by an IFRS or Ind AS; or (b) results in the financial
statements providing reliable and more relevant information about the effects of
transactions on the entity’s financial position, financial performance or cash flows.5
“Reliable” means that the financial statements (i) represent faithfully the entity’s
financial position, financial performance and cash flows; (ii) reflect the economic
substance of transactions, and not merely the legal form; (iii) are neutral, i.e. free
from bias; (iv) are prudent; and (v) are complete in all material respects. “Relevant”
means that the information that results is relevant to the economic decision-making
needs of users. A company’s anxiety to maintain a certain level of profitability in a
bad year or to lower the amount of income tax expense is not an acceptable reason
for a change in an accounting policy.
An accounting policy change may be voluntary or required by an IFRS or Ind AS.
When an entity changes an accounting policy voluntarily, it must apply the change
retrospectively. Retrospective application is applying a new accounting policy to
transactions as if that policy had always been applied. An entity shall account for a
change in accounting policy resulting from the initial application of an IFRS or
Ind AS in accordance with any specific transitional provisions in that standard. If
an IFRS or Ind AS does not include specific transitional provisions, the entity must
apply the change retrospectively. When a change in accounting policy is applied
retrospectively, the entity shall adjust the opening balance of each affected
component of equity for the earliest prior period presented and the other
comparative amounts disclosed for each prior period presented as if the new
accounting policy had always been applied.
When a voluntary change in accounting policy has an effect on the current period
or any prior period (even if it is impracticable to determine the related amount), or
might have an effect on future periods, an entity shall disclose (a) the nature of the
change in accounting policy; (b) the reasons for the change; and (c) the amount of
the adjustment for the current period and each prior period presented for each
financial statement line item affected.
Apart from violating comparability frequent changes are perceived by analysts
and others as desperate attempts to camouflage serious financial and business
difficulties being experienced by an enterprise. Even so, a few companies change
their accounting policies to improve their reported earnings. When accounting
changes have been made by a company, the analyst has to restate the results of
earlier periods so that the earnings series becomes comparable.
Sometimes, accounting changes intended to increase reported profit have the
effect of lowering profits in later years because of unexpected changes in the
economic environment. For example, in the early 1990s, a few companies began to
show their land holdings as inventories so as to take advantage of the boom in real
estate prices. These companies transferred the unrealized appreciation in the value
of their lands to capital reserve. However, when the property market went into a
recession, they got into trouble.
Changes in accounting estimates As a result of the uncertainties inherent in
business activities, many items in financial statements cannot be measured with
precision but can only be estimated. You have seen examples of estimates of bad
debts, inventory obsolescence, the fair value of financial instruments, the useful
lives of and/or the expected pattern of consumption of the benefits from depreciable
assets, and warranty obligations. The use of estimates is unavoidable. Estimation
involves judgments based on the latest available, reliable information. It is
important to revise an estimate if changes occur in the circumstances under which
the estimate was based or as a result of new information or experience. Recall how
we revised asset useful lives. The revision of an estimate does not relate to prior
periods and is not the correction of an error. The effect of a change in an accounting
estimate shall be recognized prospectively. An entity shall disclose the nature and
amount of a change in an accounting estimate, which has an effect in the current
period or is expected to have an effect in future periods.
Non-recurring and Non-operating Items
Certain items of income and expense may be large, or otherwise important to users
of financial statements in understanding and making projections about the financial
performance of a business. The reported results can be considered to be
representative if the underlying activities and events in a period are of a normal,
recurring nature. The effect of unusual and non-recurring events should be isolated
to predict the likely profit for the next year. In the past, items such as losses caused
by floods, earthquakes and other natural disasters and expropriation of assets by
government were disclosed as extraordinary items. Since the classification was
often subjective, the concept of extraordinary items has been eliminated. Instead, an
entity must disclose separately the nature and amount of items of income or
expense that are material.6 Sometimes these are referred to as exceptional items in
published financial statements. Circumstances which may give rise to the separate
disclosure of income and expense from ordinary activities include the following:
1. Write-down of inventories to net realizable value or of property, plant and
equipment to recoverable amount, as well as the reversal of the write-down;
2. Restructuring of an entity’s activities and reversals of any provisions for the
costs of restructuring;
3. Disposal of items of property, plant and equipment;
4. Disposal of investments;
5. Discontinued operations;
6. Litigation settlements; and
7. Other reversals of provisions.
For many companies, income from non-operating sources has been significantly
higher in recent years. Dividend income from units, dividends from subsidiaries and
associates, interest income for manufacturing and service organizations, foreign
exchange gains, and gain on sale of property, plant and equipment are examples of
income from non-operating sources, and these appear under “other income” in the
statement of profit and loss.7 Much of the “other income” comes from sources other
than a company’s core business or related to items of a non-recurring nature. Nonoperating income is increasing for many companies and even helping some of them
hide losses from their normal business operations.
Here are a few examples of how non-recurring and non-operating items affect
profit, favourably or adversely:
(a) Hindustan Unilever: The company’s June 2012 quarter net profit of `13,312
million included a one-time gain of `6,072 million from sale of property.
(b) NIIT: Net profit of `407 million for the December 2011 quarter included a gain
of `210 million from the sale of Element K, the company’s US subsidiary.
(c) Reliance Industries: The company’s June 2013 quarter ‘other income’ was
higher at `25,350 million as against `19,040 million in the year ago quarter.
Net profit was `53,520 as against `45,030 million. ‘Other income’ was mainly on
account of profit on sale of investments. Sales of investments was the second
highest contributor (after refining) to the company’s profit.
(d) Infosys: ‘Other income’ of `23,590 constituted 24 per cent of the profit before
tax for the year ended March 31, 2013.
Techniques of Financial Statement Analysis
Very few numbers in financial statements are significant in
themselves. But we can draw meaningful inferences from their
relationship to other amounts or their change from one period to
another. The tools of financial statement analysis help in
establishing significant relationships and changes. The most
commonly used analytical techniques are:
1.
2.
3.
4.
Horizontal analysis;
Trend analysis;
Vertical analysis; and
Ratio analysis.
In this section, we illustrate the application of these techniques using the 2013
financial statements of HUL. Note the following:
(a) The amounts for 2012 and 2013 are taken from the financial statements for
the respective years. However, the amounts for 2011 are those in the 2011
column in the 2012 financial statements, because the format of the financial
statements changed in 2012.8
(b) Minority interests are not liabilities, because they are not payable by the
parent to the subsidiary’s non-controlling shareholders. We include them in
shareholders’ equity.
As you would know, HUL is a leader in consumer products. It has a number of
well-known brands in a variety of segments, such as the following:
Soaps and detergents: Domex, Lifebuoy, Liril, Lux, Pears, Surf excel, Vim,
Wheel.
Personal products: Axe, Clinic, Fair & Lovely, Huggies, Lakme, Pepsodent,
Sunsilk.
Beverages: 3 Roses, Bru, Red Label, Taaza, Taj Mahal.
Foods: Annapurna, Kissan, Knorr.
Horizontal Analysis
Financial statements present comparative information for at least two years.
Horizontal analysis calculates the amount and percentage changes from the
previous year to the current year. It is a simple but useful exercise. While an
amount change in itself may mean something, converting it to percentage is more
useful in appreciating the order of magnitude of the change. Exhibits 11.3 and 11.4
present the horizontal analysis of HUL’s financial statements.
The calculations shown in Exhibit 11.3 are revealing. In 2013, sales were up 15
per cent, while net profit was up 37 per cent. This gives the impression that there
was a dramatic improvement in profitability. But the story is not that
straightforward. “Other income” and “exceptional items” consist mostly of nonoperating items and are highly volatile, and both shot up in 2013. Excluding these
items, the profit was `39,283 for 2013 and `32,484 for 2012, an increase of 21 per
cent. After tax, the growth turns out to be 11 per cent. The profit grew much slower
than the sales. Earnings quality analysis enables us to find out the real growth.
Another way to look at performance is to compare the company’s sales growth
with growth in total assets and in specific asset categories. From Exhibit 11.4, we
see that assets were up 6 per cent, less than the growth in sales. We also need to
look at the growth in individual asset categories. While non-current assets went up
25 per cent, property, plant and equipment grew much lower at 7 per cent. Capital
work-in-progress declined 2 per cent, indicating that the company is not expanding
in-house manufacturing capacity. Non-current investments which are mostly
financial assets grew over four times. Current assets were down 2 per cent.
Inventories were up
1 per cent, less than the sales growth. Receivables grew almost in step with sales.
The slow growth in inventories could have been because of better inventory
management. But this also raises a question whether the inventories are sufficient
to maintain the current momentum in sales. Lower inventories could result in loss
of production and sales, and may indicate less optimistic sales growth expectation.
These are propositions that need testing with more data. Another way to analyze
the percentage changes is to compare them with the inflation rate.
Percentage changes should be interpreted with care; otherwise, they can be
misleading. For example, tangible assets increased 7 per cent, while intangible
assets were up 21 per cent but on significantly different base amounts.
Trend Analysis
Trend analysis involves studying changes in financial statement items for many
years. It is an extension of horizontal analysis. We first assign a value of 100 to the
financial statement items in a past financial year used as the base year and then
express the amounts in the following years as a percentage of the base-year value.
Exhibit 11.5 illustrates trend analysis with sales, net profit and fixed assets for
HUL from 2009 to 2013.
To illustrate, using 2009 as the base year, the sales value in 2010 becomes 108 as
shown below:
From 2009 to 2013, sales increased 65 per cent, net profit 91 per cent and fixed
assets 44 per cent. On the whole, the three moved in the same direction, but at a
different pace. These numbers imply that profit margin and asset utilization
improved over the period.
Trend analysis helps in identifying basic changes in the nature of the business.
Since many large corporations publish performance summaries and selected
financial indicators for five or more years, it is possible to perform trend analysis.
Vertical Analysis
Vertical analysis is the proportional expression of the amount of each item on a
financial statement to the statement total. The results of vertical analysis are
presented in the form of common-size statements in which the items within each
statement are expressed in percentages of some common number and always add up
to 100. It is conventional to express items in the statement of profit and loss as
percentages of sales, and balance sheet items as percentages of the total of
shareholders’ equity and liabilities (or as percentages of total assets). Vertical
analysis helps in making comparisons of companies that differ in size since the
financial statements are expressed in comparable common-size format. Further, a
comparison of common-size statements for several years may reveal important
changes in the components from one year to another.
Exhibits 11.6 and 11.7 show HUL’s common-size statement of profit and loss and
balance sheet for 2013 and 2012. There are significant changes in expenses and tax.
Also, you should recall the earlier discussion on the effect of “other income” and
“exceptional items”. In the balance sheet, there are major changes in shareholders’
equity, short-term provisions, and current investments. Common-size statements
are especially useful in presentations where the focus is on overall comparisons.
Ratio Analysis
Ratio analysis involves establishing a relevant financial relationship between
components of financial statements. Two companies may have earned the same
amount of profit in a year, but unless the profit is related to sales or assets, it is not
possible to conclude which of them is more profitable. Ratio analysis helps in
identifying significant relationships between financial statement items for further
investigation. If used with understanding of industry factors and general economic
conditions, it can be a powerful tool for recognizing a company’s strengths as well as
its potential trouble spots. Financial ratios are used to evaluate profitability,
liquidity, solvency, and capital market strength. In the earlier chapters, you have
seen how certain financial ratios assist investors, creditors, and managers in
evaluating an enterprise. The objective of this chapter is to provide a comprehensive
coverage of all the major ratios. Commonly used financial ratios and their
interpretation are discussed in the following sections. Our evaluation is based on
the information available in published reports. We should use additional
information, such as internal benchmarks, where available.
Profitability Analysis
Profitability ratios measure the degree of operating success of a
company. The only reason why investors are interested in a
company is that they think they will earn a reasonable return in the
form of capital gain and dividends on their investment. Therefore,
they are keen to learn about the ability of the company to earn revenues in excess of
its expenses. They will not be interested in a company that does not earn a
sufficient margin on its sales. Failure to earn an adequate rate of profit over a
period will also drain the company’s cash and impair its liquidity. The commonly
used ratios to evaluate profitability are:
Profit margin;
Asset turnover;
Return on assets;
Return on equity; and
Earnings per share.
We discuss these ratios below.
Profit Margin
This ratio, also known as return on sales (ROS), measures the amount of net
profit earned from each rupee of revenue. Using the data in Exhibit 11.3, we
compute HUL’s margin as follows:
Profit margin vaulted to 14.22 per cent in 2013 from 11.95 per cent in 2012. Net
profit is a “noisy” measure, because of the inclusion of “other income” and
“exceptional items”, which are non-operating and non-recurring. If we exclude them,
the profit becomes `27,016 for 2013 and `24,269 and the revised margin is 10 per
cent for 2013 and 10.36 per cent. We get a very different picture now: the margin is
much lower for both years and it actually decreased in 2013.
Profit margin provides some indication of the cushion available to the company in
the event of an increase in costs or a drop in selling prices, because of recession or
greater competition. The margin was 15.26 per cent in 2006, but has been falling
steadily since then. But for the help from non-operating items, it would have fallen
in 2013. The pressure on margin should be analyzed by looking at major categories
of expenses, such as materials, salaries and wages, and advertising.
Asset turnover
This is a measure of a firm’s efficiency in utilizing its assets. It indicates how many
times the assets were turned over in a period in order to generate sales. If the asset
turnover is high, we can infer that the enterprise is managing its assets efficiently.
A low asset turnover implies the presence of more assets than the business needs
for its operations. Averages rather than year-end amounts of assets are a better
measure of the level of assets held during the year. The difference between average
and year-end amounts will be more pronounced for companies that are engaged in
expanding (or reducing) capacity. From Exhibit 11.4 and Appendix A, HUL’s assets
are as follows: 123,096 in 2013; 116,040 in 2012; and 105,414 in 2011. Average
assets are: 119,568 in 2013 and 110,727 in 2012. Using the sales data in Exhibit
11.3 and the average assets, we can now compute HUL’s asset turnover:
In 2013, HUL had sales of about `2.26 per rupee of investment in assets as
compared to `2.12 in 2012. The increase of 14 paise in sales per rupee of investment
indicates significant improvement in utilization of assets in 2013. This inference is
in line with our observation in horizontal analysis that assets grew slower than
sales. Increase in asset turnover could be because of capacity reduction, regular
equipment maintenance, timely availability of raw materials and power, effective
management of inventories, receivables and cash, better industrial relations, and so
on. Asset turnover rates differ from one industry to another. A fast-food restaurant
operating from rented premises may have asset turnover of 20, while a refinery’s
asset turnover could be even lower than one.
Return on Assets
Return on assets (ROA), also known as return on investment (ROI), is a
measure of profitability from a given level of investment. It is an excellent indicator
of a company’s overall performance. We compute HUL’s ROA as follows:
The increase in the ROA indicates significant improvement in the company’s
overall profitability. The ROA increased because of the improvement in both margin
and turnover, as we saw earlier. We note that the higher ROA came from a larger
investment, suggesting that the additional investment was probably even more
profitable.
The DuPont system of financial analysis clearly brings out the effect of these two
drivers on the ROA. Figure 11.1 presents the DuPont chart. It shows how profit
margin and asset turnover interact to produce ROA. Level 1 is the return on equity,
which we will consider shortly. Look at Level 2 – return on assets, and Level 3 – its
drivers, viz. profit margin and asset turnover. It is possible to produce a certain
ROA by varying the margin and turnover. For example, a 20 per cent ROA can come
from a margin of 10 per cent and a turnover of two times or a margin of 4 per cent
and a turnover of five times. Level 3 describes the calculation of margin and
turnover. A firm selects a combination that reflects how it intends to do business.
Does it want to sell upmarket, differentiated products or cheap, mass market goods?
To achieve a certain ROA, businesses can choose between various combinations of
margin and turnover. Companies that target the “mass market”, such as
supermarkets, typically have low profit margins, but keep high asset turnover.
Companies that sell premium products such as designer dresses or diamonds or
operate in a niche market enjoy high profit margins, but have low asset turnover.
Using the DuPont approach, we can analyze HUL’s ROA as follows:
This analysis shows that the company earned a higher ROA in 2013, because of
both higher margin and higher asset turnover. As a result, the ROA was up 6.82 per
cent. We can separate the effect of the two drivers to explain the change in the ROA,
as follows:
We calculate the effect of the change in margin on the ROA as follows: Change in
margin in 2013  Asset turnover in 2012. This calculation helps us answer the
question: How much did the increase in margin increase the ROA in 2013? Answer:
4.81%, i.e. 2.27%  2.12. We can now explore the effect of the change in asset
turnover as follows: Change in turnover in 2013  Margin in 2013. We can now
answer the question: What was the incremental effect of the change in asset
turnover on the ROA in 2013? Answer: 1.99%, i.e. 0.14  14.22%. The margin and
turnover effects add up to 6.80 per cent. (The change in return on assets is 6.82 per
cent. The difference is due to rounding.) The analyst investigates the factors
responsible for the deterioration and relates them to firm-specific factors, industry
trends and macroeconomic developments.
Return on Equity
Return on equity (ROE) is a measure of profitability from the shareholders’
standpoint. It measures the efficiency in the use of shareholders’ funds. In order to
moderate the influence of shareholder transactions such as share issue and buyback and the effect of change in retained earnings, analysts generally use the
average of beginning and ending amounts for the year. From Exhibit 11.4 and
Appendix A, HUL’s equity is as follows: 28,857 in 2013; 36,993 in 2012; and 27,495
in 2011.9 Average equity is: 32,925 in 2013 and 32,244 in 2012. Using the sales data
in Exhibit 11.3 and the average assets, calculated earlier, we can now compute
HUL’s ROE:
Competitors try and replicate a firm’s special advantages in product offerings, cost
efficiencies, innovation, technology, distribution network, and brands. This
adversely affects a firm’s ability to maintain a supernormal ROE. As a result, the
ROE tends to revert to the industry mean over time. The dramatic increase in the
ROE in 2013 was driven by improved ROA. Shareholders expect the ROE to be
higher than the cost of equity, the rate of return expected by the shareholders for
the risk that they take in investing in a company. HUL’s cost of equity for 2013 is
10.07 per cent (p. 113 of the 2013 annual report).
Extended DuPont Analysis
You would have noticed that in both 2013 and 2012 the ROE has been higher than
the ROA, implying that the company earned more per rupee of shareholders’ funds
than per rupee of assets. One reason for the better return to the shareholders is the
use of debt financing. When the ROA is more than the interest rate on debt, the
benefit of the spread goes to the shareholders. Leveraging, or trading on the
equity, is the use of debt finance to acquire assets in order to earn a higher ROE.
The flip side of debt financing is that, when the ROA falls below the interest rate,
shareholders will lose. We will discuss the risk of debt later in this chapter.
HUL’s use of interest-bearing debt is trivial. However, the company gets
significant interest-free credit from its suppliers of goods and services. From Exhibit
11.7, we see that 43 per cent of the company’s sources of funds are from trade
payables. To that extent, the shareholders do not pay for the company’s assets all by
themselves. Nevertheless, they reap the benefits of such interest-free financing.
Figure 11.1 provides a framework for understanding the effect of leverage on
return on assets. From Levels 1 and 2, we note that ROE is the product of leverage
and ROA, which in turn is the product of profit margin and asset turnover. For a
given ROA, it is possible to produce a higher ROE by financing a part of the assets
with debt. This is how the use of debt can “lever up” the ROA for the shareholders.
The assets-to-equity ratio is a measure of leverage.
We can now see how Figure 11.1, Level 1 works. In 2013, HUL’s ROA was 32.11
per cent. Its leverage was 3.63, calculated as follows: Assets, 119,568/Equity,
110,727. The ROE of 116.61 per cent is the product of ROA of 32.11 per cent and
leverage of 3.63.
Earnings Per Share
Financial analysts regard the earnings per share (EPS) as an important measure
of profitability. The computation of HUL’s EPS for 2013 and 2012 (based on net
profit after minority interests) is as follows:
EPS is useful in comparing performance over time. The increase in HUL’s EPS in
2013 means that the company did better from the shareholders’ perspective. But the
EPS is not of much help in making comparisons across firms, because the number of
equity shares can differ even if all of them happen to have identical amount of
shareholders’ equity. It is useful as an input into the price-earnings ratio, which we
shall see later in this chapter.
Advanced Profitability Analysis: Focus on Operations
In our analysis, we did not distinguish between operating and
non-operating items. This is true of our income measure and asset
base:
Profit after tax includes “other income” that has a number of nonoperating items.
Assets that include investments and bank deposits.
Operating Profit
Since interest expense and non-operating items are determined by factors that have
little to do with the efficiency of management of assets, analysts calculate a return
measure based on the net operating profit after tax (NOPAT). For this purpose,
we consider only revenues from sales and cost of operations and exclude nonoperating incomes – interest income and other non-operating incomes and
exceptional items – and non-operating expenses – principally, interest expense. We
have to adjust for the tax effect of these exclusions. For instance, since interest
income is taxable, the reported income tax expense includes tax on interest income.
Since operating income excludes interest income, the tax expense should also
exclude the tax effect of that income. So we deduct the tax on interest income from
the reported tax expense, as if there was no interest income. Similarly, since
interest expense is tax-deductible, the tax expense includes the tax saving on
interest expense. Since operating income excludes interest expense, the tax expense
should also exclude the tax effect of that expense. So we add back the tax saving on
interest expense from